Preparing budgets and budgetary control
Purpose and process
A budget is a quantified plan for a future period. Its purposes are planning, coordination, communication, motivation, control and performance evaluation. The budget cycle runs: set objectives, identify the limiting (principal budget) factor - usually sales - prepare functional budgets for sales, production, materials, labour and overheads, then the cash budget, and finally the master budget comprising the budgeted income statement, statement of financial position and cash flow.
Techniques
Incremental budgeting adjusts last year's figures; zero-based budgeting requires each activity to be justified from scratch; rolling budgets are continuously updated. Top-down budgets are imposed, bottom-up budgets are participative - participation improves commitment but can encourage budgetary slack. Flexed budgets restate allowed costs at the actual activity level and are the foundation of budgetary control and variance reporting.
Traps
- Putting depreciation in a cash budget: it is non-cash. Capital purchases are cash outflows but are not operating budget items.
- Using sales revenue rather than cash receipts, ignoring credit terms and timing.
- Flexing to budgeted rather than actual activity.
- Omitting opening and closing inventory from the production budget.
- Confusing the limiting factor with the principal budget factor.
Worked example
Production budget: sales 5,000 units, opening inventory 400, closing inventory 600, so production = 5,000 + 600 − 400 = 5,200 units.
Cash receipts: 60% collected in the month of sale, 40% the following month. Sales are £50,000 in January and £60,000 in February, so February receipts = (60% × £60,000) + (40% × £50,000) = £36,000 + £20,000 = £56,000.
Rule of thumb: for production, add closing inventory and subtract opening inventory; for cash, follow the money, not the sale.