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.
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.
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.
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
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