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Chapter 9

Budget Preparation

Budgeting
A budget is a detailed plan,
expressed in quantitative terms, that
specifies how resources will be
acquired and used during a given
period of time.
It is a quantified plan of action.

Nature of a Budget

Estimates profit potential


Monetary terms
A period of one year
A management commitment
Can be changed under specified
conditions
Compared with actual financial
performance
15-3

Key Purposes of the Budgeting


System
The five primary purposes are:
1. Planning.
2. Facilitating Communication and
Coordination.
3. Allocating Resources.
4. Managing Financial and Operational
Performance.
5. Evaluating Performance and Providing
Incentives.

Organizations Use Many Types of


Budgets
Organization
Organization
goals

Individual
Long-range
strategic plan

Individual goals
and values

Anticipated
conditions

Individual
beliefs

Master
budget
Strategic
evaluation

Actual period
results

Performance
evaluation

Types of Budgets
Master budget (profit plan)
a comprehensive profit plan that covers all
phases of an organizations operation.

Pro-forma (projected) financial statements


similar to historical statements, except that
they project the future.

Capital budget
Focuses on the acquisition of long-term assets

Sales of Services or Goods


Ending
Inventory
Budget

Production
Budget

Work in Process
and Finished
Goods

Ending
Inventory
Budget

Direct Materials

Direct
Materials
Budget

Direct
Labor
Budget

Overhead
Budget

Cash Budget
Budgeted Balance
Sheet
Budgeted Statement
of Cash Flows

Selling and
Administrative
Budget

Budgeted Income
Statement

Illustrating the Master


Budget

Sales Forecast
Sales Forecasting the process of
predicting sales of services or goods.
The master budget begins with a sales
forecast. Items to consider in sales
forecasts:

Past sales levels and trends


General economic conditions
Industry trends
Company pricing policies
Action of competitors
New products

Sales Budget of Collegiate


Apparel
Collegiate
Collegiate Apparel
Apparel Company
Company is
is preparing
preparing
budgets
budgets for
for the
the year
year ending
ending December
December 31,
31,
20x1.
20x1.
Budgeted
Budgeted sales
sales are:
are:
First
15,000
First quarter
quarter
15,000 units
units
Second
Second quarter
quarter 5,000
5,000 units
units
Third
10,000
Third quarter
quarter
10,000 units
units
Fourth
Fourth quarter
quarter 20,000
20,000 units
units
The
The selling
selling price
price is
is $12
$12 per
per unit.
unit.

Sales Budget of Collegiate


Apparel

Production Budget
Sales
Budget
m
o
C

pl

ed
t
e

Production
Budget

Plan of resources needed to meet current


sales demand and ensure inventory levels
are sufficient for future sales.

Forecasting Production
Rearrange the basic inventory formula as follows . . .
Units in
beginning
inventory

Required
+ production
in units

Sales
in
Units

Units in
ending
=
inventory

Now, solve for required production . . .


Units
to be
Produced

Sales
in
Units

Units in
ending
inventory

Expected
beginning
inventory

The Production Budget


Collegiate Apparel wants units in
ending finished goods inventory to be
10% of the next quarters expected
sales in units.
At the beginning of the year, 1,500
completed units were on hand.
During the first quarter of 20x2, 15,000
units are expected to be sold.

Let
Lets
s prepare
prepare the
the production
production budget.
budget.

The Production Budget

5,000 10% = 500 units

Direct-Materials Budget
Direct materials needed for the budget
period can be determined as follows . . .
Required
materials
purchases

Materials
used in
production

Ending
materials
inventory

Beginning
materials
inventory

Direct-Materials Budget
At
At Collegiate
Collegiate Apparel
Apparel 1.5
1.5 yards
yards of
of fabric
fabric are
are
required
required per
per unit
unit of
of product.
product.
Management
Management wants
wants fabric
fabric on
on hand
hand at
at the
the end
end of
of
each
each quarter
quarter to
to be
be 10%
10% of
of next
next quarter
quarters
s raw
raw
materials
materials required.
required. On
On January
January 1
1stst,, 2,100
2,100 yards
yards of
of
fabric
fabric are
are on-hand.
on-hand. During
During the
the first
first quarter
quarter of
of
20x2,
20x2, Collegiate
Collegiate expects
expects 21,000
21,000 yards
yards of
of fabric
fabric to
to
be
be required.
required.
Each
Each yard
yard of
of fabric
fabric cost
cost the
the company
company $2.
$2.

Let
Lets
s prepare
prepare the
the direct
direct materials
materials budget.
budget.

Direct-Materials Budget

8,250 10% = 825 units

Responsibility for Budget


Administration
Budget Committee Consists of key
senior executives who may advise the
budget director during the preparation
of the budget.
The authority to give final approval to
the budget usually rests with the
board of directors.

Budget Department
Publishes procedures and forms for budget
preparation.
Publishes assumptions for the basis of
budgets.
Facilitate communications among
departments.
Makes analyses and budget
recommendations.
Administers budget revisions.
Analyzes performance against budget.
15-20

Participative Budgeting
Participative Budgeting the use of
input from lower- and middlemanagement employees.
The process is time consuming but
enhances employee motivation and
acceptance of goals.
Budget negotiation is the heart of
budgeting process.

Advantages of Participative
Budgeting
1.
1. Individuals
Individuals at
at all
all levels
levels of
of the
the organization
organization are
are viewed
viewed
as
as members
members of
of the
the team
team whose
whose judgments
judgments are
are valued
valued
by
by top
top management.
management.
2.
2. Budget
Budget estimates
estimates prepared
prepared by
by front-line
front-line managers
managers
are
are often
often more
more accurate
accurate than
than estimates
estimates prepared
prepared by
by
top
top managers.
managers.
3.
3. Motivation
Motivation is
is generally
generally higher
higher when
when individuals
individuals
participate
participate in
in setting
setting their
their own
own goals
goals than
than when
when the
the
goals
goals are
are imposed
imposed from
from above.
above.
4.
4. A
A manager
manager who
who is
is not
not able
able to
to meet
meet aa budget
budget imposed
imposed
from
from above
above can
can claim
claim that
that itit was
was unrealistic.
unrealistic. SelfSelfimposed
imposed budgets
budgets eliminate
eliminate this
this excuse.
excuse.

Budgets and Feedback


Budgets offer feedback in the form of
variances: actual results deviate from
budgeted targets
Variances provide managers with
Early warning of problems
A basis for performance evaluation
A basis for strategy evaluation

Budgeting and Human


Behavior
The budgeting process may be abused
both by superiors and subordinates,
leading to negative outcomes
Superiors may dominate the budget
process or hold subordinates
accountable for events they have no
control over
Subordinates may build budgetary
slack into their budgets

Ethical Problems in
Budgeting
Much of the information for the budget is provided
by persons whose performance is then
compared with the budget they help develop.
Lets prepare the
sales forecast with a
4% increase, so we
will really look good!

I think sales
will increase by
10% next year.

Critics of Budgeting
Budgeting process is inefficient
Senior managers spend 10% to 20% of
their time on budgeting. Yet, most
suggest that budgeting is not a valuable
use of their time.

It becomes obsolete rapidly.


It does not motivate the right behavior.
It is out of sync with the strategic
planning.
15-26

Budgetary Slack: Padding the


Budget

Padding
Padding the
the budget
budget means intentionally
underestimating
underestimating revenues
revenues or
or overestimating
overestimating
costs.
costs.
The
The difference
difference between
between the
the revenue
revenue or
or cost
projection
projection that
that aa person
person provides
provides and a
realistic
realistic estimate
estimate of
of the
the revenue
revenue or
or cost
cost is
is
called
called budgetary
budgetary slack.
slack.
A
A solution:
solution: reward
reward managers
managers for
for making
making
accurate
accurate estimates.
estimates.