Chapter 21

The Budgeting Process

Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objective
1. Define budgeting and explain its role in the management cycle. 2. Identify the elements of a master budget in different types of organizations and the guidelines for preparing budgets. 3. Prepare the operating budgets that support the financial budgets.
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Learning Objective (contd)

4. Prepare a budgeted income statement, a cash budget, and a budgeted balance sheet. 5. Describe managements role in budget implementation.

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The Budgeting Process

Objective 1
Define budgeting and explain its role in the management cycle

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Budgeting
is the process of identifying, gathering, summarizing, and communicating financial and nonfinancial information about an organization's future activities
Is essential part of the continuous planning for an organization in order to accomplish long-term goals

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The Budgeting Process

Budgets
Plans of action based on forecasted transactions, activities, and events
Are synonymous with managing an organization
Essential to accomplishing goals in the strategic plan

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The Budgeting Process (contd)

Budgets are used to
Communicate information
Coordinate activities and resource usage Motivate employees Evaluate performance Manage and account for cash
Establish minimum levels of cash receipts and expenditures

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The Budgeting Process (contd)

Many forms of budgets
Examples
Cash budget
Focuses on financial information Shows, among other things, how cash resources will be allotted to operating, investing, and financing activities over a future period

Production budget
Focuses on nonfinancial information

Shows planned production in units

Identifies activities needed to meet certain requirements or standards

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Budgeting and Goals

Strategic planning
Process by which management establishes an organizations long-term goals

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Long-Term Goals
define the strategic direction an organization will take over a five- to ten-year period

Are the basis for

Making annual operating plans
Preparing budgets
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Long-Term Goals (contd)

Should take into consideration
Economic and industry forecasts Employee-management relations Structure and role of management Organizational capacity Any other operational and tactical issues facing the organization
Expected quality of products or services Growth rates Desired market share

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Long-Term Goals (contd)

Must set specific targets and timetables

Must assign responsibility for achieving the goals to specific personnel

A range of long-term goals should be included in the organization's strategic plan
Should give direction to efforts to achieve these goals
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Short-Term Goals
Involve every part of an enterprise

Much more detailed than long-term goals

To formulate an annual operating plan, long-term goals must be restated in terms of what needs to be accomplished during the next year
Short-term goals are the basis of an organizations operating budgets for the year
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Short-Term Goals (contd)

Organizations controller takes charge of coordinating the budget process
Designs a complete set of budget-development directions
Timetable with deadlines

Assigns clearly defined responsibilities for carrying out each part of the budgets development
To specific individuals or management teams

The budget may be reviewed and revised during the year

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Importance of Participation
The key to a successful budget is participative budgeting
Process in which personnel at all levels of an organization actively engage in making decisions about the budget
Gives a sense of ownership
Helps ensure that departments will attain targets and stay within the budget

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Importance of Participation (contd)

Participative budgeting depends on joint decision making
Controller must be able to communicate and negotiate effectively with people in all levels of an organization
Senior managers
Formulate organizational long-and short-term goals

Middle managers Supervisors

Responsible for daily operations

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Importance of Participation (contd)

Authoritative budgeting
Senior executives dictate targets
Do not allow middle managers and supervisors a voice in setting them Targets may be unrealistic and impossible to attain
Will undermine motivation of managers and supervisors
Cooperation is essential for successful budget implementation

Senior executives allow controller to develop budget without consulting other managers
Managers may feel budgeting is not a top priority

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Budgeting and the Management Cycle

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Budgeting and the Management Cycle

Planning
Budgeting
Originates in this stage Helps managers to
Relate the organizations long-term goals to its shortterm activities
Distribute resources and workloads Communicate responsibilities Select performance measures Set goals for bonuses and rewards

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Budgeting and the Management Cycle

Executing
Budgeting helps managers to
Communicate expectations Measure performance and motivate employees

Coordinate activities and allot resources

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Budgeting and the Management Cycle

Reporting
Budgeting helps managers to
Communicate budget information Provide continuous feedback

Support operating decisions

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Budgeting and the Management Cycle

Reviewing
Budgeting helps managers to
Evaluate performance Determine timeliness

Find variances and create solutions

Compare planned performance with actual performance

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Discussion
Q. How are short-term goals related to strategic planning?
A. Short-term goals define the strategic direction an organization will take over the next year. They are determined to help accomplish the long-term goals that are established during the strategic planning process

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The Master Budget

Objective 2
Identify the elements of a master budget in different types of organizations and the guidelines for preparing budgets

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The Master Budget

consists of a set of operating budgets and a set of financial budgets that detail an organizations financial plans for a specific accounting period, generally a year

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The Master Budget (contd)

Operating budgets
Plans used in daily operations Basis for financial budgets

Financial budgets
Projections of financial results for the accounting period Include
Budgeted income statement

Capital expenditures budget

Cash budget Budgeted balance sheet
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The Master Budget (contd)

Process of preparing a master budget is similar in all three types of organizations
Manufacturing Retail Service

The process differs mainly in the kinds of operating budgets each type of organization prepares
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Preparation of a Master Budget for a Manufacturing Organization

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Preparation of a Master Budget for a Retail Organization

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Preparation of a Master Budget for a Service Organization

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The Master Budget (contd)

Sales budget
Is prepared first
Used to estimate sales volume and revenues Once developed, other budgets can be developed
These other budgets will help manage the organization's resources so that profits can be generated on sales
In a service organization, the sales budget is called the service revenue budget

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The Master Budget (contd)

No standard format for budget preparation
Procedures vary from organization to organization

Only universal requirement is that budgets communicate the appropriate information to the reader in a clear and understandable manner

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The Master Budget (contd)

Managers can improve the quality of budgets by using the following guidelines
1. Know the purpose of the budget 2. Identify the user group and its information needs 3. Identify sources of accurate, meaningful budget information 4. Establish a clear format for the budget 5. Use appropriate formulas and calculations to derive quantitative information 6. Revise the budget until it includes all planning decisions
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Discussion
Q. Which budget must be prepared first?
A. The sales budget. This budget is used to estimate sales volume and revenues. Once established, the other budgets can be developed

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Operating Budgets
Objective 3
Prepare the operating budgets that support the financial budgets

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Operating Budgets
are a set of budgets that are used in planning the daily operations of an organization

Are part of the master budget

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Operating Budgets
Procedures for preparing operating budgets include
Cost behavior analysis Cost-volume-profit analysis A product costing method

Organizations that manufacture a variety of products or services may prepare

Separate operating budgets, or One comprehensive budget for each product or service

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Sales Budget
is a detailed plan, expressed in both units and value, that identifies the product (or service) sales expected in an accounting period

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Sales Budget (contd)

Sales mangers use the information to
Plan sales- and marketing-related activities Determine human, physical, and technical resource needs

Accountants use the information to

Determine estimated cash receipts for the cash budget

To determine the total budgeted sales

Total Budgeted Sales = Estimated Selling Price per Unit x Estimated Sales in Units
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Sales Budget (contd)

Selecting the best estimates for selling price per unit and the sales demand in units can be difficult
If the organization wants to increase its share in the market
An estimated selling price below the current selling price may be needed

If the organization has improved the products quality by using more expensive materials or production processes
The estimated selling price may have to be higher than the current price
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Sales Budget (contd)

Estimated sales volume is very important
Will affect the level of operating activities and amount of resources needed for operations Managers may use a sales forecast
A projection of sales demand based on an analysis of internal and external factors

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Sales Budget (contd)

External factors taken into consideration in a sales forecast include
1. The state of the local and national economies

2. The state of the industrys economy

3. The nature of the competition and its sales volume and selling price

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Sales Budget (contd)

Internal factors include
1. The number of units sold in prior periods
2. The organizations credit policies 3. The organizations collection policies 4. The organizations pricing policies 5. Any new products the organization plans to introduce to the market 6. The capacity of the organizations manufacturing facilities
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Sales Budget (contd)

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The Production Budget

is a detailed plan showing the number of units a company must produce to meet budgeted sales and inventory levels
Production managers use this information to plan for the materials and human resources that production activities will require
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The Production Budget (contd)

To prepare a production budget, managers must know
Budgeted number of sales units
From the sales budget

Desired level of ending finished goods inventory for each period in the budget year
Often stated as a percentage of the next periods budgeted unit sales

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The Production Budget (contd)

To determine the production needs for an accounting period
Total Budgeted Production = Sales in Units Units + Desired Units of Ending Finished Goods Inventory Desired Units of Beginning Finished Goods Inventory

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Production Budget

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The Direct Materials Purchases Budget

is a detailed plan that identifies the quantity of purchases required to meet budgeted production and inventory needs and the costs associated with those purchases

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The Direct Materials Purchases Budget (contd)

Purchasing department
Uses information to plan purchases of direct materials

Accountants
Use information to estimate cash payments to suppliers

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The Direct Materials Purchases Budget (contd)

To prepare a direct materials purchases budget managers must know
What production needs will be in the next accounting period
Provided in the production budget

Desired level of direct materials inventory for each period Per unit cost of direct materials Desired level of ending direct materials inventory
Usually stated as a percentage of the next periods production

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The Direct Materials Purchases Budget (contd)

Steps to prepare a direct materials purchasing budget
1. Calculate each periods total production needs in units of direct materials 2. Determine the total number of units of direct materials to be purchased during each accounting period in the budget
Total Units of Direct = Materials to Be Purchased Total Production Needs in Units of Direct Materials Desired Units of Ending + Direct Materials Inventory Desired Units of Beginning Direct Materials Inventory

3. Calculate the cost of the direct materials purchases

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Direct Materials Purchases Budget

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The Direct Labor Budget

is a detailed plan that estimates the direct labor hours needed in an accounting period and the associated costs

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The Direct Labor Budget (contd)

Production managers use estimated direct labor hours to plan
How many employees will be required during the period The hours each employee will work

Accountants use estimated direct labor costs to plan

For cash payments to workers

Human resource managers use information on the direct labor budget to

Decide whether to hire new employees Reduce the existing work force Train employees Prepare schedules of employee fringe benefits
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The Direct Labor Budget (contd)

Steps in preparing a direct labor budget
1. Estimate the total direct labor hours
Multiply estimated direct labor hours per unit by the anticipated units of production

2. Calculate the total budgeted direct labor cost

Total Budgeted Direct Labor Cost = Estimated Total Direct Labor Hours x Estimated Direct Labor Cost per Hour

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Direct Labor Budget

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The Manufacturing Overhead Budget

is a detailed plan of anticipated manufacturing costs, other than direct materials and direct labor costs, that must be incurred to meet budgeted production needs

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The Manufacturing Overhead Budget (contd)

Two purposes
1. Integrate the overhead cost budgets developed by managers of production and production-related departments 2. Group information for the calculation of manufacturing overhead rates for the forthcoming accounting period

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The Manufacturing Overhead Budget (contd)

Presentation of information is flexible

Grouping by activities is useful for organizations using activity-based costing

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Manufacturing Overhead Budget

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The Selling and Administrative Expense Budget

is a detailed plan of operating expenses, other than those related to production, that are needed to support sales and overall operations in an accounting period
Accountants use this budget to estimate cash payments for products or services used in nonproduction-related activities
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Selling and Administrative Expense Budget

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The Cost of Goods Manufactured Budget

is a detailed plan that summarizes the estimated costs of production in an accounting period

Sources of information
Direct materials, direct labor, and manufacturing overhead budgets
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Cost of Goods Manufactured Budget

Note that most companies anticipate some work in process at the beginning or end of a period covered by the budget
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Discussion
Q. What are the sources of information for preparing the cost of goods manufactured budget?
A. Direct materials budget Direct labor budget Manufacturing overhead budget

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Financial Budgets
Objective 4
Prepare a budgeted income statement, a cash budget, and a budgeted balance sheet

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Financial Budgets
are projections of financial results for an accounting period Include
Budgeted income statement Capital expenditures budget

Cash budget
Budgeted balance sheet
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The Budgeted Income Statement

projects an organizations net income in an accounting period based on revenues and expenses estimated for that period

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Budgeted Income Statement

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The Capital Expenditures Budget

. is a detailed plan outlining the anticipated amount and timing of capital outlays for long-term assets in an accounting period

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The Capital Expenditures Budget (contd)

Managers rely on information in a capital expenditures budget when making decisions about such matters as
Buying equipment Building a new plant Purchasing and installing a materials handling system Acquiring another business

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The Cash Budget

is a projection of the cash an organization will receive and the cash it will pay out in an accounting period

Summarizes the cash flow prospects of all transactions considered in the master budget
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The Cash Budget (contd)

Information it provides enables managers to plan for
Short-term loans when the cash balance is low

Short-term investments when the cash balance is high

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The Cash Budget (contd)

Excludes some planned noncash transactions
Depreciation expense Issuance and receipt of stock dividends

Uncollectible accounts expense

Gains and losses on sales of assets

May also exclude

Deferred taxes
Accrued interest

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The Cash Budget (contd)

To calculate the estimated ending cash balance
Estimated Ending = Cash Balance Total Estimated Cash Receipts Total Estimated Cash Payments + Estimated Beginning Cash Balance

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The Cash Budget (contd)

Sources for estimating cash receipts
Sales budget
Budgeted income statement Cash budgets from previous periods Cash collection records and analyses of collection trends Records pertaining to notes, stocks, and bonds

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The Cash Budget (contd)

Sources for estimating cash payments
Operating budgets
Budgeted income statement Capital expenditures budget Previous years financial statements Loan records

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The Cash Budget (contd)

Supporting schedules
Schedule of expected cash collections from customers
Schedule of expected cash payments for direct materials Cash budget

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Schedule of Expected Cash Collections from Customers

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Schedule of Expected Cash Payments for Direct Materials

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Cash Budget

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The Cash Budget (contd)

Organizations may maintain a minimum cash balance
To cover unusual expenditures

If the ending cash balance on the cash budget

Falls below the minimum level required
Short-term borrowing may be necessary

Is significantly larger than the minimum level required

May invest excess in short-term securities to generate additional income

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The Budgeted Balance Sheet

projects an organizations financial position at the end of an accounting period

Uses all estimated data compiled in the course of preparing a master budget
Is the final step in that process

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Budgeted Balance Sheet

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Discussion
Q. How is the ending cash balance estimated?
A. Subtract total estimated cash payments from total estimated cash receipts, then, add the estimated beginning cash balance

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Budget Implementation
Objective 5
Describe managements role in budget implementation

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Budget Implementation
Budget committee
Oversees each stage in the master budget preparation
Decides any departmental disputes that might arise in the process Gives final approval to the budget

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Budget Implementation (contd)

Budget committee members
Controller
Has overall responsibility for budget implementation

President
Vice presidents
The make-up of the committee ensures that the budgeting process has a companywide perspective

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Budget Implementation (contd)

A master budget may go through many revisions after approval
Budget committee monitors the progress the company is making in attaining budget targets
Using periodic reports from department managers

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Budget Implementation (contd)

Successful budget implementation depends on two factors
1. Clear communication 2. Support of top management
Middle- and lower-level managers must see that top management supports the budget and encourages its implementation

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Discussion
Q. What two factors are necessary for successful budget implementation?
A. Clear communication and support of top management

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Time for Review

1. Define budgeting and explain its role in the management cycle 2. Identify the elements of a master budget in different types of organizations and the guidelines for preparing budgets 3. Prepare the operating budgets that support the financial budgets
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And Finally
4. Prepare a budgeted income statement, a cash budget, and a budgeted balance sheet 5. Describe managements role in budget implementation

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