UNIT 3

Budgeting
 Budgeting

• Budgets play a crucial role in businesses

• Without budgets, it’s difficult for managers and their employees to know whether
they’re on target for their growth and spending goals.
• You might think a budget is only for companies that are in financial difficulty (such as
Citigroup) or whose profit margins are slim—Wal-Mart, for example
• Even companies that sell high-dollar value goods and services adhere to budgets.
• Southwest Airlines uses budgets to monitor and manage fuel costs
• Wal-Mart depends on its budget to maintain razor-thin margins as it competes with
Target
• Gillette uses budgets to plan marketing campaigns for its razors and blades.
 Budgeting
• A common accounting tool that companies use for implementing strategy.
• Management uses budgets to communicate directions and goals throughout a
company
• Budgets turn managers’ perspectives forward and aid in planning and controlling
the actions managers must undertake to satisfy their customers and succeed in
the marketplace
• Budgets provide measures of the financial results a company expects from its
planned activities and help define objectives and timelines against which progress
can be measured
• Through budgeting, managers learn to anticipate and avoid potential problems.
• Interestingly, even when it comes to entrepreneurial activities, business planning
has been shown to increase a new venture’s probability of survival, as well as its
product development and venture organizing activities.
Budget
(a) the quantitative expression of a proposed plan of action by
management for a specified period
(b) an aid to coordinate what needs to be done to implement that
plan
(c) includes both financial and nonfinancial aspects of the plan,
and it serves as a blueprint for the company to follow in an
upcoming period
(d) A financial budget quantifies management’s expectations
regarding income, cash flows, and financial position
(e) Just as financial statements are prepared for past periods,
financial statements can be prepared for future periods—for
example, a budgeted income statement, a budgeted statement
of cash flows, and a budgeted balance sheet
(f) Underlying these financial budgets are nonfinancial budgets
for, say, units manufactured or sold, number of employees, and
number of new products being introduced to the marketplace
Significance of Budgeting
• Budgeting is most useful when it is integrated
with a company’s strategy. Strategy specifies
how an organization matches its own capabilities
with the opportunities in the marketplace to
accomplish its objectives
• Strategic plans are expressed through long-run
budgets and operating plans are expressed via
short-run budget
• Budgets help managers assess strategic risks
and opportunities by providing them with
feedback about the likely effects of their
strategies and plans. Sometimes the feedback
signals to managers that they need to revise their
plans and possibly their strategies
 Budgeting Cycle
Well-managed companies usually cycle through the following budgeting steps during the course
of the fiscal year:
1. Working together, managers and management accountants plan the performance of the
company as a whole and the performance of its subunits (such as departments or divisions).
Taking into account past performance and anticipated changes in the future, managers at all
levels reach a common understanding on what is expected.
2. Senior managers give subordinate managers a frame of reference, a set of specific financial
or nonfinancial expectations against which actual results will be compared
3. Management accountants help managers investigate variations from plans, such as an
unexpected decline in sales. If necessary, corrective action follows, such as a reduction in
price to boost sales or cutting of costs to maintain profitability.
4. Managers and management accountants take into account market feedback, changed
conditions, and their own experiences as they begin to make plans for the next period. For
example, a decline in sales may cause managers to make changes in product features for
the next period.
 Master Budget
• The working document at the core of the process of
budgeting cycle is called the master budget
• Expresses management’s operating and financial
plans for a specified period (usually a fiscal year),
and it includes a set of budgeted financial statements
• It is the initial plan of what the company intends to
accomplish in the budget period.
• Evolves from both operating and financing decisions
made by managers.
• Operating decisions deal with how to best use the
limited resources of an organization.
• Financing decisions deal with how to obtain the funds
to acquire those resources.
Importance of Master Budget
The master budget summarizes the
financial projections of all the company’s
budgets. It expresses management’s
operating and financing plans—the
formalized outline of the company’s
financial objectives and how they will be
attained. Budgets are tools that, by
themselves, are neither good nor bad.
Budgets are useful when administered
skilfully
 Terminological differences
• The terminology used to describe
budgets varies among companies.
• Pro forma statements
• Targeting.
• Profit plan.
• Commitments
 Advantages of Budgets

• Promote coordination and communication

among subunits within the company
• Provide a framework for judging
performance and facilitating learning
• Motivate managers and other employees
Challenges in administering budgets
Bottom-up aspect: all level commitment

Time-consuming process: . It has been estimated that senior managers spend about 10% to
20% of their time on budgeting, and finance planning departments spend as much as 50% of
their time on it

Jack Welch has also referred to the budgeting process as “the most ineffective process in
management,” and as “the bane of corporate America”

Administering budget rigidly

Political, legal, and economic environments

Foreign Exchange rates

 Developing and Operating Budget
• Deciding time period of budget
• Businesses are increasingly using rolling budgets. A rolling
budget, also called a continuous budget, is a budget that is
always available for a specified future period. It is created
by continually adding a month, quarter, or year to the period
that just ended
• Steps in Preparing an Operating Budget
• Identify the problem and uncertainties---->Obtain information----
>Make predictions about the future---->Make decisions by choosing
among alternatives----->Implement the decision, evaluate
performance, and learn
• The master budget is finalized only after several rounds of
discussions between top management and managers
responsible for various business functions in the value chain
 Real World Vignette
Consider Electrolux, the global appliance company, which has a three- to five-year
strategic plan and a four-quarter rolling budget. A four-quarter rolling budget for the
April 2011 to March 2012 period is superseded in the next quarter—that is in June
2011—by a four-quarter rolling budget for July 2011 to June 2012, and so on. There is
always a 12-month budget (for the next year) in place. Rolling budgets constantly
force Electrolux’s management to think about the forthcoming 12 months, regardless
of the quarter at hand. Some companies prepare rolling financial forecasts that look
ahead five quarters. Examples are Borealis, Europe’s leading polyolefin plastics
manufacturer; Millipore, a life sciences research and manufacturing firm
headquartered in Massachusetts; and Nordea, the largest financial services group in
the Nordic and Baltic Sea region. Others, such as EMC Corporation, the information
infrastructure giant, employ a six-quarter rolling-forecast process so that budget
allocations can be constantly adjusted to meet changing market conditions
 Types of Budget: Static and Flexible Budgeting
• The static budget, or master budget, is based on the level of output
planned at the start of the budget period.
• The master budget is called a static budget because the budget for
the period is developed around a single (static) planned output
level.
• A flexible budget calculates budgeted revenues and budgeted
costs based on the actual output in the budget period.
• The only difference between the static budget and the flexible
budget is that the static budget is prepared for the planned output
whereas the flexible budget is based on the actual output.
 Example of Stylistic Furniture
• Stylistic sells two models of granite-top coffee tables: Casual and Deluxe
• Revenue unrelated to sales, such as interest income, is zero. Work-in-process inventory is negligible and is ignored
• Direct materials inventory and finished goods inventory are costed using the first-in, first-out (FIFO) method. Unit costs
of direct materials purchased and unit costs of finished goods sold remain unchanged throughout each budget year
but can change from year to year.
• There are two types of direct materials: red oak (RO) and granite slabs (GS). Direct material costs are variable with
respect to units of output—coffee tables.
• Direct manufacturing labor workers are hired on an hourly basis; no overtime is worked.
• There are two cost drivers for manufacturing overhead costs—direct manufacturing labor-hours and setup labor-
hours.
• Direct manufacturing labor-hours is the cost driver for the variable portion of manufacturing operations overhead. The
fixed component of manufacturing operations overhead is tied to the manufacturing capacity of 300,000 direct
manufacturing labor-hours that Stylistic has planned for 2012.
• Setup labor-hours is the cost driver for the variable portion of machine setup overhead. The fixed component of
machine setup overhead is tied to the setup capacity of 15,000 setup labor-hours that Stylistic has planned for 2012.
• For computing inventoriable costs, Stylistic allocates all (variable and fixed) manufacturing operations overhead costs
using direct manufacturing labor-hours and machine setup overhead costs using setup labor-hours
• Nonmanufacturing costs consist of product design, marketing, and distribution costs. All product design costs are fixed
costs for 2012. The variable component of marketing costs equals the 6.5% sales commission on revenues paid to
salespeople. The variable portion of distribution costs varies with cubic feet of tables moved.
 Data Available for Stylistic Furniture
• Direct materials:
• Red Oak= $ 7 per board foot (b.f.) (same as in 2011)
• Granite= $10 per square foot (sq. ft.) (same as in 2011)
• Direct manufacturing labor= $20 per hour
 Preparation of Master Budget
Step 1: Prepare the Revenues Budget
• starting point for the operating budget
• the production level and the inventory level as well as nonmanufacturing costs, generally
depend on the forecasted level of unit sales or revenues. Many factors influence the sales
forecast, including the sales volume in recent periods, general economic and industry
conditions, market research studies, pricing policies, advertising and sales promotions,
competition, and regulatory policies
 Preparation of Master Budget
Step 2: Prepare the Production Budget (in Units).
• The total finished goods units to be produced depend on budgeted unit sales and
expected changes in units of inventory levels
• Budgeted Production(in units)=
• Budgeted sales + Total finished goods inventory-Beginning Finished goods inventory
 Preparation of Master Budget
Step 3: Prepare the Direct Material Usage Budget and Direct Material Purchases Budget
• The number of units to be produced in step 2 is the key to computing the usage of direct
materials in quantities and in dollars.
• The direct material quantities used depend on the efficiency with which materials are
consumed to produce a table
• In determining budgets, managers are constantly anticipating ways to make process
improvements that increase quality and reduce waste, thereby reducing direct material
usage and costs.
• Like many companies, Stylistic has a bill of materials, stored and updated in its computer
systems.
• Bill of Material identifies how each product is manufactured, specifying all materials (and
components), the sequence in which the materials are used, the quantity of materials in
each finished unit, and the work centers where the operations are performed.
• For example, the bill of materials would indicate that 12 board feet of red oak and 6
square feet of granite are needed to produce each Casual coffee table, and 12 board feet
of red oak and 8 square feet of granite to produce each Deluxe coffee table.
 Preparing Master Budget: Step 3 continue..
• The purchasing manager prepares the budget for direct material purchases,
calculated in Schedule 3B, based on the budgeted direct materials to be used, the
beginning inventory of direct materials, and the target ending inventory of direct
materials:
• Purchase of Direct Material=
• Direct Material used in production + target ending inventory of DM - beginning inventory of DM
Preparing Master Budget
Step 4: Prepare the Direct Manufacturing Labor Costs Budget
• Manufacturing managers use labor standards, the time allowed per unit of
output, to calculate the direct manufacturing labor costs budget in Schedule 4.
These costs depend on wage rates, production methods, process and
efficiency improvements, and hiring plans.
Step 5: Prepare the Manufacturing Overhead Costs
Budget
Schedule 5: Part 1
Schedule 5: Part 2
Step 6: Prepare the Ending Inventories Budget
• Stylistic treats both variable and fixed manufacturing overhead as
inventoriable (product) costs
• Manufacturing operations overhead costs are allocated to finished goods
inventory at the budgeted rate of $30 per direct manufacturing labor-hour (total
budgeted manufacturing operations overhead, $9,000,000 ÷ 300,000
budgeted direct manufacturing labor-hours).
• Machine setup overhead costs are allocated to finished goods inventory at the
budgeted rate of $200 per setup-hour (total budgeted machine setup
overhead, $3,000,000 ÷ 15,000 budgeted setup labor-hours)
Step 7: Prepare the COGS Budget
Step 8: Preparing the non-manufacturing costs
budget
• Product design costs are fixed costs, determined on the basis of the product design work
anticipated for 2012.
• The variable component of budgeted marketing costs is the commissions paid to sales
people equal to 6.5% of revenues.
• The fixed component of budgeted marketing costs equal to $1,330,000 is tied to the
marketing capacity for 2012.
• The cost driver of the variable component of budgeted distribution costs is cubic feet of
tables moved (Casual: 18 cubic feet 50,000 tables + Deluxe: 24 cubic feet 10,000 tables =
1,140,000 cubic feet).
• Variable distribution costs equal $2 per cubic foot. The fixed component of budgeted
distribution costs equals $1,596,000 and is tied to the distribution capacity for 2012
Budgeted Income Statement
• Use of schedule 1,7 and 8