DEPT.

OF FINANCIAL MANAGEMENT

OVERVIEW OF BUDGETING
AND FINANCIAL
MANAGEMENT

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 LEARNING OUTCOMES
▪ Explain the general principles of budgeting, its functioning and the
link between long-and short term planning,
▪ Illustrate the sequence of successive planning on the basis of
partial plans,
▪ Do cost planning for direct costs, variable indirect costs and fixed
costs using a case study on their own,
▪ Draw up a performance budget according to the cost sales style
and the expenditure style of presentation,
▪ Draw up a financing plan according to the direct and indirect
method as well as a budgeted balance sheet in the form of a
changing balance sheet on their own,
▪ Calculate forecasts and deviation analyses
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▪ Analyze, interpret and evaluate the results of a performance
 CONTENT

1.1. Introduction
1.2. The role of budgets
1.3. Budgeting and forecasting
1.4. Types of budgets
1.5. Budget process

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 INTRODUCTION

What is a budget?
• A budget is a financial plan that takes into
account estimated revenue and expenses over
a certain period of time.
• Re-evaluated periodically
• Three types of budgets: Operating budget;
Capital budget; Cash budget.
 THE ROLE OF BUDGETS

• Meeting the • Management

organization’s contract
objectives • Communicating
• Planning • Providing a basis for
• Monitoring and authorizing
controlling expenditure and
• Co-ordinating delegating
• Evaluating responsibility
performance • Identifying scarce
• Improving resources
performance • Allocating resources 5
 Meeting objectives
What the organization’s objectives are?
- The primary objective: seek to maximize returns to their
owners (maximize profit) in the long run.
- The secondary objective: achieving certain levels of
market share, developing new products and developing staff
capabilities or new technologies.
===> Budgets should be linked to objectives and strategy

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 Planning
• The budget can act as a plan to help us to achieve
our objectives. In fact, in many organizations, the
budget is often referred to as the annual operating
plan.
• A different view and probably a different approach:
a budget should be a costed version of what we are
going to do over the year, in fact budget performance
with no variances should perhaps be viewed with
some suspicion.
• Producing a costed plan may be easier for some
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 Monitoring and controlling
• To control costs, income and cash, we need to start
with a good plan, against which we can monitor its
performance.
• In most organizations, variances from budget are
produced every month with major variations from
budget requiring an explanation. It would be better to
focus on a few key figures that made up most of the
budget.
• The managers can monitor other figures that lead
expenditure or income 8
 Co-ordinating
• The act of putting together budgets helps us to
coordinate the activities of different parts of the
organizations.
• The budgets and plans need to fit and work
together
• Different departments’ and units’ plans need to
make the best use of the organization’s limited
resources (known as the limiting factors)
• All departments need to be consistent in order to9
 Evaluating performance
• Performance should also be measured in terms other than
just the performance against the budget. Perhaps budgets
should be judged in conjunction with other KPIs.
• Managers should be measured on what they control (as the
profit in his/her store)
• Often cost and profitability are affected by teams of people
working across different departments and functions.
• A department manager may underspend his budget but
deliver poor performance in terms of the output of the
department. 10
 Improving performance
• Budgets are sometimes seen as targets to beat to deliver
improved performance.
• If the budget is a target, it should be set carefully. Too
challenging, may be de-motivated; too easy, no strive to do
their best.
• The remedy is to put in some additional measures beyond
the budget that include continuous improvement targets
(such as reducing unit costs) or relative performance.
• Performance benchmarking: the kind of indicators to
look out for are: market share, total shareholder returns
(TSRs) compared to peer companies, and level of customer
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 Motivating managers
• Managers may be motivated to perform since
they are being judged against a budget.
• A manager’s approach to delegating budgets
will be influenced by how he views staff and
perceives how they are motivated.

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 A management contract

• Ideally, a budget should be seen as a contract between the manager

and the organization
• The contract should cover what the manager will deliver at what cost
and this will negotiated and agreed with the line manager.

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 Communicating

• A key to effective budgeting must be good communication

• Budgets inform managers and employees of the plans and strategy of
the organization expressed in financial terms.

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 Providing a basis for authorizing expenditure
and delegating responsibility

• Budgets fail when authority and responsibility are not matched

• Budgets may be delegated through responsibility centres, these are
usually called cost centres or profit centres, a rather term is investment
centres.

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 Identifying scarce resources

• The process of building a budget may help us to identify scarce

resources and resources that need to be managed carefully or
increased
• Building a budget for an organization may take much negotiation and
result in many iterations or rounds.
• Budgeting at a strategic level must also consider longer-term capacity
planning. Building too little capacity constrains the organization;
building too much leads to needless extra cost and suboptimal
operations.

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 Allocating resources

• Budgets may be used to allocate resources, sometimes based on a

formula.

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 Demonstrating and delivering good corporate
governance
• The budgetary control system is effectively part of the internal
control system within an organization

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 BUDGETING AND FORECASTING
• Budgets describe what the future is most likely to look like (based upon
plans)
• Forecasts describe what the budget is most likely to look like.
• Forecasts as updates to the annual budget
• Rolling forecasts: forecasts can also be produced on a rolling basis
beyond the end of the current financial year. The time period of forecasting
depends upon the company and the industry.

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 BUDGETING AND FORECASTING…

Forecasts as updates to the annual budget…

▪ When the budget is produced it may require some forecasting to derive
some of the figures
▪ “The forecast” is an updated estimate of the outturn or result for the year
▪ A reforecast is normally produced every quarter or every month.
▪ The process of reforecasting encourages managers to rethink how the
year’s result is going to develop, this may enable them to identify
problems sooner and become more proactive and less reactive when
managing the budget.

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 Forecasts, projects and contracts

• Working on a project/contract, you could forecast to its end. This

approach might help you identify problems earlier.
• Reviewing the project just on its performance to date may make you
complacent.
• When producing the forecast, you need to remember the matrix of
impact and variability described earlier.

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 Forecasting tools and techniques

• Within the business there are a variety of figures which may be

forecasted including:
▪ Sales
▪ Profit and loss
▪ Cash flow
• The best way to produce a forecast and its required predictive
accuracy will depend upon exactly why the forecast is required.

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 Sales forecasting
■In many business the starting point for a budget
or plan will be the expected or potential sales.
■Sales may be limited by production or service
capacity constraints.
■Be determined by customer demand, competitor
action, economic circumstances and the
possibility of substitutes (customers buying
alternative products or services to meet their
demands).
■Two main broad approaches to producing a 23
 Quantitative
■Based upon statistical analysis
■The analysis is done typically by looking at past
data
■Many companies using quantitative techniques
will produce forecasts using Microsoft Excel

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 Quantitative forecasting
techniques
■Naïve forecast
■Moving averages
■Weighted moving averages
■Exponential smoothing
■Regression analysis

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 Regression analysis
■Step 1: chart (graph) the sales data with a scatter
graph. Highlight the grey cells and select insert
chart, then select “scatter graph”.
■Step 2: Click on the data points on the graph and
“add a trendline”. You have a number of different
types of graph you could choose to get the best
fit.
= FORECAST or FORECAST.LINEAR in the cell

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 Qualitative
■Based upon opinion and judgement
■In many organizations, sales forecasts will be
generated by sales and marketing professionals,
trying to make judgements about market demand
and how much market share the company can
win.
■Salespeople may be able to identify potential
upcoming orders and contracts and assign a
probability of winning them.
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 Qualitative
■Sales in the very near future can often be
predicted very accurately as a customer may have
already placed an order although it may not have
been delivered.
■When people produce forecasts, they often have
their own agendas
■Forecasts can also be subject to political bias
(managers at all levels may be tempted to adjust
or influence the figures to match their own
requirements)
■Both market research and test marketing may 28
 Measuring and improving
forecast accuracy
■Two simple numerical measures of forecast
accuracy are: Mean squared error (MSE) and
Mean absolute percentage error (MAPE)
■MSE is the average of the square of the “errors” –
the lower the MSE figure the better
■MAPE is the average of percentage “absolute”
differences between the forecast and the actual
result – the lower the MAPE the better the
forecast
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 Example 1: calculation of MSE and
MAPE
Perio Foreca Actua Error Error Absolut Absolute
d st l squared e error percentage error
1 100 110 (10) 100.0 10 9.09%
2 110 121 (11) 121.0 11 9.09%
3 121 112 9 81.0 9 8.04%
4 112 115 (3) 9.0 3 2.61%
5 115 116 (1) 1.0 1 0.86%
6 116 118 (2) 4.0 2 1.69%
Sum 316 31.38%
MSE MAPE
Averag 52.7 5.23%
e

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 Example 2:
Here are 2 sales forecasts:
■Forecast A is based on a three-month (or
period) moving average (3PMA)
■Forecast B is based upon exponential
smoothing, with an alpha of 0.7
The results rounded are shown as follows
Calculate the MSE and MAPE.

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Period Actual sales Forecast A Forecast B
Alpha = 0.7
1 1,160
2 1,223 1,160
3 1,120 1,204
4 1,150 1,168 1,145
5 1,150 1,164 1,149
6 1,300 1,140 1,150
7 1,400 1,200 1,255
8 1,360 1,283 1,356
9 1,370 1,353 1,359

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 New product sales forecasting
■A frequently used approach is to forecast “by analogy”,
taking the sales of similar products and predicting their
sales growth following a similar pattern.
■New products in many industries tend to have a very
high failure rate
■Marketing analysis should help to reduce these risks and
improve sales forecasts
■Other potential factors to consider in sales forecasts
include: short term (competitor action, supply
shortages, commodity prices change) and long term
(product lifecycle, competitor action, substitutes,
changing technological, economic and social 33
 Discuss…
Analyze the long-term factors to consider in
sales forecasts of a company?

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 Types of Budgets

• The combined budgets generate a budgeted income statement,

balance sheet, and cash flow statement.
• There are 3 types of budgets: Operating budget; Capital budget;
Cash budget:

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 Operating budget

• Revenues and associated expenses in day-to-day operations are

budgeted in detail and are divided into major categories such as
revenues, salaries, benefits, and non-salary expenses.

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 Capital budget

• Capital budgets are typically requests for purchases of large assets

such as property, equipment, or IT systems that create major
demands on an organization’s cash flow. The purposes of capital
budgets are to allocate funds, control risks in decision-making, and
set priorities.

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 Cash budget

• Cash budgets tie the other two budgets together and take into
account the timing of payments and the timing of receipt of cash from
revenues. Cash budgets help management track and manage the
company’s cash flow effectively by assessing whether additional
capital is required, whether the company needs to raise money, or if
there is excess capital..

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Budget process

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 Budget process
• The budgeting process for most large companies usually begins four to six months
before the start of the financial year, while some may take an entire fiscal year to
complete. Most organizations set budgets and undertake variance analysis on a
monthly basis.
• Starting from the initial planning stage, the company goes through a series of
stages to finally implement the budget.
• Common processes include communication within executive management,
establishing objectives and targets, developing a detailed budget, compilation and
revision of budget model, budget committee review, and approval.

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