CHAPTER THREE

BUDGETING

3.1The Overall Plan and Its Characteristics

Overview of Budgeting
A budget is (a) the quantitative expression of a proposed plan of action by management for a specified
period and (b) an aid to coordinate what needs to be done to implement that plan. It is also defined as a
quantitative plan for acquiring and using resources over a specified time period.

A budget generally includes both financial and nonfinancial aspects of the plan, and it serves as a blueprint
for the company to follow in an upcoming period.
 A financial budget quantifies management’s expectations regarding income, cash flows, and
financial position.
 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.
 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.

A budget is a financial or nonfinancial expression of an organization’s plan of action for a specified period;
it identifies the resources and commitments required to achieve the organization’s goals for the period
identified.
The budget for a period is both a guideline for operations and a projection of the operating results for the
budgeted period. The process of preparing a budget is called budgeting.
In addition to being a plan of operations, a budget plays an important role in allocating resources,
coordinating operations, identifying constraints and limitations, communicating expected actions and
results, authorizing activities, motivating and guiding implementation, providing guidelines for control of
operations, managing cash flows, and serving as a criterion in performance evaluations.
Purposes of Budgeting
Budgets are used for two distinct purposes— planning and control.
 Planning involves developing goals and preparing various budgets to achieve those goals.

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  Control involves the steps taken by management to increase the likelihood that all parts of the
organization are working together to achieve the goals set down at the planning stage.
 To be effective, a good budgeting system must provide for both planning and control.
 Good planning without effective control is a waste of time and effort.

Budgeting Cycle
Well-managed companies usually cycle through the following budgeting steps during the course of the
fiscal year:
1. Planning the Performance of the Organization
 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. Providing a Frame of Reference
 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. Investigating Variations from Plans
 Management accountants help managers investigate variations from plans, such as an unexpected
decline in sales.
4. Correcting Action follows if necessary
 If necessary, corrective action follows, such as a reduction in price to boost sales or cutting of costs to
maintain profitability.
5. Planning Again
 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.

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 Advantages of Budgeting

Budgets are a big part of most management control systems. Organizations realize many benefits from
budgeting. A budget
1. compels strategic planning and implementation of plans.
 Planning is setting goals and developing strategies to achieve those goals. Budgets show how
resources will be deployed to implement strategy.
 The master budget is not in itself a strategic plan, rather, it helps managers implement their strategic
plans.
 Budgets forces managers to think about and plan for the future. In the absence to prepare a budget,
mangers would spend all of their dealing with daily emergencies.
2. provides a frame work for judging performance
 Budgets can serve as benchmarks for evaluating performance.
 Budget enables company's managers to measure actual performance against predicted performance.
 Actual results compare against past performance or expected performance (budget). But, budget is
potentially superior to using past performance. Because past performance has a number of limitations.
 Past results often incorporate past miscues or faults.
 Future conditions can be expected to differ from the past.
 Past performance fails to consider several changes that affect current and future activities
such as changes in economic conditions, shifts in competitive advantages within the
industry, new product developments, and increased or decreased advertizing.
Budget can overcome these limitations of using past performance.
3. motivates managers and employees
 Budgets that are challenging improve performance. An inability to achieve budgeted numbers is
viewed as a failure. Most individuals are motivated to work more intensely to avoid failure than to
achieve success.
 Creating a little anxiety improves performance. but overly ambitious and unachievable budgets
increase anxiety without motivation.
 Setting challenging budgets as energizing, motivating, and satisfying for managers and employees.
 Budget motivates people to work to attain the budgeted goals. To enhance the role of budget as a
motivating device, many organizations have employees participate in the budgeting process.

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4. promotes coordination and communication among subunits within the company
 Budgets coordinate the activities of the entire organization by integrating the plans of its various
parts.
 Coordination is meshing (bringing into harmony) and balancing all factors of production or service,
and all departments and business functions in the best way for the company to meet its goals.
 The master budget helps coordinate the various business functions, such as production and marketing.
Hence, it forces managers to think of the relationships among departments, within the company,
between the company, and its supply chain partners.
 Communication is getting those objectives understood and accepted by all the employees in the
various departments and functions.
 Budget is formal way of communicating what the management is planning to do throughout the
organization. Top management defines its plan and goals for the period, and then other managers and
employees have access to this information.
5. Can uncover potential bottlenecks before they occur.
 The budget also can help managers identify current and potential bottlenecks in operations. Critical
resources then can be mustered to ease any bottlenecks and prevent them from becoming obstacles to
attaining budgetary goals.
6. Provides a means of allocating resource to organization's subunits.
 The budgeting process provides a means of allocating resource to departments, divisions or branches
of the organization.
7. is a controlling device
 Budget is a good way of mechanism to control resource from wastage.
Types of Budgets
Organizations use many types of budgets.
Operating Budget
 Ordinarily covers a one - year period corresponding to a company's fiscal year.
 Many companies divide their annual operating budget into four quarters or twelve months.
Rolling/Revolving/Continuous/Perpetual Budget
 It is usually a 12 - month budget that rolls forward one month as the current month is completed.
 It is continually updated by adding a period to the total budget period, and dropping the period just
completed.
Capital Budget

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  A plan for the acquisition of fixed asset.
 It deals with acquisition of capital assets normally cover several years.
Financial Budget
 It is a budget on the planned sources of funds.
 It shows how the organization will acquire its financial resources.
Pro forma Financial Statements
 They show how the organization's financial statements will appear at the end of the budget period.

Participation in Budget Process

The success of a budget program is largely determined by the way a budget is developed. In the most
successful budget programs, managers actively participate in preparing their own budgets rather than
having them imposed from above. Participative or self-imposed budget is a budget that is prepared with
the full cooperation and participation of managers at all levels.

The participative approach is particularly effective when budgets are used to evaluate a manager’s
performance because imposing expectations from above and then penalizing employees who do not meet
those expectations will generate resentment rather than cooperation and commitment

Exhibit 2.1 The Initial Flow of Budget Data

The initial flow of budget data in a participative system is from lower levels of responsibility to higher
levels of responsibility. Each person with responsibility for cost control will prepare his or her own budget
estimates and submit them to the next higher level of management. These estimates are reviewed and
consolidated as they move upward in the organization.

Self-imposed budgets have a number of advantages:

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 1. Individuals at all levels of the organization are viewed as members of the team whose judgments
are valued by top management.

2. Budget estimates prepared by front-line managers are often more accurate than estimates prepared
by top managers.

3. Motivation is generally higher when individuals participate in setting their own goals than when
the goals are imposed from above.

4. A manager who is not able to meet a budget imposed from above can claim that it was unrealistic.
Participative budgets eliminate this excuse.

Human Factors in Budgeting

The success of a budget program depends on three important factors:

1. Top management must be enthusiastic and committed to the budget process.

2. Top management must not use the budget to pressure employees or blame them when something
goes wrong.

3. Highly achievable budget targets are usually preferred when managers are rewarded based on
meeting budget targets.

The Budget Committee

A standing budget committee is usually responsible for overall policy relating to the budget program and
for coordinating the preparation of the budget itself.

This committee may consist of the president; vice presidents in charge of various functions such as sales,
production, and purchasing; and the controller.

Difficulties and disputes relating to the budget are resolved by the budget committee. In addition, the
budget committee approves the final budget.

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Master budget

What is A Master Budget?

Master budget is a comprehensive expression of managements operating and financial plans for a future
time period. In other words, it is a comprehensive set of budgets covering all phases of the organization's
operations for a specified period of time. It is summarized or comprised in a set of budgeted financial
statements.

The master budget is the initial plan of what the company intends to accomplish in the budget period. It
reflects the impact of both operating and financing decisions.
 Operating decisions deal with how to best use of scarce resources of the organization.
 Financing decisions deal with how to obtain the funds to acquire those resources.

Developing the Master Budget

 A master budget is a formal, comprehensive plan for a company’s future. It contains several
individual budgets that are linked with each other to form a coordinated plan.
 The master budget is a set of interrelated budgets that constitutes a plan of action for a specified
time period.
 The master budget consists of a number of separate but interdependent budgets.
 The master budget contains two classes of budgets.
 Operating budgets are the individual budgets that result in the preparation of the budgeted
income statement. These budgets establish goals for the company’s sales and production
personnel.
 Financial budgets are the capital expenditure budget, the cash budget, and the budgeted balance
sheet. These budgets focus primarily on the cash resources needed to fund expected operations
and planned capital expenditures. It focuses on how operations and planned capital outlays affect
cash.

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 Exhibit 2.2 The Master Budget Interrelationships

Sales budget

Ending inventory
budget Production budget

Manufactu
Direct materials overhead bu
budget Direct laborbudget

Cash Budget

Budgetedincomestatement

Sales Budget

 The first step in preparing the master budget is planning the sales budget.
 It shows the planned sales units and the expected dollars from these sales.
 The sales budget is the starting point in the budgeting process because plans for most departments
are linked to sales.
 Each of the other budgets depends on the sales budget.
 It is the most difficult because it is affected by external environment.
 Sales forecasting is the process of predicting sales of goods and services. Among the major factors
considered when forecasting sales are:
1) Past sales levels and trends

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 2) General economic trends
3) Economic trends in the company’s industry
4) Other factors expected to affect sales in the industry
5) Political and legal events
6) The intended pricing policy of the company
7) Planned advertising and product promotion
8) Expected action of competitors
9) New products contemplated by the company or other firms
10) Market research studies
 An inaccurate sales budget may adversely affect net income. For example, an overly optimistic
sales budget may result in excessive inventories that may have to be sold at reduced prices. In
contrast, an unduly conservative budget may result in loss of sales revenue due to inventory
shortages.
Revenue = Number of units x Expected
Budget to be sold Price

Production Budget

 The production budget shows the units to produce to meet anticipated sales.
 Production requirements are determined from the following formula.

Units to be = Total projected + Desired ending - Expected beginning

produced Sales in units inventory inventory
Units to be = Total units Needed - Expected beginning
produced (or Total units available for sale) inventory

A realistic estimate of ending inventory is essential in scheduling production requirements.

Excessive inventories in one quarter may lead to cutbacks in production and employee layoffs in a
subsequent quarter. On the other hand, inadequate inventories may result either in added costs for
overtime work or in lost sales.

Direct Materials Budget

 A direct materials budget is prepared after the production requirements have been computed.

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 The direct materials budget details the raw materials that must be purchased to fulfill the
production budget and to provide for adequate inventories.
 The direct materials budget shows both the quantity and cost of direct materials to be purchased.
 The quantities of direct materials are derived from the following formula.

( )[
Direct Material
¿ be Purchased =
(units)
Budgeted ∏ . x Std RM Requirmnts
¿ units per unit
+ ](
Desired End .
RM Inventory )
- ( Inventory
Beg . RM
)
( )(
Direct Material
¿ be Purchased =
(units)
RM Needed for
Production
+ )(
Desired End .
RM Inventory
- )(
Beg . RM
Inventory )

( )(
Direct Material
¿ be Purchased =
(units)
Total DM Needed for
Production
- )(
Beg . RM
Inventory )

( )( )(
Direct Material Direct Material
¿ be Purchased = ¿ be Purchased x
¿ Birr (units)
Price per unit
Raw Material )
Direct Manufacturing Labor Budget
 The direct labor budget shows the direct labor-hours required to satisfy the production
budget.
 Shows the number of hours and the cost of direct labor to be used during the budget period
 In this budget, manufacturing managers use labor standards, the time allowed per unit of output.
Total Budgeted = Total Budgeted x Standard
DL hours Production Labor hrs
Total Budgeted = Total Budgeted x Wage Rate
DL Cost DL hours per hour

Manufacturing Overhead Budget

 Manufacturing overhead budget shows the cost of overhead expected to be incurred in the
production process during the budget period.
 This budget distinguishes between variable and fixed overhead costs. Variable overhead cost is
budgeted based on cost driver.
Ending Inventory Budget - in dollars
 It describes inventory to be reported in the balance sheet.

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 Ending finished goods inventory budget is prepared based on the per unit costs of direct material,
direct manufacturing labor, and manufacturing overhead.
Ending FG inventory = Direct Material + Direct Mfg Labor + MOH
costs per unit Cost Cost Cost
Ending Raw Material = Target Ending inventory x Price
Budget (FIFO) (in units) per unit

Cost of Goods Sold Budget

 The manufacturing and purchase managers, together with the management accountant will prepare
cost of goods sold budget by using the necessary information.
 It is to be reported in the income statement.
CGS Budget = Beginning FG + Cost of Production - Ending FG
(FIFO) inventory (or Cost of goods Mfd)* inventory
CGS Budget = Cost of goods available - Ending FG
(FIFO) for sale inventory
*
Cost of goods = DMs used + Direct Mfg + MOH
manufactured labor

Non-Production Costs/Non-Manufacturing Costs/Selling and Administrative Expense Budget

 The selling and administrative expense budget lists the budgeted expenses for areas other
than manufacturing.
 It shows the planned amounts of expenditures for selling, general, and administrative expenses
during a budget period
 In large organizations, this budget would be a compilation of many smaller, individual budgets
submitted by department heads and other persons responsible for selling and administrative
expenses. For example, the marketing manager would submit a budget detailing the advertising
expenses for each budget period.
 Like the manufacturing overhead budget, the selling and administrative expense budget is
divided into variable and fixed cost components.
 The budgeted variable selling and administrative expenses are determined by multiplying the
budgeted units sold by the variable selling and administrative expense per unit.
 The fixed selling and administrative expenses are then added to the variable selling and
administrative expenses to arrive at the total budgeted selling and administrative expenses.

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Illustration on Master Budget
Halifax Engineering is a machine shop that uses skilled labor and metal alloys to manufacture two types of
aircraft replacement parts - regular and heavy duty. Halifax Managers are ready to prepare a master budget
for the following year. The following assumptions are made:
1) The only source of revenues is sales of the two parts. Revenue unrelated to sales, such as interest
income, is zero.
2) WIP is negligible and is ignored.
3) RMs inventory and finished goods inventory are costed using the FIFO cost flow assumption.
4) Unit cost of DMs purchased and finished goods sold remain unchanged throughout the budget year.
5) There are two types of direct materials: 111 alloy and 112 alloy. Direct material costs are variable
with respect to units of output—aircraft replacement parts.
6) Direct manufacturing labor workers are hired on an hourly basis; no overtime is worked.
7) All manufacturing overhead costs are allocated using a single allocation base - direct manufacturing
labor hours.
8) Direct manufacturing labor-hours is the cost driver for the variable portion of manufacturing
overhead. The manufacturing overhead is tied to the manufacturing capacity of 30,000 direct
manufacturing labor-hours that Halifax Engineering has planned for period.
9) The forecasted per unit cost of inputs is given below:
Direct Materials
Materials 111 alloy $7 per kg.
Materials 112 alloy $10 per kg.
Direct Mfg. Labor $20 per hr.
MOH $40 per hr.
Content of each product per unit is given below:
Regular Heavy duty
111 alloy 12 kgs 12 kgs
112 alloy 6 kgs 8 kgs
Direct labor 4 hrs 6 hrs
Additional information regarding the year is as follows:
Regular Heavy duty
Expected sales in units 5000 units 1000 units
Selling price per unit $600 $800

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 Target ending inventory in units 1100 50
Beg. inventory in units 100 50
Beg. inventory in dollars $38,400.00 $26,200.00
Direct Materials
111 alloy 112 alloy
Beg. inventory in kgs 7000 6000
Target ending inventory in kgs 8000 2000
The total manufacturing overhead costs for the year are forecasted to be $1,200,000
Total budgeted non - manufacturing cost ................... $870,000
1. Sales (Revenue) Budget
Product Units Price/unit Total
Regular 5000 $600 $3,000,000
Heavy duty 1000 $800 800,000
$3,800,000
2. Production Budget - in units
Regular Heavy duty
Budgeted sales 5000 units 1000 units
Target Ending inventory 1100 50
Total units needed during the period 6100 1050
Deduct: Beg. inventory 100 50
To be produced 6000 1000
3. Direct Materials Usage Budget
111 alloy 112 alloy Total
Regular 72,000 kgs 36,000 kgs
(12x6000) (6x6000)
Heavy duty 12,000 kgs 8,000 kgs
(12x1000) (8x1000)
DMs to be used in production 84,000 44,000
Deduct: Beg. inventory 7,000 6,000
DM purchased used in production 77,000 38,000
Multiply by cost per unit $7 $10
Cost of DM used from purchases $539,000 $380,000 $919,000
Add: Cost of Beg. DM inventory 49,000 60,000 109,000

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 Total cost of DM used in production $588,000 $440,000 $1,028,000
4. Direct Materials Purchase Budget
111 alloy 112 alloy Total
DM to be used in production 84,000 kgs 44,000 kgs
Add: Target Ending inventory 8,000 2,000
Total DM requirements 92,000 46,000
less: Beg. DM inventories 7,000 6,000
DM purchase 85,000 40,000
Multiply by cost per kg $7 $ 10
Total cost of purchase 595,000 400,000 $995,000
5. Direct Manufacturing Labor Budget
Regular Heavy duty
Units to be produced 6,000 units 1,000 units
DL hours per unit 4 hrs 6 hrs
Total labor hours 24,000 hrs 6,000 hrs
Hourly rate (wage rate per hr) $ 20 $ 20
Total labor cost $480,000 $120,000
6. Manufacturing Overhead Cost Budge
Manufacturing overhead cost.............................................................................. Br. 1,200,000
7. Ending Inventory Budget
Finished goods
Regular Heavy duty .
Input per unit Cost per input Total Input per unit Cost per input Total
111 alloy 12 kgs $7 $84 12 kgs $7 $84
112 alloy 6 10 60 8 10 80
MOH 4 hrs 40 160 6 hrs 40 240
DL 4 hrs 20 80 6 hrs 20 120
$384 $524
Direct Materials Inventory Finished Goods Inventory
111 Alloy 112 Alloy Regular Heavy duty
Units 8000 2000 1100 units 50 units
Cost per units $7 $10 $384 $524
Total cost $56,000 $20,000 $422,400 $26,200

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 $76,000 $448,600

8. Cost of Goods Sold Budget

Beg. Inventory $64,600
DM used 1,028,000
Direct Labor 600,000
MOH 1,200,000
Cost of goods Manufactured 2,828,000
Cost of goods available for sale 2,892,600
less: Target Ending Inventory (448,600)
Cost of goods sold 2,444,000
9. Non - Manufacturing Cost Budget/Selling & Administrative Expense Budget
Total budgeted non - manufacturing cost ............................................................... $870,000

Budgeted Income Statement for Halifax Engineering

For the Year Ended December 31, 20XX

Revenues ................................................................................................... $3,800,000

Cost of goods sold ...................................................................................... 2,444,000

Gross margin ............................................................................................... 1,356,000

Operating expenses ....................................................................................... 870,000

Budgeted Operating Income ....................................................................... $486,000

10. The Cash Budget

 The chapter illustrated the operating budget, which is one part of the master budget. The other part
is the financial budget, which comprises the capital expenditures budget, the cash budget, the
budgeted balance sheet, and the budgeted statement of cash flows.
 A cash budget shows expected cash receipts and disbursements; it indicates the months having cash
shortages and excesses.
 A cash budget brings together the cash effects of all budgeted activities. A cash budget depicts the
firm’s cash position during the budget period.

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 A cash budget includes all items that affect cash flows and pulls data from almost all parts of the
master budget.
 Preparing a cash budget requires a careful review of all budgets to identify all revenues, expenses,
and other transactions that affect cash.
 The cash budget is a schedule of expected cash receipts and disbursements. It predicts the effects on
the cash position at the given level of operations.
 Cash budgets help avoid unnecessary idle cash and unexpected cash deficiencies. They thus keep
cash balances in line with needs. Ordinarily, the cash budget has these main sections:
a. Cash available for needs (before any financing).
 Beginning cash balance plus cash receipts equals the total cash available for needs before any
financing.
 Cash receipts depend on collections of accounts receivable, cash sales, and miscellaneous
recurring sources, such as rental or royalty receipts.
 Information on the expected collectability of accounts receivable is needed for accurate
predictions. Key factors include bad-debt (uncollectible accounts) experience and average
time lag between sales and collections.
b. Cash disbursements. Cash disbursements include the following:
i. Direct material purchases.
ii. Direct labor and other wage and salary outlays.
iii. Other costs. These depend on timing and credit terms. Note, depreciation does not require a
cash outlay.
iv. Other disbursements. These include outlays for property, plant, equipment, and other long-
term investments.
v. Income tax payments.

c. Financing effects.
 Short-term financing requirements depend on how the total cash available for needs
compares with the total cash disbursements, plus the minimum ending cash balance desired.
 The financing plans will depend on the relationship between total cash available for
needs and total cash needed. If there is a deficiency of cash, loans will be obtained and
stocks will be issued. If there is excess cash, any outstanding loans will be repaid and it will
be invested.

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 d. Ending cash balance.
 The cash budget shows the pattern of short-term “self-liquidating” cash loans.
 The loan is self-liquidating in the sense that the borrowed money is used to acquire
resources that are used to produce and sell finished goods, and the proceeds from sales are
used to repay the loan. This self-liquidating cycle is the movement from cash to inventories
to receivables and back to cash.
Ending cash balance = Total cash available for needs - Total disbursements
+ Total effects of financing
Example:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Cash collection $ 913,700 $984,600 $976,500 $918,400
Disbursement 1,105,880 918,776 835,546 845,586
Additional Information
 The company wants to maintain a $35,000 - minimum cash balance at the end of each quarter.
 The company borrows at the beginning of each quarter and repays at the end. Borrowing and
repayment is made in multiples of $1000. Management does not want to borrow any more short
term cash than is necessary.
 Interest is computed and paid when the principal is paid. The annual interest rate is 12%.
 Beginning cash balance for 1st quarter is $30,000.

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Year

Beginning Cash Bal. $30,000 $35,820 $35,934 $44,998 $ 30,000
Collection 913, 700 984,600 976,500 918,400 3,793,200
Total cash avail. for disburs. $943,700 $1,020,420 $1,012,434 $963,398 3,823,200
Total disbursements 1,105,880 918,766 835,546 845,586 3,705,778
Minimum cash balance 35,000 35,000 35,000 35,000 35,000
Total cash needed 1,140,880 953,766 870,546 880,586 3,740,778
Surplus (Deficit)* (197,180) 66,654 141,888 82,812 (82,422)
Financing
Borrowing $198,000 $0 $0 $0 $198,000
Repayment
Principal** 0 (62,000) (121,000) 15,000 (198,000)
Interest (12%)*** 0 (3,720) (10,890) (1,800) (16,410)

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Total effects of financing $198,000 (65,720) (131,890) (16,800) $ (16,410)
Ending Cash Balance**** 35,820 35,934 44,998 101,012 $ 101,012
*
Surplus/deficit = Excess of total cash available for needs - Total cash needed before financing.
**
Surplus ≥ Principal + Interest
***
The specific computations regarding interest are $62,000 x 12% x 6/12 = $3,720; $121,000 x 12% x
9/12 =
$10,890; $15,000 x 12% x 12/12 = $1,800.
****
Ending cash balance = Total cash available for needs - Total disbursement + Total effects of financing.
Ending cash balance for quarter 1 = 943,700 - 1,105,880 + 198,000 = 35,820

Reading Assignment:
 Sensitivity Analysis in Budgeting
 Difficulties of sales forecasting
 Behavioral Aspects of Budgeting

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