The Budgeting Process in More Detail (Problem on last page)

There are many purposes of budgeting, but one purpose (and end result) is to prepare pro-
forma, or “as if” financial statements. Once a business is up and running, many
businesses do very little in the budgeting area, and some of them manage to do quite well.
And many of the businesses that do have a budget process in place, do not carry it out to
the full extent of preparing pro-forma financial statements.

Budgets and Financial Statements

Remember that financial statements in general report actual past results. These actual
past results are based on all of the actual transactions (and their consequences) that have
occurred. Budgets, on the other hand, represent future goals and/or expectations. If we
have a complete budget that covers all of the expected aspects of a company’s operations,
we can use that information to prepare “pro forma” financial statements. Note that if a
company prepares a budget for only some of its operations (for example, a company
might use a budget in order to manage and control expenses, but not use a budget on the
sales side), then one cannot prepare pro forma financial statements.

Budget Process Considerations for an Existing Business

Assuming that an existing business has existing financial statements for the most recent
year(s), the existence of the statements has implications for the budget process.
Remember that a budget is based on estimates, and the amount of work that is put into
developing those estimates can vary widely. Even for one company preparing a budget
for one year, some parts of the budget might be prepared using nothing more than “rough
guesses” whereas other parts might be prepared using very detailed analyses.

The first implication of having existing actual financial statements when preparing a
budget is that they serve as a starting point to prepare the budget for future periods. This
starting point, of course, makes the budget process easier. In addition, by using the past
actual results, it is less likely that you will forget to include something, such as a category
of expenses. Lastly, this “actual results” starting point is often more accurate than
making estimates where you have no actual past history.

The second implication is that the company can choose to not only “start with” the past
results, but can also almost “end with” them as well. In other words, your budget could
be prepared simply by saying, “Assume that all revenues and expenses go up by 5%.”
Thus, with very little work you can have your complete budget finished. How good such
a budget is, of course, is another matter. In other words, for an existing business, you can
use the past financial statements as a starting point, and from there do very little work, or
a large amount of work, in preparing the budget.
Preparing a Budget for a business that does not yet exist.

When preparing a business plan for a startup business, there is no past history to use as a
starting point for the budget part of the business plan. Thus, the only option is to use
other means to somehow develop an estimate for each and every event (or series of
events) that might take place. This process must include not only the revenues and
expenses, but must also include capital expenditures that the company will make during
the period.

Capital expenditures include acquisitions of items such as equipment and land that the
company will use for many years. These capital expenditures can be especially
significant when a business is starting up and first acquiring the equipment that it needs
to operate. An ongoing business can sometimes delay capital expenditures during
difficult times and continue to use existing equipment, but a startup doesn’t have any old
equipment that it can use a while longer.

The real difficulty in budgeting for a startup is the fact that you must develop all the
numbers “from scratch.”

The Budget Process in General

In an existing business, there are many approaches as to how the budget is actually
prepared. In some companies, top management develops it without any help from others
inside the company. At the other extreme, top management might ask all department
managers to prepare a budget for his or her department. Then these would be assembled
and connected together. If you don’t yet have a business in existence, it is you (and the
others, if any, starting the business) who must do all of this work.

Usually the sales budget is the starting point. The company makes an estimate of what it
can sell, and from that the other budgets are prepared. If there is some other constraint,
such as the amount of product that can be produced, the budget process might start there.
Regardless of where it starts, there will be a sequence in which the budgets are prepared.
There are some budgets that are “pre-requisites” to other budgets, some are more or less
independent. For example, for a manufacturer you must know the sales budget before
you can prepare the production budget, and you must know the production budget before
you can prepare the raw materials purchasing budget or the labor budget.

Once you have prepared all of the component budgets, you then take the appropriate
numbers from each and can prepare budgeted, or pro forma, financial statements. One of
the financial statements is the cash flow statement, thus in the entire budgeting process
you must also determine the amounts and timing of the cash payments and receipts that
are related to the budget items. It is not enough to know that you will purchase $260,000
of raw materials in the year, but you need to determine exactly when those amounts are to
be paid. This will help you determine if you’ll have adequate cash on hand or have an
impending cash crunch that you’ll need to take steps to avoid.
Relationship of Component Budgets

There is no single hierarchy of budget components. Assuming that all else depends on
the Sales budget, they could be related as below for a manufacturer:

Sales budget
 Production Budget
o Raw materials purchasing budget
o Direct labor budget
o Overhead budget
 Utilities budget
 Factory repair and maintenance budget
 Indirect factory labor budget
 Indirect materials budget
 Other overhead items budget
 Selling, general and administrative expense budget
o Selling expenses budget
 Salesperson salaries and commissions budget
 Advertising expense budget
 Salesperson company car budget
 Misc. selling expense budget
o Research and Development Budget
o Information Technology Budget
o General and miscellaneous expenses budget
 Capital Expenditures budget
Then you would use:
 Production budget components to prepare a budgeted cost of good manufactured
and budgeted cost of goods sold
 All of the budgets that involve cash to prepare an overall cash budget
 All of the budgets to prepare budgeted financial statements
Bicycle Cash budget problem

A bike manufacturer is preparing its cash payments budget. In this problem you will
develop only a few inputs to the overall cash payments budget. In this problem we work
on preparing a production budget for a manufacturer. For a retailer we use the budgeted
sales to determine inventory needs, and used inventory needs to determine quantities to
be purchased and when they need to be purchased. For a manufacturer, the same general
approach is used, except that there are more steps and more components. Again, we’ll
start with sales, but that will lead to production needs, rather than purchasing needs.
Once we know production needs, we determine the needs for direct labor, direct materials
and overhead. For raw material purchases, we’ll look at production needs and the
inventory on-hand requirements needs (based on company policy) of raw materials.
Finally, for all items we’ll need to determine the cash paid out (how much in each period)
based on an assumed cash payment pattern.

Tips

In the spreadsheet, all amounts below the blue line (data analysis section) should be
formulas or references to cells in the data input.

The physical quantities are done first, with the cash disbursement section below the
physical quantity computations.

The flow for any raw materials purchases is similar to that for finished goods, which is
completed in the template. The aluminum is complicated a bit by the limitation that it be
purchased in 5000 lb. lots.

The general flows are similar to those from the schedules shown in the comprehensive
text example that starts on page 619.

For each cash disbursement monthly amount, you can either use one formula and cell for
the entire amount of cash paid out in the month, say for labor (payments to employees),
or you could show one cell for the amount paid in this month from the prior month (the
20%) and a second cell for the amount paid this month from work done this month (the
80%).

There is an excel template provided to get you started.

For Monday, June 28, you need to determine only the budgeted cash disbursements
related to the labor and the wheel purchases. We’ll do the Aluminum in class Monday.
1. Labor
2. Wheels
3. Aluminum for the frames
We know that sales are forecast as follows:
Jan. Feb. Mar. April May June
2,000 5,000 8,000 6,000 5,000 4,000

 Each bicycle takes 8 hours of labor at $20.00 per hour.

 Each bicycle needs two wheels (I realize that some of you already knew this!) :)
 Each bicycle uses four pounds of aluminum.
 Wheels cost $60 each, and are paid for 60% in the month of purchase, 40% in the
month following purchase.
 Aluminum for frames costs $8.00 per pound. It is paid 100% in the month
following purchase.
 Aluminum must be purchased in 5000 pound increments.
 Desired month-end finished goods inventories are 80% of the following month’s
sales.
 Desired month-end inventory of aluminum is at least enough for the next month’s
production plus one-half of the production for the month after that. Month-end
inventories might need to be higher due to the need to purchase in 5000 pound
increments.
 Desired month-end inventories of wheels are enough for 75% of the following
month’s production.
 Labor is paid 80% in the month the work is done, and 20% in the following
month.
 Expected Jan. 1 inventories are:
o Wheels: 2,500
o Aluminum: 15,000 pounds
o Bicycles: 1,900
 Jan. 1 Salaries payable: $60,000
 Jan. 1 Accounts payable, wheels: $96,000
 Jan. 1 Accounts payable, aluminum: $55,000

Determine the cash disbursements for the months of January, February and March related
to labor and wheel and aluminum purchases. In the spreadsheet template, all of the given
information is already entered in the data entry section, as well as some of the analysis.
You are asked only for the disbursements for Jan-Mar, although there are columns up
through June. Realize that the amounts will not be complete for May and June because
there are no budgeted sales amounts for July and August. Don’t worry about this. Note
that the January 1 inventories don’t match up with the regular “formula.” This is because
the budget preparer has more current info about where inventories are expected to stand.