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Factors in Business Cash Budgeting: With Examples

Contents (Jump to)
Task One (p3d) XYZ Traders – Cash Budget
Task Two (p3abc) Alpha Manufacturing – Budgets
Task Three (p4abc) Beales Manufacturing – Variances
Task Four (p2ab) Beales Manufacturing – Standard Cost
Bibliography

XYZ Traders – Cash Budget Introduction
In this report Part A presents a cash budget for XYZ Traders for the six month period from December 2008 to May 2009. Part B comments on the cash flow forecast and outlines the benefits of improved cash flow for the Company and recommends management consider a cash flow improvement program.
Part A – Cash Flow Budget December 2008 – May 2009
Table 1
Table 1 shows the cash flow budget based on the following criteria:
Cash balance as at 1 December 2008 totals £2,600
Furniture units sold at £100 each
Furniture units purchased for £60 each
Customer collections on the basis of 50% in month of sale and the balance the following month
Purchases paid for in the month following delivery
Fixed expenses are £4,000 per month
Loan repayment of £10,000 due in April 2009
Stock units carried over from October into November 2008 unknown
Part B – Budget Cash Flow Commentary
The cash flow budget/forecast for the next six months:
is cash positive for each of the six months under review
will generate sufficient cash for the £10,000 loan repayment on schedule in April 2009
will allow supplier payment on time one month after receipt of goods
has a lowest cash balance of £1,200 at the end of April following the loan repayment in the same month
Recommendation – Cash Flow Improvement Program
The cash flow budget indicates that XYZ can continue trading for the next six months without recourse to additional funding. However improving cash-flow can have a number of benefits including:
reducing the equity required to finance the business
reducing loans and interest payments required for working capital
releasing funds for expansion and/or new business activities
providing funds for profit distribution to the owners/shareholders
We recommend management plan and implement a coordinated program to improve cash-flow. Specific areas for consideration are:
minimise inventory by introducing a “just-in-time” (JIT) arrangement where suppliers orders are placed at the time of customer purchase for receipt a day or two before delivery to the customer
eliminate inventory (except for show-room stock) by arranging for suppliers to deliver direct to customers under XYZ Traders instructions and identity
negotiate extended payment terms with the suppliers, say, three months credit
encourage customers to pay the full purchase price on order placement
offer sales on credit with a reputable finance company
increase sales volumes with well designed and executed advertising and customer incentive programs
reduce overheads and expenses with a cost-reduction program
Alfa Manufacturing – Budget Report Introduction
This report recommends Alfa Manufacturing introduce a budgetary control system. Section A outlines the purpose and benefits of budgets and Section B describes two possible budget formats, incremental and zero based budgeting and examines the advantages and disadvantages of each method.
Section A – Budgets, Purposes and Benefits
The primary purpose for introducing a budgeting system is to provide the Company with a powerful tool for planning and monitoring business performance. It improves productive effectiveness and enhances coordination between the various arms of management to achieve the overall Company aims. Budgets represent the primary means of communicating agreed-upon objectives throughout the organization.
A budget is a formal written statement of the Companies plans for a specified time period. The principle element of a budget is to plan and predict future income and expenditure against a time-scale, usually on a monthly basis covering a calendar or accounting year. Actual income and expenditure is recorded as it occurs and monitored on a regular basis against the plan or budget. The differences between planned and actual results are monitored, reported and the variances analysed and explained.
In summary, the benefits of a budget are that:
Management must develop a comprehensive plan for the future.
Key objectives are agreed for monitoring and performance evaluation.
Potential problems are identified well in advance.
Coordination of activities within the business is facilitated.
Management is more aware of the Companies overall operations.
Each level of management participates in the planning, preparation and monitoring of financial activity.
The budget must have the complete support of top management and is an important tool for measuring and evaluating managerial performance. Contemporary budgeting has been defined as a system wherein managers are provided with the flexibility to utilize resources as required, in return for their commitment to achieve certain performance results (Deloitte Touche Tohmatsu, 2008).
Section B – Budgeting Systems
This section contrasts and compares two basic budgeting methodologies currently in use in industry today, Incremental Budgeting and Zero Based Budgeting.
Incremental Budgeting (IB) is the traditional approach to budgeting which relies on historical information and the previous years budget as a basis for the preparing the input and data for the following year’s budget. For example, let’s say last year’s sales budget was for 1000 units at £500, giving sales revenue of £500,000. For next year’s budget the market for the product is anticipated to improve by 10% giving unit sales at 1100 thus giving budget sales revenue of £550,000. Similarly costs would be based on last years budget, modified by projected inflationary factors. Anticipated raw material price increases and labour rates are used in the cost of production and increases in say, rent and utilities would reflect in overheads. Managers will prepare their individual budgets based on a series of pre-determined criteria and assumptions which are normally provided by top management, finance and accounts.
The advantages of IB are that it is:
relatively easy to implement
easy to understand and appreciate
less time-consuming to prepare than ZBB
a “top down” approach with the same basic assumptions for all
The disadvantages of IB are that it:
assumes that the budget methodology and cost structure is correct
encourages expectations of inflationary increases
predicts sales will reflect the market without competitive analysis
encourages departments to spend all of their allocated budget
Zero Based Budgeting (ZBB) is an approach to budgeting that starts from the premise that no costs or activities should be factored into the plans for the coming budget period, just because they figured in the costs or activities for the current or previous periods. Rather, everything that is to be included in the budget must be considered and justified. (Chartered Institute for Public Finance and Accounting, 2006). Another definition is the use of budgets which start from a present base of zero and regard all future expenditure as being on new items rather than a continuation of existing ones. In practice this means that a budget has to be justified in full for each year of operation (Steven A. Finkler, 2003). In implementing this process each manager must critically examine his own activities and operations and build his budget from scratch.
The advantages of ZBB are that it:
questions accepted beliefs
focuses on value for money
links budgets and objectives
involves managers leading to better communication and consensus
can lead to better resource allocation
is an adaptive approach in changing circumstances
The disadvantages of ZBB are that it:
is time-consuming and adds to the effort involved in budgeting
can be difficult to identify suitable performance measures
can be seen as threatening–careful people management is required
is about costs and resources of options ignoring current practice
can be difficult to comprehend and execute by managers with little financial knowledge and skills
Recommendation
Since Alpha Manufacturing has no previous experience of budgetary control it is recommended that an Incremental Budgeting program is introduced initially. The budget can be prepared using historical data with guidelines and assumptions provided to each manager by the Finance Department.
Beales Manufacturing plc: Flexible Budgeting Introduction
This report examines the budget and actual results for October. It flexes the budget to actual output, provides a variance analysis and identifies possible causes for each negative variance. Managerial accountability for each variance is suggested and possible remedial actions for the unfavourable variances identified. The benefits of using flexible budgets are explained and it is recommended that this technique be introduced as a feature of Beales’ regular budget reviews.
Variance Analysis and Explanations
Table1 shows the results of the budget and actual output for October, flexed to actual output with each variance examined for possible causes, accountabilities and suggested remedial actions.

Benefits of Flexible Budgeting
Static budgets have the disadvantage of providing a single specific predicted volume of output. In reality, it very unlikely that the actual output exactly matches the budget. Thus any comparison of actual output to budget suffers from the problem that some of the variances, particularly for variable costs such as labour and materials, will be as a direct result of the differences in the volume of output.
Flexible budgets provide an after the facts device to tell what it should have cost for the volume level actually attained (Steven A. Finkler 2003) They are a useful tool for analysing the effects of variations in volume of output against the original budget. Dennis Caplan (2006) suggests that “the motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10,000 units, then management should compare actual factory costs for 10,000 units to what the factory should have spent to make 10,000 units, not to what the factory should have spent to make 9,000 units or 11,000 units or any other production level.”
Recommendation
For Beales Manufacturing to make the best use of the budgeting process it is recommended that flexible budgets are prepared each month. Variance analysis as demonstrated above will assist management to implement contingency plans to correct any unfavorable trends and enhance profitability.
Beales Manufacturing plc: Standard Costing Introduction
This section defines and describes the principles of Standard Costing. It is an accounting technique which provides a powerful tool for management to analyze business performance and plan improvements. An example of a standard cost is derived from the October budget and the use of variance analysis to identify problem areas and possible remedial actions.
Definition
Standard costing involves the development of a product or service cost using estimates of both the resources consumed and the prices of those resources. The standard cost may then be increased by an estimated profit margin to produce a standard selling price. These estimates of cost and revenue then provide a foundation for further planning and control (Barrie Mitchinson 2000)
Illustration
The best way to illustrate the benefits of standard costing is to use the October budget data to arrive at an example of a Standard Cost. This cost can then be compared with the actual unit cost for October and the variances analysed as shown in Table 3 below.
Standard Unit Cost vs. Actual (October)

From this analysis specific product cost information can be derived. For example, although raw material costs per meter were below standard cost, more material than standard was required to complete the production schedule. Why was that? The manager responsible for production will be able to use the information to investigate the unfavourable variance. Possibly scrap rates were excessive so improved quality control could help reduce or eliminate the problem. Raw material costs were also above standard which will alert the purchasing manager to an overrun of purchasing costs which may require action.
Recommendation
We recommend that Beales consider the introduction of Standard Costing to provide management with a powerful tool to improve efficiency, productivity and product profitability.
Bibliography Deloitte Touche Tohmatsu, 2008, Budgeting

Traditional Costing Method vs ABC

Introduction In this essay we will discuss the traditional costing method and consider the alternative method offered by Activity Based Costing (ABC) technique. We will discuss how the two methods differ from each other and also from the direct costing systems. The essay will also evaluate the value added by each costing system within a company’s decision making process, in terms of the accuracy of information they provide.
Cost systems differ in terms of which costs are allocated to the cost objects i.e. product, service etc and also in terms of their levels of allocation ingenuity. There are three main cost systems in existence, namely, the direct costing system, the traditional absorption costing system and the activity based costing system.
The direct costing system as suggested by its name, only allocates direct costs to the products or services; it does not attempt to allocate indirect costs. Therefore, it reports only the contribution attributable from the product or service towards indirect costs incurred by the business. It is often referred to as a partial costing system. The direct costing method is only pertinent for decision making process where the indirect costs are small part of the overall organisational costs or does not fluctuate greatly to changes in demand.
Both the traditional and ABC system assign indirect costs to the product or service to give full costing information to the organisation in its decision making process.

As illustrated in figure 1.0 above, there are two systems of assigning indirect costs to cost objects, namely, traditional costing system and ABC system. The traditional costing system has been in use since early 1900 and is still being used today. The traditional costing method relies to a large extent on the use of arbitrary cost allocation, commonly the use of either labour or material absorption rate.
Decision Making In order for companies to make viable decisions, they require accurate product costs. Without sufficient allocation of indirect costs it would be difficult for companies to differentiate between profitable and loss-making products and services. Therefore cost systems needs to accurately reflect the consumption of resources by products, otherwise, product costs will be distorted and profitable products will be discontinued or rejected by the company and loss-making ones will be continued.
Traditional costing system varies greatly in the level of sophistication to that of ABC in allocating indirect costs to the cost object. There is a general consensus that the traditional system is simplistic whereas ABC is more complex in its allocation technique. Therefore, traditional cost systems are inexpensive to operate, as it extensively uses an arbitrary cost allocation and results in low levels of accuracy. This in turn leads to higher cost of errors in product decisions being undertaken by organisations. ABC on the other hand, is more expensive to operate as it makes extensive use of cause and effect cost allocations (use of cost drivers), but results in greater levels of accuracy and leads to less errors in decision making process.
Traditional vs. ABC The ABC system devises a number of activity based cost centres, whereas with traditional systems, overheads tend to be pooled by departments (cost centres).
Traditional costing method like ABC system use a two-stage process to allocate indirect costs, with the first stage comprising of overhead being allocated to departments both production and service, the service departmental costs are subsequently reallocated to production departments. ABC, however, assigns overheads to individual activity instead of departments. The second stage of the allocation process involves allocating costs from individual departments under traditional method and activity cost centres under the ABC system, into the cost objects. The traditional system uses only a small number of second stage allocation bases, which are linked to volume produced. ABC system on the other hand uses a large number of second stage cost drivers; including non-volume based drivers i.e. number of production runs, number of purchase orders etc.
In summary, the major distinguishing features of ABC system to that of the traditional method is that, a greater number of cost centres together with a variety of second stage cost drivers exist. This result in the ABC system delivering more accurate measurement of resources being consumed by a cost object, ensuring that management undertakes correct decisions.
Conclusion ABC came to prominent during the 80’s as a result of the limitations of traditional costing method and its value to decision making process of large blue chip organisations. In today’s volatile market place where blue chip organisations are involved in the production and delivery of complex products and services, the traditional costing system and its use of volume based cost drivers like direct labour hours represent only a small fraction of total object costs.
Volume based cost drivers assume that product’s consumption of overhead resources is directly connected to units produced. The use of volume based drivers to allocate indirect costs, which are considerably larger, results in inaccurate product costs and provides management with information which is of minute or no value. In fact the organisation runs the risk of making incorrect decisions about its profitable and unprofitable products and services which could result in financial ruin for the organisation and threaten its long term survival.
Therefore, unsophisticated volume based overhead allocations using a declining direct labour cannot be warranted, principally when information processing costs are no longer a barrier to introducing more sophisticated cost systems like ABC. Furthermore, the intense global competitiveness within the market place had made decision errors due to poor cost information more probable and more costly.
Therefore, with use of traditional costing system, misleading information is reported. However, ABC system recognises that overheads are caused by other factors, beside volume, and it allocates overheads based on cause and effects, resulting in more accuracy in organisational decision making.
However, surveys of management accounting practices continue to present evidence of organisation’s still using traditional costing. Hughes, S.B. and Paulson Gjerde, K.A. (2003) carried out a survey of US manufacturing companies and reported 35 per cent of respondent using traditional costing and a further 30 per cent using a combination of traditional with ABC. Therefore, it is evident that traditional costing still provides information which is useful for blue chip Company’s decision making process, but they must use the information only with the knowledge of its drawbacks.
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References

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