Chapter 9

Budgeting systems

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 Outline
Strategic planning and budgeting
systems
Purposes of budgeting
Responsibility accounting
The annual budget: a planning tool
Budget processes
Behavioural consequences of budgeting
Zero-base budgeting and program
budgeting
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 Strategic planning and
budgeting systems
A budget is
A detailed plan of future operating activities
A financial model of future operations
A core component of an organisations
planning and control system
A critical way of providing information to
managers
Regarded as short-term planning, typically
for one year (cont.)

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 Strategic planning and
budgeting systems (cont.)
Strategic planning is long-term
planning usually undertaken by senior
managers
Decisions about corporate strategy
Decisions about business strategy
A time horizon of three or more years
Formulated in broad terms
Directly influences the formulation of
budgets
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 Purposes of budgeting
Planning
Expresses a plan of action in financial
terms
Facilitating communication and
coordination
Provides a formal mechanism to enable
communication and coordination
Allocating resources
Provides a way of allocating limited
(cont.)
resources among competing users
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 Purposes of budgeting (cont.)
Controlling profit and operations
The budget can serve as a benchmark
Evaluating performance and
providing incentives
Comparing actual results with a budget
helps managers evaluate performance
Achievement of budget targets may be
linked to the payment of cash rewards or
profit sharing

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 Responsibility accounting
Budgets usually reflect managers
areas of responsibility
Responsibility accounting
Managers are responsible for their area
of the business
Managers of various departments
Develop budget estimates for their area
of responsibility
They are then held responsible for
meeting those budget targets (cont.)

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Responsibility accounting (cont.)
Responsibility centres
A unit of the organisation whose
manager is held accountable for the
units activities and performance
Cost centre, revenue centre, profit
centre and investment centre
The type of responsibility centre
determines the type of financial results
for which a manager is held accountable

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The annual budget: a planning tool
The annual budget (or master budget) is
a comprehensive set of budgets that
covers all aspects of a firms activities
Consists of several interdependent budgets
Financial budgets
Operating budgets
Large organisations: comprehensive formal
processes
Smaller organisations: less formal processes
(cont.)

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 Components of the annual budget

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 The annual budget:
a planning tool (cont.)
Operating budgets
Sales budget
Various cost budgets
Financial budgets
Budgeted income statement
Budgeted balance sheet
Cash budgets
Capital expenditure budget
(cont.)

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 The annual budget:
a planning tool (cont.)
Budgets are developed for specific time
periods
Rolling budgets are continually updated
by adding a new time period and
dropping the period just completed
Budgets vary in their level of detail,
often dependent on the size and
complexity of the organisation

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 Strategic plans and budget
assumptions
Budgets commence with an
understanding of the strategy of the
organisation
The budget should support the
organisations strategic plans
The budget is based on assumptions
about the competitive and economic
environment
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 Operating budgets:
the sales budget
A detailed summary of estimated
sales units and revenues
Sales volume is based on the sales
forecast
Sales forecasting is a critical early
stage of the budgeting process
Market research may be used to
estimate sales volume, selling price,
(cont.)
etc.
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 Operating budgets:
the sales budget (cont.)
Relevant factors depend on the type of
industry and nature of the organisation
Internal factors: past sales levels, new
products planned, intended pricing policy,
and planned advertising and promotions
External factors: general economic trends,
specific industry trends, political and legal
events, expected activities of competitors
and customers

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Case 9.42 Sales budget
Sales increase 10%

December January February March 1st quarter

Total sales $400 000 $440 000 $484 000 $532 400 $1 456 400

Cash sales* 100 000 110 000 121 000 133 100 364 100

Credit sales 300 000 330 000 363 000 399 300 1 092 300

Sales budget:
* 25% of total sales.
75% of total sales.

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 Operating budgets:
the cost budget
Manufacturing firms
Production budget of direct materials,
direct labour and overheads
Budgets for selling and administrative
expenses
Retailers and wholesalers
Purchasing budget of goods purchased for
resale
Service firms
Costs incurred to provide services
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 Detail of operating budgets for a
manufacturing business

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Case 9.42 Purchase budget
December January February March 1st quarter
Budgeted cost of goods
sold $280 000 $308 000 $338 800 $372 680 $1 019 480
Add Desired ending
inventory 154 000 169 400 186 340 186 340** 186 340

Total goods needed 434 000 477 400 525 140 559 020 1 205 820
Less Expected beginning
inventory 140 000* 154 000 169 400 186 340 154 000

Purchases $294 000 $323 400 $355 740 $372 680 $1 051 820

* Equals December budgeted COGS 0.50.

** Since Aprils expected sales and cost of goods sold are the
same as the projections for March, the desired ending inventory for
March is the same as that for February.
The desired ending inventory for the quarter is equal to the
desired ending inventory on 31 March.

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 Financial budgets
The cash budget
Expected cash receipts and planned cash
payments for the budget period
Timing of all cash movements
Allows the business to plan its financial
resources
Capital expenditure budget
A plan for the acquisition of long-term
assets, such as buildings
May involve cash flows over many years
(cont.)
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Case 9.42 Cash receipt Budget
January February March 1st quarter

Cash sales $110 000 $121 000 $133 100 $364 100

Cash collections from credit sales

made during current month* 33 000 36 300 39 930 109 230
Cash collections from sales made
during preceding month 270 000 297 000 326 700 893 700

Total cash receipts $413 000 $454 300 $499 730 $1 367 030

Cash receipts budget:

* 10% of current months credit sales.
90% of previous months credit sales.

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 Case 9.42 Cash Payment Budget
January February March 1st quarter
Inventory purchases:
Cash payments for purchases during the
current month* $129 360 $142 296 $149 072 $ 420 728
Cash payments for purchases during the
preceding month 176 400 194 040 213 444 583 884
Total cash payments for inventory purchases $305 760 $336 336 $362 516 $1 004 612
Sales salaries 18 000 18 000 18 000 54 000
Advertising and promotion 19 000 19 000 19 000 57 000
Administrative salaries 21 000 21 000 21 000 63 000
Interest on borrowings** 15 000 0 0 15 000
Property taxes** 0 5 400 0 5 400
Sales commissions 4 400 4 840 5 324 14 564
Total cash payments for other expenses $ 77 400 $ 68 240 $ 63 324 $ 208 964
Total cash disbursements $383 160 $404 576 $425 840 $1 213 576
Other expenses:
* 40% of the current months purchases (Schedule 3).
60% of the prior months purchases (Schedule 3).
** Interest is paid every six months, on January 31 and July 31. Property taxes also are paid
every six months, on February 28 and August 31.
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Case 9.42 Summary Cash Budget
January February March 1st quarter
Cash receipts (from Schedule 2) $413 000 $454 300 $499 730 $1 367 030
Less: Cash disbursements (from (383 160) (404 576) (425 840) (1 213 576)
Schedule 4)
Change in cash balance during period
due to operations $ 29 840 $ 49 724 $ 73 890 $ 153 454
Sale of marketable securities (1 January) 15 000 15 000
Proceeds from bank loan (1 January) 100 000 100 000
Purchase of equipment (125 000) (125 000)
Repayment of bank loan (31 March) (100 000) (100 000)
Interest on bank loan* (1 250) (1 250)
Payment on dividends (50 000) (50 000)
Change in cash balance during 1st quarter $ (7 796)
Cash balance, Beginning 35,000 54,840 104,564 35 000
Cash balance, Endding 54,840 104,564 27,204 $ 27 204

* Interest on the bank loan = $100 000 5% per year year = $1 250.
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 Financial budgets (cont.)
Budgeted income statement
Shows expected revenues and planned
expenses for the budget period
Budgeted balance sheet
Shows expected assets and liabilities at
the end of the budget period
Both statements may be broken down
by quarter or month of the year

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Case 9.42 Analysis of short-term
needs

Projected cash balance as of 31 December $ 35 000

Less Minimum cash balance 25 000
Cash available for equipment purchases 10 000
Projected proceeds from sale of marketable securities 15 000
Cash available 25 000
Less Cost of investment in equipment 125 000
Required short term borrowing $(100 000 )

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Case 9.42 Income Statement
Universal Electronics Company
Budgeted Income Statement
for the first quarter
Sales revenue $1 456 400
Less Cost of goods sold 1 019 480
Gross margin 436 920
Less Other expenses
Sales salaries $63 000
Sales commissions 14 564
Advertising and promotion 48 000
Administrative salaries 63 000
Depreciation 75 000
Interest on borrowings 7 500
Interest on short-term bank loan 2 500
Property taxes 2 700
Total selling and administrative expenses 276 264
Net profit $ 160 656

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Case 9.42
Statement of Retained Earnings

Universal Electronics Company

Budgeted statement of retained earnings
for the first quarter
Retained earnings, 31 December $ 107 500
Add Net profit 160 656
Earnings available for distribution $268 156
Less Dividends 50 000
Retained earnings, 31 March $ 218 156

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Case 9.42 Balance Sheet
Universal Electronics Company
Budgeted Balance Sheet
31 March
Cash $ 25 954
Accounts receivable* 359 370
Inventory 186 340
Buildings and equipment (net of accumulated depreciation) 676 000
Total assets $1 247 664
Accounts payable** $ 223 608
Interest payable on borrowings 5 000
Property taxes payable 900
Long term borrowings 300 000
Share capital 500 000
Retained earnings 218 156
Total liabilities and shareholders equity $1 247 664
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Case 9.42 Balance Sheet
* Accounts receivable, 31 December $ 270 000
Add Sales on credit (Schedule 1) 1 092 300
Less Total cash collections from credit sales ($109 230 + $893 700)
(1 002 930
)
Accounts receivable, 31 March $ 359 370
Buildings and equipment (net), 31 December $ 626 000
Add Cost of equipment acquired 125 000
Less Depreciation expense for 1st quarter (75 000 )
Buildings and equipment (net), 31 March $ 676 000
** Accounts payable, 31 December $ 176 400
Add Purchases (Schedule 3) 1 051 820
Less Cash payments for purchases (Schedule 4) (1 004 612
)
Accounts payable, 31 March
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 Budgets in not-for-profit
organisations and
government agencies
Annual budget has many of same
components as for-profit organisation
No sales budget if services provided for no
charge
Service levels may drive the resources that
are needed and hence the cost budgets
Other revenue budgets may be estimated
Government grants, donations, sponsorships
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 Budgeting processes
In large organisations, formal processes are
often used to collect data
Budget administration often responsibility of
senior management
A budget manual communicates:
who is responsible for providing information
when the information is required
what form it will take
A budget committee may be appointed
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 Behavioural consequences
of budgeting
A budget affects virtually all staff in an
organisation
Individuals reactions to the budgeting
process may affect an organisations
effectiveness
Three main issues to consider
Participative budgeting
Budgetary slack
Budget difficulty
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 Participative budgeting
Where managers develop their own
initial budget estimates for their own
area of operations
Top-down budgeting is where senior
managers impose budget targets
Bottom-up budgeting is where lower
managerial and operations levels are
active in setting their own budgets
(cont.)

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 Participative budgeting (cont.)
Participative budgeting benefits
Encourages coordination and
communication between managers and
the wider organisation
Leads to more accurate budget
estimates
Leads to individuals identifying more
closely with the budget targets
(cont.)

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Participative budgeting (cont.)
Participative budgeting costs
Expensive and time-consuming
Can cause delays and indecisiveness
May aggravate differences and
disagreements
Provides opportunities for padding the
budgets
Employee empowerment is a wider
concept than budgetary participation
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 Padding the budget
Managers intentionally underestimate
revenues or overestimate costs
Budgetary slack
Difference between the (padded) estimated
revenue or cost projection and a realistic
estimate of revenue or cost
Reasons for padding the budget
Managers performance looks better when they
exceed their budget
A way of coping with uncertainty
To guard against initial budget requests being
cut back by senior management
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 Budget difficulty
Ensuring employees are motivated to
achieve the budget targets as their own
Achieving goal congruence
when the organisations goals coincide
with the individuals goals
Budgets should be set at a level that
provides challenge and stretch, but
are not unachievable
(cont.)

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 Budget difficulty (cont.)
Budget acceptance occurs when
Targets are developed with employees
participation
Targets are considered achievable
There is frequent feedback on
performance
Individuals are held responsible for
activities that are within their control
Achievement of targets is accompanied by
rewards that are valued
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 The effect of budget difficulty on
employee performance

Source: Emmanuel, Olley & Merchant (1990, p. 173)

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 Zero-base budgeting (ZBB)
Managers must justify each activity in
order to receive an allocation of
resources
Time-consuming and expensive to
implement
Not useful in identifying areas of
waste, redundant activities or ways to
improve performance
Can be too introspective
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 Program budgeting
Budgets prepared for individual
programs and program objectives
Control is achieved through
quantitative and qualitative
performance measures
Often associated with budgeting in
government departments
Focus is on outputs not inputs

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 Summary
Budgeting is a detailed plan summarising the
organisations financial activities
Five major purposes of a budgeting system are
planning
communication and coordination
allocating resources
controlling profit and operations
evaluating performance and providing incentives
Budgets are developed along responsibility
lines
Various formal budgeting systems
Budgeting can have behavioural implications
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