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BUDGETING

LEARNING OBJECTIVES
At the end of this topic, students should be able to:

1. Define budgeting and discuss its role in planning, control, and decision making.

2. Define and prepare the master budget, identify its major components, and explain the interrelation-
ships of the various components.

3. Explain and illustrate the use and relevance of cash budgeting as a planning aid in the coordination
of business activity

4. Prepare the budgeted income statement and balance sheet and its supporting budget schedules.

KEY TOPICS
1. Description of budgeting 

2. Preparing the master budget 

3. Preparing the cash budget

4. Preparing the budgeting income statement and balance sheet

1. DESCRIPTION OF BUDGETING
BUDGETING DEFINED

A Master (comprehensive) budget is a formal statement of management's expectation regarding sales,

costs, output, and other financial transactions of the firm for the coming period. Simply put, a budget is a
set of projected or planned financial statements. It consists basically of a pro forma income statement, a
pro forma balance sheet, and a cash budget. A budget is a tool used for both planning and control. At the
beginning of the period, the budget is a plan or standard; at the end of the period it serves as a control
device to help management measure its performance against the plan so that future performance may be
improved

Budgeting is a planning and control tool used by managers.

Planning Tool Control Tool

Identify objectives. Compare actual results with budgeted (planned)

amounts.
Identify actions needed to achieve Corrective action can be taken, if needed.
objectives.

The steps involved in the planning and control process are as follows:
 Develop a strategic plan. A strategic plan identifies strategies for future activities and operations,
generally covering at least five years.
 Translate the strategic plan into long-term and short-term objectives.
 From the objectives, develop short-term plans.
 Develop budgets based upon the short-term plans.
 Compare actual results with planned (budgeted) amounts.
 Take corrective action, if necessary.

Advantages of Budgeting

Advantages of budgeting include the following:

 Budgets force managers to plan.
 Budgets provide information that can be used to improve decision making.
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 Budgets provide standards used for performance evaluation and control. Control involves com-
paring actual results with budgeted amounts and taking corrective action whenever actual perfor-
mance deviates significantly from planned performance.
 Budgets improve communication and coordination.

2. PREPARING THE BUDGET

Most budgets are for a one-year period, further broken down into quarterly and/or monthly budgets.

A continuous budget is a moving twelve-month budget. As a month expires in the budget, an additional
month is added so that the company always has a twelve-month plan on hand.

A. The Master Budget

The master budget is a comprehensive financial plan consisting of various individual budgets.

Master Budget

Operating Budgets Financial Budgets

Definition: budgets concerned with income-generating budgets concerned with cash flows and
activities financial position at end of period
Examples: sales budget cash budget
production budget budgeted balance sheet
direct materials purchases budget budget for capital expenditures
direct labor budget
overhead budget
selling and administrative expenses budget
ending finished goods inventory budget
cost of goods sold budget
budgeted income statement

The major steps in preparing the master budget are:

1. Prepare a sales forecast.

2. Determine production volume.

3. Estimate manufacturing costs and operating expenses.

4. Determine cash flow and other financial effects.

5. Formulate projected financial statements.

Preparing the Master Budget

THE SALES BUDGET

The sales forecast is the basis for the sales budget and is usually the responsibility of the marketing
department.

The sales budget is the starting point in preparing the master budget, since estimated sales volume
influences nearly all other items appearing throughout the master budget. The sales budget ordinarily
indicates the quantity of each product expected to be sold. Basically, there are three ways of making
estimates for the sales budget:

1 . Make a statistical forecast on the basis of an analysis of general business conditions, market
conditions, and product growth curves.

2. Make an internal estimate by collecting the opinions of executives and salespersons.

3. Analyze the several factors that affect sales revenue and then predict the future behavior of each
of these factors.
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After sales volume has been estimated, the sales budget is constructed by multiplying the expected sales
in units by the expected unit sales price. Generally, the sales budget includes a computation of expected
cash collections from credit sales, which will be used later for cash budgeting.

The sales budget is the projection of expected sales in units and dollars.

Sales Budget

Jan Feb Mar Apr

Expected Sales in units

x Unit Selling Price

Total Sales

Production Budget
The production budget indicates the number of units of finished product to be produced in order to meet:
 sales needs
 inventory requirements

If production is related to sales of the next period, production needs for a manufacturer can be calculated
as follows:
Production Budget

Jan Feb Mar Apr

Budgeted sales in units
+ Desired ending inventory in units
= Total units needed
– Beginning inventory (units on hand)
= Units to be produced

Direct Materials Purchases Budget

The direct materials purchases budget is a budget of the expected usage of materials in production and
the purchase of the direct materials required.

The steps involved in preparing a direct materials purchases budget are as follows:
1. Determine the amount of direct materials necessary to manufacture the number of units to be
produced.
2. Determine the quantity of direct materials to be purchased.
3. Determine the cost of the direct materials to be purchased by multiplying the quantity of direct
materials to be purchased by the expected cost per unit of direct material.
Materials Budget
Jan Feb Mar Apr
Units to be produced

x Material requirement per unit

= Quantity of direct materials needed for production

+ Desired ending inventory of direct materials

= Total quantity of direct materials needed

– Beginning inventory of direct materials

= Quantity of direct materials to be purchased

x Price per kg/lb

= Purchases
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Direct Labor Budget

The direct labor budget is a budget of planned expenditures for direct labor. The direct labor budget
indicates the rate per hour and the number of hours necessary to meet production requirements.
Labour Budget
Jan Feb Mar Apr
Units to be produced

x Labour hours required per unit

= Total Labour hours needed for production
x Standard labour rate per unit

= Total labour cost

Overhead Budget
The overhead budget shows the expected cost of all manufacturing costs other than direct materials and
direct labor. Budgeted variable overhead costs are based on a budgeted variable overhead rate multiplied
by budgeted activity. Budgeted fixed overhead costs remain unchanged as the activity level changes
within the relevant range.

Overhead Budget

Jan Feb Mar Apr

Total labour hours needed for production

x Variable overhead rate per hour

= Total Variable Overhead

+ Fixed Production overheads

= Total Production overheads

Cost of Goods Sold Budget

The cost of goods sold budget calculates the expected costs of the goods to be sold.

Budgeted cost of goods sold is calculated as follows:

Cost of Direct materials used
+ Cost of Direct labor used

+ Total Production overhead

= Budgeted manufacturing costs

+ Beginning finished goods

= Goods available for sale

– Ending finished goods

= Budgeted cost of goods sold

Selling and Administrative Expenses Budget

The selling and administrative expenses budget is a budget of planned expenditures for nonmanufac-
turing activities, such as sales commissions and office salaries.
Budgeted Income Statement 5
The budgeted income statement calculates net income as follows:

Sales

– Cost of goods sold

= Gross Profit (margin)

– Selling and administrative expenses

= Operating income

– Interest expense

= Income before taxes

– Income taxes

= Net income

C. Preparing the Financial Budget

The financial budgets are:

1. the cash budget

2. the budgeted balance sheet, and

3. the budget for capital expenditures

Cash Budget

The cash budget is a summary of planned cash receipts and cash payments.

The cash budget is prepared for the purpose of cash planning and control. It presents the expected
cash inflow and outflow for a designated time period. The cash budget helps management keep cash
balances in reasonable relationship to its needs. It aids in avoiding unnecessary idle cash and possible
cash shortages. The cash budget consists typically of four major sections:

1. The receipts section, which includes cash sales, cash collections on accounts receivable, and
other cash receipts

2. The disbursement section, which comprises all cash payments made by purpose/function

3. The cash surplus or deficit section, which simply shows the difference between the cash
receipts section and the cash disbursements section

4. The financing section, which provides a detailed account of the borrowings and repayments
expected during the budgeting period
Depreciation is considered a fixed cost; however, it is not a cash outflow. Therefore, depreciation
would not be included in the cash budget.
Bad debt expense is included in the selling and administrative expenses budget; however, it is not
included in the cash budget. Instead, bad debt expense is shown as a reduction in the amount the firm
expects to collect on accounts receivable.
Only purchases of property and equipment requiring cash would be shown on the cash budget. If the
property or equipment purchase was financed by long-term debt, cash repayments of the debt would
be shown as a cash payment in the cash budget.
A firm may desire or be required to maintain a minimum cash balance.

Excess cash should be invested to earn a return.

If the firm has a cash deficiency, borrowing will be necessary to maintain the minimum cash balance.
 FORMAT FOR CASH BUDGETS 6

CASH BUDGET FOR PERIOD ENDING ……..

Period1 Period2 Period3 Periodn

RECEIPTS

Cash Sales
Receipts from Debtors

Sale of Capital items

Any other cash receipts

TOTAL RECEIPTS

PAYMENTS

Cash Purchases
Payment to Creditors

Wages and Salaries

Operating Expenses
Capital Expenditure
Any other cash disbursements

TOTAL PAYMENTS

NET INFLOW/(OUTFLOW)

+ OPENING CASH BALANCE

= EXCESS CASH (OR DEFICIENCY)

INVESTMENTS:

– Investment of excess cash

+ Liquidation of investment

FINANCING

+ Borrowing to cover deficiency

+ Proceeds from share issues
– Repayment of loans
– Interest payments

ENDING CASH BALANCE

Budgeted Balance Sheet

The budgeted balance sheet is developed by beginning with the balance sheet for the year just ended
and adjusting it, using all the activities that are expected to take place during the budgeting period. Some
of the reasons why the budgeted balance sheet must be prepared are:

- It could disclose some unfavorable financial conditions that management might want to avoid.

- It serves as a final cheek on the mathematical accuracy of all the other budgets.

- It helps management perform a variety of ratio calculations.

It highlights future resources and obligations.