Chapter 6: Using Cost Data for Planning

Introduction

In the ongoing process of a company, plans are prepared at the beginning of each period and implied during the period.

In other words, managers use the plans as paths to follow, as well as control points to determine if they are on the route to their strategic goals or not.

Budgets as Planning Tools

For all companies, planning plays a crucial role. Managers mostly require a proposed plan to take action. Failure to plan may result in financial disaster. On the other hand, deciding on a movement requires both the prediction of results and preparation of necessary resources, which are generally measured in monetary terms.

Definition of Budget

Budget is a quantitative expression of the managements’ plans for a specific period of time, either in physical or financial terms or both.

The procedures applied to prepare the budgets, constitute the budgeting system. A well-established budget system primarily works for planning purposes.

Budgets for Planning

Management establishes organizational goals, which are the strategic objectives regarding the mission of the company, and develops strategic plans to achieve these goals.

Capital budgeting is the process of evaluating the feasibility of a project, using some indicators such as rate of return, the time needed to pay back, etc.

A master budget is the combination of operational and financial budgets covering all aspects of company’s operations for a period of time

Objectives and Benefits of Budgeting

Companies need plans to survive in the short-term and attain organizational goals in the long-term period.

Objectives of Budgeting

Managers prepare budgets with the objectives of;

1. allocating the company’s resources to each operation effectively,
2. communicating the objectives and goals to the subordinates,
3. motivating the superiors and subordinates towards the goals,
4. providing coordination among all divisions or employees,
5. comparing the actual and budgeted results, and take corrective actions, if necessary,
6. taking necessary precautions for the possible bottlenecks that the company may face in the following period.

Benefits of Budgeting

Benefits of budgeting can be explained as follows:

Efficient Resource Allocation: By preparing the budget, the required amount of all resources to use in operations can be predicted approximately, before the period begins.

Communication: Once the objectives are determined and the plans are prepared, management should ensure that all subordinates and superiors understand the objectives and the short-term plan.

Coordination: Since the organization of a company is a chain of operations, any inefficiency in a division affects the whole organization’s success.

Performance Evaluation: By determining goals for each division, the budget reveals targets for superiors or subordinates to meet during the budget period.

Time Management: Comparing the actual results with the targets does not help managers only with evaluating the performance, but also saves their time by identifying current and potential bottlenecks in operations.

Motivation: Providing reasonable targets to employees motivates them to work efficiently in order to attain the expected results.

Types of Budget

Classifications can be made in several aspects such as;

1. Time Coverage
2. Scope of Coverage
3. Level of Considering the Cost Behavior

Classification According to Time Covered

A well-organized decision by management consists of two planning phases.

Short-term budgets determine the goals to reach in the short-term period, which is usually a 12 months period.

Long-term budgets, on the other hand, are prepared considering the strategic goals and the mission of the company.

Classification According to the Scope of Coverage

Master budget; is the comprehensive set of schedules and budgets that covers all phases of the company’s operations and describes the company’s overall financial plans for the following period.

Operating budgets ; are the budgets that companies assign objectives for the income generating operations of the company, such as sales, production, operating activities, etc.

Financial budgets ; are the budgets representing the sources and uses of cash during the budget period, as well as the expected financial position as of the end of the period.

Functional Budgets; are the components of the master budget, and they are separately prepared for each process or department.

Classification According to Capacity Utilization

Static (Fixed) budgets; are the budgets, in which the predetermined sales levels are used in preparing the budgets

Flexible budgets; are prepared to prevent the unexpected effects of uncertainties in activity volumes, as opposed to static budgets.

Preparation of Budgets

Budgeting Process

The process starts with the formation of a budget committee. This committee is the highest-level authority on budgeting matters. A budget committee is made of Chief Executive Officer (CEO), Chief Financial Officer (CFO), vice presidents and heads of strategic business units.

The budget committee determines the budget period, which is usually considered as a fiscal year.

Preparing the Master Budget

At the beginning of the budgeting process, budget director alerts every division to the need for gathering information to help to make predictions about the future.

Sales Budget

The first budget to prepare in the budgeting process is the sales budget. It is the quantitative representation of the expected sales volume for the coming period in terms of both units and Turkish Liras.

Production Budget

Production budget represents the planned volume of production for the following year (or quarters).

If the company is a merchandising company, no production budget is prepared. Instead, merchandising companies prepare Merchandise Purchase Budget to identify the needed units of merchandise inventory to purchase during the year. The basic format of this budget is the same as the production budget, except that the bottom line represents “budgeted purchases”

Direct Materials Budget

Managers use production budgets to prepare plans for gathering the necessary resources for the budgeted production. One of those necessary resources is direct materials. Plans regarding the direct materials are prepared with the help of two budgets, which are;

1. Direct materials usage budget,
2. Direct materials purchase budget

Bill of materials is a kind of recipe for production. It identifies the use of direct materials in production,

including the sequence and required amount of materials to produce each finished unit.

Direct Labor Budget

The direct labor budget represents the number of hours and corresponding costs of direct labor needed for making the budgeted production.

Manufacturing Overhead Budget

Efficient management of overhead costs is also crucial for a company on the way to attaining the shortterm objectives. Managers should understand the nature of various activities that create indirect costs and assign cost drivers for those activities by establishing cause-and-effect relationships.

Ending Inventories Budget

Ending inventories budget provides an important input for the preparation of both pro forma balance sheet and cost of goods sold budget. However, in order to prepare this budget, production cost per unit for the period should be calculated at first.

Cost of Goods Sold Budget

Direct materials, direct labor and manufacturing overhead budgets together represent the total manufacturing cost expected for the following year

Operating Expenses Budget

In order to attain the short-term goals of the company, not only sales and production activities are considered. The efficiency of operating activities is also important, as they are part of operating income (because these activities incur in order to generate the sales of relevant periods). Thus, budgets for operating expenses are prepared for each period, stating the expected consumption of resources for these activities.

Budgeted Income Statement

Upon the completion of all revenue and expense related budgets, the budgeted income statement can be prepared. All the needed data for preparation is taken from previously prepared budgets (schedules).

Preparing the Financial Budget

With the preparation of operating budgets, expectations on sales and required amounts of resources for all operations are determined. By considering these figures, companies prepare financial budgets in order to prepare their financial infrastructures to meet the needs of the period and state the desired financial position at the end of the year.

Cash Budget

With the help of cash budget, managers may initiate financing plans before any possible shortfall, as well as planning investments in case of excess cash. Therefore, a profitable operating budget is not enough itself to go on business, the managers need also cash budget for planning the future operations.

Financial leverage, is the use of debt in financing the acquisition of new assets. By using debt financing, a return that is generated over equity is increased as well as the tax to pay decreases, because of interest expense.

Budgeted Balance Sheet

The budgeted (pro forma) balance sheet is constructed by using the information included in the current period-end balance sheet and the schedules of the master budget. It shows the desired financial position of the company at the end of the budgeting period after the short-term plans are implemented.

Alternative Budgeting Techniques

Over the years, budgeting techniques have taken different forms in order to improve the efficiency of planning and executing the operations.

As a philosophy of continuous improvement, it may be the best choice to apply kaizen budgeting instead of the other techniques.

Incremental Budgeting

In this easy-to-implement technique, what managers need to do is just adjusting the current year’s budget for small changes.

A common method for this is to adjust the current year’s items for inflation.

Zero-Based Budgeting (ZBB)

As opposed to traditional budgeting that starts with the current budget, zero-based budgeting requires managers to prepare the budget with zero-base, meaning that all items to be included in the following year’s budget should be analyzed and determined by considering only the next year’s operations.

Activity-Based Budgeting

By applying this technique, the budgeting process is saved from the chart of accounts structure (such as depreciation, marketing, salaries, etc.).

Kaizen Budgeting

With the kaizen budgets, expectations on continuous improvement are incorporated with the budgeting process. The required amounts of resources are adjusted every time according to the desired levels of efficiency and productivity. Kaizen budgeting approach is much more effective when combined with activity-based budgeting technique.

Behavioral Aspects of Budgeting

Although managers use the budgets in planning the activities and communicating the goals to subordinates or superiors, people behaviorally do not like budgets. Because budgets represent constraining effects and evaluations of their performances according to the budgeted targets threatens them.

Behavioral Issues of Budgeting

Some of the behavioral issues of budgeting are as follows:

Budgetary slack (padding the budget); is one of those behavioral issues, which states that managers consciously include higher expenditures and lower revenues than they actually believe will occur.

Goal congruence; is a term that states the consistency between the objectives of the organization and its subordinates is important to achieve the desired results.