Chapter Two Master Budget
Chapter Two Master Budget
Chapter Two Master Budget
MASTER BUDGET
2.1 INTRODUCTION
Like many accounting terms, budgeting is used commonly in our everyday language. The news
media discuss budgets of federal and state governments, and many people describe a variety of
resource allocation decisions, ranging from vacation planning to the purchase of food and
clothing, as budgeting. The purpose of this chapter is to introduce the framework for the
budgeting process, define budgeting terms, and enumerate the principal advantages of budgeting.
Although the primary emphasis in this chapter is on business budgeting, most of the concepts are
also applicable to non-business activities..
A budget entity can be as a specific as a single project such as Addisalem’sLangano trip or it can
be a broad activity, such as the budget for an entire manufacturing firm, or for the Ethiopian
government.
Budgets should express the expected financial consequences of programs and activities planned
for a specific period of time. Annual budget are widespread. In addition to annual budgets,
budgets for many other time periods are prepared. The planning horizon for budgeting may vary
from one day to many years. For example, master budget usually cover 1 month to 1year where
as long-range plan are prepared for 2 to 10 years.
In planning for profits, managers must consider two time horizons: the short term and the long
term.
Short-term planning is the process of deciding what objectives to pursue during a short, near-
future period, usually one year, and what to do to achieve those objectives. The typical short-
term budget covers one year and is broken down into monthly or quarterly units.
Another method frequently used to prepare a short-term budget is the continuous budget.
budget. This
kind of budget starts with an annual budget broken down into 12 monthly units. As each month
arrives, it is dropped from the plan and replaced by a new month so that at any given time, the
next 12 months are always shown. Thus, in a budgetary period covering January through
December 20X4, when January 20x4 arrives, it would be dropped from the plan and replaced by
January 20x5, thus creating a new budgetary period covering February 20x4 through January
20x5. Using this technique, a firm always has guidance for the full following year. When a
continuous budget is not used, a firm will have guidance for only a month or two as it
approaches the end of its budgetary period.
Long-term planning,
planning, also known as strategic planning,
planning, is the process of setting long-term goals
and determining the means to attain them. Short-term planning is concerned with operating
details for the next accounting period, but long-term planning addresses broad issues, such as
new product development, plant and equipment replacement, and other matters that require years
of advance planning. For example, short-term planning in the automotive industry would be
concerned with which and how many of the current year’s models to manufacture, while long-
range planning would focus on new model development and major changes, as well as
2
equipment replacements and modifications. The time frame for long-range planning may extend
as far as 20 years in the future, but its usual range is from 2 to 10 years. An important part of
long-term planning is the preparation of the capital budget,
budget, which details plans for the
acquisition and replacement of major portions of property, plant, and equipment.
Quantitative plan.Often
plan.Often budgets contain materials describing the various programs and activities
planned by the company. This chapter focuses primarily in the way that cost and revenue
estimates of the activities are expressed by the budget. All planned projects or activities for the
organization are reduced to the common denominator of money and other quantitative measures,
such as units of input or output.
As noted earlier, a budget is a detailed plan expressed in quantitative terms that specifies how
resources will be acquired and used during a specific period of time. The act of preparing a
budget is known as budgeting.The
budgeting.The use of budgets to control a firm’s activities is called
budgetary control.
Companies realize many benefits from a budgeting program. Among these benefits are the
following:
Requires periodic planning.
Fosters coordination, cooperation, and communication.
Provides a framework for performance evaluation.
Means of allocating resources.
Satisfies legal and contractual requirements.
Created an awareness of business costs.
3
To sum up, budgets forces managers to think a head to anticipate and prepare for the changing
conditions. The budgeting process makes planning an explicit management responsibility.
In a nutshell, a good budget process communicates both from the top down and from the bottom
up. Top management makes clear the goals and objectives of the organization in its budgetary
directives to middle and lower level managers, and also to all employees. Employees and lower
level managers inform top-level managers how they can plan to achieve the objectives.
Budgets are generally a better basis for judging actual results than is past performance. The
major drawback of using historical results for judging current performance is that inefficiencies
may be concealed in the past performance.
Generally, organizations resources are limited, and budgets provide one means of allocating
resources among competing uses. The city of Addis Ababa, for example, must allocate its
revenue among basic life services (such as police and fire protection), maintenance of property
4
and equipment (such as city streets, parks and vehicles) and other community services (such as
programs to prevent alcohol and drug abuse).
Cost Awareness. Accountants and financial managers are concerned daily about the cost
implications of decisions and activities, but many other managers are not. Production managers
focus on input, marketing manager’s focuses on sales, and so forth. It is easy for people to
overlook costs and cost-benefit relationships. At budgeting time, however, all managers with
budget responsibility must convert their plans for projects and activities to costs and benefits.
This cost awareness provides a common ground for communication among the various
functional areas of the organization.
The master budget is the total budget package for an organization; it is the end product that
consists of all the individual budgets for each part of the organization aggregated into one overall
budget for the entire organization.
The two major components of master budget are the operating budget and the financial budget.
Operating budget.
budget. It focuses on income statement and its supporting schedules. It is also called
profit plan.
plan. However, such budget may show a budgeted loss, or can be used to budget expenses
in an organization or agency with no sales revenues.
Financial budget.
budget. It focuses on the effects that the operating budget and other plans will have on
cash. The usual master budget for a non-manufacturing company has the following
components.
5
1. Operating budget includes: 2. financial budget include:
a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget
In addition to the master budget there are countless forms of special budgets and related reports.
For example, a report might detail goals and objectives for improvements in quality or customer
satisfaction during the budget period.
OPERATING BUDGET
The operating budget is composed of the income statement elements. A manufacturing business
budgets both manufacturing and non-manufacturing activities. Below the various elements of the
operating budget of a manufacturing firm have been discussed.
Sales Budget:The
Budget:The sales budgetis the first budget to be prepared. It is usually the most important
budget because so many other budgets are directly related to sales and are therefore largely derived
from the sales budget. Inventory budgets, purchases budgets, personnel budgets, marketing budgets,
administrative budgets, and other budget areas are all affected significantly by the amount of
revenue that is expected from sales.
Sales budgets are influenced by a wide variety of factors, including general economic conditions,
pricing decisions, competitor actions, industry conditions, and marketing programs. In an effort to
develop anaccurate sales budget, firms employ many experts to assist in sales forecasting.
The sales budgetis usually based on a sales forecast. A sales forecast is a prediction of sales under a
given conditions. The objective in forecasting sales is to estimate the volume of sales for the period
based on all the factors, both internal and external to the business that could potentially affect the
level of sales. The projected level of sales is then combined with estimated of selling prices to form
the sales budget.
6
Sales forecasts are usually prepared under the direction of the top sales executive. Important factors
considered by sales forecasters include:
7
Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost
of products that are sold. Consequently, the cost of goods sold budget follows directly from the
production budget. However, a merchandising firm has no production budget. The cost of goods
sold budget comes directly from merchandise inventory and the merchandise purchases budget.
Operating Expense Budget: The budgeting of operating expenses depends on various factors.
Month – to – month fluctuation in sales volume and other cost-drivers activities
activities directly
influence many operating expenses. Examples of expenses driven by sales volume include sales
commissions and many delivery expenses. Other expenses are not influenced by sales or other
cost-driver activity (such as rent, insurance, depreciation, and salaries) within appropriate
relevant ranges and are regarded as fixed.
FINANCIAL BUDGET
The second major part of the master budget is the financial budget, which consists of the capital
budget, cash budget, ending balance sheet and the statement of changes in financial position.
Although there are some differences in operating budgets of manufacturing, merchandising and
service firms, very little difference exists among financial budgets of these entities.
8
plans for an organization for the budget period. It contains some of the most critical budgeting
decisions of the organizations.
Cash budget:
budget: The cash budget is a statement of planned cash receipts and disbursements. The
cash budget is composed of four major sections:
If there is a cash deficiency during any budget period, the company will need to borrow funds. If
there is cash excess during any budget period, funds borrowed in previous periods can be repaid
or the idle funds can be placed in short-term or other investments.
iv. The financing section:This
section:This section provides a detail account of the borrowing and
repayments projected to take place during the budget period. It also includes a detail of
interest payments that will be due on money borrowed.
Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted statement
of financial position, is derived from the budgeted balance sheet at the beginning of the budget
period and the expected changes in the account balance reflected in the operating budget, capital
budget, and cash budget.
9
2.4.2 Preparing the Master Budget
The master budget is a network consisting of many separate but interdependent budgets. This
network is illustrated in Exhibit 6-1. The master budget can be a large document even for a small
organization. The simple example that follows on the next page for Blue Nile Company’s give
some indication of the potential size and complexity of the master budget of a business. The
example illustrates a fixed or static budget prepared for a single expected level of activity.
Flexible budgeting that involves various activity levels will be discussed later in the next unit.
Example 1:Blue
1:Blue Nile Company’s newly hired accountant has persuaded management to prepare
a master budget to aid financial and operating decisions. The planning horizon is only three
months, January to March. Sales in December (20x3) were Br. 40, 000. Monthly sales for the
first four months of the next year (20x4) are forecasted as follows:
January Br. 50, 000
February 80, 000
March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are on credit sales. All credit sales are
collected in the month following the sales. Uncollectible accounts are negligible and are to be
ignored.
Because deliveries from suppliers and customer demand are uncertain, at the end of any month
Blue Nile wants to have a basic inventory of Br. 20, 000 plus 80% of the expected cost of goods
to be sold in the following month. The cost of merchandise sold averages 70%of sales. The
purchase terms available to the company are net 30 days. Each month’s purchase are paid as
follows: 50% during the month of purchase and,
50% during the month following the purchases.
Monthly expenses are:
Wages and commissions…………………Br. 2, 500 + 15%of sales, paid as incurred.
Rent expense………………………………………..Br. 2, 000 paid as incurred.
Insurance expense…………………………………..Br.200 expiration per month.
Depreciation including truck……………………….Br.500 per month
Miscellaneous expense…………………………….5% of sales, paid as incurred.
10
In January, a used truck will be purchased for Br. 3, 000 cash. The company wants a minimum
cash balance of Br. 10, 000 at the end of each month. Blue Nile can borrow cash or repay loans
in multiples of Br. 1, 000. Management plans to borrow cash more than necessary and to repay
as promptly as possible. Assume that the borrowing takes place at the beginning, and repayment
at the end of the months in question. Interest is paid when the related loan is repaid. The interest
rate is 18% per annum. The closing balance sheet for the fiscal year just ended at December 31,
20x3,is:
Blue Nile Company
Balance Sheet
December 31, 20x3
ASSETS
Current assets:
Cash Br. 10, 000
Account receivable 16,000
Merchandise inventory 48, 000
Unexpired insurance 1, 800 Br.75, 800
Plant assets:
Equipment, fixture and other Br.37, 000
Accumulated depreciation 12, 80024, 200
Total assets Br.100,
Br.100, 000
Instructions:
1) Using the data given above, prepare the following detailed schedules for the first quarter of
the year:
a) Sales budget
b) Cash collection budget
c) Purchase budget
d) Disbursement for purchases
11
e) Operating expenses budget
f) Disbursement for operating expenses
2) Using the budget data given above and the schedules you have prepared, construct the
following pro forma financial statements
a. Income statement for the first quarter of the year.
b. Cash budget including receipts, payments, and effect of financing
c. Balance sheet at March 31, 20x3.
1. a) Sales budget
*December sales are included in the schedule (a) because they affect cash collected in
January.
b)
b) Cash collection budget
a) Purchase budget
12
January February March Jan.-Mar.
Wages and commissions Br.10, 000 Br.14, 500 Br.11, 500 Br.36, 000
Rent expense 2, 000 2, 000 2, 000 6, 000
Insurance expense 200 200 200 600
Depreciation expense 500 500 500 1, 500
Miscellaneous expense 2, 500 4, 000 3, 000 9, 500
Total Br.15,
Br.15, 200 Br.21,
Br.21, 200 Br.17,
Br.17, 200 Br.53,
Br.53, 600
Sales (schedule
(schedule 1(a))
1(a)) Br.190, 000
Cost of goods sold (schedule
(schedule 1(c))
1(c)) 133,000
Gross profit 57,000
Operating expenses
Wages and commissions Br.36, 000
Rent expense 6, 000
Insurance expense 600
Depreciation expense 1, 500
Miscellaneous expense 9, 500 53, 600
Operating income 3, 400
Interest expense* 885
Net income 2, 515
14
Total equities Br.109,
Br.109, 055
15