Before budgeting process even starts, top management usually defines and communicates strategic plans which specify long-term (5 years or more) strategic orientations for the company. They also provide with some broad directives about a set of assumptions or premises which should be common to all parts of the organization.
A strategic plan is the top management’s vision of what the organization has to achieve in the long term.
The budgeting process then involves many interactions between all the functions of the organization. While each step may require several iterations, rounds of negotiations, and mutual adjustments, before arriving at a common feasible plan, it usually follows a clear sequence illustrated in the following flow chart:
The starting point of any budget is a sales forecast produced by the sales and marketing department. This document indicates the expected sales volumes for the different products and services of the company. It proceeds not only from expectations about the future competitive environment, but also from the company’s objectives and strategies. It is therefore intimately tied to the pricing policy, credit terms, selling and marketing expenses which all are constitutive of the sales budget. However, before this sales budget can be finalized, the production must be planned to determine whether it is feasible.
The sales forecast is thus communicated to the production. Based on this forecast, available capacity, and inventory policies, the production department establishes a production schedule specifying the volumes to be produced in each period to satisfy the demand. If a feasible production schedule is established, the production department can communicate its needs for raw materials to the purchasing department (or procurement) and its needs for labor to the human resources department.
These departments communicate in return the raw materials costs and labor costs as well as related credit terms which are used to build a direct materials purchase budget, a direct labor budget, and a manufacturing overhead budget which together constitute the inventory and production budget. This budget is typically built using techniques seen in Chapters 2 (costing) and 3 (cost estimation).
When available inventory and productive capacity are not sufficient to meet the demand, the production managers can send requests for capital expenditures (or “CAPEX” requests). Such long-term investment decisions to increase capacity necessitate the constructions of capital budgets. If the request is denied because future cash flows appear insufficient to justify the investment, the sales department may have to revise the sales forecasts and the sales budget to account for the capacity constraints. Otherwise, the depreciation of the new productive equipment is integrated in the manufacturing overhead budget.
The administrative budget (i.e. administrative expenses related to administration, legal counsel, accounting services, and other corporate functions) is built in parallel of the other budgets. Indeed, since administrative costs are discretionary costs, they are set independently of the expected volume of activity (only variable costs and capacity fixed costs depend on planned activity). However, they may also be revised if they exceed what the company can afford based on estimated cash flows.
The finance department gather all these budgets (sales budget, inventory and production budget, administrative budget, and capital budgets) and use them to build a cash budget summarizing cash inflows and outflows from operating and investing activities. This cash budget allows the finance department to assess the resources needed to finance operations.
If initial budgets prove to be impossible or unacceptable, planners repeat the budgeting cycle with a new set of decisions. Once a coherent, feasible, and acceptable set of budgets have been agreed upon, usually after multiple iterations and interactions across functions, pro-forma financial statements (i.e. budgeted income statement, balance sheet, and cash flow statement) are produced and communicated to the direction.
This process results in a master budget, which is a comprehensive set of operating budgets (about operating activities) and financial budgets (about financial resources needed to support operations).
A master budget is a financial summary of all planned operating, investing, and financing activities of an organization over a specific period of time (usually a fiscal year broken down into quarters and months).
Operating budgets cover the organization’s planned operating activities for a particular period of time. They gather the sales, production, procurement, and administrative budgets (which feed the pro-forma income statement in financial budgets).
Financial budgets cover the organization’s planned investing and financing activities for a particular period of time. They include capital budgets for investments, cash project for financing, as well as the pro-forma financial statements (income statement, balance sheet and statement of cash flows).
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