Budgeting.

Learning Objectives:

At the end of the topic, the students are expected to be able to:

1. Discuss the different concepts in budgeting

2. Explain the different types of budget.

3. Apply the concepts of budgeting in the preparation of various budgets .

Budgeting Defined

Budgeting is the process of planning the overall activity of a business for a future
period of time, usually one year. A budget is a formal plan expressed in financial terms.

Characteristics of Budgets

A budget may be characterized as follows:

1. A budget is a comprehensive plan. It is a plan covering the activities of an entire

business.
2. A budget is an integrated plan. It consists of interrelated budget schedules for
the different functions or segments of a business.
3. It is prepared for a future period of time. The budget may cover a period of one
month, a quarter, six months, or one year. The budget period, however, is
usually one year, with the budget period divided into months.
4. It is expressed in financial terms. It incorporates only transactions which can be
expressed in terms of money. It does not include nonmonetary factors.

Objectives of Budgeting

The objectives of budgeting are the following:

1. Planning

Budgeting involves the determination of how much to produce and carry in

inventory, how much and when to buy materials and supplies, how much to incur
for various expenses, when to borrow funds for short-term purposes, and others.

2. Coordination

Budgeting tends to synchronize the firm’s operations, because the budget

serves as a guide as to what the company should achieve. Estimates of sales by
the sales department are used to plan production, manpower requirements, and
 production facilities; materials are purchased to suit production requirements,
funds are collected and borrowed to meet the requirements of the various
departments for cash; or funds are invested when they are not needed for
operations.

3. Control

Budgeting provides a basis for evaluating performance, for identifying

causes of unsatisfactory performance, and for initiating possible corrective
action.

4. Motivation

Budgeting can be used as a means of enlisting the participation and

cooperation of officers and employees in attaining the profit objectives of a
business.

Advantages of Budgeting

Budgeting has the following advantages:

1. The preparation of a budget forces management to think in advance. With

forward planning, problems are anticipated and carefully studied, better decisions
are made, and resources are used in the most profitable activities.

2. Budgeting sees to it that the activities of the various departments are not in
conflict with each other. Conflicts between individuals or group of individuals,
duplication of efforts, inefficiency, and waste of resources are reduced.

3. Budgeting provides a sense of direction to management in running a business.

Budgets set goals for management to achieve. Adherence to the budget can be
enforced and results can be interpreted in the light of the objectives.

4. The process of preparing and executing budgets can give a sense of

participation to officers and employees in the affairs of a business and in its
success or failure.

Phases of Budgeting

The responsibility for the preparation of a budget rests with top management.
However, the actual preparation of budgets may be delegated to the executives or
managers of the major departments of a business. Each manager or executive
prepares a budget for his department with the help of his subordinates. The budget of
the various departments are brought together to form an overall budget for the whole
enterprise.

A budget committee may be established to direct the preparation, coordination,

and execution of budgets. The committee is composed of the executives of the major
departments of the business such as the sales manager, production manager, treasurer,
and controller. The committee is headed by a budget director who is responsible for the
final preparation of the budget.

The final approval of a budget is made by top management or by the board of

directors. Upon approval, the budget is disseminated to the managers for execution.

A review of performance using the budget is a necessary part of budgeting. A

consistent review is necessary to determine if actual performance conforms to the
budget. This provides a basis for making the necessary corrections or adjustments.
The review is conducted by the manager himself and also by the budget director or
budget committee.

Types of Budgets

Budgets may be classified in various ways, as follows:

A. According to Time Span

1. Capital Budget

A capital budget is a long-range budget prepared for five or more

years into the future. A capital budget incorporates plans for plant
expansion, equipment purchases, addition of product lines,
replacement of existing facilities, and other similar matter.

2. Master Budget.

A master budget is one prepared for a short period of time, usually

one year. It consists of budget schedules or component budgets and
may be broken down into months, quarters, or other fractional part of a
year.
A continuous, rolling, or progressive budget is a form of a master
budget which is extended one additional month at the end of every
month so that the total months covered by the budget is always 12
months.
 B. According to Flexibility

1. Static Budget. This is a budget based on a single volume of

operations. The master budget is an example of a static budget.

2. Flexible or variable Budget. A flexible budget is a set of budgets which

is based on several levels of operation.
C. According to Object

1. Project or Production Budget. This is a budget prepared for a division

or segment of a business, a project, or a product line.

2. Responsibility Budget. This is a budget for the individual who is

responsible for the incurrence of costs or who is in charge of a
responsibility center.

The Master Budget

A master budget consists of the following budgets and supporting schedules:

A. Operating Budget
1. Sales Budget
2. Production Budget
3. Production (Manufacturing) cost Budget
a. Direct Materials Budget
b. Direct Labor Budget
c. Factory Overhead Budget
4. Selling Expense Budget
5. Administrative Expense Budget
B. Financial Budget

1. Cash Budget (cash receipts and disbursements budgets

2. Budgeted Statement of Financial Operation
3. Budgeted Statement of Financial Position
4. Budgeted Funds Flow Statement

C. Capital Expenditures Budget.

This involves plans on material modification, acquisition and disposal of

property, plant and equipment or material modification, acquisition or renewal
of a firm’s computerized accounting information system.
 D. Budgeted Financial Ratios. The ratios computed are taken from the
budgeted financial statements prepared.

General Guidelines in the Preparation of a Master Budget

1. Formulation of the corporate objectives, plans, policies and assumptions, which

will give direction in the formulation of the budget estimates. This is the task of
top management.

2. Establish or estimate sales projection or targeted sales. The sales projection

serve as a basis in determining the targeted number of units (volume) to be sold.

3. Individual budgets from the different functional areas as well as sub-units or

responsibility centers (example – production, marketing, research, finance
department, etc.) of the company are prepared based on the planned volume of
units to be sold. Heads or supervisors from each of the areas are responsible
for the preparation of their individual budgets. Under this process, the production
schedule and the associated use of new raw materials, direct labor and overhead
are done to compute cost of goods sold.

4. Consolidation of the individual budgets is done to create a draft master budget.

The corporate planning department of the firm can do this.

5. Revision of the preliminary drafted master budget is done to come up with the
final draft subject to the approval of top management.

6. Approval and dissemination of final master budget to department heads or

supervisors

The Sales Budget

The starting point of budgeting is the sales budget. The sales budget provides
the basis for estimating production, inventory levels, purchases and operating
expenses.
The sales budget is derived from a forecast of sales. In forecasting sales, the
following factors are considered:
a. The general economic outlook
b. The conditions in the industry
c. The position of the company in the industry
The sales forecast may be broken down by product lines, regions, customers,
channels of distribution, salesmen, or divisions.

Methods of Estimating Sales

 1. Sales Trend Analysis. Under this method, the product life cycle is used in
making the forecast. The growth commences at the introduction of the
product and accelerates during its middle year and then plateaus then it
declines. A rough plotting of product life cycle could be presented using letter
“S”. In using sales trend analysis, it is essential that the company estimate
what part of the life cycle is the product.

2. Sales force Composite Method. Under this method, each salesman

estimates the sales in his particular territory. Historical sales may be used by
each salesman as basis for estimating the probable sales for the next period.
3. Executive Opinion Method. Under this method, the views of a number of top
executives are culled to arrive at a sales estimate.

4. Industry Trend Analysis Method. Under this method, the relationship between
expected industry sales and the company sales in terms of market share is
determined. The growth statistics of the entire industry is assessed and a
forecast is made. The firm’s growth pattern is also determined and compared
with that of the industry’s to come up with the trend. When the trend is
determined, a percentage of the expected total market for the budget period
is estimated. The percentage is then multiplied to the estimate of the total
industry sales, and the result is considered the sales forecast of the company.

5. Correlation Analysis Method. This is a more scientific means of forecasting

sales by using regression analysis. In statistics we were taught that linear
regression equations are used to determine or predict the movement or
existence of a dependent variable , Y (sales) depending on the movement or
existence of an independent variable, X (could be anything like personal
disposable income of customers or prices of raw materials, etc.). The
variables are placed in the equation and thus, predict what sales would be.
The regression equation is used to determine the cause and effect
relationship between sales and the factors affecting it.

6. Multiple approach Method. This method uses a combination of the various

methods discussed.

The Sales Budget

Assume that the Enoch Company produces and sells a single product. A sales
forecast for the next four months is given below.

October, 2015 5,400 units

November, 2015 6,000 units
December, 2015 6,600 units
January, 2016 4,000 units
 The selling price of the company’s product is P50 per unit. Sales returns and
allowances average 5% of gross sales. Using the following information, the sales
budget of Enoch Company for the Quarter is presented below.

Enoch Company
Sales Budget
For the Quarter ended December 31, 2015
October November December Total
Gross Sales P270,000 P300,000 P330,000 P900,000
Less Sales Returns & 13,500 15,000 16,500 45,000
Allowances
Net Sales P256,500 P285,000 P313,500 P855,000

The Production Budget

The production budget is dependent on sales, inventory plans, and the capacity
of the manufacturing division.
If production is primarily dependent on sales, production will vary with sales.
Production will increase or decrease with increases or decreases in sales. Inventory
levels will not vary to any large extent. If production is made to depend primarily on
sales, the capacity of the plant must be adequate to meet any sales demand.
Production may be held relatively stable throughout the year. In such case, it is
not necessary that a large production capacity be maintained. Inventory can be built up
during the slack periods to provide for sales during peak months. The inventory level
will therefore be variable.
The quantity of units to be produced can be determined as follows:

Units to be produced = Units to be sold – units desired in beginning inventory – Units

desired in ending inventory.

The Enoch Company sets its level of production during any given month at a
volume equal to the sales for the following month. Hence, the inventory of finished
goods at the end of the month is equal to the sales for the following month.
The production budget of the Enoch Company for the fourth quarter of 2015 is
shown below:

Enoch Company
Unit Production Budget
For the Quarter ended December, 2015
October November December Total
 Units to be Sold 5,400 6,000 6,600 18,000
Less desired finished goods
inventory 5,400 6,000 6,600 5,400
beginning
Total 0 0 0 12,600
Add desired finished goods , 6,000 6,600 4,000 4,000
ending
Units to be produced 6,000 6,600 4,000 16,600

Methods of Estimating Sales

1. Sales Trend analysis

Under this method, the product life cycle is used in making the forecast.
The growth commences at the introduction of the product and accelerates during
the middle year and then plateaus then it declines.

2. Sales Force composite Method

Each salesman estimates the sales in his particular territory. Historical
sales may be used by each salesman as basis for estimating the probable sales
for the next period.

3. Executive Opinion Method

The views of a number of top executives are culled to arrive at a sales
estimate.
4. Industry Trend Analysis Method
The relationship between expected industry sales and the company sales
in terms of market share is determined. The growth statistics of the entire
industry is assessed and a forecast is made. The firm’s growth pattern is also
determined and compared with that of the industry’s to come up with the trend.
When the trend is determined, a percentage of the expected total market for the
budget period is estimated. This percentage is then multiplied to the estimate of
the total industry sales, and the result is considered the sales forecast of the
company.

5. Multiple Approach Method

It uses a combination of the various methods.

Cash Budget

The basic objective of cash management is to maintain cash in an amount

adequate to meet current operating costs and capital expenditures that are to be
incurred during the budget period. If the amount of cash carried is not adequate, the
business cannot pay its obligations promptly and cannot take advantage of discounts
or other favorable prices. On the other hand, if the business carries too much cash, the
business will be foregoing the revenue that would be earned if the extra cash were
invested elsewhere. The problem therefore is cash management- thus we have to find
out the proper amount of cash to carry.

The following factors are to be considered in determining the minimum cash

balance to be maintained:

1. The level of operating costs required to maintain the business. Payments for
operating costs include purchases of merchandise, wages, rent, repairs and
maintenance, and other ordinary expenses.

2. Capital expenditures to be made during the current period

3. The desire to take advantage of favorable prices such as buying the bulk or
buying in anticipation of a possible price increase.

4. The need to maintain extra cash to meet contingencies.

A cash budget is used to plan cash requirements, specially the amount of cash
required and the time when the cash is needed to pay various costs. The amount of
cash required is determined in relation to the cash expected to be made available from
operations and other sources. If cash receipts are not adequate to meet budgeted
disbursements, the business may resort to short-term borrowings or sale of short-term
securities. On the other hand, the cash budget may indicate that cash receipts may
exceed cash payments. If cash receipts exceed cash payments, it is necessary to
determine how the extra cash can be utilized. Excess cash can be invested in
marketable securities or be used to pay short-term loans.

The sources of information in preparing the cash budget are the sales budget, the
production cost budget, the selling expenses budget, the administrative budget and
other sources outside the budgets. The cash receipts from operation are determined
from the sales budget while payment for operating costs are determined from the
production cost budget and operating expense budgets. Other cash receipts and
disbursements such as dividends, sale of investments, principal and interest payments
on loans are determined from other sources.

Parts of a Cash Budget

The cash budget consists of the following parts:

1. The beginning cash balance

2. Cash Receipts
3. Total cash available
4. Cash disbursements
5. Ending cash balance

The relationship of the parts of a cash budget may be expressed as follows:

Beginning cash balance + cash receipts = Total cash available – cash

disbursements = Ending cash balance.

A cash budget may be prepared in the following forms:

Beginning cash balance Pxxx

Add Cash Receipts xxx
Total Cash Available Pxxx
Less cash disbursements xxx
Excess (deficiency) of total cash available over total disbursements Pxxx
Add(deduct) Borrowings (Repayments) xxx
Sale (Purchases) of short-term investments xxx
Ending Cash Balance Pxxx
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Sample of a Cash Budget

Enoch Retail Store

Cash Budget
For the Months of May and June 2015
May June
Cash Balance, Beginning P 5,500 P 56,984
Add Receipts 333,876 329,694
Total Cash Available P 339,376 P 386,678
Less Disbursements
Purchases 230,428 235,044
Expenses 51,964 50,335
Total Disbursements 282,392 285,379
Cash Balance, Ending P 56,984 P 101,299