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Accounting: The Language of Business - Vol. 1 (Part 131)

"I don't have any use for bodyguards, but I do have a specific use for two highly trained certified public accountants."

—Elvis Presley

 Budgeting  (Part D)

by

Charles Lamson

Master Budget

Manufacturing operations require a series of budgets that are linked together in a master budget. The major parts of the master budget are as follows:

Exhibit 6 shows the relationship among the income statement budgets. The budget process begins by estimating sales. The sales information is then provided to the various units for estimating the production and selling and administrative expenses budgets. The production budgets are used to prepare the direct materials purchases, direct labor cost, and factory overhead cost budget. These three budgets are used to develop the cost of goods sold budget. Once these budgets and the selling and administrative expenses budget have been completed, the budgeted income statement can be prepared, as we illustrate in the following section.

EXHIBIT 6 Income Statement Budgets

After the budgeted income statement has been developed, the budgeted balance sheet can be prepared. Two major budgets comprising the budgeted balance sheet are the cash budget and the capital expenditure budget, which we illustrate later.

Income Statement Budgets

In the following sections, we will illustrate the major elements of the income statement budget. We will use a small manufacturing business, Elite Accessories Inc., as the basis for our illustration.

Sales Budget

The sales budget normally indicates for each product (1) the quantity of estimated sales and (2) the expected unit selling price. These data are often reported by regions or by sales representatives.

In estimating the quantity of sales for each product, past sales volumes are often used as a starting point. These amounts are revised for factors that are expected to affect future sales, such as the factors listed below.

• backlog of unfilled sales orders

• planned advertising and promotion

• expected industry and general economic conditions

• productive capacity

• projected pricing policy

• findings of market research studies

Once an estimate of the sales volume is obtained, the expected sales revenue can be determined by multiplying the volume by the expected unit sales price. Exhibit 7 is the sales budget for Elite Accessories Inc.

EXHIBIT 7 Sales Budget

For control purposes management can compare actual sales and budgeted sales by product, region, or sales representative. Management would investigate any significant differences and take possible corrective actions.

Production Budget

Production should be carefully coordinated with the sales budget to ensure that production and sales are kept in balance during the period. The number of units to be manufactured to meet budgeted sales and inventory needs for each product is set forth in the production budget. The budgeted volume of production is determined as follows:

Exhibit 8 is the production budget for Elite Accessories Inc.

EXHIBIT 8 Production Budget

Direct Materials Purchases Budget

The production budget is the starting point for determining the estimated quantities of direct materials to be purchased. Multiplying these quantities by the expected unit purchase price determines the total cost of direct materials to be purchased.

In Elite Accessories Inc.'s production operations, leather and lining are required for wallets and handbags. The quantity of direct materials expected to be used for each unit of product is as follows:

Based on these data and the production budget, the direct materials purchases budget is prepared. As shown in the budget in Exhibit 9, for Elite Accessories Inc. To produce 520,000 wallets, 156,000 square yards (520,000 units * 0.30 square yard per unit) of leather are needed. Likewise, to produce 292,000 handbags, 365,000 square yards (292,000 units * 1.25 square yards per unit) of leather are needed. We can compute the needs for lining in a similar manner. Then adding the desired ending inventory for each material and deducting the estimated beginning inventory determines the amount of each material to be purchased. Multiplying these amounts by the estimated cost per square yard yields the total materials purchase cost.

EXHIBIT 9 Direct Materials Purchases Budget

The direct materials purchases budget helps management maintain inventory levels within reasonable limits. For this purpose, the timing of the direct materials purchases should be coordinated between the purchasing and production departments. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 878-882*

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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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Accounting: The Language of Business - Vol. 1 (Part 129)

“There is no business like show business. There is also no business like certified public accounting, but that doesn’t rhyme as well.”

—Craig Shaw Gardner, Author, A Changeling Star

Budgeting (Part B)

by

Charles Lamson

Human Behavior and Budgeting

In the budgeting process, business, team, and individual goals are established. Human behavior problems can arise if (1) the budget goal is unachievable (too tight), (2) the budget goal is very easy to achieve (too loose), or (3) the budget goals of the business conflict with the objectives of employees (goal conflict).

Setting Budget Goals Too Tightly

People can become discouraged if performance expectations are set too high. For example, would you be inspired or discouraged by a guitar instructor expecting you to play like Eric Clapton after only a few lessons? You would probably be discouraged. This same kind of problem can occur in businesses if employees view budget goals as unrealistic or unbelievable. In such a case, the budget discourages employees from achieving the goals. On the other hand, aggressive but attainable goals are likely to inspire employees to achieve the goals. Therefore, it is important that employees (managers and non managers) be involved in establishing reasonable budget estimates.

Involving all employees encourages cooperation both within and among departments. It also increases awareness of each department's importance to the overall objectives of the company. Employees view budgeting more positively when they have an opportunity to participate in the budget-setting process. This is because employees with a greater sense of control over the budget process will have a greater commitment to achieving its goals. In such cases, budgets are valuable planning tools that increase the possibility of achieving business goals.

Setting Budget Goals Too Loosely

Although it is desirable to establish attainable goals, it is undesirable to plan lower goals than may be possible. Search budget "padding" is termed budgetary slack. An example of budgetary slack is including spare employees in the plan. Managers may plan slack in the budget in order to provide a "cushion" for unexpected events or improve the appearance of operations. Budgetary slack can be avoided if lower and mid-level managers are required to support their spending requirements with operational plans.

 Slack budgets can cause employees to develop a "spend it or lose it" mentality. This often occurs at the end of the budget. When actual spending is less than the budget, employees may attempt to spend the remaining budget (purchase equipment, hire consultants, purchase supplies) in order to avoid having the budget cut next period.

Setting Conflicting Budget Goals

Goal conflict occurs when individual self-interest differs from business objectives. This can happen when management establishes individual goals that conflict with overall business objectives. Often, such conflicts are subtle. For example, the Sales Department manager may be given a sales goal, while the Manufacturing Department manager may be given a cost reduction goal. It is possible for both goals to conflict. The Sales Department may increase sales by promising customers small product deviations that are difficult and unprofitable to make. This would increase sales at the expense of Manufacturing's expense reduction role and impact the overall profitability objectives of the firm. Likewise, Manufacturing may schedule the plant for maximum manufacturing efficiency with little regard for actual customer product demand. This would reduce manufacturing costs at the expense of the sales goal and reduce the overall profitability of the firm. Goal conflict can be avoided if budget goals are carefully designed for consistency across all areas of the organization. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 873-874*

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