The goals, assumptions, and predicted revenue and expenses information are passed from the senior manager to middle managers, who further pass the information downward. The top-down approach typically begins with senior management. (Figure) shows the general difference between the top-down approach and the bottom-up approach. For example, budgets can be derived from a top-down approach or from a bottom-up approach. There are various strategies companies use in adjusting the budget amounts and planning for the future. To save time and eliminate unnecessary repetition, management often starts with the current year’s budget and adjusts it to meet future needs. The budget development process results in various budgets for various purposes, such as revenue, expenses, or units produced, but they all begin with a plan. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license) / adjusted for Australian terminology How are budgets developed? Operating Budgets, Financial Budgets, and the Relationship between Budgets. The figure below lays out how operating budgets and financial budgets are related within a master budget. Current costs are used to develop standard costs for the price of materials, the direct labour rate, as well as an estimate of overhead costs. Companies use the historic quantities of the amount of material per unit and the hours of direct labour per unit to compute a standard used to estimate the quantity of materials and labour hours needed for the expected level of production. To create these budgets we use information such as the standard quantity and standard price for raw materials that need to be purchased, the standard direct labour rate and the standard direct labour hours that need to be scheduled, and the standard costs for all other direct and indirect operating expenses. Overhead is generally the fixed costs that support manufacturing – such as rent for the premises, costs to maintain machines, power to run machines. Labour is the variable cost of people used to manufacture the item. The materials are variable cost raw materials used to manufacture the item. The production budget is then broken up into budgets for materials, labour, and overhead. This information in units and in dollars becomes the production budget. Management uses the number of units from the sales budget and the company’s inventory policy to determine how many units need to be produced. The sales budget is the foundation for other operating budgets. It then breaks down estimated sales into quarters, months, and weeks and prepares the sales budget. For example, management estimates sales for the upcoming few years. The operating budget has several subsidiary budgets that all begin with projected sales. The operating budget helps plan future revenue and expenses and results in a projected income statement. The financial budget plans the use of assets and liabilities and results in a projected balance sheet. The master budget has two major categories: the financial budget and the operating budget. It will contain every source of revenue coming into the business and every cost the business will need to pay for. The master budget is exactly as the term describes – the budget that exists above all others.
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