Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 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).


Budgets and the Organization

Budgets facilitate planning and coordination.

A budget is a quantitative expressionof a plan of action that imposes

the formal structure of an organization.

LearningObjective 1

Managers use budgeting as an effective cost-management tool.


Benefits of Budgets

Provide an opportunity to reevaluate existing activities

and evaluate new ones.

Aid managers in communicating objectives and coordinating

actions across the organization.

Compelmanagers to think ahead

Provide benchmarks to evaluate subsequent performance.


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.

A zero-based budget:


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

LearningObjective 2



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.


Message conveyed by the budget system may be misaligned with incentives provided by the compensation system.

Misalignment between performance goals stressed in budgets versus performancemeasures the company uses to reward employees and managers can limit advantages of budgeting.



Dysfunctional Incentives

Dysfunctional incentives lead managers to make poor decisions – lying if the budget process creates incentives to bias budget information.

And one more complication—managerial bonuses based on making budget.

Budgetary slack (budget padding) - an over- statement or understatement of budgeted revenue to create an easier goal to achieve.

LearningObjective 3


Sales Forecasting

A sales forecast is a prediction of salesunder a given set of conditions.

Sales forecasts are usually prepared underthe direction of the top sales executive.

LearningObjective 4

The sales budget is the result of decisions to create conditions that will

generate a desired level of sales.


Competitors’

actions

Past patterns

of sales

Estimates made

by sales forceGen

eral

econom

ic

conditi

ons

Factors to Consider When Forecasting Sales

Changes in the

firm’s pricesChanges in

product mix

Market

research

studies

Advertisin

g

and sales

prom

otion p

lans


Types of Budgets

Strategic plan Long-range planning

Capital budget

Master 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-rangeplanning, which produces

forecasted financial statementsfor five- to ten-year periods.


Long-range plans…

are coordinated with capital budgets, which detail the planned expenditures for facilities, equipment, new products,

and other long-term investments.

Long-Range Plans

Master budgets link to both long-range plans and short-term budgets.


Master Budget

The master budgetis a detailed and

comprehensive analysis of the first year of the

long-range plan. It summarizes theplanned activitiesof all subunits ofan organization.

LearningObjective 5


Continuous Budget

Rolling budgets...

are a common form ofmaster budgets that add a month in the future as the month

just ended is dropped.


Operating budget(profit plan). . .

Financial budget. . .

Master Budget

Focuses on the income statement

and supporting schedules or

budgeted expenses.

Focuses on the effects that the

operating budget and other plans will

have on cash balances.


Steps in Preparing the Master Budget

1. Supporting data

LearningObjective 6



1. Basic dataa. Sales budgetb. Cash collections from customersc. Purchases and cost-of-goods sold budgetd. Cash disbursements for purchasese. Operating expense budgetf. Cash disbursements for operating expenses

The principal steps in preparingthe master budget:



3. Financial Budget: Prepare forecasted financial statements:a. Capital budgetb. Cash budgetc. Budgeted balance sheet

2. Operating Budget:Prepare budgeted income

statement using basic data in step 1.


Operating Budget

Salesbudget

LearningObjective 7


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 inventoryPurchases

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.


Other expenses are not influenced by salesor other cost-driver activity and are regardedas fixed, within appropriate relevant ranges.

Rent

Insurance

Depreciation

Salaries

Operating Expense Budget


Operating Expense Disbursements

Disbursements for operating expenses arebased 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 thenused in preparing the cash budget.


Budgeted Income Statement

The income statement will be completeafter addition of the interest expense,

which is computed after the cashbudget has been prepared.

Budgeted income from operationsis often a benchmark for judging

management performance.


The cash budget is a statement of planned cashreceipts and disbursements that contains these major sections: available cash balance, net cash receipts, and disbursement financing.

Financial BudgetLearningObjective 8

The second major part of the master budget is the financial budget, which consists of the capital budget, cash budget, and ending balance sheet.


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 dependon 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

Other disbursements include outlays forfixed assets, long-term investments,

dividends, and the like.

Disbursements for some costs and expenses depend on: contractual terms for installment payments, mortgage payments, rents, leases, and miscellaneous items.


Cash Budget

Ending cash balance= Beginning cash balance+ Receipts – Disbursements+ Cash from financing

The cash from financing can beeither positive (borrowing)or negative (repayment).


Budgeted Balance Sheet

The final step in preparing the master budgetis to construct the budgeted balance sheetthat projects each balance sheet item inaccordance 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

An activity-based budgetary system emphasizes the planning and control

purpose of cost management.

Functional budgeting focuses on preparing budgets for various functions such as production,

selling, and administrative support.


Financial Planning Models

Financial models are only as good as the assumptions and the inputs used to

build and manipulate them.

Financial planning models are mathematical models that can incorporate the effects of

alternative assumptions about sales, costs, or product mix.


Spreadsheets for Budgeting

Arithmetic errors are virtually nonexistent.

Spreadsheet software for personal computers, a powerful and flexible tool for budgeting,

can be used to prepare mathematical models.

LearningObjective 9

Models can be applied with a variety of assumptions that reflect changes in expected

sales, cost drivers, cost functions, etc.


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Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 7 - 1.

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