The Benefits of budgeting

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Cash Budget

The cash budget is probably the most important of all budgets. Almost all companies prepare one. Indeed, banks will often insist on a cash budget before they lend money to small business. For a sole trader, the cash budget is often as important as the trading and profit and loss account and balance sheet. It reflects the need to balance profitability and liquidity.

Essentially, cash budget looks into the future. We start with the opening cash balance. Receipsts are then recorded, for example, cash received from cash sales, from debtors or from the sale of fixed assets. Cash payments are then listed, for example cash purchases from goods, payments to creditors or expenses paid. Receipts less payments provides the monthly cash flow. Opening cash and cash flow determine the closing cash balance.

Other Budgets

Sales Budget

The sales budget is determined by examining how much the business is likely to sell during the forthcoming period. Sales budgets like many other budgets can be initially expressed in units before being converted to £s. In many businesses, the sales budget is the key budget as it determines the other budgets. The sales budget is, therefore, often set first.

Debtors Budget

The debtors budget begins with opening debtors (often taken from the opening balance sheet) to which are added credit sales (often taken from the sales budget). Cash receipts are then deducted, leaving closing debtors.

Creditors Budget

In many ways the creditors budget is the mirror image of the debtors budget. It starts with opening creditors (often taken from the opening balance sheet), add credit purchases and then deduct cash paid. The result is closing creditors.

Manufacturing Budgets

Production cost budget

The production cost budget, as its name suggests, estimates the cost of production. This involves direct labour, direct materials and production overheads. There may often be sub-budgets for each of these items. Once the production cost is determined, the finished goods budget can be prepared. It is important to realise that the budgeted production levels are generally determined by the amount the business can sell.

Raw Materials Budget

The raw materials budget is particularly useful as it provides a forecast of how much raw material the company needs to buy. This can supply the purchases figure for the creditors budget. It starts with opening stock of raw materials (Often taken from the opening balance sheet); purchases are then added. The amount used in production is then subtracted, arriving at closing stock.

Finished Goods Budget

The finished goods budget is similar to the raw materials budget except it deals with finished goods. It starts with the opening stock of finished goods (often taken from the balance sheet), the amount produced is then added (from the production cost budget). The cost of sales (i.e., cost of the goods sold) is then deducted. Finally, it finishes with the closing stock of finished goods. The finished goods budget is useful for keeping the a check on whether the business is producing sufficient goods to meet demand.

Jones, M. (2006) Management Accounting, John Wiley & Sons Ltd. (pp 81-87)

Responsibility Centres.

The first requirement of a good system of budgetary control is to set up acoounts for collecting data on inputs and outputs at the lowest distinct level of activity. These accounts are called cost centres. Individual managers will be responsible for one or more of these cost centres and togwther such cost centres form a responsibily centre.

Types of responsibility centres

Expense Centres

An expense centre occurs when the expense of a responsibility centre are measured but not the monetary value of outputs. This is typically the case for public sector organisations where outputs obviously exist but are either not measurable at all, or are measurable in physical but not monetary terms.

Profit Centres

If outputs in the form of goods or services are charged for in such a way that the fees are meant to relate to the value of the goods or services, then both inputs (income) and outputs (expenses) can be expressed in monetary values. The difference between the two is profit. Even if there is no intention of making profit or even to break even, a profit centre might still exist.

Investment Centres

If not only the profits but also the capital employed in a responsibility centre are measured then an investment centre exists. With an investment centre the profit can be related tothe capital employed to produce a rate of return.

Jones, R. and Pendlebury, M. (2000) Public Sector Accounting, 5th edition, Financial Times, Prentice Hall, Edinburgh Gate Harlow.

Methods of Budgeting (Weetman, 2006)

Input-Based Budget systems

In designing the presentation of the budget, some organisations produce line item budgets where each line in the budget relates to functions in the organisation. This approach emphasizes the inputs to the work of the enterprise.

Incremental Budgets

One commonly used approach to estimating the budgeted costs is to start with the previous year's expenditure budget, adding a percentage to cover inflation and making adjustment for any unusual factors or incremental changes. The success of the incremental budget approach depend critically on the suitability of the previous year's figures. Any errors in estimation would continue indefinitely. If there was inefficient use of resources in previous periods, that inefficient will built into the budgets. No challenges are made to separate department to review their use of resources in a more fundamental manner. If a new activity has been developed it may be difficult for those involved to bid for support because there will ber no previous budget on which to build.

Zero-Based Budgeting

Zero-base budgeting in its pure form is precisely what its name implies, i.e. the preparation of operating budgets from a zero base; even though the organisation might be operating more or less as in previous years, the budgetary process assumes that it is starting a new. Resources are not necessarily allocated in accordance worth previous patterns and consequently each existing item of expenditure has to be annually rejustified. Thus by focusing on this need to rejustify existing levels of expenditure the apparent weakness of incremental budgeting , i.e. the perpetuation of obsolete expenditure, is avoided. Zero-base budgeting has therefore an obvious appeal to a society which continually demands assurances concerning the most effective allocation of scarce public resources.

(Jones, R. and Pendlebury, M. (2000) Public Sector Accounting, 5th edition, Financial Times, Prentice Hall, Edinburgh Gate Harlow.)

Output-Based budgeting

Rather than quantify inputs, it would be equally valid to approach the budgetary process from a totally different direction and concentrate on outputs from the process. An output-based approach could be taken by any organisation, but the greatest extent of its practical application has been observed in the non-profit making organisations, where their activity output is the most important focus or their work.

Disadvantages of zero base budgeting

1 it is a time consuming exercise

2 it requires management to apply higher skills in planning.

3 it diverts managers' attention from their primary areas of responsibility.

4 it could lose the benefit of longer-term comparisons of trends in efficiency and control.

Disadvanteges of incremental budgeting

1 It assumes activities continue at the current levels.

2 It does not leave space for new developments.

3 It is backward-looking and does not encourage innovation.

4 It builds efficiency and discourages cost saving initiatives.

5 it is seen as being driven by the accounting processes rather than by those who deliver the products and services of the organsiations. (Weetman, 2006)