Plan Financial Management Approaches

“A budget is defined as the formal expression of plans, goals, and objectives of management that covers all aspects of operations for a designated time period. The budget is a tool providing targets and direction. Budgets provide control over the immediate environment, help to master the financial aspects of the job and department, and solve problems before they occur. Budgets focus on the importance of evaluating alternative actions before decisions actually are implemented.”

^{(Shim, Siegel and Shim 2011, 1)}

Put simply, budgets and financial plans are planning documents that use estimations of future income and expenses for all aspects of a business (e.g., materials, merchandise, labour) in order to assist key stakeholders to make well-informed business decisions. It is extremely rare for an organisation to develop a single budget. Budgets are usually developed for each different area of an organisation – budgets can be developed for each product, function, division, location, quarter or any other factor of an organisation (Gazley and Lambert 2006). Once all the necessary budgets have been developed, organisations will attempt to operate within the bounds of their various budgets.

Financial statements are different to budgets and plans. Financial statements document past/current performance and are created using the financial information recorded through ‘actual’ businesses operations. Typically, information is collected from areas such as sales, purchases, and taxation, and either recorded in financial management software, or more simplistically, a paper-based financial ledger. Even the smallest business will typically use some form of double-entry book keeping in which all transactions in the business are recorded in the ledger as either a debit or a credit. For example, if a business purchases stock they will record a debit in the stock account and a credit in the cash account. Depending on the size of the business, a ledger may contain anywhere from one to hundreds of accounts. In a paper based accounting system a ledger is kept in ‘the books’ with a separate page for each ledger account. In a computerized system the ledger is made up of interlinked digital files, but it still follows the same accounting principles as a paper based system. Such a system helps ensure that the business is clear on where money is going. The information recorded in the ledger is then used to develop the three major financial statements used in almost any business, which are the profit and loss statement, the cash flow statement, and the balance sheet. These statements track profit and loss, cash on hand, and assets, liabilities, and equity respectively (Banks, 2010). Financial statements are produced in order to present the financial position of a business as accurately and concisely as possible, which are then used to develop future budgets and financial plans.

Understanding and managing budgets and financial plans is a vital aspect of a manager’s role. For a manager, the budget and financial planning process has less to do with adding columns on a spreadsheet and more to do with understanding the financial philosophy of their organisation and being able to translate that understanding into successful implementation. It is vital for all managers to understand the overall financial management process within their organisation (Marsh 2012). The figure below outlines the general financial management process.

Essentially, financial management begins at the top, with business owners, CEO’s, and senior management engaging in organisational and operational planning. From this they develop overall business missions, values, and objectives from which they will then set specific organisational and departmental budgets. In some organisations, managers will be involved in the budget-setting process for their work area. While not every manager will develop their own budget, all managers need to understand their role in the remainder of the financial management process – plan financial management approaches, implement financial management approaches, monitor and control finances, and review and evaluation the financial management process. The four sections of this module align with these final four stages of the financial management process.

This first section of the module focuses on the processes managers need to complete in order to plan their own financial management processes within their work area. This involves accessing budgets and financial plans, clarifying budgets and plans, negotiating changes as needed, and preparing contingency plans.

In order to plan their own financial management approaches line managers, middle managers or supervisors first need to access budgets and financial plans for their work team. There are various types of budgets and financial plans that managers should be aware of. Each plan contains different information and serves a different purpose. In this module we will be discussing:

• Sales budgets
• Materials budget
• Labour budget
• Overhead budget
• Cost of goods sold budgets
• Balance sheet statements 
• Cash flow statements
• Profit and loss statements

Each of these budgets or plans will now be discussed in more detail. It is important that you understand how these budgets/statements are generated and what information they contain so that you can apply any relevant information to your work role. Additionally, you should take note of how many of these budgets relate to each other and flow on from each other.

Sales Budget

The sales budget is considered the starting point of any budget or financial plan. The sales budget shows projected sales of a specific period, usually a financial year. It is critical that the sales budget is as accurate as possible because all subsequent budgets and plans flow from the sales budget. The following is an example of a sales budget for a soft drink producer

Product	Expected Sales	Unit Price	Sales Revenue
Cola	50 000	$1.00	$50 000
Lemon	40 000	$1.00	$40 000
Orange	20 000	$1.00	$20 000
Total	110 000	$1.00	$110 000

^{(Adapted from Shim, Siegel and Shim 2011)}

Production Budget

Once the sales budget is complete various other budgets can then be determined. If a company produces or manufactures their own products, they will prepare a production budget. The production budget details the number of units which need to be produced to meet expected sales and required inventory. If the company produces their product to order, there will be no inventory.

The following is an example of a production budget for a soft drink producer.

Product	Expected Sales	(+) Ending Inv	(-) Starting Inv	Production
Cola	50 000	5 000	3 000	52 000
Lemon	40 000	4 000	2 000	42 000
Orange	20 000	2 000	1 000	21 000
Total	110 000	11 000	6 000	115 000

^{(Adapted from Shim, Siegel and Shim 2011)}

Merchandise Budget

In the previous example the company produced their own soft drink. If they were to purchase and resell their soft drink they would need to create a merchandise budget. The merchandise budget is very similar to the production budget however it depicts the amount of product to be purchased rather than produced.

Merchandise budgets can be in dollars or units.

Product	Expected Sales	(+) Ending Inv	(-) Starting Inv	Total
Cola	$50 000	$5 000	$3 000	$52 000
Lemon	$40 000	$4 000	$2 000	$42 000
Orange	$20 000	$2 000	$1 000	$21 000
Total	$110 000	$11 000	$6 000	$115 000

^{(Adapted from Shim, Siegel and Shim 2011)}

Materials Budget

Once the production budget had been determined, it will then be necessary to determine the amount of material required. The production budget shows the amount of product that needs to be produced, the amount of materials needed per unit of production and the unit price of the materials in order to determine the total cost of materials.

Product	Production	(×) Materials	(×) Unit Price	Total
Cola	52 000	2	$0.05	$5 200
Lemon	42 000	2	$0.05	$4 200
Orange	21 000	2	$0.05	$2 100
Total	110 000	2	$0.05	$11 500

^{(Adapted from Shim, Siegel and Shim 2011)}

Labour Budget

The production budget is once again used to determine the amount of labour required to meet production needs. The labour budget shows the number of units required, the labour hours it takes to make each unit and the cost of labour per hour in order to determine the total cost of labour required.

Product	Production	(×) Hrs/Unit	(×) Labour/Hr	Labour Cost
Cola	52 000	0.005	$25.00	$6 500
Lemon	42 000	0.005	$25.00	$5 250
Orange	21 000	0.005	$25.00	$2 625
Total	110 000	0.005	$25.00	$14 375

^{(Adapted from Shim, Siegel and Shim 2011)}

Overhead Budget

The overhead (OH) budget describes all other costs besides materials and labour. Overhead costs can be fixed or variable but are usually a combination of both. Fixed costs are costs that usually stay the same or aren’t dependant on any other factors for example rent or stationary. Variable costs on the other hand can vary depending on a number of factors such as labour hours (as in the example below) or number of units produced.

Product	Fixed OH	Labour Hrs	Variable OH	Total OH
Cola	$1 000	260	$5.00/hr	$2 300
Lemon	$1 000	210	$5.00/hr	$2 050
Orange	$1 000	105	$5.00/hr	$1 525
Total	$3 000	575	$5.00/hr	$5 875

^{(Adapted from Shim, Siegel and Shim 2011)}

Cost of Goods Sold Budget

The cost of goods sold budget or COGS budgets gathers information from the materials, labour and overhead budgets to determine the total costs of products sold. To calculate the COGS you simply add the cost of materials, labour, overhead and the value of the beginning inventory and subtract the value of the desired ending inventory. The COGS will then be inputted into the profit and loss statement. Note: in the table below (and in most budgets and financial plans) parenthesis or brackets indicate a negative value.

Product	Materials	Labour	Overhead	Start Inv	End Inv	COGS
Cola	$5 200	$6 500	$2 300	$3 000	($5 000)	$12 000
Lemon	$4 200	$5 250	$2 050	$2 000	($4 000)	$9 500
Orange	$2 100	$2 625	$1 525	$1 000	($2 000)	$5 250
Total	$11 500	$14 375	$5 875	$6 000	($11 000)	$26 750

^{(Adapted from Shim, Siegel and Shim 2011)}

Balance Sheet

The balance sheet is used to predict the value of an organisation’s assets, liabilities and equities. For a balance sheet to be balanced the total assets should be equal to the total liabilities plus the total equities. For this reason the balance sheet is often depicted with assets on one side and liabilities and equity on the other so that the two sides can be seen to balance.

Unlike all the budgets and financial statements we have examined so far, the balance sheet is unique in that it depicts a specific moment in time rather than a time period. For this reason we have included two balance sheets exactly one year apart so you can see the changes. You may also notice that certain entries in the balance sheet are derived from other budgets and financial statement such as cash balance, production inventory the taxes. In the examples on the following page, the first balance sheet represents the actual balance sheet for one year (2010) while the second balance sheet represents the predicted balance sheet for the following year (2011).

Balance Sheet 31 December 2010
Assets (current)		Liabilities
Cash balance	28 250	Accounts payable	3 000
Accounts receivable	30 000	Tax payable	5 000
Production inventory	11 000	Total Liabilities	8 000
Assets (non current)		Owners Equity
Land	30 000	Capitol Stock	0
Building and equipment	50 000	Retained earnings	137 250
Accumulated depreciation	(4 000)	Total owners equity	137 250
Total	$145 250	Total	$145 250

Balance Sheet 31 December 2011
Assets (current)		Liabilities
Cash balance	20 000	Accounts payable	2 000
Accounts receivable	8 000	Tax payable	5 000
Production inventory	6 000	Total Liabilities
Assets (non current)		Owners Equity
Land	30 000	Capitol Stock	0
Building and equipment	35 000	Retained earnings	90 000
Accumulated depreciation	(3 000)	Total owners equity	90 000
Total	$97 000	Total	$97 000

^{(Adapted from Shim, Siegel and Shim 2011)}

Cash Flow Statement

The cash flow statement depicts the expected inflow and outflow of cash over a certain time period. Instead of predicting how much money an organisation will make, this statement predicts how much cash it will have on hand at any one time. Cash flow is usually separated into operating, financing and investing. The cash flow statement is closely related to the budgets, the profit and loss statement and the balance sheets.

Cash Flow Statement 2011
Cash balance beginning	$20 000
Cash flow from operating activities
Add: Collections from customers	90 000
Less: Material costs	(11 500)
Less: Labour costs	(14 375)
Less: Overhead costs	(5 875)
Less: Selling and admin expenses	(10 000)
Less: Taxes	(5 000)
Less: Dividends	(20 000)
Cash flows from financing activities
Add: Borrowing
Less: Repayments
Less: Interest
Cash flows from investing activities
Less: Purchase of fixed assets	(15 000)
Add: Sale of fixed assets
Cash balance ending	$28 250

^{(Adapted from Shim, Siegel and Shim 2011)}

Ageing summary

An ageing summary is a simple tool used to keep a business manager informed of what clients or customers owe the organisation money and whether they are overdue in their payment. It is a useful method for businesses to maintain awareness of how much money they are owed and how this will affect their cash flow. Usually this information is presented in monthly increments. If a client hasn’t paid you in 30 days, you send them a letter that notes the amount due and how overdue the payment is. The following is an example of an ageing summary report.

Company	Current month	1-30 days	31-60 days
KB Industrial	7000	15000	0
Solve Mechanics	10000	0	0
Southern Chemicals	10000	12000	14000
Munster Fitting	5000	0	0

In the above ageing summary KB Industrial is between one day and one month overdue in their payment of $15000. Southern Chemicals is overdue by two monthly payments of $12000 and $14000. Both Solve Mechanics and Munster Fitting are not overdue in their payments as the bill they have accumulated is not yet due for payment.

Profit and Loss Statement

The profit and loss statement, also sometimes called the income statement, outlines the revenue and expenses of the business. Like most budgets and financial plans, profit and loss statements can cover a month, a quarter, a calendar year or a financial year (Shim, Siegel and Shim 2011). The example below is a continuation of the soft drink company example we have been using so far.

Profit and Loss Statement 2011
Sales	110 000
Less: Cost of goods sold	(26 750)
Gross margin	83 250
Less: Selling and admin expenses	(10 000)
Operating income	73 250
Less: Interest expenses	(1 000)
Net income before taxes	72 250
Less: Taxes	(5 000)
Net income after tax	$67 250
Gross margin: Sales minus cost of goods sold Operating income: Gross margin minus selling and admin expenses Net income before taxes: Operating income minus interest expenses Net income after taxes: Net income before taxes minus taxes

^{(Adapted from Shim, Siegel and Shim 2011)}

This is by no means an exhaustive list, however we have covered the basic types of budgets and financial plans that you should be aware of in order to plan, implement, monitor and control financial management processes.

Once you have accessed and reviewed the relevant budgets and financial plans for your department you may need to seek clarification from financial managers, accountants, financial controllers or your manager to ensure that budgeted outcomes are achievable, accurate and understandable.

While every organisation’s approach to financial management will be different, there are two general approaches to budgeting known as top down and bottom up budgeting. In top down or authoritarian budgeting relatively few (usually high-level) managers are responsible for planning and budgeting for the entire organisation (Zelman, McCue, Millikan and Glick 2009). Top down budgets will generally reflect management’s larger strategic objectives, coordinate the budgets of various departments, and encourage middle managers to meet challenging targets. Despite these advantages top down budgeting also has several disadvantages. Firstly, high level managers are often far removed from the realities of day to day operation of the organisation, causing their budget goals to be inaccurate, unachievable or unclear. Secondly, the middle managers responsible for implementing and monitoring budgets may feel disenfranchised from the budget setting process and lack the motivation to achieve budget goals (Harvard Business School 2005).

The alternative to top down budgeting is bottom up or participatory budgeting. There are various levels of participatory budgeting, ranging from departments developing their own budgets for management approval through to top management developing budgets in consultation with departments and line managers. This approach solves many of the problems of top down budgeting while still achieving the strategic objectives of the organisation (Zelman, McCue, Millikan and Glick 2009).

Regardless of whether your organisation has adopted an authoritarian or participatory approach, middle managers, line manager and supervisors should still seek budget clarification, from relevant authorities. The relevant authority will vary depending on the organisation and your role but may include your immediate supervisor, the company accountant, financial manager, financial controller or a senior manager. According to Zelman, McCue, Millikan and Glick (2009) the advantages of participating in the budget process by seeking clarification can include:

• Ensuring that you are both clear about the goals and objectives of the organisation 
• Fostering cooperation and coordination between organisational departments
• Clarifying your role and responsibilities in the financial management process
• Providing financial managers with accurate front line information
• Ensuring the commitment of front line staff to budget goals

In most organisations the first budget is almost never the final, agreed budget. Usually budgets will go through a serious of budget negotiations and revisions before they are approved. Due to the diverging needs of front line managers and senior managers, first round budgets are almost never approved. Line managers will always want more resources for their department and senior managers will always want to economise (Finkler and McHugh 2008). This is where the negotiation and revision process comes in.

During the budget negotiation process line managers need to find ways of economising or be able to convince senior management that their department merits additional resources. If the line manager is successful in justifying the additional resources, senior management and financial control will be forced to find savings in other departments.

The Harvard Business School (2005, 179) suggests the following tips for negotiating budgets:

As you have probably already gathered, budgeting is not an exact science, especially when there are high levels of risk involved. In order to counteract this uncertainty it is necessary to develop contingency plans. Contingency planning involves anticipating and being prepared for unexpected events or emergencies which could cause an organisation to exceed their anticipated budget (Coke 2002). In the extract below, Bloom (2006) provides an excellent rationale for contingency planning.

There are two general approaches to contingency planning. One method involves allocating a predetermined fraction of the budget to deal with contingencies based on the level of risk (Delany 2013). The second method involves identifying potential risks and preparing contingency plans in the event that the initial budget or plan needs to be altered. Both of these methods involve identifying and analysing risks. While the best method will depend upon individual business factors, often a combination approach is the most appropriate option.

Risk identification is the first stage of the risk management process. Risk identification involves identifying as many risks as possible regardless of how unlikely they may seem. The most important factor in risk analysis is to identify every possible risk. If a risk is not identified it cannot be treated. One of the best ways to identify risks is by including a wide variety or relevant personnel. Each individual brings a new perspective to risk identification and knows best the risks which are most likely to affect them (Anandarajah, Aseervatham and Reid 2008). Risks that are may affect the financial management process include:

• Increased competition
• Economic uncertainty 
• Political turmoil 
• High turnover
• Negative cash flow
• Fraud or theft
• Equipment failure
• Natural disasters
• Inaccurate forecasting
• Human error

The next stage of the risk management process is risk analysis. Risk analysis involves assessing the likelihood and impact of a given risk in order to determine its priority. In other words, how likely is it and how sever are the consequences. The priority of a given risk can be determined using a matrix like the one below, which measures likelihood on one axis and impact on the other. The relative priority of a risk determines the amount of time and effort an organisation should devote to preventing it (Anandarajah, Aseervatham and Reid 2008).

Once you are aware of and understand the likelihood and impact of the various risks facing the organisation you can then begin to develop your contingency plan. The first method of contingency planning involves allocating a predetermined fraction of the budget to deal with contingencies based on the level of risk (Delany 2013). If a risk or unforeseen event occurs during the budget period, the contingency can then be put in place to recover from or adapt to that change. This is why the amount of contingency is so dependent on the level of risk. The more risks there are and the higher their priority, the higher the contingency needs to be. Contingencies can range from 1% to 10% of the total budget or sometimes more depending on the level of risk (Venkataraman and Pinto 2011).

In addition to allocating a contingency budget, businesses frequently develop contingency plans to be used in the event that the initial budget or plan needs to be altered. According to Shim, Siegel and Shim (2011, 40) “contingency planning involves identifying the possible occurrence, ascertaining warning signs and indicators of a problem, and formulating a response.” Contingency planning may include:

• Contracting out or outsourcing human resources and other functions or tasks
• Diversification of outcomes
• Finding cheaper or lower quality raw materials and consumables
• Introducing benchmarking or best practices
• Increasing sales or production
• Recycling and re-using
• Rental or hire of required materials, equipment and stock
• Replacing outdated equipment with state of the art equipment
• Restructuring of organisation to reduce labour costs
• Using less-skilled labour for certain processes
• Using contract labour during temporary increases in production
• Outsourcing processes or supply of component parts
• Seeking further funding
• Strategies for reducing costs, wastage, stock or consumables
• Reducing the amount of inventory
• Increasing advertising expenditure
• Introducing new product lines
• Opening additional stores
• Renovating existing stores

^{(Anandarajah, Aseervatham and Reid 2008)}

The following case study has been developed to assist in your learning. In the case study below, the sales manager of a small soft drink manufacturer develops a contingency plan to be put in place if the original budgets need to be varied.

In this section you have learned how to access budget/financial plans for the work team. You then learned how to clarify and negotiate budgets with relevant personnel to ensure that documented outcomes are achievable, accurate and comprehensible. Finally, you learned how to prepare contingency plans in the event that initial plans need to be varied.