Budgeting

The Basics of Budgeting

All companies – large and small – have limits on the amount of money or resources they can receive and pay out. How these resources are used to reach their goals and objectives must be planned. The quantitative plan estimating when and how much cash or other resources will be received and when and how the cash or other resources will be used is the budget. As you've learned, some of the benefits of budgeting include improved communication, planning, coordination, and evaluation.

All budgets are quantitative plans for the future and will be constructed based on the needs of the organization for which the budget is being created. Depending on the complexity, some budgets can take months or even years to develop. The most common time period covered by a budget is one year, although the time period may vary from strategic, long-term budgets to very detailed, short-term budgets. Generally, the closer the company is to the start of the budget's time period, the more detailed the budget becomes.

Management begins with a vision of the future. The long-term vision sets the direction of the company. The vision develops into goals and strategies that are built into the budget and are directly or indirectly reflected on the master budget.

The master budget has two major categories: the financial budget and the operating budget. The financial budget plans the use of assets and liabilities and results in a projected balance sheet. The operating budget helps plan future revenue and expenses and results in a projected income statement. The operating budget has several subsidiary budgets that all begin with projected sales. For example, management estimates sales for the upcoming few years. It then breaks down estimated sales into quarters, months, and weeks and prepares the sales budget. The sales budget is the foundation for other operating budgets. Management uses the number of units from the sales budget and the company's inventory policy to determine how many units need to be produced. This information in units and in dollars becomes the production budget.

The production budget is then broken up into budgets for materials, labor, and overhead, which use the standard quantity and standard price for raw materials that need to be purchased, the standard direct labor rate and the standard direct labor hours that need to be scheduled, and the standard costs for all other direct and indirect operating expenses. Companies use the historic quantities of the amount of material per unit and the hours of direct labor per unit to compute a standard used to estimate the quantity of materials and labor hours needed for the expected level of production. Current costs are used to develop standard costs for the price of materials, the direct labor rate, as well as an estimate of overhead costs.

The budget development process results in various budgets for various purposes, such as revenue, expenses, or units produced, but they all begin with a plan. To save time and eliminate unnecessary repetition, management often starts with the current year's budget and adjusts it to meet future needs.

There are various strategies companies use in adjusting the budget amounts and planning for the future. For example, budgets can be derived from a top-down approach or from a bottom-up approach. Figure 7.2 shows the general difference between the top-down approach and the bottom-up approach. The top-down approach typically begins with senior management. The goals, assumptions, and predicted revenue and expenses information are passed from the senior manager to middle managers, who further pass the information downward. Each department must then determine how it can allocate its expenses efficiently while still meeting the company goals. The benefit of this approach is that it ties in to the strategic plan and company goals. Another benefit of passing the amount of allowed expenses downward is that the final anticipated costs are reduced by the vetting (fact checking and information gathering) process.

In the top-down approach, management must devote attention to efficiently allocating resources to ensure that expenses are not padded to create budgetary slack. The drawback to this approach to budgeting is that the budget is prepared by individuals who are not familiar with specific operations and expenses to understand each department's nuances.

Figure 7.2 Top-Down versus Bottom-Up Approach to Budgeting. The top-down approach to budgeting starts with upper-level management, while the bottom-up approach starts with input from lower-level management.

The bottom-up approach (sometimes also named a self-imposed or participative budget) begins at the lowest level of the company. After senior management has communicated the expected departmental goals, the departments then plans and predicts their sales and estimates the amount of resources needed to reach these goals. This information is communicated to the supervisor, who then passes it on to upper levels of management. The advantages of this approach are that managers feel their work is valued and that knowledgeable individuals develop the budget with realistic numbers. Therefore, the budget is more likely to be attainable. The drawback is that managers may not fully understand or may misunderstand the strategic plan.

Other approaches in addition to the top-down and bottom-up approaches are a combination approach and the zero-based budgeting approach. In the combination approach, guidelines and targets are set at the top while the managers work to develop a budget within the targeted parameters.

Zero-based budgeting begins with zero dollars and then adds to the budget only revenues and expenses that can be supported or justified. Figure 7.3 illustrates the difference between traditional budget preparation and zero-based budgeting in a bottom-up budgeting scenario. The advantage to zero-based budgeting is that unnecessary expenses are eliminated because managers cannot justify them. The drawback is that every expense needs to be justified, including obvious ones, so it takes a lot of time to complete. A compromise tactic is to use a zero-based budgeting approach for certain expenses, like travel, that can be easily justified and linked to the company goals.

Figure 7.3 Comparison of Traditional Budgeting Process and Zero-Based Budgeting Process. In a bottom-up budgeting environment, the budget process begins with lower level or operational management. Under a traditional budgeting, last year's budget would be the starting point for creating the current budget. Under a zero-based budgeting approach, all budget numbers are derived newly each year or budget cycle.

Often budgets are developed so they can adjust for changes in the volume or activity and help management make decisions. Changes and challenges can affect the budget and have an impact on a company's plans. A flexible budget adjusts the cost of goods produced for varying levels of production and is more useful than a static budget, which remains at one amount regardless of the production level. A flexible budget is created at the end of the accounting period, whereas the static budget is created before the fiscal year begins.

Additionally Figure 7.4 shows a comparison of a static budget and a flexible budget for Bingo's Bags, a company that produces purses and backpacks. In the flexible budget, the budgeted costs are calculated with actual sales, whereas in the static budget, budgeted costs are calculated with budgeted sales. The flexible budget allows management to see what they would expect the budget to look like based on the actual sales and budgeted costs. Flexible budgets are addressed in greater detail in Prepare Flexible Budgets.

	Flexible budget			Static budget			Sales Volume Variance
	Budgeted Cost (A)	Actual Sales Volume (B)	Flexible Budget (A x B)	Budgeted Cost (C)	Budgeted Sales Volume (D)	Static Budget (C x D)	Flexible Budget - Static Budget (A x B) - (C x D)
Direct Materials
Backpacks	$5.720	71,600	$409,552	$5.720	72,000	$411,840	$ (2,288) F
Purses	7.460	37,000	276,020	7.460	35,000	261,100	14,920 U
Total direct materials cost			$685,572			$672,940	$12,632 U
Direct labor
Backpacks	$3.450	71,600	$247,020	$3.450	72,000	$248,400	$ (1,380) F
Purses	2.220	37,000	82,140	2.220	35,000	77,700	4,440 U
Total direct labor cost			$329,160			$326,100	$ 3,060 U
Variable Overhead (60% x Direct labor cost)
Backpacks	$2.130	71,600	$152,508	$2.130	72,000	$153,360	$ (852) F
Purses	1.820	37,000	67,340	1.820	35,000	63,700	3,640 U
Total variable overhead cost			$219,848			$217,060	$ 2,788 U

Figure 7.4 Comparison of a Flexible Budget and a Static Budget.

In order to handle changes that occur in the future, companies can also use a rolling budget, which is one that is continuously updated. While the company's goals may be multi-year, the rolling budget is adjusted monthly, and a new month is added as each month passes. Rolling budgets allow management to respond to changes in estimates or actual occurrences, but it also takes management away from other duties as it requires continual updating. Figure 7.5 shows an example of how a rolling quarterly budget would work. Notice that as one month rolls off (is completed) another month is added to the budget so that four quarters of a year are always presented.

Figure 7.5 Rolling Budget. In a quarterly operating budget, the budget always projects forward for four months, or one quarter.

Because budgets are used to evaluate a manager's performance as well as the company's, managers are responsible for specific expenses within their own budget. Each manager's performance is evaluated by how well he or she manages the revenues and expenses under his or her control. Each individual who exercises control over spending should have a budget specifying limits on that spending.