Master Budgeting

Learning Objectives Define budget, and understand why organizations budget and the approach they use to create budgets Prepare a sales budget, including a schedule of expected cash receipts Prepare a production budget Prepare a direct material purchases budget, including a schedule of expected cash payments Prepare a cash budget Prepare a budgeted income statement and a budgeted balance sheet

Budget and Related Terms Defined A budget is a formal plan that shows how financial and other resources are to be obtained and used during an upcoming period of time (normally a year). The collection of various budgets brought together to form an overall (comprehensive) plan is called the master budget. The act of preparing a budget is called budgeting. The use of budgets to control an organization’s activities is known as budgetary control.

Uses of Budget A budget serves several purposes: It forces managers to think about and plan for the future It is a means of coordinating the activities of an organization, and of aligning goals of various units with those of the organization It is a means of communicating an organization's plans and strategies to the various responsibility center managers It is a benchmark for evaluating the performance of responsibility centers and their managers It is a source of motivating managers to achieve their responsibility centers' goals, and thus the goals of the whole organization

Participatory Budget System Flow of Budget Data

The Budget Committee A standing committee responsible for overall policy matters relating to the budget coordinating the preparation of the budget

The Master Budget A master (overall) budget includes three principal parts: Operating budgets (showing planned operations for the coming period, e.g., year) A capital expenditures budget (showing planned changes in property, plant and equipment) A cash budget (showing the anticipated cash receipts and payments in that year) and other financial budgets (income statement, balance sheet, etc.)

The Master Budget Sales forecast Plant capacity Sales Budget Selling and Administrative Budget

The Master Budget Long-range sales forecast Sales Budget Capital Exp. Ending Inventory Budget Selling and Administrative Budget Production Budget Direct Material Pur- chases Budget Direct Labor Budget Manufacturing Overhead Budget

Budgeted Financial Statements The Master Budget Sales Budget Capital Exp. Budget Ending Inventory Budget Selling and Administrative Budget Production Budget Direct Material Pur- chases Budget Direct Labor Budget Manufacturing Overhead Budget Cash Budget Budgeted Financial Statements

Preparing the Master Budget As indicated in the previous slides: Sales budget is prepared first because the other operating budgets and also financial budgets depend on the information provided by it The remaining operating budgets and also the capital expenditures budget are prepared next A cash budget is then prepared The other financial budgets are prepared last

Sales Budget A sales budget shows an estimate of the quantity and dollar amount of sales, either in total or by segment, e.g., territory. Normally includes a schedule of expected cash receipts Planning sales is most difficult, because sales depend on general market conditions and the actions of the customers. Basically, there are two ways to estimate (forecast) sales: Make a forecast on the basis of a statistical analysis of market conditions, general business conditions, and organization specific information (e.g., plant capacity and planned selling expenses). Make a judgmental forecast by collecting the opinions of managers or marketing people.

Budgeting Example Royal Company is preparing budgets for next year. Budgeted sales by quarters are: Q1 100 units Q2 200 units Q3 150 units Q4 250 units The selling price is $2 per unit. At the end of current year, net accounts receivable is $20. Usually 80% of each quarter’s sale is collected in the same quarter and another 15% in the following quarter. Let’s prepare the sales budget and the related schedule of expected cash receipts.

Sales Budget Q1 Q2 Q3 Q4 Year Sales (in units) 100 200 150 250 700 Sales (in dollars) 200 400 300 500 1,400 Schedule of expected cash receipts: Collection on sale of: Q4 this year 20 20 Q1 next year 160 30 190 Q2 next year 320 60 380 Q3 next year 240 45 285 Q4 next year 400 400 Total $180 $350 $300 $445 $1,275 80% × $200 = 160 15% × $200 = 30

Production Budget A production budget shows the number of units to be produced. Production must be adequate to meet budgeted sales and provide sufficient ending inventory. Royal desires ending inventory to be 25% of next quarter’s budgeted sales in units. At the end of current year, 25 units are on hand. Let’s prepare the production budget.

Production Budget Assumed Q1 Q2 Q3 Q4 Year Budgeted sales Q2 200 Desired percent 25% Desired inventory 50 Current year ending inventory Assumed Q1 Q2 Q3 Q4 Year Budgeted sales 100.0 200.0 150.0 250.0 700.0 + Desired EI 50.0 37.5 62.5 40.0 40.0 Total needs 150.0 237.5 212.5 290.0 740.0 - BI 25.0 50.0 37.5 62.5 25.0 Bud. Production 125.0 187.5 175.0 227.5 715.0

Manufacturing Budget The manufacturing budget shows the expected manufacturing costs. It is based on production budget and price information on materials, labor and overhead. In many manufacturing companies, the manufacturing budget is actually prepared in three sub-budgets: materials, labor and overhead.

Direct Material Purchases Budget DM purchases budget shows the quantity and the cost of materials to be purchased. Purchases must be adequate to meet production needs and provide sufficient ending inventory of materials. At Royal, management desires materials on hand at the end of each quarter equal to 20% of the next quarter’s production needs. Two pounds of materials are required for each unit; materials costs $.10 per pound. At the end of current year, 50 pounds of materials are on hand. Let’s prepare the direct material purchases budget.

Direct Material Purchases Budget From production budget 20% of next quarter’s prod. Current year ending inventory Assumed Q1 Q2 Q3 Q4 Year Production 125.0 187.5 175.0 227.5 715.0 Production needs 250.0 375.0 350.0 455.0 1,430.0 + Desired EI 75.0 70.0 91.0 80.0 80.0 Total needs 325.0 445.0 441.0 535.0 1,510.0 - BI 50.0 75.0 70.0 91.0 50.0 Bud. Purchases (lb) 275.0 370.0 371.0 444.0 1,460.0 Bud. purchases ($) 27.5 37.0 37.1 44.4 146.0

Selling and Administrative Expense Budgets The estimates of most selling expenses (e.g., salaries and commissions) are based on the sales budget. Some selling expenses (e.g., depreciation, rent, and utilities) are not a function of sales. Most of the administrative expenses do not depend on sales; some (e.g., bad debt expense) do.

Capital Expenditures Budget The capital expenditures budget is simply a list of new property, plant, and equipment that will be purchased and those that will be disposed of. The decision to purchase capital assets is based primarily on long-range sales forecast, but also on planned production and other activities for the next year.

Cash Budget Cash budget shows the anticipated cash receipts and payments over the budget period. Cash budget is an important budget since it is used to manage cash. The cash budget is prepared by analyzing operating, capital expenditures and other plans, and estimating the cash receipts and payments associated with those plans.

Cash Budget Cash, beginning Schedule of expected cash collections cash disbursements Capital expenditures budget Manufacturing budgets Selling & Admin Cash, beginning + Expected cash receipts (Customers, Sale of assets, Issuance of bonds/stocks) Total cash available - Expected cash payments (Suppliers, Labor, Overhead, Selling and Admin, Purchase of assets, Retirement of bonds/stocks, Dividend) Excess (deficiency of) cash Financing: + Borrowing - Repayment - Interest Cash, ending

Budgeted Income Statement and Balance Sheet Budgeted income statement and balance sheet are prepared from the information provided by all other budgets. Usually a worksheet is used since a large number of transactions and account balances must be accumulated, summarized, and classified to prepare an income statement and a balance sheet. For simple cases, an inspection of other budgets would suffice.

International Aspects of Budgeting Multinational companies face special problems when preparing a budget: Fluctuations in foreign currency exchange rates High inflation rates in some foreign countries Differences in local economic conditions Local governmental policies