Session-6

 Profit planning and activity based budgeting:

Master Budget- Operating and Financial Budget.

18-10-2022
 Analyst’s point
2

 The premise of responsibility accounting is that managers

should be held responsible only for those items that they can
control to a significant extent.
 Responsibility accounting systems enable organizations to react
quickly to deviations from their plans and to learn from
feedback obtained by comparing budgeted goals to actual
results.
 The point is not to penalize individuals (those managers who
are responsible) for missing targets but to improve efficiency.

Note: Focus for responsibility accounting: planning and Control

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 Planning and Control
3

 Planning involves developing objectives and preparing various

budgets to achieve those objectives.
 Control involves the steps taken by management to increase
the likelihood that the objectives set down at the planning
stage are attained and that all parts of the organization are
working together toward that goal.
 To be effective, a good budgeting system must provide for
both planning and control. Good planning without effective
control is time wasted.

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 What the practice says?
4

1. Most companies (do not rely exclusively upon self-imposed

budgets in the sense that top managers usually initiate the
budget process) issue broad guidelines in terms of overall
target profits or sales. Lower level managers are directed to
prepare budgets that meet those targets.
2. Self-imposed budgets should be reviewed by higher levels of
management. Without such a review, self-imposed budgets
may have too much “budgetary slack,” or may not be aligned
with overall strategic objectives.
3. Budgetary Slack: The practice of underestimating budgeted
revenues, or overestimating budgeted expenses, in an effort
to make the resulting budgeted goals (profits) more easily
attainable 18-10-2022
 The Basic Framework of Budgeting
5

 A budget is a detailed quantitative plan for acquiring and using

financial and other resources over a specified forthcoming time
period.
 The act of preparing a budget is called budgeting.
 The use of budgets to control an organization’s activities is known
as budgetary control.

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 Human Factors in Budgeting
6

The success of a budget program depends upon three important

factors:
A. Top management must be enthusiastic and committed to the
budget process, otherwise nobody will take it seriously.
B. Top management must not use the budget to pressure
employees or blame them when something goes wrong. This
breeds hostility and mistrust rather than cooperative and
coordinated efforts.
C. Highly achievable budget targets are usually preferred
(rather than “stretch budget” targets) when managers are
rewarded based on meeting budget targets.

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 What we can achieve through budget
7

A. Budgets communicate management’s plans throughout the

organization.
B. Budgets force managers to think about and plan for the future.
C. The budgeting process provides a means of allocating resources
to those parts of the organization where they can be used most
effectively.
D. The budget process can uncover potential bottlenecks before
they occur.
E. Budgets coordinate the activities of the entire organization by
integrating the plans of its various parts.
F. Budgets define goals and objectives that can serve as
benchmarks for evaluating subsequent performance.
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 Focus of discussion
8

 Our focus of discussion is preparing operating

budgets for a one month (or one-year) time frame,
longer term budgets also can be very helpful to
organizations from a planning standpoint.

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 Choosing the Budget Period
9

 Operating budgets ordinarily cover a one-year

period corresponding to a company’s fiscal year.
Many companies divide their annual budget into
four quarters. We focus on one-month operating
budgets.
 A continuous or perpetual budget is a 12-month
budget that rolls forward one month (or quarter) as
the current month (or quarter) is completed. This
approach keeps managers focused on the future at
least one year ahead.
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 Master Budget
10

1. The master budget consists of a number of separate but

interdependent budgets.
2. The sales budget shows the expected sales for the budget
period expressed in dollars and units. It is usually based on a
company’s sales forecast.
3. All other parts of the master budget are dependent on the
sales budget.
4. The production budget is prepared after the sales budget. It
lists the number of units that must be produced during each
budget period to meet sales needs and to provide for the
desired ending inventory.

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 Master Budget
11

5. The production budget in turn directly influences the direct

materials, direct labor, and manufacturing overhead budgets,
which in turn enable the preparation of the ending finished
goods inventory budget.
6. These budgets are then combined with data from the sales
budget and the selling and administrative expense budget to
determine the cash budget.
7. The cash budget is a detailed plan showing how cash
resources will be acquired and used over a specified time
period. All of the operating budgets have an impact on the
cash budget.
8. The last step of the process is to prepare a budgeted income
statement and a budgeted balance sheet.18-10-2022
 The Master Budget: An Overview
12
Sales budget

Selling and
Ending inventory administrative
Production budget
budget budget

Direct materials Direct labor Manufacturing

budget budget overhead budget

Cash Budget

Budgeted
Budgeted
income
balance sheet
statement
Budgeted Statement 18-10-2022
of Cash Flows
 Master Budget (MB)
13

 It is a comprehensive budget
 MB consists of a number of separate but
independent budgets that formally lay out the
company’s sales , production, and financial goals
etc.
 The MB culminates in a cash budget, a budgeted
income statement, and a budgeted balance sheet.

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 Components of Master Budgets
14

A. Operating Budget – building blocks leading to the creation

of the Budgeted Income Statement

B. Financial Budget – building blocks based on the Operating

Budget that lead to the creation of the Budgeted Balance
Sheet and the Budgeted Statement of Cash Flows

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 Implication
15

 Master budget is an outlay showing the proposed

activity and the anticipated financial results during
the budget year.
 It is presented before the BOD for adoption and
approval. Then various functional budgets (as part
of master budget) send to the concerned
departments for action.

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16 18-10-2022
 Types of Budget
17

Classification is
 Budgets are the end product of the budgeting
based on Time, process. The numbers and types of budgets in
function, Coverage a firm depends on size and nature of business.
, and flexibility. 1. Time: Long term, short term and current
budget.
2. Operating (Activities) or Functional-
Sales, production, Direct material usage,
Direct material purchase, Direct labor cost,
factory overhead, plant utilization,
production cost, stock budget, cost of goods
sold, administration cost, selling and
distribution cost, research and development
cost, capital expenditure, cash.
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 Budget Classification
18

On the basis of coverage:

A. Functional budget:
a) Sales budget,
b) Production budget
c) Production cost budget ( Direct materials budget, Direct Labor budget, Factory
overhead budget)
d) Ending inventory budget
e) Cost of goods sold budget
f) Selling Expenses budget
g) Administrative Expense budget
h) Budgeted Income statement
B. Master budget- summary of all functional budget
Classification according to flexibility (Capacity)
A. Fixed budget
B. Flexible budget

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 In summary:
19

Budgets can be classified under the following groups:

1. Operating or functional budget or Activity budget
2. Cash Budget
3. Capital Budget
4. Master budget or comprehensive budget

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 Basic Operating Budget Steps
20

1. Prepare the Revenues Budget

2. Prepare the Production Budget (in Units)
3. Prepare the Direct Materials Usage Budget and Direct Materials Purchases
Budget.
4. Prepare the Direct Manufacturing Labor Budget
5. Prepare the Manufacturing Overhead Costs Budget
6. Prepare the Ending Inventories Budget
7. Prepare the Cost of Goods Sold Budget
8. Prepare the Operating Expense (Period Cost) Budget
9. Prepare the Budgeted Income Statement
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 Financial Budget Steps
21

Based on the Operating Budgets prepare:

1. Capital Expenditures Budget
2. Cash Budget
3. Budgeted Balance Sheet
4. Budgeted Statement of Cash Flows

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 Case: Hypothetical Ltd.
22

 Prepare the master budget for the company for the

month of January only.
 Refer the excel file for detail discussion.

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 Sales Budget
23

 Sales budget (SB): detailed schedule showing expected sales

for the budget period.
 Accurate sales budget is the key to the entire budgeting
process.
 All other parts of the master budget depend on sales budget.
 SB helps in determine how many units need to be produced.
Thus the production budget is prepared after sales budget.
 Sales budget is based on company’s sales forecast.

Note: SB is the subject that is most appropriately covered in

marketing courses.

Refer the excel sheet

18-10-2022
 Production Budget (PB)
24

 The PB is prepared after sales budget.

 PB lists the required production units must be produced to satisfy
sales needs and provide for desired ending inventory.
 PB in turn is used to determine the budgets for manufacturing
costs including direct materials budget, direct labor budget, and
the manufacturing overhead budget.

 Note: These budgets are then combined with data from sales
budget and selling and administrative expense budget to
determine the cash budget.
 We need inventory on hand at the end of the period to minimize
the likelihood of an inventory stock-out.
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 An Example: Production Budget
25

Budgeted unit sales 9,000

Add: Desired ending inventory 2,400

= Total needs 11,400

Less: Beginning inventory 1,800

= Required production 9,600

Note: 1. Management believes that an ending inventory equals

to 20% of the following (next) months (or period’s) sales strikes
the appropriate balance.
2. Production requirements are influenced by the desired level
of ending inventory. 18-10-2022
 Implication
26

The production budget must be adequate to

meet budgeted sales and to provide for
the desired ending inventory.

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 Implication
27

 Hypothetical Limited prepares a production budget because it is

a manufacturing company. If it were a merchandising company- It
would prepare a Merchandising Purchases budget, showing the
amount of goods to be purchased from suppliers during the
period.
 The merchandising purchases budget has the same basic format

as the production budget.

Budgeted unit sales 9,000
Add: Desired ending merchandising inventory 2,400
= Total needs 11,400
Less: Beginning merchandising inventory 1,800
= Required purchases 9,600
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 Cash Budget (CB)
28

 CB is a detailed plan showing how cash resources

will be acquired and used.
 CB indicate anticipated receipts and payment of
cash during the budget period.
 CB is considered as the nerve centre of the entire
budgetary control system.
 Most of the necessary information for this budget
are available from sales budget, production
budget, overhead budget and capital expenditure
budget.
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 Implication
29

 Master Budget interrelationship illustrates that all of

the operating budgets have an impact on the cash
budget.
 Note: after the CB prepared, the budgeted income
statement and then the budgeted balance sheet
can be prepared.

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 Format of the Cash Budget
30

 The preparation of the cash budget can be quite complex. This budget should be broken down
into time periods that are as short as feasible. It consists of four major sections:

1. Cash receipts section lists all cash inflows excluding cash received from
financing;
2. Cash disbursements section consists of all cash payments excluding
repayments of principal and interest;
3. Cash excess or deficiency section determines if the company will need to
borrow money or if it will be able to repay funds previously borrowed; and
4. Financing section details the borrowings and repayments projected to take
place during the budget period.

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 Mechanism
31

 The numbers for the budgeted income statement come from other
budgets that have already been prepared.
 More specifically, the sales revenue comes from the sales budget.

 The cost of goods sold, on a per unit basis comes from the

ending finished goods inventory budget.

 The selling and administrative expenses come from the S & A

budget.
 The interest expense comes from the cash budget

Note: With the income statement complete, we can move on to the

budgeted balance sheet.

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 Other Budgeting Issues
32

• Financial-planning software may be employed to

conduct sensitivity (“what-if”) analysis to assist in the
budgetary process
• Kaizen Budgeting – incorporating continuous
improvement factors in the budgeting process
• Activity-Based Budgeting – incorporating Activity-
Based Costing in the budgetary process

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