Financial and Management Decisions
Week 1
Chapter 7: Introduction to Budgets and Preparing the Master Budget
Explain how budgets facilitate planning and coordination.
Budget = a quantitative expression of a plan of action that imposes the formal structure of an
organization. Managers can use budgeting as an effective cost-management tool. Budgets
facilitate planning and coordination. Advantages of budgeting:
- Formalization of planning. To prepare a budget, managers should set objectives and
policies.
- Evaluation of activities. Budgeting uses the current activities in the organization as a
starting point. 1) It is assumed these activities will be the same for the new budget. 2)
Current activities will not be automatically continuing, need for every expenditure for
every activity (zero-based budget).
- Communicating objectives and coordination. Top-down and bottom-up
communication about opportunities and challenges ahead.
- Performance evaluation. It provides a good benchmark for the actual results. Better
than past results, due to changes in economic conditions, technology, personal,
competition etc.
Three problems that can limit the advantage budgeting:
1. Low levels of participation in the budget process and lack of acceptance of
responsibility for the final budget. The main factors of this are:
I. The perceived attitude of top management. They will influence the lower-level
managers’ and employees’ attitudes.
II. The level of participation in the budget process.
III. The degree of alignment between the budget and other performance goals.
Management should seek to create an environment where there is a true two-way flow of
information.
Participate budgeting = budgets formulated with the active participation of all affected
employees. Message conveyed by the budget system may be misaligned with incentives by
the compensation system.
2. Incentives to lie and cheat in the budget process.
- Dysfunctional incentives lead managers to make poor decisions.
- Lying can arise if the budget process creates incentives to bias the budget
information.
- Budgetary slack (budget padding) = the overstatement of budgeted costs (or
understatement of budgeted revenue) to create a goal that is easier to achieve.
3. Difficulties of obtaining accurate sales forecast. This is the foundation of budgeting.
Important factors of sales forecasting:
1. Past patterns of sales combined with product line, geographic region, and type of
customer.
2. Estimates made by the sales force. Best source of information about desires and
plans of customers.
3. General economic conditions.
4. Competitors’ action. Consider likely strategies and reactions of competitors.
5. Changes in the firm’s prices. High prices = less units – low prices = more units.
6. Changes in the product mix. Finding most profitable product and promote to
increase sales.
7. Market research studies.
8. Advertising and sales promotion plans.
, Sales forecast = a prediction of sales under a given set of conditions. Usually prepared under
the direction of the top sales executive.
Sales budget = the sales forecast that is the result of decisions to create conditions that will
generate a desired level of sales.
Explain the major features and advantages of a master budget.
Type of budgets:
Strategic plan = a plan that sets the overall goals and objectives of the organization. Most
forward-looking and least detailed budget. It does not deal with a specific timeframe. It leads
to long-range plan
Long-range plan = forecasted financial statements. The decisions made here include addition
or deletion of product lines, design and location of new plants, acquisitions of building and
equipment, and other long-term commitments.
Capital budget = details the planned expenditures for facilities, equipment, new products, and
other long-term investments. It is combined with the long-range plan.
Master budget = an extensive analysis of the first year of the long-range plan. It summarizes
the activities of all sub-units of the organization.
- Quantifies targets for sales, purchases, production, distribution, and financing in the
form of forecasted financial statements and supporting operating schedules.
- It includes forecasts of sales, expenses, balance sheets, and cash receipt and
disbursements.
Continuous budget (rolling budget) = a common form of master budget that adds a month in
the future as the month just ended is dropped.
Components of the Master Budget:
Operating budget (profit plan) = a major part of a master budget that focusses on the income
statement and its supporting schedules.
- Sales budget
- Operating expense budget
- Purchases of cost-of-goods-sold budget
- Budgeted income statement
Financial budget = focuses on the effects that the operating budget and other plans (such as
capital budgets and repayments of debt) have on cash balances.
- Cash budget
- Capital budget
- Budgeted balance sheet.
Week 1
Chapter 7: Introduction to Budgets and Preparing the Master Budget
Explain how budgets facilitate planning and coordination.
Budget = a quantitative expression of a plan of action that imposes the formal structure of an
organization. Managers can use budgeting as an effective cost-management tool. Budgets
facilitate planning and coordination. Advantages of budgeting:
- Formalization of planning. To prepare a budget, managers should set objectives and
policies.
- Evaluation of activities. Budgeting uses the current activities in the organization as a
starting point. 1) It is assumed these activities will be the same for the new budget. 2)
Current activities will not be automatically continuing, need for every expenditure for
every activity (zero-based budget).
- Communicating objectives and coordination. Top-down and bottom-up
communication about opportunities and challenges ahead.
- Performance evaluation. It provides a good benchmark for the actual results. Better
than past results, due to changes in economic conditions, technology, personal,
competition etc.
Three problems that can limit the advantage budgeting:
1. Low levels of participation in the budget process and lack of acceptance of
responsibility for the final budget. The main factors of this are:
I. The perceived attitude of top management. They will influence the lower-level
managers’ and employees’ attitudes.
II. The level of participation in the budget process.
III. The degree of alignment between the budget and other performance goals.
Management should seek to create an environment where there is a true two-way flow of
information.
Participate budgeting = budgets formulated with the active participation of all affected
employees. Message conveyed by the budget system may be misaligned with incentives by
the compensation system.
2. Incentives to lie and cheat in the budget process.
- Dysfunctional incentives lead managers to make poor decisions.
- Lying can arise if the budget process creates incentives to bias the budget
information.
- Budgetary slack (budget padding) = the overstatement of budgeted costs (or
understatement of budgeted revenue) to create a goal that is easier to achieve.
3. Difficulties of obtaining accurate sales forecast. This is the foundation of budgeting.
Important factors of sales forecasting:
1. Past patterns of sales combined with product line, geographic region, and type of
customer.
2. Estimates made by the sales force. Best source of information about desires and
plans of customers.
3. General economic conditions.
4. Competitors’ action. Consider likely strategies and reactions of competitors.
5. Changes in the firm’s prices. High prices = less units – low prices = more units.
6. Changes in the product mix. Finding most profitable product and promote to
increase sales.
7. Market research studies.
8. Advertising and sales promotion plans.
, Sales forecast = a prediction of sales under a given set of conditions. Usually prepared under
the direction of the top sales executive.
Sales budget = the sales forecast that is the result of decisions to create conditions that will
generate a desired level of sales.
Explain the major features and advantages of a master budget.
Type of budgets:
Strategic plan = a plan that sets the overall goals and objectives of the organization. Most
forward-looking and least detailed budget. It does not deal with a specific timeframe. It leads
to long-range plan
Long-range plan = forecasted financial statements. The decisions made here include addition
or deletion of product lines, design and location of new plants, acquisitions of building and
equipment, and other long-term commitments.
Capital budget = details the planned expenditures for facilities, equipment, new products, and
other long-term investments. It is combined with the long-range plan.
Master budget = an extensive analysis of the first year of the long-range plan. It summarizes
the activities of all sub-units of the organization.
- Quantifies targets for sales, purchases, production, distribution, and financing in the
form of forecasted financial statements and supporting operating schedules.
- It includes forecasts of sales, expenses, balance sheets, and cash receipt and
disbursements.
Continuous budget (rolling budget) = a common form of master budget that adds a month in
the future as the month just ended is dropped.
Components of the Master Budget:
Operating budget (profit plan) = a major part of a master budget that focusses on the income
statement and its supporting schedules.
- Sales budget
- Operating expense budget
- Purchases of cost-of-goods-sold budget
- Budgeted income statement
Financial budget = focuses on the effects that the operating budget and other plans (such as
capital budgets and repayments of debt) have on cash balances.
- Cash budget
- Capital budget
- Budgeted balance sheet.
