Budgeting

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States what is budgeting, its advantages, purpose, classification and scope, budget period, budget structure and responsibility for budgeting.

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Budgeting

  1. 1. BUDGETING COOP 4073 Cooperative Business Planning and Budgeting Submitted By: Bernard Arpilleda Judy Grace Barcarse Ma. Joana Barrion Abigail Espera Willesa Go Adrian Paolo Ruiz Submitted To: Prof. Al A. Fontamillas 2nd Semester, SY 2013-2014 BCFMA3-1
  2. 2. DEFINITION A budget (derived from old French word bougette, purse) is a quantified financial plan for a forthcoming accounting period. Budget is a detailed plan defining or outlining the sourcing and uses and financial and other resources of the company in a given period of time. This is the plan expressed in quantitative terms. Every organization or individual has to budget their scarce resources to make the best use of resources (time, money, and energy.) A budget is an important concept in microeconomics, which uses a budget line to illustrate the trade-offs between two or more goods. In other terms, a budget is an organizational plan stated in monetary terms. Budgeting is a necessary exercise in a business firm that should be performed in order to plan for the present and the future. Budgeting is the process of stating in quantitative terms their operations, usually in units and pesos and planned their organizational activities for a given period of time. Budgeting is the best approach to planning, controlling as well as cost reduction program of the company. ADVANTAGES OF BUDGETING  Budgeting forces managers to do better forecasting. Managers should be constantly scanning the business environment to spot changes that will impact the business. Vague generalizations about what the future may hold for the business are not good enough for assembling a budget. Managers must put their predictions into definite and concrete forecasts.  Budgeting motivates managers and employees by providing useful yardsticks for evaluating performance. The budgeting process can have a good motivational impact by involving managers in the budgeting process and by providing incentives to managers to strive for and achieve the business’s goals and objectives.  Budgets provide useful information for superiors to evaluate the performance of managers and can be used to reward good results. You can work with
  3. 3. employees to set up their goals for a budgeting period, and possibly also tie bonuses or other incentives to how they perform. You can then create budget versus actual reports to give employees feedback regarding how they are progressing toward their goals. This approach is most common with financial goals, though operational goals (such as reducing the product rework rate) can also be added to the budget for performance appraisal purposes. This system of evaluation is called responsibility accounting. For example, budgets supply baseline financial information for incentive compensation plans. And the profit plan (budget) for the year can be used to award year-end bonuses according to whether designated goals were achieved.  Budgeting can assist in the communication between different levels of management. Putting plans and expectations in black and white in budgeted financial statements — including definite numbers for forecasts and goals — minimizes confusion and creates a kind of common language. Well-crafted budgets can definitely help the communication process.  Budgeting is essential in writing a business plan. New and emerging businesses need to present a convincing business plan when raising capital. Because these businesses may have little or no history, the managers and owners must demonstrate convincingly that the company has a clear strategy and a realistic plan to make profit. A coherent, realistic budget forecast is an essential component of a business plan.  Planning orientation. The process of creating budget takes management away from its short-term, day-to-day management of the business and forces it to think longer-term. This is the chief goal of budgeting, even if management does not succeed in meeting its goals as outlined in the budget - at least it is thinking about the company's competitive and financial position and how to improve it.  Provide structure. A budget is especially useful for giving a company guidance regarding the direction in which it is supposed to be going. Thus, it forms the basis for planning what to do next. A CEO would be well advised to impose a budget on a company that does not have a good sense of direction. Of course, a budget will not provide much structure if the CEO promptly files away the budget and does not review it again until the next year. A budget only provides a significant amount of
  4. 4. structure when management refers to it constantly, and judges employee performance based on the expectations outlined within it.  Model scenarios. If a company is faced with a number of possible paths down which it can travel, you can create a set of budgets, each based on different scenarios, to estimate the financial results of each strategic direction.  Profitability review. It is easy to lose sight of where a company is making most of its money, during the scramble of day-to-day management. A properly structured budget points out what aspects of the business produce money and which ones use it, which forces management to consider whether it should drop some parts of the business, or expand in others. However, this advantage only applies to a budget sufficiently detailed to describe profits at the product, product line, or business unit level.  Assumptions review. The budgeting process forces management to think about why the company is in business, as well as its key assumptions about its business environment. A periodic re-evaluation of these issues may result in altered assumptions, which may in turn alter the way in which managements decides to operate the business.  Funding planning. A properly structured budget should derive the amount of cash that will be spun off or which will be needed to support operations. This information is used by the treasurer to plan for the company's funding needs.  Predict cash flows. Companies that are growing rapidly, have seasonal sales, or which have irregular sales patterns have a difficult time estimating how much cash they are likely to require in the near term, which results in periodic cash-related crises. A budget is useful for predicting cash flows in the short term, but yields increasingly unreliable results further into the future.  Cash allocation. There is only a limited amount of cash available to invest in fixed assets and working capital, and the budgeting process forces management to decide which assets are most worth investing in.  Bottleneck analysis. Nearly every company has a bottleneck somewhere, and the budgeting process can be used to concentrate on what can be done to either expand the capacity of that bottleneck or to shift work around it.
  5. 5.  Cost reduction analysis. A company that has a strong system in place for continual cost reduction can use a budget to designate cost reduction targets that it wishes to pursue.  Shareholder communications. Large investors may want a benchmark against which they can measure the company’s progress. Even if a company chooses not to lend much credence to its own budget, it may still be valuable to construct a conservative budget to share with investors. The same argument holds true for lenders, who may want to see a budget versus actual results comparison from time to time.  Price Setting. Market conditions such as your competitors’ prices aren’t the only parameters you need to set your fees, rates and prices. You must know your manufacturing and overhead costs before you set your prices. A budget lets you project your utility, health care, marketing, rent, wages, debt service and other costs so you can learn the true cost per unit of making your products or delivering your service. Once you know this, you can set your prices to make the profit you want. If this price is too high for you to be competitive in your marketplace, you can use your budget to identify areas where you can reduce your costs.  Capital and Credit Procurement. Few venture capitalists, banks, suppliers or other lenders will give you money or credit unless you have financial data to demonstrate you are a going concern. Unless you have assets you can use as collateral, you’ll need to show financial statements that prove you are stable. If you are a new business, or are expanding, a budget will show potential partners how their participation will affect your sales and profits.  Flexibility. A budget lets you track your business’ performance throughout the year, allowing you to make necessary changes to rein in costs or increase spending to take advantage of growth opportunities. If your marketing is effective, a budget will let you know if you have funds available to increase your advertising to grow your sales. If your sales are slow, a budget identifies areas where you can cut discretionary costs to make you more competitive or tide you through slow periods.
  6. 6. PURPOSE OF BUDGETING  Planning First and foremost, a business budget is a planning tool. It allows businesses to attain their goals through planning how to use revenue and expenses. Businesses should use budgeting to look back at previous time periods and to look forward at future time periods. A business’s master budget is a plan of financial activities involving assets, liabilities, equity, revenue, expenses, and costs for a given time period. Owners first develop a master or static budget with the numbers based on the planned inputs (sales revenue) and outputs (expenses) for the firm. Think of this in very simple terms. The owner is looking at what the firm will take in from sales revenue and what the firm will pay out in expenses. The budget is done for a specific period of time, perhaps a month, a quarter, or a year.  Control Businesses also use budgets for the purpose of control. If owners have a master budget to follow, then they can carefully control expenditures during the time period of the budget by comparing them to the master budget. Budgets help prevent overspending. The budget also gives the company a benchmark to use by which to evaluate the firm. Not only can expenditures be monitored, but so can revenue inputs. Budgets cannot always stay static or the same. There are times when expenditures must change from the budgeted amount and revenues will change from that which is forecasted. Budgets are not designed to stay the same. Business owners know when they are developed that there will be changes in just about every line item by the end of the time period. Budgets, however, give some guidelines to the firm and prescribe some sort of limits.  Motivation Budgeting helps to motivate managers and employees to strive to achieve budget goals.
  7. 7.  Evaluation of Performance Budgets are a valuable tool for owners to use to evaluate the performance of their firm at the end of the time period that the budget covers. Owners should look at actual expenses, for example, as compared to budgeted, or planned, expenditures. By doing this, the owner can see how much actual expenses varied from planned expenses in order to improve the budgeting process in the next time period. The same is true for the revenue side of the equation. Owners want to see if planned revenue equaled actual revenue as this will help them plan revenue inputs for the future.  Accountability It also helps co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments. In summary, the purpose of budgeting is tools: 1. Tools provide a forecast of revenues and expenditures, that is, construct a model of how a business might perform financially if certain strategies, events and plans are carried out. 2. Tools enable the actual financial operation of the business to be measured against the forecast. 3. Lastly, tools establish the cost constraint for a project, program, or operation. CLASSIFICATION AND SCOPE OF BUDGET Master Budget The master budget is also known as the financial plan. Master budgets form the basis of the control systems in organizations. The master budget may take the form of a profit and loss account and a balance sheet at the end of the budget period. It shows the gross and the net profits and the important accounting ratios. It has three components:
  8. 8. A. Capital budget. Capital budgeting is budgeting for the large expenses in a business firm. This is used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is the process of budgeting for obtaining, expanding, and replacing fixed assets. Doing a good job budgeting for fixed assets like buildings, equipment, tools, and other fixed assets that last more than one year is important simply because they last a long time. B. Cash Flow/ Cash Budget. This is a prediction of future cash receipts and expenditures for a particular time period. It usually covers a period in the short term future. The cash flow budget helps the business determine when income will be sufficient to cover expenses and when the company will need to seek outside financing. The cash flow budget is incredibly important for the business firm. It is a budget showing expected cash inflows (receipts) and cash outflows (expenses). The cash flow budget shows whether or not enough cash will be available to meet monthly expenses. If not, the cash flow budget shows how you can borrow if you don't have enough money to meet expenses and how you can invest if you have more money than you need in a given month. C. Operating Budget – This is the detailed schedule for each item in the operation of business (sales, production, purchases and operating expenses). A business's forecasted revenues along with forecasted expenses, usually for a period of one year or less. The operating budget is based primarily on the firm's sales forecast. It is a budget of sales revenue minus expenses and essentially ends up with gross profit. In the operating budget, you have to determine what you need in sales revenue to meet your expenses and achieve your profit goal.  Sales budget – or Sales Forecast, is the starting point of all operating budget. It is a detailed schedule showing the expected sales for the coming year. It shows both peso sales and units of products or level of services. It is used to create company sales goals.
  9. 9.  Revenue budget – consists of revenue receipts of government and the expenditure met from these revenues. Tax revenues are made up of taxes and other duties that the government levies.  Expenditure budget – includes spending data items; an estimate prepared for travel, utilities, office supplies, telephone, and many other common business expenses for a given period.  Production budget – starts with the sales budget's estimates of the total number of units projected to be sold to meet the sales goals, then translates this information into estimates of the cost of labor, material, and other expenses required to produce them. Production budget involves planning the level of production which in turn involves the answer to the following questions:  What is to be produced?  When is it to be produced?  How is it to be produced?  Where is it to be produced?  Marketing budget – an estimate of the funds needed for promotion, advertising, and public relations in order to market the product or service.  Project budget – a prediction of the costs associated with a particular company project. These costs include labor, materials, and other related expenses. The project budget is often broken down into specific tasks, with task budgets assigned to each. A cost estimate is used to establish a project budget.  Cost of Goods Sold budget – shows the total number of units sold and its average unit prices; includes direct labor and manufacturing overhead budgets for a manufacturing firm which are related to production budget.  Budgeted Income Statement – is prepared based on the detailed operating budgets and will show how profitable operations in the period. This will be used as the basis for evaluating the performance of the company by comparing the budget and the actual results at the end of each year.
  10. 10. BUDGETING PROCESS Sales Budget Production Budget Purchases Budget Cost of Goods Sold Budget Operating Expenses Budget Budgeted Statement of Income Budgeted Balance Sheet Cash Budgets Capital Budget s Ending- Inventory Budget OperatingBudget Financial Budget
  11. 11. BUDGET PERIOD Even though yearly budgets are the most commonly used, the length of time of a budget depends on its purpose and nature. A capital budget may extend for a couple of years if, for example, it entails building a warehouse. But, whether a budget is a capital or operating budget, they are usually broken down into smaller periods of time to better control their activities. Budget periods are usually years, quarters or months and directly link to the completion of specific portions of a project or activity.  Activity-based budget is the budget for the costs of individual activities. In activity-based budgeting, all costs are allocated to cost centers and then are assigned to activities. Products or customers are allocated the costs based on the amount of activity they consume. Activity-based budgets ensure cost reduction and performance improvement. As activity-based budgeting requires a new budgeting model, it requires careful planning and implementation.  Add-on budget is the budget based on the previous years’ budgets adjusted for current information. For example, add-on budgets can be adjusted for new levels of inflation, employee wage rates, or new requirements.  Bracket budget is the budget at higher and lower levels than the base estimate. Essentially bracket budgets are contingency expense plans for downside risks. For example, such budgets allow management to estimate an impact of decreased sales on earnings. In bracket budgeting, management identifies potential problems and acceptable profit. In this way, management can test different alternatives and improve planning process.  Continuous (rolling) budget is the budget revised on a regular basis. As the period ends, a new budget period is added. For example, the budget can be regularly extended for another month (or quarter) at the end of each month (or quarter). As the result, continuous budgets are based on the most recent information and ensure proper planning and performance. The drawback of continuous budgets is that they require continuous planning. Computer technology permits companies to employ continuous or perpetual budgets.
  12. 12. These budgets may be constantly updated to relate to the next 12 months or next 4 quarters, etc. as one period is completed, another is added to the forward looking budgetary information. This approach provides for continuous monitoring and planning and allows managers more insight and reaction time to adapt to changing conditions. An analogy might be made to driving. A bad driver might focus only on getting from one intersection to the next. A good driver will constantly monitor conditions well beyond the upcoming intersection, anticipating the need to change lanes as soon as distant events first cone into view.  Encumbrances. In working with budgets, especially budgets of governmental units, you may encounter an “encumbrance”. An encumbrance is a budgetary restriction occurring in advance of a related expenditure. The purpose of an encumbrance is to embark funds for a designated future purpose. For instance, a department may have $100,000 budgeted for office supplies for the upcoming year. However, the department may have already entered into a $500 per month contract for copy machine repair service. Although $100,000 is budgeted, the remaining free balance is only $94,000 because $6,000 has already been committed for the repair service. At any point in time, the total budget, minus actual expenditures, minus remaining encumbrances, would result in the residual free budget balance for the period.  Flexible Budgets. Flexible budgets relate anticipated expenses to observed revenue. To illustrate, if a business greatly exceeded the sales goal, it is reasonable to expect costs to also exceed planned levels. After all, some items like cost of sales, sales commissions, and shipping costs are directly related to volume. Failing to meet sales goals should be accompanied by a reduction in variable costs. A flexible budget is one that reflects expected costs as a function of business volume; when sales rise so do certain budgeted costs, and vice versa.  Incremental budget is the budget adjusted for incremental increases in terms of dollars or percentages. Historically incremental budgeting has been the most common budgeting method. It is based on the prior’s year expenditures. In incremental budgeting, each budget line receives the same increment (e.g., 10%
  13. 13. percent) increase or decrease for the next budget cycle. Projects can also be segregated in multiple increments, and each increment is then allocated labor and other resources to complete the project. Incremental budget are easy to prepare. However, they have multiple drawbacks. Incremental budgets are based on aggregate data. They might not match company’s targets. Incremental budgets can potentially cause over- or underfunding of certain areas.  Strategic budget is the budget adjusted for strategic planning. Strategic budgets are used under conditions of uncertainty or instability. Strategic budgeting is the mixture between the top-down approach – when top management allocates resources – and the bottom-up approach – when lower management participates in resource allocation.  Stretch budget is the budget based on sales and marketing forecasts that are higher than estimates. Stretch budgets are not used for estimating expenditures; expenses are estimated at the budget target. Stretch budgets can be too subjective or complex.  Supplemental budget is the budget for an area that is not included in the main (base) budget.  Target budget is the budget that matches major expenditures to company’s goals. RESPONSIBILITY FOR BUDGETING Operations and responsibilities are normally divided among different segments and managers. This introduces the concept of “responsibility accounting.” Under this concept, units and their managers are held accountable for transactions and events under their direct influence and control. Budgets should provide sufficient detail to reflect anticipated revenues and costs for each unit. This philosophy pushes the budget down to a personal level, and mitigates attempts to pass blame to others. Without the harsh reality of an enforced system of responsibility, an organization will quickly become less efficient. Deviations do not always suggest the need for imposition of penalties.
  14. 14. Poor management and bad execution are not the only reasons things don’t always go according to plan. But, deviations should be examined and unit managers need to explain/justify them. Budget Committee The budget committee is responsible for the over-all policy matters related to budgeting process. It is responsible in making the budget program and in coordinating with the preparation of the budget itself. It is usually composed of the president, vice presidents in charge of various functions. It resolves any difficulties or conflicts between the departments or segments of the organization. The budget committee approves the final budget and receives periodic reports on the progress of the company in attaining budgeted goals. Further, the budget committee is tasked to prepare the budget manual. Budget manual is the handbook where all rules, procedures, and policies are outlined. Contents of Budget Manual:  Objectives and policies of the enterprise  Definition of line of authority and responsibility  Functions and responsibilities of the budget committee and the budget officer  Time schedules for budget preparation  Instructions and forms to be used  Program for preparation of budgets  Procedures for obtaining approval  Forms, nature and responsibility for the preparation of the budget  Procedures for budgetary control and account codes in use Some Basic Factors to Consider in Preparing the Budget  Nature of demand for the product  Length of trade cycle  Length of production cycle  Functional area covered
  15. 15.  Need for control of operations  Time interval necessary for financing production well in advance of actual results  The accounting period Some Limitations of Budgeting  Accuracy of estimates. As budgets are prepared for the future, data are purely based on estimates and those estimates are the product of different bases on hand at present which may lead to some errors.  Adverse reactions from employees. People preparing the budget must consider the reasonable degree at achievability; otherwise, it may demoralize the concerns.  Amount of work used in developing good budget. As the budget has to be completed at a specified period, the time used may not be enough to come up with good estimates. BUDGET STRUCTURE The best kind of budget is the one that works. You can choose from three key approaches to developing a budget. Each has its advantages and disadvantages, and each approach can work well, although the pendulum is clearly swinging in favor of the bottom up approach.  Top down (or mandated budgets): Budgets are prepared by top management and imposed on the lower layers of the organization. They can cover sales goals, expenditure levels, guidelines for compensation, and more. Top down budgets clearly express the performance goals and expectations of top management, but can be unrealistic because they do not incorporate the input of the very people who implement them.  Bottom up (or participative budgets): Supervisors and middle managers prepare the budget for their units. These individual budgets are then grouped and regrouped to form a divisional budget with mid-level executives adding their input
  16. 16. along the way and then forward them up the chain of command for review and approval. These budgets tend to be more accurate and can have a positive impact on employee morale because employees assume an active role in providing financial input to the budgeting process.  Zero-based budgeting: Each manager prepares estimates of his or her proposed expenses for a specific period of time as though they were being performed for the first time. Zero is taken as the base and a budget is developed on the basis of likely activities for the future period. In other words, each activity starts from a budget base of zero. By starting from scratch at each budget cycle, managers are required to take a close look at all their expenses and justify them to top management, thereby minimizing waste.
  17. 17. REFERENCES Walther, L. M. & Skousen, C. J. (2009). Budgeting and decision making. USA: Ventus Publishing ApS. http://bizfinance.about.com/od/businessbudgeting/a/BusBudgets.htm http://bizfinance.about.com/od/glossary1/g/budgeting.htm http://en.wikipedia.org/wiki/Budget http://simplestudies.com/what-are-budget-types-in-accounting.html/page/2 http://smallbusiness.chron.com/advantages-budgeting-business-21740.html http://wiki.answers.com/Q/Classification_of_budgets?#slide2 http://www.accountingtools.com/questions-and-answers/what-are-the-advantages-of- budgeting.html http://www.accountingweb.com/blog-post/advantages-budgeting http://www.accountingtools.com/questions-and-answers/what-are-the-objectives-of- budgeting.html http://www.dummies.com/how-to/content/benefits-of-budgeting-that-relate-to-business- mana.html http://www.dummies.com/how-to/content/choosing-a-budget-method.html http://www.dummies.com/how-to/content/choosing-a-budget-method.html http://www.principlesofaccounting.com/chapter21/chapter21.html http://www.willamette.edu/~fthompso/pubfin/Responsibility_Budgeting.html http://yourbusiness.azcentral.com/length-normal-budget-period-6100.html

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