BUDGETING

SUB TOPIC
I. OVERVIEW
Budgeting is a forecasting tool to determine future sources and uses of resources. It is also a tool used
for strategic and tactical planning intended to control costs to attain customer satisfaction and become
successful against its competitors.

Budgeting is the tactical implementation of a business plan. To achieve the goals in a business’s strategic
plan, we need some type of budget that finances the business plan and sets measures and indicators of
performance. We can then make changes along the way to ensure that we arrive at the desired goals.

A. Budgets and the budgeting cycle

1. Planning
a. It is a quantitative expression of what management wants to attain. The budget should be
specific, measurable, attainable, realistic, and time-bound (SMART)
b. It also serves as a guideline on what to do to attain desired outcomes or objectives.

2. The budgeting cycle

a. Top level management sets the overall goals and objectives of the company. They are
responsible in providing the guidelines that must be followed in the preparation and
implementation of the budget. The planning process requires the concerted effort of everyone in
the organization. Plans are cascaded to mid-level management for implementation and
monitoring. This is the application of the concept of Goal Congruence.
b. The next step is providing a basis for performance evaluation. This stage will set the specific
outcomes based on the overall goals and objectives as a basis for comparison with actual
results.
c. Next is investigating deviations or variances from plans. The purpose of variance analysis is to
determine factors that created the variance as a basis of formulating corrective actions to attain
efficiency in the future. Only significant variances will be investigated whether favorable or
unfavorable.
d. The last step goes back to the first step or planning after corrective actions are created in the
previous step.

B. Advantages and uses of budgets

The preparation of a budget is supported by the principle of Reasonable assurance, that is benefits
should be greater than the cost.
1. Compels periodic planning
a. Top level management is forced to formulate strategies. It tries to answer the following questions.
What was our attainment? What are we now? What do we want to happen in the future?
b. Planning require the preparation of long-run strategies and short-run tactical and operational
planning
c. It provides feedback that may require changes in plans and strategies before and during actual
implementation

2. Basis of performance evaluation

a. Budgets are prepared based on norms and standards. Moreover, the desired outcomes are
stated when the budget are prepared. The same outcomes and standards will be the benchmark
of performance evaluation.
b. Performance evaluation is intended to improve future operations based on feedback from past
performance. It is not a fault finding process, rather it is a constructive process.
c. It helps identify limited resources that future operations require. With this information before hand,
management can outsource needed funds to sustain future operations.

3. Motivational tool
a. Everybody will do their best to attain desired outcomes to avoid unfavorable performance.
b. Setting goals and objectives before actual implementation of plans will bring out the best of
individuals upon actual operations.

4. Promotes coordination within the company

The preparation of budget requires the concerted effort from everybody. Different components of
the budget require that each department in the company should prepare its own budget with the
supervision of the Budget Committee. The budgets are inter-related from other. Erroneous budgets
will have a domino effect rendering the budget useless.

5. Enhances communication within the company

Top level management uses budgets as a communication tool. Management sets the overall
goals and objectives and will as the opinion of mid-level management to rank-and-file in terms of
tactical and operational plans. Any feedback can be infused in the budget. The acceptance and
understanding of the budget will significantly determine the budget’s effectiveness and efficiency.
C. Budget Administration
1. Benefits of budgeting will be attained if all levels in the company understand and support the budget,
and the control system
2. Top management should spearhead the preparation of the budget to attain active line-management
participation
3. The budget could be revised during the implementation phase provided it is justified and with the
consent of the Budget Committee.

D. Time frame of budgets

1. Purpose of budget will determine its time coverage
2. Long-term plans require Strategic budgets and short-term plans require Tactical budgets. Rolling
budget (sliding, continues, perpetual) is the most common short-term budget with a time frame of a
year to less than one year.
SUB TOPIC
II. THE MASTER BUDGET
All the functional division of the organization prepares the budget for the particular division. The master
budget is the sum total of all the divisional budgets that is prepared by all the divisions. Further, it also includes
the financial planning, cash-flow forecast and budgeted profit and loss account and balance sheet of the
organization. It is the goal of the organization to reach a level in a particular period. Normally master budget is
prepared for a year.

Sometimes, it may be misunderstood that master budget is one large budget of the organization. However, it
is not the case. Master Budget is the summary of the divisional budget. It is a continuous financial plan. It is the
overall plan of a company. It is also the budgeted pro-forma financial statements of a company. The master
budget is composed of two major budgets, the Financial and Operating budgets.
A. Financial budget: includes cash, capital expenditure, balance sheet, and cash flows
The technically the cash budget is the desired ending cash balance and the budgeted cash flows is
the budget indicating the sources of uses of cash arising from Operating, Investing, and Financing
activities. The two terminologies are often interchanged. The capital expenditure budget is the budget
of the company for future acquisition of non-current assets. It is extensively discussed in Financial
Management under the category Capital Budgeting. Budgeted Balance sheet is the budgeted
financial position of the company for the budget year.

B. The Operating budget: budgeted income statement and its supporting budget schedules
Steps in preparing the operating budget:
Step 1: Revenues budget, in units to determine production budget then converted to money for the
Sales budget. The sales budget is the foundation of the master budget. All the procurements, staff
requirements and administration cost are based on the sales. First and foremost, the number of units
to be sold and price per unit are derived. On the basis of that, the value of sales is calculated.

Step 2: Production budget (in units) The production budget is mainly based on the sales budget.
However, following factors shall be considered;
Inventory at the beginning of the year
Inventory to be maintained at the end of the year
Number of units manufactured
Buffer stock to be maintained throughout the year

The production budget is divided into further three parts which are the next three steps
Step 3: Direct materials usage and purchases budgets
Step 4: Direct labor budget
Step 5: Manufacturing overhead budget

If the company is not having manufacturing unit, we require a number of units to purchase instead
of the production budget.

Step 6: Ending inventories budget, is prepared based on the level of units the company deems
necessary to be in the ending inventory. After setting the ending inventory, the next budget is
prepared.

Step 7: Cost of goods sold budget, is a product of production budget and the ending inventories
budget.

Step 8: Non-manufacturing costs budget, it comprise the budgeted selling and administrative
expenses needed to sustain operations for the budget year.

Step 9: Budgeted income statement, is the end product of the operations budget.
SUB TOPIC
III. OTHER TYPES OF BUDGETS
1. Kaizen budgeting: this is the budget that supports Total Quality Management. Kaizen budgeting is
defined as a budgeting technique focusing on continuous improvement from a service or product
perspective. Kaizen budgeting requires management to set goals based on future plans for process
and operational improvements, rather than creating budgets based on the existing cost structure. The
unique characteristic of the budget is based on the concept that costs are gradually declining which
attaining production efficiency. Revenues need not increase but current revenues must be
maintained. Income increases as a result of decreasing cost and expenses.

2. Activity-based budgeting: this is the budget that supports Activity Based Management. Activity-
based budgeting is a planning system under which costs are associated with activities, and
expenditures are then budgeted based on the expected activity level. It ignores past data. This
approach differs from the more traditional budgeting system, where existing cost levels are adjusted
for inflation and major revenue changes in order to derive the annual budget. Budgets are allowed
only for value added activities needed to produce and sell products and services. No budget is
allocated for non-value added activities, because it is eliminated even in the planning phase.

3. Static (Fixed) budget: budget that is prepared for a single level of output. Usually the output is the
planned level of production that will satisfy sales units and desired ending inventories. It can also be
based on normal capacity. A static budget is a budget that does not change with variations in activity
levels. Thus, even if actual sales volume changes significantly from the expectations documented in
the static budget, the amounts listed in the budget are not changed. A static budget model is most
useful when a company has highly predictable sales and expenses that are not expected to change
much through the budgeting period (such as in a monopoly situation). In more fluid environments
where operating results could change substantially, a static budget can be a hindrance, since actual
results may be compared to a budget that is no longer relevant.

4. Flexible budget: this is the only budget that is adjusted to actual level of output. It enhances variance
analysis compared to static budgets. A flexible budget adjusts to changes in actual revenue levels.
Actual revenues or other activity measures are entered into the flexible budget once an accounting
period has been completed, and it generates a budget that is specific to the inputs. The budget is
then compared to actual expenses for control purposes. This approach varies from the more common
static budget, which contains nothing but fixed amounts that do not vary with actual revenue levels.
Budget versus actual reports under a flexible budget tend to yield variances that are much more
relevant than those generated under a static budget, since both the budgeted and actual expenses
are based on the same activity measure.
SUB TOPIC
IV. SOURCE OF INFORMATION
The following are typical sources of information needed in budgeting.
a. Past company records, these records are useful for long-term sales trends.
b. Benchmark with industry competitors
c. Standards developed by company
i. Standard: carefully predetermined price, cost, or quantity based on efficient operations and
usually expressed on a per unit basis
ii. Standard input: carefully predetermined quantity of inputs required for one unit of output
iii. Standard price: carefully determined price expected to pay for a unit of input
iv. Standard cost: carefully predetermined cost of a unit of output

d. Standard are either Attainable (Practical) or Theoretical (Ideal). Attainable standards allow
allowance for down-time and rest periods. Theoretical standards assume 100% efficiency.

Ideal standards are standards that do not allow for normal wastage and work interruption
due to breakdown of machinery, employees’ rest periods, shortage of raw materials or any other
reason. The achievement of such standards requires highly skilled and motivated workers and
the best possible use of production facilities. In short, we can say that the ideal standards can
only be achieved under the best and perfect work circumstances. It is ideally used for Production
budgets. The use of ideal standards is not common among companies because they are based
on highly strict assumptions that do not allow even the normal inefficiencies.

Practical standards are standards that are challenging but achievable through the use of
efficient and motivated workers under normal working conditions. They allow for work
interruptions because of machine breakdowns, workers’ rest periods and other conditions that are
considered normal in a particular work environment. Usually it is best suited for Cash and Sales
budgets. Most of the companies using standard costing system set practical standards rather
than ideal standards.

e. Budgets are determined based on standard costs. Usually it is stated as a total amount. In
contrast, standards are on a per unit basis.