Chapter 8

Master Budgeting
 Learning objectives
• 1. Understand why organizations budget
• 2. Prepare operating budgets
 Sales budget
 Production budget
 Direct materials budget
 Direct labor budget
 Manufacturing overhead budget
 Ending finished goods inventory budget
 Selling and administrative budget
• 3. Prepare financial budgets
 Budgeted income statement
 Cash budget

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 Budget
• A budget is a plan for using limited resources:
 The goals we’re trying to achieve in a specific
period
 How we plan to achieve these goals
 The act of preparing a budget is called
budgeting
 The use of budgets to control an organization’s
activities is known as budgetary control

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 Three Purposes of Budgeting
• Planning
 Planning involves developing objectives and preparing various budgets
to achieve those objectives
 Budgets force managers to think ahead regarding how to achieve
various financial goals
 The budgeting process leads to the best way to use available resources
• Coordination
 Budgets highlight linkages among departments and force them to
communicate and to work toward company goals
• Control
 Budgets define goals and objectives that can serve as benchmark for
evaluating actual performance
 Detect problem areas
 Evaluate managers’ performance

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 Choosing a Budget Period
• Annual operating budget covers a one-year period
corresponding to a company’s fiscal year
 Many companies divide their annual budget into four quarters

• A continuous budget is a 12-month budget that rolls

forward one month (or quarter) as the current month (or
quarter) is completed

Operating Budget

2014 2015 2016 2017

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 Preparing the Master
Budget*

* master budget – full package of operating

budgets for all areas of operations + financial
6 budgets
 An Overview of Master Budget
Operating budgets
Sales
Sales budget
budget

Ending Selling
Selling and
and
Ending Production
inventory Production budget
budget administrative
administrative
inventory
budget budget
budget
budget

Direct
Direct materials
materials Direct
Direct labor
labor Manufacturing
Manufacturing
budget
budget budget
budget overhead
overhead budget
budget

Cash
Cash Budget
Budget
Not required
Budgeted
Budgeted Budgeted
Budgeted
income
income balance
balance sheet
sheet
statement
statement
Financial budgets
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 Sales Budget
• Starting point for master budget
 How much sales revenue will we earning in the following year?
• Based on:
 The budgeted price you expect to charge
 Expected future unit sales (estimates from Marketing)

Budgeted Sales Revenue = Budgeted price *

Budget unit sales

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 Example: Royal Company
• Royal Company is preparing budgets for the quarter ending June
30th. Budgeted sales for the next five months are:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units
• The budgeted selling price is $10 per unit.
• The sales budget for the second quarter is

April May June Quarter

Budgeted 20,000 50,000 30,000 100,000

sales in units
Selling price $10 $10 $10 $10
Budget sales $200,000 $500,000 $300,000 $1,000,000
revenue
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 Production Budget
• How many units do we need to produce?
• Budgeted production depends on:
 expected sales in units (from the sales budget)
 firm’s inventory policy for finished goods

Sales
Sales budget
budget

Production
Production budget
budget

Ending Inventory = Beginning Inventory for the following period

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 Production Budget
Example: The management at Royal Company wants ending inventory
to be equal to 20% of the following month’s budgeted sales in units
Beginning Inventory in April = Ending Inventory in March = 20,000*20%=4,000
Budgeted sales in July is 25,000 units

April May June Quarter From the Sales

budget
Sales in units 20,000 50,000 30,000 100,000
+Desired ending 50,000*20% 30,000*20% 25,000*20% 5,000 based on
inventory inventory policy
=10,000 =6,000 =5,000
=Total requirements 30,000 56,000 35,000 105,000
-beginning inventory 4,000 10,000 6,000 4,000 =ending inventory
from previous
=Units to be produced 26,000 46,000 29,000 101,000 quarter

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 Exercise: Production Budget
April May June
Desired ending inventory (1) (4) (6)
Beginning inventory 1,000 (3) (5)
Budgeted sales 10,000 15,000 20,000
Budgeted production (2) 15,500 21,000
Inventory policy: desired ending inventory for current month = 10%
of expected sales for next month.

Required: Fill in the missing numbers

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 Budgets for Inputs (DL, DM and Overhead)
• Direct Materials Budget
• Based on estimates of materials per unit of product, and
prices of materials
• Direct Labor Budget
• Based on estimates of DL hours per unit of product, and
wage per hour
• Manufacturing Overhead
• Based on estimates of fixed overhead and variable
overhead per unit of product

Production
Production budget
budget

Direct
Direct materials
materials Direct
Direct labor
labor Manufacturing
Manufacturing
budget
budget budget
budget overhead
overhead budget
budget
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 Direct Materials Budget
The direct materials budget details
Production
Production budget
budget
the raw materials that must be
purchased to fulfill the production
budget and to provide for adequate Direct
Direct materials
materials budget
budget
inventories

Example: at Royal Company, 5 pounds of materials are

required per unit of product.
Management wants materials on hand at the end of each
month equal to 10% of the following month’s production.
On March 31, 13,000 pounds of materials are on hand.
Material cost is $0.40 per pound.

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 Direct Materials Budget for Royal Company
April May June Quarter
Units to be produced 26,000 46,000 29,000 101,000
Materials per unit (lbs) 5 5 5 5
Production needs (26000*5) = 230,000 145,000 505,000
130,000
Add: Desired ending 230,000*10% 145,000*10% 11,500 11,500
Inventory =23,000 =14,500 (assumed)

Total needed 153,000 244,500 156,500 516,500

Less: Beginning Inventory 13,000 23,000 14,500 13,000
Materials to be purchased 140,000 221,500 142,000 503,500
Cost of materials 140,000*0.4 221,500*0.4 142,000*0.4= 503,500*0.4
purchased =56,000 =88,600 56,800 =201,400
Desired ending inventory = 10% of the following month’s production needs
On March 31, 13,000 pounds of materials are on hand.
Material cost is $0.40 per pound.

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 Direct Labor Budget

The direct labor budget shows the Production

Production budget
budget
direct labor-hours required to satisfy
the production budget
Direct
Direct labor
labor budget
budget

• At Royal, each unit of product requires 0.05 hours (3

minutes) of direct labor.
• Because of no-layoff policy, the direct labor workforce
will be paid for a minimum of 1,500 hours per month for
the next three months
• Workers are paid at the rate of $10 per hour regardless
of the hours worked.

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 Direct Labor Budget for Royal Company
April May June Quarter
Units to be produced 26,000 46,000 29,000 101,000
Direct Labor per unit (hrs) 0.05 0.05 0.05 0.05

Labor hours required 1,300 2,300 1,450 5050

Guaranteed labor hours 1,500 1,500 1,500

Labor hours paid 1,500 2,300 1,500 5,300

Hourly wage rate $10 $10 $10 $10
Total direct labor costs 1500*10= 2300*010= 1500*10= 5300*10=
$15,000 $23,000 $15,000 $53,000

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 Manufacturing Overhead Budget

The manufacturing overhead Production

Production budget
budget
budget includes budgeted variable
overhead cost and fixed overhead
Manufacturing
Manufacturing overhead
overhead
cost budget
budget

• At Royal, manufacturing overhead is applied to units

of product on the basis of direct labor hours
• The variable manufacturing overhead rate is $20 per
direct labor hour
• Fixed manufacturing overhead is $50,000 per month
(primarily depreciation of plant assets)

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 Manufacturing Overhead Budget for Royal Company

April May June Quarter

Direct Labor Hours 1,300 DLH 2,300 DLH 1,450 DLH (1300+2300
Required +1450)=
5,050 DLH
Variable manufacturing $ 20 per DLH $ 20 per DLH $ 20 per DLH $20 per DLH
overhead rate
Budgeted variable $26,000 $46,000 $29,000 $101,000
manufacturing
overhead cost
Budgeted fixed $50,000 $50,000 $50,000 $150,000
manufacturing
overhead cost
Budgeted total $76,000 $96,000 $79,000 $251,000
manufacturing
overhead cost

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 Ending Finished Goods Inventory Budget
• Ending finished goods inventory budget details the budgeted
unit product cost, ending finished goods inventory in units (the
number of unsold units), and ending finished goods inventory in
dollars (the cost of unsold units)
• Ending finished goods inventory needed for two reasons
 To determine the cost of goods sold on the budgeted income
statement
 To value ending inventories on the budgeted balance sheet

Production
Production budget
budget

Ending
Ending finished
finished goods
goods
inventory
inventory budget
budget

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 Ending finished goods inventory budget for Royal Company
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $0.4 $2.00
Direct labor 0.05 hrs. $10.0 $0.50
Manufacturing overhead 0.05 hrs. $49.7 $2.49
$4.99

Budgeted finished goods inventory

Ending inventory in units

Unit product cost $4.99

Ending finished goods inventory ???

Total mfg. OH for quarter $251,000

Total labor hours required 5,050 = $49.70 per hour

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 Ending finished goods inventory budget for Royal Company

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $0.4 $2.00
Direct labor 0.05 hrs. $10.0 $0.50
Manufacturing overhead 0.05 hrs. $49.7 $2.49
$4.99

Budgeted finished goods inventory

Ending inventory in units 5,000

Unit product cost $4.99

Ending finished goods inventory 24,950

Production Budget

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 Selling and Administrative Expense Budget

• Selling and Administrative Sales

Sales budget
budget
Budget lists non-
manufacturing expenses Selling
Selling &
& Administrative
Administrative
Budget
Budget

• At Royal, the selling and administrative expense budget is divided

into variable and fixed components
• The variable selling and administrative expenses are $0.50 per
unit sold
• Fixed selling and administrative expenses are $70,000 per month
• The fixed selling and administrative expenses include $10,000 in
costs – primarily depreciation – that are not cash outflows of the
current month

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 Selling and Administrative Budget for Royal Company

From Sales
Budget

April May June Quarter

Budgeted sales 20,000 50,000 30,000 100,000
Budgeted Variable S&A 0.5 0.5 0.5 0.5
rate
Budgeted Variable S&A 10,000 15,000 15,000 50,000
expenses
Budgeted Fixed S&A 70,000 70,000 70,000 210,000
expenses
Budgeted Total S&A 80,000 95,000 85,000 260,000
expenses

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 Consolidate for Financial Budgets
Operating budgets
Sales
Sales budget
budget

Selling
Selling and
and
Ending
Ending administrative
Production
Production budget
budget administrative
inventory
inventory budget
budget
budget
budget

Direct
Direct materials
materials Direct
Direct labor
labor Manufacturing
Manufacturing
budget
budget budget
budget overhead
overhead budget
budget

Budgeted
Budgeted
Financial budgets income
income Cash
Cash budget
budget
statement
statement

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 Budgeted Income Statement
• Budgeted income statement shows the company’s
target revenues, expenses and profit.
 It summarizes the financial results of operation budgets,
including sales, production, direct materials, direct labor,
manufacturing overhead, and selling and administrative
budgets
• Budgeted income statement serves as a benchmark
against which subsequent actual performance can be
measured
 Detect the problematic areas in a firm
 Evaluate the performance of managers

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 Royal Company
Budgeted Income Statement
For the Three Months Ended June 30

Sales (100,000 units @ $10) $1,000,000 Sales Budget

Less: Cost of goods sold (100,000 @ $499,000 Ending Finished
Goods Inventory
$4.99) Budget

Gross margin $501,000

Selling and
Selling and administrative expenses $260,000 Administrative
Expense Budget
Operating income $241,000

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 Cash Budget
• Cash Budget details cash inflows and outflows
• Revenues and costs on the income statement differ
from actual cash inflows and outflows
 revenues are recorded when the product was sold, not when
the $$$ was actually received
 product costs are expensed when the product was sold
(matching of costs to revenues), not when the cost was actually
incurred
 depreciation is a non-cash cost item (not a cash outflow)
 special items
• Firms use cash budget to determine whether they
will have enough cash on hand to sustain operations
 Cash shortage can be managed by accelerating revenues,
deferring payments, or borrowing

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 Format of the Cash Budget
• The cash budget is divided into four sections:
 Cash receipts section lists all cash inflows excluding cash
received from financing
 Cash disbursements section consists of all cash payments
excluding repayments of principal and interest
 Cash excess or deficiency section determines if the
company will need to borrow money or if it will be able to repay
funds previously borrowed; Cash inflow – cash outflow
 Financing section details the borrowings and repayments
projected to take place during the budget period

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 Cash Inflows from Operations
• The main cash inflow is proceeds from sales
• To estimate cash inflows, sales revenue needs to be adjusted
for the firm’s credit policy:
 if you offer credit to customers, some of them will pay you weeks or
months after the sale
 sales revenue is recognized on the income statement when the sale
took place, not when you actually received the $$$

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 Example: Cash receipts from Credit Sales
• Many of your customers buy on credit (i.e., part of sales
revenue is collected several months after the sale).
On average, you collect 60% of revenue in the month of sale,
35% of revenue in the following month, and 5% of revenue 2
months later. What are your cash inflows in May?

Month Sales Month March April May

March $150
April $100
March 150x60%1 150x35% = 150x5% =
May $130 52.5 7.5
April 100x60%= 100x35% =
60 35
May 130x60% =
78
Cash 78+35 +7.5
Collection = 120.5
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 Exercise: Cash receipts from credit sales
• Wallmart’s budgeted sales are as follows:
January $150,000
February $160,000
March $172,000
The company expects to collect 75% of a month’s
sales in the month of sale and 25% in the following
month.
• Question: What are the cash receipts for February?

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 Example: Royal Company’s Cash Receipts
Royal Company’s Sales Budget
April May June Quarter
Budgeted sales in units 20,000 50,000 30,000 100,000
Selling price $10 $10 $10 $10
Budget sales revenue $200,000 $500,000 $300,000 $1,000,000

• At Royal Company, all sales are on account.

• Royal’s credit policy is
 70% collected in the month of sale
 25% collected in the month following sale
 5% uncollectible
• In April, the March 31st accounts receivable balance of $30,000 will
be collected in full.

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 Royal Company’s expected cash receipts
April May June Quarter
Accounts receivable 3/31 $30,000 $30,000

April Sales

70% * $200,000 $140,000 $140,000

25% * $200,000 $50,000 $50,000

May Sales

70%*$500,000 $350,000 $350,000

25%*$500,000 $125,000 $125,000

June Sales

70%*$300,000 $210,000 $210,000

Total cash collections $170,000 $400,000 $335,000 $905,000

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 Cash Outflows from Operations
Cash outflows from operations: purchases of direct
materials, payment to direct labor, expenditures on
manufacturing overhead and SG&A costs
 adjust for credit terms with suppliers
 adjust for non-cash items (e.g., depreciation)

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 Example: Royal Company’s Cash Disbursement

Royal Company’s Direct Materials Budget

April May June Quarter
Materials to be purchased (lbs) 140,000 221,500 142,000 503,500
Materials price per pound $0.4 $0.4 $0.4 $0.4
Cost of materials purchased $56,000 $88,600 $56,800 $201,400

Royal pays $0.4 per pound for its materials

• Royal Company’s cash payment policy
 50% of a month’s purchase is paid for in the month of purchase;
50% is paid in the following month
 The March 31 accounts payable balance is $12,000

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 Royal Company’s expected cash disbursement for materials

April May June Quarter

Accounts payable 3/31 $12,000 $12,000

April Purchases

50% * $56,000 $28,000 $28,000

50% * $56,000 $28,000 $28,000

May Purchases

50%*$88,600 $44,300 $44,300

50%*$88,600 $44,300 $44,300

June Purchases

50%*$56,800 $28,400 $28,400

Total cash disbursements $40,000 $72,300 $72,700 $185,000

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 Royal Company’s Cash Disbursement for labor, manufacturing
overhead, selling & administrative expenses

• Royal Company - Non Cash Items

 Fixed manufacturing overhead includes $20,000 of noncash costs
(primarily depreciation of plant assets)
 Fixed selling and administrative expenses include $10,000 in costs –
primarily depreciation – that are not cash outflows of the current month

Cash disbursement April May June Quarter

Budgeted direct labor cost $15,000 $23,000 $15,000 $53,000
Budgeted variable manufacturing $26,000 $46,000 $29,000 $101,000
overhead

Budgeted fixed manufacturing 50,000-20,000 50,000-20,000 50,000-20,000 $90,000

overhead =30,000 =30,000 =30,000

Budgeted variable S&A expenses 10,000 15,000 15,000 $50,000

Budgeted fixed S&A expenses 70,000-10,000 70,000-10,000 70,000-10,000 $180,000
=60,000 =60,000 =60,000

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 Special Items
• Adjust for special items
 Cash outflows: purchase of machines, payment of dividends, loan
payments
 Cash inflows: sale of machines, sale of stock in capital market, loans
received
•Special items in Royal Company
 An April 1 cash balance of $40,000
 Purchases $143,700 of equipment in May and $48,300 in June
(both purchases paid in cash)
 Pays a cash dividend of $49,000 in April
 Maintains a minimum cash balance of $30,000
 Borrows on the first day of the month and repays loans one year
later

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 Royal Company’s Cash Budget
April May June Quarter
Beginning cash balance $40,000 $30,000 $30,000 $40,000
Add: Cash collections $170,000 $400,000 $335,000 $905,000
Total cash available $210,000 $430,000

Less: Cash disbursements

Materials $40,000 $72,300 $72,700 $185,000

Direct labor $15,000 $23,000 $15,000 $53,000
Manufacturing overhead $56,000 $76,000 $59,000 $191,000
Selling and administrative $70,000 $75,000 $75,000 $230,000
Equipment purchase - $143,700 $48,300 $192,000
Dividend $49,000 - - $49,000
Total disbursements $230,000 $400,000 270,000 $900,000
Excess (deficiency) $(20,000) $30,000 95,000 $45,000
Financing:

Borrowing $50,000 - - $50,000

Repayments - - -

Total financing $50,000 - -

Ending cash balance $30,000 $30,000 $95,000 $95,000

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