Profit Planning

Budgeting and Planning and Control

Planning and control are tied together. Planning is looking ahead to see what actions should be taken to realize particular goals. Control is looking backward determining what actually happened and comparing it with the previously planned outcomes. This comparison is then used to adjust the budget, looking forward once more.

Budgets are financial plans for the future. They identify objectives and the actions needed to achieve them. Before a budget is prepared, a strategic plan should be developed. A strategic plan identifies strategies for future activities and operations. This can be translated into long and short term objectives.

A budgetary system gives an organization several advantages.

1. It forces managers to plan.
2. It provides information that can be used to improve decision making.
3. It provides a standard for performance evaluation.
4. It improves communication and coordination.

Types of Budgets

A master budget is a comprehensive financial plan for the organization as a whole. it can be broken down into quarterly and monthly budgets. Typically, the master budget is for a one-year period.

A continuous budget is a moving 12-month budget. As a month expires in the budget, an additional month in the future is added so that the company always has a 12-month plan on hand.

Most organizations prepare the master budget for the coming year during the last four or five months of the current year. This is done by the budget committee, who:

  1. Reviews the budget
  2. Provides policy guidelines and budgetary goals
  3. Resolves differences that arise as the budget is prepared
  4. Approves the final budget
  5. Monitors the actual performance of the organization as the year unfolds

The controller usually serves as the budget director. The budget director is responsible for directing and coordinating the organization's overall budgeting process.

A master budget can be divided into two main sections. These are the operational budgets and the financial budgets. The operational budgets describe the income-generating activities of a firm. The financial budgets detail the inflows and outflows of cash and the overall financial position.

Preparing the Operating Budget

The operating budget consists of a budgeted income statement accompanied by the following supporting schedules:

1. Sales budget
2. Production budget
3. Direct materials purchases budget
4. Direct labor budget
5. Overhead budget
6. Selling and administrative expenses budget
7. Ending finished goods inventory budget
8. Cost of goods sold budget

Sales Budget

The sales budget is the projection approved by the budget committee that describes expected sales in units and dollars. It is the basis for all of the other operating and most of the financial budgets. The following are the sales budget preparation steps.

1. Develop a sales forecast. This is usually the responsibility of the marketing department. it uses a bottom-up approach, where salespeople submit sales projections.
2. Forecast is reviewed by the budget committee.
3. Budget Committee recommends changes prior to approval.

Production Budget

The production budget describes how many units must be produced in order to meet sales needs and satisfy ending inventory requirements. The formula for the production budget is:

Units to be produced = Expected unit sales + Units in ending inventory - Units in beginning inventory

Direct Materials Purchases Budget

The direct materials purchases budget tells the amount and cost of raw materials to be purchased in each time period. The formula for direct materials purchases budget is:

  Direct materials needed for production
+ Desired direct materials in ending inventory
- Direct materials in beginning inventory
  Direct materials to be purchased

Direct Labor Budget

The direct labor budget shows the total direct labor hours needed and the associated cost for the number of units in the production budget.

Overhead Budget

The overhead budget shows the expected cost of all production costs other than direct materials and direct labor. Overhead costs are separated into fixed and variable costs and a variable rate is calculated. Ending Finished Goods Inventory Budget

The ending finished goods inventory budget supplies information needed for the balance sheet. It serves as an important input for the preparation of the cost of goods sold budget.

Cost of Goods Sold Budget

The cost of goods sold budget reveals the expected cost of the goods to be sold.

Selling and Administrative Expenses Budget

The selling and administrative expenses budget outlines planned expenditures for non manufacturing activities. Selling and administrative expenses can be broken down into fixed and variable components.

Budgeted Income Statement

With the completion of the budgeted cost of goods sold schedule and the budgeted selling and administrative expenses budget, a company has all the operating budgets needed to prepare an estimate of operating income. The eight budgets along with the budgeted operating income statement define the operating budget for a company.

Preparing the Financial Budget

The usual financial budgets prepared are:

1. The cash budget
2. The budgeted balance sheet
3. The budget for capital expenditures

Cash Budget

By knowing when cash deficiencies and surpluses are likely to occur, a manager can plan to borrow cash when needed and to repay the loans during periods of excess cash. The basic structure is shown below:

Budgeted Balance Sheet

The budgeted balance sheet depends on information contained in the current balance sheet and in the other budgets in the master budget.

Using Budgets for Performance Evaluation

Positive behavior occurs when the goals of each manager are aligned with the goals of the organization and each manager has the drive to achieve them. Goal congruence is the alignment of managerial and organizational goals. Dysfunctional behavior is the individual behavior that is in basic conflict with the goals of the organization. Managers need frequent timely performance reports to:

  1. Know how successful their efforts have been
  2. Take corrective action
  3. Change plans as necessary

Incentives are the means an organization uses to influence a manger to exert effort to achieve an organization's goal. Both monetary and non-monetary incentives are used.

Participative Budgeting

Rather than impose budgets on subordinate managers, participative budgeting allows subordinate managers considerable say in how the budges are established. This has advantages and disadvantages.

Advantages

  1. Communicates a sense of responsibility to subordinate managers
  2. Fosters creativity
  3. Budget goals will more likely become the manager's personal goals

Disadvantages

  1. Setting standards that are either too high or too low
  2. Tempted to build slack in the budget - Budgetary slack, or padding the budget, exists when a manager deliberately underestimates revenues or overestimates costs in an effort to make the future period appear less attractive in the budget than he or she thinks it will be in reality.
  3. Pseudoparticipation - This means that top management assumes total control of the budgeting process

Realistic Standards

Budgeted objectives are used to gauge performance. They should be based on realistic conditions and expectations.

Controllability of Costs

Ideally, managers are held accountable only for costs they can control. Controllable costs are the costs whose level a manager can influence.

Multiple Measures of Performance

Overemphasis on financial measures can lead to a form of dysfunctional behavior called myopia, or milking the firm. Myopia is when a manager takes actions that improve budgetary performance in the short run but bring long-run harm to the firm.