Ch-3

THE FUNDAMENTALS OF BUDGETING

Budget
 It is a comprehensive formal management
plans expressed in quantitative terms,
describing the expected operations of an
organization over some future time period.
 deals with a specific entity
 covers a specific future time period
 is expressed in quantitative terms.
 Cont…
Budget entity
 A specific budget must apply to a clearly defined
accounting entity
 For budgeting purpose the entity may consist of a small
part of a business, a single activity, or a specific project.
 A budget entity can be as a specific as a single project
such as Addisalem’s Langano trip or it can be a broad
activity, such as the budget for an entire manufacturing
firm, or for the Ethiopian government.
 Cont..
A budget can be:
1. Short-term planning (continuous budget)
 is the process of deciding what objectives to follow
during a short, near-future period, usually one
year, and what to do to achieve those objectives.
2. Long-term planning(strategic planning or capital
budget)
 is the process of setting long-term goals and
determining the means to attain them.
PRINCIPAL ADVANTAGES OF BUDGETING

• Requires periodic planning.

• Fosters coordination, cooperation, and
communication.
• Provides a framework for performance
evaluation.
• Means of allocating resources.
• Satisfies legal and contractual requirements.
• Created an awareness of business costs.
 THE MASTER BUDGET-A NETWORK OF
INTERRELATIONSHIPS
Components of Master Budget
master budget
• is the total budget package for an organization
• it is the end product that consists of all the
individual budgets for each part of the
organization aggregated into one overall budget
for the entire organization.
• The two major components of master budget are
the operating budget and the financial budget.
 Cont…
1.Operating budget
• It focuses on income statement and its
supporting schedules.
• It is also called profit plan.
• However, such budget may show a budgeted
loss
• can be used to budget expenses in an
organization.
 Cont…
1. Operating budget includes
• Sales budget
• Operating expense budget
• Cost of goods sold budget
• Purchases budget
 Cont…
2. Financial budget.
• It focuses on the effects that the operating
budget and other plans will have on cash.
Financial budget include:
• Budgeted statement of cash flows
• Cash budget
• Budgeted balance sheets
• Capital budget
 Cont…
Sales Budget:
• The sales budget is the first budget to be prepared.
• It is usually the most important budget because so
many other budgets are directly related to sales and
are therefore largely derived from the sales budget.
• Inventory budgets, purchases budgets, personnel
budgets, marketing budgets, administrative budgets,
and other budget areas are all affected significantly
by the amount of revenue that is expected from
sales.
 Cont…
• Sales budgets are influenced by a wide variety of
factors, including general economic conditions,
pricing decisions, competitor actions, industry
conditions, and marketing programs.
• In an effort to develop an accurate sales budget,
firms employ many experts to assist in sales
forecasting.
• The sales budget is usually based on a sales
forecast.
 Cont…
• Sales forecasts are usually prepared under the
direction of the top sales executive.
• Important factors considered by sales
forecasters include:
 Cont…
a) Past patterns of sales:
b) Estimates made by the sales force:
c) General economic conditions:
d) Competitive actions:
e) Changes in the firm’s prices:
f) Changes in product mix:
g) Market research studies:
h) Advertising and sales promotion plans:
 2. Purchases Budget:

• After sales are budgeted, prepare the purchases budget.

• The total merchandise needed will be the sum of the desired
ending inventory plus the amount needed to fulfill budgeted
sales demand.
• These purchases are computed as follows:
Budgeted Desired Cost of Beginning
Purchases = Ending inventory + Goods Sold - Inventory
 3. Budgeted cost of goods sold:

• For a manufacturing firm cost of goods sold is the production

cost of products that are sold.
• Consequently, the cost of goods sold budget follows directly
from the production budget.
• However, a merchandising firm has no production budget.
• The cost of goods sold budget comes directly from merchandise
inventory and the merchandise purchases budget.
4. Operating Expense Budget:
• The budgeting of operating expenses depends on various factors.
• Month – to – month fluctuation in sales volume and other cost-
drivers activities directly influence many operating expenses.
 Cont…
• Examples of expenses driven by sales volume include sales
commissions and many delivery expenses.
• Other expenses are not influenced by sales or other cost-driver
activity (such as rent, insurance, depreciation, and salaries) within
appropriate relevant ranges and are regarded as fixed.
5. Budgeted Income Statement:
• The budgeted income statement is the combination of all of the
preceding budgets.
• This budget shows the expected revenues and expenses from
operations during the budget period.
• A firm may have budgeted non-operating items such as interest on
investments or gain or loss on the sale of fixed assets.
 Cont…
• Usually they are relatively small, although in large firms the
birr amounts can be sizable.
• If non-operating items are expected, they should be included
in the firm’s budgeted income statement.
• Income taxes are levied on actual, not budgeted, net income.
• But the budget plan should include expected taxes.
• Therefore, the last figure in the budgeted income statement is
budgeted after tax net income.
 FINANCIAL BUDGET

• The second major part of the master budget is the financial

budget, which consists of the capital budget, cash budget,
ending balance sheet and the statement of changes in financial
position.
• Although there are some differences in operating budgets of
manufacturing, merchandising and service firms, very little
difference exists among financial budgets of these entities.
1. Capital expenditure budget:
• Capital budgeting is the planning of investments in major
resources like plant and equipment, and other types of long-
term projects, such as employee education programs.
 Cont…
•The capital expenditure budget or capital budget describes the
capital investment plans for an organization for the budget period.
• It contains some of the most critical budgeting decisions of the
organizations.
2. Cash budget:
• The cash budget is a statement of planned cash receipts and
disbursements.
• The cash budget is composed of four major sections:
I. The receipts section:
• It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period.
• Generally the major source of receipts will be from sales.
 Cont…
II. The disbursement section:
• It consist of all cash payments that are planned for the budget
period.
• These payments will include inventory purchases, wages and
salary payments and so on.
• In addition, other cash disbursements such as equipment
purchases, dividends, and other cash withdrawals by owners
are listed.
 Cont…
III. The cash excess or deficiency section:
• The cash excess or deficiency section is computed as follows:
Cash balance, beginning xxx
Add receipts xxx
Total cash available before financing xxx
Less disbursements (x x x)
Excess (deficiency) of cash available over disbursements xxx
• If there is a cash deficiency during any budget period, the
company will need to borrow funds.
• If there is cash excess during any budget period, funds
borrowed in previous periods can be repaid or the idle funds
can be placed in short-term or other investments.
 Cont…
IV. The financing section:
• This section provides a detail account of the borrowing and
repayments projected to take place during the budget period.
• It also includes a detail of interest payments that will be due on
money borrowed.
3. Budgeted Balance Sheet:
• The budgeted balance sheet, sometimes called the budgeted
statement of financial position.
• It is derived from the budgeted balance sheet at the beginning of
the budget period and the expected changes in the account
balance reflected in the operating budget, capital budget, and
cash budget.
 Cont…
3. Budgeted Statement of Changes in Financial Position:
• The final element of the master budget package is the
statement of changes in financial position.
• It has emerged as a useful tool for managers in the financial
planning process.
• This statement is usually prepared from data in the budgeted
income statement and changes between the estimated balance
sheet at the beginning of the budget period and the budgeted
balance sheet at the end of the budget period.