Master Budgeting: A Comprehensive Guide to Financial Planning
Concept Underlying the Budgeting Process
Budgeting is the process of identifying, gathering, summarizing, and communicating financial and non-financial information about an organization’s future activities. The budgeting process provides managers of all types of organizations with the opportunity to align their organizational goals with the resources necessary to achieve those goals. Budgeting empowers everyone in the organization to understand organizational goals in terms of their responsibilities and be held accountable for budget plans, as they can be compared.
Budgeting and Management
Budgeting is synonymous with managing an organization. Budgets are plans of action based on forecasted transactions and activities. Managers and employees will understand their organizational roles and responsibilities based on how the budget links the organization’s strategic plans to its annual plans. Because the budget expresses these goals and objectives in concrete monetary terms, managers and employees are able to understand and act in ways that will achieve them. Budgeting enhances comparability, as budget-to-actual comparisons give managers and employees a means of monitoring the results of their actions. Budgeting is not only an essential part of planning, but also helps managers command, control, evaluate, and report on operations.
The Master Budget
The master budget consists of a set of operating budgets and a set of financial budgets that detail an organization’s financial plans for a specific period, generally a year. When a master budget covers an entire year, some of the operating and financial budgets may show planned results by month or quarter.
Operating Budgets
Operating budgets are plans used in daily operations. Budgets include the sales budget, production budget, direct materials purchases budget, direct labor budget, selling and administrative expenses budget, and cost of goods manufactured budget. The sales budget is prepared first because it is used to estimate sales volume and revenues. Once managers know the quantity of products or services to be sold and how many sales dollars to expect, they can develop other budgets that will enable them to manage their resources so that they generate profits on those sales.
Financial Budgets
Operating budgets are also the basis for preparing financial budgets, which are projections of financial results for the period. Financial budgets include a budgeted income statement, a capital expenditures budget, a cash budget, and a budgeted balance sheet.
Pro Forma Financial Statements
The budgeted income statement and budgeted balance sheet are also pro forma financial statements, meaning that they show projections rather than actual results. Pro forma financial statements are often used to communicate business plans to external parties. Budgeted financial statements are often referred to as forecasted financial statements, pro forma financial statements, or forward-looking financial statements.
Preparation of a Master Budget
The elements of a master budget for a manufacturing organization, retail organization, and a service organization, respectively. As these illustrations indicate, the process of preparing a master budget is similar in all three types of organizations in that each prepares a set of operating budgets that serve as the basis for preparing the financial budgets. The sales budget (or, in service organizations, the service revenue budget) is prepared first because it is used to estimate sales volume and revenues. Once managers know the quantity of products or services to be sold and how many sales dollars to expect, they can develop other budgets that will enable them to manage their resources so that they generate profits on those sales. The process differs mainly in the kinds of operating budgets that each type of organization prepares. The operating budgets of manufacturing organizations, such as Framecraft, GM, and Harley-Davidson, include budgets for sales, production, direct materials, direct labor, overhead, selling and administrative expenses, and cost of goods manufactured. Retail organizations, such as Michaels, Old Navy, and Lowe’s, prepare a sales budget, a purchases budget, a selling and administrative expenses budget, and cost of goods sold budget. The operating budgets of service organizations, such as Enterprise Rent-A-Car, include budgets for service revenue, direct labor, overhead, and selling and administrative expenses.
Budget Procedures
Because procedures for preparing budgets vary from organization to organization, there is no standard format for budget preparation. The only universal requirement is that budgets communicate the appropriate information to the reader in a clear and understandable manner. Managers can improve the quality of budgets in any type of organization:
- Know the purpose of the budget.
- Clearly identify who is responsible for carrying out the activities in the budget.
- Identify the user group and its information needs.
- Identify sources of accurate, meaningful budget information. Such information may be gathered from documents or from interviews with employees, suppliers, or managers who work in the related areas.
- Establish a clear format for the budget. A budget should begin with a clearly stated heading that includes the organization’s name, the type of budget, and the accounting period under consideration. The budget components should be clearly labeled, and the unit and financial data should be listed in an orderly manner.
- Use appropriate formulas and calculations in deriving the quantitative information.
- Revise the budget until it includes all planning decisions. Several revisions may be required before the final version is ready for distribution.
Operating Budgets
We use Framecraft company to illustrate how a manufacturing organization prepares its operating budgets. Because Framecraft makes only one product – a plastic picture frame – it prepares only one of each type of operating budget as it plans for daily operations in the coming year. Organizations that manufacture a variety of products or provide many types of services may prepare either separate operating budgets or one comprehensive budget for each product or service.
The Sales Budget
The first step in preparing a master budget is to prepare a sales budget. A sales budget shows the expected sales during a period, expressed in both units and dollars. Sales managers use this information to plan sales- and marketing-related activities and to determine their human, physical, and technical resources needs. Accountants use this information to determine estimated cash receipts for the cash budgets. Total Budgeted Sales = Estimated Selling Price per Unit x Estimated Sales in Units. Although the calculation is easy, selecting the best estimates for the selling price per unit and the sales demand in units can be difficult. An estimated selling price below the current selling price may be needed if competitors are currently selling the same product or service at lower prices or if the organization wants to increase its share of the market. On the other hand, if the organization has improved the quality of its products or service by using more expensive materials or processes, the estimated selling price may have to be higher than the current price. The estimated sales volume is very important because it will affect the level of operating activities and the amount of resources needed for operations.
Sales Forecast
To help estimate sales volume, managers often use a Sales Forecast, which is a projection of the estimated sales in units, based on an analysis of external and internal factors. External factors include:
- The state of the local and national economies.
- The state of the industry’s economy.
- The nature of the competition and its sales volume and selling price.
Internal factors include:
- The number of units sold in prior periods.
- The organization’s credit policies.
- The organization’s collection policies.
- The organization’s pricing policies.
- Any new products that the organization plans to introduce to the market.
- The capacity of the organization’s manufacturing facilities.
The Production Budget
The production budget shows the number of units that a company must produce to meet budgeted sales and inventory needs. Production managers use this information to plan for the materials and human resources that production-related activities will require. To prepare a production budget, managers must know the budgeted number of units sales (which is specified in the sales budget) and the desired level of ending finished goods inventory for each period in the budgeted units sales.
The Direct Materials Purchase Budget
The direct materials purchase budget identifies the quantity of purchases required to meet budgeted production and inventory needs and the cost associated with those purchases. A purchasing department uses this information to plan purchases of direct materials. Accountants use the same information to estimate cash payments to suppliers. To prepare a DM Purchases budget, managers must know what production needs will be in each period. This information is provided by the production budget. They must also know the desired level of the DM inventory for each period and the per-unit cost of DM. The desired level of ending DM inventory is usually stated as a percentage of the next period’s production needs.
The Direct Labor Budget
The direct labor budget shows the DL hours needed during a period and the associated costs. Production managers use estimated DL hours to plan how many employees will be required during the period and the hours that each will work. Accountants use estimated DL budget in deciding whether to hire new employees or reduce the existing workforce. The DL budget also serves as a guide in assessing employees’ training needs and preparing schedules of employee benefits.
The Overhead Budget
The overhead budget shows the anticipated manufacturing costs, other than DM and DL costs, that must be incurred to meet budgeted production needs. It has two purposes:
- To integrate the overhead cost budgets developed by the managers of production and production-related departments.
- To group information for the calculation of overhead rates for the next accounting period.
The format presenting information in an overhead budget is flexible. Grouping information by activities is useful for organizations that use activity-based costing. This approach makes it easier for accountants to determine the application rates for each cost pool.
The Selling and Administrative Expenses Budget
The selling and administrative expenses budget shows the operating expenses, other than those related to production, that are needed to support sales and overall operations during a period. Accountants use this budget to estimate cash payments for products or services not used in production-related activities.
The Cost of Goods Manufactured Budget
The cost of goods manufactured budget summarizes the estimated costs of production during a period. The sources of information for total manufacturing costs are DM, DL, and overhead budgets. Most manufacturing organizations anticipate some work in process at the beginning or end of a period.
Financial Budgets
With revenues and expenses itemized in the operating budgets, an organization is able to prepare the financial budgets, which are projections of financial results for the period. Financial budgets include a budgeted income statement, a capital expenditures budget, a cash budget, and a budgeted balance sheet.
The Budgeted Income Statement
The budgeted income statement projects an organization’s net income for a period based on the revenues and expenses estimated for that period.
The Capital Expenditures Budget
The capital expenditures budget outlines the anticipated amount and the timing of capital outlays for long-term assets during a period. Managers rely on the information in a capital expenditures budget when making decisions about such matters as buying equipment, building a new plant, purchasing and installing a materials handling system, or acquiring another business. This information is necessary for preparing the company’s cash budget.
The Cash Budget
The cash budget is a projection of the cash that an organization will receive and pay out during a period. It summarizes the cash flow prospects of all transactions considered in the master budget. The elements of a cash budget relate to operating, investing, and financing activities. A cash budget excludes planned noncash transactions, such as depreciation expense, amortization expense, issuance and receipt of stock dividends, uncollectible accounts expense, and gains and losses on sales of assets. Some organizations also exclude deferred taxes and accrued interest from the cash budget. In estimating cash receipts and cash payments for the cash budget, many organizations prepare supporting schedules. For example, Framecraft’s controller converts credit sales to cash inflows and purchases made on credit to cash outflows and then discloses those conversions to support the cash budget.
Cash Collections
The expected cash collection for each quarter and for the year appear in the total cash receipts section of the cash budget.
Cash Payments
This information is summarized in the first line of the cash payments section of the company’s cash budget.
Cash Budget
It shows the estimated cash receipts and cash payments for the period, as well as the cash increase or decrease. The cash increase or decrease plus the period’s beginning cash balance equals the ending cash balance anticipated for the period. Note that each quarter’s budgeted ending cash balance becomes the next quarter’s beginning cash balance. Also note that equal income tax payments are made quarterly.
Minimum Cash Balance
Many organizations maintain a minimum cash balance to provide a margin of safety against uncertainty. If the ending cash balance on the cash budget falls below the minimum level required, short-term borrowing may be necessary to cover planned cash payments during the year. If the ending cash balance is significantly larger than the organization’s needs, it may invest the excess cash in short-term securities to generate additional income. On the other hand, the balance at the end of the fourth quarter may be higher than the company wants, in which case management might invest a portion of the idle cash in short-term securities.
The Budgeted Balance Sheet
The budgeted balance sheet projects an organization’s financial position at the end of a period. It uses all estimated data compiled in preparing a master budget and is the final step in the budgeting process.
Advantages of Budgeting for Organizations
Budgeting fosters organizational communication, ensures a focus both on future events and on resolving day-to-day issues, assigns resources and the responsibility to use them wisely to managers who are held accountable for their results, can identify potential constraints before they become problems, facilitates congruence between organizational and personal goals, defines organizational goals and objectives numerically, against which actual performance results can be evaluated.
Budgeting and Goals
Budgeting helps managers achieve both long-term and short-term goals.
Long-Term Goals
Strategic planning is the process by which management establishes an organization’s long-term goals. These goals define the direction that an organization will take and are the basis for making annual operating plans and preparing budgets. Long-term goals cannot be vague. They must set specific tactical targets and timetables and assign responsibility to specific personnel.
Short-Term Goals
Annual operating plans involve every part of an enterprise and are much more detailed than long-term goals strategic plans. To formulate an annual operating plan, an organization must restate its long-term goals in terms of what it needs to accomplish during the next year. The process entails making decisions about sales and profit targets, human resources needs, and the introduction of new products or services.
Inviting Employee Participation
Because an organization’s main activities – such as production, sales, and employee training – take place at its lower levels, the information necessary for establishing a budget flows from the employees and supervisors of those activities through middle managers to senior executives. Each person in this chain of communications thus plays a role in developing a budget, as well as in implementing it.
Participative Budgeting
Participative budgeting is a process in which personnel at all levels of an organization actively engage in making decisions about the budget. Participative budgeting depends on joint decision-making. Without it, the budgeting process will be authoritative rather than participative, and the budget targets may be unrealistic and impossible to attain.
Selecting the Budget Period
Budgets, like the company’s fiscal period, generally cover a one-year period of time. An annual operating budget may be divided further into monthly or quarterly periods, depending on the detail of information needed.
Static Budgets
Static budgets are prepared once a year and do not change during the annual budget period.
Continuous Budgets
To ensure that its managers have continuously updated operating data against which to measure performance, an organization may select an ongoing budgeting process, called a continuous budget. It is a 12-month forward-rolling budget that summarizes budgets for the next 12 months. Each month, managers prepare a budget for that month, 12 months hence.
Zero-Based Budgeting
Traditional budgeting approaches require managers to justify only budget changes over the past year. An alternative to traditional budgeting is zero-based budgeting, which requires that every budget item be justified annually. So, each year, the budget is built from scratch.
Implementing the Budget
“Budget Committe”- which include the constroller and many of the organization’s top managment, has overall repsonsiblity for budget implementation. The buget comitte: Oversees each stage in the preparation of the organization’s overall budget, mediates any department disputes that may arise in the process, gives final approval to the budget. the budget may go through many revisions before it includes all planning decisions and has the approval of the committee. once approved, periodic reports form the department managers allow the committee to monitor the comapny’s progress in attaining budget targers.
Operating Budgets-We use Framecreaft company illustrate how a manufacturing organzation prepares its operating budgets. Becasuse Framecrafts makes only one product- a plastic picture frame-it prepares only one of each type of operating budget as it plans for daily operations in the coming year. Organizations that manufacture a variety of products or provide many types of services may prepare either seperate operating budgets or one comprehensive budget for each product or service. The Sales Budget- The first step in preparing a master budget is to prepare a sales budget . A sales budget shows the expected sales during a period, expressed in both units and dollars. Sales managers use this information to plan sales- and marketing-related activities and to determine their human, physical, and technical resources needs. Accountants use this information to determine estimated cash receipts for the cash budgets. Total Budgeted Sales= Estimated Selling Price per Unit X Estimated Sales in Units. Although the calculation is easy, selecting the best estimates for the selling price per unit and the sales demand in units can be difficult. An estimated selling price below the current selling price may be needed if competitiors are currently selling the same product or service at lower prices or if the organizations wants to increase its shares of the market. On the other hand, if the organization has improved the quality of its products or service by using more expensive materials or process, the estimated selling price may have to be higher than the current price. The estimated sales volume is very important because it willl affect the level of operating activities and the amount of resources needed for operations. To help estimate sales volume, managers often use a Sales Forecast, which is a projection of the estimated sales in units, based on an analysis of external and internal factors. External facros include: The state of the local and national economies, the state of the industry’s economy, the nature of the competition and its sales volume and selling price. Internal factors include: the number of units sold in prior periods, the organization’s credit policies, the organization’s collection policies, the organization’s pricing policies, any new products that the organization plans to introduce to the market, the capacity of the organization’s manufacturing facilities. The production budget- shows the number of unites that a company must produce to meet budgeted sales and inventory needs. Production managers use this information to plan for the materials and human resources that production-related activies will require. To prepare a production budget,mangagers must know the budgeted number of units sales(which is specified in the sales budeget) and the desired level of ending finished goods inventory for each period in the budgetd units sales.