Chapter 7

 
Introduction to Budgets and the
Master  Budget
• WHAT
• WHY
• TYPES
• MASTER BUDGET
• STATIC AND FLEXIBLE BUDGET
 Budget
• A condensed business plan for the forthcoming year (or less)

• A budget is used in attracting funds from investors and banks and by managers to guide them in
allocating resources, maintaining control, and measuring and rewarding progress.
• The most important functions of budgets are for planning, performance evaluation, and
communication.
• Budgets provide a comprehensive financial overview of planned company operations.
• Budgets highlight potential problems and opportunities early, allowing managers to take steps to
avoid the problems or use the opportunities wisely.
• Budgets are used for performance evaluation. Managers use budgets as a benchmark – a
measure of expected or desired performance—against which they compare actual performance.
• Finally, budgets provide an important two-way communication channel.
Potential Problems in Implementing
Budgets
• Budget Participation and Acceptance of the Budget
• Incentives to Lie and Cheat
If organizations use budgets as a target for performance evaluations,
managers may create budgetary slack or budget padding—overstate
their budgeted costs or understate their budgeted revenues to create a
budgeted profit level that is easier to achieve
• Difficulties of Obtaining Accurate Sales Forecasts
 Types of Budgets

•  The planning horizon for budgeting may vary from one day to many years.
• Strategic Plan—the most forward-looking budget, which sets the overall
goals and objectives of the organization.
• Long-Range Planning—forecasted financial statements for 5- or 10-year
periods. Long-range planning includes decisions about the addition or
deletion of product lines, design and location of new plants, acquisition of
buildings and equipment, and other long-term commitments.
• Capital Budgets—detail the planned expenditures for facilities,
equipment, new products, and other long-term investments in
coordination with long-range plans.
 Master Budget (Pro Forma Statements)—
• It is a periodic business plan that includes a coordinated set of
detailed operating schedules and financial statements.
• It includes forecasts of sales, expenses, cash receipts and
disbursements, and balance sheets.
• Managers may also prepare daily or weekly task-oriented budgets
that help them carry out their particular functions and meet
operating and financial goals.
 Continuous Budgets (Rolling Budgets)—
• Common form of master budgets that add a month in the future as
the month just ended is dropped.
• This type of budget forces managers to think specifically about the
forthcoming 12 months and thus maintain a stable-planning horizon.
• While a new month is added to a continuous budget, the other 11
months can also be updated.
15.2a

Why do we produce budgets?

1. To aid the planning of actual operations:

• by forcing managers to consider how conditions might

change and what steps should be taken now.

• by encouraging managers to consider problems before

they arise.

2. To co-ordinate the activities of the organization:

• by compelling managers to examine relationships

between their own operation and those of other
departments.
15.2b

Why do we produce budgets?

3. To communicate plans to various responsibility centre managers:

• everyone in the organization should have a clear

understanding of the part they are expected to play in
achieving the annual budget.

• by ensuring appropriate individuals are made

accountable for implementing the budget.

4. To motivate managers to strive to achieve the budget goals:

• by focusing on participation

• by providing a challenge/target.
15.2c

5. To control activities:

• by comparison of actual with budget (attention

directing/management by exception).

6. To evaluate the performance of managers:

• by providing a means of informing managers of how

well they are performing in meeting targets they
have previously set.
15.3

Stages in the budgeting process

1.Communicate details of budget policy and guidelines to those people responsible
for preparing the budget.

2. Determine the factor that restricts output.

3. Preparation of the sales budget.

4. Initial preparation of budgets.

5. Negotiation of budgets with higher management. (See figure on slide 7.)

6. Co-ordination and review of budgets.

7. Final acceptance of budgets.

8. Ongoing review of the budgets.

1. The Budget Committee
Various budgets are
approved by a budget
committee that is
composed of senior
managers such as the
president, CFO, VP of
operations, and the
controller. Budgets may
be developed with either
a top-down or bottom-up
approach.
2. The Budget Time Period

Budgets may cover a

variety of time periods
including a month,
quarter, year, or even
longer. Generally,
longer budget periods
provide less detail.
3. Zero Base Budgeting
Budgets are often adjusted up
or down on the basis of a
previous period adjusted for
current conditions. Zero base
budgeting requires that all
budget amounts be currently
justified even if they were
supported in prior budgets.
Due to the cost of the
process, this zero base
budgeting is often not used in
business.
III. Selected Budget Formats
A. Sales Budget
B. Production Budget
C. Direct Materials Budget
D. Direct Labor Budget
E. Overhead Budget
F. Cash Receipts and Disbursements Budget
A. Sales Budget

Projected sales
x Selling price per unit
= Budgeted sales revenue
Production Budget
• Plants' sales budget is 160,000 units
• Management estimates that there will be 5,000 units
in beginning inventory and 15,000 in ending inventory.
160,000 15,000 5,000 170,000
units + units – units = units

Budgeted sales in units

+ Desired ending inventory of finished goods
= Total needs
- Beginning inventory of finished goods
= Units to be produced
C. Direct Materials Budget
Units to be produced
x Cost of parts per unit
= Cost of parts needed for production
+ Desired ending inventory of parts
= Total needed
- Beginning inventory of parts
= Cost of purchases
Direct Materials Example
 LO
13-4

Direct Materials Example

$
D. Direct Labor Budget

Direct labor hours per unit

x Labor rate per hour
= Direct labor cost per unit
x Units to be produced
= Total direct labor cost
 LO
13-4

Direct Labor Example

Labour time required to

manufacture 1 unit is 30
minutes and the rate per hour
is $ 22
 LO
13-4

Overhead Example
Santiago Pants
Schedule of Budgeted Manufacturing Overhead
For the Budget Year Ended December 31
Variable overhead needed to product 170,000 units:
Indirect materials and supplies @ $0.30 per unit $ 51,000
Materials handling @ $0.40 per unit 68,000
Other indirect labor @ $0.10 per unit $ 17,000
Total variable overhead $136,000

Fixed manufacturing overhead (supervisory labor $102M,

maintenance and repairs $50M, plant administration $85M,
utilities $55M, depreciation $140M, insurance $30M,
property taxes $60M, and other $22M) $544,000
Total manufacturing overhead $680,000
 LO
13-4

Marketing and Administrative Budget Example

E. Overhead Budget

Units to be produced
x Variable costs per unit
= Total variable overhead
+ Budgeted fixed overhead
= Total budgeted overhead
- Noncash expenses
= Cash disbursements for overhead
F. Cash Receipts and Disbursements Budget

Cash receipts
- Cash disbursements
= Excess (deficiency) of cash
available over disbursements
+ Beginning cash balance
= Ending cash balance
IV. Static v. Flexible Budget
A. Static Budget
B. Static Budget Illustration
C. Flexible Budget
D. Flexible Budget Illustration
A. Static Budget
Why are
we so off A budget designed for only one
from level of activity. Differences
budget?
from the budget can be
misleading when an
organization actually operates
at a different level of activity.
 B. Static Budget Illustration
Standard
cost per Original
unit Actual Budget Variance
Units produced and sold 8,000 10,000 2,000 U

Variable Overhead Costs:

Maintenance $ 0.60 $ 4,500 $ 6,000 $ 1,500 F
Indirect materials 1.40 12,000 14,000 2,000 F
Utilities 1.00 9,500 10,000 500 F
26,000 30,000 4,000 F

Fixed Overhead Costs:

Depreciation 40,000 40,000 $ -
Supervision 49,000 50,000 1,000 F
Insurance 10,000 10,000 -
Total fixed overhead 99,000 100,000 1,000 F
Total overhead costs $ 125,000 $ 130,000 $ 5,000 F
C. Flexible Budget

A budget designed to
cover a range of
activity. Can be used
to compare actual
costs incurred to
budgeted costs around
that level of activity.
Static Budgets and
Performance Reports
F = Favorable variance since actual costs
Static
are less than budgeted Actual
costs.
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Indirect labor $ 40,000 $ 34,000 $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Since
Fixed cost variances are favorable, have
costs
we done a good job controlling
Depreciation 12,000 costs?
12,000 0
Insurance 2,000 2,000 0
Total overhead costs $ 89,000 $ 77,300 $11,700 F

11-31
Flexible Budget
Performance Report
Variable Total
Cost Fixed Flexible Actual
Per Hour Costs Budget Results Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed Expenses
Depreciation $12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,000 0
Total fixed costs $ 14,000 $ 14,000 0
Total overhead costs $ 74,000 $ 77,300 $ 3,300 U

11-32
 D. Flexible Budget Illustration
Standard
cost per unit Units
Units produced and sold 5,000 10,000 15,000

Variable Overhead Costs:

Maintenance $ 0.60 $ 3,000 $ 6,000 $ 9,000
Indirect materials 1.40 7,000 14,000 21,000
Utilities 1.00 5,000 10,000 15,000
$ 3.00 15,000 30,000 45,000

Fixed Overhead Costs:

Depreciation 40,000 40,000 40,000
Supervision 50,000 50,000 50,000
Insurance 10,000 10,000 10,000
Total fixed overhead 100,000 100,000 100,000
Total overhead costs $ 115,000 $ 130,000 $ 145,000