CHAPTER TWO

MASTER BUDGET

WHY PLANNING
Many Good Reasons to Develop a Plan
For most of us, it would be inconceivable to embark on a journey without having clearly identified the
purpose of the journey, destination and how we intend to get there. This holds true for any and every
organization. Organizations should outline their objectives and how and when the objectives are to be
achieved. A business plan is a tool that serves both the internal management needs of the private entity
and the informational needs of external entities that are critical to the business’s success. Specifically, the
business plan is a guiding document because it establishes the venture's business objectives, strategy and
approach to achieving those objectives, and also serves to provide a tool for monitoring and controlling
venture operations. It describes every major aspect of the business, including products, services,
marketing, staffing, and facilities. Financial projections are also central to any business plan. Since
business plans are such good summaries of operations, lenders and investors demand to see them as tools
for evaluating requests for financing.
Formally developing a plan:
 Forces thinking about the future direction of the organization
 Provides a road map for all involved to follow
 Acts as a tool to coordinate everyone’s efforts
 Enables the organization to be proactive rather than reactive
 Provides a framework for evaluating opportunities and threats
 Provides a sense of a purpose and a future for the organization
 Provides a tool for measuring progress
 Helps convince others to invest their time and money in the company
Probably the biggest benefit of all is the dialog that takes place among those involved in the planning
process regarding the company and its future. The bottom line is a greater likelihood of improved
performance and profitability.
A plan provides no assurance of business’s success. However, a well-prepared plan does provide
reasonably good assurance that the venture is well-thought out. A venture that is not well-thought-out is
almost certainly doomed to failure. Therefore, preparation of a plan should not be viewed as a drudgery,
to be avoided if possible, in starting up an operation. Accordingly, the resources and time invested
initially in a well-prepared plan can preclude the subsequent loss of tens of millions of birr in a misguided
venture.

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In the current fast changing environment, it is important to be mindful that a business plan has a rapid
shelf life. Therefore, it must be continually updated if it is to maintain its usefulness in providing a critical
internal focus as well as key information to third parties who are essential to business success.
Fear and/or Ignorance Typically Underlay Not Planning
The majority of companies Presidents/CEOs have at least a vague strategic plan in their minds. Few,
however, take the time and effort to formally involve others, fully develop, write down and effectively
communicate their plans. They seem to think their organization intuitively understands their plan from
what they say and do – it’s communicated, somehow, by osmosis. Unfortunately, this typically is not
what happens. Without really understanding the plan most employees have no real sense of the purpose or
the future of the organization.
When applied to business activity, the three levels of planning are called strategic planning, capital
budgeting, and operations budgeting.
 Strategic planning involves making long-term decisions such as defining the scope of the
business, determining which products to develop, deciding whether to discontinue a product, and
determining which market niche should be most profitable. Upper-level management is
responsible for these decisions. Strategic plans are stated in descriptive rather than quantified
terms. Objectives such as “to be the largest firm” or to be the best quality producer” result from
strategic planning.
 Capital budgeting deals with intermediate range planning. It involves making decisions such as
whether to buy or lease equipment, to stimulate sales, or to increase the company’s asset base.
 The operating budget constitutes the central focus of this chapter. It involves the establishment of
a master budget that will direct the firm’s activities over the short term. The master budget states
objectives in specific quantities and includes sales targets, production objectives, and financing
plans.

Definition of Budget
As has been said earlier, planning is critical to the operation of a profitable business. The area of planning
that is associated with financial matters is commonly called budgeting, which is a process that involves
coordinating the finances of all areas of the business.
A budget is a quantitative expression of a proposed plan of action by management for a specified period
and is an aid to coordinating what needs to be done to implement that plan. A budget can cover both
financial and non-financial aspects of the plan and acts as a blueprint for the company to follow in the
upcoming period. When administered wisely, budgets compel planning, provide performance criteria, and
promote coordination and communication within the company. In general, budgeting is about making
plans for the future, implementing those plans and monitoring activities. Targeting and profit plans are
some of the terminologies used to describe business budgets.
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Well-managed companies often use the following budgeting cycle:
 Planning the performance of the company as a whole as well as its subunits.
 Providing a frame of reference, a set of specific expectations against which actual results can be
compared.
 Investigating variations from plans and, if necessary, taking corrective action.
 Planning again, in light of feedback and changed conditions.

Benefits of Budgeting:
A budget outlines how resources are expected to be received from, and used in, the operating, investing,
and financing activities of the business during a specified period of time. A properly prepared budget
provides a company with the following primary benefits:-
Planning
Almost everyone makes plans. Shortly after waking up each morning, most people think about what they
will do during the day. This thinking ahead is a form of planning. Likewise, most business managers
naturally think ahead about how they will conduct their business. The primary purpose of a budget is,
therefore, to present and describe the financial ramifications of plans for the future. It quantifies a plan of
action. The budget process requires individuals to consider possible future courses of action and the
resources needed to accomplish the various activities. Budget formalizes the manager’s plan in a
document that clearly communicates objectives to both superiors and subordinates. Plans and budgets are
interrelated and affect one another. Budget provides feedback to managers about the likely effects of their
strategic plan. Managers then use this feedback to revise their strategic plan.
[

Coordination and Communication

Coordination is the meshing and balancing of all factors of production or services and of all the
departments and business functions so that the business can meet its objectives. Communication refers to
getting those objectives understood and accepted by all departments and functions.
Thus the budgeting process forces managers of departments, sections, and segments to think of the
relationship of their function with other centers, departments, and how to coordinate with other
departments to achieve the overall company plan. Coordination forces executives to think of relationships
among individual operations, departments, and the company as a whole. For example, the production
department can not formulate its manufacturing plan until it knows how many units of product to
produce. The level of production, on the other hand, depends on the sales projection, which the marketing
department normally develops. The marketing department cannot project sales volume until it knows the
type of product that the company will sell. This information comes from the research and development
department. This scenario implies that in order for the company to function effectively, managers and

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other employees must understand the interaction among the departments and how the actions of one
department affect another department.
For coordination to succeed, communication is essential. The purchasing manager must know the
production plan. The production manager must know the sales plan, and so on. Therefore budget is a
formal document used to communicate a consistent set of plans to the organization as a whole.
Resource Allocation
Businesses operate with limited resources, which, therefore, require some type of allocation. Budgeting
aids resource allocation by ensuring that information is available to help managers determine which
activities should receive the limited resources of the company. In addition, through the budgeting process,
companies can analyze activities to determine if they add value to the company.
Evaluation and control
Budgets represent a specific, quantitative statement of management’s objectives. As such a budget serves
as a useful benchmark against which to evaluate and control actual performance. Budget can overcome
two key limitations of using past performance as a basis for judging actual results. The first limitation is
that past results incorporate past miscues and substandard performance. Second, the future may be
expected to be very different from the past. The evaluation process consists of comparing actual
performance results to the budget to determine what areas deviated from planned activities and whether to
make corrective actions so that the business can operate under control
Motivation
The involvement of lower management in preparation of budgets, promotes common understanding &
acceptance of organizational goals. Setting up a challenging & achievable target acceptable by managers
encourages initiative, responsibility & commitment.
Achievable budgets serve as goals and improve performance. That's because people view an inability to
meet budgeted numbers as a failure. Individuals are motivated to work hard to avoid failure more so than
they are motivated to achieve success. As individuals get closer to a goal, they work harder to achieve it.
For these reasons, many executives like to set challenging but achievable goals for their subordinates.
Creating a little anxiety improves performance, whereas unachievable budgets increase anxiety without
motivation because individuals cannot avoid failure.

Points to Remember
 Budgeting is most useful when done as an integral part of the company's strategy. Strategy
specifies how a company matches its own capabilities with the opportunities in the marketplace to
accomplish its objectives. Strategic analysis underlies both short-run and long-run planning. In
turn, these plans lead to the formulation of budgets.

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  Pressures often exist within companies for budgeted revenues to be overestimates and/or budgeted
costs to be underestimates of the expected amounts. For example, some businesses set high
budgets for revenues and/or low budgets for costs in an attempt to motivate managers and
employees to put forth extra effort and achieve better performance. In other cases, budgets may
require below-average effort to be attained. Budgetary slack is the practice of underestimating
budgeted revenues, or overestimating budgeted costs, to make budgeted targets more easily
achievable. Budgetary slack provides managers with a hedge against unexpected adverse
circumstances. A major challenge in budgeting is providing managers with incentives to make
honest budget forecasts.
 Budgets are used to motivate individuals, appraise performance, and achieve coordination of the
enterprise in pursuit of its overall goals. A budget should spell out specific assumptions relating to
the state of the economy, product line changes, industry competition, and government regulations.
As a result, future plans as well as past performance are considered in preparing a budget. If any
assumptions are changed, then the budget must be revised.
 The five general principles of budgeting include top-management support, participation in goal
setting, timely communication of results, flexibility in design, and follow-up. Without adherence to
these principles, budgets often fails due to employee resistance, lack of commitment, ignorance,
and a focus on trivia.
 Software packages are readily available to reduce the computational burden and time required to
prepare budgets. These packages perform the calculations for financial planning models, which
are mathematical representations of the relationships among operating activities, financing
activities, and other factors that affect the master budget. These models enable managers to
prepare the first draft of the master budget, and conduct "what if" (sensitivity) analysis of the
effects on this budget of changes in the original predicted data or in the underlying assumptions.
Sensitivity analysis is especially valuable for examining the effects of multiple changes to
parameters in the master budget;
 Budgeting is much more than the mechanical tool. Human factors play a crucial part in budgeting.
Each manager, regardless of his or her level in the company, is in charge of a responsibility centre.
A responsibility centre is a part, subunit, or segment of a company whose manager is accountable
for a specified set of activities. The higher the manager's level, the broader the responsibility
centre he or she manages and, generally, the larger the number of his or her subordinates.

Budgeting Strategy: A budgetary strategy is the manner in which a company approaches the
budgeting process. The strategy adopted by the company impacts who is involved in the budgeting
process and how the budget numbers are derived. The four budgeting strategies are:-

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Mandated Budgeting: - It relies on predetermined standards set by upper level managers for its budget
levels. It is also known as top-down budgeting because top management develops the budget and passes
them down the organizational hierarchy to various divisions and/or departments without input from lower
levels of management and employees.
Participative budgeting: - It allows individuals who are affected by the budget to have input into the
budgeting process. It also known as bottom-up budgeting because the budgeting process begins at lower
levels of the organizational hierarchy and continues up through the organization to top management.
Incremental Budgeting: - is a strategy whereby the company uses the current period’s budget as a
starting point in preparing the next period’s budget.
Zero-Based Budgeting: - is a strategy in which the company begins each budget period with a zero
budget requires consideration of every activity undertaken by the department or segment.

Types of Budgets
Budgets are classified in different ways.

A. Based on capacity Based on the capacity, budgets are classified as fixed and flexible budgets.

Fixed Budgets: A fixed budget is one which will remain unchanged immaterial of the level of activity.
These budgets are prepared for fixed expenses and their aim is to control cost.
Flexible Budgets: A flexible budget is designed so as to change with the fluctuations in output, turnover
and other factors, which are variable. These budgets will change with the change in activity. These
budgets are prepared for various level of activity. While preparing flexible budgets the expenses are
broadly classified as fixed, variable and semi- variable expenses.
A fixed budget is rigid and does not change with the volume of activity achieved, whereas a flexible
budget can be changed to suit the level of activity to be achieved. Flexible budget is not rigid. A fixed
budget is prepared for a particular level of activity and for a particular set of conditions. It is prepared
under the premise that there will be no change in the outside conditions. Flexible budget is prepared for
various levels of activities.

B. Based on Time
Though budgets may cover long periods (called long-range budgets), the most frequently used budget
period is one year (short-range budgets). The annual budget is often subdivided by months for the first
quarter and by quarters for the remainder of the year.
Companies are increasingly using rolling budgets. A rolling budget is always available for a specified
future period by adding a period (month, quarter, or year) in the future as the period just ended is
dropped. Rolling budgets are sometimes called revolving budgets or continuous budgets.

C. Based on the coverage budgets are classified as Functional Budgets & Master Budgets.
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1. Functional Budgets
Functional budgets are budgets that relate to the various functions of the business. Functional budgets are
further grouped as follows:
 Physical Budget: These are budgets, which provide information about the physical units like sales,
production etc. A few examples are Quantity of sales, Quantity of production.
 Profit Budgets: These are budgets that ascertain the profits. Like Sales budget, Profit and Loss
Budget.
 Cost Budgets: These provide information on costs like manufacturing costs, selling costs
administration costs.
 Financial Budgets: These provide information on the financial position of the firm. Examples are
cash budget, Capital expenditure Budget.
A few of the functional budgets are as follows:

 Sales Budget: Sales forecast is the startup to budgeting and is crucial for a meaningful budget.
Sales budget represents total sales in volume and value for the future period. Anticipation of
customers’ need, impact of new products, selling and promotion strategies, product visibility are
vital factors in determining a sales forecast. The purpose of sales budget is to develop a plan with
clearly defined objectives towards which the operational effort is to be directed.

 Production Budget: The production budget reflects the production for the budget period based on
production capacity, sales forecast and stock position. Production budget is normally expressed in
units of output. Production budget would indicate the maximum production possible and
minimum quantity of stock required.

 Selling and Distribution Cost Budget: Selling costs may be defined as costs directly related to
selling of products by creating and stimulating demand. Advertising, sales promotion, salesmen
salaries, market research, after sales service, collection costs form part of selling costs.

 Distribution costs are the costs related to making products available for dispatch and ends with
the return of empty package. Transport costs, storage, warehousing etc form part of distribution
costs. Preparation of selling and distribution costs budget enables the concern to know the
percentage of selling and distribution to sales price and devise pricing strategies accordingly.

 Capital expenditure budget: This is a very important budget as it throws light on the concern's
capital outlay and expansion and diversification programme. This budget may not be restricted to
a single year and may be prepared to cover a long period of years. While preparing this budget
factors such as sales potential for the increased production, possibility of price reduction, and
increased selling and advertising costs are to be considered. The capital expenditure budget

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 enables the concern to establish a system of priorities, and serves as a tool for controlling
expenditure. It also facilitates cost reduction programme particularly when modernization and
renovation is covered by this budget.

2. Master Budget
Master budget is a consolidated summary of the various operational and financial budgets. The term
“master” in master budget refers to it being a comprehensive, organization-wide set of budgets. It
coordinates all the financial projections in the organization’s individual budgets in a single organization-
wide set of budgets for a set time period. It incorporates the impact of both operating decisions and
financing decisions. Operating decision centers on the acquisition and use of scarce resources whereas
financial decisions centers on how to get the funds to acquire resources. Master budget consists of:-
(1) An operating budget that results in a projected income statement, and
(2) A financial budget that results in a projected balance sheet.

Master Budget Preparation

The master budget expresses management's operating and financial plans for a specified period (usually
a year) and comprises a set of budgeted financial statements. The two main components of the master
budget are the operating budget and the financial budget. The operating budget is the budgeted income
statement and its supporting budget schedules. The financial budget consists of the capital expenditures
budget, cash budget, budgeted balance sheet, and budgeted statement of cash flows.
Preparation of the master budget begins with the preparation of the planned operating budget, which is
prepared for the planning of future earnings, and results in a projected income statement. In preparing a
planned operating budget, normally the sales budget is prepared first. Accurate sales forecasting is
critical in deriving a sales budget. Production budgets are set after the sales budget is completed. The
level of demand during each period must be weighed against the advantage of a steady level of production
when setting production levels. The production budget should identify expenses as variable or fixed.
Selling and administrative expense budgets are prepared in much the same manner as production
budgets. The final step in the preparation of the operating budget is a projected income statement for the
forthcoming period.
Operating budgets are usually followed by financial budget which consists of the capital expenditures
budget, cash budget, budgeted balance sheet, and budgeted statement of cash flows. Capital budgets are
prepared for additions to property and equipment while a Cash budget is used to ensure that cash will be
available throughout the budget year.
In manufacturing companies the operating budget includes the sales budget, the production budget (in
units), the direct materials usage budget and direct materials purchases budget, the direct manufacturing

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labor budget, the manufacturing overhead budget, the ending inventories budget, the cost of goods sold
budget, the non-manufacturing costs budget, the budgeted income statement. Master budget preparation
for merchandising firm is the same as that of manufacturing business except for production related
budgets.

Difficulties of Sales Forecast

The usual starting point for the preparation of master budget is a sales revenue budget based on forecasted
sales of goods and services. The accuracy of the sales budget is critical because it acts as the data source
for all other budgets. If the sales figures are unreliable, the entire budget process is a waste of time. Thus
it is easy to understand why every available effort is made to obtain reliable estimates of projected sales.
All companies have two things in common when it comes to forecasting sales: sales forecasting is a
critical step in the budgeting process, and it is very difficult to do it accurately. Sales forecasting is the
process of predicting sales of goods or services. Various procedures are used in sales forecasting, and the
final forecast usually combines information from many different sources.
Though the marketing department normally coordinates the effort to establish the sales forecast, many
firms have a top-management-level market research staff whose job is to coordinate the company’s sales
forecasting efforts. A great deal of effort generally goes into the sales forecast, since it is such a critical
step in the budget process. A slightly inaccurate sales forecast, coming at the very beginning of the budget
process, will throw off all of the other schedules that make up the master budget. The starting point in the
sales forecasting process is generally the sales level of the prior year. The following factors are some of
the major factors that must be taken into account at the time when sales are forecasted.
1. Past sales levels and trends for the company that develops the forecast and for the entire industry.
2. General economic trends (is the economy growing? How fast? Is economic recession or slowdown
expected?)
3. Economic trends in the company’s industry(in the petroleum industry, for example, is personal
travel likely to increase, thereby implying increased demand for gasoline)
4. Other factors expected to affect sales in the industry
5. Political and legal events. ( for example, changes in political power and legislations)
6. The intended pricing policy of the company
7. Planned advertising and product promotion
8. Expected actions of competitors
9. New product development(substitute or complement) by the company itself or other firms
10. Market research studies
11. Internal capacity and situation of the company.

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Exercises
1. Mamo Company has budgeted sales for 2005 as follows:
January February March April May
Sales in units 10,000 12,000 14,000 16,000 11,000
The ending inventory of finished goods for each month should equal 25% of the next month’s budgeted
sales in units. The finished goods inventory at the start of the year is 2,500 units. Four pounds of raw
material are required for each unit produced. Raw materials on hand at the start of the year total 4,200
pounds. The raw materials inventory at the end of each month should equal 10% of the next month’s
production needs in material.
Required:
a) Prepare a production budget for the first quarter of 2003. Include a column for the quarter’s total.
b) Prepare a direct material purchases budget for the first quarter of 2003. Include a column for the
quarter’s total.
2. Bereket Products needs a cash budget for October. The following information is available:
a. The cash balance at the beginning of October is Br 9,000
b. The actual sales for August and September and expected sales for October are as follows:
August September October
Cash sales Br 6,500 Br 5,250 Br 7,400
Sales on account 20,000 30,000 40,000
Sales on account are collected over a three-month period in the following ratio: 10% in the month of sale,
70% in the month following sale, and 18% in the second month following sale. The remaining 2% is
uncollectible.
c. Purchases of inventory will total Br 25,000 for October; 20% will be paid for in October. Accounts
payable from September's inventory purchases is Br 16,000, all of which will be paid in October.
d. Selling and administrative expenses are budgeted at Br 13,000 for October; of which Br 4,000 is for
depreciation.
c. Equipment costing Br 18,000 will be purchased for cash during October, and cash dividends totaling Br
3,000 will be paid during the month.
f The company must maintain a minimum cash balance of Br 5,000. An open line of credit is available
from the company's bank as needed.
Required:
A. Prepare a schedule of expected cash collections for October.
B. Prepare a schedule of expected cash payments for suppliers for inventory purchases.
C. Prepare a cash budget for October. Indicate any borrowing that will be needed.

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3. Home Company will open a new store on January 1. Based on experience from its other retail outlets,
Home Company is making the following sales projections:
Cash Sales Credit Sales
January Br 60,000 Br 40,000
February 30,000 50,000
March 40,000 60,000
April 40,000 80,000
Home Company estimates that 70% of the credit sales will be collected in the month following the month
of sale, with the balance collected in the second month following the month of sale.
Required: Compute
a. The balance in accounts receivable on January 31
b. The March 31 balance in accounts receivable
c. The total cash receipts for April
4. The Almaz Company makes and sells only one product called a Dob. The company is in the process of
preparing its Selling and Administrative Expense Budget for next year. The following budget data are
available:
Monthly Fixed Cost Variable Cost per Dob Sold
Sales Commissions ----- Br 0.80
Shipping ----- 1.30
Advertising Br 40,000 0.20
Executive Salaries 25,000 -----
Depreciation on Office Equip. 20,000 -----
Other 7,000 -----
All of these expenses (except depreciation) are paid in cash in the month they are incurred.
Required
a. If the company has budgeted to sell 18,000 Dobs in January, then the total budgeted variable selling
and administrative expenses for January will be:
b. If the company has budgeted to sell 16,000 Dobs in February, then the total budgeted fixed selling and
administrative expenses for February are:
c. If the company has budgeted to sell 20,000 Dobs in March, then the budgeted cash disbursements for
selling and administrative expenses for March would be:

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