A budget model for a small manufacturing firm.
But what is an operating budget? Basically, it is a plan of action stated in monetary terms and usually for a period of a year. Yearly budgets are often detailed by months or quarters. These budgets are based on agreed-upon objectives that have the approval of managers and higher authority. Eventually, actual performance is compared with the budget, and variances are computed and analyzed to determine the cause. If warranted, corrective action is immediately undertaken.
The advantages of a well prepared budget are numerous. Budgets provide a disciplined approach to managing because they force managers to plan ahead and coordinate their activities with those of other managers, and with the firm's goals and objectives. In addition, budgets pinpoint potential weaknesses and bottlenecks before they occur, forcing managers to address problem areas. They also help in directing capital and effort into a company's most profitable products. As a result, an atmosphere of cost-consciousness and profit-mindedness is developed. A comparison of actual costs with budget provides valuable information and helps determine where efficiencies as well as inefficiencies occur. The latter can be corrected, thus avoiding future unnecessary costs. A well managed budgeting system also motivates managers and employees to optimize performance, and can serve as a basis for distributing rewards. Clearly, however, budgets do not eliminate the administrative role of managers since budgets are not meant to be a rigid dictator of behavior. They serve only as a plan to achieve corporate goals.
No company, regardless of size, should operate without a budget. Obviously, the budget should have the solid backing of top management and be taken seriously by all employees. Large companies frequently have budget committees whose responsibilities include overseeing budget preparation and coordination. Such firms are likely to have the resources for sophisticated budgeting procedures, sound accounting and reporting, and corrective action programs, all time-phased and integrated in their overall planning and control system. Even though small firms may be lacking in resources, it is imperative that they also have a sound budgeting system. Therefore, the following is a relatively simple, low-cost budgeting model that a small manufacturing firm can utilize as a planning and control system.
A firm does not have one budget, rather it has a series of budgets which are coordinated into a package called the master budget. The master budget for a hypothetical firm is presented in Figure 1. This schematic demonstrates how the budgeting process begins with sales and ends with projected financial statements. All aspects of the individual budgets are tied together and coordinated with each other. Hence, even though some of the detail might be in units, the bottom line of each individual budget must be in dollars.
To the extent feasible, it is usually preferable for non-management employees to participate in establishing the budgets. Participative budgeting is based on the philosophy that motivation and acceptance of budgets are higher when individuals participate in the budgeting process. Still, the small firm CEO must resist the temptation of over-emphasizing participation, as the time, costs, and complexities of budget preparation can increase.
Review of current year's operation
Although much has been written about the advantages of zero-based budgeting, a small firm will usually rely heavily on past years' performance (including the current year) as the basis for its estimates. Since a two-to four-month time frame is needed to prepare a master budget, it is necessary to include in the year-to-date actual figures, a forecast for the remainder of the current year. Inefficiencies and non-recurring costs should be eliminated from past performance, and anticipated variables included before these numbers are appropriate for projection into the future. The update of the current period expectations should terminate with the three basic financial statements - Statement of Financial Position, Statement of Income, and Cash Flow Statement - in order that the firm has a close estimate of its expected position at year end.
Goals and strategies
Before detailed preparation of the budget begins, top management must establish the firm's primary goals, ranked in order of importance. If possible, these goals should be measurable. For example, a goal might be to increase sales by 3 percent. At the end of the period, a comparison of actual with budgeted sales will confirm if the 3 percent goal was met.
Next, strategies must be developed. How is the firm going to increase sales? Possible answers include price cutting, adding new customers, increasing promotions, and improving quality. Clearly, the strategies must be feasible and consistent with the managers' capabilities and the firm's environment.
Assumptions that support the goals and strategies must also be identified. These include such factors as: inflation rate; wage and material cost increases; lead time from suppliers; income tax rate; cost of borrowing; and collection and payment time periods. The goals, strategies, and assumptions should be agreed upon, or at least accepted as reasonable, by all those involved in the budgeting process. Now, work can commence with the individual budgets, starting with sales.
From the goals and strategies set for the budget year, the sales manager projects total sales and breaks the sales figures into the various types of products (by dollars and quantity), time-phased by months. The product mix is evaluated in order to achieve monthly targets as well as annual goals. In lieu of an arbitrary division of the annual sales goal by twelve months, cyclical sales patterns must be taken into consideration so that each month's sales figures reflect expected reality.
The sales manager is also responsible for the annual and monthly marketing expense budget. This schedule of expenses attributable to the sales department includes such expenses as travel and lodging, promotions, auto expenses, delivery charges, entertainment, and advertising. Of course, such projections must agree with the strategies adopted to achieve sales goals.
The sales budget is now forwarded to the production manager who is responsible for the following budgets:
* Production quantity budget - number of units to be produced by product.
* Inventory budget - estimated ending inventory requirements for each type of inventory.
* Direct material budget - units and cost of raw material necessary to meet production demands.
* Direct labor budget - hours and rates necessary to meet production demands.
* Manufacturing overhead budget - indirect cost of production.
Small firms may or may not have separate engineering and purchasing departments, or these functions may be under the production manager. If separate, the purchasing manager would prepare the inventory and direct material budgets. If purchasing and engineering are under the production manager, their managers can still lend expertise to appropriate portions of the budget.
From the sales budget, the production manager can determine the number of units of each product that must be produced monthly. Review labor to determine if current personnel can meet the necessary production levels. If not, a strategy must be adopted, such as adding additional personnel, working overtime, or outside contracting. Similarly, production must ascertain if existing production facilities can meet production requirements, and if raw material will be available as needed.
Ideally, the manufacturing overhead budget is organized by variable and fixed costs. Variable cost can be calculated on a base, such as direct labor dollars, or it can be projected as the number of units to be manufactured times an estimated variable overhead cost per unit. Fixed costs do not change with output. As a result, these costs can be projected for the year and assumed to be stable for each month.
All of the above budgets are then forwarded to the controller who has the responsibility of coordinating them and reviewing for errors and incompatibilities. In addition, the controller prepares the administrative expense budget, which is probably limited to expected cost by account. From the five budgets forwarded by production, a cost of goods sold budget can be prepared. Data for the projected statement of income is either lifted from one of the individual budgets or calculated. For example:
1. Sales is taken from the sales budget; 2. Cost of goods sold is forwarded from the cost of goods sold budget; 3. Administrative expenses come from the administrative expense budget; and 4. Marketing expense is transferred from the marketing expense budget.
The controller should be aware of any anticipated miscellaneous income or expense. Depreciation expense is calculated on expected capital assets, and income tax expense is computed on budgeted profit before tax, utilizing the income tax rates assumed when strategies were established.
The capital expenditure budget is based on the input of sales, production, and engineering in so far as what new capital acquisitions or expenditures will be necessary to meet production demands. As with other cost budgets, the capital expenditure budget must conclude with the timing of the cash outflow dollars. When capital expenditures are expected to be high, consideration must be given to how the firm expects to raise the cash necessary to pay for them. The cash outflow portion will be included in the cash budget, whereas cash obtained through borrowing or the sale of equity securities will also be reflected on the statement of financial position.
The cash budget is critical because it helps management utilize the scarce resource of cash to optimal advantage. Cash shortages should be avoided so that bills can be paid on time. A firm's good credit rating remains intact, and required borrowings can be projected to minimize interest cost. On the other hand, a high cash surplus should be invested in high-yield securities until needed, or distributed to the stockholders.
Utilizing input from the previous budgets, financial statements, and established ratios (i.e., number of days in accounts receivable, current ratio and debt equity), the statement of financial position is prepared. For example, cash can be traced to the cash budget. Inventories are based on the inventory budget. Plant assets are increased by the amount of the capital expenditure budget and decreased by expected dispositions. Accumulated depreciation includes the depreciation expense previously calculated for the statement of income, minus that attributable to items expected to be disposed of during the forthcoming year. Retained earnings reflects the projected profit, or loss, from the statement of income minus planned dividends, if any. The final statement to be prepared is the statement of changes in cash.
Review and approval
As mentioned previously, the controller is responsible for reviewing all work for accuracy and plausibility. This includes checking the individual schedules for mathematical accuracy and reconciling with figures presented on supporting statements. An additional function of the controller is to prepare comments on the various statements. Topics include, but are not limited to, the feasibility of the figures as presented, the extent to which the company's goals will be met, and suggestions on how to better achieve stated objectives.
The entire draft budget package is now returned to each manager for review; giving managers an opportunity to write their own comments and questions for use during a budget meeting. During this meeting, the managers discuss the individual budgets in the same order prepared. This allows managers a better insight into the preparation process and the rationale used in preparing each budget. Each manager is given an opportunity to agree or disagree with any portion of the budget.
Items that are disagreed on are discussed in greater detail, including the reasons for the disagreement. Try to eliminate or reduce disagreement. This might result in a possible modification of portions of the budgets. Changes to individual budgets are made by the responsible manager. The revised departmental budgets are then returned to the controller for revision of the entire master budget.
It may be desirable to repeat the above process if substantial changes are necessary. Still, considerable effort should be expended to reduce the number of times the budget travels through the chain of command, since too many times will increase the budget preparation period, boost cost, encourage haphazard budgeting, deteriorate morale, and reinforce the notion that budgeting is not to be taken seriously. It is important that managers control the system, rather than vice-versa.
After all revisions have been made, the master budget is approved by top management. A copy of the entire final budget package is given to all managers for implementation in their respective areas. Managers are expected to use the budget to help make decisions and track their own plans and performance. The firm's reward system may or may not be tied in to meeting the budget.
Financial statements based on actual dollars are prepared by accounting. Monthly and year-to-date actual figures are reported against the budgeted figures and variances computed. Key ratios and a comparison of targets to actuals are included in the performance reports along with the controller's comments. Individual managers are asked to explain large variances as well as suggest and implement procedures to correct recurring inefficiencies.
The essential ingredients for success are to keep the budgetary process as simple as possible, to render relevant, accurate, and timely reports, and to provide strong management support. Consistency of budget contents, applications, and implementations provides a strong foundation upon which managers can base their decisions. Such a system can substantially reduce risk, stress, and human insecurities.
Longevity of a small firm is dependent upon its ability to plan and control operations. Planning is future oriented and forms the foundation of control. Control is established through calculation and analysis of variances, that is, the difference between budgeted costs and actual costs. This analysis is extremely important because it either suggests corrective action, a revision of objectives, and/or a modification of plans.
A well-prepared master budget approved and supported by top manager is essential. Effort should be made to establish the budget at a reasonable level of performance since extremely tight budgets discourage managers and subordinates. On the other hand, loose budgets do not motivate employees. Care must be taken about when to hold employees responsible for meeting or failing to meet budgets. If meeting budgets means success or failure to the employee, the budget may be looked upon as something to be feared. Employees may retaliate by ignoring it, suffering anxiety, becoming disgruntled, or putting slack in their budgets. An atmosphere of trust and support for one another can do much toward alleviating pressure and establishing budgeting as a sound tool for planning and control decisions.
Mary M.K. Fleming, CPA, CMA, is a professor of accounting at California State University, Fullerton. She has a DBA degree from the University of Southern California.