Chapter 7: Budgeting
The operating budget is the budget for all the activities that get reported in the income statement, and it is presented in
the same format as the income statement.
The main difference is the income statement summarizes past events, while the budget forecasts future events. The
cash budget is a list of forecast receipts and payments and their effect on cash balances.
If the primary purpose of the budget is to support the planning process, the most imp. Characteristics:
-integrated with the organizational objectives and strategy
-should be accurate.
Ways to create budgets
1) Previous Year’s budget: unrealistic as it could be based on out of date data.
2-Previous year’s budget + inflation adjustment: more realistic, 3% inflation rate won’t necessarily be relevant to all
expense items. It’s hard to tell if the budget is adequate and it’s reckless to commit to a budget without full
3-Previous year actual + Inflation adjustment: expenses are under presented. It’s incorrect to base next year’s budget
on the expenses incurred in a certain month like September. September is not a typical month, any given month is
4-Zero based budgets: assumes a starting point of 0, every expense is justified before being included.
-2 problems: unreasonable amount of time to prepare budgets this way
-managers who are preparing budgets soon become adept at sneaking unjustified expenses into the list to pad the
budget. It’s unmanageable to do every year but as an occasional exercise in cost control it can be recommended.
5-The padded budget: the accounting department routinely cut them back 10%. She’d add 10% to each of the line
items. Only reason the department should have to cut back a budget by an arbitrary amount is if it expects managers to
pad the budget in the first place, so the remedy is giving rise to the disease here.
6-The compromise budget: base the budget of one year on the previous year to make appropriate adjustments in
respect to changes such as inflation. Example salaries are the largest line item; there’d be a periodic review of what
7-Activity based costing
8-Benchmarking: compare the cost of activities with competitors. Car makers for example can do this and share this
information at various car plants. Then budgets may be benchmarked against the best standards in the industry.
9-Kaizen system: standing still is unacceptable. Each period’s costs must be lower than the previous period, so a
continuous series of efficiency based improvement. This system is widely used in manufacturing situations.
Budgeting for service departments are somewhat but not totally separated from the issue of how much work they is
expected to do.
In addition to departments creating budgets for individual responsibility areas, there’s going to be a master budget for
the entire organization. The master budget will look like an income statement listing sales revenues, budgeted costs and expenses. Including
the budgeted operating income and the budgeted net income.
Other than an operating budget, most will prepare for a range of other items such as a capital budget (major
investment expenditures), a cash budget (movements in cash balances) and a budgeted balance sheet.
Operating budget: -starts with a forecast of sales. All organizations are subject to limiting factor that determines the
highest level of activity.
- Because of our economy, sales is most