Chapter 8 Budgeting for Planning and Control Learning Objectives

Budgeting for Planning and Control

After studying this chapter, you should be able to:

This chapter explains how budgeting plays a key role in planning, controlling, and decision making, as well as improving communication and coordination. The chapter focuses on the master budget and identifies its major components. The process of preparing a set of operating and financial budgets for the budget period is described with the emphasis on the interrelationships of the various budgets. The chapter concludes by describing budgets for merchandising and service firms.

I. The Role of Budgeting in Planning and Control

Budgeting plays a crucial role in planning and control.

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  Budgets are the quantitative expressions of plans that identify an organization’s objectives and the actions needed to achieve them. They form the basis for operations.
  
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  Control is the process of setting standards, receiving feedback on actual performance, and taking corrective action.
  
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  Budgets can be used to compare actual outcomes with planned outcomes.
  

A. Purposes of Budgeting

The system of budgets serves as the comprehensive financial plan for the organization as a whole.

Advantages of budgeting include:

1. Budgeting forces management to plan for the future—to develop an overall direction for the organization, foresee problems, and develop future policies.

2. Budgeting helps convey significant information about the resource capabilities of an organization, making better decisions possible. Example: A cash budget points out potential shortfalls.

3. Budgeting helps set standards that can control the use of a company’s resources and control and motivate employees.

4. Budgeting improves the communication of the plans of the organization to each employee. Budgets also encourage coordination because the various areas and activities of the organization must all work together to achieve the stated objectives.

B. The Budgeting Process

The budgeting process can range from fairly informal to elaborately detailed.

1. Directing and Coordinating

a. The budget director, usually the controller or someone who reports to the controller, is responsible for coordinating and directing the overall budgeting process.

b. The budget committee has the responsibility to oversee the budgeting process that will:

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  Review the budget.
  
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  Provide policy guidelines and budgetary goals.
  
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  Resolve differences that may arise as the budget is prepared.
  
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  Approve the final budget.
  

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  Monitor the actual performance of the organization as the year unfolds.
  
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  Ensure that the budget is linked to the strategic plan of the organization.
  

a. The master budget is a comprehensive financial plan made up of various individual departmental and activity budgets for the year. A master budget can be divided into:

(1) Operating budgets, which outline the income-generating activities of a firm (sales, production, and finished goods inventories).

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  The outcome of the operating budgets is a pro forma (budgeted) income statement.
  

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  The outcome of the financial budgets includes a cash budget and a pro forma (budgeted) balance sheet.
  

The yearly master budget can be broken down into quarterly and monthly budgets to allow managers to compare actual data with budgeted data as the year unfolds and to make timely corrections.

b. A continuous (or rolling) budget is a moving 12-month budget.

As a month expires in the budget, an additional month in the future is added so that the company always has a 12-month plan on hand.

c. A continuously updated budget updates the master budget each month as new information becomes available.

It works like a rolling forecast that provides year-to-date results and the forecast for the remainder of the year.

C. Gathering Information for Budgeting

The primary sources of data that are used to create budgets include:

1. Historical Data

Based on their knowledge of coming events, managers can use historical data from similar previous situations to predict costs.

2. Sales Forecasts

The sales forecast is the basis for all of the other operating budgets and most of the financial budgets. Thus, it is important to have accurate sales forecasts. The accu­racy of the sales forecast can be improved by:

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  Considering external factors, such as the general economic climate, competition, advertising, and pricing policies.
  
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  Using formal approaches, such as time-series analysis, correlation analysis, econo­metric modeling, and industry analysis.
  

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  Costs and cash-related items are critical.
  
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  Many of the same factors considered in sales forecasting apply to cost forecasting.
  

The first part of the master budget is the operating budget. The components of the operating budget include the following:

A. The sales budget is the projection approved by the budget committee that describes expected sales for each product in units and dollars for the coming period.

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  The sales budget may reveal seasonal fluctuations in sales.
  

B. The production budget describes how many units must be produced to meet sales needs and satisfy ending inventory requirements.

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  The production budget must consider the company’s inventory policy and, thus, the beginning inventory and desirable ending inventory levels.
  

Note that the production budget is driven by the sales budget.

C. The direct materials purchases budget outlines the expected usage of materials for production, inventories, and purchases of the direct materials required.

The direct materials usage is determined by the input-output relationship of each product as follows:

Note that a separate schedule is prepared for each kind of direct material.

D. The direct labor budget shows the total direct labor hours needed and the associated cost based on the input-output relationship of each product.

Expected DL hours = DL hours needed per unit of output × Units of output

DL costs = Expected DL hours × Wage rate

E. The overhead budget shows the expected cost of all indirect manufacturing items.

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  The estimated overhead is divided into variable and fixed components:
  

F. The ending finished goods inventory budget supplies information needed for the balance sheet and serves as input for the preparation of the cost of goods sold budget.

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  It provides information for the unit cost of a finished product and the cost of the expected inventories.
  

H. The marketing expense budget outlines planned expenditures for selling and distribution activities.

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  The estimated marketing expense is divided into variable and fixed components:
  

I. The research and development expense budget outlines the estimated expenditures of research and development activities for the coming year.

J. The administrative expense budget consists of estimated expenditures for the overall organization and operation of the company.

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  Most of the administrative expenses are fixed costs with respect to sales.
  

III. Preparing the Financial Budget

The financial budgets are the second part of the master budget. The financial budgets usually include the cash budget, the budgeted balance sheet, the budgeted statement of cash flows, and the budget for capital expenditures.

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  Note that the master budget and the associated financial budget are plans for one year.
  
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  The capital expenditures budget is a financial plan outlining the expected acquisition of long-term assets, typically over a number of years.
  

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:

Cash receipts include primarily:

a. Cash sales.

b. Collection from sales on account (credit sales).

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  The collection pattern of credit sales can be determined by past experience using an accounts receivable aging schedule.
  

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.

4. 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.

B. Budgeted Balance Sheet

The preparation of the budgeted balance sheet depends on information from the current balance sheet and the information in the other budgets in the master budget.

IV. Operating Budgets for Merchandising and Service Firms

1. 
   A merchandising firm has a merchandise purchases budget to identify the quantity of each item that must be purchased for resale, the unit cost of the item, and the total purchase cost.
   
2. 
   In a for-profit service firm, the sales budget identifies each service and the quantity that will be sold.
   

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  The sales budget is also the production budget because the service produced will be identical to the service sold.
  

3. 
   In a not-for-profit service firm, the sales budget identifies the level of various ser­vices that will be offered for the coming year and the associated funds that will be assigned to the services.