FIXED OR FLEXIBLE BUDGET

A static/fixed budget

is a budget that is based upon one level of output and is not adjusted or altered after it is finalised.  It is drawn up prior to the start of the budget period and is a budget for the planned level of activity and so the budgeted costs are not adjusted to the actual level of activity.  It is unlikely to be very useful to the company unless the sales, output levels and other factors remain static as in the budget.

When a single fixed budget (i.e. master budget) is prepared for planning purposes, the level of activity used to determine the costs and revenues relevant to the budget will reflect the level which is most likely to be attained.  But fixed budgets may not serve equally well for control purposes as it is necessary to compare like with like, i.e. actual with budgeted during that period.

A flexible budget

is a budget that is developed using budgeted revenue or costs amounts and it is adjusted to the actual level of output achieved or expected to be achieved during the budgeting period.  The flexible budget enables managers to compute a richer set of variances than the static budget.  Because some costs vary with changes in the level of activity, it is essential when preparing performance reports for cost centres to take into account the variability of costs.

The key to flexible budgeting is understanding the firm’s pattern of cost incidence and in particular the separation of fixed and variable costs.  Only if the flexible budget is based on a valid understanding of the relationship between operating activities and costs being incurred will it be possible to gauge the impact of changes in the activity level on the periods results.  Flexing a budget means revising it to that which it would have been, had the planned level of output been some different figure. In the context of control, the budget is flexed to reflect the volume which actually occurred. To be able to flex the budget a company needs to know which items are fixed and which are variable, relative to the level of output.  Once it has flexed the budget with the revised figures, it will indicated the sales volume variance.

SUBSIDIARY BUDGETS TO FEED THE MASTER BUDGETS

The Master Budget

The Master Budget for a profit oriented organisation seeks to build a set of interrelated budgets which provide a complete “picture” of the operations of the business over some future period, usually twelve months.  The elements of the master budget addresses both operating and financial concerns and comprises of the Cashflow forecast, the Profit and loss and the balance sheet. The major elements of the Master Budget are:

The Operating Budget

The Operating Budget is made up of the Sales Budget, Production Budget and Expenses Budget.

The Sales Budget

The volume of sales and the sales mix determine the level of a company’s operations when sales demand is the factor that restrict output.  Hence this is the most important budget, but is the most difficult to predict because sales revenue relies upon the actions of customers.  The sales budget forecasts the sales for the company over the budgeted period, and will for many businesses be a budget by product or product line and by territory, again depending on the nature of the business. The sales budget is the most important element in the master budget as all other budget assumptions flow from the sales forecasts in the budget. While it can readily be seen that the cost of raw materials and direct labour are directly related to the level of sales, it might not be so obvious how other budget elements relate. Here are some relationships:

•The level of capital expenditure will depend on the level of sales. If a company is showing rapid sales and therefore production growth, there may not be sufficient manufacturing capacity and the company will need to buy more capacity. This will require capital expenditure.

•The level of sales which are on credit will influence the Balance Sheet because it drives the level of Accounts Receivable

•The level of sales will drive selling and marketing expenses because extra sales means extra distribution costs and may relate to bonuses paid to the sales force

•The mix of sales can relate to the level of selling and marketing expenses. If a company is introducing a new product there may be a high level of sales expenses as new advertising campaigns are ramped up

•The sales made by a company generates a positive cash flow and so the level of sales are important in determining the cash flow of the company and, in turn, the cost of debt finance for the business

The sales budget will depend on the successful forecasting of a number of factors including:

• The state of the overall economy

• The competitive position

• The plans to introduce new products

• The success of advertising and marketing campaigns

• Product:

Here the management will wish to know sales revenue by product line. Budgets may differ from company to company. Some companies will be able  to budget down to the individual product line and show budgeted product sales by product code in terms of units of production and revenue per item.

Period:

The periods into which the budget may be divided might be by quarter, by month or even in some companies, by week. As discussed above, the overall budget will typically be for a financial year

• Sales territory:

As well as breakdowns by product, it will often be necessary to analyse budgeted sales by sales territory. This might be based upon a geographic territory within a country, a breakdown by countries or regions and in some cases by class of customer.

The Production Budget:

The first thing to do is  work out how many items of production will be made in the budgeted period. The production must satisfy those sales in the current period that cannot be supplied from current production and also provide a surplus to put into the finished goods inventory. The level of production in a period will be determined by using the output from the sales budget and will incorporate some assumptions on the desired level of closing inventory.

A manufacturing firm such as this would seek to budget the costs of producing the finished goods including the cost of raw materials and direct labour that go into the manufacturing process as well as overheads in the manufacturing process such as the cost of buildings, light, heat power and supervisory staff within the factory. The production budget for manufacturing firms is made up of three elements:

•Raw Materials budget

which establishes the cost of the material content of the production process.  The first of the costs of conversion to take the elements of a manufactured product from its raw materials to the finished product is, not surprisingly, the cost of the raw materials themselves.  The raw materials which go into a product can be very complex.

• Direct Labour budget

which budgets for the cost of those staff directly involved in the production of manufactured products Direct Labour Budget.  It is normal to see the direct labour budget as responding directly to production levels.

• Overhead budget

A variety of overhead costs associated with running the manufacturing process Is included in the Factory Overhead budget. Some of the costs which are included in this category include:

•Incidental materials costs including cleaning and some packaging costs

•The “on costs” of direct Labour such as idle time, employers’ contribution to the employees’ superannuation fund and payroll taxation

• Factory rent or lease costs, heating or cooling, power and  maintenance

• Quality assurance

• Supervision and factory management

• Depreciation of factory equipment

These costs are of both a fixed and variable nature. Some examples of fixed and variable costs are:

Variable

•Incidental materials costs including cleaning and some packaging costs

•The “on costs” of direct labour  such as idle time, employers’ contribution to the employees’ superannuation fund and payroll taxation

Fixed

•Factory rent or lease costs, heating or cooling, power and maintenance

•Supervision and factory management

• Depreciation of factory equipment

For many companies, the budget will calculate an appropriate overhead application rate and apply the overhead to the budgeted production using the application base. Typical application methods are direct labour hours, units of production or machine hours.

Budgeting for the Cost of Production

The elements of the production budget for a manufacturing firm is made up of a budget for the cost of the raw materials that goes directly into the manufactured product, the cost of the labour used in the manufacturing process and the cost of the other inputs into the process such as heating, lighting, supervision and depreciation.

The Expenses Budget

are for the various sales, marketing  and administrative costs of doing business. The expenses budget is made up of:

Selling expenses

• Sales commissions

• Distribution costs

• Some travel costs

• Warranty costs

• Sales discounts

• Fixed

• Salaries

• Some travel costs

• Rates, light, heat and power etc

Marketing expenses

• Marketing costs

Advertising campaign costs

Other Budgets to be accounted for:

Administrative Expenses Budget

The administrative expenses budget encompasses a range of expenses that relate to the general management of the company and to the financing of the company. Some of the expenses that would be encompassed in the administrative expenses budget include:

• Wages and salaries of general management

• Bad and doubtful debts

• Insurance

• Interest

While many of the expenses in the administrative expenses are of a fixed nature, some are influenced by the level of sales activity. Some of these relationships are:

Capital expenditure budget -

A capital item is usually defined as one which will last longer than twelve months and exceeds a certain amount.  The capital expenditure budget will be highly dependent on the level of sales forecast in the sales budget.

Budgeted Income Statement -

The Sales Budget and the various expense budgets are brought together in a budgeted Income Statement. The format of the Income Statement will vary from company to company depending on how much information is relegated to schedules.

The Financial Budget

The Financial Budget is made up of the Cash Flow and Capital Expenditure Budgets and the Budgeted Balance Sheet.

The Cash Flow Budget is the “glue” which binds the whole budget together. Every budget decision from the level of sales to labour costs and spending on capital items has some impact on cash flows. The cash flow budget seeks to show the cash funding necessary for the budget period.  It is a projection of the business’s cash inflows and outflows over a certain period of time. A typical cash flow budget predicts the anticipated cash receipts and disbursements of a business on a month-to-month basis. However, a cash flow budget could predict the cash inflows and outflows on a weekly or daily basis. Because of the uncertainty involved in the cash flow budget, trying to project too far into the future may prove to be less than worthwhile. At the same time, a cash flow budget that doesn’t look far enough into the future will not predict future events early enough for  corrective action to be taken.

The primary purpose of using a cash flow budget is to predict the business’s ability to take in more cash than it pays out. This will give some indication of the business’s ability to create the resources necessary for expansion, or its ability to support  the business owners. The cash flow budget can also predict the business’s cash flow gaps — periods when cash outflows exceed cash inflows when combined with cash reserves.

Preparing a cash flow budget involves four steps:

1.preparing a sales forecast

2.projecting  anticipated cash inflows

3.projecting  anticipated cash outflows

4.putting the projections together to come up wi

The closing balance of cash is the figure which is the “balancing item” and which is the final figure which binds all the various budgets together.