Budgeting - Explained
What is Budgeting?
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What is Budgeting?
A budget is a plan of the resources needed to achieve the organization’s goals.
Top Down and Bottom Up Budgets
Some companies prefer to take a “top-down” approach to budgeting, in which upper management establishes the budget with little input from other employees.
These budgets are imposed on the organization and do little to motivate employees or to gain acceptance by employees.
Successful companies approach budgeting from the bottom up. This requires the involvement of various employees within the organization, not just upper management.
Lower- level employees often know more about their functional areas than upper management, and they can be an excellent source of information for budgeting purposes.
Although getting input from employees throughout the organization can be time consuming, this approach tends to increase employee motivation and acceptance of the budget.
The Budgeting Process
The budgeting process starts with the sales budget.
Also, note Manufacturing companies tend to have more budget schedules than other types of organizations because their operations are more complex.
Once you understand budgeting in a manufacturing environment, you can easily modify the process to perform budgeting in other organizations.
The sales budget is an estimate of units of product the organization expects to sell times the expected sales price per unit.
This is perhaps the most important budget as it drives most of the other budgets.
Forecasting sales often involves extensive research and numerous sources.
Companies typically start with their sales staff since salespeople have daily contact with customers and direct information about customer demand.
Some companies pay for market trend data to learn about industry and product trends.
Many organizations hire market research consultants to obtain and review industry data and ultimately to predict customer demand.
Larger companies sometimes employ economists to develop sophisticated models used to project sales.
Smaller, less sophisticated organizations simply base their estimates on past trends.
The production budget is developed next and is based on sales budget projections. What is a production budget, and how is it prepared?
If the organization uses a just-in-time production system, where production occurs just in time to ship the products to the customer, units produced each quarter would be exactly the same as projected sales.
However, most companies maintain a certain level of finished goods inventory. Thus production is typically not the same as projected sales.
The production budget is an estimate of units to be produced and is based on sales projections plus an estimate of desired ending finished goods inventory less beginning finished goods inventory, as summarized in the following:
For the sake of simplicity, assume work-in-process inventory is insignificant, and therefore beginning and ending work-in-process inventory is zero.
Units to be produced = Expected sales in units + Desired units of ending inventory − Units in beginning inventory
Direct Materials Purchases Budget
The number of units of finished goods to be produced each quarter from the production budget is the starting point for the direct materials purchases budget.
The direct materials purchases budget is an estimate of raw materials needed to achieve a desired level of production.
Identify the finished units will be produced in the first quarter.
Establish a direct materials purchases budget that answers the questions: how many pounds of material must be purchased during the first quarter to achieve this production, and what is the cost of these materials?
This amount is labeled as materials needed in production in the direct materials purchases budget
Companies will have materials in beginning raw materials inventory and prefers to maintain a certain level of ending raw materials inventory.
Thus direct materials purchased is based on materials needed in production plus an estimate of desired ending raw materials inventory less beginning raw materials inventory.
We summarize this in the following equation.
Materials to be purchased = Materials needed in production + Desired materials in ending inventory − Materials in beginning inventory
Notice the similarity of this equation to the inventory equation presented earlier for the production budget.
To estimate the cost of purchasing the pounds of material, multiply the number of pounds to be purchased by the cost per pound.
Direct Labor Budget
The direct materials purchases budget is the first of three supporting budgets for production. The second is the direct labor budget.
The direct labor budget is an estimate of direct labor hours, and related costs, necessary to achieve a desired level of production.
This budget answers the questions: how many direct labor hours will be necessary to achieve this production, and what will this labor cost?
For example, assume it takes 0.10 direct labor hours (or 6 minutes) to produce 1 unit of product. Thus 4,080 hours of direct labor will be required to produce 40,800 units of product (= 40,800 finished units produced × 0.10 direct labor hours per unit).
Given an average hourly rate of $13, the direct labor cost for the first quarter totals $53,040 (= 4,080 hours × $13 per hour).
The production manager uses this information to ensure the appropriate number of employees is available to meet production goals.
Notice that the number of direct labor hours needed in production for the third quarter is significantly higher than each of the two previous quarters.
Again, this is why organizations prepare budgets: to plan for these types of events. Lynn will have to start planning for this spike in direct labor hours, either by asking employees to work overtime or by hiring additional employees.
Manufacturing Overhead Budget
The manufacturing overhead budget is the third of three supporting production budgets. What is a manufacturing overhead budget, and how is it prepared?
The manufacturing overhead budget is an estimate of all production costs, other than direct materials and direct labor, necessary to achieve a desired level of production.
Notice that overhead costs are separated into variable and fixed components.
Total overhead cost ÷ units to be produced for the year. Then, Deduct depreciation to get the actual cash payment for overhead.
By definition, total variable overhead costs change with changes in production and are calculated by multiplying units to be produced by the cost per unit.
Fixed costs generally do not change with changes in production and therefore remain the same each quarter.
(Note: In some situations, fixed overhead costs can change from one quarter to the next. For example, hiring additional salaried personnel during the year would increase fixed overhead costs, and purchasing equipment during the year would increase depreciation costs. In this example, we assume fixed overhead costs do not change during the year.)
Depreciation is deducted at the bottom of the manufacturing overhead budget to determine cash payments for overhead because depreciation is not a cash transaction.
We use this information later in the chapter for the cash budget.
Selling and Administrative Budget
Now that the sales and production-related budgets are complete, it is time to estimate selling and administrative costs.
The selling and administrative budget is an estimate of all operating costs other than production.
Many organizations may have variable and fixed costs in this budget, while others treat all selling and administrative costs as fixed costs.
Once again, depreciation is deducted at the bottom of this budget to determine cash payments for selling and administrative costs.
Deduct depreciation to get the actual cash payment for selling and administrative costs.
Budgeted Income Statement
Budgets completed to this point include sales, production, direct materials, direct labor, manufacturing overhead, and selling and administrative.
This is enough information to prepare the budgeted income statement.
The budgeted income statement is an estimate of the organization’s profit for a given budget period.
Most organizations prepare the budgeted income statement using the accrual basis of accounting: revenues are recorded when earned and expenses are recorded when incurred.
The first line in the budgeted income statement, sales, comes from the sales budget.
The next line, cost of goods sold, is calculated by multiplying unit sales by the cost per unit.
If the company uses full- absorption costing, all manufacturing costs related to goods sold are included (or fully absorbed) in cost of goods sold.
The third line, gross margin, is simply sales minus cost of goods sold.
The fourth line, selling and administrative costs, comes from the selling and administrative budget.
The bottom line of the budgeted income statement, net income, is gross margin minus selling and administrative costs.
Income tax expense is not included in this example for the sake of simplicity.
However, income taxes can significantly reduce projected net income and cash flows.
The budgeted income statement is perhaps the most carefully scrutinized component of the master budget.
The management and employees throughout the organization use this information for planning purposes and to evaluate company performance.
The board of directors and budget committee are responsible for approving the budget and often review periodic reports comparing actual net income to budgeted net income to determine if profit goals are being achieved.
Lenders and owners often review the budget to ensure the organization is on track to meet its goals.
The budgeted income statement answers the question: what profits does the organization expect to achieve?
After completing the budgeted income statement, only three budgets remain:
- the capital expenditures budget,
- the cash budget, and
- the budgeted balance sheet.
We discuss the capital expenditures budget next.
Capital Expenditures Budget
The capital expenditures budget is an estimate of the long-term assets to be purchased during the budget period.
This includes purchases of tangible long-term assets such as property, plant, and equipment, and intangible assets, such as patents, copyrights, and trademarks.
This budget can have a significant impact on cash flow and requires careful planning and analysis.
Because long-term asset purchases occur at the end of the year, depreciation will begin the following year.
Thus depreciation shown in the manufacturing overhead and selling and administrative budgets will not be affected until the following year.
The cash outlay required to make these purchases is reflected in the cash budget.
The cash budget is an estimate of the amount and timing of cash inflows and outflows for the budget period.
Although the budgeted income statement provides an estimate of profitability, it stops short of providing cash flow information.
A section of the cash budget will show when cash from sales will be received.
The cash budget has the following sections
- Cash collections from sales
- Cash payments for purchases of materials
- Other cash collections and payments
Amounts shown in parentheses represent cash outflows; amounts without parentheses represent cash inflows.
Does not include depreciation since depreciation expense does not involve a cash payment.
Excess of collections over payments = Cash collections from sales – Cash payments for materials purchases – Other cash payments.
Beginning cash balance = Cash balance at end of previous period. Balance for first quarter is given.
Ending cash balance = Excess of collections over payments for the quarter + Beginning cash balance.
Budgeted Balance Sheet
The budgeted balance sheet is the last piece of the budget process.
What is the budgeted balance sheet, and how is it prepared?
The budgeted balance sheet is an estimate of the ending balances for all balance sheet accounts.
Managers use this to assess the impact that budgeted sales and costs will have on the financial condition of the organization.
Budgeting in Merchandising Organizations
Merchandising organizations typically purchase finished goods and sell them to retail or wholesale customers. Because merchandisers do not produce goods, they do not use production or production-related budgets.
Direct materials are not needed, and all labor and overhead costs are included in the selling and administrative budget.
Master Budget Schedules for a Merchandising Organization
The most important aspect of budgeting for merchandising organizations is the merchandise purchases budget.
The merchandise purchases budget estimates the units of merchandise to be purchased and the cost per unit.
Much like the production budget for a manufacturing company, the merchandise purchases budget estimates units to be purchased (instead of units to be produced) and is based on sales projections, as well as an estimate of desired ending merchandise inventory less beginning merchandise inventory.
Budgeting in Service Organizations
Service organizations, such as architectural and accounting firms, provide services rather than tangible goods.
These organizations do not have raw materials, finished goods, or merchandise inventories, and therefore they do not have production or merchandise purchases budgets.
Instead, the focus is on projected sales revenue from services provided and the labor necessary to achieve sales revenue projections.
Service organizations must constantly estimate services to be provided and make sure labor force resources are available to meet customer demand.
Budgeting in Not-for-Profit Organizations
Not-for-profit organizations, such as school districts and charitable organizations, also use budgets for planning and control purposes.
The budgeting process in most not-for-profit organizations is critical because the approved budget often serves as the legal authority for expenditures.
Because not-for-profit organizations are very diverse in nature — it is difficult to generalize about which master budget components apply and which do not.
However, with an understanding of the budget components used by manufacturing, merchandising, and service organizations, one can establish a budgeting process for virtually any not-for-profit organization.
For an example of how one not-for-profit organization goes about the budgeting process, read .
For example, the committee responsible for ticket sales estimates sales revenue based on expected ticket sales times the average sales price.
Anticipated increases in sales price are considered in the sales budget.
Expenses are also budgeted based on last year’s actual results. Those requesting increases in budgeted expenditures must justify them.
Once the budget committee has balanced the budget, reviewed it for reasonableness, and approved it, it goes to the board of directors for approval.
The control phase of the budgeting process requires that all expenditures be in accordance with the budget.
A financial report comparing actual revenues and expenditures with budgeted revenues and expenditures is submitted to the board of directors monthly.
What is a Flexible Budget?
Organizations use a modified budget called a flexible budget. A flexible budget is simply a revised master budget based on the actual activity level. It represents what costs should be given a certain level of activity.
- Job Costing vs Process Costing
- Assign Overhead Costs to Products
- Plantwide Cost Allocation
- Department Cost Allocation
- Activity-Based Costing
- Weighted-Average Cost of Products
- Production Cost Report
- Fixed, Variable, and Mixed Cost Estimations
- Contribution Margin Income Statement
- Cost-Volume-Profit Analysis
- Margin of Safety
- Contribution Margin per Unit of Constraint
- Absorption Costing vs Variable Costing
- Differential Analysis and Decisions
- Cost Decisions for Joint Products
- Capital Budgeting
- Life Cycle Costing
- The Master Budget
- Activity-Based Budgeting
- Standard Costs
- Imputed Value
- Variance Analysis for Product Costs
- Absorption Pricing
- Price Variance
- Absorption Variance
- Responsibility Centers
- Comparing Segmented Income
- Using ROI to Evaluate Performance
- Using Residual Income to Evaluate Performance
- Use Economic Value Added to Evaluate Performance
- Transfer Pricing