Chapter Outline

Budget and the Budget Cycle

Advantages and disadvantages of budgeting
Developing an operating budget
Time coverage of operating budget and Human
aspect of budgeting
Responsibility accounting
Controllability

Learning Objectives
After completing this chapter, students are expected
to :
Describe the master budget and explain its benefits
Describe the advantages and demerit of budget
Prepare the operating and Financial budget and its
supporting schedules.
Describe responsibility centers and responsibility
accounting.e human aspects of budgeting

Introduction:

Budgeting is the most widely used accounting

tool
for
planning
and
controlling
organizations.

A budget is the quantitative expression of a

proposed plan of action by management for a
future time period and an aid to the
coordination and implementation of the plan.

Basic Terminologies
A budget:

Is

a financial or nonfinancial expression of a plan of

action for a specified period
Identifies the resources and commitments required to
achieve the organizations goals for an upcoming period

Budgeting:

The process of preparing a budget (or set of

budgets) is called budgeting

The Budgeting Process

Budgeting
is
an
important
part
of
an
organizations entire planning process
Budgets
are
the
financial
culmination
of
predictions and assumptions about achieving not
only financial but also nonfinancial goals and
objectives
Nonfinancial performance goals and objectives
may include throughput, customer satisfaction,
defect minimization, and on-time deliveries.

Budgeting contd
Budgets can help identify potential problems in
achieving specified organizational goals and
objectives.
By quantifying potential difficulties and making
them visible, budgets can help stimulate
managers to think of ways to overcome those
difficulties before they are realized.
A well-prepared budget can also be an effective
device to communicate objectives, constraints,
and expectations to all organizational personnel.

Budgeting contd

Such communication promotes understanding of what

is to be accomplished, how those accomplishments are
to be achieved, and the manner in which resources are
to be allocated
Participation in the budgeting process helps to produce
a spirit of cooperation, motivate employees, and instill
a feeling of teamwork.
Employee participation is needed to effectively
integrate necessary information from various sources
as well as to obtain individual managerial commitment
to the resulting budget.

Budgeting contd

The budget sets the resource constraints under

which managers must operate for the upcoming
budget period. Thus, the budget becomes the
basis for control-ling activities and resource
usage.
The budgeting and planning processes are
concerned with all organizational resourcesraw
material, inventory, supplies, personnel, and
facilities and can be viewed from a long-term or a
short-term perspective.

Characteristics of a budget
A good budget is characterized by the following:

Participation: involve as many people as possible in

drawing up a budget.
Comprehensiveness: embrace the whole organization.
Standards:
base it on established standards of
performance.
Flexibility: allow for changing circumstances.
Feedback: constantly monitor performance.
Analysis of costs and revenues: this can be done on the
basis of product lines, departments or cost centers.

Why Budgeting?
It is a vehicle of communication by managers
about strategic plan to the entire organization.
Provides a framework for judging performance
Motivates employees and managers

Self

imposed participative budget

Promotes coordination and communication

Budgets force managers to
think about and
plan for the future.

Why Budgeting?
Provides a means of allocating resources to
those parts of the organization where they
can be used most effectively.
Can uncover potential
bottlenecks before
they occur

Limitation of Budgeting

There are several limitations and problems

associated with the master budget that need to
be considered by management.
These problems involve :
Uncertainty,
Behavioral bias
Costs.
The time involved in producing such a budget.

Strategic Plan

Strategic planning

Managers who plan on a long-range basis (5 to 10

years) are engaged in strategic planning.
Top-level management performs this process, often
with the assistance of several key staff members.
Strategic planning is not concerned with day-today operations, although the strategic plan is the
foundation on which short-term planning is based

Strategic planning
Managers engaging in strategic planning
should identify key variables, believed to be
the direct causes of the achievement or nonachievement of organizational goals and
objectives.
Key variables can be internal (under the
control
of
management)
or
external
(normally non-controllable by management).

Master Budget

Is a detailed and comprehensive analysis of the

first year of the long range plan.
It is static in the sense that it is based on a single
level of output demand
It summarized the planned activities of all
subunits of the organization.
It embraces the impact of both operating and
financing decisions.

Master Budget

Operating decisions: deals with how to best

use of the limited resources of an
organization.

Financing decisions: deals with how to

obtain
the
funds
to
acquire
those
resources.

Master Budget

Operating budget
(Profit plan). . .

Focuses on the Income

Statement and supporting
schedules or budgeted
expenses.

Financial budget. . .

Focuses on the effects that the operating

budget and other plans will have on cash
balances.

Continuous Budget
Rolling budgets...
are a common form of
master budgets that
add a month in the
future as the month
just ended is dropped.

Types of Budgets
Capital budgets with acquisitions
that normally cover several years.

Long Range Budgets

1999

Continuous
or
Rolling Budget

2000

This
This budget
budget is
is usually
usually aa twelve-month
twelve-month
budget
budget that
that rolls
rolls forward
forward one
one month
month
as
as the
the current
current month
month is
is completed.
completed.

Financial budgets with financial

resource acquisitions.

2001

2002

Sales of Services or Goods

9-22

Ending
Inventory
Budget

Production
Budget

Work in Process
and Finished
Goods

Ending
Inventory
Budget

Direct Materials

Direct
Materials
Budget

Direct
Labor
Budget

Overhead
Budget

Cash Budget
Budgeted Balance
Sheet
Budgeted Statement of Cash
Flows

Selling and
Administrative
Budget

Budgeted Income
Statement

Stop and Apply

Identify the order in which the following budgets are
prepared:
1.

Overhead budget

2.

Production budget

3.

Direct labor budget

4.

Direct materials purchases budget

5.

Sales budget

6.

Budgeted balance sheet

7.

Cash budget

8.

Budgeted income statement

Sales Budget

The sales budget is the most important element in the

master budget as all other budget assumptions flow from
the sales forecasts in the budget.
The foundation and starting point for the master budget.
Determines the anticipated unit and Birr (dollar) sales for
the budgeted income statement.
May also include a schedule of expected cash collections
which determines the amount of expected cash
collections from customers for each period based on an
expected collections pattern.

Sales budget contd

The sales budget is the only budget based on an estimate

of customer demand.
The sales budget will depend on the successful
forecasting of a number of factors including:
1.
2.
3.
4.

The state of the overall economy

The competitive position
The plans to introduce new products
The success of advertising and
campaigns

marketing

Sales Budget contd.

Sales managers use this information to plan sales- and

marketing-related activities and to determine their
human, physical, and technical resource needs.
Accountants use the information to determine estimated
cash receipts for the cash budget
In general companies can made sales forecast by:

Sales Staff
Market Researchers
Trend Analysis
Delphi Techniques
Econometric Analysis

Factors to Consider When Forecasting Sales

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Example on Sales Budget

Company A is expecting to sell 10,000 cases in
July, 20,000 cases in August, and 30,000 in
September of Year 2. Selling price per case is
Br 30. All sales are on account. The sales are
collected 70% in the month of sale and 30% in
the month following sale. June sales totaled Br
200,000. Bad debts are negligible and can be
ignored.

Required:
A.
B.

C.

Prepare a sales budget.

Prepare a schedule of expected cash
collections from sales, by month and in
total, for the third quarter.
Assume that the company will prepare a
budgeted balance sheet as of September
30. Determine the accounts receivable as of
that date.

Production Budget

The production budget is prepared after the sales

budget.
The production budget lists the number of units that
must be produced during each budget period to meet
sales needs and to provide for the desired ending
inventory.
Production needs can be determined as follows

Production Budget

Production requirements for a period are

influenced by the desired level of ending
inventory.
Inventories should be carefully planned.
Excessive inventories tie up funds and create
storage problems. Insufficient inventories can
lead to lost sales or crash production efforts in the
following period.

Examples of Production Budget

ABC Corporation has just made its sales forecast
and its marketing department estimates that the
company will sell 24,000 units during the coming
year. In the past, management has maintained
inventories of finished goods at approximately one
months sale. The inventory at the start of the
budget period is 1,300 units. Sales occur evenly
throughout the year.
Required: Estimate the production level for the
coming year to meet these objective.

Additional Exercise on Production

Budget
Additional Illustration on Production Budget

Direct Materials Budget:

Determines the quantity of direct raw materials

that must be purchased each period to meet
anticipated production needs (from the production
budget) and to provide for adequate levels of
direct raw materials inventories.
Remember that raw materials inventory may also
include indirect materials. This budget addresses
only the direct materials portion of raw materials
inventory.
The indirect materials portion is
addressed as part of the overhead budget

Direct Materials Budget:

The first step in the direct materials budget is to

convert units of finished goods produced into
direct materials needed to produce them
by
multiplying the number of units produced by the
direct materials required to produce one unit of
finished goods.
The final step in the direct materials budget to
determine the cost of the direct materials
purchased by multiplying the quantity to be
purchased by the purchase price per unit

DIRECT MATERIAL BUDGET

Direct Material Purchase Budget Formula.doc

Example on DM Budget
Texas Products has developed a very powerful
electronic calculator. Each calculator requires three
small chips that cost Br 2.00 each and are purchased
from an overseas supplier. Texas Products has
prepared a production budget for the calculator by
quarters for Year 2 and for the first quarter of Year 3,
as follows:
Year 2

Q1
Budgeted Pdn in Calculator

60,000

Q2
90,000

Year 3

Q3

Q4

Q1

150,000

100,000

80,000

Example on DM Budget continued

The inventory of the chips at the end of a quarter
must be equal to 20% of the following quarters
productions needs. There will be 36,000 chips on
hand to start the first quarter of Year 2.
Required:
Prepare direct materials budget for the chips, by
quarter and in total, for Year 2 including the dollar
amount of purchases for each quarter and for the
year in total.

Direct Labor Budget

Determines the direct labor hours and direct labor

dollars required each period to meet anticipated
production needs (from the production budget).
The indirect labor costs are addressed as part of
the overhead budget.
Direct labor budget may be affected by overtime
costs, inelastic supply of labor, a minimum number
of hours to be worked and other unique
requirements.

Direct Labor Budget

Enables the personnel department to

plan for hiring & repositioning of
employees, based on production
needs

Is prepared for each class (type) of

labor, e.g., skilled
and semi-skilled

Examples on Direct Labor budget

Direct Labor Budget.doc

Manufacturing Overhead Budget

The manufacturing overhead budget has two

components variable and fixed overhead.
Budgeted variable overhead expenses depend on
the number of units produced from the
production budget and a budgeted variable
overhead cost per unit.
Budgeted fixed overhead expenses depend on
the total cost expected to be incurred for each
type of fixed overhead cost.

Manufacturing Overhead Budget

Any noncash fixed manufacturing overhead costs,

such as depreciation expense, is deducted from
the total manufacturing overhead to determine
the cash disbursements for manufacturing
overhead.
The cash was spent when the depreciable asset
was acquired and not when the asset is
depreciated.)

Example on Manufacturing Overhead Budget

Company Cs variable manufacturing overhead

rate is Br 2.00 per direct labor-hour and the
companys fixed manufacturing overhead is Br
40,250 per quarter. The only non-cash expense
included in the fixed overhead is depreciation of
Br 12,000 per quarter.
Budgeted direct labor hours

First

Second

Third

Fourth

5,000

6,500

6,000

5,500

Example on Manufacturing Overhead Budget

Required:
A. Construct
companys manufacturing overhead
budget for the year.
B. Compute the companys manufacturing overhead
rates (variable, fixed and total) for the year.

Selling and Administrative Expense Budget

Selling and Administrative (S&A) expense budget is

similar to the manufacturing overhead budget as it
includes variable and fixed expenses.
Budgeted variable S&A expenses depend on the number
of units sold or sales dollars from the sales budget.
Budgeted fixed S&A expenses depend on the total cost
expected to be incurred for each type of fixed S&A cost.
Any noncash fixed S&A costs, such as depreciation
expense, is deducted from the total S&A expenses to
determine the cash disbursements for S&A expenses.

Cash Budget

Little is more important to business success than

effective cash management.
If a company experiences cash shortages, it will be
unable to pay its debts and may be forced into
bankruptcy.
If excess cash accumulates, a business loses the
opportunity to earn investment income or reduce
interest costs by repaying debt.
Preparing a cash budget alerts management to
anticipated cash shortages or excess cash balances.

Cash Budget

The cash budget estimates the expected receipts (inflows) and

payments (outflows) of cash for a period of time.
It summarizes the cash flow prospects of all transactions
considered in the master budget.
The information that the cash budget 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.
A cash budget excludes planned noncash transactions, such as
depreciation expense, amortization expense, issuance and receipt
of stock dividends, uncollectible accounts expense, and gains and
losses on sales of assets.

Cash Budget

The cash budget is composed of four major

sections:
1.
2.
3.
4.

The
The
The
The

receipts section.
disbursements section
cash excess or deficiency section.
financing section.

Cash Budget

The cash budget uses information from all of the

other budgets:
Cash receipts from the sales budget,
Cash disbursement s from direct materials
budget, cash disbursements from the direct
labor, manufacturing overhead and selling
administrative expense budget.

Cash Budget

The company may also have to meet a minimum

balance requirement for its cash account which is
imposed by the bank.
If the cash balance falls short of the minimum
required, the company will have to borrow money
to increase the cash balance to the minimum.
If the company has cash in excess of the minimum
balance required, it is obligated to pay off any
outstanding borrowings and the related interest
payable.

Cash Budget

After the borrowings and interest have been paid off,

the company may leave the excess cash in the cash
account.
The receipts section lists all of the cash inflows,
except from financing, expected during the budget
period. Generally, the major source of receipts is from
sales.
The disbursements section summarizes all cash
payments that are planned for the budget period.
These payments include DM purchases, direct labor
payments, MOH costs, and so on,

Cash Budget

The cash excess or deficiency section is computed

as
follows:
Cash
Balance, Beginning
xxx
Add Receipts

xxx

Total Cash Available

xxx

Less Disbursement

(xxx)

Excess (deficiency) of cash Available over Disbursement

xxx

If a cash deficiency exists during any budget

period, the company will need to borrow funds. If
there is a cash excess during any budget period,
funds borrowed in previous periods can be repaid
or the excess funds can be invested

Example on Cash Budget

Example on Cash Budget.doc

Budgeted Income Statements

A budgeted income statement can be prepared

from the data developed in the previous
operating budget.
The budgeted income statement is one of the key
schedules in the budget process.
It shows the companys planned profit and serves
as a benchmark against which subsequent
company performance can be measured.

Budgeted Income Statement

Operating income is not equivalent to the net

income of a firm.
To yield net income, interest expense and taxes
must be subtracted from operating income. The
interest expense deduction is taken from the cash
budget. The taxes owed depend on the current
tax laws

Budgeted Balance Sheet

Statements of financial position, combine an

estimate of financial position at the beginning of
the budget period with the estimated results of
operations for the period (from the income
statements) and estimated changes in assets and
liabilities.

Budgeting and Responsibility Accounting

To attain the goals described in the master budget,

a company must coordinate the efforts of all its
employees from the top executive through all levels
of management to every supervised worker.
Coordinating
the
companys
efforts
means
assigning responsibility to managers who are
accountable for their actions in planning and
controlling human and other resources.
How each company structures its own organization
significantly shapes how the companys efforts will
be coordinated.

Responsibility Accounting

Organization structure is an arrangement of lines

of responsibility within the organization.
Each manager, regardless of level, is in charge of
a responsibility center.
A responsibility center is a part, segment, or
subunit of an organization whose manager is
accountable for a specified set of activities.
The higher the managers level, the broader the
responsibility center and the larger the number of
his or her subordinates.

Responsibility Accounting & Centers

Responsibility accounting is a system that

measures the plans, budgets, actions, and actual
results of each responsibility center.

Four types of responsibility centers are as

follows:
1.
2.
3.
4.

Cost center
Revenue center
Profit center
Investment center

Controllability Concept

The
controllability concept is crucial to an
effective responsibility accounting system.
Managers should only be evaluated based on
revenues or costs they control.
Holding individuals responsible for things they
cannot control is de-motivating.
Isolating control, however, may be difficult, as
illustrated in the following case.

Controllability

Controllability can be difficult to determine exactly

because most items can be affected or influenced by
the actions of more than one manager, and because
the controllability of items depends to a certain
extent on the period being measured since most
items are controllable in the long run.
Responsibility accounting should focus first on whom
to ask for information and not on whom to blame .

E-Budgeting
9-63

Employees
Employees throughout
throughout an
an organization
organization can
can submit
submit
and
and retrieve
retrieve budget
budget information
information electronically.
electronically.
This
This tends
tends to
to streamline
streamline the
the entire
entire budgeting
budgeting
process.
process.

Behavioral Impact of Budgets

9-64

The
budgetingprocessmaybeabusedboth
by
superiorsand subordinates, leading to negative
outcomes
Budgetary Slack or Padding the Budget
People often perceive that their performance will look
better in their superiors eyes if they can beat the
budget.
Budgetary Slack
The
practiceof
underestimating
budgetedrevenues,or
overestimating budgetedexpenses, in anefforttomakethe
resulting budgetedgoals (profits) moreeasilyattainable

Behavioral Impact of Budgets

Spending the budget is another issue;

managers often feel if they do not use
all the resources they receive, next
years budget may be cut.

Participative Budgeting
9-66

T o p M a n a ge m e nt
M id d le
M a na g e m e nt
S u p e rv is o r

S u p e rv is o r

M id d le
M a na g e m e nt
S u p e rv is o r

Flow of Budget Data

S u p e rv is o r

Controllability

Controllability refers to the degree of

influence that a manager has over the
revenues, costs, and other related
items for which the manager is
responsible.

The End