Budget Preparation for an Enterprise

The planning process is a means of communicating objectives and coordinating organizational activities in such a way as to meet those objectives. In order to meet these objectives effectively and efficiently the management of the organization should develop different types of begets. One of the most commonly used budget is the master budget which is particularly suitable for controlling costs which are unrelated to activity.

 

In some organizations budgets are set by higher levels of management and then communicated to the lower levels of management to whose areas of responsibility they relate. Thus, such budgets are seen by those lower-level managers as being imposed up on them by their superiors in the organizational hierarchy without their being allowed to participate in the budget-setting process and therefore without their being able directly to influence the budget figures. This approach to involvement in the budgetary system is consistent with Douglas McGregor's Theory X view of how people behave in the organization. Theory X view is based on the assumption that people in the work environment are basically lazy and dislike work and any responsibility associated with it. They are motivated by money to meet their basic needs. Therefore, the Theory X style of management is authoritarian, based on direction and control down through the organization.

The other end of the spectrum is described by McGregor as Theory Y. This is a participative theory of management, assuming that people in a work environment do seek more responsibility and do not have to be so tightly controlled. Therefore, it is in organizations where a Theory Y style of management predominates that one is more likely to come across a fully participative approach to the setting of budgets.

The general argument is that the more individual managers are allowed to participate i.e., to influence the budgets for which they are held responsible, the more likely that they will accept the targets in the budgets and strive actively towards the attainment of those targets.

There are limitations on the extent of the effectiveness of participation in the budget setting process. If budgets are used both in a motivational role and for the evaluation of managerial performance then a serious conflict arise. A manager through participation may be able to influence the budget upon which he is subsequently evaluated. By lowering the standard in the budget he has biased the budget and he may then appear to attain a better actual performance in any comparison with it. The effects of this sort of bias can be minimized by careful control, and the budget setting stage, over any change in the budget from one year to the next, which are not due to external factor.

Participation will also be less effective in organizational situations where a manager or employee feels that he has little scope to influence the actual results for the budgeted area of responsibility.

 

There are two types of budget. These are:

     1. Fixed Budgets

It is also known as master budget and it shows income/costs for a single level of activity.

A fixed budget makes no attempt to separate the costs into those, which are fixed, and those, which are variable. It is therefore unsuitable for use as a basis of comparison with actual costs where such costs are known to vary with activity and the level of activity differs from that budgeted.

However, a fixed budget is particularly suitable for controlling costs, which are unrelated to activity. These are usually indirect costs and the aim is to limit expenditure on these items. An example would be Research and Development expenditure.

     2. Flexible Budgets

A flexible budget is a budget, which shows cost/revenues for different levels of activity by recognizing the behavior of each cost.

The flexible budget is suitable for use as a comparison with actual costs incurred when the activity level differ from that budgeted. Such budgets can therefore be used to measure efficiency but are not suitable as a means of capping expenditures.

 

The master or static budget is prepared for a single level of volume based on management's best estimate of the level of production and sales for the coming period. The master budget includes the following individual budgets.

Budgeted Income Statement                                               

• Sales budget                                                                
• Cost of good sold budget                                           
• Production budget
• Direct material budget
• Direct labor budget
• Selling and administrative budget

Budgeted Balance sheet

• Cash budget
• Capital expenditure budget

The income statement budget for a manufacturer will be emphasized in this unit.

 

• Sales Budget
  In preparing a budget, management must consider all the items of income and expense. The usual starting point in the budgeting process is a sales forecast, followed by a determination of inventory policy, a production plan, a budget of manufacturing costs, and a budget for all administrative and selling expenses. The final product is the amount of net income budgeted for the year.
  Although all of the aforementioned budgets are important, the sales budget is especially significant, because management must use this information as a basis for preparing all other budgets. The sales budget projects the volume of sales both in units and birr. In estimating the sales for the forth-coming year, the sales department must take into consideration present and future economic situations. It should research and carefully analyze market prospects for its products and give considerations to the development of new products and the discontinuance of old products. It should make these analysis by territory, by type of product, and possibly by type of customer. Marketing researchers should also carefully survey and evaluate consumer demand. After this detailed examination, the mix of the products to be sold as well as the volume and the sales price can be determined.
   
• Production Budget
  After the sales mix and volume plans have been made, the factory can proceed with the determination of production requirements.

  In actual practice, this computation is more complex, management must try to achieve a satisfactory balance between production, inventory, and the timely availability of goods to be sold. For example, if the company's sales are seasonal rather than evenly distributed throughout the year, stable production might result in excessive inventories of items in the store.

  Another situation is for management to schedule different levels of production each month in order to maintain a relatively stable inventory and to minimize the number of units stored. This condition would require hiring new employees in the periods of rising production, with the problem of the high cost of recruiting and training as well as the problem of quality production with new, possibly inexperienced employees. In the later periods, as production drops many workers would be laid off, creating considerable additional expense for unemployment compensation.
   

• Direct Materials Budget
  Once the production budget has been prepared the individual budges for manufacturing costs can be prepared, which include the direct materials budget, the direct labor budget and the factory overhead budget. The format of the direct materials budget is very similar to the production budget. The desired ending inventory quantity of each material is added to the quantity of that material needed to meet production needs, and then, the total is reduced by the estimated quantity of beginning inventory to determine the amount of materials to be purchased. Multiply the quantity of material to be purchased by the predetermined standard cost per measure of that material yields the total materials purchased.
   
• Direct Labor Budget
  The total production requirements determined from the production budget are also needed for the preparation of the direct labor budget. The standard labor time per unit for each factory operation is multiplied by the number of production units to obtain the total direct labor hours required to produce the period requirements. The total hours required for each operation are then multiplied by the hourly rate earned by employees in each department to obtain the total budgeted direct labor cost.
  Just as there was a need for close coordination between purchasing and production functions, interaction between the human resource and production department is equally important to ensure that there is enough of the right kind of labor available to meet production requirements.
   
• Factory Overhead Budget
  Here all costs incurred in the factory not chargeable directly to the finished product are called factory overhead. These operating costs of the factory cannot be traced specifically to a unit of production. When it is difficult to charge an expenditure to either of the "direct" factory accounts (i.e., direct material or direct labor), it is classified as factory overhead. Generally, factory overhead account includes (1) indirect materials consumed in the factory, such as cleaning materials and lubricants required for production; (2) indirect factory labor; such as wages of janitors, forklift operators and overtime premiums paid to all factory workers; and (3) other indirect manufacturing expenses, such as rent, insurance, property taxes, depreciation, heat light, and power.
   
• Cost of Good Sold Budget
  The cost of good sold budget may be prepared upon completion of the direct materials, direct labor, and factory overhead budgets. The estimated beginning inventories, as well as the desired ending inventories of working process and finished goods, must be included in the computation of cost of good sold.
   
• Selling And Administrative Expenses Budget
  After a company has determined its level of activity for sales, it can prepare a selling and administrative expense budget. The sales forecast will affect the planned expenditure level for such items as sales force compensation, advertising, and travel. The budget has separate section for selling and for administrative expense, with line items for each major category.
   
• Budgeted Income Statement
  After completion of the preceding budgets, the company can prepare a budgeted income statement for the year. The budgeted income statement summarizes the date from all of the other operating budgets and enables man agement to determine the impact of all of the budget estimates on operating income. If the budgeted profit does not meet expectation, management will revisit the individual budget estimates with operating personnel, for the purpose of determining what change, if any, can be made to improve profitability.
   
• Other Budgets
  The company can now prepare its balance sheet budgets. The cash budget shows the anticipated flow of cash and the timing of receipts and disbursements based on projected revenues, the production schedule, and expenses. Using this budget, management can plan for necessary financing or for temporary investment of surplus fund.
  The accounts receivable budget, based on anticipated sales, credit terms, the economy, and other relevant factors, will influence the cash budget by showing when cash can be expected from the turnover of inventory and receivables.
  A company may also prepare a capital expenditure budget, which is a plan for the timing of acquisitions of buildings, equipments or other significant assets during the year.

 

3.5 Summary

The budgeting process for a manufacturing firm is much more complex than for a merchandising or service business. Manufacturers have to budget for the acquisition of raw materials and labor, as well as for the incurrence of a significant amount of manufacturing overhead costs. Merchandises purchase products in their final form, and service businesses provide a service rather than a product, thus simplifying the budgeting process. In preparing our budget we should have to first develop the sales budget for the company, which shows projected sales volume. Based on this sales figure we can forecast the total no of units that should be manufactured in order to satisfy our customers and/or stock requirement. Third; now the manufacturing of this units in the production department involves cost so we have to prepare the material, labor and factory overhead budgets. The fourth step will be the preparation of selling or administrative budget for the company. The final step is the preparation of budgeted income statement, which is the summary of the above four major steps.