Chapter 6: Budgeting

Budgets
Budget The quantification of an organizations expectations of the inflow and outflow of
resources for a set time period of a proposed future plan of action by management
A budget is (a) the quantitative expression of a proposed plan of action by management
for a specified period and (b) an aid to coordinate what needs to be done to implement
that plan.
A budget generally includes both financial and non-financial aspects of the plan, and it
serves as a blueprint for the company to follow in an upcoming period.
A financial budget quantifies managements expectations regarding income,
cash flows, and financial position
Budgeting The process of gathering information to assist in making those forecasts
Budgeting is most useful when it is integrated with a companys strategy.
Strategy specifies how an organization matches its own capabilities with the
opportunities in the marketplace to accomplish its objectives

Budgeting Cycle
Well-managed companies usually cycle through the following budgeting steps during
the course of the fiscal year:
1. Working together, managers and management accountants plan the performance of
the company as a whole and the performance of its subunits (such as departments or
divisions). Taking into account past performance and anticipated changes in the future,
managers at all levels reach a common understanding on what is expected.
Plan the performance of the organization and sub-units
2. Senior managers give subordinate managers a frame of reference, a set of specific
financial or non-financial expectations against which actual results will be compared.
Provide a frame of reference against which results can be compared
3. Management accountants help managers investigate variations from plans, such as an
unexpected decline in sales. If necessary, corrective action follows, such as a reduction in
price to boost sales or cutting of costs to maintain profitability.
Implement the budget, investigate variations, and implement corrective actions
as necessary
4. Managers and management accountants take into account market feedback, changed
conditions, and their own experiences as they begin to make plans for the next period.
For example, a decline in sales may cause managers to make changes in product features
for the next period.
Plan again, considering changed conditions and feedback from investigations
Master Budget (Short-Term Budget Application)
Coordinates and summarizes all the financial projections of all the organizations
individual budgets in a single document for a set period of time
Includes operating estimates, a cash budget, and pro forma financial statements
(balance sheet, income statement, and statement of cash flows)
Embraces operating and financing activities and decisions

 The master budget expresses managements operating and financial plans for a
specified period (usually a fiscal year), and it includes a set of budgeted financial
statements.
The master budget is the initial plan of what the company intends to accomplish in the
budget period.
The master budget evolves from both operating and financing decisions made by
managers
Operating decisions deal with how to best use the limited resources of an
organization.
Financing decisions deal with how to obtain the funds to acquire those resources.
Pro forma statements Budgeted financial statements
Advantages of Budgets
Promotes planning, including the implementation of plans
Link the budget with strategic analysis for the organization including overall
objectives, trends, risks, alternative strategies
Promotes coordination and communication among subunits within the company
Motivates managers and other employees
Apply and influence control
Assign responsibilities by allocating resources to managers
Set targets and goals
Provide performance evaluation and feedback criteria
Comparing actual performance against a budget is better than comparing this
years achievements to last years results including corrective action
More revenue, less costs is not always better any deviation from budget is not
good
If the market grew by 100% and we made 10%? Made more than budget, but
less than the market
Compels planning and monitoring of the implementation
Coordination and Communication
Coordination is meshing and balancing all aspects of production or service and all
departments in a company in the best way for the company to meet its goals.
Communication is making sure those goals are understood by all employees.
Types of Budgets
Strategic Plan sets overall goals and objectives for the organization
Capital budget long range plan for investing in and financing long term assets such as
buildings and equipment
Master budget yearly projection of revenues, costs and volumes including operating
schedule and financial statements
Continuous budgets (rolling budgets) add one month in the future as the current month
is combined
Strategic Planning
1) Selecting overall objectives
Qualitative how to accomplish quantitative objective
Quantitative Increase revenues by #%, Increase dividend pay out by #%,
reduce operating expense
2) Choosing markets
Where to operate; city, region, national, international
3) Selecting products to produce
4) Determining price/quantity mix

 Lower quality Cheaper price

5) Choosing technologies
Will have direct impact on budgets
Short-Term Budgets (1 year or less)
Focus on quantities to produce, quantities to sell, supplies acquisitions, and financial
resources needed
Long-Term Budgets (More than one year)
Focuses on forecasts of large asset acquisitions, financing plans, research and
development plans
Divisions of Master Budgets
Operating budget the set of budgets leading to the pro forma (budgeted) income
statement (excludes financing and taxes)
Budgeted income statement and its supporting budget schedules
Financial budget the set of budgets that comprise and lead to the capital budget, cash
budget, pro forma balance sheet and the proforma statement of cash flows
Part of the master budget that focuses on how operations and planned capital
outlays affect cash. It is made up of the capital expenditures budget, the cash budget,
the budgeted balance sheet, and the budgeted statement of cash flows.
Basic Operating Budget Steps
Prepare the Revenues Budget
Prepare the Production Budget (in Units)
Prepare the Direct Materials Usage Budget and Direct Materials Purchases Budget
Prepare the Direct Manufacturing Labour Budget
Prepare the Manufacturing Overhead Costs Budget
Prepare the Ending Inventories Budget
Prepare the Cost of Goods Sold Budget
Prepare the Operating Expense (Period Cost) Budget
Prepare the Budgeted Income Statement
Basic Financial Budget Steps
Based on Operating Budgets:
Prepare the capital expenditures budget
Prepare the cash budget
Prepare the budgeted balance sheet
Prepare the budgeted statement of cash flows
Organizational Structure
Organization structure an arrangement of lines of responsibility within the organization.
Responsibility Centre
Each manager, regardless of level, is in charge of a responsibility center.
A responsibility center a part, segment, or subunit of an organization whose manager is
accountable for a specified set of activities.
The higher the managers level, the broader the responsibility center and the
larger the number of his or her subordinates.
Responsibility accounting a system that measures the plans, budgets, actions, and
actual results of each responsibility center.

Types of Responsibility Centers

If deviation from budget, must be able to pinpoint where it occurred not good or bad,
but investigate-able
Areas of responsibility if you are a cost center, your budget targets and goals will be
different from other cost centers
Cost Centre
Accountable for costs only no revenue
Eg. given bonus based on net profit of company, but have no control over
revenues; how do you set
around revenues when youre a cost center? Budget has
to be set according to the correct center
Eg. If running website or HR, how can you give a bonus based on revenues of the
firm?
Revenue
Accountable for revenues only
Eg. Sales center; no control over production, rent, utilities; only control over sales
cannot be evaluate
on profitability (includes cost)
Profit
Accountable for revenues and costs
Eg. Mid-level management is responsible for profit budgets
Investment
Accountable for investments, revenues, and costs; Responsible for capital budgeting;
o D or C level (Directors, CEO etc)
Budgets and Feedback
Budgets coupled with responsibility accounting provide feedback to top management
about the performance relative to the budget of different responsibility center managers.
Differences between actual results and budgeted amountscalled variancesif
properly used, can help managers implement and evaluate strategies
Budgets offer feedback in the form of variances: actual results deviate from budgeted
targets
Variances provide managers with
Early warning of problems
Variances alert managers early to events not easily or immediately
evident. Managers can
then take corrective actions or exploit the available
opportunities. For example, after observing
a small decline in sales this period,
managers may want to investigate if this is an indication of
an even steeper
decline to follow later in the year.
A basis for performance evaluation
Variances prompt managers to probe how well the company has
performed in implementing
its strategies. Were materials and labor used
efficiently? Was R&D spending increased as
planned? Did product warranty costs
decrease as planned?
A basis for strategy evaluation
Variances sometimes signal to managers that their strategies are
ineffective. For example, a
company seeking to compete by reducing costs
and improving quality may find that it is
achieving these goals but that it
is having little effect on sales and profits. Top management
may then want to
reevaluate the strategy.
Controllability
Controllability The degree of influence that a manager has over costs, revenues, or
related items for which he is being held responsible
A controllable cost is any cost that is primarily subject to the influence of a given

responsibility center
manager for a given period
Responsibility Accounting Focuses on information sharing, not in laying blame on a
particular manager
A responsibility accounting system could either exclude all uncontrollable costs from a
managers performance report or segregate such costs from the controllable costs.
Responsibility accounting is more far-reaching.
It focuses on gaining information and knowledge, not only on control.
Responsibility accounting helps managers to first focus on whom they should ask to
obtain information and not on whom they should blame.
Budgeting and Human Behaviour
The budgeting process may be abused both by superiors and subordinates, leading to
negative outcomes
Superiors may dominate the budget process or hold subordinates accountable for
events they have no control over
Subordinates may build budgetary slack into their budgets
Budgetary slack The practice of underestimating budgeted revenues, or
overestimating budgeted
expenses, in an effort to make the resulting budgeted
goals (profits) more easily attainable
Master Budget for a Retailer

Master Budget for a

Manufacturer

The Master Budget tie-in to the Cash Budget

Advantages of Budgeting

Cash Budget
Expected cash inflows (receipts)
Expected cash outflows (disbursements)
Predicts cash position for specific level of activity
Predicts timing of bank loans & repayments
Provides information (inputs) to the pro forma income statement and balance sheet
Schedule of expected cash receipts and disbursements