A budget serves many purposes for organizations; it translates strategic and tactical
goals into financial terms, providing managers with an action plan for the future, and
allowing management to monitor performance. In this brief course you will learn about
the basics of budgeting, including the varying types of budgets, and you will explore the
benefits of budgeting.
Learning Outcomes
4. Identify the components and calculations used to create a master budget and
recognize uses for this information
6. Recognize how sales, production, and cost of goods sold budgets are created and
perform related calculations
7. Recognize the purpose of cash budgets and how they are prepared
8. Identify ways the budget process can be managed for optimal results and
recognize the benefits and limitations of the management-by-objective system
Budget Basics
Budgets can cover different time periods. For example, if a project will take three years
to complete, a budget that covers three years would be appropriate. A budget will
typically be subdivided into shorter periods, such as months or quarters. The most
commonly used period for a budget is one year. In a rolling budget, also called a
continuous budget, as each time period ends, another equivalent time period is added to
the budget.
Uses of Budgets
Education educating managers about their unit and interrelationship with firm
Most organizations want these objectives reflected in the activities of the next level of
responsibility--at the business unit or divisional level. Business unit or divisional
objectives are meant to sync-up with the overall objectives for the organization and are a
way to execute the corporate strategy.
This translates into much more specific objectives at the operational level: goals for sales
and marketing, goals for customer service, and other tactical efforts by the organization.
What is important to remember is that at every level these objectives are meant to act in
harmony with the corporate objectives.
What do all these goals and objectives mean in more specific planning terms?
It means that any manager in an organization must be aware of all of the demands he or
she faces when planning for the future.
Click through the interactive image below using the black arrows in the lower right
corner.
Planning must take into account all of these objectives, which, at times, can conflict.
That's why a written plan of action is so helpful; it is a way of thinking through priorities
for the future.
Questions
To test your understanding of the content presented in this assignment, please click on
the Questions icon below. If you have trouble answering any of the questions presented
here, you are always free to return to this or any assignment to re-read the material.
Strategic Budgeting
Click through the interactive image below to see the planning process in action. Use the
black arrows in the lower right corner to navigate.
When most people think of the word budget, they think in terms of money or dollars.
However, budgets can also be developed to plan for other important resources. One such
resource is time. Consider some of the jobs you've had and ask yourself these questions:
3. How much pressure did you feel to meet the time budget?
Managers can plan meticulously, but they must also be prepared to handle incorrect
estimates. Sensitivity analysis allows managers to prepare for potential changes to what's
expected.
Successful budgeting should provide goals not just for the company as a whole, but also
for subunits, such as departments or divisions. Variations in performance from the
budgeted amounts should be investigated, and corrective action should be taken, if
necessary. Further planning should take into account such variations, as well as changed
conditions. A budget should facilitate judging performance and motivating managers and
other employees.
People have become more important in the budgeting process, in part, because of the
influence of computer technology. Computers can now handle the "number crunching"
side of budgeting, and managers can begin to concentrate on the human element.
Questions
To test your understanding of the content presented in this assignment, please click on
the Questions icon below. If you have trouble answering any of the questions presented
here, you are always free to return to this or any assignment to re-read the material.
The Master (or Static) Budget
A master budget is a comprehensive budget plan which includes all the individual
budgets related to sales, cost of goods sold, operating expenses, capital expenditures,
and cash.
A master budget should place emphasis on the performance of the total system
(organization) rather than the various subsystems or functional areas.
In practice this means the master budget is comprehensive enough to ensure that all the
resources (equipment, materials, labor, supplies, etc.) needed by the organization will be
at the right place at the right time. It also is designed to insure the same mix of products
produced is the mix of products that sales/marketing is planning to sell (based on the
sales budget).
This is a more complex, detailed model of the master budget. You can roll your cursor
over the areas highlighted in orange for further information.
Source: International Accounting Network/Rutgers Accounting Web
There are a number of assumptions budgeters generally make when creating a master
budget. To remove some of the external complexities, the following are held constant
during the budget period:
1. sales prices
This leads to a more linear budget, but it makes the master budget more understandable.
Within the master budget individual business units may look at more non-linear models
for sales and production, but the more comprehensive budget usually offers one set of
numbers.
The master budget also provides goals against which the performance of employees and
segments of the company can be measured, in order to permit an informed evaluation of
employees or business segments and hopefully to motivate employees and business
segments to improve their performance.
The master budget is best used to measure the performance of those managers who are
responsible for the overall performance of the company or a business segment, or the
performance of those managers who are responsible for generating the sales, or
revenues, of a company or business segment. Managers who are only responsible for
controlling costs should more appropriately be measured against a flexible budget, which
is based on actual sales, not planned or expected sales. The master budget typically
covers a one year period, but other time periods can be used.
Example
The master budget consists of an operating budget and a financial budget. The
operating budget contains several component budgets. First, the sales or revenues
budget and the ending inventory budget must be created. Based on these budgets a
production budget can be created. Based on the production budget the budgets for direct
materials, direct labor, and manufacturing overhead can be produced. The cost of goods
sold budget can be created based on these last three budgets plus the ending inventory
budget. After additional budgets are created for various operating expenses such as
research and development, marketing costs, and administrative costs, the budgeted
income statement can be produced.
How to calculate
Budgeted sales (revenues) = (budgeted units sold) x (budgeted sale price per unit)
Budgeted variable costs = (budgeted units sold) x (budgeted variable cost per
unit)
Example
The Green Company plans to sell 20,000 units of its product at a price of $30 per unit. Its
variable costs per unit are expected to be $5 for direct materials, $3 for direct labor, and
$2 for manufacturing overhead. Its fixed costs are expected to be $50,000. Its master
(static) budget would be:
Variable Costs
Problem
Bobble Inc. manufactures wobbly-headed dolls for dashboards. They plan to sell 75,000
wobbly-headed donkeys to global vendors at a price of $3 per unit. The variable costs per
wobbly-headed donkey are expected to be $0.75 for direct materials, $0.50 for direct
labor, and $0.20 for manufacturing overhead. Fixed costs are expected to be $30,000.
What does the master (static) budget look like? (remember: do not include any commas
in your answers)
Bobble, Inc.
Master Budget
Units sold =
Sales = $
Variable costs:
Direct materials = $
Direct labor = $
Manufacturing overhead = $
Contribution margin = $
Fixed costs = $
Operating income = $
Suppose that the Green Company needs to evaluate the performance of its employees in
achieving budgeted goals, and then determine why some goals were not met. It needs to
compare its actual results with its budgeted goals, and then calculate the variances from
the master (static) budget.
How to calculate
Please note: For units sold, sales, contribution margin, and operating income a
positive variance is favorable, indicating that the company's goals
were exceeded.
Example
Shown below are the master (static) budget variances that would be calculated based on
the budgeted amounts and actual results given below for the Green Company.
Type either a U or an F into each text box, depending on whether the variance should be
considered Favorable or Unfavorable. Click the "Check" button below to see if your
answers are correct.
Static Budget
Static Budget Actual Results U/F
Variance
Variable Costs:
The benefits of a master budget are that it motivates employees to improve their
performance, provides standards against which to judge employee performance, and
improves coordination as all departments are working toward the same numerical goals.
It also focuses attention on the goals that the company wants to achieve.
The limitations of a master budget are that the achievement of short-term targets may
diminish the focus on long-term objectives, that managers may focus more on achieving
their own goals than on the larger objective of improving the performance of the
company as a whole, and that the focus on quantitative goals may diminish the attention
to qualitative measures of performance such as providing good customer service or
maintaining standards of ethical behavior.
Questions
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the Questions icon below. If you have trouble answering any of the questions presented
here, you are always free to return to this or any assignment to re-read the material.
Operating Budgets
After additional budgets are created for various operating expenses such as research and
development (R&D), marketing costs, and administrative costs, the budgeted income
statement can be produced.
Here are some of the major alternative budget systems in use in the United States and
globally. Click on each term in the table below to read more about each.
Activity-based A budget system that uses activity based cost measures to better
budgeting (ABB) estimate requirements for new and existing programs
Zero-based A budget system where managers start from zero and all
budgeting (ZBB) expenditures must be justified each new period
When a firm is looking to assess the performance of a stand-alone project, it will often
turn to a project budget system, which is designed for a project separate from the
other operations of the organization.
Questions
To test your understanding of the content presented in this assignment, please click on
the Questions icon below. If you have trouble answering any of the questions presented
here, you are always free to return to this or any assignment to re-read the material.
The sales budget, the production budget and the cost of goods sold budget are the
operating budgets most widely used within organizations.
The sales budget is important in developing the annual profit plan because it tells you
how much revenue you plan to earn. It is also important because all, or almost all, of the
other budgets in the annual profit plan are influenced by the sales budget, since the level
of sales affects the cost of goods sold as well as many other expenses.
The sales budget affects the production budget, since you generally need to make more
units if you plan to sell more units.
The sales budget is based on the number of units that can be sold and the price that can
be charged per unit. Both of these amounts will be affected by customer needs, recent
sales volume, advertising and promotional activity, competition, economic conditions, and
the regulatory environment. Many companies perform or obtain market research to
better understand some of these factors. Also, keep in mind that the number of units sold
may be limited by the productive capacity of the company.
To produce a sales budget, you need to determine the number of units that can be sold
and the price that can be charged per unit. You can then compute the total amount of sales
in dollars. This must be done for each time period covered by the sales budget.
How to calculate
Example
Suppose the number of units that can be sold in January is 1,400 and the price that can
be charged per unit sold is $50, then the budget for January would be:
Units sold =
Sales price = $
Total sales = $
If inventory levels are held constant from the beginning of the period to the end of the
period, the number of units produced would equal the number of units sold. Because
inventory levels usually do change from the beginning of the period to the end of the
period, the number of units produced usually does not equal the number of units sold,
but a higher level of units sold does tend to increase the number of units produced.
A higher ending inventory of finished goods will require a higher level of production, since
the additional goods will need to be produced. Likewise, a lower ending inventory will
require a lower level of production. A higher beginning inventory of finished goods will
require a lower level of production, since more of the goods required can come from that
beginning inventory. Likewise, a lower beginning inventory will require a higher level of
production.
In determining the desired level of the inventory of finished goods, there is a trade-off,
because a shortage of inventory can lose sales, while excessive inventory is costly to
maintain. Other factors to consider in preparing a production budget are a company's
production yields and quality, the availability of the resources of production, and the
question of stable production, which causes inventory to build up when sales are slow,
versus a flexible production schedule, which may require overtime pay when sales are
strong.
The planned level of production depends upon the planned level of sales and the planned
levels of inventory. Keep in mind that since the current period's ending inventory will
become the next period's beginning inventory, the desired level of the current period's
ending inventory will normally be based on the planned level of sales for the next period.
How to calculate
PC = SC + EIC - BIC
Example
Assume that a company plans to sell 400 units of its product in January and 500 units in
February. Assume that the company desires its inventory at the end of each month to be
15% of the planned sales for the next month, and that it expects to begin January with 60
units in its inventory. We can calculate the desired level of ending inventory for January
and the budgeted number of units to produce in January as follows:
Problem
Frankfort Inc. plans to sell 200 canisters of chemicals in July and 350 canisters in August.
They desire their inventory at the end of each month to be 20% of the planned sales for
the next month, and they expect to begin July with 45 canisters in their inventory.
Calculate the desired level of ending inventory for July and the budgeted number of units
to produce in July.
EIC = canisters
PC = canisters
All other things being equal, the higher the level of production called for in the production
budget, the greater will be the purchases of direct materials and direct labor. However,
the level of purchases of direct materials will also be affected by the levels of inventories
of direct materials.
The components of the cost of goods sold budget are the three manufacturing costs -
direct materials, direct labor, and manufacturing overhead - and the finished goods
inventories at the beginning and end of the period. When products are sold, the cost of
those goods, which is the cost of goods sold, comes out of the inventory asset and
becomes an expense. Therefore, the higher the cost of goods sold, the lower the amount
of inventory on the balance sheet, and the lower the net income on the income statement
(since the additional expense reduces net income.)
(NOTE: all figures in the calculations below would be budgeted, or expected, figures, not
actual figures, except for the finished goods beginning inventory, which may be an actual
or a budgeted figure).
How to calculate
Example
A company expects direct materials cost of $30,000, direct labor cost of $70,000, and
manufacturing overhead cost of $50,000. Its finished goods beginning inventory was
$10,000 and its finished goods ending inventory is expected to be $25,000.
Problem
What is the budgeted cost of goods sold for this company if the direct materials cost is
$40,000 and its finished goods ending inventory is expected to be $30,000?
Here are some of the major alternative budget systems in use in the United States and
globally.
Web Resources
Master budgets
The purpose of the cash budget is to estimate how much cash is being received and
spent in each time period, so that a company can make sure that it has enough cash at
all times to meet its needs. If the cash budget indicates a shortage of cash in any time
period, the company can arrange to borrow enough money to cover the shortage. The
cash budget can also help identify when the company will have enough cash to repay
such borrowings.
The cash budget is related to the other budgets because it takes the projected results from
other budgets and shows how they would affect the company's cash. For example, it uses
the sales shown on the sales budget to estimate how much cash will be collected from
customers in each time period.
Example
The cash budget uses the purchases shown on the direct materials purchases budget to
estimate how much cash will be spent on direct materials in each time period.
The elements of the cash budget are the cash balance at the beginning of the period, cash
collections, cash disbursements, cash balance before financing, the effects of financing
transactions (borrowings or repayments of principal or interest), and the cash balance at
the end of the period. The cash budget is affected by the company's policies on collection
of receivables and payment of payables because these policies influence the timing of the
collections and payments.
Example
If a company pays its payables in 30 days, a one month delay, then any purchases on
credit that it makes in May will not be paid until June.
When preparing a cash budget, any depreciation expense or bad debt expense should be
not be included as cash disbursements, because depreciation is an expense that does not
directly affect cash and bad debts are reflected in the cash collections section as a
reduction in the collections. The formulas below will aid in the preparation of the cash
budget.
In order to prevent the cash budget from being too cluttered, it may be a good idea to
prepare a schedule of cash receipts and a schedule of cash payments for direct material
purchases prior to the preparing the cash budget, which would then incorporate the
figures from those two schedules.
How to calculate
Example
A landscaping company that also produces and sells flower pots has the following
budgeted figures from its various budgets for a 3 month period:
Service Revenue
Selling expenses
Administrative expenses
The sales of flower pots are on a cash basis. The services are billed at the beginning of
each month with term 2/10, n/30. Customers pay 60% of the bills within 10 days (to get
the 2% discount), 20% of the bills in 30 days, and 15% in 60 days. The other 5% are
never paid. Purchases of direct materials are made on credit; 70% of them are paid in the
month of the purchase and 30% in the month following the purchase. The company has a
cash balance of $25,000 at the beginning of May. It wants a minimum balance of
$20,000, and has a line of credit on which it can borrow, and interest of 1% per month is
paid when the principal is repaid. Borrowings are assumed to be made at the beginning of
the month and repayments are assumed to be made at the end of the month. No money
is owed on line of credit on May 1.
May
$319,56
Total cash collected
0
$13,40
Total cash payments on direct material purchases
0
344,56
Cash available
0
333,40
Total cash disbursements
0
Repayment of principal 0
Interest paid 0
$20,00
Ending cash balance
0
June
Cash collected from payments within 10 days 82,320 140,000 x .60 (1-.02)
$15,40
Total cash payments on direct material purchases
0
388,32
Cash available
0
Borrowing 0
$83,90
Ending cash balance
3
What would interest equal if the cash balance before financing for May was $12,000?
Interest: $
The budget committee should provide guidelines that all responsibility centers should
follow in preparing their budgets. The budget guidelines should outline short-term goals
for the company that will set the tone for and govern the preparation of the budget. The
committee should consider many factors in providing these guidelines, including:
financial resources
For example, if the firm is expanding into new markets and will be hiring additional
employees, that should be reflected in the budget guidelines.
Management-by-Objective (MBO)
Click on the links below to read more about the benefits and limitations of Management-
by-0bjective.
Benefits
Limitations
Questions
To test your understanding of the content presented in this assignment, please click on
the Questions icon below. If you have trouble answering any of the questions presented
here, you are always free to return to this or any assignment to re-read the material.
Self-Assessment
Question 1
B. divisions
C. departments
Question 2
A budget improves:
A. Communication
B. Coordination
C. Both A and B
D. Neither A nor B
Question 3
The last step of the development of the operating budget is the creation of the:
Question 4
Question 5
A. The achievement of short-term targets may diminish the focus on long-term objectives
B. the agreed upon goals may become obsolete in the face of changes in corporate objectives or
changes in the competitive environment
C. Both A and B
D. Neither A nor B
Question 6
A. 10 months
B. 8 weeks
C. 1 year
Question 7
If as each time period ends, another equivalent time period is added to the budget, such a budget is called a
A. perpetual budget
B. rolling budget
C. continuous budget
D. Either B or C
Question 8
Question 9
Question 10
Question 11
A. Sales Budget
B. Master Budget
C. Production Budget
Question 12
C. planning/communication