What is budgeting?

 A budget is a detailed plan for the acquisition and use of financial and other resources
over a specified time period
 Its different from a forecast because it is a prediction of what is likely to happen in the
future, given a certain set of circumstances

Advantages of budgeting

 Define goal and objectives

 Think about and plan for the future

 Communicating plans

 Means of allocating resources

 Uncover potential bottlenecks

Types of budgets

1. Incremental budgeting

Traditional approach – base next year’s budget on a modification of this year’s budget

2. Zero based budgeting

Each budget is prepared from the very beginning each period (doesn’t build on previous
year)

3. Rolling budgets

Prepare more regularly (e.g. monthly) and each of these budgets would plan for e.g. the
next 12 months. Current budget is extended by an extra period as the current period ends
(also called continuous or perpetual)

The Sales Budget

 The sales budget is a detailed schedule showing the expected sales for the coming
period.
 Can express in £ and/ or units of the product.
 Usually accompanied by a schedule of expected cash collections
 The schedule of expected cash collections should take into account delays in
collecting credit sales.
The Production Budget
 Work out the budgeted production for each period:
 Production required = Budgeted sales + ending inventory – opening inventory
In a retail firm, a purchases budget would replace the production budget.

Direct Materials Budget

 When you know how much you need to produce you can work out how much raw
material you will need to do that.
 Enough raw material must be acquired to meet both production needs and to provide
for desired ending inventories.

Raw materials required = Needed for production+ ending inventory – opening inventory

Direct Labour Budget

 Once production needs are known, the direct labour budget must be prepared so that
the company will know whether sufficient labour time is available to meet those
needs.
 Can express in £ and / or direct labour-hours needed
 Questions may ask you to think about cost of labour carefully as we saw with relevant
costs – overtime hours / cost, extra employment etc

Cash Budget

The cash budget includes:

 The receipts / collections
 The disbursements / payments:

Opening cash
Plus cash receipts
(Less cash payments)
Cash balance

If there is likely to be a shortage of cash, additional funds must be arranged for. Important
to alert management to problems that may occur due to fluctuations in cash flows.

The Master Budget

Performance measurement
Return on Investment:

ROI is often used as a measure to monitor the performance of an investment

centre. It shows how much profit has been earned in relation to the amount of capital
invested in the centre.

ROI = Controllable divisional profit X 100%

Divisional capital employed = X%

Profit
= operating profit or profit before interest and tax

Capital employed
= non-current assets + net current assets
= equity +loans

Return on investment

ROI = profit/capital employed x 100%

A major disadvantage of ROI is that managers may be motivated to make decisions that
make the company worse off.
Relative merits of ROI

Strengths of ROI
 A good measure for comparison
 Easily calculated
 Easily understood by internal and external users of accounts
 Focuses attention on existing capital funds

Weaknesses of ROI
 Can be inflated by allowing depreciation to erode capital base
 Disincentivises new investment
 Perverse incentive to disinvest

Residual Income:

RI is an alternative way of measuring performance of an investment centre, which is based

on the centre’s profit after deducting a notional or imputed interest cost of the capital
invested in the centre.

Controllable divisional profit X

Imputed interest cost of capital (x)
Residual income X

RI can avoid some of the behavioural problems of dysfunctionality that arise with the use of
ROI

Residual income

Residual income
= Operating profit - Cost of capital employed
= Operating profit – (capital employed) x cost of capital %

Strengths of RI

 Reduces the problem of under investing in new assets and projects

 More consistent with corporate objectives such as maximising profit
 Different rates of interest can be used to reflect cost of capital
 Emphasises the cost of financing

Weaknesses
Limitations of financial performance measures

 Reflects past strategic decisions

 Not good predictor of future financial performance
 Ignores quality issues
 Does not facilitate strategy development and management (leading indicators)
 Easily manipulated