CHAPTER 9

The Budget Preparation

In this chapter, we will discuss:

The basics of budgeting

Why budgets are important for control purposes
Various types of budgets
When each type of budget is used
How to prepare some of the important budgets
What are their limitations
Behavioral implications

What is a budget?
Budgets

are summaries of short-term

operational activities of a firm.
For example, a firm may prepare cash
budget to predict cash inflows and
outflows or
A production budget to plan its
production levels.
Budgets are quantitative representations.

How does a budget differ from a forecasting?

A forecast

is a prediction and usually

There are many ifs and buts before a
forecast resembles reality.
Most importantly, a forecaster can only
predict (sales would increase by 20% by
next year). However,
A forecaster cannot shape the selling
events to make the sales go up by 20%

How does a budget differ from a forecasting?

In contrast, a budget is a plan (sales must go
up by 20% by next year).
The budget plan is based on facts, events in
progress, actions planned, etc.
The budget preparer must consult those
affected, obtain input before preparing the
budget, and
The Manager of a unit must take active steps
to achieve the budget.
Both forecasts and budgets are necessary.
Forecast is useful for planning while budget is
useful for both planning and for controlling.

Characteristics of a budget

Stated in monetary units but,

Could contain non-monetary items such as units
produced, sold, no. of items processed etc.
Usually, short-term (one year) but could be
extrapolated from or to the longer term.
Senior management must be involved in the
process and must approve it.
Most important budgets must be compared to
actual and the variances must be investigated.

Usefulness of the budget

Fundamentally, it is a planning and control tool

(coordination, problem signaling, and problem-solving
activities).
It is a good tool to communicate short-term goals to
employees.
It also helps senior management in assessing whether
organizational goals are met (e.g. improvement in customer
service but no allocation for employee training).
Since input is required from multiple units, it promotes
coordination, planning, and sharing.
Allows a firm to anticipate problems so that corrective
action can be taken early.

How does a budget help with strategic planning?

Strategic Plan: Tells managers what the organizational

goals for this year are (e.g. sales growth, profits, new
products, expansion in production capacity).
To accomplish the plan, every unit must contribute through
its efforts.
Therefore, each unit is subjected to a budgeting plan,
process, and proposed results (operational plan).
Collectively, the individual budgets would point out whether
the strategic plan is likely to be achieved or not.
If not, what corrective actions must be taken.
Consequently, budget not only demands responsibility but
also accountability.

Budget helps strategic planning

A real-world example
Repertory

Theatre of St. Louis (somewhat

like Music Academy).
Not-for-profit professional art/music
theater supported by contributions from
donors and members and from ticket
sales.
Initial financial assessment indicated that
the theater is doing well.

Repertory Theater of St. Louis The problems

However, a

five-year budget showed that

expenses are likely to exceed revenues
within a few years.
Additional contribution from donors will
not bridge the gap.
Cost cutting would not work because it is
already low.
Ticket prices cannot be increased because
of competitive pressures.

Repertory Theater of St. Louis The Solution

Build

a second main-stage performing

space that would allow the theater to
Put on more performances
Sell more tickets.
Thus, the long-range budget identified a
financial crisis and suggested a strategic
solution to deal with the problem.

How does a budget help with performance

evaluation or accountability?
By

creating benchmarks.
A budget is a rationally prepared set of
benchmarks.
By comparing actual performance to the
budget, deviations can be ascertained and
evaluated.
Within reasonable limits, the budget
points to accomplishments or lack thereof.

Various types of budgets

Two

major types:

Operating budgets (most middle level managers

would be involved in this process)

Capital or Investment budgets (mostly senior
managers are involved in this process).

Operating budget could includes several subbudgets (e.g. Revenue budget, production
budget, marketing budget, etc.)

The Budgeting Process

Where do we begin and when do we end it?

An organizations strategic goals is the starting

point for the budgeting process.
Projected financial results for the next year is
compared to the goals to assess acceptability.
The budgeting process is driven by the demand
forecast (demand for a product at a given price).
Demand forecast can be developed in multiple
ways (market survey, growth trends, or other
estimates).
Based on demand forecast, prepare a sales plan for
each product line and services.

The budgeting process (continued)

Based

on the sales plan, develop the

factors of production (or other
procurement) raw materials, labor,
overheads, cash.
Lots of details would improve the
budgeting process but is time consuming
and expensive. Strike a balance.
We will work on one or two budgets later.

Preparing the initial budget

Initial

budget preparation is done by each

responsibility center (revenue centers, cost
centers, etc.)
Because, they know more about their
individual units, requirements,
constraints, etc.
Thee centers must consider both external
factors and internal factors that could
have an impact on their budget estimates.

Top
Management

Middle
Management

Middle
Management

Supervisor

Supervisor

Supervisor

Supervisor

Note: Initial flow of budget data in a participatory system is from lower levels of responsibility to
higher levels of responsibility. Each responsibility center manager prepares his/her budget
estimates and submits to the next higher level of management. These estimates are reviewed and
consolidated as they move upward in the organization.

Budgeting Process The Role of the

Responsibility Centers
Prepare the budget compatible with
organizational goals.
Communicate with other units and validate
units numbers.
Dont be optimistic but do not be pessimistic to
show achievement of budget targets.
Remember that eventually, resp. center
budgets are subject to approval by senior
managers and analysts, and are subject to
revisions.

What we rarely discuss

Human Factors in Budgeting
Regardless of what we discussed so far,
Budget process depends on 1) the degree to
which top management accepts the budget
program and 2) the way top management uses
the budget data.
Top management should NOT use the budget
as a weapon to pressure employees or to blame
if something goes wrong.
There should be meaningful dialogue.
The human aspect is the key.

Let us now prepare one or two small

budgets use the description and the
numbers given in the next set of slides.
The exercises would give you a basic idea of
the budgeting process (although not the
human interactions involved during such a
process)

Mylar Company
Manufactures

and sells a product that has

seasonal variations in demand with peak
sales coming in the 3rd quarter. The
following information concerns operations
for Year 2 the coming year and for the
first two quarters of Year 3.

Mylar Company data

The companys single product sells for $8 per unit.
Budgeted sales in units for the next six quarters are as
follows:
Year 2 Quarter
1
Budgeted
Sales in
Units

40,000

2
60,000

3
100,000

Year 3
Quarter
4
50,000

1
70,000

2
80,000

Mylar Company Data

Sales are collected: 75% in the qr. Sales are made, remaining 25% in the
following quarter. On Jan. 1, Year 2, the balance sheet showed $65,000 in
accounts receivable, all of which will be collected in the first quarter of
the year. Bad debts are negligible and can be ignored.
Company desires an ending inventory of finished units on hand at the
end of each quarter equal to 30% of the budgeted sales for the next
quarter. On Dec. 31, year 1, the company 12,000 units on hand.
Five pounds of raw materials are required to complete one unit of
product. Company requires an ending inventory of raw materials on
hand at the end of each quarter equal to 10% of the production needs of
the following quarter. On Dec. 31, Year 1, the company had 23,000
pounds of raw materials on hand.
The raw material costs $0.80 per pound. Purchases of raw material are
paid for in the following pattern: 60% in the quarter purchases are
made, remaining 40% in the following quarter. On Jan. 1, Year 2, the
companys balance sheet showed $81,500 in accounts payable for raw
material purchases, all of which will be paid for in the first quarter of the
year.

Mylar Company
We

will prepare:
A sales budget and a schedule of expected
cash collections.
A production budget
A direct materials purchases budget and a
schedule of expected cash payments for
material purchases.

Sales Budget for Mylar

Year 2 Quarter
1
Bud.
Sales

40,000

Selling X $8
price
per unit
Total
Sales

Year

60,000

100,000

60,000

250,000

X $8

X $8

X $8

X $8

$320,000 $480,000 $800,000 $400,000

$2,000,000

Based on these numbers, we will prepare a schedule of cash collections

Mylar Schedule of Cash Collections

Year 2 Quarter
1
A/Rec. Beg. Bal.
1st Qr. Sales
(320,000x75%, 25%)

65,000
240,000

2nd Qr. Sales

(480,000 x75%, 25%)

80,000
360,000

320,000
120,000
600,000

4th Qr. Sales

(400,000x75%, 25%)
305,000

Year
65,000

3rd Qr. Sales

(800,000x75%, 25%)

Total Cash Collections

440,000

720,000

480,000
200,000

800,000

300,000

300,000

500,000

1,965,000

Based on Sales Budget, The Production Budget for Mylar

Mylar Production Budget Raw Material Requirement

One more example for you to take a look at Revenue (Sales) budget
Davenport Company Data

Davenport Co. makes cash (20% of total sales),

credit card (50% total sales) and account sales
(30% of total sales). Credit card sales are
collected in the month following the sale, net of
3% credit card fee. Account sales are collected
as follows: 40% in the first month following the
sales, 50% in the second month following the
sale, 8% in the third month following the sales,
and 2% is never collected.
Using the data from the table, prepare a
statement showing the cash expected each
month.

Davenport Co. Projected Sales

Month

Sales

Month

Sales

Jan.

12,369,348

July

21,747,839

Feb.

15,936,293

Aug

14,908,534

Mar.

13,294,309

Sep

11,984,398

Apr.

19,373,689

Oct

18,894,535

May

20,957,566

Nov

21,983,545

June

18,874,717

Dec

20,408,367