Budgeting introduction

8th April 2020 1 By indiafreenotes

Budgeting is the process of preparing detailed projections of future amounts. Companies often engage in two types of budgeting:

  • Operational budgeting, and
  • Capital budgeting

Examples of Operational Budgeting

In a business, the budgeting for operations will include preparing the following projections for the next accounting year:

  • Amounts for sales
  • Amounts for producing goods
  • Amounts for each department’s expenses
  • Summarizing the above budgets into a master budget or profit plan
  • Cash receipts and disbursements for a cash budget
  • Projected financial statements also referred to as pro-forma financial statements

Once prepared and approved, the budgeted amounts are used as a guide or road map in controlling the next year’s business activities.

Example of Capital Budgeting

Capital budgeting involves future projects which overlap several or many future accounting periods. Capital budgeting usually means listing each project along with its cash outlays and expected cash inflows for each year. The amounts should be discounted to their present values and also ranked by priority and profitability.

Once prepared, the capital budget provides a guide for investing in future fixed assets as well as arranging for the financing of the projects.

Approaches to budgeting process

Budgeting can be done in a variety of ways, and it is always a smart choice to be aware of more than just a single way of budgeting. However, two of the most important approaches to budgeting process are:

Top-Down Budget

In the top-down budgeting process, the primary input is made by the top-level executives of the business. The echelon of a certain organizational hierarchy lays down all the guidelines according to which budget will be made. They outline the financial goals that a budget should maintain. Moreover, guidelines related to sales budget, compensation, etc. are all given by the top management. The lower level management is given the least amount of participation in the budgeting process. They are only involved in executing these guidelines.

Bottom-Up Budget

The bottom-up approach to budgeting adopts a more inclusive approach towards the budgeting process. Although the upper-level management gives out the general guidelines related for a budget, however, employees and the lower management formulate these budgets. Each division of the organization forms its budget in accordance to the general guidelines. In the end, the budget of the entire organization is formed by combining the individual budgets of each division. The bottom-up approach for a budgeting process is highly inclusive in nature. The employees overall tend to be much more committed to working under the budget in this approach. This is due to the fact that employees have participated in drawing up a budget and therefore they know that the budget is very acceptable.

Components of budget

There are many divisions of an organization and therefore budgeting for each of the division is specific to its needs. When all the budgets of each division are combined, it results into the final budget, which is often referred to as the “Master Budget”. Various components of the budget are discussed as follows:

Sales Budget

Sales budget outlines the forecasted income stream of the business. It is usually the first budget to be prepared as the revenue generated will ultimately determine the level of expenditure. Under the sales budget, sales of the business are forecasted. Sales are forecasted in terms of sales volume and the sales revenue. The forecasting is done on the following basis:

  • Previous pattern of sales
  • Economic conditions e.g. rate of inflation, interest rate, exchange rate, economic growth rate
  • Political conditions
  • State of competition in the market
  • Other factors that can affect the sales e.g. technology, etc.

Production Budget

The production budget is of high importance in the overall budgeting process. It determines the number of units of a product that will be produced by the business. It also determines the cost at which the products have to be produced. Production budget is made according to the sales budget. Required sales units, opening inventory and required closing inventory are used to reach the number of units that have to be produced in a budgeted period.

Direct Material Purchases Budget

Direct materials, like the name suggests, are the ones that are being used directly in the production of goods. The budget related to direct material determines the amount and cost of these resources that will be required in the production activity.

Labor, Overhead, and SG&A Budget

Budgets related to labor, overhead and SG&A (selling, general and administrative) are prepared separately. They are then combined under a single head.

The direct labor budget is prepared. Labor that participates in the production process forms the direct labor cost. This budget is prepared according to the number of labor hours and the cost per hour.

Overheads are those costs that are not incurred directly in the production of goods, but are indispensable with regard to the production activity e.g. rent of the factory. The budget of the overhead cost is prepared in relation to the direct labor hours.

SG&A costs are incurred in order to conduct the day to day operations of a business. They consist of fixed and variable costs.

Cash Budget

Cash is known to have a similar importance to a business as blood has to body. No matter how successful a business is, if it runs out of cash, its survival is seriously jeopardized. In order to ensure smooth operations of the business, strong emphasis must be laid upon the development of cash budget. Cash budget helps to formulate in advance the payment and receipt cycles of the business and thus it ensures that cash is readily available to a business. By formulating cash budget, the business can keep track of its accounts receivables and accounts payable. In order to avoid shortage of cash, the business can arrange its credit plans related to accounts receivables and accounts payable accordingly.

Budgeted Financial Statements

Budgeted financial statements are prepared on the basis of each budget component. These budgeted financial statements are called pro forma financial statements. Through the budgeted financial statements, a business will be able to forecast its profits. Profit forecasting is important because it will determine the viability of carrying out the business.

Steps in the budgeting process

Budgeting is a detailed process with several intricate steps leading up to understanding it at large. A step-by-step guide to the budgeting process is given as below.

  1. Update budget assumptions

Budgets are always prepared on certain assumptions. Those assumptions could be related to the sales trends, cost trends or environmental conditions. Before embarking on preparing the budget, these assumptions must be thoroughly reviewed according to the recent environmental conditions.

  1. Note Available funding

Limited funding can greatly hinder the growth projects of the business. Therefore, in the preparation of budgets adequate attention has to be given to the available funding as the availability of investable funds will determine the initiation of viable projects.

  1. Step costing points

The business environment is subject to dynamism. Every day it is posed with challenges that can completely change its cost structure. Therefore, in the budgeting process certain factors that can affect the costing for the business should be closely considered. These factors should be identified beforehand in order to make the budget realistic.

  1. Create budget package

In budget package, previous standards related to the budgeting process are taken in order to formulate a budget for the current period. Previous standards are updated according to the recent environmental conditions. Budget package is a kind of outline according to which budget has to be prepared.

  1. Obtain revenue forecast

There is no denying the fact that sales budget is the most crucial budget of all. All the budgets are based on the sales budget. Furthermore, sales budget determines whether the business is generating enough revenue necessary for its survival. Therefore, adequate attention must be given to the preparation of sales budget by forecasting demand accurately.

  1. Obtain department budgets

The department budgets will help to reach a budgeted expenditure for the budgeted period. Each department will prepare its own budget and then all of them will be combined to become a part of the master budget.

  1. Validate compensation

Compensation plans are a significant component of the budgeting process. As compensation is subject to an annual increase, therefore, it should be prepared with great care. The approval for compensation increase should first be taken from the top management, and then it should be augmented in the budgeted compensation plans.

  1. Validate bonus plans

In order to maintain the morale of the employees, bonuses are frequently given to out motivated workers. Bonuses act as an appraisal method. Bonus announcements that are not considered in the budgeting process can create havoc in the profits of the business. Therefore, any bonus plans should be taken into consideration beforehand. The top management should be consulted for any bonus plans.

  1. Obtain capital budget requests

Capital expenditure ensures expansion of the business. It helps the business to avail the opportunities necessary for business growth. Any capital expenditure plans should be taken in advance, and they should be included in the budgeting process accordingly.

10. Update the budget model

Any changes in the assumptions of the budget model should be updated, and final budget should be prepared accordingly. A delay in this may lead to glitches later on that could cause confusion.

11. Review the budget

The budget should be reviewed thoroughly once it is prepared in order to correct any flaws. A little decimal placed wrongly can create quite an unbalance in the budget sheet.

12. Obtain approval

The budget should be presented to the top management. They will evaluate whether it has been prepared according to their requirements and finally l approve it if it does not need any changes.

13. Issue the budget

The budget should be formally issued after its approval. All the operations there and then will take place according to it.

Methods of Budgeting

  1. Incremental Budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget.  It is the most common method of budgeting because it is simple and easy to understand.  Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year.  However, there are some problems with using the method:

  • It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.
  • It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.
  • It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs. Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.
  1. Activity-Based Budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company.  For example, a company sets an output target of $100 million in revenues.  The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

  1. Value Proposition Budgeting

In value proposition budgeting, the budgeter considers the following questions:

  • Why is this amount included in the budget?
  • Does the item create value for customers, staff, or other stakeholders?
  • Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

  1. Zero-Based Budgeting

As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch.  Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs.  However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.