Operational Budgeting

Operational budgeting involves the development of financial plans for the organization, typically for a year. While annual budgets need not be subdivided into shorter periods, monthly or quarterly budgets are especially useful for anticipating cash needs and for comparing actual experience with plan. A comprehensive master budget requires planning for all phases of the operation: sales, marketing, manufacturing, engineering and general administration. The budgeting process requires the following steps. Note the relationship(s) between and among the various steps. These relationships will be important in the preparation of any budgeting projects that you work on.

Step #	Task: Questions to Ask	Product or Output: Manufacturing Firm	Product or Output: Retailer or Wholesaler
1	How many units (tons, quarts, gallons, pieces, etc.) will we sell next year, and at what price will they be sold?	Sales budget, usually by month or by quarter. If we sell more than one item, separate schedules for each and a summary of all sales will be required. Includes details about prices and quantities.
2	Given anticipated demand from step 1, how many units of product will we have to produce? For a retailer or wholesaler, the corresponding question is "How much merchandise [and in what mix] to we have to buy?"	For a manufacturing firm: production budget. This will provide details about the amounts and timing of production. We want to avoid stockouts. Not being able to meet demand from customers clearly has an adverse impact on customer relations and profitability. However, carrying excess inventory is expensive so we need to balance the risk of stockouts against the added cost of carrying inventory that we cannot sell.	For a retailer/wholesaler: purchases budget. The purchases budget will describe the quantities and timing of merchandise purchases. The same concern about stockouts and inventory carrying costs applies.
3	Given anticipated demand and production requirements, what manufacturing resources [labor, material and overhead] will be required to sustain the necessary production schedule?	The raw material purchases budget summarizes the quantities and timing of raw material purchases. The direct labor budget provides details about the skills, required production hours and wage rates which will be needed to produce the desired production. The overhead budget summarizes the cost and timing of acquisition of overhead resources that will be required during the fiscal period.	N/A
4	Given the required sales and production efforts, what will be required of sales, marketing, engineering, finance and general administrative management?	The general sales and administrative expense budget provides details about the cost of these resources and when they will be needed.
5	Determine the pattern of cash inflows: how even or uneven will receipts from sales be?	The cash receipts budget will depend on the timing of sales and the timing of the receipts of the cash from those sales. Cash from cash sales is received immediately. Receipt of the cash from sales on account may be delayed one or more months, depending on the speed with which we are able to induce customers to pay. considerations include discounts [e.g., 2/10; net 30] for prompt payment as well as the recognition that, despite our best efforts, some customers may hold out as long as they can and some may never pay.
6	Determine the pattern of cash disbursements: how even or uneven will payments for inventory, labor, overhead, and administrative resources be?	The cash disbursements budget will reflect any lag between the acquisition of resources and the payment for them. Considerations include any discounts on merchandise purchases as well as any accruals [e.g., payroll for the latter part of one month paid early in the next month].
7	What is the impact of [5] and [6] together on our cash balance?	The cash budget [beginning cash balance + anticipated receipts - expected disbursements = ending cash balance] will provide information about any need for working capital, such as a line of credit, short term financing, or an infusion of capital from the owners of the business. The cash budget necessarily takes into account any payments on existing indebtedness, receipts of interest on customer financing arrangements, and any anticipated capital expenditures.
8	How much income will we have?	The profit plan or pro forma income statement provides an indication of the level of profit that can be anticipated, given the assumptions built into the budget.
9	What will be balances in our accounts look like?	The pro forma balance sheet gives owners and managers an idea of the financial position of the firm at the end of the planning period. As with all the other elements of the budget, the accuracy of the balance sheet is contingent on our ability to accurately forecast all the events that may or may not occur over the course of the year.

Some additional considerations in development of the operating budget:

In all but the most simple settings, development of an operating budget requires meticulous organization of relatively large amounts of information. Careful attention to detail is essential.

Development of the estimates regarding events several months to a year in the future is at best a chancy business. Forecasting techniques range from such sophisticated procedures as econometric forecasting to things as simple as "winging it" or coin flipping. Historical evidence may be useful in some parts of the process, such as estimating the pattern of receipts from sales. However, developing the sales forecast itself may depend on a variety of factors, many of which may be subject to only crude estimates. Business which are heavily weather dependent, such as ski resorts, gardening supply houses and beach attire are good examples.

The fact that estimates are likely to be both numerous and highly uncertain makes it advisable to develop a number of potential scenarios to determine "What if?" What if the weather is terrible for the ski season? What if the gardening weather is "ideal?" What if beach resorts experience a wet, soggy July, but the weather forecast for August is for a record-breaking heat wave? At a minimum, a best case, worst case, most likely outcome set of forecasts should be developed. This combination of outputs would enable managers to plan for at least some of the potential contingencies.

The need for large amounts of information, meticulous organization, a variety of estimates, and contingency planning all combine to make computer spreadsheets an ideal medium for the development of a master budget. The number of potential scenarios one can try is limited only by time and imagination. Once a budget is adopted, it can be updated periodically as new information becomes available.

Finally, note that a major portion of the calculations in the budgeting process require the application of a very simple concept: BASE.

B	Beginning balance: how much [inventory, cash, accounts receivable or whatever] do we have to start with? This information will come from the beginning balance sheet [ = the ending balance sheet from the prior period].
A	Additions: how much more [and at what intervals] do we expect to add to what was there to start with?
S	Subtractions: how much are we going to use or spend, and at what intervals?
E	Ending balance: how much will we have left at the end?

Note that this can all be designated as follows: B + A - S = E. The relationship is linear, and if we know any three of the elements, we can find the fourth, simply by doing the algebra. Furthermore, note that B + A = the total amount of a resource available. For example, beginning cash plus total additions to cash [receipts] will give us the total available cash for the period. Similarly, consider an item like cash or inventory, for which we are likely to have a required minimum ending balance. S + E = the total amount "used," whether used to satisfy demand, or used to satisfy an ending balance requirement.

Flexible budgets:

An especially important concept in developing estimates of costs is the flexible budget [or flexible budget equation]. a flexible budget is of the general form TC = VC[X] + C, where TC = total costs, VC = variable costs per unit, X = the number of units, and C = fixed costs for the relevant fiscal period. Thus, if the variable cost per unit is $10.00, monthly production is expected to be 1,000 units, and fixed costs are $5,000 per month, total costs for the month would be [10 * 1000] + 5000, or $15,000. If production were 1,500 units. total costs would be $20,000. This concept is especially important when we get to comparisons of budgeted and actual conditions. if budgeted sales are 1,000 units, and actual sales turned out to be 1,500 units, a comparison of the total costs are the two levels of sales would be inappropriate. We would want to compare the projected costs at 1,500 units with the actual experience at 1,500 units.

Copyright © 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.

Last modified: August 03, 2005