Chapter Three

Information for budgeting, planning and control purposes

Introduction
Like many accounting terms, budgeting is used commonly in our everyday language. The news media
discuss budgets of federal and state governments, and many people describe a variety of resource
allocation decisions, ranging from vacation planning to the purchase of food and clothing, as budgeting.
The purpose of this chapter is to introduce the framework for the budgeting process, define budgeting
terms, enumerate the principal advantages of budgeting, explain the concepts of responsibility
accounting and participatory budgeting and provide a clear understanding of the concepts of budgeting.
Although the primary emphasis in this chapter is on business budgeting, most of the concepts are also
applicable to non-business activities.

THE FUNDAMENTALS OF BUDGETING

A budget is a comprehensive formal management plans expressed in quantitative terms,
describing the expected operations of an organization over some future time period. A budget
deals with a specific entity, covers a specific future time period and is expressed in quantitative terms.
Budget entity: - The entity concept, so important in financial accounting, is essential to budgeting
also. A specific budget must apply to a clearly defined accounting entity. For budgeting purpose the
entity may consist of a small part of a business, a single activity, or a specific project. The
concept of a budget entity applies to individuals as well. For example, a student interested in
budgeting the cost of a first year’s college education should not include in the budget the cost of three
weeks’ vacation or the purchase of a Br. 5800 guitar. Although these two expenditures may be cost of
the period, they are not college education expenses. A budget entity can be as a specific as a single
project such as Addis-Langano trip or it can be a broad activity, such as the budget for an entire
manufacturing firm, or for the Ethiopian government.
Future time period:-Many financial figures are meaningless unless they are couched in some time
references. For example, income statements are annual, quarterly, or monthly. A job offer of Br.
40,000 is of little value without knowing if the figure represents pay for a month, a year, a lifetime or
some other time period. We might assume the Br. 40,000 is annual salary. In accounting, however,
time reference should be clearly stated.
Budgets should express the expected financial consequences of programs and activities planned
for a specific period of time. Annual budget are widespread. In addition to annual budgets, budgets
for many other time periods are prepared. The planning horizon for budgeting may vary from one day
to many years. For example, master budget usually cover 1 month to 1 year where as long-range plan
are prepared for 2 to 10 years. In planning for profits, managers must consider two time horizons:
the short term and the long term.
Short-term planning is the process of deciding what objectives to pursue during a short, near-
future period, usually one year, and what to do to achieve those objectives. The typical short-term budget
covers one year and is broken down into monthly or quarterly units. Another method frequently used to
prepare a short-term budget is the continuous budget. This kind of budget starts with an annual budget
broken down into 12 monthly units. As each month arrives, it is dropped from the plan and replaced by
a new month so that at any given time, the next 12 months are always shown. Thus, in a
budgetary period covering January through December 2014, when January 2014 arrives, it would be
dropped from the plan and replaced by January 2015, thus creating a new budgetary period covering
February 2014 through January 2015. Using this technique, a firm always has guidance for the full
following year. When a continuous budget is not used, a firm will have guidance for only a month or two
as it approaches the end of its budgetary period.

Long-term planning, also known as strategic planning, is the process of setting long-term goals and
determining the means to attain them. Short-term planning is concerned with operating details for the

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 next accounting period, but long-term planning addresses broad issues, such as new product development,
plant and equipment replacement, and other matters that require years of advance planning. For
example, short-term planning in the automotive industry would be concerned with which and how
many of the current year’s models to manufacture, while long- range planning would focus on new
model development and major changes, as well as equipment replacements and modifications. The time
frame for long-range planning may extend as far as 20 years in the future, but its usual range is from
2 to 10 years. An important part of long-term planning is the preparation of the capital budget, which
details plans for the acquisition and replacement of major portions of property, plant, and equipment.
 Quantitative plan: - Often budgets contain materials describing the various programs and activities
planned by the company. This chapter focuses primarily in the way that cost and revenue
estimates of the activities are expressed by the budget. All planned projects or activities for the
organization are reduced to the common denominator of money and other quantitative measures, such
as units of input or output.

Principal Advantages of Budgeting

As noted earlier, a budget is a detailed plan expressed in quantitative terms that specifies how
resources will be acquired and used during a specific period of time. The act of preparing a budget is
known as budgeting. The use of budgets to control a firm’s activities is called budgetary control.
Companies r e a l i z e many benefits from a budgeting program. Among these benefits a re the
following:
o Requires periodic planning.
o Fosters coordination, cooperation, and
communication.
o Provides a framework for performance evaluation.
o Means of allocating resources.
o Satisfies legal and contractual
requirements.
o Created an awareness of business costs.
Periodic Planning (Formalization of Planning):- The most obvious purpose of a budget is to quantify a
plan of action. The development of a quarterly budget for a Sheraton Hotel, for example, forces
the hotel manager, the reservation manager, and the food and beverage manager to plan for the staffing
and supplies needed to meet anticipated demand for the hotel’s services. To sum up, budgets forces
managers to think a head to anticipate and prepare for the changing conditions. The budgeting process
makes planning an explicit management responsibility.
Coordination, Cooperation and Communication:- Planning by individual managers does not ensure
an optimum plan for the entire organization. Therefore, any organization to be effective, each
manager throughout the organization must be aware of the plans made by other managers. In
order to plan reservations and ticket sales effectively, the reservation manager for Ethiopian Air Lines
must know the flight schedules developed by the airline’s route manager. The budget process pulls
together the plans of each manager in an organization. In a nutshell, 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 to middle and lower level managers, and
also to all employees. Employees and lower level managers inform top-level managers how they can
plan to achieve the objectives.
Performance Evaluation or Framework for Judging Performance: - Budgets are estimates of future
events, and as such they serve as estimates of acceptable performance. Comparing actual result against
budgeted results helps managers to evaluate the performance of individuals, departments, or entire
companies.
Budgets 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.

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Means of Allocating Resources: - Because we live in a world of limited resources, virtually all individuals
and organizations must ration their resources. The rationing process is easier for some than for other. Each
person and each organization must compare the costs and benefits of each potential project or activity and
choose those that result in the most appropriate resource allocation decision.
Generally, organizations resources are limited, and budgets provide one means of allocating
resources among competing uses. The city of Addis Ababa, for example, must allocate its revenue among
basic life services (such as police and fire protection), maintenance of property and equipment
(such as city streets, parks and vehicles) and other community services (such as programs to
prevent alcohol and drug abuse).
Legal and Contractual Requirements: - Some organizations are required to budget because of legal
requirements. Others commit themselves to budgeting requirement when signing loan agreements or
other operating agreements. For example, a bank may require a firm to submit an annual operating budget
and monthly cash budget throughout the life of a bank loan. Local police department, for example, would
be out of funds if the department decided not to submit a budget this year.
Cost Awareness:- Accountants and financial managers are concerned daily about the cost
implications of decisions and activities, but many other managers are not. Production managers focus
on input, marketing manager’s focuses on sales, and so forth. It is easy for people to overlook costs and
cost-benefit relationships. At budgeting time, however, all managers with budget responsibility must
convert their plans for projects and activities to costs and benefits. This cost awareness provides a
common ground for communication among the various functional areas of the organization.
Behavioural aspects of budgeting
The way in which budgets are administered impacts on their effectiveness in helping to achieve an
organisation’s goals. ‘The budget in any company has a dual role of being a forecast of the year and a yard
stick of managerial performance.’ It can also be argued that by using the budget to measure managerial
performance there is an attempt to use it as a tool for control. If this is linked with a reward and/or
punishment system, there is a general tendency for managers to distort the information they pass on to their
superiors, so that the unfavourable items are under-emphasised’. Such distortion of information is
undesirable and counter-productive.
Some organisations use sanctions and punishment to encourage adherence to budget. The use of sanctions
and punishment is synonymous with an authoritarian style of management. Typical responses to this use of
budgets are:
 Manager: - The important thing for us to do is to follow up. The supervisor’s interest lags unless
someone is constantly checking up on him … I think there is a need for more pressure … I think that
man is inherently lazy and if we could only increase the pressure budgets would be more effective.
 Supervisor:-The use of sanctions and punishment is more likely to lead to resentment and further
attempts to beat the system. At best it will result in a defeated and less than enthusiastic employee. It
will certainly encourage behaviour such as ‘padding the budget’
Padding the budget means overestimating costs and/or underestimating revenue. The difference between
the padded estimate and a realistic estimate is known as budgetary slack. For example, if Mr. X believes
that a realistic estimate for administrative salaries for the year is birr 160 000 but he submits birr 180 000 to
the budget committee, he has built birr 20 000 slack into the budget.
An additional reason why managers pad the budget is that in many organisations the submitted estimate is
changed by the resource allocation authority, that is budgeted costs are reduced and budgeted revenues
increased.
Participation in the budgetary process
The managers were both more productive and more satisfied with their job and their colleagues when
operating their own plans. Less time is wasted on competition between the planners and implementers when
the managers implemented their own plans. It is suggested that lower level manger should be included in the
budget setting process and their opinions be sought and carefully considered.
Techniques of Budgeting
Different organizations prepare budget using different techniques that may be grouped as follows:

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 1. 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.
2. Zero based budgeting: - In a dynamic business it often makes sense to 'start a fresh' 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 a fresh is usually required in
most business organizations, where the business environment is volatile that require continues effort of
incorporating changes in budget thinking.
3. Continuous/Perpetual/Rolling Budget: - is budget that covers a 12-month period but which is
constantly adding a new month on the end as the current month’s completed. It is a common form of master
budget. It makes the budgeting an ongoing process rather than a periodic process.
4. 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.
5. 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.
Uncertainty and budgeting
Every budgeting exercise has three primary objectives: to set targets in order to motivate and reward
performance; to coordinate resources by predicting midterm financial results and preparing accordingly; and
to exert control by setting limits on costs and centrally influencing cost allocation.
Heightened uncertainty and volatility make it exceedingly difficult to achieve any of these goals. First,
sudden market headwinds or unexpected windfalls cause absolute budget targets to be less and less useful.
Comparing actual results against budgets no longer reliably indicates manager performance. Second, it has
become more and more difficult to predict results in great detail and over long time horizons. In many cases,
single-point estimates will almost certainly be wrong. Third, in uncertain times, managers must be able to
respond quickly to changing circumstances. This frequently requires going over or under budget limits for
entirely justified reasons. Control via rigid budget limits has become far less effective.
These issues only add to all the well-known, long-standing budgeting challenges: considerable effort and a
high degree of complexity, intentionally pessimistic or unreachable targets, spend-it-or-lose-it behavior,
quickly outdated assumptions, and the like. In short, setting detailed, rigid budgets a year or more in advance
is increasingly a useless exercise.
TYPES OF BUDGET
Budgets are classified in different ways:
A) Based on capacity
i) Fixed budget –is a budget that remains unchanged with level of activity.
ii) Flexible budget –it is the budget that will fluctuate with the level of output.
B) Based on time
i) Long-rang budget –a budget that may cover long periods.
ii) Short-rang budget –a budget that covers less than one year.
C) Based on coverage
i) Functional budget –budgets related to the various functions of a business.
 Functional budget includes:
a) Physical budget –budgets of quantity of sales & productions.
b) Profit budget –budgets that ascertains the profit; like sales budget, profit & sales
budget, etc.
c) Cost budget –these provide information on costs like manufacturing cost, selling &
administration costs etc.
d) Financial budgets –these provide information on the financial position of the firm. e.g.;
cash budget, capital expenditure budget etc.

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 ii) Master budget – is a consolidated summary of the various operation & financial budgets. Or
- It is a set of budgets prepared collectively for all activities of a company.

Master Budget
A master budget is a comprehensive expression of managements operating and financial budget for future
time period usually for a year. A master budget summarizes the planned activities of all sub units of an
organization – sales, production, distribution and finance.
Advantages of master budget:
 It helps in implementing a strategic plan that efficiently & effectively achieves organization
objectives.
 It coordinates activities among various segments of an organization.
 It provides means of communicating the plan throughout the organization.
 It provides a standard for evaluating manager’s performance.

Components of Master Budget

The master budget is the total budget package for an organization; it is the end product that consists
of all the individual budgets for each part of the organization aggregated into one overall budget for the
entire organization.
The two major components of master budget are the operating budget and the financial budget.
Operating budget: It focuses on income statement and its supporting schedules. It is also called profit
plan. However, such budget may show a budgeted loss, or can be used to budget expenses in an
organization or agency with no sales revenues.
Financial budget: It focuses on the effects that the operating budget and other plans will have on cash.
Preparing the Master Budget
The master budget is a network consisting of many separate but interdependent budgets. This network is
illustrated in Exhibit 1-1. The master budget can be a large document even for a small organization. The
simple example that follows on the next page for Great Company give some indication of the
potential size and complexity of the master budget of a business. The example illustrates a fixed or
static budget prepared for a single expected level of activity. Flexible budgeting that involves various
activity levels will be discussed later in the next unit.
Preparation of Master Budget (Manufacturing Company)
Example (2) Great Company manufactures and sells a product whose peak sales occur in the third
quarter. Management is now preparing detailed budgets for 2014- the coming year and has assembled
the following information to assist in the budget preparation:
1) The company’s product selling price is Br. 20 per unit. The marketing department has
estimated sales as follows for the next six quarters.
2014 Quarters 2015 Quarters

1 2 3 4 1 2

Budgeted sales in units 10, 000 30,000 40, 000 20, 000 15, 000 15, 000

2) Sales are collected in the following pattern: 70% of sales are collected in the quarter in which the
sales are made and the remaining 30% are collected in the following quarter. On January1,
2014, the company’s balance sheet showed Br.90, 000 in account receivable, all of which will be
collected in the first quarter of the year. Bad debts are negligible and can be ignored.
3) The company maintains an ending inventory of finished units equal to 20% of the next quarter’s
sales. On December 31, 2013, the company had 2, 000 units on hand to start the New Year.
4) Fifteen pounds of raw materials are needed to complete one unit of product. The
company requires an ending inventory of raw materials on hand at the end of each quarter

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 equal to 10% of the following quarter’s production needs of raw materials. On December 31,
2013, the company had 21, 000 pounds of raw materials to start the New Year.
5) The raw material costs Br.0.20 per pound. Raw material purchases are paid for in the following
pattern: 50% paid in the quarter the purchases are made, and the remainder is paid in the
following quarter. On January 1,2014, the company’s balance sheet showed Br.25, 800 in
accounts payable for raw material purchases, all of which be paid for in the first quarter of the
year.
6) Each unit of Great’s product requires 0.8 hour of labor time. Estimated direct labor cost per
hour is Br.7.50.
7) Variable overhead is allocated to production using labor hours as the allocation base as follows:
Indirect materials Br.0.40
Indirect labor 0.75
Fringe benefits 0.25
Payroll taxes 0.10
Utilities 0.15
Maintenance 0.35
Fixed overhead for each quarter was budgeted at Br. 60, 600. Of the fixed overhead
amount, Br. 15, 000 each quarter is depreciation. Overhead expenses are paid as incurred.
8) The company’s quarterly budgeted fixed selling and administrative expenses are as
follows:
2014 Quarters
1 2 3 4
Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000

Executive salaries 55, 000 55, 000 55, 000 55, 000
Insurance - 1, 900 37,750 -
Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000
The only variable selling and administrative expense, sales commission, is budgeted at Br.1.80 per unit of
the budgeted sales. All selling and administrative expenses are paid during the quarter, in cash, with
exception of depreciation. New equipment purchases will be made during each quarter of the budget
year for Br. 50, 000, Br. 40, 000, & Br.20, 000 each for the last two quarter in cash, respectively. The
company declares and pays dividends of Br.8, 000 cash each quarter. The company’s balance sheet at
December 31, 2013 is presented below:

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The company can borrow money from its bank at 10% annual interest. All borrowing must be done at the
beginning of a quarter, and repayments must be made at the end of a quarter. All borrowings and all
repayments are in multiples of Br. 1,000.
The company requires a minimum cash balance of Br.40, 000 at the end of each quarter. Interest is
computed and paid on the principal being repaid only at the time of repayment of principal. The company
wishes to use any excess cash to pay loans off as rapidly as possible.
Instructions: Prepare a master budget for the four-quarter period ending December 31. Include the
following detailed budget and schedules:
a) A sales budget, by quarter and in total
b) A schedule of budgeted cash collections, by quarter and in total
c) A production budget
d) A direct materials purchase budget
e) A schedule of budgeted cash payments for purchases by quarter and in total
f) A direct labor budget
g) A manufacturing overhead budget
h) Ending finished goods inventory budget
i) A selling and administrative budget
2. A cash budget, by quarter and in total
3. A budgeted income statement for the four- quarter ending December 31, 2014
4. A budgeted balance sheet as of December 31, 2014.
Solution-Preparation of Master Budget (Manufacturing Company)
1. a) Sales Budget

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 Quarter
1 2 3 4
Expected sales in 10, 000 30, 000 40, 000 20, 000
units

Selling price per unit x B r. 2 0 x Br. 20 x Br.20 x Br.20

Total sales Br.200, 000 Br.600, 000 Br.800, 000 Br.400, 000

b) Schedule of Expected Cash Collections

Quarter
1 2 3 4 Total
30% of the previous Br. 90, 000 Br.60, 000 Br.180, 000 Br.240, 000 Br.570, 000
quarter sales

70% of the current 140, 000 420, 000 560, 000 280, 000 1, 400, 000
quarter sales

Total collections Br.230, 000 Br.480, 000 Br.740, 000 Br. 520, 000 Br.1, 970, 000
c) Production Budget
After the sales budget has been prepared, the production requirements for the forth-coming budget period
can be determined and organized in the form of a production budget. Sufficient goods will have to be
available to meet sales and provide for the desired ending inventory. A portion of these goods will
already exist in the form of a beginning inventory. The remainder will have to be produced.
Therefore, production needs can be determined as follows:

The schedule given below shows the production budget for Great Company. Note that the
desired level of the ending inventory influences production requirements for a quarter. Inventories
should be carefully planned. Excessive inventories tie up funds and create storage problems.
Insufficient inventories can lead to lost sales or crash production efforts in the following period

Quarter Total
1 2 3 4
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending Inventory 6, 000 8, 000 4, 000 3, 0 00 3, 000
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000

Lees: Beginning Inventory 2, 000 6, 000 8, 000 4, 0 00 2,

000
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Units to be produced 14, 000 32,000 36, 000 1 9, 0 00 101,

000
d) Direct Materials Budget
Returning to Great Company’s budget data, 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:

Quarter Total
1 2 3 4
Production needs(pounds) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
Add: Desired ending 48, 000 5 4, 0 00 2 8, 5 00 2 2, 5 00 22, 500
inventory

Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 4 8, 0 00 5 4, 0 00 2 8, 5 00 21, 000
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516,500
purchased(pounds)

Raw Materials to be purchased (in birrs)

1 2 3 4 Total
Raw materials to be 237, 000 486, 000 514, 500 279, 000 1, 516, 500
purchased (pounds)

Raw materials cost per x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20

pound

Total Br.47, 400 Br.97, 200 Br.102, 900 Br.55, 800 Br.303, 300

e) Schedule of Expected Cash Disbursements (for Materials Purchase)

Quarter Total
1 2 3 4

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 50% of the previous quarter Br. 25, 800 Br.23, 700 Br.48, 600 Br.51, 450 Br.149, 550
50% of the current quarter 23, 700 48, 600 51, 450 27, 900 151, 650
Total cash disbursement Br.49, 500 Br.72, 300 Br.101, 050 Br.79, 350 Br.301, 200

f) 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 just what will be needed in the way of labor time throughout the
budget year, the company can develop plans to adjust the labor force as the situation may require. Firms
that neglect to budget run the risk of facing labor shortage or having to hire and lay off at awkward
times. Erratic labor policies lead to insecurity and inefficiencies on the part of employees. To compute
direct labor requirements, the number of units of finished product to be produced each produced each
period (month, quarter, and so on) is multiplied by the number of direct labor-hours required to
produce a single unit. Many different types of labor may be involved. If so, then the computation should
be by type of labor needed. The labor requirements can then be translated into expected direct labor
costs. How this is done will depend on the labor policy of the firm. In schedule given below, the
management of Great Company has assumed that the direct labor force will be adjusted as the work
requirement change from quarter to quarter (for example as units produced changes from l4, 000 units in
quarter 1 to 32, 000 units in quarter 2 for Great Company, the direct labor work force will be fully adjusted
to the workload, i.e., total hours of direct labor time needed). In that case, the total direct labor cost is
computed by simply multiplying the direct labor- hour required by the direct labor rate hour as was done
in the schedule here under.

Quarter Total
1 2 3 4
Direct labor time 11, 200 25, 600 28, 800 15, 200 80, 800
needed

Direct labor cost per x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50 x Br.7.50

hour

Total direct labor Br.84, 000 Br.192, 000 Br.216, 000 Br.114, 000 Br.606, 000
cost

g) Manufacturing Overhead (MOH) Budget

The manufacturing overhead budget provides a schedule of all costs of production other than direct
materials and direct labor. These costs should be broken down by cost behavior for budgeting
purposes and a predetermined overhead rate developed. This rate will be used to apply manufacturing
overhead to units of product throughout the budget period.
A computation showing budgeted cash disbursement for manufacturing overhead should be made
for use in developing the cash budget. Since some of the overhead costs do not represent cash
outflows, the total budgeted manufacturing overhead costs must be adjusted to determine the cash
disbursement for manufacturing overhead. At Great Company, the only significant noncash
manufacturing overhead cost is depreciation. Any depreciation charges included in manufacturing
overhead must be deducted from the total in computing expected cash payments, since
depreciation is a noncash charge.
Quarter Total
1 2 3 4 Page 10 of 23
Variable overhead Br.22, 400 Br.51, 200 Br.57, 600 Br.30, 400 Br.161,600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
h) Ending Finished Goods Inventory Budget

After completing schedules (a) to (g), the company had all of the data needed to compute unit product
costs. This computation was needed for two reasons: first, to know how much to charge as cost of
goods sold on the budgeted income statement; and second, to know what amount to put on the
balance sheet inventory account for unsold units. The carrying cost of the unsold units is computed on
the ending finished goods inventory budget

i) Selling and Administrative Expenses Budge

Quarter Total
1 2 3 4
Variable selling Br.18, 000 Br.54, 000 Br.72, 000 Br.36, 000 Br.180, 000
expenses Page 11 of 23
Fixed selling &
administrative
expenses
 Disbursement for Selling & Administrative Expenses

Quarter Total
1 2 3 4
Budgeted Selling & Br.103, Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
Administrative 000
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements Br.93, 000 Br.130, 900 Br.184, 750 Br.129, 150 Br.537, 800

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Page 13 of 23
Page 14 of 23
Preparation of Master Budget for Merchandising Business
The usual master budget for a non-manufacturing company has the following components.

In addition to the master budget there are countless forms of special budgets and related reports. For
example, a report might detail goals and objectives for improvements in quality or customer satisfaction

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during the budget period.

Exhibit 3-1 above show graphically the follow of process in development of the master budget
for a non-manufacturing firm. The master budget example that follows should clarify the steps
required to prepare the budget package. After studying the entire example, return to Exhibit 1-1
and follow the example through the flow diagram.

Operating Budget
The operating budget is composed of the income statement elements. A manufacturing business
budgets both manufacturing and non-manufacturing activities. Below the various elements of the
operating budget of a manufacturing firm have been discussed.
Sales Budget: The sales budget is the first budget to be prepared. It is usually the most important budget
because so many other budgets are directly related to sales and are therefore largely derived from the
sales budget. Inventory budgets, purchases budgets, personnel budgets, marketing budgets,
administrative budgets, and other budget areas are all affected significantly by the amount of
revenue that is expected from sales.
Sales budgets are influenced by a wide variety of factors, including general economic conditions,
pricing decisions, competitor actions, industry conditions, and marketing programs. In an effort to
develop an accurate sales budget, firms employ many experts to assist in sales forecasting. The sales
budget is usually based on a sales forecast. A sales forecast is a prediction of sales under a given
conditions. The objective in forecasting sales is to estimate the volume of sales for the period based on
all the factors, both internal and external to the business that could potentially affect the level of sales.
The projected level of sales is then combined with estimated of selling prices to form the sales budget.
Sales forecasts are usually prepared under the direction of the top sales executive. Important factors
considered by sales forecasters include:
a) Past patterns of sales: Past experience combined with detailed past sales by product line,
geographical region, and type of customer can help predict future sales.

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 b) Estimates made by the sales force: A company’s sales force is often the best source of information
about the desires and plans of customers.
c) General economic conditions: Predictions for many economic indicators, such as gross
domestic product and industrial production indexes (local and foreign), are published regularly.
Knowledge of how sales relate to these indicators can aid sales forecasting.
d) Competitive actions: Sales depend on the strength and actions of competitors. To forecast sales, a
company should consider the likely strategies and reactions of competitors, such as changes in their
prices, products, or services.
f) Changes in the firm’s prices: Sales can be increased by decreasing prices and vice versa. Planned
changes in prices should consider effects on customer demand.
f) Changes in product mix: Changing the mix of products often can affect not only sales levels but
also overall contribution margin. Identifying the most profitable products and devising methods to
increases sales is a key part of successful management.
g) Market research studies: Some companies hire market experts to gather information about market
conditions and customer preferences. Such information is useful to managers making sales forecasts
and product mix decisions.
h) Advertising and sales promotion plans: Advertising and other promotional costs affect sales levels.
A sales forecast should be based on anticipated effects of promotional activities.
Purchases Budget: After sales are budgeted, prepare the purchases budget. The total merchandise
needed will be the sum of the desired ending inventory plus the amount needed to fulfill budgeted
sales demand. The total need will be partially met by the beginning inventory; the remainder must
come from planned purchases. These purchases are computed as follows:

Budgeted Desired Cost of

Beginning
Purchases = Ending inventory + Goods Sold -
Inventory
Budgeted cost of goods sold: For a manufacturing firm cost of goods sold is the production cost of
products that are sold. Consequently, the cost of goods sold budget follows directly from the
production budget. However, a merchandising firm has no production budget. The cost of goods sold
budget comes directly from merchandise inventory and the merchandise purchases budget.
Operating Expense Budget: The budgeting of operating expenses depends on various factors.
Month – to – month fluctuation in sales volume and other cost-drivers activities directly influence
many operating expenses. Examples of expenses driven by sales volume include sales
commissions and many delivery expenses. Other expenses are not influenced by sales or other
cost-driver activity (such as rent, insurance, depreciation, and salaries) within appropriate relevant
ranges and are regarded as fixed.
Budgeted Income Statement: The budgeted income statement is the combination of all of the
preceding budgets. This budget shows the expected revenues and expenses from operations during
the budget period.
A firm may have budgeted non-operating items such as interest on investments or gain or loss on
the sale of fixed assets. Usually they are relatively small, although in large firms the birr amounts
can be sizable. If non-operating items are expected, they should be included in the firm’s budgeted
income statement. Income taxes are levied on actual, not budgeted, net income, but the budget
plan should include expected taxes; therefore, the last figure in the budgeted income statement is
budgeted after tax net income.

Financial Budget
The second major part of the master budget is the financial budget, which consists of the capital budget,
cash budget, ending balance sheet and the statement of changes in financial position. Although there are

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some differences in operating budgets of manufacturing, merchandising and service firms, very little
difference exists among financial budgets of these entities.
Capital expenditure budget: Capital budgeting is the planning of investments in major resources like
plant and equipment, and other types of long-term projects, such as employee education programs. The
capital expenditure budget or capital budget describes the capital investment plans for an organization
for the budget period. It contains some of the most critical budgeting decisions of the organizations.
Cash budget: The cash budget is a statement of planned cash receipts and disbursements. The cash
budget is composed of four major sections:

 The receipts section: It consists of a listing of all of the cash inflows, except for financing,
expected during the budget period. Generally the major source of receipts will be from sales.
 The disbursement section: It consists of all cash payments that are planned for the budget
period. These payments will include inventory purchases, wages and salary payments and so on. In
addition, other cash disbursements such as equipment purchases, dividends, and other cash
withdrawals by owners are listed.
 The cash excess or deficiency section: The cash excess or deficiency section is computed as
follows:

If there is a cash deficiency during any budget period, the company will need to borrow funds. If there
is cash excess during any budget period, funds borrowed in previous periods can be repaid or the
idle funds can be placed in short-term or other investments.
 The financing section: This section provides a detail account of the borrowing and repayments
projected to take place during the budget period. It also includes a detail of interest payments that
will be due on money borrowed.

Budgeted Balance Sheet: The budgeted balance sheet, sometimes called the budgeted statement of
financial position, is derived from the budgeted balance sheet at the beginning of the budget
period and the expected changes in the account balance reflected in the operating budget, capital budget,
and cash budget.
Budgeted Statement of Changes in Financial Position: The final element of the master budget
package is the statement of changes in financial position. It has emerged as a useful tool for
managers in the financial planning process. This statement is usually prepared from data in the budgeted
income statement and changes between the estimated balance sheet at the beginning of the budget
period and the budgeted balance sheet at the end of the budget period.

Example 1: Blue Nile Company’s newly hired accountant has persuaded management to prepare a
master budget to aid financial and operating decisions. The planning horizon is only three months,
January to March. Sales in December (2013) were Br. 40, 000. Monthly sales for the first four
months of the next year (2014) are forecasted as follows:
January Br. 50, 000
February 80, 000

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 March 60, 000
April 50, 000
Normally 60% of sales are on cash and the remainders are credit sales. All credit sales are collected in
the month following the sales. Uncollectible accounts are negligible and are to be ignored. Because
deliveries from suppliers and customer demand are uncertain, at the end of any month Blue Nile
wants to have a basic inventory of Br. 20, 000 plus 80% of the expected cost of goods to be sold in the
following month. The cost of merchandise sold averages 70%of sales. The purchase terms available to
the company are net 30 days. Each month’s purchase are paid as follows:
50% during the month of purchase and, 50% during the month following the purchase
Monthly expenses are:

Wages and commissions……………………………Br. 2, 500 + 15%of sales, paid as incurred.

Rent expense………………………………………..Br. 2, 000 paid as incurred.

Insurance expense…………………………………..Br.200 expiration per month
Depreciation including truck……………………….Br.500 per month
Miscellaneous expense…………………………….5% of sales, paid as incurred.
In January, a used truck will be purchased for Br. 3, 000 cash. The company wants a minimum cash
balance of Br. 10, 000 at the end of each month. Blue Nile can borrow cash or repay loans in
multiples of Br. 1, 000. Management plans to borrow cash more than necessary and to repay as promptly
as possible. Assume that the borrowing takes place at the beginning, and repayment at the end of the
months. Interest is paid when the related loan is repaid. The interest rate is 18% per annum. The closing
balance sheet for the fiscal year just ended at December 31, 2013 is:

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Solution-Preparation of Master Budget (Merchandising Company)

STEPS IN PREPARATION OF MASTER BUDGET

1. A) Sales budget

December* January February March Jan.-Mar.

Total
Cash sales (40%) Br.24, 000 Br.30, 000 Br.48, 000 Br.36, 000 Br.114, 000
Credit sales (60%) 16 , 00 0 20, 000 32 , 00 0 2 4, 00 0 76, 000
Totals Br.40, 000 Br.50, 000 Br.80, 000 Br.60, 000 Br.190, 000

*December sales are included in the schedule (a) because they affect cash collected in January.

b) Cash collection budget

January February March
Cash sales of the Br.30, 000 Br.48, 000 Br.36, 000
month
Credit sales of last 1 6, 0 00 20 , 00 0 32, 000
month
Total cash collected Br.46, 000 Br.68, 000 Br.68, 000

c) Purchase budget

January February March Jan.-Mar

Required ending Br.64, 800 Br.53, 600 Br.48, 000
inventory
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 Cost of gods sold 35, 000 56, 000 42, 000 Br.133, 000
Total needed Br.99, 800 Br.109, 600 Br.90, 000
Beginning inventory 48, 000 6 4, 8 00 53, 600
Purchases budget Br.51, 800 Br.44, 800 Br.36,
4 00

d) Disbursement for purchases

January February March

50% of last month’s purchase Br.16, 800 Br.25, 900 Br.22, 400
50% of current month’s 25, 900 22, 400 18, 200
purchase
Total disbursement for Br.42, 700 Br.48, 300 Br.40, 600
purchase

e) Operating expense budget

January February March Jan.-Mar.

Wages and commissions Br.10, 000 Br.14, 500 Br.11, 500 Br.36, 000
Rent expense 2, 000 2, 000 2, 000 6, 000
Insurance expense 200 200 200 600
Depreciation expense 500 500 500 1, 500
Miscellaneous expense 2 , 50 0 4 , 00 0 3 , 00 0 9 , 50 0
Total Br.15, 200 Br.21, 200 Br.17, 200 Br.53, 600

f) Disbursement for operating expenses budget

January February March

Wages and commissions Br.14, 250 Br.14, 500 Br.11, 500
Rent expense 2, 000 2, 000 2, 000
Miscellaneous expense 2 , 50 0 4 , 00 0 3, 000
Total Br.18, 750 Br.20, 500 Br.16, 500

2. A) Budget income statement

Blue Nile Company

Budget Income Statement
For the Quarter Ended, March 31,
20x4
Sales (schedule 1(a)) Br.190, 000
Cost of goods sold (schedule 1 33 , 00 0
1(c))
Gross profit 57, 000
Operating expenses
Wages and commissions Br.36, 000
Rent expense 6, 000
Insurance expense 1, 500

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 Depreciation expense 600
Miscellaneous expense 9 , 50 0 5 3, 6 00
Operating income 3, 400
Interest expense* 885
Net income Br. 2, 515

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