© 1989 John Petroff
INTRODUCTION TO BUDGETING
Budgets are formal operating plans expressed in financial terms. Budgets help management
1- planning for the future and setting goals,
2- motivating employees,
3- coordinating activities,
4- identifying problem areas with performance evaluation, and, thus,
5- correcting difficulties.
THE BUDGET PERIOD
Most companies use a budget period which corresponds to their fiscal year. Annual budgets are often split into shorter periods - quarter or month - over which greater control can be exercised. When budgets are revised periodically to take account of changing internal and external conditions, this is called continuous budgeting. Budgeting extending over several years is referred to as long range planning.
The preparation of budgets is the responsibility of the budget committee. The budget committee is usually composed of employees of all levels of management because the success of the budgeting process depends on the cooperation of all departments and all employees. The preparation of budgets follows a sequence in which departmental estimates based on sales forecasts are received and combined into a master budget which must be approved by upper management. Most businesses initially base their estimates on prior years. But government agencies and not-for-profit organizations commonly prepare estimates as if the organization has just been created (which is called zero-base budgeting).
THE MASTER BUDGET
The master budget integrates all the departmental budgets. It is used to prepare projected financial statements called pro forma income statement and pro forma balance sheet. The contents of the master budget differ depending on the type of business (manufacturing, merchandising or services). But they always help management make operating, financing and capital expenditure decisions.
COMPONENTS OF A MASTER BUDGET
The master budget is composed of three parts:
1- the operating budget,
2- the capital expenditure budget, and
3- the cash or financial budget.
The operating budget is further decomposed into
1- the sales budget,
2- the cost of goods sold budget, and
3- operating expenses budget.
The budgeting process always starts with the sales budget.
BUDGETED FINANCIAL STATEMENTS
The budgeted (or pro forma) income statement is based on the sales forecast and the cost data contained in the operating budgets. Financial ratios are used to assess the contribution of various budgeted items of the income statement to profitability, and to analyze the anticipated liquidity, leverage and return on equity portrayed by the budgeted balance sheet.
BUDGET PERFORMANCE REPORTS
Budget performance reports compare budgeted figures with actual results. They reveal problem areas and help management correct them, as well as improve estimation methods. Because of the role of external factors, management is not always blamed for shortfalls. Nevertheless, it is essential that budgets contain achievable targets which motivate employees avoiding frustration which unmet goals can cause.
When changing levels of production are build into budgets, the budgets are said to be flexible budgets. Costs are classified as
1- fixed, which do not change with the production level,
2- variable, which are tied to the production level, or
3- semi-variable, which vary only beyond a given production level.
Flexible budgets gives recognition to the fact that the different variable costs do not vary in the same proportion to production levels.
COMPUTERS & BUDGETING
Most large businesses use computers to assist them in their budgeting efforts. The advantages of using computers are
1) they allow cost savings,
2) the data can be updated quickly and easily, and
3) the preparation of flexible and continuous budgets is simplified.
Standard cost systems are designed to measure the efficiency of manufacturing operations. A standard cost is the cost of a product determined by combining past year direct materials cost, factory overhead cost and direct labor cost, to arrive at the cost which can be anticipated for a "normal" level of production. Standard costs are used in job order and process cost accounting systems. The difference between the standard cost and the actual cost is called a variance. Variances are calculated for the total standard cost as well as for its components: materials, labor and overhead. Standard costs are revised when changes occur in the manufacturing process.
DIRECT MATERIALS COST VARIANCE
A direct materials cost variance is broken down into
1- a quantity variance (whether or not too much material was used), and
2- a price variance (whether or not the price was higher than anticipated).
A significant unfavorable materials quantity variance suggests the need to review the production process. A significant unfavorable materials price variance points at the purchasing department.
DIRECT LABOR COST VARIANCE
A direct labor cost variance is broken down into
1- a direct labor time (or efficiency) variance, and
2- a direct labor rate (or wage) variance.
Significant direct labor time variances suggest problems in productive efficiency. Significant direct labor rate variances require review of company personnel policies.
FACTORY OVERHEAD COST VARIANCE
A factory overhead cost variance is decomposed into
1- factory overhead volume variance (which is primarily affected by production being below 100% of capacity), and
2- factory overhead spending or controllable variance (which is capturing differences in the overhead amount itself).
Analysis of factory overhead variances is more difficult than other variances because overhead, being by nature fixed, is less under management's control, and because overhead is made of many different types of expenses. Since changes in levels of production are critical in this variance, flexible budgets are especially useful.
RECORDING STANDARDS IN ACCOUNTS
Variances are most clearly revealed when the use of standard costs is incorporated into the work in process inventory account: crediting for standard cost and debiting for actual cost leaves any balance in the account in excess of ending inventory as a variance. The analysis of that variance is useful for management to understand the income statement better.
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