Prepared by Debby Bloom-Hill CMA, CFM

Budgetary Planning and Control CHAPTER 10 Budgetary Planning and Control

Budgetary Planning and Control Budgets are the formal documents that quantify a company’s plans for achieving its goals. For many companies, the entire planning and control process is built around budgets.

Use of Budgets in Planning and Control Budgets enhance communication and coordination. The process of developing a budget forces managers to consider their goals and objectives and to specify means of achieving them. Budgets become the vehicle for communicating information about where the company is heading.

Use of Budgets in Planning and Control Budgets provide a basis for evaluating performance. Control makes sure the company is heading in the proper direction and operating efficiently. To control a company, it is essential to assess the performance of managers and the operations for which they are responsible.

Developing the Budget Budgets are prepared for: Departments. Divisions of a company. For the entire company. Often the group within a company that is responsible for approval of the various budgets is the budget committee.

Budget Time Period Managers must decide on an appropriate budget period. Depending on needs, budgets can be prepared for a variety of time periods: Long run budgets are prepared for a three or even a five year period. Short run budgets may cover a month, a quarter, or a year. Generally, the longer the time period, the less detailed the budget.

Zero Base Budgeting A common starting point in budgeting is previous period revenues and costs. Zero base budgeting requires budgeted amounts to be justified by each department at the start of each period. This results in a fresh consideration for the validity of budgeted amounts. It is a time consuming and expensive process. Not widely used by business enterprises.

The Master Budget The master budget is a comprehensive planning document that incorporates a number of individual budgets. Typically, it includes budgets for sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative expense, capital acquisitions, and cash receipts and disbursements. Also includes budgeted income statement and balance sheet.

Sales Budget The first step involved preparation of sales forecasts and a sales budget. Prepared first because an estimate of sales is needed for other budgets. Companies use numerous methods to estimate sales, including: Economic models. Sales trends. Trade journals. Sales force.

Production Budget The quantity that must be produced is calculated using the following formula: Finished units to be produced = Expected sales in units + Desired ending inventory of finished goods - Beginning inventory of finished units

Direct Material Purchases Budget The amount of direct materials that must be purchased depends on: The amount needed for production, and The amount needed for ending inventory. The amount that must be purchased can be calculated from the following formula: Required purchases of direct materials = Amount required for production + Desired ending inventory of direct materials - Beginning inventory of direct materials

Direct Labor Budget The direct labor budget presents the direct labor cost by quarter. Direct labor cost is calculated by multiplying the number of units produced each quarter by the labor hours per unit and the rate per hour. The direct labor budget can be used to budget the number of employees needed.

Manufacturing Overhead Budget The manufacturing overhead budget separates variable and fixed costs. The cost per unit of production of each variable cost item is multiplied by the quantity produced each quarter. The fixed costs are identical each quarter except for the amount of depreciation. Budget information is also needed for selling and administrative expenses.

Budgeted Income Statement Much of the information contained in the budgets already described is utilized in the preparation of a budgeted income statement. The sales figures come directly from the sales budget. Cost of goods sold is based on information from the production budget. Sales and administrative expense data come from their respective budgets.

Capital Acquisitions Budget For decisions with respect to long-lived assets such as plant and equipment: Incremental cash flows along with net present value and internal rate of return are used for evaluation. The final list of approved projects is documented in the capital acquisitions budget.

Cash Receipts and Disbursements Budget Managers must plan for the amount and timing of cash flows. Careful planning of receipts and disbursements is necessary to: Anticipate cash shortages and arrange to borrow funds. Anticipate cash surpluses and seek productive uses.

Budgeted Balance Sheet The last component of the master budget is the budgeted balance sheet. This is simply a planned balance sheet. Sometimes called a pro forma balance sheet. Managers can use this budget to assess the effect of their planned decisions on the future financial position of the firm.

Use of Computers in the Budget Planning Process Computers are very useful in budgeting. Most companies define the budget relationships in a computer model. With computerized budget information, an item can be changed and the computer can recalculate that budget and any other budget affected by the change.

Budgetary Control Budgets facilitate control by providing a standard for evaluation. The standard is the budgeted amount, against which actual results are compared. Differences between budgeted and actual amounts are referred to as budget variances.

Investigating Budget Variances Using a management by exception approach, only exceptional variances are investigated. Generally, variances that are large in absolute dollars or relative to budgeted amounts are considered exceptional. It is important to point out that both exceptional “unfavorable” and exceptional “favorable” variances should be investigated.

Conflict in Planning and Control Uses of Budgets Budgets are used for both planning and control. With respect to planning, they communicate company goals and help coordinate various activities. With respect to control, they focus the attention of managers on meeting or beating budget targets. There are inherent conflicts when budgets are used for both planning and control.

Issues With Budget-Based Compensation The first problem is that managers have incentive to pad a budget and create budget slack. Budget slack is a budget with targets that are easy to achieve. The lower the budget target, the more likely it is that managers will receive the hurdle and variable bonus. Managers can create slack by lowering sales and increasing cost forecasts.

Issues With Budget-Based Compensation The second problem relates to the fact that managers who are evaluated may have an incentive to shift income from one period to another. Consider a manager who estimates that it is unlikely that the target will be met. The manager has an incentive to shift income from a future period to the current period.

Issues With Budget-Based Compensation The best that can be done to mitigate the conflict between the planning and control uses of budgets is to assure managers that their performance in comparison to the budget will be fairly evaluated and compensated. Managers should be confident that they will be allowed to comment on the real causes of budget variances and tell their side of the story.

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