Accounting Business Reporting for Decision Making

CHAPTER 9 Budgeting 387

The planning process is strengthened by considering the interrelationship between profit, cash and

return on investment. Simons’s three wheels of planning highlights the impact of decisions on each. The

three wheels (cash, profit and return on investment) are interlocking and turn simultaneously. For example,

the entity may be able to generate more sales in the coming year. However, will there be enough cash flow

to  acquire the inventory to support sales or acquire other necessary resources? Will  the increased sales

lead to higher profits, which in turn will enable investment in assets that should lead to higher sales and

more profits? The higher profit will lead to an increase in the return on owner’s investment.

Simons highlights the need for those within the entity to work together to develop the profit plan for the

coming year. The sales manager provides important information about the potential sales levels for the

coming year and the operational personnel will assess whether there are the necessary resources required to

achieve these sales or alternatively recommend process changes to achieve the sales goal. The financial per-

sonnel will assess both the cash flow resulting from the plans to assess the need for cash to cover day-to-day

operations and the profitability of the planned activities. Overall, the interaction of the various personnel

enables them to understand the impact of their decisions and to assess whether value is created for the entity.

When not executed well, the budgeting process can produce negative, unintended consequences. For

example, the budget targets may be unreasonable or too difficult to achieve. This may have a discour-

aging effect on the managers who prepare the budgets, those who are held accountable for budget targets

and on the staff generally. The behavioural aspects of budgeting are explored later in this chapter.

9.3 Types of budgets

LEARNING OBJECTIVE 9.3 Explain the different types of budgets.

The nature of the entity will determine the types of budgets prepared. Nevertheless, budgets commonly

prepared include the following.

• Sales or fees budget, which also serves as an important input variable for other budgets and is, there-

fore, often referred to as the ‘cornerstone’ of the budgeting process. The sales or fees budget is com-

monly used to set the expected level of activity for the budget period. The expected level of activity is

an important consideration for many of the other budgets. This central role of the sales or fees budget

is further underpinned in Simons’s three wheels of planning.

• (Operating) expenses budget, which is commonly an aggregation from functional, sectional or depart-

mental expense budgets, and which also serves as an input variable to other budgets. For example,

the expenses budget relating to the operation of the accounting department is used, along with other

(e.g. marketing) departmental budgets to build the overall operating expenses budget. It is sometimes

simply called the cost budget.

• Production and inventory budgets, which are necessary in manufacturing environments for planning

production levels and managing inventory levels. There are usually sub-budgets relating to direct mat-

erials, direct labour (if any) and indirect manufacturing overhead costs.

• Purchases budget, for both merchandising and manufacturing entities, which will set the required

level of inventory/direct materials purchases based on data from the sales budget, and possibly from

the production and inventory budgets as well.

• Manufacturing overhead budget, which is concerned with estimating the overheads or expenses

associated with production activities.

• Budgeted statement of profit or loss, which is essentially an aggregation of many of the other sub-

budgets, including the sales budget and operating expenses budget.

• Cash budget, which focuses on cash in the same way that the statement of cash flows does, and may

be viewed as a statement of the expected future cash receipts and cash payments.

• Budgeted balance sheet, which shows what the entity’s financial position is expected to be as at the

end of the period.

• Capital budget, which deals with expenditure relating to long-term investments. (Capital budgeting is

discussed in chapter 12.)