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Objective 1.

What is a budget?  A budget is a financial plan that managers use to coordinate the business’s activities. All types
of companies can benefit from using budgets, including nonprofit organizations

Budgeting Benefits 

Budgeting requires managers to plan, promote coordination and communication, and provides a benchmark for
evaluating actual performance.

Planning  Budgeting requires managers to plan for the company’s future. Decisions are then based on this
formalized plan, which helps prevent haphazard decision making. For example, if the company plans to expand into a
new market, the budget will include expected funding sources and expenditures for the expansion. Keep in mind,
however, that budgets are plans for future activities and may need to be modified.

Coordination and Communication  The budget coordinates a company’s activities. Creating a budget facilitates
coordination and communication by requiring managers at different levels and in different functions across the
entire value chain to work together to make a single, unified, comprehensive plan for the business.

Benchmarking: The practice of comparing a company with its prior performance or with best practices from other
companies.

Participative Budget  A budgeting process where those individuals who are directly impacted by a budget are
involved in the development of the budget.

Budgeting and HR:

What is the most important part of a budgeting system? It is getting managers and employees to accept the budget
so the company can benefit from the control and feedback illustrated in Exhibit 22-1.  If managers use the budget
as a benchmark to evaluate employees’ performance, managers must first motivate employees to accept the
budget’s goals. Here is how they can do it:

 Managers must support the budget themselves, or no one else will

 Managers must show employees how budgets can help them achieve better results.
 Managers must have employees participate in developing the budget so that employees feel the goals are
realistic and achievable

Budgetary Slack  Occurs when managers intentionally understate expected revenues or overstate expected
expenses to increase the chances of receiving favorable performance evaluations. 
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Objective 2.

The Different types of budgets

Zero-based Budget  all revenues and expenses must be justified for each new period. This approach assumes that
operations are being started for the first time and the previous year’s actual results are ignored.

Strategic and Operational Budgets:

1. Strategic Budget  A long-term financial plan used to coordinate the activities needed to achieve the long-
term goals of the company.
2. Operational Budget  A short-term financial plan used to coordinate the activities needed to achieve the
short-term goals of the company  Operational budgets are most often one year in length (generally
encompassing the fiscal year) but may also span only a week, a month, or a quarter, depending on the
company’s needs

Continuous Budget  Involves continuously adding one additional month to the budget as each month goes by.

Static Budget  A budget prepared for only one level of sales volume. For example, Smart Touch Learning, the
fictitious company we have used to illustrate accounting concepts throughout the textbook, may prepare a
budget based on annual sales of 2,000 touch screen tablet computers. All revenue and expense calculations
would be based on sales of 2,000 tablets

Flexible Budget  A budget prepared for various levels of sales volume.This type of budget is useful for what if
analysis. Smart Touch Learning may expect to sell 2,000 tablet computers, but a flexible budget showing results
for selling 1,600 tablets, 1,800 tablets, 2,000 tablets, 2,200 tablets, and 2,400 tablets allows managers to plan for
various sales levels. Flexible budgets are covered in detail in the next chapter.

Master Budget  The set of budgeted financial statements and supporting schedules for the entire
organization; includes the operating budget, capital expenditures budget, and financial budget.

Operating Budget  The set of budgets that projects sales revenue, cost of goods sold, and selling and
administrative expenses, all of which feed into the cash budget and then the budgeted financial statements.

Capital Expenditures Budget  The budget that presents the company’s plan for purchasing property, plant,
equipment, and other long-term assets.

The exhibit shows that the master budget includes three types
of budgets:

 The operating budget 1

 The capital expenditures budget 2
 The financial budget 3
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The operating budget  The set of budgets that projects sales revenue, cost of goods sold, and selling and
administrative expenses, all of which feed into the cash budget and then the budgeted financial statements.

Capital Expenditures Budget  The budget that presents the company’s plan for purchasing property,
plant, equipment, and other long-term assets.
Financial Budget  The budget that includes the cash budget and the budgeted financial statements.
Cash Budget  The budget that details how the business expects to go from the beginning cash balance to
the desired ending cash balance
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Objective 3. How are operating budgets prepared for a manufacturing company?
Sales Budget  The budget that estimates the amount of sales revenue.

Production Budget  Budgeted products to be sold + Desired products in ending inventory = Total products
needed. and is the basis for the production costs budgets: direct materials budget, direct labor budget, and
manufacturing overhead budget. Additionally, the information is used to complete the cost of goods sold
budget.

Once the calculations for desired ending inventory are determined, the company can determine the
production for each quarter. Exhibit 22-5 illustrates the production budget for Smart Touch Learning. Notice
that the desired ending inventory is added to the budgeted tablets to be sold to determine the total needed.
The beginning inventory is then subtracted to determine the number of tablets to be produced each quarter.
The beginning inventory for the first quarter is found on the December 31, 2020, balance sheet (Exhibit 22-3)
which indicates the Finished Goods Inventory account has a balance of $55,000, consisting of 200 tablets at a
cost of $275 each. The ending inventory of one quarter always becomes the beginning inventory of the
following quarter.
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Objective 4.
Capital Expenditures Budget
The capital expenditures budget estimates the purchases of property, plant, and equipment, such as delivery
trucks, computer systems, office furniture, and manufacturing equipment.

Cash Budget:
The cash budget estimates the cash receipts and cash payments for a period of time and pulls information
from the other operating budgets previously prepared. The cash budget includes three sections: cash
receipts, cash payments, and short-term financing.

Cash Receipt  cash sales and credit sales

Cash Payments
Smart Touch Learning has cash payments for capital expenditures, product costs (direct materials purchases,
direct labor costs, and manufacturing overhead costs), and selling and administrative expenses. Therefore,
the calculations for cash payments require reference to several previously developed budgets.
Short-term Financing  Ending cash balance before financing + Total effects of financing = Ending cash
balance - Principal x Rate x Time = Interest Expense
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Objective 5.

Sales Budget 
In a merchandising company, just as with a manufacturing company, the forecast of sales revenue is the
cornerstone of the master budget because the level of sales affects expenses and almost all other elements
of the master budget. Budgeted total sales for each product equal the sales price multiplied by the expected
number of units sold.

Inventory, Purchases, and Cost of Goods Sold Budget

The budget that estimates the cost of goods sold, ending Merchandise Inventory, and merchandise
inventory purchases needed for the company’s projected sales.

Objective 6.
Cash Receipts 
The primary source of cash is from customers. The sales budget illustrated in Exhibit 22-21 shows the total
sales for the period. Recall that the company’s sales are 60% cash and 40% on credit. The 40% credit sales
are collected the month after the sale is made. Exhibit 22-24 shows that April’s budgeted cash collections
consist of two parts
1. April’s cash sales from the sales budget in Exhibit 22-21 ($30,000
2. Collections of March’s credit sales ($16,000 Accounts Receivable from the March 31 balance sheet,
Exhibit 22-20).

Cash Payments.
Greg’s Games pays for merchandise inventory purchases 50% during the month of purchase and 50% the
month after purchase. Use the inventory, purchases, and cost of goods sold budget from Exhibit 22-22 to
compute budgeted cash payments for purchases of inventory. April’s cash payments for purchases consist of
two parts:
1. Payment of 50% of March’s purchases ($16,800 Accounts Payable balance from the March 31 balance
sheet, Exhibit 22-20).
2. Payment for 50% of April’s purchases (50% * $51,800 = $25,900).
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Objective 7.

Budgets require companies to complete many calculations and technology can make it more cost effective for
managers to
1. Conduct sensitivity analysis
2. Combine individual unit budgets to create the company wide master budget.

Sensitivity Analysis.
 The master budget models the company’s planned activities. Top management pays special attention to
ensure that the results of the budgeted income statement and the budgeted balance sheet support key
strategies
 Actual results, however, often differ from plans. Management, therefore, wants to know how budgeted
income and cash flows would change if key assumptions turned out to be incorrect. We previously defined
sensitivity analysis as a what if technique that asks what a result will be if a predicted amount is not achieved
or if an underlying assumption changes. What if the stock market crashes? How will this affect Smart Touch
Learning’s sales? Will it have to postpone a planned expansion? What will the company’s cash balance be on
June 30 if the period’s sales are 25% cash, not 30% cash? Will Smart Touch Learning have to borrow more
cash?
 Many companies use computer spreadsheet programs like Excel to prepare master budget schedules and
statements. Today, what if budget questions are easily answered within Excel with a few keystrokes
 Check Your Understanding 22-1 and 22-2 (located in the review section) are examples of sensitivity analyses
for Smart Touch Learning.

Budgeting Software
 Companies often turn to budget-management software to solve this problem. Often designed as a
component of the company’s Enterprise Resource Planning (ERP) system, this software helps managers
develop and analyze budgets.
 Software also allows managers to conduct sensitivity analyses on their own segment’s data. When the
manager is satisfied with his or her budget, he or she can easily enter it in the companywide budget. His or
her segment’s budget automatically integrates with budgets from all other business segments—from around
the building, around the state, around the country, or around the world.
 Whether at headquarters or on the road, top executives can log into the budget system through the Internet
and conduct their own sensitivity analyses on individual business segments’ budgets or on the companywide
budget. The result is that managers spend less time compiling and summarizing data and more time
analyzing and making decisions that ensure the budget leads the company to achieve its key strategic goals.