Budgeting and how it Benefits a Company

Answer

Budgeting and how it Benefits a Company

Introduction

Production costs constitute the largest costs for manufacturing companies. Some of the major costs that a company incurs before producing and marketing the final product include labor costs, raw materials costs and factory overhead costs. Optimizing production operations to meet these costs requires the company’s accounting financing and production departments to regularly perform sales forecasting. In many organizations, sales forecasting is often done quarterly or biannually and forms the basis of preparing both the production budget and the direct material purchases budget. This means that the process not only helps an organization to meet market demand for their products, but it also goes a long way in minimizing inventory management costs. As Isnaeni and Widayanti (2019) points out, it is through preparing precise production budgets that a company can effectively assign its profits, and above all, avoid under or over buying raw materials. The focus of this paper is to look at the importance of performing sales forecasting during the preparation of a master budget. Further, the various ways that a company can benefit from preparing a formal budget are discussed.

Why Preparing a Sales Forecast is the Earliest Step in Preparing a Master Budget

Master budget has multiple components, and sales forecasting is the first and most the crucial components. A sales forecast (also a sales budget) attempts to estimate the volume or number of units to be sold over a given period of time, and thus takes into account the company’s inventory policy and production plan. For the Chicago Furniture Company, for example, the company maintains an inventory policy that the inventory at the end of each month must be equal to 40% of the forecasted sales of the following month. Creating a sales forecast marks the first step in the preparation of a master budget because a sales budget is the backbone of the budgeting process; that is, all the other business budgets and their components are based on it.  For instance, by forecasting which products to add and which ones to modify, sales budget affects the variable elements of the selling and administrative budgets as and also forms the basis of the production budget. With a production budget, a company can now accurately develop both the direct labor, direct materials and manufacturing overhead cost budget. Information from these budgets feed into other subsequent budgets in the budgeting process, including the finished goods inventory budget, the cash budget, and income statement, and ultimately, the balance sheet. The fact that information from the sales budget affects all these business budgets means that sales forecasting is fundamental to the entire budgeting process, and thus should be as effective and accurate as possible.

Additionally, it is only through a sales forecast that a company will understand how much to be spent on commissions, advertising, bonuses, production and other variable aspects and expenses of the business operation. In the case of the Chicago Furniture Company, for instance, it could have been difficult to determine the cost of the required direct material purchases with a sales forecast.

Ways a Company can benefit from Preparing a Formal Budget

Creating a formal budget – a detailed documentation of all the anticipated expenditures, revenue earning returns and profit – is one of the important steps in the implementation of a company’s strategic plan. An effective budgeting system provides the management with opportunities to understand, plan and control the company’s resources, business problems, and financial options among other key activities. Thus, the benefits that come with an effectively prepared formal budget, as outlined below, range from improved financial support to strengthened management team.

1. Communicating a Company’s Financial Goals and Plan

Budgeting allows a company to conveniently and effectively communicate its financial goals and the overall strategic plan to key internal stakeholders, including top managers and executives, in a more formal way. Effective communication of both short- and long-term goals and plans increases the management’s awareness of the company’s resources and environment. This way, an organization can effectively monitor its financial resources, and accordingly protect the resources from fraud, accounting malpractices and other devastating financial risks (Abdo, 2019). Further, formal budgets enables the management to communicate the anticipated revenues and expenses to other departments in the organization.       

1. Planning

Preparing a formal budget is one of the strategic methods that a company can use to plan its financial goals both in the short- and long-run based on its position in the market and performance of each department. Budgeting, therefore, provides a company with a financial roadmap by helping it to determine the most appropriate strategies and goals, and the required to meet the goals. This way, a formal budget enables the management to strategically allocate resources to different functions in the organization, thereby serving as a powerful business management tool.  Budgeting also identifies or predicts bottlenecks in the company’s financial system, which enables the management to proactively solve such bottlenecks and other potential problems (Hermason, Edwards & Maher, 2016).

• Evaluation

Another way that a formal budget benefits a company is by facilitating performance evaluations is such areas as finance, production and human resources. By comparing actual results to budgeted revenue and expenses, a formal budget allows to understand how different units, departments, functions strategies, and divisions performed during the financial period (Hermason, Edwards & Maher, 2016). It also provides the management with early alerts about cash flows for different production levels and when credit financing may be required or minimized.