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Corporate
Finance FIN 622
VU
Lesson
24
BUDGETING
PROCESS
The
following topics will be
discussed in this lecture.
Budgeting
process
Purpose
/ functions of budgets
Cash
budgets Preparation &
interpretation
The
Budget Process
The
Budget process allows the
company to:
set
its fiscal objectives in
respect of revenue, expenditure, debt
repayment and investment;
maintain an
effective fiscal control and
plan for the coming year and
beyond;
allocate
the available resources, consistent
with the Company's strategic
objectives and
priorities;
fulfill
the legislative requirements for the
Budget; and
Seek
authority from Parliament
for spending.
All
Managers have a key role in
the budget process. Together, they agree on the budget
strategy and
priorities
for spending. On an individual level,
Managers identify priorities
for departmental chief
executives
to guide preparation of Budget
submissions.
Budget
Preparation Process:
1.
Budget Policy & Details
Communicating To All
This
includes disseminating details
like the budgeting period, time table and
formation of budgeting
committee.
The
main objective is to make clear of the
scope and roles of people
involved in this process.
Normally,
budgeting
period is a period of 12 months. It may
be calendar year or any
combination of 12 months.
However,
it is always broken down
into 12 periods of one month
or into quarters because of
comparison
with
actual performance and
control purposes.
This
process is formalized by forming a
committee comprising of different front
line managers and a
very
senior
person is appointed to head this
committee. Such a person should
have a clear vision of
future and
unambiguous
understanding of corporate objectives.
Budgets are used to
translate the ultimate objectives
into
monetary terms as a course of action to
accomplishment of those
objectives.
A budget
has to be finalized before the start of
the period for which it is being
prepared. For
example,
budget
for 2006 must be completed
before January 2006. The time to
complete budget will vary firm
to
firm,
on the type of budget and the budget period. There
are different phases in budget
preparations and
timeliness
is set for each
phase.
2.
Determining The Limiting
Factor
Budget
preparation normally begins with the
identification of limiting factor. This
refers to a factor
that
limits
the stretch of company or hinders
company's achievement of specific
objective. The first step
will be
to
determine the sales during the budget
period. The first question
will be "do we have the
capacity to
produce
this much?" Assuming that the
answer is "no" then, production
capacity is the limiting factor.
You
can't
achieve what you have determined
and need to cut-down your
plans or revise your target
sales.
The
other areas may be the
availability of labor force and/or
raw materials. If there's no
limiting factor then
company
can start with the target
sales and if there's one
that hampers target, then it
would be what can be
achieved
with the available
resources.
3. Production
Budget Preparation
The
primary source of inflow comes
from the principal activity or
sale of goods. Therefore, in
budget
preparation
sales is the kick off
point.
Sales
budget is prepared in quantitative form.
Each product sales is mentioned in number
of units to be
produced.
There is a standard specification of a unit in
terms of the input material
requirements; labor time
and
amount of overhead needed to manufacture
it. There's also a standard
selling price of each
product
unit.
Sales
in monetary term are calculated by
multiplying number of units to be produced by standard
selling
price.
79
Corporate
Finance FIN 622
VU
Next
step will be to determine the
expense side of number of units to be produced in the
budget period.
This
is known as production cost budget
and is divided into three
categories.
First
step will be to determine the
total raw material
requirements by multiplying the number of units to
be
produced by
standard quantities of input materials.
The dollar value of direct
material cost is calculated
by
multiplying
derived quantities by the standard purchase
price.
In
second step, direct material
requirements are worked out.
Standard time to produce one
unit is multiplied
with
number of units to be produced. The total
production hours are
multiplied by standard labor
rate per
hour
to reach at total labor
cost.
The
third segment in cost of
sales determination is to estimate the
overhead to be absorbed per
unit of
output.
This is normally done by dividing the
estimated amount of overheads by the
activity level labor
hours.
Adding
these three segments direct
materials, direct labor and
overhead render total cost
of production.
4. Other
Ancillary Policy Issues
Determination
The
other items that are
determined in this phase includes but
not limited to the minimum level of
finished
goods
level, purchases of each raw
materials and raw material
ending inventory levels.
5.
Functional Budgets &
Negotiation
After
the sales and production
cost budget has been determined
then comes the step where
individual
departments
or functional budgets are
prepared. Every functional
manager is required to prepared
and
present
before the budget committee budget for the
forthcoming period.
6.
Adjustments & Trimming
Once
the sales, production cost
and functional budgets have
been submitted to the committee then
there
are
discussions and negotiations and
adjustments are made in the
light of available resources
and short term
objective of the
firm. If there is shortage of
resources then departmental budgets
are trim down. At the
point
where the trade off between
resources and resource
utilization is achieved, it is deemed as
final.
7.
Finalization Of Budget &
Implementation
Final
version of budget is presented to head of
committee who then present
it to chief executive officer. If
CEO
has some reservations it may
ask for reconsideration or
can approve as is. After CEO
ratification the
budget is approved
for implementation.
8. Variance
Analysis & Investigation
After
the budget is approved and implemented, the actual
performance is compared with the
budgeted one
and
variances are calculated.
Variance is the difference between the
actual and budgeted numbers.
The
variance
is investigated as to know the root
cause of difference. The information is
used to adjust the
next
budgets
period.
Specific
Phases of the
Budget
The
Budget process can be
divided into distinct
phases:
Common
Purposes/Functions behind Budget
Activity
Planning
--
involves determining organizational and program
objectives and evaluating alternative
means
for
their achievement. Planning also
includes prioritizing.
Control
--
defined as monitoring, comparing
information to a standard and
taking corrective action. For a
budget
to
serve this function well it
must have four
characteristics:
It
must be well-conceived (i.e., result
from a good planning
process) and be approved by the
board
It
must be broken down into
increments corresponding to the periodic financial
statements
Financial
statements must be prepared on a
timely basis and compared to
the budget
The
board and staff must take action
where such comparison
indicates a potential problem.
Management
--
allocating resources deliberately and
prudently to achieve program
objectives.
This
includes programming approved goals into
specific projects and
activities, the design of
organizational
units to
carry out programs, staffing,
and procurement of resources.
Cash
Budgets
80
Corporate
Finance FIN 622
VU
An
Introduction to Preparing Cash
Budgets
When
many people first have to
prepare a cash budget or a cash
flow statement they start
out thinking that
they're
easy to do. Half way
through, though, a mist
seems to settle over their
eyes and they become
impossible
to do.
The
problem usually comes down
to matters such as the layout, the
balances brought down and
carried
down
and the debtors and
creditors.
Most
things to do with the cash itself
are simple to account for:
the day we receive the cash, we
put it into
the
statement; the day we pay
some cash, we put that in
the statement ... that's
pretty well all there is to
do
with
the cash itself.
OK, so
the cash itself is simple to
deal with but there is
still a lot more to be
worried about I can hear
you
screech!
Fear not, though, help is at
hand on this very page.
We'll
start by taking a look at the
layout and contents of cash
budget overall. Then we'll have a look at
an
alternative layout,
remembering that whatever the layout,
they should all give the same answer!
Finally, we'll
spend
some time solving all of your
debtor and creditor
worries!
Overall
Layout of a Cash
Budget
Here
we have a cash budget statement
that starts with the cash
balance brought down (b/d)
from last
month,
last week or yesterday (this is the
cash we had in the safe or
our purse or wallet at the end of
the
previous period).
Then we add the cash
receipts to the balance b/d to give us the
total amount of cash we
then
have available to us: this is the amount
of money we can
spend.
However,
we usually have bills to
pay, so we take away from
the cash available the amount of money
we
have
to pay for our bills,
utilities, materials, labor
and so on. Starting with the
balance b/d adding the
receipts
and taking away the payments
leaves us with the balance
carried down (C/D); and this
is what we
have
left at the end of the month
ready for use at the start
of the following month.
Alternative
Layout of a Cash
Budget
In
addition to dealing with
debtors and creditors, which
we will deal with shortly,
there is the key issue
of
alternative
layouts. Here we see an alternative
layout that has exactly the
same information in as the
previous
example but they are
presented in a different order.
81
Corporate
Finance FIN 622
VU
Most
importantly, though, the balances C/D at
the end of each month are
the same whichever layout we
use.
Just compare this new layout
and the balances C/D with the previous
layout we saw above.
Cash
Flow Statement
This
statement is governed by international
accounting standard # 7
·
Purpose of cash flow
statement is to provide information
about the inflows and
outflows of cash
and
cash equivalents. The
inflows and outflows are
grouped into three
categories.
·
Cash & cash equivalents
are short term, highly
liquid investments that are
both readily convertible
to
cash and without loss of
value.
·
Statement is divided into
three categories
operating activities
investing activities
financing activities
·
Purpose of cash flow
statement
· To
identify and assess the
ability to generate future net
cash flow from operations to
pay debt,
interest
and dividends
·
External financing
requirements
· To
see the effects of cash &
non cash investing and
financing transactions.
·
Assess the reasons for
differences between income
and associated cash receipts
and payments
82
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