NOTES ON BUDGET

Budgeting is performed for planning and control purposes. Budgeting allows identifying and setting
business objectives and goals. There is a variety of budgets. The most common budget types include the
following:
 master budget
 operating budget
 financial budget
 cash budget
 static budget
 flexible budget
 capital expenditure budget, and
 program budget

These budget types are briefly explained below.

Master budget is the set of financial and operating budgets for a specific accounting period, usually the
next fiscal or calendar year. Master budget is prepared quarterly or annually. The format of the master
budget varies with business nature and size. Operating budgets are used in daily operations and are the
basis for financial budgets. Operating budgets include the following: sales, production, direct materials,
direct labor, overhead, selling and administrative expenses, cost of goods manufactured, and cost of
goods sold. Financial budgets include a budgeted income statement and balance sheet, cash budget, and
capital expenditures budget. Budgeted income statement and budgeted balance sheet are also called pro
forma financial statements.

Operating budget is the budget for income statement elements such as revenues and expenses. The
operational budget covers revenues and expenses surrounding the day-to-day core business of a
company. Revenues represent sales of products and services; expenses define the costs of goods sold
as well as overhead and administrative costs directly related to producing goods and services. While
budgeted annually, operating budgets are usually broken down into smaller reporting periods, such as
weekly or monthly. Managers compare ongoing results to budget throughout the year, planning and
adjusting for variations in revenue.

Financial budget is the budget for balance sheet elements. In other words, financial budget deals with
the expected assets, liabilities, and stockholders’ equity. A financial budget outlines how a business
receives and spends money on a corporate scale, including revenues from core business plus income
and costs from capital expenditures. Managing assets such as property, buildings, investments and major
equipment may have a significant effect on the financial health of a company, particularly through the
peaks and troughs of daily business. Executive managers use financial budgets to leverage financing and
value the company for mergers and public offerings of stock.
Cash budget is the budget for expected cash inflows and outflows during the specific period of time.
Cash budget consists of four sections: receipts, disbursements, cash surplus or deficit, and financing
section. The receipts section lists the beginning cash balance, cash collections from customers, and other
receipts. The disbursements section shows all cash payments (characterized by purpose). The cash
surplus (deficit) section provides the difference between cash receipts and cash disbursements. Finally,
the financing section examines in detail expected borrowings and repayments during the period.

Static (fixed) budget is the budget at the expected capacity level. Because static budget is fixed, it is
usually used by stable companies. Also, this type of budget can be used by departments with operations
independent from capacity levels. For example, operations of administrative and general marketing
departments usually does not depend on the level of production and sales and is rather determined by the
department’s management; as the result, static budget can be used by such departments.

Thus, a static budget contains elements where expenditures remain unchanged with variations to sales
levels. Overhead costs represent one type of static budget, but these budgets aren't confined to
traditional overhead expenses. Some departments may have a fixed amount of money set in budget to
spend, and it is up to managers to make sure such amounts are spent without going over-budget. This
condition occurs routinely in public and nonprofit sectors, where organizations or departments are funded
largely by grants.

Flexible (expense) budget is the budget at the actual capacity level. Because flexible budget is dynamic,
it is commonly used by companies. Flexible budget is adjusted to the actual activity of the company. It can
be easily prepared using a computerized spreadsheet (e.g., Excel). At first, the relevant activity range is
determined for the coming period. Next, costs that are expected be incurred over the relevant range are
analyzed. These costs are then separated based on their cost behavior: fixed, variable, or mixed. Finally,
the flexible budget for variable costs at different points throughout the relevant range is prepared. In other
words, flexible budget matches expenses to specific revenue levels or activity levels. For example, utility
costs can be tied to the number of machines in operation.

Capital expenditure budget is the budget for expected investments in capital assets and long-term
projects. It is usually prepared for 3 to 10 years. Investments in capital assets include purchasing fixed
assets such as plant, land, buildings, machinery, equipment, and mineral resources. Long-term projects
might be undertaken to develop new products, expand existing product lines, or reduce costs. Sometimes
a capital project committee is created to overlook capital budgeting processes. Such a committee is
typically separate from the budgeting committee.
Following are the types of budget used in practice.

 Fixed budgeting.

Fixed budget is the original budget designed to forecast future performance andchallenges faced
by the business. So that resources can be arranged and competences can be developed to face
these challenges. Fixed budgets can be used motivate employees. It also communicates the
employees what level of performance is expected of them. It helps to harmonize the activities
across the organization. Ex. Production manager will be informed in advance what quantity and
quality of goods are required.

 Master budget.

Master budget is also called cash budget. It is the head of all budgets. It is prepared at last after all
other departmental budgets are finalized. In other words, Master budget is a fixed budget
comprised all sub-fixed budgets. It help businesses to manage their cash flows. It enables
businesses to arranged for cash flows. Ex. If business are about to acquire an item of machinery,
cash can be managed by reducing some research & development expenditure.

 Incremental budgeting
Incremental budgeting as the name suggests budgeting based on previous year budget. Previous year
budget is adjusted for inflation and activity level. It assumes that factors affecting the business will remain
same as before. So it is suitable for stable business environments. It requires little time and resources as
compared to other types of budgeting. It can be used by small businesses with lesser resources, simple
business activities, fewer products and managed by owners. In practice is it widely used approach to
budgeting particularly by not-for-profit organizations.

 Flexible budgeting

Flexible budgeting is used for determining the possible impact on business objectives for range of
circumstances, Ex. What will be the profit figure if business sells 10,000 units instead of 15,000
units. Flexible budget is used as feed forward control (Take action before thing go wrong)
mechanism.
 Flexed budgeting.

Flexed budget is used for performance measurement purpose. Variables like activity level (sales
volume) are changed to facilitate comparison with actual or competitors results. It make the
performance evaluation more meaningful in the way the performances between divisions or whole
businesses are compared under same circumstances. Ex, if actual results are for activity level of
20,000 units then it will be meaningless if compare the original budget based on 30,000 units. By
flexing it to 20,000 units, now it make sense to evaluate revenues, costs and efficiencies of the two
divisions or business.

 Rolling budgeting.

Rolling budget is not a one time activity, it is a process which continues throughout the life of the
business. Initially first budget is prepared on quarterly or yearly basis. Afterwards, when each
month passes, new month is added to the budget at it end. Also the existing remaining months are
also reviewed for changing circumstances that might require the budget to be revised. In this way
business have always quarterly or yearly budget present ahead. Rolling budget gives
more realistic budgeted figures. It consumes plenty of managerial time and cost. This may be
justified if benefit exceeds costs. It is suitable for rapidly changing environment.

 Zero-based budgeting.

Zero-based budgeting is the budgeting process starts from zero. It means all budget figure are
gathered in the light of current circumstances. What was done before is ignored. This process
repeats each year. It is very time consuming and costly approach to budgeting. It is suitable for
business having activities of non-repetitive nature. Like construction business in which every
projects are different.

 Activity based budgeting.

Activity based budgeting is the approach based on data available for activity based costing. This
approach is different from all above approaches in the way it is the budgeting based on activities,
while traditional budgeting is based departmental jurisdictions. Department based budgets focuses
on cost and revenues of their own area while business is performed by carrying out activities. So
activities based budgeting gives information in the way business operates. Control are better
exercised by focusing on activities, which activity to improve, increase, decrease and discontinue. It
requires sound information gathering systems through the use of information technology. This is
the most complex form of budgeting requires training, technology and time to implement it.
 Preparing budgets
A budget allows you to plan, control and make decisions related to the revenue, resources and
financial commitments of your business. Without a budget, your business runs the risk of spending
more money than it generates in revenue, or not spending enough to allow your micro-business to
grow.
There are many different types of budgets that can be prepared for businesses. It is important to
ensure you prepare budgets that best reflect your business' needs.
The following points list the main types of budgets and the reasons why they are important:

 Sales budget – to provide details with regards to the expected sales for the budgeted period.

 Production budget – to describe how many units must be produced in order to meet the budgeted
sales.

 Expense budget – to estimate all the costs (including material, labour, overhead, and other
operating costs) that are likely to be incurred in meeting the budgeted sales targets.

 Cash flow budget – to forecast all the future cash inflows and outflows for the budgeted period.

 Budgeted profit and loss statement – to estimate projected sales, expenses and net income (or
loss) for the budgeted period.

 Budgeted balance sheet – to predict the values of business’ assets, liabilities and equity at the
end of the budgeted period.

Note on Zero based budget

• Start each budget period afresh-not based on historical data

• Budgets are zero unless managers make the case for resources-the relevant manager
must justify the whole of the budget allocation

• It means that each activity is questioned as if it were new before any resources are
allocated to it.

• Each plan of action has to be justified in terms of total cost involved and total benefit
to accrue, with no reference to past activities.

• Zero based budgets are designed to prevent budgets creeping up each year with
inflation

ZERO BASED BUDGET IN A NEW TECHNIQUE IN BUDGETING. ELABORATE? – (MO

13- 6 MRKS)
Budgeting: Planning and Control System

 Budgeting is a management planning and control system.

 Budgeting process consists of deciding the objectives of an organization for a defined
period, say one year and breaking them down into detailed objectives and activities
required to meet them. Activities throw up the requirement of resources.
 Based on this, the yearly financial plan is made. It is calculated as to how much
money will be needed to perform the desired activities for achievement of the
objectives.
 These plans are made at every departmental level and then integrated at the
organizational or corporate level.
 Entire process aims at justification of the financial allocations for every objective and
every job.
 The budgets thus drafted are studied for viability of the expected profitability in the
organization and finally, new draft of budget is prepared by making necessary
changes in the budget. The final budget is then approved by the management.
 The actual expenditure is then compared and controlled throughout the year so that
it remains within the approved budgets and predicted profitability is achieved.

Conventional Budgeting

 Departments prepare their budgets based on the previous year's budgets.

 Departments justify only the increases in the expenses required for the current year;
they need not have to justify the expenses/budget already approved in the previous
year.
 It is taken for granted that the previous year's expenses will have to be made in any
case to maintain the regular business level.

Zero Based Budgeting: Unconventional

 In contrast to conventional budgeting, zero based budgeting system in

unconventional.
 It is not based on previous year's budget.
 It is not formulated by just incrementing the previous year's expenditure for the
current year.
 It starts with zero base. It's a clean slate approach.
 Departmental objectives are decided within the frame work of corporate or
organizational objectives and then broken down into detailed objectives and
activities/tasks.
 The resources and therefore, the expenses required to acquire and use those
resources are calculated at the current market conditions.
 Additionally, at every step, questions are asked whether the activities to be
undertaken to achieve the objectives are value adding and the scopes of
improvements in business, administrative and technical processes are thought of.
 Overall cost control and cost management are the important key aspects in drawing
the zero based budget.
 The budget thus formulated may be lower than or equal to or higher than the
previous year's budget. But looks like, that it is necessary to allocate and use that
kind of money for better performance and better profitability.
 This kind of budget seems more realistic and more precise.
  The expenditures can now be controlled and profits as predicted realized with lot
more surety.

Advantages of Zero Based Budgeting

 It questions the current budgets/expense levels, the effectiveness and efficiency of

current processes.
 Thus, overall cost management/control is in-built.
 It focuses on corporate or organizational objectives and within them, the
departmental objectives. Thus budget supports their achievements; it supports the
overall business very effectively.
 It drives the departments' plans and so, the planning process starts right away with
the formulation of the budgets right at the beginning of the year.
 Ultimately focuses on value for money (VFM).
 It is based on current market and business realities and therefore, more realistic.

Disadvantages of Zero Based Budgeting

 More time and effort are required in zero based budgeting as compared to the
incremental or conventional budgeting.
 Questioning the current ways of doing business may be threatening to some people
within the organization.
 Deciding the departmental objectives within the frame work of organization
objectives necessitates top down communication of these objectives with lots of
clarity. This is often not done.

 Components Of The Budget
 Business processes are highly complex and require considerable effort to coordinate.
Managers frequently cite coordination as one of the greatest leadership challenges. The
comprehensive or master budget is an essential part of the coordinating effort. Such budgets
consist of many individual building blocks that are tied together in logical harmony and reflect
the organization’s financial plan.
 The base or foundation for the master budget is an assessment of anticipated sales volume via
the sales budget. The expected sales level drives both the production plans and the selling,
general, and administrative budget. Production drives the need for materials and labor.
Factory overhead may be applied based on labor, but it is ultimately driven by overall
production. The accompanying graphic is a simplified illustration of these budget building
blocks.
 The planned business activities must be considered in terms of their cash flow and
financial statement impacts. It is quite easy to plan production that can outstrip the
resources of a company. In addition, a business should develop plans that have a
successful outcome; the budgeted financial statements are key measures of that
objective. It would be very easy to expand the illustration to reflect additional
interactions and budgets (e.g., the coordination of a long-term capital spending
budget).
 Comprehensive budgeting entails coordination and interconnection of various
components. Electronic spreadsheets are useful in compiling a budget. If care is used
in constructing the embedded formulas, it becomes very easy to amend the budget
to examine the impact of different assumptions about sales, sales price, expenses,
and so forth.

 Sales Budget

 All budgets rely on information from the sales budget. The

operating budget process begins with the sales budget which includes a
forecast of revenues generated by the sales department and sales VPs
in the company. A number of sources are used by managers to estimate
how much sales will occur in the future including economic forecasts,
mathematical models, industry data, and statistical trend analysis. The
budgeting process usually begins with a sales budget. The sales budget
reflects forecasted sales volume and is influenced by previous sales
patterns, current and expected economic conditions, activities of
competitors, and so forth. The sales budget is complemented by an
analysis of the resulting expected cash collections. Sales often occur on
account, so there can be a delay between the time of a sale and the
actual conversion of the transaction to cash. For the budget to be
 useful, careful consideration must also be given to the timing and
pattern of cash collections.

 For most companies, sales forecasting is the most difficult part of

budgeting. Fortunately for you, it is the easiest part because this
information will be given to you. If it were up to you to forecast sales,
problems would result with a different solution for each person in the
classroom.
 Example
 At January 1, 2012, Arrant, Inc. had 1,100 stools on hand. Its policy is to
maintain an ending inventory equal to 15% of the next month’s sales.
Arrant Co. estimates it will sell 44,000 step stools during the first month of
2008 with a 7% increase in sales each subsequent month. Each stool is
sold for $16. Prepare a sales budget for the first three months of the year.

 Solution
 A lot more information is provided in this problem than what you need.
Because sales is an independently generated amount that is not based on
the number of units in inventory, so all of the inventory information
provided in this problem is irrelevant for the sales budget. You have been
provided the sales in units for January. February's also will be 7% larger
than January so multiply January units by 107% or 1.07 to get February's
sales. March's sales add an increase of another 7% on top of the already
increased February sales. The sales for each month are as follows:
 Sales in units for January = 44,000
 Sales in units for February = 44,000*1.07 = 47,080
 Sales in units for March = 47,080*1.07 = 50,376
 Sales revenue for March = 50,376
 In preparing the budget, you should never show prior period
amounts. Only amounts for future periods should be included in
the budget. Every budget should begin with a standard, three-line
statement heading which includes with the company name, the
name of the budget, and the time period it covers. The sales
budget for this example will appear as follows:

DT. Inc.
Sales Budget
Three Months Covering January thru March of 2012
January February March
Sales in units 44,000 47,080 50,376
Selling price per unit $ 16.00 $ 16.00 $ 16.00
Budgeted sales revenue $704,000 $753,280 $806,010
 Production Budget
The production department manufactures products based on the
number of units the sales people have forecasted to sell. The sales
budget reflects the number of units to be sold. The production schedule
enables the production supervisor to hire and schedule employees and
the purchasing department to plan for ordering materials needed.
It is important to make the distinction between two types of
units--.finished goods units and raw materials units. Sales drive the level
of production. Production is also a function of the beginning finished
goods inventory and the desired ending finished goods inventory. The
budgeted units of production can be calculated as the number of units
sold, plus the desired ending finished goods inventory, minus the
beginning finished goods inventory. In planning production, one must
give careful consideration to the productive capacity, availability of raw
materials, and similar considerations.

 Think about which of these units the company will sell. Because finished
goods are the units that are sold, these are the units that are produced.
 Budgeted sales of finished units
 + Desired ending inventory of finished goods (FG) units
 − Beginning inventory of FG units
 = FG units to be produced
 Example
 Schroeder Inc. sells placemats for $15 each. The company’s
budgeted unit sales for 4 months during 2008 appears below.
February 39,000
April 42,000
May 44,000
June 40,000

 Schroeder needs to have total mats on hand at the end of each month
equal to 15 percent of the following month’s budgeted unit sales. Each
mat requires 0.25 yards of fabric. At the end of each month, Schroeder
desires to have 20 percent of production material needs required for the
next month on hand. The fabric costs $2.60 per yard. Each mat produced
requires 0.15 hours of direct labor. How many mats should Schroeder
produce during the month of April?

 Solution
 Begin with the number of units the company expects to sell during April, a
total of 42,000. The production people need to make enough units to
cover the 42,000 to be sold, plus enough left over at the end of the month
 of which to start the next month. THe company wants to have 15% of what
they expect to see the next month, May, left over: 15% x 44,000 = 6,600.
FG units to be sold 42,000
+ Desired FG ending inventory 6,600
 However, the company had some completed units left over at the
beginning of April that reduce the number of units that need to be
produced during April. The inventory balance at the end of March was
budgeted at 15% times April sales, giving 15% x 42,000, or 6,300 units left
over at March 31. The last day of March and the first day of April should
always have the same inventory balance.

DT. Inc.
Production Budget
Month Ending April 30, 2008
FG units to be sold 42,000
+ Desired FG ending inventory (15%*44.000) 6,600
- Beginning FG inventory on hand expected (15%*42,000) (6,300)
FG units (Placements) to be produced 42,300

 Because the production budget only determines the number of units to be
produced, no dollar signs should be displayed.

 Direct Materials Purchases Budget

 The direct materials purchase budget depends on the amounts needed for
production and the amount of raw materials needed for the ending inventory and
held in the beginning inventories.

 The amount of direct materials to be purchased is calculated as follows:

 Budgeted FG units to be produced
 x RM needed for each FG unit
 = Total RM needed for production
 + Desired RM ending inventory
 − Beginning RM on hand
 = RM needed to purchase
 x Cost per RM unit
 = Budgeted cost of purchases
 The general approach is to begin with production units, not sales units.
Why? You want to know how much to 'produce', not to sell, so use the
production units.

 In dealing with production, there are three issues you must consider: the
number of FG units, the number of units of raw materials (pounds,
yards, etc.) and the cost per unit. You must remember two crucial rules
 in materials purchases budgets. First. convert each amount used in the
materials purchases budget to whatever denomination in which
materials are ordered, i.e., pounds, yards, grams, kilos, etc. Second,
always wait until the last step to consider the cost of the materials.

 Example:
 Trump Inc. produces trinkets. Each trinket requires 0.4 board feet of wood
and 1.25 hours of direct labor. Wood costs $1.40 per board foot. Trump
pays it employees $18.00 per hour. Trump desires to have 20% of the
materials needed for production during the next month on hand at the end
of each month, and 15% of the number of trinkets to be sold the next
month on hand at the end of each month. Scheduled sales and production
in units are:
Budgeted Sales Budgeted Production
April 4,200 4,100
May 4,500 4,700
June 5,200 5,300
 Prepare a materials purchases budget for May in good form. Calculate
budgeted raw materials inventory on the balance sheet at April 30 & May
31.

 Solution
 While both units to be sold and units to be produced are listed, you only
need 'produced' because those are the units in which the materials will be
consumed during the period. The second line of the budget immediately
converts the FG units to be produced to the denomination in which they
are bought....i.e., in board feet. Every amount from this point on is listed in
board feet.

Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880

 You now add in the desired ending inventory. This is often tricky because
two different 'ending inventories' are cited in the problem. Be sure you
focus on 'raw materials' and not 'finished goods.' We are concerned with
the 20% inventory levels, not the 15% levels that appear in this problem.
The 15% amount pertain to finished goods--we already know how many
finished goods to produce, i.e., the budgeted production numbers provided
above.

 The raw materials requirements state: Trump desires to have 20% of the
materials needed for production during the next month on hand at the end
of each month, Dates are important. The end of the budget period is May
 31. The 'next' month's production is the month of June, so the company
wants enough materials to make 20% of June's units...20% times 5,300
units to be produced in June times 0.4 board feet each, for a total of 424
board feet.

Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired RM ending inventory 424

 Next is to subtract out the beginning inventory which is left over from the
previous month (April,) At the end of April, management desires to have
20% of the materials needed for the next month---May. 4,700 will be
produced in May, so 4,700 times 0.4 board feet each times 20% gives us
376 feet. Adding the board feet needed to the ending inventory minus the
beginning inventory gives us 1,928 feet needed for purchase.

Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired RM ending inventory 424
Less beginning RM on hand (376)
Board feet needed to purchase 1,928

 Once the number of feet to be purchased is determined, finally the cost
per board foot is factored in.

Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired RM ending inventory 424
Less beginning RM on hand (376)
Board feet needed to purchase 1,928
Cost per board foot $1.40
Budgeted cost of purchases $2,699

 Note that last line represents the 'cost' of purchases, not the cash to be
paid for purchases, and not the cost of goods sold. Cash payments are
often made partially during the current month and part the next month.

 To calculate budgeted raw materials inventory on the balance sheet at
April 30 & May 31, we look at the budget to determine the number of feet
 that were scheduled to be on hand on those dates. This calculation is the
same amount you use for beginning and ending inventory on the materials
purchases budget multiplied by the cost per board foot. Note that balance
sheet amounts are always in dollars, not feet, pounds, yards, etc.
 Board feet at April 30 = 20% x 4,700 x 0.4 = 376 board feet
 Cost at April 30 = 376 BF x $1.40 = $526.40

 Board feet at May 31 = 20% x 5,300 x 0.4 = 424 board feet
 Cost at May 31 = 424 BF x $1.40 = $593.60