Question

Once a budget is made then it must be managed throughout the period covered by the budget.

Income is naturally a very important part of the budget.

Q1. Name and explain how this information is collected and list three sources of income records that you would use to monitor the budget:

q2.

From analyzing some budget figures you notice some deviations, but decide to do nothing about them.

Explain why this could be a legitimate form of action (or inaction):  

Answer 1

Question 1

Budget is prepared before the beginning of the period and budgeting is the monitoring done throughout the period. When a budget is prepared, the objective is to make a best estimate of the actual performance considering the factors that may occur during the period.

How the information is collected?

Income statement

Starting point of preparing the budget is sales/revenue forecast as it gives the level of activity at which the company expects to perform and this is a basis for calculation of variable costs (material, labour, other direct expenses,etc.). The sales forecast will need to be prepared by collating the information from the sales and business developement team which would include customer-wise, region-wise, product-wise sales forecasts. The forecasts need to bear a rationale if a significant variation from existing trend is forecasted. E.g. Lets say the forecast suggests a growth of 30% in revenue for a matured company. Now, unless there is an expectation of a substantial change in the market, the growth of 30% would be unachievable.

Next point would be to calculate the variable costs(material, labour, other direct expenses,etc.). These are generally taken as percentage of sales as these % tend to remain constant. But if there is an expectation that during the period material or labour cost would undego an increase, such expectation needs to be built in the budget. Post this activity, closing inventory would need to ascertained to arrive at gross profit. Closing inventory could also help the company understand the production during the year (Production = Sales - Opening inventory + closing inventory)

After gross profit, the comapany will need to budget for below the line (BTL) expenses in the nature of general and administration costs, selling, marketing and distribution costs, advertising costs, etc. Administative cost tend to reamin the same while selling and distribution would generally be taken as percentage of sales.

Balance Sheet

The working capital would be calculated using past trends and best estimate of the future.

Working capital would consist of,

1. Inventory- The inventory will be basis the days of inventory held ratio in the past. Also, any expectation in future, like increased or decreased levels of inventory than normal, needs to be built in the forecast.

2. Receivables- The receivables will be basis the days of receivables ratio in the past. Also, any expectation in future, like increased or decreased credit period to the debtors, needs to be built in the forecast.

3. Payables- The peceivables will be basis the days of payables ratio in the past. Also, any expectation in future, like increased or decreased credit period from the creditors, needs to be built in the forecast.

After working capital, the capital structure would be budgeted by adjusting existing levels of debt and equity to suit the future needs. E.g. if company plans to issue fresh capital by issuing shares during budget period, it will need to include the same in the budget. The information regarding the same would need to be gathered from discussion with the management.

Three sources of income records that I would use to monitor budget would be

1. Sales / Revenue

This is sales by selling the core product or providing the core services. The sales numbers, alternatively referred as top line, are under constant scanner by the management as the business growth is driven by sales. The sales numbers should be recurring and sustainable in the future. Also, as emphasised earlier, the sales numbers affect a lot of other factors in the budget.

2. Other operating income

Other operating income generally moves in proportion with sales. E.g. other operating revenue can be scrap sales, duty drawbacks, etc. These items supplement the revenue and are generally part of the top line.

3. Other non-operating income

These would include dividend income, rental income, gain or loss on sale of assets, etc.

Question 2

This can be expained with the help of following example:

Consider that the sales forecast was derived from expected market size and market share calculation. Assume the market size was expected to be $100 million and the market share was expected to be 20% which translates to $20 million in revenue for the firm. Due to macro-economic factors beyond company's control, the market size shrunk to $80 million. In this case, the revenue would come down to $16 million (20% of $80 million). This would also affect your sales based budget numbers. This is a deviation that is explained by macro economic factors and there is nothing the company can do about it. So, inaction is the only legitimate form of action in such a case.