The Master Budget – A Few Thoughts
•
When you complete your study of material in this section, you should be able to:
. Explain and illustrate the following terms:
-. activity-based budget
base budgeting
-. budget
-. budget slack (padding the budget)
-. controllable cost
-. controllability
-. Goal congruence
-. master budget
-. pro forma statements
-. rolling budget or continuous budget
-. Sales forecast
-. Zero-base budgeting
- Be able to discuss budgetary slack, when it is most likely to occur and why employees would pad the
budget.
- Provide a basic definition of budgeting.
- Know the difference between an operating budget and a financial budget. Also, know
examples of each.
- Take a factual situation and calculate a sales budget, production budget, purchases budget and
a cash budget (both receipts and disbursements).
- Discuss the advantages of the budgetary process.
•. Remember Alice in Wonderland!!
• A master budget is an overall budget that combines a series of financial and operating budgets. The
end result of the budget process is the master budget. The master budget is a summary of all phases
of a company's plans and goals for the future.
The master budget is static, not flexible. It is based on a single level of output demand (which is
the most probable level of output demand). NOTE: This level of output drives all of the other
budgeting decisions.
The master budget can be divided into two major parts--operating budgets and financial budgets.
1. Financial budgets include a company's capital budgets as well as the company's pro
forma income statement, balance sheet and its statement of cash flows. Note that
Capital budgets cover the acquisition of land, buildings, and other items of capital
equipment and, unlike the other financial budgets, may have time horizons that extend
many years into the future.
2. Operating budgets include the cash budget and budgets for sales, production, material
purchases and related areas.
1
* These budgets usually have a time horizon of one year.
* Operating budgets may be prepared on a continuous (rolling) or perpetual
basis.
* Monetary details from the operating budgets are used to prepare the pro forma
financial statements, which give managers a preview of how things will turn
out if actual activities conform to budgeted activities.
•. Major Features of Budgets
•. Budgets can help identify problems in achieving goals and objectives. For example:
- Sales volume is 50% less than production targets.
- Plant is unable to make the product we expect to sell.
- There is not adequate cash to meet the purchase budget.
•.
. Quantitative Plan of Action
-. Aids in the coordination and implementation of management's plan
-. Budget Cycle
-. The budget is, in essence, an agreement on what is expected.
-. The budget provides a frame of reference for comparing actual results with expected
results.
-. Budgets allow us to investigate variations from the plan and make necessary
adjustments.
•. Advantages of Budgeting
. Strategy & Planning - Forces you to look at the future - Causes managers to THINK! A
budget is the quantification of management’s plan of action.
. Standard to Judge Performance (this allows you to control performance, the word control has
a negative connotation)
-. Historical data are available but may incorporate inefficiencies; in addition, the future
may differ from the past.
. Coordination & Communication -- various department heads have to get together to plan --
budget helps managers see the relationships within the company.
• Budgets provide an allocation mechanism—no organization has unlimited resources.
•. NOTE: A Master budget is not itself a strategic plan, rather it helps managers implement a chosen strategy.
Budgets are planning tools BUT there is more to planning than budgeting!
•.CAUTION: Managers often spend much time working on budgets. Given the uncertainties, it is difficult to
budget. If the budget is rigidly implemented, employees may take actions that will help meet the budget but
will hurt the company in the long-run (e.g., deferring maintenance).
2
•. Types of Budgets
. Vary by Time Span (short-term vs long-term)
. Long-range vs short-range planning
. Long-range plans usually have a time horizon of three to five years.
. LR plans involve looking at expected market trends and economic factors, inflation, population growth,
personal consumption, consumer debt, and indexes of production.
. Also, LR planning considers the desired rate of return on the assets employed and whether or not planned
increases in income will keep pace with the increases or decreases in corporate assets.
. Short-range plans (budgets) may cover from 3 up to 12 months (they're usually 12 months but then
broken down into quarterly and monthly totals). Some companies may use an 18-month budgetary
period, adding 3 months of the previous budget period to a new 12-month budget period plus the first
three months of the following third accounting period's (or fiscal) budget.
. Purpose
-. Performance Reports
-. Specific Needs .
-. Activity-based budgeting -- focuses on the costs of activities necessary to produce and sell
products and services.
•. Budget Limitations:
. Sales Forecasting (Sales budget is critical) - Accuracy: "Garbage-in, Garbage-out"! When future events
vary substantially from the budget, budget revisions (or complete revamping) may be necessary.
. The goals and objectives of management (or a manager) may not be in the best interest of an
organization.
. Top management must give more than lip service, otherwise, the budget is an exercise in frustration for
lower levels of management.
. Managers may overuse the budget as an evaluation tool! This may lead to Budgetary Slack, which is
most likely to occur in a participatory setting and involves underestimating revenues or
overestimating costs: Why?
. Time--it simply takes time for a firm and its employees to learn the in and out of the budgetary process.
Budgetary Development and Implementation
. Employees don't just know how to budget! Top management should provide guidance so that all
management levels understand the assumptions underlying the budget and have knowledge of the
firm's agenda.
. Participation in the budgetary process (all levels of management) should be encouraged (this depends
upon top management's philosophy--theory x versus theory y)
. The process should aim to eliminate anxiety and defensiveness, thus reducing the need to incorporate
budgetary slack.
. Budgets should be challenging but realistic. We should always investigate why our costs were greater or
3
our revenues were less than budget. ALWAYS make a distinction between what managers could
control and what they could not control.
. Use the computer to do a lot of "What Ifs"!
Budgetary Principles and Human Behavior
. The rewards (or incentives) must be established so that the goals of management and the organization are
not dysfunctional! In other words, can we design incentives so that an employee can have a cake and
at least eat a bite of it.
. Emphasis should be placed on positive reinforcement rather than negative! Focus on rewarding success!
. Rapid feedback (immediate would be ideal) with respect to performance so that corrective actions can be
taken.
•. How do budgets affect human behavior?
• How do we get a sales estimate (forecast)?
- Let's get input from our friends in the marketing department
- Sources of estimates (forecasts)
+ sales force
+ past sales
+ market researchers
+ Delphi technique
+ Econometric models
+ other
. general economic conditions
. industry conditions
. level of competition
. market share
. advertising and promotion
• political and legal events
• pricing policy
NOTE: A sales estimate (forecast) and a sales budget are not usually one and the same
. The sales budget is expressed in terms of dollars and units BECAUSE most managers are more
accustomed to discussing their activities in terms of units and their responsibilities are more easily
denoted in units.
4
Sales budget example (for five months and the first quarter ending March 31) for the GOO-GOO Gasket Company
Let's assume that we manufacture and sell gaskets. Each gasket sells for $.50 and the price is the same for all
sales territories and all customers (example contrary to this is the McDonald's at the south rim of the Grand
Canyon).
January 440,000
February 410,000
March 387,000
April 360,000
May 390,000
Production Budget (flows from the sales budget and uses information regarding the type, quantity and timing of units
to be sold). This budget demands information related to a firm's ending inventory policy as specified by
management.
Assume GOO-GOO's policy is that the finished goods inventory needs to be 7 percent of the next month's sales.
(Also, assume that no work-in process inventory exists).
5
The direct materials budget flows from the production budget. Assume that GOO-GOO makes gaskets and that each
gasket requires 4 ounces of zippy do. Assume GOO-GOO's policy is that the direct materials ending inventory
needs to be 5 percent of the next month's direct materials production requirements sales. (Also, assume that no
work-in process inventory exists).
What are the direct material purchases required for each month of the first quarter and the total production needs for
the quarter?
6
The purchases budget can now be determined. Assume that each ounce of zippy do costs $.24. (NOTE: the direct
materials budget and the purchases budget may be combined into a single budget usually referred to as a direct
material budget ). What is our purchases budget for each month and for the first quarter?
7
Next, is the direct labor budget. Assume that GOO-GOO's standard amount of direct labor for each gasket is .3 of an
hour and that the wage rate is $15 an hour, which includes fringe benefits equal to 30% of the base wage rate.
.
8
The Sales budget for Cards, Inc., is forecasted as follows:
Month Sales Revenue
May $60,000
June 80,000
July 90,000
August 60,000
To prepare a cash receipts budget, the company must determine the budgeted cash collections from
sales. Historically, the following trend has been established regarding cash collection of sales:
60 percent in month of sale,
20 percent in month following sale,
15 percent in second month following sale,
5 percent uncollectible.
The company gives a 2 percent cash discount for payments made by customers during the month of
sale. Prepare a schedule of budgeted cash collections from sales for May, June and July.
9