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4. Budgets and Budgeting

BUDGETS AND BUDGETING

A budget is a comprehensive, formal plan that estimates the probable
expenditures and income for an organization over a specific period.
Budgeting describes the overall process of preparing and using a
budget. Since budgets are such valuable tools for planning and control
of finances, budgeting affects nearly every type of organization—from
governments and large corporations to small businesses—as well as
families and individuals. A small business generally engages in
budgeting to determine the most efficient and effective strategies for
making money and expanding its asset base. Budgeting can help a
company use its limited financial and human resources in a manner
which best exploits existing business opportunities.
Intelligent budgeting incorporates good business judgment in the
review and analysis of past trends and data pertinent to the business.
This information assists a company in decisions relating to the type of
business organization needed, the amount of money to be invested,
the type and number of employees to hire, and the marketing
strategies required. In budgeting, a company usually devises both
long-term and short-term plans to help implement its strategies and to
conduct ongoing evaluations of its performance. Although budgeting
can be time-consuming and costly for small businesses, it can also
provide a variety of benefits, including an increased awareness of
costs, a coordination of efforts toward company goals, improved
communication, and a framework for performance evaluation.

PLANNING FOR PROFIT AND WEALTH

The idea behind any profitable commercial enterprise lies in
employing resources to exploit various business opportunities. If the
profits are consistent, a company may purchase more assets and,
therefore, expand its base of wealth. To do this effectively, a company
undertakes the budgeting process to assess the business
opportunities available to it, the keys to successfully exploiting these
opportunities, the strategies the historical data support as most likely
to succeed, and the goals and objectives the company must establish.
The company must also plan long-term strategies which define its
overall effort in building market share, increasing revenues, and
decreasing costs; short-term strategies to increase profits, control
costs, and invest for the future; control mechanisms incorporating
performance evaluations and good business judgment; and control
mechanisms for making modifications in the above strategies when
and where necessary.
Although opportunities initially find their impetus in the business
judgment of company leaders, a company expresses its assessment
of them and formulates its strategies in quantifiable terms, such as:
the volume of units which the company expects it can sell, the
percentage of market share the volume of units represents, the dollars
of revenues it will receive from these sales, and the dollars of profit it
will earn. Likewise, a company outlines its long-term goals and
specifies its short-range plans in quantifiable terms which detail how it
expects to accomplish its goals: the dollars the company will spend in
selling the units; the dollar costs of producing the units; the dollar
costs of administering the company's operations; the dollars the
company will invest in expanding and upgrading facilities and
equipment; the flow of dollars into the company coffers; and the
financial position, expressed in dollars, at specific points in the future.

FINANCIAL FORECASTS AND BUDGETS

A financial forecast projects where the company wants to be in three,
five, or ten years. It quantifies future sales, expenses, and earnings
according to certain assumptions adopted by the company. The
company then considers how changes in the business climate would
affect the outcomes projected. It presents this analysis in the pro
forma statement, which displays, over a time continuum, a comparison
of the financial plan to "best case" and "worst case" scenarios. The
pro forma statement acts as a guide for meeting goals and objectives,
as well as an evaluative tool for assessing progress and profitability.
Through forecasting a company attempts to determine whether and to
what degree its long-range plans are feasible. This discipline
incorporates two interrelated functions: long-term planning based on
realistic goals and objectives and a prognosis of the various conditions
that possibly will affect these goals and objectives; and short-term
planning and budgeting, which provide details about the distribution of
income and expenses and a control mechanism for evaluating
performance. Forecasting is a process for maximizing the profitable
use of business assets in relation to: the analyses of all the latest
relevant information by tested and logically sound statistical
and econometric techniques; the interpretation and application of
these analyses into future scenarios; and the calculation of reasonable
probabilities based on sound business judgment.
Future projections for extended periods, although necessary and
prudent, suffer from a multitude of unknowns: inflation, supply
fluctuations, demand variations, credit shortages, employee
qualifications, regulatory changes, management turnover, and the like.
To increase control over operations, a company narrows its focus to
forecasting attainable results over the short-term. These short-term
forecasts, called budgets, are formal, comprehensive plans that
quantify the expected operations of the organization over a specific
future period. While a company may make few modifications to its
forecast, for instance, in the first three years, the company constructs
individual budgets for each year.
A budget describes the expected month-to-month route a company
will take in achieving its goals. It summarizes the expected outcomes
of production and marketing efforts, and provides management
benchmarks against which to compare actual outcomes. A budget
acts as a control mechanism by pointing out soft spots in the planning
process and/or in the execution of the plans. Consequently, a budget,
used as an evaluative tool, augments a company's ability to more
quickly react and make necessary alterations.

PRINCIPLES AND PROCEDURES FOR

SUCCESSFUL BUDGETING
To be successful, budgets should be prepared in accordance with the
following principles:
REALISTIC AND QUANTIFIABLE In a world of limited resources, a
company must ration its own resources by setting goals and
objectives which are reasonably attainable. Realism engenders loyalty
and commitment among employees, motivating them to their highest
performance. In addition, wide discrepancies, caused by unrealistic
projections, have a negative effect on the credit worthiness of a
company and may dissuade lenders. A company evaluates each
potential activity to determine those that will result in the most
appropriate resource allocation. A company accomplishes this through
thequantification of the costs and benefits of the activities.
HISTORICAL The budget reflects a clear understanding of past results
and a keen sense of expected future changes. While past results
cannot be a perfect predictor, they flag important events and
benchmarks.
PERIOD SPECIFIC The budget period must be of reasonable length. The
shorter the period, the greater the need for detail and control
mechanisms. The length of the budget period dictates the time
limitations for introducing effective modifications. Although plans and
projects differ in length and scope, a company formulates each of its
budgets on a 12-month basis.
STANDARDIZED To facilitate the budget process, managers should use
standardized forms, formulas, and research techniques. This
increases the efficiency and consistency of the input and the quality of
the planning. Computer-aided accounting, analyzing, and reporting not
only furnish managers with comprehensive, current, "real time"
results, but also afford them the flexibility to test new models, and to
include relevant and high-powered charts and tables with relatively
little effort.
INCLUSIVE Efficient companies decentralize the budget process down
to the smallest logical level of responsibility. Those responsible for the
results take part in the development of their budgets and learn how
their activities are interrelated with the other segments of the
company. Each has a hand in creating a budget and setting its goals.
Participants from the various organizational segments meet to
exchange ideas and objectives, to discover new ideas, and to
minimize redundancies and counterproductive programs. In this way,
those accountable buy into the process, cooperate more, work harder,
and therefore have more potential for success.
SUCCESSIVELY REVIEWED Decentralization does not exclude the
thorough review of budget proposals at successive management
levels. Management review assures a proper fit within the overall
"master budget."
FORMALLY ADOPTED AND DISSEMINATED Top management formally
adopts the budgets and communicates their decisions to the
responsible personnel. When top management has assembled the
master budget and formally accepted it as the operating plan for the
company, it distributes it in a timely manner.
FREQUENTLY EVALUATED Responsible parties use the master budget
and their own department budgets for information and guidance. On a
regular basis, according to a schedule and in a standardized manner,
they compare actual results with their budgets. For an annual budget,
managers usually report monthly, quarterly, and semi-annually. Since
considerable detail is needed, the accountant plays a vital role in the
reporting function. A company uses a well-designed budget program
as an effective mechanism for fore-casting realizable results over a
specific period, planning and coordinating its various operations, and
controlling the implementation of the budget plans.
FUNCTIONS AND BENEFITS OF
BUDGETING
Budgeting has two primary functions: planning and control. The
planning process expresses all the ideas and plans in quantifiable
terms. Careful planning in the initial stages creates the framework for
control, which a company initiates when it includes each department in
the budgeting process, standardizes procedures, defines lines of
responsibility, establishes performance criteria, and sets up
timetables. The careful planning and control of a budget benefit a
company in many ways, including:
ENHANCING MANAGERIAL PERSPECTIVE In recent years the pace and
complexity of business have outpaced the ability to manage by "the
seat of one's pants." On a day-to-day basis, most managers focus
their attention on routine problems. However, in preparing the budget,
managers are compelled to consider all aspects of a company's
internal activities. The act of making estimates about future economic
conditions, and about the company's ability to respond to them, forces
managers to synthesize the external economic environment with their
internal goals and objectives.
FLAGGING POTENTIAL PROBLEMS Because the budget is a blueprint
and road map, it alerts managers to variations from expectations
which are a cause for concern. When a flag is raised, managers can
revise their immediate plans to change a product mix, revamp an
advertising campaign, or borrow money to cover cash shortfalls.
COORDINATING ACTIVITIES Preparation of a budget assumes the
inclusion and coordination of the activities of the various segments
within a business. The budgeting process demonstrates to managers
the inter-connectedness of their activities.
EVALUATING PERFORMANCE Budgets provide management with
established criteria for quick and easy performance evaluations.
Managers may increase activities in one area where results are well
beyond exceptions. In other instances, managers may need to
reorganize activities whose outcomes demonstrate a consistent
pattern of inefficiency.
REFINING THE HISTORICAL VIEW The importance of clear and detailed
historical data cannot be overstated. Yet the budgeting process
cannot allow the historical perspective to become crystallized.
Managers need to distill the lessons of the most current results and
filter them through their historical perspective. The need for a flexible
and relevant historical perspective warrants its vigilant revision and
expansion as conditions and experience warrant.

CLASSIFICATIONS AND TYPES OF

BUDGETS
The budgeting process is sequential in nature, i.e., each budget
hinges on a previous budget, so that no budget can be constructed
without the data from the preceding budget. Budgets may be broadly
classified according to how a company makes and uses its money.
Different budgets may be used for different applications. Some
budgets deal with sources of income from sales,
interest, dividend income, and other sources. Others detail the
sources of expenditures such as labor, materials, interest payments,
taxes, and insurance. Additional types of budgets are concerned with
investing funds for capital expenditures such as plant and equipment;
and some budgets predict the amounts of funds a company will have
at the end of a period.
A company cannot use only one type of budget to accommodate all its
operations. Therefore, it chooses from among the following budget
types.
The fixed budget , often called a static budget, is not subject to
change or alteration during the budget period. A company "fixes"
budgets in at least two circumstances:

1. The cost of a budgeted activity shows little or no change when

the volume of production fluctuates within an expected range of
 values. For example, a 10 percent increase in production has
little or no impact on administrative expenses.
2. The volume of production remains steady or follows a tight, pre-
set schedule during the budget period. A company may fix its
production volume in response to an all inclusive contract; or, it
may produce stock goods.

The variable or flexible budget is called a dynamic budget. It is an

effective evaluative tool for a company that frequently experiences
variations in sales volume which strongly affect the level of production.
In these circumstances a company initially constructs a series of
budgets for a range of production volumes which it can reasonably
and profitably meet.
After careful analysis of each element of the production process,
managers are able to determine over-head costs that will not change
(fixed) within the anticipated range, overhead costs that will change
(variable) as volume changes, and those overhead costs which vary to
some extent, but not proportionately (semi-variable) within the
predicted range.
The combination budget recognizes that most production activities
combine both fixed and variable budgets within its master budget. For
example, an increase in the volume of sales may have no impact on
sales expenses while it will increase production costs.
The continuous budget adds a new period (month) to the budget as
the current period comes to a close. Under the fiscal year approach,
the budget year becomes shorter as the year progresses. However,
the continuous method forces managers to review and assess the
budget estimates for a never-ending 12-month cycle.
The operating budget gathers the projected results of the operating
decisions made by a company to exploit available business
opportunities. In the final analysis, the operating budget presents a
projected (pro forma) income statement which displays how much
money the company expects to make. This net income demonstrates
the degree to which management is able to respond to the market in
supplying the right product at an attractive price, with a profit to the
company.
The operating budget consists of a number of parts which detail the
company's plans on how to capture revenues, provide adequate
supply, control costs, and organize the labor force. These parts are:
sales budget, production budget, direct materials budget, direct labor
budget, factory overhead budget, selling and administrative expense
budget, and pro forma income statement.
The operating budget and the financial budget are the two main
components of a company's master budget. The financial budget
consists of the capital expenditure budget, the cash budget, and the
budgeted balance sheet. Much of the information in the financial
budget is drawn from the operating budget, and then all of the
information is consolidated into the master budget.

PREPARATION OF THE MASTER

BUDGET
The master budget aggregates all business activities into one
comprehensive plan. It is not a single document, but the compilation of
many interrelated budgets which together summarize an
organization's business activities for the coming year. To achieve the
maximum results, budgets must be tailor-made to fit the particular
needs of a business. Standardization of the process facilitates
comparison and aggregation even of mixed products and industries.
Preparation of the master budget is a sequential process which starts
with the sales budget. The sales budget predicts the number of units a
company expects to sell. From this information, a company
determines how many units it must produce. Subsequently, it
calculates how much it will spend to produce the required number of
units. Finally, it aggregates the foregoing to estimate its profitability.
From the level of projected profits, the company decides whether to
reinvest the funds in the business or to make alternative investments.
The company summarizes the predicted results of its plans in a
balance sheet which demonstrates how profits will have affected the
company's assets (wealth).
THE SALES FORECAST AND BUDGET The sales organization has the
primary responsibility of preparing the sales forecast. Since the sales
forecast is the starting point in constructing the sales budget, the input
and involvement of other managers is important. First, those
responsible for directing the overall effort of budgeting and planning
contribute leadership, coordination, and legitimacy to the resulting
forecast. Second, in order to introduce new products or to repackage
existing lines, the sales managers need to elicit the cooperation of the
production and the design departments. Finally, the sales team must
get the support of the top executives for their plan.
The sales forecast is prerequisite to devising the sales budget, on
which a company can reasonably schedule production, and to
budgeting revenues and variable costs. The sales budget, also called
the revenue budget, is the preliminary step in preparing the master
budget. After a company has estimated the range of sales it may
experience, it calculates projected revenues by multiplying the number
of units by their sales price.
The sales budget includes items such as: sales expressed in both the
number of units and the dollars of revenue; adjustments to sales
revenues for allowances made and goods returned; salaries and
benefits of the sales force; delivery and setup costs; supplies and
other expenses supporting sales; advertising costs; and the
distribution of receipt of payments for goods sold. Included in the sales
budget is a projection of the distribution of payments for goods sold.
Management forecasts the timing of receipts based on a number of
considerations: the ability of the sales force to encourage customers
to pay on time; the impact of credit sales, which stretch the collection
period; delays in payment due to deteriorating economic and market
conditions; the ability of the company to make deliveries on time; and
the quality of the service and technical staffs.
THE ENDING INVENTORY BUDGET The ending inventory budget presents
the dollar value and the number of units a company wishes to have in
inventory at the end of the period. From this budget, a company
computes its cost of goods sold for the budgeted income statement. It
also projects the dollar value of the ending materials and finished-
goods inventory, which eventually will appear on the budgeted
balance sheet. Since inventories comprise a major portion of current
assets, the ending inventory budget is essential for the construction of
the budgeted financial statement.
THE PRODUCTION BUDGET After it budgets sales, a company examines
how many units it has on hand and how many it wants at year-end.
From this it calculates the number of units needed to be produced
during the upcoming period. The company adjusts the level of
production to account for the difference between total projected sales
and the number of units currently in inventory (the beginning
inventory), in the process of being finished (work in process
inventory), and finished goods on hand (the ending inventory). To
calculate total production requirements, a company adds projected
sales to ending inventory and subtracts the beginning inventory from
that sum.
THE DIRECT-MATERIALS BUDGET With the estimated level of production
in hand, the company constructs a direct-materials budget to
determine the amount of additional materials needed to meet the
projected production levels. A company displays this information in
two tables. The first table presents the number of units to be
purchased and the dollar cost for these purchases. The second table
is a schedule of the expected cash distributions to suppliers of
materials. Purchases are contingent on the expected usage of
materials and current inventory levels. The formula for the calculation
for materials purchases is:
Materials to Be Purchased for Production Units of Materials to Be
Used Units Desired in Ending Inventory-Units of Material in Beginning
Inventory.
Purchase costs are simply calculated as:
Materials Purchase Costs Unit of Materials to Be Purchased X Unit
Price.
A company uses the planning of a direct-materials budget to
determine the adequacy of their storage space, to institute or refine
Just-in-Time (JIT) inventory systems, to review the ability of vendors
to supply materials in the quantities desired, and to schedule material
purchases concomitant with the flow of funds into the company.
THE DIRECT-LABOR BUDGET Once a company has determined the
number of units of production, it calculates the number of direct-labor
hours needed. A company states this budget in the number of units
and the total dollar costs. A company may sort and display labor-hours
using parameters such as: the type of operation, the types of
employees used, and the cost centers involved.
THE PRODUCTION OVERHEAD BUDGET A company generally includes all
costs, other than materials and direct labor, in the production
overhead budget. Because of the diverse and complex nature of
business, production overhead contains numerous items. Some of the
more common ones include:

1. Indirect materials—factory supplies which are used in the

process but are not an integral part of the final product, such as
parts for machines and safety devices for the workers; or
materials which are an integral part of the final product but are
difficult to assign to specific products, for example, adhesives,
wire, and nails.
2. Indirect labor costs—supervisors' salaries and salaries of
maintenance, medical, and security personnel.
3. Plant occupancy costs—rent or depreciation on buildings,
insurance on buildings, property taxes on land and buildings,
maintenance and repairs on buildings, and utilities.
4. Machinery and equipment costs—rent or depreciation on
machinery, insurance and property taxes on machinery, and
maintenance and repairs on machinery.
5. Cost of compliance with federal, state, and local regulations—
meeting safety requirements, disposal of hazardous waste
materials, and control over factory emissions (meeting class air
standards).
BUDGET OF COST OF GOODS SOLD At this point the company has
projected the number of units it expects to sell and has calculated all
the costs associated with the production of those units. The company
will sell some units from the preceding period's inventory, others will
be goods previously in process, and the remainder will be produced.
After deciding the most likely mix of units, the company constructs the
budget of the cost of goods sold by multiplying the number of units by
their production costs.
ADMINISTRATIVE EXPENSE BUDGET In the administrative expense
budget the company presents how much it expects to spend in
support of the production and sales efforts. The major expenses
accounted for in the administrative budget are: officers' salaries; office
salaries; employee benefits for administrative employees; payroll
taxes for administrative employees; office supplies and other office
expenses supporting administration; losses from uncollectible
accounts; research and development costs; mortgage payments, bond
interest, and property taxes; and consulting and professional services.
Generally, these expenses vary little or not at all for changes in the
production volume which fall within the budgeted range. Therefore, the
administrative budget is a fixed budget. However, there are some
expenses which can be adjusted during the period in response to
changing market conditions. A company may easily adjust some
costs, such as consulting services, R&D, and advertising, because
they are discretionary costs. Discretionary costs are partially or fully
avoidable if their impact on sales and production is minimal. A
company cannot avoid such costs as mortgage payments, bond
interest, and property taxes if it wishes to stay in production into the
next period. These committed costs are contractual obligations to third
parties who have an interest in the company's success. Finally, a
company has variable costs, which it adjusts in light of cash flow and
sales demand. These costs include such items as supplies, utilities,
and the purchase of office equipment.
BUDGETED INCOME STATEMENT A budgeted income statement
combines all the preceding budgets to show expected revenues and
expenses. To arrive at the net income for the period, the company
includes estimates of sales returns and allowances, interest income,
bond interest expense, the required provision for income taxes, and a
number of nonoperating income and expenses, such as dividends
received, interest earned, nonoperating property rental income, and
other such items. Net income is a key figure in the profit plan for it
reflects how a company commits the majority of its talent, time, and
resources.

FINANCIAL BUDGET
The financial budget contains projections for cash and other balance
sheet items—assets and liabilities. It also includes the capital
expenditure budget. It presents a company's plans for financing its
operating and capital investment activities. The capital expenditure
budget relates to purchases of plant, property, or equipment with a
useful life of more than one year. On the other hand, the cash budget,
the budgeted balance sheet, and the budgeted statement of cash
flows deal with activities expected to end within the 12-month budget
period.
THE CAPITAL EXPENDITURES BUDGET A company engages in capital
budgeting to identify, evaluate, plan, and finance major investment
projects through which it converts cash (short-term assets) into
longterm assets. A company uses these new assets, such as
computers, robotics, and modern production facilities, to improve
productivity, increase market share, and bolster profits. A company
purchases these new assets as alternatives to holding cash because it
believes that, over the long-term, these assets will increase the wealth
of the business more rapidly than cash balances. Therefore, the
capital expenditures budget is crucial to the overall budget process.
Capital budgeting seeks to make decisions in the present which
determine, to a large degree, how successful a company will be in
achieving its goals and objectives in the years ahead. Capital
budgeting differs from the other financial budgets in that they require
relatively large commitments of resources, extend beyond the 12-
month planning horizon of the other financial budgets, involve greater
operating risks, increase financial risk by adding long-term liabilities,
and require clear policy decisions that are in full agreement with the
company's goals. For the most part, a company makes its decisions
about investments by the profits it can expect and by the amount of
funds available for capital outlays. A company assesses each project
according to its necessity and potential profitability using a variety of
analytical methods.
THE CASH BUDGET In the cash budget a company estimates all
expected cash flows for the budget period by stating the cash
available at the beginning of the period, adding cash from sales and
other earned income to arrive at the total cash available, and then
subtracting the projected disbursements for payables, prepayments,
interest and notes payable, income tax, etc.
The cash budget is an indication of the company's liquidity, or ability to
meet its current obligations, and therefore is a very useful tool for
effective management. Although profits drive liquidity, they do not
necessarily have a high correlation. Often when profits increase,
collectibles increase at a greater rate. As a result, liquidity may
increase very little or not at all, making the financing of expansion
difficult and the need for short-term credit necessary.
Managers optimize cash balances by having adequate cash to meet
liquidity needs, and by investing the excess until needed. Since
liquidity is of paramount importance, a company prepares and revises
the cash budget with greater frequency than other budgets. For
example, weekly cash budgets are common in an era of tight money,
slow growth, or high interest rates.
THE BUDGETED BALANCE SHEET A company derives the budgeted
balance sheet, often referred to as the budgeted statement of financial
position, from changing the beginning account balances to reflect the
operating, capital expenditure, and cash budgets. (Since a company
prepares the budgeted balance sheet before the end of the current
period, it uses an estimated beginning balance sheet.)
The budgeted balance sheet is a statement of the assets and liabilities
the company expects to have at the end of the period. The budgeted
balance sheet is more than a collection of residual balances resulting
from the foregoing budget estimates. During the budgeting process,
management ascertains the desirability of projected balances and
account relationships. The outcomes of this level of review may
require management to reconsider plans which seemed reasonable
earlier in the process.
BUDGETED STATEMENT OF CASH FLOWS The final phase of the master
plan is the budgeted statement of cash flows. This statement
anticipates the timing of the flow of cash revenues into the business
from all resources, and the outflow of cash in the form of payables,
interest expense, tax liabilities, dividends, capital expenditures, and
the like.
The statement of cash flows includes:

 The amount of cash the company will receive from all sources,
including nonoperating items, creditors, and the sale of stocks
and assets. The company includes only those credit sales for
which it expects to receive at least partial payment.
 The amount of cash the company will pay out for all activities,
including dividend payments, taxes, and bond interest expense.
 The amount of cash the company will net from its operating
activities and investments.

The net amount is a clear measure of the ability of the business to

generate funds in excess of cash outflows for the period. If anticipated
cash is less than projected expenses, management may decide to
increase credit lines or to revise its plans. Note that net cash flow is
not the same as net income or profit. Net income and profit factor in
depreciation and nonoperating gains and losses which are not cash
generating items.

SUMMARY
Budgeting is the process of planning and controlling the utilization of
assets in business activities. It is a formal, comprehensive process
which covers every detail of sales, operations, and finance, thereby
providing management with performance guidelines. Through
budgeting, management determines the most profitable use of limited
resources. Used wisely, the budgeting process increases
management's ability to more efficiently and effectively deploy
resources, and to introduce modifications to the plan in a timely
manner