Financial and management decisions summary
Chapter 7 Introduction to Budgets and Preparing the Master Budget.
When you have finished studying this chapter, you should be able to:
1. Explain how budgets facilitate planning and coordination.
2. Anticipate possible human relations problems caused by budgets.
3. Explain potentially dysfunctional incentives in the budget process.
4. Explain the difficulties of sales forecasting.
5. Explain the major features and advantages of a master budget.
6. Follow the principal steps in preparing a master budget.
7. Prepare the operating budget and the supporting schedules.
8. Prepare the financial budget.
9. Use a spreadsheet to develop a budget.
A budget is a quantitative expression of a plan of action that imposes the formal
structure of an organization. Managers use budgeting as an effective cost-
management tool. Budgets facilitate planning and coordination.
Advantages of budgeting:
1. Forces managers to think ahead by formalizing their responsibilities for
planning.
A manager should take planning into their daily business.
2. Provides opportunities for managers to re-evaluate existing activities and
evaluate possible new activities
- Zero-base budget = a budget that requires justification of expenditures
for every activity, including continuing activities.
→ a budget that starts all over again at a new year, including continuing
activities.
3. Aids managers in communicating objectives and coordinating actions
across the organization
Budgeting forces managers to communicate and coordinate their
department’s activities with those of other departments and the company
as a whole.
4. Provides benchmarks to evaluate subsequent performance
It is better to evaluate actual results than comparing with past
performance, as economic and technological conditions change fast.
Potential problems implementing budgets
1. Low levels of participation in the budget process and lack of acceptance of
responsibility for the final budget.
The main factors affecting budget acceptance are the:
1. perceived attitude of top management
2. level of participation in the budget process
3. degree of alignment between the budget and other performance goals.
Management should seek to create an environment where there is a true
two-way flow of information in the budget process so that lower level
managers and employees perceive that their input has a real effect on
budget outcomes. An environment where there is a two-way flow of
information reduces negative attitudes. Budgets created with the active
participation of all affected employees—called participative budgeting—
are generally more effective than budgets imposed on subordinates.
, -Participative budgeting = budgets formulated with the active participation
of all affected employees.
2. Incentives to lie and cheat in the budget process.
Message conveyed by the budget system may be misaligned with
incentives provided by the compensation system. Misalignment between
the performance goals stressed in budgets versus the performance
measures the company uses to reward employees and managers can also
limit the advantages of budgeting.
Dysfunctional incentives lead managers to make poor decisions.
Lying can arise if the budget process creates incentives to bias the budget
information.
-Budgetary Slack (budget padding) = the overstatement of budgeted
costs (or understatement of budgeted revenue) to create a goal that is
easier to achieve.
3. Difficulties in obtaining accurate sales forecasts.
Sales forecast = a prediction of sales under a given set of conditions.
Foundation of budgeting. Usually prepared under the direction of the
top sales executive.
Sales budget = the result of decisions to create conditions that will
generate a desired level of sales.
1. Past patterns of sales: Past experience combined with detailed past sales
by product line, geographic region, and type of customer can help predict future
sales.
2. Estimates made by the sales force: A company’s sales force is often the
best source of information about the desires and plans of customers.
3. General economic conditions: The financial press regularly publishes
predictions for many economic indicators, such as gross domestic product and
,industrial production indexes (local and foreign). Knowledge of how sales relate
to these indicators can aid sales forecasting.
4. Competitors’ actions: Sales depend on the strength and actions of
competitors. To forecast sales, a company should consider the likely strategies
and reactions of competitors, such as changes in their prices, product quality, or
services.
5. Changes in the firm’s prices: A company should consider the effects of
planned price changes on customer demand (see Chapter 5). Normally, lower
prices increase unit sales while higher prices decrease unit sales.
6. Changes in product mix: Changing the mix of products often can affect not
only sales levels but also overall contribution margin. Identifying the most
profitable products and devising methods to increase their sales is a key part of
successful management.
7. Market research studies: Some companies hire marketing experts to
gather information about market conditions and customer preferences. Such
information is useful to managers making sales forecasts and product-mix
decisions.
8. Advertising and sales promotion plans: Advertising and other promotional
costs affect sales levels. A sales forecast should be based on anticipated effects
of promotional activities.
Types of budgets
Strategic plan = a plan that sets the overall goals and objectives of the
organization.
Long-range plan = forecast for 5/10 years
, - Master budget = a detailed and comprehensive analysis of the first
year of the long-range plan. It quantifies targets for sales, purchases,
production, distribution, and financing in the form of forecasted
financial statements and supporting operating schedules.
➔ It summarizes the planned activities of all subunits of an
organization.
Sales, purchases, production, distribution
- Continuous budgets or rolling budgets are master budgets that
simply add a month (or quarter) in the future as they drop the month
(or quarter) just ended. In this way, budgeting becomes an ongoing
process instead of an annual exercise. Continuous budgets force
managers to always think about the next full year, not just the
remainder of the current fiscal year.
The sales budget is the starting point for budgeting because planned inventory
levels, purchases, and operating expenses all depend on the expected level of
sales. Cash collections from customers include the current month’s cash sales
plus collection of the previous month’s credit sales.
The elements of the purchases budget are tied together by a simple intuitive
identity that ignores minor complications such as returns and defects but relates
the fundamental uses of inventory to the sources: Inventory is either sold or
else carried over to the next period as ending inventory. Inventory comes from
either beginning inventory or purchases. Month-to-month changes in sales
volume and other cost-driver activities directly influence many operating
expenses.
Chapter 7 Introduction to Budgets and Preparing the Master Budget.
When you have finished studying this chapter, you should be able to:
1. Explain how budgets facilitate planning and coordination.
2. Anticipate possible human relations problems caused by budgets.
3. Explain potentially dysfunctional incentives in the budget process.
4. Explain the difficulties of sales forecasting.
5. Explain the major features and advantages of a master budget.
6. Follow the principal steps in preparing a master budget.
7. Prepare the operating budget and the supporting schedules.
8. Prepare the financial budget.
9. Use a spreadsheet to develop a budget.
A budget is a quantitative expression of a plan of action that imposes the formal
structure of an organization. Managers use budgeting as an effective cost-
management tool. Budgets facilitate planning and coordination.
Advantages of budgeting:
1. Forces managers to think ahead by formalizing their responsibilities for
planning.
A manager should take planning into their daily business.
2. Provides opportunities for managers to re-evaluate existing activities and
evaluate possible new activities
- Zero-base budget = a budget that requires justification of expenditures
for every activity, including continuing activities.
→ a budget that starts all over again at a new year, including continuing
activities.
3. Aids managers in communicating objectives and coordinating actions
across the organization
Budgeting forces managers to communicate and coordinate their
department’s activities with those of other departments and the company
as a whole.
4. Provides benchmarks to evaluate subsequent performance
It is better to evaluate actual results than comparing with past
performance, as economic and technological conditions change fast.
Potential problems implementing budgets
1. Low levels of participation in the budget process and lack of acceptance of
responsibility for the final budget.
The main factors affecting budget acceptance are the:
1. perceived attitude of top management
2. level of participation in the budget process
3. degree of alignment between the budget and other performance goals.
Management should seek to create an environment where there is a true
two-way flow of information in the budget process so that lower level
managers and employees perceive that their input has a real effect on
budget outcomes. An environment where there is a two-way flow of
information reduces negative attitudes. Budgets created with the active
participation of all affected employees—called participative budgeting—
are generally more effective than budgets imposed on subordinates.
, -Participative budgeting = budgets formulated with the active participation
of all affected employees.
2. Incentives to lie and cheat in the budget process.
Message conveyed by the budget system may be misaligned with
incentives provided by the compensation system. Misalignment between
the performance goals stressed in budgets versus the performance
measures the company uses to reward employees and managers can also
limit the advantages of budgeting.
Dysfunctional incentives lead managers to make poor decisions.
Lying can arise if the budget process creates incentives to bias the budget
information.
-Budgetary Slack (budget padding) = the overstatement of budgeted
costs (or understatement of budgeted revenue) to create a goal that is
easier to achieve.
3. Difficulties in obtaining accurate sales forecasts.
Sales forecast = a prediction of sales under a given set of conditions.
Foundation of budgeting. Usually prepared under the direction of the
top sales executive.
Sales budget = the result of decisions to create conditions that will
generate a desired level of sales.
1. Past patterns of sales: Past experience combined with detailed past sales
by product line, geographic region, and type of customer can help predict future
sales.
2. Estimates made by the sales force: A company’s sales force is often the
best source of information about the desires and plans of customers.
3. General economic conditions: The financial press regularly publishes
predictions for many economic indicators, such as gross domestic product and
,industrial production indexes (local and foreign). Knowledge of how sales relate
to these indicators can aid sales forecasting.
4. Competitors’ actions: Sales depend on the strength and actions of
competitors. To forecast sales, a company should consider the likely strategies
and reactions of competitors, such as changes in their prices, product quality, or
services.
5. Changes in the firm’s prices: A company should consider the effects of
planned price changes on customer demand (see Chapter 5). Normally, lower
prices increase unit sales while higher prices decrease unit sales.
6. Changes in product mix: Changing the mix of products often can affect not
only sales levels but also overall contribution margin. Identifying the most
profitable products and devising methods to increase their sales is a key part of
successful management.
7. Market research studies: Some companies hire marketing experts to
gather information about market conditions and customer preferences. Such
information is useful to managers making sales forecasts and product-mix
decisions.
8. Advertising and sales promotion plans: Advertising and other promotional
costs affect sales levels. A sales forecast should be based on anticipated effects
of promotional activities.
Types of budgets
Strategic plan = a plan that sets the overall goals and objectives of the
organization.
Long-range plan = forecast for 5/10 years
, - Master budget = a detailed and comprehensive analysis of the first
year of the long-range plan. It quantifies targets for sales, purchases,
production, distribution, and financing in the form of forecasted
financial statements and supporting operating schedules.
➔ It summarizes the planned activities of all subunits of an
organization.
Sales, purchases, production, distribution
- Continuous budgets or rolling budgets are master budgets that
simply add a month (or quarter) in the future as they drop the month
(or quarter) just ended. In this way, budgeting becomes an ongoing
process instead of an annual exercise. Continuous budgets force
managers to always think about the next full year, not just the
remainder of the current fiscal year.
The sales budget is the starting point for budgeting because planned inventory
levels, purchases, and operating expenses all depend on the expected level of
sales. Cash collections from customers include the current month’s cash sales
plus collection of the previous month’s credit sales.
The elements of the purchases budget are tied together by a simple intuitive
identity that ignores minor complications such as returns and defects but relates
the fundamental uses of inventory to the sources: Inventory is either sold or
else carried over to the next period as ending inventory. Inventory comes from
either beginning inventory or purchases. Month-to-month changes in sales
volume and other cost-driver activities directly influence many operating
expenses.
