Lesson 22--Budgetary Planning

Budgetary Planning

Every organization realizes, at one point or another, that its resources are limited. Despite a company's efficiency and profit record, each accounting period brings new competition, changing economic conditions, and challenges to continued existence. The budgeting process illustrated in Chapter 22 represents a tool which is necessary for both effectiveness (accomplishing goals) and efficiency (using resources wisely).

As pointed out in your text, a budget can be thought of as both a planning tool, and, after results are determined, a control tool. The results of operating for a period of time can be compared to the original plan, and an organization can learn to understand its cost and revenue behaviors better over time. Some benefits of of budgeting are described in your text. Budgets enhance communication between managers and workers, put an emphasis on conservation of resources, and help to improve company performance. A budget demonstrates the company's commitment to plans and goals, by attaching money to them.

Operating and Financial Budgets

A budget, or "master budget" is really a system of related budgets. Your text defines two types of budgets: operating budgets, the result of which is a budgeted income statement; and financial budgets, which culminate in a budgeted balance sheet. A diagram appears in your text that shows the budgets used to forecast the budgeted income statement:

Sales Budget

Cost of Goods Sold Budget, which incorporates the following budgets:
Production Budget
Direct Materials Budget
Direct Labor Budget
Factory Overhead Budget

Selling and Administrative Budget

If you examine the budget list above, you can visualize an income statement for a manufacturer: Sales - Cost of Goods Sold - Selling and Administrative Expenses = Net Income.

The budgeted balance sheet budgets will include these budgets:
Cash Budget, which relies on the Schedule of Cash Collections and the Schedule of Cash Payments
Capital Expenditures Budget
Additionally, some of the ending balance sheet values such as the accounts receivable, finished goods and raw materials inventories can be derived as a result of the income statement budgets.

Clearly, this chapter is largely focused on the operating budgets.

Notice that the first budget to be prepared is the sales budget. The organization must predict the level of sales that it expects to achieve in the upcoming year. From this sales forecast, the number of units to be produced, the labor cost required, the required capacity, and various other costs can be estimated. The sales budget, therefore, may be the most important budget in that all other budgets are derived from it.

This dependence on the sales forecast has its equivalent in non-profit organizations as well. A school starts its budgeting process by determining how many full-time-equivalent students it plans to educate in the upcoming year; a club must determine how many members it can retain and accept, in order to make decisions on equipment or building needs; a government must decide how much service it must provide to its constituents as a preliminary to setting its labor and facilities budgets. Think about the organization you work for--what is the operating activity that you would need to consider in order to produce a budget?

Sales Budget

A diagram of a sales budget appears below. This sales budget may show the sales anticipated by month, or by quarter, and may also divide the sales into two categories--cash sales and credit sales. Thinking ahead, this budget will be used to create the revenue portion of the budgeted income statement, as well as the ending cash balance, and accounts receivable balance, on the budgeted balance sheet.

Some companies start at the unit level in the construction of a sales budget. This is useful for a manufacturer in that once you know the number of units you will sell, you can then create subsidiary budgets for direct materials, direct labor and manufacturing overhead. Here is a typical format for a sales budget:

Quarter

Q1

Q2

Q3

Q4

Year

Unit Sales

xxx

xxx

xxx

xxx

xxx

Selling Price

xxx

xxx

xxx

xxx

xxx

Total Sales

xxx

xxx

xxx

xxx

xxx

Notice that total budgeted sales is computed in the far right hand column. This total will appear on the budgeted income statement for the year.

The Basic Inventory Formula

Once the sales budget has been determined, the sales each quarter can provide a foundation for a production budget. For calculating the purchases of inventory we need to make, we use an "altered" form of a formula you already know. Thinking back to your beginning course in accounting, we use the following formula when calculating Cost of Goods Sold using the periodic inventory system:

Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory

As an example, Johnson Company started the year with $10,000 of inventory. During the year, they purchased $100,000 of inventory. A count of inventory at the end of the year revealed that $20,000 of inventory remained. What was the Cost of Goods Sold for the year? Answer: 10,000 + 100,000 minus 20,000 = Cost of Goods Sold of $90,000.

If you use this formula in a budgeting context, your sales budget will tell you your sales. What you want to solve for in a budget is the amount of inventory you need to purchase or manufacture.

Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory (...original formula)

Now, let us turn the inventory formula around::

Purchases = Cost of Goods Sold + Ending Inventory - Beginning Inventory (...altered version to solve for Purchases)

Looking at the latter version of the formula, we can determine the required purchases by calculating the Cost of Goods Sold, adding in a desired Ending Inventory figure, and subtracting the Beginning Inventory.

Production Budget

Manufacturing companies prepare a production budget based on units. The reasoning is quite similar to what was outlined above.

Beginning Inventory + Units Manufactured – Ending Inventory = Units Sold

When preparing the Production Budget, we turn this formula around, as follows:

Units Sold + Ending Inventory – Beginning Inventory = Units to Manufacture

This formula is used both for determining how many units of finished goods need to be manufactured; it can also be used, with slight modification, for determining how many units of raw materials need to be purchased.  The Units Sold will come from the Sales Budget; the Ending Inventory is a "desired" amount.

The production budget has the following format:

Quarter

1

2

3

4

Year

Unit Sales (from sales budget)

xxx

xxx

xxx

xxx

 
+ Desired Ending Inventory

xxx

xxx

xxx

xxx

 
Units Required

xxx

xxx

xxx

xxx

 
- Beginning Inventory

xxx

xxx

xxx

xxx

 
Units to Produce

xxx

xxx

xxx

xxx

xxx

The Unit Sales row would come directly from the Sales Budget, and is for finished goods inventory. Important point: The ending finished goods inventory of one quarter is equal to the beginning inventory of the next quarter. For example, the ending inventory of quarter 1 is equal to the beginning inventory of quarter 2. Consider also, that the ending inventory for quarter 4 would be the inventory figure that would appear on the end-of-year balance sheet. Remember: the production budget is in units, not dollars.

Note the two cells that are boldfaced in the table above. In a production budget we are not only budgeting for the sales we plan to make, we are also budgeting for additional inventory to have on hand in case our sales forecast is too low. The production budget recognizes that the ending budget for quarter 1 becomes the beginning budget for quarter two. Therefore, the two boldfaced items must be equal. Similarly, though I did not use boldfacing, the ending inventory for quarter 2 must be equal to the beginning inventory of quarter 3.

Direct Materials Budget

A Direct Materials Budget can be created, for keeping track of materials used as inputs to a product.

Quarter

1

2

3

4

Year

Units to Produce (from Prod. Budget)

xxx

xxx

xxx

xxx

 
Pounds of Material Required Per Unit

xxx

xxx

xxx

xxx

 
Pounds Required for Production

xxx

xxx

xxx

xxx

 
+ Desired Ending Inventory of Material

xxx

xxx

xxx

xxx

 
Subtotal

xxx

xxx

xxx

xxx

 
- Beginning Inventory

xxx

xxx

xxx

xxx

 
Units to Purchase

xxx

xxx

xxx

xxx

Price Per Unit of Material

$xxx

$xxx

$xxx

$xxx

 
Total Direct Material Purchases

$xxx

$xxx

$xxx

$xxx

$xxx

It is quite similar in logic to the production budget, and uses that same basic inventory formula for determining how many pounds of direct materials need to be purchased. Similar to the production budget, the ending inventory of one quarter becomes the beginning inventory for the next. The ending inventory for quarter 4 will show up on the balance sheet as the ending raw materials inventory--on the balance sheet. Note that in this budget, we start with sales of finished units, convert to pounds of material, and finally end up with a dollar amount of purchases.

I have boldfaced two items in the direct materials budget to remind you that the ending inventory of one quarter becomes the beginning inventory of the next quarter.

Direct Labor Budget

The Direct Labor budget is likewise related to the original Sales Budget. The labor hours required per unit must be used in order to compute direct labor cost.

Quarter

1

2

3

4

Year

Units to Produce (from Prod. Budget)

xxx

xxx

xxx

xxx

 
Labor Time Required Per Unit

xxx

xxx

xxx

xxx

 
Total Labor Hours Required

xxx

xxx

xxx

xxx

 
Direct Labor Rate Per Hour

$xxx

$xxx

$xxx

$xxx

 
Total Direct Labor Cost

$xxx

$xxx

$xxx

$xxx

$xxx

Manufacturing Overhead Budget

As you might expect, after seeing budgets for material and labor, a manufacturing overhead budget must also be prepared. This budget is separated into variable costs and fixed costs. Variable costs would include indirect materials and indirect hourly labor. Fixed costs would include supervisory salaries, depreciation on factory and machines, and property taxes on the factory.

Quarter

1

2

3

4

Year

Units to Produce (from Prod. Budget)

xxx

xxx

xxx

xxx

 
Times Variable Overhead Cost Per Unit

$xxx

$xxx

$xxx

$xxx

 
Subtotal

xxx

xxx

xxx

xxx

 
+ Fixed Costs

$xxx

$xxx

$xxx

$xxx

 
Total Overhead

$xxx

$xxx

$xxx

$xxx

$xxx

Direct Labor Hours Used

xxx

xxx

xxx

xxx

xxx DLH

Predetermined Overhead Rate         $xxx / xxx DLH

Once the total manufacturing overhead is determined for the year, a predetermined overhead rate would also be computed. Direct labor hours, direct labor cost, or machine hours can also be estimated for the year, which makes it convenient to compute the Predetermined Overhead Rate for the year. Although there are quarterly variations in overhead costs and direct labor hours anticipated, the predetermined overhead rate is based on total budgeted manufacturing overhead for the year divided by total budgeted direct labor hours.  If a company based its predetermined overhead rate on direct labor cost, machine hours, or some other base, the appropriate modifications would be made to the denominator.

Reflecting upon the earlier chapters on manufacturing accounting, these overhead costs are anticipated to become product costs, applied using the predetermined overhead rate.

Selling and Administrative Budget

In addition to the various manufacturing budgets, a manufacturer may create a Selling and Administrative Expense budget, which details the non-manufacturing costs estimated for the year. This budget is self-explanatory; like the manufacturing overhead budget, the various costs are separated into variable and fixed categories. These selling and administrative costs will be considered period costs and will be expensed in the quarter incurred.

Cost of Goods Sold Budget

Your textbook presents a Cost of Goods Sold Budget, which is similar to the Cost of Goods Manufactured schedule that you worked on in chapter 18. I will present an example on your website, using numbers, to help clarify the COGS budget. A point to remember about the COGS budget is that it will rely on desired inventory levels of direct materials inventory, work in process inventory, and finished goods inventory--but the unit cost of the inventory will conform with the direct materials, direct labor and factory overhead budgets.

In contrast to the operating budgets illustrated above, the financial budgets are oriented toward the balance sheet. Specifically, these budgets consist of the Cash Budget, the Capital Expenditures Budget, and the budgeted balance sheet. The Capital Expenditures budget is covered in a later chapter, and is concerned with purchases of buildings and equipment that are have lives greater than one year.

Cash Budget

The basic setup of a Cash Budget is just as you would expect—a schedule of anticipated cash receipts and cash disbursements. Your textbook illustrates an additional desirable feature, a financing section, which can be used to show anticipated borrowings and repayments during the year. Many businesses are seasonal, suggesting that cash flows are low during part of the year, and high at other times. A company might therefore borrow cash to build up inventories during the low periods; as the busy season comes along, the increased cash flows can be used to pay off the short term debt.

A cash budget relies on two schedules--a schedule of cash receipts and a schedule of cash payments. In a schedule of cash receipts, we are primarily looking at the pattern of how the accounts receivable are collected. For example, suppose that the sales budget shows sales of $100,000 in quarter 1 and $120,000 in quarter two, and $140,000 in quarter 3. And also assume that we generally collect 60% of sales in the month of sale, and 40% of sales in the month following the sale. In other words, there is a lag in collecting the receivables. We are trying to calculate the amount of cash collected each month. Examine the following table.

Cash Collections Schedule Q1 Q2 Q3 Q4
Sales Revenue(from Sales Budget) $100,000 $120,000 $140,000  
Cash Receipts        
In the Month of Sale (60%) $60,000 $72,000 $84,000  
In the Month Following Sale (40%)   $40,000 $48,000 $56,000
         
Total Cash Collections $60,000 $112,000 $132,000  

I have boldfaced the pattern of collections from quarter 1 sales. Only 60% of the $100,000 of sales in Q1 are collected in Q1. The rest (40% of $100,000) are collected in Q2. If sales in Q2 are 120,000, 60% of that is collected in Q2, and 40% collected in Q3. If you are looking for the total cash collected in Q2, it would be $112,000. But what if you wanted to know the total cash collected from sales in Q1? You would need to know the sales made in Q4 of last year, and take 40% of that amount.

A Schedule of Cash Payments works quite similarly. Johnson Company pays its expenditures for labor, materials and factory overhead in a certain pattern--80% in the month of purchase, and 20% the month after.

Cash Payments Schedule Q1 Q2 Q3 Q4
Costs of Materials, Labor and Overhead $70,000 $80,000 $90,000  
Cash Payments        
In the Month of Purchase (80%) $56,000 $64,000 $72,000  
In the Month Following Purchase (20%)   $14,000 $16,000 $18,000
         
Total Cash Collections $60,000 $112,000 $132,000  

Johnson incurred $70,000 of product costs in quarter 1. They pay off 80% of that in quarter 1, and the other 20% in quarter 2. Remember that this is a cash payments schedule, and some costs are not paid in cash. For example, if depreciation costs are incurred, would these costs appear in a cash payments schedule. No--depreciation is a noncash expense.

The cash receipts and cash payments come together in a cash budget, which is illustrated in your text. Here is one format:

Quarter

1

2

3

4

Total Cash Receipts

xxx

xxx

xxx

xxx

-Cash Cash Payments

xxx

xxx

xxx

xxx

Cash increase (decrease)

xxx

xxx

xxx

xxx

         
+Cash balance at beginning of Qtr

xxx

xxx

xxx

xxx

=Cash balance at end of Qtr

xxx

xxx

xxx

xxx

         
Minimum Cash Balance

xxx

xxx

xxx

xxx

Excess (deficiency)

xxx

xxx

xxx

xxx

 

A company will try to maintain a standard or minimum cash balance. If the cash budget shows that a deficiency will occur, the company will need to find a short term loan or other financing to reach the minimum cash balance.

The Capital Expenditures Budget

The capital expenditures budget is briefly illustrated in your textbook. Capital expenditures are long term investments in property, plant and equipment. Unlike the operating budgets, the capital expenditures budget plans for several years into the future, and provides insights on other costs such as depreciation and maintenance.