Identified Budgeting Needs

The implications of the identified budgeting needs of a business unit with reference to management expenses and economic viability.

It is important that you understand costs fully so that you can turn out a clear-cut budget that contains accurate forecasts and provides a better basis for analysis and decisions. A cost can be defined as the amount of money that has been spent or will be spent in the normal course of business in bringing a product or a service to the customer.

You should understand what drives costs to be clear on cause-and-effect (have you spent more because you are busier or just less efficient?) as well as to gain more accurate expenditure estimates and more useful analysis.

Think about this: If an organisation doubles its sales will all, some or none of its costs also double? Will bought-in raw materials double? Probably they will, but will head office costs double? Almost certainly, they will not. Why are certain costs incurred: is it for one or for many purposes? How should the cost then be allocated between the goods, services and departments use cost?

Let’s have a look at some of the terms used when referring to costs:

Cost Centre: A cost centre can be a location, such as a factory, office, department or an item of equipment e.g. a scanner or an entity such as a film production unit; or a person such as a rock star, where costs may be collected and related to cost units.

Cost Unit: A cost unit is a quantity produced (e.g. a motor car) or a service undertaken (e.g. a dental treatment) or time spent (e.g. an hour with your solicitor), in relation to which the costs of the operation may be conveniently collected.

Costs should be looked at from two standpoints; fixed or variable and direct or indirect.

Let’s have a look at these costs:

Fixed Costs: Fixed costs are those costs that tend to remain unchanged in total for the short term, even if activity increases. Examples of fixed costs are rent, rates, salaries and some insurance costs.

Let’s take a closer look:

Let’s say that each person in the department is paid a salary of R5000.00 per month. This amount will not change in the next 12 months. The budget has been set for those twelve months – this would then be considered a Fixed Cost.

Another example of a fixed cost would be the rent that is paid for the building in which the business is housed. This rent will not increase in the short term, say 12 months and is not set according to the amount of activity that takes place within the building.

Variable Costs: Variable costs are those costs that change directly in relation to changes in activity and volumes. Examples of variable costs are electricity, water and raw materials.

These costs are easier to understand. If we live in a house or a flat we have to pay for our electricity and water and so does a business. The accounts that we receive every month are never for the same amount. Therefore these are variable costs.

Direct Costs: Direct costs are those which can be charged to or allocated to cost centres or cost units specifically concerned with the production of goods or services. Examples would be raw materials, labour, production equipment.

Indirect Costs: (also known as shared costs). All the other costs brought about in supporting the production and sale of the product or service. Examples would be administration costs, distribution, marketing and sales effort.

Management Costs/Expenses: Various costs can also be found in the Profit and Loss Account and are deducted to determine operating profit. These costs are called Selling, General and Administration Costs or Operating Expenses. They cover any expenses not listed under Cost of Sales. They include marketing and advertising which are listed under selling expenses. General and administration costs would cover head office and administration costs.

Once you have completed your budget, it will need to be sent to top management. It is important that you are well prepared so that you can put forward the best possible case for your department.

In summary: A direct cost is incurred for the benefit of just one product or service, whereas an indirect cost is incurred for the benefit of many. It is important to know how to allocate costs back to products and services. For example, you will need to decide how much of the head office cost each item will bear. This will affect each product’s profitability and can be used by senior management to assess its viability.

Forecasting: Forecasting is a planning tool that is used before preparing the budget. It is concerned with the probability or likelihood of something happening in response to a set of circumstances. For example, your business may decide to halve the price of its most popular product line – it is obvious that in doing this, that sales will probably increase.

Forecasting does not rely on the luck of a manager reading the market right or guesswork. A lot of technical research by economists, actuaries and accountants goes into the final establishment of a forecast. As a supervisor, you will receive guidelines from the forecast that you will build into your budget. For the purpose of this course, we will not explore the technical detail of forecasting.

The Probability Theory: This is one technique that is used in forecasting. The likelihood of an event happening is calculated and re-calculated as the actual events happen. This theory is used to forecast sales, the effects of a price increase and price reductions. The lessons learnt from this application must be recorded and stored in a database for future reference.

This technique takes into account two types of behaviour:

Deterministic: This behaviour takes into account that an event can be accurately determined from past experience. For example, we switch on our radio because our past experience tells us what will happen when we do.

Probabilistic: Is action dependant on a result within a wide range of probabilities; for example: when we go gambling and play on the Roulette Wheel and the National Lottery. The chances of winning the Lottery are probably 14 million to one, but we know from previous experience that the larger the prize money, the more people will play. Despite the fact that the odds of a certain number coming up do not change, more people are inclined to buy a ticket.

Let’s look at retail and apply this theory:

When a company has sold out of a certain product, it needs to record the effect that this has upon the customer, for future reference. If Joe Boggs goes to a retail outlet to buy a product and finds that it is not available, will Joe Boggs walk away from the shop without buying anything or will Joe buy a similar or completely different product? This is known as the substitution effect and if the retail store can identify the customer’s original purchase intention and record the actual purchase then the probable success or failure of this substitution effect can be monitored. This would assist management in calculating the minimum and maximum stock levels.