Accounting: The Language of Business - Vol. 1 (Part 130)

“People are accustomed to thinking of accounting as dry and boring, a necessary evil used primarily to prepare financial reports and survive audits, but that is because accounting is something that has become taken for granted.”

—Eric Ries, Author, The Startup Way

  Budgeting (Part C)

by

Charles Lamson

Budgeting Systems

Budgeting systems vary among businesses because of such factors as organizational structure, complexity of operations, and management philosophy. Differences in budget systems are even more significant among different types of businesses, such as manufacturers and service businesses. The details of a budgeting system used by an automobile manufacturer would obviously differ from a service company such as an airline company. However, the basic budgeting concepts illustrated in the following paragraphs apply to all types of businesses and organizations.

The budgetary period for operating activities normally includes the fiscal year of a business. A year is short enough that future operations can be estimated fairly accurately, yet long enough that the future can be viewed in a broad context. However, to achieve effective control, the annual budgets are usually subdivided into shorter time periods, such as quarters of the year, month, or weeks.

A variation of fiscal year budgeting, called continuous budgeting, maintains a twelve-month projection into the future. The twelve-month budget is continually revised by removing the data for the period just ended and adding estimated budget data for the same period next year, as shown in Exhibit 2. 

EXHIBIT 2 Continuous Budgeting

Developing budgets for the next fiscal year usually begins several months prior to the end of the current year. This responsibility is normally assigned to a budget committee. Such a committee often consists of the budget director and such high-level executives as the controller, the treasurer, the production manager, and the sales manager. Once the budget has been approved, the budget process is monitored and summarized by the accounting department, which reports to the committee.

There are several methods of developing budget estimates. One method, termed zero-based budgeting, requires managers to estimate sales, production, and other operating data as though operations are being started for the first time. This approach has the benefit of taking a fresh view of operations each year. A more common approach is to start with the last year's budget and revise it for actual results and expected changes for the coming year. Two major budgets using this approach are the static budget and the flexible budget.

Static Budget

A static budget shows the expected results of a responsibility center [a functional entity within a business that has its own goals and objectives, dedicated staff, policies and procedures, and financial reports (accountingtools.com)] for only one activity level. Once the budget has been determined, it is not changed, even if the activity changes. Static budgeting is used by many service companies and for some administrative functions of manufacturing companies, such as purchasing, engineering, and accounting. For example, the assembly department manager for Colter Manufacturing Company prepared the static budget for the upcoming year, shown in Exhibit 3.

EXHIBIT 3 Static Budget

A disadvantage of static budgets is that they do not adjust for changes in activity levels. For example, assume that the actual amounts spent by the Assembly Department of Colter Manufacturing totaled $72,000, which is $12,000 or 20% ($12,000 / $60,000) more than budgeted. Is this good news or bad news? At first you might think that this is a bad result. However, this conclusion may not be valid, since static budget results may be difficult to interpret. To illustrate, assume that the assembly manager constructed the budget based on plans to assemble 8,000 units during the year. However, if 10,000 units were actually produced, should the additional $12,000 in spending in excess of the budget be considered "bad news"? Maybe not. The Assembly Department provided 25% (2,000 units / 8,000 units) more output for only 20% more cost.

Flexible Budget

Unlike static budgets, flexible budgets show the expected results of a responsibility center for several activity levels. You can think of a flexible budget as a series of static budgets for different levels of activity. Such budgets are especially useful in estimating and controlling factory costs and operating expenses. Exhibit 4 is a flexible budget for the annual manufacturing expense in the Assembly Department of Colter Manufacturing Company.

EXHIBIT 4 Flexible Budget

When constructing a flexible budget, we first identify the relevant activity levels. In Exhibit 4, there are 8,000, 9,000, and 10,000 units of production. Alternative activity bases, such as machine hours or direct labor hours, may be used in measuring the volume of activity. Second, we identify the fixed and variable cost components of the costs being budgeted. For example, in Exhibit 4, the electric power cost is separated into its fixed cost ($1,000 per year) and variable cost ($0.50 per unit). Lastly, we prepare the budget for each activity level by multiplying the variable cost per unit by the activity level and then adding the monthly fixed cost.

With a flexible budget, the department manager can be evaluated by comparing actual expenses to the budgeted amount for actual activity. For example, if Colter Manufacturing Company's Assembly Department actually spent $72,000 to produce 10,000 units, the manager would be considered over budget by $1,000 ($72,000 - $71,000). Under the static budget in Exhibit 3, the department was $12,000 over budget. This comparison is illustrated in Exhibit 5. The flexible budget for the Assembly Department is much more accurate than the static budget, because budget amounts adjust for changes in activity.

EXHIBIT 5 Static and Flexible Budgets

Computerized Budgeting Systems

In developing budgets, many firms use computerized budgeting systems. Such systems speed up and reduce the cost of preparing the budget. This is especially true when large quantities of data need to be processed. Computers are also useful in continuous budgeting. Reports that compare actual results with amounts budgeted can also be prepared on a timely basis through the use of computerized systems.

Managers often use computer spreadsheets or simulation models to represent the operating and budget relationships. By using computer simulation models, the impact of various operating alternatives on the budget can be assessed. For example, the budget can be revised to show the impact of a proposed change in indirect labor wage rates. Likewise, the budgetary effect of a proposed product line can be determined.

A common objective of using computer-based budgeting is to tie all the budgets of the organization together. The newest budgeting and planning (B&P) systems are accomplishing this by using web-based applications to tie thousands of employees together. In the next post, we will illustrate how a company ties its budgets together to develop a complete plan. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 874-878*

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