Part-1, Section B, Topic 4—Budgeting Methodologies

Master Budget
An organization’s master budget, also known as an annual business plan or profit plan, is a
comprehensive budget for one year or less. Every aspect of the company’s revenue and cost
flows is projected, starting with the sales forecast and ending with a set of pro forma financial
statements. The benefits of having a master budget are numerous and the drawbacks are few.
Virtually every company needs some form of master budget.

Six different budgeting systems that a company can use to create its budgets are:

1. Project budgeting. Used for creating a budget for specific projects rather than for an entire
company. The time frame for a project budget is simply the duration of the project. A multiyear
project could be broken down by year. Successful past project budgets for similar projects can
be used as benchmarks when developing project budgets.
Project budgets are developed using the same techniques and components as shown for
developing a master budget, except that the focus will be solely on costs related to the project
instead of the company as a whole.
One advantage of a project budget is the ability to contain all of a project’s costs so that its
individual impact can be easily measured.

A potential limitation of project budgets occurs when projects use resources and staff that are
committed to the entire organization rather than dedicated to the project.

2. Activity-based budgeting. Focuses on classifying costs based on activities rather than based
on departments or products. Proponents of ABB believe that traditional costing obscures the
relationships between costs and outputs by oversimplifying the measurements into one
category such as labor hours, machine hours, or output units for an entire process or
department. Instead of using only volume drivers as a measurement tool, ABB uses activity-
based cost drivers, such as number of setups, to make a clear connection between resource
consumption and output. ABB will also use volume-based drivers if they are the most
appropriate measurement unit for a particular activity. If the relationships are made clear,
managers can see how resource demands are affected by changes in products offered, product
designs, manufacturing techniques, customer base, and market share.

3. Incremental budgeting. Starts with the prior year’s budget or actual results and makes minor
changes to come up with the next year’s budget. An incremental budget is a general type of
budget that starts with the prior year’s budget or actual results and uses projected changes in
sales and the operating environment to adjust the individual items in the budget either upward
or downward. It is the opposite of a zero-based budget.
The primary advantage of incremental budgeting is its simplicity. Another advantage is that it
fosters operational stability. The main drawback to using this type of budget (and the reason
that some companies use zero-based budgets) is that the budgets tend to only increase in size
over the years. Managers build in budgetary slack by forecasting too little revenue growth or
excessive expenses. The result of budgetary slack most often is to have favorable variances,
which makes the manager “look good.”

4. Zero-based budgeting. Starts each new budgeting cycle from scratch as though the budgets
are prepared for the first time. A traditional budget focuses on changes to the past budget,
while the zero-based budget focuses on constant cost justification of each and every item in a
budget. Managers must conduct in-depth reviews of each area under their control to provide
such justification. The strength of the zero-based budget is that it forces review of all elements
of a business. Zero-based budgets can create efficient, lean organizations and, therefore, are
popular with government and nonprofit organizations. A zero-based budget is a way of taking a
new look at the operations. Theoretically, zero-based budgets have the advantage of focusing
on every line item instead of just the exceptions. This should motivate managers to identify and
remove items that are costlier than the benefits they provide. These budgets are especially
useful when new management is hired.
One issue with zero-based budgeting is that the annual review process is time consuming and
expensive. As a result, the review may often be less thorough than it is intended to be. In
addition, by not using prior budgets, the firm may be ignoring lessons learned from prior years.
If used every year, a zero-based budget actually may become little more than an incremental
budget with a little extra processing. Managers simply remember their old justifications and
figures and use them the following year.

5. Continuous (or rolling) budgeting. Allows the budget to be continually updated by removing
information for the period just ended (March of this year) and adding estimated data for the
same period next year (March of next year). A continuous budget will be more relevant than a
budget prepared once a year.
It can reflect current events and changed estimates. It has the advantage of breaking down a
large process into manageable steps. Because managers always have a full time period of
budgeted data, they tend to view decisions in a longer-term perspective rather than what
happens with a one-year budget, which will cover a shorter and shorter period of time as the
year progresses.

Potential disadvantages of continuous budgets include the need to have a budget coordinator
and/or the opportunity cost of having managers use part of each month working on the next
month’s budget. Continuous budgets are appropriate for firms that cannot devote a large block
of time to a once-a-year budget process. These types of budgets are also useful for companies
that want their managers to have a longer-term view of the firm.

6. Flexible budgeting. Serves as a control mechanism that evaluates the performance of

managers by comparing actual revenue and expenses to the budgeted amount for the actual
level of activity, and not the original budgeted level of activity

These budgeting systems are not mutually exclusive; in fact, a company can choose to adopt
several of them simultaneously. The benefits of using a flexible budget include the ability to
make better use of historical budget information to improve future planning. There are few
disadvantages to using flexible budgeting, but there is the potential for the firm to focus
principally on the flexible budget level of output and disregard the fact that the sales target was
missed. However, most businesses use flexible budgets because they allow for extremely
detailed variance analysis.
Part-1, Section-B: Topic: 5: Annual Profit Plan and Supporting Schedules
Master Budget
The master budget provides all of an entity’s budgets and plans for the operating
and financing activities of its subunits. It is the place where everything must add
up, where strategy and long-term plans meet up with short-term objectives.

A. Operating Budget:
In creating an operating budget, the various pieces are assembled, including, for
instance, the sales budget, the production budget, the direct materials budget,
the direct labor budget, the overhead budget, and the S&A expense budget. The
individual operating budgets are then used to create the pro forma (or budgeted)
income statement.

1. Sales Budget
An accurate sales forecast is needed to create the sales budget. A sales forecast is
a subjective estimate of the entity’s future sales for the upcoming period. Without
an accurate sales forecast, all other budget elements will be inaccurate.
Forecasters consider historical trends for sales, but also take into consideration
economic and industry conditions and indicators, competitors’ actions, rising
costs, policies on pricing and extending credit, the amount of advertising and
marketing expenditures, the number of unfilled back orders, and sales in the sales
pipeline (unsigned prospects).

2. Production Budget
The production budget is created next. The production budget is a plan for
acquiring resources and combining them to meet sales goals and maintain a
certain level of inventory. The budgeted production in units is calculated as shown
next.
Budgeted Production = Budgeted Sales + Desired Ending Inventory −
Beginning Inventory
Budgeted sales are the basis of what logistics managers use to plan resource
needs for the coming year, develop manufacturing schedules, and create shipping
policies. When actual sales either fall short or significantly exceed projected
revenue, the entire inventory system is affected.
 3. Direct Materials Budget
The direct materials budget (or the direct materials usage budget) determines
the required amount of materials, based on the quality level of the materials
needed
to meet production. While the production budget specifies only the number of
finished units to be produced, the usage budget specifies the amount and cost of
materials needed for the production. The direct material purchases budget
specifies the amount and cost of materials that must be purchased to meet the
production requirement.

4. Direct Labor Budget

The direct labor budget is prepared by the production manager and human
resources manager. It specifies the direct labor needed to meet the production
requirements. The direct labor requirement is determined by multiplying the
expected production by the number of direct labor hours (DLH) required to
produce one finished good unit. This number is then multiplied by the direct labor
cost per hour to calculate the budgeted direct labor cost. Labor budgets are
usually broken down into categories, such as skilled, semiskilled, and unskilled.

5. Overhead Budget (Factory Overhead Budget)

All other production costs that are not in the direct materials and direct labor
budgets are in the overhead budget. Rent and insurance, for instance, remain
stable even if production goes up or down. There are some overhead costs that
do vary with production—variable costs such as batch setup costs, the costs of
utilities, and fringe benefits. Fixed costs will not vary with production as long as
production volume remains within the relevant range.

6. Fixed Overhead Rate Determination

The fixed overhead budget is also prepared at the department-account level of
detail.

7. Standard Cost Sheet Development

Now all the necessary information has been developed to make it possible to
prepare the product standard cost sheet(s). A standard cost sheet shows the
resources needed and the costs of those resources to manufacture one unit of a
product. A cost sheet may be used to value inventory, to measure contribution
margin, to set selling prices, and, as will be seen in a later topic, to measure the
performance of departments within the purchasing and production functions.
Resources includes the physical units (such as pounds or linear feet or gallons) of
each item of direct material required to produce one unit of product. The unit of
measure used on the standard cost sheet can vary by industry and/or product.

8. Cost of Goods Sold Budget

The cost of goods sold budget indicates the total cost of producing the product
sold for a period. This budget is sometimes called the cost of goods manufactured
and sold budget, because it often also includes items budgeted to be in inventory.
This budget is created only after the production, direct materials, direct labor, and
overhead budgets are formed, because it relies on all of these budgets.

9. Selling and Administrative Expense Budget

Nonmanufacturing expenses are often grouped into a single budget called a
selling
and administrative (S&A) expense budget or nonmanufacturing costs budget. The
selling expense components of this budget include salaries and commissions for
the sales department, travel and entertainment, advertising expenditures,
shipping, supplies, postage and stationery (related to sales), and so on. Sales
expenses are included in this category because they are not allowed to be
allocated to production.
The administrative expense components of this budget, however, include
management salaries, legal and professional services, utilities, insurance expense,
non– sales-related stationery, supplies, postage, and the like. GAAP requires that
both the selling and the administrative costs be expensed as incurred. These costs
are often called operating expenses. Just as with overhead expenses, S&A
expenses can be categorized into fixed costs and variable costs.

10.Pro Forma (or Budgeted) Income Statement

Various pieces of the operating budget that were developed are used to prepare
the pro forma (or budgeted) income statement, which shows the profits for the
company based on all the assumptions used throughout the budgeting process. A
budgeted income statement is therefore a benchmark to be used in evaluating
actual results.
 B. Financial Budgets
Once a company completes the various pieces of the operating budget and
creates the pro forma (or budgeted) income statement, it next develops the
necessary financial budgets to identify the assets and capital (both debt and
equity) needed to support the operation. These financial budgets include the
capital expenditure budget, the cash budget, the pro forma (or budgeted) balance
sheet, and the pro forma (or budgeted) statement of cash flows.