Rolling, Activity Based, Functional and Master Budgets and How They Link

A budget approved in December is out of date by March if a currency devalues, a competitor cuts its price or a supplier fails. A company that insists on judging managers against the December figures all year ends up measuring the distance between a plan and a world that no longer exists.

This topic deals with budgets that try to stay useful:

• the rolling budget, which is renewed as time passes
• the activity based budget, which builds overhead budgets from the activities that cause cost
• the functional budgets and cash budget that feed into the master budget

It explains how each is prepared, with a worked example for each, and the benefits and drawbacks.

It builds on the earlier topic on preparing fixed and flexed budgets. The next topic covers the beyond budgeting model.

Rolling budgets

A rolling budget, also called a continuous budget, is a budget that is continuously updated by adding a new period, such as a month or a quarter, and removing the earliest. A company that rolls its budget every quarter always has four quarters ahead.

For a year ending 31 December, the budget prepared in December covers January to December of Year 2; in March, after the first quarter, a new budget is prepared for April of Year 2 to March of Year 3; in June, one for July to June; and so on.

Each update uses the latest actual results and a revised forecast of the periods still to come, with a fresh forecast for the new period at the end.

The steps are:

• define the length of the budget and the frequency of updating
• prepare the initial budget
• at each update collect actual data and analyse it
• adjust the remaining periods in the light of experience and new information
• add the new period
• communicate the changes to everyone affected

Rolling budgets are particularly useful for cash budgets, since an organisation must always know whether it will have enough cash, and actual cash flows often differ from the plan. A new cash budget each month gives twelve rolling budgets a year.

• Benefits. Budgets stay relevant because they are continually reviewed and revised; the company is not committed to a fixed plan that has become irrelevant; planning always looks a full period ahead, which encourages a longer view; accuracy improves because forecasts are made nearer the time; and control can be exercised by comparing current forecasts with strategic targets, a form of feed-forward control.
• Drawbacks. They take time and divert managers from running the business; each revision must be communicated. Some managers may not be told; frequent revision may weaken commitment to a target (“the goalposts keep moving”); they cost more to prepare; and a rolling budget can be unsuitable where results are very stable or where the business has a strong annual cycle.

Activity based budgeting and the functional budgets

Activity based budgeting

ABB is a planning system under which costs are linked to activities and budgets are compiled from the expected level of those activities. It is an extension of activity based costing (ABC). Traditional budgets for overhead absorb cost by a volume measure such as direct labour hours, which is hard to justify when overheads are large relative to direct costs and are caused by things other than volume. ABB asks what causes each overhead.

1. Identify the activities and the cost driver of each: the factor that determines the cost of the activity (purchase orders for ordering, inspections for quality control, set-ups for machine preparation).
2. Forecast the number of units of each cost driver needed for the planned level of output.
3. Calculate the cost driver rate: budgeted cost of the activity ÷ expected units of the driver.
4. Build the budget: driver units × rate for each activity, and attach the cost to products or departments by the drivers they use.
5. Monitor actual driver volumes and costs against the budget.

Advantages: managers see the link between cost and what drives it; attention is focused on expensive activities; resources can be matched to demand, bottlenecks relieved and activities that add no value identified and removed; product costs are more accurate.

Disadvantages: it is complex and hard to set up; it needs much analysis to trace costs to activities; accounting systems must be changed; it is costly (most useful where ABC is already used); and it is not practical where resources move between activities in response to demand, as in many service settings.

Functional budgets

A functional budget covers one function. The sales budget (quantity × price) is normally first, because sales demand is usually the principal budget factor, and it is the basis of the profit forecast. The production budget is prepared by forecasting sales, deciding the desired closing stock, and calculating the units to produce: production = sales + closing stock − opening stock.

The materials, labour and overhead budgets follow, and then expenditure budgets for the administration, selling and distribution centres.

The cash budget and the master budget

A cash budget forecasts cash receipts and payments over the period, month by month, and the resulting closing cash balance, so that shortages can be financed and surpluses invested.

It is built by defining the period; estimating cash inflows (sales receipts allowing for credit terms, other income, capital raised); estimating outflows (suppliers allowing for credit taken, wages, overheads, capital items, tax, dividends); calculating net cash flow; and adding it to the opening balance. Non-cash items such as depreciation are excluded.

The master budget is the final, approved budget summarising all the functional budgets as a budgeted statement of profit or loss, a budgeted statement of financial position and a cash budget. It is approved by the budget committee and the board and becomes the plan against which performance is measured.

Layouts for rolling, activity based and cash budgets

1. Rolling budget. Actual for the completed period; revised forecasts for the remaining periods; new forecast for the added period; total.
2. Production budget. Sales + closing stock − opening stock.
3. ABB. Cost of activity ÷ driver units = rate; rate × driver units used by each product.
4. Cash budget. Receipts − payments = net flow; opening + net flow = closing.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Drop the first quarter, now complete (actual 1,850 against budget 2,000, a shortfall of 150).
2. Revised remaining quarters: Q2 2,000 (was 2,200); Q3 2,200 (was 2,400); Q4 2,350 (was 2,600).
3. Add Q1 Year 3: 2,400.
4. New twelve-month budget:
   2,000 + 2,200 + 2,350 + 2,400 = 8,950 units, against the original 9,200.
   The budget now allows for the shortfall and the cooler market, so that production and purchases can be adjusted early.

1. Cost driver rates.
   Ordering 5,400,000 ÷ 12,000 = ₦450 an order.
   Handling 2,400,000 ÷ 8,000 = ₦300 a movement.
   Inspection 1,500,000 ÷ 600 = ₦2,500 an inspection.
   Total ₦9,300,000.
2. Product A.
   3,000 × 450 = 1,350,000; 4,000 × 300 = 1,200,000; 100 × 2,500 = 250,000; total ₦2,800,000.
3. Product B.
   9,000 × 450 = 4,050,000; 4,000 × 300 = 1,200,000; 500 × 2,500 = 1,250,000; total ₦6,500,000.
4. Labour hour absorption.
   9,300,000 ÷ 100,000 hours = ₦93 an hour.
   A: 40,000 × 93 = ₦3,720,000.
   B: 60,000 × 93 = ₦5,580,000.
5. Comment. Absorption by hours overloads A by ₦920,000 and under-charges B by the same amount. B uses most of the orders and inspections and is the more costly product to support. The ABB budget points management to where costs arise: ordering is the biggest activity, so reducing the number of orders is the best saving.

1. Receipts.
   January 0.6 × 4.0 + 0.4 × 3.0 = ₦3.6m.
   February 0.6 × 5.0 + 0.4 × 4.0 = ₦4.6m.
   March 0.6 × 6.0 + 0.4 × 5.0 = ₦5.6m.
2. Net flow.
   January 3.6 − 3.2 = +0.4
   February 4.6 − 4.4 = +0.2
   March 5.6 − 5.8 = −0.2.
3. Closing balance.
   January 0.5 + 0.4 = 0.9m
   February 0.9 + 0.2 = 1.1m
   March 1.1 − 0.2 = 0.9m.
4. Comment. Cash stays positive, but growth in sales tightens the position because payments rise ahead of receipts; March is the first month with a net outflow.

Expect variants: a production budget with a stock policy, ABB for a service business, a rolling cash budget with credit terms, or a discussion of the limits of each.

Cash budget and the overdraft

The master budget includes a cash budget that shows receipts, payments and the closing balance for each month. A negative closing balance shows when an overdraft or loan will be needed, so that it can be arranged before it is needed and the cost of interest can be included in the budget.

For example, opening cash of ₦20m, receipts of ₦180m and payments of ₦215m give a closing balance of −₦15m, an overdraft of ₦15m; against an agreed facility of ₦25m the headroom is ₦10m. A rolling budget updates the cash forecast each period, so that the need for borrowing is seen early.

Cash management: the Miller-Orr model

The Miller-Orr model sets control limits for the cash balance when daily cash flows are uncertain. Spread = 3 × [(3/4 × transaction cost × variance of daily cash flows) ÷ daily interest rate]^(1/3). The lower limit is set by management (a safety balance); the upper limit = lower limit + spread; the return point = lower limit + spread ÷ 3.

When the balance reaches the upper limit, buy securities to bring cash back to the return point; when it reaches the lower limit, sell securities to return to the return point. Example. Transaction cost ₦5,000; standard deviation of daily cash flow ₦40,000, so variance ₦1,600,000,000; daily interest 0.04%; lower limit ₦100,000. (3/4 × 5,000 × 1,600,000,000) ÷ 0.0004 = 1.5 × 10^16; the cube root is about 246,600; spread = 3 × 246,600 = about ₦739,900. Return point = 100,000 + 246,600 = about ₦346,600; upper limit = about ₦839,900.

A higher variance or transaction cost widens the spread; a higher interest rate narrows it.

Cash budget with credit periods, operational budgets with losses, and the economic order quantity

Cash budget. Cash is received and paid after the sale or purchase, so use the credit periods. Example. Opening receivables ₦400,000; opening creditors ₦150,000; customers pay one month after the sale and suppliers are paid two months after the purchase. Sales for the quarter ₦2.4m, evenly spread (₦800,000 a month); purchases ₦900,000 (₦300,000 a month); other cash expenses ₦200,000; wages ₦240,000; depreciation is not a cash flow.

Receipts: opening receivables 400,000 + sales of months 1 and 2, 1,600,000 = ₦2,000,000 (month 3 sales are still owed). Payments to suppliers: opening creditors 150,000 + month 1 purchases 300,000 = ₦450,000 (months 2 and 3 are still owed). Total payments 450,000 + 200,000 + 240,000 = ₦890,000; net cash flow ₦1,110,000. The benefits of a cash budget: it shows surpluses and deficits in advance, helps to arrange borrowing or investment, supports liquidity planning and controls spending.

Production and purchases budgets with losses. Units to produce = units to sell + increase in finished stock, grossed up for rejects: if 2% of production is rejected, production = good units ÷ 0.98. Materials to buy = materials for production + increase in material stock, grossed up for wastage: if 5% of the gross input is wasted, gross input = net need ÷ 0.95. Example. Sales 9,500 units; finished stock to rise by 300; good units needed 9,800; production = 9,800 ÷ 0.98 = 10,000 units.

Net material 2 kg a unit gives 20,000 kg; gross = 20,000 ÷ 0.95 = 21,053 kg; at ₦30 a kg, ₦631,579.

Economic order quantity. EOQ = √(2 × annual demand × cost per order ÷ holding cost per unit a year). Annual demand 36,000 kg, order cost ₦40, holding cost ₦3 a kg: √(2 × 36,000 × 40 ÷ 3) = √960,000 = about 980 kg, or about 37 orders a year. A constant safety stock does not change the EOQ. The model assumes known, constant demand and no stock-outs.

Cash budget checklist for a seasonal business

Work in this order: (1) Production = sales + closing stock − opening stock, month by month (seasonal sales and rising stock). (2) Purchases follow production when materials are bought a month ahead, so the purchase for a month is the next month’s production. Payment may be split between the month of purchase and the next.

(3) Receipts: the cash share of sales in the month, then collections of the credit sales in the later months in the stated percentages; sales of an asset on credit arrive when the credit ends. (4) Wages and variable overhead are paid in part in the month and part later; depreciation is included in overhead but is not paid, so remove it.

(5) Fixed overhead is paid in the month; a quarterly insurance premium falls in the first month of the quarter. (6) Dividends paid are outflows in the months stated; dividends received are inflows. (7) The closing balance each month becomes the next opening balance. A negative balance is an overdraft, to be compared with the facility limit, and an excess over the limit needs other finance.

Common mistakes

• Forgetting to drop the completed period in a rolling budget.
• Production equal to sales without the stock adjustment.
• Using volume as the ABB driver for overhead that is not volume-related.
• Including depreciation in the cash budget.
• Timing receipts and payments wrongly against the credit terms.
• Calling a rolling budget a revised annual budget. It always keeps the full period ahead.

Quick revision

• Rolling: add a period, drop a period, always a full period ahead; benefits relevance and accuracy; costs time.
• ABB: activities, drivers, rate = cost ÷ driver units; shows what drives cost; complex.
• Production = sales + closing − opening stock; cash budget excludes non-cash items; master budget = P&L, SFP, cash.

How the marks are earned

• Calculate each budget in the right order.
• Explain the method.
• Evaluate benefits and drawbacks.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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