Chapter Three

Information for Budgeting,

Planning And Control Purpose
3.1 Objectives and concepts of budgetary systems
Concepts of Budget?
 A budget is a financial document used to protect future
income and expenses.
 It could also be defined as a formal statement of the
financial resources set aside for carrying out specific
activities in a given period of time.
 It is the most widely used means for planning and
controlling activities at every level of an organization.
 A budget indicates the expenditures, revenues, or profits
planned for some future date.
 The planned figures become the standard by which
future performance is measured.
 Budgeting is a proactive approach rather than a
reactive approach to managing resources.
 Budgeting makes it easier for governments,
government departments, businesses and
individuals with incomes and expenses of all sizes
to make conscious decisions about how they will
prefer to allocate their resources. Therefore,
 Budgeting is the complete process of designing,
implementing and operating budgets.
 The main emphasis in this is short-term budgeting
process involving the provision of resources to support
plans which are being implemented.
 Budgetary control is intimately connected with
budgets.
 The Chartered Institute of Management
Accountants, London defines Budgetary control as
“the establishment of budgets, relating the
responsibilities of executive to the requirements
of a policy and the continuous comparison of
actual with budgeted results either to secure by
individual action the objectives of that policy or to
provide a firm basis for its revision”.
 A budgetary control system secures control over
performance and costs in the different parts of a
business:
 The budget is a blue-print of the projected plan of
action expressed in quantitative terms and for a
specified period of time.
 The budgets put the plan in a concrete form and
follow up action to see that plan is adhere to
complete the system of control.
 In other words, while budgeting is the art of
planning, budgetary control is the act of adhering
to the plan.
 In fact, budgetary control involves continuous
comparison of actual results with the budgets and
taking appropriate remedial action promptly.
Rowland and William in their book entitled Budgeting
for Management Control has given the difference
between budget, budgeting and budgetary control as
follows:
 “Budgets are the individual objectives of a
department, etc. whereas budgeting may be said to be
the act of building budgets.
 Budgetary Control embraces all this and in addition
include the science of planning the budgets
themselves and the utilisation of such budgets to
effect an overall management tool for the business
planning and control”.
 Thus, a budget is a financial plan and budgetary
control results from the administration of the financial
 Budget: financial roadmap of the organization
chx - prepared in advance
- futurity of objectives
- quantitative
Advantages - way of communicating
- as benchmark
- as a means of educating
- reducing wastages and losses
 Principal budget factor: Major constraints/limiting
factors/bottlenecks

Examples: sale materials

labor Availability of
Budgeting and Behavioral Influences
 There are behavioral issues relating to budgets
such as dysfunctional behaviors of manager
and budgetary slack.
 These behavioral issues become more obvious
when their actual performance is to be compared
with and evaluated against budget performance.
 Overconfidence affects estimators and managers
alike.
 While we often accuse managers and study leads
of being too optimistic about design
complexities or technology, we estimators can
also be overconfident in our ability to predict
costs.
Quantitative aids in budgeting: learning curve
theory and application; limiting factors and
linear programming
 Finance being the life of the business, financial
planning is of at most significance to a businessman.
 A budget is an important tool for planning and
control.
 Financial Planning
rising of funds and their effective utilization
It includes:
 The amount of fund needed for implementing various business
plans.
 The pattern of financing, i.e., the forms and proportion of various
corporate securities, such as, shares, debentures, bonds, bank
loans to be issued or raised.
• The time of floatation/ or selling of various securities.
 In spite of a good financial plan, the desired result
may not be achieved if there is no effective control
to ensure its implementation.
 The budget represents a set of yardsticks or
guidelines for use in controlling internal operations
of an organization.
 The management, through budgets, can evaluate
the performance of every level of the organization.
 The difference between plan performance and
actual performance is highlighted through
budgets.
 The organization may have to change the course of
its operations in a particular area or revise its plans
Activity-based budgeting
 Activity-based budgeting (ABB) is a method of
budgeting where activities that incur costs are
recorded, analyzed and researched.
 It is more rigorous than traditional budgeting processes,
which tend to merely adjust previous budgets to account
for inflation or business development.
 method which management prepares annual budget base
on next year’s activity. It is depended on the
activities based costing, which analyzes all variable and
overhead costs associate with activities, the non-value
added cost will not be included.
To Demonstrate how ABB can be implemented, it is useful
to compare it to a traditional budgeting method.
 Suppose Company ABC expects to sell 1,000 units of
its product over the next month, and the product costs $5
to produce. Under activity-based budgeting, the
company will estimate the cost of goods sold to be
$5,000.
 Also, assume Company ABC reported a cost of goods
sold at $4,000 last month, with the rate of increase
averaging 10% each month in the past. Under the
traditional budgeting method, the company will estimate
the cost of goods sold in the upcoming month to
be $4,400 [$4,000 + ($4,000 x 10%)].
Control theory and budgeting,
 Budgetary Control CIMA, London, defines Budgetary Control
as: “The establishment of budgets relating the
responsibilities of executives to the requirements of policy
and the continuous comparison of actual with budgeted
results either to
 secure by individual action, the objective of that
policy or
 to provide a basis for its revision.”
 Budgetary Control means laying down monetary and
quantitative terms of what exactly has to be done, how it is
to be done, the actual results should not deviate much
from the budgeted results, a course of action if results
deviate and also fixing the responsibilities for various levels
of management.
OBJECTIVES/USES OF BUDGETARY CONTROL
• to achieve the targets set for the company.
• to fix the responsibilities of executives, departments and
personnel.
• comparison purpose.
• to ensure the best use of all available resources.
• the purpose of co-ordination.
• revision purpose.
• for long range plans.
• To reduce losses and wastes to the minimum.
• to remedy the situation.
• It motivates employees
• It communicates goals of the organization to the
employees.
ADVANTAGES OF BUDGETARY CONTROL SYSTEM
A. enables the management of a business concern to conduct
its business activities in the efficient manner.
B. for the control of their expenditure.
C. It provides a yardstick for measuring and evaluating the
performance of their individuals and their departments.
D. It helps in the review of current trends and framing of
future policies.
E. It inculcates the feeling of cost consciousness among
workers.
F. Management which have developed a well ordered budget
plans and which operate accordingly, receive greater favor
from credit agencies
LIMITATIONS OF BUDGETARY CONTROL SYSTEM
1. Based on estimates: Budgets may or may not be true as
they are based on estimates. Therefore, the adequacy or
otherwise of budgetary control system, to a very large
extent, depends upon the adequacy or accuracy with
which estimates are made.
2. Time factor: Management must not expect too much
during the development period.
3. Co-operation required: Staff co-operation is usually
not available during budgetary control exercise.
4. Expensive: No budgetary programme can be successful
unless adequate arrangements are made for supervision
and administration.
5. Not a substitute for management: Budget is only a
managerial tool. It cannot substitute management.
Uncertainty and budgeting,
 Uncertainty can take many forms, It may manifest as a
natural disaster, the deterioration of a foreign currency in
which your company has operations, geo-political
changes, the merger or acquisition of a competitor or a
global pandemic.
 Regardless of form, uncertainty does illuminate a certain
truth: companies must face volatile business conditions
with nimble planning, budgeting and forecasting.
 Most companies find budgeting a challenge even under
stable conditions.
 When economic forecasts fluctuate on a weekly or even
daily basis, creating one reliable budget to coordinate
business units and track performance for an entire fiscal
year is extraordinary.
BUDGETING IN THE CONTEXT OF CONTROL SYSTEM
THEORY
 A control system consists of a sensor which reports
information (a monthly operating statement).
 A comparator which measures performance (comparison
of actual with budget and identification of variances).
 An effector (management action to correct identified
deficiencies or opportunities).
ALTERNATIVE BUDGET SYSTEMS
 Incremental
 Zero based
 Flexible
 Rolling
Type: Activity Flexibility Time
Operating Static short term
Financial Flexible mid term & long term
INCREMENTAL BUDGETING
The traditional approach to budgeting,
known as incremental budgeting, bases the
budget on the current year's results plus an
extra amount for estimated growth or
inflation next year.
 It encourages slack and wasteful spending
to creep into budgets.
 concerned mainly with the increments in
costs and revenues which will occur in the
coming period.
 Reasonable procedure if current operations are
as effective, efficient and economical as they can
be.
 It is also appropriate for budgeting for costs such
as staff salaries, which may be estimated on the
basis of current salaries plus an increment for
inflation and
 are hence administratively fairly easy to prepare.
 it is an inefficient form of budgeting as it
encourages slack and wasteful spending to creep
into budgets.
 Past inefficiencies are perpetuated because cost
levels are rarely subjected to close scrutiny/
investigation.
ADVANTAGES OF INCREMENTAL BUDGETS
 quickest and easiest method of budgeting.
 Suitable for organizations that operate in a stable
environment where historic figures are reliable and
are not expected to change significantly.
 DISADVANTAGES OF INCREMENTAL BUDGETS
Builds in previous problems and inefficiencies
 Managers may spend for the sake of spending in
order to use up their budget for the year and thus
ensure that they get the same (or larger) budget next
year.
 Uneconomic activities may be continued.
 For example, a car manufacturer may continue to
make parts in-house when it may be cheaper to
outsource
ZERO BASED BUDGETING
 preparing a budget for each cost centre from a zero
base.
 Every item of expenditure has then to be justified in
its entirety in order to be included in the next year's
budget.
 ZBB rejects the assumption inherent in incremental
budgeting that this year's activities will continue at
the same level or volume next year, and that next
year's budget can be based on this year's costs plus an
extra amount, perhaps for expansion and inflation.
 In this way, every aspect of the budget is examined in
terms of its cost and the benefits it provides and the
selection of better alternatives is encouraged.
There are two types:
• Mutually exclusive packages contain alternative methods of getting the
same job done.
• The best option among the packages must be selected by comparing costs
and benefits and the other packages are then discarded.
• Incremental packages divide one aspect of an activity into different levels
of effort.
• The 'base' package will describe the minimum amount of work that must be
done to carry out the activity and the other packages describe what
additional work could be done, at what cost and for what benefits.
THE ADVANTAGES OF IMPLEMENTING ZBB
• It is possible to identify and remove inefficient or obsolete operations.
• It forces employees to avoid wasteful expenditure.
• It can increase motivation.
• It responds to changes in the business environment.
• documentation provides an in-depth appraisal of an organisation's
operations.
• It challenges the status quo.
THE LIMITATIONS OF IMPLEMENTING ZBB
the volume of extra paperwork created.
• The assumptions about costs and benefits in each package must be
continually updated and new packages developed as soon as new
activities emerge.
• Short-term benefits might be emphasized to the detriment of long-
term benefits.
It might give the impression that all decisions have to be made in
the budget.
• Management must be able to meet unforeseen opportunities and
threats at all times,
• however, and must not feel restricted from carrying out new ideas
simply because they were not approved by a decision package, cost
benefit analysis and the ranking process
• It may call for management skills both in constructing decision
packages and in the ranking process which the organisation does
not possess.
• Managers may have to be trained in ZBB techniques.
• The organization's information systems may not be capable of providing
suitable information.
• The ranking process can be difficult. Managers face three common
problems.
• A large number of packages may have to be ranked.
• It can be difficult to rank packages which appear to be equally vital, for legal
or operational reasons
• .It is difficult to rank activities which have qualitative rather than
quantitative benefits – such as spending on staff welfare and working
conditions.
• n summary, perhaps the most serious drawback to ZBB is that it requires a
lot of management time and paperwork.
• One way of obtaining the benefits of ZBB but of overcoming the drawbacks
is to apply it selectively on a rolling basis throughout the organization.
• This year finance, next year marketing, the year after personnel and so on.
• In this way all activities will be thoroughly scrutinized over a period of time.
ROLLING BUDGETS : DYNAMIC CONDITIONS
• Rolling budgets (continuous budgets) are budgets
which are continuously updated by adding a further
period (say a month or a quarter) and deducting the
earliest period.
• Rolling budgets are suitable to organizations that
operate in Dynamic (Volatile) conditions.
• Actual conditions may differ from those anticipated
when the budget was drawn up for a number of
reasons as follows:
Organizational changes may occur.
A change in structure, from a functional
basis, say, to a process-based one
New agreements with the workforce about
flexible working or safety procedures
 The reallocation of responsibilities following,
say, the removal of tiers of middle
management and the 'empowerment' of
workers further down the line.
 Action may be needed to combat an initiative
by a competitor
 New technology may be introduced to improve
productivity, reduce labour requirements or
enhance quality.
 Rolling budgets are an attempt to prepare
targets and plans which are more realistic and
certain, particularly with a regard to price
levels, by shortening the period between
preparing budgets.
for example, that a rolling budget is prepared every
three months.
 The first three months of the budget period would
be planned in great detail, and the remaining nine
months in lesser detail,
 This is because of the greater uncertainty about
the longer-term future.
 If a first continuous budget is prepared for January
to March in detail and April to December in less
detail, a new budget will be prepared towards the
end of March, planning April to June in detail and
July to March in less detail.
 Four rolling budgets would be prepared every 12
months on this 3 and 9 month basis, requiring,
inevitably, greater administrative effort.
THE ADVANTAGES OF ROLLING BUDGETS
 They reduce the element of uncertainty in budgeting
because they concentrate detailed planning and control on
short-term prospects where the degree of uncertainty is
much smaller.
 They force managers to reassess the budget regularly, and
to produce budgets which are up to date in the light of
current events and expectations.
 Planning and control will be based on a recent plan which is
likely to be far more realistic than a fixed annual budget
made many months ago.
• Realistic budgets are likely to have a better motivational
influence on managers.
• There is always a budget which extends for several months
ahead.
For example, if rolling budgets are prepared quarterly there
will always be a budget extending for the next 9 to 12 months.
THE DISADVANTAGES OF ROLLING BUDGETS
 They involve more time, effort and money in
budget preparation.
 Frequent budgeting might have an off-putting
effect on managers who doubt the value of
preparing one budget after another at
regular intervals.
 Revisions to the budget might involve
revisions to standard costs too, which in turn
would involve revisions to stock valuations.
 This could replace a large administrative
effort from the accounts department every
time a rolling budget is prepared.
CONTINUOUS BUDGETS OR UPDATED
ANNUAL BUDGETS
 If the expected changes are not likely to be
continuous there is a strong argument that
routine updating of the budget is
unnecessary.
 Instead the annual budget could be
updated whenever changes become
foreseeable, so that a budget might be
updated once or twice, and perhaps more
often, during the course of the year.
FIXED AND FLEXIBLE BUDGETS
 A fixed budget is a budget which is set for a
single activity level and It remains unchanged
regardless of the level of activity.
 A flexible budget-is a budget which recognizes
different cost behavior patterns and is
designed to change as volume of activity
changes.
 They are designed to flex with the level of
activity.
 Flexible budgets are prepared using marginal
costing and so mixed costs must be split into
their fixed and variable components
• The fixed budget‘s main purpose is to serve as a
benchmark in performance evaluation.
• It seeks to define the broad objectives of the
organization.
• A fixed budget is a budget which is normally set prior
to the start of an accounting period, and which is not
changed in response to changes in activity or
costs/revenues.
• Fixed budgets(in terms of a pre-set expenditure limit)
are also useful for controlling any fixed cost, and
• particularly non-production fixed costs such as
advertising ,because such costs should be unaffected by
changes in activity level(within a certain range).
Monitoring and controlling performance in
budgeting
 All departments are required to regularly monitor
actual activity to planned activity and control their
expenditure to ensure that it is in line with
available funds.
 If required, appropriate corrective action should
be taken to resolve significant differences between
actual and planned activity.
 The financial jargon for this process of monitoring
income and expenditure and taking corrective
action is budgetary control.
 Comparing your business budget year-on-year
with your actual performance can be a good way
of benchmarking how your business is
performing.
For example, you can compare your projected
figures with previous years to measure your
performance.
 You can also compare your figures for projected
margins and growth with those of other businesses
in the same sector, or across different parts of your
business.
MASTER BUDGET
 Master Budget

Operating budget Financial budget. . .

(profit plan). . .

Focuses on the income Focuses on the

statement and effects that the
supporting schedules operating budget
or budgeted expenses. and other plans will
have on cash
balances.
Learning
Objective Steps in Preparing the Master Budget

1. Supporting data

2. Operating budget

3. Financial budget
 Order of components of master budget

Since the components of master budget

are interconnected, it requires some flow
of data among budgets.
Meaning:
one component budget flow to another
one
components are prepared in a specific
order
MASTER BUDGET
in
Manufacturing Firms
 Sales budget

 The first and basic components of Master budget.

 Shows total sales forecasted during the period.
 The products of expected sales in units and expected
price per unit.
 Accompanied by a schedule of expected cash
receipts.
 Method of forecasting sales: Delphi, Trend Analysis
& Mkt research:
Illustration:
 The Hampton Freeze planed to have quarterly unit
sales of 10,000, 30,000, 40,000 & 20,000 and 20 $
for each case.
 Hampton Freeze Inc
Sales Budget
For the Year Ended December 31, 2008

Quarters
1 2 3 4 Year
Budgeted sales 10,000 30,000 40,000 20,000 100,000

Selling price $ 20 $ 20 $ 20 $ 20 $ 20

Total Sales 0.2 m 0.6m 0.8m 0.4m 2m

 Schedule of Expected Cash Collections

shows the budgeted collections on sales

during a period.
As % ge of budgeted sales
prepared after sales budget and
Before cash budget.
 Ignores bad debts.
Illustration:
 Hampton Freeze assumes beginning A/R amounts
$ 90,000 & 70 % of sales are collected in the
period(quarter) sale is made and the remaining is
to be collected in the following quarter.
 Production Budget
 Showing planned production in units.
 Basing sale budget data
Manufacturing Merchandising
Budgeted sales units Budgeted sales units
+ Ending Units * + Ending Units *
− Beginning in Units − Beginning in Units
Planned Prod in Units Planned Purch in Units
*endings for the period are beginnings for the next period .
Illustration: company assumes an ending
inventory equal to 20% of the next quarter’s sales.
Beginning inv of the 1st quarter and ending
inventory of 4th quarter is assumed 2,000 & 3, 000
 The Direct Materials Budget
 shows the quantity of direct material that will be used in
production.
 Formula:
Budgeted Production during the Period
× Units of Direct Material Required per Unit
= Direct Material in Units Needed for Production
+ Budgeted Ending DM
− Beginning Direct Material
= Budgeted DM Purchases in units
X Cost per DM
Budgeted DM Purchases in Birr
illustration: The company planned to have an ending inventories
equal to 10% of the following
quarter’s production needs & each requires 15 pounds of sugar
(DM for each unit to be produced)& each costs 0.2 $ per unit
.
 Schedule of Expected Cash Payments

shows the budgeted payments on purchase

during a period.
As percentage of budgeted purchases
prepared after DM purchase budget and
Before cash budget.
Illustration:
At Hampton Freeze, the policy is to pay for
50 % of purchases in the quarter in which the
purchase is made and 50% in the following
quarter. Beginning A/p amounts $ 25,800.
 The Direct Labor Budget
 shows the direct labor-hours required to satisfy
the production budget.
 Formula:
Planned Production in units
× Direct Labor Hours Required per Unit
= Budgeted Direct Labor Hours Required
× Cost per DL Hours
= Budgeted Direct Labor Cost
Illustration:
 The company expects each case requires 0.40
direct labor-hour & each costs $15 per direct
labor-hour
•
 Factory Overhead Budget

• shows all the planned manufacturing costs, other than direct costs,
needed to produce the budgeted production level.
• It has two sections: variable and fixed OH costs.
 Two alternatives to prepare OH budget
1. 2.
Total Fixed OH Total Fixed OH
+ Total Variable OH + Variable OH(V. OH rate X =
Total OH Assumed variable OH Units)

− Depreciation = Total OH
= Cash Pay’t for FOH − Depreciation
= Cash Pay’t for FOH
Illustration:
 Variable OH $ 4 per DL-hour and the fixed OH costs is $60,600
per quarter. Depreciation = $ 15,000 per quarter
 Selling and Administrative Expense Budget
• Shows planned operating expenses other than manufacturing costs.
• Common in all businesses
• Formula:
Budgeted sales
X variable selling & Adm expense per unit
= total variable selling & Administration expense
+ Total fixed selling & Adm expense
= Total selling & Administration expense
- Depreciation
= Cash Pay‘t for selling & Administration expense
Illustration:
Variable OH costs $1.8 per DL-hour and the total fixed OH
costs is $ 99,000 per quarter. Depreciation = $ 10,000 per
quarter
 cash budget
 The cash budget is composed of four major sections:
1. The receipts section.
2. The disbursements section
3. The cash excess/deficiency section.
4. The financing section.
Format
Cash balance, beginning . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Add receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Total cash available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXX
Less disbursements . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . XXXX
Excess/deficiency of cash available over payments . . . . XXXX
Illustration:
 Beginning cash balance $ 42,500 borrowings at the beginning
of 1st & 2nd quarters $ 130,000 & $ 70,000 respectively.
 Budgeted Income Statement
 shows planned profit :
 for trading and profit and loss accounts
 The budgeted trading account is to disclose the
budgeted gross profit,
 while the budgeted profit and loss account is to
disclose the budgeted net profit before tax.
 serves as a benchmark for operating performance
measurement.
Illustration:
 Hint: Consider the total sale value , CGS , Selling
& administrative expenses and interest expense,
Budgeted Income Statement
 The Budgeted Balance Sheet

It is developed using data from the balance

sheet from the beginning of the budget period
and data contained in the various schedules.
Fore instance cash budget.
Illustration:
Hampton Freeze’s budgeted balance sheet
is presented using data taken from the
company’s previous end-of-year balance
sheet for 2007, which appears below:
Budgeted balance sheet
MASTER BUDGET
in
Merchandising Firms
 Operating Budget
Learning
Objective

Sales Cash collections

budget from customers

Purchases Disbursements
budget for purchases

Operating expenses Disbursements for

budget operating expenses
Purchases Budget and Cash Disbursements
Budget cost of goods sold by multiplying
the cost of merchandise sold percentage
by budgeted sales.

The total merchandise needed is the sum

of budgeted cost of goods sold plus the
desired ending inventory.
Purchases Budget and Cash
Disbursements
Finally, compute required purchases by
subtracting beginning inventory from
total merchandise needed:

Budgeted purchases:
= Desired ending inventory
+ Cost of goods sold
– Beginning inventory
Purchases

Use the budgeted purchases to

budget cash disbursements.
 Operating Expense Budget
The budgeting of operating expenses
depends on several factors.

Month-to-month changes in sales volume and

other cost-driver activities directly influence
many operating expenses.

Expenses driven by sales volume include sales

commissions and many delivery expenses.
 Operating Expense Budget
Other expenses are not influenced by sales
or other cost-driver activity and are regarded
as fixed, within appropriate relevant ranges.

Rent
Depreciation

Insurance
Salaries
 Operating Expense Disbursements

Disbursements for operating expenses are

based on the operating expense budget.

Disbursements may include 50% of last month’s

and this month’s wages and commissions
plus miscellaneous and rent expenses.

The total of these disbursements is then

used in preparing the cash budget.
 Budgeted Income Statement

The income statement will be complete

after addition of the interest expense,
which is computed after the cash
budget has been prepared.

Budgeted income from operations

is often a benchmark for judging
management performance.
 Learning
Objective 8 Financial Budget
The second major part of the master budget is
the financial budget, which consists of the
capital budget, cash budget, and ending
balance sheet.

The cash budget is a statement of planned cash

receipts and disbursements that contains
these major sections: available cash balance,
net cash receipts, and disbursement financing.
 Cash Budget
Available cash balance
= Beginning cash balance
– Minimum cash balance desired.

Cash receipts depend on collections from:

 customers’ accounts receivable, cash
sales, and other operating income sources.
 Cash Budget
Cash disbursements for purchases depend
on the credit terms extended by suppliers
and the bill-paying habits of the buyer.

Payroll depends on wage, salary, and

commission terms and on payroll dates.
 Cash Budget
Disbursements for some costs and
expenses depend on:
 contractual terms for installment
 payments,
 mortgage payments, rents, leases, and
 miscellaneous items.

Other disbursements include outlays for

fixed assets, long-term investments,
dividends, and the like.
Cash Budget

Ending cash balance

= Beginning cash balance
+ Receipts – Disbursements
+ Cash from financing

The cash from financing can be

either positive (borrowing)
or negative (repayment).
Illustration for ABC Co. three months master budget for the year 2011
SALES BUDGET Preparation of the master budget for the first 3 months
of the new fiscal year requires a sales budget for 1 month beyond the 3
months because ABC bases its budgeted inventory purchases on the
following month's sales. The sales budget for the next 4 months is as
follows:
April $50,00
May $80,000
June $60, 000
July $50,000
The master budget also requires information about actual sales in the
previous month because ABC collects cash for the credit sales in the
month following the sale. On average, 60% of sales arc cash sales and the
remaining 40% are credit sales. Sales in March were $40,000 and the $16,
000 of accounts receivable on March 31 represents credit sales made in
March(40%of $40,000). Uncollectible accounts are negligible and thus
ignored. For simplicity's sake, we also ignore all local, stale, and federal
taxes for this illustration.
Planned Inventory Levels: Because deliveries from
suppliers and customer demands are uncertain, at
the end of each month ABC wants to have on hand a
base inventory of $20,000 plus additional inventory
equal to 80% of the expected cost of goods sold for
the following month. The cost of goods sold averages
70% of sales. Therefore, the inventory on March 31 is
$20,000+(.8 X .7 X April sales of $50,000 =$20,000 +
$28,000 = $48, 000 On average, ABC pays for 50% of
each month's purchases during the month of
purchase and 50% during the next month. Therefore,
the accounts payable balance on March 31 is 50% of
March purchases, or .5 X $33,600 = $16,800.
 ABC Company
Statement of Financial position
At March, 31,2011
Cash $10,000
A/R (.4 * march sales of 40,000) $16,000
Merchandise inventory $20,000 + .7 * (.8 * April sale of $50,000
$48,000
Unexpired insurance (April – Dec 2011) $1,800
Equipment, fixture and others $37,000
Accu. Depn 12,800
Total Assets $100,000
A/P (0.5 * march purchase of $33,600) $16,800
Accrued wages and commission payable(1,250 + 3000) 4250
Owners equity 78,950
Total liabilities and owners equity $100,000
Wages And Commissions: ABC pays wages and
commissions twice each month, with payments
lagged half a month after they are earned. Bach
payment consists of two components:
i. one-half of monthly fixed wages of S2.500, and
ii. commissions equal to 15% of sales, which we
assume are uniform throughout each month.
To illustrate the wage and commission payments, the
March 31 balance of accrued wages and commissions
payable is (.5 X $2,500) + .5 X (.15 X $40,000) = $I,250
+$3,000 = $4,250. Because of the half-month lag. ABC
will pay this $4,250 balance on April 15.
Capital Expenditures And Operating Expenditures:
ABC's only planned capital expenditure is the
purchase of new fixtures for $3,000 cash in April.
ABC has monthly operating expenses as follows:
Miscellaneous expense 5% of sales, paid as
incurred
Rent $2,000 paid as incurred
Insurance $200 expiration per month
$500 per month
Depn including new
fixtures
Cash Balances: Because collections lag credit sales,
ABC often struggles to come up with the cash to pay
for purchases, employee wages, and other outlays.
 To meet cash needs, ABC uses short-term loans
from local hanks, paying them buck when excess
Cash is available. ABC maintains a
minimum$10,000 cash balance at the end of each
month for operating purposes and can borrow or
repay loans only in multiples of $1,000.
 Assume that borrowing occurs at the beginning
and repayments occur at the end of the month.
Also assume that interest of 1% per month is paid
in cash at the end of each month.
Steps in Preparing the Master Budget
1. Using the data given, prepare the following budgets and schedules for
each of the months of the planning horizon ( Basic Data):
Schedule a. Sales budget
Schedule b. Cash collections from customers
Schedule c. Purchases and cost-of-goods-sold budget
Schedule d. Cash disbursements for purchases
Schedule e. Operating expense budget
Schedule f. Cash disbursements for operating expenses
Operating Budget
2. Using the supporting budgets and schedules, prepare a budgeted income
statement for the 3 months ending June 30, 201I.
Financial Budget
3. Prepare the following budgets and forecasted financial statements:
a. Capital budget
b. Cash budget, including details of borrowings, repayments, and interest
for each month of the planning horizon
STEP 1A: SALES BUDGET The sales budget is the
starting point for budgeting because planned
inventory levels, purchases, and operating expenses
all depend on the expected level of sales. Schedule a
includes information about actual March sales
because March credit sales affect cash collections in
April.
Schedule a SALES BUDGET

March April May June April – June

total sale
Total sale $40,000 $50,000 $80,000 $60,000 $190,000
STEP IB:CASH COLLECTIONS FROM CUSTOMERS
Schedule b uses the sales budget to plan when ABC
will collect cash. In turn, we will use Schedule b to
prepare the cash budget in step 3. Cash collections
from customers include the current month's cash
sales plus collection of the previous month's credit
sales.
April May June

Cash sales (60% of current month $30,000 $48,000 $36,000

sales)
Collection of last month's credit 16,000 20,000 32,000
sales (40% of previous month sales
Total collections $46,000 $68,000 $68,000
STEP 1C: PURCHASES BUDGET The elements of the purchases
budget are tied together by a simple intuitive identity that
ignores minor complications such as returns and defects but
relates the fundamental uses of inventory to the sources:
 Inventory is either sold or else carried over to the next
period as ending inventory.
 Inventory comes from either beginning inventory or
purchases. Therefore, cost of goods sold plus ending
inventory equals beginning inventory plus purchases.
 We budget cost of goods sold by multiplying the cost of
merchandise sold percentage (70%) by budgeted sales.
 The total merchandise needed is the sum of budgeted cost
of goods sold plus the desired ending inventory. Finally, we
compute required purchases by subtracting beginning
inventory from the total merchandise needed:
 Schedule c: Purchases Budget
March April May June April-June
Total

Budgeted cost of goods sold $35,000 $56,000 $42,000 $133,000

Plus: Desired ending inventory ** 64,800 53,600 48,000

Total merchandise needed $99,800 $109,600 $90,000

Less: Beginning inventory 48,000 64,800 53,600

Purchases $33,600* $51,800 $44,800 $36,400

STEP 1D: DISBURSEMENTS FOR PURCHASES We use
the purchases budget to develop Schedule d. In our
example, disbursements are 50% of the current
month's purchases and 50% of the previous month's
purchases.
Schedule d: Cash Disbursements for Purchases
April May June

50% of lost month's $16,800 $25,900 $22,400

purchases
Plus 50% of (his month's 25,900 22,400 18,200
purchases
Disbursements for $42,700 $48,300 $40,600
purchases
STEP 1E: OPERATING EXPENSE BUDGET Month-to-
month changes in sales volume and other cost-driver
activities directly influence many operating expenses.
 Examples of expenses driven by sales volume
include sales commissions and delivery expenses.
 these arc included in miscellaneous expenses for
ABC.
 Other expenses, such as rent, insurance,
depreciation, and wages, are not influenced by
sales (within appropriate relevant ranges), and we
regard them as fixed.
 Schedule e summarizes operating expenses for
ABC.
Schedule e: Operating Expense Budget
March April May June April-June
Total
Wages (fixed) $2,500 $2,500 $2,500 $2,500

Commissions (15% of current 6,000 7,500 12,000 9,000

month's sales)
Total wages and $8,500 $10,000 $14,500 $11,500 $36,000
commissions
Miscellaneous expenses 2,500 4,000 3,000 9,500
(5%of current sales)
Rent (fixed) 2,000 2,000 2,000 6,000

Insurance (fixed) 200 200 200 600

Depreciation (fixed) 500 500 500 1,500

Total operating expenses $15,200 $21,200 $17,200 $53,600

STEP 1F: DISBURSEMENTS FOR OPERATING
EXPENSES Disbursements for operating expenses are
based on the operating expense budget.
 Disbursements include50% of last month's wages
and commissions, 50% of this month's wages and
commissions, and miscellaneous and rent
expenses.
 There is no monthly cash disbursement for
Insurance (which is paid annually at the beginning
of the year) nor for depreciation (which does not
involve any periodic cash disbursement).
 We will use the total of these disbursements for
each month in preparing the cash budget.
Schedule f: Disbursements for Operating Expenses
April May June
Wages and commissions
50% of last month's expenses $4,250 $5,000 $7,250

50% of this month's expenses $5,000 7,250 5,750

Total wages and commissions $9,250 $12,250 $13,000

Miscellaneous expenses 2,500 4,000 3,000

Rent 2000 2000 2000

Total disbursements $13, 750 $18,250 $18,000

Step 2: Preparing the Operating Budget
 Steps 1a, 1c. and 1e,along with interest expense
from the cash budget (which we will construct in
step 2),
 provide information to construct the budgeted
income statement.
 Budgeted income from operations is often a
benchmark for judging management performance.
 The ABC Company Budgeted Income Statement
for Three Months Ending June 30, 2011
Data Source of Data
Sales $190,000 Schedule a
Cost of goods sold 133, 000 Schedule c
Gross margin $57,000
Operating expenses:
Wages and commissions $36,000 Schedule e
Rent 6,000 Schedule e
Miscellaneous 9,500 Schedule
e Insurance 600 Schedule
e
Depreciation 1,500 53,600 Schedule e
Income from operations $3,400
Interest expense 410 Cash budget
Net income $2,990
Step 3: Preparation of Financial Budget
 The second major part of the master budget is the
financial budget, which consists of the capital budget,
cash budget, and ending balance sheet.
STEP 3A: CAPITAL BUDGET In our illustration, the
$3,000 planned purchase of new fixtures in April is the
only item in the capital budget.
STEP 3B: CASH BUDGET The cash budget is a
statement of planned cash receipts and disbursements.
 Cash budgets help management avoid either
unnecessary idle cash or unnecessary cash deficiencies.
 The cash budget is heavily affected by the level of
operations summarized in the budgeted income
statement.
CASH BUDGET April May June
Beginning cash balance $10,000 $10,410 $10,720
Minimum cash balance desired 10,000 10,000 10,000
Available cash balance (x) $0 $410 $720
Cash receipts and disbursements
Collections from customers (Schedule b*) $46,000 $68,000 $68,000
Payments for merchandise (Schedule d) (42,700) (48,300) (40,600)
Payments for operating expenses (Schedule f) (13,750) (18,250) (18,000)
Purchase of new fixtures (Step 3a) (3,000) ------- ------
Net cash receipts and disbursements (y) (13,450) $1,450 $9,400
Excess (deficiency) of cash before financing (x +y) (13,450) $1,860 $10,120
Borrowing (at beginning of month) $14,000
Repayments (at end of month) ($1,000) ($9,000)
Interest payments (1% per month, end of month**) (140) (140) (130)
Total cash increase (decrease) from financing (z) $13,860 ($1,140) ($9,130)
Ending cash balance (beginning +y z) S 10,410 $10,720 S 10,990
Letter x, y and z are keyed to the explanation in the text
 'Borrowing and re payment of principal are made in multiple of
$1,000, at an Interest rate of 1% per month.
 'Interest computation** $14,000 x 01 = $140; $14,000 x .01=
$140; $13,000X .01 = $130
Note: The total cash increase (decrease) from financing (z) depends
on the total available cash balance (x) and the net cash receipts and
disbursements (y). If cash available plus net cash receipts less
disbursements is negative, borrowing is necessary
 Illustration shows that ABC will borrow S 14,000 in April to
cover the planned deficiency. cash available plus net cash receipts
less disbursements is sufficiently positive, ABC can repay loans
 it repays $ 1,000and $9,000 in May and June, respectively. This
section of the cash budget also generally contains the outlays for
interest expense. Trace the calculated interest expense, which in
our example is the same as the cash interest payments for the 3
months.
STEP 3C: BUDGETED BALANCE SHEET
 The final step in preparing the master budget is to
construct the budgeted balance sheet.
 that projects each balance sheet item in
accordance with the business plan as expressed in
the previous schedules.
 The ABC Company
Budgeted Balance Sheet June 3, 2011
Assets
Current Assets
Cash $10,990
Accounts receivable, net (.4 X June sales of 560,000) 24,000
Inventory (Schedule c) 48,000
Unexpired insurance (for July-December) 1,200 $84,190
Plant Assets
Equipment, fixtures, and other ($57,000 + $3,000) $40,000
Accumulated Depreciation ($12,800 + $1,500) (14,300) 25,700
Total assets $109,890
Liabilities and Owners' Equity
Accounts payable (.5 x June purchases of $36,400) $18,200
Short term loan 4,000
Accrued wages and commissions payable (.5X11,500) 5,750 $27,950
Owners' equity (78,950 x 2,990 net income) 81,940
Total liabilities and owners' equity $109,890

Note: March 31, 2011 beginning balance are used tor computation of unexpired Insurance,
 Advantages
 It provides a way to manage an organization
that would otherwise be unmanageable.
Assigning responsibility to lower level
managers allows higher level managers to
pursue other activities such as long term
planning and policy making.
It also provides a way to motivate lower
level managers and workers.
 measurements that emphasize their
individual performances.
 Disadvantages

It ignores the interdependencies

within the organization.
segments tend to compete to
optimize their own performance
measurements rather than working
together to optimize the
performance of the system/firm.
The End of
chapter 3
Thank You!