Sequence N°: 04

Title: Budgeting Process

A. Concepts the Budgeting Process

Budgeting is the process of identifying, gathering, summarizing, and communicating

financial and nonfinancial information about an organization’s future activities. The
budgeting process provides managers of all types of organizations the opportunity to match
their organizational goals with the resources necessary to accomplish those goals. Budgeting
empowers all in the organization to understand organizational goals in terms of their
responsibilities and be held accountable for budget plans and results since they can be
compared. Budgeting is synonymous with managing an organization. Budgets are plans of
action based on forecasted transactions, activities, and events.

The concepts of understandability and comparability underlie the power of budgeting.

Budgeting enhances understandability, since managers and employees will understand their
organizational roles and responsibilities based on how the budget links the organization’s
strategic plans to its annual plans. Because the budget expresses these plans and objectives in
concrete monetary terms, managers and employees are able to understand and act in ways that
will achieve them. Budgeting enhances comparability, since budget-to-actual comparisons
give managers and employees a means of monitoring the results of their actions. As you will
see in this sequence, budgeting is not only an essential part of planning; it also helps managers
command, control, evaluate, and report on operations.

B. The Master Budget

A master budget consists of a set of operating budgets and a set of financial budgets
that detail an organization’s financial plans for a specific period, generally a year. When a
master budget covers an entire year, some of the operating and financial budgets may show
planned results by month or by quarter. As the term implies, operating budgets are plans
used in daily operations.

Operating budgets include:

■■ sales budget
■■ production budget
■■ direct materials purchases budget
■■ direct labor budget
■■ overhead budget
■■ selling and administrative expenses budget
■■ cost of goods manufactured budget

The sales budget is prepared first because it is used to estimate sales volume and
revenues. Once managers know the quantity of products or services to be sold and how many
sales dollars to expect, they can develop other budgets that will enable them to manage their
resources so that they generate profits on those sales.
Operating budgets are also the basis for preparing the financial budgets, which are
projections of financial results for the period.

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Financial budgets include:
■■ a budgeted income statement
■■ a capital expenditures budget
■■ a cash budget
■■ a budgeted balance sheet

The budgeted income statement and budgeted balance sheet are also called pro forma
financial statements, meaning that they show projections rather than actual results. Pro
forma financial statements are often used to communicate business plans to external parties.
For example, if you apply for a bank loan to start a new business, you would have to present a
pro forma income statement and balance sheet showing that you could repay the loan with
cash generated by profitable operations.

C. Preparation of a Master Budget

Exhibits 1, 2, and 3 display the elements of a master budget for a manufacturing
organization, a retail organization, and a service organization, respectively. As these
illustrations indicate, the process of preparing a master budget is similar in all three types of
organizations in that each prepares a set of operating budgets that serve as the basis for
preparing the financial budgets. The sales budget (or, in service organizations, the service
revenue budget) is prepared first because it is used to estimate sales volume and revenues.

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 D. Budget Procedures
Because procedures for preparing budgets vary from organization to organization, there
is no standard format for budget preparation. The only universal requirement is that budgets
communicate the appropriate information to the reader in a clear and understandable manner.
Using the following guidelines, managers can improve the quality of budgets in any type of
organization:

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■■ Know the purpose of the budget, and clearly identify who is responsible.
■■ Identify the user group and its information needs.
■■ Identify sources of accurate, meaningful budget information.
■■ Establish a clear format for the budget.
■■ Use appropriate formulas and calculations in deriving the quantitative information.
■■ Revise the budget until it includes all planning decisions.

E. Operating Budgets

We use company makes only one product—a plastic picture frame—it prepares only
one of each type of operating budget as it plans for daily operations in the coming year. In this
example they are showing how a manufacturing organization prepares its operating budgets.
Because in this company that manufacture a variety of products or provide many types of
services may prepare either separate operating budgets or one comprehensive budget for each
product or service.

 The Sales Budget

The first step in preparing a master budget is to prepare a sales budget. A sales budget
shows expected sales during a period, expressed in both units and dollars. Sales managers use
this information to plan sales- and marketing-related activities and to determine their human,
physical, and technical resource needs. Accountants use the information to determine
estimated cash receipts for the cash budget.
The following equation is used to determine the total budgeted sales:

Total Budgeted Sales = Estimated Selling Price per Unit × Estimated Sales in Units

Although the calculation is easy, selecting the best estimates for the selling price per
unit and the sales demand in units can be difficult. An estimated selling price below the
current selling price may be needed if competitors are currently selling the same product or
service at lower prices or if the organization wants to increase its share of the market. On the
other hand, if the organization has improved the quality of its product or service by using
more expensive materials or processes, the estimated selling price may have to be higher than
the current price.

 The Production Budget

A production budget shows the number of units that a company must produce to
meet budgeted sales and inventory needs. Production managers use this information to plan
for the materials and human resources that production-related activities will require. To
prepare a production budget, managers must know the budgeted number of unit sales (which
is specified in the sales budget) and the desired level of ending finished goods inventory for
each period in the budget year. That level is often stated as a percentage of the next period’s
budgeted unit sales.

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The following formula identifies the production needs for each period:

Total Production = Budgeted Sales + Desired Units of – Desired Units of

Units in Units Ending Finished Beginning Finished
Goods Inventory Goods Inventory

 The Direct Materials Purchases Budget

A direct materials purchases budget identifies the quantity of purchases required to
meet budgeted production and inventory needs and the costs associated with those purchases.
A purchasing department uses this information to plan purchases of direct
materials.Accountants use the same information to estimate cash payments to suppliers.
To prepare a direct materials purchases budget, managers must know what production
needs will be in each period. This information is provided by the production budget. They
must also know the desired level of the direct materials inventory for each period and the per-
unit cost of direct materials. The desired level of ending direct materials inventory is usually
stated as a percentage of the next period’s production needs.

 The Direct Labor Budget

A direct labor budget shows the direct labor hours needed during a period and the
associated costs. Production managers use estimated direct labor hours to plan how many
employees will be required during the period and the hours that each will work. Accountants
use estimated direct labor costs to plan for cash payments to the workers. Managers of human
resources use the direct labor budget in deciding whether to hire new employees or reduce the
existing work force. The direct labor budget also serves as a guide in assessing employee
training needs and preparing schedules of employee benefits.

 The Overhead Budget

An overhead budget shows the anticipated manufacturing costs, other than direct
materials and direct labor costs, that must be incurred to meet budgeted production needs. It
has two purposes:
■■ To integrate the overhead cost budgets developed by the managers of production and
production-related departments.
■■ To group information for the calculation of overhead rates for the next accounting period.

 The Selling and Administrative Expenses Budget

A selling and administrative expenses budget shows the operating expenses, other
than those related to production, that are needed to support sales and overall operations during
a period. Accountants use this budget to estimate cash payments for products or services not
used in production-related activities.

 The Cost of Goods Manufactured Budget

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A cost of goods manufactured budget summarizes the estimated costs of production during
a period. The sources of information for total manufacturing costs are the direct materials,
direct labor, and overhead budgets. Most manufacturing organizations anticipate some work
in process at the beginning or end of a period.

F. Financial Budgets

With revenues and expenses itemized in the operating budgets, an organization is able
to prepare the financial budgets, which are projections of financial results for the period.
Financial budgets include a budgeted income statement, a capital expenditures budget, a cash
budget, and a budgeted balance sheet.

 The Budgeted Income Statement

A budgeted income statement projects an organization’s net income for a period
based on the revenues and expenses estimated for that period.

 The Capital Expenditures Budget

A capital expenditures budget outlines the anticipated amount and timing of capital
outlays for long-term assets during a period. Managers rely on the 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, or acquiring
another business.

 The Cash Budget

A cash budget is a projection of the cash that an organization will receive and pay
out during a period. It summarizes the cash flow prospects of all transactions considered in
the master budget.
A cash budget excludes planned noncash transactions, such as depreciation expense,
amortization expense, issuance and receipt of stock dividends, uncollectible accounts expense,
and gains and losses on sales of assets. Some organizations also exclude deferred taxes and
accrued interest from the cash budget.

 The Budgeted Balance Sheet

A budgeted balance sheet projects an organization’s financial position at the end of a
period. It uses all estimated data compiled in preparing a master budget and is the final step in
the budgeting process.