A budget is a comprehensive, formal plan that estimates the probable expenditures and income for an organization over a specific period. Budgeting describes the overall process of preparing and using a budget. Since budgets are such valuable tools for planning and control of finances, budgeting affects nearly every type of organization—from governments and large corporations to small businesses—as well as families and individuals. A small business generally engages in budgeting to determine the most efficient and effective strategies for making money and expanding its asset base. Budgeting can help a company use its limited financial and human resources in a manner which best exploits existing business opportunities.
Intelligent budgeting incorporates good business judgment in the review and analysis of past trends and data pertinent to the business. This information assists a company in decisions relating to the type of business organization needed, the amount of money to be invested, the type and number of employees to hire, and the marketing strategies required. In budgeting, a company usually devises both long-term and short-term plans to help implement its strategies and to conduct ongoing evaluations of its performance. Although budgeting can be time-consuming and costly for small businesses, it can also provide a variety of benefits, including an increased awareness of costs, a coordination of efforts toward company goals, improved communication, and a framework for performance evaluation.
The idea behind any profitable commercial enterprise lies in employing resources to exploit various business opportunities. If the profits are consistent, a company may purchase more assets and, therefore, expand its base of wealth. To do this effectively, a company undertakes the budgeting process to assess the business opportunities available to it, the keys to successfully exploiting these opportunities, the strategies the historical data support as most likely to succeed, and the goals and objectives the company must establish. The company must also plan long-term strategies which define its overall effort in building market share, increasing revenues, and decreasing costs; short-term strategies to increase profits, control costs, and invest for the future; control mechanisms incorporating performance evaluations and good business judgment; and control mechanisms for making modifications in the above strategies when and where necessary.
Although opportunities initially find their impetus in the business judgment of company leaders, a company expresses its assessment of them and formulates its strategies in quantifiable terms, such as: the volume of units which the company expects it can sell, the percentage of market share the volume of units represents, the dollars of revenues it will receive from these sales, and the dollars of profit it will earn. Likewise, a company outlines its long-term goals and specifies its short-range plans in quantifiable terms which detail how it expects to accomplish its goals: the dollars the company will spend in selling the units; the dollar costs of producing the units; the dollar costs of administering the company's operations; the dollars the company will invest in expanding and upgrading facilities and equipment; the flow of dollars into the company coffers; and the financial position, expressed in dollars, at specific points in the future.
A financial forecast projects where the company wants to be in three, five, or ten years. It quantifies future sales, expenses, and earnings according to certain assumptions adopted by the company. The company then considers how changes in the business climate would affect the outcomes projected. It presents this analysis in the pro forma statement, which displays, over a time continuum, a comparison of the financial plan to "best case" and "worst case" scenarios. The pro forma statement acts as a guide for meeting goals and objectives, as well as an evaluative tool for assessing progress and profitability.
Through forecasting a company attempts to determine whether and to what degree its long-range plans are feasible. This discipline incorporates two interrelated functions: long-term planning based on realistic goals and objectives and a prognosis of the various conditions that possibly will affect these goals and objectives; and short-term planning and budgeting, which provide details about the distribution of income and expenses and a control mechanism for evaluating performance. Forecasting is a process for maximizing the profitable use of business assets in relation to: the analyses of all the latest relevant information by tested and logically sound statistical and econometric techniques; the interpretation and application of these analyses into future scenarios; and the calculation of reasonable probabilities based on sound business judgment.
Future projections for extended periods, although necessary and prudent, suffer from a multitude of unknowns: inflation, supply fluctuations, demand variations, credit shortages, employee qualifications, regulatory changes, management turnover, and the like. To increase control over operations, a company narrows its focus to forecasting attainable results over the short-term. These short-term forecasts, called budgets, are formal, comprehensive plans that quantify the expected operations of the organization over a specific future period. While a company may make few modifications to its forecast, for instance, in the first three years, the company constructs individual budgets for each year.
A budget describes the expected month-to-month route a company will take in achieving its goals. It summarizes the expected outcomes of production and marketing efforts, and provides management benchmarks against which to compare actual outcomes. A budget acts as a control mechanism by pointing out soft spots in the planning process and/or in the execution of the plans. Consequently, a budget, used as an evaluative tool, augments a company's ability to more quickly react and make necessary alterations.
To be successful, budgets should be prepared in accordance with the following principles:
REALISTIC AND QUANTIFIABLE In a world of limited resources, a company must ration its own resources by setting goals and objectives which are reasonably attainable. Realism engenders loyalty and commitment among employees, motivating them to their highest performance. In addition, wide discrepancies, caused by unrealistic projections, have a negative effect on the credit worthiness of a company and may dissuade lenders. A company evaluates each potential activity to determine those that will result in the most appropriate resource allocation. A company accomplishes this through the quantification of the costs and benefits of the activities.
HISTORICAL The budget reflects a clear understanding of past results and a keen sense of expected future changes. While past results cannot be a perfect predictor, they flag important events and benchmarks.
PERIOD SPECIFIC The budget period must be of reasonable length. The shorter the period, the greater the need for detail and control mechanisms. The length of the budget period dictates the time limitations for introducing effective modifications. Although plans and projects differ in length and scope, a company formulates each of its budgets on a 12-month basis.
STANDARDIZED To facilitate the budget process, managers should use standardized forms, formulas, and research techniques. This increases the efficiency and consistency of the input and the quality of the planning. Computer-aided accounting, analyzing, and reporting not only furnish managers with comprehensive, current, "real time" results, but also afford them the flexibility to test new models, and to include relevant and high-powered charts and tables with relatively little effort.
INCLUSIVE Efficient companies decentralize the budget process down to the smallest logical level of responsibility. Those responsible for the results take part in the development of their budgets and learn how their activities are interrelated with the other segments of the company. Each has a hand in creating a budget and setting its goals. Participants from the various organizational segments meet to exchange ideas and objectives, to discover new ideas, and to minimize redundancies and counterproductive programs. In this way, those accountable buy into the process, cooperate more, work harder, and therefore have more potential for success.
SUCCESSIVELY REVIEWED Decentralization does not exclude the thorough review of budget proposals at successive management levels. Management review assures a proper fit within the overall "master budget."
FORMALLY ADOPTED AND DISSEMINATED Top management formally adopts the budgets and communicates their decisions to the responsible personnel. When top management has assembled the master budget and formally accepted it as the operating plan for the company, it distributes it in a timely manner.
FREQUENTLY EVALUATED Responsible parties use the master budget and their own department budgets for information and guidance. On a regular basis, according to a schedule and in a standardized manner, they compare actual results with their budgets. For an annual budget, managers usually report monthly, quarterly, and semi-annually. Since considerable detail is needed, the accountant plays a vital role in the reporting function. A company uses a well-designed budget program as an effective mechanism for fore-casting realizable results over a specific period, planning and coordinating its various operations, and controlling the implementation of the budget plans.
Budgeting has two primary functions: planning and control. The planning process expresses all the ideas and plans in quantifiable terms. Careful planning in the initial stages creates the framework for control, which a company initiates when it includes each department in the budgeting process, standardizes procedures, defines lines of responsibility, establishes performance criteria, and sets up timetables. The careful planning and control of a budget benefit a company in many ways, including:
ENHANCING MANAGERIAL PERSPECTIVE In recent years the pace and complexity of business have outpaced the ability to manage by "the seat of one's pants." On a day-to-day basis, most managers focus their attention on routine problems. However, in preparing the budget, managers are compelled to consider all aspects of a company's internal activities. The act of making estimates about future economic conditions, and about the company's ability to respond to them, forces managers to synthesize the external economic environment with their internal goals and objectives.
FLAGGING POTENTIAL PROBLEMS Because the budget is a blueprint and road map, it alerts managers to variations from expectations which are a cause for concern. When a flag is raised, managers can revise their immediate plans to change a product mix, revamp an advertising campaign, or borrow money to cover cash shortfalls.
COORDINATING ACTIVITIES Preparation of a budget assumes the inclusion and coordination of the activities of the various segments within a business. The budgeting process demonstrates to managers the inter-connectedness of their activities.
EVALUATING PERFORMANCE Budgets provide management with established criteria for quick and easy performance evaluations. Managers may increase activities in one area where results are well beyond exceptions. In other instances, managers may need to reorganize activities whose outcomes demonstrate a consistent pattern of inefficiency.
REFINING THE HISTORICAL VIEW The importance of clear and detailed historical data cannot be overstated. Yet the budgeting process cannot allow the historical perspective to become crystallized. Managers need to distill the lessons of the most current results and filter them through their historical perspective. The need for a flexible and relevant historical perspective warrants its vigilant revision and expansion as conditions and experience warrant.
The budgeting process is sequential in nature, i.e., each budget hinges on a previous budget, so that no budget can be constructed without the data from the preceding budget. Budgets may be broadly classified according to how a company makes and uses its money. Different budgets may be used for different applications. Some budgets deal with sources of income from sales, interest, dividend income, and other sources. Others detail the sources of expenditures such as labor, materials, interest payments, taxes, and insurance. Additional types of budgets are concerned with investing funds for capital expenditures such as plant and equipment; and some budgets predict the amounts of funds a company will have at the end of a period.
A company cannot use only one type of budget to accommodate all its operations. Therefore, it chooses from among the following budget types.
The fixed budget , often called a static budget, is not subject to change or alteration during the budget period. A company "fixes" budgets in at least two circumstances:
The variable or flexible budget is called a dynamic budget. It is an effective evaluative tool for a company that frequently experiences variations in sales volume which strongly affect the level of production. In these circumstances a company initially constructs a series of budgets for a range of production volumes which it can reasonably and profitably meet.
After careful analysis of each element of the production process, managers are able to determine over-head costs that will not change (fixed) within the anticipated range, overhead costs that will change (variable) as volume changes, and those overhead costs which vary to some extent, but not proportionately (semi-variable) within the predicted range.
The combination budget recognizes that most production activities combine both fixed and variable budgets within its master budget. For example, an increase in the volume of sales may have no impact on sales expenses while it will increase production costs.
The continuous budget adds a new period (month) to the budget as the current period comes to a close. Under the fiscal year approach, the budget year becomes shorter as the year progresses. However, the continuous method forces managers to review and assess the budget estimates for a never-ending 12-month cycle.
The operating budget gathers the projected results of the operating decisions made by a company to exploit available business opportunities. In the final analysis, the operating budget presents a projected (pro forma) income statement which displays how much money the company expects to make. This net income demonstrates the degree to which management is able to respond to the market in supplying the right product at an attractive price, with a profit to the company.
The operating budget consists of a number of parts which detail the company's plans on how to capture revenues, provide adequate supply, control costs, and organize the labor force. These parts are: sales budget, production budget, direct materials budget, direct labor budget, factory overhead budget, selling and administrative expense budget, and pro forma income statement.
The operating budget and the financial budget are the two main components of a company's master budget. The financial budget consists of the capital expenditure budget, the cash budget, and the budgeted balance sheet. Much of the information in the financial budget is drawn from the operating budget, and then all of the information is consolidated into the master budget.
The master budget aggregates all business activities into one comprehensive plan. It is not a single document, but the compilation of many interrelated budgets which together summarize an organization's business activities for the coming year. To achieve the maximum results, budgets must be tailor-made to fit the particular needs of a business. Standardization of the process facilitates comparison and aggregation even of mixed products and industries.
Preparation of the master budget is a sequential process which starts with the sales budget. The sales budget predicts the number of units a company expects to sell. From this information, a company determines how many units it must produce. Subsequently, it calculates how much it will spend to produce the required number of units. Finally, it aggregates the foregoing to estimate its profitability.
From the level of projected profits, the company decides whether to reinvest the funds in the business or to make alternative investments. The company summarizes the predicted results of its plans in a balance sheet which demonstrates how profits will have affected the company's assets (wealth).
THE SALES FORECAST AND BUDGET The sales organization has the primary responsibility of preparing the sales forecast. Since the sales forecast is the starting point in constructing the sales budget, the input and involvement of other managers is important. First, those responsible for directing the overall effort of budgeting and planning contribute leadership, coordination, and legitimacy to the resulting forecast. Second, in order to introduce new products or to repackage existing lines, the sales managers need to elicit the cooperation of the production and the design departments. Finally, the sales team must get the support of the top executives for their plan.
The sales forecast is prerequisite to devising the sales budget, on which a company can reasonably schedule production, and to budgeting revenues and variable costs. The sales budget, also called the revenue budget, is the preliminary step in preparing the master budget. After a company has estimated the range of sales it may experience, it calculates projected revenues by multiplying the number of units by their sales price.
The sales budget includes items such as: sales expressed in both the number of units and the dollars of revenue; adjustments to sales revenues for allowances made and goods returned; salaries and benefits of the sales force; delivery and setup costs; supplies and other expenses supporting sales; advertising costs; and the distribution of receipt of payments for goods sold. Included in the sales budget is a projection of the distribution of payments for goods sold. Management forecasts the timing of receipts based on a number of considerations: the ability of the sales force to encourage customers to pay on time; the impact of credit sales, which stretch the collection period; delays in payment due to deteriorating economic and market conditions; the ability of the company to make deliveries on time; and the quality of the service and technical staffs.
THE ENDING INVENTORY BUDGET The ending inventory budget presents the dollar value and the number of units a company wishes to have in inventory at the end of the period. From this budget, a company computes its cost of goods sold for the budgeted income statement. It also projects the dollar value of the ending materials and finished-goods inventory, which eventually will appear on the budgeted balance sheet. Since inventories comprise a major portion of current assets, the ending inventory budget is essential for the construction of the budgeted financial statement.
THE PRODUCTION BUDGET After it budgets sales, a company examines how many units it has on hand and how many it wants at year-end. From this it calculates the number of units needed to be produced during the upcoming period. The company adjusts the level of production to account for the difference between total projected sales and the number of units currently in inventory (the beginning inventory), in the process of being finished (work in process inventory), and finished goods on hand (the ending inventory). To calculate total production requirements, a company adds projected sales to ending inventory and subtracts the beginning inventory from that sum.
THE DIRECT-MATERIALS BUDGET With the estimated level of production in hand, the company constructs a direct-materials budget to determine the amount of additional materials needed to meet the projected production levels. A company displays this information in two tables. The first table presents the number of units to be purchased and the dollar cost for these purchases. The second table is a schedule of the expected cash distributions to suppliers of materials. Purchases are contingent on the expected usage of materials and current inventory levels. The formula for the calculation for materials purchases is:
Materials to Be Purchased for Production Units of Materials to Be Used Units Desired in Ending Inventory-Units of Material in Beginning Inventory.
Purchase costs are simply calculated as:
Materials Purchase Costs Unit of Materials to Be Purchased X Unit Price.
A company uses the planning of a direct-materials budget to determine the adequacy of their storage space, to institute or refine Just-in-Time (JIT) inventory systems, to review the ability of vendors to supply materials in the quantities desired, and to schedule material purchases concomitant with the flow of funds into the company.
THE DIRECT-LABOR BUDGET Once a company has determined the number of units of production, it calculates the number of direct-labor hours needed. A company states this budget in the number of units and the total dollar costs. A company may sort and display labor-hours using parameters such as: the type of operation, the types of employees used, and the cost centers involved.
THE PRODUCTION OVERHEAD BUDGET A company generally includes all costs, other than materials and direct labor, in the production overhead budget. Because of the diverse and complex nature of business, production overhead contains numerous items. Some of the more common ones include:
BUDGET OF COST OF GOODS SOLD At this point the company has projected the number of units it expects to sell and has calculated all the costs associated with the production of those units. The company will sell some units from the preceding period's inventory, others will be goods previously in process, and the remainder will be produced. After deciding the most likely mix of units, the company constructs the budget of the cost of goods sold by multiplying the number of units by their production costs.
ADMINISTRATIVE EXPENSE BUDGET In the administrative expense budget the company presents how much it expects to spend in support of the production and sales efforts. The major expenses accounted for in the administrative budget are: officers' salaries; office salaries; employee benefits for administrative employees; payroll taxes for administrative employees; office supplies and other office expenses supporting administration; losses from uncollectible accounts; research and development costs; mortgage payments, bond interest, and property taxes; and consulting and professional services.
Generally, these expenses vary little or not at all for changes in the production volume which fall within the budgeted range. Therefore, the administrative budget is a fixed budget. However, there are some expenses which can be adjusted during the period in response to changing market conditions. A company may easily adjust some costs, such as consulting services, R&D, and advertising, because they are discretionary costs. Discretionary costs are partially or fully avoidable if their impact on sales and production is minimal. A company cannot avoid such costs as mortgage payments, bond interest, and property taxes if it wishes to stay in production into the next period. These committed costs are contractual obligations to third parties who have an interest in the company's success. Finally, a company has variable costs, which it adjusts in light of cash flow and sales demand. These costs include such items as supplies, utilities, and the purchase of office equipment.
BUDGETED INCOME STATEMENT A budgeted income statement combines all the preceding budgets to show expected revenues and expenses. To arrive at the net income for the period, the company includes estimates of sales returns and allowances, interest income, bond interest expense, the required provision for income taxes, and a number of nonoperating income and expenses, such as dividends received, interest earned, nonoperating property rental income, and other such items. Net income is a key figure in the profit plan for it reflects how a company commits the majority of its talent, time, and resources.
The financial budget contains projections for cash and other balance sheet items—assets and liabilities. It also includes the capital expenditure budget. It presents a company's plans for financing its operating and capital investment activities. The capital expenditure budget relates to purchases of plant, property, or equipment with a useful life of more than one year. On the other hand, the cash budget, the budgeted balance sheet, and the budgeted statement of cash flows deal with activities expected to end within the 12-month budget period.
THE CAPITAL EXPENDITURES BUDGET A company engages in capital budgeting to identify, evaluate, plan, and finance major investment projects through which it converts cash (short-term assets) into longterm assets. A company uses these new assets, such as computers, robotics, and modern production facilities, to improve productivity, increase market share, and bolster profits. A company purchases these new assets as alternatives to holding cash because it believes that, over the long-term, these assets will increase the wealth of the business more rapidly than cash balances. Therefore, the capital expenditures budget is crucial to the overall budget process.
Capital budgeting seeks to make decisions in the present which determine, to a large degree, how successful a company will be in achieving its goals and objectives in the years ahead. Capital budgeting differs from the other financial budgets in that they require relatively large commitments of resources, extend beyond the 12-month planning horizon of the other financial budgets, involve greater operating risks, increase financial risk by adding long-term liabilities, and require clear policy decisions that are in full agreement with the company's goals. For the most part, a company makes its decisions about investments by the profits it can expect and by the amount of funds available for capital outlays. A company assesses each project according to its necessity and potential profitability using a variety of analytical methods.
THE CASH BUDGET In the cash budget a company estimates all expected cash flows for the budget period by stating the cash available at the beginning of the period, adding cash from sales and other earned income to arrive at the total cash available, and then subtracting the projected disbursements for payables, prepayments, interest and notes payable, income tax, etc.
The cash budget is an indication of the company's liquidity, or ability to meet its current obligations, and therefore is a very useful tool for effective management. Although profits drive liquidity, they do not necessarily have a high correlation. Often when profits increase, collectibles increase at a greater rate. As a result, liquidity may increase very little or not at all, making the financing of expansion difficult and the need for short-term credit necessary.
Managers optimize cash balances by having adequate cash to meet liquidity needs, and by investing the excess until needed. Since liquidity is of paramount importance, a company prepares and revises the cash budget with greater frequency than other budgets. For example, weekly cash budgets are common in an era of tight money, slow growth, or high interest rates.
THE BUDGETED BALANCE SHEET A company derives the budgeted balance sheet, often referred to as the budgeted statement of financial position, from changing the beginning account balances to reflect the operating, capital expenditure, and cash budgets. (Since a company prepares the budgeted balance sheet before the end of the current period, it uses an estimated beginning balance sheet.)
The budgeted balance sheet is a statement of the assets and liabilities the company expects to have at the end of the period. The budgeted balance sheet is more than a collection of residual balances resulting from the foregoing budget estimates. During the budgeting process, management ascertains the desirability of projected balances and account relationships. The outcomes of this level of review may require management to reconsider plans which seemed reasonable earlier in the process.
BUDGETED STATEMENT OF CASH FLOWS The final phase of the master plan is the budgeted statement of cash flows. This statement anticipates the timing of the flow of cash revenues into the business from all resources, and the outflow of cash in the form of payables, interest expense, tax liabilities, dividends, capital expenditures, and the like.
The statement of cash flows includes:
The net amount is a clear measure of the ability of the business to generate funds in excess of cash outflows for the period. If anticipated cash is less than projected expenses, management may decide to increase credit lines or to revise its plans. Note that net cash flow is not the same as net income or profit. Net income and profit factor in depreciation and nonoperating gains and losses which are not cash generating items.
Budgeting is the process of planning and controlling the utilization of assets in business activities. It is a formal, comprehensive process which covers every detail of sales, operations, and finance, thereby providing management with performance guidelines. Through budgeting, management determines the most profitable use of limited resources. Used wisely, the budgeting process increases management's ability to more efficiently and effectively deploy resources, and to introduce modifications to the plan in a timely manner.
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SEE ALSO: Business Planning