4 Budgeting for Planning and Control

How operating budgets fit together

A budget is a quantified plan for a future period. Operating budgets translate expected sales and operating activity into planned revenues, production, and expenses. Together, they help managers coordinate work, allocate resources, and compare actual results with expectations.

The sequence of operating budgets

The Sales budget is usually prepared first because expected sales drive many other plans. For a manufacturer, operating budgets generally proceed from sales to production, production costs, selling and administrative expenses, and finally a budgeted income statement.

1. Sales budget: forecasts units to sell and sales revenue.

2. Production budget: calculates units to make to meet sales and inventory needs.

3. Production-cost budgets: estimate materials, labor, and manufacturing overhead needed for planned production.

4. Selling and administrative expense budget: estimates operating expenses outside manufacturing.

5. Budgeted income statement: combines budgeted revenue and expenses to estimate operating results.

These schedules are connected. A change in expected sales may change production, resource requirements, and expenses.

Estimating sales

A Sales budget estimates the number of units expected to be sold and the revenue from those sales. Its calculation is:

For example, if a company expects to sell $1{,}000$ units at $\$50$ each, its budgeted sales revenue is $\$50{,}000$. Sales forecasts should reflect relevant information such as prior sales, market conditions, pricing, and planned sales activity.

Planning production

A Production budget calculates the number of units to make so the company can support budgeted sales and reach its desired ending finished-goods inventory:

For example, if expected sales are $1{,}000$ units, desired ending inventory is $150$ units, and beginning inventory is $100$ units, planned production is $1{,}050$ units. Inventory amounts in this calculation are measured in units, not dollars.

Estimating operating expenses

Expense budgets estimate the resources and costs needed to carry out the operating plan. For a manufacturer, production-related budgets commonly cover the following:

• Direct materials: materials required for planned production. When budgeting purchases, adjust for desired and beginning raw-material inventory.

• Direct labor: labor hours required for planned production multiplied by the expected wage rate.

• Manufacturing overhead: production costs other than direct materials and direct labor, such as factory utilities or equipment depreciation.

A selling and administrative expense budget covers costs outside manufacturing, including sales commissions, advertising, office salaries, and rent. Managers often separate variable expenses, which change with activity, from fixed expenses, which remain constant within a relevant range. This distinction helps explain and forecast total costs.

For example, if selling expense includes a $\$4$ commission per unit sold and $\$12{,}000$ of fixed monthly expenses, then at $1{,}000$ units the budgeted selling expense is $\$16{,}000$:

The assumption about what drives each expense should be made explicit.

Using budgets for planning and control

Planning uses budgets to set targets and decide in advance how to use resources. Control compares actual performance with the plan, identifies meaningful differences, and investigates their causes.

A Variance is not automatically evidence of poor performance. It may reflect changed conditions, an unrealistic assumption, or a controllable operating issue. Managers should consider the cause of a difference rather than treating every variance as a performance failure.

Comparing results at actual activity

A Static budget is prepared for one planned activity level. If actual activity differs substantially from plan, comparing actual costs directly with a static budget can be misleading.

A Flexible budget recalculates expected revenues and costs for the actual activity level. This helps managers distinguish the effect of activity changes from other cost differences.

Building useful budgets

Budgets are most useful when they rely on realistic assumptions, are coordinated across departments, and are reviewed as conditions change. Input from managers who understand day-to-day operations can improve estimates and commitment. Targets that are too rigid or unrealistic can undermine a budget's usefulness.