BUDGETS
BUDGETS
INTRODUCTION TO BUDGETING
Budgets are formal operating plans
expressed in financial terms. Budgets help management
1- planning for the future and
setting goals,
2- motivating employees,
3- coordinating activities,
4- identifying problem areas with
performance evaluation, and, thus,
5- correcting difficulties.
THE BUDGET PERIOD
Most companies use a budget period
which corresponds to their fiscal year. Annual budgets are often split into
shorter periods - quarter or month - over which greater control can be
exercised. When budgets are revised periodically to take account of changing
internal and external conditions, this is called continuous budgeting.
Budgeting extending over several years is referred to as long range planning.
BUDGET PREPARATION
The preparation of budgets is the
responsibility of the budget committee. The budget committee is usually
composed of employees of all levels of management because the success of the
budgeting process depends on the cooperation of all departments and all
employees. The preparation of budgets follows a sequence in which departmental
estimates based on sales forecasts are received and combined into a master
budget which must be approved by upper management. Most businesses initially
base their estimates on prior years. But government agencies and not-for-profit
organizations commonly prepare estimates as if the organization has just been
created (which is called zero-base budgeting).
THE MASTER BUDGET
The master budget integrates all
the departmental budgets. It is used to prepare projected financial statements
called pro forma income statement and pro forma balance sheet. The contents of
the master budget differ depending on the type of business (manufacturing,
merchandising or services). But they always help management make operating,
financing and capital expenditure decisions.
COMPONENTS OF A MASTER BUDGET
The master budget is composed of
three parts:
1- the operating budget,
2- the capital expenditure budget,
and
3- the cash or financial budget.
The operating budget is further
decomposed into
1- the sales budget,
2- the cost of goods sold budget,
and
3- operating expenses budget.
The budgeting process always
starts with the sales budget.
BUDGETED FINANCIAL STATEMENTS
The budgeted (or pro forma) income
statement is based on the sales forecast and the cost data contained in the
operating budgets. Financial ratios are used to assess the contribution of
various budgeted items of the income statement to profitability, and to analyze
the anticipated liquidity, leverage and return on equity portrayed by the
budgeted balance sheet.
BUDGET PERFORMANCE REPORTS
Budget performance reports compare
budgeted figures with actual results. They reveal problem areas and help
management correct them, as well as improve estimation methods. Because of the
role of external factors, management is not always blamed for shortfalls.
Nevertheless, it is essential that budgets contain achievable targets which
motivate employees avoiding frustration which unmet goals can cause.
FLEXIBLE BUDGETS
When changing levels of production
are build into budgets, the budgets are said to be flexible budgets. Costs are
classified as
1- fixed, which do not change with
the production level,
2- variable, which are tied to the
production level, or
3- semi-variable, which vary only
beyond a given production level.
Flexible budgets gives recognition
to the fact that the different variable costs do not vary in the same
proportion to production levels.
COMPUTERS & BUDGETING
Most large businesses use
computers to assist them in their budgeting efforts. The advantages of using
computers are
1) they allow cost savings,
2) the data can be updated quickly
and easily, and
3) the preparation of flexible and
continuous budgets is simplified.
STANDARD COSTS
Standard cost systems are designed
to measure the efficiency of manufacturing operations. A standard cost is the
cost of a product determined by combining past year direct materials cost,
factory overhead cost and direct labor cost, to arrive at the cost which can be
anticipated for a "normal" level of production. Standard costs are
used in job order and process cost accounting systems. The difference between
the standard cost and the actual cost is called a variance. Variances are
calculated for the total standard cost as well as for its components:
materials, labor and overhead. Standard costs are revised when changes occur in
the manufacturing process.
DIRECT MATERIALS COST VARIANCE
A direct materials cost variance
is broken down into
1- a quantity variance (whether or
not too much material was used), and
2- a price variance (whether or
not the price was higher than anticipated).
A significant unfavorable
materials quantity variance suggests the need to review the production process.
A significant unfavorable materials price variance points at the purchasing
department.
DIRECT LABOR COST VARIANCE
A direct labor cost variance is
broken down into
1- a direct labor time (or
efficiency) variance, and
2- a direct labor rate (or wage)
variance.
Significant direct labor time
variances suggest problems in productive efficiency. Significant direct labor
rate variances require review of company personnel policies.
FACTORY OVERHEAD COST VARIANCE
A factory overhead cost variance
is decomposed into
1- factory overhead volume
variance (which is primarily affected by production being below 100% of
capacity), and
2- factory overhead spending or
controllable variance (which is capturing differences in the overhead amount
itself).
Analysis of factory overhead
variances is more difficult than other variances because overhead, being by
nature fixed, is less under management's control, and because overhead is made
of many different types of expenses. Since changes in levels of production are
critical in this variance, flexible budgets are especially useful.
RECORDING STANDARDS IN ACCOUNTS
Variances are most clearly
revealed when the use of standard costs is incorporated into the work in
process inventory account: crediting for standard cost and debiting for actual
cost leaves any balance in the account in excess of ending inventory as a
variance. The analysis of that variance is useful for management to understand
the income statement better.