CHAPTER 9

Budgeting

Budgeting

A budget is a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a given period of time.

It is a quantified plan of action.

Nature of a Budget

Estimates profit potentialMonetary termsA period of one yearA management commitmentCan be changed under specified conditionsCompared with actual financial performance

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Key Purposes of the Budgeting System

The five primary purposes are:1. Planning. 2. Facilitating Communication and Coordination.3. Allocating Resources.4. Managing Financial and Operational Performance.5. Evaluating Performance and Providing Incentives.

Organizations Use Many Types of Budgets

Organizationgoals

Individual goalsand values

Long-rangestrategic plan

Anticipatedconditions

Masterbudget

Actual periodresults

Individualbeliefs

Performanceevaluation

Strategicevaluation

Organization Individual

Types of Budgets

• Master budget (profit plan)– a comprehensive profit plan that covers all phases of

an organization’s operation.

• Pro-forma (projected) financial statements– similar to historical statements, except that they

project the future.

• Capital budget– Focuses on the acquisition of long-term assets

Budgeted Income Statement

Cash BudgetCash Budget

Sales of Services or GoodsSales of Services or Goods

EndingInventoryBudget

Work in Processand Finished

Goods

EndingInventoryBudget

Work in Processand Finished

Goods

ProductionBudget

ProductionBudget

DirectMaterialsBudget

DirectMaterialsBudget

Selling andAdministrative

Budget

Selling andAdministrative

Budget

DirectLabor

Budget

DirectLabor

Budget

OverheadBudget

OverheadBudget

EndingInventoryBudget

Direct Materials

EndingInventoryBudget

Direct Materials

Budgeted Balance Sheet

Budgeted Statement of Cash Flows

Illustrating the Master Budget

Schedule Title of Schedule

1 Sales Budget

2 Production Budget

3 Direct-Materials Budget

4 Direct-Labor Budget

5 Manufacturing Overhead Budget

6 Selling, General, and Administrative Expense Budget (SG&A)

7 Cash Receipts Budget

8 Cash Disbursements Budget

9 Cash Budget

10 Budgeted Schedule of Cost of Goods Manufactured and Sold

11 Budgeted Income Statement

12 Budgeted Balance Sheet

Sales Forecast

Sales Forecasting the process of predicting sales of services or goods.

The master budget begins with a sales forecast. Items to consider in sales forecasts:◦ Past sales levels and trends◦ General economic conditions◦ Industry trends◦ Company pricing policies◦ Action of competitors◦ New products

Sales Budget of Collegiate Apparel

Collegiate Apparel Company is preparing budgets for the year ending December 31, 20x1.

Budgeted sales are:First quarter – 15,000 unitsSecond quarter – 5,000 unitsThird quarter – 10,000 unitsFourth quarter – 20,000 units

The selling price is $12 per unit.

Collegiate Apparel Company is preparing budgets for the year ending December 31, 20x1.

Budgeted sales are:First quarter – 15,000 unitsSecond quarter – 5,000 unitsThird quarter – 10,000 unitsFourth quarter – 20,000 units

The selling price is $12 per unit.

Sales Budget of Collegiate Apparel

Production Budget

Sales Budget

ProductionBudget

Complete

d

Plan of resources needed to meet currentsales demand and ensure inventory levels

are sufficient for future sales.

Forecasting Production

Rearrange the basic inventory formula as follows . . .

Units inbeginninginventory

Units inbeginninginventory

Requiredproduction

in units

Requiredproduction

in units

Salesin

Units

Salesin

Units

Units in ending

inventory

Units in ending

inventory+ – =

Now, solve for required production . . .

Unitsto be

Produced

Unitsto be

Produced=

Salesin

Units

Salesin

Units+

Units in ending

inventory

Units in ending

inventory–

Expectedbeginninginventory

Expectedbeginninginventory

The Production Budget

Collegiate Apparel wants units in ending finished goods inventory to be 10% of the next quarter’s expected sales in units.

At the beginning of the year, 1,500 completed units were on hand.

During the first quarter of 20x2, 15,000 units are expected to be sold.

Let’s prepare the production budget.

Collegiate Apparel wants units in ending finished goods inventory to be 10% of the next quarter’s expected sales in units.

At the beginning of the year, 1,500 completed units were on hand.

During the first quarter of 20x2, 15,000 units are expected to be sold.

Let’s prepare the production budget.

The Production Budget

5,000 × 10% = 500 units5,000 × 10% = 500 units

Direct-Materials Budget

Direct materials needed for the budget period can be determined as follows . . .

Requiredmaterialspurchases

Requiredmaterialspurchases

=Materialsused in

production

Materialsused in

production+

Endingmaterialsinventory

Endingmaterialsinventory

–Beginningmaterialsinventory

Beginningmaterialsinventory

Direct-Materials Budget

At Collegiate Apparel 1.5 yards of fabric are required per unit of product.

Management wants fabric on hand at the end of each quarter to be 10% of next quarter’s raw materials required. On January 1st, 2,100 yards of fabric are on-hand. During the first quarter of 20x2, Collegiate expects 21,000 yards of fabric to be required.

Each yard of fabric cost the company $2.

Let’s prepare the direct materials budget.

At Collegiate Apparel 1.5 yards of fabric are required per unit of product.

Management wants fabric on hand at the end of each quarter to be 10% of next quarter’s raw materials required. On January 1st, 2,100 yards of fabric are on-hand. During the first quarter of 20x2, Collegiate expects 21,000 yards of fabric to be required.

Each yard of fabric cost the company $2.

Let’s prepare the direct materials budget.

Direct-Materials Budget

8,250 × 10% = 825 units8,250 × 10% = 825 units

Responsibility for Budget Administration

Budget Committee – Consists of key senior executives who may advise the budget director during the preparation of the

budget. The authority to give final approval to the

budget usually rests with the board of directors.

Budget Department

Publishes procedures and forms for budget preparation.

Publishes assumptions for the basis of budgets.Facilitate communications among departments.Makes analyses and budget recommendations.Administers budget revisions.Analyzes performance against budget.

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Participative Budgeting

Participative Budgeting – the use of input from lower- and middle-management employees.

◦ The process is time consuming but enhances employee motivation and acceptance of goals.

◦ Budget negotiation is the heart of budgeting process.

Advantages of Participative Budgeting1. Individuals at all levels of the organization are

viewed as members of the team whose judgments are valued by top management.

2. Budget estimates prepared by front-line managers are often more accurate than estimates prepared by top managers.

3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above.

4. A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse.

1. Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management.

2. Budget estimates prepared by front-line managers are often more accurate than estimates prepared by top managers.

3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above.

4. A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse.

Budgets and Feedback

Budgets offer feedback in the form of variances: actual results deviate from budgeted targets

Variances provide managers with Early warning of problems A basis for performance evaluation A basis for strategy evaluation

Budgeting and Human Behavior

The budgeting process may be abused both by superiors and subordinates, leading to negative outcomes

Superiors may dominate the budget process or hold subordinates accountable for events they have no control over

Subordinates may build “budgetary slack” into their budgets

Ethical Problems in Budgeting

Much of the information for the budget is provided by persons whose performance is then compared with the

budget they help develop.

I think saleswill increase by10% next year.

Let’s prepare thesales forecast with a4% increase, so we

will really look good!

Critics of Budgeting

Budgeting process is inefficient Senior managers spend 10% to 20% of their time on

budgeting. Yet, most suggest that budgeting is not a valuable use of their time.

It becomes obsolete rapidly. It does not motivate the right behavior.It is out of sync with the strategic planning.

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Budgetary Slack: Padding the Budget

Padding the budget means intentionally underestimating revenues or overestimating costs.

The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack.

A solution: reward managers for making accurate estimates.

Padding the budget means intentionally underestimating revenues or overestimating costs.

The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack.

A solution: reward managers for making accurate estimates.