Chapter 7

The Master Budget

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:

1. Explain the major features and advantages of a master budget.

2. Follow the principal steps in preparing a master budget.

3. Prepare the operating budget and the supporting schedules.

4. Prepare the financial budget.

5. Understand the difficulties of sales forecasting.

6. Anticipate possible human relation problems caused by budgets.

7. Use a spreadsheet to develop a budget (APPENDIX 7-A).

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CHAPTER 7: OVERVIEW
This chapter covers the preparation and need for the master budget.

Section One: Defines the strategic plan, long-range planning, capital budgets, the master
budget, pro forma statements, and continuous budgets. The components
of the master budget are identified including the operating budget (sales
budget, purchases budget, cost of goods sold budget, operating expenses
budget, and budgeted income statement) and the financial budget (capital
budget, cash budget, and budgeted balance sheet). The advantages of
budgeting are also discussed.

Section Two: Illustrates the preparation of the master budget through the use of
information on the Cooking Hut Company (CHC). From the information
provided for CHC, each of the steps in preparing the master budget is
shown. The major steps in preparing the master budget are the
preparation of the operating budget, budgeted income statement, and the
financial budget.

Section Three: The difficulty of and the importance of sales forecasting is presented. The
sales budget is derived from the sales forecast. Several other budgets are
dependent on the sales budget. Therefore, successful sales forecasting is
critical to accurate budgeting. Factors to consider in preparing the sales
forecast are the past pattern of sales, estimates by the sales force, general
economic conditions, competitors' actions, changes in the firm's prices,
changes in the product mix, market research studies, and the advertising
and sales promotions planned for the budget period.

Section Four: Considers the behavioral consequences of budgeting. People make

budgets and are evaluated using them. The effect of the budget on
managers and their subordinates must be anticipated and considered in
setting the budget and in using it as a control device. Participative
budgeting is mentioned.

Section Five: The role that financial planning models have in organizations today is
examined. Mathematical models of the company's master budget can be
constructed which assist managers in analyzing the impact of various
assumptions about sales, product mix, etc. on the profitability of the firm.
Various alternatives can be examined before final decisions are selected.

Section Six: Appendix A illustrates the use of microcomputer spreadsheets in

constructing the master budget. It is important to have an area for input
values and to use cell formulas to construct the budgets.

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CHAPTER 7: ASSIGNMENTS
COGNITIVE EXERCISES

21 Budgets as Limitations on Spending

22 Sales Personnel and Budgeting
23 Master Budgets for Research and Development
24 Production Budgets and Performance Evaluation

EXERCISES

25 Fill In The Blanks

26 Cash Budgeting
27 Purchases and Cost of Goods Sold
28 Purchases and Sales Budgets
29 Sales Budget
30 Sales Budget
31 Cash Collection Budget
32 Purchase Budget
33 Purchase Budget
34 Cash Budget (Exhibit 7-11)

PROBLEMS

35 Cash Budget
36 Cash Budget
37 Budgeting at Ritz-Carlton
38 Activity-Based Budgeting
39 Budgeting, Behavior, and Ethics
40 Spreadsheets and Sensitivity Analysis of Income Statements
41 Spreadsheets and Sensitivity Analysis of Operating Expenses

CASES

42 Comprehensive Cash Budgeting (Exhibits 7-12, 7-13, and 7-14)

43 Cash Budgeting for a Hospital
44 Comprehensive Budgeting for a University

COLLABORATIVE EXERCISES

45 Personal Budgeting
46 Internet Exercise - Carnival Corporation
(http://www.carnivalcorp.com)

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CHAPTER 7: OUTLINE

I. Budgets and the Organization

Budget - a condensed business plan for the forthcoming year (or less). It is used in
attracting funds from investors and banks, and by managers to guide them in
allocating resources, maintaining control, and measuring and rewarding progress.

A. Advantages of Budgets {L. O. 1}

1. It compels managers to think ahead by formalizing their
responsibilities for planning.
2. It provides definite expectations that are the best framework for
judging subsequent performance.
3. It aids managers in coordinating their efforts, so that the
objectives of the organization as a whole match the objectives of its
parts.

B. Formalization of Planning

Forces managers to think ahead - to anticipate and prepare for changing

conditions. Planning is an explicit management responsibility. Managers will
set goals and objectives and establish policies to aid in their achievement.
The objectives are the destination points, and budgets are the road maps
guiding us to those destinations.

C. Framework for Judging Performance

Budgeted goals and performance are generally a better basis for judging
actual results than is past performance. The major drawback of using
historical results for judging current performance is that inefficiencies may be
concealed in the past performance. Changes in economic conditions,
technology, personnel, competition, etc., also limit the usefulness of
comparisons with the past.

D. Communication and Coordination

Budgets tell employees what is expected of them. A good budget process

communicates both from the top down and from the bottom up. Top
management makes clear the goals and objectives of the organization in its
budgetary directives. Employees and lower-level managers then inform
higher-level managers how they plan to achieve the goals and objectives.
Budgets also help managers coordinate objectives. The budgetary process
forces managers to visualize the relationship of their department's activities to
those of other departments and the company as a whole.

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5
E. Types of Budget

The planning horizon for budgeting may vary from one day to many years.
Strategic Plan - the most forward-looking budget which sets the overall
goals and objectives of the organization. Long-Range Planning - forecasted
financial statements for 5- or 10-year periods. Long-range planning includes
decisions about the addition or deletion of product lines, design and location
of new plants, acquisition of buildings and equipment, and other long-term
commitments. Capital Budgets - detail the planned expenditures for
facilities, equipment, new products, and other long-term investments in
coordination with long-range plans.

A budget is a formal, quantitative expression of management plans. Master

Budget (Pro Forma Statements) - summarizes the planned activities of all
subunits of an organization (e.g., sales, production, distribution, and finance).
It quantifies targets for sales, cost-driver activity, purchases, production, net
income, and cash position, and any other objective that management
specifies. It is a periodic business plan that includes a coordinated set of
detailed operating schedules and financial statements. It includes forecasts of
sales, expenses, cash receipts and disbursements, and balance sheets.
Managers may also prepare daily or weekly task-oriented budgets that help
them carry out their particular functions and meet operating and financial
goals.

Continuous Budgets (Rolling Budgets) - common form of master budgets

that add a month in the future as the month just ended is dropped. This type
of budget forces managers to think specifically about the forthcoming 12
months and thus maintain a stable-planning horizon. While a new month is
added to a continuous budget, the other eleven months can also be updated.

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F. Components of a Master Budget

The usual master budget for a nonmanufacturing company has the following
components:

1. Operating Budget

a. Sales budget (and other cost-driver budgets as necessary)

b. Purchases budget
c. Cost of goods sold budget
d. Operating expenses budget
e. Budgeted income statement

2. Financial budget

a. Capital budget
b. Cash budget
c. Budgeted balance sheet

See EXHIBIT 7-1 for a condensed diagram of the relationships among the
various parts of the master budget for a nonmanufacturing company.
Manufacturing companies must prepare ending inventory budgets and
budgets for labor, materials, and factory overhead in addition to the budgets
indicated for nonmanufacturing organizations.

The two major parts of the master budget are the operating budget and the
financial budget. Operating Budget - focuses on the income statement and
its supporting schedules. It is sometimes called a Profit Plan, although it
may show a budgeted loss or may be used to simply budget expenses in an
agency with no revenues. Financial Budget - focuses on the effects that the
operating budget and other plans (e.g., capital budgets and repayments of
debt) will have on cash.

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II. Preparing the Master Budget

A. The COOKING HUT COMPANY

Background information on the company used to illustrate the preparation of

the master budget, Cooking Hut Company (CHC), is provided. The actual
March Sales of $40,000 and expected sales for the next five months are
provided. See EXHIBIT 7-2 for a balance sheet at the beginning of the
budget period. The details regarding the composition of sales as to whether
they are cash or credit is given as is the collection pattern for the credit sales.
The company's inventory policy, the payment pattern for purchases, wages
and commissions, and for various operating expenses are supplied. Also, the
desire of the company to maintain a minimum cash balance at the end of each
month is expressed. Borrowings and repayments of loans are said to be in
multiples of $1,000. Loans are made at the beginning of a month and
repayments occur at the end of a month with interest computed using an 18%
annual rate.

B. Steps in Preparing the Master Budget {L. O. 2}

The principal steps in preparing the master budget are:

1. Step 1: Preparing the Operating Budget {L. O. 3}

Using the data given in the description of the problem, the following
schedules are prepared:

a. Sales Budget (Schedule a) {L. O. 3}

This schedule shows, by month, the expected credit, cash, and
total sales. Total sales for the budget period are shown on the
budgeted income statement (EXHIBIT 7-3).

b. Cash Collections (Schedule b)

This schedule indicates the sources for the cash collections as

the current month's cash sales and the collection of the prior
month's credit sales. Total cash collections for each month
are the sum of these two amounts. The total of these
disbursements is used in helping to construct the cash budget
(EXHIBIT 7-4).

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 c. Purchases Budget (Schedule c)

The budgeted purchases are found using the following

equation:

budgeted purchases = desired ending + cost of goods sold – beginning

inventory inventory

The cost of goods sold is derived from the sales budget by

multiplying an appropriate percentage by the budgeted sales.
The total amount of this expense appears in the budgeted
income statement (EXHIBIT 7-3).

d. Disbursements for Purchases (Schedule d)

The monthly payment for purchases is based on the dollar

purchases derived in Schedule c and the company's payment
pattern for its merchandise purchases. CHC pays for half of its
purchases in the month of purchase and the other half in the
month following purchase. Therefore, payments for purchases
include half of the current month's purchases and half of the
prior month's purchases. The total of these disbursements is
used in helping to construct the cash budget (EXHIBIT 7-4).

e. Operating Expense Budget (Schedule e)

This schedule details the amounts of wages, commissions,

miscellaneous, rent, insurance and depreciation expenses for
each month. Some of these vary with activity, while others are
usually fixed each period. Totals for the budget period for these
items are included on the budgeted income statement
(EXHIBIT 7-3).

f. Operating Expense Disbursements (Schedule f)

The payments for these expenses include half of last month's

wages and commissions, half of the current month's wages and
commissions, and the current period's rent and miscellaneous
expenses. The total of these disbursements is used in helping to
construct the cash budget (EXHIBIT 7-4).

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2. Step 2: Preparing the Budgeted Income Statement

Amounts from the sales, purchases, and operating expenses schedules

are used in helping to construct the budgeted income statement
(EXHIBIT 7-3). Interest expense, determined in the cash budget
(EXHIBIT 7-4) also is needed to complete the budgeted income
statement.

3. Step 3: Preparation of Financial Budget {L. O. 4}

The second part of the master budget is the financial budget, which
consists of the capital budget, cash budget, and ending balance sheet.
This chapter focuses on the cash budget and the budgeted balance
sheet. The capital budget is discussed in Chapter 11.

a. Cash Budget (EXHIBIT 7-4)

The cash budget is constructed using three major sections.

First, expected cash receipts (Schedule b) are added to the
beginning cash balance to get the total cash available before
financing. Then, cash disbursements for purchases (Schedule
d), operating expenses (Schedule f), and capital acquisitions or
other cash expenses are added to the minimum cash balance
desired to get the total cash needed.

An excess or deficiency of cash is computed as the difference

between the cash available and the total cash needed in order to
determine whether the company needs to borrow funds or if
prior borrowings and interest may be paid off. The last section
of the cash budget details the financing activity and indicates
the ending cash balance.

b. Budgeted Balance Sheet (EXHIBIT 7-5)

The final step in preparing the master budget is to construct the

budgeted balance sheet that projects each balance sheet item in
accordance with the business plan expressed in the previous
schedules. The first draft is rarely the final draft. As it is
reworked, the budgeting process becomes an integral part of the
management process itself - budgeting is planning and
communicating.

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III. Difficulties of Sales Forecasting {L. O. 5}
The sales budget is the foundation of the entire master budget. The accuracy of the
estimated purchases budgets, production schedules, and costs depends on the detail
and accuracy (in dollars, units, and mix) of the budgeted sales. Sales Forecast (i.e.,
a prediction of sales under a given set of conditions) is used to prepare the Sales
Budget (i.e., the result of decisions to create the conditions that will generate a
desired level of sales). A firm may have sales forecasted for various levels of
advertising. Once a decision has been made regarding the level of advertising
expenditures, the sales budget is determined.

Sales forecasts are usually prepared under the direction of the top sales executive.
Important factors considered by a forecaster include:

1. Past patterns of sales

2. Estimates made by the sales force
3. General economic conditions
4. Competitors' actions
5. Changes in the firm's prices
6. Changes in product mix
7. Market research studies
8. Advertising and sales promotion plans

Sales forecasting usually combines various techniques. In addition to the opinions of

sales staff, statistical analysis of correlations between sales and economic indicators
(prepared by economists and members of the market research staff) and opinions of
line management provide valuable help. Ultimately, the sales budget is the
responsibility of line management.

IV. Getting Employees To Accept The Budget {L. O. 6}

In order to benefit an organization, budgets need the support of all the firm's
employees. Top management's support of the budget can influence that of lower-
level managers. Since budgets are often used to compare with actual results in
evaluating subordinates, subordinates may regard them as straightjackets that are
unduly restrictive. Accountants and higher-level managers need to show how
budgets can help each manager and employee achieve better results. Also, problems
may arise if the employees and managers are rewarded on dimensions other than
meeting budgets. Participative Budgeting - since the effectiveness of any budget
depends on whether the affected managers and employees understand and accept the
budget, some companies involve the affected personnel.

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V. Financial Planning Models

Financial Planning Models - mathematical models, used by most companies, of the

master budget that can react to any set of assumptions about sales, costs, product
mix, etc. Dow Chemical's model that uses 140 separate, constantly revised cost
inputs that are based on several different cost drivers is used as an example. The
models give managers answers to "what-if" questions concerning deviations from
sales targets, changes in input prices, and others.

TEACHING TIP: Activity-Based Budgeting - have your students read the boxed
insert showing Activity-Based budgeting. This describes a way of formulating
budgets using activity information. Ask your students how this differs from the
budgets shown earlier in the chapter.

VI. Appendix: Use of Spreadsheets for Budgeting {L. O. 7}

This appendix shows how budgets can be prepared using spreadsheet computer
software (see EXHIBIT 7-7, EXHIBIT 7-8, EXHIBIT 7-9, and EXHIBIT 7-10
for spreadsheet examples). It is important to have a data section where input values
are located and to use cell formulas to construct the budgets. Then, one can easily
alter the input data to instantly see the impact on the budget. Sensitivity Analysis
(or what if analysis) - the systematic varying of budget data input to determine the
effects of each change on the budget.

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CHAPTER 7: TRANSPARENCY MASTERS
The following exhibits are reproduced as transparency masters at the end of this manual:

Exhibit 7-1 Preparation of Master Budget for Nonmanufacturing Company

Exhibit 7-2 The Cooking Hut Company Balance Sheet - March 31, 20X1

Exhibit 7-3 The Cooking Hut Company Budgeted Income Statement for 4 Months
Ending July 31, 20X1

Exhibit 7-4 The Cooking Hut Company Cash Budget for 4 Months Ending July 31,
20X1

Exhibit 7-5 The Cooking Hut Company Budgeted Balance Sheet -- July 31, 20X1

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CHAPTER 7: Quiz/Demonstration Exercises
Learning Objective 1

1. details the planned expenditures for facilities, equipment, new products,

and other long-term investments.

a. Capital budgeting b. Strategic planning

c. Long-range planning d. Master budgeting

2. The summarizes the planned activities of all subunits of an

organization - sales, production, distribution, and finance - and is the periodic business
plan that includes a coordinated set of detailed operating schedules and financial
statements.

a. master budget b. sales budget

c. strategic plan d. long-range plan

3. The includes the sales budget, purchases budget, cost of goods sold budget,
operating expenses budget, and budgeted income statement, while the
includes the capital budget, cash budget, and the budgeted balance sheet.

a. financial budget, operating budget

b. operating budget, financial budget
c. strategic plan, financial budget
d. strategic plan, operating budget

4. _______ is another term for forecasted financial statements.

a. Long-range financial statements

b. Pro forma financial statements
c. Future-oriented financial statements
d. Estimated financial statements

14
Learning Objective 2

5. The first step in the budgeting process is the preparation of the:

a. production budget
b. sales budget
c. operating expense budget
d. cash budget

6. One of the following is usually prepared before the direct materials purchases budget:

a. production budget
b. cash budget
c. operating expense budget
d. budgeted balance sheet

Learning Objective 3

7. Root Company sells a product for $35. Budgeted sales for the first quarter of 2002 are
as follows:

January $600,000
February 300,000
March 900,000

The company collects 70% in the month of sale and 25% in the following
month. Five percent of all sales are uncollectible and are written off.

Budgeted cash receipts for March are:

a. $600,000 b. $690,000 c. $900,000 d. $360,000

8. Projected sales for Joshua, Inc., for next year and beginning and ending inventory data:

Sales 60,000units
Beginning Inventory 12,000units
Targeted Ending. Inv. 30,000units

The selling price is $20 per unit. Each unit requires 4 pounds of material, which costs
$5 per pound. The beginning inventory of raw materials is 7,000 pounds. The
company wants to have 6,800 pounds of material in inventory at the end of the year.
Budgeted sales would be:

a. $840,000 b. $960,000 c. $1,120,000 d. $1,200,000

15
Use the following information for questions 9 through 11.

Projected sales for Frances Company for the next month and beginning and ending
inventory data are as follows:

Sales 40,000 units

Beginning inventory 3,000 units
Targeted ending inventory 7,000 units

The selling price is $20 per unit. Each unit requires 4 pounds of material, which costs
$5 per pound. The beginning inventory of raw material is 15,000 pounds. The
company wants to have 20,000 pounds of material in inventory at the end of the
month.

9. Budgeted sales would be:

a. $600,000 b. $720,000 c. $800,000 d. $880,000

10. According to the production budget, how many units should be produced:

a. 36,000 units b. 40,000 units c. 44,000 units d. 50,000 units

11. Pounds of material to be purchased would be:

a. 165,000 lbs. b. 181,000 lbs. c. 205,000 lbs. d.

245,000 lbs.

Learning Objective 4

12. Which of the following is not a part of the financial budget?

a. capital budget
b. cash budget
c. budgeted balance sheet
d. budgeted income statement

13. In constructing the cash budget, the finance section does not include:

a. borrowing
b. repayments
c. collections from customers
d. interest payments

16
Learning Objective 5

14. Which of the following is not an important factor considered by sales forecasters?

a. market research studies

b. input from the human resources department
c. competitors' actions
d. changes in product mix

15. Different types of organizations face an important task that is similar to sales
forecasting. These organizations include:

a. state government
b. federal government
c. charitable organization
d. university
e. all of the above

Learning Objective 6

16. In order for budgets to be helpful in assisting an organization to accomplish its

objectives

a. they must be understood and accepted by the affected managers and employees
who may have participated in constructing the budgets.
b. they should have as its primary purpose the pointing out of managers' failings.
c. they must come from the top of the organization with very little input from
lower level managers and employees.
d. they must be unrealistic and vague.

17. In order for budgets to be accepted by all the affected employees, the following process
should be used:

a. participative budgeting
b. autocratic budgeting
c. authoritarian budgeting
d. socialist budgeting

17
CHAPTER 7: Solutions to Quiz/Demonstration Exercises

1. [a] 2. [a] 3. [b] 4. [b] 5. [b] 6. [a]

7. [b] The $690,000 expected cash receipts include $630,000, which represents
70% of March's sales and $60,000 which is 25% of February's purchases.

8. [d] 60,000 units x $20 sales price per unit.

9. [c] Budgeted sales are 40,000 units x $20/unit selling price which is
$800,000 in sales.

10. [c] The units to be produced are found by adding the units expected to be sold to
the targeted ending inventory and then deducting the beginning inventory as
shown below:

Sales 40,000 units

+ Targeted ending inventory 7,000 units
= Total needed 47,000 units
- Beginning inventory 3,000 units
= Production needed 41,000 units

11. [b] The number of pounds of material to be purchased is based on the production
needs, target ending inventory, and the inventory of material already on hand.
The computation appears below.

Materials needed for production 44,000 units

x 4 lbs./unit
176,000 lbs.
+ Desired ending inventory 20,000 lbs.
= Total material needs 196,000 lbs.
- Beginning inventory of material on hand 15,000 lbs.
= Pounds of material to be purchased 181,000 lbs.

12. [d] 13. [c]14. [b] 15. [e]16. [a] 17. [a]

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