UNIT 10. BUDGETING

Balance Sheet Budget

Statement of Financial Objectives

The Statement of Financial Objectives will set out our objectives for key areas concerning profitability, liquidity and security. Once the other budgeted financial statements have been prepared we can then complete a ratio analysis to ensure that the objectives are achievable.

It is important to be realistic in this task. For example, we might decide an ROI objective of 30% per annum is desirable yet we can only produce a budget for 15%. Something has to give! Do we try and stretch the budget to such an extent that it might become unachievable or do we modify our budget expectations? The best answer is to set objectives that are realistic but will stretch management performance. If over several budget periods the expected performance does not look like coming up to standard quickly enough, we should modify our plans accordingly.

Profit & Loss Statement Budget

The budgeted Profit & Loss Statement, Funds Statement and Balance Sheets will look just like the financial statements you have been used to looking at in other parts of this course.

In the end, all actual figures should be summarised in the same format as the budgets are prepared in to enable easy comparison and isolation of key variance areas.

The best starting point for budgeting is sales forecasting. We should prepare a sales budget using past figures as a guide. We should think very logically about potential sales in each area of the business and prepare separate sales budgets for key customers, key products and key geographical areas if necessary. We might expand these into greater detail for the sales consultant concerned. It is best if each sales consultant has a budget to achieve so that we can "manage by objectives".

The sales budget figures must follow preparation of the marketing plan. Each of the figures therefore represents the consequence of the various marketing mix inputs. In other words, each figure assumes some fundamental logic concerning pricing, commission policy, product mix, promotion, sales training, etc.

A key issue is to classify expenses as to whether they are "fixed" or "variable". Once we know what our fixed costs are (overheads) and our net profit target we can calculate the level of sales required. The method is as follows:

Net Profit Target (based on ROI objective) say                 10,000

Budgeted Fixed Costs                                                             50,000

Budgeted Contribution (a concept similar to Gross Profit) 60,000

Budgeted Contribution % of Sales say                                     10%

Budgeted Sales                                                                         600,000

Our Budgeted Profit Statement would then read as follows:

Budgeted Sales                                                                     600,000 100%

Commission say 15%                                                            90,000 15%

less Variable Costs (eg. Sales Commission)                      30,000 5%

Contribution                                                                           60,000 10%

less Fixed Costs                                                                     50,000 8.3%

Net Profit                                                                                 10,000 1.7%

Once we know our contribution margin (based on past performance), in this case 10%, we can set a sales volume target to achieve our profitability objectives. Conversely when we are given a sales volume estimate we can calculate quickly what the net profit should be by automatically saying that our contribution will be 10%, and deducting our fixed costs.

The key to this approach is identifying fixed and variable costs. It assumes that our fixed costs will remain fixed over a range of sales volume estimates. Where the range is very wide we may need to step up our fixed costs accordingly. For example, our fixed costs at a sales volume level of $600,000 will not be the same for $6 million. It is likely however they will remain fairly constant across a narrow range, eg. $500,000-700,000.

The latter figures are given purely for illustration and the actual range in real life would have to be determined for that particular situation. To illustrate, the existing floor space and therefore the rental of the agency premises might be able to cope with a sales volume of $1 million and therefore the volume range for this cost item might extend from $0-$1 million.

Cash Budgeting

Set out below is a cash budget for Jones Travel.

JONES TRAVEL

Cash Flow Budget

as at 30 June 1986

                                           JULY 1986                          AUG 1986                      SEPT 1986

The best way to remember how to do a cash flow is to recognise that total inflows refer to all the items you would expect in the future to go through your cash receipts book. Conversely total outflows would be all the items that you would expect to go through your cash payments book.

All we are doing with the cash flow budget is predicting what our bank balance will be. As you can see in the cash flow budget above the balances B/Fwd and C/Fwd are the expected opening and closing balances for the Jones Travel bank account for each month.

We started with a budgeted opening bank balance in July 1986 of $2,416 and we expected our end of July balance to be $2,065. It wasn't because it actually turned out to be $3,423, a favourable variance of $1,358. You can see by comparing each individual item that this variance was brought about by a higher than budget level of commissions which more than offset the higher level of spending.

The best kind of cash flow budget is one that will accommodate columns for budget, actual and variance. You can even be more sophisticated and include percentage columns. An ideal way of keeping track of cash flow is using a computerised spreadsheet analysis.

Budgeted Funds Statements

When we come to do a budgeted funds statement we can approach the task in two ways.

Firstly, we can list the total funds we think we can raise from all sources and then decide on a range of investments to spend this money.

Secondly, and this is the more normal approach, we can draw up a "shopping list" of prospective investments, screening them carefully in terms of their impact on liquidity, profitability and security and then decide what total funds are required to implement the investment programme. We can then set out to identify all the possible sources of funds to see if we can fund the total investment programme. In the final analysis we will have to compromise on either uses of funds or sources of funds or both.

Budgeted Balance Sheet

Once the Funds Statement is prepared we can calculate the Balance sheet very simply just by adding the sources and use figures to the last Balance Sheet figures. This is the reverse of what we did in Unit 9.

Copyright © Bill Wright 1994