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Financial Planning & Analysis - Budgeting & Forecasting
Financial, Regulatory or Management Reporting
Reconciliation
Month-End Close
Variance Analysis
Master Data Management
Interface Management
Fixed Assets Transaction Processing
The Difference Between Forecasting vs. Budgeting

They are both financial projections, but there are major differences. A forecast looks at market trends to
predict whether revenues and expenses might be up or down. The budget presents a plan for managing
cash flow and paying expenses for a fiscal year based on expected revenues and expenses. Many
people believe that the budget generally is based on the forecast, but others argue that point.
Overview
In Financial Reporting, you create rolling forecast reports to display data for multiple periods and scenarios. For
example, you display actual data from the beginning of the year to the current month, and budget data from the
following month to the end of the year.
When you select April for the current month in the user Point of View (POV), the rolling forecast report displays Actual
data from January through April, and Budget data from May to December.
Rolling Forecasts
With instant access to a 3-year forecast and automatic quarterly updates, you have a continuous
rolling view of performance trends. What if the Fed raises interest rates? What if we add a
branch? Easily modify projections as you test ideas and formulate an action plan.
Immediate Start
Using call report data, built-in modeling features, and forecasted rate information, BankersGPS
automatically creates a 3-year projection for your bank.
There's no need to spend weeks compiling data into spreadsheets only to get bogged down in
detail. In seconds, you get an executive-level forecast to work from, giving you time to focus on
analyzing and fine-tuning your plan rather than building it. Get instant access to forecasted rate
information and your bank's:
Historical balance sheet, income statement, and performance ratios
Product pricing patterns against built-in drivers
A 3-year financial projection with automatic quarterly updates
Key financial ratio trends and risk analysis
What-If?
With online access and built-in quick edit features, modifying your plan is simple.
Use the streamlined editing features to easily alter your forecast as conditions change
Instantly see the impact on your bottom-line as you evaluate alternative 'what-if?' tactics
Save as many scenarios as you like, graphically see how they compare, then determine your best course of
action
Use the Notes feature to record assumptions and action plans for quick future reference
Benchmark to Competition
Once you have created your plan, see how your projections stack up to the anticipated
performance of key rivals and peers, providing you a unique competitive perspective to complete
your planning process.
Merge Your Bank
Is part of your strategy to merge with another bank? BankersGPS now lets you merge banks,
develop a new operating plan, and measure the benefits of the combined organization. Compare
the new bank to competitors and identify potential strengths and weaknesses.
Flexible Reporting Options
It's easy to produce reports exactly the way you need them.
Drop down menus offer views of alternative time periods
Choose to display key metrics, charts, graphs, or traditional financial report formats
Instantly generate a complete financial report package, including: balance sheet, income statement, yields,
ratios, assumptions, and Notes
Point-and-click to create a custom report package with outputs to a PDF file or Microsoft Excel
Rolling Forecast. Part 2 What is a Rolling Forecast?

Most of us know what a Forecast is, or you wouldnt even be a reader of this blog. Its a projection. But what makes a
rolling forecast, well rolling?
Thats the heart of the matter and thats where we want to focus our attention.
A rolling forecast is one where the assumptions of original projection are revisited, and a new projection, based on
those new assumptions, is produced. By that broad definition, most organizations are doing a rolling forecast
today. Heres what I mean.
The organizations Ive worked with have all produced an annual plan/ budget. It goes by a lot of names (when I
worked at Pepsi we called it the AOP or Annual Operating Plan). Thats the budget that gets approved by the Board
of Directors, and is the foundation for executive bonuses.
The budget is blessed, and then the year begins. Things change. Some of what we thought would happen didnt.
Other things we didnt think would happen did. Surprise. So the organization comes up with a new projection based
on X months of actual results and Y months of projections. This, as we know, is called a forecast.
Most commonly, each quarter a company produces a balance of year forecast. Some organizations do it more
frequently than that, perhaps every month. At Readers Digest we did a formal forecast on a quarterly basis, but
would also produce a forecast on a dime if something important happened and we wanted to see what the financial
impact might be.
If the preceding paragraph describes what your organization does, then youre doing a rolling forecast.
Congratulations.
Now I can hear the Rolling Forecast purest groaning, Its more complicated than that. So let me get to the more
complicated approach to rolling forecast.
An 18 month rolling forecast means each month the company produces a forecast of the next 18 months. A 6 quarter
rolling forecast means each quarter, the company produces a forecast of the next 6 quarters. A 4 quarter rolling
forecast means each quarter, the company produces a forecast of the next 4 quarters.
You get the idea.
So how does, say a rolling 4 quarter forecast, compare to what most companies are doing today? Well lets look at
that.
For our example, lets take a company that has a calendar fiscal year. They start their budget process in Q4 of the
current year, and produce a balance of year forecast each quarter. Thats pretty common. So what does their
planning calendar look like?
You can see that they produce a balance of year forecast each quarter, and in Q4 they budget for the following year.
Okay, lets look at the Rolling 4 Quarter forecast calendar to see whats different.
At the start if Q1, this company produces a projection of each of the four quarters of the current year. Then at the
start of Q2 they produce a forecast of each of the remaining quarters of the current year [plus] the first quarter of the
following year. Then, at the start of Q3, they produce a forecast of the remaining two quarters of the current year
[plus] the first two quarters of next year. And so on.
Now, comparing these two calendars, whats different?
Well, with the rolling 4 quarter forecast, the company is peering into the next year earlier than with the traditional
planning calendar. But not a full year basis; the view is isolated to specific quarters.
Is there more to rolling forecast than that? There can be. Some proponents of rolling forecast also recommend that
the company produce forecasts by creating complex algebraic formulas (also known as financial models) to
automatically produce projections based on the input of key variables. But exactly how a company goes about
creating their rolling forecast projections is ultimately up to them.
So how does a rolling X quarter forecast calendar address the problems that organizations have with
planning/ budgeting? Thats the subject of the next blog.
Part 3: Assessment of Rolling Forecast
XLerant is a SaaS software solutions company that builds and implements innovative, practical and incredibly
powerful browser-based budget preparation software for mid-sized and large organizations and higher education
institutions, energizing a Culture of Budget Accountability among users. The company serves customers in several
industries. XLerants premier budgeting and planning application, BudgetPak, replaces spreadsheet-based budgeting
and provides maximum user flexibility and financial controls. Improved communication, greater ownership of the
numbers and increased transparency enable companies to better manage financial performance throughout the fiscal
year.
Tags: ,bpm, Budget, budgeting, cpm, planning, rolling forecast
LEARNING OBJECTIVES
After you have read and studied this chapter, you should be able to:
1. Discuss the concept of financial performance including the elements involved.
2. Describe four types of budgets and how they are used for different types of
costs.
3. Outline the main parts of a master budget including the sequence in which
they are developed.
4. Discuss the purposes and benefits of the master budget.
5. Discuss the limitations and problems associated with the master budget.
6. Briefly describe the assumptions underlying the master budget.
7. Describe responsibility accounting and discuss the controversy associated
with this concept.
8. Discuss the sources of the various information needed for the master budget.
9. Explain the difference between standard costs and budgeted costs.
10. Prepare the various schedules or sub-budgets included in a master budget or
financial plan.
INTRODUCTION
The purpose of this chapter is to introduce the master budget or financial plan. This
topic includes an important set of concepts and techniques that represent the major
planning device for an organization, as well as the foundation for a traditional
standard cost performance evaluation and control system.1 The chapter includes seven
sections. The first section provides a discussion of the underlying concepts of
financial planning and budgeting including the various types of budgets. This section
also includes a diagram of the master budget that provides an overview of the overall
budgeting process. Sections two and three include short, but important discussions of
the purposes and benefits of budgeting and the limitations and problems involved in
budgeting. The assumptions upon which the budget is based are briefly described in
section four. Section five introduces the underlying concept of responsibility
accounting and provides a brief discussion of a controversial issue associated with this
concept. The techniques used to prepare a master budget are discussed and illustrated
in section six. This is the longest section and includes a discussion of where the
budget director obtains the budget information as well as how the information is used
to complete the various schedules and sub-budgets involved. The last section includes
a simplified, but fairly comprehensive example. A somewhat more involved example
is provided in Appendix 9-1. Appendix 9-2 provides instructions for using a computer
program designed to facilitate the preparation of a master budget.
BUDGETING CONCEPTS
Budgeting involves planning for the various revenue producing and cost generating
activities of an organization. The importance of budgeting is emphasized by an old
saying, "Failing to plan, is like planning to fail." Budgeting is essentially financial
planning, or planning for financial performance. Consider the conceptual view of
financial performance presented in Exhibit 9-1. As illustrated in the exhibit, financial
performance depends on revenue and cost. Revenue is provided from sales of
merchandise by retailers, sales of products, harvested, mined, constructed, formed,
processed or assembled by farms, mining companies, construction companies and
manufacturers and from sales of various services by firms involved in activities such
as banking, insurance, accounting, law, medical care, food distribution, repair and
entertainment. In addition to producing revenue, all of these companies generate three
types of costs including discretionary, engineered and committed costs. Various costs
fall into one of these three categories based on the cause and effect relationships
involved. Although there are a variety of ways to define costs, categorizing costs in
terms of the cause and effect relationships is a prerequisite for understanding the
different types of budgets that are introduced in this chapter. These three cost concepts
are summarized in Exhibit 9-2 and discussed in more detail below.
Discretionary Costs
Many activities are viewed as beneficial to an organization, even thought the benefits
obtained, or value added by performing the activities cannot be defined precisely,
either before or after the activity is completed. The costs of the inputs, or resources
required to perform such activities are referred to as discretionary costs. These costs
are discretionary in the sense that management must choose the desired level of the
activity based on intuition or experience because there is no well defined cause and
effect relationship between cost and benefits. Discretionary costs are usually
generated by service or support activities. Examples include employee training,
advertising, sales promotion, legal advice, preventive maintenance, and research and
development. The value added by each of these activities is intangible and difficult, if
not impossible to measure, where value added refers to the benefits obtained by either
internal or external customers. In terms of cost behavior, discretionarycosts may be
fixed, variable or mixed.
Exhibit 9-2
Cost Defined in Terms of Cause and Effect
Cause & Effect or Cost
Type of Cost Benefit Relationship Cost Behavior Examples
Relationships are Fixed, variable Cost of administrative and support services such as
difficult or impossible to and mixed in the employee training, advertising, sales promotion, legal
Discretionary
define. short run. advice, preventive maintenance, and research and
development.
Relationships are Variable in the Direct resources used in production activities such as
Engineered relatively easy to define. short run. direct materials and direct labor and many indirect
resources such as electric power.
Relationships can be Fixed in the short Cost of establishing and maintaining the readiness to
Committed estimated, but not run. conduct business, such as the cost associated with
defined precisely. plant and equipment.
Engineered Costs
Engineered costs result from activities with reasonably well defined cause and effect
relationships between inputs and outputs and costs and benefits. Direct material costs
provide a good example. Engineers can specify precisely how many parts (inputs) are
required to generate a specific output such as a microcomputer, a coffee maker, an
automobile, or a television set. Direct labor also falls into the engineered cost category
as well as indirect resources that vary with product specifications and production
volume. Although the cause and effect relationships are not as precise for indirect
resources, these relationships can be established using statistical techniques such as
regression and correlation analysis. A key difference between discretionary costs and
engineered costs is that the value added by the activities associated with engineered
costs is relatively easy to measure. Engineered costs are variable in terms of cost
behavior.
Committed Costs
Committed costs refers to the costs associated with establishing and maintaining the
readiness to conduct business. The benefits obtained from these expenditures are
represented by the company's infrastructure. For example, the costs associated with
the purchase of a franchise, a patent, drilling rights and plant and equipment create
long term obligations that fall into the committed cost category. These costs are
mainly fixed in terms of cost behavior and expire to become expenses in the form of
amortization and depreciation.
Four Types of Budgets
Four types of budgets are used for planning and controlling the various types of costs
discussed above. These four techniques are summarized in Exhibit 9-3.
Exhibit 9-3
Budget Types and Characteristics
Type of Caracteristics of the
Type of cost or Expenditure Examples
Budget Technique
A maximum amount is
Employee training, advertising, sales
Appropriation established for certain
Discretionary costs. promotion and research and
Budget expenditures based on
development.
management judgment.
The static part: salaries, depreciation,
A static amount (a) is The static amount (a)
property taxes and planned
established for fixed costs includes both discretionary
maintenance. The flexible part: direct
Flexible and a variable rate (b) is and committed costs while
material, direct labor and variable
Budget determined per activity the flexible part (b)
overhead. Also, some costs related to
measure for variable costs, includes engineered costs
sales reps such as sales commissions
i.e., Y = a + bX per X value.
and travel.
Decisions concerning
potential investments are
Capital Budget Committed costs. New plant and equipment.
made using discounted cash
flow techniques.
A comprehensive plan is
Master Discretionary, engineered All revenue and expenditures for any
developed for all revenue
Budget and committed costs. company.
and expenditures.
Appropriation Budgets
The oldest type of budget is referred to as an appropriation budget. Appropriation
budgets place a maximum limit on certain discretionary expenditures and may be
either incremental, priority incremental, or zero based. Incremental budgets are
essentially last year's budget amount plus an increment, i.e., small increase. Priority
incremental budgets also involve an increase, but require managers to prioritize, or
rank discretionary activities in terms of their importance to the organization. The idea
is for the manager to indicate which activities would be changed if the budget were
increased or decreased. Zero based budgeting was popular for a while around the time
of Jimmy Carter's Presidency, but was dropped by most users because it was too
expensive and time consuming.2 The technique is expensive to use because zero based
budgets theoretically require justification for the entire budget amount. When it was
popular, a more typical approach was to justify the last twenty percent of the budget,
i.e., use eighty percent based budgeting.
From a control perspective, appropriation budgets are effective in limiting the amount
of an expenditure, but create a behavioral bias to spend to the limit. Establishing a
maximum amount for an expenditure encourages spending to the limit because
spending below the limit implies that something less than the maximum appropriation
was needed. Spending below the limit might result in a budget cut in future periods.
Since nearly every manager views a budget reduction in their discretionary costs as
undesirable, there are frequently crash efforts at the end of a budget period to spend
up to the limit. (See Supplemental Exhibit).
Flexible Budgets
The flexible budget was introduced in Chapter 4. Recall that flexible budgets are
based on a cost function such as Y = a + bX, where Y represents the budgeted cost, or
dependent variable. The constant "a" represents a static amount for fixed costs and the
constant "b" represents the rate of change in Y expected for a unit change in the
independent variable X. The expression " bX" is the flexible part of the budget cost
function. The flexible budget technique is used for planning and monitoring all types
of costs. The static amount "a" includes both discretionary and committed costs, while
the flexible part "bX" includes various types of engineered costs. The flexible
characteristic of the technique enables the flexible budget to play a key role in both
financial planning and performance evaluation. The planning dimension is
emphasized in this chapter and the performance evaluation aspect is given
considerable attention in Chapters 10 and 13.
Capital Budgets
Capital budgets represent the major planning device for new investments. Discounted
cash flow techniques such as net present value and the internal rate of return are used
to evaluate potential investments. Capital budgets are part of a somewhat more
encapsulating concept referred to as investment management. Investment
management involves the planning and decision process for the acquisition and
utilization of all of the organization's resources, including human resources as well as
technology, equipment and facilities. The concept of investment management includes
the discounted cash flow methods, but is more comprehensive in that the
organization's portfolio of interrelated investments is considered as well as the
projected effects of not investing.
Master Budgets
The fourth type of budget is referred to as the master budget or financial plan. The
master budget is the primary financial planning mechanism for an organization and
also provides the foundation for a traditional financial control system. More
specifically, it is a comprehensive integrated financial plan developed for a specific
period of time, e.g., for a month, quarter, or year. This is a much broader concept than
the first three types of budgeting. The master budget includes many appropriation
budgets (typically in the administrative and service areas) as well as flexible budgets,
a capital budget and much more. A diagram illustrating the various parts of a master
budget is presented in Exhibit 9-4.
The master budget has two major parts including the operating budget and the
financial budget (See Exhibit 9-4). The operating budget begins with the sales budget
and ends with the budgeted income statement. The financial budget includes the
capital budget as well as a cash budget, and a budgeted balance sheet. The main focus
of this chapter is on the various parts of the operating budget and the cash budget. The
budgeted balance sheet is covered briefly, but not emphasized. A detailed discussion
of capital budgeting and investment management is provided in Chapter 18 after some
other prerequisite concepts are introduced. In the next section, we consider the
purposes, benefits, limitations and assumptions of the master budget.
THE PURPOSES AND BENEFITS OF THE MASTER BUDGET
There are a variety of purposes and benefits obtained from budgeting. Consider the
following:
Integrates and Coordinates

The master budget is the major planning device for an organization. Thus, it is used to
integrate and coordinate the activities of the various functional areas within the
organization. For example, a comprehensive plan helps ensure that all the needed
inputs (equipment, materials, labor, supplies, etc.) will be at the right place at the right
time when needed, just-in-time if possible. It also helps insure that manufacturing is
planning to produce the same mix of products that marketing is planning to sell. The
idea is that the products should be pulled through the system on the basis of the sales
budget, rather than produced speculatively and pushed on the sales force. As
discussed in Chapter 8, excess inventory and other resources hide problems and add
unnecessary costs. The integrative nature of the budget provides a way to implement
the lean enterprise concepts of just-in-time and the theory of constraints where the
emphasis is placed on the performance of the total system (organization) rather than
the various subsystems or functional areas.
Communicates and Motivates
Another purpose and benefit of the master budget is to provide a communication

device through which the companys employees in each functional area can see how
their efforts contribute to the overall goals of the organization. This communication
tends to be good for morale and enhance jobs satisfaction. People need to know how
their efforts add value to the organization and its' products and services. The
behavioral aspects of budgeting are extremely important.
Promotes Continuous Improvement
The planning process encourages management to consider alternatives that might

improve customer value and reduce costs. Recall that "Plan" is the first step in the
Shewhart-Deming plan- do-check-action continuous improvement cycle discussed in
Chapter 8. The PDCA cycle supports specific improvements in the companys
processes. The financial plan and subsequent financial performance measurements
reflect the financial expectations and consequences of those efforts.
Guides Performance
The master budget also provides a guide for accomplishing the objectives included in
the plan. The budget becomes the basis for the acquisition and utilization of the
various resources needed to implement the plan. Perfection of the guidance aspect of
budgeting can significantly reduce the amount of uncertainty and variability in the
companys operations. In a JIT environment, the budget can also serve as a guide to
vendors. For example, suppliers to General Motors Saturn plant in Tennessee have
access to Saturns production schedule through an on-line database. This information
allows Saturns vendors to deliver the required parts in the order needed to precise
locations just-in-time without a purchase order or delivery schedule.3
Facilitates Evaluation and Control
The master budget provides a method for evaluating and subsequently controlling
performance. We will develop this idea in considerable detail in the following chapter.
Performance evaluation and control is a very powerful and very controversial aspect
of budgeting. (For example, see the discussion of Johnson's ABM Model in Chapter
8).
LIMITATIONS AND PROBLEMS
There are several limitations and problems associated with the master budget that
need to be considered by management. These problems involve uncertainty,
behavioral bias and costs.
Uncertainty
Budgeting includes a considerable amount of forecasting and this activity involves a

considerable amount of uncertainty. Uncertainty affects both sides of the financial
performance dichotomy, (see Exhibit 9-1) but uncertainty on the revenue side presents
a more serious limitation for planning. The sales budget is frequently based on a
forecast supported by a variety of assumptions about the economy, the actions of the
federal reserve board and congress in implementing monetary and fiscal policy, and
the actions of competitors, suppliers, and customers. The uncertainty associated with
sales forecasting creates a greater problem than uncertainty on the cost side because
the other parts of the budget (see Exhibit 9-4) are derived from the sales forecast. This
forces management to constantly monitor and analyze changes in the economic
environment. From the planning perspective, the inability to accurately forecast the
future reduces the usefulness of the original budget estimates for materials
requirements planning (MRP) and planning for other resource needs. Uncertainty on
the cost side tends to be less of a problem because management has more influence
over the quantities of resources consumed than over the quantities of their own
products purchased by customers. From a performance evaluation and control
perspective, uncertainty on both sides of the financial performance dichotomy is not
as much of a problem because flexible budgets are used to fine tune the original
budget to reflect expectations at the current level of activity. The manner in which
flexible budgets are used for performance evaluation is given considerable attention in
Chapters 10 and 13.
Behavioral Bias
A second problem involves a variety of behavioral conflicts that are created when the
budget is used as a control device. To be effective, the budget must be used by the
managers it is designed to help. Thus, it must be acceptable to all levels of
management. The behavioral literature on budgeting supports the view that the budget
should reflect what is most likely to occur under efficient operating conditions. If a
budget is to be used as an effective planning and monitoring device, it should
encourage a high level of performance and efficiency, but at the same time, it should
be fair and obtainable. If the budget is viewed by managers as unfair, (too optimistic)
it may intimidate rather than motivate. One way to gain acceptance is referred to as
participative (rather than imposed) budgeting. The idea is to include all levels of
management in the budget preparation process. Of course this process must be
coordinated by a budget director to ensure that a fair budget is obtained that will help
achieve the goals of the total organization.
Another way to reduce the behavioral bias against budgeting is to recognize the
concepts of variation and interdependence when using the budget to evaluate
performance. Recall from our discussion of the statistical control concept in Chapter 3
that there is variation in all performance and most of this variation is caused by the
system , (i.e., common causes) not the people working in the system. The concept of
interdependence refers to the fact that the various segments of a company are part of a
system. Inevitably, these segments, or subsystems influence each other. Failure to
adequately recognize the interdependencies within an organization tends to cause
behavioral conflicts and motivate participants to optimize the performance of the
various segments (subsystems) rather than to optimize the performance of the overall
system.
Finally, the behavioral conflicts associated with budgeting are reduced by using
flexible budgets when evaluating performance. We will return to these ideas below
and again in Chapter 10.
Costs
A third problem or limitation is that budgeting requires a considerable amount of time

and effort. Many companies maintain a twelve month budget on a continuous basis by
adding a future month as the current month expires.4 While this does not create a
major expenditure for large or medium sized organizations, smaller companies may
find it difficult to justify the costs involved. Many small, potentially profitable firms,
do not plan effectively and eventually fail as a result. Cash flow problems are
common, e.g., not having enough cash available (or accessible through a line of credit
with a bank) to pay for merchandise or raw materials or to meet the payroll. Many of
these problems can be avoided by preparing a cash budget on a regular basis.
THE ASSUMPTIONS OF THE MASTER BUDGET
Typically, the following simplifying assumptions are made when preparing a master
budget: 1.) sales prices are constant during the budget period, 2.) variable costs per
unit of output are constant during the budget period, 3.) fixed costs are constant in
total and 4.) sales mix is constant when the company sells more than one product.
These assumptions facilitate the planning process by removing many of the economic
complexities. The overall effects of these simplifications are illustrated graphically in
Exhibit 9-5. Instead of planning on the basis of the more complicated non-linear
model on the left, the master budget is very similar to the more easily understood
linear model on the right.5 These assumptions are discussed in more depth in Chapter
11 where the illustrations in Exhibit 9-5 are developed and explained. In addition, a
practical approach for analyzing the differences between budgeted and actual sales
prices, unit cost, sales mix and sales volume is discussed in Chapter 13. For now,
think of Exhibit 9-5 as a preview of those future topics.
RESPONSIBILITY ACCOUNTING
Responsibility accounting is an underlying concept of accounting performance
measurement systems. The basic idea is that large diversified organizations are
difficult, if not impossible to manage as a single segment, thus they must be
decentralized or separated into manageable parts. These parts, or segments are
referred to as responsibility centers which include: 1) revenue centers, 2) cost centers,
3) profit centers and 4) investment centers. This functional approach allows
responsibility to be assigned to the segment managers that have the greatest amount of
influence over the key elements to be managed. These elements include revenue for a
revenue center (a segment that mainly generates revenue with relatively little costs),
costs for a cost center (a segment that generates costs, but no revenue), a measure of
profitability for a profit center (a segment that generates both revenue and costs) and
return on investment (ROI) for an investment center (a segment such as a division of a
company where the manager controls the acquisition and utilization of assets, as well
as revenue and costs). We will discuss the return on investment measurement in detail
later in Chapter 14. Conceptually, ROI is some measure of the segment's income
divided by some measure of the segment's investment. Typically, ROI is net income
divided by total assets, but an operational definition requires a great deal more
specificity, as we shall see in Chapter 14. (See Summary Exhbit).
Advantages and Disadvantages
Responsibility accounting has been an accepted part of traditional accounting control

systems for many years because it provides an organization with a number of
advantages.6 Perhaps the most compelling argument for the responsibility accounting
approach is that it provides a way to manage an organization that would otherwise be
unmanageable. In addition, assigning responsibility to lower level managers allows
higher level managers to pursue other activities such as long term planning and policy
making. It also provides a way to motivate lower level managers and workers.
Managers and workers in an individualistic system tend to be motivated by
measurements that emphasize their individual performances. However, this emphasis
on the performance of individuals and individual segments creates what some critics
refer to as the "stovepipe organization." Others have used the term "functional silos"
to describe the same idea.7 Consider Exhibit 9-6. Individuals in the various segments
and functional areas are separated and tend to ignore the interdependencies within the
organization. Segment managers and individual workers within segments tend to
compete to optimize their own performance measurements rather than working
together to optimize the performance of the system.
Summary and Controversial Question
An implicit assumption of responsibility accounting is that separating a company into

responsibility centers that are controlled in a top down manner is the way to optimize
the system. However, this separation inevitably fails to consider many of the
interdependencies within the organization. Ignoring the interdependencies prevents
teamwork and creates the need for buffers such as additional inventory, workers,
managers and capacity.8 Of course, a system that prevents teamwork and creates
excess is inconsistent with the lean enterprise concepts of just-in-time and the theory
of constraints. For this reason, critics of traditional accounting control systems
advocate managing the system as a whole to eliminate the need for buffers and excess.
They also argue that companies need to develop process oriented learning support
systems, not financial results, fear oriented control systems. The information system
needs to reveal the company's problems and constraints in a timely manner and at a
disaggregated level so that empowered users can identify how to correct problems,
remove constraints and improve the process. According to these critics, accounting
control information does not qualify in any of these categories because it is not timely,
disaggregated, or user friendly.
This harsh criticism of accounting control information leads us to a very important

controversial question. Can a company successfully implement just-in-time and other
continuous improvement concepts while retaining a traditional responsibility
accounting control system? Although the jury is still out on this question, a number of
field research studies indicate that accounting based controls are playing a decreasing
role in companies that adopt the lean enterprise concepts. In one study involving nine
companies, each company answered this controversial question in a different way by
using a different mix of process oriented versus results oriented learning and control
information.9 Since each company is different, a generalized answer to this question
for all firms in all situations cannot be given in a textbook. However, a great deal
more information is provided in the next chapter to help you answer this question for
the companies you are likely to encounter in practice. This chapter concentrates on the
planning aspects of budgeting, while the next chapter addresses the control
methodology. (See MAAW's Budgeting and Responsibility Accounting topics for
more information on these issues).
PREPARING A MASTER BUDGET
THE OPERATING BUDGET
Preparing an Operating Budget is a sequential process of developing nine sub-

budgets. Except for one or two exceptions the sub-budgets must be prepared in the
following order: sales, production, direct materials, direct labor, factory overhead,
ending inventory, cost of goods sold, selling & administrative and income statement
(see Exhibit 9-4). Each part is described below.
1. SALES BUDGET
Developing a sales budget involves the following calculations:
Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)
Current Period Cash Collections = Current Period Cash Sales + Current Period
Credit Sales Collected in Current Period + Prior Period Credit Sales Collected in
Current Period
These calculations are relatively simple, but where does the budget director obtain this
information? Well, sales forecasting is a marketing function. Sales estimates are
frequently generated by the company's sales representatives who discuss future needs
with customers (wholesalers and retailers). Statistical forecasting techniques can also
be used to make estimates of expected future sales, considering the company's
previous sales performance and various assumptions about the future economic
climate, and the actions of competitors and consumers. Pricing is also a marketing
function, but many prices are based on costs plus a markup (the supply function) and
consideration of what consumers are willing and able to pay for the product (the
demand function). Thus, the budgeted sales price is usually determined after the
budgeted unit cost has been calculated (see 6b. below).
The information needed to develop an equation for collections is provided by the

finance department and is normally based on past experience. These calculations are
somewhat more involved than they appear to be in the equation above because of the
effects of cash discounts and the time lags between credit sales and collections. Cash
discounts are frequently used to speed up cash inflows. This puts the funds back to
work sooner and reduces the need for short term loans. However, even with a
generous cash discount for prompt payment, collections for credit sales are typically
spread out over several months. The examples illustrated below provide some of the
possibilities.
2. PRODUCTION BUDGET
Preparing a production budget includes consideration of the desired inventory change

as follows:
Units To Be Produced = Budgeted Unit Sales (from 1) + Desired Ending

Finished Goods - Beginning Finished Goods
The desired ending inventory is usually based on the next periods sales budget.
Considerations involve the time required to produce the product, (i.e., cycle time or
lead time) as well as setup costs and carrying costs. In a just-in-time environment the
desired ending inventory is relatively small, or theoretically zero in a perfect situation.
In the examples and problems in this chapter, the ending finished goods inventory is
stated as a percentage of the next period's (month's) unit sales.
3. DIRECT MATERIAL BUDGET
The direct materials budget includes five separate calculations.
a. Quantity of Material Needed for Production = (Units to be

Produced)(Quantity of Material Budgeted per Unit)
The quantity of material required per unit of product is determined by the industrial
engineers who designed the product. Materials requirements are frequently described
in an engineering document referred to asa "bill of materials".
b. Quantity of Material to be Purchased = Quantity of Material Needed for

Production + Desired Ending Material - Beginning Material
This calculation is more involved than equation 3b appears to indicate because it

includes information for two future periods. The desired ending materials quantity is
normally based on the next period's (month's) materials needed for production and this
amount depends on the third period's budgeted unit sales. Of course inventories of raw
materials (just like finished goods) are kept to a minimum in a JIT environment.
Factors that influence the desired inventory levels include the reliability of the
company's suppliers, as well as ordering and carrying costs.
c. Budgeted Cost of Material Purchases = (Quantity of Material to be

Purchased)(Budgeted Material Prices)
This amount is needed to determine cash payments. Once the quantity to be purchased
has been determined, the cost of purchases is easily calculated. Budgeted material
prices are provided by the purchasing department.
d. Cost of Material Used = (Quantity needed for Production)(Budgeted Material

Prices)
The cost of materials used is needed in the cost of goods sold budget below.
e. Cash Payments for Direct Material Purchases = Current Period Purchases Paid
in Current Period + Prior Period Purchases Paid in Current Period
The information needed to determine budgeted cash payments is provided by

accounting, (accounts payable) and is usually based on past experience. Normally the
budget should reflect a situation where the company pays promptly to take advantage
of all cash discounts allowed, thus 3e may be equal to 3c.
4. DIRECT LABOR BUDGET
Fewer calculations are needed for direct labor than for direct materials because labor
hours cannot be stored in the inventory for future use. Time can be wasted, but not
postponed.
a. Direct Labor Hours Needed For Production = (Units to be Produced)(D.L.
Hours Budgeted per Unit)
The amount of direct labor time needed per unit of product is determined by industrial
engineers. Estimates are frequently made using a technique referred to as motion and
time study. This involves measuring each movement required to perform a task and
then assigning a precise amount of time allowed for these movements. The cumulative
time measurements for the various tasks required to produce a product provide the
estimate of a standard time per unit. There are alternative techniques that are less
expensive, but motion and time study provides estimates that are very precise.
Learning curves provide another quantitative technique that is helpful in establishing
labor standards.
b. Budgeted Direct Labor Cost = (D.L. Hours needed for Production)(Budgeted

Rates Per Hour)
The budgeted rates per hour for direct labor are provided by the human resource
department. Frequently the labor (union) contract provides the source for this
information. Many different types of labor may be required with different levels of
expertise and experience. Thus, Equations 4a and 4b may include several calculations.
5. THE FACTORY OVERHEAD BUDGET
The factory overhead budget is based on a flexible budget calculation as described in

Exhibit 9-3. More specifically, the calculation is as follows:
a. Budgeted Factory Overhead Costs = Budgeted Fixed Overhead + (Budgeted

Variable Overhead Rate)(D.L. Hours needed for Production from 4a)
This is a cumulative equation that combines the equations for the company's various
types of indirect resources. This same idea was illustrated in Chapter 4 when
introducing predetermined overhead rates. The predetermined overhead rates
developed in Chapter 4 and the budgeted overhead rates discussed in this chapter are
conceptually the same.
A plant wide rate based on direct labor hours is used as the overhead allocation basis
in this chapter and subsequent chapters mainly to simplify the illustrations. Keep in
mind however, that although many companies are still using a single production
volume based measurement for overhead allocations, most companies use
departmental rates and many companies are now using activity based rates.
The calculation for cash payments reflects one of the differences between cash flows
and accrual accounting. Since some costs, like depreciation, do not involve cash
payments in the current period, these costs must be subtracted from the total overhead
costs to determine the appropriate amount.
b. Cash Payments for Overhead = Budgeted Factory Overhead Cost -

Depreciation and other costs that do not require cash payments
Alternative Calculation for Budgeted Factory Overhead Costs
Although budgeted factory overhead costs can be calculated in the manner presented
above, there is an alternative approach that illustrates the difference between budgeted
and standard costs. Budgeted factory overhead costs can be calculated by determining
the standard factory overhead costs and then adjusting for the planned production
volume variance. The planned production volume variance is similar to the capacity
(or idle capacity) variance illustrated in Chapter 4. It is the difference between the
denominator inputs used to calculate the overhead rates, i.e., direct labor hours in our
example, and the budgeted direct labor hours needed for production, multiplied by the
budgeted fixed overhead rate.
The alternative calculation for factory overhead costs is:
Budgeted factory overhead costs = (Total budgeted overhead rate per hour)(D.L.
hours needed for production from 4a)
+ Unfavorable planned production volume variance or - Favorable planned
production volume variance
Multiplying the total overhead rate by the number of direct labor hours needed for
production provides the standard or applied overhead costs. However, if the number
of direct labor hours needed for planned production (i.e., budgeted hours) is not equal
to the number of hours used to calculate the overhead rates (i.e., denominator hours),
then standard fixed overhead costs will not be equal to budgeted fixed overhead costs.
The difference is the planned production volume variance. This is illustrated
graphically in Figure 9-1.
Since the difference is caused by the way fixed overhead costs are treated, it can be
illustrated by comparing standard fixed overhead costs with budgeted fixed overhead
costs. Figure 9-1 shows that if planned or budgeted hours (BH1) are less than
denominator hours (DH), the planned production volume variance (PPVV) is
unfavorable and represents underapplied fixed overhead. However, if planned or
budgeted hours (BH2) are greater than denominator hours (DH), then the planned
production volume variance (PPVV) is favorable and represents overapplied fixed
overhead.
The difference between budgeted and standard total factory overhead costs can be
illustrated by simply adding variable overhead costs to the graph. Since budgeted and
standard variable overhead costs are always equal at any level of production, the
difference between standard and budgeted total overhead costs is the same as the
difference between standard and budgeted fixed overhead costs. The difference is the
planned production volume variance. This is illustrated in Figure 9-2
Summary of the PPVV Concept
At any particular level of production, e.g., 1,000 hours, budgeted and standard
variable overhead costs are always equal. However, budgeted and standard fixed
overhead costs are only equal when the budgeted hours planned for the month are
equal to the denominator hours used to calculate the overhead rates. The difference
between the budgeted hours planned and the denominator hours, multiplied by the
fixed overhead rate is the difference between budgeted and standard fixed overhead
costs as well as the difference between budgeted and standard total overhead costs.
When working with a budget this difference is referred to as the planned production
volume variance.
6. ENDING INVENTORY BUDGET
The dollar amount for the ending inventory of finished goods is needed below to
determine cost of goods sold. The dollar amounts for ending direct materials and
finished goods are needed for the balance sheet.
a. Ending Direct Materials = (Desired Ending Materials from 3b)(Budgeted
Prices)
b. Budgeted or Standard Unit Cost = (Quantity of D.M. required per

Unit)(Budgeted Prices) + (D.L. Hours required per Unit)(Budgeted Rate)
+ (Total Overhead Rate)(D.L. Hours required per Unit)
The budgeted or standard unit cost can be calculated at any time after the budgeted
quantities per unit and input prices are obtained. The calculation is placed here
because it is needed for 6c.
c. Ending Finished Goods = (Desired Ending Finished Goods from 2)(Budgeted

Unit Cost)
7. COST OF GOODS SOLD BUDGET
Cost of goods sold is needed for the income statement. One method of determining
budgeted COGS involves accumulating the amounts from the previous sub-budgets as
follows.
a. Budgeted Total Manufacturing Cost = Cost of Direct Material Used (from

3d.) + Cost of Direct Labor Used (from 4b.)
+ Total Factory Overhead Costs (from 5a.)
b. Budgeted Cost of Goods Sold = Budgeted Total Manufacturing Cost (from

7a.) + Beginning Finished Goods (from previous ending or calculate from 2 and
6b) - Ending Finished Goods (from 6c or calculate from 2 and 6b)
This is the same approach used in Chapter 2 to determine cost of goods sold, but when
developing a budget we typically assume no change in Work in Process. Therefore,
budgeted cost of goods manufactured is equal to budgeted cost of goods sold.
Alternative Calculation for Budgeted Cost of Goods Sold
Budgeted cost of goods sold can also be calculated by determining standard cost of
goods sold, and then adjusting for the planned production volume variance. The
alternative calculation for cost of goods sold is:
Budgeted Cost of Goods Sold = (Budgeted unit sales)(Budgeted unit cost)

+ Unfavorable planned production volume variance
or - Favorable planned production volume variance
Although budgeted unit cost equals standard unit cost, budgeted cost of goods sold is
not equal to standard cost of goods sold. Again, the difference between standard and
budgeted costs is the production volume variance. There are two reasons to become
familiar with this alternative. First, it helps strengthen your understanding an
important concept that appears again in subsequent chapters, e.g., Chapters 10 and 12.
A second reason is that the alternative approach provides a much faster way to
calculate budgeted cost of goods sold. Therefore it can be used as a stand alone
method, or as a way to check the accuracy of your calculations in 7a and b.
You may wonder why a company would plan a production volume variance in the
budget. This occurs because the denominator activity for a particular month is
normally the average monthly production based on one twelfth of the planned
production for the entire year. The denominator may also be an average based on
normal, practical, or theoretical maximum capacity for the year. When the planned
production for a particular month is higher or lower than the monthly average, a
planned production volume variance results. Actual production volume variances also
occur as we shall see in the next chapter.
8. SELLING & ADMINISTRATIVE EXPENSE BUDGET
The preparation of the selling and administrative expense budgets is very similar to
the approach used for factory overhead.
a. Budgeted Selling and Administrative Expenses = Budgeted Fixed Selling &

Administrative Expenses + (Bud Variable Rate as a Proportion of Sales
$)(Budgeted Sales $)
b. Cash Payments for Selling & Administrative Expenses = Budgeted Selling &
Administrative Expenses - Depreciation and other cost which do not require
cash payments
Although we will place less emphasis on this part of the master budget, (mainly to
simplify the illustrations) these costs are usually significant. Also remember that many
appropriation budgets (treated as fixed costs) may be included, particularly for certain
administrative costs. In addition, as pointed out earlier in the text, a more precise
traceable costing approach might be used for management purposes where some
selling and administrative costs are allocated (i.e., traced to products) in determining a
more precise product cost. Remember however, that selling and administrative costs
are treated as expenses (period costs) in the conventional inventory valuation
methods.
9. BUDGETED INCOME STATEMENT

Preparing the budgeted income statement involves combining the relevant amounts
from the sales, cost of goods sold and selling & administrative expense budgets and
then subtracting interest, bad debts and income taxes to obtain budgeted net income.
These amounts are provided by the finance department. In a comprehensive practice
problem, the applicable amount for interest expense may need to be calculated from
information associated with the cash budget. Bad debt expense is based on the
expected proportion of uncollectibles stated in the information related to cash
collections.
a. Budgeted Sales $ - Budgeted Cost of Goods Sold = Budgeted Gross Profit
b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses =

Operating Income
c. Operating Income - Interest Expense - Bad Debts Expense = Net Income

Before Taxes
d. Net Income Before Taxes - Income Taxes = Net Income After Taxes
THE FINANCIAL BUDGET
As indicated in Exhibit 9-4, the financial budget includes the cash budget, the capital
budget and the budgeted balance sheet. The cash budget and budgeted balance sheet
are discussed below. A detailed discussion of the capital budget is provided in Chapter
18.
10. CASH BUDGET
a. Budgeted Cash Available = Beginning Cash Balance + Budgeted Cash

Collections from 1
b. Budgeted Cash Excess or Deficiency = Budgeted Cash Available - Budgeted

Cash Payments from 3e, 4b, 5b and 8b
c. Ending Cash Balance = Cash Excess or Deficiency + Borrowings -

Repayments including Interest
11. BUDGETED BALANCE SHEET
Preparing the budgeted balance sheet involves accumulating information from the
previous periods balance sheet, the various operating sub-budgets, the cash budget
and other accounting records.
ASSETS
a. Current Assets:
Cash (from the cash budget 10c)
Accounts Receivable (from the sales budget and previous balance sheet)
Direct materials (from the ending inventory budget 6a)
Finished goods (from the ending inventory budget 6c)
b. Long Term Assets:

Land (from previous balance sheet and budgeted activity)
Buildings (from previous balance sheet and budgeted activity)
Equipment (from previous balance sheet and budgeted activity)
Accumulated depreciation (from the accounting records)
Total Assets
LIABILITIES
c. Current Liabilities:
Accounts Payable (from various operating sub-budgets)
Taxes Payable (from income statement)
d. Long term Liabilities
Total Liabilities
SHAREHOLDERS EQUITY
e. Common Stock (from previous balance sheet and budgeted activity)
f. Retained Earnings (from previous balance sheet and income statement)
Total Shareholders Equity
Total Liabilities and Shareholders Equity
EXAMPLES AND PRACTICE PROBLEMS
The following examples and end of chapter practice problems will help you become
familiar with the master budget concepts and techniques. The examples and practice
problems are simplified to facilitate the learning process. The first example below and
most of the practice problems assume that only one period is involved and that only
one product is produced from a single direct material. Of course these assumptions are
not realistic, but they allow us to prepare budgets by hand in a timely manner to
develop an understanding of the budgeting process. A second example is provided in
appendix 9-1 that adds more realism and complexity. Although the second example is
still relatively simple, it shows how additional periods, products and product
requirements cause the complexity of the budget to mushroom quickly. A similar
practice problem is included in the end of chapter materials.
EXAMPLE 9-1
The Expando Company produces entertainment centers from a type of pressed wood
referred to as particle board. Other materials, such as glue and screws are viewed as
insignificant and are charged to overhead as indirect materials. Budgeted, or standard
quantities allowed per unit along with the budgeted prices and rates are as follows:
Type of Input Inputs per output Cost per Input Cost per Output
Direct materials 2 particle board sheets* $10 $20
Direct labor .4 hours 15 6
Factory overhead:
Variable .4 hours 30 12
Fixed .4 hours 50 20
Total cost per output $58
* Particle board is purchased in sheets that are 3/4" by 4'by 8'.
Overhead rates are based on 4,800 standard direct labor hours per month, or average
monthly production of 12,000 units, i.e., (.4)(12,000) = 4,800 hours. Desired ending
inventories are 10% of next periods material needs for direct material and 5% of next
periods sales for finished goods. Unit Sales are budgeted as follows for the first six
months of the year.
January February March April May June

9,000 10,000 11,000 12,000 14,000 14,500
The budgeted sales price is $100 per unit. Sales are budgeted as 50% cash and 50%
credit sales. Past experience indicates that 80% of the credit sales are collected during
the month of sale, 18% are collected in the following month, and 2% are
uncollectible. A 1% cash discount is allowed to customers who pay within the month
the sale takes place including cash sales.
Variable selling and administrative expenses are budgeted at 10% of sales dollars. The
budget for fixed selling and administrative expenses is $50,000 per month. Cash
payments are made for all expenditures made during the month except for
depreciation of $100,000 in manufacturing and $25,000 in the selling and
administrative area. The budgeted beginning cash balance for March is $100,000 and
the tax rate is 40%. Budgeted income taxes from January and February are $200,000.
This amount is to be paid at the end of march along with the current months taxes. A
three month note for $50,000 is to be repaid at the end of March. The interest rate on
the note is 12 percent.
Some additional account balances budgeted for the end of February include: Land
$5,000,000, buildings and equipment $15,000,000, accumulated depreciation
$6,000,000, other current liabilities 0 , long term liabilities 0, common stock
$5,000,000 and retained earnings $8,993,000.
The following illustrations include a partial master budget for March including the
various parts of the operating budget, a cash budget and an abbreviated balance sheet.
Budgets for February and April can also be prepared with the given data. However, a
budget for January would require unit sales for December. A budget for May would
require unit sales for July.
APPENDIX - EXAMPLE 9-2
Example 9-2 is more involved than the previous illustration. The idea is to provide a
better view of the budgeting process and to show how the size of the budget grows
rapidly as additional products and product requirements are added. For example, this
problem requires a budget for three months for a company that produces two products
in two departments. In addition the products require two types of direct materials and
direct labor. It is placed on a separate page because it goes beyond an introductory
level problem. (See Chapter 9 Appendix).
FOOTNOTES
1
Budgeting is revered by some and scorned by others, but according to a survey of
2,700 corporate executives, it is the most important accounting knowledge and skill
area for those who enter management accounting. See Siegel, G. and J. E. Sorensen.
1994. What corporate America wants in entry-level accountants.Management
Accounting (September): 26-3
2
See Anthony, R. N. 1977. Zero-base budgeting is a fraud. The Wall Street
Journal(April 27); and 1977. Zero-based budgeting: A useful fraud? Government
Accountants Journal (Summer): 7-10. PPBS is a closely related topic. Planning,
programming, and budgeting systems were popular for government decision making
in the 1960's. See Frank, J. E. 1973. A framework for analysis of PPB success and
causality.Administrative Science Quarterly 18(4): 527-543. (JSTOR link).MAAW's
ZBB section includes many other articles.
3 Walmart, Levi Strauss and Ford Motor Company have similar relationships with
their vendors. See Hammer, M. and J. Champy. 1993. Reengineering The
Corporation. Harper Business Press: 43, 61, 62 and 90.
4 Some companies find it more convenient to use thirteen four week periods, i.e.,
(28)(13) = 364. An advantage of this approach is that performance is more easily
compared from one period to the next. One method of handling the extra day, or two
days in leap-years, is to include it in the thirteenth period. For a more extensive
discussion of this issue, see Folsom, M. B. 1930. The thirteen-month
calendar.Harvard Business Review (January): 218-226.
5
The linear model on the right-hand side of Exhibit 9-5 is based on direct costing.
This model is discussed in Chapter 11 and altered to conform to absorption costing in
Chapter 12.
6
An early discussion of the responsibility accounting concept appears in Alford, L. P.
1928. Laws of Management Applied to Manufacturing. Ronald Press. Also see
Higgins, J. 1952. Responsibility accounting.Arthur Andersen Chronicle(April).
According to Anthony, Higgins was first to use the term "responsibility center" in this
paper. See Anthony, R. N. 1989. Reminiscences about management
accounting.Journal of Management Accounting Research (1): 1- 20. (Summary).
7
. Robert K. Elliot, used the term stovepipe organization in Elliot, R. K. 1992. The
third wave breaks on the shores of accounting. Accounting Horizons (June): 61-85.
(Summary). Hammer and Champy refer to functional silos in Reengineering The
Corporation. Deming discusses the same idea in different terms. He refers to
traditional performance evaluation methods as one of the seven deadly diseases of
American management. See the Deming topic for more information on Deming's
theory of management.
8
To visualize the idea, refer back to Figures 8-10 and8-11.
9
See McNair, C. J. and L. P. Carr. 1994. Responsibility redefined. Advances in
Management Accounting (3): 85-117. (Summary).
QUESTIONS
1. Define three types of cost in terms of: a) the relationship between the inputs and
outputs involved, b) the behavior of the cost, i.e., fixed, variable or mixed, c) whether
the cost are viewed as short run or long run, and d) how the cost are evaluated. (See
Exhibit 9-2).
2. Define four types of budgets. (See Exhibit 9-3).
3. Discuss three types of appropriation budgets. (See Chapter 9 Supplement).
4. Discuss the purposes of budgeting or financial planning. (See Purposes & Benefits).
5. Which purpose tends to cause behavioral conflicts? (See Limitationsand the

discussion of the Johnson Model of ABM in Chapter 8).
6. Discuss the limitations of budgeting. (See Limitations).
7. Describe the concept of responsibility accounting. (See Responsibility

Accounting,Exhibit 9-6 and the Chapter 9 Supplement).
8. Discuss the controversy concerning responsibility accounting.
9. What are the two main parts of the master budget? (See Exhibit 9-4).
10. Refer to Exhibits 9-2 and 9-4. What type of costs are involved in the production
budget, i.e., engineered, discretionary and/or committed?
11. Refer to Exhibit 9-4. Will the net amount of cash collections and payments equal
net income? Explain.
12. Refer to Exhibit 9-4. What is the connection between the income statement and
the balance sheet?
13. What are four assumptions underlying the master budget? Explain each. (See
Assumptions).
14. In preparing the sales budget, what functional area would estimate unit sales?
How are these estimates made? (See Sales Budget).
15. How are budgeted collections estimated? (See Sales Budget).

16. What is the difference between budgeted unit sales and budgeted units to be
produced? (See Production Budget).
17. What factors should be considered in determining the desired ending inventory of
finished goods? (See Production Budget).
18. Which calculation in the master budget normally requires data for three periods?
Why? (See Direct Material Budget).
19. Why is the direct labor budget less involved than the direct materials budget? (See
Direct Labor Budget).
20. Explain two alternative ways to calculate budgeted overhead costs? (See Overhead
Budget and Figures 9-1and 9-2).
21. What is the difference between budgeted unit cost and standard unit costs?
22. What is the difference between budgeted total cost and standard total costs? (See
Figure 9-2)
23. Describe two alternative ways to calculate budgeted cost of goods sold? (See
COGS Budget)
24. What drives variable selling and administrative costs in traditional cost systems?
(See S&A Budget).
25. To be consistent with the matching concept, what should be the basis of the
amount of bad debts that appears on the income statement? Explain. (See Budgeted
Income Statement).
26. Basically, what does a cash budget show? (See Cash Budget).
27. Mind expanding question. If budgeted units to be produced are increased without
a corresponding increase in unit sales, what effect will this have on budgeted net
income before taxes? Use the Expando Company to test your answer. Assume that
units to be produced are arbitrarily increased from 11,050 (from the production
budget) to 11,300. Hint: The answer can be found quickly by using the alternative
approach to recalculate budgeted cost of goods sold. You might also find it useful to
review the discussion of the behavioral aspects of inventory valuation in Chapter 8.
PROBLEMS
PROBLEM 9-1
Choose the best answer for the following multiple choice questions.
1. Which of the following statements is false?
a. The master budget is a flexible budget for the denominator activity level.
b. The technique of flexible budgeting is used to fine tune the master budget for
performance evaluation purposes, i.e., to prepare budgets which are comparable
with the actual results.
c. The master budget includes appropriation budgets.
d. Appropriation budgets are used to set the maximum amounts for many types
of discretionary expenditures.
2. Budgeted unit sales is normally determined by:
a. The accounting department.

b. The engineering department.
c. The personnel department.
d. The marketing department.
e. None of these.
3. Standard quantities per unit of product for direct labor are normally determined by:
a. The accounting department.

b. The engineering department.
c. The personnel department.
d. The marketing department.
e. None of these.
4. If a decrease in the time lag between ordering and receiving direct materials could
be obtained by switching to a new vendor, then the average inventory of direct
material could be decreased. This would most likely,
a. Increase net income in the current month.

b. Decrease cash outflows in the current month.
c. Increase net income in future months as well as decrease cash outflows in the
current and future periods.
d. All of these.
e. None of these.
5. Which of the following is a purpose or advantage of the master budget process?

a. Coordination of the activities of the different functional areas of the firm.
b. Communication to managers of how their efforts add value to the
organization's products or services.
c. Forces management to establish profit objectives.
d. Provides a tool for evaluation and control.
e. All of these.
6. Which of the following statements is true? The master budget process for a
manufacturing firm
a. may be referred to as either incremental budgeting or zero base budgeting.

b. may include appropriation budgets.
c. may include continuous budgets.
d. b. and c.
e. All of the above.
7. Appropriation budgets are
a. flexible budgets
b. static (fixed) budgets.
c. incremental budgets.
d. zero base budgets.
e. None of these.
8. The planned production volume variance is
a. the difference between planned unit sales and production multiplied by the
budgeted fixed overhead rate per unit.
b. the difference between planned unit sales and denominator units multiplied by
the budgeted fixed overhead rate per unit.
c. the difference between planned production units and denominator units
multiplied by the budgeted fixed overhead rate per unit.
d. the difference between planned direct labor hours and actual direct labor
hours multiplied by the fixed overhead rate per hour.
e. None of these.
PROBLEM 9-2
Bibb Company produces and sells a single product with standard costs as follows:
Resource Standard Inputs Cost per Input Cost per Unit

Direct materials 2 lbs $4.00 $8.00
Direct labor 3 hours 6.00 18.00
Variable overhead 3 hours 9.00 27.00
Fixed overhead 3 hours 10.00 30.00
Total Unit Cost $83.00
Overhead rates are based on 2,000 units per month or 6,000 standard direct labor
hours, i.e., this is the master budget denominator activity level. Overhead is applied on
the basis of direct labor hours.
Desired ending inventories of materials and finished goods are based on 5% of next
periods needs.
Unit Sales are budgeted as follows:
January February March April May

2,000 2,000 2,100 1,900 1,800
The budgeted sales price is $160 per unit. All sales are budgeted as credit sales. Past
experience indicates that 80% are collected during the month of sale, 18% are
collected in the following month, and 2% are uncollectible. A 1% cash discount is
allowed to customers who pay within the month the sale takes place.
Required:
A Partial Master Budget for March as follows.
1. Sales budget for March, including net sales dollars.

2. Calculate collections for March.
3. Production Budget, i.e., units to be produced for March.
4. Direct Material quantity needed for production for March.
5. Direct Material quantity to be purchased for March.
6. Budgeted cost of direct material purchases for March.
7. Budgeted cost of direct material used for March.
8. Direct labor needed for production for March.
9. Budgeted cost of direct labor used for March.
10. Budgeted factory overhead costs for March.
11. Budgeted cost of goods sold for March.
12. Prepare a simple Budgeted Income Statement for March. Assume selling and
administrative expenses are $54,992. Ignore taxes and interest, but don't forget
bad debts.
PROBLEM 9-3
Barker Company produces and sells a single product with budgeted or standard costs
as follows:
Inputs Standards
Direct materials 10 lbs at $10.00 per pound
Direct labor 8 hours at $12.50 per hour
Variable factory overhead 8 hours at $20.00 per hour
Fixed factory overhead 8 hours at $40.00 per hour
Overhead rates are based on 8,000 standard direct labor hours per month, i.e., this is
the master budget denominator activity level.
Desired ending inventories of materials are based on 10% of the next months
materials needed. Desired ending finished goods are based on 5% of next periods
budgeted unit sales.
January February March April

1,000 1,200 1,600 1,400
The budgeted sales price is $1000 per unit. Sales are budgeted as 80% credit sales and
20% cash sales. Past experience indicates that 60% of credit sales are collected during
uncollectible. A 1% cash discount is allowed to all customers (cash or credit) who pay
within the month the sale takes place. Selling and administrative expenses are:
Variable = 20% of sales dollars, Fixed = $250,000 per month. The budget assumption
concerning cash payment proportions is that all current purchases of direct material,
direct labor, factory overhead and selling and administrative items will be paid for
during the current period. The beginning cash balance for February is $10,000.
Depreciation and other non-cash fixed costs are: manufacturing = $100,000, selling
and administrative = $75,000.
Required:
A Partial Master Budget for February as follows.
1. Sales budget for February, including net sales dollars.

2. Calculate collections for February.
3. Production Budget, i.e., units to be produced for February.
4. Direct Material quantity needed for production for February.
5. Direct Material quantity to be purchased for February.
6. Budgeted cost of direct material purchases for February.
7. Budgeted cost of direct material used for February.
8. Direct labor needed for production for February.
9. Budgeted cost of direct labor used for February.
10. Budgeted factory overhead costs for February.
11. Budgeted cost of goods sold for February.
12. Prepare a simple Budgeted Income Statement for February.
13. Prepare a cash budget for February.
PROBLEM 9-4
This problem was omitted but is similar to the appendix problem.
PROBLEM 9-5
I. Master Budget: Grand Company produces and sells a single product with budgeted
or standard unit costs as follows:
Inputs Standards Cost Per Unit

Direct materials 3 lbs at $10.00 $30
Direct labor 2 hours at 12.00 24
Variable factory overhead 2 hours at 20.00 40
Fixed factory overhead 2 hours at 40.00 80
Total Unit Cost $174
Overhead rates are based on a capacity level of 1,200 units per month, i.e., this is the
master budget denominator activity level.
Desired ending inventories of materials are based on 4% of the next months materials
needed. Desired ending finished goods are based on 10% of next periods budgeted
unit sales.

800 1,000 1,200 1,400
within the month the sale takes place. Selling and administrative expenses are
budgeted as follows: Variable expenses are 10% of sales dollars, budgeted expenses
are $50,000.
Required:
A Partial Master Budget for February as follows.
1. Sales budget for February, including net sales dollars.

2. Calculate collections for February.
3. Production Budget, i.e., units to be produced for February.
4. Direct Material quantity needed for production for February.
5. Direct Material quantity to be purchased for February.
6. Budgeted cost of direct material purchases for February.
7. Budgeted cost of direct material used for February.
8. Direct labor needed for production for February.
9. Budgeted cost of direct labor used for February.
10. Budgeted factory overhead costs for February.
11. Budgeted cost of goods sold for February.
12. The amount and status (i.e., favorable or unfavorable) of the planned
production volume variance for February.
13. Budgeted selling and administrative expenses for February.
14. The amount of Bad debts which should appear on the February Income
Statement.
PROBLEM 9-6
AUTOMATED PLANT WHERE ANY DIRECT LABOR IS INCLUDED IN

OVERHEAD
The Microtable Company produces and sells special wood tables that are used with
microcomputers. The various parts of the table are cut and assembled by robots, thus
direct labor is not involved. Budgeted or standard costs for each table are as follows:

Direct materials 20 board feet at $3.00 $60
Variable factory overhead .1 hour* at $100.00 10
Fixed factory overehead .1 hour* at $400.00 40
* Robot (machine) hours.
Overhead rates are based on a capacity level 500 machine hours per month and
overhead is applied on the basis of robot (machine) hours.
Desired ending inventories of materials are based on 10% of the next months
materials needed for production. Desired ending finished goods are based on 15% of
next periods budgeted unit sales.
Unit Sales are budgeted as follows for 2005

4,500 5,000 5,200 5,500
The budgeted sales price is $250 per table. Sales are budgeted as 90% credit sales and
within the month the sale takes place. Selling and administrative expenses are
budgeted as follows: Variable expenses are 20% of sales dollars, fixed expenses are
$50,000.
Required:
Calculate the budgeted amounts indicated below, then circle the letter for the answer
you choose. Show all your supporting calculations next to the question.
1. The net sales dollars budgeted for February:
a. $1,250,000 b.1,240,000 c. 1,241,000 d. 1,239,750 e. None of these.
2. The cash collections budgeted for February:
a. $ 891,000 b. 1,186,875 c.1,014,750 d. 908,125 e. None of the above.
3. Budgeted units (i.e., tables) to be produced for February:
a. 5,000 b.4,970 c. 5,030 d. 5,780 e. None of these.
4. For the remainder of this problem ignore your answer to question 3 and assume that
the budgeted units to be produced for February are 5,030.
The number of board feet of Direct Material to be purchased for February:
a. 100,600 b. 101,110 c. 100,170 d. 101,030 e. Some other amount.
5. The Budgeted cost of direct material used for February:
a. $303,090 b. 301,800 c. 300,000 d. 300,510 e. None of these.
6. The budgeted total factory overhead costs for February:
a. $250,300 b. 251,500 c. 250,000 d. 201,200 e. Some other amount.
7. The cost of goods sold for February stated at standard cost:
8. The amount and status (i.e., favorable or unfavorable) of the planned production
volume variance for February:
a. Zero b. 1,200 favorable c. 120 unfavorable d. 1,200 unfavorable e. Some other

amount.
9. The Budgeted selling and administrative expenses for February:
10. During February no specific accounts receivable were determined to be

uncollectible. The amount of bad debt expense that should appear on the Budgeted
Income Statement for February:
a. Zero b. $37,500 c. 33,750 d. 33,413 e. Some other amount.
11. The ending accounts receivable balance budgeted for February before subtracting
the allowance for bad debts:
12. Assume 100 additional units of production are budgeted for February with no
change in budgeted unit sales. What effect will this have on budgeted net income for
February?
a. Budgeted net income will not change.

b. Budgeted net income will increase by $11,000.
c. Budgeted net income will increase by $4,000.
d. Budgeted net income will decrease by $11,000.
e. None of the above.
PROBLEM 9-7
The R. G. Phelps Company produces and sells a single product with budgeted or
standard unit costs as follows:

Direct materials 6 gallons at $5.00 per gallon $30
Direct labor .5 hours at 10.00 per hour 5
Variable factory overhead .5 hours at $100.00 per hour 50
Fixed factory overhead .5 hours at $200.00 per hour 100
Overhead rates are based on a capacity level of 2,000 units (or 1,000 direct labor
hours) per month, i.e., this is the master budget denominator activity level. Desired
ending inventories of materials are based on 10% of the next months materials needed
for production. Desired ending finished goods are based on 20% of next periods
budgeted unit sales.
Unit Sales are budgeted as follows for 2005:
January February March April May June

1,500 1,800 2,000 2,500 2,600 2,800
the month of sale, 8% are collected in the following month, and 2% are uncollectible.
A 1% cash discount is allowed to all customers (cash or credit) who pay within the
month the sale takes place. Selling and administrative expenses are budgeted as
follows: Variable expenses are 10% of sales dollars, fixed expenses are $100,000.
Required: Choose the best answer for the following questions.
1. The net sales dollars budgeted for March are
2. The cash collections budgeted for March are

3. Budgeted units to be produced for March are
a. 2,000 b. 2,100 c. 1,900 d. 2,040 e. None of these.
4. For the remainder of this problem ignore your answer to question 3 and assume that
the budgeted units to be produced for March are 2,100.
The number of gallons of Direct Material to be purchased for March is
a. 12,600 b. 12,852 c. 12,900 d. 13,200 e. Some other amount.
5. The Budgeted cost of direct material used for March is
6. The budgeted cost of direct labor used for March is
7. The budgeted total factory overhead costs for March are
8. Now, ignore your answers to questions 5, 6 and 7 and assume that budgeted total
manufacturing cost is $378,500. The budgeted cost of goods sold for March is
9. The amount and status (i.e., favorable or unfavorable) of the planned production
volume variance for March is
a. Zero b. $10,000 Unfavorable c. 10,000 Favorable d. 15,000 Unfavorable e.

Some other amount.
10. The Budgeted selling and administrative expenses for March are
11. During March of the previous year $8,000 in actual receivables were written off as
uncollectible. The amount of bad debt expense that should appear on the Budgeted
Income Statement for March is
a. Zero b. $9,600 c. 8,000 d. 7,200 e. Some other amount.
12. The ending accounts receivable balance budgeted for March before subtracting the
allowance for bad debts is
Problem Solutions
Extra MC Questions
Budgets
What is in this guide:
1. Why should organisations use budgets

2. Important things to know about budgets
3. How to draw up a budget
4. How to use a budget for financial management
1. Why should organisations use budgets
Every organisation survives by receiving some money from members, donors, fund-raising or
selling of services - this is called income. Organisations also spend money to run its programmes
and these are called expenses. The budget is a table which shows the actual amounts that the
organisation expects its expenses and income to be for a fixed period of time, such as one year.
The budget tells you how much the organisation thinks it will need to do its work, where it hopes
it will come from and how much money it still needs to find.
The budget is an essential to tool help you run a more effective organisation. In the same way
that the government needs to draw up an annual budget, to make sure that all plans and
programmes are properly funded, an organisation needs to prepare a budget in careful detail.
Budgeting is part of planning - you start with setting your objectives, then you draw up action
plans and budgets. [See Guide on Planning]
Unless you know how much money you will need to carry out your plans, and where you expect
to get that money from, you may end up halfway through the year with no money to go any
further. Preparing a budget forces you to plan your spending and your fund-raising and to be
realistic about what you can afford to do. Without a budget there can be no effective
implementation.
A budget also serves a lot of other purposes:
It is a simple way to make financial information accessible to all people in the organisation who
need to use it. Each member or staff member should know how much money is available for what
part of your work.
It helps you to understand exactly what your work will cost and what limitations your have so that
your plans can be made more realistic.
It clarifies where your have gaps and need to do more fund-raising. It also helps to write fund-
raising proposals based on realistic costing.
All financial statements should be written in terms of the budget so that it is easier to be
transparent and accountable and to ensure that no money is spent on costs that you have not
budgeted for.
It helps members or executive members or management to monitor expenditure throughout the
year and to make sure that it is in line with the budget amounts - monitoring should happen every
month or two and should be in terms of the budget categories.
It makes reporting to members or funders much easier since the expenditure can be compared to
the amounts that you actually budgeted.
A good budget can also help to avoid waste. When every amount is carefully calculated, it is easy
to see how your money is being spent and to decide whether your are making any unnecessary
expenditure.
2. Important things to know about budgets
A budget should be drawn up on the basis of three main factors:
A budget should always be based on proper plans, drawn up to make sure that you reach your
goals for that year. A budget should be the summary of all the costs and income that you will
receive that will make sure that your plans are implemented.
The costs in the budget should be based on your financial statements of the previous year and
the budget items should compare the expenditure of the previous year to this year. This will show
that your budget is based on fact and experience.
The budget should be realistic and should also show what income you expect and what income
you would still need to raise.
Every budget should contain a number of categories. The two main categories are "Expected
Expenditure" and "Expected Income".
Under the Expected Expenditure the categories could be:
Capital costs - things that you have to buy like computers, cars etc.
Running costs - expenditure that will help your organisation to run an office and administration
to do its work: items like rent, electricity, telephone, hiring of equipment.
Staff costs - salaries, staff benefits, staff training etc.
Project costs or operational costs - costs that are linked to the specific projects or campaigns
that you plan to run that year. This would include things like buying materials, printing costs,
transport costs, workshop costs, catering, media production, venues, sound systems etc.
Under the Expected Income of the organisation you should include categories like:
Donor funds - list each funder and the amount you expect from them,
Membership fees - if your members pay fees list the amount you expect to get this year,
Donations - list the amount you expect to get from small public donations,
Fund-raising events - if you plan to organise events, list what profit you expect to make and
Sales - if you sell your services or any products.
The budget should clearly show whether there is a difference between your Expected
Expenditure and your Expected Income. If you will get more money than you will spend, this is
called an expected surplus; if you will get less money it is called a deficit. When your budget
shows a deficit you will obviously need to either cut the budget or do some serious fund-raising
to make up the amount.
It is very important to write a budget in such a way that all amounts are justified and explained.
For example if you want to spend R100 000 on salaries, you should explain how many people
will be employed for how much money. For example:
SALARIES 100 000
1 coordinator @ R60 000 per year
1 administrator @ R40 000 per

year.
The budget can be drawn up by anyone in the organisation who is clear about the plans of the
organisation as well as the possible income and expenditure. It is usually done by the treasurer,
the co-ordinator or director or by a budget or finance committee. Whoever prepares the budget
must work together with others, especially people in charge of the programmes of the
organisation and people responsible for bookkeeping. Once the budget has been prepared, it
needs to be checked and discussed by other members of your organisation such as executive or
staff who will be using the money.
Budgets are usually drawn up for one year but you can also draw it up for a few years at a time,
or have a budget that is just for a specific project that may only last a month or two. A budget
should be used as the basis for any audits that are done of your organisation. Audits are usually
done by independent accountants who go through all your financial records to check that the
money was spent for what it was intended. A budget is used as the main tool for judging this.
The budget is not simply a document for funders and executives to see whether you have used
the money properly. It should be a living tool for financial management. The budget is never set
in stone. Circumstances and the needs of your organisation may change during the year and a
budget can also be changed if necessary. The overall budget of your organisation is an internal
one, and can be amended.
A budget for a specific project that you send to a funder is not so easy to change, since you have
promised to do the work that is reflected in the budget and you only have a set amount of money
available to do this work. If you want to change a budget that has been approved by a funder,
you should only do that in consultation with, and with the permission of the funder.
Sometimes it is necessary to have two different budgets for your organisation. One as the ideal
budget that you would like to have and a second one as a minimum budget of the money that is
absolutely necessary for your organisation to survive. Often when your draw up the ideal budget,
your are not yet sure that your will get all the money your need and a minimum budget will help
you to decide which costs can be cut, if your don't manage to raise the necessary funds.
3. How to draw up a budget
The most important thing that should be written at the top of a budget is, what period the budget
covers. It is best to make your budget cover the same period as the financial year of the country
or, of specific donors. Usually financial years are from the first of March to the end of February
of the next year.
You also have to have to decide how detailed you want to make the budget. There are no set
rules for this but generally, the more detail you have, the easier it is to use the budget as a
financial management tool. The examples we will show in this section are for a detailed budget.
The next step, is to decide exactly what your organisation has to achieve in the next year. This
should be based on your strategic planning process. [see Planning Guide for more detail] Once
you have a list of activities that will make you achieve your objectives, you should calculate
exactly what each activity will cost.
When you calculate expenses, it is important to think of everything that you could possibly have
to spend. Also, you should look at your financial records of previous years, to make sure that you
are not missing any obvious expenses.
Here are some examples of the expenses that you could have in your organisation:
Capital Costs
Purchase of vehicles
Purchase of computer and printer
Purchase of property.
Running Costs/Administration
Rent,
Service contracts for copiers, etc,
Electricity,
Telephone, cell-phone and fax bills,
Internet provider,
Postage,
Vehicle maintenance,
Equipment rental,
Insurance,
Bank charges,
Auditor's fees,
Legal fees.
Staff Costs
Salaries,
Medical aid,
Pension contribution, UIF and other levies,
Staff training
Operational Costs
Printing,
Research,
Materials development,
Media production,
Publicity,
Transport and other travel,
Venue hire
Catering.
Here is an example of how a particular expense could be written in a detailed budget - the right
hand figure is projected transport costs for the budget year, the left hand figure is actual
expenditure in the last financial year. The calculations below Transport, show how you worked
out the amount of R20 000:
2000/1 2001/2
Transport: 18 540 R20 000
10,000km @ R1 per kilometre -

R15 000
2 Return National Airfares - R4

000
Public Transport - R1 000
When you are basing your budget on previous expenditure, it is important to take inflation and
cost-of- living increases into account. If your inflation rate is 6% you should add about 7% to
costs for the next year. If your activities are going to increase from the last year, you will also
have to work out how much more you have to allocate to each item.
Under Income in your budget you should use categories like the following:
Grants from funders - list each funder separately and the amount that is expected from them.
Membership fees
Local donations
Income generated - fees that you charge for your services, sales of publications etc.
Fund raising events.
You should make it clear in your budget, which of these amounts you have already received, or
have an existing a letter of commitment for, and which amounts you are expecting to raise. In the
same way that you put the amount spent in the previous year next to your Expenditure column,
you should do the same with expected income. This will help to make it clear whether your
expected income is realistic.
If you choose not to have a very detailed budget that shows all the calculations, it is very
important to have explanatory notes that accompany your budget, where the calculations are
clearly explained.
If the work of your organisation is a little unpredictable, then it is useful to include an item called
Contingency Fund in your budget. This should never be more than 10% of your overall budget.
In your explanatory notes, you should justify the contingency fund by listing some of the
unbudgeted expenses that happened in the previous financial year.
It is also useful to include contributions to your organisation that are not financial, at the end of
your budget. For example, if a company has promised to donate 2 computers to you, you should
include that as a note, at the end of the budget. This gives a full picture of how you will get what
you need, even if it is not money.
Before you submit your budget to anyone, double-check all your calculations and make sure that
it has been worked out and added up correctly. Check your spelling, make sure that the budget is
clearly written or typed, and that it is set out in such a way that it is easy for people to look at
separate categories and items. Make sure that you have the dates covered by the budget at the
top. At the bottom of the budget, you should write the date when the budget was prepared.
Here is an example of a simple organisational budget for an organisation that runs public
education workshops on Human Rights. It includes a column on the previous year's expenditure
and income:
BUDGET FOR 1 MARCH 2002 TO 28 FEBRUARY 2003
EXPENDITURE 2001/2 2002/3

1. RUNNING COSTS:
Rent @ R500 per month 5 490 6 000
Phone @ R333 per month 3 665 4 000
Transport 18 540 20 000
10,000km @ R1 per kilometre -

R15 000
2 Return National Airfares - R4 000
Public Transport - R1 000
Equipment hire 1 920 2 400
Copier @ R200 per month

2. CAPITAL COSTS
Computer @ R7000 7 000
3. STAFF COSTS
Salaries: 100 000 110 500
Coordinator
@ R5000 x 13 mths: R65 000
Administrator
@ R3500 x 13 mths: R45 500
Levies and benefits: 8090 8 500
4. PROJECT COSTS
Publicity: 2 890 3 300
100 posters @ R3
10 000pamphlets @ R0.30
Venue hire 5 010 6 000
30 workshops x R200
Catering; 9 200 10 000
1 000 people x R10
Materials 9 872 10 000
1000 people x R10
5. CONTINGENCY 8 909 9 385
@ 5% of R187 700
TOTAL EXPENDITURE 173 586 197 085
INCOME
1. DEFINITE INCOME
2001/2 2002/3
Funder X 50 000 60 000

Funder Y 45 000 nil
Funder Z 45 000 45 000
2. EXPECTED INCOME
Membership fees 7 900 8 000
Donations 2 300 2 500
Fundraising 23 900 25 000
TOTAL 174 100 140 500
Deficit -56 585
LIST OF DONATIONS IN KIND:
Office furniture 5 000
Free use of meeting venue 2 400
TOTAL 7 400
This budget shows a deficit of R56 583 which the organisation will have to raise. If they cannot
do this they will have to cut their costs by that amount.
4. How do you use a budget for financial management
Once you have drawn up and finalised your budget, it becomes the most important tool for
financial management in your organisation. To manage your finances you should:
Analyse projected income and expenditure and Identify shortfalls and make plans to raise the
deficit
Cut costs if needed
Monitor monthly spending
Analyse projected income and expenditure
In your budget, you have all your different expenditures first and then all your different sources
of income. The budget alone cannot tell you which sources of income will pay for which
expenditures.
It is useful to draw up a table that will show this more clearly. Here is an example:
Members Funds
ITEM Funder A Funder B TOTAL
fees needed
Running
10 000 20 000 5 000 5 000 40 000
Costs
100
Staff Costs 20 000 40 000 5 000 35 000
000
150
Project costs 50 000 60 000 40 000
000
290
TOTAL 80 000 120 000 10 000 80 000
000
On the left hand side of the table are the items of expenditure: running costs, staff costs, project
costs. On the right side are the totals you have in your budget for each of these items. Each
source of income is then listed in a column, with the amount from that source that is allocated to
each item of expenditure.
So, for example, Funder B in Column 2 will give you R120 000 and is paying for 40% of your
salary costs, half of your running costs and R60 000 towards your project costs.
The membership fees in Column 3 will pay for a small part of your running and staff costs, but
does not cover any project costs.
Once you have filled in all the columns, you can then add up each item to see whether you have
reached the total income that you need to pay for all the expenses you will have in that category.
If there is a shortfall, it should be written in the column, Funds Needed. This is your deficit and
is the amount what you will have to fundraise for. Decide if it is realistic and possible to raise
that amount and make plans to do so immediately. If it is not possible, your only alternative is to
cut the expnses in your budget.
Cut costs if needed
No organisation can plan to run with a deficit. It simply means that at some point in the year you
will run out of money, your staff will not be paid, your offices will close and your projects will
collapse. If you are forced to cut costs, do it as early as you can so that you can plan to do the
least possible damage.
When you are trying to cut a budget, it is important to categorise the different items under
expenditure into those that are absolutely essential for your organisation to survive and those that
are not essential. This will guide you and help you decide which cuts you can make. When you
look at the expenditure items, you should also decide if any of them can be found in kind rather
than in money. For example, if you have a salary budget for 10 people, can you budget for only 5
people and use volunteers to do the rest of the work? Or if you have a budget for office furniture,
can you try to get donations of furniture from businesses in your area, instead of buying them.
Cost cutting can be difficult and painful. It may involve people losing their jobs or projects
closing down. But if you do not have the money you have no choice.
There are two very important rules in financial management for organisations:
1. Do not spend on an item that there is no income for.

2. Do not borrow money, since you are not a business and have no assurance of income in the year
ahead.
Monitoring
You cannot monitor your budget and use it for financial management, unless you have a proper
bookkeeping system. [See Bookkeeping guide]. Your financial records should be added up at the
end of every month and you should check against the budget to see how much money has been
spent in each category.
It helps to divide your budget into the 12 months of the year so that you can tell at a glance
whether you are over-spending on an item or not. So, for example, if your budget for telephone
costs is R6000 per year, you should spend around R500 per month on your phone bills.
You should monitor spending in two ways:
1. The amount spent each month should be checked against the amount allowable in each month,
and
2. The accumulated amount that you have spent that year should be checked against the amount
allowed for the number of months that have passed. It is not good enough to only check the
monthly expenditure since you will spend much less in holiday months than in very busy months.
Proper monitoring of your expenses should happen every month if possible, but at least every 2
months at a minimum. When you give financial reports to your executive or your members, it
should be done in a format that makes it easy for people to compare the expenditure to the
budget. A detailed financial statement is not a very useful way to report, since most people
cannot easily understand accounting detail. It is much better to report by showing people the
budget, and the amounts spent so far.
For example you can show your running costs like this:
Item Budget Budget for 2 Spent 1st 2 Difference

mths mths
Phone 6 000 1000 1420 420
Copier 5 000 832 720 -112

Rent 6 000 1000 1 000 nil
Insurance 2 400 400 390 10
Total 19 400 3 232 3 530 298
In this example the organisation overspent by R298 in two months. The reasons for overspending
on the phone bill should be analysed. There are three options:
1. Cut costs on the phone bill

2. Change the budget and allocate extra funds from another item
3. Find more money for the budget as a whole
If costs cannot be cut, the budget should be changed to accommodate this spending pattern. The
best way to re-allocate funds is to do it within a category - so to take from one part of running
costs and add it to the phone budget. In this example it would be possible to take some of the
copier budget and re-allocate it. It is not always this simple and often the money has to be found
by cutting project costs. If donor's funds are involved in the changed allocation, they should be
consulted.
If the overspending means that there will be a shortfall of funds, immediate action should be
taken to raise more funds.
Budget, Budgeting Process, and Variance

Explained
Definitions, Meaning, and Budget Examples
Business Encyclopedia, ISBN 978-1-929500-10-9. Updated 2015-08-26.
In large organizations, the Budget Office Director and staff work with individual managers and others seeking funding approval. As a
result, budget proposals conform to local policies and rules and the entire proposal package aligns with organizational objectives.
In business, budget can be defined as a plan for an organization's outgoing expenses and incoming revenues
for aspecific time period.
Budgets are used in many organizations to . . .
Track and control spending.

To ensure that available funds are used according to plan, within preset limits and not exceeding available
funds.
Support funding requests.
To justify the use of funds and help plan future spending accurately by describing how funds will be used.
This article defines, explains, and illustrates the term budget, with examples, in context with related terms
including capital budget, operating budget, cash budget, zero-based budgeting, and variance analysis.
Contents
What is the meaning of the budgeting? What is a budget variance?
What are the differences between capital budgets and and operating budgets?
- Capital spending (CAPEX) compared to operating expenses (OPEX).
- Capital budget defined.
- Operating budget defined.
What is a cash budget?
What is the budget planning cycle? What is the budgeting process?
What is zero based budging and how does it compare to incremental budgeting?
What is budget variance analysis? What is a flexible budget?
What is the meaning of budgeting? What is a budget variance?
In its simplest form a budget is a plan or forecast in the form of a list, showing spending items and/or incoming
revenue items, with a figure for each item. As time passes, actual spending or revenue may be entered into the
list to compare with the originally budgeted figure. If there is a difference between planned and actual figures,
the difference is called a variance.
A company's operating budget, for instance, may forecast spending for employee training. The annual training
spending figure may be set first, for management and control purposes, but this can be broken down later into
monthly or quarterly figures. Two quarters into an annual budget cycle, figures for budget item "Employee
Training" might look something like this:
Employee training is a single budget item for one company. The budget initially contains only the budgeted spending figures for
each quarter. When it occurs, however, actual spending is entered next to budgeted spending, along with the budget variance.
A variance for each quarter is found by subtracting planned spending from actual spending. The variance is
usually presented both in currency units and as a percentage of the planned figure. Here, a positive variance
means that spending is over budget and a negative variance means that spending is under budget. However,
note that this convention is not universally observed: some people prefer to show overspending as a negative
figure by calculating variance as the planned figure less the actual figure.
In the real business world, some variance between actual and budgeted figures is normal and expected. Large
quarterly variances, however, call for either (1) adjusting the forecast to represent the new expected reality, or
(2) controlling actual spending in future quarters so that the yearly variance comes closer to zero. (For more on
these options, see the section Variance analysis and flexible budgets below.)
Most organizations plan spending and revenue management with a budget hierarchy. That means that
planning begins with high level budgets, such as the company wide (or organization wide) capital and operating
budgets. In these high level plans, spending items and revenues usually correspond closely to the revenue and
expense items in the organization's chart of accounts. Lower level plans may further divide higher level
categories, or even represent single, specific revenue or spending items.
Here are a few of the levels in one company's budget hierarchy:
Part of one company's budget hierarchy. Funding requests for the next budgeting cycle will normally be solicited from the
"bottom up." Once all requests are "rolled up" through the highest level, the Budget Office and senior management will start
making budgetary spending decision for the highest levels, and then move downward.
In setting planned figures, senior management is responsible for authorizing spending amounts for high level
categories (for example, the "Marketing Budget" above). Middle and lower level managers in Marketing will be
responsible for dividing the marketing budget further into lower level budgets for areas such as research,
advertising, and events. Each of these areas may be further divided, as the chart suggests.
What are the differences between capital budgets and operating budgets?
At the top of the hierarchy in most companies and organizations stand two major kinds of plans, a capital
budget and an operating budget. These do not overlap: they handle distinctly different spending categories.
Capital and operating budgets, moreover, are built through different processes, usually by different managers,
and they use different criteria for prioritizing and deciding spending.
Capital spending (CAPEX) vs. operating expenses (OPEX)
Whether or not an expenditure qualifies as a capital expenditure (CAPEX) or as an operating expense (OPEX)
depends on what is purchased, what it is used for, and also upon the country's tax laws. Companies and
organizations normally designate specific criteria that must be met for an acquisition to qualify as "capital," such
as a minimum useful life (e.g., one year or more) and a minimum purchase price (e.g., $1,000).
The country's tax authorities also have a say in what may be considered a capital expense.
Tax authorities specify which item categories appear on the balance sheet as capital assets. On the
income statement, these items create a depreciation expense for each year of the asset's depreciable life.
This lowers reported income (), thereby creating a tax savings. Spending on operating expenses, by
contrast, impacts reported profit and taxes on earnings only in the reporting period they are incurred.
Tax authorities determine which expenditures for businessstart up cost, for instance, can be capitalized. In
the United States and a few other countries, the costs of professional services (such as systems
integrations services) can, under some conditions be "bundled" into the full capital costs of acquiring
assets (for example, a large IT system).
Acquisitions that typically meet company and government criteria as capital assets typically include such things
as purchased:
Vehicles
Factory machinery and production equipment
Store equipment and furnishings
Laboratory equipment
Large IT systems (Hardware and/or Software)
Buildings
Office Furniture and Office Equipment.
Operating budgets, by contrast, cover operating expenses (OPEX), spending on predictable, repeatable costs
for items or services that are not registered as capital assets and are not depreciated. That means the
company charges the full amount against income during that reporting period, taking all tax savings for these
expenses during that period.
Operating expenses typically represent spending for such things as:
Employee salaries/wages and overhead
Office space rental and utilities costs

Employee travel and training expenses
Marketing communication / advertising expenses
Telephone and internet services
Insurance costs
Outside consultant fees
Note that there is also a major income statement category called "Operating Expenses," which appears
beneath the gross profit line, and aboveExtraordinary Items and Financial Income/Expenses. Income statement
"Operating Expenses" category items thus do not impact reported gross profit or gross margin. When used in
the budgetary sense, however, "operating expense" can include expense items above the gross profit line.
Wages for direct laborin product manufacturing, for instance, are forecast in the Manufacturing operating
budget and appear on the income statement above the gross profit lines as part of Cost of Goods Sold.
Capital budget defined
Capital budgets forecast and spending for capital expenditures (CAPEX), the acquisition of capital assets
usually long lasting, expensive acquisitions that go onto the company's balance sheet as assets. On the
company's income statement, capital assets contribute to depreciation expense throughout their depreciable
lives.
When deciding which capital investments to make, companies usually use a combination of formal financial
criteria, including
Net present value (NPV),
internal rate of return (IRR),
return on investment
payback period.
Potential investments are also evaluated with respect to strategic consistency and risk. And, because capital
spending is planned to maximize value, investments should be undertaken only when expected returns are
equal to or greater than the average cost of capital.
Capital planning is usually accomplished through an organization's Budget Office or through a Capital Review
Committee, which establish their own criteria for prioritizing proposals and for setting the capital budget ceiling.
In order for a specific capital expenditure to be funded, its sponsors may have to justify it with a formal business
caseanalysis, including estimates of NPV, IRR, payback period and other financial criteria. If the company has
limited capital funds, moreover, the potential capital expenditure may have to enter a competitive capital review
process, where all requested expenditures are compared, and only the most favorable receive funding.
Those who propose or request funding for capital expenditure should be sure they understand:
The organization's criteria for prioritizing capital expenditure proposals.
The timing of the current and next capital planning and spending cycles.
The current or expected capital spending ceiling.
Operating budget defined (OPEX)

Generally, an operating budget covers operating expenses (OPEX) for normal operations. Operating budgets
are typically developed through a process different from that used for capital budgets. In some companies, all
management above a certain level participate in the process. Planned spending on operating expenses is
usually not changed during the periodexcept possibly for emergency reductions following unexpectedly poor
sales results or other disasters. In other words, spending plans for operating expenses are more often treated
as static budgets rather than flexible budgets.
What is a cash budget?
A cash budget is a tool for planning and controlling near-term spending, normally including both incoming cash
flows and cash outflows (usually for spending on expenses). In business, these serve a purpose similar to the
checkbook register used by individuals to track deposits and checks for personal checking accounts. From the
cash budget, one can see immediately the level of cash on hand and how that will change with spending,
Cash budgets are typically planned with a series of months in view, although they can also show cash
revenues and spending on a weekly, quarterly, or annual basis. The distinguishing feature of the cash budget is
that it represents actual cash inflows and outflows in the period they occur. This contrasts with the system of
accrual accountingwhich most companies use for their financial reporting, in which receivables and liabilities
are reported for the period in which they are incurred, even though the actual cash transactions may occur in
another period.
A small company's monthly cash flow budget may look like this example:
One company's cash budget for two months. The cash budget represents actual cash inflows and outflows in the period they
occur. Revenues and expenses do not appear here until cash flow associated with them occurs. The same company may use
accrual accounting for financial reporting, as well, but management will probably refer first to this cash (only) budget when
dealing with cash flow issues.
The example cash flow budget show the budget as it stands in mid-February. Figures for January are now
history and will not change. "Actual" figures for February are current as of mid-month, but these may change by
the end of the month. This example includes forecast inflows and outflows, actual inflows and outflows, and a
computed variance for each item. The variance is the actual figure less the forecast figure. With this
convention, a positive variance means that inflows or spending were above the forecast amount, and a
negative variance means the actual amount was less than planned. Notice in the example that actual cash on
hand at the end of January (Cash income less cash expenses = $131,614) is carried over to February as actual
starting cash for that month.
When large variances appear between forecast and actual inflows or outflows, the cash budget helps identify
the source of the variances. In the example above, for instance, the overall negative cash flow variance for
January was not due to overspending in that month, but rather, the variance clearly results from product and
service sales revenues falling below forecast. For future months, the manager's options are to either (1) take
action to increase incoming revenues, (2) or to lower the forecast revenues and spending figures.
What is the budget planning cycle? What is the budgeting process?
Companies and organizations typically develop and implement budgets on a periodic basis at fixed intervals.
The norm in private industry is to produce a plan for each fiscal year. Some government organizations also
prepare annual plans, but two-year (biennial) budgets are also common in government. Although plans are
sometimes adjusted in "real time" (that is, they are treated as flexible budgets after start of the planning period
they cover), such changes are exceptions to the normal rule, which is to keep the forecast intact (static) once
implemented.
In the period of time between issuance of one budget and the next, planning-related decisions and plans are
referred to as the budget cycle or process. In large companies, large educational institutions and non profit
organizations, and in government organizations, the process normally extends across months, if not the entire
period between budgets.
For those involved in the budgeting process there can be many specific steps and requirements to meet, and
the nature and timing of these vary widely among companies and organizations. Most large organizations in
fact publish a description of their own process, calendar, and approval requirements on the internet. This
information is sometimes publicly accessible, or it may be accessible only to employees with authorized access
to it. In any case, anyone setting out to prepare a funding request for the first time will normally begin by
accessing this source.
Although specific steps and timing vary from organization to organization, the budgeting process everywhere
almost always includes steps for:
Assessing variances between actual and forecasted figures in the previous period's plan.
Identifying and then prioritizing business needs and objectives for the forthcoming period.
Identifying and evaluating:
Incoming revenue forecasts.
Current trends or changes that may have spending or revenue implications, such as new mandates to reduce
spending, expected changes in staffing levels, or changes in expected business volume.
Risks or potential emergencies that could impact either incoming funds or spending needs.
Ensuring that individual funding proposals in the complete plan package are prepared in consistent format,
and that proposals competing for funds can be compared fairly.
Ensuring that procedures and methods are in place for implementing the plan and monitoring actual
spending and incoming revenues.
Packaging and communicating funding requests to those responsible for reviewing and approving budget
proposals.
In large companies and organizations the process is managed and "driven" by, a Budget Office. This office
works with managers, department heads, and others who will seek funding approval, but also with the senior
management, legislative bodies, and senior officials who will make approval decisions. The result is that all
budget proposals are developed according to local policies and rules, and that the entire proposal package is
reasonable and aligned with organizational objectives.
What is zero based budgeting and how does it compare to incremental

budgeting?
Zero based budgeting is an approach to budgeting requiring that every expenditure be justified. In other
words, each potential spending item starts with an assumed value of 0, with all changes above that having to
be justified. This contrasts with the more usual practice, incremental budgeting, in which each spending item
is started at last year's (or last term's) level, and the next period's level is planned as an increment (positive or
negative change) to that level.
Advocates of the zero based planning favor the approach because it is based on demonstrated needs and
resources, not on historical spending levels, which arguably leads to more efficient allocation of resources. The
zero based approach can be very effective, for instance, in detecting and eliminating inflated budgets, or those
that include obsolete or wasteful operations.
Zero based budgeting also helps avoid a practice common under the incremental approach, whereby
managers approaching the end of the budget period ensure that they spend all funds available to them,
whether such spending is necessary or not. Some managers believe that if they do not spend all of this period's
plan, they will receive less in the next period (in some organizations, this belief is supported by historical fact).
In a large organization, however, the zero based approach may call for very substantial research and analysis
in order to justify every funding requestan investment in time and organizational resources that is not, in its
own right, justified. Under the Incremental approach, formal justification (e.g., business case analysis) is
normally required only for capital spending proposals or for significant spending increases in operating expense
categories.
What is budget variance analysis? What is a flexible budget?
A variance (difference between actual and forecast figures) is a signal to management that revenues or
spending did not go according to plan. If the variance represents overspending, moreover, it is an indicator that
there may be problems paying future expenses. Variance analysis attempts to find the reasons that actual
figures were over or under forecast so that either
Corrective action can be taken to reduce variances in the future, (an exercise in static budgeting) or
Figures for future spending can be adjusted as necessary (the practice of flexible budgeting).
Confusion sometimes arises in variance analysis because two different conventions for calculations commonly
used.
Convention 1:
Incoming revenue variance = Actual Forecast

Expense spending variance = Actual Forecast
This convention is used in this encyclopedia and in many organizations. Under this approach, a positive
variance always means the actual result was greater than the budgeted amount.
Convention 2:
Some organizations (such as the Project Management Institute), however, recommend using the above
convention for revenue, but reversing the order for expense items:
Incoming revenue variance = Actual Forecast

Expense spending variance = Forecast Actual
Under this convention, positive variances are always "good things" (more revenue or less spending than
expected), and negative variances are always "bad things."
Obviously, anyone involved in planning and analyzing spending needs to ascertain which convention is used
locally.
In many companies, variance analysis is often an especially important issue in planning for two areas: (1)
Direct and indirect manufacturing costs, and (2) sales revenues and sales costs. Revenues and costs in these
areas are often difficult to predict accurately. Variance analysis for these areas is, in fact, a substantial and
sometimes complex topic in the teaching of cost accounting. The simple example below is meant only to
illustrate one kind of approach.
Variance analysis typically begins with variance reports at the end of each month, quarter, or year, showing the
difference between actual spending and forecasted spending. As an example, consider a small manufacturing
company's quarterly variance report for one plan item, "Manufacturing overhead." The variance report shows
that Manufacturing overhead is $76,400 over plan for the quarter. The variance is 7.4% of the budgeted figure:
Management will probably call for variance analysis when a large budget item turns out to be substantially over budget. In this
case, to understand why quarterly spending on hourly wages is 9.6% over budget, variance analysis will have to consider the
interrelationships among all budget items in "Manufacturing Overhead." The analysis will also have to determine whether or not
the unexpected spending on wages is compensated by increased income.
The Manufacturing overhead variance is a substantial percentage of a large budget item. Management will
certainly want to know the reason or reasons for the variance, and then what can be done to prevent
recurrence in the next quarters. The next step in variance analysis is to identify the components of the cost item
(Manufacturing overhead), and sources of variance within them.
The table above lists six line item components. Note that some of these are fixed costs, and others are variable
costs. Fixed costs are (in principle) independent of manufacturing volume and should be more predictable than
variable costs. Nevertheless, management salaries (a fixed cost) were $2,000 over forecast. Why? It turns out
that during the quarter, the four managers involved took a total of two weeks paid sick leave among them,
requiring other management labor to cover for them. Insurance costs (another fixed cost item) were 5% over
forecast. Why? Here, there was an unexpected increase in insurance premiums during the quarter. In general,
variances in fixed costs can be traced to:
Unexpected problems or emergencies
Unexpected cost changes
Underestimated need for utilization of fixed cost resources.
In the table above, however, two variable cost components of Manufacturing overhead cost stand out with
strikingly large variances: Hourly wage costs (9.6% over plan) and utilities costs (24.2% over plan). The hourly
wage variance draws attention, especially, because it represents a very large component of the overall
Manufacturing overhead variance.
Hourly wages are a variable cost item because they depend on manufacturing volume (units produced). Note,
however, that two variable factors also contribute to total hourly wage costs: Labor hours per unit, and the cost
of labor (here, dollars per hour). In fact, Hourly wage costs are the simple product 3 factors:
Hourly wage cost = (Units manufactured) * ( Labor hours per unit ) * (Labor cost per hour)
The table below shows how actual figures for these factors compare with forecast:
A budget item with a positive variance is not necessarily a bad outocome. In this case, the hourly wage variance results from
higher than expected work volume. This could mean the company produced and sold more products than expected.
Adding 100% to each of the variance figures, the unit variance is 105% of forecast, the hours per unit variance
is 90% of forecast, and the labor cost per hour variance is 116% of forecast. These percentages, multiplied
together, account for the actual labor cost:
Actual hourly labor cost = Forecast labor cost * 105% * 90% * 116%
= $690,000 * 105% * 90% * 116%
= $756,000
From this analysis, management may draw conclusions such as these:
The positive variance in units is not a bad result. On the contrary, the higher unit count is probably
associated with increased sales revenues and profits. However, if unit volume can now be forecast at
higher figures in subsequent quarters, management may consider additional hiring so that the work can be
done without extensive labor overtime.
The efficiency gain in hours per unit is also a good result. Management will want to ask if this can be
sustained or even improved further. If so, the change may be reflected in future spending forecasts.
The positive variance in average hourly wage rates should move management to find ways to provide
more labor hours at the standard rate rather than the much higher overhead rate. This hourly cost variance
providesalong with the positive unit volume variance abovemore evidence that management may want
to consider additional hiring.
Management can use the "Actual hourly labor cost" formula above to try out different proposed figures and
variances, to see the impact on actual cost.
In addition, the very large variance for utilities costs (24.2% over plan) bears looking into in the same way, even
though the actual spending figures are small compared to the wage cost variance. The same kind of analysis
here, however, promises more complexity. Utilities costs will be the additive combination of phone costs, water
costs, and electricity costs, Each of these, in turn, involves the product of price variances, efficiency variances,
and usage variances.
A variance presents management with two alternatives: either adjust the plan in future periods, to conform
more closely with revenue or spending realities, or take action to impact future spending and revenues so as to
bring forecast and actual figures closer together. The former option (adjusting the plan) is called flexible
budgeting. The latter option is an instance of static budgeting.
Most large organizations permit at least a limited level of flexible planning. Most managers responsible for
lower level budgets (e.g., for a department budget or for an operational area such as "Advertising") have the
ability to adjust their own plans "in real time" by moving planned levels from one category to another (except
that movements from "capital spending" authorizations to "operating expense" cannot be done so easily).
However, if a manager needs to increase his or her overall spending total above plan, that normally requires
the use of a process called "emergency funding" or request for non-budgeted funds that is presented to the
next higher management level. The next higher level may designate funds specifically set aside for such
contingencies. Or, upon demonstrated need, these funds may have to come from current assets, such as cash
on hand or the sale of stock owned for investment purposes.
07 Apr 2015 | Brian J Harford FCCA, FIAB - Principal at Woodgrove Tutorials | 0 Comments
Cash budgeting &forcasting
This post has been produced by B J Harford FCCA, FIAB, Principal at Woodgrove Tutorials
Woodgrove Tutorials is an IAB Accredited Training Provider. Their Principal, Brian J Harford FCCA
is an Award Winning qualified Accountant with 36 years teaching experience in Bookkeeping &
Accounts including 17 years as a Part Time Lecturer at the London Metropolitan University (formerly
Guildhall University)
For website see: www.woodgrove-tutorials.co.uk.
Cash flow is the life blood to all businesses especially new ones which are particularly cash sensitive.
It is important for a business to be able to project how its current cash resources will profile over a given
period. This forecast cannot be accurate because the various items which go to make up the cash budgets will
be based on estimates. However it is better to plan ahead than not to do so and, with experience predictions of
costs and revenues will become more accurate. The Cash Budget will identify when cash shortages may occur
and armed with this knowledge the owner of the business can make suitable arrangements. Specifically, this
can mean that the potential provider of Finance can be approached and a Finance facility arranged. The Lender
is sure to look more favourably on the request if it is supported by a professionally produced cash forecast for
the next (say) twelve months of trading.
Preparing the Cash Budget
It is important to always remember that the Cash Budget relates to the movement of cash. It differs from the
Profit and Loss Account insomuch as it is concerned with cash inflows and outflows. For example, if rates of
15,000 are paid for fifteen months the full cash outlay will appear in the Cash Budget whereas only 12,000
(the charge for the year) will appear in the Profit and Loss Account.
Another example is the acquisition of a fixed asset (say for 100,000). This will appear in the Cash Budget as
an item of outgo but in the Profit and Loss Account only the depreciation (say 10% x 100,000) charge will
appear.
Format of the Cash Budget
The Cash Budget should show:
(i) Opening Balance - available cash resources at the start of the period.
(ii) Receipts - from sales, investments, rent receivable etc on a month by month basis
(iii) Payments - to creditors for purchases, payments of all running expenses on a month by month basis.
(iv) Balance for the month i.e. the surplus of cash receipts over cash payments or the excess of payments over
receipts.
(v) Closing Balance i.e. the year to date cumulative balance existing at the end of each month which includes
all previous balances.
To illustrate the format an example of simple Cash Budget follows:
J. SMITH - CASH BUDGET FOR THE THREE MONTHS ENDING 31Dec.
Oct Nov Dec Total
Opening Balance 1,000 1,000

Receipts:-
Sales 4,000 5,000 8,000 17,000
Other 1,000 1,000 1,000 3,000

Total Receipts 5,000 6,000 9,000 21,000
Payments:-
Purchases (2,000) (3,000) (4,000) (9,000)

Rent (2,000) (2,000)
Wages (500) (500) (500) (1,500)
Office Expense (1,500) (1,500) (1,500) (4,500)
Purchase of a Fixed Asset (2,000)(2,000)
Total Payments (4,000)(9,000)(6,000)(19,000)
Monthly Balance 2,000 (3,000) 3,000 2,000
Closing Balance 2,000 (1,000) 2,000 2,000
Notes
(i) For month one the opening balance of 1,000 is included in the closing balance of 2,000. This comprises:-
Opening Balance 1,000

Receipts 5,000
Payments (4,000)
Closing Balance 2,000
(ii) The closing cumulative balance will, for month one, always be the same as the monthly balance because at
this stage the monthly and cumulative balances are the same as both represent the movement for the first
month. Thereafter the cumulative balance represents the balance after two months, three months etc etc.
(iii) All payments have been bracketed to highlight the fact that they are outgoings.
(iv) The total column is very important because it acts as a check on the final closing balance of 2,000. If the
balance in the total column came to anything other than 2,000 then an adding up error, either vertically or
horizontally, would have occurred.
Interpretation of the Cash Budget Statement

As stated earlier, the results shown by the statement are not actuals, they are the best guess of how financial
events will profile during the first three months of trading. The quality of the input reflects the quality of the
output. If correct and detailed research has been carried out then the result will be far closer to what will
actually happen. If projections have simply been thrown together without much thought or research then the
actual result will probably not resemble the Cash Budget predicted results.
If the Cash Budget has been carefully prepared and all known items of income and expenditure have been
included then the owner of the business can identify how and when cash shortfalls (or surpluses) will arise. For
example, in the above illustration the owner of the business can see that in month two (November) he expects
to be in an overdraft position. In anticipation of this he can approach his bank manager with his carefully
prepared cash flow projections and request an overdraft facility to tide him over the period when the cash
deficit occurs.
CASH BUDGETS - A fully worked example
The previous example illustrates the layout of the Cash Budget but it is too simplistic as it assumes that all
purchases and sales are on a strict cash basis. Also stock holdings are ignored. This represents an unlikely
business situation. A more comprehensive example now follows:-
A. Trader starts business on 1st Jan 2015 with 10,000 of his/her own money. A Trader also borrows 10,000
from a relative who wishes to help get the business up and running.
During the first five months of trading the purchases and sales were as follows:-
Purchases Sales
January 6,000 12,000

February 7,000 14,000
March 8,000 16,000
April 10,000 20,000
May 12,00024,000
43,00086,000
Notes
(i) All purchases and sales are on a credit basis with creditors allowing A. Trader one month credit and A.
Trader allowing their debtors two months credit, i.e. creditors are to be paid one month following the month of
purchase and debtors will pay two months following the month of sale.
(ii) A Trader allows debtors to take discount provided they pay within two months from the month of sale. The
total discount taken by the debtors is as follows:

March 1,000 (relating to sales made in January)
April 2,000 (relating to sales made in February)
May 2,000 (relating to sales made in March)
(iii) In addition to the purchases shown Mr Trader is to purchase (in January) an initial stock of 5,000. This
purchase is to be on the same basis as the main purchases. This stock is to be held in the business at a value of
5,000.
(iv) In March six months rent amounting to 6,000 is to be paid.
(v) In March a motor van is to be purchased for the business at a cost of 10,000. A Trader intends to
depreciate this asset over the next 50 months.
(vi) Wages are to be paid at the rate of 4,000 per month.
(vii) General expenses are to paid at a rate of 3,000 per month. These are to be paid in the month following
that during which they are incurred.
(viii) The owner of the business plans to take drawings of 1,000 per month.
Workings
Before preparing the Cash Budget it is worth working out the cash inflows and outflows in relation to sales and
purchases as follows:-
PURCHASES
Cash
Purchase Payments to Creditors at
Purchases of Stock Total Creditors 31st May
Month
January 6,000 5,000 11,000
February 7,000 7,000 11,000
March 8,000 8,000 7,000
April 10,000 10,000 8,000
May 12,00012,00010,000
43,0005,00048,00036,000 12,000 *
This represents the May creditors to be paid in June.*
SALES
Cash
Receipts
Discount Net amount from Debtors
Month Sales Allowed Due Debtors at 31st May
January 12,000 1,000 11,000

February 14,000 2,000 12,000
March 16,000 2,000 14,000 11,000
April 20,000 20,000 12,000
May 24,00024,00014,000
86,0005,00081,00037,00044,000**
**This represents the sales for April and May which are to be paid for in June and July respectively.
The Cash budget for the first 5 months of 2015 will appear as follows:-
January February March April May Total

Opening Balance 20,000 20,000
Receipts:
Debtors 11,000 12,000 14,000 37,000
Payments:
Creditors (11,000) (7,000) (8,000) (10,000) (36,000)
Rent (6,000) (6,000)
Motor van (10,000) (10,000)
Wages (4,000) (4,000) (4,000) (4,000) (4,000) (20,000)
General Expenses (3,000) (3,000) (3,000) (3,000) (12,000)
Drawings (1,000) (1,000) (1,000) (1,000) (1,000) (5,000)
Total payments (5,000) (19,000) (31,000) (16,000) (18,000) (89,000)
Monthly balance 15,000 (19,000) (20,000) (4,000) (4,000) -
Cumulative balance 15,000 (4,000) (24,000) (28,000) (32,000) (32,000)
The cash budget shows that the overdraft peaks at 32,000 in May 2015 and would start to reduce in
subsequent months as sales build up and the differential between the lead time taken to receive money from
debtors (two months) and that taken to pay creditors (one month) is made up by the gross profit margin. The
gross profit margin means the mark up that the trader makes on his purchases. The total purchases (excluding
stock) cost 43,000 but have a sales value of 81,000 after allowing for discounts.
So in this instance Finance of at least 32,000 would need to be arranged and a repayment profile agreed with
the lender.
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A business needs to budget for the future. The reason for this is that by looking
ahead Management can identify likely events that may influence the profitability of
the business. Some of these predicted events will be within the Organisation i.e. the
decision to have a sales drive to promote flagging sales of a particular product,
launch of a new product, matters impacting expenses such as size of salary
increments or relocation of part of the operation to another part of the country.
Another class of events affecting the business will not be within its control and in some cases these will be
impossible to predict. Consequently, when they happen the budget will need to be changed to incorporate
them. Examples of just a few of these external factors are income or corporation tax rate changes, employer
national insurance rate changes, VAT rate changes, company mergers and acquisitions, new product launches
by competitors.
A budget will be prepared at the outset of the business but this needs to be revised each year using a formal
budgeting process. The methodology for this can be either top down or bottom up. Top down means that
the top Management of the Organisation decide the high level goals to be met for the coming year i.e. level of
sales, expenses and net profit. These goals will then be passed down the line to individual managers to prepare
the budgets for the specific areas under their control.
When all of the sub budgets are collated they will be adjusted to ensure that they reflect the original goals set
by the top Management of the Company.
Bottom up means that each line Manager will plan ahead for his or her specific area of responsibility and draw
up a budget in consultation with their fellow line Managers.
The budgets prepared by all of the line Managers will be aggregated and the consolidated results reviewed by
the Management of the Company.
Whichever method is used, and it may even be a combination of both of them, the process will be an iterative
one. There will be many versions of the budget as its highly unlikely that it will be right first time. Certain
parts of it may be acceptable i.e. correct level and distribution of sales but other segments of the budget i.e.
expenses may not be as required and the line Manager(s) concerned will have to revisit and rework these.
The high level operating areas of the business will include the following: -
Sales
Cost of sales
Gross profit margin
Overheads (administration and sales and marketing expenses)
Net profit
BUDGETS AND FORECASTS
Let us consider each of these in turn: -
Sales budget
This process will depend on the structure of the Organization. Suppose that Company X operates from a
single Head Office but sells just one product from two regional outlets then its sales budget may appear as
follows:
Region A - Sales budget for next year: -
Units Selling price Sales Value
Per Unit
Jan 2,000 20 40,000
Feb 1,000 20 20,000
March 4,000 21 84,000
April 7,000 22 154,000
May 3,000 21 63,000
June 2,000 20 40,000

July 1,500 19 28,500
Aug 1,500 19 28,500
Sept 1,500 19 28,500
Oct 2,000 20 40,000
Nov 4,000 21 84,000
Dec 8,000 23 184,000
Totals 37,500 794,500
Region B - Sales budget for next year: -
Units Selling price Sales Value
Per Unit
Jan 1,000 10 10,000
Feb 2,000 10 20,000
March 2,000 10 20,000
April 3,000 11 33,000
May 3,000 11 33,000
June 2,000 11 22,000
July 2,000 11 22,000

Aug 3,000 11 33,000
Sept 2,000 11 22,000
Oct 2,000 11 22,000
Nov 1,000 11 11,000
Dec 2,000 12 24,000
Totals 25,000 272,000
Note:
The demand for the product sold by Region 2 is expected to remain fairly flat but the demand for the product
sold by Region 1 is seasonal. Advertising campaigns in the spring and in November are expected to raise
demand for this product. In anticipation of this increased demand the selling price of the product will be
increased during periods of high demand.
The consolidated sales budget for Company X will be as follows: -
Sales Value
Jan 50,000
Feb 40,000
March 104,000
April 187,000
May 96,000
June 62,000
July 50,500
Aug 61,500
Sept 50,500
Oct 62,000
Nov 95,000
Dec 208,000
Totals 1,066,500
This budget would be agreed with those actually responsible for meeting the sales targets. If they do not buy
into the budget at the outset then there will be little chance of success, as they will perceive that the targets for
next year have simply been imposed on them.
Cost of Sales budget
Now that the Sales budgets have been set we need to turn to the cost of those sales. Let us suppose that
Company X does not manufacture the products, which it sells but buys them from a third party in their
completed state and sells them at a markup of 25%. (1/4) on cost. This equates to a mark up 33.3% (1/3) on
sales so we can work back to the cost per unit and compute the cost of sales budget for Company X as follows:
-
Sales Value Mark up @ Cost of sales
1/3 on sales (Sales less mark up)

value

Jan 50,000 16,666 33,334
Feb 40,000 13,333 26,667

March 104,000 34,667 69,333
April 187,000 62,333 124,667
May 96,000 32,000 64,000
June 62,000 20,667 41,333
July 50,500 16,833 33,667
Aug 61,500 20,500 41,000
Sept 50,500 16,833 33,667
Oct 62,000 20,667 41,333
Nov 95,000 31,667 63,333
Dec 208,000 69,333 138,667
Totals 1,066,500 355,499 711,001
Now that the cost of sales budget has been established this will need to be agreed with the Manager(s)
responsible for procuring the product to be sold.
Please note that if Company X were to manufacture its own product then budgets would be required for the
total cost of production. These would include all of the costs incurred in manufacturing the goods. Specifically
this would include budgets for:
Raw materials to be purchased

Wages of staff who are to work in the production process
Any other costs which have direct correlation with production
Stock levels
The above example assumes that the exact amount of units sold will be purchased.
In practice this may not be the case, as the business would hold stocks of each product at all times. If stock
levels were to remain constant then this would have no impact on the cost of sales budget. However, if stock
levels were to increase then additional purchases would need to be factored into the budget to cater for the
higher levels of stock to be held. On the other hand if stock levels were to be reduced then purchases of the
goods would need to be reduced as some of the stock could be released.
Expenses budget
Now that the sales and cost of sales budgets have been set the expected gross profit for Company X can be
determined. This would profile as follows: -
Total sales 1,066,500
Cost of sales 711,001
Gross profit 355,499
This is the estimated gross profit that is available to support the expenses of the Company. In this example
these expenses will fall into two categories administration and sales expenses. The two sales regions will
compute their sales expenses budgets. The administration side of the business will produce their budget. This
process can take the form of distributing expense budget packs to line managers giving detailed instructions as
to how they are to compute their budgets. This information pack will give information about various items
including:
Level of expected sales

Expected headcount for salaries calculation
Staff oncosts (benefits etc)
Inflation rate to be assumed
Any projects that are to be undertaken in order to achieve the goals of the
Company
A timetable should also be included to ensure timely completion of the expense packs. When completed for
each area of operation (sometimes called a cost centre) the budgets will need to be sent to a central point for
consolidation so it is vital that each cost centre Manager submits their budget to the central point by the agreed
deadline. Failure to do this will cause a delay in the whole process, as a complete expense budget cannot be
computed until all of the budget submissions have been received.
The expense budget is vital as it determines the net profit of the business. Now that the gross profit has been
established the net profit can be computed by deducting the expenses.
The expense budget for Company X could take the following format: -
a) Regional sales offices
000
Expense Jan Feb Mar Apr May Jun Jly Aug Sep Oct Nov Dec Total
Salaries 7 7 7 7 7 7 7 7 7 7 7 7 84
Oncosts 2 2 2 2 2 2 2 2 2 2 2 2 24
Rent 3 3 6
Advertising 3 3 3 3 12
Sales Promotion 7 7 6 10 30
Commission 2 4 4 2 2 2 2 2 2 2 4 5 33
Printing 3 3 6
Stationery 1 1 1 2 5
15 23 24 14 12 11 11 16 11 14 22 27 200
b) Head Office - administration
000
Expense Jan Feb Mar Apr May Jun Jly Aug Sep Oct Nov Dec Total
Salaries 12 12 12 12 12 12 12 12 12 12 12 12 144
Oncosts 3 3 3 3 3 3 3 3 3 3 3 3 36
Rent 6 6 12
Office 2 2 2 2 2 2 2 2 2 2 2 2 24
machinery
Employee 1 1 1 1 1 1 1 1 1 1 1 1 12
expenses
Computer 2 2 2 2 2 2 2 2 2 2 2 2 24
consumables
Printing 2 2 4
Stationery 1 1 1 1 1 1 1 1 1 1 1 1 12
Depreciation 2 2 2 2 2 2 2 2 2 2 2 2 24
Office 4 4 8
maintenance
29 23 23 29 23 23 23 29 23 29 23 23 300
The total expense budget for Company adds up to 500,000. This can now be entered into the budget profit
and loss account to give the following position:
Total sales 1,066,500
Cost of sales 355,499
Gross profit 711,001
Expenses 500,000
Net profit 211,001
Providing the Executive of Company X deem this profit to be a reasonable expectation of next years trading
position they will formally accept the budget. It is vital that all line Mangers are made aware of this decision so
that they all know exactly what targets are expected for the following year.
Monitoring the budget
The budget must serve as a tool to monitor operational progress. Matching actual performance against the
budget can attain this. Preparing a variance analysis report will do this. The report just needs to show the actual
results compared with the budget and the variance arising. If performance is worse than budget i.e. expenses
are over budget or sales are below budget then this gives rise to an adverse variance. If performance is better
than budget i.e. expenses are under budget or sales are over budget then this gives rise to a favourable
variance.
It does not always follow that an adverse variance is a measure of bad performance and a favourable variance
is an indication of good performance. For example if certain expenses are over budget this could be because
those expenses are related to sales and have increased as sales are over budget. Here we have a trade off in the
two variances. Further if sales are over budget this in itself is a good thing but it may just mean that the sales
targets were not realistic or could indicate that market trends are such that sales should be even higher and the
Organisation is not attaining its market share.
Whatever the reason for the variance the Manager(s) responsible for that particular segment of the budget must
investigate it. The level of investigation depends on the size of the variance.
Variance analysis reports must be produced on a timely basis and distributed to cost centres Managers for
action.
A variance report for Head Office expenses for the first quarter of the year is as follows: -
Head Office administration
000
Expense Jan Feb Mar First quarters First quarters First quarters
budget actual variance
Salaries 12 12 12 36 41 (5)
On costs 3 3 3 9 11 (2)
Rent 0 5 (5)
Office machinery 2 2 2 6 4 2
Employee expenses 1 1 1 3 4 (1)
Computer consumables 2 2 2 6 7 (1)
Printing 2 2 3 (1)
Stationery 1 1 1 3 1 2
Depreciation 2 2 2 6 6 0
Office maintenance 4 4 2 2
29 23 23 75 84 (9)
Note:
Brackets = adverse variance
This variance report would be sent to the line Manager(s) responsible for the control of expenses for their
particular area of operation. The Managers would be asked to explain the material variances in order that
corrective action can be taken.
Similar variance reports would be prepared for Sales and those responsible would be asked to explain the
variances.
The underlying reasons for the variances will give an input which will assist as part of the learning curve for
the preparation of the next budget therefore giving Managers a deeper understanding of the business
operations.
Fixed and flexible budgets

A fixed budget is set at the beginning of the year and is compared to actual results as they emerge during the
year. The limitation of this approach is that as the year progresses the budget assumptions may become out of
date.
A flexible budget is one, which is set at the beginning of the year but is flexed to incorporate changes that
arise as the year progresses. This type of budget has the advantage that it is always up to date. Consequently
when it is compared to actual results the variances arising are more meaningful.

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Financial Planning & Analysis - Budgeting & Forecasting

Financial, Regulatory or Management Reporting

Master Data Management

Fixed Assets Transaction Processing

The Difference Between Forecasting vs. Budgeting

Historical balance sheet, income statement, and performance ratios

Product pricing patterns against built-in drivers

A 3-year financial projection with automatic quarterly updates

Key financial ratio trends and risk analysis

Flexible Reporting Options

Drop down menus offer views of alternative time periods

Rolling Forecast. Part 2 What is a Rolling Forecast?

You get the idea.

Now, comparing these two calendars, whats different?

Part 3: Assessment of Rolling Forecast

Tags: ,bpm, Budget, budgeting, cpm, planning, rolling forecast

Four Types of Budgets

THE PURPOSES AND BENEFITS OF THE MASTER BUDGET

Integrates and Coordinates

Communicates and Motivates

Another purpose and benefit of the master budget is to provide a communication

Promotes Continuous Improvement

The planning process encourages management to consider alternatives that might

Facilitates Evaluation and Control

LIMITATIONS AND PROBLEMS

Budgeting includes a considerable amount of forecasting and this activity involves a

A third problem or limitation is that budgeting requires a considerable amount of time

Advantages and Disadvantages

Responsibility accounting has been an accepted part of traditional accounting control

An implicit assumption of responsibility accounting is that separating a company into

This harsh criticism of accounting control information leads us to a very important

PREPARING A MASTER BUDGET

THE OPERATING BUDGET

Preparing an Operating Budget is a sequential process of developing nine sub-

Developing a sales budget involves the following calculations:

Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)

The information needed to develop an equation for collections is provided by the

Preparing a production budget includes consideration of the desired inventory change

Units To Be Produced = Budgeted Unit Sales (from 1) + Desired Ending

3. DIRECT MATERIAL BUDGET

The direct materials budget includes five separate calculations.

a. Quantity of Material Needed for Production = (Units to be

b. Quantity of Material to be Purchased = Quantity of Material Needed for

This calculation is more involved than equation 3b appears to indicate because it

c. Budgeted Cost of Material Purchases = (Quantity of Material to be

d. Cost of Material Used = (Quantity needed for Production)(Budgeted Material

The information needed to determine budgeted cash payments is provided by

4. DIRECT LABOR BUDGET

b. Budgeted Direct Labor Cost = (D.L. Hours needed for Production)(Budgeted

5. THE FACTORY OVERHEAD BUDGET

The factory overhead budget is based on a flexible budget calculation as described in

a. Budgeted Factory Overhead Costs = Budgeted Fixed Overhead + (Budgeted

b. Cash Payments for Overhead = Budgeted Factory Overhead Cost -

Alternative Calculation for Budgeted Factory Overhead Costs

The alternative calculation for factory overhead costs is:

6. ENDING INVENTORY BUDGET

b. Budgeted or Standard Unit Cost = (Quantity of D.M. required per

c. Ending Finished Goods = (Desired Ending Finished Goods from 2)(Budgeted

7. COST OF GOODS SOLD BUDGET

a. Budgeted Total Manufacturing Cost = Cost of Direct Material Used (from

b. Budgeted Cost of Goods Sold = Budgeted Total Manufacturing Cost (from

Alternative Calculation for Budgeted Cost of Goods Sold

Budgeted Cost of Goods Sold = (Budgeted unit sales)(Budgeted unit cost)