CHAPTER TWO

MASTER BUDGET AND

RESPONSIBILITY
ACCOUNTING
 LEARNING OBJECTIVES
 Understand what a master budget is and explain
its benefits
 Describe the advantages of budgets
 Prepare the operating budget and its supporting
schedules
 Prepare an activity-based budget
 Describe responsibility centers and responsibility
accounting
 Explain how controllability relates to
responsibility accounting
 Budgets and the Budgeting Cycle
• Budgeting – common accounting tool companies
use for planning and controlling to satisfy customers
and succeed in the marketplace.
• The act of preparing a budget is called budgeting.
• A budget is (a) the quantitative expression of a
proposed plan of action by management for a
specified period and (b) an aid to coordinate what
needs to be done to implement that plan.
• A budget generally includes both financial and
nonfinancial aspects of the plan, and it serves as a
blueprint for the company to follow in an upcoming
period.
• A financial budget quantifies management’s
expectations regarding income, cash flows, and
financial position.
• Just as financial statements are prepared for past
periods, financial statements can be prepared for
future periods—for example, a budgeted income
statement, a budgeted statement of cash flows, and a
budgeted balance sheet.
• Underlying these financial budgets are nonfinancial
budgets for, say, units manufactured or sold,
number of employees, and number of new products
being introduced to the marketplace.
 Advantages of Budgets
Promote coordination and communication among
subunits within the company
 Coordination is meshing 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 by all employees.
 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.
Provide a framework for judging performance and
facilitating learning
 Budgets enable a company’s managers to measure
actual performance against predicted performance.
 It is important to remember that a company’s budget
should not be the only benchmark used to evaluate
performance.
 Many companies also consider performance relative to
peers as well as improvement over prior years.
 The problem with evaluating performance relative only
to a budget is it creates an incentive for subordinates
to set a target that is relatively easy to achieve
Motivate managers and other employees
 Research shows that challenging budgets improve
employee performance because employees view
falling short of budgeted numbers as a failure.
 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.
Types of Budget and Budgeting Techniques
Strategic Plan:
• The most forward looking budget is the strategic plan, which
sets the overall goals and objective of the organization.
• Some organization won’t classify the strategic plan as an
actual budget though because it does not deal with a specific
time frame and it does not produce forecasted financial
statement.
• In any case, the strategic plan leads to long range planning
which produce forecasted financial statement for five or
ten years.
• The financial statements are estimates of what management
would like to see in the company’s future financial
statement.
Capital Budget:
• Capital budget is a budget that details the planned
expenditure for facilities, equipment, new product, and
other long-term investments.
Master budget:
• A master budget is a short-term, comprehensive plan to
achieve the financial and operational goals of an
organization.
• Master budget comprises of the organizations overall
plan for the given period and the budget for the various
functional areas the make up the organization.
• Master budget can be prepared as a standalone for one
year or one operating cycle or in a continuous basis.
• Different organizations prepare budget using
different techniques
Incremental budgeting:
• Is a budget set based on past year’s actual
performance.
• In this technique a budget for the coming year is
simply this year budgeted or actual results plus
or minus some amount for expected change on
planned operation or change in the market price.
Zero based budgeting:
• In a dynamic business it often makes sense to
'start afresh' when developing a budget, rather
than basing ideas too much on past performance.
• In this technique each budget is therefore
constructed without much reference to previous
budgets.
• Preparing a budget afresh is usually required in
most business organizations, where the business
environment is volatile that require continues
effort of incorporating changes in budget
Rolling budgets:
• Given the speed of change and general uncertainty in the
external environment, shareholders seek quick results.
• US companies typically report to shareholders every three
months, compared with six months in the UK.
• Rolling budgets involve evaluating the previous twelve
months' performance on an ongoing basis, and
forecasting the next three months' performance.
Strategic budgeting:
• This involves identifying new, emerging opportunities,
and then building plans to take full advantage of them.
• This is closely related to zero based budgeting and helps to
concentrate on gaining competitive advantage.
Activity based budgeting:
• This examines individual activities and assesses
the strength of their contribution to company
success.
• They can then be ranked and prioritized, and be
assigned appropriate budgets.
 Budgeting Cycle and Master Budget
• Well-managed companies usually cycle through the
following budgeting steps during the course of the fiscal
year:
Working together, managers and management accountants
plan the performance of the company as a whole and the
performance of its subunits (such as departments or
divisions).
 Taking into account past performance and anticipated
changes in the future, managers at all levels reach a common
understanding on what is expected.
Senior managers give subordinate managers a frame of
reference, a set of specific financial or nonfinancial
expectations against which actual results will be compared.
 Management accountants help managers investigate
variations from plans, such as an unexpected decline in
sales.
 If necessary, corrective action follows, such as a reduction in
price to boost sales or cutting of costs to maintain
profitability.
 Managers and management accountants take into account
market feedback, changed conditions, and their own
experiences as they begin to make plans for the next period.
 For example, a decline in sales may cause managers to make
changes in product features for the next period.
 The working document at the core of this process is called
the master budget.
 Master budget

• The master budget is a summary of a company’s plans

that sets specific targets for sales, production,
distribution, and financing activities.
• The master budget is the initial plan of what the
company intends to accomplish in the budget period.
• It generally culminates in a cash budget, a budgeted
income statement, and a budgeted balance sheet (pro
forma statements ).
• In short, it represents a comprehensive expression of
management’s plans for the future and how these plans
are to be accomplished.
• The master budget evolves from both operating and
financing decisions made by managers.
 Parts of A Master Budget
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.
Financing 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.
 Steps in Budget Development
1. If you are asked to prepare a master budget
how can you start?

2. Is it the operating budget or the cash budget

that must be prepared?

3. What are the relevant data and how they are

processed and result the final master budget?
 Steps in developing an operating budget
• The Operating Budget refers to the budgeted income
statement and all the supporting schedules.
• One way to think about the 1st question is to
understand that 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.
• 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
 Steps in developing an operating budget
• Budgeted income statement and its supporting budget
schedules
Step 1: Prepare the revenues budget: usual starting point
in budgeting
Step 2: Prepare the production budget (in units)
Step 3: Prepare the direct materials usage and purchases
budgets
Step 4: Prepare the direct manufacturing labor budget
Step 5: Prepare the manufacturing overhead budget
Step 6: Prepare the ending inventories budget
Step 7: Prepare the cost of goods sold budget
Step 8: Prepare the nonmanufacturing costs budget
Step 9: Prepare the budgeted income statement
The Master Budget Interrelationships
The Sales Budget
• A sales budget is a detailed schedule showing the
expected sales for the budget period; typically, it is
expressed in both dollars and units.
• An accurate sales budget is the key to the entire
budgeting process.
• If the sales budget is sloppily done, then the rest of
the budgeting process is largely a waste of time.
• The sales budget helps determine how many units
need to be produced.
• Thus, the production budget is prepared after the
sales budget.
• The production budget in turn is used to determine
the budgets for manufacturing costs including the
direct materials budget, the direct labor budget, and
the manufacturing overhead budget.
• These budgets are then combined with data from the
sales budget and the selling and administrative
expense budget to determine the cash budget.
• In essence, the sales budget triggers a chain reaction
that leads to the development of the other budgets.
 Budgeting Example

• Royal Company is manufacturing business which

produces and sold product X to its existing and new
customers. The company is preparing budgets for the
quarter ending June 30, 2017.
• Budgeted sales for the next five months are:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units.
The selling price is $10 per unit. So based on the given
information prepare the sales (revenue)budget for the
quarter end June 30,2017.
 The Cash Budget
• Once the operating budgets (sales, production, and so on) have
been established, the cash budget and other financial budgets can
be prepared.
• A cash budget is a detailed plan showing how cash resources will
be acquired and used over some specified time period.
• Consider the sales budget and the following additional
information for Royal Company
 All sales are on account.
 Royal’s collection pattern is:
– 70% collected in the month of sale,
– 25% collected in the month following sale,
– 5% uncollectible.
 The March 31 accounts receivable balance of $30,000 will be
collected in full.
Note: The 25% of June sales ($75,000) to be collected in July
becomes the Accounts Receivable balance at the end of June.
 The Production Budget information
• The production budget is prepared after the sales budget.
• The production budget lists the number of units that must be
produced during each budget period to meet sales needs and to
provide for the desired ending inventory.
• Production
Budgeted unit sales needs can be determined as follows:
XXXX
Add desired ending inventory XXXX
Total needs XXXX
Less beginning inventory XXXX
Required production XXXX

• Note that production requirements for a quarter are influenced by

the desired level of the ending inventory.
• Inventories should be carefully planned.
• Excessive inventories tie up funds and create storage problems.
• Insufficient inventories can lead to lost sales, high-cost crash
• The management at Royal Company wants ending
inventory to be equal to 20% of the following month’s
budgeted sales in units.
• On March 31, 4,000 units were on hand.
 Inventory Purchases—Merchandising Company
• Royal Company prepares a production budget, since it is
a manufacturing company.
• If it were a merchandising company, it would instead
prepare a merchandise purchases budget showing the
amount of goods to be purchased from its suppliers
during the period.
• The merchandise purchases budget has the same basic
formatBudgeted
as thesales production budget, as shown
XXXXXbelow:
Add desired ending merchandise inventory XXXXX
Total needs XXXXX
Less beginning merchandise inventory XXXXX
Required purchases XXXXX
 The Direct Materials Budget
• Returning to Royal Company after the production
requirements have been computed, a direct materials
budget can be prepared.
• The direct materials budget details the raw materials
that must be purchased to fulfill the production budget
and to provide for adequate inventories.
• The required purchases of raw materials are computed as
follows:
Raw materials needed to meet the production schedule XXXXX
Add desired ending inventory of raw materials XXXXX
Total raw materials needs XXXXX
Less beginning inventory of raw materials XXXXX
Raw materials to be purchased XXXXX
 At Royal Company, five pounds of material are required
per unit of product.
 Management wants materials on hand at the end of each
month equal to 10% of the following month’s production.
 On March 31, 13,000 pounds of material are on hand.
Material cost is $0.40 per pound.
Schedule of expected cash disbursements for purchases
of materials
• The direct materials budget (and the merchandise
purchases budget for a merchandising company) is
usually accompanied by a schedule of expected cash
disbursements for raw materials (or merchandise
purchases).
• This schedule is needed to prepare the overall cash
budget.
• Disbursements for raw materials (or merchandise
purchases) consist of payments for purchases on account
in prior periods plus any payments for purchases in the
current budget period.
 Royal pays $0.40 per pound for its materials.
 One-half of a month’s purchases is paid for in the month
of purchase; the other half is paid in the following month.
 The March 31 accounts payable balance is $12,000.
 The Direct Labor Budget
• The direct labor budget is also developed from the production
budget.
• Direct labor requirements must be computed so that the company
will know whether sufficient labor time is available to meet
production needs.
• By knowing in advance how much labor time will be needed
throughout the budget year, the company can develop plans to
adjust the labor force as the situation requires.
• Companies that neglect to budget run the risk of facing labor
shortages or having to hire and lay off workers at awkward times.
• Erratic labor policies lead to insecurity, low morale, and
inefficiency.
 At Royal, each unit of product requires 0.05 hours (3 minutes) of
direct labor.
 The Company has a “no layoff” policy so all employees will be
paid for 40 hours of work each week.
 For purposes of our illustration assume that Royal has a “no
layoff” policy, workers are pay at the rate of $10 per hour
regardless of the hours worked.
 For the next three months, the direct labor workforce will be paid
for a minimum of 1,500 hours per month.
 The Manufacturing Overhead Budget
• The manufacturing overhead budget provides a
schedule of all costs of production other than direct
materials and direct labor.
 At Royal, manufacturing overhead is applied to
units of product on the basis of direct labor hours.
 The variable manufacturing overhead rate is $20
per direct labor hour.
 Fixed manufacturing overhead is $50,000 per
month, which includes $20,000 of noncash costs
(primarily depreciation of plant assets).
Note: - depreciation is non-cash expense
 Ending Finished Goods Inventory Budget
• Now, Royal can complete the ending finished goods
inventory budget.
• At Royal, manufacturing overhead is applied to units of
product on the basis of direct labor hours.
The Selling and Administrative Expense Budget
•The selling and administrative expense budget lists
the budgeted expenses for areas other than
manufacturing.
•In large organizations, this budget would be a
compilation of many smaller, individual budgets
submitted by department heads and other persons
responsible for selling and administrative expenses.
•For example, the marketing manager in a large
organization would submit a budget detailing the
advertising expenses for each budget period.
•At Royal, the selling and administrative expense
budget is divided into variable and fixed components.
 The variable selling and administrative expenses are
$0.50 per unit sold.
 Fixed selling and administrative expenses are
$70,000 per month.
 The fixed selling and administrative expenses include
$10,000 in costs – primarily depreciation – that are
not cash outflows of the current month.
The Cash Budget
• The cash budget is divided into four sections:
1. Cash receipts section lists all cash inflows excluding
cash received from financing;
2. Cash disbursements section consists of all cash
payments excluding repayments of principal and
interest;
3. Cash excess or deficiency section determines if the
company will need to borrow money or if it will be
able to repay funds previously borrowed; and
4. Financing section details the borrowings and
repayments projected to take place during the budget
period.
• Assume the following additional information for
Royal:
– Maintains a 16% open line of credit for $75,000
– Maintains a minimum cash balance of $30,000
– Borrows on the first day of the month and repays
loans on the last day of the month
– Pays a cash dividend of $49,000 in April
– Purchases $143,700 of equipment in May and
$48,300 in June (both purchases paid in cash)
– Has an April 1 cash balance of $40,000
Note: - $50,000 × 16% × 3/12 = $2,000 Borrowings on April 1 and repayment of
The Budgeted Income Statement
• After we complete the cash budget, we can
prepare the budgeted income statement for Royal
based on the information available from the above
budgets.
• It shows the company’s planned profit for the
upcoming budget period, and it stands as a
benchmark against which subsequent company
performance can be measured.
The Budgeted Balance Sheet
• The budgeted balance sheet is developed by beginning
with the balance sheet from the beginning of the budget
period and adjusting it for the data contained in the
various schedules.
•Royal reported the following account balances prior to
preparing its budgeted financial statements:
• Land $50,000
• Common stock $200,000
• Retained earnings $146,150
(April 1)
 Responsibility Accounting

• The basic idea Responsibility Accounting is that

large diversified organizations are difficult, if not
impossible to manage as a single segment, thus they
must be decentralized or separated into manageable
parts.
• These parts or segments are referred to as
responsibility centers.
• An underlying concept of responsibility accounting is
referred to as controllability.
• Conceptually, a manager should only be held
responsible for those aspects of performance that he
or she can control.
• The purpose of a responsibility accounting system is
to ensure that each manager and worker in an
organization strives towards the overall goals set by
top management.
• The basis of a responsibility accounting system is the
designation of each sub-unit in the organization as
a particular type of responsibility center.
• A responsibility center is a sub-unit in an
organization whose manager is held accountable for
specified financial and non-financial results of the
sub-unit’s activities.
• Thus, responsibility accounting is a system that measures
the plans and actions of each responsibility center.
• There are four common types of responsibility centers:
i. Cost center is an organizational unit whose
manager is responsible for costs only. Examples:
Production Department of Manufacturing Companies.
ii. Revenue center is a responsibility center whose
manager is held accountable for the generation of
revenues. Examples: Sales departments, marketing
departments, etc
iii. Profit centers are sub-divisions of a business assigned
responsibility for both costs and revenues. Example: - A
restaurant of a large hotel
iv. Investment centers accountable for costs, revenues and
the profitable utilization of invested capital. Example:
Divisions of large companies.
End of chapter