Module 6 LCP - workplacement.nsw.edu.au 6 LCP.pdf · work through the module to: confirm or revise your answers ... LCP should implement a range of planning ... and were designed

001

Introduction

In this module we look at the budget — a key mechanism, or tool, to help with financial planning and control.

The module also looks at signs that give warning of financial instability or non -viability.

Before you begin

If you already have some knowledge of the mechanisms for financial planning and control, particularly budgets, you might choose to begin with

the Quick quiz on page 22 at the end of this module and then complete the Review tasks on page 23. When you have answered as many of the quiz and review questions as you can, begin to work through the module to:

confirm or revise your answers

find the answers you did not know.

When you have completed the module, you should revise the quiz and the review tasks. If you have little or no knowledge of financial planning and control, read on.

Key learning outcomes

The learning outcomes for this module are divided into two categories — learning which involves improving your knowledge or understanding, and learning which develops skills and strategies.

After successfully completing all the exercises in this module you will:

4 understand the place and importance of budgeting in planning, controlling and evaluating the financial position of an organisation

4 be able to recognise and analyse variance in financial reporting information

4 be able to recognise financial warning signs as they relate to budget and performance.

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Accounting Practices: Budget analysis and control

Activities for planning and control

LCP should implement a range of planning and control activities to ensure that the business of the organisation is focussed on achieving agreed goals and objectives.

Budgets

Budgets are integral to the process of planning and control and are prepared by an organisation to assist with planning for the future. Budgets are considered essential to the achievement of the organisation’s financial goals.

What does the term ‘budget’ mean to you in the context of your organisation?

A budget is a plan or forecast of anticipated financial results for a specified period.

Usually budgets are presented in a form similar to the normal accounting reports. These are:

4 budgeted Income and Expenditure Statement. This shows expected earnings and costs.

4 budgeted Balance Sheet. This shows the expected financial position of the organisation.

4 cash budget. This is a budgeted Cash Flow Statement.

Depending on its size, an organisation may prepare its budgets for the short term (eg the next three months or the next year), or for the long term (eg the next five years).

A budget, diligently prepared by experienced people, can provide the basis of the control of an organisation’s future activities. The management committee can use budgets to effectively control the affairs of the organisation.

Budgeting is a management tool that helps to control an organisation’s operations.

The Budgeting Process

The budgeting process has three stages — planning, controlling and evaluating.

1. Planning

Targets are set for a specific period (one month, one quarter, one year, five years). These provide definite goals to work towards, and limits to stay within. A well-planned budget allows management to look ahead and be ready for changing conditions. Planning for the future of an organisation is much more accurate and focused when one or more budgets are prepared.

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2. Controlling

Clear limits are established as to how much can be spent.

3. Evaluating

Actual results are compared with budgeted figures to see how closely actual performance match estimated performance.

The table on the following page shows the range of activities involved in the three stages of the budgeting process.

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Step 1

Gather & analyse all relevant information: § historical results § known internal changes, eg new courses

§ known external changes, eg funding variations .

Step 2

Estimate future revenues and future expenditures , using the analysis from Step 1. § be objective and realistic § avoid setting ‘easy’ targets, eg low fees § avoid “padding”, ie including buffers in cost budgets.

Step 3

Formulate and implement the organisation’s budget: § use the organisation’s chart of accounts to dictate the

level of detail in the budgets § use the organisation’s reporting cycle to dictate the

budget periods, eg monthly § present the budgets in the format of the organisation ’s

standard reports, eg Income and Expenditure Statement § compare dollar values and ratios in the budget with

historical results as a “reality check” § communicate the operational parameters embodied

within the budget to operational staff .

Step 4

Process the organisation’s actual results through the accounting system each period.

Step 5

Compare and analyse actual results relative to budget and identify reasons for short-term variances .

Step 6

Evaluate the reasons for variances and act on the outcomes of that evaluation: § move to correct processes giving rise to unfavourable

variances § identify sources of variances with long- term or ongoing

implications .

Planning

Controlling

Evaluating

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Assessing Budget Performance

Comparing performance and expectations

Budgets and other yardsticks, such as targets for student contact hours or student enrolments, are used to compare and judge actual performance against what was expected, ie against agreed goals or objectives. Usually the budget compares actual performance to:

4 current period results to the same period last year

4 current year-to-date results to both the budget and the same period last year.

Budgets prepared prior to the accounting period

Budgets prepared prior to the accounting period should set out what the organisation plans to do. They:

4 show the financial impacts of the proposed operational plans

4 allow the committee to decide if the operational plan is financially realistic

4 allow responsibility for implementation to be delegated to management (within budgets)

4 provide the committee with a yardstick to monitor actual performance over the year.

Variance

The comparison of actual results with budgets will inevitably reveal variances. Variances relate to Revenue and Costs and they enable the reconciliation of actual results with the budgeted expectations. Variances can be favourable or unfavourable.

Favourable and unfavourable variances

A favourable variance leads to an increase in operating profits. An unfavourable variance leads to a decrease in operating profits. The table below gives examples:

Variances Favourable Unfavourable

Revenue variances Actual sales revenue is greater than budgeted sales revenue.

Actual sales revenue is less than budgeted sales revenue.

Cost variances Actual costs and expenses are less than budgeted costs and expenses.

Actual costs and expenses are greater than budgeted costs and expenses.

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Reasons for variance from the budget

Variance from the budget can occur because:

4 the budget was based on faulty or incorrect data

4 the organisation’s circumstances have changed since the budget was prepared

4 budgetary guidelines were not followed

4 a combination of the above.

What does budget variation reveal about performance?

Budget variances may reveal:

4 financial risk

4 financial opportunities.

Risk can arise from unexpectedly low income or cash inflow and unexpectedly high expenses (cash outflow). Opportunities can arise from unexpectedly high income or cash inflow and unexpectedly low expenses (cash outflow).

What does favourable budget variation reveal about financial viability?

A positive or favourable budget variation can mean that the organisation has sufficient financial resources to enable it to:

4 continue to achieve its objectives

4 meet its commitments as and when they fall due, ie they have the cash to pay all creditors due to be paid in the next period.

Corrective measures for unfavourable variances

When variances are unfavourable, corrective measures can be introduced. These may include:

4 re-evaluation of budgeting techniques

4 stronger supervision of the implementation of budgetary guidelines.

How are budget variances measured and disclosed?

Variances may be measured and disclosed in the following two ways:

4 the absolute size of the variance, namely, the difference between actual results attained and the original master budget

4 percentage analysis, where the absolute size of the variance is divided by the budget amount. The use of percentage analysis will enable the comparison of two divisions which are not equal in size or operating characteristics.

Below is an analysis of a Sunnyway budget using variances to determine the financial position of the organisation

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Sunnyway Training Inc — first quarter of 2006

Income was expected to be $65,000 ($18,000 from funding allocations, $45,000 from fees, and $2,000 from interest, dividends and other income).

Wages were expected to total $34,000.

Other operating expenses were budgeted at $22,000.

At the end of the p eriod the management committee was asked to compare the actual figures to those in the budget. Certain unfavourable variances were identified which led the committee to reassess its expenditure in particular areas over the next period.

The Income and Expenditure Budget based on these figures is set out in the table below:

Item Budget Actual Variance from budget

Income from funding allocations 18,000 18,000 0 -

Student fees 45,000 49,400 4,400 F

Interest, dividends, other income 2,000 1,800 (200) U

Total income 65,000 69,200 4,200 F

Operating expenses

Salaries and wages 34,000 35,000 1,000 U

Course costs 4,000 5,100 1,100 U

Depreciation 1,300 1,600 300 U

Rent 7,000 7,000 −

Other operating expenses 9,700 10,900 1,200 U

Total expenditure 56,000 59,600 3,600 U

Surplus 9,000 9,600 600 F

F indicates a favourable variance U indicates an unfavourable variance The Sunnyway treasurer provided further explanation of the budget figures:

Two new introductory courses in computing, on offer for the first time by the organisation, proved far more popular than anticipated. The courses were set up as the basis for new computing streams, and were designed to attract new students and then feed into more advanced and specialised computing courses. For this reason it was decided to take advantage of the initial strong interest in the courses and accept the overflow of enrolment applications.

Existing accommodation was adequate for the higher numbers and so there was no impact on rental costs. Expenditure on additional computers, however, which had been budgeted for the second half of the year was brought forward. This resulted in increased depreciation costs. Course costs increased as minor modifications were made to the course delivery methods to cater for larger classes, and as additional sets of course materials had to be produced.

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Salaries, wages and other operating costs also increased with extra overtime, postage, printing and stationery, and repairs and maintenance costs incurred in accommodating the higher enrolments.

Notwithstanding the extra costs, the extra enrolments added a small ($600) return to the bottom line. It is expected that, with the benefit of hindsight and better preparation in the future, these courses and the follow-on courses that they feed into will generate much greater returns.

This example illustrates a number of points:

4 Income and costs from operations will not deviate from a well-constructed budget without good reasons. Part of the responsibility of running an organisation is knowing what those reasons are.

4 Variances from budget do not usually occur in isolation. Factors which impact upon the operations can give rise to a number of variances, some of which may be favourable (increased revenues from strong enrolments) and some which may be unfavourable (higher costs of running the courses). In these situations, the overall impact must be considered along with the individual variances.

4 A budget should not act to constrain an organisation from making sound commercial decisions, consistent with its overall strategic plan. In this example, Sunnyway was in a position to take advantage of unanticipated strong demand for new courses, even though it meant bringing forward expenditure on computers and incurring additional expenditure in order to meet the demand.

4 The need for an organisation to be able to react to its circumstances applies equally in adverse conditions. Had Sunnyway’s new courses attracted low enrolments, it would have had to review its expenditure levels for those courses, possibly re-think its approach to promoting the courses in the market, and revise its plans for expenditure on additional computers in the latter half of the year. It would also have had to consider the implications for any planned follow-on courses.

There is a need for constant monitoring of financial performance. The organisation as a whole must commit to the principle of budgetary control.

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Budget responsibilities of committee members

The management committee should:

4 ask for explanations for every variance, both unfavourable and favourable

4 make further inquiries when not satisfied with explanations

4 look for any signs of financial instability

4 take action at every opportunity to rectify a known unfavourable variance

4 adhere to budgets that are appropriate, even those set by predecessors

4 ensure any new direction or emphasis is derived from the overall strategic plan

4 act upon all variances and follow through with corrective measures where necessary.

Danger signs

When you are comparing performance and budget you should look for any signs that give warning of financial instability or non-viability. The table below gives examples of financial danger signs and what action the committee should take.

Danger signs Action the committee should take

Declining working capital. Constant spending in excess of the limits set by the budget. (This can cause a cash drain)

Review the Cash Flow Statement to establish which areas of the organisation have caused the decline in working capital.

Review the operating statements. Unfavourable variances may indicate that insufficient revenue is being generated to sustain the positive cash flows for the operation.

High levels of external debt. Establish whether the external borrowings are:

in line with budgeted borrowings

being used to fund losses or to finance capital expenditure. If so there are solvency implications and the trend needs to be monitored.

Review the profitability of each operating unit.

Tighten reporting procedures.

Review financial delegations.

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Exercise 6.1: Analysing and explaining variance

Below is ARC ’s Income and Expenditure Statement as at 31 March 2006. Review the statement and the budget variances and

explain what each budget variance means

indicate, in the table below, whether each variance is favourable or unfavourable

identify implications that might result from these variances and make recommendations to management on what actions should be taken.

Annual budget

Item Year-to-date budget

Year-to-date actual

Budget variance

Income

38,000 Funding allocation 10,000 10,000 -

69,000 Student fees 18,000 21,000 3,000

500 Other income 100 120 20

107,500 Total income 28,100 31,120 3,020

Expenditure

66,000 Salaries, including super 16,000 17,800 1,800

3,000 Provision for leave 800 950 150

2,000 Staff development − − −

6,000 Advertising 3,000 2,000 (1,000)

0 Rent 0 500 500

1,200 Travel costs 500 490 (10)

12,000 Interest 3,500 3,500 −

1,500 Depreciation 350 350 −

0 Loss on sale of assets − − −

7,000 Curriculum costs 1,200 1,500 300

10,000 Course costs 4,000 5,500 1,500

108,700 Total expenditure 29,350 32,590 3,240

(1,200) Surplus/(Deficit) (1,250) (1,470) (220)

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Indicate in th e table below whether each variance is favourable or unfavourable, and identify what implications or actions might result

Budget variance U or F Implications and actions to be taken

Income

3,000

20

Expenditure

1,800

150

(1,000)

500

(10)

300

1,500

Surplus/(Deficit)

(220)

Tip for committee action

If your organisation has high levels of debt, and the causes of this debt are not within the budget or the agreed management plan, you need to establish what action the management of the organisation will take to address this.

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Answers 6.1

You were asked to review the Income and Expenditure Statement from ARC Adult Education and explain what each budget variance means, state whether each variance is favourable or unfavourable based on those variances, make recommendations to management on implications and actions to be taken.

Budget Variance

U or F Implications and actions to be taken

Income

3,000 F ARC has been successful in achieving higher than budgeted income from student fees. A review of what contributed most to this success would be warranted so that the outcome can be replicated, and perhaps even improved upon, in future periods. Future budgets should ta ke these results into account.

20 F This variance is too small to be significant.

No action is required.

Expenditure

1,800 U Salary costs are up and warrant investigation. It may be the result of processing and servicing higher-than-planned enrolments. If this is the case, future planning for higher enrolments may keep this cost in check.

150 U Leave provisions are up. This cost can be kept in check indirectly, (through close control on the salary budget), and directly (by ensuring staff take their leave entitlements and do not accumulate excessive leave). Be mindful that every time a staff member’s rate of pay increases, the value of leave owing to them at that time also increases.

(1,000) F Advertising costs are down. ARC has not spent any money on advertising in the last three years. This period’s result may reflect inexperience in identifying the costs of advertising when preparing the budget, or it may reflect incomplete or delayed implementation of ARC’s advertising program. Perhaps if the budget had been fully expended, enrolments and income would have been higher. Investigation is warranted.

A

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500 U ARC has invested in its own land and buildings so did not expect to incur rental costs. The reasons for the rental costs need to be investigated, eg was ARC locked into lease agreements, were its own premises not ready for use, were the new premises inadequate to meet its needs?

(10) F Variance in travel costs is not significant.

No action is required.

300 U Curriculum costs are higher than budgeted and the reasons should be identified. The increase may have flowed from the higher than planned enrolments, where costs were incurred to adapt courses for larger class sizes. This may have implications for future budgets.

1,500 U Course costs are over budget. With the higher enrolments, some overrun is to be expected, but it should not be excessive. An optimistic outlook for revenues does not justify lack of attention to cost control. In the case of ARC, course costs have exceeded budget by more than 37%. The causes need to be investigated.

Surplus/(Deficit)

(220) U ARC had budgeted for a deficit in this quarter. It has achieved better than budgeted revenues, but additional costs have exceeded this gain and the deficit is even greater than planned. It would be reasonable to expect that the gain in revenues would reduce the deficit or even turn it into a surplus.

If ARC is to remain viable, it must consider two issues — the pricing of its courses and control over costs.

Tip for committee action

If you ‘hear’ that your organisation is having difficulty paying its debts, do not disregard your informal networks. If you know people in business who deal with the organisation ask them about their experiences. Keep your fellow committee members informed of your findings.

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Exercise 6.2: Calculating variance

The mid-year financial statements (30 June 2006) for ARC Adult Education include the following items.

Item Budget Actual

Student fees $36,000 $44,000

Salaries and oncosts $32,000 $34,800

Advertising 5,000 3,500

Rent 0 500

Curriculum costs 2,400 2,500

Course costs 9,000 12,300

In the tables below:

calculate the amount of variance in each item

indicate whether each item shows a favourable or unfavourable budget variance

suggest what opportunities/challenges these results present for the organisation.

Item Amount of variation U/F

1. Student fees

2. Salaries and oncosts

3. Advertising

4. Rent

5. Curriculum costs

6. Course costs

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Opportunities Challenges

1.

2.

3.

4.

5.

6.

Answers 6.2

You were asked to:

analyse budget variance

indicate which items show favourable or unfavourable budget variances

suggest what opportunities or challenges the results present for ARC Adult Education .

Item Amount of variation U/F

Student fees $8,000 F

Salaries and oncost $2,800 U

Advertising ($1,500) F

Rent $500 U

Curriculum costs $100 U

Course costs $3,300 U

A

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Opportunities Challenges

1. Student fees are up on budget — ARC may be able to turn its budgeted deficit into a surplus and start paying its way.

The challenge is to continue the momentum, maintain service levels for larger numbers of students, and not become complacent about cost control.

2. Salaries and oncosts are up on budget. Opportunities exist to improve the rewards to staff — professionally and financially — facilitated by organisation growth. Opportunity also exists, by managing salary costs, to improve returns through a higher ratio of fees to salaries.

The challenge is NOT to let salaries “blow out”. Work practices may need to be looked at so that increasing student numbers do not compromise efficiency of staff.

3. Advertising costs are below budget. There is opportunity here to use the savings to fund other needs, to reduce the deficit or to create a surplus. There is also opportunity to consider the possibility of further gains from expending the full advertising budget.

The challenge is to identify the best use for this gain, and to avoid spending it for the sake of spending it.

4. Rent is up from its budget of nil. A new opportunity may now exist for ARC to generate its own rental income from its new facilities.

The challenge is to manage ARC ’s new facilities as a piece of commercial real estate, so that the returns on the organisation’s investment can be maximised.

5. Curriculum costs are up from budget, but the variance has improved from the position at the end of the first quarter. Opportunity exists to gain an understanding of the extra costs incurred in the first quarter, (in the face of higher enrolments), and of the ramifications this has had for costs in this quarter. More cost-efficient curriculum preparation may follow in subsequent quarters.

The fact that the variance to budget has improved from the end of the first quarter to the end of this quarter means costs this quarter were actually lower than budget. One challenge will be to maintain this. The other challenge is to identify the opportunity this situation presents. Analysing opportunities to discover how to make the most of them is, in itself, a challenge.

6. Course costs are running well above budget. The opportunity here is to identify where the overruns are occurring — either ARC is incurring unnecessary costs, in which case costs can be saved, or the original budget is flawed, in which case ARC may be able to revisit its strategies, eg course pricing.

The challenges here are to identify the reasons for the overruns and then devise, implement and enforce steps to deal with them. Reining in costs and revising strategies could be unpopular and may meet with resistance.

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Exercise 6.3: Controlling the organisation’s finances

You are a member of the management committee of ARC Adult Education . Usually the ARC management committee is provided with a list of receipts and payments every six months, at the August meeting (covering the January to June period), and the February annual meeting (covering the July to December period). In the following two situations, what changes would you request to these financial reporting practices in order to effectively control any financial situations that may arise? Situation A You hear that the organisation is having difficulty paying its debts as they fall due. Situation B The organisation is in the process of introducing a major new program. A. Changes needed in financial reporting if the organisation is having difficulty paying its debts as they fall due:

B. Changes needed in financial reporting if the organisation is in the process of introducing a major new program:

See Modules 3, 4 and 5 for more information on monitoring financial reports

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Answers 6.3

Situation A

You were asked to request changes to financial reporting if the organisation is having difficulty paying its debts as they fall due. These should include:

Preparing an up-to-date balance sheet, showing both the actual and budgeted positions for ARC.

Preparing and reviewing the Income and Expenditure Statement. This should show ARC’s year-to-date actual results, year-to-date budget and total budget for the year. Analysis would be aided by inclusion of month-by-month results. By obtaining this level of detail problem areas can be identified and the timing of problems can be considered.

Preparing a Cash Flow Statement to help gain an understanding of what cash resources have been received and where they have been utilised.

Possible revision of all budgets for future periods, taking into account ARC’s actual financial position at the current time.

At least monthly reporting of ARC’s financial statements , comparing actual results with budget.

Reviewing the actions of management and staff, to determine whether they have acted prudently and within the bounds of their authorities.

Possible temporary revocation of authorities of management staff in relation to discretionary expenditure, ie all discretionary expenditure to be approved by the committee.

Possible increase in the scope of the external audit, with the auditor to report to the committee specifically on internal control procedures and compliance with those procedures.

Situation B

You were asked to request changes to financial reporting if the organisation is in the process of introducing a major new program. These should include:

Preparing an income and expenditure budget, a balance sheet budget and a cash budget, to predict the impact of the new program on the organisation.

Monthly reporting of actual results against budget, to monitor actual performance.

Collection and reporting of non-financial statistics, eg staffing levels, enrolments, attendances, pass rates (if assessed), withdrawals and resource utilisation for the program. While these are strictly non-financial statistics, objective collection and analysis of this sort of information can help to make sense of the financial results for new programs.

A

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Exercise 6.4: Discussing financial information

The following information has been provided to the ARC management committee for discussion at its next meeting. Examine the information.

ARC Adult Education Inc Financial Results to 30 September 2006

Last Year 2005

This Year’s Budget -2006

Year-to-Date Budget

Actual to 30/9/06

$’000 $’000 $’000 $’000

Government Grants 36 38 29 32

Course fees 63 69 53 66

Salaries paid 67 66 49 53

Non -salary costs 35 43 33 37

Equipment purchases 26 7 7 5

You have been asked to lead the discussion about the results. Prepare a list of key information questions you might ask the principal, coordinator or executive officer, to help guide a discussion and come to a more informed conclusion about the results. Questions to ask:

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Answers 6.4

You were asked to prepare a list of key information questions you might ask the principal, coordinator or executive officer, to help you come to a more informed conclusion about the results. Some suggested questions to ask about the results are: Funding allocation

Why are funding allocations over budget?

Have allocations in respect of the December quarter already been received? If so, have they been recorded as revenue rather than unearned income?

Course fees

Course fees are well up on budget.

Have we ensured that all fees received in advance for the next quarter have been treated as unearned income in this quarter?

Is any of the increase due to re -pricing of courses since the budgets were finalised?

How much of the increase is due solely to increased enrolments? What has been the trend in enrolments through the course of the year — has there been an obvious upward trend?

What are the implications for future Government funding levels?

What are the implications for next year’s budget?

What are the implications for strategic planning?

Salaries

Salaries are running over budget for the year to date. Have there been any increases in rates of pay not foreseen in the budget? Have

staffing levels increased above budgeted levels?

Has overtime increased above budgeted levels?

Are the overruns confined to any particular area or areas of the organisation?


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Non-salary costs

Non-salary costs are also running over budget.

Which specific costs have exceeded budget?

How much of the overrun is due to higher enrolments?

Have any costs been incurred that were not specifically budgeted for?

How much of the overrun is due to increases in prices not anticipated in the budget?

Did management staff warn the committee that overruns were expected?

Was expenditure in excess of budget authorised?

What steps were taken to ensure overruns were kept to a minimum?

In incurring budget overruns did management exceed its authority?


Equipment purchases

Equipment purchases are below budget.

Have all budgeted equipment purchases been made?

Is any of the saving due to more favourable pricing than anticipated in the budget?

Has spending in this area been cut because of overruns in other areas?

Was the original budget for equipment purchases adequate, given the increase in enrolments?


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Quick quiz

Use the questions below to check your understanding of the material covered in this module. If you are unable to complete the quiz, review the appropriate section of the module.

Write short answers in the spaces provided, eg Question 5. In other questions, eg Questions 1 & 6 , you are given more than one possible answer. In these cases tick the box or boxes that you think are correct. In Question 4 you are required to number the boxes 1 to 5.

q plans or forecasts of anticipated financial results

1 Budgets are ...

q summaries of financial achievement or performance

1

2

2 List the three stages of the budgeting process.

3

1 budgeted balance sheets

2

3 The most common forms for budgets are similar to the normal accounting reports. These are .....

3

q process the organisation’s actual results

q gather and analyse all relevant information

q formulate and implement the organisation’s budget

q compare actual results with the budget figures

4 Correctly order, 1 to 5, the activities involved in financial planning and control.

q evaluate the reasons for variances

5 Budgets are used to compare actual performance with ...

q the difference between actual results and expected results

q revenue

6 Budget variances show ...

q costs

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Review tasks

Task 1 Variances

Variances occur regularly in budgets. List three reasons why there may be variances between actual results and the budgeted figures.

1.

2.

3.

How would you define a favourable variation?

How would you define an unfavourable variation?

Task 2 Responsibilities of management committee members

List three responsibilities that members of a management committee have in relation to budgets.

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Task 3 Signs of financial risk or danger

List two financial danger signs in a budget and what action the committee should take in each case

Danger sign

Actions the committee should take

1.

2.

Documents

Module 6 LCP - workplacement.nsw.edu.au 6 LCP.pdf · work through the module to: confirm or revise your answers ... LCP should implement a range of planning ... and were designed