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By Puneet Mathur
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1
Budget Preparation
2
Key Topics
• The basics of budgeting
• Why budgets are important for control purposes
• Various types of budgets
• When each type of budget is used
• How to prepare some of the important budgets
• What are their limitations
• Behavioral implications
3
What is a budget?
• Budgets are summaries of short-term
operational activities of a firm.
• For example, a firm may prepare cash budget
to predict cash inflows and outflows or
• A production budget to plan its production
levels.
• Budgets are quantitative representations.
4
How does a budget differ from a forecasting?
• A forecast is a prediction and usually
• There are many ifs and buts before a forecast
resembles reality.
• Most importantly, a forecaster can only predict
(sales would increase by 20% by next year).
However,
• A forecaster cannot shape the selling events to
make the sales go up by 20%
5
How does a budget differ from a forecasting?
• In contrast, a budget is a plan (sales must go up by 20%
by next year).
• The budget plan is based on facts, events in progress,
actions planned, etc.
• The budget preparer must consult those affected, obtain
input before preparing the budget, and
• The Manager of a unit must take active steps to achieve
the budget.
• Both forecasts and budgets are necessary. Forecast is
useful for planning while budget is useful for both
planning and for controlling.
6
Characteristics of a budget
• Stated in monetary units but,
• Could contain non-monetary items such as units
produced, sold, no. of items processed etc.
• Usually, short-term (one year) but could be extrapolated
from or to the longer term.
• Senior management must be involved in the process and
must approve it.
• Most important – budgets must be compared to actual
and the variances must be investigated.
7
Usefulness of the budget
• Fundamentally, it is a planning and control tool (coordination,
problem signaling, and problem-solving activities).
• It is a good tool to communicate short-term goals to employees.
• It also helps senior management in assessing whether
organizational goals are met (e.g. improvement in customer
service but no allocation for employee training).
• Since input is required from multiple units, it promotes
coordination, planning, and sharing.
• Allows a firm to anticipate problems so that corrective action
can be taken early.
8
How does a budget help with strategic planning?
• Strategic Plan: Tells managers what the organizational goals for this
year are (e.g. sales growth, profits, new products, expansion in
production capacity).
• To accomplish the plan, every unit must contribute through its efforts.
• Therefore, each unit is subjected to a budgeting plan, process, and
proposed results (operational plan).
• Collectively, the individual budgets would point out whether the
strategic plan is likely to be achieved or not.
• If not, what corrective actions must be taken.
• Consequently, budget not only demands responsibility but also
accountability.
9
How does a budget help with performance evaluation or accountability?
• By creating benchmarks.
• A budget is a rationally prepared set of
benchmarks.
• By comparing actual performance to the budget,
deviations can be ascertained and evaluated.
• Within reasonable limits, the budget points to
accomplishments or lack thereof.
10
Static (Fixed) vs. Flexible Budgets
Static Budget Flexible Budget
• Prepared for only one level
of sales volume
• Prepared for several different
volume levels within a
relevant range
• Separates fixed and variable
costs
Variance = difference between actual and budgetVariance = difference between actual and budget
Favorable – actual amount increases income
Favorable – actual amount increases income
Unfavorable – actual amount decreases income
Unfavorable – actual amount decreases income
10
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Static Budget Variances
Sales Volume VarianceFlexible Budget Variance
Actual Results
Flexible Budgetbased on actual
number of outputs
Static Budgetbased on expectednumber of outputs
Static Budget Variance
11
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Budget Variances
Sales Volume VarianceSales Volume Variance
Flexible Budget (for the number of units actually sold)
Flexible Budget (for the number of units actually sold)
Master Budget (for the expected
number of units to be sold)
Master Budget (for the expected
number of units to be sold)
Flexible Budget Variance
Flexible Budget Variance
Actual results(for the actual number
of units to be sold)
Actual results(for the actual number
of units to be sold)
Flexible Budget (for the number of units actually sold)
Flexible Budget (for the number of units actually sold)
12
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Example
Actual Results at
Actual Prices
Flexible Budget
Variance
Flexible Budget for Actual # of Output Units
Sales Volume Variance
Static Budget
Output units 41,000 - 41,000 7,000 F 34,000
Sales revenue 215,000$ -$ 215,000$ 19,000$ F 196,000$ Variable costs 85,000 6,000 U 79,000 9,000 U 70,000 Fixed costs 107,000 6,000 U 101,000 - 101,000
Total costs 192,000 12,000 U 180,000 9,000 U 171,000 Operating income 23,000$ 12,000$ U 35,000$ 10,000$ F 25,000$
White Pro CompanyIncome Statement Performance
Year Ended J uly 31, 2011
13
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MASTER BUDGETMASTER BUDGET
A comprehensive—master—budget is a formal
statement of management’s expectation regarding
sales, expenses, volume, and other financial
transactions for the coming period. It consists
basically of a pro forma income statement, pro
forma balance sheet, and cash budget.
The budget is classified broadly into two categories:
1. Operating budget
2. Financial budget
15
Various types of budgets
• Two major types:
• Operating budgets (most middle level managers would be involved
in this process)
• Capital or Investment budgets (mostly senior managers are
involved in this process)
• Operating budget could includes several sub-budgets (e.g.
Revenue budget, production budget, marketing budget, etc.)
• Budgeted Balance Sheet & cash flow statement also worked out as
part of the budgeting process
• MBOs & role of MBO in the budgeting process
16
CAPITAL BUDGETINGCAPITAL BUDGETING
Capital budgeting relates to planning for the best selection and
financing of long-term investment proposals.
Capital budgeting decisions are not equally essential to all
companies. The relative importance of this function varies with
company size, the nature of the industry, and the growth rate
of the firm.
As a business expands, problems regarding long-range
investment proposals become more important.
17
CAPITAL BUDGETINGCAPITAL BUDGETING
The two broad categories of capital budgeting decisions are
screening decisions and preference decisions.
Screening decisions relate to whether a proposed project
satisfies some current acceptance standard. For instance, a
company may have a policy of accepting cost reduction
projects only if they provide a return of, say, 15 percent.
Preference decisions apply to selecting from competing
courses of action. For example, a company may be looking at
four different manufacturing machines to replace an existing
one. The selection of the best machine is referred to as a
preference decision.
18
The Budgeting Process –Where do we begin and when do we end it?
• An organization’s strategic goals is the starting point for
the budgeting process.
• Projected financial results for the next year is compared to
the goals to assess acceptability.
• The budgeting process is driven by the demand forecast
(demand for a product at a given price).
• Demand forecast can be developed in multiple ways
(market survey, growth trends, or other estimates).
• Based on demand forecast, prepare a sales plan for each
product line and services.
19
The budgeting process (continued)
• Based on the sales plan, develop the factors of
production (or other procurement) – raw
materials, labor, overheads, cash.
• Lots of details would improve the budgeting
process but is time consuming and expensive.
Strike a balance.
20
Budget Preparation Process – Role of Budget Dept
• Publishes procedures & forms for budget
• Coordinates & publishes corporatewide assumptions that are the
basis for the budget
• Provides assistance to the budgetees in budget preparation
• Analyzes proposed budgets & makes recommendations initially
to budgetee & then to Sr. mgmt
• Administers process of making budget revisions during the year
• Coordinates work of budget depts within the units
• Analyzes reported performance against budget, interprets the
results & prepares summary reports for Sr mgmt
21
Key Steps in Budget Formulation
• Budget Committee Formulation
• Issuance of Guidelines
• Initial Budget Proposal
• Negotiation
• Review & Approval
• Budget Revisions
• Contingency Budgets
22
Preparing the initial budget
• Initial budget preparation is done by each
responsibility center (revenue centers, cost
centers, etc.)
• Because, they know more about their individual
units, requirements, constraints, etc.
• Thee centers must consider both external factors
and internal factors that could have an impact on
their budget estimates.
23
TopManagement
Middle Management
Middle Management
Supervisor Supervisor Supervisor Supervisor
Note: Initial flow of budget data in a participatory system is from lower levels of responsibility to higher levels of responsibility. Each responsibility center manager prepares his/her budget estimates and submits to the next higher level of management. These estimates are reviewed and consolidated as they move upward in the organization.
24
Budgeting Process – The Role of the Responsibility Centers
• Prepare the budget compatible with organizational
goals.
• Communicate with other units and validate unit’s
numbers.
• Don’t be optimistic but do not be pessimistic to show
achievement of budget targets.
• Remember that eventually, resp. center budgets are
subject to approval by senior managers and analysts,
and are subject to revisions.
25
What we rarely discuss – Human Factors in Budgeting
• Regardless of what we discussed so far,
• Budget process depends on 1) the degree to which top
management accepts the budget program and 2) the way
top management uses the budget data.
• Top management should NOT use the budget as a weapon
to pressure employees or to blame if something goes wrong.
• There should be meaningful dialogue
• The human aspect is the key
• Budget Dept plays key role in maintaining balance
26
Let us now prepare one or two small budgets – use the description and the numbers given in the next set of slides.
The exercises would give you a basic idea of the budgeting process (although not the human interactions involved during such a process)
27
Mylar Company
• Manufactures and sells a product that has
seasonal variations in demand with peak sales
coming in the 3rd quarter. The following
information concerns operations for Year 2 –
the coming year – and for the first two quarters
of Year 3.
28
Mylar Company data
The company’s single product sells for $8 per unit. Budgeted sales in units for the next six quarters are as follows:
Year 2 Quarter Year 3
Quarter
1 2 3 4 1 2
Budgeted Sales in Units
40,000 60,000 100,000 50,000 70,000 80,000
29
Mylar Company Data• Sales are collected: 75% in the qr. Sales are made, remaining 25% in the following quarter. On
Jan. 1, Year 2, the balance sheet showed $65,000 in accounts receivable, all of which will be
collected in the first quarter of the year. Bad debts are negligible and can be ignored.
• Company desires an ending inventory of finished units on hand at the end of each quarter
equal to 30% of the budgeted sales for the next quarter. On Dec. 31, year 1, the company
12,000 units on hand.
• Five pounds of raw materials are required to complete one unit of product. Company requires
an ending inventory of raw materials on hand at the end of each quarter equal to 10% of the
production needs of the following quarter. On Dec. 31, Year 1, the company had 23,000
pounds of raw materials on hand.
• The raw material costs $0.80 per pound. Purchases of raw material are paid for in the
following pattern: 60% in the quarter purchases are made, remaining 40% in the following
quarter. On Jan. 1, Year 2, the company’s balance sheet showed $81,500 in accounts payable
for raw material purchases, all of which will be paid for in the first quarter of the year.
30
Mylar Company
• We will prepare:
• A sales budget and a schedule of expected
cash collections.
• A production budget
• A direct materials purchases budget and a
schedule of expected cash payments for
material purchases.
31
Sales Budget for Mylar
Year 2 Quarter
1 2 3 4 Year
Bud. Sales 40,000 60,000 100,000 60,000 250,000
Selling price per unit
X $8 X $8 X $8 X $8 X $8
Total Sales
$320,000 $480,000 $800,000 $400,000 $2,000,000
Based on these numbers, we will prepare a schedule of cash collections
32
Mylar – Schedule of Cash Collections
Year 2 Quarter
1 2 3 4 Year
A/Rec. Beg. Bal. 65,000 65,000
1st Qr. Sales
(320,000x75%, 25%)
240,000 80,000 320,000
2nd Qr. Sales
(480,000 x75%, 25%)
360,000 120,000 480,000
3rd Qr. Sales
(800,000x75%, 25%)
600,000 200,000 800,000
4th Qr. Sales
(400,000x75%, 25%)
300,000 300,000
Total Cash Collections 305,000 440,000 720,000 500,000 1,965,000
33
Year1 2 3 4 1 2
40,000 60,000 1,00,000 50,000 2,50,000 70,000 80000Desired End. Inv.* 18,000 30,000 15,000 21,000 21,000 24,000Total needs 58,000 90,000 1,15,000 71,000 2,71,000 94,000
-12,000 -18,000 -30,000 -15,000 -12,000 -21,00046,000 72,000 85,000 56,000 2,59,000 73,000
*30% of following qr. Budgeted sales in units
Req. Production
Year 2 Quarter Year 3 Quarter
Bud. Sales (units)
Less. Beg. Inv.
Based on Sales Budget, The Production Budget for Mylar
34
Year 2 Yr. 3 Qr. 11 2 3 4
46,000 72,000 85,000 56,000 2,59,000 73,000x 5 x 5 x 5 x 5 x 5 x 5
2,30,000 3,60,000 4,25,000 2,80,000 12,95,000 3,65,00036,000 42,500 28,000 36,500 36,500
2,66,000 4,02,500 4,53,000 3,16,500 13,31,500 23000 36000 42500 28000 23000
2,43,000 3,66,500 4,10,500 2,88,500 13,08,500
Less Beg. RM (lbs.)Raw materials to purchase (lbs.)
Year 2 Quarter
Req. Production
Raw Materials (lbs.)
Production needs (in lbs.)
Add. Desired End. Inv.
Total Needs (lbs.)
Mylar – Production Budget – Raw Material Requirement