Budget Defined

A budget is a financial plan of the resources needed to carry out tasks and
meet financial goals. It is also a quantitative expression of the goals the
organization wishes to achieve and the cost of attaining these goals.

The act of preparing a budget is called budgeting. The use of budgets to

control a firm's activities is known as budgetary control.

The overall or master budget (also known as planning budget or budget plan)
indicates the sales levels, production and cost levels, income and cash flows
that are anticipated for the coming year.

The master budget is a summary of all phases of a company's plans and

goals for the future. In short, it represents a comprehensive expression of
management's plans for the future and how these plans are to be
accomplished.

Difference between Planning and Control

Planning and control are two quite distinct concepts. Planning involves
developing objectives and preparing various budgets to achieve these
objectives Control involves the steps taken by management to ensure that
the objectives set down at the planning stage are attained and to ensure that
all parts of the organization function in a manner consistent with
organizational policies. An effective budgeting system must provide for both
planning and control. Good planning without effective control is time wasted.
On the other hand, unless plans are presented or known in advance, there
are no objectives toward which control can be directed.

Functions of Budgeting

Properly conceived, budgeting can mean the difference between a general

drift that may or may not lead to a desired goal and a carefully plotted course
toward a predetermined objective that holds drift to a minimum. Budgets make
the decision-making process more effective by helping managers meet
uncertainties. The objective of budgeting is to substitute deliberate, well-
conceived business judgment for accidental success in enterprise
management. Budgets should not be expressions of wishful thinking but
rather descriptions of attainable objectives.

The Purposes of the Budget

A budget is a description in quantitative - usually monetary terms of a desired

future result. The process of preparing the budget requires management at all
levels to focus on the future of the business entity. The benefits that may be
realized from a budgeting program are

1. Defining broad objectives and goals and formulating strategies to achieve

such objectives;
2. Coordinating the activities of the organization by integrating the plans of the
various parts thereby pulling every one in the same direction;

3. Allocating resources to those parts of the organization where they can be

used most effectively;

4. Communicating management's approved plans throughout the

organization;

5. Uncovering and preparing for potential bottleneck in the operations before

they occur.

6. Motivating managers to achieve the desired results, and

7. Setting a standard or benchmark for evaluating actual performance.

Discussion of the Purposes of Budget

1. Planning Function

The first step in a company's planning process is the establishment of its

broad goals or objectives. After the objectives have been defined, strategies
to achieve these desired objectives must be formulated, and tentative
budgetary schedules must be developed. Each time a budget is prepared,
there is a period of critical self-appraisal during which policies and procedures
come up for review: When planning is done well in advance, many problems
are anticipated long before they arise, and solutions can be sought through
deliberative study. Planning ideally should occur at three levels, namely 
a) Strategic planning which focuses on long-range horizon and is performed
by the highest level of management.

b) Programming or intermediate-range planning which involves identification

of broad programs in the functional areas such as marketing plan, a finance
plan, and a production plan. This is performed by higher and middle
management, and

c) Short-term budget which a quantitative detailed plan covering typically one

year established by all managers at all levels. Logically, the budget is an
expression of the strategic planning and programming also being conducted.

2. Coordination and Allocating Resources function for Goal Congruence

The budget serves as a tool through which the actions of different parts of an
organization can be welded into a harmonious unit working toward a common
objective. Goal congruence is the term used to refer to a firm's striving to
achieve a common set of objectives. It is also an ideal that can be attained
only to the extent that individuals can be convinced that what is best for the
company is also best for them and that their own welfare is congruous or
aligned with the welfare of the organization. Individuals when left to
themselves may go in different directions believing that he or she is acting in
the best interests of the enterprise as a whole. Budgeting will reconcile the
differences between the sales, manufacturing, purchasing, finance and
personnel departments for the common good of an organizational system.
Limited resources will also be properly allocated for optimum returns.

3. Communication function

If an organization is to operate as an efficient unit, there must be definite lines

of communication, so that the employees in the various departments can be
kept fully informed of objectives, policies, plans and achievements. Each
employee should have a clear understanding of the company's goals and the
part that he or she is expected to play in their attainment. To a certain extent
the employees can gain understanding of how they can positively contribute
toward accomplishing organizational goals. This is achieved through their
participation in the budgeting process. Furthermore, everyone who has
responsibility under the budget should be informed on how his/her actual
performance compares with budget plans. Budgeting also facilitates
decentralized decision making It serves as authorization for a manager to act
since it delineates available resources and goals Decentralized decision
making means that higher management is freed from such bordens and has
more time to focus on programs and strategic planning

4. Motivation function

Budgeting can be a force for good and evil. A budgeting approach in which
managers prepare their own budget estimates called a self imposed budget or
participative budget is generally considered to be the most effective method of
budget preparation. If a firm's employees have actively participated in budget
preparation and if they are convinced that their own personal interests are
closely allied with the firm's success, budgets provide motivation in the form of
goals to be attained. Most people like to face up to a challenge and take
satisfaction in operating efficiently and effectively under a budget they
participated in planning. On the other hand, if the budget is dictated from
above by top management and poses a threat rather than a challenge to the
employees, then it becomes something to be resisted rather than accepted
and it can do more harm than good from the viewpoint of organizational
operating performance

5. Control function

Budgets represent management's formal commitment to take positive actions

to make actual events correspond to the formal plan Profit plans also contain
explicit statements concerning implementation of management objectives for
a period of time, managers communicate these to all parties with control
responsibility Comparison of actual results with the profit plan forms the basis
for management control, motivation, and performance evaluation. Many
problems occur when managers are evaluated on their ability to achieve the
budget. The most serious consequences occur when the budget is the sole or
overriding criterion of performance In such situations, managers may reach
the budget by devious or shortsighted means. To alleviate the problems of
employing budgets to evaluate performance, the following should be
considered

1) Flexibility which means that the budget is viewed as a plan, not set in
concrete A variance (difference between actual and budget) should merely
raise a question as to why we are off the plan and managers should feel that
they have the freedom to deviate from the plan when necessary.

2) Focus on controllable costs. Managers should be evaluated only on

controllable costs over which they have "significant influence" Holding a
manager responsible for noncontrollable costs or costs which he did not
authorize, causes frustration and mistrust and is demotivating, and

3) Nonpunitive approach. The focus of analysis should not be solely on

unfavorable variances as a punitive device to make sure that managers do
not go over budget. Rather, any significant variance (whether over or under
budget) should be investigated. Examining variances may reveal situations in
which a manager should be praised for strong performance - a motivating
event. Large variances in either direction require analysis to either alter the
plan or take appropriate actions, not to find fault with managers.

6. Standards in evaluating performance.

Management must keep clearly in mind that rather than being used as a
pressure device, the budget should be used as a positive instrument to assist
in establishing goals, in measuring operating results, and in isolating areas
that are in need of extra effort or attention. The ultimate objective must be to
develop the realization that the budget is designed to be a positive aid in
achieving both individual and company goals.

Advantages and Limitations of Budgets

The advantages of budgeting include:

(1) It forces planning and exposes situations in which plans subcomponents

are inadequate to attain the total organization objectives.

(2) It allows a reiterative process to bring the goals of the organization and the
subcomponents into agreement.

(3) It provides a means of communicating organization goals down through

the organization and sub-unit operational limitations up though organization.

(4) It provides a basis for financial planning, sub-unit coordination, resource

acquisition, inventory policy, scheduling and output distribution
(5) It provides a basis by which activity can be monitored, with actual results
being compared to the planned results. 

The limitations of budgeting are:

(1) Budgets tend to oversimplify the real situation and fail to allow variations in
external factors. They do not reflect qualitative variable

(2) It is difficult to prepare a detailed budget for an organization that has never
existed or for a new division, product, or department of an existing firm.

(3) There may be lack of higher and lower management commitment because
of lack of understanding of the fundamentals of budget preparation and
utilization.

(4) The budget is only a representation of future plans or a means to the goal
of profitable activity and not an end in itself. It may interfere with the
supervisor's style of leadership and can therefore stifle initiative

(5) Budget reports usually emphasize results, not reasons.

Types of Budgets

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 subclassification of the above-mentioned types

budget for a manufacturing firm

A. Operating Budget
1. Budgeted Income Statement
a. Sales budget
b. b Production budget
1) Materials 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. 2 Cash budget
C. Capital Investment Budget
Budgeting Terminologies Defined

Budgeted Income Statement - refers to projection of revenue, expenses,

and results of operations for a definite period of time.

Cash Budget - a period-by-period statement of cash at the start of a budget

period, expected cash receipts classified by source; expected cash
disbursements, classified by function, responsibility, and form; and the
resulting cash balance at the end of the budget period

Financial Budget - refers to the budget of the financial resources as reflected

in the budgeted statement of financial position and cash budget. 

Fixed budget - projection of cost at a particular or one level of production

(usually at normal capacity) for a definite time period.

Flexible (variable) budget -  - projection of cost at different levels of

production for a definite period of time.

Participative budget - budget prepared using employees at all levels in the

organization.

Physical budget - budget that is expressed in units of materials, number of

employees, or number of man-hours or service units rather than in pesos.

Planning budget (static. budget) - another term for master budget.

Production budget - production plan of resources needed to meet current

sales demand and ensure adequate inventory levels.

Program budget - budget for the major programs or projects that the
company plans to undertake.

Operating budget - refers to the plans for the conduct of business for the
planning period; it includes the budgeted income statement and all its
supporting budgets..

Responsibility budget - budget for a responsibility center.

Rolling (continuous, progressive) budget - budget which is prepared

throughout the year, that is, as one month elapses, a budget is prepared for
one more month in the future.

Sales budget - budget that shows the quantity of each product and the
revenue expected to be sold.

Traditional budgeting - a system of budgeting which concentrates on the

incremental change from the previous year assuming that the previous year's
activities are essential and must be continued.
Zero-based budgeting - a system of establishing financial plans beginning
with an assumption of no activity and justifying each program or activity level.

The Management Process of Preparing the Master Budget

Organization for Budget Preparation

It is essential that the manager of an entity assigns the most qualified

personnel to the preparation of the budget. A budget committee with
representation from the different functional areas (marketing, production,
finance, and administration) is generally considered an effective body to
oversee preparation and administration of the budget. The controller may be
selected to serve as

head of the committee for two major reasons: 

(1) Controller's is independent from the operating parts of the organization.
(2) He has the skills and experiences in coping with the intricacies of setting
up a budget.

The controller acts as a coordinator in the budgeting operation. He

recommends how budgets should be prepared, assembles the budgets,
prepares periodic reports showing variances of the actual results from the
budgeted results, interprets variances and offers suggestions for improvement
whenever possible.

The budget committee decides how budgets shall be prepared, passes on the
final budget, and settles disputes in one segment of the business and another
when differences of opinion arise. The committee also receives budget
reports and makes policy decisions with respect to budget revisions and other
problems of budget administration.

The Budget Period

As a general rule, the period covered by a budget should be long enough to

show the effect of managerial policies but short enough so that estimates can
be made with reasonable accuracy. This suggests that different types of
budgets should be made for different time spans.

A master budget is an overall financial and operating plan for a coming fiscal
period and the coordinated program for achieving the plan. It is usually
prepared on a quarterly or an annual basis. Long range budgets called capital
budgets. which incorporate plans for major expenditures for plant and
equipment or the addition of product lines, might be prepared to cover plans
for as long as 5 to 10 years. Responsibility budgets which are segments of the
master budget relating to the aspect of the business that is the responsibility
of a particular manager are often prepared monthly. Cash budgets may be
prepared on a day-to-day or monthly basis. Some companies follow a
continuous budgeting plan whereby budgets are constantly reviewed and
updated. The updating is accomplished, for example, by extending the annual
budget one additional month at the end of each month. A review of the budget
may also suggest that the budget be changed as a result of changing
business and operating conditions.

Budget Cycle of a Manufacturing Firm

Managerial plans are implemented through budgets that are developed for the
various departments of a company. These budgets should be based on the
lines of authority and responsibility fixed by the organization chart. An
overview of the budget cycle is shown in Figure 14.1 which also depicts the
sequence and types of budgets commonly found.

Steps in Developing a Master Budget

The major steps in developing a Master Budget may be outlined as follows:

1. Establish basic goals and long-range plans for the company. will serve as
guidelines in the preparation of budget estimates.
2. Prepare a sales forecast for the budget period. 
3. Estimate the cost of goods sold and operating expenses.
4. Determine the effect of budgeted operating results on assets, liabilities and
ownership equity accounts. The cash budget is the largest part of this step,
since changes in many asset and liability accounts will depend upon the cash
flow forecast.
5. Summarize the estimated data in the form of a projected income statement
for the budget period and the projected statement of financial position as of
the end of the budget period.

Sales Budget

The sales budget showing what products will be sold in what quantities of
what prices, is the foundation on which all other short-term budgets are built.
The sales budget triggers a chain reaction that leads to the development of
many other budget figures in an organization. The sales budget provides the
revenue predictions from which cash receipts from customers can be
estimated and supplies the basic data for constructing budgets for production
costs and selling and administrative expenses. In short, the sales forecast is
the keystone of the budget structure. The accuracy and reasonableness of the
sales data will affect the whole budget. The sales forecast is made after
consideration of the following factors.

1 Past sales volume

2. General economic and industry conditions indicators
3. Relationship of sales to economic
4. Relative product profitability
5. Market research studies and competition 
6. Pricing, advertising and other promotion policies
7. Production capacity 
8. Quality of sales force
9. Seasonal variations
10. Long-term sales trends for various products

Production Budget

After the sales budget has been set, a decision can be made on the level of
production that will be needed for the period to support sales and the
production budget can be set as well. The production budget becomes a key
factor in the determination of other budgets, including the direct materials
budget, the direct labor budget and the manufacturing overhead budget.
These budgets in turn are needed to assist in formulating a cash budget.

FLEXIBLE BUDGETING

The budgets that have been presented in the first part of this Chapter were
essentially static in nature. A static budget has two characteristics. 
1. It is geared toward only one level of activity. 
2. Actual results are always compared against budgeted costs as the
original budget activity level.

Fixed budgeting is appropriate only if a company can estimate its operating

volume within close limits and if the costs are behaving predictably. Few
companies are fortunate enough to fall into this group. As a result of these
factors, a fixed or static budget is generally not adequate

A flexible budget is an alternative to the fixed budget. A flexible budget

adjusts revenues, costs, and expenses to the actual volume experienced and
compares these amounts to actual results. Flexible budgets incorporate
changes in volume to provide a valid basis of comparison with actual costs

The basis steps in preparing a flexible budget are as follows.

1. Determine the relevant range over which activity is expected to fluctuate

during the coming period
2. Analyze the costs that will be incurred over the relevant range in order to
determine cost behavior patterns (variable, fixed, or mixed).
3. Separate the costs by behavior, and determine the formula for variable and
mixed costs, as discussed in Chapter 11
4. Using the formula for the variable portion of the costs, prepare a budget
showing what costs will be incurred at various points throughout the relevant
range.