Chapter 3

Chapter 3
Financial Planning and Budgets
Introduction:
The purpose of budgeting is basically to provide a model of how the business might perform,
financially speaking, if certain strategies, events and plans are carried out. In constructing a
business plan, the manager attempts to forecast income and expenditures, hence profitability.
Specific Objectives:
At the end of the lesson, the students should be able to:

• Describe the relationship of strategic planning and budgeting.
• Explain the process of preparing the master budget.
Duration: 4 hours (Lecture/Discussion/Problem Solving)
LESSON PROPER
Role of Budget
Budgets are necessary to highlight the financial implications of plans, to define the
resources required to achieve the plans and to provide a means of measuring, viewing and
controlling the obtained results, in comparison with the plans. Any large company
prepares budgets, because managers are forced to foresee, to study trends and develop
necessary strategies.
Advantages of Budgeting
1) Budgets can be used by top management to communicate its plans and goals throughout
the organization.
2) Budgets force management to think about and plan for the future.
3) Through budgeting, resources are more appropriately allocated.
4) Through budgeting, potential bottlenecks can be discovered before they occur.
5) Budgeting promotes coordination of the activities of the entire organization.
6) The goals and objectives identified in the budgeting process can serve as benchmarks or
standards for evaluating performance.
The Initial Budget Proposal.

Based on the initial budget guidelines, each responsibility center prepares its initial budget
proposal. In preparing an initial budget proposal, the following factors should be
considered by a budget unit:
a) Internal factors
• Introduction of a new product
• Adoption of new manufacturing process
• Changes in availability of equipment or facilities
• Changes in product design or product mix
• Changes in expectation or operating processes of other budget units that the
budget unit relies on for its input materials or other operating factors.
• Changes in other operating factors or in expectations or operating processes in
those other budget units that rely on the budget unit to supply their components.
b) External Factors
• Competitors’ actions
• Changes in the labor market
• Availability of raw materials or components and their prices.
• Industry’s outlook for the near term.
The Master Budget

The master budget is the aggregation of all lower-level budgets produced by a company’s
various functional areas. It includes budgeted financial statements, a cash forecast and a
financing plan.
It is typically presented in either a monthly or quarterly format , and usually covers the
company’s entire fiscal year. An explanatory text may be included with the master budget,
which explains the company’s strategic direction, how the master budget will assist in
accomplishing specific goals and the management actions needed to achieve the budget.
Steps in Developing a Master Budget

The major steps in developing a master budget can be outlined as follows:
1) Establish basic goals and long range plans for the company. These will serve as guidelines
in the preparation of budget estimates.
2) Prepare a sales forecast for the budget period.
3) Estimate the cost of sales and operating expenses.
4) Determine the effect of budgeted operating results on assets,liabilities and ownership
equity accounts. The cash budget is the largest part of this step, since changes in many
asset and liability accounts will depend upon the cash flow forecast.
5) Summarize the estimated data in the form of a projected income statement for the budget
period, the projected statement of financial position as of the end of the budget period and
the projected cash flow statement.
Zero Based Baudgeting

It is a method of budgeting in which all expenses must be justified for each new period.
The process of zero-based budgeting starts from a “zero base” and every function within
an organization is analyzed for its need and costs. The budgets are then built around what
is needed for the upcoming period, regardless of whether each budget is higher or lower
than the previous one.
Activity Based Budgeting

Activity based budgeting is a method in which budgets are prepared using Activity Based
Costing after considering the overhead costs. Simply stated, activity based budgeting is a
management accounting tool which does not consider the previous year’s budget to arrive
at current year’s budget. Instead, the activities that incur the costs are analyzed and
researched. Based on the outcome of the study, the resources are allocated to an activity.
Kaizen (Continuous Improvement) Budgeting

Kaizen is a Japanese term which means “continuous improvement”, on which Lean
manufacturing system is based.
Unlike traditional budgeting, which defines success as adherence to the budget, Kaizen
measures success through cost reduction and performance improvement. Managers
must continually monitor and adjust, which helps improve the company’s overall
operational efficiency, productivity and profitability.
Ethical issues in budgeting

Ethical issues in budgeting include:
1) Preventing concealment of information
A significant portion of information in budgeting is provided by people whose
performance is evaluated against the budget.
2) Avoidance of having a higher budget goal

Employees breach the code of ethics if they deliberately furnish data for budgeting
purposes that would lead to lower performance expectation.
3) Inclusion of budget slack

Budget slack, or padding the budget, is the practice of knowingly including a
higher amount of expenditure in the budget than managers truly feel is needed.
Managers usually justify such practice as insurance against uncertain future events.
4) Spending the budget to avoid having it cut back

Managers may believe that if they do not use up all the budgeted amounts, future
budgets will be reduced. To avoid cuts in their budgets, managers may resort to
wasteful spending to exhaust the remaining budgeted amount before the end of the
period. As a result, precious resources are wasted on activities that yield little or
no benefit to the firm.
Activity
Discussion of exercises/problems in Ch. 5, Strategic Cost Management, 2021 edition, Ma. Elenita
B.Cabrera.

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Chapter 3

Financial Planning and Budgets

At the end of the lesson, the students should be able to:

Duration: 4 hours (Lecture/Discussion/Problem Solving)

The Initial Budget Proposal.

The Master Budget

Steps in Developing a Master Budget

Zero Based Baudgeting

Activity Based Budgeting

Kaizen (Continuous Improvement) Budgeting

Ethical issues in budgeting

2) Avoidance of having a higher budget goal

3) Inclusion of budget slack

4) Spending the budget to avoid having it cut back

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