Learning objectives

After studying this presentation you should be able to:

Chapter 6 6.1 demonstrate an understanding of the role of
budgets in developing both short- and long-term
plans
Operational budgets 6.2 describe the role of the master budget and develop
a master budget
6.3 develop a cash budget
6.4 explain the use of budget targets as performance
benchmarks
6.5 illustrate how budgets are used to monitor and
motivate performance.

Budgeting — a tool for short- and long-term Budgeting — a tool for short- and long-term
planning planning

• A budget is a formalised financial plan for operations of

an entity for a specified future period.
• A budget is an entity’s financial roadmap to:
• coordinate activities
• determine resources required to carry out plans
• define responsibilities and financial decision-
making authority.

Budget cycle The role of the master budget

• A master budget is a comprehensive plan for an

upcoming financial period, usually one year.
• A master budget is summarised in a set of budgeted
financial statements.
 The role of the master budget Developing a master budget

• A master budget consists of: • Based on a set of budget assumptions (plans and
• an operating budget: a firm’s plan for revenues, predications about next period’s operating activities).
production and operating costs • An analysis of past revenue and cost trends and
– leads to a budgeted statement of profit or loss behaviour is conducted to develop the next period’s
budget.
• financial budgets: management’s plan for capital • Given a strategy, the master budget is developed by first
expenditures, long-term financing and cash flows forecasting sales volume and revenues and then
(includes cash budget) following the sequence shown in figure 6.3. Alternative
– leads to a budgeted balance sheet and budgeted methods are possible (i.e. simultaneous or independent
statement of cash flows. development of other budgets).

Developing a manufacturer’s master budget Developing a master budget

• Likely order of creating individual budgets:

1. revenue budget
2. production budget
3. direct materials budget
4. direct labour budget
5. manufacturing overhead budget
6. inventory and cost of goods sold budget
7. support department budgets
8. budgeted financial statements.

Budgeting in non-manufacturing entities Developing a cash budget

• The specific types of budgets that comprise a master • The cash budget:
budget depend on the nature of the organisation’s • reflects the effects of management’s plans on cash
goods or services and its accounting system. • summarises information about expected amounts
• Service entities: no inventory; direct costs of and timing of cash receipts and disbursements
producing services are recognised as period costs. • may be prepared quarterly, monthly, weekly or even
No direct materials. daily.
• Not-for-profit entities: budgets used for
operations management.
• Government entities: legally adopted, placing
restrictions on spending
 Developing a cash budget Developing a cash budget

• Operating cash receipts are estimated from budgeted • Other planned cash flows:
revenues, taking into account nature of transactions. • other types of cash flows apart from operating cash
• Forecasts need to allow for timing of payments flows include:
and likelihood of bad debts. • purchasing or selling property, plant and
• Operating cash disbursements are estimated for direct equipment
materials, direct labour, manufacturing overhead and • borrowing or repaying long-term debt
support departments. • paying interest on debt
• Timing depends on payment terms for employers • issuing or redeeming shares
and suppliers. • paying dividends to shareholders.

Developing a cash budget Developing a cash budget

• Short-term borrowing or investing • To prepare a cash budget, three types of cash

• Managers use short-term loans or investments to transactions are planned:
balance the cash budget, taking into account the 1. cash receipts
desired cash balance. 2. cash disbursements
• Purpose of cash budget is to ensure adequate 3. short-term borrowings or investments.
levels of cash for day-to-day operations.

Budgets as performance benchmarks Budgets as performance benchmarks

• Differences between budgeted and actual results are • Determining underlying causes of variances is
called budget variances. sometimes complicated.
• A favourable variance occurs if: • Budgets are based on forecasts; impossible to prevent
– actual revenues are larger than budget variances.
– actual costs are lower than budget. • Significant budget variances are likely to occur:
• An unfavourable variance occurs if: • in highly competitive industries
• when selling newly developed goods and services
– actual revenues are lower than budget • when subject to fluctuating raw materials costs such
– actual costs are higher than budget. as petroleum prices.
 Budgets as performance benchmarks Budgets, incentives and rewards

• Static and flexible budgets • Managers are:

• Interpretations of budget variance are complicated • given responsibility over resources
by deviations from budgeted volume levels. • held responsible for meeting budget benchmarks.
• If a static budget is compared to results for different • Performance is monitored by measuring actual results
levels of volume, budgeted variables costs are to the budget.
overstated when fewer units or services are • Bonuses based on meeting or exceeding budget goals
produced than budgeted. help motivate performance.
– A budget prepared for a single level of sales
volume is called a static budget.

Budgets, incentives and rewards Budgets, incentives and rewards

• Budget plans are developed top-down, using • Participative budgeting:

information gathered from bottom-up. • where managers who are responsible for meeting
• Top management provide strategies and suggested budgets also prepare the initial budget forecasts,
organisational targets (top-down). setting targets for themselves
• Division and department managers incorporate • theoretically, should improve budget achievement
these into the budgeted operating plan. due to buy-in. However, incentives exists for
• Departmental budget requests are communicated managers to set easily achievable targets.
bottom-up to top management for final approval. • if targets are too high or too low, employees have
little motivation to improve performance
• negotiations are often required.

Budget manipulation Budget manipulation

• Budgetary slack is the practice of intentionally setting • Incentives to manipulate budgets increase in larger
revenue budgets too low and cost budgets too high. entities where managers tend to focus only on resources
• To minimise budgetary slack: and performance of their own departments, rather than
– independent consultants or market experts may considering the entity as a whole.
prepare forecasts
– independent forecasts are compared to budgeted
estimates to provide scrutiny
– bonuses can be given for accurate forecasts as
well as for operating within budget.
Challenges in appropriately assigning decision Adjustments to be made when using budgets
rights to measure performance

• With authority over resources comes responsibility for • Use a flexible budget to determine expected revenues
meeting budget benchmarks. based on budgeted prices and actual volumes.
• Use a flexible budget to determine expected variable
costs based on budget variable costs rates and actual
volumes.
• Remove allocated costs that are not controllable by
managers in the departments receiving allocations.
• Update costs for any anticipated price changes in
direct materials, direct labour and overhead-related
resources.

Appendix 6A The interrelationship of budget obstacles

• Turning budgeting pain into budgeting gain

• There are three areas to address to improve the
budgeting process and build a more accurate
budget that inspires confidence:
1. people problems
2. tool troubles
3. process pain.

Source: ‘Turning budgeting pain into budgeting gain’, by John Orlando, Strategic Finance, Institute of Management Accountants,
March 2009, pp 47–51.

Appendix 6A Appendix 6A

• Why the budget matters: • Improvement plan:

• a cash flow management tool 1. evaluate your process
• a forecasting tool 2. upgrade your technology
3. communicate
• a reporting/disclosure mechanism 4. communicate some more
• the tool for measuring progress 5. train and educate
• a factor in compensation 6. collaborate
• a crystal ball. 7. follow through.
 Summary

• Demonstrate an understanding of the role of budgets

in developing both short- and long-term plans.
• Describe the role of the master budget and develop a
master budget.
• Develop a cash budget.
• Explain the use of budget targets as performance
benchmarks.
• Illustrate how budgets are used to monitor and
motivate performance.