CHAPTER THREE

3. MASTER BUDGET
Learning objective:
 after completing this section you will be able to:
 Define budgeting and explain its advantage.
 Provide an overview of the budgeting process
 Prepare a master budget and explain the interrelationships among its supporting
schedules
 Describe the role of budgets in the overall management process
 Discuss the importance of strategy and its role in the master budgeting process
 Identify the reasons for sales forecast
 Understand the difficulties of sales forecasting
3.1. THE OVERALL PLAN AND CHARACTERISTICS OF
BUDGET
The master budget is the aggregation of all lower-level budgets produced by a company's
various functional areas, and includes budgeted financial statements, cash forecast, and a
financing plan. The master budget is typically presented in either a monthly or quarterly
format, or usually covers a company's entire fiscal year. An explanatory text may be
included with the master budget, which explains the company's strategic direction, how
the master budget will assist in accomplishing specific goals, and the management
actions needed to achieve the budget. There may also be a discussion of the headcount
changes that are required to achieve the budget. A master budget is the central planning
tool that a management team uses to direct the activities of a corporation, as well as to
judge the performance of its various responsibility centers.
3.1. The Overall Plan and Its Characteristics
Finance being the lifeblood of a business, financial planning is of utmost significance to a
businessman. Budget is an important tool for financial planning and control. Financial
planning is concerned with rising of funds and their effective utilization with a view to
maximize the wealth of the organization. In spite of a good financial plan, the desired
results may not be achieved if there is no effective control to ensure its effective
implementation. The budget represents a set of yardsticks and guidelines for use in
controlling internal operations of an organization. The discrepancy between plan
performance and actual performance is highlighted through the budgets. The organization
may have to change the course of its operation in a particular area or rallies its plans
keeping in view the changing conditions.
What is budget?
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific
period of time, usually a year. In other words, a budget is a systematic plan for the
utilization of manpower and natural resources. In a business budget represents an

1
 estimate of future costs and revenues. A budget prepared for the organization as a whole
is called master budget. Master budget is a comprehensive expression of managements
operating and financial plans for a future expression of managements operating and
financial plans for a future time period (usually a year) that is summarized in a set of
budgeted financial statements. If embraces the impact of both operating decisions and
financing decisions. Operating decisions centre on the use of scarce resources. Financing
decisions centre on how to obtain funds to acquired those resources. The master budget
has two components. These are operating budget and financial budget.
Operating budgets includes budgeted income statement and its supporting schedules.
Financial budget comprises the capital budget. Cash budget, budgeted balance sheet, and
budgeted statement of cash flows.
Master Budget

Operating Financial budget

Budget
How to utilize How to raise funds
The funds raised for the activities
Characteristics of budget
 It is prepared in advance and is derived from the long-term strategy of the organization.
 It relates to future period for which objectives or goals have already been laid down.
 It is expressed in quantitative form, physical or monetary or both

3.2. Advantages of Budgeting

Budgeting is advantageous for organizations, because:

1. Budgets foster organizational communication.
2. Budgets ensure a focus both on future events and on resolving day-to-day issues.
3. Budgets assign resources and the responsibility to use them wisely to managers who
are held accountable for their results.
4. Budgets can identify potential constraints before they become problems.
5. Budgets facilitate congruence between organizational and personal goals.
6. Budgets define organizational goals and objectives numerically, against which actual
performance results can be evaluated.

Budgeting: The act of preparing a budget is called budgeting. Budgeting is the process of
formulating an organization’s plan.
Budgeting is most useful when it is integrated with a company’s strategy.
Strategy specifies how an organization matches its own capabilities with the
opportunities in the marketplace to accomplish its objectives.
 What are our objectives?

2
  How do we create value for our customers while distinguishing ourselves from
our competitors?
 Are the markets for our products local, regional, national, or global?
 What trends affect our markets?
 How are we affected by the economy, our industry, and our competitors?
 What organizational and financial structures serve us best?
 What are the risks and opportunities of alternative strategies, and
 What are our contingency plans if our preferred plan fails?
Budgeting strategies
Budgeting strategy is the manner in which a company approaches the budgeting
processes.
NB: Budgeting strategy is the starting point in preparing plans and budgets.
The four budgeting strategies are
a. Mandated budgeting or top down budgeting
It is developed by the top management and passes to the lower level managements for
implementation.
b. Participative budgeting or bottom up budgeting
It is developed by the lower level managers and continues up to the top managers.
c. Incremental budgeting
It uses the current period’s budget as a starting point in preparing the next period’s
budget.
d. Zero based budgeting
In which the company begins from zero in each budget period.
Do you think really know where your money is going?
3.2. ADVANTAGES OF BUDGETING
A. Coordination and Communication
 Coordination is interconnecting and balancing all aspects of production or
service and all departments in a company in the best way for the company to meet
its goals.
 Communication is making sure those goals are understood and accepted by all
employees.

3
Thus the budgeting process forces managers of departments, sections, and segments to
think of the relationship of their function with other centers, departments, and how to
coordinate with other departments to achieve the overall company plan, Coordination
forces executives to think of relationships among individual operations, departments, and
the company as a whole.
For coordination to succeed, communication is essential. The purchasing manager must
know the production plan. The production manager must know the sales plan, and so on.
Therefore budget is a formal document used to communicate a consistent set of plans to
the organization as a whole.
B. Resource Allocation
Because of resources are limited, businesses require some type of allocation for
operation. Businesses aids resource allocation by ensuring that information is available to
help managers and determine which activities should receive the limited resources of the
company. In addition, through the budgeting process, companies can analyze activities to
determine if they add value for the company.
C. Performance measurement (evaluation and control)
Evaluation and control process consists of comparing actual performance result to the
budget to determine deviated areas from the planned activities and to make corrective
actions
A budget is also a financial plan to control future operations and results. It is expressed in
numbers, such as dollars, units, pounds, hours, manpower, and so on. It is needed to
operate effectively and efficiently.
As such a budget serves as a useful benchmark against which to evaluate and control
actual performance.
D. Motivation
Most employees are motivated to work more intensely to avoid failure than to achieve
success. As employees get closer to a goal, they work harder to achieve it. Therefore,
many executives like to set demanding but achievable goals for their subordinate
managers and employees.
The involvement of lower management in preparation of budgets, promotes common
understanding & acceptance of organizational goals. Setting up a challenging &

4
achievable target acceptable by managers encourages initiative, responsibility &
commitment.
Individuals are motivated to work hard to avoid failure more so than they are motivated
to achieve success, as individuals get closer to a goal, they work harder to achieve it.
3.3. TYPES OF BUDGETS
Budgets are classified in different ways.
A. Based on capacity:
Based on the capacity, budgets are classified as fixed and flexible budgets.
Fixed Budgets: A fixed budget is one which will remain unchanged immaterial of the
level of activity these budgets are prepared for fixed expenses and their aim is to control
cost. A fixed budget is rigid and does not change with the volume of activity achieved.
A fixed budget is prepared for a particular level of activity and for a particular set of
conditions.
It is prepared under the premise that there will be no change in the outside conditions.
Flexible Budgets: These budgets will change with the change in activity these budgets
are prepared for various level of activity. While preparing flexible budgets the expenses
are broadly classified as fixed, variable and semi-variable expenses.
A flexible budget can be changed to suit the level of activity to be achieved. Flexible
budget is not rigid. Flexible budgets are prepared for various levels of activities.
B. Based On Time
Though budgets may cover long periods (called long-range budgets), the most frequently
used budget period is one year (short-range budgets). The annual budget is often
subdivided by months for the first quitter and by quarters for the remainder of the year.
Companies are increasingly using rolling budgets. A rolling budget is always available
for a specified future period by adding a period (month, quarter, or year) in the future as
the period just ended is dropped. Rolling budgets are sometimes called revolving
budgets or continuous budgets. Therefore continuous (rolling) budget is a budget
system that has a budget for a set number of months, quarters, or years at all times–as one
period ends another is added
C. Based on coverage
On the basis of coverage, budgets are classified as functional and master budget.

5
 i. Functional budgets
It represents the budgets that relates to the various functional activities of an organization.
Functional budgets are classified as physical budgets, profit budgets, cost budgets and
financial budgets.
ii. Master budgets
Activity: What is master budget?
Definition: Master budgets are the consolidated summary of various functional budgets.
It is the aggregation of all lower-level budgets produced by a company's various
functional areas, and also includes budgeted financial statements, cash forecast, and a
financing plan. The master budget is typically presented in either a monthly or quarterly
format, or usually covers a company's entire fiscal year.
A master budget is the central planning tool that a management team uses to direct the
activities of a corporation, as well as to judge the performance of its
various responsibility centers.
Thus budget represents the “grand plan of action” for an upcoming period and translates
the organization’s short-term objectives into action.
3.4. DEVELOPING THE MASTER BUDGET
The master budget expresses management’s operating and financial plans for a specified
period (usually a year) and comprises a set of budgeted financial statements. The two
main components of the master budget are the operating budget and the financial
budget.
Components of operating budget
A. the sales budget
 The starting point of budgeting
 Includes both cash and credit sales
 A detailed schedule showing the expected sales for the budgeted period
B. The schedule of expected cash collection
Prepared to show how match cash expected to be received from customers
Includes- current month’s cash sales plus
-the previous month’s credit sales expected to be collected in the current month
C. The inventory (merchandise) purchase budget

6
Prepared to show the amount of goods to be purchased from suppliers during the period
The total amount of inventory needed can be obtained from two sources
1. Beginning inventory and
2. The company’s planned purchases
The inventory purchase budget format
Budgeted cost of goods sold--------------- xxxx
Add: desired ending inventory ----------- xxxx
Total inventory needed -------------------xxxxx
Less: Beginning inventory ---------------xxxxxx
Required purchase --------------------------xxxxxx
D. the schedule of expected cash disbursements for purchases
A disbursement for inventory purchased consists of payments for purchases on account
made in prior periods plus any payment for inventory purchases made on the current
budget period.
E. operating expense budget
All budgeted selling and administrative expenses would be compiled and listed down.
The amount of interest expense cannot be determined until the amount of expected
borrowing has been established through the preparation of cash budget.
F. The schedule of expected cash disbursements for operating expenses
Cash expense are paid as incurred
Depreciation expense is not included in the cash disbursements for operating expenses.
Because depreciation is non cash expense
G. The budgeted or pro – forma income statements
It shows the company’s planned profit for the upcoming budget period.
It will be complete after addition of the interest expense, which is computed after the cash
budget, has been prepared.
The main reason why the budgeted income statement is prepared before the cash budget
is to show that the ultimate output of the operating budget (in budgeted income
statement.)
Components of financial budget
Financial budget consists

7
 1. capital budget: plan for the acquisition of capital assets such as building and
equipment
2. Cash budget: prepared to advise management of anticipated cash shortage or
excessive cash balances.
It is a statement of planned cash receipts and disbursements and pulls together
much of the data developed in the preceding steps:
It is composed of four sections
A. Receipt (cash collection) sections: consists of a listing of all of the cash inflows
B. Disbursement (cash payment) sections: consists all cash payments that are planned
for the budget period
- Includes: raw materials - Dividends
purchased - Manufacturing costs
- Direct labor payments - Operating expense and so on
- Equipment purchase
C. Cash excess or deficiency sections: it is computed as:
Beginning cash balance ---------------------xxx
Add: receipts ----------------------------------xxx
Total cash available before financing ----xxx
Less: disbursements ------------------------ xxx
Excess (deficiency) of cash ----------------- xxx
D. Financing sections: includes
 Borrowings
 Repayments
 Interest payments
3. budgeted balance sheet
4. budgeted statements of cash flows
NB: Preparation of the master budget begins with the preparation of the planned
operating budget, whereas, production budget are set after sales budget is completed.
3.4.1Master budget for Merchandising Firms
Example: Aman Company is a merchandising firm and office supplies specialty stored in
Addis Ababa. The company prepares its master budget in quarterly basis. The following

8
data have been assembled to assist in the preparation of the master budget for the first
quarter of 2005.
a. As December 31, 2004, the following general ledger showed the following account
balances.

Debit Credit
Cash $ 48,000
Account receivable 224,000
Inventory 60,000
Building and equipment 370,000
Account payable $93, 000
Capital stock 500 000
Retained earnings 109,000
702,000 702,000
b. Actual sales for December 2004 and budgeted sales for the next four months of 2005
are as follows :

December (actual) sales 280,000

Budgeted sales of 2005
January 400, 000
February 600,000
March 300,000
April 200, 000
c. Sales are for 20% for cash and 80% on credit. All payments on credit sales are
collected in the month following sale. The account receivable at December 31, 2004
is a result of December credit sale.
d. The company’s gross profit is 40% of sales in a month.

e. Monthly expenses are budgeted as follows.

Salaries and wages 27,000 per month

Advertising 70,000 per month
Shipping 5% of sales
Depreciations 14,000 per month
Other expenses 3% of sales

*Note that cash expenses are paid as incurred .

9
f. Desired ending inventory equals to 25% of the following month’s sales needs, stated
at cost (cost of goods sold).
g. 50% of month’s inventory purchases are paid for in the month of purchase and the
remaining 50% is paid for the following month.
h. During February the company will purchase a new copy machine for $1,700 cash.
During March other equipment will be purchased for cash at a cost of $ 84,500
i. During January the company will declare and pay $45,000 in cash dividends.
j. The company must maintain a minimum cash balance of $30,000 each month. All
borrowing is made at the beginning of a month and all payments are paid at the end of
a month. Borrowings and repayments of principal must be in multiples of $1000
(countable in thousands). Interest is paid only at the time of payment of principal.
The annual interest rate is 12%.

Required: Using the data for Aman Company, You are required to prepare the necessary
operating and financial budget.
Solution 1-Operating budget
a. Sales Budget

Aman Company
Sales Budget
For the quarter ended March 31,2005
Months
January February March Quarter
Budgeted cash sales (20%) 80,000 120,000 60,000 260,000
Budgeted credit sales (80%) 320,000 480,000 240,000 1,040,000
Total Budgeted sales 400,000 600,000 300,000 1,300,000

b. Schedule of budgeted cash collection

Aman Company
Cash Collection Budget
For the quarter ended, March 31, 2005

Months

10
 January February March Quarter
Account receivable 224,000 --- - 224,000
beginning balance
January sales (400,000*20%, 400,000*80%) 80,000 320,000 ------ 400,000
February sale (600,000*20%, 600,000*80%) 120,000 480,000 600,000

March sale (300,000*20%) 60,000 60,000

60,000 60,000
Total cash collection 304,000 440,000 540,000 1,284,000

c. The inventory (merchandise) purchase budget

Aman Company
Inventory (Merchandise) purchase Budget
For the quarter ended, March 31, 2005
Months
…………………… January …… February ….. March ...… Quarter

Budged cost of goods sold

(60% of sale because gross profit is 40%) .. ………… 240,000…360,000 ……180,000 ….780, 000
Add: Desired ending inventory………………………… 90,000 … 45,000 …………30,000….…30,000
Total inventory needed……………………………….. 330,000 ....405,000…… .210,000……….810, 000
Less: Beginning inventory……………………………60,000……90,000…………450,000……...60,000*
Required purchase……………………………… 270,000……315,000 ………. 165,000………750,000
Note:*Because the beginning of quarter is the same as the beginning inventory of January.

d. Schedule of expected cash disbursements for inventory purchases

Aman Company
Schedule of expected cash disbursements for inventory purchases
For the quarter ended, March 31, 2005
Months
……January ……..February…….March ………Quarter
Accounts payable beginning balance ……...93,000 ……... - …... - …….. …... 93,000
January purchases (270,000*50%, 50%) 135,000 135,000 - .......---------.270, 000

11
February purchases (315,000*50%, 50%) … …………….157, 000 ……157,000……315, 000
March Purchases (165,000*50%, 50%) …….. -……………..- …82,500 ……...82,500
Total disbursements for purchases ……..228,000 ………….292,500 ...... 240,000 ……... 760,500
e. The operating expense Budget
Aman Company
Operating expense Budget for the quarter ended, March 31, 2005
Months
…………January ……..February…….March ………Quarter
Salaries and wages ………………………..27,000 27,000 27,000…………81,000
Advertising expense ………………………70,000………. 70,000 …………..70,000……… …70,000
Shipping (5% sales) expense………………20,000……….30, 000………..…15,000 .. 65,000
Depreciation expense ……………………14,000 ……….14,000 ……….14,000 …………….14,000
Other expenses (3% of sales)…………….12,000……….18,000…………….9,000 …………….39,000
Total operating expense budget……………143,000 ……159,000……….135,000 ………….437,000
f. Schedule of expected cash disbursements for operating expense
Aman Company
Schedule of expected cash disbursements for operating expense
For the quarter ended March 31, 2005
Months
…………January ……..February…….March ………Quarter
Salaries and wages ……………………….27, 000…………27,000…………27,000……….81,000
Advertising expense …………………….70, 000……….70,000………… 70,000 ………….210,000
Shipping (5% sales) expense …………20, 000 30,000 …15,000… ……….65,000
Other expenses (3% sales) …………….….12,000……… .18,000 ……….9,000 …….39,000
Total cash disbursements for
Operating expense…………………….. .129,000……….145,000……121,000 ………….395,000
g. Budgeted income statement
Aman Company
Budgeted income statement
For the quarter ended, March 31, 2005
Sales…………………………………………………………………………...1, 300,000
Less: cost of goods sold ………………………………………………………780,000
Gross profit ……………………………………………………………………520,000
Less: operating expenses:
Salaries and wages……………………………………81,000

12
 Advertising expense…………………………………..210,000
Shipping expense …………………………………….65, 000
Depreciation expense………………………………….42, 000
Other expenses………………………………………….39,000
Total operating expenses…………………………………………………….….. (437,000)
Net operating income ………………………………………………………………83,000
Less: interest expense …………………………………………………………………..2,400
Net income……………………………………………………………………………..80,600

Solution 2.Financial budget

a) Cash budget
Aman Company
Schedule of expected cash disbursements for operating expense
For the quarter ended, March 31, 2005
Months
…….. January …… February…… March……….. Quarter
Cash balance beginning ………..48,000 ……30,000……….30, 800…………...48, 000
Add Receipts:
Collection from customers ……….304,000………. 440,000 ……….540,000…………1,284,000
Total cash available..…….………..352,000……….470,000………. 570,000…………1,332,000
Less: disbursement:
Purchase of inventory …..……. 228,000 ………. 292,500 ………. .240,000 ……. 760,500
Operating expenses ……………129,000 ………. 145,000……….121,000……………….395,000
Purchase of equipment ……….- ……….………….1,700…………..84,500………………..86,200
Cash dividend ……………45,000 ………. - ………. -……….………….….… 45,000
Total disbursement ………. 402,000 …….439,200 ……….445,500 ………….1,286,700
Excess or deficiency of cash ………. (50,000)……….30, 800…………125,300……………45,300
Financing:
Borrowing (at the beginning) ………...80,000 ……… - ………………. -………………..80,000
Payments (at the end) …...-………...-………………..…… (80,000) ……….(80,000)
Interest (at 12% per year)* ………... - ………... - ………... … (2,400) ……….........
(2,400)
Total financing ………............... 80,000………... -……………………..82,400………..........82,400
Cash balance ending ………................30,000 ………...30,800………….42, 900 ……….....42,900
*(Interest=80,000*12%/12)=800 per month. For three months=800*3=2400)
b) Budgeted balance sheet
Aman Company
Budgeted balance sheet
For the quarter ended, March 31, 2005
Asset
Current asset:
Cash ……………………………………………42,900

13
 Account Relievable ……………………………240,000
Inventory ………………………………………30,000
Total current asset …………………………………………312, 900
Plant asset:
Building and equipment (net)……………………………..414, 200
Total assets………………………………………………….................727, 100
Liabilities and stockholders’ equity
Current liabilities:
Account payable ……………………………………………82,500
Stockholders’ equity
Capital stock ……………………………………………..500,000
Retained earnings ………………………………………….144,600
Total Liabilities and stockholders’ equity……………………………..727,100
c) Budgeted statement of cash flows
Aman Company
Budgeted statement of cash flows
For the quarter ended, March 31, 2005
Cash flow from operating activities:
Cash collections from customers……………………….1, 284,000
Cash disbursement for purchase of inventory………… (760,500)
Cash disbursement for operating expenses…………… (397,500)
Net cash flow from operating activities………………………………128, 500
Cash flow from investing activity:
Cash out flow to purchase equipment…………………………………… (86,200)
Net cash flow from investing activity………………………………….. (86,200)
Cash flow from financing activities:
Cash disbursement for dividends ……………………….. (45,000)
Cash disbursement for interest expense………………….. (2,400)
Inflow from borrowing……………………………………80,000
Out flow for repayment…………………………………. (80,000)
Net cash flow from financing activities………………………………… (47,
400)

14
 Net change in cash (deficit)………………………………………………... (5,100)
Plus: beginning cash balance…………………………………….…………………48,000
Ending: cash balance…………………………………………..………………….42,900
3.5. DIFFICULTIES OF SALES FORECASTING
The usual starting point for the preparation of master budget is a sales revenue budget
based on forecasted sales of goods and services the accuracy of the sales udder is critical
because it acts as the data source for all other budgets. If the sales figures are unreliable,
the entire budget process is a waste of time. Thus it is easy to understand why every
available effort is made to obtain reliable estimates of projected sales.
All companies have two things in common when it comes to forecasting sales: sales
forecasting is a critical step in the doubting process, and it is very difficult to do it
accurately. Sales forecasting is the process of predicting sales of goods or services
various procedures are used in sales forecasting, and the final forecast usually combines
information from many different sources.
Though the marketing department normally coordinates the effort to establish the sales
forecast, many firms have a top-management-level market research staff whose job is to
coordinate the company’s sales forecasting efforts. A great deal of effort general goes
into the sales forecast, since it is such a critical step in the budget process. A slightly
inaccurate sales forecast, coming at the very beginning of the budget process, will throw
off all of the other schedules that make up the master budget. The tarring point in the
sales forecasting process is generally the sales level of the prior year. The following
factors are some of the major factors that must be taken into account at the time when
sales are forecasted.
 Past sales levels and trends for the company that develops the forecast and for the
entire industry
 General economic trends (is the economy growing? How fast? Is economic
recession or slowdown expected?)
 Economic trends in the company’s industry (in the petroleum industry, for
example, is personal travel likely to increase, thereby implying increased demand
for gasoline)
 Other factors expected to affect sales in the industry

15
 Political and legal events.(for example, changes in political power and
legislations)
 The intended pricing policy of the company
 Planned advertising and product promotion
 Expected actions of competitors
 New product development (substitute or complement) by the company itself or
other firms
 Market research studies
 Internal capacity and situation of the company.

16