Let us assume that you’ve never been involved in the budget process at your organization,

| October 22, 2018

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Module 6: Budgeting – Part I

Table of Contents

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I. Purpose of the Budget
A company’s budget is its
strategic plan set to numbers and goals. Long-term strategic goals set specific
tactical targets and timetables assigning responsibilities for achieving the
goals to specific managers. The long-term goals include profit projections that
must be achieved through implementing strategies that will utilize resources.
The budget communicates the expected resources that will be used and the
expected profit that will be attained by implementing the strategic plan of the
organization. For example, if the vice president of marketing is charged with
achieving a 10% market share increase in five years, she must build a budget
with expenses and revenues that will achieve an increase in market share.
The budgeting process, if
implemented successfully, involves all functional area managers in the
organization. Since managers are responsible for their budgets, it is essential
that they are involved in the development of the budget. If managers feel they
have a voice in setting the budget targets, they will be motivated to ensure
that their departments attain those targets and stay within the budget. If
senior executives develop the budget without gathering input from operational
level managers, the process will be authoritative and limit the control
managers require to achieve the targets for which they are responsible. If the
senior executives allow the company controller to develop the budget without
input from the operational managers, the managers will not understand the
importance of the budget process.
Managers use budget
information to control daily operations and measure employee performance. As
actual expenses are compared to budgeted expenses and actual revenues are
compared to budgeted revenues, managers are able to assess the success of
strategies being implemented. If the variances between budget and actual are
substantial, managers may have to investigate further the reasons for the
variances. The variances could be caused by inaccurate estimates based on
information not known at the time the budget was developed, or it may be
related to employee performance. Some organizations review the budget and the
assumptions made when preparing the budget on a regular basis throughout the
year. Since budgets are prepared with spreadsheets, revising the budget when
new assumptions arise can be accomplished more frequently than once a year
without expending the scarce resource of management’s time.
II. Components of the Master Budget
A master budget begins with
the strategic plan of the organization and ends with the projected financial
statements for the budget period. Depending on the type of organization, the
master budget will have different components. A master budget for a
manufacturing company typically includes more components than any other type of
organization. The master budget for a manufacturing company includes a cost of
goods manufactured budget which is comprised of a materials budget, a labor
budget, and an overhead budget. In addition, major areas of the income statement
and balance sheet are supported with separate budgets. For example, a selling
and administrative expense budget supports the selling and administrative
expenses on the budgeted income statement and the cash budget supports the cash
figure on the budgeted balance sheet.
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The capital expenditures
budget supports the large cash outlays that are projected for the budget
period. If equipment is to be purchased in the coming budget year, then the
capital expenditures budget would include the financing required for the
capital outlay as well as any cash that would be used.
The master budget for a
service organization is similar to a manufacturing organization’s as functional
area budgets are compiled to complete the master budget package. A service
organization includes a service overhead budget and a labor budget, but does
not include a materials budget as there are no materials used in a service
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The strategic plan includes
market share projections that the sales manager must translate into the sales
budget or the service revenue budget. The sales budget is the first component
prepared in the master budget. In a service organization, the service revenue
budget is the first component prepared in the process.
Once the service revenue or
the sales budget is prepared, the cash expected to flow into the organization
is known, so the expenses can be projected based on the sales and production
projections. Continuing the example using a service organization, the labor
budget, the services overhead budget, and the selling and administrative
expense budget can all be prepared based on the service revenues projects. For
example, certain figures in the service overhead budget may be based on a
percentage of the sales revenue budget. Multiplying the budgeted sales revenue
for the year by the percentage projected for the items in the overhead budget
would provide the figures for the services overhead budget.
After the operating budgets
are complete, the financial budgets may be prepared. The budgeted income statement
is prepared using the figures from the service revenues budget, the labor
budget, and service overhead budget, and the selling and administrative
expenses budget. The budgeted income statement is prepared using accrual based
accounting assumptions. The cash budget is prepared using cash inflows and
outflows without regard to accrual based accounting. The budgeted balance sheet
is completed using the ending cash figure from the cash budget and any changes
in capital equipment included in the capital expenditures budget. The budgeted
income statement flows into the budgeted balance sheet through retained
earnings just as in actual financial statements.
Every company has a budget
process for the functional managers to follow. The process of preparing the
budgets may be slightly different in every company, but the end result in every
company is an operating budget for each functional area and budgeted financial
statements for the organization.

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