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Budget For Planning and Control

An integral part of the modern business enterprise, budgeting not only aids in the planning process, but it also
provides an array of accounting measures that can be used to hold managers accountable for the firm's
performance.

By Richard Sansing

A budget is a projected set of consequences of carrying out planned activity. Firms use budgets to facilitate the
communication of specialized information from throughout the firm so that an internally consistent production plan can be
devised. The budgeted numbers are then used to record certain transactions. Differences between budgeted and actual
performance then appear in the accounting records, and can be analyzed so as to evaluate the performance of the firm.

The budgeting process interacts with the operations research process in two ways. First, the budget process facilitates the
transfer of both accounting and non-accounting information to those involved in operations. This information provides a
basis for the formulation of the firm's production plan. Second, the budget reflects the production plan, and becomes a
benchmark for subsequent performance evaluation. An analysis of deviations from the budget provides additional
information that can be used when formulating the next period's production plan.

The Planning Stage
Feldman Toy Company makes two types of toys, regular and deluxe. Each toy requires the use of machine time in the
production process. To illustrate the way the budget process works, consider the machinery department in Feldman. First,
the department develops a flexible budget. A flexible budget for the machinery department is a prediction of that
department's expenses during the accounting period as a function of its level of activity. By analyzing prior results, the
department forecasts the relationship between its costs and activity level. For example, the department may use linear
regression analysis to identify the relationship between costs and activity levels. An activity that is highly correlated with
costs is sometimes referred to as a cost driver. Suppose monthly department costs vary with the number of machine
hours (M) used during the month in the following manner.
(1) Department costs = $60,000 + $15M
The slope term reflects the cost of an additional machine hour, often referred to as the marginal cost of machine time. It is
tempting, but imprecise, to refer to the intercept term as the department's fixed cost. If the true relationship between
department costs and machine hours is nonlinear, e.g., if marginal costs are increasing, the intercept term will reflect both
the fixed costs (department costs when machine hours are zero) as well as the nonlinearities in the cost function. For
example, suppose the true relationship was:
(2) Department costs = $68,000 + $7M + .002M2
If monthly machine usage was 2,000 hours per month, true total costs would be $90,000 and the marginal cost of
machine time would be $15. A linear regression would produce an equation like that in (1); the total and marginal costs
would be correct, but the intercept would not be a good approximation of the true fixed costs. The equation in (1) is
sometimes referred to as a local linear approximation (LLA) of the firm's cost curve.

In addition to the flexible budget, the machinery department provides an estimate of machine time usage for each product
as well as an estimate of total capacity for the month. Suppose the department estimates that the regular toy uses four
minutes of machine time and the deluxe toy uses eight minutes of machine time. These estimates, or standards, may
reflect average efficiency, ideal efficiency, or something in between. The department also estimates available machine
time for the month to be 2,000 hours. The production plan would reflect the marginal cost of machine time to be $1 per
unit for the regular toy (4 minutes @$15 per hour) and $2 per unit for the deluxe toy (8 minutes @$15 per hour). It would
also reflect the capacity constraint shown in (3).
(3) 4r + 8d < 120,000
The Production Stage
After accumulating information from throughout the firm, a production plan is chosen. Suppose this month's production
calls for 10,000 of each type of toy. The budgeted numbers now become the basis of the firm's standard costing system.
Under this system, department costs are assigned to products based on the standards reflected in the budget. Unlike the
planning stage, which only used the marginal costs of the machinery department, the assignment of costs during the
production stage should reflect all the costs of the department. This is called full absorption costing. Therefore, the
intercept of (1) should be assigned to products.

Because the department expects to use 120,000 minutes of machine time, it allocates $.50 for each minute used, so that
the intercept is "absorbed" into inventory. It allocates the marginal cost of $0.25 per minute to inventory as well. To
simplify the accounting process and prepare for the creation of evaluation measures, the department records actual costs
incurred in a temporary account, but assigns costs to products based on standard, not actual, usage. Therefore, $3 of
department costs are assigned to each regular toy produced (four minutes @ $0.75 per minute), and $6 of department
costs are assigned to each deluxe toy produced (eight minutes @ $0.75 per minute).

Suppose during the month the department actually incurs costs of $85,000. It worked on 11,000 regular toys and 9,000
deluxe toys. Total machine time was 118,000 minutes. How well did the department do, and why?

First, consider how the transactions were recorded during the month. The department accumulated the $85,000 costs
incurred in an overhead account. It then allocated $3 as each regular toy was produced, and $6 as each deluxe toy was
produced. This left a credit balance of $2,000 in the overhead account, which is closed to income at the end of the month.
This balance, or variance, can be decomposed into three distinct variances: the spending variance, the efficiency
variance, and the volume variance.

The spending variance is the difference between actual costs incurred and what would have been budgeted had the level
of the cost driver been known in advance. Using (1), the budget would have been $60,000 + ($0.25 x 118,000) = $89,500.
Therefore, there is a favorable spending variance of $4,500; costs were $4,500 lower than what we would have expected
based on prior experience, given that level of the cost driver.

The efficiency variance is the difference between what would have been budgeted given actual activity and what would
have been budgeted given actual output at standard usage. We would have expected to use total machine time of
[(11,000 x 4) + (9,000 x 8)] = 116,000 minutes, given actual production of 11,000 regular toys and 9,000 deluxe toys. At
standard usage, we would have budgeted overhead costs of $60,000 + ($0.25 x 116,000) = $89,000. Therefore, there is
an unfavorable efficiency variance of $500. The efficiency variance reflects the difference between actual and expected
machine usage, given output, multiplied by the marginal cost of machine time.

Finally, the volume variance is the difference between what would have been budgeted at standard usage and what was
actually assigned to products. Since $89,000 would have been budgeted, but only $87,000 was assigned to products, we
have an unfavorable volume variance of $2,000. This represents the difference between the 116,000 of standard usage
and 120,000 of capacity, multiplied by the $0.50 rate at which the intercept of (1) is assigned to products. Note that the
volume variance does not represent the opportunity cost of unused capacity.

Summing the three variances together yields a favorable variance of $2,000, the balance in the overhead account. The
variances are summarized in Figure 1. The analysis of the variance suggests we paid less than usual for the items that go
into overhead, used more machine time than our standards suggest, and had unused capacity.


Figure 1

The Evaluation Stage
These cost variances can be helpful in evaluating the performance of those responsible for them. The controllability
principle states that managers should only be evaluated based on those measures that they can control. However, this
principle is often misinterpreted. Suppose the machinery department production foreman is either competent or
incompetent. Consider four possible outcomes of efficiency and volume overhead variances: both favorable (FF),
favorable efficiency and unfavorable volume (FU), unfavorable efficiency and favorable volume (UF), and both
unfavorable (UU). Prior experience suggests the probabilities of each type of foreman and each combination of variances
is shown in Figure 2.


Figure 2

Casual application of the controllability principle suggests the foreman should be held responsible for efficiency variances,
but not volume variances; competent managers are more likely than incompetent managers to get a favorable efficiency
variance, but are just as likely to get a favorable volume variance. However, conditioned on the efficiency variance, the
volume variance is informative regarding the foreman's competence. Suppose your prior belief is that the manager is
competent with probability 50 percent. Upon seeing both favorable variances, you update your beliefs using Bayes' rule
so that the probability that the manager is competent is 75 percent. If you see a favorable efficiency and unfavorable
volume variance, however, the probability the manager is competent is only two-thirds.

Conclusion
Budgeting is a integral part of the modern business enterprise. It is a useful communication device for planning purposes,
and provides an array of accounting measures that can be used to hold managers accountable for the firm's performance.
4. Budgeting System used as instruments for planning and control

The budget is a short-term financial plan for the business that is prepared within the framework of the long-term plan.
Control can be exercised through the comparison of budgeted and actual performance. Where a significant divergence
emerges, some form of corrective action should be taken. If the budget figures prove to be based on incorrect
assumptions about the future, it might be necessary to revise the budget.
Figure 4.1 The planning and control process
Identify business objectives
Consider options
Evaluate options & make a selection
Prepare budgets
Perform and collect information on actual performance
Respond to variances and exercise control
Revise plans and (budgets) if necessary

As instrument for Planning

Budgeting systems turn managers perspectives forward and by looking to the future and planning, managers are able to
anticipate and correct potential problems before they arise (Horngren, Foster & Datar, 2000). Through budgeting,
management can plan ahead and maintain enough cash to pay creditors, to have adequate raw materials to meet
production requirements, and to have sufficient finished goods to meet expected sales (Kieso, 2002).
Careful planning is required to guide all parts of the organization towards its strategic long-term and short-term objectives.
Anthony & Govindarajan (2000) saw strategic planning as being focused on several years, contrasted to budgeting that
focuses on a single year and so a budget is a one-year slice of the organizations strategic plan. The budget prepared for
planning purposes, as part of the strategic planning process, is the quantitative plan of managements belief of what the
businesss costs and revenues will be over a specific future period (Davies & Boczko, 2005). According to Atrill &
McLaney (2002), a budgets role is to convert the long-term plans into actionable blueprints for the immediate future and
budgets will define precise targets concerning:
I. Cash, receipts and payments
II. Sales, broken down into amounts and prices for each of the products or services provided by the business
III. Detailed stock requirements
IV. Detailed labour requirements
V. Specific production requirements.
A series of long-term plans identifies how each objective is to be pursued, and budgets identify how the long-term plan is
to be fulfilled (Atrill & McLaney, 2002) and a master budget expounds action plans to attain the organizations short-term
objectives (Blocher & et al., 2008).
Hence, the long-term [strategic] objectives may be divided and broken down into short-term [budget planning] objectives
and budgeting can be used to fulfill these objectives as it provides a written plan of action that facilitates proactive
management whereby diverse elements of the organization are guided towards a common set of objectives and
managers are forced to develop a set of actions ahead of time and quantify them in financial terms (Berry, 2006).
Figure 4.2 shows the sequences of each step in the process and the relationship between strategic planning and
budgeting and how budgeting can fit into the overall strategic planning process.
Figure 4.2 The strategic planning relationship with budgeting
Budget revision
1.
Strategic planning
2. Operational planning planning
3. Budgeting
4. Controlling and measuring
5. Reporting, analyzing and feedback
Revision of strategic plans
Operational plans revised
action
Source: Davies & Boczko (2005, p.412)
In addition, budget can be used to plan for capital expenditure of the organization. Capital investment is often costly and is
tied to strategic and operational planning of an organization. According to Blocher & et al. (2008), long range plan
[strategic] often entails capital budgeting, which is a process for evaluating, selecting and financing major projects such as
purchases of new equipment and addition of new products. These plans will need to be carefully monitored and action
taken to combat the effects of changes in the perceived environment. Through budgeting, management can allocate
sufficient funding for this capital expenditure, if justified. It is important to calculate the return of investment [ROI], conduct
risk analysis and risk assessment so as to justify for every capital expenditure in the budget and to note that all budgets,
eg. Sales, production, capital expenditure, research and development, are interrelated.

As instrument for Control
Control and monitoring are the continuous comparison of actual results with those planned, both in total, and for the
separate divisions within the organization, and taking appropriate management action to correct adverse variances and to
exploit favorable variances (Davies & Boczko, 2005).
The budgeting system also provides a mechanism for achieving control for both costs and revenues by continuously
comparing actual with planned results (Chadwick, 2002). Hence, by setting a budget in advance, organization can control
the expenditure as well as the production costs by performing the variance analysis to compare the actual with planned
budgets so as to avoid over-spend on the budget allocated.
Areas of efficiency and inefficiency are also identified through reporting of variances, and variance analysis will prompt
remedial action where necessary. For example, in reporting the variances, those that are considered to be significant and
the reasons why they have occurred, should be highlighted on the comparative statement. This will subsequently enable
management to focus on them, and give priority to sorting out the appropriate corrective action. Chadwick (2002)
describes this system of highlighting significant variances as management by exception.
Part of the budget process should identify the people responsible for items of cost and revenue so that areas of
responsibility are clearly defined. Budget holders can only be responsible for controllable costs or revenues within their
areas of responsibility. For example, a production manager may be responsible for ensuring that he does not exceed the
number of direct labour hours allowed within their area of responsibility for a given level of output. In a similar way, a
budget holder may be responsible for controlling costs of a department that relate to sales volumes or other variable
activities. Monitoring of actual performance against the budget is used to provide feedback in order to take the appropriate
action necessary to reach planned performance, and to revise plans in the light of changes.
The budget prepared for control purposes is used for motivational purposes to influence improved departmental
performance. Budget has the ability to motivate managers to better performance. Having a stated task can motivate
managers and staff in their performance. Atrill & McLaney (2002) argues that managers will be better motivated by being
able to relate their particular role in the business to the overall objectives of the business. Since budgeting are directly
derived from corporate objectives, budgeting makes this possible.
Budget can also provide a basis for a system of control (Atrill & McLaney, 2002). If senior management wishes to control
and to monitor the performance of more junior staff, it needs some yardstick against which the performance can be
measured and assessed. If there are data available concerning the actual performance for a period, and this can be
compared with the planned performance, then a basis for control will have been established
CHAPTER 8
Budgeting for Planning and Control

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Define budgeting and discuss its role in planning, controlling, and decision making.
2. Prepare the operating budget, identify its major components, and explain the interrelationships of the various
components.
3. Identify the components of the financial budget, and prepare a cash budget.
4. Describe budgets for merchandising and service firms.
CHAPTER SUMMARY
This chapter explains how budgeting plays a key role in planning, controlling, and decision making, as well as improving
communication and coordination. The chapter focuses on the master budget and identifies its major components. The process of
preparing a set of operating and financial budgets for the budget period is described with the emphasis on the interrelationships of
the various budgets. The chapter concludes by describing budgets for merchandising and service firms.
CHAPTER REVIEW
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 organizations 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.
Review textbook Exhibit 8-1, which illustrates the
relationship of budgets to planning, operating, and control.
A. 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 futureto 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 companys 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
Learning Objective #1
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 companys 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.
Review textbook Exhibit 8-2, which illustrates the components of the master budget.
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
Review textbook Schedule 1, which provides a numeric example of the sales budget.
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 companys inventory policy and, thus, the beginning inventory
and desirable ending inventory levels.
Units to be produced =
Ending inventory units + Units sales Beginning inventory units
Review textbook Schedule 2, which provides a numeric example of the production budget.

Note that the production budget is driven by the sales budget.
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
Review textbook Schedules 3,4, and 5, which provide numeric examples of the direct material purchases
budget, the direct labor budget, and the overhead budget.
Note that the direct materials purchase budget, the direct labor budget, and the overhead budget
are based on the production budget.
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.
Review textbook Schedules 6 and 7, which provide numeric examples of the ending finished goods
inventory budget and the cost of goods sold budget.
Note that the ending finished goods inventory budget and the cost of goods sold
budget draw information from the direct materials purchases budget, the direct labor
budget and the overhead budget.
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
Review textbook Schedule 8, which provides a numeric example of the
marketing expense budget.
Note that the marketing expense budget is driven by the sales budget.
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.

II. 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.
Review textbook Exhibit 8-4, which shows the cash budget equation.
Review textbook Schedule 12, which provides a numeric example of the cash budget.
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.