14

Budgeting and Forecasting

14.1 Budgeting Basics

14.2 The Sales Forecast

14.3 The Production and Inventory Budgets

14.4 The Operating Expenses Budget

14.5 The Budgeted Income Statement

14.6 The Cash Budget

14.7 The Budgeted Balance Sheet

14.8 Automating the Budget Process

14.1 Budgeting Basics

This subchapter explains how forecasts and budgets are used and introduces you to the different types of budgets you can make. You learn how budget data flows from forecasts, which budgets are most important, and how they all fit together.

Why Budget?

Not everyone is a big fan of budgets. It’s understandable; budgets take a lot of work to put together and can leave you feeling constrained and like you’ve blown it if you don’t follow them to the letter. That’s why most accountants prefer to focus on forecasting rather than budgeting.

We don’t want you to think of your budget as something set in stone, where if you spend one more cent than what’s allocated, you’ve failed. Instead, throughout this chapter we talk about a budget as a set of guidelines, not rules, based on the best forecasts at the time but always open to amendment as circumstances warrant.

Forecasting, done properly, can provide you with both a road map and a measure of security for the year. A road map because it lays out plans and projections for your company in economic terms. If you know what you expect to be spending and bringing in, it’s harder to be surprised. And a budget can serve as a warning system, alerting you to any problems or variations as they occur. This enables you to react quickly and maintain more control over your business.

Types of Budgets

To be useful, a budget needs to be based on reality. As anyone who’s tried to set up a personal budget can tell you, first you need to know how much money you have and expect to earn and what your expenses are. Only then can you set goals for saving and decide where it’s possible to cut back. The budgeting process in business is much the same. You need data—projections of what you expect to come in and go out—before you can start setting down guidelines for spending.

You’ll usually start the budget process a couple months before the new year—and before you get caught up in the closing process for the current year.

SEE ALSO 10.1, “The Closing Process”

SEE ALSO 11.1, “Year-End Closing Procedures”

There are several budgets you might find useful at your company or business. Your first budgeting task, however, is to set up the sales forecast, which is based on sales projections for the coming year. When you know what you hope to sell, you’ll have a pretty good idea of what you need to produce. In a manufacturing company, this means forecasting your manufacturing needs for the year by setting up a production budget. When you’ve projected how much product you need, next you prepare the manufacturing budget to see how much it will cost you. In a merchandising company, you’ll put together a merchandising purchases budget.

The next area you need to look at is your expenses. You can prepare selling and general and administrative expenses budgets based on anticipated production levels and past history. Now that you have projected your costs, you can put together the budgeted income statement.

On the financial budget side, the cash budget is one of the most critical budgets you make, as it lays out both spending and earning plans. It draws on information contained in manufacturing and operating expense budgets, as well as from your sales forecast and budgeted capital expenditures. Looking at the balance sheet, you then might consider a capital expenditures budget if you plan on buying new equipment.

After you’ve completed all these specialized budgets, you put them all together into what’s often called the master budget. Many companies even go so far as to compile budgeted (or projected) balance sheets and income statement to further quantify forecasts.

This diagram lays out some of the different budgets and shows how they connect.

In the following subchapters, we look at each of these budgets individually and show you how to put them together and use them.

14.2 The Sales Forecast

The sales forecast is your starting point—the one that serves as the basis for the other budgets. In this subchapter, you learn about what goes into a good sales forecast and how to make one.

Forecasting

The sales forecast is a prediction of what you expect your sales to be in the upcoming year. Sales forecasts can be derived from any number of places—industry reports, economic reports, conversations with salespeople, customers, competitors, and so on. The idea is to use your best estimate of what you expect sales to be. This projection usually encompasses sales by product, territory, etc.

In both manufacturing and merchandising operations, it’s best to start with the individual line or product, projecting per-unit sales and then multiplying by the sales price. Remember, even though these are only projections, budgeting sales too high can cause problems. You can end up with too much inventory, for example, that you end up discounting later. Many companies in cyclical businesses do quarterly budgeting to take slow seasons into account. Some larger companies put together monthly forecasts to keep on top of any unforeseen shifts in the market.

A Sample Forecast

To keep things simple, let’s assume Soft Soundz Company markets and sells only one item—a musical sound system sold on the web and designed to go in infant cribs. Soft Soundz has come up with the following sales forecast for next year:

SOFT SOUNDZ COMPANY
SALES FORECAST
FOR THE YEAR ENDING DECEMBER 31

Soft Soundz’s owner based these projections on past sales history, plus a slight increase after discussions with customers and individual salesman reports. The device has tended to sell better over the Christmas holidays and also in the second quarter, due to the high number of babies born in the spring. Sales are forecasted by quarter based upon anticipated units and the selling price. These figures now serve as the basis for Soft Soundz’s remaining projections.

14.3 The Production and Inventory Budgets

When you know the quantities you expect to sell, you’re ready to calculate how much product you need to make or buy. In this subchapter, you learn how to set up budgets for production, manufacturing costs, and merchandise purchases.

The Production Budget

A production budget tells you how much you need to make to meet estimated sales demands. To compute production quantities needed, use the following formula:

Budgeted sales + Finished goods inventory desired at the end of period – Finished goods inventory at beginning of period = Goods to be produced

In the case of Soft Soundz, let’s assume the company cut it pretty close with inventory last year and will only have about 30 units in stock at the beginning of the budgeted period. The company has adjusted sales up slightly but still would like to keep more of a cushion in ending inventory, say 300 units, which is about 20 percent of first quarter sales.

To arrive at goods to be produced, they would do the following calculation:

Budgeted sales + Ending inventory – Beginning inventory = Goods to be produced

9,400 + 300 – 30 = 9,670

The Soft Soundz production budget would appear as follows:

SOFT SOUNDZ COMPANY PRODUCTION BUDGET
FOR THE YEAR ENDED 12/31

In this case, the finished goods inventory each quarter is determined by taking 20 percent of the next quarter’s projected sales.

The Manufacturing Budgets

When you’ve computed units to be produced, you’re ready to budget your manufacturing costs. Using the per unit cost as recorded in your inventory records and the units needed, you can prepare budgets for the materials, labor, and overhead costs that go into the product by using the following worksheets.

SEE ALSO 5.3, “Figuring Inventory Costs”

The Direct Materials Budget

This budget helps you decide how much raw material you need to purchase. You start by looking at what you need for expected production and what you already have in inventory. In this example, you’re also budgeting a conservative cushion remaining in inventory after production of 10 percent of the next quarter production in case you go over or if there are delays in getting new product.

SOFT SOUNDZ COMPANY
DIRECT MATERIALS BUDGET
FOR THE YEAR ENDED 12/31

SEE ALSO 5.3, “Figuring Inventory Costs”

The Direct Labor Budget

The direct labor budget also uses planned production quantities to determine how much labor should be forecast for each quarter. As the following table demonstrates, you need to know direct labor hours or direct labor costs per unit to complete this budget.

SEE ALSO 5.3, “Figuring Inventory Costs”

SOFT SOUNDZ
DIRECT LABOR BUDGET
FOR THE YEAR ENDED 12/31

The Manufacturing Overhead Budget

This budget projects the amount of indirect variable and fixed costs that will be incurred in the course of production during the year. To complete this budget, you need to carry over direct labor hours required from the direct labor budget.

SOFT SOUNDZ
MANUFACTURING OVERHEAD BUDGET
FOR THE YEAR ENDED 12/31

Variable costs are those that fluctuate with production. Fixed costs are those that stay the same regardless of production levels. If we were costing actual inventory production instead of doing a forecast, we would apply these costs separately by period. But because this is a projection, we’re using an aggregate rate based on total projected overhead for the year of $43,515 ÷ total projected direct labor hours of $14,505 or $3 per direct labor hour.

SEE ALSO 5.3, “Figuring Inventory Costs”

The Merchandise Purchases Budget

For companies that buy their goods as opposed to making them, the purchases budget takes the place of the manufacturing budgets. You would use the same sales and production forecasts as well as the computations involving beginning and required ending inventory to cost your merchandise.

As an example, say International Hats, Inc., plans to sell 140,000 baseball caps over the next four quarters. It starts out with an inventory of 7,000 hats and hopes to end up with about 5,000 at the end of the year. Each hat costs $1.

You could compute International Hats’ cost of merchandise as follows:

Sales (Units)	140,000
Required Units in Ending Inventory	5,000
# Hats Required	145,000
Less: Hats in Beginning Inventory	(7,000)
Merchandise Purchases Required	138,000
Unit Cost	$1
Cost of Merchandise Purchases	$138,000

The other budgets and budgeted statements for a merchandising company (cash budget, operating expenses, capital expenditures, income statement, and balance sheet) would be the same as for a manufacturer.

14.4 The Operating Expenses Budget

This subchapter shows you how to prepare budgets for selling expenses and general and administrative expenses. These schedules can be combined, but we show them separately to highlight differences in costs.

The Selling Expenses Budget

Selling expenses are those that are directly related to the sales, delivery, and marketing of a product. Common selling expenses include delivery costs, sales commissions, advertising expenses, and promotional expenses.

The first step in preparing a budget for selling expenses is preparing a schedule of what these expenses are for your company. Because Soft Soundz does most of its marketing over the internet, its selling expenses consist of advertising expenses and delivery costs. The company is a sole proprietorship with few employees, so it doesn’t have sales salaries to include in these calculations.

After identifying selling costs, Soft Soundz must now determine whether they are fixed (meaning they remain the same whether they sell 1 item or 3,000) or variable (meaning they fluctuate depending on sales quantity).

Soft Soundz’s delivery expenses depend on the number of systems sold and are considered a variable cost. Advertising is paid in a flat fee per month, regardless of whether it brings in sales, so it would be considered a fixed cost. Soft Soundz figures delivery costs at $2.50 a unit, while advertising for the year runs $6,000. (Advertising, being a fixed cost, would be divided evenly among the four quarters.)

We could compute delivery expenses using quarterly unit sales estimates as follows:

Soft Soundz could now compose the following forecast for selling expenses:

SOFT SOUNDZ COMPANY
SELLING EXPENSES BUDGET
FOR THE YEAR ENDED 12/31

The General and Administrative Expenses Budget

General and administrative expenses, also called G&A expenses, include office expenses and other costs of running the company that don’t relate directly to producing or selling the product. Common G&A expenses include rent, administrative salaries, insurance, office supplies, utilities, and telephone charges.

To prepare a budget for G&A expenses, follow the same procedures outlined for selling expenses by first making a schedule of G&A costs and then determining which costs are variable and which are fixed. For Soft Soundz, none of the G&A expenses are variable. But the company does have fixed expenses of $80,000 for salaries, $30,000 for rent, and $5,000 for insurance.

The company’s G&A Expenses Budget could be prepared as follows:

SOFT SOUNDZ COMPANY
G&A EXPENSES BUDGET
FOR THE YEAR ENDED 12/31

The operating expenses budget is usually done in two parts: the selling expenses budget, which covers costs like delivery and advertising, and the general and administrative (G&A) expenses budget. The totals from these forecasts are then carried forward to the budgeted income statement, discussed in the next subchapter.

14.5 The Budgeted Income Statement

This subchapter discusses how to convert your forecasted sales and expense data into a budgeted income statement. Once again, the usefulness of this statement depends on how solid your forecasting is and how much things go as planned. Changing circumstances that effect costs or revenues should also alter your expectations.

Computing Cost of Goods Sold

When you’ve completed the sales and manufacturing and operating expense budgets, you’re ready to project your net income for the year. But first you need to compute cost of goods sold. For a merchandising firm, this means multiplying units sold by the cost per unit. If your company is a manufacturer, you have to add your costs for raw materials, direct labor, and overhead and then multiply that figure by units sold.

Soft Soundz can compute cost of goods sold as follows:

Computing Budgeted Income

Soft Soundz now has all the pieces in place to put together its budgeted income statement for the year:

Remember, the budgeted income statement is a projection. You’re trying to get a sense for what performance might be given how much reality adheres to your forecasts. However, as with the other projected statements in this chapter, it can be a useful tool to help you stay on track.

14.6 The Cash Budget

All your forecasts so far—sales, manufacturing, purchases, and expense budgets—contain cash flow data. This subchapter shows how to pull it all together to prepare your cash budget.

Projecting Cash Flow

The cash budget is one of the most important forecasts you’ll put together, because it gives you an idea of what your cash position should be throughout the year. To complete the budget, you’re going to need to draw data from all the budgets you’ve already prepared.

The essential format of the budget is this:

Starting cash balance

+ Cash inflows

– Cash outflows

= Cash balance before financing

+ Cash proceeds from financing (loans)

– Cash repayments

= Ending cash balance

Cash Inflows

Cash inflows include items such as receipts from sales, customer account payments, and proceeds from the sale of assets. To determine inflows for your company, look at your various budgets and statements from previous years. Put together a schedule of typical cash inflows. Then make an educated estimate of what these amounts are likely to be in the budget year.

Your biggest inflow is likely to come from sales. You can estimate collections based upon a percentage of the current month’s sales and the previous months’ sales. For example, Soft Soundz Company estimates that it collects 60 percent of sales in the current quarter and 40 percent in the following. This is how it would compute budgeted payments from customers.

SOFT SOUNDZ COMPANY
SCHEDULE OF PROJECTED COLLECTIONS

The amounts of expected collections for each quarter and the year can then be added to the cash budget. If you add sales ($752,000) to the beginning accounts receivable balance ($50,000) and subtract the total expected collections ($674,000), that gives you your accounts receivable balance ($128,000) on the proforma balance sheet.

Cash Outflows

Cash outflows include any payments made to creditors or suppliers. Two places to look for cash outflows are the manufacturing costs budgets and the operating expense budgets. For budgeting purposes, let’s assume Soft Soundz pays 50 percent of its raw materials expenses in the current quarter and the other half in the next:

Using the raw material purchases excerpted from Soft Soundz’s direct materials budget, we can compute payments made to suppliers using the following schedule:

Soft Soundz pays direct labor; manufacturing overhead; and selling, general, and administrative expenses in the same quarter, so figures from those budgets can be brought directly forward to the cash budget.

Capital Expenditures

Capital expenditures, or the purchase of plant property and equipment, also affect the cash budget as an additional outlay. Further, if a fixed asset is to be sold, the proceeds must be included in the cash receipts section of the cash budget. Companies that expect to have a lot of activity in fixed assets often prepare a capital expenditures budget for the period.

Soft Soundz has projected two capital expenditures during the year: updated manufacturing equipment and land for a new office. These are detailed in the following budget:

SOFT SOUNDZ COMPANY
CAPITAL EXPENDITURES BUDGET
FOR THE YEAR ENDED 12/31

Cash outlays for these projected expenditures will be carried forward to the projected cash budget.

SEE ALSO 7.1, “Property, Plant, and Equipment”

Financing Activities

The financing activities section is also sometimes referred to as the borrowing portion of the cash budget. Included here are any loan funds expected to be received or repaid. For example, if Soft Soundz plans to borrow $2,500 in the third quarter and expects to pay it back with interest in the fourth quarter, this is factored into the cash budget.

Preparing the Cash Budget

Based upon the data from the operating budgets and accompanying expense schedules, we can now prepare the cash budget for Soft Soundz. Assume Soft Soundz had a $43,000 cash balance at the start of the year:

SOFT SOUNDZ COMPANY
CASH BUDGET
FOR THE YEAR ENDING 12/31

The cash budget is put together using forecasts for sales, customer collections, capital expenditures, manufacturing costs, and other expenses. One purpose of plotting out expected cash inflows and outflows is to help manage cash and avoid situations where you might have a cash shortage. If, for example, you’d planned both your capital expenditures for land and equipment in the first quarter, you would have come up with a negative cash balance and an excess of disbursements over available cash. Looking ahead can help you avoid this type of situation and make adjustments in your planning.

The cash budget is similar in some ways to the statement of cash flow. But always remember, the cash forecast is only a prediction, while the cash flow statement shows your actual cash position during the period.

SEE ALSO 11.4, “Generating Financial Statements”

14.7 The Budgeted Balance Sheet

The final part of the budgeting process is to produce a budgeted balance sheet for the period, which we show you how to do in this subchapter.

The budgeted or pro forma balance sheet shows your projected financial position at the end of a period, typically a year. You can prepare it using the balance sheet from the previous year as well as the operating and financial budgets you prepared for the current year.

By the time you’re ready to put together the budgeted balance sheet, much of your work has already been done for you. Account balances for assets, liabilities, and owner’s equity are derived either from financial statements for the previous year and forecasts for the upcoming year. Owner’s equity comes from the previous year’s balance sheet, for example, while cash is the forecasted ending balance on the cash budget.

The budgeted balance sheet, like the budgeted income statement, is a good start to plotting where you might go during the year. Having a plan—and in this case a projected end point—can help you stay on track and spot potential problems early on. But again, we emphasize that you are forecasting here, and nothing is set in stone. Business always has a few surprises in store; budgets are merely tools to help you better deal with them.

14.8 Automating the Budget Process

Manually preparing the detailed budgets we’ve described in this chapter can be a time-consuming process, which is why accounting software has been such a boon for many businesses. Even the most basic programs now give you the ability to project the future performance or financial position of your enterprise at the touch of a button. For small businesses in particular, this means the forecasting process no longer has to be a once-a-year exercise. By punching in a few numbers, business owners are now able to adjust their projections to actual circumstances and see how they’re doing whenever it’s warranted.

In addition to helping with midyear adjustments, an automated system makes it quick and easy to forecast profits and losses and project cash flows, two of the more useful pieces of information for business planning purposes. Note how the Sage Peachtree Accounting program allows you to compute cash flow for any period of time, even if it’s just the week ahead.

Sage Peachtree allows you to get a snapshot of your company’s cash position for any period of time.

(Peachtree Accounting ©2012 Sage Software, SB, Inc. All rights reserved. Peachtree and the Peachtree logo are the registered trademarks of Sage Software, SB, Inc. Screenshots are reprinted with permission.)

More advanced software applications can give you the ability to track budgets by different departments or cost centers, which can be beneficial for larger companies.

That said, it’s important to remember that whether you’re crunching the numbers yourself or having this done automatically, budgets are only as good as the assumptions behind them. Without a reasonable forecast for revenue and growth, it’s impossible to establish a budget with any relevance. So focus first on your forecasting to come up with realistic goals and expectations. Having done that, you can create budgets to set some limits and parameters for spending. But even then, stay flexible.