Unit 4 - Budgeting

Copyright © 2014 Pearson Education 7-1
Chapter 7
Introduction to Budgets
and Preparing the Master Budget

Chapter 7 Learning Objectives
When you have finished studying this

chapter, you should be able to:
1. Explain how budgets facilitate planning

and coordination.
2. Anticipate possible human relations

problems caused by budgets.
3. Explain potentially dysfunctional incentives

in the budget process.

Chapter 7 Learning Objectives
4. Explain the difficulties of sales forecasting.

5. Explain the major features and advantages of a
master budget.
6. Follow the principal steps in preparing a
master budget.
7. Prepare the operating budget and the
supporting schedules.
8. Prepare the financial budget.
9. Use a spreadsheet to develop a budget
(Appendix 7).

Learning
Objective 1 Budgets and the Organization
A budget is a quantitative expression

of a plan of action that imposes
the formal structure of an organization.
Managers use budgeting as an

effective cost-management tool.
Budgets facilitate planning

and coordination.
Benefits of Budgets
Compel Provide an opportunity to

managers to reevaluate existing activities
think ahead and evaluate new ones.
Aid managers in communicating

objectives and coordinating
actions across the organization.
Provide benchmarks to evaluate

subsequent performance.

Zero-based Budget
A zero-based budget:
Requires justification of expenditures for

every activity, including continuing
activities.
Starts with the assumption that current

activities will not automatically be continued;
every activity starts at zero budget.

Learning
Objective 2 Possible Human Relations Problems
Problems in implementing budgets:

- Low level of participation in the budget
process,
- Lack of acceptance of responsibility for the
final budget,
- Incentives to lie and cheat in the budget
process,
- Difficulties in obtaining accurate sales
forecasts

Possible Human Relations Problems
The advantages of budgeting:

- The perceived attitude of top management,
-The level of participation in the budget process,
-The degree of alignment between the budget
and other performance goals.
An environment where there is a two-way flow

of information reduces negative attitudes.
Participative budgets are formulated with the

active participation of all affected employees.
Possible Human Relations Problems
Message conveyed by the budget system may

be misaligned with incentives provided by the
compensation system.
Misalignment between performance goals

stressed in budgets versus performance
measures the company uses to reward
employees and managers can limit
advantages of budgeting.
Copyright © 2014 Pearson Education 7 - 10

Learning
Objective 3 Dysfunctional Incentives
Dysfunctional incentives lead managers to make

poor decisions – lying if the budget process
creates incentives to bias budget information.
Budgetary slack (budget padding) - an over-

statement or understatement of budgeted
revenue to create an easier goal to achieve.
And one more complication—managerial

bonuses based on making budget.

Learning
Objective 4 Sales Forecasting
A sales forecast is a prediction of sales

under a given set of conditions.
Sales forecasts are usually prepared under

the direction of the top sales executive.
The sales budget is the result of

decisions to create conditions that will
generate a desired level of sales.

Factors to Consider When
Forecasting Sales
Es
t
by ima al ic s
sa tes r
e m n
Pa le m n
e noitio
st sf a G o d s’
p or de o r
of att
sa er ce econ e tit s
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o mpction
C a
keth Ch
a r
M earc ang
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s C r ic e
i ng ns pr ha es
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Adandotio ix
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Types of Budgets
Strategic plan Long-range planning
Master budget
Capital budget Continuous budget

Strategic Plan
The most forward-looking budget

is the strategic plan, which sets
the overall goals and objectives
of the organization.
The strategic plan leads to long-range

planning, which produces
forecasted financial statements
for five- to ten-year periods.

Long-Range Plans
Long-range plans…
are coordinated with capital budgets,

which detail the planned expenditures
for facilities, equipment, new products,
and other long-term investments.
Master budgets link to both long-range

plans and short-term budgets.

Learning
Objective 5 Master Budget
The master budget

is a detailed and
comprehensive analysis
of the first year of the
long-range plan.
It summarizes the
planned activities
of all subunits of
an organization.

Continuous Budget
Rolling budgets...
are a common form of

master budgets that
add a month in the
future as the month
just ended is dropped.

Master Budget
Operating budget Financial budget. . .

(profit plan). . .
Focuses on the Focuses on the

income statement effects that the
and supporting operating budget
schedules or and other plans will
budgeted have on cash
expenses. balances.

Learning Steps in Preparing the
Objective 6
Master Budget
1. Supporting data

Steps in Preparing the Master Budget
The principal steps in preparing

the master budget:
1. Basic data
a. Sales budget
b. Cash collections from customers
c. Purchases and cost-of-goods sold budget
d. Cash disbursements for purchases
e. Operating expense budget
f. Cash disbursements for operating expenses

Steps in Preparing the Master Budget
2. Operating Budget:
Prepare budgeted income
statement using basic data in step 1.
3. Financial Budget: Prepare forecasted

financial statements:
a. Capital budget
b. Cash budget
c. Budgeted balance sheet

Learning
Objective 7 Operating Budget
Sales
budget

Cash Collections
It is easiest to prepare budgeted

cash collections at the same
time as the sales budget.
Cash collections include

the current month’s cash
sales plus the previous
month’s credit sales.

Purchases Budget and
Cash Disbursements
Budget cost of goods sold by

multiplying the cost of
merchandise sold percentage
by budgeted sales.
The total merchandise needed

is the sum of budgeted cost
of goods sold plus the desired
ending inventory.

Purchases Budget and
Cash Disbursements
Finally, compute required purchases by

subtracting beginning inventory from
total merchandise needed:
Budgeted purchases:
= Desired ending inventory
+ Cost of goods sold
– Beginning inventory
Purchases
Use the budgeted purchases to

budget cash disbursements.

Operating Expense Budget
The budgeting of operating expenses

depends on several factors.
Month-to-month changes in sales volume and

other cost-driver activities directly influence
many operating expenses.
Expenses driven by sales volume include sales

commissions and many delivery expenses.

Operating Expense Budget
Other expenses are not influenced by sales

or other cost-driver activity and are regarded
as fixed, within appropriate relevant ranges.
Rent
Depreciation
Insurance
Salaries

Operating Expense Disbursements
Disbursements for operating expenses are

based on the operating expense budget.
Disbursements may include 50% of last month’s

and this month’s wages and commissions
plus miscellaneous and rent expenses.
The total of these disbursements is then

used in preparing the cash budget.

Budgeted Income Statement
The income statement will be complete

after addition of the interest expense,
which is computed after the cash
budget has been prepared.
Budgeted income from operations

is often a benchmark for judging
management performance.

Learning
Objective 8 Financial Budget
The second major part of the master budget is

the financial budget, which consists of the
capital budget, cash budget, and ending
balance sheet.
The cash budget is a statement of planned cash

receipts and disbursements that contains
these major sections: available cash balance,
net cash receipts, and disbursement financing.

Cash Budget
Available cash balance

= Beginning cash balance
– Minimum cash balance desired.
Cash receipts depend on collections from:

 customers’ accounts receivable, cash
sales, and other operating income sources.

Cash Budget
Cash disbursements for purchases depend

on the credit terms extended by suppliers
and the bill-paying habits of the buyer.
Payroll depends on wage, salary, and

commission terms and on payroll dates.

Cash Budget
Disbursements for some costs and

expenses depend on:
 contractual terms for installment
 payments,
 mortgage payments, rents, leases, and
 miscellaneous items.
Other disbursements include outlays for

fixed assets, long-term investments,
dividends, and the like.

Cash Budget
Ending cash balance

= Beginning cash balance
+ Receipts – Disbursements
+ Cash from financing
The cash from financing can be

either positive (borrowing)
or negative (repayment).

Budgeted Balance Sheet
The final step in preparing the master budget

is to construct the budgeted balance sheet
that projects each balance sheet item in
accordance with the business plan.
Beginning balances would be increased or

decreased in light of the expected cash
receipts and disbursements and the effects
of noncash items on the income statement.

Strategy and the Master Budget
The master budget is an important

management tool for evaluating
and revising strategy.
The first draft of a master budget is rarely the

final draft. As managers revise strategy, the
budgeting process becomes an integral part of
the management process itself—budgeting is
planning and communicating.

Activity-Based Master Budgets
Functional budgeting focuses on

preparing budgets for various
functions such as production,
selling, and administrative support.
An activity-based budgetary system

emphasizes the planning and control
purpose of cost management.

Financial Planning Models
Financial planning models are mathematical

models that can incorporate the effects of
alternative assumptions about
sales, costs, or product mix.
Financial models are only as good as the

assumptions and the inputs used to
build and manipulate them.

Learning
Objective 9 Spreadsheets for Budgeting
Spreadsheet software for personal computers,

a powerful and flexible tool for budgeting,
can be used to prepare mathematical models.
Models can be applied with a variety of

assumptions that reflect changes in expected
sales, cost drivers, cost functions, etc.
Arithmetic errors are virtually nonexistent.

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Copyright © 2014 Pearson Education 7-1

Copyright © 2014 Pearson Education 7-2

When you have finished studying this

1. Explain how budgets facilitate planning

2. Anticipate possible human relations

3. Explain potentially dysfunctional incentives

Copyright © 2014 Pearson Education 7-3

4. Explain the difficulties of sales forecasting.

Copyright © 2014 Pearson Education 7-4

A budget is a quantitative expression

Managers use budgeting as an

Budgets facilitate planning

Compel Provide an opportunity to

Aid managers in communicating

Provide benchmarks to evaluate

Copyright © 2014 Pearson Education 7-6

Requires justification of expenditures for

Starts with the assumption that current

Copyright © 2014 Pearson Education 7-7

Problems in implementing budgets:

Copyright © 2014 Pearson Education 7-8

The advantages of budgeting:

An environment where there is a two-way flow

Participative budgets are formulated with the

Message conveyed by the budget system may

Misalignment between performance goals

Copyright © 2014 Pearson Education 7 - 10

Dysfunctional incentives lead managers to make

Budgetary slack (budget padding) - an over-

And one more complication—managerial

Copyright © 2014 Pearson Education 7 - 11

A sales forecast is a prediction of sales

Sales forecasts are usually prepared under

The sales budget is the result of

Copyright © 2014 Pearson Education 7 - 12

Strategic plan Long-range planning

Capital budget Continuous budget

Copyright © 2014 Pearson Education 7 - 14

The most forward-looking budget

The strategic plan leads to long-range

Copyright © 2014 Pearson Education 7 - 15

are coordinated with capital budgets,

Master budgets link to both long-range

Copyright © 2014 Pearson Education 7 - 16

The master budget

Copyright © 2014 Pearson Education 7 - 17

are a common form of

Copyright © 2014 Pearson Education 7 - 18

Operating budget Financial budget. . .

Focuses on the Focuses on the

Copyright © 2014 Pearson Education 7 - 19

Copyright © 2014 Pearson Education 7 - 20

The principal steps in preparing

Copyright © 2014 Pearson Education 7 - 21

3. Financial Budget: Prepare forecasted

Copyright © 2014 Pearson Education 7 - 22

Copyright © 2014 Pearson Education 7 - 23

It is easiest to prepare budgeted

Cash collections include

Copyright © 2014 Pearson Education 7 - 24

Budget cost of goods sold by

The total merchandise needed

Copyright © 2014 Pearson Education 7 - 25