CHAPTER 1



CHAPTER 20

The Budgeting Process

reviewing the chapter

Objective 1: Define budgeting, and explain management’s role in the budgeting process.

1. Budgeting is the process of identifying, gathering, summarizing, and communicating financial and nonfinancial information about an organization’s future activities. It is an essential part of the continuous planning all types of organizations must do to accomplish their long-term goals and intermediate objectives. Budgets—plans of action based on forecasted transactions, activities, and events—are synonymous with managing an organization. They are used for a variety of purposes, including communicating information, coordinating activities and resource usage, motivating employees, and evaluating performance.

2. Strategic planning is the process by which management establishes an organization’s long-term goals. These goals define the strategic direction an organization will take over a five- to ten-year period and are the basis for making annual operating plans and preparing budgets. Annual operating plans involve every part of an enterprise and are much more detailed than long-term strategic plans. To formulate an annual operating plan, an organization must restate its long-term goals in terms of what it needs to accomplish during the next year. The short-term goals identified in an annual operating plan are the basis of an organization’s operating budgets for the year.

3. The key to a successful budget is participative budgeting. This is a process in which personnel at all levels of an organization take an active and meaningful part in the creation of the budget.

4. A budget committee made up of top management has overall responsibility for budget implementation. The committee oversees each stage in the preparation of the master budget, decides any departmental disputes that may arise in the process, and gives final approval to the budget. After the committee approves the master budget, periodic reports from department managers enable it to monitor the progress the company is making in attaining budget targets. To ensure the cooperation of personnel in implementing the budget, top managers must clearly communicate performance expectations and budget targets. They must also show their support for the budget and encourage its implementation.

5. Budgeting is helpful to managers at each step of the management process.

a. When managers plan, budgeting helps relate long-term strategic goals to short-term activities, distribute resources and workloads, communicate responsibilities, select performance measures, and set standards for bonuses and rewards.

b. When managers perform daily activities they use budget information to communicate expectations, measure performance and motivate employees, coordinate activities, and allot resources.

c. When managers evaluate performance results, they look for variances between planned and actual performance; and they create solutions to any significant variances that they detect.

d. Managers use budgets as a reference point when communicating information about the performance of an organization’s financing, investing, and operating activities. Managers issue reports based on budget information throughout the year.

Objective 2: Identify the elements of a master budget in different types of organizations and the guidelines for preparing budgets.

6. 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 accounting period, generally a year. Operating budgets are plans used in daily operations. They are also the basis for preparing the financial budgets, which are projections of financial results for the accounting period. Financial budgets include a budgeted income statement, a capital expenditures budget, a cash budget, and a budgeted balance sheet. The budgeted income statement and budgeted balance sheet are also called pro forma statements, meaning that they show projections rather than actual results.

7. The process of preparing a master budget is similar in manufacturing, retail, and service organizations in that each prepares a set of operating budgets that serve as the basis for preparing the financial budgets. The process differs mainly in the kinds of operating budgets that each type of organization prepares.

a. Manufacturing organizations prepare operating budgets for sales, production, direct materials purchases, direct labor, overhead, selling and administrative expenses, and cost of goods manufactured.

b. Retail organizations prepare operating budgets for sales, purchases, selling and administrative expenses, and cost of goods sold.

c. Service organizations prepare operating budgets for service revenue, labor, services overhead, and selling and administrative expenses.

d. The sales budget (or in service organizations, the service revenue 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 organization’s resources so that they generate profits on those sales.

8. No standard format for budget preparation exists. The only universal requirement is that budgets communicate the appropriate information to the reader in a clear and understandable manner. General guidelines for preparing budgets include identifying the purpose of the budget, the user group and its information needs, and appropriate sources of budget information; establishing a clear format for the budget; using suitable formulas and calculations to derive the quantitative information; and revising the budget until it includes all planning decisions.

Objective 3: Prepare the operating budgets that support the financial budgets.

9. A sales (or service revenue) budget is a detailed plan, expressed in both units and dollars, that identifies expected product (or service) sales for a future period. The following equation is used to determine budgeted sales:

|Total Budgeted |= |Estimated Selling |× |Estimated Sales in |

|Sales | |Price per Unit | |Units |

Estimated sales volume is very important because it will affect the level of operating activities and the amount of resources needed for operations. A sales forecast can help in making this estimate. A sales forecast is a projection of sales demand (the estimated sales in units) based on an analysis of external and internal factors.

10. Once the sales budget has been established, managers can prepare a production budget. A production budget shows how many units a company must produce to meet budgeted sales and inventory needs. The production budget is based on the following formula:

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

|Units | |in Units | |Ending Finished | |Beginning |

| | | | |Goods Inventory | |Finished Goods |

| | | | | | |Inventory |

11. After the production budget has been prepared, managers can prepare a direct materials purchases budget. This budget is a detailed plan that identifies the quantity of purchases required to meet budgeted production and inventory needs and the costs associated with those purchases. The first step in preparing a direct materials purchases budget is to calculate the total production needs in units of materials. In the second step, the following formula is used to determine the quantity of direct materials to be purchased during each accounting period in the budget:

|Total Units of |= |Total Production |+ |Desired Units |– |Desired Units of |

|Direct Materials | |Needs in Units of| |of Ending | |Beginning Direct |

|to Be Purchased | |Direct Materials | |Direct | |Materials |

| | | | |Materials | |Inventory |

| | | | |Inventory | | |

The third step is to calculate the cost of the direct materials purchases by multiplying the total number of unit purchases by the direct materials cost per unit.

12. A direct labor budget is a detailed plan that estimates the direct labor needed in an accounting period and the associated costs. The first step in preparing a direct labor budget is to estimate the total direct labor hours by multiplying the estimated direct labor hours per unit by the anticipated units of production. The second step is to calculate the total budgeted direct labor cost by multiplying the estimated total direct labor hours by the estimated direct labor cost per hour. A company’s human resources department provides an estimate of the hourly labor wage.

13. An overhead budget is a detailed plan of 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 of the production department and production-related departments, and to group information for the calculation of overhead rates for the forthcoming period.

14. A selling and administrative expense budget is a detailed plan of operating expenses, other than those related to production, that are needed to support sales and overall operations in a future accounting period.

15. A cost of goods manufactured budget is a detailed plan that summarizes the costs of production in a future period. The sources of information for this budget are the direct materials, direct labor, and overhead budgets. (See Exhibit 7 in the text for an example of a cost of goods manufactured budget.)

Objective 4: Prepare a budgeted income statement, a cash budget, and a budgeted balance sheet.

16. After revenues and expenses have been itemized in the operating budgets, the budgeted income statement can be prepared. A budgeted income statement projects an organization’s net income in an accounting period based on the revenues and expenses estimated for that period. Data related to projected sales and costs come from several of the operating budgets.

17. A capital expenditures budget is a detailed plan outlining the anticipated amount and timing of capital outlays for long-term assets in an accounting period. Managers rely on the capital expenditures budget when making decisions about such matters as buying equipment or building a new facility. The information in this budget affects the cash budget and the budgeted balance sheet.

18. A cash budget is a projection of the cash an organization will receive and the cash it will pay out in an accounting period. It summarizes all planned cash transactions found in the operating budgets and the budgeted income statement. The information it provides enables managers to plan for short-term loans when the cash balance is low and for short-term investments when the cash balance is high. The components of a cash budget are estimated cash receipts, cash payments, beginning cash balance, and ending cash balance. The ending cash balance is computed as follows:

|Estimated Ending |= |Total Estimated |– |Total Estimated |+ |Estimated |

|Cash Balance | |Cash Receipts | |Cash Payments | |Beginning Cash |

| | | | | | |Balance |

Estimates of cash receipts and cash payments are based on information from several sources, including the operating budgets. For example, the sales budget may be the main source of data for predicting cash receipts.

19. A budgeted balance sheet projects an organization’s financial position at the end of an accounting period. It uses the estimated data compiled in the course of preparing a master budget and is the final step in that process. (See Exhibit 12 in the text for a complete list of the data sources.)

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