Functional Budgets

A functional budget is a budget which relates to any of the functions of an undertaking, e.g., sales, production, research and development, cash etc.

Following functional budgets are generally prepared:  

(i) Sales Budget:

Sales budget is the most important budget and of primary importance. It forms the basis on which all the other budgets are built up. This budget is a forecast of quantities and values of sales to be achieved in a budget period. Every effort should be made to ensure that its figures are as accurate as possible because this is usually the starting budget (sales being limiting factor on which all the other budgets are built up).

The Sales Manager should be made directly responsible for the preparation and execution of the budget. The sales budget may be prepared according to products, sales territories, types of customers, salesmen etc.

In the preparation of the sales budget, the sales manager should take into consideration the following factors:

1. Past Sales Figures and Trends:

The complier of the sales budget should be assisted by graphs recording sales of the previous year and the general sales trend (upward and downward) should be noticed from the graphs. The record of previous year’s sales is the most reliable basis as to future sales as the past performance is based on actual business conditions. But in addition to past sales, other factors affecting future sales, e.g., seasonal fluctuations, growth of market, trade cycle etc., should be considered in the preparation of the sales budget.

2. Salesmen’s Estimates:

In preparing the sales budget, the sales manager should consider the estimates of sales received from salesmen because they can make more accurate estimates, being in direct contact with the customers. However, it should be seen that salesmen’s estimates should neither be over-optimistic nor too conservative.

3. Plant Capacity:

The budget should be within the plant capacity available and should ensure proper utilisation of plant facilities. Proposed plant extensions should be allowed for in the preparation of the sales budget.

4. Availability of Raw Material and Other Supplies:

Adequate supply of raw materials and other supplies should be ensured before preparing the sales estimates. Sales estimates should be adjusted according to the availability of raw material if the raw materials are in short supply.

5. General Trade Prospects:

The probability of the sales going up or down depends on the general trade prospects. In this connection valuable information may be gathered from financial papers and magazines such as the Economic Times, the Financial Express, the Commerce, etc.

6. Orders in Hand:

In boom periods or where production is a very lengthy process the value of orders in hand may have considerable influence on the amount of sales to be budgeted.

7. Seasonal Fluctuations:

In preparation of the sales budget, seasonal fluctuations should be considered because sales are affected by these fluctuations. In order to have an even flow of production, efforts should be made to minimise the effects of seasonal fluctuations on sales by giving special concessions or added inducements during the off- season.

8. Financial Aspect:

The sales budget should be within the financial capacity of the concern. Sales expansion usually requires an increase in capital outlay. Thus, if any big sales expansion is planned, it must be ensured that facilities are available to finance the operations.

9. Adequate Return on Capital Employed:

The sales volume budgeted should produce an adequate return on the capital employed.

10. Competition:

The nature and degree of competition within the industry should be considered in the preparation of the sales budget to have a realistic sales budget capable of being achieved in the face of competition.

11. Miscellaneous Considerations:

Other considerations such as advertising and sales promotion efforts, government intervention, import possibility, product profitability, market research studies, pricing policies etc. should also be kept in view.

The sales manager, after taking into consideration the above factors, should prepare the sales budget in terms of quantities and amounts and the sales estimates must be analysed for products periods and territories. The sales budget should include an estimate of selling and distribution costs in addition to an estimate of the total proceeds.

(ii) Production Budget:

Production budget is a forecast of the total output of the whole organisation broken down into estimates of output of each type of product with a scheduling of operations (by weeks and months) to be performed and a forecast of the closing finished stock. This budget may be expressed in quantitative (weight, units etc.) or financial (rupees) units or both.

This budget is prepared after taking into consideration the estimated opening stock, the estimated sales and the desired closing finished stock of each product.

The Works Manager is responsible for the total production budget and the departmental managers are responsible for the departmental production budget.

In preparing the production budget, the following factors are considered:

(1) The time lag between the production in the factory and sales to the customer should be considered so as to allow for the time required for the despatch of goods from the factory to the place of the customers.

(2) The stock of goods to be maintained both at the factory’s godown and at the sales centres.

(3) The level of production needed to meet the sales programme. Monthly production targets should be fixed and it should be seen that production is kept more or less at a uniform level throughout the year.

Planning the level of production involves the answer of four questions:

(a) What is to be produced?

(b) When is it to be produced?

(c) How is it to be produced?

(d) Where is to be produced?

The material, labour and plant requirements should be ascertained to have the desired production to meet the sales programme.

The sales and the production budget are inter-dependent because production budget is governed by the sales budget and the sales budget is largely determined by the production capacity and by production costs. The specimen proforma of production budget is given on the next page.

(iii) Cost of Production Budget:

After determining the volume of output the cost of procuring the output must be obtained by preparing a cost of production budget. This budget is an estimate of cost of output planned for a budget period and may be classified into material cost budget, labour cost budget and overhead budget because cost of production includes material, labour and overheads.

Materials Budget:

In drawing up the production budget, one of the first requirements to be considered is material. As we know, materials may be direct or indirect. Thus materials budget deals with the requirement and procurement of direct materials. Indirect materials are dealt with under the works overhead budget.

The budget should be related to the production budget and the period of the budget should be of short duration because this budget has an important bearing on the cash budget.

The preparation of the materials budget includes:

(1) The preparation of estimates of different types of raw materials needed for various products.

(2) Procuring or purchasing raw materials in required quantities at the required time.

In preparing the materials budget the following factors are considered:

(i) Raw materials required for the budgeted output.

(ii) The percentage of raw materials to total cost of products should be calculated on the basis of previous records. On the basis of this percentage a rough total value of raw materials required for the budgeted output will be ascertained.

(iii) Consideration must be given to the company’s stocking policy. Figures related to the anticipated raw materials stock to be held at different times should be known.

(iv) Consideration must be given to the lag between the placing of the order of the purchase of materials and the receipt of materials.

(v) The seasonal nature in the availability of raw materials should be considered.

(vi) The price trend in the market.

Materials budget can be classified into material requirement budget and material procurement purchase budget. The material requirement budget gives information about the quantity of materials required during the budget period to attain the production target. Material requirement budget takes into consideration the inventory of materials and the materials on order at the beginning of a budget period, and the anticipated inventory of materials are the materials to be on order on the closing date of the budget period.

Purchase Budget:

Purchase Budget is mainly dependent on production budget and material requirement budget. This budget provides information about the materials to be acquired from the market during the budget period.

Following factors should be taken into consideration while preparing a purchase budget:

1. Quantity and quality of each material needed according to the production target;
2. Capital items, tools and general supplies required during the budget period ;
3. The present stock position and materials expected to arrive, already covered by purchase orders ;
4. The dates on which purchase items are required ;
5. Prices of items to be bought and possibility of quantity discount;
6. Sources of supply ;
7. Availability of cash to settle accounts of suppliers ;
8. Transport requirements ;
9. Inspection and receiving arrangements ; and
10. Storage capacity and other factors such as handling of stocks, insurance, obsolescence and shrinkage.

Purchase budget should be prepared by the purchase manager by getting relevant information about capital items, tools, general supplies and direct materials required during the budget period from other related departments. Like other budgets, the purchase budget has to be approved by the budget committee.

After approval it becomes the responsibility of the purchase officer to see that purchases are made as per the purchase budget.

(iv) Labour and Personnel Budget:

Direct Labour Budget:

This budget gives an estimate of the requirements of direct labour essential to meet the production target. This budget may be classified into labour requirement budget and labour recruitment budget. The labour requirement budget is developed on the basis of requirement of the production budget given and detailed information regarding the different classes of labour, e.g. fitters, welders, turners, millers, grinders, drillers etc., required for each department, their scales of pay and hours to be spent.

This budget is prepared with a view to enable the personnel department to carry out programmes of training and transfer and to find out sources of labour needed so that every effort may be made to remove difficulties arising in production through lack of suitable personnel.

Labour recruitment budget is prepared on the basis of labour requirement budget after taking into consideration the available workers in each department, the expected changes in the labour force during the budget period due to the labour turnover.

This budget gives information about the personnel specifications for the jobs for which workers are to be recruited, the degree of skill and experience required and the rates of pay. In preparing the labour cost budget, the question of overtime should not be overlooked because workers are to get higher rates of wages if they work on overtime.

Regular overtime should be avoided by engagement of additional workers and extension of plant. Where standard costing system is applied, the labour cost budget is developed on the basis of standard labour cost per unit multiplied by the quantity of anticipated production determined in the production budget. If standard costing system is not being followed in the organisation, the information of labour cost may be obtained from past records or estimated cost.

Manpower Budget:

This budget gives the requirements of direct and indirect labour necessary to meet the programme set out in the sales, manufacturing, maintenance, research and development and capital expenditure budgets. The labour requirements are expressed in terms of rupee value, number of labour hours, number and grade of workers etc. This budget makes provision for shift and overtime work and for the effective training for new workers on labour cost.

The main purposes of this budget are:

(1) It provides efficient personnel management.

(2) It helps to make provision for a suitable yardstick with which the actual labour force may be compared and controlled.

(3) It helps in reducing labour turnover by providing favourable conditions.

(4) It also helps to measure and stabilise the ratio between direct labour and indirect labour.

(5) It gives the requirements of cash for paying wages and thus facilitates the preparation of Cash Budget.

(v) Manufacturing (or Production) Overheads Budget:

This budget gives an estimate of the works overhead expenses to be incurred in a budget period to achieve the production target. The budget includes the cost of indirect materials, indirect labour and indirect works expenses. The budget may be classified into fixed cost, variable cost and semi-variable cost. It can be broken into departmental overhead budget to facilitate control.

In preparing the budget, fixed works overhead can be estimated on the basis of past information after taking into consideration the expected changes which may occur during the budget period. Variable expenses are estimated on the basis of the budgeted output because these expenses are bound to change with the change in output.

The Cost Accountant prepares this budget on the basis of figures available in the manufacturing overhead ledger or the head of the workshop may be asked to give estimates for the manufacturing expenses. A good method is to combine the estimates of the Cost Accountant and the shop executive.

(vi) Administration Expenses Budget:

This budget covers the expenses incurred in framing policies, directing the organisation and controlling the business operations. In other words, the budget provides an estimate of the
expenses of the central office and of management salaries. The budget can be prepared with the help of past experience and anticipated changes.

Budget may be prepared for each administration department so that responsibility for increasing such expenses may be fixed and related to the different executives. Much difficulty is not experienced in developing such budget as most of the administration expenses are of a fixed nature.

Although fixed expenses remain constant and are not related to sales volume in the short run, they are dependent upon sales in the long run. With a small change in output, they do not change.

However, if there is a persistent fall in output, administration expenses will have to be reduced by discharging the services of some members of the staff and taking other economy measures. On the other hand, with persistent increase in output or business activity, administration expenses will increase but they may lag behind business activity.

(vii) Plant Utilisation Budget:

This budget lays down the requirements of plant capacity to carry out the production as per the production programme. This budget is expressed in terms of convenient physical units as weight or number of products or working hours.

The main functions of this budget are:

(i) It will show the machine load in each department during the budget period.

(ii) It will indicate the overloading on some departments, machine or group of machines and alternative courses of actions as working overtime, off-loading, procurement or expansion of plants, sub-contracting etc., can be taken.

(iii) Idle capacity in some departments may be utilised by making efforts to increase the demand for the products by providing after sale service, conducting advertisement campaign, reducing prices, introducing lucky prize coupons, recruiting efficient sales staff etc.

(viii) Capital Expenditure Budget:

The capital expenditure budget gives an estimate of the amount of capital that may be needed for acquiring the fixed assets required for fulfilling production requirements as specified in the production budget. The budget is prepared after taking into consideration the available productive capacities, probable reallocation of the existing assets and possible improvement in production techniques. Separate budgets may La prepared for different items of fixed assets such as plant and equipment budget, building budget etc.

The capital expenditure budget is an important budget providing for acquisition of assets, necessitated by the following factors:

(i) Replacement of existing assets.

(ii) Purchase of additional assets to meet a proposed increase in production due to increase in demand.

(iii) Purchase of additional assets because of starting up of new lines of production.

(iv) Installation of an improved type of machinery so as to reduce cost of production.

Thus, the capital expenditure budget enables one to know what new fixed assets are needed and what will be their costs and rates of return.

(ix) Research and Development Cost Budget:

While developing research and development cost budget, it should be clear in mind that work relating to research and development is different from that relating to the manufacturing function. Manufacturing function gives quicker results than research and development which may go on for several years. Therefore, these budgets are established on a long term basis say for 5 to 10 years which can be further subdivided into short-term budgets on annual basis.

As a rule research workers are less cost conscious; so they are not susceptible to strict control. A research and development budget is prepared taking into consideration the research projects in hand and the new research and development projects to be taken up. Thus this budget provides an estimate of the expenditure to be incurred on research and development during the budget period.

After fixation of the research and development cost budget, the research executive fixes priorities for the various research and development projects and submits research and development project authorization forms to the budget committee.

The projects are finally approved by the senior executive. Before giving the approval, the expenditure on research and development is matched against the benefits likely to be availed of from the new object. After the approval of the budget, a close watch is kept on the expenditure so that it may not exceed budget provisions. It is also seen that extent of progress made is commensurate with the expenditure incurred.

(x) Cash (or Financial) Budget:

This budget gives an estimate of the anticipated receipts and payments of cash during the budget period. Therefore, this budget is divided into two parts, one showing the estimated cash receipts on account of cash sales, credit collections and miscellaneous receipts and the other showing the estimated disbursement on account of cash purchases, amount payable to creditors, wages payable to workers, indirect expenses payable, income tax payable, dividend payable, budgeted capital expenditure etc. In short, every factor which affects the receipts and payments of cash is taken into account in the preparation of this budget.

Cash budget makes a provision for a minimum cash balance which will be available at all times. In general, this balance should be equal to one month’s operating expenses plus some provision for contingencies. The minimum balance of cash will help in tiding over adverse conditions of a minor nature. Meanwhile management can make alternative arrangement for additional cash.

This budget is prepared by the Chief Accountant for the guidance of management so that arrangements may be made for the requirements of the organisation.

Advantages of Cash Budget:

Following are the main advantages of preparing cash budget:

(i) It provides an opportunity to review the cash flow for future periods as realistically as possible and make sure that cash is available for revenue and capital expenditure.

(ii) Where adequate amount of cash is not likely to be available during certain periods e.g. when payment of bonus, dividend, tax etc. fall due the company can know in advance so that advance action can be taken to make available the required amount on the most advantageous terms.

(iii) If large surplus of cash is likely to result during certain periods then it will be possible to plan most profitable investment of these funds.

(iv) Preparation of a cash budget by a company will help to plan its cash position in such a way that maximum seasonal discounts can be availed of.

(v) Even for obtaining funds from financial institutions, the system of preparing cash budget helps to convince the bank or other financial institutions about the benefices of the company’s requirements.

(vi) The importance of cash budget may be more in some trades than in others e.g. in trades where there are wide seasonal fluctuations or where long contracts are undertaken.

There are three methods of preparing cash forecasts:

(i) Receipt and Payment Method

(ii) Balance Sheet Forecast Method

(iii) Profit Forecast Method.

(i) Receipt and Payment Method:

This method is useful for forecasting all cash receipts and payments for a short period. Forecasts of cash receipts and payments are made on the basis of the provisions made in the individual functional budgets including the capital expenditure budget and research and development budget. In short, this method of cash forecasts is the same as we have described in the beginning of the discussion on cash budget. Following illustration will make it more clear.

(ii) Balance Sheet Forecast Method:

This method is used for long term forecasting of cash. Forecast of cash is made on the basis of changes in the balance sheet. The opening balance of cash all anticipated changes in the assets and liabilities are added or deducted according to the nature of the time.

Decreases in assets and increases in liabilities are added to the opening balance of cash and increases in assets and decreases in liabilities are deducted from the opening balance of cash. The resulting figure is the estimated cash in hand or cash required at the end of the period.

This method suffers from the following defects:

(a) This method does not take into consideration items of expenses and incomes on the assumption that there is a regular pattern of inflow and outflow of cash.

(b) This method does not give an idea of surplus or deficiency of cash occurring within the budget period because it shows cash in hand or cash required at the end of the budget period.

(iii) Profit Forecast Method:

This method is also helpful for long term forecast of cash and is based on the assumption that it is the profit which makes cash available to the opening balance of cash, estimated net profit adjusted by adding back depreciation (not being outflow of cash), decrease in amount due to stock, bills receivable, debtors, work-in-progress and fixed assets, capital receipts, increase in liabilities and amount received on issue of shares and debentures are added.

Increase in amount due to current assets and fixed assets, decrease in liabilities, dividend payments and prepayments are deducted and the resultant figure will be cash in hand or cash required at the end of the budget period.

This method also has the same drawbacks which balance sheet forecast method has. Of all the three methods, receipt and payment method is the most popular because it shows surplus or deficiency of cash occurring within the budget period.