Lesson 5

STRATEGIC COST MANAGEMENT
LESSON 5 - STRATEGY AND THE MASTER BUDGET

ROLE OF A BUDGET
A budget is a financial plan of the resources needed to carry out tasks and meet
financial goals. It is also a quantitative expression of the goals the organization wishes
to achieve and the cost of attaining these goals.
The act of preparing a budget is called budgeting. The use of budgets to control
a firm’s activities is known as budgetary control.
Budgets and the budgeting process are intertwined with all aspects of
management. In addition to being a plan of operations, a budget plays an important
role in allocating resources, coordinating operations, identifying constraints and
limitations, and communicating expected actions and results, authorizing activities,
motivating and guiding implementation, providing guidelines for control of operations,
managing cash flows, and serving as criteria in performance evaluation.
In the process of preparing a firm’s budget, managers need to be forward-looking
in evaluating upcoming events and situations as they relate to the firm’s strategic goals.
Budget preparation allows management the opportunity and time to work out any
potential problems that the company might meet in the coming periods. The firm is able
to minimize if not totally avoid the adverse effects that anticipated problem could have
on operation. Budgeting can also help managers identify current and potential
bottleneck in operation. Critical resources can then be mustered to ease any bottleneck
in operations and prevent them from becoming obstacles to attaining budgeting goals.
Completion of a budget for all units of an organization also mandates
coordinating operations among all budgeted units and synchronizing the operating
activities of various department. Budgets help firms to run smoother operations and
achieve better results.
Budgets make the decision-making process more effective by helping managers
meet uncertainties. The objective of budgeting is to substitute deliberate, well-
conceived business judgment for accidental success in enterprise management.
Budgets should not be expressions of wishful thinking but rather description of
attainable objectives.
IMPORTANCE OF STRATEGY IN BUDGETING

A firm’s strategy is the path it chooses for attaining its long-term goals and
mission. It is the starting point in preparing its plans and budgets.
Formulation of Strategy
The process of determining a company’s strategy starts with the assessment of
external factors that affect operation and evaluating internal factors than can be its
strength and weakness.
External factors typically include

 Competition
 Technical, economic, political, regulatory, social and environmental factors
Internal factors include operating characteristics such as

 Financial strength
 Managerial talent and expertise
 Functional structure, and
 Organizational structure
Strategic Goals and Long-Term Objectives

An organization presents its strategic goals and long-term objectives through
capital budget and master budget.
Strategy provides the framework or parameters within which a long-range plan is

developed. A firm’s long-range plan identifies required actions over a 5-year to 10-year
period to attain the goals set forth in their strategies.
Long Range Planning
Long range planning often entails capital budgeting, which is a process of

evaluating proposed major projects such as purchases of new equipment, construction
of a new factory, and addition of new products and planning for resource requirements.
Capital budgets are prepared to bring an organization’s capabilities into line with the
needs of its long-range plan and long-term forecast. An organization’s capacity is a
result of capital investments made in prior budgeting periods.
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.
A firm 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.
Figure 5.1 presents the relationship between strategic goals, long-term objectives and
plan, short-term goals, budget, operations and control.
THE MANAGEMENT PROCESS OF PREPARING THE MASTER BUDGET
Top Management Involvement
For a budget to be effective, management needs to be involved and show strong

interest in budget results. A good balance of top management involvement with lower-
level managers will make an effective master budget.
Top management ensures that budget guidelines are being followed through the
budget review and approval process. Active involvement by top management in
reviewing and approving the proposed budget is an effective way to discourage lower-
level managers from playing budget games. Budgeting processes usually include
formation of a budget committee; determination of the budget guidelines; preparation of
the initial budget proposal; budget negotiation, review and approval; and budget
revision.
Organization for Budget Preparation
It is essential that the manager of an entity assigns the most qualified personnel
to the preparation of the budget. A budget committee with representation from the
different functional areas (marketing, production, finance and administration) is
generally considered an effective body to oversee preparation and administration of the
budget. The controller may be selected to serve as head of the committee for two major
reasons:
1) Controller’s position is independent from the operating parts of the organization

2) He has the skills and experience in coping with the intricacies of setting up a budget
The controller acts as a coordinator in the budgeting operation. He recommends

how budgets should be prepared, assembles the budgets, prepares periodic reports
showing variances of the actual results from the budgeted results, interprets variances
and offers suggestions fro improvement whenever possible.
The budget committee decides how budgets shall be prepared, passes on the
final budget, and settles disputes in one segment of the business and another when
difference of opinion arise. The committee also receives budget reports and makes
policy decisions with respect to budget revisions and other problems of budget
administration.
Budget Guidelines
The starting point in developing budget guidelines is the firm’s strategy. In

developing the initial budget guidelines, the budget committee also needs to consider
development that have occurred since the adoption of the strategic plan; the general
outlook of the economy and the market; the goal of the organization for the budgeting
period; specific corporate policies such as mandates for downsizing, re-engineering,
and the operating results of the year to date.
The Budget Period
As a general rule, the period covered by a budget should be long enough to

show the effect of managerial policies but short enough so the estimates can be made
with reasonable accuracy.
Master Budget is an overall financial and operating plan for a coming fiscal
period and the coordinated program for achieving the plan. It is usually prepared on a
quarterly or an annual basis.
Long-range budgets called capital budget, which incorporates plans for major
expenditures for plant and equipment or the addition of product lines, might be prepared
to cover plans or as long as 5 to 10 years.
Responsibility budgets which are segments of the master budget relating to the
aspect of the business that is the responsibility of a particular manager are often
prepared monthly.
Cash budgets may be prepared on a day-to-day or monthly basis.
The Initial Budget Proposal
Based on the initial budget guidelines, each responsibility center prepares its
initial budget proposal. In preparing an initial budget proposal, the following factors
should be considered by a budget unit.
Internal Factors:
 Introduction of new products
 Adoption of new manufacturing process
 Changes in availability of equipment or facilities
 Changes in product design or product mix
 Changes in expectations or operating processes of other budget units that the
budget unit relies on for its input materials or other operating factors.
External factors:
 Competitor’s actions
 Changes in the labor market
 Availability of raw materials or components and their prices
 Industry’s outlook for the near term
Budget Negotiation, Review and Approval, Revision
The head of the budget units examines the initial budget proposal to determine
whether the proposal is within the budget guidelines. The head also checks to see if the
budget goals can be reasonably attained and in line with the goals to the budget units at
the next level up, and the budgeted operations are consistent with the budgeted
activities of another budget unit. Negotiation occur at all levels of the organization. As
budget units approve their budgets, the budgets go through the successive levels of the
organization until they reach the final level, when the combined unit budgets become
the budget of the organization.
The Master Budget
A master budget is a comprehensive budget for a specific period, it consists of

many interrelated operating and financial budgets. Some firms refer to the process of
preparing a master budget as profit planning or targeting.
Steps in Developing a Master Budget
The major steps in developing a Master Budget may be outlined as follows:
1. Establish basic goals and long-range plans for the company. These will serve
as guidelines in the preparation of budget estimates.
2. Prepare a sales forecast for the budget period
3. Estimate the cost of sales and operating expenses
4. Determine the effect of budgeted operating results on assets, liabilities and
ownership equity accounts. The cash budget is the largest part of this step,
since changes in many asset and liability accounts will depend upon the cash
flow forecast
5. Summarize the estimated data in the form of a projected income statement for
the budget period, the projected statement of financial position as of the end of
the budget period and the projected cash flow statement.
Preparation of Comprehensive Master Budget Illustrated

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STRATEGIC COST MANAGEMENT

LESSON 5 - STRATEGY AND THE MASTER BUDGET

IMPORTANCE OF STRATEGY IN BUDGETING

External factors typically include

Internal factors include operating characteristics such as

Strategic Goals and Long-Term Objectives

Strategy provides the framework or parameters within which a long-range plan is

Long Range Planning

Long range planning often entails capital budgeting, which is a process of

Short-Term Objectives and The Master Budget

Top Management Involvement

For a budget to be effective, management needs to be involved and show strong

1) Controller’s position is independent from the operating parts of the organization

The controller acts as a coordinator in the budgeting operation. He recommends

The starting point in developing budget guidelines is the firm’s strategy. In

The Budget Period

As a general rule, the period covered by a budget should be long enough to

Cash budgets may be prepared on a day-to-day or monthly basis.

The Initial Budget Proposal

Budget Negotiation, Review and Approval, Revision

A master budget is a comprehensive budget for a specific period, it consists of

Steps in Developing a Master Budget

The major steps in developing a Master Budget may be outlined as follows:

Preparation of Comprehensive Master Budget Illustrated

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