Chapter 9: Budgeting

Objective 1 - Explain why organizations budget and describe the processes they use to create budgets.


The Basic Framework of Budgeting

Budget - A detailed plan for the future typically expressed quantitatively.

  • Budgeting – Act of preparing the budget.
  • Budgetary Control – Use of budgets to control a firm’s activities.

Master Budget – A summary of a company’s plans in which specific targets are set for sales, production, distribution, administrative, and financing activities.

  • It culminates in a cash budget, budgeted income statement, and budgeted balance sheet.

Budget’s Dual Role - Planning and Control

  • Planning – develop objectives and prepare budgets to achieve them.
  • Control – gather feedback to assess the extent to which objectives are being attained.


Advantages of Budgeting

  1. Communicate management’s plans to employees throughout the organization – better understanding of goals/objectives.
  2. Requires managers to think about and plan for the future.
  3. Provides a way to allocate resources effectively.
  4. Uncovers bottlenecks – Machines, activities, or processes that limit total output because they are at capacity.
  5. Coordinate the activities of the entire organization by integrating plans of areas.
  6. Define benchmarks for evaluating subsequent actual performance.


Responsibility Accounting

  • A system of accountability in which managers are held responsible for those items of revenue and cost over which they can exert significant influence – and only those items.
  • Managers are responsible for differences between budgeted and actual results.
  • Managers are not penalized if there are differences, but they must take corrective action to fix this.
  • Goal is to make sure managers react quickly and appropriately to deviations from plans and learn from feedback.


Choosing a Budget Period

  • Continuous or Perpetual Budget – A 12 month budget that rolls forward one month or quarter as the current one is completed.
  • An additional month or quarter gets added as the current one ends – this keeps managers focused at least 1 year ahead.


The Participative Budget Approach

  • Participative Budget – Method of preparing budgets where managers prepare their own budget estimates.
  • Estimates are reviewed by the manager’s supervisor, issues are resolved by mutual agreement, leading to a completed budget.


  • Advantages
  1. All level individuals are members of the team – their views and judgement are valued.
  2. Front-line managers’ budgets are often more accurate and reliable because they have more detailed knowledge.
  3. Motivation is higher when individuals participate in setting goals.
  4. Managers set the budget so they have to take responsibility.


  • Budgetary Stack – Difference between revenues and expenses a manger believes can actually be achieved and the amounts included in the budget.
  • Slack exists when revenue budgets are intentionally below expected levels and expense budgets are set above expected levels.
  • May occur if there is no review from higher level managers.
  • Budget Committee – A group of key management personnel responsible for overall policy matters related to the budget program, coordinating preparation of the budget, coordinating the preparation of the budget, handling budget disputes, and approving the final one.
  • Companies typically use the Top-Down Approach instead of participative because it is more efficient – there are no negotiations or discussions.


Behavioural Factors in Budgeting

  • The importance of budgeting must be consistent across all levels of management because their attitudes may be similar.
  • If top management uses budgeting to blame employees for discrepancies, there will be negative factors such as hostility and tension.
  • Pressure to “meet the budget” may cause negative consequences such as manipulating account numbers or taking short term measures.
  • Stretch Budget – A budget that is highly difficult to achieve. Attainment often requires considerable changes to the way activities are performed.
  • More appropriate budgets help to build a manager’s confidence and reduce the chance of undesirable behaviour.


Zero-base Budgeting

  • A method of budgeting in which managers are required to justify all costs as if the activities involved were being proposed for the first time.
  • Alternative approach – The baseline is zero rather than last year’s budget.
  • Effective for identifying inefficiencies and reducing costs.
  • Challenge - Requires considerable time and effort.


Benchmarking

  • Best-in-class company is known for achieving exceptional levels of performance in operations.
  • Benchmarking – identify factors that allow other companies/business units to achieve superior performance.
  • Influences budgeting by giving managers targeted levels of sales/expenses to aim for.
  • Goals should still be attainable and realistic.
  • Budget targets may reflect progress toward achieving performance.


Objective 2 – Prepare the supporting components of a master budget and the budgeted financial statements.


The Master Budget

  • Master budget consists of a number of separate but interdependent budgets.


The Sales Budget Defined

  • A detailed schedule showing the expected sales for coming periods: these sales are typically expressed in both dollars and units.
  • All other parts depend on the sales budget, so it must be accurate.
  • Helps determine how many units must be produced for manufacturing companies – directly followed by the production budget, and so on.


The Cash Budget Defined

  • A detailed plan showing how cash resources will be acquired and used over a specific time period.
  • All operating budgets impact cash budget – the impact comes from planned cash expenditures in those budgets.


Sales Forecasting – A Critical Step

  • Sales budget is based on sales from prior years as a starting point.
  • Utilize unfilled orders, pricing policy, marketing plans, industry trends, and general economic conditions.


Preparing the Master Budget

  • The following schedules are prepared
  • Sales Budget (with schedule of expected cash collection)
  • Production Budget
  • Direct Materials Purchases Budget (with schedule of expected cash disbursements for raw materials)
  • Direct Labour Budget
  • Manufacturing Overhead Budget
  • Ending Finished Goods Inventory Budget
  • Selling and Administrative Expense Budget
  • Cash Budget
  • Budgeted Income Statement
  • Budgeted Balance Sheet


The Sales Budget

  • Starting point in prepping the Master Budget – all other items depend on it.
  • Sales Budget - Total Budgeted Sales = Multiply the budgeted sales in units by the selling price.
  • Schedule of Expected Cash Collections: Consist of the accounts receivable at different quarters –nth Quarter Sales = Total Budgeted Sales x Percentage Sold.

Image result for sales budget


The Production Budget

  • A detailed plan showing the number of units that must be produced during a period to meet both sales and inventory needs.
  • Prepared right after the sales budget and lists the number of units that must be produced to meet expected sales and provide for desired ending inventory.
  • Production Budget
  • Budgeted Sales in units
  • + Desired Ending Inventory =
  • Total Needs.
  • Beginning Inventory =
  • Required Production


Inventory Purchases – Merchandising Firm

  • For merchandising firms, a Merchandise Purchases Budget is used instead of a production budget.
  • Same basic format but uses Goods to be purchases instead of Goods to be produced.
  • Use Required Purchases for the final account.


Direct Materials Purchases Budget

  • Detailed plan showing amount of raw materials that must be purchases during a period to meet both production and inventory needs.
  • Direct Materials Purchases Budget
  • Raw materials
  • + Desired Ending Inventory of raw materials =
  • Total Raw Materials needs
  • – beginning inventory of raw materials =
  • Raw Materials to be purchased.
  • Insignificant raw materials are included in variable MOH.

  • Schedule of Expected Cash Disbursements for Raw Materials
  • Needed to prepare the overall cash budget, consists of payments for purchases on account in prior periods + payments for purchases in the current budget period.


The Direct Labour Budget

  • A detailed plan showing labour requirements over a specified time period.
  • Developed from the production budget – company can plan to adjust number of employees.
  • Firms that neglect labour budgets face risk of labour shortages or having to hire/layoff at awkward times.
  • Direct Labour Budget
  • Units to be produced
  • x Direct Labour Time per unit =
  • Total direct labour hours needed.
  • x direct labour cost per hour =
  • Total Direct Labour Cost
  • If there is a guaranteed amount of hours of pay each quarter at a certain rate – the minimum direct labour cost for a quarter may be higher.
  • # of workers x # of guaranteed hours x Rate per hour = New DL Cost.

The Manufacturing Overhead Budget

  • A detailed plan showing the indirect production costs that will be incurred over a specified time period.
  • Recall
  • Variable MOH = # of DLH x MOH cost per DLH.
  • MOH Budget
  • Budgeted Direct Labour Hours
  • x Variable Overhead Rate =
  • Variable Manufacturing Overhead
  • + Fixed Manufacturing Overhead =
  • Total Manufacturing Overhead
  • – Depreciation =
  • Cash Disbursements for Manufacturing Overhead
  • Other Calculations
  • Total Manufacturing Overhead
  • / Budgeted Direct Labor Hours =
  • Predetermined Overhead Rate for the Year
  • If Fixed Costs’ expected capacity utilized > company’s current capacity, then fixed costs may be increased or vice versa.
  • Once determined in the budget, they really are fixed.
  • If some of the OH costs are not cash outflows, the total budgeted MOH costs must be adjusted to determine the cash disbursements for MOH – can be depreciation, etc.


The Ending Finished Goods Inventory Budget

  • A budget showing the dollar amount of cost expected to appear on the balance sheet for unsold units at the end of a period.
  • After completing the previous schedules, all of the data required for unit product cost is available.
  • Used to determine COGS on the budgeted income statement.
  • Used to identify the amount to put on the BS inventory account for unsold units.
  • Production Cost Per Unit
  • Quantity x Cost = Total – do this for DL, DM, and MOH.
  • Budgeted Finished Goods Inventory
  • Ending finished goods inventory in units
  • x unit product cost
  • Ending Finished Goods in Dollars


The Selling and Administrative Expense Budget

  • Detailed schedule of planned expenditures that will be incurred in areas other than manufacturing during a budget period.
  • Compiles fixed S&A costs and variable S&A costs (Multiply units x S&A cost per unit)
  • S&A Expense Budget
  • Budgeted Sales in Units
  • x Variable Selling and Administrative Expenses Per Unit
  • Budgeted Variable Expense
  • + Budgeted Fixed Selling and Administrative Expenses (Add up all individual expenses here, i.e. depreciation, insurance)
  • Total Budgeted Selling and Administrative Expenses
  • – Any non-cash items
  • + Any cash disbursements
  • Cash Disbursements for S&A Expenses


The Cash Budget

  • Integrates data developed from preceding steps.
  • Comprised of 4 major sections
  • Receipts Section – List of all cash inflows besides financing expected during the period. (Usually sales is the most)
  • Disbursements Section – All cash payments planned for the budget period.
  • Cash Excess or Deficiency Section – May result from ensuring meeting a target minimum cash balance – it can be invested.
  • Cash balance, Beginning
  • + Receipts
  • Total Cash Available Before Financing
  • - Disbursements
  • Excess (Deficiency) of cash available over disbursements.
  • Financing Section– detailed account of the borrowings and loan repayments projected to take place, and also details interest budget.
  • Cash Budget needs to be broken down into time periods short enough to capture major cash balance fluctuations.
  • Monthly is common but can also be weekly/daily for start-ups.
  • Separate the cash budget into quarters.

  • To solve for the borrowing required to meet a specific cash balance next quarter:
  • Excess Cash (Deficiency) + (Borrowing Rate) Borrowing – Interest on Borrowing = Target Cash Balance.
  • If all loans are not repaid and a budgeted income statement or balance sheet is being prepared, interest must be accrued on outstanding loans for the period.
  • Doesn’t appear on the cash budget but appears as an interest expense on the budgeted income statement.
  • Total amounts for the total periods may not equal the actual sum.


The Budgeted Income Statement

  • Prepared from data developed across schedules, is a key schedule in the budget process.
  • Shows planned profit for upcoming budget period and can be used to benchmark against another company.
  • Items
  • Sales
  • Less COGS
  • Gross Margin
  • Less Selling and Administrative Expenses
  • Operating Income (Before Taxes and Interest)
  • Less Income taxes
  • Less Interest Expense
  • Net income


The Budgeted Balance Sheet

  • Developed using the actual balance sheet at the end of the most recent fiscal period as a starting point.
  • Not all companies prepare it because responsibility accounting focuses on comparing actual results for revenues/expenses to budgeted amounts.
  • External stakeholders may require it for making decisions about credit terms.
  • Consists of:
  • Current Assets (Cash, AR, Raw Materials Inventory, Finished Goods Inventory)
  • Plant and Equipment (Land, buildings, furniture, equipment, accumulated depreciation)
  • Current Liabilities (AP)
  • Shareholders’ Equity (Common Shares, retained earnings)


Objective 3 – Prepare a flexible budget and explain the need for the flexible budget approach.


Flexible Budget

  • Static Budget – A budget designed for only the planned level of activity.
  • Flexible Budget – A budget that provides estimates of what revenues and costs should be for any level of activity within a specified range.
  • Adjusts for stagnating actual level of activity in a period.


How a Flexible Budget Works

  • Budget is adjusted to show what revenues and costs should be for a specific level of activity within a relevant range of activity,
  • Flexible Budget Income Statement follows the Contribution Format Income Statement and uses variable costing approach.
  • Revenues and expenses are calculated by multiplying amounts per unit for sales and variable expenses by activity level (units).


Objective 4 – Prepare a performance report using the flexible budget approach.


Using the Flexible Budgeting Concept in Performance Evaluation

  • A Flexible budget performance report has 3 main components
  1. Actual Revenues and Expenses for the Year based on actual sales.
  2. Flexible Budget based on actual sales.
  3. Flexible Budget Variance – difference between actual results and flexible budget – they are labeled favourable or unfavourable.
  • Using flexible budget variance, we can identify possible causes for the difference in income – such as unfavourable sales variance, cost control, etc.
  • Static Budget Variance – Difference between actual and static budget amounts for revenues and expenses.
  • It is misleading because nearly all values are unfavourable when activity stagnates. (e.g. sell more than expected)
  • Not beneficial for evaluating managers controlling costs at actual levels of activity.
  • Sales Volume Variance – Difference between flexible and static budget amounts for revenues and expenses caused by actual activity levels differing from static budget amounts.
  • Included in a Comprehensive Performance Report and allow managers to isolate the part of the static budget variance caused solely by activity differences.


Objective 5 – Describe variations in the master budget process when applying it to Not-For-Profit Situations.


Budgeting for NFP Organizations

  • For NFP entities, there is often no relationship between expected revenues and expected expenditures.
  • Profit motive is replaces with a service orientation – budget info is used to assist in deciding in programs and expenditures.
  • NFP entity must estimate revenues and expenditures for supporting these programs.
  • Accountability – Very important for NFP to get support from donors so they know how resources will be used effectively and efficiently.
  • Budget should be approved by the governing body – and may be prepared on an expenditure basis or a program basis.
  • Expenditure Basis – Lists total expected costs of expenditure items such as rent, insurance, supplies.
  • Program Basis – Facilitates performance evaluation and allows for comparison of budgeted revenues/expenses on each program with actual amounts periodically.



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