MODULE 5: STRATEGY AND THE MASTER BUDGET

Expected Learning Outcomes

After studying this module, you should be able to….

1. Explain what a budget is and its role in the management process

2. Describe the importance of strategy in budgeting and its relationship to the strategic long-
term and short-term goals of the firm
3. Explain the management process of preparing the master budget
4. Prepare a sales budget including a computation of expected cash receipts
5. Prepare a production budget, direct materials budget, direct labor budget including the
computation of expected cash disbursements for purchases of material and payment of
direct labor
6. Prepare a manufacturing overhead budget and a selling and administrative expense budget
and expected cash disbursements relative thereto
7. Prepare a cash budget
8. Prepare a budgeted income statement and a budgeted statement of financial position
9. Describe the alternative approach in budgeting such as zero-base budgeting, activity-based
budgeting and Kaizen(Continuous improvement) budgeting
10. Explain the ethical issues in budgeting
ROLE OF A BUDGET

Budget is a financial plan of the resources needed to carry out tasks and meet financial goals. It is
also a quantitative expression of the goals the organization wishes to achieve and the cost of
attaining these goals.

Budgeting is the act of preparing a budget

Budgetary control is the use of budgets to control a firm’s activities

Budget plays an important role in:

• Allocating resources
• Coordinating operations
• Identifying constraints and limitations
• Communicating expected actions and results
• Authorizing activities
• Motivating and guiding implementation
• Providing controls of operations
• Managing cash flows
• Serving as criteria in performance evaluation

In the process of preparing a firm’s budget, managers need to be forward -looking in evaluating
upcoming events and situations as they relate to the firm’s strategic goals. Budget preparation
allows management the opportunity and time to work out any potential problems that the company
might meet in the coming periods . The firm is able to minimize if not totally avoid the adverse
effects that anticipated problem could have on operation. Budgeting can also help managers
identify current and potential bottleneck in operations and prevent them from becoming obstacles
to attaining budgeting goals.

Completion of a budget for all units of an organization also mandates coordinating operations
among all budgeted units and synchronizing the operating activities of various departments.
Budgets help firms to run smoother and achieve better results.

Budgeting can mean the difference between a general drift that may or may not lead to a desired
goal and a carefully plotted course toward a predetermined objective that holds drift to a minimum.
Budgets make the decision-making process more effective by helping managers meet uncertainties

The objective of budgeting is to substitute deliberate and well-conceived business judgment

for accidental success in enterprise management.

Budgets should not be expressions of wishful thinking but rather descriptions of attainable
objectives.
IMPORTANCE OF STRATEGY IN BUDGETING

A firm’s strategy is the path it chooses for attaining its long-term and mission. It is the starting
point in preparing its plans and budgets. Subsequent budget of the firm reflect of the strategic
decision.

Formulation of Strategy (PEST and SWOT Analysis)

The process of determining a company’s strategy starts with the assessment of external factors that
affect operation and evaluating internal factors than can be its strength and weakness.

External factors typically include:

• Competition
• Technical, economic, political, regulatory, social and environmental factors

A careful examination of such factors can help the firm identify opportunities, limitations and
threats

Internal factors on the other hand, include operating characteristics such as

• Financial strength
• Managerial talent and expertise
• Functional structure, and
• Organizational culture

Figure 5-1: Development of a Firm’s Product Strategy

Strategic Goals and Long-Term Objectives

An organization presents its strategic goals and long-term objectives through capital budget and
master budgets.

Long-range plan identifies required actions over a 5-year to 10-year period to attain the goals set
forth in their strategies

Long-range Planning

Long-range planning often entails capital budgeting, which is a process of evaluating proposed
major projects such as purchases of new equipment, construction of a new factory, and addition of
new products and planning for resource requirements

Capital budgets are prepared to bring an organization’s capabilities into line with the needs of its
long-range plan and long-term forecast. An organization’s capacity is a result of capital
investments made in prior budgeting periods

Short-Term Objectives and The Master Budget

Short-term objectives are goals for the coming period, which can be a month, a quarter, a year, or
any length of time desired by the organization for planning purposes. A firm determines short-
term objectives for the budget period based on strategic goals, long-term objectives and plans,
operating results of past periods, and expected future operating and environmental factors
including economic, industry and marketing conditions.

Figure 5-2: The Relationship between Strategic Goals, Long-Term Objectives and Plans,
Short-Term Goals, Budget, Operations and Control
THE MANAGEMENT PROCESS OF PREPARING THE MASTER BUDGET

Top Management Involvement

Top management ensures that budget guidelines are being followed through the budget review
and approval process. Active involvement by top management in reviewing and approving the
proposed budget is an effective way to discourage lower-level managers from playing budget
games (e.g., budgets with easy, target and adding stock to a budget).

Budgeting processes usually include formation of :

• Budget committee
• Determination of the budget guidelines
• Preparation of the initial budget proposal
• Budget negotiation
• Review and approval
• Budget revision

Organization for Budget Preparation

A budget committee with representation from the different functional areas (marketing,
production, finance, and administration) is generally considered an effective body to oversee
operation and administration of the budget. The controller may be selected to serve as head of the
committee for two major reasons:

1) Controller’s position is independent from the operating parts of the organization

2) He has that skills and experiences in coping with the intricacies of setting up a budget

The controller acts as a coordinator in the budgeting operation. He recommends how budgets
should be prepared, assembles the budgets, prepares periodic reports showing variances of the
actual results from the budgeted results, interprets variances and offers suggestions for
improvement whenever possible.

The budget committee decides how budgets shall be prepared, [passes on the final budget, and
settles disputes in one segment of the business and another when differences of opinion arise. The
committee also receives budget reports and makes policy decisions with respect to budget revisions
and other problems of budget administration.

Budget Guidelines

One of the responsibilities of the budget committee is to provide initial budget guidelines that set
the tone for the budget and govern budget preparation.
 The starting point in developing budget guidelines is the firm’s strategy. In developing the initial
budget guidelines, the budget committee also needs to consider development that have occurred
since the adoption of the strategic plan; the general outlook of the economy and the market;
the goal of the organization for the budgeting period; specific corporate policies such as
mandates for downsizing, reengineering, and the operating results of the year to date.

The Budget Period

Master budget is an overall financial and operating plan for a coming fiscal period and the
coordinated program for achieving the plan. It is usually prepared on a quarterly or an annual basis.

Long range plans called capital budgets, which incorporate plans for major expenditures for plant
and equipment or the addition of product lines, might be prepared to cover plans for as long as 5
to 10 years.

Responsibility budgets which are segments of the master budget relating to the aspect of the
business that is the responsibility of a particular manager are often prepared monthly.

Cash budgets may be prepared on a day-to-day or monthly basis.

Continuous budgeting plan budgets are constantly reviewed and updated. A review of the budget
may also suggest that the budget be changed as a result of changing business and operating
conditions.

The Initial Budget Proposal

Based on the initial budget guidelines, each responsibility center prepares its initial budget
proposal. In preparing an initial budget proposal, the following factors should be considered by a
budget unit.

Internal Factors:

• Introduction of new products.

• Adoption of new manufacturing processes.
• Changes in availability of equipment or facilities.
• Changes in product design or product mix.
• Changes in expectations or operating processes of other budget units that the budget unit
relies on for its input materials or other operating factors.
• Changes in other operating factors or in the expectations or operating [processes in those
other budget units that rely on the budget unit to supply them components

External factors:
 • Competitor’s actions
• Changes in the labor market
• Availability of raw materials or components and their prices
• Industry’s outlook for the near term.

Budget Negotiation, Review and Approval, Revision

The head of the budget units examines the initial budget proposal to determine whether the
proposal is within the budget guidelines. The head also checks to see if the budget goals can be
reasonably attained and in line with the goals of the budgets units at the next level up, and the
budgeted operations are consistent with the budgeted activities of another budget unit. Negotiation
occurs at all levels of the organization. As budget units approve their budgets, the budgets go
through the successive levels of the organization until they reach the final level, when the
combined unit budgets become the budget of the organization.

The budget committee reviews and gives final approval to the budget. The chief executive officer
then approves the entire budget and submits the budget to the board of directors.

Systematic, periodic revision of the approved budget or the use of a continuous budget can be an
advantage in dynamic operations because the updated budget provides better operating guidelines.
Regular budget revision may encourage responsibility not to prepare their budgets with due
diligence.

The Master Budget

A master budget is a comprehensive budget for a specific period. It consists of many interrelated
operating and financial budgets.

Figure 5-3: The Master Budget

Steps in Developing a Master Budget

The major steps in developing a Master Budget may be outlined as follows:

1. Establish basic goals and long-range plans for the company. These will serve as guidelines
in the preparation of budget estimates
2. Prepare a sales forecast for the budget period.
3. Estimate the cost of sales and operating expenses
4. Determine the effect of budgeted operating results on assets, liabilities and ownership
equity accounts. The cash budget is the largest part of this step, since changes in many
assets and liability accounts will depend upon the cash flow forecast.
5. Summarize the estimated data in the form of a projected income statement for the budget
period and projected cash flow statement.

Preparation of Comprehensive Master Budget Illustrated

Gilbert Manufacturing Company manufactures a special line of tools. As of December 31, 20X1,
the financial statement of the firm is as follows:

The following information is available for the development of its Master Budget for 20X2:
Sales Budget
The sales budget showing what products will be sold in what quantities at what prices, is the
foundation on which all other short-term budgets are built. The sales budget triggers a chain
reaction that leads to the development of many other budget figures in an organization. The sales
budget provides the revenue predictions from which cash receipts from customers can be estimated
and supplies the basic data for constructing budgets for production costs and selling and
administrative expenses. In short, the sales forecast is the keystone of the budget structure. The
accuracy and reasonableness of the sales data will affect the whole budget. The sales forecast is
made after consideration of the following factors.

1. Past sales volume

2. General economic and industry conditions
3. Relationship of sales to economic indicators
4. Relative product profitability
5. Market research studies and competition
6. Pricing, advertising and other promotion policies
7. Production capacity
8. Quality of sales force
9. Seasonal variations
10. Long-term sales trends for various products

The Gilbert Company, the sales budget is presented as follows:

Production Budget

The production budget becomes a key factor in the determination of other budgets, including the
direct materials budget, the direct labor budget and the manufacturing overhead budget. These
budgets in turn are needed to assist in formulating cash budget.

Using the data from the previously prepared sales budget as well as the inventory summary
information, the following production budget is developed.
Raw Materials Budget

After determining the number of units to be produced, The Raw Materials purchases can now be
prepared, as follows:

Direct Labor Budget

The preliminary data show that the budgeted direct labor cost per unit is P146. This must have
been arrived at after considering such factors as skills level of the workers, labor rate per hour,
time requirement, conditions of union contracts, etc.

Therefore the direct labor is as follows:

Overhead Costs Budget

Study of past records will show how the cost reacts to changes in volume or I relation to other
factors. Some overhead items may be projected on the basis of direct labor hours or on materials
costs or on machine hours.

The overhead costs budget for 202X2 is illustrated below using the basic information from the
preliminary data previously established.

Budgeted Cost of Sales

The Budgeted Cost of sales Statement can now be developed using the data from the following:

Production Budget Schedule 2

Raw Materials Budget Schedule 3

Direct Labor Budget Schedule 4

Overhead Cost Budget Schedule 5

Budgeted Statement of Schedule 6

Cost of Sales
Marketing And Administrative Budget

Marketing and administrative expenses are also made up of fixed and marketing variable
exponents. The marketing and administrative expense budget for 20X2 is shown below.
Cash Budget

Cash Receipts

The bulk of a firm’s cash receipt comes from customers. The possibility of cash from other sources
(such as additional investments, sales of assets, borrowings) should likewise be considered when
cash receipts are being budgeted.

Cash Disbursements

Various adjustments and additions will have to be, made when preparing the budget for payments,
accruals as well extraneous items (such as the purchase of new equipment, dividend payment)that
do not show up in any of the individual budgets already prepared. If te financial policy of the
company requires that a minimum cash balance be maintained at all times, the cash budget must
be altered to accommodate bank loans and their repayment.

Using the data collected in the various budgets and the information that has been previously
provided, the following Cash Budget Statement is developed.
Budgeted Income Statement

The budgeted income statement is showing the net income that is to be expected during the budget
period.

Budgeted Statement of Financial Position

The budgeted statement of financial position is developed by beginning with the current statement
of financial position and adjusting it for the data contained in the other budgets.
Budgeting in Service Industries

A service organization achieves its budgeted goals and fulfils its mission through providing
services.

Budgeting for service firms is similar to budgeting for manufacturing and marketing firms the
difference is in the absence of products or merchandise purchase budget and their ancillary budget.

An important focal point in its budgeting is personal planning. A service firm must ensure that it
has personnel with the appropriate skills and competence to perform the services required for the
budgeted sales revenue.

Budgeting in Not-for-Profit Organization

A not-for-profit organization’s objective is to provide services efficiently and effectively as

mandated in its charter, while not spending more than the allowed expenditure level.

The objectives of not-for-profit organizations are different from those of for-profit organizations.

The master budget of a not-for-profit organization often becomes an authorization document for
allowable expenditures and activities. In effect, the budget for a not-for-profit organization often
becomes the source of both the power and limitations of the budgeted unit

Budgeting in International Setting

Subsidiaries or subdivisions of a multinational firm often have their own budgets. They must
follow the firm’s budget procedure and coordinate their budgets with other divisions of the firm.
The superior divisions then approve the budget in sequence until the final approval by the corporate
budget committee.

Alternative Approaches in Budgeting

Zero-base Budgeting

Zero-base budgeting is a budgeting process that requires manager s to prepare budgets from a zero
base. A typical and traditional budgeting process is an incremental process that starts with the
current budget. The primary focus in a typical budgeting process is on changes to the current
operating budget.
A zero-base budgeting process allows no activities or functions to be included in the budget unless
managers can justify their needs. Zero-base budgeting process encourages managers to be aware
of activities or functions that have outlived their usefulness or have been a waste of resources. A
tight, efficient budget often results from zero-base budgeting.

Activity-based Budgeting

Activity-based budgeting (ABB) is a budgeting process based on activities and cost-drivers of

operations. ABB starts with the budgeted output and segregates costs required for the budgeted
output into homogenous activity cost pools such as unit, batch, product-sustaining activity cost
pools based on similarity of their resource and activity consumption cost drivers.

Activity-based budgeting can be a simple extension of a firm’s activity-based costing systems that
has grouped its costs into activity cost pools. The firm needs to review the appropriates of its
activity cost pools and accuracy of its activity costs for the budget period.

Kaizen (Continuous Improvement) Budgeting

Kaizen budgeting is a budgeting approach that explicitly demands continuous improvement in

operation processes and incorporates the improvements in the budget. A firm using kaizen
budgeting prepares budgets based on the desired future operating processes for the budget period.

Kaizen budgeting begins by analysing practices to identify areas for improvement and determine
expected changes needed to attain the desired improvements. Budgets are prepared based on
improved practices or produces. Budgeted cost is often lower than those in the preceding period,
and the firm expects to be able to manufacture products or render services at lower costs.

ETHICAL ISSUES IN BUDGETING

Ethical issues in budgeting include:

• Preventing concealment of information

• Avoidance of having a higher budget goal
• Inclusion of budget slack
• Spending the budget to avoid having it cut back

Behavioral issues in budgeting encompass:

 • Difficulty level of budget targets
• Drawbacks and advantages of authoritative and participate budgeting process
• Extent of involvement of top management in budgeting
• Role of the budget department or controller on budgeting

Ethical issues permeate all aspects of budgeting. A significant portion of information used in
budgeting is provided by people whose performance is evaluated against the budget.

Spending the budget is another serious ethical issue in budgeting. Managers may believe that if
they do not use up all budgeted amounts, the future budgets will be reduced. To avoid cuts in their
budgets, managers may resort to wasteful spending to exhaust the remaining budgeted amount
before the end of the period.

Goal Congruence

Goal congruence is the consistency between the goals of the firm and the goal of its employees.
A perfect goal congruence is the ideal for which many firms strive. Realistically, perfect goal
congruence almost never exists because resources for satisfying short-term goals of individuals
are often conflict with those of the firm.

A budget that aligns the goals of the firm those of its employees has much better chance of leading
to successful operations. One approach that encourages the goal congruence is avoiding
authoritative budgeting and using participative budgeting as much as possible.

Authoritative or Participative Budgeting

Authoritative budgeting in a top-down budgeting process top management prepares budgets for
the entire organization, including those for lower-level operations. A participative budgeting
process is bottom-up approach that involves the people affected by the budget, including lower-
level employees in preparing the budget.

Authoritative budgeting provides better decision-making control than participative budgeting. Top
management sets the overall goals for the budget period and prepare a budget for operations to
attain the goals. An authoritative budget often lacks commitment on the part of the lower-level
managers and workers responsible for the implementation of the budget.

A participative budget is a good communication device. The process of preparing a participative

often gives top management a better grasp of the problems their people face and enables employees
to gain a better understanding of the quandaries top management deals with.
A participative budget may lead to easy budget targets or targets not in compliance with the
organization’s strategy or budget targets. An effective budgeting process therefore usually
combines both top-down and bottom-up budgeting approaches. The final budget usually from
more participation not enforced negotiations.

Activity

Matching Type. Match the definitions enumerated on the right column with the terms on the left
column.

1. Sales forecast A. A quantitative benchmark for measuring

company achievement.
2. Management by exception B. A budget reflecting long-range decisions
of the company.
3. Responsibility accounting C. The most important input for budget preparation.
All estimates of activity depend upon this
information.
4. Statement of financial position D. An integrated plan of action for the firm as a
Whole, expressed in financial term.
5. Performance budget E. A system that relates costs to organizational
Structure.
6. Objective F. An integrated statement of resource levels and
their sources.
7. Capital expenditures budget G. A set of statements providing broad direction for
the firm.
8. Profit plan H. The practice of focusing attention on those
activities where the actual performance differs
significantly from planned performance.
9. Master budget I. A budget prepared after the fact, showing what
costs should have been at the actual level of
activity.
10. Goals J. An opening budget for a specific future period of
Time.