Professional Documents
Culture Documents
Introduction
The Master Budget for a profit oriented organisation seeks to build a set of
interrelated budgets which provide a complete "picture" of the operations
of the business over some future period, usually twelve months.
The elements of the master budget addresses both operating and financial
concerns. The major elements of the Master Budget are:
The Cash Flow budget is the "glue" which binds the whole budget
together. Every budget decision from the level of sales to labour costs and
spending on capital items has some impact on cash flows. The cash flow
budget seeks to show the cash funding necessary for the budget period.
The sales budget is the most important element in the master budget as
all other budget assumptions flow from the sales forecasts in the budget.
While it can readily be seen that the cost of raw materials and direct
labour are directly related to the level of sales, it might not be so obvious
how other budget elements relate. Here are some relationships:
Period: The periods into which the budget may be divided might be by
quarter, by month or even in some companies, by week. As discussed
above, the overall budget will typically be for a financial year.
The Sales Budget for a hypothetical company, the Software Factory for
the first and fourth quarters for the year ended 31 December 19x1 is
shown below.
Let us look at some of the factors which went on, in building the sales
budget.
Whilst there is only one recommended retail price for all customers, the
amount received by the company varies depending on the method of
distribution. For example, the sales in the Northern Sales region to the
SoHo market is through agents and the average dollars per package is
less than in the more direct sales to large customers by the Southern
Sales Region.
Introduction
Production Budget
The first thing we must do is to work out how many items of production
that will be made in the budgeted period. The production must satisfy
those sales in the current period that cannot be supplied from current
production and also provide a surplus to put into the finished goods
inventory. Of course, many manufacturing processes are "on demand" and
will not have any finished goods but the great majority of manufacturing
organisations will maintain a level of finished goods inventory. The level
of production in a period will be determined by using the output from the
sales budget and will incorporate some assumptions on the desired level
of closing inventory:
The production budget for the Software Factory for the first three months
of the budget year is shown below:
The technology and cost of producing the 4D Spreadsheet MegaMultiMedia
database is very imilar, so the production budget for the Software Factory
shows the production and cost combined for both products.
The finished goods inventory, in units, that is required at the end of each
period should be sufficient to meet all of the next period's sales and still
have one quarter of the month's sales left over. So the closing inventory
at the end of January is 125% of the February sales rounded to the
nearest 10 units. Closing inventory is, then, 770 * 125% = 962.5 units
which when rounded to the nearest ten units becomes 960 units. The level
of finished goods inventory not only has implications for the number of
units to be produced in the manufacturing process but also relates to the
Balance Sheet as it will impact on the dollar valuation of finished goods.
The raw materials which go into a product can be very complex. The
number of items that go into a typical computer can range up to several
hundred separate items once we count in all of the components on the
main system board, the casing, keyboard and display screen.
The raw materials that go into producing the software manufactured by
the Software Factory would include:
The estimated cost of all of the various items of raw materials in the
production process is $12.50 and this is expected to be constant
throughout the 19x1 financial year. Because the raw materials are rather
generic in nature, being primarily paper and diskettes, and therefore
readily obtainable only a relatively small amount of raw materials
inventory is required at the end of each period. The budget assumption is
that 50% of the requirements for the next month should be on hand at
the end of each month. The closing inventory for the month of February is
$5,250 or 50% of March's raw materials consumption of $10,500.
Factory Overhead
These costs are of both a fixed and variable nature. Some examples of
fixed and variable costs are:
Variable
Fixed
Let us look at the factory administration cost structure and the factory
administration budget of the Software Factory
All of the factory overhead for the Software Factory is of a fixed nature.
The only change that we can in the first quarter is for factory depreciation
which moves from $13,200 in February to $13,600 in March. This has
been caused by the purchase of additional manufacturing plant in the
month as will be explained, below, in the context of the Capital
Expenditure budget.
A summary
You will notice that the total cost of the product moves substantially from
a high of $44.36 per unit in January to a low of $33.50 in November.
What is driving this variation where January is one third more expensive
than November?
The answer is to be found in the fixed costs of factory overhead. You will
notice that production in January totals 725 units whilst in November is
1,200 units as the company ramps up production for the summer break.
The largely fixed costs of factory overhead are being spread over a much
larger number of units. This seasonal pattern to production is typical for
many types of businesses and is illustrated in a hypothetical example :
In this case the quarterly manufacturing overhead costs are constant at
$800,000 per quarter but the production varies considerably from 450,000
units in Quarter 2 to 825,000 units in the fourth quarter. The cost per unit
ranges from $1.78 Per unit down to $0.94 per unit whereas the average is
$1.33 per unit.
The calculation of inventory balances for the first and fourth quarters of
the budget period is:
You will notice that the quantity and costs of the opening inventory is
summed to the quantity and costs of the production for the month and a
total calculated. A new average is calculated which is then applied to the
cost both of sales in the period as well as the cost of the finished goods.
Expenses budget
The cost of the two expenses categories of selling and marketing and
administration costs flow from the
Variable
1. Sales commissions
2. Distribution costs
3. Some travel costs
4. Warranty costs
5. Sales discounts
Fixed
1. Salaries
2. Some travel costs
3. Rates, light, heat and power etc
"Discretionary"
1. Marketing costs
2. Advertising campaign costs
So we can see that there is a direct link between the level of sales in
dollar terms and the budgeted sales commissions to the sales force and
the physical level of sales and distribution costs. Similarly, the more a
company sells the greater will be the cost of meeting warranty claims on
items sold.
The selling expenses budget for the first and fourth quarters for the
Software Factory is:
You will notice that the sales commission to the sales staff of the Software
Factory is three percent of the sales revenue of the company. The
distribution costs are $3 per unit of sales. Note that the distribution costs
of finished goods are for the company more closely related to the physical
units rather than the dollar value of the sales.
You will remember that elements of the company's product line relates to
the SoHo market and is, therefore, dependent on sales at the Christmas
break. The marketing program is moulded to fit this cycle. Marketing
programs are typically $20,000 Per month but the company has planned a
major campaign for the end of the year and marketing programmes go up
to $75,000 in October and November and peak in December at $85,000.
This an example of what might be termed "discretionary" expenses. The
depreciation expense and marketing overhead are examples of fixed
overhead.
Putting it Together
A capital item is usually defined as one which will last longer than twelve
months and exceeds a certain amount
Some of the other relationships which the capital expenditure budget has
with other budgets are:
Let us return for a moment to the factory administration budget of the
Software Factory where we see that the budgeted depreciation expense
has gone from $13,200 in the month of January to $15,800 in the month
of December
The Sales Budget and the various expense budgets are brought together
in a budgeted Income Statement. The format of the Income Statement
will vary from company to company depending on how much information
is relegated to schedules. In the case of the Software Factory most of the
information is contained in the schedules so the Income Statement is of a
summary nature only:
Due to the nature of the business, the gross profit for the Software
Factory is very high as most of the cost structure in the business is in the
selling and administrative expenses. This is due to the very high level of
marketing expenditure required in this business sector and the customer
support and research and development which is contained in the
administrative expenses budget.
This in turn has an impact on the Cash Flow Budget as the level of Raw
Materials must be funded.
The Balance Sheet has as might be expected a number of relationships
with other budgets. The Balance Sheet and some of the relationships the
budgeted balances have with other budgets for the Software Factory:
Cash at bank is a "balancing item" and shows the residual of the impact
of all of the transactions for the period. It is drawn from the cash flow
statement, as we will explore in more detail in a moment.
Accounts Receivable is based upon an assumption of the numbers of
days outstanding of credit sales which is drawn from the Sales Budget.
In this case the budget assumes that none of the sales made in any
given month will have been collected in cash at the end of the month
but all the cash will be received in the next month
Raw Materials and Finished Goods are drawn completely from the
Production budget as we saw above.
Provision for Taxation is drawn from both the Income Statement for the
expenses and from the cash flow statement where the payment to the
taxation office is recorded.
Factory Plant, Sales Equipment and Administrative Equipment are
driven by the Capital Expenditure budget.
Accumulated Depreciation on Factory Plant is driven by the expenses
shown in the budget for factory overhead and, similarly;
Accumulated Depreciation on Sales Equipment and Administrative
Equipment is driven by the budget for selling expenses and
administrative expenses, respectively.
Term Loan balances are influenced by additional loans or repayments
shown in the Cash Flow statement.
Retained Earnings are drawn from the profit and loss statement.
The budgeted cash flow can be seen as the glue which holds the budget
process together. It is highly significant to the process of the budget as
the level of financing may well be at the heart of the very survival of the
company. As we will discuss shortly, the impact of changes in budget
assumptions can radically impact on the cash generation ability of the firm
and on the financing of the business.
The closing balance of cash is the figure which is the "balancing item" and
which is the final figure which binds all the various budgets together.
The Master Budget - A Simplified Example – The Personal Software
Factory Pty Ltd
Introduction
In this section we can show the overall budget for the Software Factory
for the year ended 31 December 19x1. It commences with a summary of
the budget position for each of the four quarters and then shows the first
and fourth quarters of the detailed budgets.
Budget overview and financials for the 19x1 year
Sales budget
Production budget
Expenses budget
Budgeted cash flow
Budgeted Income Statement
Introduction
Of these two, the level of sales activity is clearly the most important driver
of the overall results of the company. Nonetheless changes in the cost of
raw materials can make quite a difference to the standing of the company.
So we have presented three scenarios to management
The "base case" which is the generally agreed position for the company
The "absolute best case" which assumes a ten per cent increase in
sales $ revenue over the base case and a five Per cent reduction in
the amount the company has to pay for raw materials
The "absolute worst case" which assumes a ten per cent reduction in
sales $ revenue over the base case and a five Per cent increase in
the amount the company has to pay for raw materials
What difference does that make to the level of profitability and cash
generation ability of the company?
Base Case
First, let's remind ourselves of what the "base case" looks like. There is, of
course, no change from the master budget in the level of sales and raw
material costs.
The "Very Best Case" shows a 10% improvement in the level of sales and
5% improvement in the cost of raw materials from the master budget.
The company under the "Very Best Case" scenario would expect to earn
an after tax profit of $799,585 for the year and have $930,770 in cash at
the end of the period.
Worst Case
The "Very Best Case" shows a 10% reduction in the level of sales and 5%
increase in the cost of raw materials from the master budget.
The company under the "Very Worst Case" scenario would expect to earn
an after tax profit of $211,077 for the year and have just $56,412 in cash
at the end of the period.
Analysis of the What If Scenarios
We can also put a summary of the what if scenarios in a table and show
each case against some key variables such as the Sales Revenue and Net
Profit after Tax for the period and Cash on Hand
We can see that moving from the Very Worst to the Very Best case gives
rise to major changes in all major variables. Sales would increase by 41%
but Net Profit after Tax increases by 300% and Cash on Hand by 1,048%!.
Using a Spreadsheet to Build the Budget
Introduction
You will have noticed that the analyses in the previous section changed
significant variables such as Sales Revenue and yet the Balance Sheet
flexed and still balanced. That was because the Budget model for the
company was built in a spreadsheet which was designed to be fully
integrated and support flexing.
Some of the formulae that might be used include "IF" statements and
formulae that choose some value based upon a predetermined value such
as "CHOICE" and "VLOOKUP" and "HLOOKUP".