Strategic Cost Management: Module 3

BUDGETING

Budgeting

 A detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a given period of time
 It is a quantitative plan for acquiring and using resources over a specific time period to achieve its goals and objectives
 Formal documents that quantify a company’s plans for achieving its goals

Function of the Budget

Advantages and Limitations of Budgeting

Advantages Limitations

1. Communicate management’s plans throughout the 7. It takes considerable amount of resources (time,
organizations cost, etc) to develop

2. Force managers to think and plan for the future 8. At the end of the day, budgets are still type of
forecast (no matter how knowledge-based or
3. Allocate resources when they can be used most effectively scientific based) requires judgment and guessing
which may or may not occur- needs for modification,
4. Uncover potential bottlenecks
and or revisions
5. Coordinate the activities of the entire organization
9. Cooperation and participation of the different level of
6. Serve as benchmarks for evaluating subsequent performance the organization is required

10. A budget is an aid to management not a substitute

for management

Essentials of an Effective Budgetary Process

● Depends in a sound organizational structure with authority and responsibility for all phases of operations clearly defined

○ Top management must be enthusiastic and committed to the budget process

○ Top management must not use the budget to pressure employees or blame them when something goes wrong

○ Highly achievable budget targets are usually preferred when managers are rewarded based on meeting budget targets

● Based on research and analysis with realistic goals

● Accepted by all levels of management

 ● In relation to Responsibility accounting- managers should be held responsible for those items- and only those items- that they can
actually control

Types of Budgets

● As to Activity Base

○ Static- projection of budget data using one level of activity and ignoring different levels of activity

○ Flexible- projection of budget data for various level of activity

● As to approaches/basis of preparation

○ Incremental (Rolling) Budgeting- the starting point for the new budget is the budget for the previous year adjusted for actual
results achieved

○ Base Budgeting- the organization’s activities and departments are given a minimum base package of resources

○ Zero-Based Budgeting- each organization unit is assumed to require no resources and all budgetary requests must be fully
justified in terms of element’s continued usefulness

● As to coverage

○ Short-term (Current Budget)- one that is related to current conditions and usually prepared on an annual basis and then
broken into either quarterly or monthly budget

○ Long-term Budget- one that is established as a plan for the long-term development of the business and covers a period of
between 3 to 20 years

● As to subject matter

○ Master Budget- usually prepared annually for the upcoming years, it consist of different financial schedules intertwined with
one another ultimately producing projected financial statements

● Operational Budget

● Sales Budget

● Production Budget

● Purchase and Direct Materials Budget

● Direct Labor budget

● Manufacturing Overhead budget

● Selling and Administrative budget

● Budgeted Income Statement

● Financial Budget

● Cash Budget

● Budgeted Balance Sheet

○ Capital Budget- covers the different investment projects of the business

● As to parties involve
 ○ Participative Budget (Self-imposed)- a financial plan develop through collaborative efforts of top executive and operation
personnel

○ Imposed Budgeting- a financial plan develop by top level executive with little or no consultation with operation personnel

Terminologies in the Budgetary Process

● Budget Manual- this book should clearly define the objectives and procedures involved in the preparation of the budget

● Budget Committee:

○ The committee usually consists of member of the board of directors or senior management representing each area of the
business and they have responsibility for approving each functional area budget

○ A standing committee responsible for:

■ Overall policy matters relating to the budget

■ Coordinating the preparation of the budget

■ Resolving disputes related to the budget

■ Approving the final budget

● Budget Director- often the controller, has direct responsibility for construction of an entity’s budget as well as determination of the
accompanying procedures (deadlines, information formats, etc)

● Department Budgets- departments should be responsible for setting their own budgets but they will have to communicate with other
departments and coordinate their activities

● Responsibility centers- this is a function or section of the organization which is headed by a manager who is responsible for the
budget targets for the particular center.

The management process of preparing the master budget

1. Communicating details of budget policy and guidelines to those people responsible for the preparation of budgets

2. Determining the factor which restricts output

3. Preparation of the sales budget

4. Initial preparation of various budgets

5. Negotiation of budgets with superiors

6. Coordination and review of budgets

7. Final acceptance of budgets

8. Ongoing review of budgets

Steps in Preparing a Master Budget

1. Sales Budget

a. A summary of expected sales for the year (Starting point of the master budget)

b. Prepared by multiplying expected units sales volume for each product by the anticipated unit selling price (Expected Units
Sold x Selling Price)
 c. Sales can be classified using the product line, geographical locations, channels of distribution, functional departments, etc.

d. In forecasting sales, factors to be consider includes historical sales, general economic conditions, industry status,
researches, trends, etc.

2. Production Budget

a. The objective is to produce the necessary amount to support the quarter’s sales, plus an inventory “buffer” carryover for the
subsequent quarter, less what is already in finished goods inventory at the start of the quarter

b. If production capability will not be enough to cover for the forecasted sales, the following actions may be considered by
management:sub contracting, overtime , work-shifting, purchasing or leasing additional machinery, purchase bought-out
components, improvements in the method of production, etc.

c. Formula:

Budgeted Sales (in units) XX

Add: Desired Ending Finished Goods Inventory XX

Total Required (Total Goods Available for Sale) XX

Less: Beginning Finished Goods Inventory (XX)

Required Production Units XX

3. Direct Materials Budget

a. Has the same calculational structure as the production budget, however it is based on the required units of production

b. Separate budget will be prepared for each of the direct materials component of a product

c. This schedule consists of two parts: direct materials needs (just like the production budget with the production budget as the basis)
and required payments for those direct materials

d. Formula:

Required Production (units) XX

Multiply: Direct materials required per unit XX

Direct Materials unit required for production XX

Add: Desired ending direct materials inventory XX

Total Required (total materials available for use) XX

Less: Beginning Direct Materials inventory (XX)

Required Direct materials to be purchased XX

4. Direct Labor Budget

a. Show both quantity of hours and cost of direct labor necessary to meet production requirements

b. Using required production from the production schedule and multiplying it by the direct labor hours per unit of production, and then
multiplying those hours by the cost per labor hour to derive the total dollar cost of direct labor

c. Formula:

Required Production (units) XX

Multiply by: Direct Labor Time per unit XX

Total Direct labor hours required XX

Multiply by: Direct Labor Cost per unit XX

Total Budgeted Direct Labor Cost XX

5. Manufacturing Overhead Budget

a. The variable overhead application rate is multiplied by budgeted direct labor hour (or machine hours or other activity base) to obtain
the total budgeted variable overhead. Fixed overhead is added and the sum of the two is total manufacturing overhead

b. Formula:

Required Production (units) XX

Multiply by:Chosen activity base time per unit XX

Total Activity base hours required XX

Multiply by: Variable overhead cost per activity base XX

Budgeted variable overhead costs XX

Add: Budgeted fixed overhead costs XX

Total budgeted manufacturing overhead XX

6. Selling and Administrative Budget

a. It has the same calculational structure as the overhead budget. It includes both variable and fixed expenses, the variable expenses
are calculated based on predetermined rate per item sold, then fixed expenses are added to derive the total expense

b. Formula:

Budgeted Sales (units) XX

Multiply by: VSAE per unit XX

Budgeted Variable Selling and Administrative XX

Add: Budgeted FSAE XX

Total Budgeted selling and administrative expenses XX

7. Budgeted Income Statement

a. Important end-product of the operating budgets since it indicates expected profitability of operations and provides a basis for
evaluating company performance

b. Prepared from the operating budgets (1-6) will also be used in computing the budgeted cost of goods sold

8. Cash Budget

a. It begins with cash balance per the balance sheet from the beginning of the budget period, add cash receipts, subtract cash
disbursements and arrives at a projected ending cash balance per period. Adjusted for any minimum cash balance requirements and
financing activities (borrowing and payment of principal and interest)

b. Basic Format:
 Beginning Cash Balance XX

Add: Cash Receipts (cash sales, collection, etc) XX

Total Available cash XX

Less: Cash Disbursement (cash purchases, payment of payables,

selling and admin budget less non cash expenses like depreciation (XX)

Excess (deficiency) of available cash over disbursement XX

Financing: Borrowing /Payments XX/(XX)

Ending Cash Balance XX

C. Minimum Cash Requirement

● It provides a cushion that can absorb forecast errors

● Provide some allowance made for contingencies and miscalculations in planning

D. Financing

● When the amount of cash goes below zero or the minimum cash balance, whichever is higher

● Borrowing is assumed to have been made at the beginning of the period and payment is made when there is already sufficient cash-
not below zero or the minimum cash balance

● Interest payments are made at the time of settlement of the principal

9. Budgeted Balance Sheet

a. A projection of financial position at the end of the budget period

b. Developed from the budgeted balance sheet for the preceding year and the budgets for the current year

c. Has the same format with regular financial statement-however, it is based on budgeted data.

d. Format:

Cash (from the cash budget) XX

Receivables (from sale and collection budget) XX

Inventory (from the production and purchase budget) XX

PPE (beginning balance adjusted for any addition/disposal and depreciation) XX

Total Assets XX

Accounts Payable (from purchase budget) XX

Other Payables (from financing section of the cash budget) XX

Total Liabilities XX

Paid in capital (adjusted for sale of shares, if there’s any) XX

Retained Earnings (beg balances plus net income less any dividends) XX
 Total Liabilities and Equity XX

Sample Problem

Abbot Company prepared the following sales projections for the year ending December 31, 2004

Quarter

Units

1st 60000

2nd 80000

3rd 45000

4th 55000

The inventory of finished goods at December 31 of the prior year was 18,000 units. The quantity of finished goods at the end of each quarter is
to be 30% of the next quarter's budgeted

sales in units

1. How much should be the production budget show for units to be produced during the first quarter ?

2. If abbot's actual sale in the first quarter were 70,000 units, how many units be produced in the second quarter?