FINANCING AND

BUDGETING
CHAPTER 5

KINDS OF CAPITAL
In common usage the word "capital"
is the single term used to cover the
land, buildings, machinery, tools, and
materials of a productive enterprise.
Technically, whereas land is capital, it
is distinguished from the other means
of production because they are
reproducible and land is not.
Rarely does the businessman make
this distinction.
In the word capital, he lumps
together all the elements he will need

He thinks of capital most often in

money terms.
Promoting a new enterprise is very
largely a financial operation.
Since money and credit are the chief
means for acquiring the instruments
of production, the word capital has
this financial aspect.
And this is the way we shall use it
here.
Applied to industrial financing, capital
means the cash money and credit
needed to start and to operate an
enterprise

These forms of capital are best

understood when we examine the
capital requirements of an
ordinary industrial enterprise.
In this way, too, the connection
will be clear between money,
capital and productive capital,
the tangible instruments of
production.
If an industrial enterprise is to be
started from the ground up. so to
speak, it will need land and

Assets of this kind, intended to be

used over and over again in
production for a long period of time,
are commonly called fixed capital and
the money and credit required to pay
for such assets take the same name.
An enterprise also requires funds to
cover its operations-to maintain the
plant, to purchase materials and
supplies, to pay salaries and wages,
to cover storage, transportation, and
shipping services, for advertising,
and to tide over the enterprise during
the time lag between the sale of its

SOURCES OF CAPITAL FUNDS

To finance modern industry, large-scale savings are
necessary.
By large scale savings we commonly mean money
savings arising in a variety of ways throughout the
economy. Individuals, rich and poor, save.
The rich save directly, largely because their income
exceeds even the large spending they do for
themselves and their families.
They also save indirectly as when they pay life
insurance premiums, purchase annuities, establish
funds, etc.
From the wealthy to the lower income group, there
are gradations in the amount of direct savings like
savings bank accounts, building and loan shares,
savings bonds; and much of the steady savings is
done through such indirect means as life insurance.
The very poor cannot save for themselves at all their
income is all used up in living expenses, But the
spending of an individuals from the very poor to the

Governments make up the third large group of

savers.
There are about 100,000 government units in the
United States -Federal, state, and local. When anyone
of these units collects more in taxes than is used for
operating expenses and uses the balance for public
works, the part so used represents government
savings.
The savings take the form of public works such as
highways, river and harbor construction,
sewage-disposal and water systems, transportation
facilities, public buildings, and the assets in a
growing list of government enterprises.
In addition, government purchases many billions of
dollars' worth of goods and services a portion of
which finds its way into business capital savings for
future investment.
So far as the stream of savings and investments is
concerned, government savings perform very much
the same function as do business savings.

THE MONEY MARKET

The financial requirements of modern industrial
enterprise are so great that a large network is
needed to mobilize the money and credit
resources needed.
The money market does this- and is therefore
one of the chief reservoirs of capital.
What do we mean by the commercial money
market?
If a definition were attempted, it might read
something like this:
In its broadest sense, the money market is the
total of individuals, firms, institutions, and the
process by which money and credit are
collected, accumulated, and administered for
the financing of economic activities.
The market is not a single place, or channel, or

Long-Term Capital
For long-term capital, industrial borrowers may tap
several channels.
Large investment banking houses serve large
industrial enterprises by undertaking to underwrite
and to market stock and bond issues.
Insurance companies have lately become an
important source for long-term capital funds by
taking the security issues of industrial enterprises
(particularly utilities) by direct, private placement.
Institutional and endowment trust funds may also
supply capital by direct placement, but usually they
do their investing by purchasing securities
distributed by other agencies.
In the past, commercial banks dealt mainly in shortterm loans, but financial changes in the last 20 yearshave induced them to seek outlets for their funds in
fixed-term investments for as long as 10 to 15 years'
maturity.
Rarely do wealthy individuals make independent

Intermediate and Short-Term Loans

Whereas intermediate and short-term
loans represent different types of
financing, both are virtually serviced by
the same types of lending agencies.
Short-term loans may range from 30 days
up to 2 years, and intermediate term
loans to 5 years, depending upon the
character and circumstances of the loan.
This is the field occupied by the regular
commercial banks which in local
communities throughout the nation have
traditionally served the current credit
needs of business enterprises.
Some changes have been taking place in

For one thing, the very large industrial companies

increasingly tend to finance themselves in matters
of intermediate- and short-term credit.
On the other hand. the need for bank liquidity, the
high lending standards. and the riskiness of small
business tend to make commercial banks
reluctant to serve the credit needs of small
enterprises. unless Federal lending agencies
participate with the banks.
To a considerable extent also the banks have
enlarged their role as a financial service agency in
the community in handling the flow of funds.
Thus they have increased their activities in
making personal, automobile, appliance, and
home-improvement loans to individuals and
business.
Where gaps in financing operations have been left
open by the commercial banks, various other
lending agencies have become active.

The chattel-mortgage, finance, and

investment companies operate in a
variety of forms.
The rates they charge are likely to be
higher, the conditions put upon the
borrower more burdensome, and the
resultant cost of the loan much higher
than regular bank credit.
Commercial factors, frequently
referred to as the "middlemen of
credit," have come to occupy an
important place in industrial and
business finance.
Originally the commercial factor

In time the factor came to deal extensively in

financing operations through the purchase of
accounts receivable, installment contracts,
promissory notes, and other commercial paper
based on transactions, inventories, and
warehouse stocks.
Many of them specialize in aiding struggling
entrepreneurs as well as established firms
hard pressed for working capital.
In most cases they operate in areas where
banks are reluctant to enter, and they charge
higher rates for accepting the unusual risks.
With the aid of a factor a manufacturer can
turn orders into cash without waiting weeks
and months for a return to be realized.
This is an important but costly and sometimes
unreliable service to small and medium-sized

Trade Credits
Not mentioned as yet, because it is
not exactly a lending agency, is the
trade credit.
This is the mainstay of intermediate
and short-term financing,
particularly for the small
enterprise.
It covers not only commodities and
supplies, but also machinery,
fixtures, equipment, and other
items of longer term financing.
The small manufacturer simply

A new twist on the trade credit may emerge

from the practice by which a large
corporation sometimes gives financial aid to
some among its cluster of smaller satellite
suppliers.
In a somewhat similar manner, large buyers
such as mail-order houses and department
stores sometimes aid those whose
production they buy entirely or in
substantial part.
A new form of financing relationship may
grow out of these practices, just as factor
financing grew out of merchandising
functions originally performed by factors for
manufacturers.
In boom times and even in times of normal

Credit Instruments
Credit instruments are the legal
forms through which loans are
made.
They differ with the type of loan,
the length of time it is to run, the
use to which the funds are to be
put, and the type of borrower.
They differ also by the way in
which they affect third parties.
Only the more general types of
credit instruments can be touched
upon here because each case is

Long-term credit, if required for equity or

fixed capital, usually takes the form of
securities-stocks or bonds of the
borrowing company which ultimately
come to be held by individuals, banks,
investment trusts, and other investors.
Commercial credit for other than fixed
capital of permanent nature is usually
represented by promissory notes, backed
by collateral of various kinds, and almost
always negotiable. In some cases the
collateral takes the form of mortgages
against the firms real estate, machinery,
equipment, and other chattels.
In other cases the collateral maybe

Short-term credits or commercial loans

intended to finance single transactions or a
group of transactions that are to be
completed in short time are ordinarily
evidenced by promissory notes, drafts, bills
of exchange or trade acceptances.
These may or may not be supported by bills
of lading, warehouse receipts, or chattel
mortgage contracts as against materials
involved in transactions, and other claims
upon property.
When accounts receivable are accepted as
collateral to a loan, or taken over outright by
a lending agency, the usual form is to as sign
such accounts to the lender.
If the firm markets its products direct to the
consumer and takes installment notes or

PLANNING THE FINANCIAL STRUCTURE.

Few people will deny that enterprises may
still be started on a shoestring and may be
developed into large-scale companies.
This is less possible in the old-line
industries where established firms offer
strong competition than it is in the newer
industrial fields where demand and supply
forces are not fully established.
The automotive, airplane, and homeappliance industries are examples of
established fields, while plastics, light
metals, and electronics are examples of the
new fields.
The problem of starting a new enterprise is
always much more difficult than that of

Financing the Non-corporate Enterprise

In the case of the single proprietorship and
the partnership the initial capital comes from
the individuals directly interested and
possibly through the loans and investments
that their friends are willing to make in the
business.
In addition to cash, these individuals may
contribute the actual land, buildings,
machinery, and materials needed to make up
the productive capital of the business.
We shall see later how these enterprises can
augment their initial capital with working
capital from various sources, but at the start
they are largely dependent upon their own
resources.

Corporate Capitalization
It is the corporate enterprise that is
most concerned with the problems of
formal capitalization.
At the time of incorporation the
promoters or prospective managers
must make the policy decision as to the
total amount at which the enterprise is
to be capitalized and what forms the
capital structure should take.
The chief factors in this decision are the
nature and size of the business.
From careful analysis of the elements in
these factors, analysis of the product,
market studies, and a general business

If real estate, buildings, equipment,

and other tangible property are
contributed by the organizers, the
cost or value of such assets will be
part of the total.
To this sum there will have to be
added an amount sufficient to cover
necessary promotion, engineering,
and developmental expenses.
It is essential to have a fund of
working capital sufficient in the
beginning to carry the firm through
the production cycle to the point when
substantial and sustained returns

In some few cases the capitalization may

take account of
patents, secret processes, trademarks,
and other intangible items, but in the
untried enterprise there is little basis for
anything other than nominal values on
these items.
Current legal requirements, state and
Federal, will have to be considered
because they affect franchise fees,
taxation, security sales.
And other affairs of the company. Initial
capitalization might also be planned with
an eye toward future expansion and
toward the problem of future
marketing of corporate securities, but

CLASSIFICATION OF STOCK
To complete the basic
financial structure, the
authorized stock will have to
be classified to define the
relations of stockholders to
the enterprise, to fix the
status of the corporation
with creditors and the
public, and to provide the

COMMON STOCK All the authorized

capital stock of a company may be
issued in a single classification,
common stock.
No special rights or privileges are
attached to common stock.
It bears the full risk of the
enterprise, its successes and
failures.
Common-stock holders are in law
the real owners of the enterprise,
and they are entitled to the net
assets of the business.

PREFERRED STOCK Preferred stock is the

second of the main classes into which
authorized capital stock may be divided.
The chief reason for it is to offer
inducements to attract investors.
The stock may be preferred as to
dividends and assets it may be
convertible into common stock on
attractive terms; a sinking fund may be
set up to guarantee safety of the
investment; it may have other rights.
On the other hand, it may have limited or
no voting power since its other privileges
protect it from the risks which common
shareholders assume.

No arbitrary rules can be set for division between,

common and preferred stock.
This is a matter of judgment in each case, in answer
to such questions as:
How and by whom is the enterprise to be controlled?
How much capital will have to be sought from
outsiders?
To what extent is it wise to burden the company with
obligations to pay fixed dividends?
What legal and tax considerations are involved?
How will the sale of securities be affected by
different classes of stock?
What financial structure is most assuring to
creditors?
What is the most desirable basis for the division of
earnings and of
assets of the company on dissolution?
These are a few of the questions entering into the
decision when stock is to be set up in classes.

Bond Issues (Company Indebtedness)

When the earnings record is good,
assets are substantial, and prospects of
expansion favorable, a good method of
raising needed capital is to borrow it on
bond issues.
In essence, bond issues are company
promises to repay the loan at stated
periods and are backed by a mortgage
on part or all of the company's property.
They take the form of bonds debentures
certificates, or notes of issue based
upon a trust agreement or indenture
which contains all the rights and
obligations between the company-

The essential relationship between the

company and the bondholders is that of
debtor-creditor.
While this means that bondholders have
no ownership
interest in the company, it also implies
that their rights are superior to those of
the stockholders until the bonds are
retired.
A company contemplating a bond issue
should make careful studies not only of
the varieties of bonds which may be
issued, but of the wisdom of floating a
bond issue at all.
Whereas borrowing for industrial
expansion has many advantages, it also

Working Capital
In the new enterprise, working
capital must come largely through
the initial financing.
After the firm is in operation, other
sources will be open to it.
Chief of these sources, of course, is
the current operations of the
enterprise.
These operations should be
sufficient to produce all the
financing required to meet the
routine current needs of the

In common usage, working capital is

the total of current assets consisting
of merchandise and materials, cash,
accounts receivable, and other liquid
assets, less current liabilities.
Proper ratios should be sought
between current assets and current
liabilities and between current assets
and capital assets.
What these ratios should be depends
upon the type of enterprise and other
factors; no fixed rule can be applied to
all concerns.
In general, working capital should be

A budget plan is the best device to

develop and control the flow of
working capital.
It sizes up the prospects of the
business in advance, proportions
the various parts of the enterprise
in proper relation, sets the timing
of income-in relation to
expenditures, prepares for
contingencies, and keeps a reserve
in readiness for unexpected
opportunities.
A soundly operated enterprise with

Reserves and Expansion

Sound financial administration
requires the setting up of
reserves for working
capital, to liquidate debts, to
cover credit losses, against
contingencies such as fire, theft,
and unexpected liabilities, for
depreciation and obsolescence, to
offset price fluctuations on
inventories, for taxes, to provide
for improvements and expansion,

Ordinarily a going concern will

accumulate some capital for expansion
through operations.
Where the competitive price structure
allows and in state-regulate. enterprises
like utilities, the unit price of the product
or service may contain a fractional Sum
to be set aside in the form of reserves for
expansion of the business.
Closely analogous to financing expansion
through a specific part of the price are
the common methods of "plowing back
the earnings" and depreciation reserves.
Taxes, however, have become so
burdensome that there is a real problem

When greater amounts of capital

are needed for expansion, the
firm may seek equity capital
through sales of stock to
employees, customers, sometimes
to creditors, and the general
public.
Stock rights issued to existing
shareholders often result in
increased equity capital for the
company.
In recent years sources of
expansion funds may be found, in

One of the chief methods of expansion, used

extensively in the last half century, is to combine
two or more enterprises.
So far as financing is concerned, combination is a
method of raising equity capital and often of
strengthening the working capital of the surviving
enterprise.
It should not be attempted lightly or without a
thorough study of the many problems involved.
Is the 'physical property of the concern to be
merged in good condition?
How long has the company been in business?
What advantages or disadvantages will be
inherited from its position in the industry and
trade?
What are its financial history and record of
earnings?
Are the earnings of the combination likely to

These and many other questions must be

answered with great care to be certain that
the weight of advantage lies with the new
company over the former separate
concerns.
Although a caution sign should always be
raised when a successful, going concern
considers a merger with another concern in
difficulties, business history abounds with
just such combinations.
Where the company in difficulties has
particular weaknesses, such as insufficient
working capital, poor management,
inadequate sales personnel, or poor
distribution network, but possesses a
distinctive product, established place in

In particular, tax-loss carry forward

has come to play a prominent part
in many recent mergers. On the
other hand, expansion generated
by promoters who saw profits in
the manipulation of companies
rather, than in running a sound
industrial enterprise has led to
great abuses in the past and
should be avoided.
At all events, the lure of great
profits and the dazzle of empire
building through expansion should

The Special Problem of Small Business

Small enterprise is an important element
in the entire economy.
Numerically it is the largest sector of the
economy, but if measured by employment
provided and value of products in the
manufacturing field, it is overshadowed
by medium- and large-scale enterprises.
But these are not the only considerations.
Small enterprise provides a source of
specialized products and services, a
source of supplies and parts for large
enterprise, a market for goods and
services, a healthy element of competition
in the economy, a source of employment
for many persons, and a field for

Because of small size, limited capital

and earnings, lack of personnel for
specialized management, and
intense competition, the small
enterprise has
difficulty in getting equity capital at
the start and in financing itself later
through operations.
For his initial capital the small
enterpriser often has to rely upon his
own resources and upon the
willingness of friends, relatives, and
potential business associates to

Some community banks make short-term loans

to small enterprise, but the aid is limited and
rarely covers capital expansion.
The trade credit is an important mainstay of
small-business financing, but it is costly,
limited in amount, and not sufficiently reliable.
In many cases funds have to be sought from
commercial factors, mortgage and finance
companies, and personal loan agencies.
For each satisfactory relationship with these
sources, there are many other small business
concerns which have had painful experiences
with this type of financing.
Many such loans carry hidden "service"
charges, authorize lenders to hold back funds,
tie up all available collateral, and allow lenders
to interfere in the management of the
enterprise.

But in many cases the small

enterpriser himself is partly at fault
for his plight.
Small enterprises frequently suffer
from bad management, loose
accounting practices, too liberal
granting of credit to their customers,
excessive withdrawals of cash by
owners, and premature unwise
expansion.
These conditions make small
enterprises high risks, and lenders
who share in those risks seek
compensation through high rates and

CAPITAL ALLOCATION
Assuming investment capital is available,
there is almost always a choice of ways to
invest it.
The two most important criteria of
worthiness are the risks involved and the
pattern of cash flow.
An evaluation of risk results from
questioning the likelihood of expected
returns. Many appropriate questions were
posed in the previous chapter.
When it is possible to measure
probabilities of success for alternative
investments, the preferred solution
can be obtained quantitatively.

The time-scaled pattern of

receipts and disbursements
should always be
Quantitatively evaluated.
The time value of money is
synonymous with interest.
Interest, or the cost of
borrowing capital, has been
an accepted aspect of capital
management for centuries.
In the last 30 years much

Receiving a dollar today is

preferable to receiving it a year
from now.
Part of the reason is that inflation
may detract from the buying power
of the delayed dollar, but the more
germane consideration is that the
dollar received today can be put to
work in the interim period.
It can earn interest during the year
it works before the delay dollar is
received.
The amount it earns divided by the
amount invested for the year is the

There are several ways to utilize

interest rates in the evaluation of
proposed investments-payout
period, present worth, equivalent
annual cost, capitalized cost, rate
of return-but only rate of return
will be described here.
The rate of return is a percentage
figure, equivalent to an interest
rate, which indicates the return
earned over the life of an
investment.
It is calculated from the cash-flow

Three possible cash-flow

patterns are shown.
All three represent returns
over a period of 10 years
received from an initial
investment of $1,000 made at
time O.
Disregarding taxes, the three
patterns all have the same
rate of return.
The obvious conclusion to be

After the rate of return has been computed

by discounting the cash flow of each
alternative, the final step is to decide
which, if any, of the alternative
investments should be made.
An investment promising a rate of return
less than could be earned from investing in
conservative bonds would hardly be
attractive.
Each enterprise has its own minimum
acceptable rate of return, larger for highrisk endeavors and lower for conservative
operations such as public utilities.
Proposals failing to meet the minimum are
discarded unless there are very significant
intangible benefits involved.

THE BUDGET
It is the long-term responsibility
of management to so use
investment that
it will yield the largest possible
profit or return, and it is the
function of budgeting to plan
that profit picture.
Perhaps this planning can be
understood better if we first
examine the components of
profit.

Starting with the upper right-hand comer

of the chart we find that working capital is
made up of inventories, accounts
receivable, and cash.
These the permanent investment in
assets such as land, building, and
equipment comprise the total investment
of the company.
We determine how hard this investment is
being worked by comparing it with total
sales for the designated period of, let us
say, one year.
If sales were $400,000 and investment
$100,000 the turnover of investment for
the year would be four or, in other words,

The next question, then, is how

much did each turnover yield?
The lower part of the chart in Figure
5-3 shows the method for
calculating earnings in terms of the
percentage of the sales dollar.
Note that the costs of sales are
listed in the lower right-hand comer.
These comprise the cost of making
the product and getting it to the
customers and must be deducted
from total income from sales to
determine earnings on sales.
If we find that earnings on sales is

PLANNINGTHROUGHTHEBUDGET The task in

budgeting is to plan production in accordance
with sales estimates land a minimum cost.
Recent trends toward decentralization of authority
and responsibility, discussed in preceding
chapters, are especially applicable in budget
planning.
Under this system only a relatively small finance
staff is maintained at headquarters under the
supervision of a controller.
He may personally exercise the leadership in
budget planning or he may delegate this to a
budget director.
Each operating division or plant is provided with
its own staffs in accounting, industrial
engineering, industrial relations, and in some
instances product development, where the
company is organized on a product basis.

This is in contrast with some centralized

situations, although certainly not all,
where the profit budget is prepared in
headquarters and the division manager is
handed a pattern of operation with
predetermined standards against which his
operations will be evaluated.
In such a situation he feels little concern
for profit.
Under the decentralized system he is
considered an executive in charge of a unit
of the investment which is expected to
produce its share of the return.
Furthermore, it is his responsibility to
spread this concern for profit throughout
his unit to department heads, supervisors,

Sales may or may not be decentralized by

plants or divisions.
If decentralized, sales will operate as a
separate staff unit working with the budget
director and the plant manager in the
establishment of sales goals and production
requirements to serve those goals.
In small and medium-sized companies the
job of budget planning operates in much the
same way that it operates in a division of a
larger company except that it may not have
the benefit of extensive data gathering and
research provided by headquarters of the
large company.
On the other hand, managers of small
companies should have an advantage in

CONTROL THROUGH THE BUDGET It should

be understood that a budget is a means
toward an end and is not an end within
itself.
Budgets are made to be used.
They establish goals to which each
department and each worker within a
department must contribute his
designated share in terms of the unified
plan.
This leads toward precision and
confidence.
A department head knows what is laid out
for his department to accomplish.
He knows what is expected of him.

Through recording of actual

results against the estimates
of the budget,
reports are constructed that
reveal the points of difficulty
and danger-the
points which must be
analyzed and improved
upon.
Management operating on

COORDINATION THROUGH THE BUDGET

Budgets should be constructive aids to all
departments, within an organization in
achieving their common goals.
Unfortunately, however, this purpose is
frequently misunderstood.
The early emphasis given to budgets as
controls of expenditures established in the
minds of subordinates the attitude that
budgets were negative controls only-devices
to limit expenditures.
This led to the "padding" of departmental
budgets, the idea being for each department
to get as large an allotment of expenditures as
possible.
When all budgets were assembled and
reductions were deemed essential, each

Budgets, properly
constructed and operated,
may have a constructive
influence on the personnel
of an organization.
Budgets may serve as a
means for bringing about an
understanding of the
common goals of all who
belong to the organization

TYPES OF BUDGETS
There are two principal types of
budgets: the static, or fixed, budget
and the variable, or flexible, budget.
The static budget depends upon
ability to predict income, sales, or
shipments with at least a reasonable
degree of accuracy.
Using this prediction as a base. fixed
sums are allocated for expenditures
with a fixed budget of production
operations for the period in question.
The variable budget recognizes the

1. The static budge/ Industry inherited

the static budget from governmental
and institutional organizations.
This type of budget served a valuable
purpose in the
planning and control of certain fixed
types of expenditures.
The in adequacies of such a budget
however, were soon felt when industry
moved into the period of mass production
where margins of profit per unit of
production were small and planning and
control over all operations became more
essential.
Through study it was found that costs per

2. The variable budget The

variable budget is constructed
in anticipation of variations in
sales.
It provides in advance for
orderly change in the volume
of production
and in expenditures.
This tabulation is based on
the recording of costs of
previous periods or on the

Figure 5-4 is a simplified version

of a typical cost curve intended
to show the variation in costs as
volume increases.
Note that three types of cost are
illustrated: fixed or stand by
costs representing those items
of overhead which must be met
even though the plant is closed
down; semi-fixed costs; and
variable costs.
Actually, however, the semi fixed

For purposes of simplicity and clarity

the rise in semi-fixed costs is indicated
at points where the rise is more
pronounced, i.e., at points where it
becomes necessary to establish
additional shifts with the addition of
foremen, sweepers, extra maintenance
crews, etc.
The same effect would be obtained at
points where additional buildings have
to be opened for increased volume of
production.
The greatest variation in costs, however,
is in those items which are classified as

There are two interpretations of the

terms "fixed" and variable" costs.
One interpretation considers a fixed cost
as one that is constant in total amount
for a given period, while a variable cost
increases or decreases in proportion to
the volume of production.
The second interpretation defines a fixed
cost as one that is constant in amount per
unit of production but varies in total,
while a variable cost changes in amount
per unit but remains constant in its total
amount for a given period.
It will be noted that these two
interpretations are directly opposite in

Salaries of major executives, capital

taxes, depreciation, etc., remain fixed
regardless of the volume of production.
These are known as fixed costs.
Other items, such as direct labor and
direct material, vary almost in
proportion to the amount of production
and are termed variable costs.
Most costs are subject to some
variation.
Cost of electricity may be considered
relatively
constant, but even that will vary with
extreme changes in volume of
production which may require changes

Holding to the principle of variable budgets,

variations in the form of budgeting procedure
may be established to meet the peculiar needs
of a specific enterprise.
In general, we may say that simplicity in
budgeting should be held as a primary virtue.
Detailed clerical work involved in the
preparation and operation of a budget should
be held to a minimum.
This principle not only leads to the elimination
of unnecessary costs in budgeting but in
general promotes ease in the interpretation
and control of the budget.
In a small company where; costs are easily
identified and controlled or in companies
where there is little variation in production
volume, a very simple type of budget becomes

Variable budgets are of two principal

types.
One is the step budget which is really
a series of budgets set up at
different levels of volume of
production or sales.
These steps are usually established
at points in the variation in volume
where pronounced changes in costs
will occur, such as additional shifts,
buildings, and supervisory personnel.
The budget for each step recognizes
a point of maximum and minimum
production.

The second type of variable budget

provides an estimate of the variable rate
of cost per unit of production or per
dollar shipments of sales.
Any estimate of the variable rate of cost
must recognize maximum and minimum
volumes.
As previously stated, the rate of cost of
material maybe
expected to decrease as volume
increases, owing to advantages that
maybe attained through purchasing in
larger lots.
Greater labor efficiency however, may be
obtained from the regular force of 1,000
workers than would be realized per unit

PREPARING THE BUDGET

Mention was made earlier regarding the
,function of the budget director, most
frequently the controller or assistant
controller serving in this capacity
He serves. as a coordinator between
divisions or departments in budget
preparation.
Usually the heads of these divisions,
together with selected staff
representatives, will serve as the budget
committee of the company.
This committee receives and approves all
forecasts, departmental or division
budgets, and periodic reports showing

The budget officer must see that all

department estimates are prepared
with sufficient supporting data to
provide an adequate basis for effective
consideration by the committee.
He has the responsibility for the
presentation of these budgets to the
committee and for transmitting back
to the departments the
recommendations of acceptance or
revision.
The budget officer is also responsible
for the organization of a system of
regular periodic reports regarding the

The preparation of budget estimates

within each department should also
be a committee proposition.
This is in adherence to the same
principle of participation as a means
toward cooperation participation in
the preparation of a budget serves
to familiarize the personnel with the
problems involved.
With this knowledge of the problems
and the feeling of having a part in
setting the goals and limitations of
the department, the personnel will

The head of the department may act

as chairman of the department
committee but, in the case of a large
department, he should delegate
responsibility for the gathering of
details for use by his committee.
In other words, he should have an
organization within his own
department for the preparation of
the budget that follows the same
general pattern as the budget
organization for the enterprise as a
whole.

Adequate Cost Information

Adequate cost information is a prime
essential of budgeting.
It constitutes the foundation for the
conversion of forecast and business
policy into production.
Our forecast tells us how much we can
sell at a given price level.
Our cost information tells us how much
it will cost to produce it in the, volumes
specified.
Full realization of cost in advance of
budget preparation
may cause management to question the

Perhaps the most important advantage to be

gained through the availability of accurate
cost information is that budgeting can be
based on facts instead of personal guesswork.
The individual who is called upon to provide
estimates without facts on which to base
these estimates is in the long run facing
trouble.
Through superior personal judgment he may
receive the
praise of management when times are good
and when production is progressing t a
relatively even tempo.
If he is wise he will probably allow reasonably
safe margins to protect himself from the
possible errors of his
judgment.

Those are the times when the individual may be

forced to eliminate those margins of safety.
He promises to operate at less cost yet he does
not have a detailed plan approved by
management as to just how those costs are to be
reduced.
The chances are that they will not be reduced
and he will be criticized, if not discharged, for
poor management of his department.
How much better it would be if he could supply
facts regarding costs-facts that could be
interpreted by any member of the management
group.
The individual could then relieve himself of
reliance on personal judgment alone and present
his estimates accompanied by systematically
prepared data.
Once the estimates are accepted by the budget

The Sales Budget

As previously mentioned, the
estimates of future sales set the
bounds of limitations for other
budgets of the enterprise.
There are two principal sources of
data for use in the preparation of
sales estimates:
(I) past performance (sales of
previous periods) and (2) market
analysis.
Both Sources are generally used in
gaining a

Salespersons can playa significant role in the

preparation of the sales budgets.
They are in personal contact with the customer.
They are able to obtain firsthand information
regarding his wants. his attitude toward future
business conditions, his attitude toward the
services provided by the enterprise, his attitude
toward the program of advertising, etc.
If salespersons are trained in the importance of
this information and the methods by which it
should be produced, the enterprise can develop
within its own organization a valuable source of
market information.
Many companies make the preparation of sales
estimates and the introduction of new products
to the market a cooperative undertaking which
includes participation by vote on the part of each
salesperson.

Manufacturing Budgets
The number and division of budgets for the
manufacturing division of an enterprise will,
of course, vary with the size and type of
enterprise and the products it manufactures.
In general, it may be said that six basic
budgets are needed:
(I) the production budget which outlines the
schedule of product
units to be manufactured;
(2) the materials budget which specifies the
direct material needed to produce the
number of units scheduled;
(3) The plant and equipment budget that sets
forth the requirements of space and
machinery;
(4) the maintenance budget;

The production budget is taken

directly from the sales estimates,
except that it attempts in so far as
possible to spread the work evenly
over the period.
This budget forms the basis for other
manufacturing budgets as listed
above.
With the aid of the materials
specifications sheets for each
product, the materials budget can be
prepared by months for the guidance
of the purchasing department.

The Financial Budget

The financial budget presents a summary
of anticipated receipts and
disbursements for the budget period.
Its purpose is to plan for the allocation of
working capital as represented by the
current assets of the enterprise.
Data for the financial budget are derived
from the budgets as prepared by the
various divisions.
The financial budget must anticipate the
cash receipts
by months or at other designated points
of the period and make allowance for the
raising of additional funds, if needed, to

Expenditures maybe planned in

consideration of two primary
factors:
(I)the absolute necessities of the
budgets of the various divisions,
i.e., monthly requirements of
materials for production,
payroll, etc.; and
(II)the-limitations of available
cash.
It is not considered good business
to have large
amounts of cash lying idle during

Good business policy would suggest

that attempts
should be made either to spread the
added
expenses of these two months over
a longer
period or to borrow additional funds
through
short-term notes.
There are many problems arising
out of attempted
control of working capital, and
there are likewise
many possible solutions that may be

There are times, of course, when the

limitations of capital may make the
plans as set forth in the budgets of
various divisions prohibitive.
This is especially true during
periods of rapid expansion when
additional plant and equipment
must be provided in order to meet
the budgeted schedule of
production.
In such case the financial budget
acts as a negative control over other
divisions.