Financial Forecasting In The Budgeting Process Accounting Essay
A budget is a forecast of future events and the budgeting process is often called financial forecasting. The systematic process of allocating expenditures that would provide return over time is known as budgeting techniques. Budgeting techniques would be a valuable tool for the organization to gauge their financial performance throughout the year and adjust expenditures to ensure a certain amount of profit. Budgeting would be an essential step in effective financial planning the use of budgets and financial projections would be the key elements of financial planning that assist management in controlling unnecessary costs. An important step in controlling expenditures and ultimately profit is by creating a budget for an organization. Financial projections quantified future sales, expenses, and earnings according to certain assumptions adopted by the organization. If budgeting is done rightly it results into better financial projections which would provide enormous benefits to business managers including expected level of sales, production units to be manufactured, prediction of various overhead expenses , profit margin, cash in and out flows, borrowing money and thinking about the firm's goals & purpose and how to achieve them. Formulation of budget would be extremely an important element in the financial area of business. Budgets help with a variety of tasks, such as giving you a good idea of how much you are spending and if you are exceeding your spending limits in certain areas, and the most important thing, it helps to track the flow and progress of your business.
Through financial projections company would attempt to determine whether and to what extent its long term plans would be feasible. Be realistic your projections should be as real and accurate as possible. Budgeting is a target which the organization would set for itself in controlling internal operations, unnecessary expenditures and to allocate resources to maximize the profitability. Since companies strive for profitability through the efficient and economical use of material resources and labor budget helps executives in controlling overspendings in less productive areas and put more material resources into areas which generate significant profit. Master budget would be a summary of company's plans that sets specific targets to be achieved like sales, production, distribution and financing activities. It culminates in a cash budget, a budgeted income statement and a budgeted balance sheet.
(Jean Murray, about.com) defines budget as financial document used by the organization to project future income and expenses. The budgeting process may be carried out by the organizations to estimate whether the company can continue to operate with its projected income and expenses.
(Financial Dictionary, 2010) defines budget as an estimation of the revenue and expenses over a specified future period of time. A budget can be made for a family, group of people, a business, government, country or multinational organization or just about anything else that makes and spends money.
(Answers.com) interpret that budget is an itemized summary of estimated or intended expenditures for a specific period of time along with proposals for financing them. Budget is more accurate than forecast. A budget can be had from historic data whereas forecast/projection looks into the future trends.
(Economics Dictionary, 2010) defines budget as a description of a financial plan which includes estimates of revenues to and expenditures by an organization for stated period of time. Normally a budget describes a period in the future not the past.
2.2 History of Budgeting
The budget is one of the most significant policy documents for management of any organization as well as for the government of a country. The practice of budgeting has existed for ages. In ancient times individuals and societies engaged in processes of planning their economic activities, evaluating the annual outcomes, and revising when necessary. Through observation and experimentation, agrarian peoples discovered, invented, and standardized various practices to increase the quality and quantity of their yields. The desire for excess supplies to sell for profits, and for storage as wealth, led people to make plans to maximize their income by budgeting a certain amount of money and energy for stabilizing farming conditions. In Great Britain government budgeting was established in the late 17th century. Parliament gradually established spending programs and by the 1820s published detailed annual financial statements showing revenues and expenditures and a projected surplus or deficit. In United States Congress passed the Budgeting and Accounting Act in 1921 along with the creation of a centralized bureau of Budget.
2.3 Budget Types
Most common types of budgets for a manufacturing company include, operating budget, capital expenditures budget and budgeted financial statements which are given below:
2.3.1 Operating Budgets
Operating budgets are directed towards achieving short term operational goals of the organization. The elements of operating budget vary depending upon the size and nature of the business, however an operational budget would include;
2.3.2 Sales Forecast: The sales forecast termed as future sales and would be the starting point in the preparation of master budget. The sales projections would be prepared on the basis of past sales figures and business trend, plant capacity, overall economic conditions, financial aspects and expected level of competition in the local/ international markets.
2.3.3 Production budget: Product oriented companies prepare production budget as an estimate of total volume of production. Once the level of sales had been forecasted the next step would be the quantity/ number of units that must be manufactured by the organization. The production budget is prepared while taking into consideration factors like, inventory policy, standard production capacity of the plant and process timings.
2.3.4 Manufacturing Costs Budget:
Manufacturing cost budget basically includes elements of costs i.e. direct material, direct labor and factory overheads. Some company's prepare separate budgets for each of said elements. Management would thoroughly analyzed variable and fixed manufacturing costs. Fixed manufacturing costs can be estimated keeping in view past information and expected changes that may occur during the budget period similar data while computing the manufacturing costs budgets. Variable overheads/costs are estimated after considering the scheduled production and operating conditions during the budget period.
2.3.5 Administrative, Selling and Distribution costs/overheads budgets: The said budget covered the administrative expenses, expenses relating to selling, advertisement and delivery of goods to the customers .The marketing budget is an estimate of the funds needed for promotion, advertising, and public relations in order to market the products. It would be better if such costs are analyzed according to products specifications, segmentation of customers and supply territories etc.
2.3.6 Capital Expenditures Budget: The capital expenditures budget covers a span of many years such budgets continuously reviewed and updated. The capital budget is a prediction of the costs associated with a particular company project. These costs include labor, materials, and other related expenses.
2.3.7 Budgeted Financial Statements
2.3.8 Budgeted Profit & Loss Account: The budgeted income statement or profit & loss account is based upon the sales forecast, the manufacturing costs comprising the cost of goods sold and the budgeted operating expenses.
2.3.9 Cash Flow Or/Cash budget: The cash flow of cash budget is a prediction of future cash receipts (inflows) and cash payments (out flows) during a particular period of time .Cash budget/cash flow usually covers a period in the short term future. The cash flow budget helps the management to determine when income will be sufficient to cover expenses and when the company will need to seek outside financing.
2.3.10 Budgeted Balance Sheet: A projected balance sheet could not be prepared until the effects of cash transactions upon various assets, liabilities and shareholders equity accounts have been determined. During the preparation of a budget management is forced to consider carefully all aspects of the company's activities. This research study would enable the managers of the company to do a better job of financial management. Large companies generally have carefully developed budgets for every aspect of their operation; inadequate budgeting techniques would be a characteristic of company with weak or inexperienced management. Hence use of budget and financial projections are key elements of financial management and also assist management in controlling costs.
2.4 Purpose of Budgeting
The management of the organization would make decisions every day that affect the profitability of the business. Business budgeting is a basic and essential process that allows management to attain many goals in one course of action. In order to make effective decisions and coordinate the decisions and actions of the various departments, an organization needs to work out a plan for its operations. Planning the financial operations of a business is known as budgeting. A business that does not have a budget and does not properly formulate financial projections would make decisions that may not contribute to the profitability of the company because management would lack a clear idea of goals to be achieved in business. The main purposes of a budget would include communication, coordination, planning, control, motivation and evaluation.
Control and Evaluation
The most obvious purpose of budgeting was that of controlling unnecessary costs and evaluation of performance. Budgeting helps the company in maintaining certain degree of control over costs, such as not allowing many types of expenses to take place if they were not budgeted for. A budget provides the management of company a benchmark through which to evaluate performance of different units/departments, departments, and even of concerned managers. The said purpose of budgeting can cause employees to have negative feelings about the budgeting and forecasting process because their compensation and jobs may be subject to meeting certain budgeting goals.
A budget is forecast of future events. Budget is ultimately the plan for the operations of an organization for a specific period of time. Planning is important purpose of budgeting it allows management to take figures of revenue and expenses from the previous period, and judge where the business would be in future periods. In larger manufacturing organizations budgeting process might be completed by initiating business units to be manufactured and compiled to form a master budget for the organization.
2.4.3 Communication and Motivation
Budgets provide management with an opportunity to co-ordinate the activities of different departments within the organization. Budgets also allow a company to motivate its employees by involving them in the budgeting process because when employees would be involved in creating his department's budget, that person will be more likely to strive to achieve those targets which were set in the budget.
Budgets indicate the expected costs and expenses for each department as well as the expected out put and revenue like units to be manufactured and sales to be made. Thus budgets provide a yard stick by which each department's actual performance may be evaluated.
2.5 Budget Variances
The profitability of the organization depends basically on three factors i.e. production, costs and sales/revenue. The efforts of the management should be to minimize the costs without compromising on the quality. This strategy must require proper monitoring of costs and sales performances. Variance means controlling the costs to keep them in line with the financial plan or the difference between the budgeted performance and actual performance is also known as variance. A budget variance arises when there is a difference between the plan and the outcome. A budget variance can be either positive (favorable) or negative (unfavorable). There would be several categories of budget variances among those profit variance is one of the most common. Under variance analysis management would compare actual costs with the budgeted amounts and would take appropriate corrective actions if required.
2.6 Classification of Budgets Budgets can be classified into different categories on the basis of ,time, function and flexibility.
Classification According to Time: In terms of time budget can broadly be classified into three further categories.
2.6.1 Long-term Budget: The budget formulated/ designed for a long period of time, generally for a period of 5 to 10 years is termed as a long term Budget. These budgets are concerned with planning of the operations of firm over a considerably long period of time.
2.6.2 Short-term Budgets: Such budgets would be formulated for a period of time generally for a period of 1 to 5 years. They are generally prepared in physical as well as its monetary units.
2.6.3Â Current Budgets: These budgets covered a very short period of say a month or a quarter. They are essentially short-term budgets adjusted to current conditions or prevailing circumstances.
2.6.4 Rolling/progressive budgets: Under this category organization would prepare a new budget in advance. A new budget is prepared after the end of each month/quarter for a full year ahead. The figures for the month or quarter which has rolled down are dropped and the figures for the next month or quarter are added.
Classification According to Functions: Classifications of budgets according to functions researcher already has discussed in detail under the heading 'types of budgets'.
Classification According to Flexibility: Flexible budget were designed to change in accordance with the level of activity attained. Such type of budget would be prepared while considering elements of fixed and variable costs and changes that may be expected for each item at various levels of operations. Flexible budget should design in such organizations where prediction of sales might be difficult due to variance in selling rates.
2.7 Budget's Role in the Organization.
A budget is a plan that outlines organization's financial as well as operational goals. The budget would be useful in setting standards of performance, motivating staff members, allocating resources, evaluating performance and formulation different plans and providing a tool to measure results. Fulfilling the organization's mission would be the main goal that budgeting makes it possible. Understanding about the importance of budget would be first step in successful financial planning. Budgeting also plays a critical role in strategic planning. Budget could help determine where the organization has been and prepare for its future. Budgeting process may not be free of weaknesses as budget fails to focus on shareholder value. Budget protects rather than reduce costs. Budgets are time consuming and expensive one. Despite few weaknesses the role of budget for the organization can not be ignored as in the absence of budget of financial projections the company may not raise money/loan from banks and financial institutions because banks would consider the budget as well as financial projections as a basis for deciding whether what you asked for was feasible and well-planned.
2.8 Effects of Budgeting on organization
An important aspect of any management control system would be proper budgeting process. Managers for a number of reasons such as; motivation, performance evaluation, reduction in unnecessary cost, improvement in product pricing, optimum production and investment planning utilize budgeting information. Moreover, a number of diverse things within the organization would determine whether the budget process will be effective. Otley (1985) stated that past research on the budgeting process has shown that budget estimates are rarely achieved for two principal reasons: (1) imperfect forecasting models and (2) divergence between budgeted and organizational goals. These problems lead to distorted, or biased, information input to the accounting system. It's imperative that managers understand budgetary biasing behavior because reliance on biased information may contribute to poor decision-making. Consequently, in order for managers to properly utilize budgetary information they must understand the circumstances under which budgets may become biased.
2.9 Capital Budgeting Techniques.
Capital budgeting decisions might be crucial to the organization success for several reasons. First, capital expenditures would require large amount funds. Secondly, management must ascertain appropriate ways to raise and repay these funds. Finally, the timing of capital budgeting decisions is important. When large amounts of funds are raised, the organization must have to pay close attention to the financial markets because capital cost would directly relate to the prevailing interest rate. A variety of measures evolved over time to analyze or evaluate the feasibility of any investment are termed as capital budgeting techniques. Let's take look at the most popular budgeting techniques for analyzing a capital budgeting proposal.
2.9.1 Net Present Value Method: The primary capital budgeting method that uses discounted cash flow method would be termed as net present value. Under the net present value net cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts would be referred as net present value. A project would be accepted when the net present value is zero or positive.
2.9.2 Pay Back Period Method: the pay back period answer the question that how long it would take the project to pay back its initial investment i.e. number of years/days to recover initial investment. The shorter the pay back period, the investment would be more attracted. The earlier recovery of funds would enable the management to use the funds for another purpose. This method would never consider time value of money, an accepted project on the basis of pay back method criteria may not have positive net present value.
2.9.3 The Internal Rate of Return: The internal rate of return (IRR) is another important common technique used to assess the financial attractiveness or viability of an investment proposal. This technique is considered to be most important alternative to net present value IRR is the discount rate that would make net present value of all cash flows equal to zero. If Internal Rate of Return would exceed the required rate of return, the investment should be accepted or should be rejected otherwise.
2.10 Financial Projections
The financial projections would quantify future sales, expenses, and earnings which are prepared by using standard production capacity of plant, historical internal accounting and sales data, in addition to external market and economic indicators, adopted by the organization. Since projecting company sales, expenditures, etc., involves uncertainty, a company must consider how changes in the business climate could affect the outcomes projected. The most difficult aspect of preparing a financial forecast would be the prediction of sales and cost of raw material (cotton) due to frequent changes in selling/buying rates in the local as well international markets. A clear business plan with sound financial projections cannot guarantee the success, whereas the absence of a financial plan or poor projections could ensure the eventual failure of a business. Forecasting would help managers respond quickly and accurately to market changes and customer requirements. Financial projections also would in reducing failures and cost in making frequent changes in the process. In the presence of forecasted results the efficiency of the organization certainly would go up.
2.11 Qualitative Forecasting Techniques
Qualitative forecasting techniques generally employ the judgment of experts in the appropriate field to generate forecasts. The management of the organization could apply qualitative forecasting techniques in situations where historical data simply may not available. In case historical data might be available, significant changes in environmental conditions affecting the relevant time series may make the use of past data irrelevant and questionable in forecasting future values of the time series.
Qualitative estimating methods depend upon expert human judgment and experience instead of on hard measurable and verifiable data and not on any specific model. For making long term investment decisions the past available data may not be reliable indicator of under such conditions while making the projections qualitative forecasting techniques would be applied including Delphi Method, Nominal Group Technique, Survey methods and Life Cycle Analogy approaches. Under Delphi technique an attempt would be made to develop forecasts through group consensus. Usually, the experts physically separated from and unknown to each other, were asked to respond to an initial questionnaire. The coordinator would edit and summarize the responses and the panel then asked to reconsider the individual responses, The answers of second round would again summarized and fed back to the experts. This process is continued until some degree of consensus among experts is reached. In this method direct interpersonal relations would avoid and no some one member can dominate the group. The nominal group technique is similar to Delphi technique except it allows discussion among experts and permit creativity. Under survey methods relevant information/ data would be collected either through a questionnaire, personal interviews, telephonic interviews, internet communication or by using mail or fax modes. In case of life cycle analogy forecasting would base on the patterns of similar products. The demand trend of a product tended to be followed a predictable pattern known as product life cycle. Hence by using aforesaid forecasting methods management could predict the volume of sales.
2.12 Quantitative Forecasting Techniques
The organization would use quantitative forecasting techniques when historical data on certain variables of interest was available, these methods are based on an analysis of historical data concerning the time series of the specific variable of interest and possibly other related time series. The organization used aforesaid techniques for production planning, procurement scheduling, and allocation of expenditures and for financial planning. There would be two major categories of quantitative forecasting methods the first type preferred the past trend of a particular variable to base the future forecasting so these techniques were termed as time series methods. The second category also used historical data but while forecasting future values of a variable, the researcher would examines the cause and effect relationships of the variable with other relevant variables such as the level of consumer confidence, changes in consumers' disposable incomes, the interest rate at which consumers can finance their spending through borrowing, and the state of the economy represented by such variables as the unemployment rate. Forecasting techniques falling under this category were called as causal methods. Quantitative forecasting methods were further classified into following categories;
2.12.1 Time Series Forecasting Method.
Time series is a statistical method which would be intensively employed by the organization for projections. The main assumption in the time series analysis would be as factors influencing units of sales would not change significantly over a period of time and the future would reflect the past. This method would be beneficial for the organization only if factors leading to the variations could easily establish or minimize.
2.12.2 Moving Average Forecasting Method
The moving average method would employ to estimate the average of a time series and thereby remove the effect of random fluctuations. This method enabled the organization to eliminate the effects of seasonality and other irregular trends in sales if seasonal effects would exist in the demand pattern of the product, in such situation at least two year's history may require to implement this method.
2.12.3 Exponential Smoothing /Weighted Moving Average Forecasting Method.
Exponential Smoothing seem most frequently used method for sales forecasting. It is weighted moving average method that provides recent observations, more weight than earlier observations. Exponential Smoothing methods would be appropriate to generate forecasting when a time series displayed no significant effects of trend, cyclical, or seasonal components.
2.12.4 Simple Projection Method.
Among the projection methods the simplest is one that used the rule of thumb by which current year's projection would arrive at by simply adding a certain percentage to the last year's sales by using the formula as Next year's Sales= (This Year's Sales)2/ Last Year's Sales. Simple projection method would result reasonable forecasting only if the sales remained stable and showing an increasing trend.
2.12.5 Casual Forecasting Methods.
Under casual methods, organization would consider the cause and effect relationship between the variable whose future values are being forecasted and other related variables or factors. The widely known causal method is called regression analysis.
Budgeting is a means of planning and evaluating. Forecasting provides advance warning of cash shortfall before crisis stage initiates as well as improves the quality of revenue and spending policy decisions by providing desired information about financial implications. (Susan,Peter, 1991).
Budgeting involves making projections for next financial year on the basis of reasonable assumptions. Costs control begins with an understanding of fixed, variable and semi fixed costs. These differences help in identifying controllable and non-controllable costs. (Singh, 2nd ed).
Budgeting is a valuable technique for a business; companies use budgets to gauge their financial performance throughout the year and adjust their expenditures to ensure a certain amount of profit through optimum production achievements. Budgeted figure for relatively short period of time enables managers to compare actual performance to the budget without waiting until year end. Budget shows expected results of future operations management is forewarned of financial problems. (William,Haka,Bettner,Carcello, 14th ed).
The budgeting techniques represent a set of guidelines to be used in controlling internal operations of an organization. The management of the organization through application of budgeting techniques can evaluate the performance of every department. The discrepancy between standard performances is highlighted through budgeting techniques. (Brabb,Burton, 2006).
Budgets provide timely warning of negative cash flow which is required to be arranged and surplus cash flow which may require to be invested exclusively for profit making purposes. The management can prepare future plan knowing what funds are required, when they are required and how much are required. (Rory, 4th ed).
The management of costs/expenditures can be divided into three basic components i.e. budget preparation, budget execution and audit and budget review. Budget preparation techniques would need to change as the economies moved to a more market oriented approach. (Barry, 2000).
The effective management can understand that what has happened so far and can regularly look into the future by comparing actual versus budgeted information along with current forecast projections to stay competitive and to meet financial goals. (Jae, Joel, 2005).
Budgets are based on plans the management of all the departments are informed about the expectations from them. The extent of expenditures they can incur is laid down in along with expected profits of their departments. The department managers make their utmost efforts to achieve the targets. (Sigh, 2010).
In order to manage costs more effectively and efficiently and to achieve optimum production, the organizations will have to imply activity based budgeting techniques (Drury, 7th ed).
Budget being a cost saving tool improves production techniques to eliminate inefficiencies in the production process. (Judith,Baker, 2005).
Management develops integrated plans for achieving different objectives, effective control of operations depends upon applications of effective budgeting techniques which provide management with detailed statement of actual costs with estimates and standards costs enables management to identify the reasons for any differences and to take appropriate actions. (Usry, Hammer, Matz, 9th ed).
Budgets of all types are good planning tools and can be serve as very valuable controlling function. The budget serves as a planning tool for the organization as a whole as well as its subunits. In order to improve probability of success all functions of the business should be included when structuring the operating budget. A good budget is one which not only uses good budgeting techniques but is also based on a sound knowledge of the business that affects it. It provides a frame of reference against which actual performance can be compared. It provides a means to determine and investigate variances. (Steven, E, 2006).
Under capital budgeting techniques, pay back period methods are used to determine the number of years required to recover the initial cash investment. The Internal rate of return (IRR) is the interest rate that makes net present value of all cash flows equal to zero whereas net present value introduces time value of money (James, Johnwachwicz, 2000).
Operational budgeting techniques involve the development of financial plans for the organization, typically for a year; quarterly budgets are especially useful for anticipating cash needs. The budget is broken down by price volume and product type using information provided by sales budget. (Michael, Clyde, Roman 10th ed.).
Budgeting compels management to think about the future to set out detailed plans for achieving the targets for each department. A budget is basically a yardstick against which actual performance is measured and assessed and control is provided by comparisons of actual results against budget plan. Management implements different budgeting techniques for the purpose of evaluating the performance and exercising the function of cost controls to understand how much they have performed in the past. (Pgopala, 1990).
While making investment in working capital the management must consider financing cost of investing in working capital against the benefits to be achieved. If there may be no sufficient investment in working capital there would be no stocks and no debtors which might result a significant decrease in sales which resultantly will generate minimum profit. ( ACCA, 2006).
While making further expansion to the existing facilities, executives usually analyze costs, benefits, and pay back period, internal rate of return, before making purchase decision. Net present value method and internal rate of return both recognize the value of money. They evaluate cash flow to decide whether to borrow money or to use cash generated by operations. (Shim, 9th ed).
The process of allocating expenditures that will provide return over time is known as budgeting techniques. Cost control always a problem budgeting process provides a set of criteria that management can use to determine which expenditures are profitable and how the organization should spend. Budget should approve by the competent person who has the complete budget in mind. (Edward 4th ed).
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