How To Perform a Budget Analysis and Forecasting
How To Perform a Budget Analysis and Forecasting: Can you survive and thrive without a budget?
Understanding the background of budgeting
- An essential management tool for both planning and controlling future activity
- Detailed plan outlining the sources and uses of resources for a specific timeframe, expressed in numbers, usually for 1 year
Why budgets?
Formalize a plan
An efficient method of communication the plans to others
Setting targets
Discovering and solving any potential bottlenecks before they occur
Coordinating and integrating the plans of all parts of an organisation Budget?
- A Plan
- A Limit
- A Schedule
- A Reality Check
- An Allocation
- Why use a budget?
- Stay within a limit
- Control
- Forecasting
- Delegate
- Prioritise Wants, Organise Needs,
- Within the realm of what we Can
- Budget – How do you define?
- “A planned expression of money”
- Wright. D 1994 “A practical foundation in costing” Routledge
- For a defined activity
- Shows;
Income & Expenditure
Total estimated costs
Defined period of time
Another definition
A budget process is a system of rules governing the decision-making that leads to a budget, from its formulation, through its legislative approval, to its execution How To Perform a Budget Analysis and Forecasting.
Karl-Martin, Ehrhart, Roy Gardner, Jürgen von Hagen, and Claudia Keser
Budget Processes: Theory and Experimental Evidence, November 2000
More definitions
Budget = Quantitative expression of a plan
Budgets involve – Planning & Control
Budgeting – an informative tool
A budget clarifies
Planning cycle
Importance
Requirement to plan to meet financial responsibilities to:
Their owners
To lenders
To employees
To suppliers
To customers
How do you build a budget in a climate of uncertainty?
Preparation of budgets
Example of Manufacturing of budget
Setting budgets
Stage 1 – what do I want to achieve
Identify Output
Stage 2 – How am I going to do achieve it?
Choose the process, the way you will achieve your output
Stage 3 – What resources will I need?
Identify the inputs
Stage 4 – How much will these resources cost?
Quantify in financial terms
Types of budgets
Static vs. Flexible vs. Rolling
Methods of budgeting
Zero-based budgeting
Approach that does not consider the previous period.
We consider each activity on its own merits and draw up the costs and benefits of the different ways of performing it (and indeed whether or not the activity should continue)
We then decide on the most effective way of performing each activity.
Clearly any changes to the way an activity is performed may require funding, and there may not be sufficient funding available for all changes proposed, and therefore they are ranked to decide which changes are made
Although this approach is in principle a much better approach to budgeting, it is time-consuming. Requires much more expertise than incremental budgeting. For this reason, it is often restricted just to a few activities each year in order that training and help may be given to the people involved. Other activities are budgeted using the incremental approach.
Methods of budgeting
Incremental budgeting
This approach is to take the previous years results and then to adjust them by an amount to cover inflation and any other known changes
It is the most common approach, is a reasonably quick approach, and for stable companies it tends to be fairly accurate
Potential problem is that it can encourage the continuation of previous problems and inefficiencies
The reason for this is that the budget is a plan for the coming year – not simply a financial forecast.
If we require a wages budget, we will probably ask the wages department to produce it and they
(using an incremental approach) will assume that our workers will continue to operate as before.
They will therefore simply adjust by any expected wage increases.
As a result, the ‘plan’ for our workers stays the same as before. Nobody has been encouraged to consider different ways of operating that may be more efficient. It is at budget time that we perhaps should be considering different ways of operating.
Budget & forecast – Key to optimization
Planning and budgeting- an iterative process
There are three common budgeting methods:
Top-down Budgeting
Bottom-up Budgeting
Iterative Budgeting
Top down approach
Potentially the most common approach
Useful if you are locked into the price at which you are selling your product
Top down budgeting
Top-Down Budgeting -a budgeting process based on estimating the cost of higher level tasks first and using these estimates to constrain the estimates for lower level tasks
Top down budgeting
A crucial factor for successfully implementing this method for estimating budgets is the experience and judgement of those involved in producing the overall budget estimate.
Top down budgeting
Takes less time
Promotes upper-level commitment
Lower management better understands what upper management expects
Top down budgeting
Disadvantages
Translating long-range budgets into short-range budgets.
Problems scheduling projects in a “sub-optimal way” to meet the strategic goals
Result of top management’s limited knowledge of specifics of project tasks and activities
Top down budgeting
Disadvantages
Competition for funds among lower-level managers,
Sometimes, unhealthy competition, non beneficial to the overall objectives of the company
This process is a zero sum game–one person’s or area’s gain is another’s loss.
Managers often feel that they have insufficient budget allocations to achieve the objectives
Top down budgeting
Advantages
Aggregate budget is quite accurate, even though some individual activities subject to large error
Budgets are stable as a percent of total allocation and the statistical distribution of the budget is also stable leading to high predictability
Small costly tasks don’t need to be identified early in this process – factored into overall estimate
Bottom up budgeting
Sometimes called Zero Based Budgeting
Bottom-up budgeting begins with
identifying all the constituent tasks that are involved in putting together a functional budget or implementing a project
and
working out the resources and funding required by each
Bottom up budgeting
Provides the opportunity to create organisation level budgets by rolling up functional/project budgets
Create centralised project level budgets
Bottom up budgeting
This method of budgeting provides the following benefits:
- Project/departmental Managers have the flexibility to define their budgets independently under corporate guidelines
- Financial Managers have the ability to centrally review the total project budget/s
Bottom up budgeting
Bottom up budgeting
Disadvantages
Top management has limited influence over the budgeting process,
Departmental managers might overstate their resource needs in the expectation that the top team is going to cut their budgets
Possibility to overlook a step of a project or task/activity
Bottom up budgeting
Disadvantage
More persuasive managers sometimes get a disproportionate share of resources
A significant portion of budget building is in the hands of the junior personnel in the organisation
Sometimes critical activities are missed and left unbudgeted
Bottom up budgeting
Advantage
Is in the accuracy of the budgets for individual tasks
Clear flow of information
Use of detailed data available at project management level as basic source of cost, schedule, and resource requirement information.
Participation in the process leads to ownership and acceptance
Bottom up budgeting
Sometimes called Zero Based Budgeting
Bottom-up budgeting begins with
identifying all the constituent tasks that are involved in putting together a functional budget or implementing a project
and
working out the resources and funding required by each
Bottom up budgeting
Provides the opportunity to create organisation level budgets by rolling up functional/project budgets
Create centralised project level budgets
Bottom up budgeting
This method of budgeting provides the following benefits:
- Project/departmental Managers have the flexibility to define their budgets independently under corporate guidelines
- Financial Managers have the ability to centrally review the total project budget/s
Bottom up budgeting
Bottom up budgeting
Disadvantages
Top management has limited influence over the budgeting process,
Departmental managers might overstate their resource needs in the expectation that the top team is going to cut their budgets
Possibility to overlook a step of a project or task/activity
Bottom up budgeting
Disadvantage
More persuasive managers sometimes get a disproportionate share of resources
A significant portion of budget building is in the hands of the junior personnel in the organisation
Sometimes critical activities are missed and left unbudgeted
Bottom up budgeting
Advantage
Is in the accuracy of the budgets for individual tasks
Clear flow of information
Use of detailed data available at project management level as basic source of cost, schedule, and resource requirement information.
Participation in the process leads to ownership and acceptance
Top Down vs. Bottom Up
Top-down Bottom-up
Problems of Bottom-up Budgeting
- Difficult to control aggregate spending
- Allocations may not be optimal
- Hard to keep multi-year perspective
Top Down & Bottom Up Compared
- Bottom-up • Top-down
– Annual – Multi-year
– Time consuming – Delegated authority
– Ownership of proposals is – Creates joint ownership of
specific proposals
– Reactive – Proactive
Activity Orientated Budget
The traditional budget is activity based
Individual expenses classified and assigned to basic budget lines e.g. phone, materials, personnel, clerical, utilities, direct labour, etc
Diffused control so widely that it was frequently non-existent
Task Orientated Budget
Also known as Program Budgeting
Aggregates income and expenditures across programs (projects)
The project has its own budget
Task Orientated Budget
Pure project organisation, the budgets of all projects are aggregated to the highest organisational level
Functional organisation income/expense for each project are shown
Planning Programming Budgeting System (PPBS)
The system focuses on funding those projects that will bring the greatest progress toward organisational goals for the least cost
Basically a Program and Planning Budgeting System
Planning Programming Budgeting System (PPBS)
Identification of goals and objectives for each major area of activity – planning
Analysis of the programs proposed to obtain organizational objectives – programming
Estimation of the total costs for each project, including indirect costs. Time phasing of costs is detailed.
Planning Programming Budgeting System (PPBS)
Final analysis of alternative projects in terms of costs, expected costs, expected benefits, and expected project lives.
Cost/benefit analyses are performed for each program so programs can be compared with each other and a portfolio of projects can be selected for funding
Behavioral aspects
If the budget process is not handled properly, it can easily cause dysfunctional activity. therefore necessary to give thought to the behavioural aspects.
Participation
Top-down budgeting
This is where budgets are imposed by top management without the participation of the people who will actually be involved for implementing it.
Bottom-up budgeting
Here the budget-holders do participate in the setting of their own budgets.
Targets can assist motivation and appraisal if they are set at the right level.
if they are too difficult then they will demotivate
if they are too easy then managers are less likely to strive for optimal performance
they should be slightly above the anticipated performance level
Behavioral aspects
Good targets should be:
agreed in advance
dependent on factors controllable by the individual
Measurable
linked to appropriate rewards and penalties
chosen carefully to ensure goal congruence
Responsibility accounting
A system of accounting that separates revenues and costs into areas of separate responsibility, which can then be assigned to specific managers
Management by objectives
A system of management incorporating clearly established objectives at every level of the organisation.
Here there is less emphasis on monetary budgets and more emphasis on taking action which helps the business to achieve its objectives.
Budgeting vs. forecasting
“…the key difference between a budget and a forecast is that the budget is a plan for where a business wants to go, while a forecast is the indication of where it is actually going.”
(www.accountingtools.com)
Mater Budgets – from A to Z
Principal budget factor
Factor that limits the activity for the budget period
Normally the level of sales and therefore the sales budget is the first budget to be prepared and thereafter other budgets can be prepared that lead to the others.
If raw materials was the limiting factors, then in this case Raw Materials would be the principal budget factor, and hence would be the first budget to be prepared
Normal ordering of budgeting
1.Sales Budget
2.Production Budget
3.Purchases Budget
4.Selling and Administrative Budget
5.Cash Budget
6.Budgeted income statement
7.Budgeted Balance Sheet
Sales Budget
Detailed schedule showing expected sales from future periods both in currency and unit formats
First budget produced because all other budgets depend on an accurate sales budget
Sales Budget often combined with a schedule of cash collections
Revenue budgets
Key success factors
Draw everyone into the process.
Key part of the planning process, hence appropriate time is required
Forward/future orientated,
Allocate resources to meet future needs
Challenge any over-spending near year end
Budgets allocate scarce resources to competing needs, hence do not ask for more than your requirements
Budgeting, planning for the future is a continuous process
Budgets allocate resources based on current priorities and anticipated, which can change
The Expenditure budget
Purchases Budget
Purchases required to support production budget
Production Budget
Estimated production to support budgeted sales
Case Study, Part 1-ABC LLC
ABC produces 3 products X, Y and Z.
Prepare
(i) Sales budget (quantity and value)
(ii) Production budget (units)
(iii) Material usage budget (quantities)
(iv) Material purchases budget (quantities and value)
(v) Labour budget (hours and value)
Details of ABC
Product A 2000 units @ AED100 each
Product B 4000 units @ AED130 each
Product C 3000 units @ AED150 each
Details of ABC
1-Sales budget (units and AED)
2-Production budget
3- Materials usage budget
4– Materials Purchase budget
5-Labour budget
Labour budget hours
A 2,100u × 4 = 8,400
B 4,200u × 6 = 25,200
C 3,100u × 8 = 24,800
Total labour hours 58,400 hours
Cost /hour = 3/ hour
Total labour costs= AED175,200
Cash budgeting – no cash no budget!
Cash versus profit
Cash versus profit
What do we want more>>>>>
Or
Sales and cash collected
Are
sales = cash collected?
Attributable costs and cash spent
Why
Attributable costs (producing and delivering items sold in the period)
Cash spent
Gross Profit, Operating Profit, EBIT, PBIT….
Why cash is king?
Profit Cash
Business
Holds stock
Gives credit
Takes credit
Working capital
https://www.youtube.com/watch?v=2yrI2sM8LhI
Working capital
Current assets
Less
Current liabilities
Current assets
Planning for cash
Cash flow forecasts
What do they tell you???
If you are going to run out of cash and when
How much cash you will need
How long will you need it for?
Key plus point of cash flow forecast is that they improve your ability to borrow
Advance warning of a cash crisis
Best time to take out a loan
Planning for cash
Cash Flows
Cash conversion cycle
Capital Budgeting – have you looked at all feasible options
Capital Budgeting
Capital expenditure (CAPEX)
Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.
The amount of capital expenditures a company is likely to have depends on the industry it occupies. Some of the most capital intensive industries include oil, telecom and utilities.
In terms of accounting, an expense is considered to be a capital expenditure when the asset is a newly purchased capital asset or an investment that improves the useful life of an existing capital asset. If an expense is a capital expenditure, it needs to be capitalized; this requires the company to spread the cost of the expenditure over the useful life of the asset. If, however, the expense is one that maintains the asset at its current condition, the cost is deducted fully in the year of the expense.
Source: www.investopedia.com
Capex expenditure
Decision based on:
Availability of funds
Comparative profitability
Riskiness
Time taken to recover the investment
Capital Budgeting/investment appraisal Techniques
Payback period = Net investment required/ Net annual cash inflow
Net Present Value (NPV)- Under this approach to investment appraisal we look at all the expected cash flows that will arisefrom an investment.
If overall the investment generates a cash surplus then we will accept and invest;
if however there is an overall cash deficit then we will reject the investment.
However, we also need to take into account interest/”profit” on the investment in the project. This is either because we borrowed money and hence will be paying interest, or because we are using money that could have been otherwise invested and be earning interest/profit rate
In either case, we account for the interest by discounting the future cash flows to get the present
The overall surplus or deficit is known as the NPV
Internal Rate of return is the rate of return of an investment project over its useful life
it is computed by finding the discount rate that will cause NPV=0
Controlling and monitoring a budget, is it worthwhile?
Budgetary Control
The ability to control anticipated
expenditures for your project using a
project cost budget.
Budgetary Controls
he Projects’ Budgetary Controls feature includes the following:
- Flexible Setup of Controls
Defines Control Amounts
Defines Control Levels
- Funds Check – Performs the available funds verifications.
- Maintenance of Available Balances – Maintains the available balance for each project budget line.
Budgetary Controls
Actual Transactions;
are recorded project costs.
Examples include labour, expense report, usage and miscellaneous costs.
Commitment Transactions;
are anticipated project costs.
Examples include purchase requisitions and purchase orders or contract commitments.
Features of an effective budget
1.Accurate forecasting
2.Based on organisational goals
3.Information is timely and accurate
4.Formed with multilevel input
5.Regular reviews are built-in
Problems with budgeting
The process is too long
There is a lot of game playing
Business decisions change but the budget does not
People in charge of budget are held accountable in areas where they have no responsibility
Applying an arbitrary percentage to prior period actual
Analysing Variance
Budget deviation analysis (variance analysis) regularly compares what you expected or planned to earn and spend with what you actually spent and earned.
Variation analysis can help greatly when detecting how well you’re tracking your plans, how much to accurately budget in the future, where there might be upcoming problems in spending.
Example of a variance report
Date: June 30, 2006
Account: Product Development MONTH TO DATE
ACCOUNT REF. ACTUAL BUDGET VARIANCE %
SALARIES 5025 £48,000 £43,750 – £4,375 – 10
TRAVEL 6442 £1,500 £1,200 – £300 – 25
SUPPLIES 5320 £500 £700 £200 28.5
Benefits to checking variance
Understand the reason for the differences
Prepare a more accurate budget in the future
Evaluate budget goals
Isolate problems
Identify weak areas
Motivate managers
Communicate with all levels
Forecast
Budgeting – an effective tool for performance management
Ratio analysis
Ratio analysis
Financial statements per se despite being useful tools to measure historical situation of the company…are not enough to fully interpret the significance of the results and movements
Calculation of ratios makes it easier to compare
the financial situation of a company,
versus its competitors and
with the sector average
…over time to establish appropriate trends and benchmarks
Ratio analysis
Used to explore important relationships among key pieces of data in the different statements, allowing us to derive conclusions on:
Liquidity Short term financial position of the company
Profitability How well a company performs given its asset base
Gearing Long term financial position of the company
Investment How well investors will appraise the company
EBITDA key for investment analysts
Liquidity
A company is liquid and a “going concern” when it when it can pay its debts as they become due…
…it can pay its suppliers as it has enough cash flow and working capital
2 key ratios used to show how liquid is the company
Current ratio
Current ratio = current assets/ current liabilities
Current assets: inventory, trade receivables, cash
Current liabilities: trade payables, other current liabilities such as current tax liabilities, bank overdraft
It is called current receivable within one year
Limitations of current ratio
A business may look healthy using the current ratio due to high amount of stock (inventory)
Stock can be converted into cash but usually it takes time and hence is not the most liquid of the assets
Quick ratio ( Acid test)
Quick ratio= current assets less stock/current liabilities
Other Liquidity ratios
Inventory days= Inventory (stock)/cost of sales * 365 days
Stock turnover = Cost of sales/ Stock value
Average collection period (receivable days)= Trade receivables/revenue * 365 days
Average payment period (payable days)= Trade payables/Purchases * 365 days
Profitability
Gross Profit margin
Net profit margin
Return on assets
Gross Profit Margin
Gross Profit %= Gross Profit/revenue *100
Note: Gross Profit= Revenue – Costs of Production (of sales)
Net Profit Margin
Net Profit %= (PBIT)/revenue * 100
Gross Profit % ( previous slide)
Note: Net Profit = revenue – total costs
Note: PBIT = Profit before interest and tax
Return on assets (RoA)
ROA=net profit/net assets *100
Return on capital employed
ROCE = PBIT/ Total long term capital
Note: Total long term capital = capital+ reserves + long-term liabilities
Gearing
Gearing= Long term liabilities/ Shareholder funds
Gearing = Total borrowings / Net Worth ( Net Assets – net liabilities)
Investor ratios
P/E ratio= Market Price/ EPS
EPS = Earnings available for distribution to equity/ Number of shares in issue
Dividend yield= Dividend per share/ Market Price
EBITDA
Earnings before Interest, tax, depreciation and amortization
Measure of profitability that is a proxy to cash
Depreciation and amortization are non cash items and
Interest is outside direct management control
However
EBITDA fails to consider amounts required for fixed asset replacement
Note: This measure is highly used in the investor community
Limitations of ratio analysis
Very few ratios mean much on their won
Useful when compared with the ratios for previous years or for similar companies
Some of the ratios are based on figures from Statement of financial position
Only represent the position at one point in time, which could be misleading
Benefit of the analysis can be limited if accounting methods change and hence no comparison possible
Attend our Training on Budget Analysis and Forecasting in Dubai for your team members.
