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The following contains both new materials and updated extracts from my book Cost and Management Accounting published by Prentice Hall 1996

Introduction

Budgets can be prepared for and used by anyone and anything. That is, we can prepare and use personal budgets and organisations, ministries and non profit making organisations can all use them.

Budgets, by definition, have to be prepared in advance; and for this reason, they are often referred to in terms of their being part of a feedforward system. Feedback is a term frequently heard both in accounting and ordinary use. Feedforward, on the other hand tends to be less frequently heard, yet this word incorporates the most important aspect of budgeting: looking at situations in advance, thinking about the impact and implications of things in advance, attempting to take control of situations in advance.

Budgets

A budget is a plan expressed in quantitative and money terms. Budgets need to be prepared and approved in advance of the period in which they are to be used. Budgets can include some or all of income, expenditure, and the capital to be employed. Moreover, a budget can be drawn up for an entire organization, any segment of the organization such as a department or sales territory or division, or for a significant activity such as the production and sale of a specific product.

We should also add that a budget can include non monetary as well as monetary information in it.

Budgetary Control

Budgets are simply exercises in calculation unless they are used. When we use a budget, we do so as part of a system of budgetary control. That is, we have some basic ideas of what we want to do, we prepare budgets to help us achieve those ideas; and then once we have done whatever it is that we wanted to do, we check to see if we kept to our budget.

Budgetary control relates to the establishment of budgets relating the responsibilities of budget holders the needs of a policy. Budgetary control also relates to the continuous comparison of actual with budgeted results: it does this to try to ensure that the objectives of that policy are achieved; or to provide a basis for the change of those objectives.

In summary, a budget is a statement setting out the monetary, numerical or non quantitative aspects of an organisation's plans for the coming week or month or year. Budgetary control is the analysis of what happened when those plans came to be put into practice, and what the organisation did or did not do to correct for any variations from these plans.

The benefits of budgeting

Many of us prepare budgets on a personal level: how much is my income for the month?; how much am I going to spend?; and, most importantly, is there anything left over? It seems true, however, that many businessmen do not prepare budgets for their businesses. Thus, even though managers prepare budgets for their relatively simple lives, when it comes to the much more complex situation of their business, they prefer to let cash inflows and outflows look after themselves. The purpose of this part of the chapter is to demonstrate that budgets are useful, informative and communicative. We will see that a budget is a necessity not a luxury.

We will also see some of the problems underlying organisations: the nature of the organisation and the interactions of the people working in them. By considering these problems, we will be considering ways in which your budgeting system, or the organisation itself, can be changed, if necessary, to overcome them.

Applicability of Budgeting and Budgetary Control

Budgeting can be applied to virtually every situation. It does not matter whether we work in the Public or Private Sector of the Economy. We may work for a profit making business or a non profit making business. Your company may be engaged in trading, manufacturing, or providing a service. In all of these situations, budgeting and budgetary control is of use to you.

As we will see, there are many issues underlying the use of a budgeting system that need careful consideration. For example, we will see that budgeting systems cannot just be imposed on an organisation nor do they run themselves. Managers at all levels often resent budgets and budget targets for a variety of reasons.

The budgeting process

It would be easy to dismiss the budgeting process as beginning when the first budget is prepared, and as being complete when the master budget is finalised. In reality, the budgeting process begins for many organisations a long time before the budget period begins; and the process ends once the budget period has ended. This means the budgeting process is a very lengthy process: typically, for a large organisation, the pre budgeting phase can begin up to a year before the budget period starts.

Jones and Pendlebury (1984), pp62-63, give us some insight into the beginning of the budgeting cycle when they present a "Timetable for preparation of detailed revenue budget and capital programme" for a Local Authority. They show that the process starts in June in the year preceding the budget period with the draft budget manual being sent to Finance Officers, who will discuss this draft with their departmental staff (with a view to adoption or amendment). The budgetary planning phase is completed in March (ready for an April start) when the printed budget book is published and the approved estimates are put into the financial control system. (Colville (1989) presents a similar view, but this time of the budgeting for a Police Authority in the UK).

The budget period

The budget period is the period for which a set of budgets is prepared: typically the budget period is of one year's duration, and will be designed to coincide with an organisation's financial, or fiscal, year. There is no reason why a budget period has to be one year, but typically it is.

On the other hand, if we are dealing with a project, then the budget will clearly be linked to that project. A three month project will have a budget covering the whole project and will thus be a three months budget.

Most organisations will divide their budget period into calendar months (or periods); whereas others have thirteen period years (all of an equal four week period). In certain situations, the budget period will be analysed according some particular feature of the work in that situation: for example, stockbrokers have their year divided into "accounts" of two and three weeks' duration. These divisions of a budget period are control periods.

Budget centres

In a similar way to the way in which the financial year is divided, the organisation will be divided up into budget centres. A budget centre is one part of an organisation for which budgets are prepared. That is, a budget centre, like a cost or profit centre, is a section of an organisation (division, department, building, individual) for which a separate budget is prepared.

Whilst there is a lot of organisational work that is put into budgeting and budgetary control, this page is concerned mainly with an outline and understanding of the preparation aspects of budgets. A later page may deal with the organisational and strategic aspects of budgetary control.

Interrelationships of budgets

One of the key reasons why management accountants and other planners are using spreadsheets more and more for budgeting purposes is because of the many inter relationships that exist in budgeting and budgetary control. If we are preparing budgets for our organisation we will quickly find that the sales budget has strong links with the stock budget and it has strong links with the cash budget. When, then, the sales budget is changed, the stock and cash budgets will also have to change. Similarly, if the stock levels are changed, as a result of a revision of managerial policy during the budgeting process, say, then that could impact on both the sales and cash budgets.

The more complex the organisation and the more complex the processes within that organisation, the greater the number and variety of interrelationships that any budget for that organisation is bound to contain. The following diagram takes a general view of some of the interrelationships found in organisation. The diagram is relatively complex but we will find that a study of it helps us to understand the examples that follow.

Not all organisations have all of these interrelationships; and, as we saw above, some organisations prepare budgets only for part of the organisation so some aspects of the above diagram will apply to them and others will not.

Whenever you come across a budgeting and budgetary control situation, try to fit that situation to this diagram: make and not any changes you feel are necessary to the diagram following on from what you have found.

We can see that this diagram begins with the sales forecast and then the sales budget. This is not an accident; and it doesn't always have to be this way. The reason that sales are the starting point of the diagram is because the organisation on which the diagram is based must believe that sales are its limiting factor. Let's consider the limiting factor.

Limiting Factor

In the example that follows, we will find: "As far as sales are concerned, they are fixed anyway: everything else depends on them." In the examples we are working through this will be true: everything the Andy's wholesaling organisation was does centres around its sales levels: both purchases and stock levels depended upon the level of sales for any given month. In this situation, Sales is considered to be the limiting factor (which is also known as the principal budget factor, and the key factor).

The limiting factor is anything that limits the activity of an entity. Examples of limiting factors are shortages of supply of a resource and a restriction on sales at a particular price. That is, the limiting factor is the one factor that dominates all other factors: the limiting factor can be any factor that is important to the carrying out of the organisation's activities can be the limiting factor.

Examples of the limiting factor

Each of the following can be, depending on the circumstances of the case, the limiting factor:

1 Cash
2 Raw materials
3 Skilled labour
4 Land
5 Equipment

The crucial element concerning the limiting factor

The most important point about the limiting factor, then, is that this must be the budget that is prepared before all others. There is no point in preparing every budget except the raw materials budget only to find that the assumptions built into all other budgets means that the amount of raw materials needed just cannot be acquired. Similarly, if cash is the limiting factor, preparing any budgets that take no account of the cash position may lead to a lot of unnecessary work having to be carried out.

The following section uses an example to demonstrate the full impact of the inter relationships of budgets: it does so in a wholesaling environment.

Worked example

Andy is a wholesaler of cricketing equipment: he trades in cricket bats, pads, gloves, sweaters and so on. Andy's territory covers much of the South and East of England and his business is sufficiently large that he needs to consider each product line as its own revenue centre. To this end, he prepares detailed budgets line by line. Consider the following details for his purchases and sales of cricket bats.

Andy's assessment of the coming season is that the weather will be hot and dry, and the demand for cricket bats will be high from June and for the rest of the season (until early September). After September, Andy will concentrate on his overseas business (selling to agents in India, Australia, New Zealand and South Africa).

Stocks at the end of any month is to be set at the level of 100 bats plus 20% of the number of bats scheduled to be sold in the following month.

Required

For the seven month period June to December 1994, prepare the stock and purchases budget and the sales budget: the selling price per bat is œ20 and the purchase price per bat is œ15.

Solution to the worked example

The first part of the solution to this example is the purchases budget, expressed in terms of units. The format is that we start the schedule with the opening stock, add purchases and subtract the closing stock to leave us with the sales amounts.

Once we have the units situation sorted out, it is a straight forward matter to multiply the relevant parts of the stock and purchases budget by the relevant cost and sales values, so that we obtain the stock, purchases and sales budgets expressed in terms of monetary amounts.

Interrelationship aspects

The interrelationship aspects of this example have probably not bothered us so far: the nature of interrelationships is that they often pass by unnoticed! In order to arrive at the purchases in units, we have had to determine the opening and closing stock amounts, and we were given the sales units. Thus, if we have calculated the stock budgets incorrectly, the purchase amounts will be wrong, and the purchases budget will be misleading. Similarly, an error in the sales budget guarantees an error in the purchase and stock budgets.

We can assess the extent of the interrelationships between the various budgets we are preparing by, for example, changing one of the variables involved in this example. Assume the stock levels are to be set at 50 bats plus 20% of the sales units for the following month: what effect does that have on the purchases, opening and closing stock budgets?

Expressing the results in units and values, the revised budgets are:

The workings for these revised schedules are identical to the workings for the original budgets.

The effects of what we have done are that the opening and closing stock units and values have changed, but the effect on purchases and sales has been nil. As far as sales are concerned, they are fixed anyway: everything else depends on them. Purchases can change with stock levels, but since the change to stock levels is constant between opening and closing stock, there is no overall change to purchases.

Conclusions

This page has introduced the basic ideas and theory underlying budgeting and budgetary control. We have explored the ideas underlying budgets: what they are and what they contain, whether that be monetary, qualitative or non quantitative aspects. We have also seen that budgeting needs to be used as part of a budgetary control system, otherwise budgets are merely arithmetical exercises that mean little.

We have also seen the basic elements of the budgeting process, the budget period and budget centres. Finally, this page has also shown the interrelationships that exist between the various parts of a budget and the nature and meaning of the limiting factor.

The next page in this series considers the preparation of functional budgets.

© Duncan Williamson
October, 1999

Project

For your own organisation assess as many interrelationships between the various budgets in the organisation as possible. In your search, make detailed notes of why the interrelationships exist.

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