Basic Budgeting For Non-Financial Professionals

3/25/2018 Skillsoft Course Transcript
Course Transcript
Basic Budgeting for Non-financial Professionals

Course Overview
Read the Course Overview .
Fundamentals of Budgeting
1. Attributes of an Effective Budget
2. Planning a Budget
3. Sales, Production, and Cash Budgets
4. Historical Budgeting
5. Zero-based Budgeting
6. Budgetary Variance Analysis
7. Capital Budgeting
8. Performing Budget Calculations
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Course Overview
[Course title: Basic Budgeting for Non-financial Professionals] It's not only the folks in the finance
department who have to plan and monitor budgets. It's actually in everyone's best interest to have some
basic budgetary knowledge. In this course, you'll learn about planning an effective budget, the stages
involved, and different types of budgets. You'll also be introduced to Historical and Zero-based
budgeting, variance analysis, capital budgeting, and performing budgeting calculations.
Attributes of an Effective Budget

Learning Objective
After completing this topic, you should be able to
recognize the attributes of an effective budget
1.
[Topic title: Attributes of an Effective Budget] Many organizations have a clear idea of what position they
wish to be in financially, but lack a realistic plan to get there. This is where the budget comes in. Simply
put, a budget is a document that outlines how an organization's financial resources are allocated to
specific activities.
But is creating a budget really that important? Well, it can benefit an organization to know how money
will be spent. This, in turn, makes it possible to plan where funds go ahead of time. Budgetary planning
also motivates different departments to coordinate with one another. This coordination helps ensure
everyone is realistic about how much funding they can expect. Another benefit is that budgeting
encourages interdepartmental collaboration when it comes to production activities. Basically, it's a good
way to – literally – get everyone on the same page.
Unfortunately, sticking to a budget is often perceived negatively. Employees may view it as the company
trying to micro-manage their every move. If large amounts of money are allocated to certain
departments, this may seem like favoritism.
As you can imagine, this may lead to interdepartmental conflict. If employees associate how much – or
how little! – money their department receives with how much they're valued, managers may not want to
keep accurate records. This can cause inflated budgets.
Then there are inflated egos – some managers may feel the need to request more money than they
actually need, to appear important. This is a great waste of money and such a budget will be ineffective.
At this point you may be asking yourself what exactly, then, would make an "effective" budget.
Well, a truly effective budget relies on various elements and strategies. One of these strategies is to
involve key individuals from various departments during the planning stages. These people may have
valuable insight and perspectives that you may not have considered. Encouraging broad participation
across all departments helps reduce the risk of employees being unhappy with the final budget.
Another characteristic of an effective budget is that it defines business goals in quantifiable terms – in
other words, the outcomes such as time and money spent, must be measurable. If your budget provides
quantifiable data, it will be easier to monitor financial progress on a regular basis.
Because circumstances can change very quickly, an effective budget should be able to adapt to
whatever happens. There should be enough flexibility in your budget to take advantage of opportunities
and respond to obstacles that are bound to pop up.
Taking the time to create an effective budget is one of the most important contributions you can make to
the success of any business.
Planning a Budget
Learning Objective
recognize the phases of the budgetary planning process
1.
[Topic title: Planning a Budget] When planning a budget, it may be tempting to rush through it so you can
get going with the project. However, budgetary planning is not a race – it's a journey. And there are
some very important stops you have to make along the way. Your planning process needs to go through
a few crucial phases if you want your budget to be effective in the long run.
So where do you start? Well, the first phase in planning your budget involves figuring out where the
goalposts are – the strategic objectives you're aiming for. Those need to be nailed down first. And to do
that, you need to know in what direction the business is headed – by asking senior executives questions
about the company's goals, weaknesses and strengths, if you need to.
For example, if there's been a change in safety regulations, a company that manufactures car seats may
want to ramp up production to meet the new requirements. So their budget would need to reflect these
new strategic goals.
Okay, so you know where you're headed, financially. But you can't get there alone. So for the next phase
in planning the budget, you need to get input from the relevant people to decide how business activities
will be performed. It may be useful to set specific targets. But remember, for targets to be realistic, you
should consult the key players in the organization.
So for the car seat manufacturer, this could mean determining the number of car seats they aim to
produce and sell during each financial quarter. And they'll establish which extra activities may need to be
performed by various departments to reach that target.
Once the targets and activities are defined, the next phase in the process is estimating the resources
you need. When we say resources, we mean not only money, but also time from employees and
materials.
In the example of the manufacturing company, this may mean getting rough estimates on how much
upholstery, fiberglass, and so on they would need to produce their target number of car seats. This may
also include calculating whether extra personnel may need to be recruited for a particular production
period.
After completing the estimation phase, it's time to move on to the last phase – providing each
department with a detailed budget. This is where things may get tricky. You may need to do some careful
negotiation to keep everyone happy. The budget may also need to be amended a few times before it's
finalized. But once the details have been agreed upon by all parties concerned, the Master Budget can
be created. The Master Budget then serves as the company's "financial road map" – to control and
monitor the progress of projects.
To ensure you end up with an effective Master Budget, it is in your best interest to be thorough in each of
the phases of budgetary planning.
Sales, Production, and Cash Budgets

Learning Objective
distinguish between different budget elements and the type of budget to which they
apply
1.
[Topic title: Sales, Production, and Cash Budgets] Keeping track of finances for the various departments
within an organization, can be tricky. This is why having a well-designed Master Budget is so important.
The Master Budget is a container for the different functional budgets created during the budget planning
process.
These include the sales, production and cash budgets. The Master Budget may also contain others –
the administration budget, the research and development budget, and the capital budget.
But let's not get ahead of ourselves. What do we mean when we talk about "functional budgets?"
The sales budget is one of the most common functional budgets. [A sample sales budget table is shown
with five columns, four for financial quarters and one for annual, each against three rows for 'Estimated
sales volume,' 'Projected sales income,' and 'Total forecasted sales.' The 'Estimated sales volume'
records the number of units and the 'Projected sales income' records the income per unit.] You'll usually
prepare the sales budget first, since its content may impact other budgets. It contains two types of
information: the estimated sales volume – the number of items you predict you'll sell – and the projected
sales income – how much the business will earn as a result. Information in the sales budget can be
organized according to quarters, seasons, or regions.
Once you've done the sales budget, you create your production budget. [A sample 'Production Budget'
is shown. It has columns for four financial quarters and a budget year, each against five rows for
'Estimated sales volume,' 'Desired ending inventory,' 'Total needs,' 'Less beginning inventory,' and 'Units
to be produced.'] This budget helps ensure the company produces a sufficient number of units to
support the total sales you're aiming for, as outlined in the sales budget.
So a production budget essentially outlines how many units need to be produced in a particular budget
period. To determine the number of units to be produced, you need to know three values – the estimated
sales volume, the beginning inventory, and the desired ending inventory.
To start calculating the number of units to produce, you add the estimated sales volume – as defined in
the sales budget – to the desired ending inventory. And because there may be some inventory left over
from the previous budget period – known as the beginning inventory – you subtract this from the
calculated number of units to determine the actual number of units required.
Aside from the sales budget's objectives, your production budget also needs to consider other factors –
your factory's capacity, the direction of stock movement, as well as outside purchases.
Once the production budget is done, you create the cash budget. A cash budget gives you an overview
of how cash flows in and out of your business during a specified period.
Cash outflows can include things like wages and loan repayments, while cash inflows typically involve
sales of goods or services. Your cash budget will also stipulate how much cash you have on hand at the
start of the budget period, and how much – if any – you'll have left over at the end of the period.
You can estimate the ending cash balance by adding the beginning cash on hand to the inflow; then you
subtract the cash outflow from that amount.
The Master Budget summarizes all the functional budgets, thereby providing a global view of all the
budgetary information. While these budgets may vary, the sales, production, and cash budgets are the
ones you'll most likely be dealing with.
Historical Budgeting
Learning Objective
recognize the advantages and disadvantages of historical budgeting
1.
[Topic title: Historical Budgeting] It can seem daunting to prepare a budget. You need to make lots of
important decisions, after all. One of the most important of these, is which budgeting method you're
going to use.
There are two commonly-used approaches: Historical budgeting and Zero-based budgeting. While these
two can be used individually just fine, they can also be used together. But deciding which approach to
use, is up to you.
"Historical budgeting" means using a previous budget as basis for creating a new one. It's also
sometimes referred to as Traditional or Incremental budgeting. Because you use an existing budget as a
starting point, and just tweak it a little, this approach relies on the assumption that the organization's
strategy hasn't changed from budgeting period to another. However, in reality, this is rarely the case.
But on the positive side, it will save time and money, since you won't need to start a budget from scratch.
Also, because you're using a budget that's been applied before, you'll know what works and what
doesn't.
Let's consider the example of a company that manufactures work clothing. The company has a ten-year
contract with another manufacturer as the sole supplier of their workwear. Now in the sixth year of the
contract, none of the original terms have changed. So a Historical budgeting approach may be ideal in
this instance, since unexpected changes are very unlikely. Also, since this approach saves time and
money, resources can be spent in other areas where they are needed more.
The biggest disadvantage of the Historical budgeting approach, however, is that it does not allow you to
deal with change effectively. In the ever-changing business landscape, relying on the assumption that
everything will remain the same is risky. The truth is that your economic circumstances and
organizational focus may change at any time. The approach also doesn't allow for regular opportunities
to rethink the status quo. Reviewing a budget can give you the opportunity to rethink your business
goals and find ways to improve the way you work. But if you're merely recycling budgets, this type of
analysis and rework is not bound to happen.
Imagine, if you will, what may happen if your budgeting approach can't adapt to a change in regulations
or any other part of how you conduct business. If your budget is set in stone, another supplier could take
a long-standing customer away from you.
Because effective budgeting governs the success of any business, you need an approach that works.
The Historical budgeting approach can save you time and money, but its lack of flexibility is a
consideration.
Zero-based Budgeting
Learning Objective
recognize characteristics, advantages, and disadvantages of zero-based budgeting
1.
[Topic title: Zero-based Budgeting] Crunching the numbers for a budget is not always an easy task. To
ensure the budget you're planning is effective, you can use one of two approaches – Historical
budgeting or Zero-based budgeting. These two are standalone, but can be used together – if you
understand the difference between them and the pros and cons of each approach.
The Zero-based budgeting approach is simple – you start the budget from scratch, or point zero.
When using this approach, you need to be able to justify the effectiveness and necessity of each activity
before it's accepted into the budget. This compels you, or any other budget planner, to reconsider the
value of activities. You may need to come up with alternative solutions to any problems you encounter.
The main benefit of using Zero-based budgeting is that it encourages innovation – you consider change
and allow for flexibility. Instead of passively accepting the current way of planning a budget, you adopt a
questioning attitude. You re-evaluate each outlined activity and approach it from a fresh perspective.
Zero-based budgeting assumes nothing and questions everything. By following this type of approach,
you may come up with new and innovative solutions to old problems.
Of course, Zero-based budgeting also has a downside. The two main disadvantages are – it can be time
consuming and costly. Starting each budget from scratch and reevaluating every activity, will inevitably
take up a great amount of time, manpower, and resources. So it's advisable to run a cost-benefits
analysis before deciding on this approach. It may turn out not to be worth the cost, in which case you
should consider a different approach.
You could consider using Zero-based budgeting in conjunction with Historical budgeting. By using Zero-
based budgeting periodically, and relying on Historical budgeting in the interim, for example. Or you can
decide to only use Historical budgeting in the more predictable areas – where procedures are well
regulated, for instance, such as in the banking sector – and apply Zero-based budgeting in departments
such as R&D where more innovation is needed.
When considering using the Zero-based budgeting approach, you'll be wise to consider its pros and
cons before you decide if it suits your organization's needs.
Budgetary Variance Analysis

Learning Objective
recognize variances that are worth analyzing
1.
[Topic title: Budgetary Variance Analysis] Any budget involves a certain amount of speculation and
guesswork, and there may be some miscalculations. So how can you ensure that your costs and
revenues won't come in much higher or lower than calculated? Unfortunately I can't predict the future,
but there are various analytical tools that may help. One such tool is budgetary variance analysis.
So what exactly does "variance" refer to? Simply put, a budget variance is the difference between the
amount you budgeted for, and the actual amount. Because life hardly ever goes according to plan,
actual results will often differ from what you planned for in your budget.
Variances can be positive or negative. Negative variances are sometimes referred to as "adverse
variances," while positive variances are also referred to as "favorable variances."
If actual results are less than what you budgeted for – that's negative variance. This can happen for
many reasons, including cost overruns, increased tax liabilities, or a drop in sales.
A positive variance, on the other hand, is when the actual results exceed what you forecast in the
budget. This can happen if tax rates or expenses are reduced, or if you have an unexpected surge in
sales.
To check whether your budget sets realistic goals, you need to run a variance analysis and review the
reports you get as a result, at regular intervals. If there are positive or negative variances – big or small –
you need to know about them ASAP. You can then decide if they're worth investigating and make
changes if you need to.
A variance report reveals the difference between the financial outcome planned in your budget, and the
actual outcome. The report usually displays the budget year, the budget items being monitored, the
actual results, the planned results, and the variance. The variance can be displayed as an amount or as
a percentage value.
Variances are more likely in some budget items than others. Budget items like direct wages, cost of
materials, and overheads, for instance, should always be included in your variance reports.
However, not all variances are significant enough to be cause for worry. If you were to investigate each
and every variance, that may be a waste of time and manpower. Luckily, there are criteria to help you
decide whether to investigate variance or not. You should consider things like size, whether the variance
is positive or negative, the likelihood of it happening again, and its controllability.
The size of any variance is probably the most important factor to consider. You need to ask yourself if
the size of the variance is large enough to be cause for concern. If a variance is particularly large, you
might want to consider running reports more often.
So to stay on track in reaching your financial goals, monitoring any variances in your budget is great –
allowing you to monitor progress and make adjustments as necessary.
Capital Budgeting
Learning Objective
recognize the key characteristics of the three methods for capital budgeting
1.
[Topic title: Capital Budgeting] When making investment decisions, always remember to "look before
your leap." And that's where capital budgeting comes in.
Capital budgeting is a "blanket term" for all the different ways to assess if an investment is a good one.
Basically, you use it to figure out whether an investment is likely to be worth your money by being
profitable.
One capital budgeting method is the Payback Period, or PP. It focuses on how long it will take a
company to recover the amount it's investing. The PP method is typically used to screen potential
investments. It's fairly simple to understand and calculate – it lets you do a quick comparison between
various investments based on their payback period.
To calculate the payback period, you divide the initial investment by the cash flow. Generally, the shorter
the payback period, the less risk is involved. And less risk means a better investment.
One drawback of the PP method is it doesn't consider the company's cash flow after the payback period.
Nor does it consider the changing value of money over time. So the PP method is best used with other
capital budgeting methods.
Another method for capital budgeting is the Net Present Value, or NPV. The NPV is the present value of
all expected cash flows combined. To calculate NPV, you subtract the total present value of investments
from the total present value of returns. Basically, a positive NPV means a good investment.
The NPV method is great for comparing mutually exclusive projects. But it's sensitive to discount rates
and time periods.
Another method you can use to appraise investments, is the Internal Rate of Return, or IRR. An
investment's IRR value is the interest rate that brings NPV to zero. Basically, the IRR method indicates
the breakeven rate at which your cash inflows and outflows will be equal. As a general rule of thumb –
the higher the IRR, the better the investment.
To calculate IRR, you divide the net cash flow by the sum of one, plus the rate of return, raised to the
power of time. In this equation, net cash flow is represented as the acronym NCF, the rate of return is
lowercase r, and the time value is lowercase letter t. But if, like me, you're not a big fan of calculations –
the IRR formula is built as a function into most spreadsheet applications.
IRR is easy to interpret, considers cash flows, and provides you with objective data.
Unfortunately, it isn't foolproof. It assumes the interest rate will not change throughout a project's life
span. Another disadvantage is that it won't work in projects where the cost of capital changes or if an
investment has fluctuating cash flows. IRR calculations also tend to rely on NPV calculations.
Choosing between investment proposals can be tricky, but with the help of capital budgeting methods it
doesn't have to be a leap of faith.
Performing Budget Calculations

Learning Objective
match the formulas for Payback Period and Net Present Value to the budget
calculation each is used to perform
1.
[Topic title: Performing Budget Calculations] Choosing the best investment for your company can be
tricky. Sure, they may all seem promising, but which one will yield a profit? The only way to be sure, is to
use suitable capital budgeting methods.
The Payback Period, or PP, method evaluates risk based on the amount of time – the payback period –
it takes a company to recover the money it's invested. This method's ideal when sifting through
investment options – use it as a preliminary screening to narrow down your options.
Because all projects differ, there are typically two types of payback periods: those with even cash
inflows, and those with uneven cash inflows. Simply put, a project could have a constant inflow of cash;
or cash may come in at odd times throughout the year.
If your project has an even cash inflow, to calculate the payback period – PP – you divide the net
investment by the annual cash inflow. Pretty straightforward.
If, however, a project has an uneven cash inflow, things are trickier. You first need to determine how
many cash flows you'll need to get your initial investment back.
Consider, for example, a project with a net investment of $30,000. Since the total revenue after three
years is only $28,500, the investment will be returned during the fourth year. So to calculate the amount
that's returned in the fourth year, you subtract the total of the first three years from the total investment.
In this case, that's $30,000 minus $28,500, which gives you $1,500.
But when in the fourth year will this amount be returned? To calculate this, you divide the payback
amount by that year's cash inflow – in this case that's $1,500 divided by $5,000, which is 0.3. To get the
payback period, you add 0.3 to the three years. And voilà. It will take 3.3 years for your investment to be
returned.
Another method used in capital budgeting is Net Present Value, or NPV. When comparing the
profitability of mutually exclusive investments, this is your best bet. This method factors in that the value
of money is likely to change over a period of time. So it measures the value of different cash flows at the
present point in time.
Once you've calculated the NPV, it's very easy to decide whether to accept or reject the proposal. If the
NPV is larger than zero, it's a go; if it is less than zero, it's a no.
Calculating the NPV is done in three steps. First, you calculate the present value of the expected
returns. Then you calculate the total present value of investments. You then subtract the total present
value of investments from the total present value of returns to get the NPV.
You then repeat the process to get the NPV for each investment you want to compare.
Using PP and NPV methods to perform budget calculations, can help you make solid investment
decisions.
© 2017 Skillsoft Ireland Limited

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3/25/2018 Skillsoft Course Transcript

Basic Budgeting for Non-financial Professionals

3. Sales, Production, and Cash Budgets

6. Budgetary Variance Analysis

8. Performing Budget Calculations

Attributes of an Effective Budget

Sales, Production, and Cash Budgets

Budgetary Variance Analysis

Performing Budget Calculations

© 2017 Skillsoft Ireland Limited

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