Budgeting

Learning Objectives Explain the use of a budget as a tool for planning and performance evaluation. Explain how a budget can affect employee motivation. Compare the four types of responsibility centers. Describe the master budget.

Organizational Plan Consists of three parts Organization Goals - Broad objectives established by mgmt. that company employees work to achieve Strategic long-range plan - Intermediate and distant future plans stated in broad terms Master Budget - Specific plan for the coming year

Master Budget Also known as the static budget Indicates sales, production and cost levels, income and cash flows anticipated for the following year Also includes an income statement and balance sheet based on budget data

Performance Evaluation Budgets provide estimates of expected performance Comparing budgeted with actual results provides a basis for evaluating performance Budgets must be prepared for individual responsibility centers in order to use them to evaluate performance

Flexible Budgets Shows the expected relation between costs and volumes Has two components: Fixed cost - expected to be incurred regardless of the activity level Variable cost - costs change in total as the activity level changes

Cost Hierarchies When preparing a master budget, it is important to understand how costs are affected by changes in activity levels The following cost hierarchy is helpful in understanding cost behavior: Unit-level activities Batch-level activities Product-level activities Customer-level activities Facility-level activities

Forecasting Sales Developing the master budget starts with forecasting sales Various methods and sources used to obtain sales forecasts include: Sales staff Market research Delphi technique Trend analysis Econometric Models

Production Budget (Slide 1 of 2) The production budget is based on the sales budget and estimates of beginning and desired ending inventories Production is calculated as follows: Number of Units to Be Sold +Units in Ending Inventory -Units in Beginning Inventory Units to Be Produced

Production Budget (Slide 2 of 2) After determining the number of units to be produced, we can budget for the following: Direct materials - traceable to units produced and almost always a variable cost Direct labor - traceable to units produced; usually a variable cost but could be a fixed cost We assume direct labor is a variable cost in this chapter Manufacturing overhead - typically has both variable and fixed components; variable overhead varies with units produced, fixed overhead gives a firm production capacity

Marketing and Administrative Budgets Budgeted marketing costs might include the following: Facility-level activities - salaries, advertising, sales office costs Unit-level activities - sales commissions, shipping Administrative costs include both fixed and variable costs

Discretionary Fixed Costs Many “fixed” costs are really discretionary costs They are budgeted as fixed costs but if, for example, the economic conditions look bad, these costs can be reduced Examples: maintenance, advertising Discretionary fixed costs should be distinguished from committed fixed costs, like rent on a factory building, which are required to run the firm

Budgeted Income Statement Also called the profit plan Prepared using a contribution margin format If management is satisfied with the budget, it is approved If not, management can look for ways to improve budget profits through, for example, sales increases or cost reductions

Accurate Forecasts An accurate sales forecast is critical to the entire budget process If forecast is too low, sales may be lost because purchasing and production have been planned at too low a level If forecast is too high, excess inventory may result

Using the Master Budget Master budget includes budgeted financial statements as well as other relevant budgets Once adopted, the master budget becomes a major planning tool Essentially, becomes authorization to produce and sell goods, purchase materials, hire employees

Comparison of Flexible and Master Budgets The flexible budget is based on actual sales and production volumes Indicates expected revenue and costs at the actual level of activity Comparison of master budget to the flexible budget forms the basis for analyzing differences in planned and actual results