Chapter 7

BUDGETING CONCEPTS
BUDGETING METHODOLOGIES
B U D G E TA RY P L A N N I N G

References:
CMA Excel Learning System – Exam Review Part 1 and Part 2 (2019) Publisher: Wiley.
Weygandt, J., Kimmel, P., and Kieso, D. (2015). Accounting Principles 12 th edition, John Wiley and Sons, Singapore.
Learning outcomes
After studying this chapter, you should be able to:
1.Define budgeting and discuss its role in planning, controlling, and decision-making.
2.Prepare the operating budget, identify its major components, and explain the
interrelationships of the various components.
3.Identify the components of the financial budget, and prepare a cash budget.
 Budget
Budget is a formal written statement of management’s plans for a specified
future time period, expressed in financial terms.

 Primary method of communicating agreed-upon objectives throughout the organization.

 Promotes efficiency.

 Control device - important basis for performance evaluation once adopted.

Learning outcomes
AFTER COMPLETING THIS TOPIC, YOU SHOULD BE ABLE TO:
1. STATE THE ESSENTIALS OF EFFECTIVE BUDGETING AND THE COMPONENTS OF THE MAS­TER
BUDGET.
2. PREPARE BUDGETS FOR SALES, PRODUCTION, AND DIRECT MATERIALS.
3. PREPARE BUDGETS FOR DIRECT LABOR, MANUFACTURING OVERHEAD, AND SELLING AND
ADMINISTRATIVE EXPENSES, AND A BUDGETED INCOME STATEMENT.
4. PREPARE A CASH BUDGET
5. APPLY BUDGETING PRINCIPLES TO NONMANUFACTURING COMPANIES.
 Budget – Control Device
o Aligning the Organization Managers work to implement strategy by
establishing operational objectives. Achieving the operational objectives is a
decision-making and management process that involves planning, controlling,
and evaluating operations in the organization.

- Operational planning is where the strategy is defined into operational

objectives, performance measures are set, and resources are committed. This
is the budgeting process for the organization.

- Controlling operational processes requires that expectations are established

and incentivized, results are gathered and reported, and variances from the
budget are computed.

- Evaluating the operations involves rewarding performance, analyzing results

to understand why objectives were met or not, and using the insight gained to
complete the feedback loop and inform the planning stage for the upcoming
operational cycle.
 Budgeting and Accounting
 Historical accounting data on revenues, costs, and expenses help in formulating
future budgets.

 Accountants normally responsible for presenting management’s budgeting goals in

financial terms.

 The budget and its administration are the responsibility of management.

 The Benefits of Budgeting
Primary benefits of budgeting:

1. Requires all levels of management to plan ahead.

2. Provides definite objectives for evaluating performance.

3. Creates an early warning system for potential problems.

4. Facilitates coordination of activities within the business.

5. Results in greater management awareness of the entity’s overall operations.

6. It motivates personnel throughout organization to meet planned objectives.

 Essentials of Effective Budgeting
• The budget clearly connects to and supports the organization's strategy.
• There should be an intelligent balance between firmness and flexibility.
• The budget should accurately represent forecasts of the overall business environment (external
factors) as well as represent realities of the organization's own environment (internal factors).
• Everyone in the organization needs to clearly understand and strongly commit themselves to the
budget.
• The budget should be motivating for everyone in the organization. Budgets effectively represent
goals and performance standards. When budget incentives are appropriate and budget expectations are
reachable with effort (i.e., stretch targets), then the budget will show motivational characteristics.
• Every budgeting cycle should be assessed to understand what was unanticipated or misunderstood,
and that insight should then inform and improve the next budgeting cycle.
 Essentials of Effective Budgeting
• effective budgeting should focus on spending and investing that clearly ties to the organization's
strategic objectives.
• Budgeting is the natural translation of strategy into quantifiable terms!

 Depends on a sound organizational structure with authority and responsibility for all
phases of operations clearly defined.

 Based on research and analysis with realistic goals.

 Accepted by all levels of management.

 THE BUDGETING PROCESS
 Base budget goals on past performance
 Collect data from organizational units.

 Begin several months before end of current year.

 Develop budget within the framework of a sales forecast.

 Shows potential industry sales.

 Shows company’s expected share.

 The Master Budget
• Set of interrelated budgets that constitutes a plan of action for a specified time period.

• Contains two classes of budgets: Individual budgets that result in the

preparation of the budgeted income
• Operating budgets. statement – establish goals for sales
and production personnel.

• Financial budgets. The capital expenditures budget, the

cash budget, and the budgeted
balance sheet – focus primarily on
cash needs to fund operations and
capital expenditures.
The Master Budget
 Sales Budget
 Accurate forecasting is crucial to successful budgeting. The most challenging forecasting
work in the organization is done for the sales budget (also called the revenue budget).
 First budget prepared.
 Derived from the sales forecast. Management’s best estimate of sales revenue for the
budget period.
 Every other budget depends on the sales budget.

 Prepared by:
 Expected unit sales volume for each product X anticipated unit selling price.
 Sales Budget
 Assume that the Sunbird Boat Company is expecting that its sales volume for the next year’s
first quarter will be 20 boats, 60 boats for quarter two, 40 boats for quarter three and 30 boats for
quarter four. It anticipated that its selling price will be $4,200 per boat. The sales budget for the
next year will be…
 Production Budget
• Shows units that must be produced to meet anticipated sales.
• For some organizations, the production budget may be relatively simple to assemble once the sales budget
is complete. Whatever is needed for the budgeted sales volume is then scheduled to be produced.
• However, inventory complicates the relationship between these two budgets. Organizations typically use
inventory as a “cushion” against unexpected or uncontrollable sales or production events. When
organizations must hold inventory, the result is that the budgeted sales volume will not equal the budgeted
production volume.
•When inventory is present in the budget, the relationship between sales volume and production volume is:
Sales volume + Ending inventory − Beginning inventory = Production volume
 Remember that:
Inventory levels are established according to budget policy.
 One production period's ending inventory level becomes the next production period's beginning
inventory level.
 Production Budget
 Sunbird management has a budget policy of planning for ending inventory levels equal to 40% of the
following quarter's sales volume needs.
 The management is forecasting the following year's Q1 sales volume to be 40 boats.
 Management is planning to end the current year with 10 boats on hand.
 Sunbird Boat Company’s production budget for the next year will be…
 Production Budget
 Note that sales volume in the first row has been carried forward from the sales budget.
 The sales volume plus ending inventory determines the number of boats needed for the quarter.
 It is important to see that the beginning inventory level in one quarter is the ending inventory level
in the previous quarter.

 Finally, note that the bottom line of the production budget is not a dollar amount. It is stated in
terms of production units.

• The organization can't simply multiply the budgeted production volume by a cost per unit (as is
done with the budgeted sales volume multiplied by price per unit). There are three types of
costs involved in the production process, each requiring its own budget (direct materials, direct
labor, and manufacturing overhead).
Test Your Knowledge (1)
Answer
 Test Your Knowledge (2)
ABC Company is preparing its master budget for 2014. Relevant data pertaining to its sales budget
are as follows:
 
Sales for the year are expected to total 12,000,000 units. Quarterly sales are 25%, 30%, 15%, and
30%, respectively. The sales price is expected to be $2.10 per unit for the first quarter and then
be increased to $2.30 per unit beginning in the second quarter.
 
Instructions:

Prepare a sales budget for 2014 for ABC Company.

Answer
 Direct Materials Budget
 Shows both the quantity and cost of direct materials to be purchased.
 It is a function of the production budget.
 Formula for direct materials quantities:
DM required for
production “Needed
for production”=
Production Volume
x
DM per unit
“standard Quantity”

Budgeted cost of direct materials to be purchased =

required units of direct materials x anticipated cost per DM “Standard Price”.
 Inadequate inventories could result in temporary shutdowns of production.
 Direct Materials Budget
 Based on a standard quantity of 80 board feet of wood per boat and a standard price of $10 per
board foot.
 Sunbird's budget policy follows a practice of maintaining inventory equal to 30% of next
quarter's production needs. 
 For the end of Q4 indicates that Sunbird management plans to produce 40 boats in the following
quarter
 (40 boats × 80 feet × 30% = 960 feet).

 The company is actually ending the current year with 600 feet.

 Sunbird Boat Company’s Direct Materials budget for the next year will be…
Note that the production volume is used to build the direct materials budget for Sunbird.
 After the materials needed for production are adjusted by Sunbird's inventory policy, the budgeted quantity of wood to
be purchased each quarter is multiplied by the standard price to determine the final direct material purchases budget.
 Direct Labor Budget
 Shows both the quantity of hours and cost of direct labor necessary to meet production requirements.
 Critical in maintaining a labor force that can meet expected production.
 Total direct labor cost formula:

 Where:
 The budgeted production volume is multiplied by the standard quantity of hours to establish the direct labor
hours needed to support production.
 The direct labor hours needed to support production are multiplied by the standard price (i.e., wage rate) for
labor to determine the budgeted direct labor payroll.
 Direct Labor Budget
 The standard quantity of hours for Sunbird Boat Company is 50 hours per boat.
 Sunbird’s standard wage rate is $28 per hour.

Sunbird Boat Company’s Direct Labor budget for the next year will be…
Test Your Knowledge (3)
Answer
Test Your Knowledge (4)
Answer
 Manufacturing Overhead Budget
 Manufacturing overhead is composed of many different kinds of costs necessary for the
organization's production process.
 In the budgeting process, manufacturing overhead is separated into variable costs and fixed
costs.

 In the Sunbird Boat Company example, management has identified 3 sources of variable
manufacturing overhead costs (indirect materials, indirect labor, and utilities).
 Management has also identified 4 sources of fixed manufacturing overhead costs (property
taxes, insurance, depreciation, and supervisor's salary).
 The budgeted costs for each quarter are presented in the MOH budget below…
 Total MOH Expense =
Total Variable MOH
+
Total Fixed MOH

Note that the depreciation of

plant assets is included in
MOH costs. However,
remember that depreciation is
a non-cash expense, which is
why depreciation expense
needs to be deducted to
determine the budgeted MOH
payments. (We'll come back
to MOH payments in cash
budgets.)
 Manufacturing Overhead Budget
 After that, the company will build standard cost rates in order to apply MOH costs to units
produced.
 This is necessary in order to establish the budgeted cost of goods sold for the income
statement.
 Overhead allocation rate = Budgeted annual MOH costs ÷ Budgeted annual activity volume

 Sunbird is using direct labor hours as the activity basis to allocate overhead costs.
 The standard MOH cost rates for Sunbird are computed below…
Manufacturing Overhead Budget
 Manufacturing Overhead Budget
Extra Note:
 Note that the variable MOH in this case study is given to you in total.

Variable MOH =
the budgeted activity base
x
V.MOH exp per unit

 If it is not given to you, you can compute it. As you know that Sunbird is using the Direct labor
hour as its activity base, So, for example, if the variable cost rate for the indirect material per
hour is $2 for each quarter and as you know from the direct labor budget that in quarter 1 the
direct labor hour is 1,700 hours. Then, the total indirect materials cost for quarter 1 = $2 x 1,700
hours = $3,400. And so on for the remaining quarters and other variable MOH, you will use the
same formula.
Test Your Knowledge (5)
Answer
 The Budgeted Standard Cost Sheet
 The standard cost sheet is necessary for the income statement. It is also a valuable management tool for
building cost variances in order to control and evaluate performance in the organization.
 The Sunbird Boat Company standard cost sheet is provided below…

Note that this cost sheet specifies the standard input quantity and standard input price of each production
cost for a single boat product.
 Selling and Administrative Budget
 These expenses typically have variable and fixed cost components.
 Sunbird Boat Company has two variable S&A expenses, which are the costs of delivering boats
($100 per boat), and the sales commissions paid ($110 per boat). Based on budgeted sales of 150
boats, Sunbird expects to spend $31,500 for these S&A expenses.
 There are also fixed S&A expenses at Sunbird. These yearly fixed expenses include an executive
salary ($96,000), depreciation on non-production assets ($4,400), and advertising ($5,200).
Hence, regardless of the number of boats sold, Sunbird is planning to spend $105,600 for fixed
S&A expenses.
 The budgeted variable and fixed S&A expense totals to $137,100.
Selling and Administrative Budget
Total S&A Expenses =
Total Variable S&A
+
Total Fixed S&A

Variable Expense =
the budgeted sales volume
x
V.exp per unit
 Budgeted Income Statement
 Important end-product of the operating budgets.
Determine:
 Indicates expected profitability of operations. 1) COGS
2) Budgeted Operating
 Provides a basis for evaluating company performance. Statement
3) Interest Exp and Tax Exp
 Prepared from the operating budgets:

► Sales ► Manufacturing Overhead

► Direct Materials ► Selling and Administrative Expense
► Direct Labor
 1) Determining the Cost of Goods Sold
 Computing the budget for cost of goods sold can be done using the traditional income statement formula.
 However, there is a shortcut computation available to compute the budgeted COGS:

 the sales volume x the standard cost = COGS.

 Sunbird Company’s budgeted COGS = (150 × $3,075 = $461,250)

 Using the shortcut computation depends on standard costs to be unchanged between the two periods.
 With the budgeted amount of COGS in hand, the operating statement will be prepared.
 2) Budgeted Operating Statement

• When combined with the $461,250 in cost of goods sold, Sunbird's budgeted operating income can be
established as $31,650.
• Later, when Sunbird management has prepared estimates for interest expense and tax expense, the
complete income statement can be prepared using this budgeted operating statement.
 3) Budgeted Income Statement

• Sunbird Company expects to have an interest expense of $1,650 and the tax rate estimated to be 10% of
income before income tax.
 Financial budgets
The cash budget
◦ Expected cash receipts and planned cash payments for the budget period
◦ Timing of all cash movements
◦ Allows the business to plan its financial resources
Capital expenditure budget
◦ A plan for the acquisition of long-term assets, such as buildings
◦ May involve cash flows over many years

(cont.)
 Financial budgets (cont.)
Budgeted income statement
◦ Shows expected revenues and planned expenses for the
budget period
Budgeted balance sheet
◦ Shows expected assets and liabilities at the end of the
budget period
Both statements may be broken down by quarter or month of
the year
 The Cash Budget
The cash budget is a detailed plan that shows all expected sources and uses of cash. Much of the
information needed to prepare the cash budget comes from the operating budgets.

The cash budget includes five main sections:

1. The total cash available section shows that:

Total cash available = Beginning balance + Cash receipts

Cash receipts include primarily:
a. Cash sales.
b. Collection from sales on account (credit sales).
The collection pattern of credit sales can be determined by past experience using accounts receivable
aging schedule.
The cash disbursements section
The cash disbursements section does not include:
a. Interest payment on short-term loans (these appear in the financing
section).
b. Noncash expenses such as depreciation.

3. The cash excess or deficiency section compares the cash available with the
cash needed.
Total cash needed = Total cash disbursements + Minimum cash balance
The minimum cash balance is the lowest amount of cash on hand that the firm
finds acceptable.
The financing section
The financing section of the cash budget consists of:
a. Borrowings.
b. Planned repayments, including interest.
5. The planned ending cash balance section reflects the inclusion of the minimum cash
balance, which was subtracted to find the cash excess or deficiency.
 Recap
1 Indicate the benefits of budgeting.

The primary advantages of budgeting are that it

◦ (a) requires management to plan ahead, (b) provides definite objectives for evaluating performance, (c) creates an early warning system for
potential problems, (d) facilitates coordination of activities, (e) results in greater management awareness, and (f) motivates personnel to meet
planned objectives.

2 State the essentials of effective budgeting.

The essentials of effective budgeting are (a) sound organizational structure, (b) research and analysis, and (c) acceptance by all levels of
management.

3 Identify the budgets that comprise the master budget.

The master budget consists of the following budgets: (a) sales, (b) production, (c) direct materials, (d) direct labor, (e) manufacturing overhead, (f)
selling and administrative expense, (g) budgeted income statement, (h) capital expenditure budget,(i) cash budget, and (j) budgeted balance sheet.

4 Describe the sources for preparing the budgeted income statement.

The budgeted income statement is prepared from (a) the sales budget, (b) the budgets for direct materials, direct labor, and manufacturing
overhead, and (c) the selling and administrative expense budget.

5 Indicate the applicability of budgeting in nonmanufacturing companies.

Budgeting may be used by merchandisers for development of a master budget. In service enterprises budgeting is a critical factor in coordinating
staff needs with anticipated services. In not-for-profit organizations, the starting point in budgeting is usually expenditures, not receipts
“CAN YOU?” CHECKLIST
Can you explain the role of budgeting in planning and control?
Can you describe the advantages of budgets for an organization?
Can you define and distinguish among the various budgets found in the operating budget?
Can you explain why all budgets depend on the sales budget?
Can you prepare a sales forecast and the resulting production budget?
Can you prepare a cash budget?