CIMA official terminology defines budget as a “plan expressed in money. It
is prepared and approved prior to the budget period and may show income,
expenditure and the capital to be employed”. It could also be defined as ‘a
quantified plan of action relating to a given period of time’.
PURPOSES OF BUDGETING
Budgets have two main roles:
(a) They act as authorities to spend, that is, they give authority to budget
managers to incur expenditure in their part of the organization.
(b)They act as comparators for current performance, by providing a
yardstick against which current activities can be monitored, and they
may be used targets to motivate managers.
Other Purposes are;
Planning is necessary for doing any work in a systematic manner. A wellprepared plan helps the organization to use the scarce resources in an
efficient manner and thus achieving the predetermined targets becomes
easy. A budget is always prepared for future period and it lays down targets
regarding various aspects like purchase, production, sales, manpower
planning etc. This automatically facilitates planning.
Evaluation of performance
A manager’s performance is often evaluated by measuring his or her
success in meeting the budgets. In some companies bonuses are awarded
on the basis of an employee’s ability to achieve the targets specified in the
periodic budgets, or promotion may be partly dependent upon a manager’s
budget record. In addition, the manager may wish to evaluate his or her
own performance. The budget thus provides a useful means of informing
managers of how well they are performing in meeting target that they have
previously helped to set.
The activities of different departments or sub-units of the organization
need to be coordinated to ensure maximum integration of efforts towards
common goals. For achieving the predetermined objectives, apart from
coordination in the sense that budgets cannot be developed in isolation
This concept of coordination implies, for example, that the purchasing
department should base its budget on production requirement and that the
production budget should in turn be based on sales expectations..
Planning is looking ahead while controlling is looking back. Preparation of
budgets involves detailed planning about various activities like purchase,
sales, production, and other functions like marketing, sales promotion,
manpower planning. But planning alone is not sufficient. There should be a
proper system of controlling which will ensure that the work is progressing
as per the plan. Budgets provide the basis for such controlling in the sense
that the actual performance can be compared with the budgeted
If an organization is to function effectively, there must be definite lines
of communication so that all the parts will be kept fully informed of the
policies, and constraints, to which the organization is expected to
understanding of the part they are expected to play in achieving the
annual budget. This process will ensure that the appropriate individuals
are made accountable for implementing the budget. Through the
budget, top management communicates its expectations to lower level
management, so that all members of the organization may understand
these expectations and can coordinate their activities to attain them. It
is not just the budget itself that facilitates communication- much vital
information is communicated in the actual act of preparing it.
The interest and commitment of employees can be retained via a system
of feedback of actual results, which lets them know how well or badly
they are performing. The identification of controllable reasons for
departures from budgets with managers responsible provides an
incentive for improving future performance.
Provides a framework for authorization
Once the budget has been agreed by the directors and senior managers
it acts as an authorization for each budget holder to incur the costs
included in the budget center’s budget. As long as the expenditure is
included in the formalized budget the budget holder can carry out day
to day operations without needing to seek separate authorization for
each item of expenditure.
REASONS FOR THE PREPARATION OF BUDGETS
To compel planning:-Planning forces management to look ahead, set
and the organization purpose and
To communicate ideas and plans to everyone affected by them. This will
ensure that each one is aware of what is expected of him.
To co-ordinate the activities of different departments or sub-unit of the
organization. For instance, the purchasing department should base on
To provide a framework for responsibility accounting whereby managers
of budget centers are made responsible for the achievement of budget
targets for the operations under their personal control.
To establish a system of control:-Budgetary control usually involves the
feedback of actual results for comparism against the budget plan.
To motivate employees to improve their performance.
Benefits of Budgeting
Budgeting plays an important role in planning and controlling. It helps in
directing the scarce resources to the most productive use and thus ensures
overall effi ciency in the organization. The benefits derived by an
organization from an effective system of budgeting can be summarized as
Budgeting facilitates planning of various activities and ensures that
the working of the organization is systematic and smooth.
Budgeting is a coordinated exercise and hence combines the ideas
of different levels of management in preparation of the same.
Any budget cannot be prepared in isolation and therefore
Budgeting helps planning and controlling income and expenditure
so as to achieve higher profitability and also act as a guide for
various management decisions.
Budgeting is an effective means for planning and thus ensures
sufficient availability of working capital and other resources.
It is extremely necessary to evaluate the actual performance with
Budgeting ensures that there are well-defined parameters and thus
the performance is evaluated against these parameters.
As the resources are directed to the most productive use,
budgeting helps in reducing the wastages and losses.
Stages in the Budgeting Process
1. Communicating details of budget policy and guidelines to those
people responsible for the preparation of budgets
Determining the factor that restricts output
Preparation of sales budget
Initial preparation of the various budgets
Negotiation of budgets with superiors
Coordination and review of budgets
Final acceptance of budgets
Ongoing review of budgets
Types of Budgets
Functional or Departmental Budgets: - They are the budgets for the
various functions and departments of an organization. Examples are
production budgets, sales budgets, purchasing budgets and research
and development budgets.
Master Budgets: - When all the functional budgets have been
prepared, they are summarized and consolidated into a master budget
which consists of the budgeted profit and loss accounts. Balance sheet
and Cash budget and these provided the overall picture of the planned
performance for the budget.
Fixed Budgets: - It is a budget which is designed to remain unchanged
regardless of the volume of output or sale. Master budgets are
examples of fixed budgets as they are prepared on an anticipated
volume of production and sales with no plans made for the situation
that, actual volumes of productions and sales with no plans made for
the situation that, actual volumes of productions and sales may be
different from planned levels.
Flexible Budgets: - Is a budget which by recognizing different cost
behavior patterns is designed to change as volumes of output changes.
At the planning stage, a fixed master budget would be prepared to
cover the most probable level of activity but a contingency flexible
budget would be also prepared to cover all the other possible levels of
activities. It must be noted that, flexible budget uses the principle of
Continuous or Rolling Budgets: - It is a budget which is continuously
updated by adding further accounting period (a month or quarter)
when the earlier accounting period has expired.
Cash Budgets: - It is a detailed budget of cash inflows and outflows
incorporating both revenue and capital items. The objective of a cash
budget is to ensure that sufficient cash is available at all times to meet
the level of operations that are outlined in various budgets.
For cost control the direct labour budget, materials usage budget and
factory overhead budget are combined into separate departmental
budgets. These budgets are normally broken down into twelve separate
monthly budgets and the actual monthly expenditure is compared with
the budgeted amounts for each of the items concerned
Methods used in Budgeting
There are two main methods used in budgeting and these are:
Incremental Budgeting: - Is a traditional approach to budgeting
and involves basing next year’s budget on the current year’s result
plus an extra amount for estimated growth or inflation for the budget
Zero Based Budgeting: - It involves preparing a budget for each
cost centre from a zero base. Every item of expenditure has to be
justified in its totality in order to be included in the next year’s
budget. This approach requires that all activities are justified and
prioritized before decisions are taken relating to the amount of
resources allocated to each activity. In incremental budgeting or
traditional budgeting, previous year’s figures are taken as base and
based on the same the budgeted figures for the next year are worked
out. Thus the previous year is taken as the base for preparation of the
budget. However the main limitation of this system of budgeting is
that an activity is continued in the future only because it is being
continued in the past. Hence in Zero Based Budgeting, the beginning
is made from scratch and each activity and function is reviewed
thoroughly before sanctioning the same and all expenditures are
analyzed and sanctioned only if they are justified.
Benefits from Zero Based Budgeting
ZBB facilitates review of various activities right from the scratch and a
detailed cost benefit study is conducted for each activity. Thus an
activity is continued only if the cost benefit study is favorable. This
ensures that an activity will not be continued merely because it was
conducted in the previous year.
A detailed cost benefit analysis results in efficient allocation of
resources and consequently wastages and obsolescence is eliminated.
A lot of brainstorming is required for evaluating cost and benefits
arising from an activity and this result into generation of new ideas and
also a sense of involvement of the staff.
ZBB facilitates improvement in communication and co-ordination
amongst the staff.
Awareness amongst the managers about the input costs is created which
helps the organization to become cost conscious.
An exhaustive documentation is necessary for the implementation of this
system and it automatically leads to record building.
Limitations of Zero Based Budgeting
The following are the limitations of Zero Based Budgeting.
It is a very detailed procedure and naturally if time consuming and lot
of paper work is involved in the same.
Cost involved in preparation and implementation of this system is very
Morale of staff may be very low as they might feel threatened if a
particular activity is discontinued.
Ranking of activities and decision-making may become subjective at
It may not advisable to apply this method when there are non-financial
considerations, such as ethical and social responsibility because this will
dictate rejecting a budget claim on low ranking projects.
Preparation of Functional budgets:
Under the functional budgets, the following budgets are opened:
A Sales Budget shows forecast of expected sales in the future period [the
period is well-defined] and expressed in quantity of the product to be sold
as well as the monetary value of the same. A Sales Budget may be prepared
salesmenwise as well as time wise like quarter wise, month wise, weekly
etc. The following factors are taken into consideration while preparing a
Analysis of past sales
Estimates given by the sales staff
Market Potential Analysis
Dependent (demand) Factor
This budget shows the production target to be achieved in the next year or
the future period. The production budget is prepared in quantity as well as
in monetary terms. Before preparation of this budget it is necessary to
study the principal budget factor or the key factor. The principal budget
factor can be sales demand or the production capacity or availability of raw
material. The policy of the management regarding the inventory is also
taken into consideration. The production budget is normally prepared for a
period of one year and then broken down on monthly basis. Production
targets are decided by adding the budgeted closing inventory in the sales
forecast and subtracting the opening inventory from the total of the same.
Production Cost Budget is prepared by multiplying the production targets
by the budgeted production cost per unit. The following illustration will
clarify the concept
Direct Material Usage and Purchase Budget
This budget shows the quantity of materials to be purchased during the
coming year. For the preparation of this budget, production budget is the
starting point if it is the key factor. If the raw material availability is the key
factor, it becomes the starting point. The desired closing inventory of the
raw materials is added to the requirement as per the production budget and
the opening inventory is subtracted from the gross requirements. This
budget is prepared in quantity as well as in the monetary terms and helps
immensely in planning of the purchases of raw materials. Availability of
maximum, minimum, re-order and economic order quantity are taken into
consideration while preparing this budget. A separate material utilization
budget may also be prepared as a preparation of material purchase budget.
Direct Labour Budget
The labor budget estimates the labor required for smooth and uninterrupted
production. The labor budget shows the number of each type or grade of
workers required in each period to achieve the budgeted output, budgeted
cost of such labor, period wise and period of training necessary for different
types of labor.
Factory Overhead Budget
This budget is prepared for planning of the factory overheads to be incurred
during the budget period. In this budget the overheads should be shown
department wise so that responsibility can be fixed on proper persons.
Classification of factory overheads into fixed and variable components
should also be shown in this budget
Selling Administration Budget
This budget covers the administrative costs for non-manufacturing business
activities. The administrative overheads include expenses like office
expenses, office salaries, directors’ remuneration, legal expenses, audit
fees, rent, interest, property taxes, postage, telephone, telegraph etc. These
expenses should be classified properly under different headings to
determine the responsibilities regarding cost control and reduction.
Preparation of Cash Budget:
A cash budget is prepared to show the expected receipts of cash and
payments of cash during the budget period. A cash budget is an estimate of
cash receipts and cash payments prepared for each month. The annual cash
budget will be divided into smaller time periods commonly of one month or
four weeks. In this budget all expected payments, revenue as well as capital
and all receipts, revenue and capital are taken into consideration. The main
purpose of cash budget is to predict the receipts and payments in cash so
that the firm will be able to find out the cash balance at the end of the
budget period. This will help the firm to know whether there will be surplus
cash or deficit at the end of the budget period. It will help them to plan for
either investing the surplus or raise necessary amount to finance the deficit.
Cash Budget is prepared in various ways, but the most popular form of the
same is by the method of Receipt and Payment method. This method is
illustrated in the following illustration.
Why is a cash budget important?
1. Allows companies to predict possible cash shortages and take corrective
action before a crisis occurs.
2. Allows companies to see if large sums of excess cash are lying idle—could
be put to better use.
Procedure involved in the preparation of a cash budget:
Determine the actual receipts to be expected from sales.
Prepare “a debtors and Creditors schedule” to derive expected cash to
be collected from debtors and expected cash to be paid to Suppliers.
Determine the expected expenses to be incurred and must be noted
that all expenses in this case are cash item.
Adjust any item that is not a cash item because the cash budget does
not take into consideration non-cash items such as depreciation, profit
or loss on the disposal of fixed assets, notional expenses, provision for
bad debts etc.
a) Briefly explain the following concepts as used in budgeting:
i. Rolling budget
iii. Budget manual
Functional or Departmental Budgets
v. Master Budgets
vi. Flexible Budgets
b) Distinguish between the following three different types of planning :
Budgetary planning, and
Coulson industries, a defence contractor, is developing a cash budget for
September were GH¢100,000 and GH¢200,000 ,respectively. Sales of GH
¢400,000 , GH¢300,000 and GH¢200,000 have been forecast for October ,
November and December , respectively. Historically, 20% of the firm’s sales
have been for cash , 50% are generated accounts receivable collected after
1 month and the remaining 30% have generated accounts receivable
collected after 2 months. Bad debt expenses ( uncollectible accounts ) have
been negligible. In December , the firm will receive a GH¢30,000 dividend
from stock in a subsidiary.
Purchases – The firms purchases represents 70% of sales. Of this
amount, 10% is paid in cash, 70% is paid in the month immediately
following the month of purchase and the remaining 20% is paid 2
months following the month of purchase.
Rent Payments – Rent of GH¢5000/month
Wages and Salaries – Fixed salary cost for the year is GH¢96,000, or
GH¢8000 per month. Wages are estimated as 10% of monthly sales.
Tax Payments – Taxes of GH¢25,000 must be paid in December.
Fixed-Asset Outlays – New machinery costing GH¢130,000 will be
purchased and paid for in November.
Interest Payments – An interest payment of GH¢10,000 is due in
Cash Dividend Payments – Cash dividends of GH¢20,000 will be paid
Principal Payments (Loans) – A GH¢20,000 principal payment is due
– No repurchase or
retirement of stock is expected between October and December.
A company manufactures two products, A and B. Standard cost data for the
products for the next year are as follows;
Product A per
X at GH 2 per Kg
Product B per Unit
Y at GH 5 per Kg
Z at GH 6 per Kg
Unskilled at GH3 per
Skilled at GH 5 per hour
Budgeted stocks for next year are as
Product A (Units)
Budgeted sales for the next year; Product A 2400 units. Product B
Prepare the following budgets for next year;
a. Production budget, in units
b. Material purchases budget, in kg and by value
c. Direct labour budget, in hours and by value
Given the information below, you are required to prepare the following
budgets for Kek Ltd for the quarter July to September 2012;
Sales budget in quantity and value
Production budget in units
Raw materials usage budget in kgs
Raw materials purchase budget in kgs and value
Labour requirements budget in hours and value
The company manufactures product X which uses three different materials.
The details are as follows;
Selling price per unit GH¢ 500
material price GH¢7 per kg
material price GH¢10.00 per kg
material price GH¢9 per kg
Direct labour 8 hours
labour rate GH¢16 per hour
The following estimates of sales demand are made for the period July to
It is the company’s policy to hold stocks of finished goods at the end of each
month equal to 50% of the following month’s sales demand, and it is
expected that the stock at the start of the budget period will meet this
At the end of the production process, the products are tested: it is usual for
10% of those tested to be faulty. It is not possible to rectify these faulty
Raw material stocks are expected to be as follows on 1 July:
Raw materials stocks are to be increased by 20% in July, and then remain at
their new level for the foreseeable future. Labour is paid on an hourly rate
based on attendance. In addition to the unit direct labour hours shown
above, 20% of the attendance time is spent on tasks which support
Gosky Plc is currently preparing its budgets for the year ending 30 th
September, 2011. The sales and production budgets have been completed
and an extract from them is shown below:
Budgeted production costs are:
Fixed overheads are absorbed on a unit basis assuming a normal production
level of 14million units per year.
Direct material are purchased in the month of usage and, where settlement
discounts are available, Gosky Plc’s policy is to pay suppliers so as to
receive these discounts. It is expected that 60% of Gosky Plc’s material
costs will be received from suppliers who offer a 2% discount for payment in
the month of purchase. Other material suppliers are to be paid in the month
Direct labour costs are paid 75% in the month in which they are incurred,
and 25 % in the following month. Variable overhead costs are paid in the
month in which they are incurred. Fixed overhead costs include GH¢16m
depreciation. Fixed overhead expenditure accrues at a constant rate
throughout the year and is paid 40% in the month in which it is incurred
and 60% in the following month.
In addition to production costs, Gosky Plc expects to incur administration
overhead costs of GH¢500,000 per month and selling overhead costs of 2%
of sales value. These costs are to be paid in the month in which they are
Gosky Plc’s customers are expected to pay for items as follows:
two after sale
three month after sale 5%
Customers paying in the month of sale are given 1% discount. 5% of sales
are expected to be bad debts.
In addition to the above, Gosky Plc expects that:
New machinery is to be acquired on 1 st February, 2011, costing GH
¢15m. This is to be paid for in May 2011.
Corporation tax of GH¢15m will be payable in June 2011
A dividend of GH¢ 9m will be paid to shareholders in July 2011
The bank balance at 1st April 2011 will be GH¢20m.
Prepare Gosky’s cash budget for the period April-July 2011, showing clearly
the receipts, payments and the resulting balances for each month.
Jireh Fabrication Company is in the process of preparing the cash budget
for the last four months of 2010 that is September to December. The
following information has been made available.
Quantity (units) 60000
Selling price is GH¢10 per unit but expected to drop by 5% from
Payment for goods sold is as follows; 20% in the month of sales,
60% the following month after sales and the balance in the second
month after sales. Bad debt is estimated at 2% of sales value.
Purchases of goods at GH¢6 per unit are as follows: September
70000 units, October 70000units, November 72000 units and
December 65000 units.
Goods purchased are paid one month in arrears.
Monthly expenses estimated at 12% on sales revenue are paid in
the month of incurrence
The company plans to buy a delivery van at GH¢270000, 40% of
the cost to be paid in October and the balance in January 2011.
The Director withdraws GH¢20000 monthly for personal expenses.
Extracts from August figures are as follows:
a. Debtors GH¢460000 out of which GH¢100000 is part of July
sales before bad debt
b. Creditors for goods GH¢200000
c. Cash GH¢70000
Prepare Monthly cash budget for the four months ending December 2010
Watson Ltd is preparing its budgets for the next quarter. The following
information has been drawn from the budgets prepared in the planning
exercise so far.
GH 1300 per
Watson sells 10 percent of its goods for cash. The remainder of the
customers receive one month’s credit
Payments to creditors are made in the month following purchase
Wages are paid as they are incurred
Watson takes one month’s credit on all overheads
Production overheads are GH3200 per month
Selling and distribution and administration overheads amounts to
GH1890 per month
Included in the amounts for overhead given above are depreciation
charges of GH300 and GH190 respectively
Watson expects to produce a delivery vehicle in August for a cash
payment of GH9870
The cash balance at the end of June is forecast to be GH1235
Prepare a cash budget for each of the months July to September
Den Ltd is an agro processing company situated in the Nsawam area. The
company is preparing its budget for the first three months of 2013 and has
approached you for assistance. The following is available:
Information extracted from the Sales budget are as follows:
Debtors settle according to the following pattern:70% within the month of sale
20% in the month following
10% in the second month after sales
Extracts from the Purchases budget were as follows:
All purchases are on credit. 90% are settled in the month following
purchase and the balance settled in the second month after purchase.
Wages are expected to be as follows:
These are to be paid one month in arrears.
Electricity of GH¢4,000 per month is to be paid one month in
Corporate tax GH¢200,000 is expected to be paid in March 2013.
The company will receive settlement of an insurance claim of GH
¢10,000 in March 2013.
Overheads are expected to be GH¢250,000 every month.
includes depreciation of GH¢10,000).
The company has an overdraft facility with GCB Bank Ltd for the
purpose of its day to day operations up to GH¢1000,000.
Prepare a monthly cash budget for the first quarter of 2013.
A redundant manager who received compensation of GH¢80000 decides to
commence business on 4th January year 8, manufacturing a product for
which he knows there is ready market. He intends to employ some of his
former worker who were also made redundant but they will not all
commence on 4th January. Suitable premises have been found to rent.
Material stocks costing GH¢10,000 and second-hand machinery costing GH
¢60,000 have already been bought out of the GH¢80,000. The machinery
has an estimated life of five years from January year 8 and no residual
value. Other data is as follows;
Product will begin on 4th January and 25 percent of the following
month’s sales will be manufactured in January. Each month
thereafter the production will consist of 75 percent of the current
month’s sales and 25 percent of the following month’s sales
Estimated sales are;
Variable production cost per unit;
Raw material requirements for January’s production will be met
from the stock already purchased. During January, 50 percent of
the material required for February’s production will be purchased.
Thereafter it is intended to buy, each month, 50percent of the
requirements the other 50 percent will be purchased in the month
Payments for raw material purchases will usually be made 30 days
after purchase, but it will be possible to delay payment if necessary
for another month. The manager does not intend to use business’s
credit rating. 10 percent of the business’s purchases will be
eligible for a 5 percent discount if payment is made immediately on
Direct workers have agreed to have their wages paid into their
bank accounts on the seventh working day of each month in
respect of the previous month’s earnings
Variable production overhead; 60 percent is to be paid in the
month following the month it was incurred and 40 percent is to be
paid one month later
Fixed overheads are GH¢4000 per month. One-quarter of this is
paid in the month incurred, one-half in the following month, and
a 5 percent cash discounts is allowed for
payment in the current month and 20 percent of each month’s
sales qualify for this discount. 50 percent of each month’s sales are
received in the following month, 20 percent in the third month and
8 percent in the fourth month. The balance of 2 percent represents
anticipated bad debts.
The manager’s intended cash policy is to maintain a minimum
month-end cash balance of GH¢5000. If cash balances are likely to
be lower than this then supplier payments will be delayed as
Prepare a cash budget for each of the first three months of the year
8, taking account of the requirement to maintain a minimum
month-end cash balance of GH¢ 5000. All calculations should be
made to the nearest pound.
Ama has been working as a Makola business woman for many years without
obtaining finance from a bank. She intends starting another business from
her own working capital, using GH¢300,000. She maintains an account with
a Bank with a minimal balance and intends to approach the bank for the
necessary additional finance.
Arrangements have been made to purchase fixed assets costing GH
¢160,000. These will be paid for at the end of September and are
expected to have a five year life, at the end of which they will
possess a nil residual value.
Stocks costing GH¢100,000 will be acquired on 28th September and
subsequently monthly purchases will be at a level sufficient to
replace forecast sales for the month.
Forecast monthly sales are GH¢60,000 for October, GH¢120,000
for November and December, and GH¢210,000 from January 2010
Selling price is fixed at the cost of stocks plus 50%
Two month’s credit will be allowed to customers but one month’s
credit will be received from suppliers of stock.
Running expenses, including rent but excluding depreciation of
fixed assets are estimated at GH¢32,000 per month
She intends to make monthly cash drawings of GH¢20,000
Prepare a cash budget for six months to 31st March, 2010
Gloryland Ltd is preparing its annual budgets for the year to 31 st December,
2013. The company manufactures and sells one product called, “DON”. The
product currently sells for GH¢300 but the results of a survey conducted by
the marketing department suggest that the price will increase to GH¢320
with effect from 1 July 2013. At this price the sales volume for each quarter
of 2013 will be as follows;
Sales for each quarter of 2014 are expected to 80000units.This forms the
basis for the calculation of the closing stock in the last quarter. Each unit of
the finished product which is manufactured requires four (4) units of
component D and three (3) of component O, together with a body shell N.
These items are purchased from an outside supplier. Their current selling
prices are as follows:
Component D 16 each
Component O 10 each
The prices of the components are expected to increase by 20% with effect
from 1 April 2013; no change is expected in the price of the shell.
Assembling the shell and the components into the finished product requires
12 labour hours: labour is currently paid GH¢ 10 per hour. A 8 % increase in
wage costs is anticipated to take effect from 1 October 2013.
Variable overheads costs are expected to be GH¢20 per unit for whole of
2013; fixed production overheads are GH¢480,000 for the year, and are
absorbed on per unit basis. Stocks on 31st December 2012 are expected to
be as follows;
Closing stocks at the end of each quarter are to be as follows;
10% of the next quarter's sales
15% of the
Prepare for Gloryland Ltd the following budgets for the year ending 31 st
December 2013 showing values for each quarter and the year total;
a. Sales budget (in units and cedis)
b. Production budget (in units)
c. Material usage budget (in units)
d. Overheads costs budget
e. Labour cost budget (in cedis)
f. Production cost budget ( in cedis)
Preparing a Master Budget
The muster budget is a detailed and comprehensive analysis of the first year
of the long range plan. It quantifies targets for sales, purchases, production,
distribution, and financing in the form of forecasted financial statements
and supporting operating schedules. These schedules provide detailed
information beyond what appears in the forecasted financial statements.
Thus, the master budget includes forecasts of sales, expenses, balance
sheets, and cash receipts and disbursements. Many companies break
A master budget helps you to plan and coordinate all of the different
budgets needed to run an enterprise. It includes budgets for sales,
production or purchases, selling and administrative expenses, an income
statement, a cash flows statement and a balance sheet. In the budgeting
process, the master budget provides a single map explaining how the
company intends to earn profits and positive cash flow for the coming
period. It also helps different parts of a business to coordinate their
activities so that together they can meet the overall goals of the business.
Components of the Master Budget
The master budget is the set of budgeted financial statements and
supporting schedules for the entire organization.
1. The operating budget
2. The capital expenditures budget
3. The financial budget
The operating budget is the set of budgets that project sales revenue, cost
of goods sold, and operating expenses, leading to the budgeted income
statement that projects operating income for the period. The first
component of the operating budget is the sales budget, the cornerstone of
the master budget. Why? Because sales affect most other components of the
master budget. After projecting sales revenue, cost of goods sold, and
operating expenses, management prepares the end result of the operating
budget: the budgeted income statement that projects operating income for
The second type of budget is the capital expenditures budget. This
budget presents the company’s plan for purchasing property, plant,
equipment, and other longterm assets.
The third type of budget is the financial budget. Prior components of the
master budget, including the budgeted income statement and the capital
expenditures budget, along with plans for raising cash and paying debts,
provide information for the first element of the financial budget: the cash
budget. The cash budget details how the business expects to go from the
beginning cash balance to the desired ending cash balance and feeds into
the budgeted balance sheet, which, in turn, feeds into the budgeted
statement of cash flows. These budgeted financial statements look exactly
like ordinary statements. The only difference is that they list budgeted
(projected) amounts rather than actual amounts.
Steps Involved in the Preparation of a Master Budget
Step 1. Project sales
Start the budgeting process by estimating sales. Go to the sales or
marketing department and request anticipated sales for the coming period.
This estimate could be based on economic projections, consultants' reports,
or a simple analysis of trends in prior years.
Step 2. Plan production
Figure out the number of units of each product that you need to produce,
Expected sales (in units) + Desired ending inventory (in units) - Beginning
inventory (in units) = Units to be produced.
This assumes that you're a manufacturer. If you're a retailer that doesn't
produce its goods, then use a similar formula to estimate the number of
units that need to be purchased;
Expected units to be sold + Desired units of ending inventory - Units of
beginning inventory = Units to be purchased.
Multiply the number of units to be produced (or purchased) by the cost per
unit to figure out the total cost of units to be produced (or purchased).
Manufacturers can skip to Step 6.
Step 3. Set materials purchases
Once you know how many units you plan to produce, it's time to figure out
how much direct material you need to purchase. Find out how many units of
direct materials are needed for each unit to be purchased. For example, if
you make cheese, then producing a single wheel of cheese might require
two gallons of milk. This is the Units required for production.
Units required for production + Desired units of desired ending inventory of
direct materials - Units of beginning inventory of direct materials = Units of
direct materials to be purchased.
Step 4. Design labor budget
The direct labor budget estimates how much work must be done to meet
your production plans, and the number of employees needed. To figure out
the direct labor budget, ascertain (1) how many hours of direct labor are
needed to produce each unit and (2) the average direct labor rate. Multiply
both these factors by the number of Units to be produced that you
estimated in the Step 2 Production budget:
Hours needed to produce each unit x Average direct labor rate x Units to be
produced = Total direct labor costs.
To figure out the number of employees needed, divide total hours to be
worked by the number of hours worked per week: (Hours needed to
produce each unit x Units to be produced) / Average number of hours
worked per week by each employee = Number of employees needed for
Step 5. Plot overhead
To prepare the Overhead budget, multiply the number of Units to be
produced by the Variable overhead cost per unit. Then add Total fixed
(Units to be produced x Variable overhead cost per unit) + Total fixed
To estimate the Variable overhead cost per unit and Total fixed overhead,
account analysis, a scattergraph of overhead, the high-low method, or
regression analysis will help you understand the relationship between
overhead costs and volume.
Step 6. Estimate selling and administrative expenses
Sales don't happen automatically. You need to pay for sales agents,
advertising, and other marketing costs. All of these estimated costs are
tabulated in the Selling and administrative expense budget.
Step 7. Lay out a capital acquisitions budget
Factory equipment requires careful maintenance and occasionally
replacement. You may also need to add more equipment to make the needed
number of Units to be produced. Therefore, set up a capital acquisitions
budget that includes the cost of any new equipment or property that needs
to be purchased during the coming period.
Step 8. Budget an income statement
Based on all of the information in the prior steps, you should be able to
project an income statement for the coming period. This will follow the
basic formula for net income: Sales - Cost of goods sold - Other expenses =
Sales come from the Sales budget (Step 1). To estimate cost of goods sold,
multiply the number of units expected to be sold (see Step 1) by the
estimated cost per unit (a sum of Steps 3, 4, and 5). Other expenses include
Selling and administrative expenses (see Step 6), general expenses,
depreciation expenses, and also income tax expenses. When complete, the
budgeted income statement answers a critically important question: Will
your company be profitable next year? If you're dissatisfied with the
estimated profits, then you may need to go back to Step 1 and rework your
Step 9. Formulate a budgeted cash flows statement
A budgeted cash flows statement adds all of the expected cash receipts and
subtracts the disbursements for the coming period. Cash receipts come
from sales - but be careful! Don't list the sales themselves, but the cash
flows from sales. This means adjusting for the rate at which you collect
payment for your sales. Cash disbursements need to be made for purchases
of raw materials (Step 3), direct labor (Step 4), overhead costs (Step 5),
selling and administrative expenses (Step 6), and capital acquisitions (Step
7). Note that cash payments for these costs usually vary from the amounts
of costs themselves. Even though you purchase $1,000,000 worth of raw
materials next year doesn't mean that you pay your supplier exactly this
Once complete, your budgeted cash flows statement will indicate whether
you will have enough cash for the coming period. If you will, then great. If
not, then you either need to revise your plans so that you have enough cash
to fund them, or find more cash, by borrowing more money or raising
capital from investors.
Step 10. Bring down a budgeted balance sheet
The budgeted balance sheet is based on the following formula: Assets =
It explains how the business plan for the coming period will affect the
company's finance position at the end of that period. Budgeting starts with
estimating sales, and ends with a budgeted income statement, balance
sheet and cash flows statement. A master budget helps you to figure out
production levels, purchases of direct materials, hiring of employees,
overhead, and purchases of new capital assets, while maintaining
profitability and positive cash flow.
You manage Greg’s Tunes, Inc., which carries a complete line of music CDs
and DVDs. You are to prepare the store’s master budget for April, May,
June, and July, the main selling season. The division manager and the head
of the accounting department will arrive from headquarters next week to
review the budget with you.
Your store’s balance sheet at March 31, 2015,
period, appears in the table below
0 Accounts payable
1600 Salary and Com
0 Total Liab
Prepaid Insurance 1800 Equity
the beginning of the budget
0 Common Stock
0 Total Equity
101 Total Liab and
A flexible budget is a budget that is a function of one or more levels of
activity. Thus, the budget depends on one or more measures of activity
volume rather than being fixed in amount. A flexible budget is a budget
which is designed to change in accordance with the LEVEL OF ACTIVITY
It is also known as Variable budget as the budget recognizes the difference
in cost behavior namely fixed and variable costs in relations to fluctuations
in output or turnover. The budget is designed to change appropriately with
For a fixed budget, the budget remains unchanged irrespective of the level
of activity actually attained.
The fixed budget is prepared based only on one level of output.
Therefore, if the level of output actually achieved differs considerably from
that budgeted, large variances will arise.
For some companies, due to the nature of business does not suit fixed
Affected by weather condition like the soft drink industry;
Companies frequently introduce new product line like the food
Production is carried out only when orders are received from
customers like shipbuilding, aircraft industries;
Affected by changes in fashion like millinery trade;
Export orientated business
So, what are the difference between Fixed and Flexible Budget? They are:
For a fixed budget, the figures are for a SINGLE level of activity while a
flexible budget is prepared for DIFFERENT levels of activity;
Under fixed budgets, managers are held responsible for variances not
under his control ( both fixed and variable cost);
The fixed budget is never able to assess properly the efficiency and
actual performance of the manager.
For example, a fixed budget is set with a planned 8,000 hours but an
actual 10,000 hours are recorded, from both the motivational or
control point, it is difficult to gauge the efficiency of the manager(s)
who are involved in the manufacture of the output at that actual level;
The flexible budget allows more meaningful comparison as it flexs to the
actual volume. It computes what costs should have been for the actual
level of activity and
The flexible budget has the advantage of assisting the managers deal
with uncertainty by allowing them to see the expected outcomes for a
range of activity;
Purpose:--The purpose of a flexible budget is to develop an estimate or
estimates of cost for one or more levels of activity. Activity levels are
typically measured in terms of activity inputs, levels, or outputs. Such a
budget is flexible in the sense that it depends upon a specified level of
activity volume. Acquisition budgets focus on the costs to be incurred to
acquire actual or planned levels of resources. Labor budgets, purchasing
plans, and similar budgets are resource acquisition oriented. Activity
budgets focus on the resources that should be required to maintain
activities at specified levels based on expected or desired levels of
efficiency. Production budgets focus on the resources that would be
required to produce a specified set of products and services. Like activity
budgets, production budgets are necessarily based on assumed levels of
efficiency. The idea of a flexible budget is applicable to all three types of
Approach:--A flexible budget requires an estimate of the relationship
between total cost and activity volume. The form of that relationship
depends on the structure of the process for which costs are being
estimated. Some criteria for choosing a measure of volume include:
1. Causality -- an individual type of cost should be related whenever
possible to that activity which causes the cost to vary.
2. Independence of activity measure -- to the extent possible, the
activity measure should be independent of other influences.
example, labor or machine hours are independent of changes in
3. Ease of understanding -- Activity measure units should be easily
understandable and obtainable at reasonable expense. Complicated
indices of activity volume are best avoided.
4. Functionality - Activity measures should be functional and thus
contribute to organizational goals. For example, poor performance
should not result in a more generous budget for performance
evaluation and control purposes.
Practice: the cost behavior assumption that underlies much of current
accounting practice is that cost is a simple linear function of volume.
Specifically, it is assumed that
Total cost C = F + vQ, where F represents total fixed cost, v represents
the variable cost per unit of activity, and Q represents the level of activity
for which the budget is to be constructed. When there are multiple cost
drivers for an activity, then the linear equation is of the form
Total cost C = F + v1Q1 + v2Q2 + + vnQn
In matrix form, we would write this as
Total cost C = F + vQ
Flexible budgeting can be implemented whenever a reasonably strong
relationship exists between total cost and some measure of activity volume.
The relationship can be curvilinear or linear. The important concept is that
the budget flexes, in a predetermined manner, with changes in volume.
Measures of Activity
1. Flexible budgets are sometimes based on measures of activity inputs
(e.g., direct labor hours) that indicate the budgeted costs necessary to
acquire a given level of resources at specified prices. These are
acquisition budgets, such as might be used to budget for the purchase of
raw materials for a specified period.
2. Flexible budgets are sometimes based on measures of activity (e.g.,
hours a production line is in operation) to forecast the cost of operating
an activity, usually for a given level of input or output (e.g., standard
hours allowed for the output achieved). In constructing such budgets,
one must specify the rate at which resources will be consumed to
maintain the activity.
3. Flexible budgets are sometimes based on measures of activity output
(e.g., number of units produced during a period). In constructing such
budgets, one must specify both the rate at which resources will be
consumed to maintain the activity and the rate at which the activity will
produce units of output. Thus, a flexible budget based on output must
be based on specified input/output ratios.
Common uses of flexible budgets include:
to estimate total indirect factory costs at different levels of activity to compute
budgeted activity cost rates,
2. to budget total indirect factory costs at different levels of activity to
compute standard activity cost rates,
3. to estimate total activity costs at different levels of activity to compute
budgeted or standard activity cost rates.
4. to estimate total activity cost for the level of activity achieved for
control and performance evaluation purposes,
5. to forecast total activity costs for cash budgeting purposes,
6. to forecast activity costs for expense budgeting purposes, and
7. to forecast total activity costs to forecast earnings under different
The steps involve in the preparation of the flexible budget as follows:
Select the measure of activity like the units of production;
Define the relevant range of activity for the budgeted performance
based on step 1;
Identify the cost items to be included in the budget;
Determine the cost behavior of each item over the relevant range;
Separate the cost items into variable, fixed and mixed;
Select the specific levels of activity to be budgeted;
Use the cost behavior under item 4 to estimate the budgeted amounts
for each cost item at the different levels selected in step 6.
Company ABC manufactures a single product and has produced the
following flexed budget for the year.
Level of Activity
Prepare a budget flexed at the 45% level of activity
Answer:[Guide: To flex the budget, we need to determine which costs are
semi-variable and calculate the variable cost per 1% change in activity as
(range of cost)/(range of activity) and fixed costs as total cost minus variable
cost at that activity level. Calculate a cost per 1% for all the variable costs,
flex them to 45% and deduct the fixed costs]
$ per 1%
Total budget cost
Production overhead is a semi-variable cost
Range of activity=90%-70%=20%
Range of production overhead costs=$(33,500-30,500)=$3,000
Therefore, variable cost per 1% change in activity=$3,000/20=$150
Fixed cost=$33,500(90% x$150)=$20,000