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. 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. 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 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 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 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. Often budgets are developed so they can adjust for changes in the volume or activity and help management make decisions. 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. 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.
In order to handle changes that occur in the future, companies can also use a rolling budget , which is one that is continuously updated.
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 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. Each individual who exercises control over spending should have a budget specifying limits on that spending. Most organizations will create a master budget—whether that organization is large or small, public or private, or a merchandising, manufacturing, or service company.
A master budget is one that includes two areas, operational and financial, each of which has its own sub-budgets. The operating budget spans several areas that help plan and manage day-to-day business. The financial budget depicts the expectations for cash inflows and outflows, including cash payments for planned operations, the purchase or sale of assets, the payment or financing of loans, and changes in equity. Each of the sub-budgets is made up of separate but interrelated budgets, and the number and type of separate budgets will differ depending on the type and size of the organization.
For example, the sales budget predicts the sales expected for each quarter. The direct materials budget uses information from the sales budget to compute the number of units necessary for production.
This information is used in other budgets, such as the direct materials budget, which plans when materials will be purchased, how much will be purchased, and how much that material should cost.
You will review some specific examples of budgeting for direct materials in Prepare Operating Budgets. Figure shows how operating budgets and financial budgets are related within a master budget. The Role of Operating Budgets An operating budget consists of the sales budget, production budget, direct material budget, direct labor budget, and overhead budget.
A budget is a financial plan for the future concerning the revenues and costs of a business. However, a budget is about much more than just financial numbers. There are many management uses for budgets. For example, budgets are used to: Control income and expenditure the traditional use Establish priorities and set targets in numerical terms Provide direction and co-ordination, so that business objectives can be turned into practical reality Assign responsibilities to budget holders managers and allocate resources Communicate targets from management to employees Motivate staff Improve efficiency Monitor performance Whilst there are many uses of budgets, there are a set of guiding principles for good budgetary control in a business.
In an effective budget system: Managerial responsibilities are clearly defined — in particular the responsibility to adhere to their budgets Individual budgets lay down a plan of action Performance is monitored against the budget Corrective action is taken if results differ significantly from the budget Departures from budgets are permitted only after approval from senior management Unaccounted for variances are investigated.
Business Study Notes Budget. Our subjects Our Subjects. They may lack confidence in the way accounting figures are generated or may prefer a less formal communication and evaluation system. Often these fears are completely unfounded, but if employees believe these problems exist, it is difficult to accomplish the objectives of budgeting. Problems encountered with such imposed budgets have led accountants and management to adopt participatory budgeting.
Participatory budgeting means that all levels of management responsible for actual performance actively participate in setting operating goals for the coming period.
Managers and other employees are more likely to understand, accept, and pursue goals when they are involved in formulating them. Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not preparers.
They should be on hand during the preparation process to present and explain significant financial data. Accountants are responsible for designing meaningful budget reports. Also, accountants must continually strive to make the accounting system more responsive to managerial needs.
That responsiveness, in turn, increases confidence in the accounting system. Although many companies have used participatory budgeting successfully, it does not always work. Studies have shown that in many organizations, participation in the budget formulation failed to make employees more motivated to achieve budgeted goals.
Participation is not the answer to all the problems of budget preparation. However, it is one way to achieve better results in organizations that are receptive to the philosophy of participation. Skip to main content. Chapter 7: Budgeting. Search for:. Top management, then, must clearly state long-range goals and broad objectives.
These goals and objectives must be communicated throughout the organization. Long-range goals include the expected quality of products or services, growth rates in sales and earnings, and percentage-of-market targets.
Overemphasis on the mechanics of the budgeting process should be avoided. Employees are more likely to strive toward organizational goals if they participate in setting them and in preparing budgets.
Often, employees have significant information that could help in preparing a meaningful budget. Also, employees may be motivated to perform their own functions within budget constraints if they are committed to achieving organizational goals. Communicating results People should be promptly and clearly informed of their progress. Effective communication implies 1 timeliness, 2 reasonable accuracy, and 3 improved understanding.
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