6 Budgeting
Learning Objectives LO
Purposes of budgeting LO1
Budgeting is a powerful tool that is widely used for planning, executing, and evaluating organizational operations. A budget is a detailed financial plan for future time periods. Budgets are typically prepared before the budgeted period begins. For this reason, budgeted amounts are estimates and not actual amounts. Most organizations use historical data and current operating plans to estimate budgeted amounts. In an established organization, an effective manager can make these estimates with remarkable accuracy. For example, if the lease payment is $2,000 per month it is easy to project in the upcoming budget that yearly rent expense will be $24,000. However, budgets are not static. Budgets are frequently revised during the period due to unforeseen circumstances such as a change in economic conditions, changes in sales demand, or other factors that affect the organization.
Budgets are used by organizations for planning, controlling, and evaluating performance.
Planning. The budget is created prior to the time period covered by the budget. The completed budget is then used by management to help plan operations including activities like scheduling production, purchasing materials, and making capital investments.
Controlling. The budget is used to control operations during the time period covered by the budget. It sets forth expected targets and limitations. The budget projects sales and revenue targets, production targets, and spending limitations for budgeted expenditures. For example, the budgets establishes the amount to be spent on raw materials; direct labor; and selling, general, and administrative expenses. It is the responsibility of management to ensure that actual expenditures are within the budgetary guidelines.
Performance evaluation. The budget is also used to evaluate the actual results achieved during the time period covered by the budget. Performance evaluation involves comparing the actual results to the results projected in the budget. Comparing budgeted activities to actual results is a widely used method for performance evaluation at all levels of the organization. For example, management can evaluate various departments or activities to see if they met expected targets or stayed within budgeted spending limitations. This feedback can be used to correct organizational inefficiencies or in some cases to justify adjusting budgeting projections and assumptions going forward.
Check your understanding LO1
Master budget LO2
An organization’s collection of budgets is known as the master budget. An organization’s master budget consists of a set of interrelated but independent budgets that articulate the organization’s sales, production, profit, and financial position for a specified time period. A master budget is a tool used by management to effectively plan, control, and evaluate business operations.
A flowchart showing significant independent budgets included in the master