Chapter 10 | Forecasting Short-Term Operating Financial Requirements

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✎ Expected Learning Outcomes
After studying Chapter 10, you should be able to:
1. Understand the relationship between financial planning and control.
2. Know the nature, purposes and limitations of the budget.
3. Enumerate the types of budgets.
4. Understand and apply the steps in developing a master budget.

Chapter 10 - Forecasting Short-Term Operating Financial Requirements

10.1: FINANCIAL PLANNING AND CONTROL PROCESS

Business is becoming increasingly competitive and corporate profitability is

increasingly dependent upon operating efficiency. This situation is desirable
from a social standpoint, for consumers are getting higher quality goods at
lower prices but intense competition does make life tough on corporate
managers.

In the previous chapter, focus was given on financial forecasting

emphasizing how growth in sales requires additional investments in assets
which in turn generally requires the firm to raise new external capital.

This chapter will now consider the planning or budgeting and control or
evaluation systems used by financial managers covering a period of one year
or less.

Financial planning involves making projections of sales, income, and assets

based on alternative production and marketing strategies and then deciding
how to meet the forecasted financial requirements. In the financial planning
process, managers should also evaluate plans and identify changes in
operations that would improve results. Financial control moves on to the
implementation phase dealing with the feedback and adjustment process
that is required (a) to ensure that plans are followed and, (b) to modify
existing plans in response to changes in the operating environment. The
process begins with the specification of the corporate goals, after which
management lays out a series of forecasts and budgets for every significant
area of the firm’s activities, as shown in Figure 10-1.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Financial forecasting analysis begins with projections of sales revenues and

production costs. In standard business terminology, a budget is a plan
which sets forth the projected expenditures for a certain activity and
explains where the required funds will come from. Thus, the production
budget presents a detailed analysis of the required investments in materials,
labor, and plant necessary to support the forecasted sales level. Each of the
major elements of the production budget is likely to have a sub-budget of its
own; thus, there will be a materials budget, a personnel budget and a
facilities budget. The marketing staff will also develop selling and advertising
budgets. Typically, these budgets will be set up on a monthly basis, and as
time goes by, actual figures will be compared with projected figures for the
remainder of the year will be adjusted if it appears that the original
projections were unrealistic.

During the planning process, the projected levels of each of the different
operating budgets will be combined, and from this set of data the firm’s cash
flow will be set forth in its cash budget. If a projected increase in sales leads
to a projected cash shortage, management can make arrangements to obtain
the required funds in the least-cost manner.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

After all the cost and revenue elements have been forecasted, the firm’s
projected statements can be developed. These projected statements are later
compared with the actual statements such as; comparisons can help the
firm pinpoint reasons for deviations, correct operating problems, and adjust
projections for the remainder of the budget period to reflect actual operating
conditions. Through its financial planning and control processes,
management seeks to avoid cash squeezes and to improve the profitability of
the individual divisions and thus the entire company.

10.2: BUDGETING DEFINED

Budgeting is the act of preparing a budget. A budget is a financial plan of the

resources needed to carry out tasks and meet financial goals. It is also a
quantitative expression of the goals the organizations wish to achieve and
the cost of attaining these goals. The use of budgets to control a firm’s
activities is known as budgetary control.

10.3: THE PURPOSES OF THE BUDGET

A budget is a description in quantitative – usually monetary – terms of a

desired levels to focus on the future of the business entity. The benefits that
may be realized from a budgeting program are;
1. Defining broad objectives and goals and formulating strategies to
achieve such objectives;
2. Coordinating the activities of the organization by integrating the plans
of the various parts thereby pulling everyone in the same direction;
3. Allocating resources to those parts of the organization where they can
be used most effectively;
4. Communicating management’s approved plans throughout the
organization;
5. Uncovering and preparing for potential bottleneck in the operations
before they occur;
6. A motivating manager to achieve the desired results; and
7. Setting a standard or benchmark for evaluating actual performance.

10.4: ADVANTAGES AND LIMITATIONS OF BUDGETS

The advantages of budgeting include:

1. It forces planning and exposes situations in which plans of
subcomponents are inadequate to attain the total organization’s
objectives.
2. It allows a reiterative process to bring the goals of the organization and
the subcomponents into agreement.
3. It provides a means of communicating organization goals down
through the organization and sub-unit operational limitations up
though the organization.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

4. It provides a basis for financial planning, sub-unit coordination,

resource acquisition, inventory policy, scheduling and output
distribution.
5. It provides a basis by which activity can be monitored, with actual
results being compared to the planned results.

The limitations of budgeting are:

1. Budgets tend to oversimplify the real situation and fail to allow for
variations in external factors. They do not reflect qualitative variables.
2. It is difficult to prepare a detailed budget for an organization that has
never existed or for a new division, product, or department of an
existing firm.
3. There may be lack of higher and lower management commitment
because of lack of understanding of the fundamentals of budget
preparation and utilization.,
4. The budget is only a representation of future plans or a means to the
goal of profitable activity and not an end in itself. It may interfere with
the supervisor’s style of leadership and can therefore stifle initiative.
5. Budget reports usually emphasize results, not reasons.

10.5: TYPES OF BUDGETS

The types of budgets or the major composition of the master budget are:
(a) The Operating Budget (b) The Financial Budget and; (c) The Capital
Investment Budget.

The following is a simplified sub classification of the abovementioned types

of budgets for a manufacturing firm:

10.5.1: The Operating Budget

1. Budgeted Income Statement
A. Sales Budget
The sales budget contains an itemization of a company’s sales expectations
for the budget period, in both units and dollars. If a company has a large
number of products, it usually aggregates its expected sales into a smaller
number of product categories or geographic regions; otherwise, it becomes
too difficult to generate sales estimates for this budget.

B. Production Budget
• Materials cost budget - The materials cost budget calculates the materials
that must be purchased, by time period, in order to fulfil the requirements of
the production budget. It is typically presented in either a monthly or
quarterly format in the annual budget. In a business that sells products, this
budget may contain a majority of all costs incurred by the company, and so
should be compiled with considerable care. Otherwise, the result may
erroneously indicate excessively high or low cash requirements to fund
materials purchases.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

• Direct labor cost budget - The direct labor cost budget is used to
calculate the number of labor hours that will be needed to produce the units
itemized in the production budget. A more complex direct labor budget will
calculate not only the total number of hours needed, but will also break
down this information by labor category. The direct labor budget is useful for
anticipating the number of employees who will be needed to staff the
manufacturing area throughout the budget period. This allows management
to anticipate hiring needs, as well as when to schedule overtime, and when
layoffs are likely. The budget provides information at an aggregate level, and
so is not typically used for specific hiring and layoff requirements.
• Factory overhead budget - The factory overhead budget contains all
manufacturing costs other than direct materials and direct labor. The
information in this budget becomes part of the cost of goods sold line item in
the master budget. The total of all costs in this budget are converted into a
per unit overhead allocation, which is used to derive the cost of ending
finished goods inventory, and which in turn is listed on the budgeted
balance sheet. The information in this budget is among the most important
of the various departmental budget models, since it may contain a large
proportion of the total amount of a company’s expenditures.
• Inventory levels - The inventory levels calculate the cost of the finished
goods inventory at the end of each budget period. It also includes the unit
quantity of finished goods at the end of each budget period, but the real
source of that information is the production budget. It contains an
itemization of the three main costs that are required to be included in the
inventory asset under both generally accepted accounting principles and
international financial reporting standards. These costs and their derivation
are direct materials, direct labor and overhead allocation.

2. Cost of Sales budget - Cost sales budget or also called cost of goods
sold (COGS) budget is essentially part of your operating budget. COGS
is the direct expense or cost of the production for the goods sold by a
business. These expenses include the costs of raw material and labor
but do not include indirect costs such as that of employing a
salesperson.

3. Selling and Administrative expenses budget - The selling and

administrative expense budget lists the operating expenses involved in
selling the products and in managing the business. Just as in the case
of the factory overhead budget, this budget can be developed using the
cost-volume (budget) formula in the form of (y = a + bx).

4. Financial expense budget - A financial budget in budgeting means

predicting the income and expenses of the business on a long-term
and short-term basis. Accurate projections of cash flow help the
business achieve its targets in the right way.

10.5.2 The Financial Budget

1. Budgeted Statement of Financial Position - Budgeted financial
statements may comprise the complete set of financial statements,

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

which are: These statements are compiled from the annual budgeting
model of a business. They are useful for estimating the financial
results, financial position, and cash flows of a business as of various
dates in the future.

2. Cash budget - A cash budget represents the expected future cash flow
of an organization over a defined period of time. It is an estimate of the
cash receipts expected in the future over the budget period, the
expenditure to be incurred in cash, and finally, the cash balance with
the company at the end of the period.

3. Budgeted Statement of Sources and Uses of Funds - The statement

of sources and uses of funds is a statement that condenses the
financial statements and financial plan in one statement. It displays
the sources from which an organization or a company manages to
generate cash and all the areas where the obtained cash is used
during an accounting period.

10.5.3: The Capital Investment Budget

Capital investment budget is the process of making investment decisions in
long term assets. It is the process of deciding whether or not to invest in a
particular project as all the investment possibilities may not be rewarding.
Thus, the manager has to choose a project that gives a rate of return more
than the cost financing such a project.

10.6: STEPS IN DEVELOPING A MASTER BUDGET

The major steps in developing a Master Budget may be outlined as follows:

1. Establish basic goals and long-range plans for the company. These will
serve as guidelines in the preparation of budget estimates.
2. Prepare a sales forecast for the budget period.
3. Estimate the cost of goods sold and operating expenses.
4. Determine the effect of budgeted operating results on assets, liabilities
and ownership equity accounts.
The cash budget is the largest part of this step, since changes in many
asset and liability accounts will depend upon the cash flow forecast.
5. Summarize the estimated data in the form of a projected income
statement for the budget period and the projected statement of
financial position as of the end of the budget period.

Figure 10-2 depicts the sequence and types of budgets commonly found.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

10.1: Illustrative Case

Comprehensive Master Budget Preparation

Gilbert Manufacturing Company manufactures a special line of tools. As of
December 31, 20X4, the Statement of Financial Position of the firm is as
follows:

Gilbert Company Statement of Financial Position

December 31, 20X4
Assets Equity
Current assets Current liabilities
Cash ₱150,000 Accounts payable ₱140,000
Accounts receivable 220,000 Taxes payable 156,000
Inventories 592,000 Current portion of
Other current assets 23,000 long-term debt 83,000
Total current assets ₱985,000 Total current liabilities ₱379,000
Long-term assets Long-term liabilities 576,000
Property, plant and Total liabilities ₱955,000
equipment ₱2,475,000 Equities
Less: Accumulated Share capital ₱ 350,000
depreciation 850,000 Retained earnings 1,305,000
Net ₱1,625,000 Total ₱1,655,000
Total assets ₱2,510,000 Total equities ₱2,610,000

The following information is available for the development of its Master

Budget for 20x5:
Estimated sales;
Units 6,400
Price per unit ₱ 800
Finished goods inventory:
Beginning 900 units @ ₱ 500
Ending 1,000
Work in process
inventory:
NONE

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Raw Materials:
Material
R S
Materials required per unit of finished 3 units 5 units
product 2,200 4,000
Beginning inventory 1,300 4,600
Ending inventory ₱ 10 ₱ 30
Unit cost
Direct labor ₱146 per unit produced

Overhead is estimated as follows:

Variable:
Indirect materials and ₱5.85 per unit produced
supplies 9.07 per unit
Materials handling 5.07 per unit
Others indirect labor
Fixed: ₱175,000
Supervisor labor 85,000
Maintenance & repair 173,000
Plant administration 87,000
Utilities 280,000
Depreciation 43,000
Insurance 117,000
Property taxes 41,000
Other
Marketing and Administrative expenses are budgeted as follows:
Marketing Variable Costs:
Sales commission ₱40.625 per unit sold
Other marketing costs ₱16.250 per unit sold
Fixed marketing costs:
Sales salaries ₱100,000
Advertising 193,000
Other 78,000
Administrative costs (all fixed):
Administrative salaries ₱254,000
Data processing services 103,000
Legal and other professional fees 180,000
Depreciation – building, furniture and 94,000
equipment 160,000
Taxes – other than income 26,000
Other

Additional information:
The treasurer’s office also provided the following information and estimates:
1. All sales are on account and collections from customers are expected
to amount to P5,185,000.
2. Equipment costing P300,000 with accumulated depreciation of
1275,000 will be sold at its net book value, New equipment costing
P320,000 will be purchased during the year.
3. Accounts payable will increase by P15,000 and assumed to be for
materials purchases only.
4. Income taxes will be provided at an average rate of 35% of income
before taxes while P252,000 will be paid during the year.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

5. Dividends amounting to P140,000 will be paid during the year and the
current portion of the long-term debt shall also be settled at the end of
the year. Interest rate is 8% per annum.

REQUIRED: Prepare the Master Budget for Gilbert Company for the year
ending December 31, 20XS.
Based on the above preliminary data, each of Gilbert Company’s budgets will
now be discussed and illustrated.

Sales Budget
The sales budget showing what products will be sold in what quantities at
what prices, is the foundation on which all other short-term budgets are
built. The sales budget triggers a chain reaction that leads to the
development of many other budget figures in an organization. The sales
budget provides the revenue predictions from which cash receipts from
customers can be estimated and supplies the basic data for constructing
budgets for production costs and selling and administrative expenses. In
short, the sales forecast is the keystone of the budget structure. The
accuracy and reasonableness of the sales data will affect the whole budget.

The sales forecast is made after consideration of the following factors:

1. Past sales volume
2. General economic and industry conditions
3. Relationship of sales to economic indicators
4. Relative product profitability
5. Market research studies and competition
6. Pricing, advertising and other promotion policies
7. Production capacity 8. Quality of sales force
8. Quality of Sales Force
9. Seasonal variations
10. Long-term sales trends for various production

For Gilbert Company, the Sales Budget is presented follows:

Section 1
Sales Budget
For 20x5
Units Price Per Unit Total Sales Revenue
Estimated 6,400 800 ₱5,120
sales

Production Budget
After the sales budget has been set, a decision can be made on the level of
production that will be needed for the period to support sales and the
production budget can be set as well. The production budget becomes a key
factor in the determination of other budgets, including the direct materials
budget, the direct labor budget and the manufacturing overhead budget.
These budgets in turn are needed to assist in formulating a cash budget.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Using the data from the previously prepared sales budget as well as the
inventory summary information, the following production budget is
developed.

Section 2
Production Budget
For 20x5
Units to be sold 6,400
Add: Desired ending 1,000
inventory 7,400
Total 900
Less: Beginning inventory 6,500
Units to be produced

Raw Materials Budget

After determining the number of units to be produced, the Raw Materials
Purchases can now be prepared, as follows:

Section 3
Raw Materials Purchases
For 20x5
Materials
Units required for production R S
R (6,500) x 3 19,500
S (6,500) x 5 32,500
Add: Desired ending inventory 1,300 4,600
Total units required 20,800 37,100
Less: Beginning inventory 2,200 4,000
Units to be purchase 18,600 33,100
Units price x P10 x P30
Total purchases ₱186,000 ₱993,000
Direct Labor Budget
The preliminary data show that the budgeted direct labor cost per unit
produced is P146. This must have been arrived at after considering such
factors as skills level of the workers, labor rate per hour, time requirement,
conditions of union contracts, etc.

The direct labor is therefore budgeted as follows:

Section 4
Numbers of units to be produced 6,500
Multiply by: Direct labor per cost per 146
unit ₱949,000
Total budgeted direct labor costs

Overhead Cost Budget

Study of past records will show how the cost reacts to changes in volume or
in relation to other factors. Some overhead items may be projected on the
basis of direct labor hours or on materials costs or on machine hours.

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

The overhead costs budget for 20X5 is illustrated below using the basic
information from the preliminary data previously established.

Section 5
Budgeted Manufacturing Overhead
For 20x5
Variable overloaded: units needed to produce 6,500 units
Indirect materials and supplies ₱38,000
(@P5.85) 59,000
Materials handling (@P9.07) 33,000
Other indirect labor (@P5.07) 130,000
Total
Fixed manufacturing overload 175,000
Supervisor labor 85,000
Maintenance & repairs 173,000
Plant administration 87,000
Utilities 280,000
Depreciation 43,000
Insurance 117,000
Property taxes 41,000
Others 1,001,00
Total ₱1,131,000
Total manufacturing overhead

Budgeted Cost of Sales

The Budgeted Cost of Sales Statement can now be developed using the data
from the following:

Production Budget Schedule 2

Raw Materials Budget Schedule 3
Direct Labor Budget Schedule 4
Overhead Cost Budget Schedule 5
Budgeted Statement of Cost of Schedule 6
Sales

Section 6
Budgeted Statement of Cost Sales
For 20x5
Beginning work in process inventory ₱ - .
Manufacturing costs
Direct materials
Beginning inventory
[(2,200 R @ ₱10) + (4,000 S @ ₱30)] ₱ 142,000
Purchases (Schedule 3) 1,179,000
Total 1,321,000
Less: Ending inventory
[(1,300 R @ ₱10) + (1,600 S @ ₱30)] 151,000
Total direct materials cost ₱ 1,170,000
Direct labor (6,500 @ ₱146) 949,000
Manufacturing overhead (Schedule 5) 1,131,000
Total manufacturing cost ₱ 3,250,000
Less: Ending work in process inventory _____-_____
Cost of goods manufactured ₱ 3,250,000

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Add: Beginning finished goods

Inventory (900 @ ₱500) 450,000
Total available for sale ₱ 3,700,000
Less: Ending finished goods
Inventory (1,000 @ ₱500) 500,000
Cost of sales ₱ 3,200,000

Marketing and Administrative Expense Budget

As with overhead costs, marketing and administrative expenses are also
made up of fixed and marketing variable components. The marketing and
administrative expense budget for 20X5 is shown on the next page.
Previously provided data are used.

Section 7
Budgeted Marketing and Administrative Cost
For 20x5
Variable marketing costs ₱260,000
Sales of commission (6,400 @ ₱40.625) 104,000
Others (6,400 @ ₱16.25) ₱364,000
Total
Fixed marketing costs ₱100,000
Sales salaries 193,000
Advertising 78,000
Others ₱371,000
Total ₱735,000
Total marketing costs
Administrative costs (all fixed) ₱254,000
Administrative salaries 103,000
Data processing services 180,000
Legal and other professional fees
Depreciation – building, furniture and equipment 94,000
Taxes – other than income 108,000
Others 26,000
Total 765,000
Total marketing and administrative costs ₱1,500,000

Cash Budget
Cash Receipts
Normally, the bulk of a firm’s cash receipts come from customers. The
possibility of cash from other sources (such as additional investments, sales
of assets, borrowings) should likewise be considered when cash receipts are
being budgeted.

Cash Disbursements
Data converted from individual budgets previously illustrated supply the
basic information for the cash disbursements budget. However, various
adjustments and additions will have to be made when preparing the budget
for prepayments, accruals as well extraneous items (such as the purchase of
new equipment, dividend payment) that do not show up in any of the

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

individual budgets already prepared. If the financial policy of the company

requires that is a minimum cash.

Section 8
Gilbert Manufacturing Company
Cash Budget
For the Budget Year Ending December 31, 20x5
Cash balance, Jan 1, 20x4 ₱ 150,000
Add estimated receipts
Collections from customers ₱ 5,185,000
Sales from assets 25,000
Total ₱ 5,210,000
Total cash available ₱ 5,360,000
Less: Estimated disbursements ₱ 1,164,000
Payment for material purchases
Direct labor 949,000
Manufacturing overhead 851,000
Marketing & Administrative expenses 1,458,000
Payments for income tax 252,000
Dividends 140,000
Reduction in long-term debt 83,000
Acquisition of new assets 320,000
Total disbarments ₱ 5,217,000
Cash balance, December 31 ₱ 143,000

Budgeted Income Statement

After the cash budget has been completed, Gilbert Company prepares the
budgeted income statement showing the net income that is to be expected
during the budget period. The information needed to prepare the budgeted
income statement comes from the previously provide preliminary data as
well as from the company’s other budgets.

Section 9
Gilbert Manufacturing Company
Budgeted Income Statement
For the Budgeted Year Ending
December 31, 20x5
Sales (Schedule 1) ₱5,120,000
Less: Cost of Sales (Schedule 6) 3,200,000
Gross profit ₱1,920,000
Less: Marketing and administrative
cost 1,500,000
(Schedule 7) ₱420,000
Net operating profit 52,000
Less: Interest expense ₱368,000
Net income before taxes 128,000
Less: Provision for income taxes (35%) ₱240,000
Net income after taxes

Budgeted Statement of Financial Position

The budgeted statement of financial position is developed by beginning with
the current statement of financial position and adjusting it for the data

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

Chapter 10 | Forecasting Short-Term Operating Financial Requirements

contained in the other budgets. Gilbert Company’s budgeted statement of

financial position is presented below:

Section 10
Gilbert Manufacturing Company
Budget Statement of Financial Position
December 31, 20x5
Assets Equities
Current assets Current Liabilities
Cash (Schedule 8) ₱143,000 Account payable ₱155,000
Accounts receivable 155,000 Taxes payable 32,000
Inventories 651,000 Current portion of
Other current assets 23,000 long-term debt ____-____
Total current assets ₱972,000 Total current
Long-term assets liabilities ₱187,000
Property, plant and ₱2,495,000 Long-term liabilities 576,000
equipment Total liabilities ₱763,000
Less: Accumulated 949,000 Equity
depreciation Share capital ₱350,000
Net ₱1,546,000 Retained earnings 1,405,000
Total assets ₱2,518,000 Total equities ₱2,218,000

Chapter 10 | Forecasting Short-Term Operating Financial Requirements