There are many different ways that companies create budgets. Some companies will use the previous year’s results and modify for expected changes. In this traditional format, managers must only justify changes to budget from the previous year’s actual results. As an alternative, budgets can also be developed using a zero-based budget. In zero-based budgeting, all revenues and expenses must be justified for each new period. This approach assumes that operations are being started for the first time and the previous year’s actual results are ignored. Zero-based budgeting is an effective way to limit the inflation of budgets and con- trol unnecessary expenses. Because there are many different ways budgets are created and many different purposes, there are many different types of budgets. Let’s look at some different types.
Strategic and Operational Budgets
The term strategic generally indicates a long-term goal. A company will develop strategies such as becoming the cost leader in a particular market or expanding into international mar- kets. It may take several years to achieve these goals. A strategic budget is a long-term financial plan used to coordinate the activities needed to achieve the long-term goals of the company. Strategic budgets often span three to 10 years. Because of their longevity, they often are not as detailed as budgets for shorter periods.
The term operational generally indicates a short-term goal. After the company devel-
Learning Objective 2 Define budget types and the components of the master budget
Zero-based Budget
A budget technique that requires managers to justify all revenue and expenses for each new period.
Strategic Budget
A long-term financial plan used to coordinate the activities needed to achieve the long-term goals of the company.
A continuous budget is a type of operational budget the involves continuously adding one additional month as each month goes by. When a company uses continuous budget- ing, the company revises the budget by replacing the month that just ended with a month at the end so there is always a continuous 12-month period. Continuous budgeting allows a company to constantly monitor the budget and keep track of current and future amounts.
Static and Flexible Budgets
A static budget is a budget prepared for only one level of sales volume. For example, Smart Touch Learning, the fictitious company we have used to illustrate accounting con- cepts throughout the textbook, may prepare a budget based on annual sales of 2,000 touch screen tablet computers. All revenue and expense calculations would be based on sales of 2,000 tablets.
A flexible budget is a budget prepared for various levels of sales volume. This type of budget is useful for what if analysis. Smart Touch Learning may expect to sell 2,000 tablet computers, but a flexible budget showing results for selling 1,600 tablets, 1,800 tablets, 2,000 tablets, 2,200 tablets, and 2,400 tablets allows managers to plan for various sales levels. Flexible budgets are covered in detail in the next chapter.
Continuous Budget Involves continuously adding one additional month to the budget as each month goes by.
Static Budget A budget prepared for only one
level of sales volume.
Flexible Budget A budget prepared for various levels
of sales volume.
San Diego Zoo is a nonprofit organization that is committed to saving species worldwide through animal care and conservation science. The zoo was founded on October 2, 1916, and is home to more than 3,500 rare and endangered animals and more than 700,000 exotic plants. In addition, the San Diego Zoo also has a Safari Park that is an expansive wildlife sanctuary, home to more than 3,000 species including African Rhinos, Cheetahs, and Tura- cos (a handsome African bird). The zoo is home to one of the most valuable collections of birds in the world.
In 2003, Southern California was hit with Exotic Newcastle Disease, one of the most infectious bird diseases in the world. San Diego Zoo was forced to shut down their bird exhibits for sev- eral months and ultimately, the zoo spent half a million dollars on quarantine efforts. The great news was that no birds got sick!
However, the significant cost and decrease in revenue from the exhibit being closed led the zoo to be very concerned about its bottom line.
How did the San Diego Zoo use budgeting to minimize the impact of these unbudgeted expenses?
Paula Brock, CFO of the San Diego Zoo, stated the organization used monthly budget reforecasts to find a way for the organization
to still meet its bottom line even though the entity had these unex- pected expenses. Monthly budget reforecast is a type of continu- ous budgeting that involves revising the budget based on actual data. At the San Diego Zoo, each department revised the budget within 7 to 10 days of the end of each month. This allowed the zoo to determine where other expenses could be cut and plan alternative revenue streams.
How can a nonprofit organization, such as the San Diego Zoo, help employees understand the importance of budgeting?
It’s important that employees understand the link between the budget process and the organization’s strategy. At the San Diego Zoo, Brock states that the budget process is like a map. It a tool that helps keep employees on track. In order to improve employee understanding of the budget process, Brock implemented budgeting that started at the department level. This allows depart- ment managers to have an understanding of how their decisions impact the organization’s overall strategy and motivates employ- ees to buy into the budgeting process.
TYING IT ALL TOGETHER
Master Budgets
The master budget is the set of budgeted financial statements and supporting schedules for the entire organization. Budgeted financial statements are financial statements based on budgeted amounts rather than actual amounts. The master budget is operational and static.
Exhibit 22-2 shows the order in which managers prepare the components of the master budget for a manufacturing company such as Smart Touch Learning.
Master Budget The set of budgeted financial
statements and supporting schedules for the entire organization; includes the operating budget, capital expenditures budget, and financial budget.
The exhibit shows that the master budget includes three types of budgets:
1. The operating budget
2. The capital expenditures budget 3. The financial budget
Exhibit22-2 | Master Budget Components—Manufacturing Company
Direct Materials
Budget
Sales Budget
Production Budget
Manufacturing Overhead
Budget
Operating Budget
Cost of Goods Sold Budget
Selling and Administrative
Expense Budget
Cash Budget Budgeted Income Statement
Budgeted Balance
Sheet
Financial Budget Capital
Expenditures Budget
Direct Labor Budget
Note the difference between the terms operational budget and operating budget. The operational budget is a general term referring to a budget length (short-term, one year
or less), whereas the operating budget is a specific part of the master budget.
The operating budget is the set of budgets that projects sales revenue, cost of goods sold, and selling and administrative expenses, all of which feed into the cash budget and then the budgeted financial statements. The first component of the operating budget
Operating Budget
The set of budgets that projects sales revenue, cost of goods sold,
The second type of budget is the capital expenditures budget. This budget presents the company’s plan for purchasing property, plant, equipment, and other long-term assets.
The third type of budget is the financial budget. The financial budget includes the cash budget and the budgeted financial statements. Prior components of the master budget provide information for the first element of the financial budget: the cash budget. The cash budget details how the business expects to go from the beginning cash balance to the desired ending cash balance and feeds into the budgeted financial statements. These bud- geted financial statements include the budgeted income statement and budgeted balance sheet and look exactly like ordinary financial statements. The only difference is that they list budgeted (projected) amounts rather than actual amounts.
In creating the master budget, managers must think carefully about pricing, product lines, job assignments, needs for additional equipment, and negotiations with banks.
Successful managers use this opportunity to make decisions that affect the future course of business.
Capital Expenditures Budget The budget that presents the company’s plan for purchasing property, plant, equipment, and other long-term assets.
Financial Budget The budget that includes the cash budget and the budgeted financial statements.
Cash Budget The budget that details how the
business expects to go from the beginning cash balance to the desired ending cash balance.
Try It!
Match the budget types to the definitions.
Budget Types Definitions
5. Financial a. Includes sales, production, and cost of goods sold budgets 6. Flexible b. Long-term budgets
7. Operating c. Includes only one level of sales volume 8. Operational d. Includes various levels of sales volumes 9. Static e. Short-term budgets
10. Strategic f. Includes the budgeted financial statements
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercise S22-2. MyAccountingLab
Note to the Instructor: Learning Objectives 3 and 4 cover budgets prepared for a manufac- turing company. Learning Objectives 5 and 6 cover budgets prepared for a merchandising company. You can choose to cover both manufacturing and merchandising or either. Each section is presented on a stand-alone basis.