3.4 Budgeting

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Learning Outcome
Explain the importance of budgeting for organizations.

Calculate and interpret variances.

Analyze the role of budgets and variances in strategic planning.

The purpose of budgets is to plan and control what the business organization will do with its resources. Unlike the Cash Flow Forecast it is not a prediction but rather an indication of spending plans. The Budget is therefore a quantitative documentation of planned spending with the intention of coordinating all the needs of the organization represented by different departments and sectors generally within a one-year period. This is done in order to ensure improved productivity through the availability of resources. A family may prepare a budget in order to ensure that enough money is available to pay the bills, increase savings and plan for vacations. This planning is conceptually no different from what Governments do with revenue from taxes, except for the vacations!

In preparing the budget, information has to be collected on all the anticipated revenue from within the business organization. As you have already concluded, all the anticipated payments or costs must also be determined and included in the budget. Information is generally determined from past performance or historical records. These are therefore estimates of anticipated inflows and outflows.

The budget must be based on a given period of time, usually one-year, also known as the business organizations fiscal year. Most businesses divide the fiscal year into four quarters. Budgets that are valid only for the planned level of activity in a fixed period are referred to as Static Budgets. This period is known as the Budget Period and it must ensure that all the different divisions or departments and revenue generating or costing activities in the organization are represented in the process. For example, the Sales Budget will represent all the anticipated cash collections from sales, the Production Budget will represent items needed to be produced to meet sales requirements. In the event that there is a difference between the actual costs incurred during the period and the originally planned cost for the period, this difference is known as a budget variance. We will look at variances analysis shortly.

One of the key factors that point to the importance if a budget is in that they are beneficial in communicating the plans of management to the rest of the business. This serves to reassure personnel and create a sense of security. In addition, budgets serve to define goals and objectives thereby forcing managers to plan and think ahead. The process is likely to be conducted by a budget committee comprising of senior personnel.
Budgets can be divided into different types. The distinction between these types is the approach to planning.

· Flexible Budgets take into account how changes in activity affect costs. This approach therefore considers what the actual costs for the level of activity should be rather than from the budgeted costs.
· A Static Budget is prepared for a particular fiscal year and is only valid for the budgeted activity. If the level of activity changes the deficiencies would be self-evident.
· Objective Budgets are strategic in nature and focus on how to attain set goals. Objective budgets are aligned to the Business’ aims and goals.
· The Operating Budget is also referred to as a Profit, or Cash Budget. The primary concern of this type of budget is the allocation of scarce resources such as raw material and cash.
· Capital Budgets are budgets that are centered in planning capital spending and liquidity or cash in the Business. These budgets focus on a plan to finance long-term expenditures for fixed assets like facilities and equipment.
· Zero-based Budgeting is used where costs are not allocated in advance but cash is allocated on the basis of need and benefit to the business. Because of the inherent difficulties of knowing what resources are needed in advance, the type of Budget is based on evaluating the need at the time the allocation is desired.
The Cash Flow Forecast that we looked at earlier is one type of cash budget. Within the business organization, the first step is in the formulation of a Sales Budgets. The Production Budget in turn is prepared after the sales budget followed by a Direct Materials Budget. For our purposes in the IB Diploma Program, we do not need to focus on all the different forms of budgeting such as the Direct Labor Budget, the Sales and Administrative Budget, the Cash Budget and the Manufacturing Overhead Budget. For your general understanding, however, it is important to realize that all the aforementioned combine to form the Master Budget. The Master Budget therefore consists of all the separate budgets as a summary statement.
Variance analysis
Variance analysis is a complicated area of Managerial Accounting. Knowledge of specific budgets and variances, for example, sales, spending, efficiency, variable and fixed-overhead, volume or budget variances among others is not required of the IB Diploma student. However, we do need to understand the elementary underpinning of variance analysis.
A budget variance is the difference between the actual or current fixed overhead costs over specific period in time and the originally budgeted fixed overhead costs in the same time period. Take exceptional note here that we assume fixed costs because variable cost would require a very different computation.
The Budge Variance formula for Fixed Overhead costs is:
Budget Variance = Actual Fixed Overhead cost – Budgeted Fixed Overhead Costs

The variance therefore represents what should have been spent relative to how much was actually spent.

· Favorable variances are when the actual amount is less than the budgeted amount
· Unfavorable or Adverse variances are when the actual amount is more than the budgeted amount.

A variance that is unfavorable would imply that scarce resources must be redistributed because a shortage may exist. Consider the Working Capital requirements in the Business Organization. In the event that the Business suffers an unfavorable Budget Variance, it may not be able to meet its day-to-day operational requirements. With respect to strategic planning, unfavorable Budget variances would impede any progress towards set goals.

However, Budgets provide clearly defined targets for the business while delegating independence and responsibility to departments and personnel alike. On the other hand, inflexible Budgets can also prevent Business’ from attaining goals due to the inflexibility. In addition, because the data used to compile Budgets can only be historical, the accuracy of the estimate will always be a source of difficulty.

Sales Budget 2009











Figure 6.

1. Determine the Budget Variances for the above Sales Budget in Figure 6 .
2. Are results favorable or Adverse? What are the implications?
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