Chapter two

The master budget

2.1. The overall plan and its characteristics

A budget is a detailed plan for the acquisition and use of financial and other resources over a
specified period of time—typically a fiscal year. A budget includes both financial and
nonfinancial aspects of planned operations and projects. The budget for a period is both a
guideline for operations and a projection of the operating results for the budgeted period. The
process of preparing a budget is called budgeting.
2.2. Advantages of budgeting
The advantages of budgeting include:
1. Planning orientation
The process of creating a budget takes management away from its short-term, day-to-day
management of the business and forces it to think longer-term. This is the chief goal of
budgeting, even if management does not succeed in meeting its goals as outlined in the
budget - at least it is thinking about the company's competitive and financial position and
how to improve it.
2. Profitability review
It is easy to lose sight of where a company is making most of its money, during the scramble
of day-to-day management. A properly structured budget points out what aspects of the
business produce money and which ones use it, which forces management to consider
whether it should drop some parts of the business, or expand in others.
3. Assumptions review
The budgeting process forces management to think about why the company is in business, as
well as its key assumptions about its business environment. A periodic re-evaluation of these
issues may result in altered assumptions, which may in turn alter the way in which
managements decides to operate the business.
4. Performance evaluations
You can work with employees to set up their goals for a budgeting period, and possibly also
tie bonuses or other incentives to how they perform. You can then create budget versus actual
reports to give employees feedback regarding how they are progressing toward their goals.
This approach is most common with financial goals, though operational goals (such as
reducing the product rework rate) can also be added to the budget for performance appraisal
purposes. This system of evaluation is called responsibility accounting.

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 5. Funding planning
A properly structured budget should derive the amount of cash that will be spun off or which
will be needed to support operations. This information is used by the treasurer to plan for the
company's funding needs.
6. Cash allocation
There is only a limited amount of cash available to invest in fixed assets and working capital,
and the budgeting process forces management to decide which assets are most worth
investing in.
7. Bottleneck analysis
Nearly every company has a bottleneck somewhere, and the budgeting process can be used to
concentrate on what can be done to either expand the capacity of that bottleneck or to shift
work around it.
Short-Term Objectives and the Master Budget
Short-term objectives are goals for the coming period, which can be a month, a quarter, a
year, or any length of time desired by the organization for planning purposes. An
organization determines short-term objectives for the budget period based on strategic goals,
long-term objectives and plans, operating results of past periods, and expected future
operating and environmental factors including economic, industry, and marketing conditions.
These objectives serve as the basis for preparing the master budget for a period.

A master budget is an organization’s operating and financing plan for the upcoming period;
it translates short-term objectives into action steps.

2.3. Parts of Master Budgets

The master budget is also a comprehensive financial summary of the organization’s budgets.
It comprises both operating budgets and financial budgets.

Operating budgets are plans that identify resources needed to implement strategic projects
and to carry out budgeted activities such as sales and customer services, production,
purchasing, marketing, and research and development, and the acquisition of these resources.
For a manufacturer, operating budgets include production, purchasing, personnel, and
marketing budgets. The set of operating budgets culminates in a budgeted income statement.

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Financial budgets identify sources and uses of funds for the budgeted operations, including
strategic projects and initiatives. Financial budgets include the cash budget, budgeted
statement of cash flows, the budgeted balance sheet, and the capital expenditures (including
strategic expenditures) budget.

2.4. Developing the master budget

A master budget is a comprehensive budget for a specific period. It consists of a capital

budget and a set of interrelated operating and financial budgets. As noted earlier, the capital
budget includes budgets to support strategic initiatives, programs, and projects.
The master budget is an integrative set of financial planning documents that incorporates a
number of individual budgets. It serves as a guide of what a company wants to achieve and
what it must accomplish to get there. It also allows the company to realistically project future
cash flows and financial position so that operations can be adjusted during the period if the
company gets off track. A key disadvantage is the extensive amount of time involved to
create the master budget. While the master budget is usually prepared on an annual basis, the
focus in this text will be primarily on budgets covering a single month or quarter for
simplicity purposes.
The individual budgets consist of several operating and financial budgets. They are all
interconnected and must be prepared in a particular order because most budgets rely on
information generated within other budgets. The following exhibit shows the flow of
information from the individual budgets into the budgeted balance sheet---the final budget.

Production budget
Materials purchase budget
Direct labor budget
Manufacturing overhead budget
Budgeted income statement Budgeted
Budgeted cash flows statement Balance sheet
Sales budget
Selling and administrative budget
Capital acquisitions budget
Cash budget

While the order in which the budgets are listed are does not reflect the order in which they
should be prepared, you should find the order of preparation logical if you think about the
format of the income statement. Because the income statement begins with sales, the
budgeting process begins with the sales budget. Because cost of goods sold appears next on

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the income statement, the manufacturing budgets, which flow into cost of goods sold, are
prepared next. The selling and administrative budget and the capital acquisitions budget are
then prepared, which are followed by the cash budget. The results of all these budgets flow
into the budgeted income statement, budgeted statement of cash flows, and finally, into the
balance sheet. This text presents the budgets in the order in which they should be prepared,
with the first three operating budgets---the sales budget, the production budget, and the
materials purchases budget---presented in this chapter.

Sales Budget

The sales budget is prepared first because all other budgets rely on its information. The
process begins a forecast of revenues generated by the company's sales department and sales
vice-presidents. A number of sources are used by managers to estimate how much sales will
occur in the future, including economic forecasts, mathematical models, industry data, and
statistical trend analysis. For most companies, sales forecasting is the most difficult part of
budgeting. Fortunately for you, it is the easiest part, because this information will be provided
as part of the problem data. If it were up to each student to forecast sales, each student would
generate a different solution.

The general format of the sales budget consists of three line items. Companies that sell more
than one product will display a separate column for each product.

Walk Through Problem - Sales Budget

At January 1, 2018, Arrant, Inc. had 1,100 step stools on hand. Its policy is to maintain an
ending inventory equal to 15% of units needed for the next month’s sales. Arrant Co.
estimates it will sell 8,000 stools during the first month of 2018 with a 5% increase in sales
each subsequent month. Each stool is sold for $16. Prepare a sales budget for the March of
2018.

Solution

Because sales is an independently generated amount that is not based on the number of units
in inventory, much of the inventory information provided in this problem is irrelevant for the
sales budget. You have been provided the sales in units for January. Sales during February
will be 5% larger than January:

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February sales in units = 8,000 x 105% = 8,400 units

Sales for March are expected to be another 5% more than February sales. The sales for March
are expected to be:
March sales in units = 8,400 x 105% = 8,820 units

Only amounts for future periods should be included in budgets. Prior period amounts are
never displayed because they are historical amounts, and by definition, a budget is an
estimate of future activity. Every budget should begin with a standard, three-line statement
heading which includes the company name, the name of the budget, and the time period it
covers. The sales budget will appear as follows:

Arrant. Inc.
Sales Budget
Month Ending March 31, 2018
Sales in units 8,820
Selling price per unit $ 16.00
Budgeted sales revenue $141,120

Production Budget

The production department manufactures products based on the number of units the sales
personnel forecast, which is reflected on the sales budget. It is prepared so that production
managers know how many units they will need to produce. This information enables the
production supervisor to hire and schedule employees and the purchasing department to plan
for ordering materials. The production budget is the only budget consisting of no monetary
amounts.

It is important to make the distinction between two types of units in budgeting---finished

goods (FG) units and raw materials (RM) units. Raw materials are used to create finished
goods. The format of the production budget is:

Budgeted sales of finished goods units

+ Desired ending inventory of finished goods units
− Beginning inventory of finished goods units
= Finished goods units to be produced

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Recall that the number of units produced rarely equals the number of units sold for most
companies. The ending balance of the current budget period is based on the number of units
to be sold during the next period. The beginning balance of the budget period is based on the
number of units to be sold during the current period, because as of the first day of the month,
the next budget period is the next 30 days of operations. Assume that the company estimates
that 100 units will be sold in June, 120 in July, and 150 in August, and the company desires
to have ending inventory equal to 10% of the units to be sold during the next month. At the
end of June, the company wants to have 10% times July's expected sales: 10% x 120 = 12
units. At the end of July, the company wants to have 10% times August's expected sales: 10%
x 150 = 15 units. Beginning inventory at the end of July is the same point in time as the end
of June. As such, because the company wants to have 12 units at the end of June, it will also
desire 12 units at the beginning of July. The following concept will always apply:

Ending inventory of one month is the same as the beginning inventory for the next month.

Walk Through Problem - Production Budget

Schroeder, Inc. sells placemats for $15 each. The company’s budgeted unit sales for 4 months
during 2018 appears below.

February 39,000
April 42,000
May 44,000
June 40,000

Schroeder desires to have total mats on hand at the end of each month equal to 15 percent of
the following month’s budgeted unit sales. Each mat requires 0.25 yards of fabric. At the end
of each month, Schroeder desires to have 20 percent of production material needs required
for the next month on hand. The fabric costs $2.60 per yard. Each mat produced requires 0.15
hours of direct labor. Prepare a production budget for the month of April.

Solution

Step 1: Begin with the number of units the company expects to sell during April, a total of
42,000. This information is taken from the sales budget.

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Step 2: Calculate the number of units the company desires to have on hand at the end of
April. The production department must produce enough units to cover the 42,000 to be sold,
plus additional units at month end, i.e., "15 percent of the following month’s budgeted unit
sales." These units will be used to begin the next month: 15% x 44,000 = 6,600 units at May
1. These units are added to the number to be sold because they are extra units that must be
produced.

Finished goods units to be sold 42,000

Step 3: Calculate the number of units the company desires to have on hand at the beginning
of April. The finished goods inventory balance at the end of March was budgeted at 15%
times April sales, giving 15% x 42,000 or 6,300 units estimated to be in inventory at March
31. The last day of March (ending inventory of one month) and the first day of April
(beginning inventory of the next month) should always have the same inventory balance.

Step 4: Add the desired ending inventory and subtract the desired beginning inventory to
determine the number of finished goods units (i.e., placemats), the company will need to
produce.

Schroeder, Inc.
Production Budget
Month Ending April 30, 2018
Finished goods units (placemats) to be sold 42,000
+ Desired finished goods in ending inventory 6,600
- Beginning finished goods inventory on hand expected (6,300)
Finished goods units (placemats) to be produced 42,300

Because the production budget determines the number of units to be produced, no dollar signs
are displayed.

Direct Materials Purchases Budget

The direct materials purchase budget depends on the units needed for production and the
change in the raw material inventories during the period. Begin with units to be produced, not
sales units. Why? Materials are purchased and used for production purposes, not to be sold.

The amount of direct materials to be purchased is calculated as follows:

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 Budgeted finished units to be produced
x Raw materials needed for each finished goods unit
= Total raw materials units needed for production
+ Desired raw materials ending inventory
− Beginning raw materials on hand
= Raw materials needed to purchase
x Cost per raw materials unit
= Budgeted cost of purchases

There are three cautions you should always remember for the direct materials purchases
budget. First, begin with units to be produced. Second, immediately convert and display all
inventories in the denomination in which the raw materials are purchased. Finally, always
wait until the last step to consider the cost of the materials.

Walk Through Problem - Direct Materials Purchases Budget

Trump Inc. produces trinkets. Each trinket requires 0.4 board feet of wood and 1.25 hours of
direct labor. Wood costs $1.40 per board foot. Trump pays it employees $18.00 per hour.
Trump desires to have 20% of the materials needed for production during the next month on
hand at the end of each month, and 15% of the number of trinkets to be sold the next month
on hand at the end of each month. Scheduled productions in units are:
April 4,100
May 4,700
June 5,300
Prepare a materials purchases budget for May in good form. Calculate budgeted raw
materials inventory on the balance sheet at May 31.

Solution
Step 1: Begin with the number of units to be produced. While both units to be sold and units
to be produced are often provided, you only need units 'produced' because those are the units
in which the materials will be consumed during the period.

Step 2: The second line of the budget converts the units to be produced (denominated in
finished goods units) to the denomination in which the materials are ordered....i.e., in board
feet. Every line item from this point forward in the materials purchases budget is

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denominated in board feet. Multiply the board feet needed for each trinket by the number of
trinkets the company plans to produce:
Budgeted trinkets (FG) to be produced 4,700
Board feet needed for each trinket 0.4
Board feet needed for production 1,880

Step 3: Calculate and add in the desired ending inventory. This is often tricky because two
different 'ending inventories' are cited in the problem. Be sure you focus on 'raw materials'
and not 'finished goods.' We are concerned with the 20% inventory levels, not the 15% levels
that appear in this problem. This is because the 15% amount pertains to finished goods, and
you already know how many finished goods units to produce (i.e., the budgeted production
numbers are provided above.)

The raw materials requirements are: "desires to have 20% of the materials needed for
production during the next month on hand at the end of each month." Dates are important.
The end of the budget period is May 31. Because the 'next' month of production is the month
of June, you can conclude that the company desires to have enough materials on hand at May
31 to produce 20% of June's budgeted finished units:

20% x 5,300 units x 0.4 board feet = 424 board feet

Budgeted trinkets (FG) to be produced 4,700

Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired raw materials ending inventory 424
Step 4: Calculate and subtract out the beginning inventory which is carried over from the
previous month (April). At the end of April, management desires to have 20% of the
materials needed for the next month---May. Production of 4,700 trinkets is expected to be
produced in May. Considering that each trinket uses 0.4 board feet of wood, the budgeted
beginning inventory is: 20% x 4,700 units x 0.4 board feet = 376 feet

The total board feet needed to purchase are determined by subtracting the beginning raw
materials inventory which results in a purchase requirement of 1,928 feet:

Budgeted trinkets (FG) to be produced 4,700

Board feet needed for each trinket 0.4

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 Board feet needed for production 1,880
Add desired raw materials ending inventory 424
Less beginning raw materials on hand (376)
Board feet needed to purchase 1,928
Step 5: Once the number of feet to be purchased is determined, the cost per board foot is
factored in. The completed budget includes a standard three-line heading
Trump, Inc.
Materials Purchases Budget
Month Ending May 31, 2018

Budgeted trinkets (FG) to be produced 4,700

Board feet needed for each trinket 0.4
Board feet needed for production 1,880
Add desired raw materials ending inventory 424
Less beginning raw materials on hand -376
Board feet needed to purchase 1,928
Cost per board foot $1.40
Budgeted cost of purchases $2,699

Note that last line of the budget represents the 'cost' of purchases, not the cash to be paid for
purchases nor the cost of goods sold. Cash payments are often paid up to 30 days after
purchases are made and are calculated in the cash disbursements budget.

Step 6: To calculate budgeted raw materials inventory on the balance sheet at May 31, begin
with the number of feet that are budgeted to be on hand on May 31. This amount is labeled as
desired raw materials ending inventory in the materials purchases budget. This ending
inventory amount is multiplied by the cost per board foot to determine the ending raw
materials inventory cost.

Note that balance sheet amounts are always in dollars, not feet, pounds, yards, etc.

Board feet at May 31 = 20% x 5,300 x 0.4 = 424 board feet

Raw materials inventory cost at May 31 = 424 feet x $1.40 = $593.60

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