MODULE 4

BUDGETING FOR PROFIT AND CONTROL

A budget is quantitative plan for acquiring and using resources over a specific time period. Budgets are
used for two distinct purposes – planning and control. Planning involves developing goals and preparing
various budgets to achieve those goals. Control involves the steps taken by management to increase the
likelihood that all parts of the organization are working together to achieve the goals set down at the
planning stage. To be effective, a good budgeting system must provide for both planning and control.
Good planning without effective control is a waste of time and effort. 1

Advantage of budgeting2

Organization realize many benefits from budgeting including:

1. Budgets communicate management’s plan throughout the organization.
2. Budgets force managers to think about and plan for the future. In the absence of necessity to
prepare a budget, many managers would spend all of their time dealing with day-to-day
emergencies.
3. The budgeting process provides a means of allocating resources to those parts of the organization
where they can be used most effectively.
4. The budgeting process can uncover potential bottlenecks before they occur.
5. Budgets coordinate the activities of the entire organization by integrating the plans of its various
parts. Budgeting helps to ensure that everyone in the organization is pulling in the same direction.
6. Budgets define goals and objectives that can serves as benchmarks for evaluating subsequent
performance.

The Management Process of Preparing the Master Budget3

Top Management Involvement

For a budget to be effective, top management needs to be involved and show strong interest in budget
results. Too much involvement, however, may make the budget and alienate lower managers. The right
answer is a good balance of top management involvement with lower-level managers.

Top management ensures that budget guidelines are being followed through the budget review and
approval process. Active involvement by top management in reviewing and approving the proposed
budget is an effective way to discourage lower-level managers from playing budget games.

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Budgeting processes usually include formation of a budget committee; determination of the budget
guidelines; preparation of the initial budget proposal; budget negotiation, review and approval; and
budget revision.

Organization for Budget Preparation4

It is essential that the manager of an entity assigns the most qualified personnel to the preparation of
the budget. A budget committee with representation from the different functional areas is generally
considered an effective body to oversee preparation and administration of the budget. The controller
maybe selected to serve as head of the committee for two major reasons:
1. Controller’s position is independent from the operating parts of the organization.
2. He has the skills and experience in coping with the intricacies of setting up a budget.

The controller acts as a coordinator in the budget operation. He recommends how budgets should be
prepared, assembles the budget, prepare periodic reports showing variances of the actual results from
budgeted results, interprets variances and offers suggestions for improvement whenever possible.

The budget committee decides how budgets shall be prepared, passes on the final budget, and settles
disputes in one segment of the business and another when differences of opinion arise. The committee
also receives budget reports and make policy decisions with respect to budget revisions and other
problems of budget administration.

Initial budget proposal5

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.

Internal factors:
 Introduction of new products.
 Adoption of new manufacturing process.
 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.

Budget Negotiation, Review and Approval, Revision6

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 units. Negotiations occur at all levels of the

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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 offices then
approve the entire budget and submits the budget to the board of directors.

Systematic, periodic revision of the approved budget or the use of 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. Organizations with systematic budget revisions need to ensure that revisions are
allowed only if circumstances have changed significantly.

Types of Budgets and Other Budgeting Concepts7

1. The MASTER BUDGET and its different components.

2. CONTINOUS (ROLLING) BUDGET - a budget that is revised on a regular basis.
3. FIXED BUDGET – a budget based on only one level of activity.
4. FLEXIBLE BUDGET – a series of budgets prepared for many levels of activity.
5. INCREMENTAL BUDGETING – a budgeting process wherein the current period’s budget is simply
adjusted to allow for changes planned for the coming period.
6. ZERO-BASED BUDGETING – a budget is prepared every period from a base of zero. All expenditures
must be justified regardless of variances from previous periods.
7. LIFE-CYCLE BUDGET – a product’s revenues and expenses are estimated over its entire life cycle.
8. ACTIVITY-BASED BUDGETING – unlike in the traditional emphasis on functions or spending
categories, activity-based budgeting applies the ABC principles and procedures to budgeting.
9. KAIZEN BUDGETING – Kaizen is a Japanese term that means continuous improvement.
10. GOVERNMENT BUDGET – unlike in a private sector budget, a government budget is not only a
financial plan and a basis for performance evaluation but also an expression of public policy and a
form of control having the force of law.

The Master Budget8

A master budget is comprehensive budget for a specific period. It consists of many interrelated
operating and financial budgets. Some firms refer to the process of preparing a master budget as profit
planning and targeting.

The Master Budget Overview9

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Steps in Developing a Master Budget

The major steps in developing a Master Budget may be outlined as follows:

1. Establish basic goals and long-range plans for the company. These will serve as guidelines in the
preparation of budget estimates.
2. Prepare a sales forecast for the budget period.
3. Estimate the cost of sales and operating expenses.
4. Determine the effect of budgeted operating results on assets, liabilities and ownership equity
accounts. The cash budget is the largest part of this step, since changes in many assets and
liabilities accounts will depend upon the cash flow forecast.
5. Summarize the estimated data in the form of a projected income statement for the budget
period, the projected statement of financial position as of the end of the budget period and the
projected cash flow statement.

Sales Budget10

The sales budget showing what products will be sold in what quantities at what prices, is the foundation
on which all other short-term budget are built. The sales budget triggers a chain reaction that leads to
the development of many other budget figures in the organization. The sales budget provides the
revenue predictions from which cash receipts from customers can be estimated and supplies the basic
data for constructing the budget for production costs and selling and administrative expenses. In short,
sales forecast is the keystone of the budget structure. The accuracy and reasonableness of the sales data
will affect the whole budget. The sales forecast is made after consideration of the following factors.

1. Past sales volume

2. General economic and industry conditions

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 3. Relationship of sales to economic indicators
4. Relative product profitability
5. Market research studies and competition
6. Pricing, advertising and other promotional policies
7. Production capacity
8. Quality of sales force
9. Seasonal variations
10. Long-term sales trends for various products

Production Budget11

After the sales budget has been set, a decision can be made on the level of production that will be
needed for the period to support sales and the production budget becomes a key factor in the
determination of other budgets, including direct material budget, the direct labor budget, and the
manufacturing overhead budget. These budgets in turn are needed to assist in formulating a cash
budget.

Cash Budget12

Cash Receipts

Normally, the bulk of a firm’s cash receipts comes from customers. The possibility of cash from other
sources should likewise be considered when cash receipts are being budgeted.

Cash disbursement

Data converted from individual budgets previously illustrated supply the basic information for the cash
disbursement budget. However, various adjustments and additions will have to be made when
preparing the budget for prepayments, accruals as well extraneous items that do not show up in any of
the individual budgets already prepared. If the financial policy of the company requires that a minimum
cash balance be maintained at all times, the cash budget must be altered to accommodate bank loans
and their repayment.

Performance Reports in Cost Centers13

Performance reports are often prepared for organizations that do not have any source of outside
revenue. In particular, in a large organization a performance report may be prepared for each
department including departments that do not sell anything to outsiders.

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Sample Quiz

Multiple Choice Questions14

1. The first step involved in preparing a master budget is
a. Preparing a forecasted income statement
b. Preparing a general operating budget
c. Preparing a forecasted statement of financial position
d. Preparing detailed period budgets

2. The second logical step in preparing a master budget would be to:

a. Estimate the cost of goods sold
b. Forecast sales, during the budget period
c. Establish the basic goals and long-range plans for the company.
d. Forecast general and administrative for the budget period.

3. Which of the following components of the master budget must be prepared before others?
a. Direct labor peso budget
b. Cost of goods sold forecast
c. Production budget
d. Raw materials purchase budget.

4. Which of the following factors are not important to consider in making a sales forecast?
a. Past sales volume
b. Distribution cost involve
c. Conditions within the industry
d. Plant capacity
e. None of the above

5. The period budget should begin with a forecast of

a. Overhead
b. Production
c. Sales
d. Direct labor

The following information pertains to questions 6 through 10:

The Dilly Company marks up all merchandise at 25% of gross purchase. All purchases are made on
account with terms of 1/10, net/60. Purchase discounts which were recorded as miscellaneous income,
are always taken. Normally, 60% of each month purchases are paid for in the month of purchase while
the other 40% are paid during the first 10 days of the first month after the purchase. Inventories of
merchandise at the end of each month are kept at 30% of the next month’s projected cost of goods sold.

Terms of sales on account are 2/10, net/30. Cash sales are not subject to discount. Fifty percent of each
month sales on account are collected during the month of sale, 45% are collected in the succeeding
month and the remainder are usually uncollectible. Seventy percent of the collections in the succeeding
month are subject to discount.

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Projected sales data for selected months follow:

Sales on Account Gross Cash Sales

December P1,900,000 P400,000
January 1,500,000 250,000
February 1,700,000 350,000
March 1,600,000 300,000

6. Projected gross purchases for January are

a. P1,400,000
b. P1,470,000
c. P1,472,000
d. P1,248,000

7. Projected inventory at the end of December is

a. P420,000
b. P441,600
c. P393,750
d. P552,000

8. Projected payments to suppliers during February are

a. P1,551,200
b. P1,535,688
c. P1,528,560
d. P1,509,552

9. Projected sales discounts to be taken by customers making remittances during February are
a. P5,250
b. P15,925
c. P30,000
d. P11,900
e. None of the above

10. Projected total collections from customers during February are

a. P1,875,000
b. P1,861,750
c. P1,511,750
d. P1,188,100

Answer Key
1. B 6. C
2. B 7. A
3. C 8. B
4. E 9. E
5. C 10. B