Budget
Preparation
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Nature of a Budget
Budgets are an
important tool for
effective short
term planning and
control in
organizations
An operating
budget usually
covers one year
and states the
revenue and
expenses planned
for that year
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Nature of a Budget
Budget has these characteristics :
• Estimates the profit potential of the business
unit
• It is stated in monetary terms
• It generally covers a period of one year
• It is a management commitment
• The budget proposal is reviewed and approved
by an authority higher than the budgetee
• Once approved, the budget can be changed
only under specified conditions
• Periodically, actual financial performance is
compared to budget, and variances are
analyzed and explained
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Nature of a Budget
Relation to Strategic
Planning
• The budgeting process focuses
on a single year whereas
strategic planning focuses on
activities that extend over a
period of several years.
• Strategic plan is essentially
structured by product lines or
other programs, while budgeting
is structured by responsibility
centers.
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Nature of a Budget
Contrast with Forecasting
• As contrasted with a budget, a forecast has the
following characteristic :
• A forecast may or may not be stated in monetary
units
• It can be for any time period
• The forecaster does not accept responsibility for
meeting the forecasted results
• Forecasts are not usually approved by higher
authority
• A forecast is updated as soon as new information
indicates there is a change in conditions
• Variances from forecast are not analyzed formally or
periodically.
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Nature of a Budget
Use of a Budget :
Preparation of an operating budget has four
principal purposes :
1. To fine tune the strategic plan
2. To help coordinate the activities of the several
parts of the organization.
3. To assign responsibility to managers, to
authorize the amounts they are permitted to
spend, and to inform them of the performance
that is expected of them
4. To obtain a commitment that is a basis for
evaluating a manager’s actual performance.
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Nature of a Budget
Content of an Operating
Budget :
• Next slide shows the content
of a typical operating budget
and contrasts the operating
budget with other types of
planning documents, the
strategic plan and the capital
budget, the cash budget, and
the budgeted balance sheet.
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Nature of a Budget
Types of Plans and Their Contents
Strategic Plan
• Revenue and
expense for each
major program
• Not necessarily by
responsibility
centers
• Not as much detail
as operating budget
• More expenses are
variable
• For several years
• Total reconciles to
operating budget
Operating Budget
• For organization as a whole
and for each business unit
• Classified by responsibility
centers
• Typically includes :
Revenues, Production cost
and cost of sales, Marketing
expense, Logistics expense,
General & administrative,
Research&development
Income taxes, Net income
• Expenses may be
Flexible,Discretionary,
Committed,
• For one year divided into
months or quarters
• Total reconciles to strategic
plan
Capital
Budget
• Each major
capital project
listed
separately
• Total project
expenditures
by quarters
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Nature of a Budget
Operating Budget Categories
Revenue Budgets
• A revenue budget consist of unit sales
projection multiplied by expected selling
prices
• The revenue budget is the most critical
• The element of budget revenue is subject
to the greatest uncertainty
• The revenue budget usually is based on
forecasts of some conditions for which the
sales manager cannot be held responsible.
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Nature of a Budget
Operating Budget Categories
Budgeted Production Cost and Cost of Sales
• Production managers make plans for obtaining
quantities of material and labor, and they may
prepare procurement budgets for long lead
times
• Production managers also develop production
schedules to ensure that resources needed to
produce the budgeted quantities will be
available
• The cost of sales reported in the summary
budget is the standard cost of the products
budgeted to be sold.
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Nature of a Budget
Operating Budget Categories
Marketing Expenses
• Marketing expenses are expenses incurred
to obtain sales
• Logistic expenses usually are reported
separately from order getting expenses
• Many companies include logistic expenses
in the marketing budget, because they
tend to be the responsibility of the
marketing organization
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Nature of a Budget
Operating Budget Categories
General and Administrative Expenses
• These are G&A expenses of staff units,
both at headquarters and at business
units.
• Overall, they are discretionary
expenses, although some components
are engineered expenses.
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Nature of a Budget
Operating Budget Categories
Research and Development
Expenses
• The R&D budget uses two
approaches
• In one approach, total amount is
the focus. This may be the
current level of spending, or it
may be a larger amount
• The alternative approach is
aggregating the planned spending
on each approved project
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Nature of a Budget
Operating Budget
Categories
Income Taxes
• Some companies do not take
income taxes into account in
preparing the budgets for
business units, because income
tax policies are determined at
corporate headquarters.
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Other Budgets
Capital Budget
• The capital budget states the approved
capital projects, plus a lump sum amount
for small projects that do not require high
level approval
• For the projects that remain, an estimate of
the cash that will be spent each quarter is
prepared. This is necessary in order to
prepare the cash flow statement.
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Other Budgets
Budgeted Balance
Sheet
• The budgeted balance
sheet shows the
balance sheet
implications of
decisions included in
the operating budget
and the capital budget.
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Other Budgets
Budgeted Cash Flow Statement
• The budgeted cash flow statement shows
how much of the cash needs during the
year will be supplied by retained earnings
and how much, if any, must be obtained by
borrowing or from other outside sources.
• It is, of course, important for financial
planning
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Other Budgets
Management by Objectives
• Some companies make their objectives
explicit
• The process is doing so is called
management by objectives in the literature
• Unfortunately, some management by
objectives (MBO) systems are separated
from the budget preparation process. MBO
and budgeting should be two parts of the
same planning process.
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Budget Preparation Process
Organization
Budget Department
• The budget department, which normally,
reports to the corporate controller, administers
the information flow of the budgetary control
system. The budget department performs the
following function :
- Publishes procedures and forms
- Coordinates and publishes the basic corporate
wide assumption
- Make sure that information is properly
communicated between organization units
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Budget Preparation Process
Organization
Budget Department
- Provides assistance to budgetees in the
preparation of their budgets
- Analyzes proposed budgets and make
recommendation to the budgetee
- Administers the process of making budget
revisions during the year
- Coordinates the work of budget departments in
lower echelons
- Analyzes reported performance against budget,
interprets the results and prepare summary
reports for senior management
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Budget Preparation Process
Organization
The Budget Committee
• The budget committee consists of members
of senior management
• The budget committee reviews and either
approves or adjusts each of the budgets.
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Budget Preparation Process
Issuance of Guidelines
• The first step in budget preparation process is
to develop guidelines that govern the
preparation of the budget, for dissemination
for all managers
• All responsibility centers must follow some of
these guidelines, such as inflation, etc
• Other guidelines are specific to certain
responsibility centers
• The budget staff develops the guidelines and
senior management approves them.
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Budget Preparation Process
Initial Budget Proposal
• Budget is based on the existing levels, which
are then modified in accordance with the
guidelines.
• Changes from the current level of
performance can be classified as :
a. Changes in external forces
b. Changes in internal policies and practices
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Budget Preparation Process
Initial Budget Proposal
a. Changes in external forces
• Changes in general level of economic
activity as it affects the volume of sales
• Expected changes in the price purchased of
materials and services
• Expected changes in labor rates
• Expected changes in the cost of
discretionary activities
• Changes in selling prices
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Budget Preparation Process
Initial Budget
Proposal
b. Changes in internal
policies and practices
• Changes in production
costs, reflecting new
equipment and methods
• Changes in discretionary
costs
• Changes in market share
and product mix
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Budget Preparation Process
Negotiation
• The budgetee
discusses the
proposed budget
with his or her
superior.
• This is the heart
of the process
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Budget Preparation Process
Review and Approval
• The proposed budgets go up through
successive levels in the organization
• In part, the analyst studies consistency
• In part, the examination asks whether the
budget will produce satisfactory profit
• Final approval is recommended by the
budget committee to the CEO
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Budget Preparation Process
Budgets Revision
• One of the principal considerations in budget
administration is the procedure for revising a
budget after it has been approved.
• There two general types of budget revisions :
1. Procedures that provide for a systematic
updating the budgets
2. Procedures that allow revisions under special
circumstances
• Budget revisions must be justified on the basis
of significantly changed conditions from those
existing when the original budget was approved
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Budget Preparation Process
Contingency Budgets
• Some companies routinely prepare
contingency budgets that identify
management actions to be taken if there is
a significant decrease in the sales volume
from what was anticipated at the time of
developing the budget.
• The contingency budget provides a way of
quickly adjusting to changed conditions if
the situation arises.
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Behavioral Aspects
Participation in the Budgetary Process
• A budget process is either “ top down “. The
top down approach rarely works, however
• Actually, an effective budget preparation
process blends the “ bottom up “
• Research has shown that budget participation
has positive effects on managerial motivation
for two reasons :
a. There is likely to be greater acceptance of
budget goals if they are perceived as being
under manager’s personal control.
b. Participative budgeting results in effective
information exchanges.
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Behavioral Aspects
Degree of Budget Target Difficulty
There are several reasons why senior management
approves achievable budgets for business units
a. If the budgeted target is too difficult, managers
are motivated to take short term actions that
may not be in the long term interests of the
company
b. Achievable budget targets reduce the
motivation for managers to engage in data
manipulation
c. If business unit profit budgets represent
achievable targets, senior management can, in
turn, divulge a profit target to security analyst
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Behavioral Aspects
Degree of Budget Target Difficulty
There are several reasons why senior
management approves achievable budgets for
business units
d. A profit budget that is very difficult to attain
usually implies an overly optimistic sales
target
e. When business unit managers are able to
meet and exceed their targets, there is a
“winning” atmosphere and positive attitude
within the company
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Behavioral Aspects
Senior Management Involvement
• Senior management involvement is
necessary for any budget system to be
effective in motivating budgetees
• Management must participate in the
review and approval of the budgets, and
the the approval should not be a rubber
stamp
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Behavioral Aspects
The Budget Department
• The budget department has a
particularly difficult behavioral
problem
• To perform their function effectively,
the members of the budget
department must have a reputation
for impartiality and fairness
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Quantitative Techniques
Simulation
• Simulation is a method that constructs a
model of a real situation and then
manipulates this model in such a way as to
draw some conclusions about the real
situation.
• With a computer simulation, senior
management can ask what the effect of
different types of changes would be and
receive almost instantaneous answers
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Quantitative Techniques
Probability Estimates
• Some authors have proposed budgets be
prepared initially using probability
distributions instead of point estimates,
that is, the budget committee would
approve a number of probability
distributions, rather than specific
amounts.
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Summary
 Budget is in a sense a one year slice of
the strategic plan. However it is
prepared in more detail than the
strategic plan, and its preparation
involves managers at all levels in the
organization.
 The process starts with the
dissemination of guidelines approved
by senior management.
 Participative budgeting, in which
managers feel they have influence on
the process, has benefits generally for
the organization.
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The End