Chapter 2
Chapter 2
Chapter 2
Thus, a budget is a tool that helps managers in both their planning and control function. A budget is a formal
written summery (statement) of management plan for a specific future time period expressed in financial terms.
It normally represents primary means of communicating agreed up on objectives throughout the business
organization. Once adopted, a budget becomes an important basis for evaluating performance. Thus it promote
efficiency and serves as a deterrent to waste and inefficiency
Budget in brief is a future plan of action expressed in quantitative terms which is also an aid to
management control and performance evaluation
Budget can cover both financial and non financial aspects of the plan that can serve as blue print for the
organization to follow in an upcoming period. A budget covers financial aspects and quantities of management
expectation regarding income, cash flows, and financial position. Like financial statements present the
historical financial condition and operating results of the business, budgeted balance sheet, cash flow and
income statement are also prepare to show the future financial condition and operational performance.
Budgeted financial statements are usually supported by detail schedule of the various operation of the firm, so
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budget also include nonfinancial aspects of the plan such as units of output to be produced and sold, number of
employee and working hours, etc.
The type of budget used by different organization differs based upon the nature of their business and the
purpose of the budget; however, the general frame work is the same. In this section we will try to see the
different type of budget their advantage and disadvantage and in what circumstance organizations prefers to
adopt a specific type of budget and budgeting techniques.
(1) Strategic Plan: The most forward looking budget is the strategic plan, which sets the overall goals and
objective of the organization. Some organization won’t classify the strategic plan as an actual budget
though because it does not deal with a specific time frame and it does not produce forecasted financial
statement. In any case, the strategic plan leads to long range planning which produce forecasted
financial statement for five or ten years. The financial statements are estimates of what management
would like to see in the company’s future financial statement. Decisions made in long range planning
include addition or deletion of department, acquisition of a new equipment or building and other long
term commitment.
(2) Capital Budget: Capital budget is a budget that details the planned expenditure for facilities,
equipment, new product, and other long-term investments.
(3) Master budget: A master budget is a short-term, comprehensive plan to achieve the financial and
operational goals of an organization. Master budget comprises of the organizations overall plan for the
given period and the budget for the various functional areas the make up the organization.
Activity2.2.4(A) : Can you explain the difference between long range and short term
planning________________________________________________________________
Long rang plane and budget gives an organization a direction and goals for the future while short
term plane and budget guide the day to day operation. Both long term and short term budgets are
relevant for archiving the overall goal of an organization, so managers are advised to give a
reasonable attention to both short and long term budgets.
Managers who pay attention to only short term budget will quickly lose sight of long term goals similarly
managers who pay attention to only the long term budget could wind up mismanaging day to day operation.
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There has to be a happy medium that allows managers to pay attention to their short term budget while still
keeping an eye on long term plan.
Master budget can be prepared as a standalone for one year or one operating cycle or in a continuous basis.
Continuous budget or rolling budget or revolving budget are a very common form of a master budget that
simply add a month in the future as the month just ended is dropped. Budgeting thus becomes an ongoing
instead of periodic process. Continuous budgets for managers to allow think about the next twelve months not
just the remaining month in fixed budgeting cycle. As they added a new twelfth month to continuous budget,
managers may update the other month as well. They can compare actual monthly result with both the
organization plan and the most recent revised plan. Continuous budgeting approach in preparing master budget
is adapted mostly when the business environment is volatile to coup up with the change.
Different organizations prepare budget using different techniques that may be grouped as follows:
(1) Incremental budgeting: is a budget set based on past year’s actual performance. In this technique a
budget for the coming year is simply this year budgeted or actual results plus or minus some amount for
expected change on planned operation or change in the market price. This budgeting technique is easy
and widely used, however it has its own draw back. As the base is the current year performance or
budget any anomaly in the current year performance or budget may be incorporated in the budget.
(2) Zero based budgeting: In a dynamic business it often makes sense to 'start afresh' when developing a
budget, rather than basing ideas too much on past performance. In this technique each budget is
therefore constructed without much reference to previous budgets. Preparing a budget afresh is usually
required in most business organizations, where the business environment is volatile that require
continues effort of incorporating changes in budget thinking.
(3) Rolling budgets: Given the speed of change and general uncertainty in the external environment,
shareholders seek quick results. US companies typically report to shareholders every three months,
compared with six months in the UK. Rolling budgets involve evaluating the previous twelve months'
performance on an ongoing basis, and forecasting the next three months' performance.
(4) Activity based budgeting: This examines individual activities and assesses the strength of their
contribution to company success. They can then be ranked and prioritized, and be assigned appropriate
budgets.
Although each organization is unique in the way it puts together its budget, all budgeting process share some
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common elements. After organizational goals, strategies, and long range plans have been developed, work
begins on the master budget, a detailed budget for the coming fiscal year with some detail.
The master budget is a comprehensive financial plan for a business. It is made up of the Operating and Financial
budgets, which are in turn made up of supporting schedules (budgets).
To envision the master budget process, picture the financial statements most commonly prepared by companies:
The income statement, the balance sheet, the cash flow statement. Then imagine the preparation of these
statements before the fiscal period operational period.
3.4.1 Parts of A Master Budget
What are the parts of a master budget?
As shown on figure on the next page master budget consists of two major parts, namely: the operating budget
and financial budget.
i Operating budget refers to the budgeted income statement and the supporting budget schedules for
various business functions in the value chain. The operating budget basically shows the expected
operating result of the organization in the upcoming operational period.
ii The financial budget is part of the master budget made up of the capital expenditures budget, the
cash budget, the budgeted balance sheet, and the budgeted statement of cash flow.
An Overview of a Master Budget
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Sales Budget
To clearly understand the steps in development of an operating budget, conceder the budget information
gathered by the controller of Gibe Furniture Manufacturing company during the process of budgeting for the
upcoming fiscal year, 2011.
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The summary of required budget information obtained from different operating units, such as sales related
information from the marketing department, production related information from production department, direct
and indirect labor related information from the human resource department, and other manufacturing and non
manufacturing overhead budgets from other departments as well as assumptions taken for the development of
an operating budget are given as follows:
(1) The only source of revenues is sales of tables and unit sold is the only revenue driver.
(2) Work in Process inventory is negligible and is ignored.
(3) Unit costs of direct materials purchased and finished goods sold remain unchanged throughout each
budget year.
(4) There are two types of Direct materials : Lumber and Metal
(5) There are two types of direct labor: Laminating labor and Machine labor.
Direct labor rates remain unchanged throughout each budget year.
(6) For computing inventor able costs, Gibe Furniture allocates all manufacturing overhead costs using
manufacturing labor hours as the allocation base.
(7) Numerical information
(a) Each table has the following product specifications:
Direct materials:
Lumber----------------- 9 board feet/table
Metal------------------- 10 board feet/table
Direct labor:
Laminating labor------0.25Hrs/table
Machine labor---------3.75 Hrs/table
(b) Inventory information in physical units for 2011.
Beginning Inventory Target Ending Inventory
Direct materials:
Lumber------------- 20,000 board feet 18,000 board feet
Metal--------------- 25,000 board feet 22,000 board feet
Finished goods:
Tables------------- 5,000 tables 3,000 tables
(c) Revenue expected from sales of tables for 2011 are:
Selling price-----------Br. 392/table
Units’ sales------------- 52,000 tables
(d) Costs expected for 2011.
2010 2011
Lumber/ board feet ------- Br. 3.90 Br. 4.00
Metal/ board feet---------- 5.80 6.00
Laminating labor/ Hr. ---- 24.00 25.00
Machine labor/ Hr. ------- 29.00 30.00
(e) Other budgeted costs and amounts for 2011 are:
Variable non-manufacturing costs------------- 13.5% of sales
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Fixed non-manufacturing costs---------------- Br. 1,400,000
Variable MOH costs---------------------------- Br. 9.50/DL Hr.
Fixed MOH costs------------------------------- Br. 1,600,000
(f) The invenotoriable cost is Br.275/table in 2010.
Now you can see each step in the preparation of the operating budget using the budget information given above.
Step 1: Preparing Revenue budget
The starting point for operating budget development for most business organizations is a revenue budget. A
revenue/Sales budget outlines the expected sales for each product in units and Birr. This budget will be
developed after the firm made a forecast of the demand for the company’s product by taking into account. In
forecasting sales different companies may adopt different forecasting techniques, however in most cases sales
forecast take into account the following points:
The sales volume in recent periods Pricing polices
General industry and economic condition Advertising & sales promotion
Market research studies Competition & regulatory policies
Based upon the forecasted sales the budgeted sale is prepared by a mere multiplication of forecasted sales
volume and selling price.
Budgeted Sales = Budgeted sales volume X Budgeted Selling price
The Revenue budget for Gibe Furniture, based upon budget information 7(C) is,
Schedule (1) Sales Budget
Budgeted Unit 52,000tables
X Budgeted Unit Selling Price Br 392/table
Budgeted Sales Br. 20,384,000
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Budgeted unit sales 52,000
Step 3: Preparing the Direct Material Usage and Direct Material Purchase Budget
The number of units to be produced calculated in production budget Schedule is the key to computing direct
materials in quantity and Birr. The direct materials budget ties the production to the Direct Materials that will
need to be purchased in order to produce the estimated units. Direct materials purchases needed for the budget
period are determined using this equation:
Required material to be + Estimated Estimated
Material = Used in Production ending materials - beginning
Purchase inventory materials inventory
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Add: Target End. Inv. 18,000b.f 22,000b.f
Total requirements 468,000b.f 522,000b.f
Deduct: Beg. Inv. 20,000b.f 25,000b.f
Units to be purchases 448,000b.f 497,000b.f
Cost Budget:
Lumber: Br.4.00 x 448,000 Br. 1,792,000
Metal: Br. 6.00 x 497,000 Br. 2,982,000
Purchases Br. 1,792,000 Br. 2,982,000 Br. 4,774,000
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Gibe Furniture inventories MOH at the budgeted rate of Br. 17.50/DL Hr.
[i.e. Br.3, 500,000/200,000Hrs] The budgeted MOH cost per table is Br. 70
[Br. 3,500,000/50,000tables]
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2.3.2.1.1. Financial Budgets
The remaining budgets that appear in the Master Budget make up the Financial Budget. The Financial Budget
typically consists of the capital expenditure budget, the Cash Budget, the Budgeted Balance Sheet and the
budgeted statement of cash flows. In this section the focus is only on the cash budget and budgeted balance
sheet, as the rest are discussed in detail in other course modules in financial accounting and financial
managements.
i) Cash budget
Cash budget is a schedule of expected cash receipt and disbursement. It predicts the effects on the cash position
at the given level of operation. Cash budget helps to avoid unnecessary idle cash and unexpected cash
deficiencies. They thus, keep cash balance in line with needs, ordinarily; the cash budget has the following main
sections.
The beginning cash balance plus cash receipt equals the total cash available before financing.
Cash receipts depend on the collection of accounts receivable, cash sales, and miscellaneous recurring sources
such as rental royalty receipts. Information on expected collectable of account receivable is needed for accurate
prediction.
Cash disbursement: Organizations make cash disbursement for various reasons such as:
Payment for direct martial purchased
Salary paid for direct labor cost and other wages
Other disbursements for property, equipment and other long term investment
Interest on long term borrowing
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Income tax payment
Others,
Short time financing requirement depends on how the total cash available for needs compare with the total cash
disbursement plus the minimum ending cash balance desired. If there is a deficiency of cash, loan will be taken,
if there is excess cash, an outstanding loan will be paid
Activities: 1. why is the cash budgeting so important in the master budgeting process?
_____________________________________
1. Why cash budget is prepared after the completion of operating budget preparation?
Suppose Gibe Furniture Company had the balance sheet for the year ended December 31, 2010 as follows:
ASSETS LIABILITIES & STOCKHOLDERS’ EQUITY
Liabilities
Cash Br. 500,000 Account payable Br. 384,000
Accounts Receivable 1,881,600 Tax payable 20,460
Direct Materials Inventory 223,000 Total current 404460
Finished Goods Inventory 1,375,000 Long term debt 2,400,000
Land 1,200,000 Total current & Liability 2,804,460
Buildings & Equipment 2,300,000 Stockholders’ Equity
Accumulated Depreciation (800,000) 1,500,000 Common Stock 3,000
Retained earnings 3,872,1403,875,140
Total Assets Br. 6,679,600 Total Liabilities & SHE Br. 6,679,600
The quarterly cash flow based on the budgeted cash effects of the operation formulated in operating budget
above is given below:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Cash Collection Br. 5,331,200 Br. 4,704,000 Br. 4,704,000 Br. 6,272,000
Disbursements:
Direct Materials 960,000 1,152,000 1,152,000 1,536,000
Payroll 1, 626 300 1,626 300 1,888,600 1,626,300
Other costs 1,580,460 1,580,460 1,580,460 1,580,460
Equipment purchase - 0- -0- 1,800,000 -0-
Interest expense 60,000 60,000 60,000 60,000
Income tax 100,000 120,460 100,000 100,000
Total Br. 4,326,760 Br. 4,539,220 Br. 6,581 060 Br. 4,902,760
Additional information
Long term debt is Br. 2.4 million at an annual interest rate of 10% with 60,000 interest payable every
quarter
The company wants to maintain a Br. 100,000 minimum cash balance at the end of each quarter
The company borrows cash in multiple of Br. 1,000 at the beginning of each quarter and repayment is made
at the end of each quarter
The company can borrow or repay money at an interest rate of 12% per year.
Management doesn’t want to borrow any money more short term cash than is necessary
Interest is computed and paid when the principal is repaid
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Tax rate is assumed to be 36%.
During the year the company paid Br. 420,640 income tax. This amount is the remaining due for the year
2010, plus four quarter payment of each Br. 100,000
Equipment amounting Br. 1,800,000 was bought in the 3rd quarter
No land is bought or sold.
Depreciation for the year is Br. 500,000.
Long term notes payable is not repaid.
No dividend is paid.
To prepare a cash budget you need to get adequate information about the cash receipt and disbursement made
by the organization during the budget period. Most of this information is obtained from the different schedules
prepared for the operating budget parts of a master budget. In addition to cash receipts and payments for
operational activities, information is required on planned investing and financing activity of the firm on the
budget period. Information on the companies desired minimum cash balance is also required.
Dear learner in preparing a cash budget noticing the following points are essential:
1. The ending balance of cash in one quarter is the beginning balance of cash for the next quarter.
2. In the year for total column the receipt and disbursement are totaled for the four quarters, however the
beginning balance in the column is the beginning balance in the column are the beginning balance in for quarter 4.
3. Depreciation is not a cash disbursement,
4. The cash receipt and disbursement for operational activity appears in all the quarter as the budgeted operation of
the company will continue in without interruption. However when you come to cash receipt and disbursement for
investing and financing activities appears only on some of the quarters. For example the firm acquired fixed asset
costing Birr 1,800,000, that is why the cash disbursement for investing activity appears only once in Q3.
5. When you cash receipt and payments related to financing activity the firm borrowed Birr 308,000 to finance
the expected short term cash shortage at quarter III, as a result cash receipt from financing activity appeared only in
this quarter. The principal amount and the interest on borrowed money are paid at quarter IV when the firm has
excess cash on hand beyond the required amount of cash for planned payments and minimum cash balance
requirement of the quarter, as a result cash payments for financing activity appears only in the fourth quarter.
Using all the information given above on illustration to the cash budget for Gibe Furniture can be prepared as
follow:
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beginning 1,504,440 1,669,220
Add Receipts:
Cash collection from 5,331,200 4,704,000 4,704,000 6,272,000 21,011,200
customers
Total Cash available 5,831,200 6,208,440 6,372,220 6,372,160 21,011,200
for needs (X)
Deduct Disbursements:
Direct materials 960,00 1,152,000 1,152,000 1,536,000 4,800,000
Payroll 1,626,300 1,626, 300 1,888,600 1,626,300 6,767,500
Other costs 1,580,460 1,580,460 1,580,460 1,580,460 6,321,840
Interest cost(long term 60,000 60,000 60,000 60,000 240,000
debts)
Machinery purchase# 0 0 1,800,000 0 1,800,000
Income tax 100,00 120,460 100,000 100,000 420,460
Total cash 4,326,760 4,539,220 6,581,060 4,902,760 20,449,800
Disbursement(Y)
Minimum Cash Balance 100,000 100,000 100,000 100,000 100,000
desired
Total Cash needed 4,426,760 4,639,220 6,681,060 4,902,760 20,349,800
Cash excess 1,404,440 1,569,220 (307,840) 1,369,440 1,061,400
(deficiency)
Financing
Borrowing at the 0 0 308,000 0 308,000
beginning
Repayment at the end 0 0 0 (308,000) (308,000)
Interest at 12% per 0 0 0 (18,480) (18,480)
annum
Total effect of 0 0 308,000 (326,484) (18,480)
financing
Ending cash balance Br1,504,440 Br Br100,160 Br1,142,920 1,142,920
1,669,220
Determine the balance of each account by analyzing the policy of the organization and all other related data.
Cash – refer to cash budget (the budgeted ending balance of cash)
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