CHAPTER 8
BUDGETING FOR PLANNING AND CONTROL
Budgeting is one topic that most students can relate to since they are involved with their own personal
budgets. Failure to plan, either formally or informally, can lead to financial disaster. Careful planning is
vital to the health of any organization.
We can look at a department’s budget from three perspectives: a traditional functional-based approach, a
flexible budgeting approach, and an activity-based approach. All three budgeting methods are discussed
in Chapter 8.
LEARNING OBJECTIVES
After studying Chapter 8, students should be able to:
1. Define budgeting, and discuss its role in planning, controlling, and decision making.
2. Prepare the operating budget, identify its major components, and explain the interrelationships of the
various components.
3. Identify the components of the financial budget, and prepare a cash budget.
4. Define flexible budgeting, and discuss its role in planning, control, and decision making.
5. Define activity-based budgeting, and discuss its role in planning, control, and decision making.
6. Identify and discuss the key features that a budgetary system should have to encourage managers to
engage in goal-congruent behavior.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. The Role of Budgeting in Planning and Control (LO 1)
2. Preparing the Operating Budget (LO 2)
3. Preparing the Financial Budget (LO 3)
4. Flexible Budgets for Planning and Control (LO 4)
5. Activity-Based Budgets (LO 5)
6. The Behavioral Dimension of Budgeting (LO 6)
I. THE ROLE OF BUDGETING IN PLANNING AND CONTROL
Students need to understand what a budget is and the role budgeting plays in an organization. You may
want to start a discussion by asking students the following two questions: What is a budget? What are the
purposes of budgeting? Planning and control should emerge as two major purposes.
Budgets are the quantitative plans for the future, stated in either physical or financial terms or both.
Budgets are the means used to translate the goals and objectives of an organization into operational terms.
By comparing actual outcomes with planned outcomes, budgets also can be used to control.
Control is the process of setting standards, receiving feedback on actual performance, and taking
corrective action whenever actual performance deviates significantly from planned performance.
It is important for students to understand that budgets are the outgrowth of strategic planning and that
they play a vital role in implementing strategic plans. The planning and control purposes of budgeting are
shown in the flow chart in Exhibit 8.1 on page 376.
Budgeting has the following purposes:
1. It forces managers to plan.
2. It provides resource information that can be used to improve decision making.
3. It aids in the use of resources and employees by setting a benchmark that can be used for the
subsequent evaluation of performance.
4. It improves communication and coordination.
The master budget is a comprehensive financial plan for the year made up of various individual
departmental and activity budgets. Exhibit 8.2 on page 378 illustrates the components of a master budget.
A master budget can be divided into operating and financial budgets. Operating budgets describe the
income-generating activities of a firm: sales, production, and finished goods inventories. Financial
budgets detail the inflows and outflows of cash and the overall financial position.
The preparation is referred to as the mechanics of budgeting and the implementation as the behavioral
dimension. Most budgets are for a one-year period and are broken down into monthly and quarterly
segments. However, some organizations have developed a continuous budgeting philosophy. A
continuous (or rolling) budget is a moving 12-month budget. As a month expires, an additional month in
the future is added so that the company always has a 12-month plan on hand.
II. PREPARING THE OPERATING BUDGET
The operating budget consists of a series of schedules for all phases of operations, culminating in a
budgeted income statement, as follows:
1. Sales budget
2. Production budget
3. Direct materials purchases budget
4. Direct labor budget
5. Overhead budget
6. Ending finished goods inventory budget
7. Cost of goods sold budget
8. Marketing expense budget
9. Research and development expense budget
10. Administrative expense budget
11. Budgeted income statement
The construction of each of the preceding schedules and statement is illustrated in Cornerstones 8.1–8.10
(pp. 382–394).
Teaching hint: Problem 8.36 can be used in class to illustrate the preparation of the operating budget.
The preparation of the sales budget is the first step in the budgeting process. All of the other operating
budgets are dependent on the level of budgeted sales. Until the company projects sales, it cannot
determine production needs. Until the company projects production needs, it cannot ascertain direct
materials or direct labor needs, and so on.
While most of the focus in this section is on the operating budget of a manufacturing company,
merchandising and service company budgeting is addressed beginning on page 395. In a merchandising
firm, the production budget is replaced with a merchandise purchases budget and, naturally, there is an
absence of a direct materials purchases and direct labor budget.
In a for-profit service firm, the sales budget is also the production budget, identifying each service and the
quantities that will be sold. Since there are no inventories for services, the services provided will be
identical to the services sold. In a not-for-profit service firm, the sales budget is replaced by a budget that
identifies the levels of the various services that will be offered for the coming year and the associated
funds that will be assigned to the services.
III. PREPARING THE FINANCIAL BUDGET
The remaining budgets found in the master budget are the financial budgets. The financial budgets
typically include:
1. The cash budget
2. The budgeted balance sheet
3. The budgeted statement of cash flows
4. The budget for capital expenditures
The general format for a cash budget is as follows:
Beginning cash balance
+
Cash receipts
Cash available
–
Cash disbursements
–
Minimum cash balance
Excess or deficiency of cash
–
Repayments
+
Loans
+
Minimum cash balance
Ending cash balance
The budgeted balance sheet and the budgeted statement of cash flows can be prepared after the
preparation of the cash budget. The capital expenditures budget is a financial plan outlining the expected
acquisition of long-term assets and typically covers a number of years.
Cornerstone 8.12 (p. 399) shows how to prepare a cash budget. Problem 8.37 presents a cash budget and
permits students to prepare a pro forma balance sheet.
In recent years, managers have found numerous shortcomings with the traditional master budget. The
traditional master budget is:
1. department oriented and does not recognize the interdependencies among departments.
2. static, not dynamic.
3. results, not process, oriented.
IV. FLEXIBLE BUDGETS FOR PLANNING AND CONTROL
Budgets are useful control measures. Before budgets can be used for control purposes in an organization,
it must be determined how budgeted amounts should be compared with actual results and what impact
budgeting may have on human behavior.
Budgets that are developed around one expected level of activity are static budgets. This is the basis for
the master budget prepared earlier in the chapter. The budget that (1) provides expected costs for a variety
of activity levels or (2) provides budgeted costs for the actual level of activity is called a flexible budget.
Flexible budgeting offers many advantages, including the following:
1. The flexible budget can be used to prepare the budget before the fact for the expected level of
activity.
2. The flexible budget can be used to compare what costs should have been for the actual level of
activity.
3. Flexible budgeting can help managers deal with uncertainty by allowing them to see the expected
outcomes for a range of activities.
Cornerstone 8.13 (p. 406) constructs a flexible budget for varying levels of activity. Cornerstone 8.14 (p.
408) illustrates the construction of a flexible budget for the actual level of activity.
Flexible budgeting can be used in an activity-based costing system by using a variety of cost drivers
rather than a single cost driver. The ABC flexible budget is a more accurate tool for planning and it gives
an indication of which activities are the most costly.
V. ACTIVITY-BASED BUDGETS
Firms with a diverse range of products may find that activity-based budgeting better suits their budgeting
requirements. Traditional budgets often plan forward from last year’s experience. The activity-based
budget (ABB) plans backwards from next year’s output. In essence, the ABB begins with output and then
determines the resources necessary to create that output.
There are four steps necessary to build an activity-based budget:
1. Determine the output of the department.
2. Identify the activities and their related drivers needed to deliver the output.
3. Estimate the demand for each activity.
4. Determine the cost of resources required to produce the relevant activities.
Problems 8.40 and 8.41 are very useful to distinguish between the flexible budget and the activity-based
budget for a plant. In Problem 8.41, students will be able to see how a company identifies the activities
necessary to run the business, examines its desired outcomes, and then builds a budget designed to meet
those outcomes.
VI. THE BEHAVIORAL DIMENSION OF BUDGETING
Budgets are often used to judge a manager’s performance. Performance is evaluated by comparing actual
outcomes with planned outcomes. Bonuses, salary increases, and promotions are often tied to budgetary
performance. Clearly, budgets can have a significant effect on the behavior of managers. Whether the
effect is positive or negative depends on how budgets are used. Hopefully, budgeting will help an
organization align managerial and organizational goals and, simultaneously, create a drive in managers to
achieve these organizational goals. This alignment is called goal congruence. Dysfunctional behavior
involves individual behavior that is in conflict with the goals of the organization.
Although no one has developed a perfect budgetary system, there are certain key features that a sound
budgetary system should possess. These factors include:
1. Frequent feedback on performance
2. Monetary and nonmonetary incentives
3. Participation
4. Realistic standards
5. Controllability of costs
6. Multiple measures of performance
VII. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described below and on the following page according to coverage of content,
learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
CS 8.1
Sales Budget
LO 2
CS 8.2
Production Budget
LO 2
CS 8.3
Direct Materials Purchases Budget
LO 2
CS 8.4
Direct Labor Budget for Service
LO 2
CS 8.5
Overhead Budget
LO 2
CS 8.6
Ending Finished Goods Inventory Budget
LO 2
CS 8.7
Cost of Goods Sold Budget
LO 2
CS 8.8
Marketing Expense Budget
LO 2
CS 8.9
Administrative Expense Budget
LO 2
CS 8.10
Budgeted Income Statement
LO 2
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
CS 8.11
Cash Receipts Budget and Accounts Receivable Aging
Schedule
LO 3
CS 8.12
Cash Budget
LO 3
CS 8.13
Flexible Budget for Varying Levels of Activity
LO 4
CS 8.14
Flexible Budget for Varying Levels of Activity
LO 4
8.15
Production Budget
LO 2
8.16
Sales and Production Budgets
LO 2
8.17
Direct Materials Purchases Budget, Direct Labor
Budget
LO 2
8.18
Sales Forecast and Budget
LO 2
8.19
Purchases Budget
LO 2
8.20
Schedule of Cash Receipts
LO 3
8.21
Schedule of Cash Receipts
LO 3
8.22
Cash Budget
LO 3
8.23
Budgeted Cash Collections, Budgeted Cash Payments
LO 3
8.24
Schedule of Cash Receipts
LO 3
8.25
Cash Disbursements Schedule
LO 3
8.26
Production, Purchases, and Direct Labor Budgets
LO 2
8.27
Flexible Budget
LO 4
8.28
Flexible Budget
LO 4
8.29
Sales Forecast and Flexible Budget
LO 2, 4
8.30
Activity-Based Budget
LO 5
8.31
CPA-Type Exercise
LO2
8.32
CPA-Type Exercise
LO2, 3
8.33
CPA-Type Exercise
LO2
8.34
CPA-Type Exercise
LO2
8.35
CPA-Type Exercise
LO2
8.36
Operating Budget, Comprehensive Analysis
LO 2, 3
8.37
Cash Budget, Pro Forma Balance Sheet
LO 3
8.38
Production, Direct Labor, Direct Materials, Sales
Budgets, Budgeted Contribution Margin
LO 2
8.39
Cash Budget
LO 3
8.40
Flexible Budget
LO 4
8.41
Flexible Budget, Multiple Regression
LO 4
8.42
Participative versus Imposed Budgeting
LO 6
8.43
Information for Budgeting, Ethics
LO 1, 6
8.44
Cyber Research Case
LO 1, 2
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 8.1
The Master Budget and Its Interrelationships
Exhibit 8.2
Components of the Master Budget
Exhibit 8.3
Short-Term Bookings Forecast for Oil Field Equipment Company
Exhibit 8.4
The Cash Budget
Exhibit 8.5
Balance Sheet for ABT, Inc.
Exhibit 8.6
Budgeted Balance Sheet for ABT, Inc.
Exhibit 8.7
ABT Performance Report for Quarter 1: Comparison of Actual with Static (Master)
Budget Amounts
Exhibit 8.8
Managerial Performance Report: Quarterly Production (in thousands)
Exhibit 8.9
Traditional Budget for the Secure-Care Department
Illustration
Topic
Exhibit 8.10
Flexible Budget for the Secure-Care Department
Exhibit 8.11
Activity-Based Budget for the Secure-Care Department