1. Depreciation never appears in a cash budget as it is a non-cash expense.

2. In respect to credit transactions time lags have to be built into the cash budget

It is useful to have a memo column to record items which will appear in the balance sheet if required. Budgeted Profit and Loss Account for six months ending 30 June 19x1

	£	£			£
Cost of sales	480,000			Sales	1,200,000
Direct wages	300,000	780,000
	----------
Operating profit		420,000
		----------			-----------
		1,200,000			1,200,000
		=======			=======
Depreciation				Operating profit	420,000
Premises	7,500
Plant	4,000
Equipment	8,000
Tools	2,000
	-------	21,500
Other expenses		240,000
Net profit		158,500
		----------			----------
		420,000			420,000
		======			======

The profit and loss account is prepared on an accruals basis unlike the cash budget which is prepared on a receipts and payments basis. Also, depreciation appears as an expense in the profit and loss account.

Budgeted Balance Sheet as at 30 June 19x1

Authorised and Issued Capital	£		£	£	£
		Fixed assets	Cost	Dep.	NBV
600,000 Ord. shares £1 each	600,000	Premises	300,000	7,500	292,500
Reserves		Plant	80,000	4,000	76,000
Profit and loss account	158,500	Equipment	160,000	8,000	152,000
		Tools	20,000	2,000	18,000
			---------	--------	---------
			560,000	21,500	538,500
			---------	---------
Current Liabilities		Current assets
Creditors	48,000	Materials	10,000
Accrued expenses	40,000	Debtors	120,000
		Cash	178,000		308,000
	--------		----------		----------
	846,000				846,000
	======				=====

Budgeted debtors, creditors and cash balance is obtained from the cash budget. Details of fixed assets can be obtained from the capital expenditure budget. Information about share capital, debentures etc. can also be obtained from the previous balance sheet.

Budgeting - the Control Process

Definition:

Budgetary control is the establishment of departmental budgets relating the responsibilities of executives and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision. The budget itself is merely a plan on paper which of itself will not be effective unless there is a system of control which can monitor the organisation’s progress to achieving the objectives.

By means of comparing actual results with the budgets and identifying any differences (variances) which occur management can take remedial action or revise the budget if necessary. The annual budgets are broken down into months so the comparison is performed regularly and results in a budget report ipresented to the departmental managers. To ensure that management are not overburdened with accounting data exception reports may be furnished. These reports identify only significant variances that require management’s attention and consequently are more user friendly and should encourage an appropriate managerial response.

Personnel Dept Monthly Budget Report February

Cost code	Description	Budget	Actual	Variance	Budget	Actual	Variance
010	Supervisors’ salary	£58,000	£65,000	£7,000 (A)	£116,000	£125,000	£9,000 (A)

Flexible Budgeting

Up to this point the budget has been fixed. This is quite appropriate for planning purposes but of little use for control purposes. The fixed budget does not respond to the actual level of activity. When organisations compile the master budget it is

based on a certain level of output and sales. In most instances, the company may find that this operating level is not set at the actual level of activity. Indeed most organisations find it difficult to forecast the actual level of activity eg. there may be a seasonal characteristic to the company’ trading. In such cases the business may find it more useful to prepare flexible budgets. A flexible budget is ‘designed to change in accordance with the level of activity attained’ (CIMA)

A fixed budget is not designed to change with different levels of activity. It does not allow for the pre-determination of costs and revenues at different levels of output which would facilitate comparison with actual costs and the identification of variances.

A flexible budget is designed to recognise cost behaviour at different levels of output so actual results can be compared with the expected results and the computation of variances and variance analysis is made possible.

Example:

A company produces garden furniture which experiences fluctuations in production levels because of its seasonal nature. The following costs for the budgeted level of activity of 20,000 units and the actual production costs fpr the period are given.

	Budget Costs (20,000 units)	Actual costs incurred (17,600 units)
	£	£
Materials - variable	21,000	20,000
Labour - variable	1,000	980
Maintenance - variable	3,000	2,680
Fixed production costs	10,000	10,000
Selling costs - fixed	5,000	6,000
	--------	--------
	40,000	39600
	--------	--------

During the relevant period, the actual number of units produced was 17,600. You are required to prepare a budget flexed at the actual level of activity. In preparing the flexed budgets it is important to identify fixed and variable costs to forecast costs at different levels of activity.

	Actual costs	Flexed budget (17,600 units)	Variance
	£	£	£
Materials	20,000	18,480	1,520 (A)
Labour	980	880	100 (A)
Maintenance	2,680	2,640	40 (A)
Fixed productioon costs	10,000	10,000	-----
Selling costs	6,000	5,000	1,000 (A)
	-------	-------	-----------
	39,660	5,000	2,660
	--------	-------	----------

The variance report highlights that in respect to actual materials, labour, maintenance and selling costs, these are higher than expected. Management can examine and analyse the variances and take appropriate action.

Many businesses prepare fixed budgets for departments where expenditure may be more predictable such as the administration department. Flexible budgets can be compiled for those departments whose expenditure is closely linked to the level of operations such as the production department.

The Human Element in Budgeting

So far the emphasis has been on the technical aspects of budgeting viz. the preparation and administration of budgets. However, the behavioural context deserves mention. One of the main components of budgeting is control which is all about altering the behaviour of the human resources in the organisation. Consequently, there may be some staff who regard budgets as a constraint on their freedom and may try to subvert the effectiveness of the budget. How can senior management ensure that the budgeting system can be most effective?

Research findings assert that managers prefer to work towards achieving objectives which motivate them. It appears that motivation is the glue which holds the budgeting and control systems together so creating this motivation is the key. There appear to be a number of factors involved.

1. Budgets (targets) should be set at a level which are stringent and challenging but attainable. If set too high to be unattainable the staff may be demoralised and may not try to achieve the targets.

2. Departmental managers in consultation with their staff should be permitted to participate in the setting of their budgets by so doing they will have ownership of them and will strive to attain them. Participation clarifies responsibilities, increases communication throughout the organisation and can help to promote line-staff relations. However, it is well to acknowledge possible dysfunctional behaviour as a consequence of participation in budget-setting such as ‘budgetary padding’ or ‘budgetary slack’. It may serve the manager to build ‘slack into the budget ie. to have a ‘pad’ between the formal plan and the expected actual results so that they have a cushion in case unanticipated events cause their performance to decline.

3. Since budgets tend to be used as a management performance criteria there should be a reward system in place. Too often budgets are used as a mechanism to focus on poor performance so is it any wonder that the staff have negative feeling about them.

4. Overemphasis on performance/variance reports may encourage negative attitudes to budgeting. Hopwood referred to the ‘budget constrained’ style of management with performance in meeting the budget as the main criteria.

The organisation should be concerned with other management performance criteria such as concern with quality, good industrial relations, cooperation with colleagues etc.

There are significant benefits for organisations which engage in budgeting.

1. Budgeting forces management to focus on the future, to consider the dynamics of the external environment and identify the potential opportunities and threats.

2. In the process of preparing the budgets managers are compelled to co-ordinate the various activities of the organisation and to be less ‘departmental minded’ and to be more ‘company minded’.

3. It tends to encourage communication throughout the organisation. Staff are aware of what they are expected to achieve and regular budget reports and budget meetings keep them informed.

4. By assigning managerial responsibility for the attainment of the budgets and the regular comparison of actual results and expected outcomes individual managerial performance can be ascertained.

5. Research has indicated the role budgets have in motivating managers to achieve the company’s objectives. Good performance can lead to career advancement so the managers desire to be successful is linked to the success of the company.