Capital Budgeting: Investment Strategies And Functioning

A budget is a financial plan for a defined period that can enhance the success of any financial undertaking. It is an estimation of revenue and expenses that's made for a specified future period. Budgets are an essential part of running a business efficiently and are usually created for each financial year.

There are several types of budgets used for investment functions, including:

- Incremental Budgeting: This approach uses the previous year's actual figures and makes adjustments by adding or subtracting a percentage to obtain the current year's budget. It is simple and easy to understand but may perpetuate inefficiencies and result in budgetary slack.

- Activity-based Budgeting: This top-down approach determines the amount of inputs required to meet the company's output targets. It helps identify bottleneck-related activities and ensures resources are directed towards the most productive activities.

- Value Proposition Budgeting: This method involves asking questions like Why is this amount included in the budget? and Does the item create value for customers or stakeholders? It aims to ensure that everything in the budget delivers value and avoids unnecessary expenditures.

- Zero-based Budgeting: This approach assumes all department budgets are zero and must be rebuilt from scratch, with managers justifying every expense. It is useful when there is an urgent need for cost containment and can be time-consuming.

Sales budget: focuses on allocating resources to achieve forecasted sales

A sales budget is a financial plan that estimates a company's total revenue within a specific time period. It is a crucial tool for business owners, as it forms the foundation for other budgets, including marketing, purchasing, and production.

The sales budget is instrumental in coordinating and controlling a company's activities by integrating selling, marketing, inventory, and production to efficiently allocate resources. It also provides real-time feedback to guide management in making necessary adjustments.

The sales budget is distinct from sales forecasting, which involves predicting future sales revenue, and a sales expense budget, which focuses on expenses over a given period.

Components of a Sales Budget

A comprehensive sales budget typically includes three key elements:

• Income statement: Presents the net income of the company and offers a financial overview.
• Balance sheet: Lists the company's liabilities, assets, and equity for a specific budgeting period.
• Cash flow statement: Details cash received and spent during the budgeting period.

Methods of Sales Budgeting

There are several methods for creating a sales budget:

• What is affordable: This approach is often used by firms dealing in capital industrial goods or those that place less emphasis on sales and marketing functions.
• Rules of Thumb: Used by mass-selling goods companies and those dominated by financial functions, this method is based on a given percentage of sales.
• Competitive parity: Employed by large companies facing intense competition, this method requires knowledge of competitors' activities and resource allocation.
• Objective and Task Method: This systematic method identifies the sales function's objective and then determines the necessary selling and related tasks, calculating their costs to establish the total budget.
• Zero-based budgeting: This approach starts from the assumption that all department budgets are zero and must be justified from scratch. It is useful when there is an urgent need for cost containment.

Steps to Creating a Sales Budget

• Choose a time period: Select a budgeting period, typically monthly, quarterly, or annually, that aligns with your business needs and the nature of your products.
• Evaluate inventory and prices: Consider your product offerings, prices, and any planned changes to predict future sales accurately.
• Analyse past sales data: Review data from previous periods matching your current budget period to make more informed and realistic predictions.
• Compare data with the current industry: Align your goals with market trends and competition by comparing your sales data with similar companies.
• Gather feedback: Engage with your sales team and customers to understand buyer expectations, preferences, and potential areas of improvement.
• Consider market trends and current events: Factor in external factors, such as the impact of the pandemic, to adjust your sales budget accordingly.
• Create your budget: Utilise the information gathered in the previous steps to build a clear and objective-focused sales budget.

Best Practices for Sales Budgeting

To ensure the effectiveness of your sales budget, consider the following best practices:

• Keep objectives clear: Clearly define what you aim to accomplish in the upcoming sales period to guide your team's efforts effectively.
• Outline key activities: Go beyond stating profit targets by detailing the critical activities that will contribute to achieving those goals.
• Generate solid expense estimates: Account for any expenses required to meet your sales projections, such as additional marketing materials for a new product launch.
• Foster coordination and communication: Ensure that all relevant teams, including sales, marketing, administrative, and production, are involved and informed about the sales budget and its implications.

Production budget: calculates the number of units to be manufactured, derived from sales forecasts and planned inventory

A production budget is a crucial component of a company's overall budgeting strategy, as it outlines the number of units that need to be manufactured to meet sales targets and maintain optimal inventory levels. This budget is derived from sales forecasts and planned inventory levels, aiming to balance the need for sufficient stock to meet demand with the desire to minimise storage costs and avoid excess inventory.

The first step in creating a production budget is estimating sales, which forms the basis for determining the desired quantity of inventory. This involves using either formal or informal sales forecasting techniques, or a combination of both. Formal techniques often involve statistical tools and economic indicators such as gross national product, population growth, and per capita income. Informal techniques may include intuition, judgement, and other environmental factors such as advertising expenditures and competitor activity.

Once sales estimates are established, the next step is to define the company's inventory policy, including the desired ending inventory. This is typically calculated as a percentage of the next period's sales, allowing for flexibility and growth while ensuring enough stock is available to meet demand. For example, a company may aim to maintain 40% of the next quarter's sales in ending inventory.

The production budget then considers the units in the sales budget and the company's inventory policy to determine the required production volume. It is important to carefully schedule production to maintain minimum inventory levels while avoiding excessive accumulation. The primary objective of the production budget is to coordinate the production and sale of goods in terms of both time and quantity.

In the case of a manufacturing company, the production budget is further broken down into sub-budgets for materials, labour, and overhead. These sub-budgets detail the specific components required for production, including raw materials, labour hours, and associated costs.

For instance, let's consider a company called Leed, which manufactures low-priced running shoes. Leed's management forecasts sales of 100,000 units for the year, with quarterly sales of 15,000, 40,000, 20,000, and 25,000 units. The selling price per pair of shoes is $40. To determine the number of units to be produced, Leed's management would consider the sales budget and their inventory policy. If they aim to maintain 40% of the next quarter's sales in ending inventory, they would calculate the desired ending inventory as 40% of the forecasted sales for the next quarter. This calculation helps them plan their production accordingly.

In summary, a production budget is a critical tool for companies to effectively manage their inventory and production. It involves estimating sales, defining inventory policies, and coordinating production to meet sales targets while minimising excess stock. By creating a comprehensive production budget, companies can ensure they have sufficient units manufactured to meet demand while optimising their resources and minimising costs.

Incremental budget: uses the previous period's budget or performance, with marginal changes for the new budget

Incremental budgeting is a common approach to budgeting that uses the previous period's budget or performance as a base, with small adjustments made to create the new budget. This method is often chosen for its simplicity and ease of use, particularly for small businesses or those new to budgeting. It is also practical, as it adjusts costs by a measurable factor, such as the rate of inflation or the increase in the Consumer Price Index (CPI).

The process involves taking the prior year's budget and adjusting for any increase in costs. The rate of inflation is commonly used as a guide for the adjustment factor, though some businesses may scrutinise each budget line item individually. While incremental budgeting does not require an in-depth analysis of expenses, significant thought should still be given to the adjustments made. This is because, unlike zero-based budgeting, incremental budgeting assumes that all current expenditures are justifiable and necessary.

Incremental budgeting is considered the most conservative approach to budgeting and is often chosen for its ability to provide stability. It ensures funding stability over time, as expenses are relatively easy to project, and it provides operational stability as budgets remain consistent and predictable. This makes it a good choice for businesses with long-term projects requiring multi-year funding. It also reduces internal rivalry as departments are not forced to compete for a larger portion of the budget.

However, incremental budgeting has several disadvantages. It can promote unnecessary spending as departments may feel pressured to spend their entire allocated budget to avoid a reduction in future periods. It may also discourage innovation as there is little room for the funding of new ideas or activities. Additionally, it fails to account for external factors and changes, assuming constant stability in the company's operations. This lack of responsiveness to potential changes can be problematic in today's fast-paced business environment.

Overall, incremental budgeting is a straightforward and stable approach to budgeting that is widely adopted in modern business settings. While it is simple to implement and manage, it may not be suitable for businesses that require flexibility and the ability to adapt to changing circumstances.

Cash flow budget: forecasts cash flow in and out of a business, assessing if there is enough cash on hand

A cash flow budget is a vital tool for businesses, providing an estimation of the cash inflows and outflows over a specific period. This could be weekly, monthly, quarterly, or annually.

Cash flow budgets are essential for businesses to understand their financial health and make informed decisions. They allow businesses to assess whether they have sufficient cash to continue operating and provide insights into cash needs and any surpluses. This, in turn, helps determine efficient cash allocation and whether the business is using cash effectively.

A well-prepared cash flow budget will include both cash inflows and outflows. Cash inflows refer to the sources of cash coming into the business, such as sales revenue, debt repayments, and proceeds from selling unnecessary assets. Outflows, on the other hand, include all cash expenditures, such as payments to suppliers, operating expenses, and investments.

By analyzing cash flow projections, businesses can identify potential cash flow gaps and take proactive measures. For example, they can optimize inventory levels, negotiate better payment terms with suppliers, or secure additional financing if needed.

Overall, a cash flow budget is a powerful tool for businesses to navigate uncertainties, mitigate risks, and steer their operations toward sustainable growth and profitability. It helps businesses ensure they have enough cash on hand to meet their short-term financial obligations and fund ongoing operations and strategic initiatives.

Business budget: estimates a company's revenue and expenses over a specific period

A business budget is a financial plan that estimates a company's revenue and expenses over a specific period, usually a month, quarter, or year. It is an integral part of running a business efficiently and serves as a plan of action for managers as well as a point of comparison at the end of the period.

There are several types of budgets used by companies, including master budgets, static budgets, operating budgets, and cash-flow budgets. A master budget is a projection for the overall company, typically forecasting the entire fiscal year. It includes projections for items on the income statement, balance sheet, and cash flow statement, such as revenue, expenses, operating costs, sales, and capital expenditures.

An operating budget highlights a company's projected revenue and expenses over a specific period and is usually prepared at the beginning of the financial year. It may include capital costs, non-operating expenses, fixed costs, or variable costs.

A static budget is based on planned outputs and inputs for each of the company's divisions and remains unchanged throughout the budget period, regardless of any fluctuations in sales or production volumes. It is often used as a baseline or starting point, particularly for industries with fixed amounts of equity, such as nonprofits, educational institutions, or government bodies.

A cash-flow budget helps managers determine the amount of cash being generated by a company during a specific period by examining inflows and outflows. This type of budget is important because it helps companies manage their cash flow effectively and plan for any cash shortages or surpluses.

The process of creating a business budget can be challenging, especially when dealing with intermittent revenue and sales or late customer payments. However, budgeting is crucial for businesses as it helps them predict cash flow and expenses, allowing management to make informed financial and operational decisions. It also enables businesses to avoid or reduce debt and increase opportunities for loans and investors.

There are several steps involved in creating a business budget:

• Gather financial data: Review past financial data, including income statements, expense reports, and sales data, to identify trends and learn from past experiences.
• Find a template or create a spreadsheet: Utilize a budget template or create a custom spreadsheet with rows and columns based on the business's needs.
• Fill in revenues: List all sources of business income and forecast revenue streams based on previous months or years.
• Subtract fixed costs: Account for recurring fixed costs, such as insurance, rent, website hosting, and internet expenses, which remain relatively stable regardless of changes in business activity.
• Consider variable costs: Variable costs, such as raw materials, packaging, shipping, utility bills, and advertising costs, will fluctuate depending on the level of production or sales.
• Set aside time for budget planning: Review the budget to determine savings and create multiple savings accounts for emergencies and business growth.
• Conduct budget reviews: Regularly compare the estimated budget to actual spending to improve revenue and expense projections. This can be done monthly, quarterly, and yearly.

Frequently asked questions