PRINCIPLES AND PROCEDURES FOR

SUCCESSFUL BUDGETING
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 highpowered 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.

FUNCTIONS AND BENEFITS OF BUDGETING

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-today 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.

CLASSIFICATIONS AND TYPES OF BUDGETS

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:
1. The cost of a budgeted activity shows little or no change when the volume of
production fluctuates within an expected range of values. For example, a 10
percent increase in production has little or no impact on administrative expenses.
2. The volume of production remains steady or follows a tight, pre-set schedule
during the budget period. A company may fix its production volume in response
to an all inclusive contract; or, it may produce stock goods.

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.

PREPARATION OF 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:
1. Indirect materialsfactory supplies which are used in the process but are not an
integral part of the final product, such as parts for machines and safety devices for
the workers; or materials which are an integral part of the final product but are
difficult to assign to specific products, for example, adhesives, wire, and nails.
2. Indirect labor costssupervisors' salaries and salaries of maintenance, medical,
and security personnel.
3. Plant occupancy costsrent or depreciation on buildings, insurance on buildings,
property taxes on land and buildings, maintenance and repairs on buildings, and
utilities.
4. Machinery and equipment costsrent or depreciation on machinery, insurance
and property taxes on machinery, and maintenance and repairs on machinery.
5. Cost of compliance with federal, state, and local regulationsmeeting safety
requirements, disposal of hazardous waste materials, and control over factory
emissions (meeting class air standards).

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.

FINANCIAL BUDGET
The financial budget contains projections for cash and other balance sheet itemsassets
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 12month 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 amount of cash the company will receive from all sources, including
nonoperating items, creditors, and the sale of stocks and assets. The company
includes only those credit sales for which it expects to receive at least partial
payment.
The amount of cash the company will pay out for all activities, including dividend
payments, taxes, and bond interest expense.
The amount of cash the company will net from its operating activities and
investments.

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.
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Budget types

Sales budget an estimate of future sales, often broken down into both units and
currency. It is used to create company sales goals.
Production budget - an estimate of the number of units that must be
manufactured to meet the sales goals. The production budget also estimates the
various costs involved with manufacturing those units, including labor and
material. Created by product oriented companies.

Capital budget - used to determine whether an organization's long term

investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing.
Cash flow/cash budget a prediction of future cash receipts and expenditures for
a particular time period. It usually covers a period in the short term future. The
cash flow budget helps the business determine when income will be sufficient to
cover expenses and when the company will need to seek outside financing.
Marketing budget an estimate of the funds needed for promotion, advertising,
and public relations in order to market the product or service.
Project budget a prediction of the costs associated with a particular company
project. These costs include labour, materials, and other related expenses. The
project budget is often broken down into specific tasks, with task budgets
assigned to each. A cost estimate is used to establish a project budget.
Revenue budget consists of revenue receipts of government and the
expenditure met from these revenues. Tax revenues are made up of taxes and
other duties that the government levies.
Expenditure budget includes spending data items.

Types of budget
Budgets can be classified as following:

activity-based budget
add-on budget
bracket budget
continuous (rolling) budget
incremental budget
strategic budget
stretch budget
supplemental budget, and
target budget