Budgeting: Principles, Process & System

A **budget** is a financial plan that tracks your income and expenses over a specific period of time. It\'s a way to ensure that you can cover your expenses and stay on track with your savings. It is also a plans future saving and spending as well as planned income and expenses. Budgeting may be ca...

A **budget** is a financial plan that tracks your income and expenses over a specific period of time. It\'s a way to ensure that you can cover your expenses and stay on track with your savings. It is also a plans future saving and spending as well as planned income and expenses. Budgeting may be carried out by individuals or by companies to estimate whether or not they can continue to operate with its projected income and expenses. The act of preparing a budget is called budgeting. The use of budgets to control a firm's activities is known as budgetary control. A **master budget** is the central financial planning document that includes how a company will spend and how much it expects to earn in a fiscal year. A master budget contains budgets of departments within the organization and projections that allow for management to plan for the upcoming year. **The Budgetary System** The CEO's mission is to achieve set objectives, or else their role is at risk. To succeed, they must develop strategies to engage people and optimize resources. Winning people's support is key, which requires encouraging employee involvement and securing their commitment to organizational goals. These could be done through the process of budgeting, which has the following uses: 1\. **Communication** This involves aligning budgeting goals with the organization's vision, mission, and strategic objectives. Effective communication ensures that everyone involved in the budgeting process understands the purpose and long-term goals. Clear goals set a direction and create a shared understanding, which is critical for consistent decision-making. 2\. **Motivation** When employees feel that their perspectives are valued, they're more likely to engage actively and contribute to the budgeting goals. Inclusivity can lead to higher morale, better collaboration, and increased ownership over budgetary decisions. The budget may be used as a target for managers to aim for. Reward should be given for operating within or under budgeted levels of expenditure. This acts as a motivator for managers. 3\. **Standards** Setting realistic and motivational standards is crucial for maintaining efficiency in budgeting. Standards provide a benchmark for performance evaluation and help in guiding efforts towards desired financial outcomes. In budgeting, standards could include cost controls, revenue targets, and resource allocation guidelines that encourage teams to meet specific targets. 4\. **Planning** Planning involves forecasting and approximating future financial needs and income. This step is about making informed assumptions on revenue, expenses, and other financial factors. Accurate planning helps organizations to anticipate potential challenges and opportunities, allowing for a proactive approach to resource allocation and risk management. A good plan must be S.M.A.R.T. (specific, measurable, attainable, realistic, and time-bounded. 5\. Organizing and Directing Resources are allocated based on the established plans. Policies, systems, strategies, and methods are created to guide activities, ensuring they align with the overall objectives. This process includes training personnel, bringing in necessary equipment, outsourcing materials, and enforcing standards. Both online and offline performance are closely monitored. Adjustments to plans may be made as needed, and corrective actions are implemented when issues arise. Effective organizing and directing ensure that every part of the organization is working in sync with the budgetary goals. 6\. Controlling and Perfomance Evaluation Controls should be developed and put in place before beginning business and operational activities. These controls are also applied throughout the process. They are categorized into feedback controls, concurrent controls, and feedforward controls. **The Budget Committee** A budget committee is a group of people within an organization that creates and maintains fiscal responsibility for that entity. In a company, this committee usually consists of top management along with the chief financial officer (CFO). The budget committee produces and updates an organization\'s budget manual, providing clear rules and guidelines for the budgeting process. The budget committee is also known in practice as the management committee or executive committee. A **budget committee** is an official group that creates and oversees the standards and best practices to implement and update an organization\'s spending and resource allocation plans while maintaining fiscal responsibility. Budget committees play a key role in the success or demise of a company or other entity that relies on generating and spending cash flows in order to remain operational. This committee is charged with keeping organizational budgets on track, which then ensure smooth operation and financial solvency and to stave off any financial problems before they get out of hand. In addition, the budget committee writes and edits the company budget manual and makes sure the departments are adhering to their submitted yearly budgets. The budget committee has a unique perspective in that they are privy to all of the financial comings and goings of an organization. They see the whole picture, whereas people in individual departments will only see their particular segment of the company. **The Master Budgets** A budget is a quantitative plan prepared for a specific time period. It is normally expressed in financial terms and prepared for one year. 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** The budgeting process for a business typically starts with the sales budget, driven by the demand for its products or services. This sales forecast then informs the creation of other budgets, including production, operating expenses, and profit or loss projections. These \"operating budgets\" are followed by \"financial budgets,\" which focus on the company\'s financial health through statements of financial position and cash flows. The culmination of all these individual budgets forms the master budget, providing a comprehensive financial plan for the business at a specific level of activity for a given period. Types of Budget The types of budgets or the major composition of the master budget are: 1\. The Operating budget 2\. The Financial Budget 3\. The Capital Budget The following is a simplified sub classification 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\. Material 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** - is a financial statement that companies use to estimate their future bottom lines. The statement takes into account a company\'s revenues and expenses, as well as its projected sales and costs. **Cash budget** - an estimation of the cash flows of a business over a specific period of time. This could be for a weekly, monthly, quarterly, or annual budget. This budget is used to assess whether the entity has sufficient cash to continue operating over the given time frame.\] **Financial Budget** - a microeconomic concept that organizations use to estimate their revenue and expenses. Budgets usually track these metrics over a specified time to determine the organization\'s financial performance. If a budget is in surplus, it predicts the organization to profit. **Fixed budget** - A financial plan that remains the same, regardless of activity or output levels. Fixed budgets are based on past data and management\'s expectations for the future. **Flexible(variable) budget** - a financial plan that varies based on activity level or production units. **Participative Budget** - a budgeting method that allows people in the lower levels of management to participate in the budget creation process. **Physical budget** - budget that is expresses in units of materials, number of employees or number of man-hour or service units rather than in pesos. **Planning budget** - another term for master budget. **Production budget** - quantifiable plan that sets out how many units of products a company needs to produce in order to meet its sales goals. **Program budget** - production plan of resources needed to meet the current sales demand and ensure adequate inventory levels. **Operating budget** - is a document that contains all expenditure and revenue that a company expects to generate from its daily operations during a specific period of time. **Responsibility budget** - budget for a responsibility center. **Rolling (continuous, progressive) budget** - a financial planning approach where the budget or forecast is regularly updated by adding a new budget period as the current one expires. **Sales budget** - itemised documents that estimate expected sales and the revenue your company will make over a specific sales period. **Traditional budgeting** - a financial planning document that you can use to express financial goals in quantifiable terms. It\'s based on the income and costs of the previous year. **Zero-based budgeting** - a budgeting technique in which all expenses must be justified for a new period or year starting from zero, versus starting with the previous budget and adjusting it as needed. **The Sales Budget** A sales budget is a financial plan that estimates a company's total revenue in a specific time period. It focuses on two things: the number of products sold and the price at which they are sold to predict how the company will perform. Mathematically, sales depend on both the price per unit and the quantity sold. The unit price itself is influenced by various factors, including production costs, competition, substitute products, market trends, regulatory requirements, demand and supply dynamics, and target profit margins, among others. Meanwhile, the quantity of units sold is directly impacted by the unit price. Additional factors that shape a sales forecast include historical sales data, overall economic and industry conditions, the connection between sales and economic indicators (such as GDP, GNP, personal income, employment rates, and industrial production prices), product profitability comparisons, findings from market research, advertising and promotional activities, sales team quality, seasonal trends, production capacity, and long-term sales trends across different product lines. In creating forecasts, factors that show a strong correlation with sales patterns are identified and applied. 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 projected number of units sold can be estimated across various categories, such as product line, department, geographic region, model, and market classification. To predict the number of units to be sold, a range of forecasting methods is utilized, often incorporating probability concepts, best-estimate models, statistical analysis, and simulation techniques. **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 50% strong, 60% fair and 10% weak. The projected number of units are 140,000 units, 70,000 units, and 40,000 units for strong, fair, and weak economic conditions, respectively. The budgeted unit sales price given the estimates in units sold is P 150. Two percent (2%) 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 Units Sales** A 140,000 50% 70,000 B 70,000 60% 46,200 C 40,000 10% 4,000 Total **120,200** 2\. The budgeted net sales in pesos shall be: x Unit sales price P 150 Budgeted gross sales in pesos 18,030,000 Less: Allowance for doubtful accounts **Budgeted net sales in pesos P 17,669,400** 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. **The Production Budget** Budgeted production relies on projected sales and established inventory policies. Typically, an inventory policy is based on the anticipated number of units to be sold in the upcoming period. The formula for budgeted production can be derived using the traditional approach to determine the number of units sold, where beginning finished goods inventory plus production, minus ending finished goods inventory, equals budgeted sales. You tweak the formula and the computation for the budgeted production is as follows: **Table 3.1. Pro-Forma Budgeted Production** 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. **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** The direct material budget for the period is calculated as the beginning materials on hand plus the costs to purchase additional inventory minus ending inventory. Its focus surrounds the cost associated with the direct materials utilized in the product for the respective period. 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. **Table 3.2. Pro-Forma Budgeted Direct Materials Used and Purchases** Add: Materials Inventory End x Total Materials for Use x Less: Materials Inventory - Beg x Budgeted direct mat. Purchases in units x x Materials cost per unit x Budgeted materials purchases in pesos **P x** **The Direct Labor Budget** In a labor-intensive operation where employees are paid hourly, the budgeted direct labor hours are calculated by multiplying the budgeted production by the standard direct labor hours required per unit. To determine the budgeted direct labor cost, the budgeted direct labor hours are then multiplied by the standard hourly labor rate. The standard labor hours per unit and the standard rate per hour are outlined on the standard cost sheet. The pro-forma computation of the budgeted direct labor cost is as follows: **Table 3.3. Pro-Forma Budgeted Direct Labor** The budgeted direct labor hours would determine the number of production personnel needed to be employed for a given budgetary period. **The Factory Overhead Budget** Factory overhead should be budgeted separately for its fixed and variable components. Fixed overhead remains constant in total, with the standard fixed overhead rate calculated based on normal capacity. For short-term budgeting, this standard fixed overhead rate is treated as a constant. Total variable overhead costs fluctuate with production levels, though the variable cost per unit remains constant. The computational guideline for the factory overhead is as follows: **Table 3.4. Budgeted Factory Overhead Computations** The standard hours per unit and standard overhead rates per hour are to be based on the standard cost sheet developed by the business. **The Budgeted Statement of Cash Flows** A cash flow statement tracks the inflow and outflow of cash, providing insights into a company\'s financial health and operational efficiency. The cash flow statement paints a picture as to how a company's operations are running, where its money comes from, and how money is being spent. Also known as the statement of cash flows, the CFS helps its creditors determine how much cash is available (referred to as liquidity) for the company to fund its operating expenses and pay down its debts. The CFS is equally important to investors because it tells them whether a company is on solid financial ground. As such, they can use the statement to make better, more informed decisions about their investments. Several models of cash management, presentation and analyses have been developed for management use, as follows: The presentation formats of these cash report presentation models are presented in each of the boxes in the following page. **Fig. 6.2 Cash Report Presentation Models**  The main components of the Cash Flow Statement are cash from three areas: Operating activities, investing activities, and financing activities. This classification mat be traced from understanding the general contents of the Statement of Financial Position and Statement of Profit and Loss.  Statement of Profit and Loss The operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company's products or services. It employs as the current assets and current liabilities. The difference of current assets and current liabilities is called the working capital. It is the fundamental resource used by the management in managing revenues, costs, and profit. As such, current items pertain to operating activities and are excluded from financing and investing activities. Investing activities include any sources and uses of cash from a company's investments. Financing activities includes the sources of cash from investors and banks, as well as the way cash is paid to shareholders. This includes any dividends, payments for stock repurchases, and repayment of debt principal (loans) that are made by the company. Under the International Financial Reporting Standards (IFRS), specifically International Accounting Standard, interest expense can be classified as either operating or investing activities based on the purpose for which it was incurred. If the interest expense is incurred to support the business\'s operating activities, it is classified as an operating item. Dividend income may be classified as either operating or investing activity depending on the nature of the investment from which the dividend is derived and the purpose of dividend distribution.