Lesson 28 - Budgeting

BUDGETING

A budget is a quantitative expression of management objectives. Simply put, a budget is a set of projected or planned financial statements. It consists basically of a pro forma income statement, a pro forma balance sheet, and a cash budget. A budget is a tool used for both planning and control. At the beginning of the period, the budget is a plan or standard; at the end of the period it serves as a control device to help management measure its performance against the plan so that future performance may be improved. An effective budget should be properly coordinated with management and accounting systems. Budgets may be short-term or long-term.

Master Budget

A master budget encompasses all functions and management levels, although the approach to formulating the budget may differ from one company to another. Two opposite and extreme views of how to develop a master budget are the top management approach (input comes only from top officers), and the grass roots approach (all levels participate in forecasting). Irrespective of who is involved in providing input, the following sequence is generally followed in constructing a master budget:

8. Cost of Goods Sold Budget	1. Sales Budget
9. Selling Expense Budget	2. Production Budget
10. Administrative Expense Budget	3. Direct Materials purchase Budget
11. Budgeted Income Statement	4. Direct Material Usage Budget
12. Capital Assets Budget	5. Direct Labor Budget
13. Cash Budget	6. Factory Overhead Budget
14. Budgeted Balance Sheet	7. Ending Inventories Budget

Flexible Budget

A budget that is based on a fixed output of production is called a static budget. When output remains relatively constant from period to period, a static budget may be appropriate for a company. However, when the company experiences changes in the output from one period to another, a flexible budget should be prepared. A flexible budget is defined as a budget in which the dollar amounts allowed for a period is based on the attained level of output. To prepare a flexible budget, it is necessary to compute the dollar flexible budget allowed for any volume of production, which is computed as:

(unit variable cost × quantity) + fixed costs

Capacity Levels

The flexible budget allowance may be based on one of several levels or volumes of production. There are four common bases of measurement of levels of production capacity as follows:

1. Theoretical or ideal capacity:The maximum capacity that a department or factory is capable of producing under perfect conditions.

2. Practical or realistic capacity: The theoretical capacity less practical constraints, such as estimated breakdowns, strikes, and delays.

3. Normal or long-run capacity:The constant, average level of utilization of plant and workers over a long period of time sufficient to even out the high and low levels of production.

4. Expected actual or short-run capacity:The expected actual capacity for the next period of operation.

Departmental Flexible Budgets

In a manufacturing company, products are produced through producing departments, and service departments provide services to producing departments. In order to have a better evaluation of performance, it is necessary to prepare budgets in terms of both producing and service departments. Computations of a flexible budget for a producing department includes the multiplication of unit variable cost by the quantity produced over a period, plus fixed costs for the department, which is mentioned earlier as a formula.

However, the flexible budget for a service department is commonly based upon the relevant range of service hours or other activity bases expected to be incurred during a specified period of time. For example, the flexible budget for a marketing department is commonly based upon the relevant range of net sales whereas for an administrative department, it may based upon a percentage of net sales or service hours provided to producing departments.

Performance Evaluation

A department's performance can be evaluated by comparing flexible budgets for actual activity base and for budgeted activity base. The variances or differences between actual and budgeted costs are then computed for reporting in a performance report. All variances, which may be favorable or unfavorable, are next analyzed and split into detailed variances.

Capital Budgeting

Capital expenditures involve the long-term commitments of a firm's resources. The capital budget, which is generally prepared for a one year period, is the key to controlling capital expenditures. Long-range capital budgets can also be prepared for periods of 5 to 10 years and are used to plan for future expenditures. The capital budget is an efficient means of consolidating requests for funds, comparing the consolidated budget with funds made available by management, and ranking projects on order of priority.

Quantitative methods have been developed to evaluate proposed projects. The six principal methods of evaluating projects are payback period, average annual return on investment, internal rate of return, net present value, index of profitability, and discounted payback.

Zero-Base Budgeting

Zero-base Budgeting is a planning and budgeting tool that uses cost-benefit analysis of projects and functions to improve resource allocation in an organization. Traditional Budgeting tends to concentrate on the incremental change from the previous year. It assumes that the previous year's activities are essential and must be continued. Under zero-base budgeting, however, cost estimates are built up from scratch, from the zero level, and must be justified.

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