Chapter IV: Financial Planning and Budgets

Financial planning is the process of:

a. Analyzing the investment and financing alternatives available to a firm
b. Forecasting the future consequences of the alternatives
c. Deciding which alternatives to undertake
d. Measuring subsequent performance against established goals

Budget: A budget is a detailed plan for acquiring and using financial and other resources over a specified period.

Stages of Budgeting:
1. Planning: Developing objectives and preparing various detailed budgets to achieve those objectives.
2. Control: The steps taken by management to attain the objectives set down at the planning stage.

Advantages of Budgets
a. Budgets communicate management’s plans throughout the organization.
b. Budgets force managers to think about and plan for the future.
c. The budgeting process provides a means of allocating resources to those parts of the organization where they
can be used most effectively.
d. The budgeting process can uncover potential bottlenecks before they occur.
e. Budgets coordinate the activities of the entire organization by integrating the plans of its various parts.
f. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.

Limitations of Budgeting
1. Since budgeting means planning for the future, the plan itself, as well as the figures therein, are merely estimates
requiring a certain amount of judgment. Nobody can predict what exactly will happen in the future. Hence, future
situations may warrant revisions or modification of plans.
2. To be successful, a budgetary system requires the cooperation and participation of all members of the
organization. Should any of these members lose enthusiasm in carrying out the plans, or should any member
fail to coordinate and cooperate with each other, the entire budgetary system will fail.
3. Some managers think that budgets restrict their movements and limit their decision-making power. Some are
even afraid that such budget may be used against them if they fail to work in accordance with the plans
contained in the budget. These factors make it difficult to sell the idea of budgeting to some people in the
organization.
4. The development and installation of a good budgetary system may be time consuming and too costly for some
organizations, such that the benefits that can be derive from budgeting may be outweighed by its costs.

Master Budget: The comprehensive set of all budgetary schedules and pro forma financial statements of an
organization

Components of a Master Budget

1. Operating budget: Shows the company’s projected revenue and associated expenses for an upcoming period
and is often presented in an income statement format.
Components:
a. Sales budget: shows the expected sales for the budget period expressed in dollars and units. It is usually
based on a company’s sales forecast.
b. Production budget: lists the number of units that must be produced during each budget period to meet sales
needs and to provide for the desired ending inventory.
c. Purchases budget
d. Direct labor budget
e. Overhead budget
f. Selling and administrative budget

2. Financial budgets: a budget that aggregates monetary details from the operating budgets.
Components:
a. Capital expenditures budget
b. Cash budget: a detailed plan showing how cash resources will be acquired and used over a specified time
period.
Components of a cash budget:
i. Cash receipts: Provides information about cash flows into the company based on sales of its services
or products
ii. Cash disbursement: consists of all cash payments excluding repayments of principal and interest.
iii. Cash excess or deficiency: The cash excess or deficiency section determines if the company will need
to borrow money or if it will be able to repay funds previously borrowed.
iv. Financing: The financing section details the borrowings and repayments projected to take place during
the budget period.
 c. Budgeted Financial Statements
Budgeted financial statements are prepared for the period(s) and reflect the results that will be achieved if
the estimates and assumptions used for all previous budgets actually occur.
Components:
i. Budgeted Income Statement
ii. Budgeted Statement of Financial Position
iii. Budgeted Cash Flows

Types of budget
1. Static: budget for a single planned output level at the start of the budget period

2. Flexible: adjusted (flexed) to recognize actual output level of budget period and help managers gain more insight
into causes of variances than available from static budgets

3. Zero-based: A budgeting method in which all expenses must be justified for each new period. The process
starts with a zero base and every function within an organization is analyzed for its needs and costs.

4. Continuous: A Continuous budget is an ongoing 12-month budget at all points in time during a budget period;
thus, a new budget month (12 months into the future) is added as each current month expires.
Benefits of a continuous budget include:
i. eliminating a fiscal year mind-set by recognizing that business is an on-going operation and should be
managed accordingly;
ii. allowing management to take corrective steps as forecasted business conditions change;
iii. eliminating the unrealistic “gap” that occurs with the first iteration of each annual budget; and
iv. reducing or eliminating the budget planning process that occurs at the end of each fiscal year.

Illustration:
JJ Incorporated is the leading manufacturer of Product X in the country. Expected sales for the first five months of 2025
were as follows:
January February March April May
Sales in units 5,000 6,000 7,000 7,500 7,600
➢ Each unit of Product X sells for 120 each. 20% of sales are made through cash and the rest are on account.
Sales made on account are collected in the following manner:
o 30% in the month of sale
o 40% one month after the month of sale
o 30% two months after the month of sale
➢ At the beginning of the year, Product X has a balance of 500 units. The desired ending inventory of Product X
each month is 20% of the following month’s expected sales.
➢ Each unit of Product X requires 3 units of Material Y, which costs 5.0 per unit. The beginning inventory of
Material Y is 10,000 units and the company’s desired ending inventory of Material Y is 10% of next month’s
production requirements.
➢ JJ acquires Material Y from a supplier on account. 50% is paid on the month of purchase, 30% the following
month and the rest is paid two months after the month of purchase.
➢ Each unit of Product X requires 2 direct labor hours at a rate of 10 per hour.
➢ Variable Overhead is applied to production at 3 per direct labor hour while fixed manufacturing overhead per
month amounts to 20,000 which includes depreciation of 5,000.
➢ Variable selling and administrative expense amounts to 2 per unit while fixed selling and administrative expense
amounts to 10,000 per month.
➢ The company’s desired ending balance of cash each month is at least 40,000. Cash has a balance of 41,000
at the beginning of the year.

Required:
Prepare the following budgets for the months of January, February and March:
1. Sales budget
2. Production budget
3. Purchases budget
4. Direct labor budget
5. Overhead budget
6. Cash Receipts Budget
7. Cash disbursement budget
8. Cash budget