BULLET NOTES ON OPERATING AND FINANCIAL BUDGETING

Budgeting Basics

 A Budget is a formal written statement of management’s plans for a specified time

period, expressed in financial terms.

ο The role of accounting during the budgeting process is to:

 Provide historical data on revenues, costs, and expenses.
 Express management’s plans in financial terms.
 Prepare periodic budget reports.

Benefits of Budgeting

The primary benefits of budgeting are as follows:

 It requires all levels of management to plan ahead.
 It provides definite objectives for evaluating performance.
 It creates an early warning system for potential problems.
 It facilitates the coordination of activities within the business.
 It results in greater management awareness of the entity’s overall operations.
 It motivates personnel throughout the organization.

Essentials of Effective Budgeting

 In order to be effective management tools, budgets must be based upon:

ο A sound organizational structure in which authority and responsibility are
clearly defined.
ο Research and analysis to determine the feasibility of new products, services, and
operating techniques.
ο Management acceptance which is enhanced when all levels of management
participate in the preparation of the budget, and the budget has the support of
top management.
 A continuous twelve-month budget results from dropping the month just ended and
adding a future month.
 Zero-based budgeting is a budget and planning process in which each manager must
justify a department’s entire budget from a base of zero every period.
 Life-cycle budget estimates a product’s revenues and expenses over its entire life
cycle beginning with research and development, proceeding through the introduction
and growth stages, into the maturity stage, and finally, into the harvest or decline stage.
 Kaizen budgeting assumes the continuous improvement of products and processes,
usually by way of many small innovations rather than major changes.
 The annual budget is often supplemented by monthly and quarterly budgets.
 The responsibility for coordinating the preparation of the budget is assigned to a
budget. The budget committee usually includes the president, treasurer, chief
accountant (controller), and management personnel from each major area of the
company.
 A budget can have a significant impact on human behavior. A budget may have a strong
positive influence on a manager when:
ο Each level of management is invited and encouraged to participate in
developing the budget.
ο Criticism of a manager’s performance is tempered with advice and assistance.
 Long-range planning involves the selection of strategies to achieve long-term goals
and the development of policies and plans to implement the Long-range plans contain
considerably less detail than budgets.

The Master Budget

 The master budget is a set of interrelated budgets that constitutes a plan of action for
a specified time period.
 Sales Budget: the starting point in preparing the master budget.
ο Each of the other budgets depends on the sales budget.
ο The sales budget is derived from the sales forecast and it represents
management’s best estimate of sales revenue for the budget period.
ο There are two classes of budgets in the master budget.
  Operating budgets are the individual budgets that result in the
preparation of the budgeted income statement.
ο Financial budgets focus primarily on the cash resources needed to fund
expected operations and planned capital expenditures.
 Production Budget: shows the units that must be produced to meet anticipated sales.
o Production requirements are determined from the following formula:
o Budgeted Sales Units + Desired Ending Finished Goods Units – Beginning
Finished Goods Units = Required Production Units.
o The production budget provides the basis for the budgeted costs for each
manufacturing cost element.
 Direct Materials: shows both the quantity and cost of direct materials to be
purchased.
ο The quantities of direct materials are derived from the following formula:
o Direct Materials Units Required for Production + Desired Ending Direct
Materials Units – Beginning Direct Materials Units = Required Direct
Materials Units to be Purchased.
ο The desired ending inventory is a key component in the budgeting process;
inadequate inventories could result in temporary shutdowns of production.
 Direct Labor: contains the quantity (hours) and cost of direct labor necessary to meet
production requirements.
ο The direct labor budget is critical in maintaining a labor force that can meet
the expected levels of production.
ο The direct labor budget is also used in preparing the budgeted cost of goods
sold and the cash budget.
 Manufacturing Overhead: shows the expected variable and fixed manufacturing
overhead costs for the budget period.
 Selling and Administrative Expense: projects anticipated selling and
administrative expenses for the budget period. This budget classifies expenses as
either variable or fixed. This budget is also used in preparing the budgeted income
statement and the cash budget.
 Budgeted Income Statement: the important end-product of the operating budgets.
ο This budget indicates the expected profitability of operations for the budget
period.
ο The budgeted income statement provides the basis for evaluating company
performance.
 Cash Budget: shows anticipated cash flows.
ο Because cash is so vital, this budget is often considered to be the most
important financial budget.
ο The cash budget contains three sections:
 Cash receipts.
 Cash disbursements.
 Financing.
ο Companies obtain data for preparing the cash budget from other budgets and
from information provided by management.
ο A cash budget contributes to more effective cash management. It shows
managers when additional financing is necessary well before the actual need
arises and it indicates when excess cash is available for investments or other
purposes.
 Budgeted Balance Sheet: The budgeted balance sheet is developed from the budgeted
balance sheet for the preceding year and the budgets for the current year.

Length of the Budget Period

 A budget may be prepared for any period of Various factors influence the length of the
budget period.
ο The type of budget.
ο The nature of the organization.
ο The need for periodic appraisal.
ο Prevailing business conditions.
 The budget period should be long enough to provide an attainable goal under normal
business conditions and should minimize the impact of seasonal or cyclical fluctations.
 The most common budget period is one year.
The Budgeting Process, Budgeting and Human Behavior
 The budget is developed within the framework of a sales forecast that shows potential
sales for the industry and the company’s expected share of such Sales forecasting
involves a consideration of various factors:
ο General economic conditions.
ο Industry trends.
ο Market research studies.
ο Anticipated advertising and promotion.
ο Previous market share.
ο Changes in prices.
ο Technological developments.
 The input of sales personnel and top management is essential to the sales forecast.
 In larger companies, a budget committee has responsibility for coordinating the
preparation of the budget.
 A budget can have a significant impact on human behavior.
o A budget may inspire a manager to higher levels of performance.
o A budget may discourage additional effort and pull down the morale of a
manager.
o In developing the budget, each level of management should be invited to
participate.
o The overall goal is to reach agreement on a budget that the managers consider
fair and achievable, but which also meets the corporate goals set by top
management.

The Concept of Budgetary Control

 The use of budgets in controlling operations is known as budgetary Such control takes
place by means of budget reports that compare actual results with planned
objectives.
 Budgetary control consists of:
ο Preparing periodic budget reports that compare actual results with planned
objectives.
ο Analyzing the differences to determine their causes.
ο Taking appropriate corrective action.
ο Modifying future plans, if necessary.
 Budgetary control works best when a company has a formalized reporting system.
This system does the following:
o Identifies the name of the budget report (i.e. sales budget).
o States the frequency of the report, such as weekly or monthly.
o Specifies the purpose of the report.
o Indicates the primary recipient(s) of the report.
 A static budget is a projection of budget data at one level of activity. These budgets do
not consider data for different levels of activity. As a result, companies always compare
actual results with budget data at the activity level that was used in developing the
master budget.
 A static budget is appropriate in evaluating a manager’s effectiveness in controlling
costs when:
ο The actual level of activity closely approximates the master budget activity
level, and/or
ο The behavior of the costs in response to changes in activity is fixed.
 A static budget report is appropriate for fixed manufacturing costs and for fixed selling
and administrative expenses.

The Flexible Budget

 A flexible budget projects budget data for various levels of activity. In essence, the
flexible budget is a series of static budgets at different levels of activity.
 To develop the flexible budget, management should:
o Identify the activity index and the relevant range of activity.
o Identify the variable costs and determine the budgeted variable cost per unit of
activity for each cost.
o Identify the fixed costs and determine the budgeted amount for each cost.
o Prepare the budget for selected increments of activity within the relevant
range.
  Flexible budget reports are another type of internal report. The flexible budget report
consists of two sections:
o Production data for a selected activity index, such as direct labor hours.
o Cost data for variable and fixed costs.
o The flexible budget report provides a basis for evaluating a manager’s
performance in two areas:
 Production control.
 Cost control.
 Flexible budget reports are appropriate for evaluating performance since both actual
and budgeted costs are based on the actual activity level achieved.

Management by Exception
 Management by exception means that top management’s review of a budget report is
focused either entirely or primarily on differences between actual results and planned
objectives.
 For management by exception to be effective, there must be guidelines for identifying an
exception. The usual criteria are:
o Materiality—usually expressed as a percentage difference from budget.
o Controllability of the item—exception guidelines are more restrictive for
controllable items than for items the manager cannot control.

Budgeting in Nonmanufacturing Companies

 Budgets are also used by:
ο Merchandisers.
ο Service enterprises.
ο Not-for-profit organization.
 The major differences between the master budgets of a merchandiser and a
manufacturer are that a merchandiser:
ο Uses a merchandise purchases budget instead of a production budget.
ο Does not use the manufacturing budgets (direct materials, direct labor, and
manufacturing overhead).
 In service enterprises, such as a public accounting firm, a law office, or a medical
practice, the critical factor in budgeting is coordinating professional staff needs with
anticipated services.
ο If a firm is overstaffed, several problems may result:
 Labor costs will be disproportionately high.
 Profits will be lower because of the additional salaries.
 Staff turnover may increase because of lack of challenging work.

ο If a service enterprise is understaffed, it may lose revenue because existing and

prospective client needs for service cannot be Also, professional staff may seek
other jobs because of excessive workloads.
 Budgeting is just as important for not-for-profit organizations as for profit-oriented
enterprises.
ο In most cases, not-for-profit entities budget on the basis of cash flows
(expenditures and receipts), rather than on a revenue and expense basis.
ο The starting point in budgeting is usually expenditures, not receipts.