Short-Term Budgeting - Lecture notes 3 PDF

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Short-Term Budgeting...

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Module 3 Short-Term Budgeting

Introduction Repeated references to budget allowances have been made throughout previous chapters and we have seen how closely accounting and budgeting are related and how one depends on the other. Accounting draws some of its data from planned performances established in the budget; in turn, recorded historical data provide a basis for determining budget estimates. Intended Learning Outcomes After studying this chapter, students should be able to 1. Define budgeting and other related terminologies 2. Understand the uses of the process of budgeting 3. Understand the functions and composition of budget committee 4. Determine the relationships between operating and financial budgets 5. Identify the different types of budgets or the major composition of the master budget 6. Prepare a master budget and its supporting schedules 7. Prepare operating and financial budgets using the flexible budget model 8. Describe the different models of budgeting 9. Relate budgeting to standards-setting, planning and controlling functions of management Budget defined A budget is a financial plan of the resources needed to carry out tasks and meet financial goals. It is also a quantitative expression of the goals the organization wishes to achieve and the cost of attaining these goals. The act of preparing a budget is called budgeting. T  he use of budgets to control a firm’s activities is known as budgetary control. The overall or master budget (also known as planning budget or budget plan) indicates the sales level, production and cost levels, income and cash flows that are anticipated for the coming year. The master budget is a summary of all phases of a company’s plans and goals for the future. In short, it represents a comprehensive expression of management’s plan for the future and how these plans are to be accomplishe. The Budgetary System

The CEO has a mission to accomplish and an objective to achieve. Otherwise, he has no business keeping his job. To achieve the objectives, he has to devise strategies to win people and optimize other resources in the organization. The key paradigm is “winning people”. To do this and to unleash the power of organizational oneness, the CEO must encourage employee participation and involvement and enlist their commitment towards the organizational objectives. These could be done through the process of budgeting, which has the following uses: 1. Communication. The most important process of management is communication . Vision, mission, goals, objectives, plans, standards, and performance evaluation measures must be clearly articulated and understood among officers and personnel. More than understanding, man in the organization must believe, get involved and work with commitment in achieving organizational goals. This could be done by clearly delineating the lines of communications i.e., an organizational structure should clearly define the lines of authority and responsibility. 2. Motivation As communication lines are cleared and made more transparent, people will understand the end-results of organizational plans and ask. As they are made part in conceptualizing the plans, they get involved and become more committed in attaining plans. This process moves people to act in accordance with organizational goals. 3. Standards. After the actions, results should be summarized and evaluated. At the very onset, the measurement to be used in evaluating performance m  ust be established. These measures of performance are called “standards”. They must be clearly defined a  nd agreed-upon b  etween the person, whose performance is evaluated, and the evaluator. If standards are too high or improbable to achieve, people get demoralized as there is no fair chance of getting a high performance rating. If standards are too low, people are not motivated to exert their best effort, thereby encouraging mediocre results. Standards are set to motivate . They are also an important basis for planning and controlling. Standards to be objective, are normally expressed in quantitative form (e.g., amount, units, hours, thirst, kilograms, number of invoices processed, etc.,). Still, the most objective mode of expressing standards is in terms of money. 4. Planning As standards are set, plans could be done better. A good plan must be S. M. A.R. T. (i.e., specific, measurable, attainable, realistic, and time-bounded). Plans must be specific to be clear, measurable to be fair in the evaluation process, attainable to elicit outstanding performance, realistic to allow people to relate to, and time-bounded to impress urgency and deadlines. The design and development of a plan must be participated in by people in the organization. This means an effective appetizer to increase one's desire in achieving an objective. As plans are developed, men must start developing a “sense of ownership“, and

eventually, commitment. Questions such as, “what resources are needed?”, “How do we do it?”, “When do we do it?“, “Who will do it?“, And “where do we do it?“ need to be resolved with acceptable certainty. Planning i s an act of approximating the future and preparing resources, systems, strategies, structures and methods that could best seize the opportunities in a given condition to increase the equity or wealth of an organization. 5. Organizing and Directing As plans are framed, resources are organized accordingly. Policies, systems, operational strategies, methods and means are devised as activities are mapped-out and lined-up to execute plans. People are trained, machines brought in, materials outsourced, systems and standards strictly implemented, and offline and online performances monitored. Revisions of plans may be done in-progress and remedial actions are devised and executed when necessary. All along, acts are done in accordance with organizational plans, goals and objectives. In this context, the importance of operational management cannot be undermined. The effectiveness and fitness of managerial judgment are tested. Resources are not only marshaled but are organized and operationally managed. Actions, processes, and transformations are done to meet the objectives of the organization. 6. Controlling and Performance Evaluation Controls are to be devised and installed prior to business and operational processes. Controls are also done during the process. Controls are classified as feedback controls, concurrent controls, and feedforward controls. Feedback controls p  ertain to completed activities, concurrent controls r efer to ongoing processes, feedforward controls a  nticipate and prevent problems. Questions such as, “what structures are best for our operation?“, “what systems and policies are best applicable under the circumstances?”, “why are we not meeting our targets or why are we extending our targets?“, “why are machines and men not performing as expected?”, “ what methods are applicable under the circumstances?“, “why is the market behaving differently?“, And “why do our financial results differ from our estimates?“ need answers.

The Budget Committee … develop an executive team! Top executives should primarily subscribe to organizational objectives. The CEO must therefore exercise competence in leading and managing his top executives. Top executives must not only be capable and competent but must have “ownership“ of organizational goals. There must be trust and openness in communication. One way to achieve this is through the creation of a Budget Committee. A budget committee i s normally composed of top executives in the administrative, operational and financial areas of business such as the Vice Presidents for Sales, Production,Purchasing, Human Resources, Information Technology, Engineering and Quality, Administration, and, most

especially, Finance. The Budget Committee is also known in practice as the management committee ( i.e., MANCOM) or executive committee ( i.e., EXECOM). The Budget Committee, which is normally headed by a Budget Director , administers the budgetary process. It is concerned at developing the budget manual that includes a budget planning calendar and distribution instructions for all budget schedules. A budget planning calendar is the schedule of activities for the development and production of the budget. It includes a list of dates indicating when the specific information is needed to be provided to other departments or units until the entire budgetary process is completed. A budget manual includes distribution instructions for all budget schedules to show that a segment’s budget is an input to another department or business unit in the preparation of their own budget. Without distribution instructions, someone who needs a particular schedule might be overlooked, and delays may occur. A planning calendar integrates the entire budgetary activities. Along the way, men should be educated about the purpose, forms, and processes of the budgetary system. They should be taught how to make their own budget using the standard chart of accounts and the standardized budget schedules, know the relevance of their schedule to another schedule, and the model of performance evaluation. The bottom-line is, everybody should be made aware of and be involved.

The Master Budgets … a financial process model! Budgets are plans expressed in quantitative form, primarily in financial expression. When plans are expressed quantitatively, they are more objective, understandable, and measurable. The budgetary process is dependent on the organizational structure and purposes. As such, the budget normally stay in answering the basic question, “Is there a market for the business?” This question directs the master budgeting process to start in the sales budget. The normal budgetary sequence is shown in figure 5.1.

Normally, the development of business is driven by its demand. In this perspective, the budgeting process starts from the sales budget. Once it is projected, the production budgets, operating expenses budgets, and the budgeted statement of profit or loss follow (i.e., operating budgets). Then, the financial budgets leading to the budgeted statement of financial position and the budgeted statement of cash flows with supporting schedules on collections from customers and payments to suppliers (i.e., financial budgets). The entirety of the operating and financial budgets comprise the master budgets of the enterprise at a given level of activity in a given business period. If there is a limitation on organizations resources such as materials and parts, direct labor hours, machine hours, financial, cultural, and regulatory aspects, the starting point in preparing the master budget shall be defined by such limitation.

Types of Budget The types of budgets or the major composition of the master budget a  re: 1) The Operating budget 2) The Financial budget 3) The Capital budget The following is a simplified subclasfficiation of the above-mentioned types of budget for a manufacturing firm: A. Operating Budget 1. Budgeted Income Statement a. Sales budget b. Production budget 1) Materials cost budget 2) Direct labor cost budget 3) Factory overhead budget 4) Inventory levels 2. Cost of Sales Budget 3. Selling and Administrative expenses budget 4. Financial Expense budget B. Financial Budget 1. Budgeted Statement of Financial Position 2. Cash Budget C. Capital Investment Budget Budgeting Terminologies Defined Budgeted Income Statement - Refers to projection of revenue, expenses, and results of operations for a definite period of time. Cash budget - A period-by-period statement of cash at the start of a budget period, expected cash receipts classified by source; expected cash disbursements, classified by function, responsibility, and form; and the resulting cash balance at the end of the budget period. Financial Budget - Refers to the budget of the financial resources as reflected in the budget statement of financial position and cash budget.

Fixed Budget - Projection of cost at a particular or one level of production (usually at normal capacity) for a definite time period. Flexible (variable) budget - Projection of cost at different levels of production for a definite period of time Participative budget - Budget prepared using employees at all levels in the organization Physical budget - Budget that is expressed in units of materials, number of employees or number of man-hours or service units rather than in pesos Planning budget (static budget) - Another term for master budget Production budget - Production plan of resources needed to meet current sales demand and ensure adequate inventory levels Program budget - Budget for the major programs or projects that the company plans to undertake Operating budget - Refers to the plans for the conduct of business for the planning period; it includes the budgeted income statement and all its supporting budgets. Responsibility budget - Budget for a responsibility center Rolling (continuous, progressive) budget - Budget which is prepared throughout the year, that is, as one month elapses, a budget is prepared for one more month in the future Sales budget - Budget that shows the quantity of each product and the revenue expected to be sold Traditional budgeting - A system of budgeting which concentrates on the incremental change from the previous year assuming that the previous year’s activities are essential and must be continued.

Zero-based budgeting - A system of establishing financial plans beginning with an assumption of no-activity and justifying each program or activity level

The Sales Budget Sales indicate meeting customers' wants, demands, needs, and desires. It fundamentally drives the creation of business activities. It is the initiating motive of business organization and the genesis of normal business planning. Mathematically, the sales are affected by the unit sales price and quantity sold. The unit sales price is affected by cost, competition, product substitutes, market trends, regulations, demand and supply behavior, and estimated profit, among other things. The number of units sold is affected by the unit sales price. Other factors influencing sales forecast include the past sales volume, general economic and industry conditions, relationship of sales to economic indicators (such as gross domestic product, gross national product, personal income, employment, prices in industrial production), relative product profitability, market research studies, advertising and other promotions, quality of salesforce, seasonal variations, production capacity, and long-run sales trends for various products. In forecasting sales, factors that have strong correlation with sales pattern are identified and used. Basically, there are three ways of making escalates for the sales budget: a. statistical forecasting based on analysis of general business conditions, market conditions, product growth curves, etc. b. Make an internal estimate by collecting the opinions of executives and sales staff. c. Analyze the various factors that affect sales revenue and then predict the future behavior of each of these factors. The estimated number of units sold could be estimated per product line, department, geographical area, model, and market classification. In projecting units to be sold, several forecasting techniques are employed which normally apply the concept of probability and best estimates models, statistics, and simulation analysis. The study of probability and other forecasting techniques are reserved in the chapter for quantitative techniques applied in business.

Sample Problem 3.1. Estimated Sales in Units and Pesos The management of New corporation is considering three state economic conditions: strong, fair, and weak. Based on some macro studies, it has been agreed that the economy in the

coming year may be 40% strong, 50% fair and 10% weak. The projected number of units are 120,000 units, 90,000 units, and 50,000 units for strong, fair, and weak economic conditions, respectively. The budgeted unit sales price given the estimates in units sold is P 120. Five percent (5%) of the gross sales are estimated to be uncollectible. Required: 1. Budgeted units to be sold in the coming year 2. Budgeted amount of sales, net of doubtful accounts.

Solutions/ Discussions: 1. The budgeted sales in units shall be determined as follows: Economy

Projected Sales Units

Probability

Budgeted Unit Sales

A

120,000

40%

48,000

B

90,000

50%

45,000

C

50,000

10%

5,000 93,000

Total 2. The budgeted net sales in pesos shall be: Budgeted sales in units x Unit sales price Budgeted gross sales in pesos Less: Allowance for doubtful accounts (P 11,160,000 x 5%) Budgeted net sales in pesos

93,000 P 120 P 11,160,000 558,000 P 10,602,000

Once the sales units are projected and the sales amount already budgeted, the budgeted costs and expenses would now be estimated, then the financial budgets all in connection with the strategic plan of the business. In the following discussions, the unit sales price and projected sales in units are normally given.

The Production Budget Budgeted production is based on budgeted sales and inventory policies. An inventory policy is normally based on the number of units to be sold in the following period. The formula for the budgeted production could be derived from the traditional method of determining number of units sold which states that finished goods inventory-beginning plus production less finished

goods inventory-ending equal budgeted sales. You tweak the formula and the computation for the budgeted production is as follows:

Table 3.1. Pro-Forma Budgeted Production Projected sales Add: Finished goods invty - end Total Goods Available for Sale Less: Finished Goods Inventory - Beg Budgeted Production

x x x x x

Once the budgeted production is set, the budgeted materials, direct labor, and variable overhead may now be prepared. The budgeted fixed overhead is based on normal capacity (e.g., normal production) which is considered flat or constant over the periods (e.g., months) covered by the budget. It differs from the master budget where its level of capacity varies from one month to another. An illustration of Budgeted Production Schedule is presented on schedule 3 of Sample Problem 3.3.

The Direct Materials Budget The raw materials budget is based on budgeted production. There are two (2) materials budgets to be estimated; 1. Budgeted direct materials used 2. Budgeted direct materials purchases Budgeted direct materials used budget Multiply the budgeted production by the standard materials per unit of finished goods and you get the budgeted direct materials to be used, or the budgeted direct materials requirements. This makes the standard costing system a “sine qua non” in the budgetary process. The standard cost is used in the preparation of the direct materials budgets, direct labor, variable overhead, fixed overhead, selling expenses, and administrative expenses budgets as well. Budgeted direct materials purchases budget Direct material purchases is direct materials used add the materials inventory ending, then deduct the materials inventory beginning.

This procedure is derived from the traditional computation of raw materials used which is raw materials inventory-beginning plus materials purchases less raw materials inventory-ending. From this standpoint, the raw materials purchases budgets are derived, as follows. Table 3.2. Pro-Forma Budgeted Direct Materials Used and Purchases Budgeted direct materials used Add: Materials Inventory End Total Materials for Use Less: Materials Inventory - Beg Budgeted direct mat. Purchases in units x Materials cost per unit Budgeted materials purchases in pesos

     P

x (Budgeted production x Std. materials per unit) x x x x x x

An illustration of Budgeted Direct Materials Used and Purchases is presented in Sample Problem 3.4,...