Chapter 6
Introduction to Budgets
and Preparing the Master Budget
Chapter 6 Learning Objectives
When you have finished studying this
chapter, you should be able to:
1. Explain how budgets facilitate planning
and coordination.
2. Anticipate possible human relations
problems caused by budgets.
3. Explain potentially dysfunctional incentives
in the budget process.
Chapter 6 Learning Objectives
4. Explain the difficulties of sales forecasting.
5. Explain the major features and advantages of a
master budget.
6. Follow the principal steps in preparing a
master budget.
7. Prepare the operating budget and the
supporting schedules.
8. Prepare the financial budget.
9. Use a spreadsheet to develop a budget
(Appendix 7).
Learning
Objective 1 Budgets and the Organization
A budget is a quantitative expression
of a plan of action that imposes
the formal structure of an organization.
Managers use budgeting as an
effective cost-management tool.
Budgets facilitate planning
and coordination.
Benefits of Budgets
Compel Provide an opportunity to
managers to reevaluate existing activities
think ahead and evaluate new ones.
Aid managers in communicating
objectives and coordinating
actions across the organization.
Provide benchmarks to evaluate
subsequent performance.
Zero-based Budget
A zero-based budget:
Requires justification of expenditures for
every activity, including continuing
activities.
Starts with the assumption that current
activities will not automatically be continued;
every activity starts at zero budget.
Learning
Objective 2 Possible Human Relations Problems
Problems in implementing budgets:
- Low level of participation in the budget
process,
- Lack of acceptance of responsibility for the
final budget,
- Incentives to lie and cheat in the budget
process,
- Difficulties in obtaining accurate sales
forecasts
Possible Human Relations Problems
The advantages of budgeting:
- The perceived attitude of top management,
-The level of participation in the budget process,
-The degree of alignment between the budget
and other performance goals.
An environment where there is a two-way flow
of information reduces negative attitudes.
Participative budgets are formulated with the
active participation of all affected employees.
Possible Human Relations Problems
Message conveyed by the budget system may
be misaligned with incentives provided by the
compensation system.
Misalignment between performance goals
stressed in budgets versus performance
measures the company uses to reward
employees and managers can limit
advantages of budgeting.
Learning
Objective 3 Dysfunctional Incentives
Dysfunctional incentives lead managers to make
poor decisions – lying if the budget process
creates incentives to bias budget information.
Budgetary slack (budget padding) - an over-
statement or understatement of budgeted
revenue to create an easier goal to achieve.
And one more complication—managerial
bonuses based on making budget.
Learning
Objective 4 Sales Forecasting
A sales forecast is a prediction of sales
under a given set of conditions.
Sales forecasts are usually prepared under
the direction of the top sales executive.
The sales budget is the result of
decisions to create conditions that will
generate a desired level of sales.
Factors to Consider When
Forecasting Sales
Types of Budgets
Strategic plan Long-range planning
Master budget
Capital budget Continuous budget
Strategic Plan
The most forward-looking budget
is the strategic plan, which sets
the overall goals and objectives
of the organization.
The strategic plan leads to long-range
planning, which produces
forecasted financial statements
for five- to ten-year periods.
Long-Range Plans
Long-range plans…
are coordinated with capital budgets,
which detail the planned expenditures
for facilities, equipment, new products,
and other long-term investments.
Master budgets link to both long-range
plans and short-term budgets.
Learning
Objective 5 Master Budget
The master budget Sales
is a detailed and
comprehensive analysis
Purchases
of the first year of the
long-range plan.
It summarizes the Production
planned activities
of all subunits of Distribution
an organization.
Continuous Budget
Rolling budgets...
are a common form of
master budgets that
add a month in the
future as the month
just ended is dropped.
Master Budget
Operating budget Financial budget. . .
(profit plan). . .
Focuses on the Focuses on the
income statement effects that the
and supporting operating budget
schedules or and other plans will
budgeted have on cash
expenses. balances.
Learning Steps in Preparing the
Objective 6
Master Budget
1. Supporting data
2. Operating budget
3. Financial budget
Steps in Preparing the Master Budget
The principal steps in preparing
the master budget:
1. Basic data
a. Sales budget
b. Cash collections from customers
c. Purchases and cost-of-goods sold budget
d. Cash disbursements for purchases
e. Operating expense budget
f. Cash disbursements for operating expenses
Steps in Preparing the Master Budget
2. Operating Budget:
Prepare budgeted income
statement using basic data in step 1.
3. Financial Budget: Prepare forecasted
financial statements:
a. Capital budget
b. Cash budget
c. Budgeted balance sheet
Learning
Objective 7 Operating Budget
Sales Cash collections
budget from customers
Purchases Disbursements
budget for purchases
Operating expenses Disbursements for
budget operating expenses
Cash Collections
It is easiest to prepare budgeted
cash collections at the same
time as the sales budget.
Cash collections include
the current month’s cash
sales plus the previous
month’s credit sales.
Purchases Budget and
Cash Disbursements
Budget cost of goods sold by
multiplying the cost of
merchandise sold percentage
by budgeted sales.
The total merchandise needed
is the sum of budgeted cost
of goods sold plus the desired
ending inventory.
Purchases Budget and
Cash Disbursements
Finally, compute required purchases by
subtracting beginning inventory from
total merchandise needed:
Budgeted purchases:
= Desired ending inventory
+ Cost of goods sold
– Beginning inventory
Purchases
Use the budgeted purchases to
budget cash disbursements.
Operating Expense Budget
The budgeting of operating expenses
depends on several factors.
Month-to-month changes in sales volume and
other cost-driver activities directly influence
many operating expenses.
Expenses driven by sales volume include sales
commissions and many delivery expenses.
Operating Expense Budget
Other expenses are not influenced by sales
or other cost-driver activity and are regarded
as fixed, within appropriate relevant ranges.
Rent
Depreciation
Insurance
Salaries
Operating Expense Disbursements
Disbursements for operating expenses are
based on the operating expense budget.
Disbursements may include 50% of last month’s
and this month’s wages and commissions
plus miscellaneous and rent expenses.
The total of these disbursements is then
used in preparing the cash budget.
Budgeted Income Statement
The income statement will be complete
after addition of the interest expense,
which is computed after the cash
budget has been prepared.
Budgeted income from operations
is often a benchmark for judging
management performance.
Learning
Objective 8 Financial Budget
The second major part of the master budget is
the financial budget, which consists of the
capital budget, cash budget, and ending
balance sheet.
The cash budget is a statement of planned cash
receipts and disbursements that contains
these major sections: available cash balance,
net cash receipts, and disbursement financing.
Cash Budget
Available cash balance
= Beginning cash balance
– Minimum cash balance desired.
Cash receipts depend on collections from:
▪ customers’ accounts receivable, cash
▪sales, and other operating income sources.
Cash Budget
Cash disbursements for purchases depend
on the credit terms extended by suppliers
and the bill-paying habits of the buyer.
Payroll depends on wage, salary, and
commission terms and on payroll dates.
Cash Budget
Disbursements for some costs and
expenses depend on:
▪ contractual terms for installment
▪ payments,
▪ mortgage payments, rents, leases, and
▪ miscellaneous items.
Other disbursements include outlays for
fixed assets, long-term investments,
dividends, and the like.
Cash Budget
Ending cash balance
= Beginning cash balance
+ Receipts – Disbursements
+ Cash from financing
The cash from financing can be
either positive (borrowing)
or negative (repayment).
Budgeted Balance Sheet
The final step in preparing the master budget
is to construct the budgeted balance sheet
that projects each balance sheet item in
accordance with the business plan.
Beginning balances would be increased or
decreased in light of the expected cash
receipts and disbursements and the effects
of noncash items on the income statement.
Strategy and the Master Budget
The master budget is an important
management tool for evaluating
and revising strategy.
The first draft of a master budget is rarely the
final draft. As managers revise strategy, the
budgeting process becomes an integral part of
the management process itself—budgeting is
planning and communicating.
Activity-Based Master Budgets
Functional budgeting focuses on
preparing budgets for various
functions such as production,
selling, and administrative support.
An activity-based budgetary system
emphasizes the planning and control
purpose of cost management.
Financial Planning Models
Financial planning models are mathematical
models that can incorporate the effects of
alternative assumptions about
sales, costs, or product mix.
Financial models are only as good as the
assumptions and the inputs used to
build and manipulate them.
Learning
Objective 9 Spreadsheets for Budgeting
Spreadsheet software for personal computers,
a powerful and flexible tool for budgeting,
can be used to prepare mathematical models.
Models can be applied with a variety of
assumptions that reflect changes in expected
sales, cost drivers, cost functions, etc.
Arithmetic errors are virtually nonexistent.
Cooking Hut Sales Budget
On average 60% of sales are cash sales
On average 40% of sales are credit sales
Sales in March were $40,000 (40% were credit sales)
Uncollectable accounts are negligible
We are also ignoring all local state and federal taxes
for this illustration
Sales budget for the next 4 months is as follows
April - $50,000
May - $80,000
June - $60,000
July - $80,000
Cooking Hut Planed Inventory
Levels
CHC wants to have an inventory of $20,000 + inventory equal to
80% of expected cost of goods sold for the following month
COGS averages at 70% of sales for that month
CHC pays for 50% of the value of COGS in the month of purchase
and the rest on the next month
Cooking Hut Wages and Commissions
• CHC pays wages twice each month
• Payments lagged half a month after they are earned
• Fixed wages are $2500 each month
• Commissions are 15% of sales
Cooking Hut Capital Expenditures
and Operating Expenditures
Plan to purchase new fixtures for $3000 cash in April
Monthly miscellaneous expenses are 5% of sales every month, paid as
incurred
Rent is $2000, paid as incurred
Insurance is $200 expiration per month
Depreciation, including new fixtures is $500 per month
Cooking Hut Cash Balances
• They use short term loans from local banks
• They maintain a minimum cash balance of $10,000 at the end of each month
• Can only borrow and repay in multiples of $1000
• Interest is 1% per month paid in ash at the end of each month
Cooking Hut Cash Balances
Supporting Budgets and schedules
Sales Budget
March April May June Apr-June total
40,000 50,000 80,000 60,000 190000
Cash Collection from customer
April May June
Cash Sales 50,000*0.60=30k 80,000*0.60=48k 60,000*0.60=36k
Collection of prev. 40,000*0.40=16k 50,000*0.40=20k 80,000*0.40=32k
credit sales
Total Collections 46000 68000 68000
Purchase Budget
• COGS averages at 70% of sales so, April->50k*0.7=35k
• Desired ending inventory for April=(Budgeted cogs of May*0.8+20k)
=56000*0.80+20000
• Total merchandise needed for April = Budgeted COGS of April + Desired
ending inventory of April = 35k + 64.8k = 99.8k
• Beginning inventory of May= Closing Inventory of April = 64.8k
• Purchases for April = Total merchandise needed for April – Beginning
inventory for April = 99.8k – 48k = 51.8k
Cash Disbursements
• April’s purchases are 51.8k, half of it is paid off in April while the
other half is paid of in May.
• Disbursements for purchases in April = 50% of March purchases
+ 50% of April purchases
Operating Expense Budget
• Commissions for may = Sales for may *0.15 = 80k * 015 = 12k
• Misc. Expenses for may = Sales for may * 0.05 = 80k*0.05 = 4k
Disbursements for Operating
Expenses
• Disbursements for wages and commissions for May =
0.5*Wages and Commissions for April + 0.5*Wages and
Commissions for May = 0.5*10k + 0.5*14.5k
Operating Budget
Cash Budget
Budgeted Balance
Sheet
Illustration
Sales Budget
October November December Total
Credit Sales , 80% 56000 68000 72000 196000
Cash Sales , 20% 14000 17000 18000 49000
Total Sales 70000 85000 90000 245000
Cash collection from customers
October November December Total
Cash Sales 14000 17000 18000 49000
Collection from prior month 48000 56000 68000 172000
Total Collections 62000 73000 86000 221000
Purchases Budget
Novembe
October r December Total
Desired ending inventory 15300 16200 9000 40500
cost of goods sold 42000 51000 54000 147000
Total needed 57300 67200 63000 187500
Less: Beginning inventory 12600 15300 16200 44100
Total Purchases 44700 51900 46800 143400
Cash Disbursements for
Purchases
October November December Total
For September 18300 18300
For October 22350 22350 44700
For November 25950 25950 51900
For December 23400 23400
Total Disbursements 40650 48300 49350 138300
Operating Expenses and Disbursements for expenses (except interest)
October November December Total
Cash Expenses : 7500 7500 7500 22500
Salaries and Wages 4200 5100 5400 14700
Freight out 6000 6000 6000 18000
Advertising 2800 3400 3600 9800
Other Expenses 20500 22000 22500 65000
Total disbursements for expenses
Non cash: expenses
Depreciation 2000 2000 2000 6000
Total expenses 22500 24000 24500 71000
Cash Budget
October November December
Beginning cash balance 9000 8000 8000
Minimum cash balance desired 8000 8000 8000
Available cash balance 1000 0 0
Cash receipts and disbursements:
Collection from customers 62000 73000 86000
Payments for merchandise -40650 -48300 -49350
Operating Expenses -20500 -22000 -22500
Equipment Purchases -19750 0 0
Dividends 0 0 -4000
Interest 0 -179 -154
Net cash receipts and disbursements -18900 2521 9996
Excess (deficiency) of cash before Financing -17900 2521 9996
Financing :
Borrowing 17900 0 0
Repayments 0 -2251 -9996
Total cash from financing 17900 -2251 -9996
Ending cash balance 8000 8000 8000
Budgeted Income Statement
October November December Total
Sales 70000 85000 90000 245000
Cost of goods sold 42000 51000 54000 147000
Gross Margin 28000 34000 36000 98000
Operating Expenses :
Salaries and Wages 7500 7500 7500 22500
Freight out 4200 5100 5400 14700
Advertising 6000 6000 6000 18000
Other 2800 3400 3600 9800
Interest 179 154 333
Depreciation 2000 2000 2000 6000
Total Operating Expenses 22500 24179 24654 71333
Net Operating Income 5500 9821 11346 26667
Budgeted Balance Sheet
Assets October November December
Current Assets
Cash 8000 8000 8000
Accounts Receivable 56000 68000 72000
Inventory 15300 16200 9000
Total current assets 79300 92200 89000
Less: Accumulated Depreciation 217750 215750 213750
Total Assets 297050 307950 302750
Liabilities and Stockholder's Equities
Liabilities
Accounts Payable 22350 25950 23400
Notes Payable 17900 15379 5383
Total Liabilities 40250 41329 28783
Shareholder's Equity
Capital Stock 180000 180000 180000
Retained earnings 76800 86621 93967
Total Stockholder's Equities 256800 266621 273967
Total liabilities and stockholder's equities 297050 307950 302750
