Chapter Three

Information for budgeting, planning and control

purposes
3.1 Concept and objectives of budgetary system
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period
of time, usually a year. In other words, a budget is a systematic plan for the utilization of
manpower and natural resources. In a business budget represents an estimate of future costs and
revenues.
Objectives of budgetary system
 To aid the planning of annual operations,
 To co-ordinate the activities of the various parts of the organization and to ensure that the
parts are in harmony with each other,
 To communicate plans to the various responsibility center managers,
 To motivate managers to strive to achieve the organizational goals,
 To control activities,
 To evaluate the performance of managers.
3.2. Types of budget
1. Fixed budget: According to CIMA, London – “A fixed budget is a budget designed to
remain unchanged irrespective of the level of activity actually attained.” Thus, a budget
which is prepared on the basis of standard or fixed level of activity is known as fixed
budget. Fixed budget is based on the assumption that there will be no change in the level
of activity. This budget is more useful for a short period of time when level of activity is
not expected to change. Practically, this budget is of less use and has limited applications
in controlling cost.
2. Flexible Budget: According to CIMA, London- “A flexible budget is a budget designed
to change with the level of activity actually attained.” The other names used for flexible
budget are variable budget and sliding scale budget. In flexible budget, budgeted figures
can be changed according to the level of activity. The budgeted figures are changed
according to these production levels. Furthermore, flexible budget recognizes the
behavior of cost into variables, semi variable and fixed cost. It is more realistic and
practically used for cost control purpose.
 The difference between fixed budget and flexible budget is called sales volume
variance arise due to output used.
3. Zero based budget: it starts right from scratch. The current year’s budgets are prepared
without considering the previous year’s budgets. Zero-based budgets are prepared right
from the beginning without considering last year’s budget. This budgeting method
allocates resources based on the needs and costs of the department.
4. Continuous (rolling) budget: is the process of continually adding one more month to the
end of a multi-period budget as each month goes by. The continuous budgeting concept is
usually applied to a twelve-month budget, so there is always a full-year budget in place.
Continuous budgets force managers to always think about the next 12 months, not just
the remaining months in a fixed budgeting cycle. For example, a budget may initially be
prepared for January to December, year 1. At the end of the first quarter, that is, at the
end of March, year 1, the first quarter’s budget is deleted. A further quarter is then added
to the end of the remaining budget, for January to March, year 2. The remaining portion
of the original budget is updated in the light of current conditions. This means that
managers have a full year’s budget always available and the rolling process forces them
to continually plan ahead.

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 5. Long-term budgets are prepared for a period exceeding one year. They are only forward
looking plans. They act as guidelines for preparing short term budgets. Long-term
budgets are not meant for immediate implementation. A budget prepared for a period less
than a year is called short-term budget. Short term budgets are prepared for actual
implementation and it has a practical value.
6. Master budget: - It summarizes the planning activities of all subunits of an organization-
sales, production, distribution and finance. The master budget is prepared for a specific
period and is static in the sense that it is based on a single level of output demand.

3.4. Master budget

A master budget consists of a set of operating budgets and financial budgets that detail an
organization’s financial plans for a specific accounting period, generally a year. When a master
budget covers an entire year, some of the operating and financial budgets may show planned
results by month or by quarter.
The master budget has two components. These are operating budget and financial budget.
Operating budgets includes budgeted income statement and its supporting schedules. Financial
budget comprises the capital budget. Cash budget, budgeted balance sheet, and budgeted
statement of cash flows.
Master Budget

Operating Budget Financial budget

How to utilize How to raise funds for
The funds rose the activities
_
3.4.1 Developing the Master Budget
Suppose you have started your own business. Whether it is a manufacturing, retail, or service
organization, to manage it effectively, you would prepare a master budget each period. A master
budget provides the information needed to match long-term goals to short-term activities and to
plan the resources needed to ensure an organization’s profitability and liquidity.
 Operating Budget
 The operating budgets of manufacturing organizations include budgets for sales, production,
direct materials, direct labor, overhead, selling and administrative expenses, and cost of
goods manufactured.
 Retail organizations prepare a sales budget, a purchases budget, a selling and administrative
expense budget, and a cost of goods sold budget.

 The operating budgets of service organizations include budgets for service revenue (sales),
labor, services overhead and selling and administrative expenses. The sales budget is
prepared first because it is used to estimate sales volume and revenues. Once managers know
the quantity of products or services to be sold and how many sales dollars to expect, they can
develop other budgets that will enable them to manage their organization’s resources so that
they generate profits on those sales.
1. The Sales Budget
As we indicated earlier, the first step in preparing a master budget is to prepare a sales budget. A
sales budget is a detailed plan, expressed in both units and dollars, which identify the sales
expected during an accounting period. Sales managers use this information to plan sales- and

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 marketing-related activities and to determine their human, physical, and technical resource
needs. Accountants use the information to determine estimated cash receipts for the cash budget.
The following equation is used to determine the total budgeted sales:
Total Estimated Estimated
Budgeted = Selling Price * Sales in
Sales per Unit Units
The estimated sales volume is very important because it will affect the level of operating
activities and the amount of resources needed for operations. To help estimate sales volume,
managers often use a sales forecast, which is a projection of sales demand (the estimated sales in
units) based on an analysis of external and internal factors. The external factors include:
1. The state of the local and national economies
2. The state of the industry’s economy
3. The nature of the competition and its sales volume and selling price
Internal factors taken into consideration in a sales forecast include:
1. The number of units sold in prior periods
2. The organization’s credit policies
3. The organization’s collection policies
4. The organization’s pricing policies
5. Any new products that the organization plans to introduce to the market
6. The capacity of the organization’s manufacturing facilities
Exhibit 1-1 sales budget

Exhibit 1-1 illustrates Frame craft Company’s sales budget for the year. The budget shows the
estimated number of unit sales and dollar revenue amounts for each quarter and for the entire
year. Because a sales forecast indicated a highly competitive marketplace, Frame craft’s
managers have estimated a selling price of $5 per unit. The sales forecast also indicated highly
seasonal sales activity; the estimated sales volume therefore varies from 10,000 to 40,000 per
quarter.
2. The Production Budget
A production budget is a detailed plan showing the number of units that a company must produce
to meet budgeted sales and inventory needs. Production managers use this information to plan for
the materials and human resources that production related activities will require. To prepare a
production budget, managers must know the budgeted number of unit sales (which is specified in
the sales budget) and the desired level of ending finished goods inventory for each period in the
budget year. That level is often stated as a percentage of the next period’s budgeted unit sales.
For example, Framecraft Company’s desired level of ending finished goods inventory is 10 percent
of the next quarter’s budgeted unit sales. (Its desired level of beginning finished goods inventory is
10 percent of the current quarter’s budgeted unit sales.)
The following formula identifies the production needs for each accounting period:
Total Budgeted Desired Units of Desired Units of
Production = Sales in + Ending Finished - Beginning
Units Units Goods Inventory Finished Goods Inventory

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Exhibit 1-2 shows Framecraft Company’s production budget for the year. Notice that each quarter’s
desired total units of ending finished goods inventory become the next quarter’s desired total units of
beginning finished goods inventory. Assume unit sales of 15,000 are budgeted for the first quarter of
next year, the ending finished goods inventory for the fourth quarter of the year is 1,500 units (0.10 X
15,000 units), which is the same as the desired number of units of ending finished goods inventory for
the entire year. Similarly, the number of desired units for the first quarter’s beginning finished goods
inventory is assume 1,000—is the same as the desired number of units of beginning finished goods
inventory for the entire year.
Exhibit 1-2 Production budget

3. The Direct Materials Purchases Budget

A direct materials purchases budget is a detailed plan that identifies the quantity of purchases
required to meet budgeted production and inventory needs and the costs associated with those
purchases. A purchasing department uses this information to plan purchases of direct materials.
Accountants use the same information to estimate cash payments to suppliers.
To prepare a direct materials purchases budget, managers must know what production needs will be
in each accounting period in the budget; this information is provided by the production budget. They
must also know the desired level of the direct materials inventory for each period and the per unit
cost of direct materials. The desired level of ending direct materials inventory is usually stated
as a percentage of the next period’s production needs. For example, Frame craft’s desired level of
ending direct materials inventory is 20 percent of the next quarter’s budgeted production needs. (Its
desired level of beginning direct materials inventory is 20 percent of the current quarter’s budgeted
production needs.)
The following three steps are involved in preparing a direct materials purchases budget:
Step 1. Calculate each period’s total production needs in units of direct materials. Plastic is the only
direct material used in Framecraft Company’s picture frames; each frame requires 10 ounces. Frame
craft’s managers therefore calculate units of production needs in ounces; they multiply the number of
frames budgeted for production in a quarter by the 10 ounces of plastic that each frame requires.
Step 2. Determine the quantity of direct materials to be purchased during each accounting period in
the budget using the following formula:
Total Units of Total Production Desired Units of Desired Units of
Direct Needs in Ending Direct Beginning Direct
Materials to = Units of Direct + Materials - Materials
Be Purchased Materials Inventory Inventory
Step 3. Calculate the cost of the direct materials purchases by multiplying the total number of unit
purchases by the direct materials cost. Frame craft’s Purchasing Department has estimated the cost
of the plastic used in the picture frames at $0.05 per ounce.

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Exhibit 1-3 shows Frame craft’s direct materials purchases budget for the year. Notice that each
quarter’s desired units of ending direct materials inventory become the next quarter’s desired units of
beginning direct materials inventory.
Exhibit 1-3 Direct Materials Purchases Budget

The company’s budgeted number of units for the first quarter of the following year is assume
150,000 ounces; its ending direct materials inventory for the fourth quarter of this year is therefore
30,000 ounces (0.20 X 150,000 ounces), which is the same as the number of desired units of ending
direct materials inventory for the entire year. _Similarly, the number of desired units for the first
quarter’s beginning direct materials inventory is assume 24,000 ounces—is the same as the
beginning amount for the entire year.
4. The Direct Labor Budget
A direct labor budget is a detailed plan that estimates the direct labor hours needed during an
accounting period and the associated costs. Production managers’ use estimated direct labor hours to
plan how many employees will be required during the period and the hours that each will work, and
accountants use estimated direct labor costs to plan for cash payments to the workers.
Managers of human resources use the information in a direct labor budget in deciding whether to
hire new employees or reduce the existing work force and also as a guide in training employees and
preparing schedules of employee fringe benefits.
The following two steps are used to prepare a direct labor budget:
Step 1. Estimate the total direct labor hours by multiplying the estimated direct labor hours per unit
by the anticipated units of production (see Exhibit 1-2).
Step 2. Calculate the total budgeted direct labor cost by multiplying the estimated total direct labor
hours by the estimated direct labor cost per hour. A company’s human resources department
provides an estimate of the hourly labor wage.

Total Budgeted Estimated Total Direct X Estimated Direct

Direct Labor Costs = Labor Hours Labor Cost per Hour

Exhibit 1-4 shows how Framecraft Company uses these formulas to estimate the total direct labor
cost. Frame craft’s Production Department needs an estimated one-tenth (0.10) of a direct labor hour
to complete one unit. Its Human Resources Department estimates a direct labor cost of $6 per hour.

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 5. The Overhead Budget
An overhead budget is a detailed plan of anticipated manufacturing costs, other than direct
materials and direct labor costs, which must be incurred to meet budgeted production needs. It
has two purposes: to integrate the overhead cost budgets developed by the managers of
production and production-related departments and to group information for the calculation of
overhead rates for the next accounting period. The format for presenting information in an
overhead budget is flexible.
Grouping information by activities is useful for organizations that use activity-based costing.
This approach makes it easier for accountants to determine the application rates for each cost
pool.
As Exhibit 1-5 shows, Framecraft Company prefers to group overhead information into variable
and fixed costs to facilitate C-V-P analysis. The single overhead rate is the estimated total
overhead costs divided by the estimated total direct labor hours.
For example, Frame craft’s predetermined overhead rate is $18.70* per direct labor hour, or
$1.87 per unit produced. The variable portion of the overhead rate is $9.70 per direct labor hour,
which includes factory supplies, $1.80; employee benefits, $2.40; inspection, $0.90; maintenance
and repairs, $1.60; and utilities, $3.00. fixed manufacturing overhead for each quarter includes
2810 for machine depreciation ,3225 for building depreciation, 9000 for supervision, 2150 for
maintenance and repair and 3175 for other overheads.
Exhibit 1-5 overhead budget

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 6. The Selling and Administrative Expense Budget
A selling and administrative expense budget is a detailed plan of operating expenses, other than
those related to production, that are needed to support sales and overall operations during an
accounting period. Accountants use this budget to estimate cash payments for products or services
not used in production-related activities.
For example, Framecraft Company’s estimated variable selling and administrative expense rate is
$0.29 per unit sold, which includes delivery expenses, $0.08; sales commissions, $0.10; accounting,
$0.07; and other administrative expenses, $0.04. Fixed selling and administrative expense includes
4,500 for sales salaries, 12,750 for executive salaries, 925 for depreciation of office equipment and
1,700 for taxes and insurance
Exhibit 1-6 Selling and Administrative Expense Budget

7. The Cost of Goods Manufactured Budget

A cost of goods manufactured budget is a detailed plan that summarizes the estimated costs of
production during an accounting period. The sources of information for total manufacturing costs
are the direct materials, direct labor, and overhead budgets. Most manufacturing organizations
anticipate some work in process at the beginning or end of the period covered by a budget.
However, Framecraft Company has a policy of no work in process on December 31 of any year.
Exhibit 1-7 summarizes the company’s estimated costs of production for the year. (The right-
hand column of the exhibit shows the sources of key data.)
The budgeted, or standard, product unit cost for one picture frame is rounded to $2.97 ($268,775
÷ 90,500 units).
Exhibit 1-7 cost of goods manufactured budget

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 8. The Budgeted Income Statement
A budgeted income statement projects an organization’s net income for an accounting period
based on the revenues and expenses estimated for that period. Exhibit 1-8 shows Framecraft
Company’s budgeted income statement for the year. The company’s expenses include 8 percent
interest paid on a $70,000 note payable and income taxes paid at a rate of 30 percent.
Information about projected sales and costs comes from several operating budgets, as indicated
by the right-hand column of Exhibit 7-8, which identifies the sources of key data and makes it
possible to trace how Framecraft Company’s budgeted income statement was developed.
Framecraft Company has no budget for cost of goods sold; that information is included in its
budgeted income statement.
Exhibit 1-8

 Financial Budgets
Financial budgets include a capital expenditures budget, a cash budget, and a budgeted balance
sheet.

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 9. The Capital Expenditures Budget
A capital expenditures budget is a detailed plan outlining the anticipated amount and timing of
capital outlays for long-term assets during an accounting period.
Managers rely on the information in a capital expenditures budget when making decisions about
such matters as buying equipment, building a new plant, purchasing and installing a materials
handling system, or acquiring another business.
Framecraft Company’s capital expenditures budget for the year includes $30,000 for the purchase of
a new frame-making machine. The company plans to pay $15,000 in the first quarter of the year,
when the order is placed, and $15,000 in the second quarter of the year, when it receives the
machine. This information is necessary for preparing the company’s cash budget.
10. The Cash Budget
A cash budget is a projection of the cash that an organization will receive and the cash that it will
pay out during an accounting period. It summarizes the cash flow prospects of all transactions
considered in the master budget. The information that the cash budget provides enables managers to
plan for short-term loans when the cash balance is low and for short-term investments when the cash
balance is high.
A cash budget excludes planned noncash transactions, such as depreciation expense, amortization
expense, issuance and receipt of stock dividends, uncollectible accounts expense, and gains and losses
on sales of assets. Some organizations also exclude deferred taxes and accrued interest from the cash
budget.

The following formula is useful in preparing a cash budget:

Estimated Total Total Estimated
Ending Cash = Estimated - Estimated + Beginning Cash
Balance Cash Receipts Cash Payments Balance

Estimates of cash receipts are based on information from several sources. Among these sources are the
sales budget, the budgeted income statement, cash budgets from previous periods, cash collection
records and analyses of collection trends, and records pertaining to notes, stocks, and bonds.
Information used in estimating cash payments comes from the operating budgets, the budgeted income
statement, the capital expenditures budget, the previous year’s financial statements, and loan records.

In estimating cash receipts and cash payments for the cash budget, many organizations prepare
supporting schedules. For example, Framecraft Company’s controller converts credit sales to cash
inflows and purchases made on credit to cash outflows and then discloses those conversions on
schedules that support the cash budget.
The schedule in Exhibit 1-9 shows the cash that Framecraft Company expects to collect from
customers during the year. Cash sales represent 20 percent of the company’s expected sales; the other
80 percent are credit sales. Experience has shown that Framecraft collects payments for 60 percent of
all credit sales in the quarter of sale, 30 percent in the quarter following sale, and 10 percent in the
second quarter following sale.
As you can see in Exhibit 1-9, Frame craft’s balance of accounts receivable was $48,000 at the
beginning of the budget year. The company expects to collect $38,000 of that amount in the first
quarter and the remaining $10,000 in the second quarter. At the end of the budget year, the estimated
ending balance of accounts receivable is $68,000—that is, $4,000 from the third quarter’s credit sales
[($50,000 X 0.80) X 0.10] plus $64,000 from the fourth quarter’s sales [($200,000 X 0.80) X 0.40].
The expected cash collections for each quarter and for the year appear in the total cash receipts section
of the cash budget.

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 Exhibit 1-9 Schedule of Expected Cash Collection from Customers

Exhibit 1-10 shows Frame craft’s schedule of expected cash payments for direct materials during the
year. This information is summarized in the first line of the cash payments section of the company’s
cash budget. Framecraft pays 50 percent of the invoices it receives in the quarter of purchase and the
other 50 percent in the following quarter. The beginning balance of accounts payable for the first
quarter is given at $4,200. At the end of the budget year, the estimated ending balance of accounts
payable is $8,250 (50 percent of the $16,500 of direct materials purchases in the fourth quarter).
Exhibit 1-10 Schedule of Expected Cash Payments for Direct Materials

Frame craft’s cash budget for the year appears in Exhibit 1-11. It shows the estimated cash receipts
and cash payments for the period, as well as the cash increase or decrease. The cash increase or
decrease plus the period’s beginning cash balance equals the ending cash balance anticipated for the
period. As you can see in Exhibit 1-11, the beginning cash balance for the first quarter is $20,000.
This amount is also the beginning cash balance for the year.
Note that each quarter’s budgeted ending cash balance becomes the next quarter’s beginning cash
balance. Also, note that equal income tax payments are made quarterly. You can trace the
development of this budget by referring to the data sources listed in the exhibit.
Many organizations maintain a minimum cash balance to provide a margin of safety against
uncertainty. If the ending cash balance on the cash budget falls below the minimum level required,
short-term borrowing may be necessary to cover planned cash payments during the year. If the

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ending cash balance is significantly larger than the organization needs, it may invest the excess cash
in short term securities to generate additional income.
For example, if Framecraft Company wants a minimum of $10,000 cash available at the end of each
quarter, its balance of $7,222 at the end of the first quarter indicates that there is a problem. Frame
craft’s management has several options for handling this problem. It can borrow cash to cover the
first quarter’s cash needs, delay purchasing the new extrusion machine until the second quarter, or
reduce some of the operating expenses. On the other hand, the balance at the end of the fourth
quarter may be higher than the company wants, in which case management might invest a portion of
the idle cash in short-term securities.
Exhibit 1-11 Cash Budget

11. The Budgeted Balance Sheet

A budgeted balance sheet projects an organization’s financial position at the end of an accounting
period. It uses all estimated data compiled in the course of preparing a master budget and is the final
step in that process. Exhibit 1-12 presents Framecraft Company’s budgeted balance sheet at the end
of the budget year. Again, the data sources are listed in the exhibit. The beginning balances for Land,
plant and equipment, accumulated depreciation, Notes Payable, Common Stock, and Retained
Earnings were $50,000,200,000,17,160 $70,000, $150,000, and $50,810, respectively.

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Exhibit 1-12 Budgeted Balance Sheet

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