business budgeting 101, budgeting definition, basics, and best practices
Whether. We're talking about an individual, a family, or a large, organization. The, overall, purpose of a budget is to clearly, establish, a plan so that performance. In relation to a goal or the plan can. Be carefully, monitored. Budgeting. Has a two-fold, purpose the. First purpose, is to allow individuals. Or companies to develop a plan to meet a specified, goal the. Second, purpose is to allow ongoing, comparison, between actual, results, and the plan now. The penalty for not budgeting, is severe, the list of companies that have failed in, recent years as a result, of poor planning and execution, is getting longer every day. Now. The basic, difference between companies. The budget, and those, that don't is that, those that budget will spend money how where. And when, they want to and those, that do not budget, often, feel like they never have enough money to purchase those, things that they need, now. Budgeting. Is critical, to the management planning process, there are two basic, types of planning, the. Long-run, planning, which includes strategic, planning and capital budgeting and short-run. Planning, which includes, production and process prioritizing. And operations. Budgeting, also, known as profit planning. Long-run. Planning, involves making strategic decisions. Where the effects will extend several. Years into the future. Long-run. Strategic, planning involves, identifying the organization's. Mission the. Goal is flowing, from that mission and the, strategies, and actions, that will be taken to accomplish, those goals. With. Strategic planning, in place the company can then plan for the purchase and use of major assets, like buildings, or equipment to, help the company meet its long-range goals, this. Type of planning is called capital, budgeting. Once. The organization's. Strategic decisions. Are in place. Managers. Are able to focus on operating, plans for the immediate month, quarter, and year, this. Short-run, operational. Planning can be divided into two categories first. Production. Prioritization. With. The capital, structure in place things, like land buildings, and equipment. Managers. To determine how to best use those committed, resources to, maximize profits. Second. Is operations, budgeting, once, the organization, has established its. Production, priorities, managers. Are ready to go to this second, category of short-run planning, operations, budgeting, sometimes. Known as profit, plans, operations.
Budgets, Are used by managers, to establish, and communicate. Daily. Weekly. And monthly goals. For the organization. Budgeting. Is such an important, activity that. The top executives. Of most companies coordinate. And participate. In the process, large. Firms usually, establish. A budget committee which may include the vice president's, for sales production, purchasing. And Finance and the controller. Or chief financial officer. These. Executives. Work to implement, the organization, strategy, by coordinating. The preparation, of a detailed, budget in their area of responsibility and. Then. Together oversee. The integration, of a comprehensive master, budget for the firm, two. Important, issues faced, by executives. In the budgeting process are. First. Behavioral. Considerations. How, will the budget affect people, and second. Involvement. In preparing the budget who gets to help we. Will discuss these, two issues in the video that follows. You. Research. And experience, has shown that several, behavioral, factors determine. How successful the, budgeting process is, going to be first. The, process, must have the support of top management without, a clear, indication, from top management that. The budgeting, process is, important, to the organization. Managers. Will not be motivated to devote the time necessary to, formulate, an effective, and efficient, budget, second. Managers. And other employees, are more, motivated, to achieve budget. Goals that they understand. And help design for. This process, to work managers. Must, feel that their opinions, are respected, and given full consideration, in addition. When, internal, or external circumstances. Change all parties. Involved should discuss the necessary, budget adjustments. Generally. The, most effective, companies, are those that involve employees, in, the decision making process, however. Involving. A lot of employees adds significant. Time and cost, to the budgeting process. Third. Deviations. Or variances from. The budget must, be addressed by managers, in a positive, and constructive manner. Identifying. Deviations, from the plan is simply, a way to focus management's. Attention on areas, needing improvement. Unfortunately. Some. Managers, treat these deviations, as, an opportunity, to find fault and. Assigned blame to lower-level managers the. Result, is usually a loss of motivation, accompanied. By such, dysfunctional. Behavior as interdepartmental, bickering. Defensive. Attitudes, and overall, unethical, behavior, one. Output of upper level managers, using budgets, strictly, as a punishing, tool is budgetary, slack in the budget system that. Is a lower, level manager, intentionally. Creating, an easy budget, target that, he or she is certain, can be met, obviously. All these, behaviors, waste an organization's, resource and do, not contribute, to meeting its strategic, and operational, goals, a more. Useful reaction, to deviations, is to, focus, on actions, that need to be taken as one. CEO stated, quote, I never. Made a dime for the company by assessing blame, or firing, a manager if, I can provide help to a manager, to solve a problem though we, can see the benefit, in, administering. The budget process it is extremely. Important, that top management, not use the budget as a club, or a whipping, stick and again. We see, budgeting. Is as much about the people as, it, is about the numbers, the. Numbers help us achieve a goal but. Always remember. That the numbers themselves they're. Not the goal. The. Top-down approach, sometimes. Referred to as authoritative. Budgeting, is when. Top management. Prepares a firm-wide operations. Budget and distributes. It to the major segments, of the firm and then hopefully it trickles, down to each lower-level. Segment manager its. Proponents, argue, that only top, management. Notice the strategic, direction of the firm and is aware of all the external factors influencing. Its operations, further. Since. Top management, involves, only a few, people who have risen to positions, where they no longer have, special, interests, to protect, they. Are in the best position to efficiently, coordinate, the competing, needs of the segment's, well that makes some sense, the. Alternative, is the bottom-up, approach also. Known as participated. Budgeting, each.
Division, Manager, in a bottom-up, approach prepares. A budget, request for his or her segments these. Requests. Are combined. And reviewed, as they move up the organizational. Hierarchy with. Adjustments. Being made to coordinate, the needs and goals of individual. Units within the overall organization. Proponents. Of this approach, contend, that segment, managers, have the best information, on the products, or services they provide the. Customers, they serve and, the, technology. That is emerging they. Are therefore in, the best position, to identify segment, needs and to, weigh alternative. Courses of action and that, makes some sense as well more. Importantly managers. Who have a role in setting segment, goals are more, motivated to achieve these, goals it's. Also a good training for managers to develop their planning skills in preparation, for promotions, to positions, of greater authority. Naturally. The. Organization, also benefits. When its managers, are proficient in planning however the, bottom-up, approach is, very costly, and time intensive when compared, to the top-down approach also. In. Order to achieve personal goals. Participants. May also engage, in political maneuvering. That creates budgetary, slack or other problems. Because. Both the top-down and, the bottom-up, approach, are legitimate, approaches, most. Organizations. Use some combination of the two the. Budget committee members know the strategic, direction of the firm and the important, external, factors that affect it so they prepare, a set of planning, guidelines that. Are then communicated. To lower-level managers, these. Guidelines include, such things as, a forecast, of key economic, variables, and their potential impact on the firm plans. For introducing and advertising, new products, and some broad sales, targets, and resource allocations. With. These guidelines in, mind, lower-level. Managers then, prepare, their individual, budgets these. Budgets, are always reviewed. To be sure they are consistent. With the objectives of other segments, and of, the company as a whole as. The. Budget committee understands. That changes, to a manager's, budget should be made with great care any reasons. For changes, should, be substantial. And should. Be discussed, with the managers, involved the. Blending, of these two approaches, will vary among organizations, a smaller. Organization. With a few, management, levels will rely more on the top-down approach then, will a larger, organization. Top. Management, in smaller, organizations tends. To be more knowledgeable about, and more, involved, in the, operating details. You. The, master budget is the most detailed and most. Heavily used budget, in an organization. This, budget is an integrated, group of detailed, budgets that together constitute, the overall operating, investing. And financing, plans, for, a specific, time period the, flow of the preparation, of the individual, budgets within this master, budget Network works like this first. The, budgeting process should. Be based on the long-term, strategic goals, and plans of the company in fact, if there is no connection between the company's long-term strategic, plans, and the company's detail budgets then, the long-term strategic plans, are irrelevant another. May, be more positive way to say that same thing is that the detailed, budgets, within the master budget give, relevance, to the company's long-term strategic goals, now. In a manufacturing, firm, the, master budget begins, with a forecast, of sales the, sales forecast in connection. With the long-term strategic plan, leads, to the capital, budget or the plan for the purchase of long-term assets, the, label capital, expenditures, is given to purchases, of long-term operating, assets such, as land buildings. And equipment these, assets, are acquired to be used over the course of several years, there. Are several financial, models, used to make capital, budgeting decisions, a simple one is called payback period, and involves.
Computing How many years it will take to recover the initial investment cost net. Present value, or NPV analysis. Involves, comparing, the cost of the asset with. The value of the expected cash inflows, after. Adjusting for the time value of money the. Value of a long-term operating, asset can disappear instantly if events, lower, expectations. About the future cash inflows, that the asset can generate these. Computations. Are very interesting, but, unfortunately, are beyond the scope of this course, now. The sales forecast, also leads to the short term operational. Plans established, by top management once. The sales forecast or sales budget is created, the, budgeting, team in a manufacturing company splits, into two sub teams one. Of the sub teams will use the sales forecast to determine the detailed plan for production, the, production budget this. Team will consider the amount and timing of purchases, of raw materials, the, hiring needs for the production Labor's and the budget for the infrastructure, or overhead, costs, this, collection of production, budgets provide a numerical. Plan for what will happen inside the factory, or the production facility, at the, same time using that same sales, budget the other sub team uses, that sales budget to then construct, a budget for the activities that occur outside the, production facility, so. This selling, and administrative expense, budget, involves, the numerical, plan for the advertising, payments. To the sales team cost, of company headquarters, and so forth the. Capital, budget production. Budgets and selling, and administrative expense. Budget then come together in the construction, of additional budgets the, cash budget and the budgeted, or pro form of financial statements, preparation. Of the cash budget is discussed, later in this course the, construction, of the pro forma financial. Statements is unfortunately, outside, the scope of this course a formalized. Budgeting, activity, forces, management, to make many important, decisions that guide a company, towards its goals, decisions. Involving, scheduling, pricing. Borrowing. Investing, and cost control so we'll begin our master budget with perhaps its most important, budget component. The sales budget the sales budget always, begins the budgeting process and dries, many of the related budgets for example how, much inventory we make is a function, of how much we're going to sell how much inventory we determined to make then drives how much material we need to purchase how many workers we need to hire and so on remember, the term master budget is not just one budget it is a series of budgets, that taken. Together comprise, what is termed the master, budget the, master, budget starts, with a long term strategic plan, made, operational, this year with the sales budget for this year. The. First step in developing a master budget is to prepare a sales budget all the, other budgets, are developed from this sales budget. Projecting. Accurate, sales is very difficult, however because sales are a function of both uncontrollable. External, variables, such as customer, tastes and economic, conditions and controllable. Internal, variables, such as price sales. Effort and advertising. Expenditures, those. Uncontrollable. External, factors driving sales include the following first. There's the business environment which, includes current government, policies and law the status. Of the economy, demographics. Which are characteristics, of the population, such as age wealth, family, status and so forth and the, state of Technology, another.
External Factor customer, needs and taste with respect to the product or service being analyzed, and other substitute, products another, factor intensity, of the competition and possible. Barriers to market entry barriers. That can include technology copyrights. Government, contracts, reputation. Or large, sales volumes, that provide economies, of scale another. External factor seasonal, cycles, creating, abrupt changes, in sales demand due to holidays, or weather patterns, and finally. External. Factors such as unexpected, events droughts, hurricanes, earthquakes, no, analysis of these external variables, is accomplished, through research, and sales forecasting, techniques these. Techniques, may be as simple as having the sales staff ask major, customers, about their buying plans for the next year or as. Sophisticated, as, statistical. Market, research techniques, some. Firms use quantitative. Forecasting models. These range from simple growth rate trends derived from the past year sales to, complex, forecasting, models that attempt to measure the influence, of many economic and industry, variables, data. Used, to drive these analyses, are obtained from a variety of sources now, for most organizations, they, divide their yearly sales budget into monthly weekly, or even daily budgets. In order to plan production, schedules and cash flows more precisely now, regardless, of whether the budget is on a quarterly, or yearly basis. The concepts, are the same remember. The sales budget is the most difficult but the most important, budget in this entire, budgeting, process, if you, give an accountant, an accurate. Sales forecast. Or he can create a very useful set of budgets for you but. If the sales forecast, is inaccurate, even, the best accountant, in the world can't, generate. Good production budgets labor budgets, or cash budgets. After. The sales budget is completed, ii, detailed budget covers the number of units to be produced during the period three. Factors, need to be considered in, preparing, this production, budget first, the projected, sales volume, for the period second. The desired amount of ending inventory and, third the amount of inventory already.
On Hand in the beginning inventory, ending. Inventory is an important figure because management, wants enough units on hand to meet customer, demands but, not so many that unnecessary. Costs will be incurred because of excessive, inventory so, let's consider the question why does the manufacturer, want, ending inventory on. One, side what, if we run out of finished goods will have lost sales perhaps, now and forever will, also have lost reputation, but. On the other hand what, if we have too many finished, goods we'll, have excess, resources tied, up in inventory the. Inventory could, get old and obsolete eventually. Having to be sold at a loss. The. Next detailed budget to be prepared is the direct materials, budget this, budget helps management, schedule purchases, from suppliers, expected. Changes, in materials prices should definitely, be included, in the budget calculations. Similar. To the production budget shown earlier the materials purchases, budget is based on the level of production and on, the required level of ending inventories, the, materials purchases, budget is then adjusted for the beginning inventory expected. For each quarter like. The production budget the, desired level of ending inventory has a big impact, on the direct materials budget if management. Does not maintain sufficient materials. Then. The production process, could be held up if inventories. Are too high inventory. Investment and storage costs can get out of control. The. Fourth budget, in the manufacturing, section of the master budget is the direct labor budget the, $20, per hour wage rate must include the cost of fringe benefits such as the cost of sick leave vacation pay. Insurance, and so forth also. We need to include the employers, portion of any payroll taxes, here. We get a hint of how important, this detailed, budgeting process is for example what. If we are considering paying or laborers a higher effective wage this.
Budgeting, Process, allows the company to see the implications, of that wage increase, before implementing. The increase, management. Must plan so that's efficient but not excessive, labour is always available otherwise, the company is likely to suffer the high cost of frequent, hiring, firing, layoffs. And overtime, work, probably. Even more important, than the high cost of employee turnover however, is the feeling of demoralization, among. Employees that, lack of job security can cause now. You, can also start, to see how our cash budget is starting to come together this, is an important aspect of budgeting, both in a business, and in, your personal finances if you, are casual, about cash budgeting, you tend to remember all of the expected cash collections, but you forget some of the necessary cash, payments, a disciplined. Budgeting, process helps you to identify all, of the, budgeted cash payments, so we better keep going. The. Manufacturing. Overhead budget includes, all production. Costs, other than those for direct materials and direct labor because. Manufacturing, overhead is a major, element of total manufacturing costs in many organizations those. Organizations. That are able to effectively plan and control these costs have a significant, advantage in the marketplace in. Preparing, a manufacturing, overhead budget the first step is to estimate the annual variable, and fixed, manufacturing, overhead, costs to, keep things simple for our example we, will assume the variable overhead costs are to be allocated on the basis of direct labor hours that is those, overhead cost increase, in proportion to our direct labor cost this, makes sense more, direct labor-hours means the need for more electricity more, wear and tear on the equipment more need for supervisor, time and so forth. Remember. That when we were talking about the master budget I said that once the sales forecast or sales budget is created, the, budgeting, team and a manufacturing, company splits, into two sub teams one, of the sub teams will use the sales forecast to determine the detailed plan for production, the production budget this, team will consider the amount and timing of purchases, of raw materials, the hiring, needs for production Labor's and the budget for the infrastructure, or overhead, costs this collection, of production, budgets provides, a numerical, plan for what will happen inside, the factory, or the production, facility, the. Other sub team at the same time uses that same sales budget to then construct, a budget for the activities, that will occur outside, the production facility, so, this selling, and administrative expense. Budget involves, the numerical plan for the advertising, payments. To sales teams cost of company headquarters, and so forth the, selling, and administrative expense. Budget includes planned expenditures. For all areas, other than production, the. Cost of supplies used by the office staff the salaries, of the sales manager, and the, company president and the depreciation of, the administrator's, office building. Not the production facility all belong, in this category and. Because this budget covers several areas it is usually quite large and may be supported, by individual, budgets for specific, departments, within the selling, and administrative functions. Similar. To our approach with the manufacturing, overhead budget depreciation. Expense is eliminated. From the budgeted selling and administrative expenses, to, determine the expected quarterly cash payments, for those expenses. Although. The selling and administrative expense. Budget illustrated, here looks reasonably, simple it is often more complex in, actual practice rather. Than classifying, these costs based on their functions, salaries. Depreciation. And so forth as seen here we, often see in practice that these budgets, are divided, into multiple categories that, may emphasize how costs are related to important, functions in the organization such. As research, and development or R&D product. Or service design marketing. Distribution, and customer service, successful. Organizations, do this in writing, and they do it all the time budgeting. Is a critical, and important, part of an organization's. Long-term, survival, remember, running, an organization without. Using a budget is a very, exciting, exercise, from, one day the next you have no idea what's coming every, morning you wake up to a whole new collection of surprises, that's, one way to run an organization a different. Way is to spend some time carefully, constructing. A numerical, plan a budget yeah. They'll still be some surprises, but you will have a framework, a plan, a budget, within which to adapt, to those surprises. There. Are several similarities, in the budgeting process for, manufacturing, businesses, merchandising.
Companies And service companies, basically. The budgeting process involves. Budgeting, or forecasting. Revenues, and the cash that will be generated by those revenues, as well as budgeting. Expenses, and cash that will be paid for those expenses. Managers. Are always interested, in how much revenue and expense they will have during each budgeted, period and how much cash and other assets and liabilities, they will have at the end of each budgeted, period because. Merchandising. Companies buy products, rather than make them their, budgeting, process is less complicated, than the budgeting done by manufacturing. Companies however, the format, of the merchandise, company's purchases, budget would be very similar to the format of the manufacturing, company's production, budget by, combining expected, sales with, desired, ending inventory and, subtracting. The beginning inventory expected, to be on hand the merchandise, company will arrive. At the number of boats to be purchased, rather than produced for the period now. These labels, manufacturing. Company and merchandising. Company may seem a bit strange but. Let me convince you that you already understand, the distinction between the two a good. Example of a manufacturing, company is, General Motors General. Motors assembles, raw materials, employs, skilled, auto workers maintains, a large infrastructure. Of production facilities machinery, and supervisory, staff and actually makes cars, and trucks GM. Then sells those manufactured. Cars and trucks to automobile, dealerships, General. Motors makes, cars, and trucks it's a manufacturing company, in contrast. A merchandising. Company doesn't, make anything a good example is Walmart the, goods sold by Walmart are all made, by other companies Procter. & Gamble PepsiCo, Kraft Foods in Campbell Soup Walmart. Buys those completed, goods puts, them on the shelves and sells them Walmart. Doesn't make anything Walmart. Is a merchandising, company the. Master budgeting process for a merchandising, firm is much less complicated than that done for a manufacturing, firm. Merchandising. Companies replace four budgets the production, budget the direct materials budget the, direct labor budget and the manufacturing, overhead budget used, by manufacturing, firms with a single, budget the purchases, budget. The sales budget and the selling and administrative expense, budget are similar to those prepared for manufacturing, firms so, we won't discuss those budgets again. Each. Year, service, companies are becoming a larger, and larger percentage of the businesses, in the United States and worldwide, service. Companies differ from manufacturing. And merchandising, companies in that they provide services, to customers instead, of a product, some. Common, service businesses, are as follows there, are law accounting, and engineering, firms their doctors and dentists, hotels. And motels hunting. And fishing guide services. Automotive. Home and appliance repair services, internet. Providers, so, here's a thought question for you is McDonald's, a service business a merchandising. Business or a manufacturing. Business think. For a second and the. Answer is the McDonald's has elements of all three types of business, mcdonald's. Manufactures. The food that you buy so, there's an element of manufacturing. Mcdonald's. Provides a service because, they prepare, the food for you and deliver it in a rapid, ready-to-eat, fashion, there's an element of service, mcdonald's. Often sells toys and other items as part of its promotions, so mcdonald's, doesn't make these toys, therefore mcdonald's is a merchandising, company. Budgeting. For service firms is similar, to budgeting for manufacturing, firms in fact you, can think of a service, company as being the same as a manufacturing, company except. That the cost of materials is very low and the focus is on the labor and on, the infrastructure, support or overhead, costs as was.
The Case with both manufacturing. And merchandising, companies the, budgeting, process for, service firms begins, with a sales budget, the. Service firm does not require a production, budget service, firms sell intangible. Products such as physician, appointments, car repairs room, rentals or a monthly internet service that, can't be inventoried. Therefore, the sales volume determined, in the sales budget is the same as the production budget for that operating period. The. Cash budget which, shows expected. Cash receipts, and disbursements during. A period is, impacted. By all of, the preceding budgets in the master budget a. Detailed. Cash budget will point out when a company has excess cash to invest and when, it has to borrow funds this. Allows a firm to earn maximum, interest, on excess funds, and to, avoid the cost of unnecessary borrowing. The. Cash receipts, section, of a cash budget summarizes. All cash, expected. To flow into the business during the budget period, because. Many companies, generally extend credit to their customers, a lot. Of their sales are originally, recorded as accounts receivable, the collection. Of accounts receivable is a major, source, of cash and its, timing, is an important, consideration in, preparing, a cash budget. Now. In our example, we assume that all customers always pay wouldn't, that be nice in truth, some customers. Never pay and these, uncollectible. Accounts must. Be considered, when analyzing, estimated, cash collections, from our accounts receivable. Economic. Factors often, play a significant. Role in the timing, of the collection, of our accounts receivable, during. Recessionary, periods, customers. Often drag. Out their payments, much longer, than they would in prosperous, times and we need to factor that in. So. Far the, budgets, discussed, in this topic or static, budgets, that is they, are geared, to only one, level of sales activity, however, as hard. As companies try to predict sales volume, these, numbers, rarely, turn out to be exactly as, predicted in fact as there, are unexpected changes. In the economy. Technology. Or competitors. Actual. Sales can turn out to be very different from planned sales. This. Is a critical, issue since, sales budgets, are the key, input. In building, the rest of the operational, budgets. Therefore. The, budgets, need to be recomputed, based, on the actual, sales activity, this. Is the process, of creating a flexible, budget a. Flexible. Budget is much, more useful for control and performance, evaluation because, it is not confined, to one level of activity. Flexible. Budgets are dynamic, that is they, can be tailored to any level, of activity within a relevant range using. A flexible budget a manager. Can look at the actual, level of activity attained. And then determine, what, the cost should, have been for, that level of activity. You.