I.

The Role of Budgeting in Planning and Control

Budgeting plays a crucial role in planning and control.
 Budgets are the quantitative expressions of plans that identify an
organization’s objectives and the actions needed to achieve them.
They form the basis for operations.
 Control is the process of setting standards, receiving feedback on
actual performance, and taking corrective action.
 Budgets can be used to compare actual outcomes with planned
outcomes.
Purposes of Budgeting
The system of budgets serves as the comprehensive financial plan
for the organization as a whole.
Advantages of budgeting include:
1. Budgeting forces management to plan for the future—to develop
an overall direction for the organization, foresee problems, and
develop future policies.
2. Budgeting helps convey significant information about the
resource capabilities of an organization, making better decisions
possible. Example: A cash budget points out potential shortfalls.
3. Budgeting helps set standards that can control the use of a
company’s resources and control and motivate employees.
4. Budgeting improves the communication of the plans of the
organization to each employee. Budgets also encourage
coordination because the various areas and activities of the
organization must all work together to achieve the stated
objectives.
B. The Budgeting Process
The budgeting process can range from fairly informal to elaborately
detailed.
1. Directing and Coordinating
a. The budget director, usually the controller or someone who
reports to the controller, is responsible for coordinating and
directing the overall budgeting process.
b. The budget committee has the responsibility to oversee the
budgeting process that will:
 Review the budget.
 Provide policy guidelines and budgetary goals.
 Resolve differences that may arise as the budget is
prepared.
 Approve the final budget.
 At this point, the final budget becomes the plan for the
coming year. Then, the budget committee will:
 Monitor the actual performance of the organization as the
year unfolds.
 Ensure that the budget is linked to the strategic plan of the
organization.
2. Building the Master Budget
a. The master budget is a comprehensive financial plan made
up of various individual departmental and activity budgets for
the year. A master budget can be divided into:
(1) Operating budgets, which outline the income-generating
activities of a firm (sales, production, and finished goods
inventories).
 The outcome of the operating budgets is a pro forma
(budgeted) income statement.
(2) Financial budgets, which outline the inflows and
outflows of cash and the financial position.
 The outcome of the financial budgets includes a cash
budget and a pro forma (budgeted) balance sheet.
The master budget is usually prepared for a one-year period
corresponding to the company’s fiscal year.
The yearly master budget can be broken down into quarterly
and monthly budgets to allow managers to compare actual
data with budgeted data as the year unfolds and to make
timely corrections.
b. A continuous (or rolling) budget is a moving 12-month
budget.
As a month expires in the budget, an additional month in the
future is added so that the company always has a 12-month
plan on hand.
c. A continuously updated budget updates the master budget
each month as new information becomes available.
It works like a rolling forecast that provides year-to-date
results and the forecast for the remainder of the year.
C. Gathering Information for Budgeting
The primary sources of data that are used to create budgets
include:
1. Historical Data
Based on their knowledge of coming events, managers can use
historical data from similar previous situations to predict costs.
2. Sales Forecasts
 The sales forecast is the basis for all of the other operating
budgets and most of the financial budgets. Thus, it is important
to have accurate sales forecasts. The accuracy of the sales
forecast can be improved by:
 Considering external factors, such as the general economic
climate, competition, advertising, and pricing policies.
 Using formal approaches, such as time-series analysis,
correlation analysis, econometric modeling, and industry
analysis.
3. Forecasting Other Variables
 Costs and cash-related items are critical.
 Many of the same factors considered in sales forecasting apply
to cost forecasting.

II. Preparing the Operating Budget

The first part of the master budget is the operating budget. The
components of the operating budget include the following:
A. The sales budget is the projection approved by the budget
committee that describes expected sales for each product in units
and dollars for the coming period.
 The sales budget may reveal seasonal fluctuations in sales.
Sales = Units × Unit selling price
B. The production budget describes how many units must be
produced to meet sales needs and satisfy ending inventory
requirements.
 The production budget must consider the company’s inventory
policy and, thus, the beginning inventory and desirable ending
inventory levels.
Units to be produced =
Ending inventory units + Units sales – Beginning
inventory units
C. The direct materials purchases budget outlines the expected
usage of materials for production, inventories, and purchases of the
direct materials required.
The direct materials usage is determined by the input-output
relationship of each product as follows:
Expected DM usage = DM units needed per unit of
output × Units of output
 Budgeted DM purchases in units =
Desired ending DM units + Expected DM usage –
Beginning DM units
DM purchase costs = Budgeted DM purchases in units ×
Unit price
Note that a separate schedule is prepared for each kind of direct
material.
D. The direct labor budget shows the total direct labor hours needed
and the associated cost based on the input-output relationship of
each product.
Expected DL hours = DL hours needed per unit of output
× Units of output
DL costs = Expected DL hours × Wage rate
E. The overhead budget shows the expected cost of all indirect
manufacturing items.
 The estimated overhead is divided into variable and fixed
components:
Total overhead = (Variable overhead rate × Activity
level per chosen cost driver)
+ Budgeted total fixed overhead
F. The ending finished goods inventory budget supplies
information needed for the balance sheet and serves as input for
the preparation of the cost of goods sold budget.
 It provides information for the unit cost of a finished product and
the cost of the expected inventories.
G. The cost of goods sold budget provides the information needed for
the pro forma income statement.
H. The marketing expense budget outlines planned expenditures
for selling and distribution activities.
 The estimated marketing expense is divided into variable and
fixed components:
Total marketing expense = (Variable marketing rate ×
Sales activity level)
+ Budgeted total fixed marketing expenses
I. The research and development expense budget outlines the
estimated expenditures of research and development activities for
the coming year.
J. The administrative expense budget consists of estimated
expenditures for the overall organization and operation of the
company.
  Most of the administrative expenses are fixed costs with respect
to sales.
K. The budgeted income statement is based on all of the component
budgets.

III. Preparing the Financial Budget

The financial budgets are the second part of the master budget. The
financial budgets usually include the cash budget, the budgeted
balance sheet, the budgeted statement of cash flows, and the budget
for capital expenditures.
 Note that the master budget and the associated financial budget are
plans for one year.
 The capital expenditures budget is a financial plan outlining the
expected acquisition of long-term assets, typically over a number of
years.
A. The Cash Budget
The cash budget is a detailed plan that shows all expected sources
and uses of cash. Much of the information needed to prepare the
cash budget comes from the operating budgets.
The cash budget includes five main sections:
1. The total cash available section shows that:
Total cash available = Beginning balance + Cash receipts
Cash receipts include primarily:
a. Cash sales.
b. Collection from sales on account (credit sales).
 The collection pattern of credit sales can be determined by
past experience using an accounts receivable aging
schedule.
2. The total cash disbursements section includes all planned cash
outlays for the
period, including the purchase of materials, payment of wages, and
payment of other
expenses.
The cash disbursements section does not include:
a. Interest payment on short-term loans (these appear in the
financing section).
b. Noncash expenses such as depreciation.
 3. The cash excess or deficiency section compares the cash
available with the cash needed.
Total cash needed = Total cash disbursements + Minimum
cash balance
The minimum cash balance is the lowest amount of cash on hand
that the firm finds acceptable.
4. The financing section of the cash budget consists of:
a. Borrowings.
b. Planned repayments, including interest.
5. The planned ending cash balance section reflects the inclusion of
the minimum cash balance, which was subtracted to find the
cash excess or deficiency.

B. Budgeted Balance Sheet

The preparation of the budgeted balance sheet depends on
information from the current balance sheet and the information in
the other budgets in the master budget.

IV. Operating Budgets for Merchandising and Service Firms

A. A merchandising firm has a merchandise purchases budget to

identify the quantity of each item that must be purchased for resale,
the unit cost of the item, and the total purchase cost.
B. In a for-profit service firm, the sales budget identifies each service
and the quantity that will be sold.
 The sales budget is also the production budget because the
service produced will be identical to the service sold.
C. In a not-for-profit service firm, the sales budget identifies the level
of various services that will be offered for the coming year and the
associated funds that will be assigned to the services.