Last month, we discussed “market research” as the first stage of the budget process for directors of companies. In this issue, we examine other components of the budget process. These comments apply to virtually all types of businesses.
Labour Budget
The labour budget should examine each individual operation of the business and identify the personnel that are going to be required to enable the product development targets to actually be produced.
Directors need to ensure that management has included sufficient people into the product development forecast to ensure the number of production units that have been forecast can, in fact, be produced.
Sales Forecast
The market research documents should identify the projected number of individual units of products the business could sell. There needs to be a connection between the product development forecast and the sales forecast. It’s no use claiming that there’s going to be sales of a million dollars if the product development budget only indicates that product, that would generate $400,000 worth of sales, is able to be produced. This could be caused by manpower problems, plant and equipment or physical restraint within the premises where the product development activities are being conducted. If the directors are satisfied that management’s estimates, relating to production and potential to sell a larger volume of products is realistic, this could lead to some discussions as to whether additional premises are required or a second shift could be worked.
Stock Budget
A stock budget is very important. The directors should be enquiring as to what’s the required investment in stock throughout the year; not just at the 30th June or the 31st December:
- Is management budgeting for seasonal build-up of stock levels when the build-up is required?
- Has management implemented policies to ensure stock orders are being placed early enough to ensure the manufacturers/distributors will be able to deliver the stock the business needs to be able to make the sales, by the date it’s anticipated the sales will be made? The same questions also apply when the company is manufacturing its own stock for sale.
- Where required, has the stock build-up been sufficient to enable the sales the company hopes to achieve to be able to make?
Debtors
Most businesses have debtors because customers insist on making payments on a credit term basis.
Directors should be monitoring the investment the company anticipates having in debtors, calculating debtors’ days outstanding and enquiring whether the debtors’ system is functioning at its highest possible level. This could include questions such as:
- Has a proper documented system been utilised for a new customer to open an account to obtain product on credit terms?
- Are tax invoices being prepared and sent promptly to the customer so that customers might be inclined to make payment earlier?
- If the company is in the habit of issuing statements to debtors, are the debtors’ statements being prepared and dispatched within a few days of the end of the month? Some businesses refuse to make payments until they’ve received the debtor’s statement. If the company is slow in getting the debtors’ statements dispatched to debtors, it can lead to a significant slow-down in debtors’ payments and a worrying increase in debtors’ days outstanding.
- Is the calculated debtors’ days outstanding, as per the budgets, realistic? Whilst it might be commendable to say that management is going to introduce new systems to reduce debtors’ days outstanding, from 60 days to 30 days, directors need to be realistic when assessing these types of forecasts because there could be a significant cashflow difference between 60 days outstanding and 30 days outstanding. If realistic forecasts are not being prepared, it might mean that the company has not applied for sufficient funding from the company’s bank.
Creditors’ Budget
A creditors’ budget is an integral part of the budget process.
In the first stage, the creditors’ budget should be prepared on the same basis as what current payments are being made to creditors, but then the predicted creditors’ days outstanding should be critically examined, to determine how the creditors’ days outstanding figure compares to the negotiated payment terms the company has with its suppliers.
If the company is trading beyond the agreed credit terms, what does this represent as a monetary amount?
Directors should be asking questions such as:
- How would the company meet its financial commitments if a number of creditors insisted on being paid strictly in accordance with their negotiated payment arrangements?
- Is the company in a position to be able to make the payments at a faster rate than what they have been doing so at this stage?
This will enable directors to ensure the budgets, which have been set for the key working capital components (debtors, stock and creditors), have been established on realistic figures.
Expense Budget
The company’s expense budget normally includes expenses that have not been directly reflected within the product development budget and labour budget and will relate to salaries, insurance, bank charges, rent, research and development, motor vehicle operating expenses, etc.
Some of these expenses may have already been allocated in some of the subsidiary budgets such as product development and labour. That type of treatment is to be encouraged because it will enable a more meaningful analysis to be undertaken on the individual components of the overall budget, rather than putting all of the expenses into the expense budget.
Ratio calculations of expenses to total turnover should be calculated and compared to actual ratios calculated on the previous financial accounts. Any significant variations should be investigated and corrected.
Cashflow Forecast
Once these individual budgets have been prepared, it’s then possible to finalise the cashflow forecast for the next 12 months.
The directors should ensure known expenses (such as capital expenditure, dividend payments, loan repayments, etc.) have been reflected within the cashflow forecast. The cashflow forecast will indicate whether there’s a need for a discussion with the company’s banker for a change in the arrangements with the bank. After all, this is one of the key purposes for preparing budgets and cashflow forecasts.
Profitability Forecast
As part of the budget and cashflow forecast, the final document is then able to be prepared. This is the profitability forecast. This reflects the key financial data from each of the operating budgets.
Once this document is prepared, Key Performance Indicators (KPIs) should then be prepared on items such as gross profit percentage in the various business activities, labour to turnover percentage, average sale, etc. The budgeted KPIs should be compared with KPIs established on actual financial accounts. If there are significant variances, they should be investigated. In most instances, it would be fairly unrealistic to expect significant changes in the KPIs within the budget, compared to actual performance in previous accounting periods, unless there are very strong reasons for the significant changes in the business operations.
This is the type of process directors undertake in ensuring accurate budgets and cashflow forecasts have been prepared for a company. Once the budgets have been adopted, it’s then important to ensure there’s regular monitoring of the actual financial performance of the company, as compared to the company’s budget.
If you have any questions on the role that budgets and cashflow forecasts play, relative to corporate governance within a company, or if you require assistance in the preparation of budgets and cashflow forecasts, please don’t hesitate to contact us.
