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COLLEGE OF ACCOUNTANCY

LEARNING MATERIALS IN CAS 13 (FINANCIAL MANAGEMENT)

Lesson 9: FORECASTING SHORT-TERM OPERATING FINANCIAL REQUIREMENTS


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Learning Outcomes:
After this lesson, students should be able to……
1. explain what a budget is and its role in the management process;
2. describe the importance of strategy in budgeting and its relationship to the strategic long-term and
short-term goals of the firm;
3. explain the management process of preparing the master budget;
4. prepare a sales budget including a computation of expected cash receipts;
5. prepare a production budget, direct materials budget, direct labor budget including the computation of
expected cash disbursements for purchases of material and payment of direct labor;
6. prepare a manufacturing overhead budget and a selling and administrative expense budget and
expected cash disbursement relative thereto;
7. prepare a cash budget
8. prepare a budgeted income statement and a budgeted statement of financial position; and
9. describe the alternative approach in budgeting such as zero-base budgeting, activity-based budgeting
and Kaizen (continuous improvement) budgeting
10. explain the ethical issues in budgeting.
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Key Concepts:
Each firm exists for a purpose and has goals to accomplish. These are set by the firm’s board of directors and
are to be accomplished by the firm’s executive team, lead by the President and his operating officers. To
ensure performance, the team must optimize the use of all resources and appropriate techniques available at
their disposal. Such resources include money, manpower, materials, machines, methods, information and
technology among others. Managerial techniques include organizational structures, policies, strategies,
standards and operating procedures.
The president must be able to communicate effectively the firm’s goals and objectives, show the direction or
ways to achieve them, set the standards of performance, motivate the firm’s people to act and establish the
necessary controls or measures in order to get things done with utmost efficiency and effectiveness. Success
depends upon the commitment of each employee, especially the mangers at the different levels and different
areas of the firm’s operations. As such, the President must encourage, if not force, the participation or
involvement of the said stakeholders in every stage of the process of attaining the firm’s goals. One of the
techniques utilized to achieve this is the budgeting process.
The budget is a detailed plan for acquiring and using financial and other resources over a specified time
period. It represents the firm’s plans for the future expressed in quantitative terms. The budget serves as a
road map that guides the managers along the way and a chart of the firm’s course of operations. Budgeting
is the act of preparing a budget and budgetary control is the use of budget to control a firm’s activities.
PURPOSES OF BUDGETS
Budgets make the decision making process more effective by helping managers meet uncertainties regarding
the future. Its objective is to promote a deliberate, well-conceived business judgment instead of accidental
success in business management. When planning is done well, many problems are anticipated before they
arise and solutions can be sought through deliberate study. Preparing a well-defined budget requires the
concerted effort of all management levels. Budgets serve a number of useful purposes, which includes:
1. Formalize the planning process – Perhaps the most purpose of budgeting is to compel managers
to think about the future. This forces them to set goals, consider future problem areas and formulate

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strategies. Budgeting motivates managers to anticipate opportunities, problems and actions rather
than to merely react. Budgeting helps the firm in defining broad objectives and goals and formulating
strategies to achieve such objectives.

2. Create a plan of action – The planning process brings together ideas, forecasts, resource
availability and financial realities to create a course of action to achieve the firm’s goals and
objectives. Build the plan, then use it.

3. Coordinate and integrate management’s efforts – The budgeting process opens the lines of
communication within the firm (a) up and down organizational lines of subordinates and superiors
and (b) across organizational lines to integrate functional tasks. It entails coordinating the activities of
the various parts of the firm and ensuring that the parts are in harmony with each other. Goal
congruence refers to a firm’s striving to achieve a common set of objectives.

4. Aid in resource allocation – Budgeting enables the firm to allocate its resources to where they can
be used most effectively.

5. Motivate managers – managers are driven to achieve their budget targets because (a) they
participated in its making and thus take pride in achieving it; (b) thru the budget, they see clearly
how their roles fit together with the firm as a whole and (c) because their promotion and incentives
are based on performance, which include meeting their budget targets. By doing so, managers are
motivated to strive in achieving the firm’s goals since their respective budget targets are in line with
it.

6. Create a basis for performance evaluation – Actual results lack meaning unless they are
compared to some target or budgeted performance. A budget serves as a benchmark or standard
against which actual results are measured and manager’s performance are evaluated. Significant
variances between actual and planned require explanations and often, corrective actions.

7. Promote continuous improvement – Budgeting quantifies and integrates into operational plan
many improvement processes such as redesigning processes, increasing productivity, eliminating non
value adding activities and minimizing quality problems.

8. Create an aura of control – A budget system serves as a fiscal disciplinarian and helps ensure that
managers understand their authority, responsibility and limitations. Budgeting forces managers to
plan, provides information for decision making, sets benchmarks for control and evaluation and
improves the process of communication and coordination.

A good budgeting system provides for both planning and control. Planning involves developing objectives and
preparing various budgets to achieve those objectives. In here, the managers anticipate the future events,
develop a plan of action and estimate future revenues and costs. Control refers to the steps taken by
management to increase the like hood of attaining the objectives set in the planning stage and that all parts of
the organization are working together toward that goal. In here, feedbacks on actual operating results are
used to compare with the plan, to evaluate performance and to make the necessary changes. This planning
and control system can be viewed as a cycle. A planning and control system includes tools, methods and
attitudes. Common elements are:
1. Strategic planning process – This long range planning defines the firm’s mission (why the firm
exists), the long range goals (what level of achievement it expects) and strategic plan (what mar kets,
price policies, resource needs, and production capabilities the firm will have).

2. Business plan and personal goal setting – Creating the annual business plan is the task of
evaluating the firm’s strengths and weaknesses, opportunities and tactics to build firm wide priorities
for the coming year. Each manager also develops a personal set of goals and a plan of achievements
that are consistent with the firm’s business plan.
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3. Planning process and timetable – A budgeting schedule includes when to start the process, submit
budgets, review and approve budgets at various management levels – who does what and when.

4. Responsibility accounting system – A planning and control system that combines responsibility
centers, control reports, activity centers and cost drivers from activity based costing.

5. Reward (Incentive) system – Rewards are given to managers who achieve their unit’s budget goals
and or MBO targets. Tying performance to compensation is becoming an increasingly common practice.
6. Financial modeling – Ability to evaluate alternative or “what if” scenarios are an expected part of
any financial planning system. Simulation can test a plan to assess goal achievement and evaluate
alternative actions.

7. Participatory budgeting – It is assumed that every manager is involved in planning and control.
Often, budget objectives are set at the executive level but budgets are constructed from the bottom
up- sometimes called as “grass roots” budgeting.

CONFLICTING ROLES OF BUDGETS


Conflicting may arise when a single budget system is used to serve several purposes, such as:
Planning vs. Motivation – demanding budgets that may not be achieved may be appropriate to motivate
maximum performance, but they are unsuitable for planning purposes. A budget should be set based on easier
targets that are expected to be met.
Planning vs. Performance Evaluation – in planning, budgets are set in advance of the budget period
based on an anticipated set of circumstances or environment. Performance evaluation should be based on
a comparison of actual performance with an adjusted budget to reflect the actual circumstances under which
managers operated.
In practice, many firms compare actual performance with the original budget (adjusted to the actual level of
activity), but if the circumstances envisaged when the original budget was set have changed then there will be
a planning and evaluation conflict. The ultimate objective must be to develop a realization that the budget is
designed to be a positive aid in achieving both individual and firm’s goals.

LIMITATIONS OF BUDGET
Budgets tend to simplify real situations by falling to consider variations in external or qualitative factors.
1. Lack of understanding of the fundamentals of budget preparation and execution adversely affects the
motivation and commitment of higher and lower management.
2. Failure to realize that a budget is just a means to attaining profitable activity, and not the end in itself,
adversely affects the leadership styles of managers.
3. Budget reports usually emphasize results, not reasons.

TYPES OF BUDGETARY SYSTEMS


A. As to level of performance standard
1. Stretch level budget – based on idealistic conditions and has small chance of being met.
2. Highly achievable budget – challenging but which can be met thru hard work.

B. As to flexibility of budget
1. Flexible budget – projection of revenues and costs at different levels of activity. It separate costs
into fixed and variable components and uses standard costing to prepare budgets at multiple activity
levels. Actual costs are compared with budgeted costs based on actual level of production to obtain
and analyze variances.
2. Fixed (static) – projection of revenues and costs at a particular or single level of activity. It does not
segregate costs into fixed and variable components. Actual costs are compared with the budgeted
costs regardless of actual level of production, to obtain and analyze cost variances.

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3. Activity-based budget – applies ABC principles and procedures to budgeting. It requires three steps,
namely: identification of activities, estimation of activity output demands and estimating the costs of
resources needed to provide the activity output demanded.
4. Kaizen budget – assumes “continues improvement” of products and processes, the effects of
improvement and the costs of their implementation.

C. As to budget period
A budget period is the length of time for which a budget is effective. Factors affecting the budget period
established includes purpose of the plan, reliability of information and normal turnover periods or seasonal
cycles.
1. Periodic (annual) budget – covers 1 year only, usually divided in quarters or months.
2. Continuous (perpetual/rolling/progressive) budget – a 12-month budget that rolls forward one
month or quarter as the current month or quarter is completed.
Irrespective of whether the budget is prepared on an annual or a continuous basis, it is
important that monthly or four-weekly budgets be used for control purposes.

3. Capital budget – a long term budget showing the planned financing, acquisition and disposal of fixed
assets.

4. Life cycle budget – a product’s revenues and expenses are estimated over its entire life cycle (from
research and development to withdrawal of customer support). It is useful in target costing & target
pricing.

D. As to base amount
1. Zero based budget – a budget wherein managers are required to justify all expenditures (costs) as if
programs involved are being proposed for the first time.
2. Incremental (traditional) budget – a budget prepared based on previous period’s budget, adjusted
based on changes expected to happen in the coming period. Managers are required to justify only the
changes (increments) made on the previous budget.

E. As a major component of the master budget


1. Operating budget – a projection of revenues, expenses and results of operations for a specific period
of time.
2. Financial budget – a budget of the financial resources as reflected in the budgeted balance sheet.
3. Capital budget

RESPONSIBILITY FOR BUDGETS


Budgetary administration refers the procedures used in preparing a budget, securing its approval and
disseminating it to the firm’s stakeholders. The primary responsibility regarding budget administration rests
with the chief executive of the firm. However, he may delegate such responsibility to an individual (usually the
controller) or to a specific group called the budget committee.

In order to ensure that the budget to be prepared will be compatible with the strategic objectives of the firm
and to minimize the possible budgetary slack, the top management must provide the guidelines and the
statistical inputs needed in preparing the budget. The top management should also provide the reward system
associated with budgetary system.

The budget committee, also known as management committee or executive committee is a group of key
management persons who are responsible for overall policy matters relating to the budget program. It
oversees the preparation and administration of the budget. Its principal functions are:
1. To formulate and decide the general policies of the firm’s budgetary system.
2. To request, review and revise individual budgets from the different units of the firm.
3. To approve the budgets and subsequent revisions therein.
4. To receive, analyze and evaluate budget reports.
5. To recommend necessary actions to improve operational efficiency and effectiveness.
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The chief executive of the firm may appoint the controller to serve as head of the committee for two major
reasons namely:
1. The controller’s position is independent from the operating parts of the firm.
2. The controller has skills and experiences in coping with intricacies of setting up the budget.
As the overall coordinator of the budgeting process, the controller recommends how budgets should be
prepared, assembles the budgets, prepares periodic reports showing variances between actual and planned
results, and interprets the variances and give recommendations for improvement where possible.

BUDGET PERIOD

The budget period is the length of time for which a budget is effective. It is determined based on factors
such as purpose of the budget, reliability of information and normal turnover periods or seasonal cycles.

A budget usually covers one year and divided into quarters or months. In some cases, the budget is prepared
for a period beyond one year, depending on how the budget is used. A budget may have no particular budget
period but it should be complete and comprehensive.

Firms are increasingly using a rolling budget, a budget that is always available for a specific period of time by
adding a month or quarter in the future as the month or quarter in the future as the month quarter just ended
is dropped. The budgeting is a continuous process, and managers are encouraged to constantly look ahead
and review future plans. Furthermore, it is likely that actual performance will be compared with a more
realistic target, because budgets are being constantly reviewed and updated.

THE INITIAL BUDGET PROPOSAL

Based on the initial budget guidelines, each responsibility center prepares its initial budget proposal. In
preparing an initial budget proposal, the following factors should be considered by a budget unit:
a. Internal factors:
 Introduction of new products.
 Adoption of new manufacturing processes.
 Changes in availability of equipment or facilities.
 Changes in product design or product mix.
 Changes in expectations or operating processes of other budget units that the budget unit relies on
for its input materials or other operating factors.
 Changes in other operating factors or in the expectations or operating processes in those other
budget units that rely on the budget unit to supply them components.
b. External factors:
 Competitor’s actions.
 Changes in the labor market.
 Availability of raw materials or components and their prices.
 Industry’s outlook for the near term.

BUDGET NEGOTIATION, AND APPROVAL, REVISION


The head of the budget units examines the initial budget proposal to determine whether the proposal is within
the budget guidelines. The head also checks to see if the budget goals can be reasonably attained and in line
with the goals of the budget units at the next level up, and the budgeted operations are consistent with the
budgeted activities of another budget unit. Negotiation occur at all levels of the organization. As budget units
approve their budgets, the budgets go through the successive levels of the organization until they reach the
final level, when the combined unit budgets become the budget of the organization.

The budget committee reviews and gives final approval to the budget. The chief executive officer then
approves the entire budget and submits the budget to the Board of Directors.

Systematic, periodic revision of the approved budget or the use of a continuous budget can be an advantage
in dynamic operations because the updated budget provides better operating guidelines. Regular budget
revision, however, may encourage responsibility centers not to prepare their budgets with due diligence.
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Organizations with systematic budget revisions need to ensure that revisions are allowed only if circumstances
have changed significantly.

MASTER BUDGET

The master budget represents the summary of the management’s plans and outlines the way to accomplish
these plans. In here, specific targets are set for sales, production, distribution and financing activities,
culminating in the preparation of a cash budget, budgeted income statement and budgeted statement of
financial position. Such budgets are separate but interdependent.

The starting point of budget effort should always be the most constraining variable, which is generally, sales.
Most managers work to generate more sales. However, other constraining variables might be:

1. Machine capacity in a specialized area (ex. Plastic extruding equipment in a plastic bottle plant.)
2. Floor space in a retail outlet
3. Salesmen’s time to make calls on customers
4. Tables in a restaurant

When a variable other than sales limits growth, it becomes the starting point for planning. But for most firms,
sales units or revenue is the limiting resource.

COMPONENTS OF THE MASTER BUDGET

A. Operating Budgets
1. Sales budgets – it is a schedule showing the expected sales over a specific time period. It is “the
key” to the budgeting process. It provides the basis for projected cash receipts as well as for
constructing the other budgets such as production, operating expenses and capital expenditure budget.
Accuracy of sales budget impacts the whole budget.
The sales department prepares the sales budget based on sales forecast considering external and
internal factors such as industry trends, economic and political conditions, purchasing power of peso,
customer preferences, pricing and promotion policies of the firm, projected plant expansion and others.
Methods of forecasting: sales department estimates, survey of customers, survey of executive opinions,
statistical methods.

2. Production budget – This is a detailed plan showing the number of units that must be produced
during a period to meet both sales and inventory requirements. It becomes the basis for determining
the budgets for direct materials, direct labor and factory overhead which in turn becomes input for the
cash expenditures budget.

3. Direct labor budget – This is a detailed plan showing labor requirements over specific period of time.
Factors affecting this budget include level of skills of laborers, labor rate per hour, and time
requirements among others.
4. Direct materials budget – It is a detailed plan showing the amount and number of units of raw
materials that must be purchased during a period to meet both production and inventory needs.

5. Manufacturing overhead budget – It is a detailed plan showing the production costs, other than
direct materials and direct labor, which will be incurred over specific period of time. Overhead costs can
either be fixed or variable, in which case the level of activity becomes relevant in computing the total
cost.

6. Ending finished goods inventory budget – This is a budget that shows the peso amount of cost
expected to appear on the statement of financial position for unsold units at the end of a period.
7. Purchases budget – It is a budget that shows the number of units and the amount of goods (raw
materials) to be purchased for the period.

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8. Budgeted cost of sales – It is a budget that shows the cost of goods manufactured, cost of goods
available at the beginning and end of period, as well as the cost of goods sold for a specific time
period.

9. Selling and administrative expense budget – This is a detailed schedule of planned expenses that
will be incurred in areas other than production, over specific time period. Like manufacturing overhead,
these costs are made up of fixed and variable components in which case the level of activity affects the
total costs to be incurred.

10. Budgeted Income Statement – It is a detailed plan showing the overall result of operations over a
specific time period.
B. Financial Budget
1. Cash budget – It is a detailed plan showing how cash resources will be acquired (cash receipt
budget) and used (cash disbursement budget) over specific time period.
Normally, the bulk of cash receipts come from customers. Other sources of cash are interest and
dividends on investments, sale of investments and other assets, and proceeds of borrowings. Cash
disbursements are made to production and operating expenses in the current year and accrued
expenses last year, currently maturing obligations and dividends.
The timing and amount of cash flows will show the available cash at a certain period. This will indicate
the timing and amount of investing activities if there is excess cash or financing activities to meet the
firm’s required minimum cash balance.
2. Capital expenditure budget – It is a budget showing the planned financing, acquisition and disposal
of fixed assets.
3. Budgeted Statement of Financial Position – It is a detailed plan of the financial position and
condition of the business over a period of time. It is developed by beginning with the current statement
of financial position and adjusting it for data contained in other budgets.
4. Budgeted Cash Flow Statement – It is similar to the cash budget but sources and uses of cash is
specified whether it is related to operating, investing or financing activities.

COMPUTATIONAL FORMATS FOR BUDGETS


BUDGETED PRODUCTION
Budgeted sales P xx
Desired inventory – end Xx
Total requirements P xx
Expected inventory –beg. (Xx)
Budgeted production (units) P xx

BUDGETED MERCHANDISE PURCHASES


Budgeted sales P xx
Desired merchandise inventory – end Xx
Total requirements P xx
Expected merchandise inventory – beg (Xx)
Budgeted merchandise purchases P xx

BUDGETED MATERIALS PURCHASES


Budgeted production (units) P xx
Multiply by: quantity of materials/unit Xx
Materials to be used P xx
Desired materials inventory – end Xx
Total requirements P xx
Expected materials inventory – beg (Xx)
Budgeted materials purchases P xx
CASH BUDGET
Cash collections (receipts) P xx
Cash payments (disbursements) (xx)
Net cash inflow (outflow) P xx

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Cash – beg. xx
Total cash available P xx
Desired (target) cash balance – end (Xx)
Cash surplus P xx

Target cash balance – the desired cash balance that a firm plans to maintain in order to conduct business
operations. Cash surplus indicates the type of investments (usually short-term investments) to acquire. Cash
deficit indicates the external financing requirement.

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