Steps during budget preparation

Last updated: 20.03.2016

 

1. CEO appoints budget committee and budget coordinator.

Budget committee is a group of people that are responsible for budget preparation, review and approval. It is usually formed by senior managers including finance director. (26)  

2. Review the system of responsibility (budget) centers – mainly whether they include all parts of the entity. Responsibility centers are important not only for budget data collection, but mainly for control purposes. 

3. Set the basic budget assumptions such as expected inflation, exchange rate, interest rate, income tax rate etc.

4. Summarize the basic strategic points (new investments, diversification, etc.).

5. In cooperation with budget committee prepare/update budget manual and distribute it to all people involved.

Budget manual is a document that contains instructions for budget preparation. It is often used in large companies and facilitates the budget coordination process. It is usually prepared by budget coordinators (e.g. financial analysts or controllers) and approved by budget committee.

It defines mainly:

  • the purpose of budgeting and its consequences (e.g. relationship with personal targets and their evaluation)
  • budget preparation details:
    • the components of budget (e.g. sales, production, cash-flow budgets)
    • periods included and the level of split within the period (e.g. monthly/quarterly)
    • budgeting approaches used:
    • structure of data required  such as the level of detail, scenarios, additional data for sensitivity analysis or probability budgeting
    • responsibilities – defines people responsible for individual budgets – i.e. budget holders who are made responsible for budget centers (usually the same as responsibility centers)
    • budgeting timetable
    • basic planning assumptions and summary of general strategic points (steps 1 & 2)
  • budget coordination details – responsibilities, steps taken, timing, the format of master budget etc.  This part may not be available in smaller companies as the budget is often prepared by just one person and no coordination is thus necessary.
  • responsibilities of budget committee and timing of budget approvals
  • future budget updates – e.g. whether rolling or flexible budgets will be prepared
  • details about budget evaluation with actuals and possible corrective actions – for example:
    • evaluation methods, timing and responsibilities
    • possible future budget/target adjustments allowed

 

6. Define the principal budget factor – it is the key and limiting factor within the entity. Because it limits other operations, budgets containing principal factor shall be prepared first. It is usually sales, but others may be possible (e.g. raw materials if they are rare). Let’s suppose that principal budget factor is sales in the following text

7. Prepare sales budget (or collect it from sales manager or sales representatives). The following items should be determined for each product/service:

  • sales volume
  • prices – consider all the factors included in setting the selling price

→ split by sales person, responsible manager or departments, products, geographic area, etc. – what is appropriate

 

8. Prepare production budget (or collect it from production manager):

→ split by responsible manager or departments, products, geographic area, etc. – what is appropriate

 

I. First determine whether there is sufficient production capacity available to be able to manufacture budgeted sales volume. If not, consider whether and how it can be resolved. If it cannot be resolved, production budget is in fact the principal budget factor and shall be prepared first instead of sales budget. If the capacity is higher than sales volume, the entity can for example consider reduction of prices (in order to sell more), strategy of diversification or other solutions mentioned below.

 

The limiting capacity factors are:

  • machine capacity =  machine hours available less inefficiencies such as idle time

→ if actual machine capacity ≠ machine capacity required, make a decision to resolve it and adjust the relevant operational budget (e.g. capital expenditure budget or inventory budget). Possible decisions can be:

  • actual < required capacity: buy or hire an additional machine or outsource production activities etc.
  • actual > required capacity: produce more units to stock, sell the redundant machine etc.
  • direct labor (workers) = labor hours available less inefficiencies such as idle time plus the effects of learning curve or  automation:

→ if actual labor hours ≠ labor hours required, make a decision to resolve it and adjust relevant operational budget (usually payroll budget). Possible decisions can be:

  • actual < required: hire additional staff, temporary help, overtimes, night shifts etc.
  • actual > required: release existing staff etc.
  • raw materials = quantity available less inefficiencies such as normal losses

→ if available raw materials are not sufficient, consider for example possibility to purchase it elsewhere or using alternative materials (possible adjustment to purchasing budget).

 

II. Set the final production volume for each product and inventory budgets:

  • production volume + finished inventory on stock > sales volume → finished goods remains at stock (i.e. inventory budget)

 

III. Set production prices (costs) – standard costing approach or pricing available from actuals is often used.

direct materials – consider:

  • purchasing terms – i.e. not only currently agreed prices, but also  results of ongoing/expected negotiations with existing or new suppliers
  • expected market changes in prices of raw materials
  • required changes in quality – higher quality materials are more expensive
  • expected changes in transport conditions (e.g. by the entity or by suppliers)
  • age of property and equipment – old assets can produce higher losses (which increase unit price)
  • expected inflation

direct labor – consider:

  • existing wages and salaries and their expected rises 
  • expected changes in the labor market
  • expected changes of the social and health insurance rate paid by the employer
  • expected inflation

other direct expenses - production overheads –consider:

  • purchasing terms and expected market changes
  • expected inflation

 

IV. Consolidate production budget

 

9. Prepare other relevant budgets (or collect them from relevant staff). The below stated budgets are not complete and the procedures are simplified.

  1. Capital expenditure (CAPEX) budget
  2. Long-term assets budget – shall include existing assets and assets acquired during budgeting period (CAPEX) less asset removals, their expected depreciation and amortization and impairment losses
  3. Payroll budget (number of staff, wages – usually for each grade of employees)
  4. Non-production costs budget - is often split into individual departments budgets such as marketing, PR, accounting, treasury budgets
  5. VAT budget
  6. Budget for receivables and payables – can be set in detail or very simplified assumption can be used in certain cases:
    •  if the entity pays and collects its invoices in 30 days (monthly) → receivables and payables shall approximately be 1/12 of the amount of revenues/ expenses
    •  if the entity pays and collects its invoices quarterly → receivables and payables shall approximately be 1/4 of the amount of revenues/ expenses

 

  • from the budgets prepared above calculate the cash-flow and prepare cash budget:
  • if cash-flow is positive = cash inflow resulting for example in additional amounts on bank account or investments bringing additional interest or other income
  • if cash-flow is negative = cash outflow: plan a loan or other means of financing causing additional interest or other expense

 

→ prepare income tax budget – make the necessary adjustments to the tax base (not all expenses are tax-deductible, not all incomes are taxable etc.) and calculate current and deferred income tax. This step is interrelated with:

  • cash-flow / financial assets / interest calculation:  interest expense/income affect income taxes and vice-versa, income tax payments affect cash-flow and resulting interest.
  • budget for receivables and payables – income tax is usually paid the following year, thus the amount remains on payables account

 

Therefore, these calculations should be made in several iterations.

 

10. Check all received budgets centrally – mainly for typical errors such as miscalculations, wrong totals, duplicities, incompleteness, missing interrelationships with other budget components, discontinuity or the variances from last actuals/past budget.

 

11. If there are any adjustments, they shall be communicated and at least send back for information to the original contributors.

 

12. Prepare preliminary master budget.

Master budget is the overall budget that summarizes lower-level operational budgets. It usually includes:

  • summary of the most important points from strategy
  • summary of planning assumptions used
  • a set of financial statements – i.e. profit and loss statement, balance sheet and cash-flow statement; often in very similar formats as in actual reporting
  • non-financial KPIs such as number of employees, number of customers, orders, calls etc.

13. Review the master budget:

  • again check for the typical errors
  • compare the budget with previous period results
  • possibly also calculate financial ratios or other financial analysis indicators and consider, whether they either make sense and whether you can explain them (mainly in the context of past figures)

14. Ask budget committee to review the master budget.

15. Obtain senior management approvals and distribute the master budget.



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