CHAPTER THREE

INFORMATION FOR BUDGETING, PLANNING AND

CONTROL PURPOSES
Introduction
A budget is a quantitative plan for acquiring and using resources over a specified time period.
Individuals sometimes create household budgets that balance their income and expenditures for
food, clothing, housing, and so on while providing for some savings. Once the budget is
established, actual spending is compared to the budget to make sure the plan is being followed.
Companies use budgets in a similar way, although the amount of work and underlying details far
exceed a personal budget. Budgets are used for two distinct purposes—planning and control.
Planning involves developing goals and preparing various budgets to achieve those goals.
Control involves the steps taken by management to increase the likelihood that all parts of the
organization are working together to achieve the goals set down at the planning stage. To be
effective, a good budgeting system must provide for both planning and control. Good planning
without effective control is a waste of time and effort.

3.1Objectives and concepts of budgetary systems

 The budget- for planning and control

Time and money are scarce resources to all individuals and organizations; the efficient and
effective use of these resources requires planning. Planning alone, however, is insufficient.
Control is also necessary to ensure that plans actually are carried out. A budget is a tool that
managers use to plan and control the use of scarce resources. A budget is a plan showing the
company’s objectives and how management intends to acquire and use resources to attain those
objectives.

Companies, non-profit organizations, and governmental units use many different types of
budgets. Responsibility budgets are designed to judge the performance of an individual segment
or manager. Capital budgets evaluate long-term capital projects such as the addition of
equipment or the relocation of a plant. This chapter examines the master budget, which consists
of a planned operating budget and a financial budget. The planned operating budget helps to

1
plan future earnings and results in a projected income statement. The financial budget helps
management plan the financing of assets and results in a projected balance sheet.

Budgets are quantitative plans for the future. However, they are based mainly on past experience
adjusted for future expectations. Thus, accounting data related to the past play an important part
in budget preparation. The accounting system and the budget are closely related. The details of
the budget must agree with the company’s ledger accounts. In turn, the accounts must be
designed to provide the appropriate information for preparing the budget, financial statements,
and interim financial reports to facilitate operational control.

The period covered by a budget varies according to the nature of the specific activity involved.
Cash budgets may cover a week or a month; sales and production budgets may cover a month, a
quarter, or a year; and the general operating budget may cover a quarter or a year.

The term budget has negative connotations for many employees. Often in the past, management
has imposed a budget from the top without considering the opinions and feelings of the
personnel affected. Such a dictatorial process may result in resistance to the budget. A number of
reasons may underlie such resistance, including lack of understanding of the process, concern for
status, and an expectation of increased pressure to perform. Employees may believe that the
performance evaluation method is unfair or that the goals are unrealistic and unattainable. They
may lack confidence in the way accounting figures are generated or may prefer a less formal
communication and evaluation system. Often these fears are completely unfounded, but if
employees believe these problems exist, it is difficult to accomplish the objectives of budgeting.

Problems encountered with such imposed budgets have led accountants and management to
adopt participatory budgeting. Participatory budgeting means that all levels of management
responsible for actual performance actively participate in setting operating goals for the coming
period. Managers and other employees are more likely to understand, accept, and pursue goals
when they are involved in formulating them.

2
Budget is a cyclical and sequential activity. In a well-managed companies, budget usually cycles
through the following steps:

1. Planning the performance of the company as a whole, as well as planning the

performance of its subunits (such as department or divisions). Managers at all level agree
on what is expected.
2. Providing a frame of reference, a set of specific expectations against which actual results
can be compared
3. Investigating variations from plans. If necessary, corrective action follows investigation
4. Planning again, in light of feedback and changed condition.

3.1.1 Purposes of Budget

Budget prepared as a formal business plan is used by all managers at different functional areas
and managerial level. Further budget is used by all types of organizations, be it a business
organization, government organization or NGO. When administered wisely budget can provide
the following benefits:

i. Efficient Allocation of Resources

Resource available to meet the objective of any organization is generally limited; therefore
efficient allocation of recourse is one of the prerequisite for successful attainment of
organizational goal. For example, an office of a city Administration must allocate its revenue
among basic societal service such as security and protection, heath, education, infrastructure etc.
In the case of business organizations, the well-designed business strategies hardly become
successful without availability and efficient allocation of resource. Therefore, adopting formal
budgetary process helps organization to identify the resource requirement of the planed activity
and allocate in accordance to the priority of each operation in achieving organizational objective.

3
 ii. Compel strategic planning and implementation of plans

The budgeting process forces managers to plan ahead. The development of budget triggers
managers to plan their operation ahead as well as to prepare on the ways of talking any change
during the implementation of the plan.

Budget enable the successful implementation of strategy that is why in most business
organization budget is considered as an integral part of strategic planning and implementation.

iii. Facilitating coordination and communication

For any organization to be effective, each manager throughout the organization must be aware of
the plan made by other managers. In large and diverse organizations the problem of coordination
becomes critical. An important role of budgeting is to improve the coordination among the
various units of the organization. Planning or budgeting means establishing objectives in
advance and identifying the steps by which the objectives are to be accomplished. The planning
process initiates coordination and clarification of sub-goals to achieve major enterprise goals.
The coordinated plan or budget provides a blue print for implementation and control.

 A good budgeting process facilitates communication in all direction in the

organization and help coordinating the various resources, manpower and units of
the organization so that goal of the organization is achieved.

iv. Frame work for judging performance

Once plans are in Place, Company’s performance can be measured against the budget
established for those plans. Budget can overcome two limitations of using past performance
as a bases of judging actual results. One limitation is that past results incorporate past misuse
and substandard performance and the other limitation of using past performance is that the
future conditions may be expect to differ from the past.

 As a performance evaluation basis budgeted performance are better than actual

results.

4
 V. Motivating Managers and Employees

Research shows that budgets that are challenging improve performance. An inability to achieve
budget numbers is viewed as failure. Most individuals are motivated to work more intensely to
avoid failure than to achieve success. As individuals get closer to goal they work harder to
achieve it. For this reason many executives like to set challenging but achieve goal for their
subordinates .Creating attitude of anxiety improves performance, but overly ambitious and
unachievable budget increase anxiety without motivation that is because individuals see little
chance of avoiding.

3.1.2 Budgeting and behavioral influences

How the budget is administrated will affect their effectiveness and efficiency in achieving the
organization’s goals. Besides using budget to forecast the organization’s coming year’s
performance, it also serves another purpose. It can be used as a performance evaluation on the
managers’ actual performance against the budgeted performance. By doing so, the organization
is trying to use budget as a tool for control. When the performance evaluation is linked with any
form of rewards and penalty system, there are possibilities that the managers will distort any
information and data passed to upper level of management (i.e. their superiors). The managers
may underestimate the revenue, over-estimate the costs required. It can have an effect on their
job performance, which will be reflected on their annual appraisals. All these will affect their
salary increment, annual bonus, chances of promotion etc. The manager’s behavior towards the
budget will be influenced as the actual performance of budget will either have a favorable or
adverse effect on his job appraisal
Below are the behavioral aspects of budgeting, which will arise:

 Dysfunctional Behavior
When the budget’s goals are the same as managers’ goals, the actual performance will meet the
expected level of performance or even exceed the expectations. This is called goal congruence. It
refers to the alignment and consistency of individual’s goals (in this instance, it is the manager)
with the organizations’ goals. The managers will be motivated to aim for the goals of the

5
organization, as this will also lead them towards their individual goals. In the case of goal
incongruence, the managers are not motivated at all. They may put in minimum efforts (in worst
case scenario, no efforts from the managers) towards the budget, thus affecting the actual
performance.
In the situations whereby the budget shows unrealistic targets from the management and/ or the
budget is implemented badly, the employee may react adversely to the budget. This will cause an
impact on the actual performance. Usually it does not meet the expected level of performance,
and it will affect the organization’s goals (short term and long term) and objectives. The display
of managers’ behaviors, which conflicts with the organization’s goals and objectives, is
dysfunctional behavior.
 Participative Budgeting
Budget is usually prepared either top down or bottom up. Under the top down budget method,
top management prepares the budget and passes on the information to the employee as what they
need to do in the budget. There is no involvement and communication from other employee.
When there is participation from the employee, they become involved in the budgeting process.
They form part of the budget. It gives them a sense of commitments and they also foster a sense
of belongings toward the budget. When they feel committed, they will be motivated aiming for
the targets. By encouraging participation from the employee, it helps to increase motivation
levels and reduce resistance level to the budget as well as reduce possible conflict within
organization. It also increases employee’ initiatives, performance level and their morale on their
jobs. By allowing participation from employee, it is likely the budget’s targets will become the
employee’ goals. They contribute to the development of the budget. This type of budgeting
allows both top management and its employee to have a better understanding on each other’s
roles and areas of concerns where budget is concerned. For example, the top management will
know whether the targets set is reasonable and realistic when they hear from employee, and
employee will know the dilemma the management needs to consider when they need to make
decision between two or more choices.
 Budgetary Slack
The difference between the allocated resources and the actual required resources is the budgetary
slack. The managers introduce the budgetary slack, also known as padding the budget, during the
budget preparation process. They will underestimate the revenues and overestimate the costs and

6
expenses. In this way, they can request for more allocation of resources from the organization.
There is a tendency for the managers to do in almost all organizations, across industries. The
managers will have past experiences when preparing the budget. The actual amount of
expenditure allocated to them is lesser than what they have requested for inside the budget. They
will tend to add in a mark-up percentage of what they have estimated for. In this way, even if the
actual amount of expenditure gets reduced, the amount allocated to them does not differ much
from what they have planned for. Managers will also built a budgetary slack by underestimating
the amount of revenue and overestimating the costs. When the actual performance exceeds the
budget performance, it appears that the managers have performed above the expectations of
budget. There is high chance that the manger has taken advantage of the budgetary slack. The
actual performance may not have been met if not for the budgetary slack. When the actual
performance has a direct link to the incentives, the manager has a higher possibility of building a
budgetary slack.

3.1.3 Quantitative aids in budgeting

Learning curve theory

Learning curve is essentially a measure of the experience gained in production of an article by an

individual or organization. As more units are produced, people involved in production become
more efficient than before. Each subsequent unit takes fewer man-hours to produce.

Learning Curve Theory is concerned with the idea that when a new job, process or activity
commences for the first time it is likely that the workforce involved will not achieve maximum
efficiency immediately. Repetition of the task is likely to make the people more confident and
knowledgeable and will eventually result in a more efficient and rapid operation. Eventually the
learning process will stop after continually repeating the job. As a consequence the time to
complete a task will initially decline and then stabilize once efficient working is achieved. The
cumulative average time per unit is assumed to decrease by a constant percentage every time that
output doubles. Cumulative average time refers to the average time per unit for all units
produced so far, from and including the first one made. Learning is the process by which an
individual acquires skill, knowledge and ability. When a new product or process is started, the
performance of a worker is not at its best and learning phenomenon takes place. As the

7
experience is gained, the performance of a worker improves, time taken per unit activity reduces
and his productivity goes up. This improvement in productivity of a worker is due to learning
effect. Cost predictions especially those relating to direct labour cost must allow for the effect of
learning process. This technique is a mathematical technique. It can be very much used to
accurately and graphically predict cost. It is a geometrical progression, which reveals that there is
steadily decreasing cost for the accomplishment of a given repetitive operation, as the identical
operation is increasingly repeated. The amount of decrease is less and less with each successive
unit produced. The slope of the decision curve can be expressed as a percentage. Experience
curve, improvement curve and progress curve are other terms which can be synonymously used.

The learning curve will pass through three different phases. In the first phase, there will be
gradual increase in production rate until the maximum expected rate is reached and this phase is
generally steep. In the second phase, the learning rate will gradually deteriorate because of the
limitations of equipment. In the third phase, the production rate begins to decrease due to a
reduction in customer requirements and increase in costs.

Under the Learning curve model, the cumulative average time per unit produced is assumed to fall by a
constant percentage every time total output of the unit doubles. Learning curve is a geometrical operation,
as the identical operation is increasingly repeated. Learning curve is essentially a measure if the
experience gained in production of an article by an organization. As more and more units re-produced,
workers involved in production become more efficient than before. Each subsequent unit takes fewer man
hours or produce. The Learning curve exists during a worker’s start up or familiarization period on a
particular job. After the limits of experimental learning are reached, productivity tends to stabilize and no
further improvement is possible. The learning curve ratio can be calculated with the help of the following
formula:

Limitations of the usefulness of the learning curve

8
The following points limiting the usefulness of learning curves should be noted:-

1. The learning curve is useful only for new operations where machines do not constitute a
major part of the production process. It is not applicable to all productions. E.g. new and
experienced workmen.
2. The learning curve assumes that the production will continue without any major
interruptions. If for any reason the work in interrupted, the curve may be deflected or
assume a new slopes
3. Charges other than learning may affect the learning curve. For example, improvement in
facilities, arrangements, and equipment as well as personnel morale and performance
may be factors influencing the curve. On the other hand, negative developments in
employee attitudes may also affect the curve and reverse or retard the progress of
improvement.
4. The characteristic 80 percent learning curve as originally obtaining in the air force
industry in U.S. A. has been usually accepted as the percentage applicable to all
industries. Studies show that there cannot be a unique percentage which can be
universally applied.

APPLICATION OF LEARNING CURVE

Application of Learning Curve Learning curve may be applied to direct labor, materials and
spoilage and defective work.

Direct Labour: Director Labour is the general application area of the learning curve since it is
only people who are capable of learning. Learning presupposes a certain degrees of inexperience
in the performance of an activity and as such, the learning curve is mainly applicable to new
activities and new labour force, whether employed on new or old activities.

Materials - Materials respond to learning only in an indirect way under specific circumstances.
learning curve is applicable mainly to sub-contract or fabrication order placed outside or
component purchased from suppliers. The cost of the sub-contract or the components purchased
would normal contain an element of labour and the purchaser will expect that at least a part of
the benefit of learning should be passed on to him in the form of reduced price for the repeat
orders for the subcontract components.

Spoilage and defective work: This is also an area for learning because with the acquirement of
more skill and efficiency, losses on account of spoilage and defective production would decline.
On the other hand, the concept of learning curve may not be gainfully applicable in the following
cases:

(i) Where machine work predominates and the operation time is limited by the speed and
feed of the machine.

9
 (ii) In old established industries where no substantial change takes place.
(iii) In industries which do not received repeat orders.
(iv) In small units where the quantity of production is small and costs are low.

Distinctive Features of Learning Curve Theory

(i) Learning curve is not a cost reduction technique. It is a naturally occurring human
phenomenon.
(ii) It is a human characteristic that a person engaged in repetitive task will improve his
performance over time.
(iii) In the initial stage of production, generally the workers do not have the confidence of
completing the job successfully. When they produce a few units, they gain confidence.
People learn from errors.
(iv) When the workers produce more and more units, they come to know the problems and
their reasons. Now they are able to avoid the problems.
(v) The workers are able to find the new methods of doing the job; they are able to complete
task in less time.
(vi) Better equipments and tools are developed.
(vii) Better product designs lead to increased efficiency.

3.1.4 Activity-Based Budgeting

What is activity-based budgeting?

Activity-based budgeting (ABB) is a budgeting system in which every activity that creates a cost
for a company gets recorded and analyzed in order to find areas for improving efficiencies.
These activities are termed activity cost drivers and can be anything that triggers a cost, such as
manufacturing changes, labor hours or facility rentals. After analysis of costs, a budget is created
based on these findings. Companies typically use this system to reduce costs, increase
productivity, gain a competitive edge and make their overall operations more efficient.

Budgeting is an important financial activity that not only maintains financial goals but can also
provide opportunity to review costs and evaluate solutions. Specific types of budgeting, such as
activity-based budgeting, can allow a company to record, track, and lower their expenses in order
to reduce overall costs and improve efficiencies. Learning more about this type of budgeting may
help you decide if it would be helpful in your accounting. In this section, we define activity-

10
based budgeting, list its benefits, offer an example for reference and give tips for creating an
activity-based budget.
This management accounting process occurs in these four steps:
1. Identify cost-incurring activities
2. Evaluate how many units of these activities are occurring
3. Calculate the cost per unit of the activity or activities
4. Multiply the cost by the level of activity
Because of its additional calculations, this type of budgeting is considered more rigorous than
traditional budgeting. However, this type of budget has an additional goal of reducing costs and
improving efficiency, not just tracking expenses or adjusting information based on inflation or
other related occurrences.

 Benefits of activity-based budgeting

There are several benefits of using activity-based budgeting. Benefits of this type of budgeting
usually include the following:

Better insights into operational costs

The main objective of this type of budgeting is cost reduction. Because of its in-depth analysis of
expenses and how they may affect entire company performance, this type of budget gives better
insight into specific and overall operational costs. These evaluations may be helpful throughout
many company departments for determining how their individual processes can be improved or
made more efficient.

Added competitive edge

This type of budgeting tool helps a company find ways to reduce production costs, increase
production efficiency and determine how to make products more cost-friendly. Using the budget
to evaluate activities may help management identify a change that can lower costs, such as a
revised facility lease or reduced shipping rate. After making the changes, the company may be
able to produce products at a lower cost than their competitors. This competitive edge gives them
a new market advantage.

Management of budget

An activity-based budget integrates operations management and accounting in the budget

process. Because information about activities is necessary for calculations, a wider variety of
staff and their expertise are included. Operations management can clarify the basis of certain
costs and better understand processes including points of inefficiency. Accounting can use their
expertise to make the proper calculations and provide results. All contributing parties to any
costs may review the budget and see how they may lower costs.

11
 Improved budget control

Activity-based budgeting helps companies make budgetary decisions based on specific activity
cost drivers, their amounts and their importance to company activities. It may be easier for a
company to gain specific and actionable budget control with activity-based budgeting. A
company can pinpoint which activity to modify, determine a change and evaluate how that
change affects the budget.

Waste elimination

Activity-based budgeting can be used to cut costs in order to improve efficiencies. Because
activity-based evaluations also rank the importance of activities, the process may identify some
company activities that are obsolete, redundant or unnecessary. When these wasteful activities
are stopped, production may become more efficient, and the company saves money.

Synergy support

Many cost drivers often involve multi-department operations. Because this budgeting system can
involve several company departments, this creates a level of synergy across these departments.
To most effectively eliminate unnecessary costs, departments can collaborate to see how they
may work together to create these efficiencies.

Example of Activity-Based Budgeting

Company A anticipates receiving 50,000 sales orders in the upcoming year, with each single
order costing $2 to process. Therefore, the activity-based budget (ABB) for the expenses relating
to processing sales orders for the upcoming year is $100,000 ($50,000 * $2).

This figure may be compared to a traditional approach to budgeting. If last year’s budget called
for $80,000 of sales order processing expenses and sales were expected to grow 10%, only
$88,000 ($80,000 + ($80,000 * 10%)) is budgeted.

3.1.5 Control theory and budgeting,

Budgeting is the complete process of designing, implementing and operating budgets. CIMA
defines Budgetary Control as: “The establishment of budgets relating the responsibilities of
executives to the requirements of policy and the continuous comparison of actual with budgeted
results either to secure by individual action, the objective of that policy or to provide a basis for
its revision.”

ADVANTAGES OF BUDGETARY CONTROL SYSTEM

12
The use of budgetary control system enables the management of a business concern to
conduct its business activities in the efficient manner.
It is a powerful instrument used by business houses for the control of their expenditure.
It provides a yardstick for measuring and evaluating the performance of their individuals
and their departments.
It reveals the deviations to management from the budgeted figures after making a
comparison with actual figures.
It helps in the review of current trends and framing of future policies. f) It inculcates the
feeling of cost consciousness among workers.
Management which have developed a well ordered budget plans and which operate
accordingly, receive greater favour from credit agencies.

LIMITATIONS OF BUDGETARY CONTROL SYSTEM

Based on estimates: Budgets may or may not be true as they are based on estimates.
Therefore, the adequacy or otherwise of budgetary control system, to a very large extent,
depends upon the adequacy or accuracy with which estimates are made.
Time factor: Budgets cannot be executed automatically. Accuracy in budgeting comes
through experience. Management must not expect too much during the development
period.
Co-operation required: Staff co-operation is usually not available during budgetary
control exercise. The success of the budgetary control depends upon willing co-operation
and teamwork.
Expensive: Its implementation is quite expensive. No budgetary program can be
successful unless adequate arrangements are made for supervision and administration.
Not a substitute for management: Budget is only a managerial tool. It cannot substitute
management.

3.2 TYPES OF BUDGETARY SYSTEMS

13
Fixed and flexible budgets
Fixed Budget

A budget prepared on the basis of standard or fixed level of activity is known as fixed budget. It
does not change with a change in the level of activities.

Flexible Budget

The Chartered Institute of Management Accountants, London defines Flexible Budget, “As a
budget which by recognizing different cost behaviour patterns, is designed to change as volume
of output changes.” It is a budget prepared in a manner so as to give the budgeted cost for any
level of activity. It recognizing the difference between fixed, semi-fixed and variable cost is
designed to change in relation to the activity attained. It is designed to furnish budgeted cost at
any level of activity attained. The main characteristic of flexible budget is that it shows the
expenditure appropriate to various levels of output. If the volume changes, the expenditure
appropriate to it can be established from the flexible budget for comparison with actual
expenditure as a means of control. It provides a logical comparison of budget allowances with
the actual cost. When flexible budget is prepared, actual cost of actual activity is compared with
budgeted cost of actual activity, i.e., two things to the same base.

 Zero-based budgets and incremental budgets

Zero base budgeting (ZBB)

Zero base budgeting means budgeting from the beginning is i.e. it prepared without any
reference to any base (past budgets and actual figures). Zero Base budgeting may be defined as a
planning and budgeting process which requires each manager to justify its budget in detail from
scratch and justify why he should spend any money. Concentration of efforts is not simply on
“how much” a unit will spend but “why” it needs to spend. Under zero base budgeting, all
activities are identified and evaluated by systematic analysis and ranked in order of importance.
Thus, the burden of proof is on manager to justify why the expenditure should be made at all and
to indicate what would happen if the proposed activity is stopped and no expenditure is made.
Under zero base budgeting, all activities and costs are re-evaluated each time budget is set. It
provides number of advantages to the organizational efficiency and effectiveness.

Incremental Budget

14
An incremental budget is a budget prepared using the previous period’s budget or actual
performance as a basis with incremental amounts added for the new budget. The allocation of
resources is based upon allocations from the previous accounting year. Here, the management
assumes that the levels of revenues and costs incurred during the current year will also be
reflected during the next year. Accordingly, it will be assumed that revenues and costs incurred
during the current year will be the starting point for estimations for the next year.

Based on the results of the current year, an allowance will be added to the next year’s budget that
takes into account possible changes in selling prices, associated costs and effects
of inflation (general rise in price levels). This is a much less time consuming and convenient
process compared to zero-based budgeting. However, incremental budgeting is criticized for a
number of limitations as per below. The main drawback of this type of budgeting is that it carries
forward the current year’s inefficiencies into the next year.

 PERIODIC AND CONTINUOUS BUDGETING

Periodic Budget

A periodic budget, as the name suggests, involves dividing the annual budget into smaller
periods. It is more useful to refer to pay periods since money coming in and out centres around
them. To establish a periodic budget, you have to know the available amount of your cash assets
when creating the budget. An up-to-date cheque book allows you instant access to this
information. Income has to be entered in the periods it is deposited. You have to be as precise as
possible when entering the amounts. Expenses also have to be entered in the exact times they
occur.

For a given period, add your income to your cash assets and then withdraw expenses. The
balance has to be positive. If this is not the case, you have to decide on how to proceed to make
the balance positive.

Continuous Budgeting

Another name for continuous budget is rolling budget. The rolling budget is continuously
updated by adding further accounting periods when the earlier accounting period is completed. It
has a dynamic approach. Instead of a static budget of 12 months, it rolls forward by a quarter or a
month. A rolling budget is the extension of the existing budget. Hence, it requires more effort to
update and implement compared to a static budget. It requires time and effort in preparation.

 SHORT-TERM Vs. LONG-TERM BUDGETS

Long Term Budgets

15
A long-term budget can be defined as a budget which is prepared for periods longer than a year.
These budgets help in business forecasting and forward planning. Capital expenditure budgets
and research developments budgets are good examples of long-term budgets

Short Term Budgets

This budget is defined as a budget which is prepared for a period less than a year and is very
useful to lower levels of management for control purposes. In an ideal situation a short-term
budget should perfectly fit into a long-term budget.

3.3 Monitoring and controlling performance; the calculation of

variances; the determination of the causes of variances

3.4 BUDGETING IN BUSINESS ORGANIZATION

3.4.1 Introduction

16
The type of budget and the extent of the budgeting activity vary considerably from organization
to organization. In smaller business organization, there may only be a sales forecast, a production
budget or a cash budget, larger organization generally prepare a master budget or a
comprehensive budget.

A master budget involves the development of a complete set of financial statement for the budget
period with supporting schedule. The primary responsibility for developing a master budget is
given to the controller and her or his staff. In large organization, a special budget committee will
be formed.

The budget committee is usually composed of several key executive from various segment of the
organization. People from finance, sales, purchasing, production, engineering and accounting are
usually represented. The procedure followed by this committee in developing the budget is
largely determined:

 By the authority it has over the finance budget

 By the amount of participation it allows from others within the organization.

The authority of the budget committee is determined by top management philosophy; top
management may have a predetermined profit objective in mind and will look to the budget as a
means to accomplish it. This objective may be stated in variety of ways, such as rate of return on
net asset, earning per share, or a specific amount of net income. It may be based on operating
results of previous years adjusted for expectations about the coming year or some desired level
of profitability. When top management has a predetermined profit objective, the budget
committee must recognize it and develop a budget that will achieve it.

If top management has no specific profit level in mind, the budget committee must first develop
some nation about what is fair and reasonable expectation for the budget period without this, the
budget process often turn in to “game” and much of the benefit is lost.

The budget committee may or may not invite other members in the organization to participate in
developing the budget. In estimating sales for the coming period, for example, sales people may
be asked to project the number of units of each product they expect to sell in their territories.

17
The sales representative on the budget committee would use these as a basis for developing the
sales forecast for the entire company participation could be carried to the extreme and every
person in the organization could asked to estimate productivity in her or his individual area. On
the other extreme, the budget committee may allow no participation. It merely may develop a
budget that will achieve the desired profit and pass it on as the standard of performance for the
budget period. More will be said about the behavioral considerations associated with employee
participation in developing the budget.

3.4.2 Process of Developing a Budget

Although each organization is unique in the way it puts together its budget, all budgeting
process share some common elements. After organizational goals, strategies, and long range
plans have been developed, work begins on the master budget, a detailed budget for the coming
fiscal year with some detail.
The master budget is a comprehensive financial plan for a business. It is made up of the
Operating and Financial budgets, which are in turn made up of supporting schedules (budgets).
To envision the master budget process, picture the financial statements most commonly prepared
by companies: The income statement, the balance sheet, the cash flow statement. Then imagine
the preparation of these statements before the fiscal period operational period.
3.4.2.1 Parts of A Master Budget

 What are the parts of a master budget?

As shown on figure on the next page master budget consists of two major parts, namely: the
operating budget and financial budget.
i Operating budget refers to the budgeted income statement and the supporting
budget schedules for various business functions in the value chain. The operating
budget basically shows the expected operating result of the organization in the
upcoming operational period.

18
 ii The financial budget is part of the master budget made up of the capital
expenditures budget, the cash budget, the budgeted balance sheet, and the budgeted
statement of cash flow.

An Overview of a Master Budget

Sales Budget

Ending Inventory Production Budget

Budget

Direct Material Direct Labor Budget Manufacturing

Budget Overhead Budget

Cost of Goods Sold

Budget

Operating Expense/none manufacturing

overhead/ Budget

Budgeted Income statement

Capital Cash Budget Budgeted Balance Sheet Budgeted Cash

Expenditure Flow statement
Budget

3.4.2.2 Steps in Budget development

3.4.2.2.1 Steps in developing an operating budget
The Operating Budget refers to the budgeted income statement and all the supporting schedules.

19
The organization has more control over some aspects of the business (for example how much to
produce) and less control over other aspects, (the demand for its product and service).
For most organizations sales is uncertain. Therefore, beginning with sales forecast, the firm can
plan the activities over which it has more control. As better information about sales becomes
available, it is reasonably easy to adjust the rest of the budget. If, on the other hand, production is
more uncertain than sales, the firm may want to begin with a raw material and production
forecast so as to reduce the uncertainty related to production.
To clearly understand the steps in development of an operating budget, consider the budget
information gathered by the controller of Gibe Furniture Manufacturing Company during the
process of budgeting for the upcoming fiscal year, 2011.

The summary of required budget information obtained from different operating units, such as
sales related information from the marketing department, production related information from
production department, direct and indirect labor related information from the human resource
department, and other manufacturing and non-manufacturing overhead budgets from other
departments as well as assumptions taken for the development of an operating budget are given
as follows:
(1) The only source of revenues is sales of tables and unit sold is the only revenue driver.
(2) Work in Process inventory is negligible and is ignored.
(3) Unit costs of direct materials purchased and finished goods sold remain unchanged
throughout each budget year.
(4) There are two types of Direct materials : Lumber and Metal
(5) There are two types of direct labor: Laminating labor and Machine labor.
Direct labor rates remain unchanged throughout each budget year.
(6) For computing inventorable costs, Gibe Furniture allocates all manufacturing overhead
costs using manufacturing labor hours as the allocation base.
(7) Numerical information
(a) Each table has the following product specifications:
1. The company’s product selling price is Br. 20 per unit. The marketing department has
estimated sales as follows for the next six quarters.

2009 Quarters 2010 Quarters

20
 Q1 Q2 Q3 Q4 Q1 Q2
Budgeted sales in units 10,000 30,000 40,000 20,000 15,000 15,000
2. Sales are collected in the following pattern: 70% of sales are collected in the quarter in which
the sales are made and the remaining 30% are collected in the following quarter. On
January1, 2009, the company’s balance sheet showed Br.90, 000 in account receivable, all of
which will be collected in the first quarter of the year.
3. The company maintains an ending inventory of finished units equal to 20% of the next
quarter’s sales. The requirement was met on December 31, 2008, in that the company had 2,
000 units on hand to start the New Year.
4. Fifteen pounds of raw materials are needed to complete one unit of product. The company
requires an ending inventory of raw materials on hand at the end of each quarter equal to
10% of the following quarter’s production needs of raw materials. This requirement was met
on December 31, 2008 in that the company had 21, 000 pounds of raw materials to start the
New Year.
5. The raw material costs Br.0.20 per pound. Raw material purchases are paid for in the
following pattern: 50% paid in the quarter the purchases are made, and the remainder is paid
in the following quarter.
6. Each unit of Gibes’s product requires 0.8 hour of labor time. Estimated direct labor cost per
hour is Br.7.50.
7. Variable overhead is allocated to production using labor hours as the allocation base as
follows:
- Indirect materials Br.0.40
- Indirect labor 0.75
- Fringe benefits 0.25
- Payroll taxes 0.10
- Utilities 0.15
- Maintenance 0.35
Fixed overhead for each quarter was budgeted at Br. 60, 600. Of the fixed overhead amount, Br.
15, 000 each quarter is depreciation. Overhead expenses are paid as incurred.
8. The company’s quarterly budgeted fixed selling and administrative expenses are as follows:

2009 Quarters
1 2 3 4
Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000
21
 Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000

The only variable selling and administrative expense, sales commission, is budgeted at
Br.1.80 per unit of the budgeted sales. All selling and administrative expenses are paid
during the quarter, in cash, with exception of depreciation. New equipment purchases will be
made during each quarter of the budget year for Br. 50, 000, Br. 40, 000, & Br.20, 000 each
for the last two quarter in cash, respectively. The company declares and pays dividends of
Br.8, 000 cash each quarter. The company’s balance sheet at December 31, 2008 is presented
below:
ASSETS
Current assets:
Cash Br. 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets Br.162, 7 00
Plant and Equipment:
Land Br.80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets Br.650, 700
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.25, 800
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity Br.650, 700
The company can borrow money from its bank at 10% annual interest. All borrowing must be
done at the beginning of a quarter, and repayments must be made at the end of a quarter. All
borrowings and all repayments are in multiples of Br. 1,000.

22
The company requires a minimum cash balance of Br.40, 000 at the end of each quarter. Interest
is computed and paid on the principal being repaid only at the time of repayment of principal.
The company wishes to use any excess cash to pay loans off as rapidly as possible.

Required: Prepare a master budget for the four-quarter period ending December 31. Include the
following detailed budget and schedules:

a) A sales budget, by quarter and in total

b) A schedule of budgeted cash collections, by quarter and in total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by quarter and in total
f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
j) A cash budget, by quarter and in total
k) A budgeted income statement for the four- quarter ending December 31, 2009
l) A budgeted balance sheet as of December 31, 2009.

a) Sales Budget
This budget is baseline budget for other budgets, and prepared at the beginning of the period.
Inventory budgets, purchases budgets, personnel budgets, marketing budgets, administrative
budgets, and other budget areas are all affected significantly by the amount of revenue that is
expected from sales.
Sales budgets are influenced by a wide variety of factors, including general economic conditions,
pricing decisions, competitor actions, industry conditions, and marketing programs. In an effort
to develop an accurate sales budget, firms employ many experts to assist in sales forecasting.
The sales budget is usually based on a sales forecast. A sales forecast is a prediction of sales
under a given conditions. The objective in forecasting sales is to estimate the volume of sales for
the period based on all the factors, both internal and external to the business that could
potentially affect the level of sales. The projected level of sales is then combined with estimated
of selling prices to form the sales budget. Sales forecasts are usually prepared under the direction
of the top sales executive. Important factors considered by sales forecasters include:

Past patterns of sales: Past experience combined with detailed past sales by product line,
geographical region, and type of customer can help predict future sales.

23
Estimates made by the sales force: A company’s sales force is often the best source of
information about the desires and plans of customers.
General economic conditions: Predictions for many economic indicators, such as gross
domestic product and industrial production indexes (local and foreign), are published regularly.
Knowledge of how sales relate to these indicators can aid sales forecasting.
Competitive actions: Sales depend on the strength and actions of competitors. To forecast sales,
a company should consider the likely strategies and reactions of competitors, such as changes in
their prices, products, or services.
Changes in the firm’s prices: Sales can be increased by decreasing prices and vice versa.
Planned changes in prices should consider effects on customer demand.
Changes in product mix: Changing the mix of products often can affect not only sales levels
but also overall contribution margin. Identifying the most profitable products and devising
methods to increases sales is a key part of successful management.
Market research studies: Some companies hire market experts to gather information about
market conditions and customer preferences. Such information is useful to managers making
sales forecasts and product mix decisions.
Advertising and sales promotion plans: Advertising and other promotional costs affect sales
levels. A sales forecast should be based on anticipated effects of promotional activities.
Sales Budget of Lemlem1 Business is presented below
Quarter
1 2 3 4
Expected sales in units 10, 000 30, 000 40, 000 20, 000
Selling price per unit x Br. 20 x Br. 20 x Br.20 x Br.20
Total sales Br.200, 000 Br.600, 000 Br.800, 000 Br.400, 000
A. Cash Collection budget

This budget shows the total cash that a company will collect from various sources during the
accounting period or the budget period.

Quarter
1 2 3 4 Total
30% of the previous quarter sales Br. 90, 000 Br.60, 000 Br.180, 000 Br.240, 000 Br.570, 000
70% of the current quarter sales 140, 000 420, 000 560, 000 280, 000 1, 400, 000
Total collections Br.230, 000 Br.480, 000 Br.740, 000 Br. 520, 000 Br.1, 970, 000

B. Production Budget
1

24
This budgeted is prepared after sales budget to fix production requirements for the forth-coming
budget period can be determined and organized in the form of a production budget. The total
number of budgeted production requirement, is therefore, the sum of budgeted sales in unit and
target ending inventory. However, if the firm is not new in operation, usually some of its
production requirement can be satisfied using the inventory kept of the beginning of the period.
Therefore, the beginning inventory should be deducted from the total production requirement to
determine the exact units in the production budget. Therefore, production needs can be
determined as follows:

Budgeted sales in units ……………………***

Plus Desired ending inventory …………… ***
Total needs ……………………………….. ***
Less Beginning inventory ………………… ***
Required Production, ……………………… ***
Quarter Total
1 2 3 4
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending Inventory 6, 000 8, 000 4, 000 3, 000 3, 000
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000
Less: Beginning Inventory 2, 000 6, 000 8, 000 4, 000 2, 000
Units to be produced 14, 000 32,000 36, 000 19, 000 101, 000
NB: Ending production is equals 20% of sales of next quarter.
C. Direct Material Budget
This budget is done after production requirement have been identified to identify how much unit
to buy to meet future direct material needs. The direct materials budget ties the production to the
direct materials that will need to be purchased in order to produce the estimated units. The
required purchases of raw materials are computed as follows:
Raw Material required for production ……………….. ***
Plus desired ending raw material inventory …………. ***
Total raw material needs …………………….. ***
Less Beginning raw material ………………... ***
Raw Material to be purchase ………………………... ***

Quarter Total

25
 1 2 3 4
Production needs(pounds) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
Add: Desired ending inventory 48, 000 54, 000 28, 500 22, 500 22, 500
Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 48, 000 54, 000 28, 500 21, 000
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516,500
purchased(pounds)
Raw material purchase cost (in Birr)
1 2 3 4 Total
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516, 500
purchased
Raw materials cost per x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20
pound
Total Br.47, 400 Br.97, 200 Br.102, 900 Br.55, 800 Br.303, 300
D. Budgeted cash disbursement for direct material purchase
Businesses make cash payments for various purposes. This budget shows cash payments that will
be made only for purchase of direct materials.
Quarter Total
1 2 3 4
50% of the previous quarter Br. 25, 800 Br.23, 700 Br.48, 600 Br.51, 450 Br.149, 550
50% of the current quarter 23, 700 48, 600 51, 450 27, 900 151, 650
Total cash disbursement Br.49, 500 Br.72, 300 Br.101, 050 Br.79, 350 Br.301, 200
E. Direct labor Budget
Direct labor budget is developed after production budget to fix the required level laborers
necessary to complete sufficient time for each production. To compute direct labor requirements,
the number of units of finished product to be produced each period (month, quarter, and so on) is
multiplied by the number of direct labor-hours required to produce a single unit. Many different
types of labor may be involved. If so, then the computation should be by type of labor needed.
The labor requirements can then be translated into expected direct labor costs.

Quarter Total
1 2 3 4
Direct labor time needed 11, 200 25, 600 28, 800 15, 200 80, 800
Direct labor cost per hour x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50
Total direct labor cost Br.84, 000 Br.192, 000 Br.216, 000 Br.114, 000 Br.606, 000
F. Manufacturing overhead (MOH) budget

The manufacturing overhead budget provides a schedule of all costs of production other than
direct materials and direct labor. These costs should be broken down by cost behavior for

26
budgeting purposes and a predetermined overhead rate developed. This rate will be used to
apply manufacturing overhead to units of product throughout the budget period.

Quarter Total
1 2 3 4
Variable overhead Br.22, 400 Br.51, 200 Br.57, 600 Br.30, 400 Br.161,600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
Total MOH Br.83, 000 Br.111, 800 Br.118, 200 Br.91, 000 Br.404,000
Less: Depreciation 15, 000 15, 000 15, 000 15, 000 60, 000
Cash disbursements Br.68, 000 Br.96, 800 Br.103, 200 Br.76, 000 Br.344, 000
for MOH
G. Ending Finished Goods Inventory Budget
After completing schedules (a) to (g), the company had all of the data needed to compute unit
product costs. This computation was needed for two reasons: first, to know how much to charge
as cost of goods sold on the budgeted income statement; and second, to know what amount to put
on the balance sheet inventory account for unsold units. The carrying cost of the unsold units is
computed on the ending finished goods inventory budget as follows:
Budgeted Finished Goods Inventory 3, 000
Unit product cost Br.13
Ending Finished Goods Inventory in birr Br.39, 000
Production Quantity (unit) Cost
Total

Direct materials 15 pounds Br.0.20 per pound

Br.3
Direct labor 0.8 hours 7.50 per hour
6
Manufacturing overhead 0.8 hours 5.00 per hour
4
Unit product cost Br.13
MOH rate= Total MOH = 404, 000 = Br.5.00
Direct labor hours 80, 800

Budgeted cost of goods sold for Gibe Furniture Manufacturing Company for the budget period is
computed as follows:

27
 Cost of goods sold=100,000*13=1,300,000
H. Operating Expense Budget (selling and Administrative Expenses)

The budgeting of operating expenses depends on various factors. Month – to – month

fluctuation in sales volume and other cost-drivers activities directly influence many operating
expenses. Examples of expenses driven by sales volume include sales commissions and many
delivery expenses. Other expenses are not influenced by sales or other cost-driver activity (such
as rent, insurance, depreciation, and salaries) within appropriate relevant ranges and are
regarded as fixed. Selling and Administrative Expenses Budget for Gore Company for the
budget period is given below:

Quarter Total

1 2 3 4

Variable selling expenses Br.18, 000 Br.54, 000 Br.72, 000 Br.36, 000 Br.180, 000

Fixed selling &

administrative expenses

Advertising 20, 000 20, 000 20, 000 20, 000 80, 000

Executive salaries 55, 000 55, 000 55, 000 55, 000 220, 000

Insurance - 1, 900 37, 750 - 39, 650

Property taxes - - - 18,150 18,150

Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000

Total budgeted selling & Br.103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
administrative expenses

Disbursement for Selling & Administrative Expenses can also be prepared from the above facts
as follows for Gibee Company:
Quarter Total
1 2 3 4
Budgeted Selling & Br.103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
Administrative
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements Br.93, 000 Br.130, 900 Br.184, 750 Br.129, 150 Br.537, 800

Budgeted Income Statement

28
The budgeted income statement is the combination of all of the preceding budgets. This budget
shows the expected revenues and expenses from operations during the budget period. A firm
may have budgeted non-operating items such as interest on investments or gain or loss on the
sale of fixed assets. Usually they are relatively small, although in large firms the birr amounts
can be sizable. If non-operating items are expected, they should be included in the firm’s
budgeted income statement. Income taxes are levied on actual, not budgeted, net income, but the
budget plan should include expected taxes; therefore, the last figure in the budgeted income
statement is budgeted after tax net income.

Budgeted Income Statement for Lemlem Company can be prepared as follows:

Lemlem Company
Budgeted Income Statement
For the Year Ended December31, 2004
Sales [100, 000units at Br.20 Schedule 1(a)] Br.2, 000, 000
Cost of Goods Sold [100, 000 units at Br.13 Schedule1 (h)] 1, 300, 000
Gross profit 700, 000
Selling & Administrative Expenses [Schedule 1 (i)] 577, 800
Net Operating Income 122, 200
Interest Expense [Schedule 2(a)] 14, 000
Net Income Br. 108, 200
Preparing Financial Budget
The second major part of the master budget is the financial budget, which consists of the capital
budget, cash budget, ending balance sheet and the statement of changes in financial position.
Although there are some differences in operating budgets of manufacturing, merchandising and
service firms, very little difference exists among financial budgets of these entities.

Capital expenditure budget: Capital budgeting is the planning of investments in major resources
like plant and equipment, and other types of long-term projects, such as employee education
programs. The capital expenditure budget or capital budget describes the capital investment

29
plans for an organization for the budget period. It contains some of the most critical budgeting
decisions of the organizations.

Cash budget: The cash budget is a statement of planned cash receipts and disbursements. The
cash budget is composed of four major sections:

1. The receipts section: It consists of a listing of all of the cash inflows, except for
financing, expected during the budget period. Generally, the major source of receipts will be
from sales.

2. The disbursement section: It consists of all cash payments that are planned for the budget
period. These payments will include inventory purchases, wages and salary payments and so on.
In addition, other cash disbursements such as equipment purchases, dividends, and other cash
withdrawals by owners are listed.

3. The cash excess or deficiency section: The cash excess or deficiency section is computed
as follows:

Cash balance, beginning xxx

Add receipts xxx
Total cash available before financing xxx
Less disbursements xxx
Excess (deficiency) of cash available over disbursements xxx

If there is a cash deficiency during any budget period, the company will need to borrow funds. If
there is cash excess during any budget period, funds borrowed previous periods can be repaid or
the idle funds can be placed in short-term or other investments.

5. The financing section: This section provides a detail account of the borrowing and
repayments projected to take place during the budget period. It also includes a detail of
interest payments that will be due on money borrowed.

30
Cash Budget for Lemlem Company for the budget period is prepared as follows:

Quarter Total
1 2 3 4
Cash balance, beginning Br.42, Br.40, Br.40, Br.40, Br.42,
500 000 000 500 500
Add : Collection from 230, 480, 740, 520, 1, 970,
customers 000 000 000 000 000
Total cash available before 272, 520, 780, 560, 2, 012,
financing 500 000 000 500 500
Less: Disbursements for
Direct materials 49, 500 72, 300 100,050 79, 350 301,200
Direct labor 84, 000 192, 216,000 114, 606,000
000 000
Manufacturing 68, 000 96, 800 103,200 76, 000 344,000
overhead
Selling & 93, 000 130, 184,750 129, 537,800
Administrative 900 150
Equipment purchases 50, 000 40, 000 20,000 20,000 130,000
Dividend 8, 000 8, 000 8, 000 8, 000 32,000
Total disbursements 352, 540,000 632,000 426,500 1,951,000
500
Minimum cash balance 40, 000 40, 000 40, 000 40, 000 40, 000
Total need 392, 580, 672, 466, 1,
500 000 000 500 991,000
Excess (deficiency) of (120, (60, 108, 94, 000 21, 500
cash available over total 000) 000) 000
need
Financing:
Borrowing(at 120,000 60, 000 - - 180, 000
beginning)
Repayments( at - - (100, (80,000) (180,000)
ending) 000)
Interest(at 10% per - - (7,500) (6,500) (14,000)
annum)
Total financing 120, 60, 000 (107,50 (86,500) (14,000)
000 0)
Cash balance, ending Br.40,0 Br.40, Br.40, Br.47, Br.47,
00 000 500 500 500

31
Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted
statement of financial position, is derived from the budgeted balance sheet at the beginning of the
budget period and the expected changes in the account balance reflected in the operating budget,
capital budget, and cash budget.

Lemlem Company
Budgeted Balance Sheet
December31, 2004
ASSETS
Current assets:
Cash [Schedule 2(a)] Br. 47, 500
Accounts Receivable 120, 000
Raw Materials Inventory 4, 500
Finished Goods Inventory 39, 000
Total current assets Br.211, 000
Plant and Equipment:
Land Br.80, 000
Building and Equipment 830, 000
Accumulated Depreciation (392, 000)
Plant and Equipment, net 518, 000
Total assets Br.729, 000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.27, 900

32
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 526, 100
Total stockholders’ equity 701, 100
Total liabilities and stockholders’ equity Br.729, 000

Preparation of Master Budget (Merchandising Company)

Example 1: Blue Nile Company’s newly hired accountant has persuaded
management to prepare a master budget to aid financial and operating
decisions. The planning horizon is only three months, January to March. Sales
in December (2012) were Br. 40, 000. Monthly sales for the first four months
of the next year (2013) are forecasted as follows:
January Br. 50, 000
February 80, 000
March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are credit sales. All
credit sales are collected in the month following the sales. Uncollectible
accounts are negligible and are to be ignored.
Because deliveries from suppliers and customer demand are uncertain, at
the end of any month Blue Nile wants to have a basic inventory of Br. 20,
000 plus 80% of the expected cost of goods to be sold in the following
month. The cost of merchandise sold averages 70%of sales. The purchase
terms available to the company are net 30 days. Each month’s purchase are
paid as follows:
50% during the month of purchase and,
50% during the month following the purchases
Monthly expenses are:
Wages and commissions……………………………Br. 2, 500 + 15%of sales, paid
as incurred.

33
 Rent expense………………………………………..Br. 2, 000 paid as
incurred.
Insurance expense…………………………………..Br.200 expiration per
month
Depreciation including truck……………………….Br.500 per month
Miscellaneous expense…………………………….5% of sales, paid as
incurred.
In January, a used truck will be purchased for Br. 3, 000 cash. The company
wants a minimum cash balance of Br. 10, 000 at the end of each month. Blue
Nile can borrow cash or repay loans in multiples of Br. 1, 000. Management
plans to borrow cash more than necessary and to repay as promptly as
possible. Assume that the borrowing takes place at the beginning, and
repayment at the end of the months in question. Interest is paid when the
related loan is repaid. The interest rate is 18% per annum. The closing
balance sheet for the fiscal year just ended at December 31, 2012,is:

Blue Nile Company

Balance Sheet
December 31, 2012
ASSETS
Current assets:
Cash Br. 10, 000
Account receivable 16,000
Merchandise inventory 48, 000
Unexpired insurance 1, 800
Br.75, 800
Plant assets:
Equipment, fixture and other Br.37, 000
Accumulated depreciation 12, 800
Br.24, 200
Total assets
Br.100,000
LIABILITIES AND OWNERS’ EQUITY
Liabilities:
Accounts payable Br.16, 800
Accrued wages and commissions payable 4, 250
Br.21, 050
Capital:

34
Owners’ equity 78, 950
Total liabilities and owners’ equity Br.100,
000

Instructions:
1) Using the data given above, prepare the following detailed
schedules for the first quarter of the year:
a) Sales budget
b) Cash collection budget
c) Purchase budget
d) Disbursement for purchases
e) Operating expenses budget
f) Disbursement for operating expenses
2) Using the budget data given above and the schedules you have prepared,
construct the following pro forma financial statements
a. Income statement for the first quarter of the year.
b. Cash budget including receipts, payments, and effect of
financing
c. Balance sheet at March 31, 2013.

STEPS IN PREPARATION OF MASTER BUDGET

1. A) Sales budget

Decembe January Februar March Jan.-Mar.

r* y Total
Cash sales Br.24, Br.30, Br.48, Br.36, Br.114,
(40%) 000 000 000 000 000
Credit sales 16, 20, 32, 76,
(60%) 000 000 000 24,000 000
Totals Br.40, Br.50, Br.80, Br.60, Br.190,
000 000 000 000 000

35
*December sales are included in the schedule (a) because they affect cash
collected in January.
b) Cash collection budget
January February March
Cash sales of the Br.30, 000 Br.48, 000 Br.36, 000
month
Credit sales of last 16, 000 20, 000 32, 000
month
Total cash collected Br.46, 000 Br.68, 000 Br.68, 000

c) Purchase budget

January February March Jan.-Mar

Required ending Br.64, Br.53, Br.48,
inventory 800 600 000
Cost of gods sold 35, 56, 42, Br.133,
000 000 000 000
Total needed Br.99, Br.109, Br.90,
800 600 000
Beginning inventory 48, 64, 53,
000 800 600
Purchases budget Br.51, Br.44, Br.36,
800 800 400

d) Disbursement for purchases

January February March

50% of last month’s Br.16, Br.25, 900 Br.22,
purchase 800 400
50% of current month’s 25, 22, 400 18,
purchase 900 200
Total disbursement for Br.42, Br.48, 300 Br.40,
purchase 700 600

e) Operating expense budget

January February March Jan.-

Mar.
Wages and Br.10, Br.14, 500 Br.11, Br.36,
commissions 000 500 000
Rent expense 2, 2, 000 2, 6,

36
 000 000 000
Insurance expense 200
200 200 600
Depreciation expense 500 1,
500 500 500
Miscellaneous 2, 4, 000 3, 9,
expense 500 000 500
Total Br.15, Br.21, 200 Br.17, Br.53,
200 200 600

f) Disbursement for operating expenses budget

January February March

Wages and commissions Br.14, 250 Br.14, 500 Br.11,
500
Rent expense 2, 000 2, 000 2,
000
Miscellaneous expense 2, 500 4, 000 3,
000
Total Br.18, 750 Br.20, 500 Br.16,
500

2. A) Budget income statement

Blue Nile Company

Budget Income Statement
For the Quarter Ended, March 31, 2013

Sales (schedule 1(a)) Br.190, 000

Cost of goods sold 133, 000
(schedule 1(c))
Gross profit 57, 000
Operating expenses
Wages and Br.36, 000
commissions
Rent expense 6, 000
Insurance expense 1, 500
Depreciation expense 600
Miscellaneous 9, 500 53, 600
expense
Operating income 3, 400
Interest expense* 885
Net income Br. 2, 515

*Interest expense computation

37
 Paid interest = 11, 000´0.18´3/12= 495
Accrued amount:
On the first batch borrowing:
8, 000´0.18´3/12= 360
On the second batch borrowing:
1, 000´0.18´2/12= 30
Total interest expense incurred Br.885

b) Cash budget including receipts, payments and effects of

financing

January February March

Beginning balance Br.10, Br.10, Br.10,
000 550 750
Collections (Schedule1 (b)) 46, 68, 68,
000 000 000
Cash available for the use (x) Br.56, Br.78, Br.78,
000 550 750
Cash disbursements for:
Purchases (Schedule 1(d)) 42, 48, 40,
700 300 600
Operating expenses 18, 20, 16,
(Schedule1 (f)) 750 500 500
Truck purchases 3, - -
000
Total disbursement (y) Br.64, Br.68, Br.57,
450 800 100
Minimum cash balance required 10, 10, 10,
000 000 000
Total cash needed Br.74, Br.78, Br.67,
450 800 100
Cash excess (deficiency) Br.(18, Br. Br.11,
450) ( 250) 650
Effects of financing
Borrowing 19, 1, -
000 000
Payment of the principal - - (11,
000)
Payment of interest - -
(495)
Net effect of financing (z) Br.19, Br.1, 000 Br.(11,
000 495)
End cash balance (x+z-y) Br.10, Br.10, Br.10,

38
 550 750 155

c) Budgeted balance sheet

Blue Nile Company

Budgeted Balance Sheet
March 31, 2013
ASSETS
Current assets
Cash Br. 10, 155
Accounts receivable 24, 000
Merchandise inventory 48, 000
Unexpired insurance 1, 200
Br. 83, 355
Plant assets
Equipment, Fixture and others 40, 000
Accumulated depreciation 14, 300 25,
700
Total assets Br. 109, 055

LIABILITIES AND OWNER’S EQUITY

Liabilities
Accounts payable Br.18, 200
Loan payable 9, 000
Interest payable 390
Total liabilities Br.27, 590
Capital
Beginning owners’ equity Br.78, 950
Net income 2, 515
Ending capital balance 81, 465
Total liabilities and owners’ equity
Br.109, 055

39