7.1 Describe How and Why Managers Use Budgets
3 min read•june 18, 2024
is a crucial tool for organizations to plan, communicate, and evaluate performance. It helps managers anticipate challenges, align activities across departments, and set clear expectations. By creating a comprehensive financial plan, companies can make informed decisions and adapt to changing circumstances.
The budgeting process involves creating both operating and financial budgets. Operating budgets focus on income-generating activities like sales and production, while financial budgets address cash flows and investments. Together, these components form a that guides the organization's financial decisions and strategies.
Advantages and Components of Budgeting
Advantages of organizational budgeting
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- Budgeting facilitates planning by
- Requiring managers to anticipate future opportunities and challenges (market trends, competitor actions)
- Helping identify potential resource constraints or excess capacity (staffing levels, production bottlenecks)
- Allowing for proactive decision making to capitalize on opportunities or mitigate risks
- Budgeting enhances communication through
- Communicating organizational goals and objectives to all employees (revenue targets, cost reduction initiatives)
- Coordinating activities across departments to ensure alignment (sales forecasts informing production plans)
- Aligning employee efforts with company strategy by setting clear performance expectations
- Budgeting enables performance evaluation by
- Providing a benchmark for actual results to measure against (budgeted vs. actual sales)
- Helping identify areas of strong or weak performance for recognition or improvement (high-performing sales regions, underperforming product lines)
- Allowing for corrective action when necessary to get back on track (cost-cutting measures, revised sales strategies)
- Facilitating to understand deviations from the
Components of master budgets
- is a comprehensive financial plan that includes
- Operating budgets focused on income-generating activities (sales, production, expenses)
- Financial budgets focused on financial resources and requirements (capital investments, cash flows, financial statements)
- components:
- projects expected sales revenue based on forecasted demand (unit sales, selling prices)
- outlines production plan to meet sales targets while managing inventory levels
- estimates raw material costs based on production requirements and purchase prices
- estimates labor costs based on production needs and wage rates
- estimates indirect production costs (utilities, maintenance, depreciation)
- estimates non-production costs (marketing, salaries, rent)
- components:
- plans for long-term asset investments (equipment purchases, facility expansions)
- projects cash inflows and outflows to ensure sufficient liquidity (customer collections, supplier payments)
- estimates financial position at end of budget period (assets, liabilities, equity)
- projects profitability for the budget period (revenues, expenses, net income)
Budgeting Approaches
Comparison of budgeting approaches
- involves
- Budgets set by upper management and pushed down to lower levels of the organization
- Advantages: ensures alignment with company strategy, faster budgeting process
- Disadvantages: may lack buy-in and commitment from lower-level managers
- features
- Budgets initially prepared by lower-level managers based on their specific knowledge and needs
- Budgets consolidated and reviewed by upper management for approval
- Advantages: more accurate estimates, greater employee motivation and ownership
- Disadvantages: time-consuming process, may not fully align with company strategy
- requires
- Starting from a "zero base" each budget period instead of basing on prior year
- Every budget item must be justified based on its necessity and contribution to organizational goals
- Advantages: reduces wasteful spending, encourages innovation and efficiency
- Disadvantages: time-consuming annual process, may be difficult to implement in established organizations
Advanced Budgeting Techniques
- adjusts the budget based on actual activity levels, allowing for more accurate performance evaluation
- continuously update budgets for future periods, providing a more dynamic planning approach
- involves employees at various levels in the budgeting process, increasing commitment and accuracy
- focuses on the activities that drive costs, leading to more precise resource allocation
Key Terms to Review (36)
Activity-Based Budgeting: Activity-based budgeting is a budgeting approach that focuses on the activities and processes required to produce products or provide services, rather than just the traditional line-item budgeting method. It aims to allocate resources more accurately by understanding the cost drivers behind different organizational activities.
Bottom-up Budgeting: Bottom-up budgeting is a budgeting approach where managers at the operational level create budget proposals based on their specific needs and requirements, which are then consolidated at higher levels of the organization. This contrasts with top-down budgeting, where budgets are set at the top and then allocated downwards.
Budget: A budget is a financial plan that estimates revenue, expenses, and resources over a specific period. It serves as a tool for decision-making and performance evaluation for managers.
Budgeted balance sheet: A budgeted balance sheet is a financial statement that projects a company's financial position at the end of a future period. It includes estimated amounts for assets, liabilities, and equity based on anticipated transactions and budgets.
Budgeted Balance Sheet: A budgeted balance sheet is a financial projection that forecasts the expected financial position of a business at a future date. It is a crucial component of the overall budgeting process, allowing managers to anticipate and plan for the company's future assets, liabilities, and equity.
Budgeted Income Statement: A budgeted income statement is a financial projection that estimates a company's future revenue, expenses, and net income for a specific period of time. It serves as a planning and control tool for managers to anticipate the financial performance of the organization.
Budgeting: Budgeting is the process of creating a plan for the allocation and management of an organization's financial resources over a specific period of time. It involves estimating and forecasting future income, expenses, and cash flow to ensure the efficient and effective use of funds. Budgeting is a critical tool for managerial accounting and is closely tied to the responsibilities of management, the distinction between financial and managerial accounting, and the development of standard costs.
Capital Expenditure Budget: A capital expenditure budget is a plan that outlines the anticipated spending on long-term assets, such as property, equipment, and other investments, that are expected to provide benefits over multiple years. It is a critical tool used by managers to allocate resources and make strategic decisions about the organization's future growth and development.
Cash budget: A cash budget is a financial plan that estimates cash inflows and outflows over a specific period. It helps businesses manage their cash needs and ensure they have sufficient liquidity to meet obligations.
Cash Budget: A cash budget is a financial plan that forecasts the expected cash inflows and outflows for a business over a specific period, typically a month or a year. It is a crucial tool that managers use to manage and control the company's cash resources, ensuring that there is sufficient cash available to meet its financial obligations and take advantage of investment opportunities.
Direct labor budget: A direct labor budget estimates the total cost of direct labor required to meet production goals for a specific period. It is a crucial component of an operating budget, helping businesses plan workforce needs and associated costs.
Direct Labor Budget: The direct labor budget is a financial plan that estimates the labor costs associated with the production of goods or services. It is a critical component of the overall operating budget and is closely tied to the production process and output levels.
Direct materials budget: A direct materials budget estimates the quantity and cost of raw materials needed for production over a specific period. It helps ensure that there are sufficient materials to meet production goals while controlling inventory costs.
Direct Materials Budget: The direct materials budget is a critical component of the overall operating budget, which outlines the planned consumption and costs of the raw materials needed to manufacture a company's products. It serves as a blueprint for managing the procurement and usage of direct materials, ensuring alignment with production goals and financial objectives.
Financial budget: A financial budget is a detailed plan that outlines an organization's expected income and expenses over a specific period. It helps managers allocate resources efficiently and forecast future financial performance.
Financial Budget: A financial budget is a comprehensive plan that outlines an organization's projected revenues, expenses, and cash flows over a specific period of time. It serves as a tool for managers to allocate resources, monitor performance, and make informed decisions to achieve financial goals.
Flexible Budgeting: Flexible budgeting is a budgeting approach that adjusts the budgeted amounts based on the actual level of activity or volume, rather than using a static, predetermined budget. It allows managers to better align budgeted costs with the organization's changing needs and circumstances, providing more accurate and relevant information for decision-making.
Manufacturing overhead budget: A manufacturing overhead budget estimates the expected costs related to production that are not directly tied to materials or labor. It includes indirect costs such as utilities, depreciation, and maintenance.
Manufacturing Overhead Budget: The manufacturing overhead budget is a comprehensive plan that estimates the indirect costs associated with the production process in a manufacturing organization. It serves as a crucial tool for managers to effectively plan, control, and monitor the indirect expenses incurred during the manufacturing of goods.
Master budget: The master budget is a comprehensive financial planning document that consolidates all of an organization’s individual budgets. It includes projections for sales, production, direct materials, labor, overhead, and administrative expenses to provide a complete picture of financial performance.
Master Budget: The master budget is a comprehensive financial plan that integrates all of an organization's individual budgets into a cohesive whole. It serves as the primary tool for planning, coordinating, and controlling a company's operations and finances for a specified time period, typically a fiscal year.
Operating budget: An operating budget is a detailed projection of all expected income and expenses during a specific period, usually one fiscal year. It serves as a financial plan that guides an organization in achieving its operational goals.
Operating Budget: An operating budget is a comprehensive plan that outlines an organization's expected revenues and expenses for a specific time period, typically a year. It is a critical tool used by managers to forecast, control, and monitor the financial performance of a business or department within the organization.
Participative Budgeting: Participative budgeting is a process where employees at various levels of an organization actively participate in the development and implementation of the organization's budget. It involves collaboration between managers and subordinates to set budget targets and allocate resources.
Production budget: A production budget estimates the number of units that must be produced to meet sales goals and maintain desired inventory levels. It is a crucial component of the master budget, helping firms plan their manufacturing activities.
Production Budget: A production budget is a detailed plan that outlines the expected production levels, costs, and resource requirements needed to manufacture a company's products or provide its services over a specific time period. It is a critical component of the overall budgeting process and is closely linked to the sales and operational plans of an organization.
Rolling budget: A rolling budget is a continuous 12-month budget that is updated regularly to add a new budget period as the most recent period is completed. It allows organizations to continuously plan for future periods without waiting for a fiscal year-end.
Rolling Forecasts: Rolling forecasts are a dynamic budgeting approach where organizations continuously update their financial projections by adding a new forecasting period as the current one ends. This allows managers to make more informed decisions by incorporating the latest market conditions and trends into their planning process.
Sales budget: A sales budget is an estimate of expected sales revenue and the number of units that will be sold for a specific period. It serves as the starting point for preparing other types of budgets within an organization.
Sales Budget: A sales budget is a financial plan that estimates the expected sales revenue for a business over a specific period of time. It is a critical component of the overall budgeting process, as it provides a foundation for the development of other budgets, such as the production budget and the cash budget, and helps guide the allocation of resources to support the organization's sales and marketing efforts.
Selling and Administrative Expense Budget: The selling and administrative expense budget is a critical component of a company's overall budget, outlining the anticipated costs associated with selling products or services and managing the administrative functions of the business. It is a crucial tool that managers use to plan, control, and monitor the non-production-related expenses of an organization.
Top-Down Budgeting: Top-down budgeting is a budgeting approach where senior management sets the overall budget targets and allocates resources to lower-level managers and departments. This approach contrasts with bottom-up budgeting, where budgets are built from the ground up based on input from operational-level managers.
Variance analysis: Variance analysis is the process of comparing budgeted financial performance to actual financial performance to identify discrepancies. It helps managers understand why variances occur and how to address them for better future planning.
Variance Analysis: Variance analysis is a management accounting technique used to identify and evaluate the differences between actual and expected or budgeted performance. It provides insights into the causes of these variances, enabling managers to make informed decisions and take corrective actions to improve operational efficiency and financial performance.
Zero-based budgeting: Zero-based budgeting is a method where each new budget period starts from a 'zero base,' and every expense must be justified. Unlike traditional budgeting, past budgets are not considered, making this approach more flexible and accurate in allocation.
Zero-Based Budgeting: Zero-based budgeting is a budgeting method where all expenses must be justified for each new budget period. Instead of using the previous year's budget as a starting point, zero-based budgeting requires managers to build a budget from scratch, evaluating each cost and determining whether it is necessary for the upcoming period.