UNIT I: MASTER BUDGET

Contents

1.0. Introduction
1.1. Learning Objectives
1.2. Budgeting Concepts
1.3. Types of Budgets
1.4. The Purposes And Benefits Of The Master Budget
1.5. Limitations And Problems
1.6. The Assumptions Of The Master Budget
1.7. Preparing A Master Budget
1.7.1. The Operating Budget
1.7.2. The Financial Budget
1.8 Summary
1.9 Answers to Check Your Progress Questions

1.0. INTRODUCTION

The purpose of this chapter is to introduce the master budget or financial plan. This topic
includes an important set of concepts and techniques that represent the major planning
device for an organization, as well as the foundation for a traditional standard cost
performance evaluation and control system. The chapter includes six sections. The first
section provides a discussion of the underlying concepts of financial planning and
budgeting including the various types of budgets. This section also includes a diagram of
the master budget that provides an overview of the overall budgeting process. Sections
two and three include short, but important discussions of the purposes and benefits of
budgeting and the limitations and problems involved in budgeting. The assumptions upon
which the budget is based are briefly described in section four. The techniques used to
prepare a master budget are discussed and illustrated in section five. This is the longest
section and includes a discussion of where the budget director obtains the budget
information as well as how the information is used to complete the various schedules and
sub-budgets involved. The last section includes a simplified, but fairly comprehensive
example.

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1.1. LEARNING OBJECTIVES

After you have read and studied this chapter, you should be able to:

ü Discuss the concept of financial performance including the elements involved

ü Outline the main parts of a master budget including the sequence in which they
are developed.
ü Discuss the purposes and benefits of the master budget.
ü Discuss the limitations and problems associated with the master budget.
ü Briefly describe the assumptions underlying the master budget.
ü Discuss the sources of the various information needed for the master budget.
ü Prepare the operating budget and supporting schedules
ü Prepare a financial budget

1.2. BUDGETING CONCEPTS

Budgeting involves planning for the various revenue producing and cost generating
activities of an organization. The importance of budgeting is emphasized by an old saying,
"Failing to plan, is like planning to fail." Budgeting is essentially financial planning, or
planning for financial performance. Financial performance depends on revenue and cost.
Revenue is provided from sales of merchandise by retailers, sales of products, harvested,
mined, constructed, formed, processed or assembled by farms, mining companies,
construction companies and manufacturers and from sales of various services by firms
involved in activities such as banking, insurance, accounting, law, medical care, food
distribution, repair and entertainment. In addition to producing revenue, all of these
companies generate three types of costs including discretionary, engineered and
committed costs. Various costs fall into one of these three categories based on the cause
and effect relationships involved. Although there are a variety of ways to define costs,
categorizing costs in terms of the cause and effect relationships is a prerequisite for
understanding the different types of budgets that are introduced in this chapter. These
three cost concepts are summarized and discussed in more detail below.

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 CAUSE & EFFECT
OR COST BENEFIT COST
TYPE OF COST RELATIONSHIP BEHAVIOR EXAMPLES

Cost administrative and support

services such as employee
Relationships are Fixed, Variable, training, advertising, sales
difficult or impossible and mixed in the promotion, legal advice, and
Discretionary to define short term research and maintenance
Direct resources used in
production activities such as
Relationships are material and direct labor and
relatively easy to Variable in the many indirect resources such as
Engineered define short run electric power
Cost of establishing and
maintaining the readiness to
Relationships can be conduct business, such as the cost
estimated but not Fixed in the short associated with plant and
Committed defined precisely run equipment

1.2.1. Discretionary Costs

Many activities are viewed as beneficial to an organization, even thought the benefits
obtained, or value added by performing the activities cannot be defined precisely, either
before or after the activity is completed. The costs of the inputs, or resources required to
perform such activities are referred to as discretionary costs. These costs are discretionary
in the sense that management must choose the desired level of the activity based on
intuition or experience because there is no well-defined cause and effect relationship
between cost and benefits. Discretionary costs are usually generated by service or support
activities. Examples include employee training, advertising, sales promotion, legal advice,
preventive maintenance, and research and development. The value added by each of these
activities is intangible and difficult, if not impossible to measure, where value added refers
to the benefits obtained by either internal or external customers. In terms of cost behavior,
discretionary costs may be fixed, variable or mixed.

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1.2.2. Engineered Costs

Engineered costs result from activities with reasonably well defined cause and effect
relationships between inputs and outputs and costs and benefits. Direct material costs
provide a good example. Engineers can specify precisely how many parts (inputs) are
required to generate a specific output such as a microcomputer, a coffee maker, an
automobile, or a television set. Direct labor also falls into the engineered cost category as
well as indirect resources that vary with product specifications and production volume.
Although the cause and effect relationships are not as precise for indirect resources, these
relationships can be established using statistical techniques such as regression and
correlation analysis. A key difference between discretionary costs and engineered costs is
that the value added by the activities associated with engineered costs is relatively easy to
measure. Engineered costs are variable in terms of cost behavior.

1.2.3. Committed Costs

Committed costs refer to the costs associated with establishing and maintaining the
readiness to conduct business. The benefits obtained from these expenditures are
represented by the company's infrastructure. For example, the costs associated with the
purchase of a franchise, a patent, drilling rights and plant and equipment create long-term
obligations that fall into the committed cost category. These costs are mainly fixed in
terms of cost behavior and expire to become expenses in the form of amortization and
depreciation.

1.3. TYPES OF BUDGETS

Four types of budgets are used for planning and controlling the various types of costs
discussed above. These four techniques are summarized in ------------------------------------

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 BUDGET TYPES AND CHARACTERISTICS

TYPE OF COST
TYPE OF CHARACTERISTICS OR
BUDGET OF THE TECHNIQUE EXPENDITURE EXAMPLES

A maximum amount is
APPROPR
established for certain Employee training, advertising,
IATION Discretionary costs
expenditures based on sales promotion and research and
BUDGET
management judgment development.

The static amount

A static amount (a) is (a) includes both The static part: salaries,
established for fixed discretionary and depreciation, property taxes and
FLEXIBLE costs and a variable rate committed costs planned maintenance. The flexible
BUDGET (b) is determined per while the flexible part: direct material, direct labor
activity measure for part (b) includes and variable overhead. Also, some
variable costs, i.e., Y = a engineered costs per costs related to sales reps such as
+ bX X value. sales commissions and travel.
Decisions concerning
CAPITAL potential investments are
BUDGET made using discounted
cash flow techniques. Committed costs New plant and equipment
A comprehensive plan is
MASTER developed for all Discretionary,
BUDGET revenue and engineered and All revenue and expenditures for
expenditures. committed costs. any company.

1.3.1. Appropriation Budgets

The oldest type of budget is referred to as an appropriation budget. Appropriation budgets

place a maximum limit on certain discretionary expenditures and may be either
incremental, priority incremental, or zero based. Incremental budgets are essentially last
year's budget amount plus an increment, i.e., small increase. Priority incremental budgets
also involve an increase, but require managers to prioritize, or rank discretionary activities
in terms of their importance to the organization. The idea is for the manager to indicate
which activities would be changed if the budget were increased or decreased. The

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technique is expensive to use because zero based budgets theoretically require justification
for the entire budget amount. When it was popular, a more typical approach was to justify
the last twenty percent of the budget, i.e., use eighty percent based budgeting.

From a control perspective, appropriation budgets are effective in limiting the amount of
expenditure, but create a behavioral bias to spend to the limit. Establishing a maximum
amount for expenditure encourages spending to the limit because spending below the limit
implies that something less than the maximum appropriation was needed. Spending below
the limit might result in a budget cut in future periods. Since nearly every manager views a
budget reduction in their discretionary costs as undesirable, there are frequently crash
efforts at the end of a budget period to spend up to the limit.

1.3.2. Flexible Budgets

Flexible budgets are based on a cost function such as Y = a + bX, where Y represents the
budgeted cost, or dependent variable. The constant "a" represents a static amount for fixed
costs and the constant "b" represents the rate of change in Y expected for a unit change in
the independent variable X. The expression " bX" is the flexible part of the budget cost
function. The flexible budget technique is used for planning and monitoring all types of
costs. The static amount "a" includes both discretionary and committed costs, while the
flexible part "bX" includes various types of engineered costs. The flexible characteristic of
the technique enables the flexible budget to play a key role in both financial planning and
performance evaluation.

1.3.3. Capital Budgets

Capital budgets represent the major planning device for new investments. Discounted cash
flow techniques such as net present value and the internal rate of return are used to
evaluate potential investments. Capital budgets are part of a somewhat more encapsulating
concept referred to as investment management. Investment management involves the
planning and decision process for the acquisition and utilization of all of the organization's
resources, including human resources as well as technology, equipment and facilities. The
concept of investment management includes the discounted cash flow methods, but is
more comprehensive in that the organization's portfolio of interrelated investments is
considered as well as the projected effects of not investing.

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1.3.4. Master Budgets

The fourth type of budget is referred to as the master budget or financial plan. The master
budget is the primary financial planning mechanism for an organization and also provides
the foundation for a traditional financial control system. More specifically, it is a
comprehensive integrated financial plan developed for a specific period of time, e.g., for a
month, quarter, or year. This is a much broader concept than the first three types of
budgeting. The master budget includes many appropriation budgets (typically in the
administrative and service areas) as well as flexible budgets, a capital budget and much
more. A diagram illustrating the various parts of a master budget is presented in ----------

DIAGRAM OF MASTER BUDGET OF A NON MANUFACTURING COMPANY

Sales Budget

Ending –inventory Purchase

Budget Budget

Operating
Budget
Cost of Goods
Sold Budget

Operating
Expenses Budget

Budgeted Statement
of Income

Financial
Budget
Capital Cash Budgeted
Budget Budget Balance Sheet
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DIAGRAM OF MASTER BUDGET OF A MANUFACTURING COMPANY

Sales Budget Long term

sales forecast

Production
Budget

Selling and
Direct Materials Direct Labour Overhead Administration
Budget Budget Budget Expense Budget

Finished Goods
Budget

Cost of goods
Sold Budget

Budgeted Income
Statement

Cash Capital
budget Budgeted

Budgeted
Balance Sheet

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The master budget has two major parts including the operating budget and the financial
budget. The operating budget begins with the sales budget and ends with the budgeted
income statement. The financial budget includes the capital budget as well as a cash
budget, and a budgeted balance sheet. The main focus of this chapter is on the various
parts of the operating budget and the cash budget. The budgeted balance sheet is covered
briefly, but not emphasized. In the next section, we consider the purposes, benefits,
limitations and assumptions of the master budget.

1.4. THE PURPOSES AND BENEFITS OF THE MASTER BUDGET

There are a variety of purposes and benefits obtained from budgeting. Consider the
following:

a. Periodic Planning (Formalization of Planning).

The most obvious purpose of a budget is to quantify a plan of action. The development of
a quarterly budget for a Sheraton Hotel, for example, forces the hotel manager, the
reservation manager, and the food and beverage manager to plan for the staffing and
supplies needed to meet anticipated demand for the hotel’s services. Thus, budgets forces
managers to think a head to anticipate and prepare for the changing conditions. The
budgeting process makes planning an explicit management responsibility.

b. Integrates and Coordinates

The master budget is the major planning device for an organization. Thus, it is used to
integrate and coordinate the activities of the various functional areas within the
organization. For example, a comprehensive plan helps ensure that all the needed inputs
(equipment, materials, labor, supplies, etc.) will be at the right place at the right time when
needed, just-in-time if possible. It also helps insure that manufacturing is planning to
produce the same mix of products that marketing is planning to sell.

c. Communicates and Motivates

Another purpose and benefit of the master budget is to provide a communication device
through which the company’s employees in each functional area can see how their efforts
contribute to the overall goals of the organization. This communication tends to be good
for morale and enhance jobs satisfaction. People need to know how their efforts add value

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to the organization and its' products and services. The behavioral aspects of budgeting are
extremely important.

c. Promotes Continuous Improvement

The planning process encourages management to consider alternatives that might improve
customer value and reduce costs.. The financial plan and subsequent financial performance
measurements reflect the financial expectations and consequences of those efforts.

d. Guides Performance

The master budget also provides a guide for accomplishing the objectives included in the
plan. The budget becomes the basis for the acquisition and utilization of the various
resources needed to implement the plan. Perfection of the guidance aspect of budgeting
can significantly reduce the amount of uncertainty and variability in the company’s
operations.

e. Facilitates Evaluation and Control

The master budget provides a method for evaluating and subsequently controlling
performance. We will develop this idea in considerable detail in the following chapter.
Performance evaluation and control is a very powerful and very controversial aspect of
budgeting.

f. Cost Awareness.
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.

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1.5. LIMITATIONS AND PROBLEMS

There are several limitations and problems associated with the master budget that need to
be considered by management. These problems involve uncertainty, behavioral bias and
costs.

a. Uncertainty

Budgeting includes a considerable amount of forecasting and this activity involves a

considerable amount of uncertainty. Uncertainty affects both sides of the financial
performance dichotomy, but uncertainty on the revenue side presents a more serious
limitation for planning. The sales budget is frequently based on a forecast supported by a
variety of assumptions about the economy, and the actions of competitors, suppliers, and
customers. The uncertainty associated with sales forecasting creates a greater problem
than uncertainty on the cost side because the other parts of the budget are derived from the
sales forecast.

b. Costs

A third problem or limitation is that budgeting requires a considerable amount of time and
effort. Many companies maintain a twelve-month budget on a continuous basis by adding
a future month as the current month expires. While this does not create a major
expenditure for large or medium sized organizations, smaller companies may find it
difficult to justify the costs involved. Many small, potentially profitable firms, do not plan
effectively and eventually fail as a result. Cash flow problems are common, e.g., not
having enough cash available (or accessible through a line of credit with a bank) to pay for
merchandise or raw materials or to meet the payroll. Many of these problems can be
avoided by preparing a cash budget on a regular basis.

c. Budgeting And Human Behavior

Budgets can have a significant behavioral effect. Whether that effect is positive or
negative depends to large extent on how budgets are used. Positive behavior occurs
when the goals of individual managers and employees are aligned with the goal of the
organization and the manager has the drive to achieve them. The alignment of managerial
and organizational goals is often referred to as goal congruence.

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If budgets is improperly administered, the may result in dysfunctional behaviour,
behaviour, a
behavior that is in basic conflict with the goals of the organization. If budgets are to
benefit an organization, they need the support all the firm’s employees. The behavioral
problems include the following: conflicting views, imposed budgets, budgets as checkup
devices, and unwise adherence to budgets.

Conflicts. The problem of conflicts in budgeting can be illustrated by considering a matter

of importance to almost any firm-inventory policy. The sales manager of a retail firm
wants inventory to be as high as possible because it is easier to make sales if the goods are
available to the customer immediately. For the same reason, the sales manager in a
manufacturing firm also wants inventory immediately ready for delivery. A financial
manager wants low inventories because of the costs associated with having inventory
(storage, insurance, taxes, interest, and so on). In a manufacturing firm, the production
manager is not interested in inventory per se, but in steady production, no interruptions for
rush orders, no unplanned overtime, and other conditions that minimize production costs.
Thus, three managers have different view on the desirable level of inventory. They will be
evaluated by reference to how well they do their job, so each has an interest in the firm’s
inventory policy. In a conventional manufacturing environment, the conflict is resolved
with great difficulty, if at all and the managerial accountant might be called in to help
determine the best inventory level for the firm.

Imposed Budgets. Significant problems can result from the imposition of unachievable
budgets. Managers can become discouraged and feel no commitment to meeting budgeted
goals. Or perhaps they will take actions that seem to help achieve goals (such as scrimping
on preventive maintenance to achieve lower costs in the short run) but are really harmful
in the long run (when machinery breaks down and production must be halted altogether).

Budgets as “Checkup” Devices. Behavioral problems do not arise solely because of the
procedure followed for developing budget allowances. Comparisons of budgeted and
actual result and subsequent evaluation of performance also introduce difficulties. In ideal
circumstances managers use actual results to evaluate their own performance, to evaluate
the performance of other, and to correct elements of operations that seem to be out of
control. The budget serves as a feedback device; it lets managers know the result of their
actions. Having seen that something is wrong, they can take steps to correct it.

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Unfortunately, budgets are often used more for checking up on manager; that is, the
feedback function is ignored. Where this is the case, managers are constantly looking over
their shoulders and trying to think of ways to explain unfavorable results. The time spent
on thinking of ways to defend the results could be more profitably used to plan and control
operations. Some evaluation of performance is necessary, but the budget ought not to be
perceived as a club to be held over the heads of managers.

Unwise Adherence to Budgets. As noted earlier, the budgets set limits on cost
incurrence, allowances beyond which managers are not expected to go. However, if
managers’ view budgeted amounts as strict limits on spending, they may spend either too
little or too much. For example, there are times when exceeding the budget benefits the
firm. Suppose a sales manager believes that a visit to several important customers or
potential customers will result in greatly increased sales. The sales manager will be
reluctant to authorize the visit if it will result in exceeding the travel budget.

At the other extreme, a manager who has kept costs well under budget might be tempted to
spend frivolously so that expenditures will reach the budgeted level. The manager may
fear that the budget for the following year will be cut because of the lower costs for the
current year, the manager might take an undesirable action-authorize an unnecessary trip-
in order to protect personal interests.

1.6. THE ASSUMPTIONS OF THE MASTER BUDGET

Typically, the following simplifying assumptions are made when preparing a master
budget:

1.) Sales prices are constant during the budget period,

2.) Variable costs per unit of output are constant during the budget period,

3.) Fixed costs are constant in total and

4.) Sales mix is constant when the company sells more than one product.

These assumptions facilitate the planning process by removing many

of the economic complexities.

Learning Activity 1.

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 1. Identify the basic purposes of budgeting for an organization
…………………………………………………………………….
……………………………………………………………………..
…………………………………………………………………….
2. What is master budget?
…………………………………………………………………….
…………………………………………………………………….
…………………………………………………………………….
3. What dysfunctional behavioral implications will have the budgeting process if it
is not well administered?
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………

1.7. PREPARING A MASTER BUDGET

The master budget is the comprehensive financial plan for the organization as a whole; it
is made up of a various 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.

1.7.1. The Operating Budget

Preparing an Operating Budget is a sequential process of developing nine sub-budgets.

Except for one or two exceptions the sub-budgets must be prepared in the following order:
sales, production, direct materials, direct labor, factory overhead, ending inventory, cost of
goods sold, selling & administrative and income statement Each part is described below.

1.7.1. 1. Sales Budget

The Sales budget is the starting point in preparing the master budget. As shown earlier, all
other items in the master budget, including production, purchase, inventories, and
expenses, depend on it in some way. Manufacturing and merchandising companies
forecast sales of their goods. Service giving companies, like, hotels forecast the number of
rooms that will be occupied during various seasons.

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Sales forecasting All companies have two things in common when it comes to forecasting
sales of services or goods: Sales forecasting is a critical step in the budgeting process, and
it is very difficult to do it accurately. Sales forecasting is the process of predicting sales of
services or goods. Various procedures are used in sales forecasting, and the final forecast
usually combines information from many different sources. Many firms have a top
management level market research staff whose job is to coordinate the company’s sales
forecasting efforts. Among the major factors considered when forecasting sales are:

1. Past sales levels and trends

2. General economic trends.
trends.
3. Economic trends in the company’s industry.
4. Other factors expected to affect sales in the industry.
5. Political and legal events.
6. The intended pricing policy of the company.
7. Planned advertising and product promotion.
8. Expected actions of competitors.

Developing a sales budget involves the following calculations

Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)

Current Period Cash Collections = Current Period Cash Sales + Current Period
Credit Sales Collected in Current Period + Prior Period Credit Sales Collected in
Current Period

These calculations are relatively simple, but where does the budget director obtain this
information? Well, sales forecasting is a marketing function. Sales estimates are frequently
generated by the company's sales representatives who discuss future needs with customers
(wholesalers and retailers). Statistical forecasting techniques can also be used to make
estimates of expected future sales, considering the company's previous sales performance
and various assumptions about the future economic climate, and the actions of competitors
and consumers. Pricing is also a marketing function, but many prices are based on costs
plus a markup (the supply function) and consideration of what consumers are willing and
able to pay for the product (the demand function).

The information needed to develop an equation for collections is provided by the finance
department and is normally based on past experience. These calculations are somewhat
more involved than they appear to be in the equation above because of the effects of cash

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discounts and the time lags between credit sales and collections. Cash discounts are
frequently used to speed up cash inflows. This puts the funds back to work sooner and
reduces the need for short term loans. However, even with a generous cash discount for
prompt payment, collections for credit sales are typically spread out over several months.

1.7.1.2. Production Budget

Preparing a production budget includes consideration of the desired inventory change as

follows:

Units To Be Produced = Budgeted Unit Sales + Desired Ending Finished Goods -

Beginning Finished Goods

The desired ending inventory is usually based on the next period’s sales budget.
Considerations involve the time required to produce the product, (i.e., cycle time or lead
time) as well as setup costs and carrying costs. In a just-in-time environment the desired
ending inventory is relatively small, or theoretically zero in a perfect situation. In the
examples and problems in this chapter, the ending finished goods inventory is stated as a
percentage of the next period's (month's) unit sales.

1.7.1.3. Direct Material Budget

The direct materials budget includes five separate calculations.

a. Quantity of Material Needed for Production

   = (Units to be Produced)(Quantity of Material Budgeted per Unit)

The quantity of material required per unit of product is determined by the industrial
engineers who designed the product. Materials requirements are frequently described in an
engineering document referred to as a "bill of materials".

b. Quantity of Material to be purchased

= Quantity of Material Needed for Production + Desired Ending Material -

Beginning Material

This calculation is more involved than equation 3b appears to indicate because it includes
information for two future periods. The desired ending materials quantity is normally

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based on the next period's (month's) materials needed for production and this amount
depends on the third period's budgeted unit sales. Of course inventories of raw materials
(just like finished goods) are kept to a minimum in a JIT environment. Factors that
influence the desired inventory levels include the reliability of the company's suppliers, as
well as ordering and carrying costs.

c. Budgeted Cost of Material Purchases

   = (Quantity of Material to be Purchased)(Budgeted Material Prices)

This amount is needed to determine cash payments. Once the quantity to be purchased has
been determined, the cost of purchases is easily calculated. Budgeted material prices are
provided by the purchasing department.

d. Cost of Material Used

   = (Quantity needed for Production)(Budgeted Material Prices)

The cost of materials used is needed in the cost of goods sold budget below.

e. Cash Payments for Direct Material Purchases

= Current Period Purchases Paid in Current Period + Prior Period Purchases Paid in
Current Period

The information needed to determine budgeted cash payments is provided by accounting,

(accounts payable) and is usually based on past experience. Normally the budget should
reflect a situation where the company pays promptly to take advantage of all cash
discounts allowed, thus 3e may be equal to 3c.

1.7.1.4. Direct Labor Budget

Fewer calculations are needed for direct labor than for direct materials because labor hours
cannot be stored in the inventory for future use. Time can be wasted, but not postponed.

a. Direct Labor Hours Needed For Production

   = (Units to be Produced)(D.L. Hours Budgeted per Unit)

The amount of direct labor time needed per unit of product is determined by industrial
engineers. Estimates are frequently made using a technique referred to as motion and time
study. This involves measuring each movement required to perform a task and then
assigning a precise amount of time allowed for these movements. The cumulative time
measurements for the various tasks required to produce a product provide the estimate of a
standard time per unit.

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b. Budgeted Direct Labor Cost

= (D.L. Hours needed for Production)(Budgeted Rates Per Hour)

The budgeted rates per hour for direct labor are provided by the human resource
department. Frequently the labor (union) contract provides the source for this information.

1.7.1.5. Factory Overhead Budget

The factory overhead budget is based on a flexible budget calculation. More specifically,
the calculation is as follows:
a. Budgeted Factory Overhead Costs
= Budgeted Fixed Overhead 
Overhead  + (Budgeted Variable Overhead Rate)(D.L. Hours
needed for Production from 4a)
The calculation for cash payments reflects one of the differences between cash flows and
accrual accounting. Since some costs, like depreciation, do not involve cash payments in
the current period, these costs must be subtracted from the total overhead costs to
determine the appropriate amount.
b. Cash Payments for Overhead
= Budgeted Factory Overhead Cost 
Cost  - Depreciation and other costs that do not
require cash payments

Multiplying the total overhead rate by the number of direct labor hours needed for
production provides the standard or applied overhead costs.

1.7.1.6. Ending Inventory Budget

The dollar amount for the ending inventory of finished goods is needed below to
determine cost of goods sold. The dollar amounts for ending direct materials and finished
goods are needed for the balance sheet.
a. Ending Direct Materials
= (Desired Ending Materials from 3b)(Budgeted Prices)
b. Ending Finished Goods
= (Desired Ending Finished Goods)(Budgeted Unit Cost)
1.7.1.7. Cost Of Goods Sold Budget

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Cost of goods sold is needed for the income statement. One method of determining
budgeted COGS involves accumulating the amounts from the previous sub-budgets as
follows.

a. Budgeted Total Manufacturing Cost

   = Cost of Direct Material Used (from 3d.) 
3d.)  + Cost of Direct Labor Used (from 4b.)
   + Total Factory Overhead Costs (from 5a.)

b. Budgeted Cost of Goods Sold

   = Budgeted Total Manufacturing Cost (from 7a.)
   + Beginning Finished Goods (from previous ending or calculate from 2 and 6b)
   - Ending Finished Goods (from 6c or calculate from 2 and 6b)

This is the same approach used in Chapter 2 to determine cost of goods sold, but when
developing a budget we typically assume no change in Work in Process. Therefore,
budgeted cost of goods manufactured is equal to budgeted cost of goods sold.

1.7.1.8. Selling & Administrative Expense Budget

The preparation of the selling and administrative expense budgets is very similar to the
approach used for factory overhead.

a. Budgeted Selling and Administrative Expenses

   = Budgeted Fixed Selling & Administrative Expenses 
Expenses  + (Budgeted Variable Rate
as a Proportion of Sales $)(Budgeted Sales $)
c. Cash Payments for Selling & Administrative Expenses
= Budgeted Selling & Administrative Expenses 
Expenses  - Depreciation and other cost which
do not require cash payments

1.7.1.9. Budgeted Income Statement

Preparing the budgeted income statement involves combining the relevant amounts from
the sales, cost of goods sold and selling & administrative expense budgets and then
subtracting interest, bad debts and income taxes to obtain budgeted net income. In a
comprehensive practice problem, the applicable amount for interest expense may need to
be calculated from information associated with the cash budget. Bad debt expense is based
on the expected proportion of uncollectible stated in the information related to cash
collections.

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a. Budgeted Sales $ - Budgeted Cost of Goods Sold
   = Budgeted Gross Profit

b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses

   = Operating Income

c. Operating Income - Interest Expense - Bad Debts Expense

   = Net Income Before Taxes

d. Net Income Before Taxes - Income Taxes

   = Net Income After Taxes

1.7.2. The Financial Budget

The financial budget includes the cash budget, the capital budget and the budgeted balance
sheet. The cash budget and budgeted balance sheet are discussed below.

1.7.2.1. Cash Budget

a. Budgeted Cash Available

   = Beginning Cash Balance + Budgeted Cash Collections from 1

b. Budgeted Cash Excess or Deficiency

   = Budgeted Cash Available - Budgeted Cash Payments

c. Ending Cash Balance

   = Cash Excess or Deficiency + Borrowings - Repayments including Interest

1.7.2.2. Budgeted Balance Sheet

Preparing the budgeted balance sheet involves accumulating information from the
previous period’s balance sheet, the various operating sub-budgets, the cash budget and
other accounting records.

ASSETS

a. Current Assets:
 Cash (from the cash budget - c)
 Accounts Receivable (from the sales budget and previous balance sheet)
 Direct materials (from the ending inventory budget-a)
 Finished goods (from the ending inventory budget -c)

20
b. Long Term Assets:
 Land (from previous balance sheet and budgeted activity)
 Buildings (from previous balance sheet and budgeted activity)
 Equipment (from previous balance sheet and budgeted activity)
 Accumulated depreciation (from the accounting records)

  Total Assets

LIABILITIES

c. Current Liabilities:
 Accounts Payable (from various operating sub-budgets)
 Taxes Payable (from income statement)

d. Long term Liabilities

    Total Liabilities

SHAREHOLDERS EQUITY

e. Common Stock (from previous balance sheet and budgeted activity)

f. Retained Earnings (from previous balance sheet and income statement)

    Total Shareholders’ Equity

    Total Liabilities and Shareholders’ Equity

EXAMPLES AND PRACTICE PROBLEMS

The following examples and end of chapter practice problems will help you become
familiar with the master budget concepts and techniques. The examples and practice
problems are simplified to facilitate the learning process. The first example below and
most of the practice problems assume that only one period is involved and that only one
product is produced from a single direct material. Of course these assumptions are not
realistic, but they allow us to prepare budgets by hand in a timely manner to develop an
understanding of the budgeting process.

PREPARATION OF MASTER BUDGET (Merchandising Company)

EXAMPLE 1.
1. YZ 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:

21
 January Br. 50, 000
February 80, 000
March 60, 000
April 50, 000

Normally 60% of sales are on cash and the remainders are 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.

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:

22
YZ 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, 800 Br.24,
Br.24, 200
Total assets Br.100,000
Br.100,000

LIABILITIES AND OWNERS’ EQUITY

Liabilities:
Accounts payable Br.16, 800
Accrued wages and commissions payable 4, 250 Br.21, 050

Capital:
Owners’ equity 78, 950
Total liabilities and owners’ equity Br.100,
Br.100, 000

Instructions:
1) Using the data given above, prepare the following detailed schedules for the first
quarter of the year:
1) Sales budget
2) Cash collection budget
3) Purchase budget
4) Disbursement for purchases
5) Operating expenses budget
6) Disbursement for operating expenses

23
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.
STEPS IN PREPARATION OF MASTER BUDGET
1. a) Sales budget
Jan.-Mar.
December* January February March Total
Cash sales (40%) Br.24, 000 Br.30, 000 Br.48, 000 Br.36, 000 Br.114, 000
Credit sales
(60%) 16, 000 20, 000 32, 000 24,000 76, 000
Totals Br.40,
Br.40, 000 Br.50,
Br.50, 000 Br.80,
Br.80, 000 Br.60,
Br.60, 000 Br.190,
Br.190, 000

*December sales are included in the schedule (a) because they affect cash collected in
January.
b)
b Cash collection budget
January February March
Cash sales of the month Br.30, 000 Br.48, 000 Br.36, 000
Credit sales of last
month 16, 000 20, 000 32, 000
Total cash collected Br.46,
Br.46, 000 Br.68,
Br.68, 000 Br.68,
Br.68, 000
c). Purchase budget
January February March Jan.-Mar
Required ending Br.64, 800 Br.53, 600 Br.48, 000
inventory
Cost of gods sold 35, 000 56, 000 42, 000 Br.133, 000
Total needed Br.99, 800 Br.109, 600 Br.90, 000
Beginning inventory 48, 000 64, 800 53, 600
Purchases budget Br.51,
Br.51, 800 Br.44,
Br.44, 800 Br.36,
Br.36, 400

d). Disbursement for purchases

24
 January February March
50% of last month’s purchase Br.16, 800 Br.25, 900 Br.22, 400
50% of current month’s purchase 25, 900 22, 400 18, 200
Total disbursement for purchase Br.42,
Br.42, 700 Br.48,
Br.48, 300 Br.40,
Br.40, 600

e). Operating expense budget

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
f). Disbursement for operating expenses budget
January February March
Wages and commissions Br.14, 250 Br.14, 500 Br.11, 500
Rent expense 2, 000 2, 000 2, 000
Miscellaneous expense 2, 500 4, 000 3, 000
Total Br.18,
Br.18, 750 Br.20,
Br.20, 500 Br.16,
Br.16, 500

g) Budget income statement

YZ Company
Budget Income Statement
For the Quarter Ended, March 31, 20x3
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

25
 *Interest
*Interest expense computation
Paid interest = 11, 000*0.18 * 3/12= 495
Accrued amount:
On the first batch borrowing:
8, 000 * 0.18* 3/12= 360
On the second batch borrowing:
1, 000 * 0.18 * 2/12= 30
Total interest expense incurred Br.885
Br.885
b) Cash budget including receipts, payments and effects of financing
January February March
Beginning balance Br.10, 000 Br.10, 550 Br.10, 750
Collections (Schedule1
(Schedule1 (b))
(b)) 46, 000 68, 000 68, 000
Cash available for the use (x
(x) Br.56, 000 Br.78,
Br.78, 550 Br.78,
Br.78, 750
Cash disbursements for:
Purchases (Schedule
(Schedule 1(d))
1(d)) 42, 700 48, 300 40, 600
Operating expenses (Schedule1
(Schedule1 (f))
(f)) 18, 750 20, 500 16, 500
Truck purchases 3, 000 - -
Total disbursement (y
(y) Br.64, 450 Br.68, 800 Br.57, 100
Minimum cash balance required 10, 000 10, 000 10, 000
Total cash needed Br.74, 450 Br.78,
Br.78, 800 Br.67,
Br.67, 100
Cash excess (deficiency) Br.(18, 450) Br.( 250) Br.11,
Br.11, 650
Effects of financing
Borrowing 19, 000 1, 000 -
Payment of the principal - - (11, 000)
Payment of interest - - (495)
Net effect of financing (z
(z) Br.19,
Br.19, 000 Br.1,
Br.1, 000 Br.(11,
Br.(11, 495)

c) Budgeted balance sheet

26
YZ Company
Budgeted Balance Sheet
March 31, 20x3
ASSETS
Current assets
Cash Br. 10, 155
Accounts receivable 24, 000
Merchandise inventory 48, 000
Unexpired insurance 1, 200 Br. 83, 355
Plant assets
Equipment, Fixture and others 40, 000
Accumulated depreciation 14, 300 25, 700
Total assets Br. 109, 055

LIABILITIES AND OWNER’S EQUITY

Liabilities
Accounts payable Br.18, 200
Loan payable 9, 000
Interest payable 390
Total liabilities Br.27, 590
Capital
Beginning owners’ equity Br.78, 950
Net income 2, 515
Ending capital balance 81, 465

Total equities Br.109,

Br.109, 055

PREPARATION OF MASTER BUDGET (Manufacturing Company)

Example (2) Great Company manufactures and sells a product whose peak sales occur in
the third quarter. Management is now preparing detailed budgets for 20x4- the coming
year and has assembled the following information to assist in the budget preparation:

The company’s product selling price is Br. 20 per unit. The marketing department has
estimated sales in units as follows for the next six quarters.

27
 20x4 Quarters 20x5 Quarters
Quarter 1 10000 15000
Quarter 2 30000 15000
Quarter 3 40000
Quarter 4 20000

Sales are collected in the following pattern: 70% of sales are collected in the quarter in
which the sales are made and the remaining 30% are collected in the following quarter. On
January1, 20x4, the company’s balance sheet showed Br.90, 000 in account receivable, all
of which will be collected in the first quarter of the year. Bad debts are negligible and can
be ignored.

The company maintains an ending inventory of finished units equal to 20% of the next
quarter’s sales. The requirement was met on December 31, 20x3, in that the company had
2, 000 units on hand to start the new year.

Fifteen pounds of raw materials are needed to complete one unit of product. The company
requires an ending inventory of raw materials on hand at the end of each quarter equal to
10% of the following quarter’s production needs of raw materials. This requirement was
met on December 31, 20x3 in that the company had 21, 000 pounds of raw materials to
start the New Year.

The raw material costs Br.0.20 per pound. Raw material purchases are paid for in the
following pattern: 50% paid in the quarter the purchases are made, and the remainder is
paid in the following quarter. On January 1,20x4, the company’s balance sheet showed
Br.25, 800 in accounts payable for raw material purchases, all of which be paid for in the
first quarter of the year.
Each unit of Great’s product requires 0.8 hour of labor time. Estimated direct labor cost
per hour is Br.7.50.
Variable overhead is allocated to production using labor hours as the allocation base as
follows:
follows:
Indirect materials Br.0.40
Indirect labor 0.75
Fringe benefits 0.25
Payroll taxes 0.10
Utilities 0.15
Maintenance 0.35

28
Fixed overhead for each quarter was budgeted at Br. 60, 600. Of the fixed overhead
amount, Br. 15, 000 each quarter is depreciation. Overhead expenses are paid as incurred.

The company’s quarterly budgeted fixed selling and administrative

expenses are as follows:

20X4 Quarters
1 2 3 4
Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000

The only variable selling and administrative expense, sales commission, is budgeted at
Br.1.80 per unit of the budgeted sales. All selling and administrative expenses are paid
during the quarter, in cash, with exception of depreciation. New equipment purchases will
be made during each quarter of the budget year for Br. 50, 000, Br. 40, 000, & Br.20, 000
each for the last two quarter in cash, respectively. The company declares and pays
dividends of Br.8, 000 cash each quarter. The company’s balance sheet at December 31,
20x3 is presented below:

ASSETS
Current assets:
Cash Br. 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets Br.162, 700
Plant and Equipment:
Land Br.80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets Br.650, 700

29
LIABILTIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable (raw materials) Br.25, 800
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity Br.650, 700

The company can borrow money from its bank at 10% annual interest. All borrowing
must be done at the beginning of a quarter, and repayments must be made at the end of a
quarter. All borrowings and all repayments are in multiples of Br. 1,000.

The company requires a minimum cash balance of Br.40, 000 at the end of each quarter.
Interest is computed and paid on the principal being repaid only at the time of repayment
of principal. The company whishes to use any excess cash to pay loans off as rapidly as
possible.

Instructions: Prepare a master budget for the four-quarter period ending December 31.
Include the following detailed budget and schedules:
1. a) A sales budget, by quarter and in total
b) A schedule of budgeted cash collections, by quarter and in total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by quarter and in total
f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
2. A cash budget, by quarter and in total
3. A budgeted income statement for the four- quarter ending December 31, 20x4
4. A budgeted balance sheet as of December 31, 20x4.

a. Sales budget
Great CO
Sales Budget

30
 For the year ended Dec. 20x5
Quarter
1 2 3 4 Year
Budgeted sales in units 10,000 30,000 40,000 20,000 100,000
Selling price per unit X $20 X $20 X $20 X $20 X $20
Total Sales $ 200,000 $ 600,000 $ 800,000 $ 400,000 $ 2,000,000

b) Schedule of Expected Cash Collections

Great Co.
Cash collection Budget
For the year ended Dec. 20x5
Quarter
1 2 3 4 Total
30% of the previous
quarter sales Br. 90, 000 Br.60, 000 Br.180, 000 Br.240, 000 Br.570, 000
70% of the current
quarter sales 140, 000 420, 000 560, 000 280, 000 1, 400, 000
Total collections Br.230, 000 Br.480, 000 Br.740, 000 Br.520, 000 Br.1, 970, 000

c) Production Budget

After the sales budget has been prepared, the production requirements for the forth-coming
budget period can be determined and organized in the form of a production budget.
Sufficient goods will have to be available to meet sales and provide for the desired ending
inventory. A portion of these goods will already exist in the form of a beginning
inventory. The remainder will have to be produced. Therefore, production needs can be
determined as follows:

Budgeted sales in units ………………………………..…………xxxx

Add desired ending inventory……………….………………….xxxx
inventory……………….………………….xxxx
Total needs…………………………………………………………xxxx
Less beginning inventory………………………………….……..xxxx
inventory………………………………….……..xxxx
Required production…………………………………….………..xxxx
production…………………………………….………..xxxx

31
 The schedule given below shows the production budget for Great
Company. Note that the desired level of the ending inventory
influences production requirements for a quarter. Inventories should be
carefully planned. Excessive inventories tie up funds and create storage
problems. Insufficient inventories can lead to lost sales or crash
production efforts in the following period

Quarter Total
1 2 3
4
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending 3, 000
Inventory 6, 000 8, 000 4, 000 3, 000
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000
Lees: Beginning Inventory 2, 000 6, 000 8, 000 4, 000 2, 000
Units to be produced 14, 000 32,000 36, 000 19, 000 101, 000

d) Direct Materials Budget

Returning to Great Company’s budget data, after the production requirements have been
computed, a direct materials budget can be prepared. The direct materials budget details
the raw materials that must be purchased to fulfill the production budget and to provide for
adequate inventories. The required purchases of raw materials are computed as follows:

Raw materials needed to meet the production schedule…………………………….xxxx

Add desired ending inventory of raw materials……………….……………………. .xxxx
.xxxx
Total raw materials needs…………………………………………………… xxxx
Less beginning inventory of raw materials………………………….… … xxxx
Raw materials to be purchased…………………………………………… xxxx

Quarter
1 2 3 4 Total
Production needs(pounds) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
Add: Desired ending
inventory 48, 000 54, 000 28, 500 22, 500 22, 500
Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 48, 000 54, 000 28, 500 21, 000

32
Raw materials to be
purchased(pounds) 237, 000 486, 000 514, 500 279, 000 1, 516,500

Raw Materials to be purchased (in birrs)

1 2 3 4 Total
Raw materials to be
purchased 237, 000 486, 000 514, 500 279, 000 1, 516, 500
Raw materials cost per
pound x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20
Br.47, Br.97, Br.102, Br.55,
Total 400 200 900 800 Br.303, 300

e) Schedule of Expected Cash Disbursements (for Materials Purchase)

Quarter Total
1 2 3 4
50% of the previous
quarter Br. 25, 800 Br.23, 700 Br.48, 600 Br.51, 450 Br.149, 550
50% of the current
quarter 23, 700 48, 600 51, 450 27, 900 151,650
Total cash
disbursement Br.49, 500 Br.72, 300 Br.101,050 Br.79, 350 Br.301, 200

f) Direct Labor Budget

The direct labor budget is also developed from the production budget. Direct labor
requirements must be computed so that the company will know whether sufficient labor
time is available to meet production needs. By knowing in advance just what will be
needed in the way of labor time throughout the budget year, the company can develop
plans to adjust the labor force as the situation may require. Firms that neglect to budget run
the risk of facing labor shortage or having to hire and lay off at awkward times. Erratic
labor policies lead to insecurity and inefficiencies on the part of employees.

To compute direct labor requirements, the number of units of finished product to be

produced each produced each period (month, quarter, and so on) is multiplied by the
number of direct labor-hours required to produced a single unit. Many different types of
labor may be involved. If so, then the computation should be by type of labor needed. The
labor requirements can then be translated into expected direct labor costs. How this is done

33
 will depend on the labor policy of the firm. In schedule given below, the management of
Great Company has assumed that the direct labor force will be adjusted as the work
requirement change from quarter to quarter (for example as units produced changes from
l4, 000 units in quarter 1 to 32, 000 units in quarter 2 for Great Company, the direct labor
work force will be fully adjusted to the workload, i.e., total hours of direct labor time
needed). In that case, the total direct labor cost is computed by simply multiplying the
direct labor-hour required by the direct labor rate hour as was done in the schedule here
under.

Quarter Total
1 2 3 4
Direct labor time
needed 11, 200 25, 600 28, 800 15, 200 80, 800
Direct labor cost
per hour x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50
Total direct labor cost Br.84, 000 Br.192, 000 Br.216, 000 Br.114, 000 Br.606, 000

g) Manufacturing Overhead (MOH) Budget

The manufacturing overhead budget provides a schedule of all costs of production other
than direct materials and direct labor. These costs should be broken down by cost
behavior for budgeting purposes and a predetermined overhead rate developed. This rate
will be used to apply manufacturing overhead to units of product throughout the budget
period.
A computation showing budgeted cash disbursement for manufacturing overhead should
be made for use in developing the cash budget. Since some of the overhead costs do not
represents cash outflows, the total budgeted manufacturing overhead costs must be
adjusted the determine the cash disbursement for manufacturing overhead. At Great
Company, the only significant non cash manufacturing overhead cost is depreciation. Any
depreciation charges included in manufacturing overhead must be deducted from the total
in computing expected cash payments, since depreciation is a non-cash charge.

34
 Quarter
1 2 3 4 Total
Variable overhead Br.22, 400 Br.51, 200 Br.57, 600 Br.30, 400 Br.161, 600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
Total MOH Br.83, 000 Br.111,800 Br.118,200 Br.91, 000 Br.404, 000
Less: Depreciation 15, 000 15, 000 15, 000 15, 000 60, 000
Cash
disbursements for
MOH Br.68, 000 Br.96, 800 Br.103,200 Br.76, 000 Br.344, 000

h) Ending Finished Goods Inventory Budget

After completing schedules (a) to (g), the company had all of the data needed to compute
unit product costs. This computation was needed for two reasons: first, to know how much
to charge as cost of goods sold on the budgeted income statement; and second, to know
what amount to put on the balance sheet inventory account for unsold units.

The carrying cost of the unsold units is computed on the ending finished goods inventory
budget
Budgeted Finished Goods Inventory 3, 000
Unit product cost Br.13
Ending Finished Goods Inventory in birrs Br.39, 000

Production cost per unit

Quantity (unit) Cost Total
Direct materials 15 pounds Br.0.20 per pound Br.3
Direct labor 0.8 hours 7.50 per hour 6
Manufacturing overhead 0.8 hours 5.00 per hour 4
Unit product cost Br.13

MOH rate= Total MOH = 404,

404, 000 = Br.5.00
Direct labor hours 80, 800

Quarter Total
1 2 3 4
Variable selling expenses Br.18, 000 Br.54, 000 Br.72, 000 Br.36, 000 Br.180, 000

35
 Fixed selling &
administrative expenses
Advertising 20, 000 20, 000 20, 000 20, 000 80, 000
Executive
salaries 55, 000 55, 000 55, 000 55, 000 220, 000
Insurance - 1, 900 37, 750 - 39, 650
Property taxes - - - 18,150 18,150
Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total budgeted selling & Br.140, Br.194, Br.139,
administrative expenses Br.103, 000 900 750 150 Br.577, 800

i) Selling and Administrative Expenses Budget

Disbursement for Selling & Administrative Expenses
Quarter Total
1 2 3 4
Budgeted Selling & Br.103, Br.140, Br.139,15
Administrative 000 900 Br.194, 750 0 Br.577, 800
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements Br.130, Br.129,
Br.93, 000 900 Br.184, 750 150 Br.537, 800

2. a) Cash Budget

Quarter Total
1 2 3 4
Cash balance, beginning Br.42, 500 Br.40,000 Br.40, 000 Br.40, 500 Br.42, 500
Add :Collection from customers 230, 000 480, 000 740, 000 520, 000 1,970, 000
Total cash available before financing
272, 500 520, 000 780, 000 560, 500 2,012, 500
Less: Disbursements for
Direct materials 49, 500 72, 300 100,050 79, 350 301,200
Direct labor 84, 000 192, 000 216,000 114, 000 606,000
Manufacturing overhead 68, 000 96, 800 103,200 76, 000 344,000
Selling & Administrative 93, 000 130, 900 184,750 129, 150 537,800
Equipment purchases 50, 000 40, 000 20,000 20,000 130,000
Dividend 8, 000 8, 000 8, 000 8, 000 32,000

36
Total disbursements 352, 500 540,000 632,000 426,500 1,951,000
Minimum cash balance 40, 000 40, 000 40, 000 40, 000 40, 000
Total need 392, 500 580, 000 672, 000 466, 500 1, 991,000
Excess (deficiency) of cash
available over total need (120, 000) (60, 000) 108, 000 94, 000 21, 500
Financing:
Borrowing(at beginning) 120,000 60, 000 - - 180, 000
Repayments( at ending) - - (100, 000) (80,000) (180,000)
Interest(at 10% per annum) - - (7,500) (6,500) (14,000)
Total financing 120, 000 60, 000 (107,500) (86,500) (14,000)
Cash balance, ending Br.40,00 Br.47,
Br.40,000 0 Br.40, 500 500 Br.47, 500

b) Budgeted Income Statement

Great Company
Budgeted Income Statement
For the Year Ended December31, 20x4
20x4
Sales [100, 000units at Br.20 Schedule 1(a)] Br.2, 000, 000
Cost of Goods Sold
[100, 000 units at Br.13 Schedule1 (h)] 1, 300, 000
Gross Margin 700, 000
Selling & Administrative Expenses [Schedule 1 (i)] 577, 800
Net Operating Income 122, 200
Interest Expense [Schedule 2(a)] 14, 000
Net Income Br. 108, 200

c) Budgeted Balance Sheet

Great Company
Budgeted Balance Sheet
December31, 20x4
20x4
ASSETS
Current assets:

37
 Cash [ Schedule 2(a)] Br. 47, 500
Accounts Receivable 120, 000
Raw Materials Inventory 4, 500
Finished Goods Inventory 39, 000
Total current assets Br.211, 000

Plant and Equipment:

Land Br.80, 000
Building and Equipment 830, 000
Accumulated Depreciation (392, 000)
Plant and Equipment, net 518, 000
Total assets Br.729, 000
LIABILTIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable (raw materials) Br.27, 900
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 526, 100
Total stockholders’ equity 701, 100
Total liabilities and stockholders’ equity Br.729, 000

Learning activity 2.
Exercise two:
Young Corporation produces Tin the projected sales for the first quarter of the
coming year and the beginning and ending inventory data are as follows:
Unit sales 100000
Unit price Br. 15
Units, beginning inventory 8,000
Units, targeted ending inventory 12000
The Tin is moulded and then painted. Each Tin requires 4 kg of metal, which

38
 costs 2.50 per kg. the beginning inventory of raw materials is 4000 kg, young
wants to have 6000 kg of metal in inventory at the end of the quarter. Each Tin
produced requires 30 Minutes of direct labour time, which is billed at Br. Per
hour.
Required:
1. Prepare the a sales budget for the first quarter
2. Prepare production budget for the first quarter
3. Prepare a direct materials purchase budget for the first
quarter
4. Prepare a direct labour budget for the first quarter.

1.8 SUMMARY

Budgeting is the creation of plan of action expressed in financial terms. Budgeting plays a
key role in planning, control, and decision-making. Budgets, among other things, force
planning, serve to improve communication and coordination, allocates scarce recourses
and used to evaluate performance.

The comprehensive set of budgets that covers all phases of an organization’s operations is
called a master budget. The first step in preparing a master budget is to forecast sales of
the organization’s services or goods. Based on the sales forecast, operational budgets are
prepared to plan production of services or goods and to outline the acquisition and use of
material, labor and other resources. Finally, a set of budget financial statements are
prepared to show what the organization’s overall financial condition will be if planned
operations are carried out.

The success of a budgetary system depends on how seriously human factors are
considered. To discourage dysfunctional behaviour, organizations should avoid
overemphasizing budgets as a control mechanism and use a participative budgeting
process.

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Participative budgeting is the process of allowing employees throughout the organization
to have a significant role in developing the budget. Participative budgeting can result in
greater commitment to meet the budget by those who participated in the process.

Budgeting systems ate costly. They are needed because it is believed and assured that the
systems will help organizations make better collective operating and financial decisions.

Check your progress question

1. CZ is a merchandising company engaged in the purchasing and selling of electrical
appliances. You as a management accountant have been asked to prepare a complete
master budget for your store for June, July and August, so you gather the following data as
of may 31, 2005:
Cash $ 21,000 Accounts Payable $ 340,000
Inventory 300,000 Owners' equity 362,000
Accounts receivable 261,000 Total liabilities and
Net furnitures and fixtures 120,000 owners' equity 702,000
Total Assets 702,000
Recent and projected sales
April $200,000
May 250,000
June 500,000
July 300,000
August 300,000
September 200,000

Credit sales are 90% of total sales. Credit accounts are collected 80% in the month
following the sale and 20% in the next following month. Assume that bad debts are
negligible and can be ignored. The average gross profit on sales is 40%.

The policy is to acquire enough inventories each month to equal the following month's
projected sales. All purchases are paid for in the month following purchase.

Salaries, wages and commissions average 20% of sales: all other variable expenses are 4%
of sales. Fixed expenses for rent, property taxes, and miscellaneous payroll and other
items are $ 40,000 monthly. Assume that these variable and fixed expenses require cash
disbursements each month. Depreciation is $ 2,000 monthly.

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In June, $ 40,000 is going to be disbursed for fixtures acquired in May. The May 31
balance of accounts payable includes this amount.

Assume that a minimum cash balance of $ 20,000 is to be maintained. Also assume that all
borrowings are effective at the beginning of the month and all repayments are made at the
end of the month of repayment. Interest is paid only at the repaying principal. Interest rate
is 12% per annum: round interest computation to the nearest ten dollars.
Required
Prepare a budgeted income statement for the coming quarter, a budgeted statement of
monthly cash receipts and disbursements (for the next 3 months), and a budgeted balance
sheet for August 30, 2005. All operations are evaluated on a before income tax basis.
(Ignore income taxes).

2. The following data relates to the operations of Good Life Ltd. a retail store:
Sales plan 2006
May Br. 60,000
June 80,000
July 100,000
August 120,000
a. Selling price per unit Br. 10
b. Cost of goods per unit is Br.6. Variable operating expenses are 20% of sales
c. Inventory is maintained at 150% of the next month’s sales in units.
d. Fixed operating expenses are Br. 180,000 per year allocated for each month
proportionately

Required:
A. Prepare a purchase budget in Br. for July 2006
B. Prepare a budget income statement for July 2006
3. Information pertaining to Brothers’ co. sales revenue as per the plan follows:
November December January February\
2005 2005 2006 2006
Cash sales Br. 80000 Br. 80000 Br. 50000 Br. 40000 Credit sales
24000 320000 170000 120000

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Management estimates that 5% of credit sales are uncollectible. Of the credit sales that are
collectible, 70% are collected in the month of sale and the remainder in the month
following the sale. Purchases of inventory each month are 60% of the next month’s
projected total sales. All purchases of inventory are on account; 30% are paid in the month
of purchase and the remainder is paid in the month following the purchase.

Required:

A. What are budgeted cash collections in December 2005 form November 2005 credit
sales.

B. What are total budgeted cash receipts in January 2006?

C. Prepare a schedule for budgeted cash payments for purchases for December 2005
and January 2006.

4. Gorgeous Retail Company has the following data

Part of the trial balance at March 1 showed:
Debit Credit
Cash Br. 12,000
Account receivable 39,000
Allowance for bad debt Br.4, 800
Merchandise inventory 24,000
Account payable (Merchandise) 18,000

The company’s purchase are payable with in 10 days. Assume that one –third of the
purchases of any month are due and paid in the following month.
The unit invoice cost of the merchandise purchased is Br. 10. At the end of each month,
the company’s policy is to have an inventory equal to 50% of the following month’s unit
sales.
Past experience indicates that 60% of the billings will be collected during the month of
sale, 30% in the following month, 6 % in the next following month and 4% will be
uncollectible.
Sales data are as follows:
Selling price per unit Br. 30
January actual sales revenue 30000
February actual sales revenue 90000
March estimated sales revenue 72000

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 April estimated sales revenue 54000
May estimated sales revenue 96000
Total sales expected for the year 900,000
The company’s fiscal year begins January 1. Exclusive of bad debts, the total budgeted
selling and administrative expenses for the year are estimated at Br. 141,000 of which Br.
42000 is fixed expenses (inclusive of a Br. 18,000 annual depreciation charge). These
fixed expenses are incurred uniformly throughout the year. The balance of selling and
administrative expense varies with sales. Expenses are paid as incurred.
Required:
Required: prepare a cash budget for March and April. (Provide a supporting schedule of
cash collection.

1. 9 ANSWER KEY TO LEARNING ACTIVITY QUESTIONS

Learning Activity 1.
1. Forces periodic planning
Fosters coordination, integration and communication
Promotes continuous improvement
Guides performance
Facilitates evaluation and control
Create cost awareness
2. Master budget is a company’s overall financial plan for the coming year or other
planning period, which usually includes an operating budget, a cash budget and
projected financial statements.
3. Problem of conflict due to conflicting interest between departments.
Imposed budget problem
Use of Budget as check up device for individual performance
Unwise adherence to budget
Learning activity 2.
1. Sales budget
Units……………………100000
X unit price …………... Br. 15
Sales Br. 1500000

2. Production budget
Sales (in units) 100000

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 Desired ending inventory 12000
Total needs 112,000
Less: beginning inventory (8,000)
Units to be produced 104,000
3. Direct materials budget
Units to be produced 104,000
Direct materials per unit (kg) x 4
Production needs (kg) 416,000
Desired ending inventory (kg) 6,000
Total needs (kg) 422,000
Less: Beginning inventory (kg) (4,000)
Materials to be purchased (kg) 418,000
Cost per kg X Br. 2.50
Total purchased cost Br. 1,045,000
4. Direct labour budget
Units to be produced 104,000
Labour: Time per unit x 0.5
Total hours needed Br. 2000
Cost per hour x Br. 9
Total direct labour cost Br. 468,000

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