BUDGETING

Since companies strive for profitability through the efficient and economical use of resources and
labor, they require financial road maps to show how they will allocate their resources to achieve their
business objectives. In other words, companies require prudent budgeting to accomplish their goals.
Companies practice budgeting—the estimation of probable expenditures and income for a specific
period—to determine the most efficient and effective strategies for making money and expanding
their assets. Budgeting allows companies to control their expenditures and to allocate resources to
maximize profits, thus allowing them to demonstrate to banks,investors, and shareholders that they
have a plan for where they are going.
Intelligent budgeting incorporates good business judgment in the review and analysis of past trends
and data pertinent to the business enterprise. This information assists a company in determining the
type of business organization needed, the amount of money to be invested, the type and number of
employees to hire, and themarketing strategies required. In budgeting, a company devises both
long-term and short-term plans to help implement its strategies and to conduct ongoing performance
evaluations.
Businesses generally develop and execute their budgeting plans each year, in a five-step process
called the planning cycle. First, companies develop a strategic plan that focuses on their long-term
goals and how to achieve them. The strategic plan typically includes general financial projections and
covers a five-year period. Second, businesses prepare an annual operating plan that provides a
detailed outlook for the coming year. This plan contains very specific financial projections and often is
what companies refer to by "budget." Third, since things change after the year actually starts,
businesses revise their plans, yielding their adjusted plan. The adjusted plan takes sudden and
unforeseen changes into consideration. Fourth, companies often make forecasts, or informal
projections, throughout the year. For example, businesses frequently predict their annual sales at
mid-year. Fifth, companies produce their business plans, which they use to apply for venture
capital and other investments. The business plans also often contain detailed financial projections.
A host of management personnel participates in the budgeting process. In general these participants
include "submitters" and "reviewers." The submitters are usually division managers who prepare and
propose possible spending plans to achieve company goals, whereas the reviewers are often
executives, controllers, or accountants who determine whether the proposed budgets and their
objectives are affordable, realistic, and attainable. These roles, however, are not mutually exclusive:
those who submit budget proposals often review other proposals and vice versa.

A HISTORICAL PERSPECTIVE
The practice of budgeting has existed for ages. In ancient times individuals and societies engaged in
processes of planning their economic activities, evaluating the annual outcomes, and revising when
necessary. Through observation and experimentation, agrarian peoples discovered, invented, and
standardized various practices to increase the quality and quantity of their yields.
The desire for excess supplies to sell for profits, and for storage as wealth, led people to make plans
to maximize their income by budgeting a certain amount of money and energy for stabilizing farming
conditions. These efforts brought about the discovery and use of crop rotation, fertilizers, fences,
scarecrows, and irrigation. While having few devices against the vagaries of the weather, ancient
peoples used their profits and hard labor to protect their fields by deploying armies, building walls,
planting in remote locations, and paying tribute to powerful neighbors. Similarly, modern peoples
employ various strategies to use their accumulated wealth to generate new profits and to continually
expand their wealth. The fact that modem budgeting generally consists of a series of 12-month
periods may reflect these agrarian origins.

PLANNING FOR PROFIT

To engage in any profitable commercial enterprise, a company employs its resources to exploit
various business opportunities. If the profits are consistent, a company may purchase more assets
and, therefore, expand its base of wealth. To do this effectively, a company undertakes the budgeting
process to assess the business opportunities available to it, the keys to successfully exploiting these
opportunities, the strategies the historical data support as most likely to succeed, and the goals and
objectives the company must establish. Companies also must plan long term strategies that define
the overall plan to build market share, increase revenues, and decrease costs. In addition,
companies require short-term strategies to increase profits, control costs, and invest for the future.
Both long-term and short-term strategies must contain control mechanisms for implementing
performance evaluations as well as control mechanisms for making modifications in the above
strategies when and where necessary.
Although company leaders generally conceive of business opportunities and initially provide the
impetus to pursue them, companies move beyond the embryonic stage by formulating their strategies
in quantifiable terms, such as: the volume of units that the company expects it can sell, the
percentage of market share the volume of units represents, the dollars of revenues it will receive from
these sales, and the dollars of profit it will earn. Likewise, a company outlines its long-term goals and
specifies its short-range plans in quantifiable terms that detail how it expects to accomplish its goals:

 the dollars the company will spend in selling the units

 the dollar costs of producing the units
 the dollar costs of administering the company's operations
 the dollars the company will invest in expanding and upgrading facilities and equipment
 the flow of dollars into the company coffers
 the financial position, expressed in dollars, at specific points in the future

To be successful, the budgeting process establishes criteria and control mechanisms for the
systematic evaluation of the company's ability to effectively implement its plans. These controls are
often detailed and complex. Therefore, the company includes in the budgeting process employees
from each organizational level and from each department. The company marshals these resources in
a coordinated effort in the following functions.

PLANNING.
The company establishes long-term financial goals and operational objectives for the future size and
activities of the company. These include products, product mix, services, markets, market share,
volume of sales, quality of sales, level of debt and capitalization, number of employees, degree of
horizontal and vertical integration,research and development , public or private
ownership, advertising campaigns, training and development, and benefit packages.

STAFFING.
The company clearly defines and assigns responsibility for the budgeting process itself, along with
the level of detail required to formulate the business plan. The treasurer's office generally organizes
and coordinates the budgetary process through a budget director, controller, or chief accountant.
Budgeting hinges on accurate accounting of all activities, including machine use, manpower needs,
employee turnover, inventory levels, supplier pricing, sales discounts, benefit costs, production
schedules, selling costs, and the like. Therefore, the accounting staff plays a central role in collecting,
analyzing, and processing the needed data. Contemporary approaches to budgeting, however, often
emphasize the role of managers in the budgeting process.

ORGANIZING.
In planning for profits the staff needs to organize for action. They provide standardized reporting
directives. The staff distributes familiar and "user-friendly" forms for collecting, organizing, evaluating,
and disseminating information. They propose procedures to form a comprehensive plan for each
activity and for the company as a whole.

DIRECTING.
The budgetary process establishes lines of reporting and accountability for the execution of the plan.
Besides spelling out the various responsibilities of the managers, it also places limits on their
authority. The budgeting process involves all levels of managerial responsibility: office, department,
division, and corporation. To maximize the benefits of the budgeting process, managers must not only
be responsible and accountable, but also need to be in agreement with overall goals and objectives.

CONTROLLING.
The budgetary process sets up the reporting procedures and techniques for evaluating both short-
term and long-term outcomes. Since the budget program is an instrument of organizational control, a
company's accounting and its chart of accounts will reflect clear lines of responsibility for each of its
divisions. Not all control activity, however, emanates from the accounting office. Line supervisors and
individual employees keep their own logs. Consequently, the accounting/budgeting staff sets up
schedules for the collection, processing, and analysis of data and its subsequent distribution to the
appropriate managers. The managers use this information to evaluate their own performance with an
eye toward making modifications where necessary.

THE FINANCIAL FORECAST AND THE

BUDGET
The end product of this process is the creation of the financial forecast. It projects where the company
wants to be in three, five, or ten years. The financial forecast quantifies future sales, expenses, and
earnings according to certain assumptions adopted by the company. Since projecting company sales,
expenditures, etc., involves uncertainty, a company must consider how changes in the business
climate could affect the outcomes projected. A company presents this analysis in the pro forma
statement, which displays, over a time continuum, a comparison of the financial plan to "best case"
and "worst case" scenarios. The pro forma statement acts as a guide for meeting goals and
objectives, as well as an evaluative tool for assessing progress and profitability.
Through forecasting a company attempts to determine whether and to what degree its long-range
plans are feasible. This discipline incorporates two interrelated functions: long-term planning based
on realistic goals and objectives and a prognosis of the various conditions that possibly will affect
these goals and objectives; and short-term planning and budgeting that provide details about the
distribution of income and expenses and a control mechanism for evaluating performance.
Forecasting is a process for maximizing the profitable use of business assets in relation to: the
analyses of all the latest relevant information by tested and logically sound statistical
and econometric techniques; the interpretation and application of these analyses into future
scenarios; and the calculation of reasonable probabilities based on sound business judgment.
Future projections for extended periods, although necessary and prudent, suffer from a multitude of
unknowns: inflation, supply fluctuations, demand variations, credit shortages, employee qualifications,
regulatory changes, management turnover, and the like. If a budget fails to distinguish between what
management can and cannot control, it also will fail to indicate whether management is successful or
unsuccessful, or merely fortunate or unfortunate. To increase control over operations, a company
narrows its focus to forecasting attainable results over the short term and identify the assumptions it
makes concerning the uncertainties. These short-term forecasts, called budgets, are formal,
comprehensive plans, using quantitative terms to describe the expected operations of the
organization over some specified future period. While a company may make few modifications to its
forecast, for instance, in the first three years, the company constructs individual budgets for each
year. Furthermore, this approach allows a company to periodically review the assumptions it makes
and revise them if necessary.
A budget delineates the expected month-to-month route a company will take in achieving its goals. It
summarizes the expected outcomes of production and marketing efforts, and provides management
benchmarks against which to compare actual outcomes. A budget acts as a control mechanism by
pointing out soft spots in the planning process or in the execution of the plans. Consequently, a
budget, used as an evaluative tool, augments a company's ability to make necessary alterations more
quickly.

PRINCIPLES AND PROCEDURES FOR

SUCCESSFUL BUDGETING
REALISTIC AND QUANTIFIABLE GOALS.
In a world of limited resources, a company must ration its own resources by setting goals that are
reasonably attainable. Realism engenders loyalty and commitment among employees, motivating
them to their highest performance. In addition, wide discrepancies, caused by unrealistic projections,
have a negative effect on the creditworthiness of a company and may dissuade lenders.
A company evaluates each potential business activity to determine which will help the company
achieve its goals the most. A company accomplishes this through the quantification of the costs and
benefits of the activities.

HISTORICAL COMPONENT.
The budget reflects a clear understanding of past results and a keen sense of expected future
changes. While past results cannot be a perfect predictor, they flag important events and
benchmarks.

PERIOD-SPECIFIC BUDGETING.
The budget period must be of reasonable length. The shorter the period, the greater the need for
detail and control mechanisms. The length of the budget period dictates the time limitations for
introducing effective modifications. Although plans and projects differ in length and scope, a company
formulates each of its budgets on a 12-month basis.
STANDARDIZATION.
To facilitate the budgeting process, managers should use standardized forms, formulas, and research
techniques. This increases the efficiency and consistency of the input and the quality of the planning.
Computer aided accounting, analyzing, and reporting not only furnish managers with comprehensive,
current "real time" results, but also afford them the flexibility to test new models, and to include
relevant and high-powered charts and tables with relatively little effort.

INCLUSIVE PROCESS.
Efficient companies decentralize the budget process down to the smallest, logical level of
responsibility, i.e., the responsibility center. Responsibility centers often include the revenue center,
the cost center, and the profit center. Those responsible for the results take part in the development
of their budgets, and learn how their activities are interrelated with the other segments of the
company. Each has a hand in creating a budget and setting its goals. Participants from the various
organizational segments meet to exchange ideas and objectives, to discover new ideas, and to
minimize redundancies and counterproductive programs. This way, those accountable buy into the
process, cooperate more, work harder, and, therefore, have more potential for success.

BUDGET REVIEW.
Decentralization does not exclude the thorough review of budget proposals at successive
management levels. Management review assures a proper fit within the overall "master budget."

ADOPTION AND DISSEMINATION.

Top management formally adopts the budgets and communicates their decisions to the responsible
personnel. When top management has assembled the master budget and formally accepted it as the
operating plan for the company, it distributes it in a timely manner.

FREQUENT EVALUATION.
Responsible parties use the master budget and their responsibility center budgets for information and
guidance. On a regular basis, according to a schedule and in a standardized manner, they compare
actual results with their budgets. For an annual budget, managers usually report monthly, quarterly,
and semiannually. Since considerable detail is needed, the accountant plays a vital role in the
reporting function.
A company uses a well-designed budget program as an effective mechanism for forecasting
realizable results over a specific period, planning and coordinating its various operations, and
controlling the implementation of the budget plans.

FUNCTIONS AND BENEFITS OF THE

BUDGETING PROGRAM
Budgeting has two primary functions: planning and control. The planning process expresses all the
ideas and plans in quantifiable terms. Careful planning in the initial stages creates the framework for
control, which a company initiates when it includes each responsibility center in the budgeting
process, standardizes procedures, defines lines of responsibility, establishes performance criteria,
and sets up timetables.
The careful planning and control of a budget benefit a company in many ways, including:
ENHANCING MANAGERIAL PERSPECTIVE.
In recent years the pace and complexity of business have out-paced the ability to manage by "the
seat of your pants." On a day-to day basis, most managers focus their attention on routine problems.
In preparing the budget, however, managers are compelled to consider all aspects of a company's
internal activities. The act of making estimates about future economic conditions and about the
company's ability to respond to them, forces managers to synthesize the external economic
environment with their internal objectives.

FLAGGING POTENTIAL PROBLEMS.

Because the budget is a blueprint and road map, it alerts managers to variations from expectations
that are a cause for concern. When a flag is raised, managers can revise their immediate plans to
change a product mix, revamp an advertising campaign, or borrow money to cover cash shortfalls.

COORDINATING ACTIVITIES.
Preparation of a budget assumes the inclusion and coordination of the activities of the various
segments within a business. The budgeting process demonstrates to managers the
interconnectedness of their activities.

EVALUATING PERFORMANCE.
Budgets provide management with established criteria for quick and easy performance evaluations.
Managers may increase activities in one area where results are well beyond exceptions. In other
instances, managers may need to reorganize activities whose outcomes demonstrate a consistent
pattern of inefficiency.

REFINING THE HISTORICAL VIEW.

The importance of clear and detailed historical data cannot be overstated. Yet, the budgeting process
cannot allow the historical perspective to become crystallized. Managers need to distill the lessons of
the most current results and filter them through their historical perspective. The need for a flexible and
relevant historical perspective warrants its vigilant revision and expansion as conditions and
experience warrant.

THE MASTER BUDGET: A PROFIT PLAN

The master budget aggregates all business activities into one comprehensive plan. It is not a single
document, but the compilation of many interrelated budgets that together outline an organization's
business activities for the coming year. To achieve the maximum results, budgets must be tailor-
made to fit the particular needs of a business. Standardization of the process facilitates comparison
and aggregation even of mixed industries, for example, financial services (General Motors Credit
Corp.) and manufacturing (General Motors Corp.).
In the following discussion the term "production" includes the manufacture of goods expressed by
their dollar value and number of units, and the provision of services expressed in labor-hours and in
dollar value.
Table A presents an overview of the master budget. The budgeting process is sequential in nature,
i.e., each budget hinges on a previous budget, such that no budget can be constructed without the
data from the preceding budget. In addition, each line budget is comprised of a number of smaller
responsibility center budgets. Responsibility budgets are an important element of an effective
accounting system.

CLASSIFICATIONS AND TYPES OF

BUDGETS
Budgets may be broadly classified according to how a company makes and uses its money. Different
budgets may be used for different applications. Some budgets deal with sources of income from
sales, interest, dividend income, and other sources. Others detail the sources of expenditures such
as labor, materials, interest payments, taxes, and insurance. Additional types of budgets are
concerned with investing funds for capital expenditures such as plant and equipment;

Table A
The Master Budget:
Common Segments Across Industries

1. OPERATING BUDGET
Sales Budget
Budget of ending inventories
Production budget
Materials budget
Director labor budget
Manufacturing overhead budget
Budgeted cost of goods sold
Administrative expense budget
Budgeted income statement
2. FINANCIAL BUDGET
Capital expenditures budget
Cash budget
Budgeted balance sheet
Budgeted statement of cash flows
and some budgets predict the amounts of funds a company will have at the end of a period.
A company cannot use only one type of budget to accommodate all its operations. Therefore, it
chooses from among the following budget types.
The fixed budget, often called a static budget, is not subject to change or alteration during the budget
period. A company "fixes" budgets in at least two circumstances.

1. The cost of a budgeted activity shows little or no change when the volume of production
fluctuates within an expected range of values. For example, a 10 percent increase in
production has little or no impact on administrative expenses.
2. The volume of production remains steady or follows a tight, preset schedule during the budget
period. A company may fix its production volume in response to an all-inclusive contract or it
may produce stock goods.

The variable or flexible budget is also called a dynamic budget. It is an effective evaluative tool for a
company that frequently experiences variations in sales volume that strongly affect the level of
production. In these circumstances a company initially constructs a series of budgets for a range of
production volumes that it can reasonably and profitably meet.
After careful analysis of each element of the production process, managers are able to determine the
fixed costs (e.g., taxes) that will not change within the anticipated range, the variable costs (e.g., raw
materials) that will change as volume changes, and the semivariable costs (e.g., equipment
maintenance fees) that vary to some extent, but not proportionately within the predicted range.
The combination budget recognizes that most production activities combine both fixed and variable
budgets within its master budget. For example, an increase in the volume of sales may have no
impact on sales expenses while it will increase production costs.
The continuous budget adds a new period (month) to the budget as the current period comes to a
close. Under the fiscal year approach, the budget year becomes shorter as the year progresses. The
continuous method, however, forces managers to review and assess the budget estimates for a
never-ending 12-month cycle.

THE BUDGET PERIOD

As a general rule, a company adopts budgets covering a period long enough to show the effects of
managerial policies, but short enough so as to make estimates with reasonable accuracy. Although
planned activities differ in the length of operation, budgets describe only what a company expects to
accomplish in the upcoming 12 months.
Capital expenditures for major investments in plant and equipment are long term by nature. A
company constructing new facilities, laying pipelines, or paving roads may design projects
encompassing periods of five to ten years. Nevertheless, a company details the ongoing expenses on
an annual basis.
Most operating and financial budgets (Table A) cover a period of one fiscal year, comprised of 12
months arranged in quarters (segments of three months) and semiannual periods (segments of six
months).

THE OPERATING BUDGET

The operating budget gathers the projected results of the operating decisions made by a company to
exploit available business opportunities. In the end analysis, the operating budget presents a
projected pro forma income statement that displays how much money the company expects to make.
This net income demonstrates the degree to which management is able to respond to the market in
supplying the right product at an attractive price, with a profit to the company.
The operating budget consists of a number of parts that detail the company's plans on how to capture
revenues, provide adequate supply, control costs, and organize the labor force. These parts are:
sales budget, production budget, direct materials budget, direct labor budget, factory overhead
budget, selling and administrative expense budget, and pro forma income statement.

PREPARATION OF THE MASTER BUDGET

Preparation of the master budget is a sequential process that starts with the sales budget. The sales
budget predicts the number of units a company expects to sell. From this information, a company
determines how many units it must produce. Subsequently, it calculates how much it will spend to
produce the required number of units. Finally, it uses all this information to estimate its profitability.
From the level of projected profits, the company decides whether to reinvest the funds in the business
or in alternative investments. The company outlines the predicted results of its plans in a balance
sheet that demonstrates how profits will have affected the company's assets.
Accounting: The Basis for Business Decisions notes the five major, sequential steps to preparing a
master budget:

1. Preparation of the sales forecast. How many units can be sold? How many units will be sold?
How much will it cost to sell these units? How much net revenue will these sales generate?
2. Preparation of the production and operating costs. How much will it cost to produce the units?
How can production be more efficient? How much will administrative expenses run?
3. Preparation of a budgeted income statement. What will be the net income? How much will be
cash, credit, and noncollectible? How much will be available for capital investments? How
much will remain as cash for financing daily operations?
4. Preparation of a cash budget. Will cash flow be adequate? Will receipts be evenly or erratically
distributed? Will third-party financing be needed? How are excess funds to be invested? How
much of the funds will be needed for capital expenditures?
5. Preparation of a budgeted balance sheet. How will the period's performance change the level
of assets and liabilities? How will the profit position of the company change? How will the
company's wealth be affected?

THE SALES FORECAST AND BUDGET

The sales organization has the primary responsibility of preparing the sales forecast. Since the sales
forecast is the starting point in constructing the sales budget, the input and involvement of most other
managers is important. First, those responsible for directing the overall effort of budgeting and
planning contribute leadership, coordination, and legitimacy to the resulting forecast. Second, in order
to introduce new products or to repackage existing lines, the sales managers need to elicit the
cooperation of the production and the design departments. Finally, the sales team must get the
support of the top executives for their plan.
The sales forecast is prerequisite to devising the sales budget on which a company can reasonably
schedule production, and to budgeting revenues and variable costs. The sales budget, also called the
revenue budget, is the preliminary step in preparing the master budget. After a company has
estimated the range of sales it may experience, it calculates projected revenues by multiplying the
number of units by their sales price.
The sales budget includes items such as: sales expressed in both the number of units and the dollars
of revenue, adjustments to sales revenues for allowances made and goods returned, salaries and
benefits of the sales force, delivery and setup costs, supplies and other expenses supporting sales,
advertising costs, and the distribution of receipt of payments for goods sold. Included in the sales
budget is a projection of the distribution of payments for goods sold. Management forecasts the
timing of receipts based on a number of considerations: the ability of the sales force to encourage
customers to pay on time, the impact of credit sales that stretch the collection period, delays in
payment due to deteriorating market and economic conditions, the ability of the company to make
deliveries on time, and the quality of the service and technical staffs.

THE ENDING INVENTORY BUDGET

The ending inventory budget presents the dollar value and the number of units a company wishes to
have in inventory at the end of the period. From this budget, a company computes its cost of goods
sold for the budgeted income statement. It also projects the dollar value of the ending materials and
finished-goods inventory, which eventually will appear on the budgeted balance sheet. Since
inventories comprise a major portion of current assets, the ending inventory budget is essential for
the construction of the budgeted financial statement.

THE PRODUCTION BUDGET

After it budgets sales, a company examines how many units it has on hand and how many it wants at
year-end. From this it calculates the number of units needed to be produced during the upcoming
period. The company adjusts the level of production to account for the difference between total
projected sales and the number of units currently in inventory (the beginning inventory), in the
process of being finished (work [goods, services] in process inventory), and finished goods in the
ending inventory.
To calculate total production requirements, a company adds projected sales to ending inventory and
subtracts the beginning inventory from that sum.

BEGINNING INVENTORY BUDGET

The products completed and available for sale at the start of the period make up the beginning
inventory budget. A company determines the value of the beginning inventory by: counting all
products on hand, multiplying this quantify by the cost per unit, and aggregating the costs of the
various products.

WORK IN PROCESS BUDGET

The work in process budget enumerates those units currently in the production phase. There
inevitably will be some work in process at every point in the budget period. Therefore, a company
needs to determine the number and value of the beginning and ending work in process inventories.
Because the items are in different stages of production and finishing, these computations present a
problem. Although computer technology has made great strides in simplifying the accounting process,
predictive accuracy is contingent on the experience of line supervisors who feed the data to the
accountants.

THE DIRECT-MATERIALS BUDGET

With the estimated level of production in hand, the company constructs a direct-materials budget to
determine the amount of additional materials needed to meet the projected production levels. A
company displays this information in two tables. The first table presents the number of units to be
purchased and the dollar cost for these purchases. The second table is a schedule of the expected
cash distributions to suppliers of materials.
Purchases are contingent on the expected usage of materials and current inventory levels. The
formula for the calculation for materials purchases is:
Purchase costs are simply calculated:
A company plans a direct-materials budget to determine the adequacy of their storage space, to
institute or refine just-in-time inventory control systems, to review the ability of vendors to supply
materials in the quantities desired, and to schedule material purchases concomitant with the flow of
funds into the company.

THE DIRECT-LABOR BUDGET

Once a company has determined the number of units of production, it calculates the number of direct-
labor hours needed. A company states this budget in the number of units and the total number of
dollar costs. A company may sort and display labor-hours using these parameters:

TYPE OF OPERATION.
A company segregates employees according to the type of work they do regardless of the products.
For example, a company will add up the costs for all assemblers even though they assemble different
products.

DIRECT-LABOR CLASSIFICATIONS.
This method sorts labor by the production process. It focuses on the different types of employees
working on one product. For example, a company constructs a budget showing the labor costs for all
employees working on the same product, regardless of their role.

LABOR STATUS.
This method classifies employees by seniority, level of skill, union affiliation, and the like. A company
uses this information to better understand the relationships between labor, skills, experience, and
production costs. This information assists management in organizing the labor force more efficiently.

COST CENTERS.
A company using the cost center approach to organization gives each unit of the company the
responsibility of controlling its labor costs. Each unit, therefore, is empowered to take corrective
action if problems arise in meeting the budget's goals.

THE PRODUCTION OVERHEAD BUDGET

A company generally includes all costs, other than materials and direct labor, in the production
overhead budget. Because of the diverse and complex nature of business, production overhead
contains numerous items. Accounting lists some of the more common ones:

1. Indirect materials—factory supplies that are used in the process but are not an integral part of
the final product, such as parts for machines and safety devices for the workers; materials that
are an integral part of the final product but difficult to assign to specific products, for example,
adhesives, wire, and nails.
2. Indirect labor costs—supervisors' salaries and salaries of maintenance, medical, and security
personnel.
 3. Plant occupancy costs—rent or depreciation on buildings, insurance on buildings, property
taxes on land and buildings, maintenance and repairs on buildings, and utilities.
4. Machinery and equipment costs—rent or depreciation on machinery, insurance and property
taxes on machinery, and maintenance and repairs on machinery.
5. Cost of compliance with federal, state, and local regulations—meeting safety requirements,
disposal of hazardous waste materials, and control over factory emissions (meeting class air
standards).

If any one cost traverses the various budgets listed in Table A, the company would apportion that cost
to reflect the benefits derived by the participating budgets.

BUDGET OF COST OF GOODS SOLD

At this point the company has projected the number of units it expects to sell and has calculated all
the costs associated with the production of those units. The company will sell some units from the
preceding period's inventory, others will be goods previously in process, and the remainder will be
produced. After deciding the most likely mix of units, the company constructs the budget of the cost of
goods sold by multiplying the number of units by their production costs.

ADMINISTRATIVE EXPENSE BUDGET

In the administrative expense budget the company presents how much it expects to spend in support
of the production and sales efforts. The major expenses accounted for in the administrative budget
are: officers' salaries, office salaries, employee benefits for administrative employees, payroll taxes
for administrative employees, office supplies and other office expenses supporting administration,
losses from uncollectible accounts, research and development, mortgage payments, bond interest
and property taxes, and consulting and professional services.
Generally, these expenses vary little or not at all for changes in the production volume that fall within
the budgeted range. Therefore, the administrative budget is a fixed budget. There are some
expenses, however, that can be adjusted during the period in response to changing market
conditions.
A company may easily adjust some costs, such as consulting services, R&D, and advertising,
because they are discretionary costs. Discretionary costs are partially or fully avoidable if their impact
on sales and production is minimal. A company, however, cannot avoid such costs as mortgage
payments and property. These committed costs are contractual obligations to third parties who have
an interest in the company's success. Finally, a company has variable costs that it adjusts in light of
cash flow and sales demand. These costs include such items as supplies, utilities, and the purchase
of office equipment.

BUDGETED INCOME STATEMENT

A budgeted income statement combines all the preceding budgets to show expected revenues and
expenses. To arrive at the net income for the period, the company includes estimates of sales returns
and allowances, interest income, bond interest expense, the required provision for income taxes, and
a number of nonoperating income and expenses, such as dividends received, interest earned,
nonoperating property rental income, and other such items. Net income is a key figure in the profit
plan for it reflects how a company commits the majority of its talent, time, and resources.

FINANCIAL BUDGET
The financial budget contains projections for cash and other balance sheet items—assets and
liabilities. It also includes the capital expenditure budget (see Table A). It presents a company's plans
for financing its operating and capital investment activities. The capital expenditure budget relates to
purchases of plant, property, or equipment with a useful life of more than one year. On the other
hand, the cash budget, the budgeted balance sheet, and the budgeted statement of cash flows deal
with activities expected to end within the 12-month budget period.

CAPITAL EXPENDITURES BUDGET

Capital expenditures budgets outline major investment goals often over a 5- to 10-year period.
Companies rely on capital budgeting to identify, evaluate, plan, and finance major investment projects
through which it converts cash (short-term assets) into long-term assets. A company uses these new
assets, such as computers, robotics, and modern production facilities, to increase productivity,
increase market share, and bolster profits. A company purchases these new assets as alternatives to
holding cash because it believes that, over the long term, these assets will increase the wealth of the
business more rapidly than cash balances. Therefore, the capital expenditures budget is crucial to the
overall budget process.
Capital budgeting seeks to make decisions in the present that determine, to a large degree, how
successful a company will be in achieving its goals and objectives in the years ahead. Capital
budgeting differs from the other financial budgets in that:

 Capital expenditures require relatively large commitments of resources whose dollar value may
exceed annual net income.
 Capital expenditures extend beyond the 12-month planning horizon of the other financial
budgets. To replace equipment may take 18 months. To build a new plant could involve years
of planning and construction.
 Capital expenditures involve greater operating risks. A company encounters more difficulties in
the long-term projecting of revenues, expenses, and cost savings. In addition, capital projects
divert employee energies away from daily operations.
 Capital expenditures increase the financial risks by adding long term liabilities. A company's
short-term liabilities, in the form of mortgage or bond interest, increase long before the project
becomes an earning asset.
 Capital expenditures require clear policy decisions that are in full agreement with the
company's goals since a company has less flexibility to modify or cancel a project in midstream
without serious potential consequences.

THE CASH BUDGET

In the cash budget a company estimates all expected cash flows for the budget period by: stating the
cash available at the beginning of the period, adding cash from sales and other earned income to
arrive at the total cash available, and subtracting the projected disbursements for payables,
prepayments, interest and notes payable, income tax, etc.
The cash budget is an indication of the company's liquidity or its availability of cash, and, therefore, is
a very useful tool for effective management. Although profits drive liquidity, they do not necessarily
have a high correlation. Often when profits increase, collectibles increase at a greater rate. As a
result, liquidity may increase very little or not at all, making the financing of expansion difficult, and the
need for short-term credit necessary.
Managers optimize cash balances by having adequate cash to meet liquidity needs, and by investing
the excess until needed. Since liquidity is of paramount importance, a company prepares and revises
the cash budget with greater frequency than other budgets. For example, weekly cash budgets are
common in an era of tight money, slow growth, or high interest rates.

THE BUDGETED BALANCE SHEET

A company derives the budgeted balance sheet, often referred to as the budgeted statement of
financial position, from the budgeted balance sheet at the beginning of the budget period and the
expected changes in the account balances reflected in the operating, capital expenditure, and cash
budgets. (Since a company prepares the budgeted balance sheet before the end of the current
period, it uses an estimated beginning balance sheet.)
The budgeted balance sheet is a statement of the assets and liabilities the company expects at the
end of the period. The budgeted balance sheet is more than a collection of residual balances
resulting from the foregoing budget estimates. During the budgeting process, management ascertains
the desirability of projected balances and account relationships. The outcome of this level of review
may require management to reconsider plans that seemed reasonable earlier in the process.

BUDGETED STATEMENT OF CASH FLOWS

The final phase of the master plan is the budgeted statement of cash flows. This statement
anticipates the timing of the flow of cash revenues into the business from all resources, and the
outflow of cash in the form of payables, interest expense, tax liabilities, dividends, capital
expenditures, and the like.
The statement of cash flows includes:

 The amount of cash the company will receive from all sources, including nonoperating items,
creditors, and the sale of stocks and assets. The company includes only those credit sales for
which it expects to receive at least partial payment.
 The amount of cash the company will pay out for all activities, including dividend payments,
taxes, and bond interest expense.
 The amount of cash the company will net from its operating activities and investments.

The net amount is a clear measure of the ability of the business to generate funds in excess of cash
outflows for the period. If anticipated cash is less than projected expenses, management may decide
to increase credit lines or to revise its plans. Note that net cash flow is not the same as net income or
profit. Net income and profit factor in depreciation and nonoperating gains and losses that are not
cash-generating items.

SUMMARY
Budgeting is the process of planning and controlling the utilization of assets in business activities. It is
a formal, comprehensive process that covers every detail of sales, operations, and finance, thereby
providing management with performance guidelines. Through budgeting, management determines
the most profitable use of limited resources. Used wisely, the budgeting process increases
management's ability to more efficiently and effectively deploy resources, and to introduce
modifications to the plan in a timely manner.