CHAPTER TWO

MASTER BUDGET

THE FUNDAMENTALS OF BUDGETING

A budget is a comprehensive formal management plans expressed in quantitative terms,

describing the expected operations of an organization over some future time period. A budget
deals with a specific entity, covers a specific future time period and is expressed in quantitative
terms.

Budget entity .The entity concept, so important in financial accounting, is essential to budgeting
also. A specific budget must apply to a clearly defined accounting entity. For budgeting purpose
the entity may consist of a small part of a business, a single activity, or a specific project. The
concept of a budget entity applies to individuals as well

A budget entity can be as a specific as a single project such as Addisalem’s Langano trip or it
can be a broad activity, such as the budget for an entire manufacturing firm, or for the Ethiopian
government.

Future time period. Many financial figures are meaningless unless they are couched in some
time references. For example, income statements are annual, quarterly, or monthly.

Budgets should express the expected financial consequences of programs and activities planned
for a specific period of time. Annual budget are widespread. In addition to annual budgets,
budgets for many other time periods are prepared. The planning horizon for budgeting may vary
from one day to many years. For example, master budget usually cover 1 month to 1year where
as long-range plan are prepared for 2 to 10 years.

In planning for profits, managers must consider two time horizons: the short term and the long
term.

Short-term planning is the process of deciding what objectives to pursue during a short, near-
future period, usually one year, and what to do to achieve those objectives. The typical short-
term budget covers one year and is broken down into monthly or quarterly units.
Another method frequently used to prepare a short-term budget is the continuous budget. This
kind of budget starts with an annual budget broken down into 12 monthly units. As each month
arrives, it is dropped from the plan and replaced by a new month so that at any given time, the
next 12 months are always shown. Thus, in a budgetary period covering January through
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Long-term planning, also known as strategic planning, is the process of setting long-term goals
and determining the means to attain them. Short-term planning is concerned with operating
details for the next accounting period, but long-term planning addresses broad issues, such as
new product development, plant and equipment replacement, and other matters that require years
of advance planning
Quantitative plan. Often budgets contain materials describing the various programs and
activities planned by the company. This chapter focuses primarily in the way that cost and
revenue estimates of the activities are expressed by the budget. All planned projects or activities
for the organization are reduced to the common denominator of money and other quantitative
measures, such as units of input or output.

PRINCIPAL ADVANTAGES OF BUDGETING

As noted earlier, a budget is a detailed plan expressed in quantitative terms that specifies how
resources will be acquired and used during a specific period of time. The act of preparing a
budget is known as budgeting. The use of budgets to control a firm’s activities is called
budgetary control.
Companies realize many benefits from a budgeting program. Among these benefits are the
following:
 Requires periodic planning.
 Fosters coordination, cooperation, and communication.
 Provides a framework for performance evaluation.
 Means of allocating resources.
 Satisfies legal and contractual requirements.
 Created an awareness of business costs.
BUDGETING AND HUMAN BEHAVIOR

Participative Budgeting: Each level of management should be invited to participate

-May inspire higher levels of performance or discourage additional effort
-Depends on how budget developed and administered
Advantages of Participative Budgeting
More accurate budget estimates because lower level managers have more detailed knowledge
Perceive process as fair due to involvement of lower level management
Overall goal - produce fair and achievable budget while still meeting corporate goals

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Its disadvantages can be
Can be time consuming and costly
Can foster budgetary “gaming” through budgetary slack
If budgets are to benefit an organization, they need the support all the firm’s employees. Lower –
level workers and managers’ attitudes toward budgets will be heavily influenced by the attitude
of top management. Even with the support of top management, however, budgets –and the
managers who implements them –can run into opposition.

Budgeting necessarily entails behavioral problems. These problems include the following:
conflicting views, imposed budgets, budgets as checkup devices, and unwise adherence to
budgets.

THE MASTER BUDGET-A NETWORK OF INTERRELATIONSHIPS

Components of Master Budget

The master budget is the total budget package for an organization; it is the end product that
consists of all the individual budgets for each part of the organization aggregated into one overall
budget for the entire organization.

The two major components of master budget are the operating budget and the financial budget.

Operating budget. It focuses on income statement and its supporting schedules. It is also called
profit plan. However, such budget may show a budgeted loss, or can be used to budget expenses
in an organization or agency with no sales revenues.

Financial budget. It focuses on the effects that the operating budget and other plans will have on
cash.
The usual master budget for a non-manufacturing company has the following components.
1. Operating budget includes: 2. Financial budget include:
a. Sales budget a. Capital budget
b. Purchases budget b. Cash budget
c. Cost of goods sold budget c. Budgeted balance sheets
d. Operating expense budget d. Budgeted statement of cash flows

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 In addition to the master budget there are countless forms of special budgets and related reports.
For example, a report might detail goals and objectives for improvements in quality or customer
satisfaction during the budget period.
OPERATING BUDGET

The operating budget is composed of the income statement elements. A manufacturing business
budgets both manufacturing and non-manufacturing activities. Below the various elements of the
operating budget of a manufacturing firm have been discussed.

I. Sales Budget: The sales budget is the first budget to be prepared. It is usually the most important
budget because so many other budgets are directly related to sales and are therefore largely
derived from the sales budget. Inventory budgets, purchases budgets, personnel budgets,
marketing budgets, administrative budgets, and other budget areas are all affected
significantly by the amount of revenue that is expected from sales.

Sales budgets are influenced by a wide variety of factors, including general economic conditions,
pricing decisions, competitor actions, industry conditions, and marketing programs. In an effort to
develop an accurate sales budget, firms employ many experts to assist in sales forecasting.

The sales budget is usually based on a sales forecast. A sales forecast is a prediction of sales under a
given conditions.

Sales forecasts are usually prepared under the direction of the top sales executive. Important factors
considered by sales forecasters include:

a) Past patterns of sales:

b) Estimates made by the sales force:.
c) General economic conditions:
d) Competitive actions:
f) Changes in the firm’s prices:
f) Changes in product mix
g) Market research studies:
h) Advertising and sales promotion plans:

Budgeted Sales = Budgeted Sales in Units X Budgeted Sales Prices

Illustration: Master Budget Preparation for Manufacturing Companies
Morka Textile Company

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Budgeted sales volume: 3,000 units in the first quarter with 500-unit increases in each succeeding
quarter for 2020 budget year ending December 31 and the first two quarters of 2021.
Sales price: $60 per unit.
Required:
Prepare: sales budget for the 4 quarters and annual sales of 2020.

II. Production Budget in units

-Shows units that must be produced to meet anticipated sales
-Derived from sales budget, Beginning finished goods inventory and the desired ending
finished goods inventory
-Essential to have a realistic estimate of ending inventory

E.G. Morka Company always believes that it can meet future sales needs with an ending
inventory of 20% of next quarter’s budgeted sales volume.
Thus, budgeted sales of each quarter in units
1 2 3 4 1 2
3,000 3,500 4,000 4,500 5,000 5,500
Desired Ending FG Inventory of each quarter in units:
1 2 3 4
700 800 900 1,000
Ending balance of current quarter will be beginning balance for the next quarter.
Therefore, the production budget of 2020 will be as follows:

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 III. Direct Materials Purchases Budget:
Shows quantity and cost of direct materials to be purchased

Illustration data
Each unit produced requires two pounds of raw materials at a cost of $4 per pound Morka Company
maintains an ending inventory of raw materials equal to 10% of the next quarter’s raw material
required for production. The desired ending direct materials amount is 1,020 pounds for the fourth
quarter of 2020.
Required: Prepare a Direct Materials purchase Budget

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 IV. Direct Labor Budget
Shows both quantity of hours and cost of direct labor necessary to meet production requirements.
Critical in maintaining a labor force that can meet expected production.
Total direct labor cost formula:

After sales are budgeted, prepare the purchases budget. The total merchandise needed will be the sum
of the desired ending inventory plus the amount needed to fulfill budgeted sales demand. The total
need will be partially met by the beginning inventory; the remainder must come from planned
purchases. Direct labor hours are determined from the production budget.
Illustration data :
Ato Morka Company, two hours of direct labor are required to produce each unit of finished goods.
The anticipated hourly wage rate is $10.
Required: Prepare direct labor cost budget

V. Manufacturing Overhead Budget

Shows expected manufacturing overhead costs for budget period

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Manufacturing overhead should be distinguished between fixed and variable overhead costs for
budgeting purpose.
Typically, the variable portion of manufacturing overhead is assumed to be proportional to budgeted
activity (production). The fixed portion manufacturing overhead is assumed to be constant in total
Illustration data
Morka Company expects variable costs to fluctuate with production volume on the basis of the
following rates per direct labor hour:
Indirect materials $1.00, indirect labor $1.40, utilities $0.40, and maintenance $0.20.
The company's Fixed OH cost are constant across each quarters as follows:
Supervisory salary $20,000, depreciation $3,800, property $9,000 tax and insurance and
maintenance(fixed element)$5,700 per quarter
Reqired: Prepare a Manufacturing Overhead Budget.

VI. Selling and Adm. Expense Budget

Illustration Data:
Variable selling and administrative expense rates are:
Sales commissions $3 per units sold and freight-out $1 per units sold.
Fixed selling and administrative expense are constant and per quarter: Advertising $5,000, salesalary
$15,000, office salary $7,500, depreciation $1,000 , property tax and insurance $1,500
Required: Prepare a selling and administrative expense budget.

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Merchandising companies Inventory purchase Budget can be computed as follows:

Budgeted Desired Cost of Beginning

Purchases = Ending inventory + Goods Sold - Inventory

Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost
of products that are sold. Consequently, the cost of goods sold budget follows directly from the
production budget. However, a merchandising firm has no production budget. The cost of goods
sold budget comes directly from merchandise inventory and the merchandise purchases budget.

Budgeted Income Statement: The budgeted income statement is the combination of all of the
preceding budgets. This budget shows the expected revenues and expenses from operations
during the budget period.

A firm may have budgeted non-operating items such as interest on investments or gain or loss
on the sale of fixed assets. Usually they are relatively small, although in large firms the birr
amounts can be sizable. If non-operating items are expected, they should be included in the
firm’s budgeted income statement. Income taxes are levied on actual, not budgeted, net income,
but the budget plan should include expected taxes; therefore, the last figure in the budgeted
income statement is budgeted after tax net income.

FINANCIAL BUDGET

The second major part of the master budget is the financial budget, which consists of the capital
budget, cash budget, ending balance sheet and the statement of changes in financial position.

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Although there are some differences in operating budgets of manufacturing, merchandising and
service firms, very little difference exists among financial budgets of these entities.

Capital expenditure budget: Capital budgeting is the planning of investments in major resources
like plant and equipment, and other types of long-term projects, such as employee education
programs. The capital expenditure budget or capital budget describes the capital investment
plans for an organization for the budget period. It contains some of the most critical budgeting
decisions of the organizations.

Cash budget: The cash budget is a statement of planned cash receipts and disbursements. The
cash budget is composed of four major sections:

i. The receipts section: It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period. Generally the major source of receipts
will be from sales.
ii. The disbursement section: It consist of all cash payments that are planned for the
budget period. These payments will include inventory purchases, wages and salary
payments and so on. In addition, other cash disbursements such as equipment
purchases, dividends, and other cash withdrawals by owners are listed.
iii. The cash excess or deficiency section: The cash excess or deficiency section is
computed as follows:
Cash balance, beginning xxx
Add receipts xxx
Total cash available before financing xxx
Less disbursements xxx
Excess (deficiency) of cash available over disbursements xxx

If there is a cash deficiency during any budget period, the company will need to borrow funds. If
there is cash excess during any budget period, funds borrowed in previous periods can be repaid
or the idle funds can be placed in short-term or other investments.
iv. The financing section: This section provides a detail account of the borrowing and
repayments projected to take place during the budget period. It also includes a detail of
interest payments that will be due on money borrowed.

Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted
statement of financial position, is derived from the budgeted balance sheet at the beginning of

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the budget period and the expected changes in the account balance reflected in the operating
budget, capital budget, and cash budget.

Illustration: Master Budget Preparation for Merchandising Companies

Blue Nile Company’s newly hired accountant has persuaded management to prepare a master
budget to aid financial and operating decisions. The planning horizon is only three months,
January to March. Sales in December (2023) were Br. 40, 000. Monthly sales for the first four
months of the next year (20x4) are forecasted as follows:
January Br. 50, 000
February 80, 000
March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are credit sales. All credit sales are
collected in the month following the sales. Uncollectible accounts are negligible and are to be
ignored.

Because deliveries from suppliers and customer demand are uncertain, at the end of any month
Blue Nile wants to have a basic inventory of Br. 20, 000 plus 80% of the expected cost of goods
to be sold in the following month. The cost of merchandise sold averages 70%of sales. The
purchase terms available to the company are net 30 days. Each month’s purchase are paid as
follows:
50% during the month of purchase and,
50% during the month following the purchases.
Monthly expenses are:
Wages and commissions…………………Br. 2, 500 + 15%of sales, paid as incurred.
Rent expense………………………………………..Br. 2, 000 paid as incurred.
Insurance expense…………………………………..Br.200 expiration per month.
Depreciation including truck……………………….Br.500 per month
Miscellaneous expense…………………………….5% of sales, paid as incurred.

In January, a used truck will be purchased for Br. 3, 000 cash. The company wants a minimum
cash balance of Br. 10, 000 at the end of each month. Blue Nile can borrow cash or repay loans
in multiples of Br. 1, 000. Management plans to borrow cash more than necessary and to repay
as promptly as possible. Assume that the borrowing takes place at the beginning, and repayment
at the end of the months in question. Interest is paid when the related loan is repaid. The interest

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rate is 18% per annum. The closing balance sheet for the fiscal year just ended at December 31,
2023,is:
Blue Nile Company
Balance Sheet
December 31, 2023
ASSETS
Current assets:
Cash Br. 10, 000
Account receivable 16,000
Merchandise inventory 48, 000
Unexpired insurance 1, 800 Br.75, 800
Plant assets:
Equipment, fixture and other Br.37, 000
Accumulated depreciation 12, 800 24, 200
Total assets Br.100, 000
LIABILITIES AND OWNERS’ EQUITY
Liabilities:
Accounts payable Br.16, 800
Accrued wages and commissions payable 4, 250 Br.21, 050
Capital:
Owners’ equity 78, 950
Total liabilities and owners’ equity Br.100, 000

Instructions:
1) Using the data given above, prepare the following detailed schedules for the first quarter of
the year:
a) Sales budget
b) Cash collection budget
c) Purchase budget
d) Disbursement for purchases
e) Operating expenses budget
f) Disbursement for operating expenses

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2) Using the budget data given above and the schedules you have prepared, construct the
following pro forma financial statements
a. Income statement for the first quarter of the year.
b. Cash budget including receipts, payments, and effect of financing
c. Balance sheet at March 31, 2024.
STEPS IN PREPARATION OF MASTER BUDGET

1. a) Sales budget

December* January February March Jan.-Mar.

Total
Cash sales (40%) Br.24, 000 Br.30, 000 Br.48, 000 Br.36, 000 Br.114, 000
Credit sales (60%) 16, 000 20, 000 32, 000 24,000 76, 000
Totals Br.40, 000 Br.50, 000 Br.80, 000 Br.60, 000 Br.190, 000

*December sales are included in the schedule (a) because they affect cash collected in
January.

b) Cash collection budget

January February March

Cash sales of the month Br.30, 000 Br.48, 000 Br.36, 000
Credit sales of last month 16, 000 20, 000 32, 000
Total cash collected Br.46, 000 Br.68, 000 Br.68, 000

c) Purchase budget

January February March Jan.-Mar

Required ending inventory Br.64, 800 Br.53, 600 Br.48, 000
Cost of gods sold 35, 000 56, 000 42, 000 Br.133, 000
Total needed Br.99, 800 Br.109, 600 Br.90, 000
Beginning inventory 48, 000 64, 800 53, 600
Purchases budget Br.51, 800 Br.44, 800 Br.36, 400
d) Disbursement for purchases

January February March

50% of last month’s purchase Br.16, 800 Br.25, 900 Br.22, 400
50% of current month’s purchase 25, 900 22, 400 18, 200
Total disbursement for purchase Br.42, 700 Br.48, 300 Br.40, 600
e) Operating expense budget

January February March Jan.-Mar.

Wages and commissions Br.10, 000 Br.14, 500 Br.11, 500 Br.36, 000
Rent expense 2, 000 2, 000 2, 000 6, 000
Insurance expense 200 200 200 600

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Depreciation expense 500 500 500 1, 500
Miscellaneous expense 2, 500 4, 000 3, 000 9, 500
Total Br.15, 200 Br.21, 200 Br.17, 200 Br.53, 600

Disbursement for operating expenses budget

January February March

Wages and commissions Br.14, 250 Br.14, 500 Br.11, 500
Rent expense 2, 000 2, 000 2, 000
Miscellaneous expense 2, 500 4, 000 3, 000
Total Br.18, 750 Br.20, 500 Br.16, 500

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