Budgeting Concepts and Process (discussion)

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Chapter 8

Budgeting

Nature and Objectives of Budgeting

Budgets play an important role for organizations of all sizes and forms.

For example, budgets are used in managing the operations of government agencies, churches, hospitals, and other nonprofit organizations.

This chapter describes and illustrates budgeting for a manufacturing company.

Objectives of Budgeting (slide 1 of 2)

Objectives of Budgeting (slide 2 of 2)

Budgeting affects the following managerial functions:

Planning

Planning involves setting goals to guide decisions and help motivate employees.

Directing

Directing involves decisions and actions to achieve budgeted goals.

A budgetary unit of a company is called a responsibility center.

Each responsibility center is led by a manager who has the authority and responsibility for achieving the center’s budgeted goals.

Controlling

Controlling involves comparing actual performance against the budgeted goals.

Such comparisons provide feedback to managers and employees about their performance.

If necessary, responsibility centers can use such feedback to adjust their activities in the future.

Human Behavior and Budgeting

Human behavior problems can arise in the budgeting process in the following situations:

Budgeted goals are set too tight, which are very hard or impossible to achieve.

Budgeted goals are set too loose, which are very easy to achieve.

Budgeted goals conflict with the objectives of the company and employees.

Human Behavior and Budgeting: Setting Budget Goals Too Tightly

If budgeted goals are viewed as unrealistic or unachievable, the budget may have a negative effect on the ability of the company to achieve its goals.

Attainable goals are more likely to motivate employees and managers.

For this reason, it is important for employees and managers to be involved in the budgeting process.

Involving employees in the budgeting process provides them with a sense of control and, thus, more of a commitment in meeting budgeted goals.

Human Behavior and Budgeting: Setting Budget Goals Too Loosely

Although it is desirable to establish attainable goals, it is undesirable to plan budget goals that are too easy.

Such budget “padding” is called budgetary slack.

Managers may plan slack in their budgets to provide a “cushion” for unexpected events.

However, slack budgets may create inefficiency by reducing the budgetary incentive to trim spending.

Human Behavior and Budgeting: Setting Conflicting Budget Goals

Budgeting Systems (slide 1 of 4)

The budgetary period for operating activities normally includes the fiscal year of a company.

For control purposes, annual budgets are usually subdivided into shorter time periods, such as quarters of the year, months, or weeks.

Budgeting Systems (slide 2 of 4)

A variation of fiscal-year budgeting, called continuous budgeting, maintains a 12-month projection into the future.

The 12-month budget is continually revised by replacing the data for the month just ended with the budget data for the same month in the next year.

Continuous Budgeting

Budgeting Systems (slide 3 of 4)

Developing an annual budget usually begins several months prior to the end of the current year.

The responsibility of developing an annual budget is normally assigned to a budget committee.

Such a committee often consists of the budget director, the controller, the treasurer, the production manager, and the sales manager.

The budget process is monitored and summarized by the Accounting Department, which reports to the committee.

Budgeting Systems (slide 4 of 4)

There are several methods of developing budget estimates.

One method, called zero-based budgeting, requires managers to estimate sales, production, and other operating data as though operations are being started for the first time.

A more common approach is to start with last year’s budget and revise it for actual results and expected changes for the coming year.

Two major budgets using this approach are the static budget and the flexible budget.

Static Budget (slide 1 of 2)

A static budget shows the expected results of a responsibility center for only one activity level. Once the budget has been determined, it is not changed, even if the activity changes.

Static budgeting is used by many service companies, government entities, and for some functions of manufacturing companies, such as purchasing, engineering, and accounting.

A disadvantage of static budgets is that they do not adjust for changes in activity levels.

Flexible Budget (slide 1 of 3)

Flexible budgets show the expected results of a responsibility center for several activity levels.

A flexible budget is, in effect, a series of static budgets for different levels of activity.

Flexible Budget (slide 2 of 3)

A flexible budget is constructed as follows:

Step 1: Identify the relevant activity levels.

The relevant levels of activity could be expressed in units, machine hours, direct labor hours, or some other activity base.

Step 2: Identify the fixed and variable cost components of the costs being budgeted.

Step 3: Prepare the budget for each activity level by multiplying the variable cost per unit by the activity level and then adding the monthly fixed cost.

Flexible Budget (slide 3 of 3)

Because the flexible budget adjusts for changes in the level of activity, it is much more accurate and useful than the static budget.

Master Budget

Master Budget for a Manufacturing Company

Operating Budgets

Sales Budget

The sales budget begins by estimating the quantity of sales.

The prior year’s sales are often used as a starting point.

These sales quantities are then revised for such factors as:

Planned advertising and promotions

Projected pricing changes

Expected industry and general economic conditions

Once sales quantities are estimated, the budgeted sales revenue can be determined as follows:

Production Budget

The production budget estimates the number of units to be manufactured to meet budgeted sales and desired inventory levels.

The budgeted units to be produced are determined as follows:

Expected units to be sold	XXX units
Desired units in ending inventory	XXX
Estimated units in beginning inventory	(XXX)
Total units to be produced	XXX units

Direct Materials Purchases Budget (slide 1 of 2)

The direct materials purchases budget estimates the quantities of direct materials to be purchased to support budgeted production and desired inventory levels.

Direct Materials Purchases Budget (slide 2 of 2)

The direct materials purchases budget can be developed in three steps:

Step 1: Determine the budgeted direct material required for production, which is computed as follows:

Step 2: The budgeted material required for production is adjusted for beginning and ending inventories to determine the direct materials to be purchased for each material, as follows:

Step 3: The budgeted direct materials to be purchased is computed as follows:

Materials required for production (Step 1)	XXX
Desired ending materials inventory	XXX
Estimated beginning materials inventory	(XXX)
Direct material quantity to be purchased	XXX

Direct Labor Cost Budget (slide 1 of 2)

The direct labor cost budget estimates the direct labor hours and related cost needed to support budgeted production.

Direct Labor Cost Budget (slide 2 of 2)

The direct labor cost budget for each department is determined in two steps, as follows:

Step 1: Determine the budgeted direct labor hours required for production, which is computed as follows:

Step 2: Determine the total direct labor cost as follows:

Factory Overhead Cost Budget

The factory overhead cost budget estimates the cost for each item of factory overhead needed to support budgeted production.

The factory overhead cost budget may be supported by departmental schedules.

Such schedules normally separate factory overhead costs into fixed and variable costs to better enable department managers to monitor and evaluate costs during the year.

Cost of Goods Sold Budget

Selling and Administrative Expenses Budget

The sales budget is often used as the starting point for the selling and administrative expenses budget.

The selling and administrative expenses budget is normally supported by departmental schedules.

Budgeted Income Statement (slide 1 of 3)

Budgeted Income Statement (slide 2 of 3)

This budget summarizes the budgeted operating activities of the company.

In doing so, the budgeted income statement allows management to assess the effects of estimated sales, costs, and expenses on profits for the year.

Financial Budgets

Cash Budgets

The cash budget estimates the expected receipts (inflows) and payments (outflows) of cash for a period of time.

Estimated Cash Receipts

The primary source of estimated cash receipts is from cash sales and collections on account.

In addition, cash receipts may be obtained from plans to issue equity or debt financing as well as other sources such as interest revenue.

To estimate cash receipts from cash sales and collections on account, a schedule of collections from sales is prepared.

Estimated Cash Payments

Estimated cash payments must be budgeted for operating costs and expenses such as manufacturing costs, selling expenses, and administrative expenses.

In addition, estimated cash payments may be planned for capital expenditures, dividends, interest payments, or long-term debt payments.

To estimate cash payments for manufacturing costs, a schedule of payments for manufacturing costs is prepared.

Completing the Cash Budget (slide 1 of 2)

The cash budget is structured for a budget period as follows:

Capital Expenditures Budget

The capital expenditures budget summarizes plans for acquiring fixed assets.

Such expenditures are necessary as machinery and other fixed assets wear out or become obsolete.

In addition, purchasing additional fixed assets may be necessary to meet increasing demand for the company’s product.

Capital expenditures budgets are often prepared for five to ten years into the future.

This is necessary because fixed assets often must be ordered years in advance.

Budgeted Balance Sheet

Budgeted revenue = Expected sales volume

Expected unit sales price

Budgeted direct material = Budgeted pr

oduction volume × Direct material quan

tity

required for production

expected per unit

Budgeted direct material = Direct mate

rial quantity to be purchased × Unit p

rice

to be purchased

Budgeted labor hours = Budgeted produc

tion volume × Direct material quantity

required for production

expected per unit

Direct labor cost = Direct labor requi

red for production (step 1) × Hourly rat