Master Budget Course

8/6/2019 Master Budget Course

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Master Budget Course - Master Index

Introduction

1.The Master Budget1.Overview of the master budget2.Sales budget

2.Budgeting for the Cost of Production1.Introduction2.Production Budget3.Raw Materials Budget4.Direct Labour Budget5.Factory Overhead6.A summary

3.Budgeting for the Cost of Inventory1.Application of Costs to Inventory

4.Budgeting for Expenses1.Expenses budgets2.Selling Expenses budget3.Administrative Expenses budget

5.Putting it Together1.Capital expenditure budget2.Budgeted Income Statement3.Budgeted Balance Sheet

4.Budgeted cash flow6.The Master Budget - A Simplified Example - The Personal Software

Factory Pty Ltd1.Introduction2.Budget overview and financials for the 19x1 year3.Sales budget4.Production budget5.Expenses budget6.Budgeted cash flow7.Budgeted Income Statement

8.Budgeted Balance Sheet7.Flexing the budget1.Introduction2.What if at the Software Factory

1.Base Case2.Very Best Case3.Worst Case4.Analysis of the What If Scenarios

8.Using a Spreadsheet to Build the Budget1.Introduction2.Logical Formulae


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The Master Budget

Overview of the master budget

The Master Budget for a profit oriented organisation seeks to build a set ofinterrelated budgets which provide a complete "picture" of the operationsof the business over some future period, usually twelve months.

The elements of the master budget addresses both operating and financialconcerns. The major elements of the Master Budget are:

The Operating Budget is made up of the Sales Budget, Production Budgetand Expenses Budget. As the name suggests the sales budget forecasts

the sales for the company over the budgeted horizon. As we will exploreshortly, the sales budget will for many business be a budget by product or


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product line and by territory, again depending on the nature of thebusiness. The Production budget for a manufacturing firm will seek tobudget the costs of producing the finished goods including the cost of rawmaterials and direct labour that go into the manufacturing process as wellas overheads in the manufacturing process such as the cost of buildings,

light, heat power and supervisory staff within the factory. The expensesbudget are for the various sales and administrative costs of doingbusiness.The Financial Budget is made up of the Cash Flow and Capital ExpenditureBudgets and the Budgeted Balance Sheet. The Capital Expenditure budgetseeks to budget for purchases of capital items that is necessary for theoperations of the business over the coming years. The budgeted BalanceSheets shows the funding impact of factors such as the level of AccountsReceivable flowing from the level of budgeted credit sales.

The Cash Flow budget is the "glue" which binds the whole budgettogether. Every budget decision from the level of sales to labour costs andspending on capital items has some impact on cash flows. The cash flowbudget seeks to show the cash funding necessary for the budget period.

Let us now look at a plan of the Master Budget in more detail:


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The production budget for manufacturing firms is made up of threeelements:

Raw Materials budget which establishes the cost of the material

content of the production process Direct Labour budget which budgets forthe cost of those staff directly involved in the production of manufacturedproducts

Overhead budget

The expenses budget is made up of:

Selling expenses which includes distribution costs, sales and marketingexpenses

Administrative expenses which includes the cost of overall corporate

management and financing costs.


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Sales budget

The sales budget is the most important element in the master budget asall other budget assumptions flow from the sales forecasts in the budget.While it can readily be seen that the cost of raw materials and direct

labour are directly related to the level of sales, it might not be so obvioushow other budget elements relate. Here are some relationships:

The level of capital expenditure will depend on the level of sales. If acompany is showing rapid sales and therefore production growth, theremay not be sufficient manufacturing capacity and the company will needto buy more capacity. This will require capital expenditure. The level ofsales which are on credit will influence the Balance Sheet because it drivesthe level of Accounts Receivable The level of sales will drive selling andmarketing expenses because extra sales means extra distribution costs

and may relate to bonuses paid to the sales force The mix of sales canrelate to the level of selling and marketing expenses. If a company isintroducing a new product there may be a high level of sales expenses asnew advertising campaigns are ramped up The sales made by a companygenerates a positive cash flow and so the level of sales are important indetermining the cash flow of the company and, in turn, the cost of debtfinance for the business

The sales budget will depend on the successful forecasting of a number offactors including:

The state of the overall economy

The competitive position

The plans to introduce new products

The success of advertising and marketing campaigns

The sales budget can be expressed in a number of different ways. Some ofthe possible combination of factors in which the management of thecompany might be interested in reviewing the budget targets are:

The factors in which management might be interested are:


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Product: Here the management will wish to know sales revenue byproduct line. Budgets may differ from company to company. For somecompanies, it will be possible to budget down to the individual product lineand show budgeted product sales by product code in terms of units of

production and revenue per item. An example of a company which willwish to budget in this manner is a motor vehicle manufacturer which willbudget not only for the general model but also variations within a model.There will be different revenues per unit for a top of the range model thanfor the entry level model within that range. It is also very likely that therewill be different gross margins for the different models within a range notonly in terms of the

Period: The periods into which the budget may be divided might be byquarter, by month or even in some companies, by week. As discussedabove, the overall budget will typically be for a financial year.

Sales territory: As well as breakdowns by product, it will often benecessary to analyse budgeted sales by sales territory. This might bebased upon a geographic territory within a country, a breakdown bycountries or regions and in some cases by class of customer. An example,

for a software company, might be sales through sales channels such aslocal agents, direct phone sales and licensing arrangements with majorcustomers such as government departments or large companies.

The Sales Budget for a hypothetical company, the Software Factory forthe first and fourth quarters for the year ended 31 December 19x1 isshown below.

The Software Factory is a manufacturer of software for the personalcomputer market. It has two products and two sales territories. It has anunusual spreadsheet the "4D Spreadsheet" which can build multi-dimensional spreadsheets with complex interlinking of spreadsheetelements. The company also has a multi-media database which allowsusers to store a variety of elements including moving images andphotographs.


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The sales budget, of which we can see just the first and fourth quarters,shows budgeted sales by product and territory. The unit price in eachterritory is an average of the three markets serviced by the territory, asdiscussed above: sales through sales channels such as local agents, directphone sales and licensing arrangements with major customers such as

government departments or large companies.

Let us look at some of the factors which went on, in building the salesbudget.

4D Spreadsheet: The Northern Sales region sells primarily into thedomestic or "SoHo" (Small office and Home) market through agents. TheSouthern Sales region sells primarily in direct sales to large customers.

The Northern Sales region is, then, particularly affected by the pre-Christmas period as the home buyers of computers have their busiest


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process and the cost of the other inputs into the process such as heating,lighting, supervision and depreciation. This can be seen in the figurebelow:

Production Budget

The first thing we must do is to work out how many items of production

that will be made in the budgeted period. The production must satisfythose sales in the current period that cannot be supplied from currentproduction and also provide a surplus to put into the finished goodsinventory. Of course, many manufacturing processes are "on demand" andwill not have any finished goods but the great majority of manufacturingorganisations will maintain a level of finished goods inventory. The levelof production in a period will be determined by using the output from thesales budget and will incorporate some assumptions on the desired levelof closing inventory:

The production budget for the Software Factory for the first three monthsof the budget year is shown below:


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The technology and cost of producing the 4D Spreadsheet MegaMultiMediadatabase is very imilar, so the production budget for the Software Factoryshows the production and cost combined for both products.

The finished goods inventory, in units, that is required at the end of eachperiod should be sufficient to meet all of the next period's sales and stillhave one quarter of the month's sales left over. So the closing inventoryat the end of January is 125% of the February sales rounded to thenearest 10 units. Closing inventory is, then, 770 * 125% = 962.5 unitswhich when rounded to the nearest ten units becomes 960 units. The levelof finished goods inventory not only has implications for the number ofunits to be produced in the manufacturing process but also relates to theBalance Sheet as it will impact on the dollar valuation of finished goods.

So if we know the quantity of opening inventory at the commencement ofthe period and we can calculate what the quantity of closing inventoryshould be and we also know what the level of sales for the period arelikely to be, we can calculate the level of production in the period. Which,again for the month of January, is shown as:

Raw Materials Budget


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The Raw Materials budget for the first quarter of the 19x1 year for theSoftware Factory is shown below:

The estimated cost of all of the various items of raw materials in theproduction process is $12.50 and this is expected to be constantthroughout the 19x1 financial year. Because the raw materials are rathergeneric in nature, being primarily paper and diskettes, and therefore

readily obtainable only a relatively small amount of raw materialsinventory is required at the end of each period. The budget assumption isthat 50% of the requirements for the next month should be on hand atthe end of each month. The closing inventory for the month of February is$5,250 or 50% of March's raw materials consumption of $10,500.

Direct Labour Budget

It is normal to see the direct labour budget as responding directly toproduction levels. The direct labour budget for a particular item in theproduct range will usually be calculated as:


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The direct labour budget for the first quarter Software Factory for the firstquarter of the financial year is shown below:

Factory Overhead

A variety of overhead costs associated with running the manufacturingprocess is included in the Factory Overhead budget. Some of the costswhich are included in this category include:

Incidental materials costs including cleaning and some packaging costs The "on costs" of direct Labor such as idle time, employers'

contribution to the employees' superannuation fund and payrolltaxation

Factory rent or lease costs, heating or cooling, power and maintenance

Quality assurance

Supervision and factory management

Depreciation of factory equipment

These costs are of both a fixed and variable nature. Some examples of

fixed and variable costs are:

Variable

Incidental materials costs including cleaning and some packaging costs

The "on costs" of direct Labor such as idle time, employers'contribution to the employees' superannuation fund and payrolltaxation

Fixed

Factory rent or lease costs, heating or cooling, power and maintenance

Supervision and factory management

Depreciation of factory equipment

For many companies, the budget will calculate an appropriate overheadapplication rate and apply the overhead to the budgeted production usingthe application base. Typical application methods are direct labour hours,units of production or machine hours.

Let us look at the factory administration cost structure and the factoryadministration budget of the Software Factory


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All of the factory overhead for the Software Factory is of a fixed nature.The only change that we can in the first quarter is for factory depreciationwhich moves from $13,200 in February to $13,600 in March. This has

been caused by the purchase of additional manufacturing plant in themonth as will be explained, below, in the context of the CapitalExpenditure budget.

A summary

Budgeting for the Cost of Inventory

Application of Costs to Inventory

We now need to consider the calculation of the overall cost of production

and the application of overhead costs to particular products.


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One of the key benefits of the budget process is to enable management toreview the estimated costs of manufacturing products in the budgetperiod. As we have discussed, this may be an iterative process asknowledge of the cost structure of a product may well impact on the salesprice and in turn changes in selling prices may impact on sales volumes.

Changes in sales volume will, in turn, impact on the cost structure and thecycle repeats itself. The total manufacturing cost for the first and fourthquarters of the Software Factory is:

You will notice that the total cost of the product moves substantially froma high of $44.36 per unit in January to a low of $33.50 in November.What is driving this variation where January is one third more expensivethan November?

The answer is to be found in the fixed costs of factory overhead. You willnotice that production in January totals 725 units whilst in November is1,200 units as the company ramps up production for the summer break.The largely fixed costs of factory overhead are being spread over a muchlarger number of units. This seasonal pattern to production is typical formany types of businesses and is illustrated in a hypothetical example :


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In this case the quarterly manufacturing overhead costs are constant at$800,000 per quarter but the production varies considerably from 450,000units in Quarter 2 to 825,000 units in the fourth quarter. The cost per unitranges from $1.78 Per unit down to $0.94 per unit whereas the average is$1.33 per unit.

To overcome this problem, some companies will budget for under-appliedoverhead in those budget periods when production is below the averageand budget for over-applied overhead in those budget periods whenproduction is above the average.The accountant for the Software Factory has taken a straightforwardapproach and allocated costs to the periods as they fall and then used aweighted average inventory valuation method to calculate the costs ofinventory.

The calculation of inventory balances for the first and fourth quarters ofthe budget period is:


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You will notice that the quantity and costs of the opening inventory issummed to the quantity and costs of the production for the month and atotal calculated. A new average is calculated which is then applied to the

cost both of sales in the period as well as the cost of the finished goods.

Budgeting for the Expenses

Expenses budget

The cost of the two expenses categories of selling and marketing andadministration costs flow from the

Selling Expenses budget

The selling expenses budget will normally be made up of a variety of coststhat are fixed and variable and what might be called "discretionary".Some of these costs are:

Variable


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1. Sales commissions2. Distribution costs3. Some travel costs4. Warranty costs

5. Sales discounts

Fixed

1. Salaries2. Some travel costs3. Rates, light, heat and power etc

"Discretionary"

1. Marketing costs2. Advertising campaign costs

So we can see that there is a direct link between the level of sales indollar terms and the budgeted sales commissions to the sales force andthe physical level of sales and distribution costs. Similarly, the more acompany sells the greater will be the cost of meeting warranty claims onitems sold.

These types of relationships are demonstrated below:

The selling expenses budget for the first and fourth quarters for the

Software Factory is:


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You will notice that the sales commission to the sales staff of the SoftwareFactory is three percent of the sales revenue of the company. Thedistribution costs are $3 per unit of sales. Note that the distribution costsof finished goods are for the company more closely related to the physicalunits rather than the dollar value of the sales.

You will remember that elements of the company's product line relates tothe SoHo market and is, therefore, dependent on sales at the Christmasbreak. The marketing program is moulded to fit this cycle. Marketingprograms are typically $20,000 Per month but the company has planned amajor campaign for the end of the year and marketing programmes go upto $75,000 in October and November and peak in December at $85,000.This an example of what might be termed "discretionary" expenses. Thedepreciation expense and marketing overhead are examples of fixedoverhead.

Administrative Expenses budget

The administrative expenses budget encompasses a range of expensesthat relate to the general management of the company and to thefinancing of the company. Some of the expenses that would beencompassed in the administrative expenses budget include:

Wages and salaries of general management

Bad and doubtful debts

Insurance

Interest

While many of the expenses in the administrative expenses are of a fixednature, some are influenced by the level of sales activity. Some of theserelationships are:.


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The administration budget for the Software Factory is:

The interest on debentures is forecasted at 12% of the outstanding levelof debentures. This figure is drawn from the budgeted Balance Sheet.

Putting it Together

Capital expenditure budget

A capital item is usually defined as one which will last longer than twelvemonths and exceeds a certain amount

The capital expenditure budget will be highly dependent on the level ofsales forecast in the sales budget:


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If we come back to our example of the Software Factory Pty Ltd, the firstand fourth quarters of the Capital Expenditure budget is reproducedbelow:

We can see that, as it happens, the only capital expenditure that isforecast is in the first and fourth quarters and three items of plant arerequired: A fully automated four colour printing press for the in-houseproduction of manuals, a 150 per hour and floppy duplicator and finally apackage assembly line which will take a stock of manuals, and floppiesassemble and shrink wrap them in the display boxes. Total spending of$200,000 will be required which will reduce the need for contract labourcosts in the production process.

Just as the capital expenditure budget is influenced by activity from, forexample, the sales budget, the capital expenditure budget influencesother budget elements. Most importantly, in order to fund capitalexpenditure cash must be found from operating inflows, by borrowing orbe raised from the owners. The level of capital expenditure will be one ofthe most importantitems in the cash flow budget.

Some of the other relationships which the capital expenditure budget has

with other budgets are:


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Let us return for a moment to the factory administration budget of theSoftware Factory where we see that the budgeted depreciation expense

has gone from $13,200 in the month of January to $15,800 in the monthof December

This reflects the budget assumption that additional depreciation is flowingfrom the acquisition of the various items of capital expenditure.

Budgeted Income Statement

The Sales Budget and the various expense budgets are brought together

in a budgeted Income Statement. The format of the Income Statementwill vary from company to company depending on how much information


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is relegated to schedules. In the case of the Software Factory most of theinformation is contained in the schedules so the Income Statement is of asummary nature only:

In this budget, the taxation expense is calculated as is the subtotals withinthe income statement and the closing balance of retained earnings.

Due to the nature of the business, the gross profit for the SoftwareFactory is very high as most of the cost structure in the business is in theselling and administrative expenses. This is due to the very high level ofmarketing expenditure required in this business sector and the customer

support and research and development which is contained in theadministrative expenses budget.

Budgeted Balance Sheet

The budgeted balance sheet is impacted by a number of assumptions fromall the other budgets. A direct relationship comes from the sales budgetwhich will determine the level of Accounts Receivable arising from CreditSales as shown below:


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Similarly the level of the Raw Materials shown as part of Current Assets onthe Balance Sheet has come directly from the Raw Materials budget in theProduction Budget.

This in turn has an impact on the Cash Flow Budget as the level of RawMaterials must be funded.


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The Balance Sheet has as might be expected a number of relationshipswith other budgets. The Balance Sheet and some of the relationships thebudgeted balances have with other budgets for the Software Factory:

Some notes on the relationships are:

Cash at bank is a "balancing item" and shows the residual of the impactof all of the transactions for the period. It is drawn from the cash flow

statement, as we will explore in more detail in a moment. Accounts Receivable is based upon an assumption of the numbers of

days outstanding of credit sales which is drawn from the Sales Budget.In this case the budget assumes that none of the sales made in anygiven month will have been collected in cash at the end of the monthbut all the cash will be received in the next month

Raw Materials and Finished Goods are drawn completely from theProduction budget as we saw above.

Provision for Taxation is drawn from both the Income Statement for theexpenses and from the cash flow statement where the payment to the

taxation office is recorded.


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Factory Plant, Sales Equipment and Administrative Equipment aredriven by the Capital Expenditure budget.

Accumulated Depreciation on Factory Plant is driven by the expensesshown in the budget for factory overhead and, similarly;

Accumulated Depreciation on Sales Equipment and Administrative

Equipment is driven by the budget for selling expenses andadministrative expenses, respectively.

Term Loan balances are influenced by additional loans or repaymentsshown in the Cash Flow statement.

Retained Earnings are drawn from the profit and loss statement.

Budgeted cash flow

The budgeted cash flow can be seen as the glue which holds the budgetprocess together. It is highly significant to the process of the budget asthe level of financing may well be at the heart of the very survival of thecompany. As we will discuss shortly, the impact of changes in budgetassumptions can radically impact on the cash generation ability of the firmand on the financing of the business.

One of the more important relationships is the impact of capitalexpenditure on the cash flow. Capital expenditure, by its very nature, canbe very "lumpy" as companies enter into major investments which relate

to multi-year projects but which must, of course, be financed in the yearof expenditure. The capital expenditure budget impacts on the BalanceSheet as new capital expenditures are capitalised beyond the currentfinancial year as well as the cash flow statement which recognises thefinancing requirements of the expenditure.


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This is just one example of the many interrelationships and otherrelationships are discussed in the context of the Software Factory. The

budgeted cash flow for the final quarter and for the complete financialyear for the Software Factory is:

Let us look at some of the more important elements of the company'sCash Flow budget. Let's look first at Accounts Receivable and AccountsPayable. In the Software Factory Pty Ltd case all purchases and otherexpenses are assumed to be paid in cash and so there are no AccountsPayable. Conversely however, all sales are assumed to be on credit andwe should, therefore, pay particular attention to the calculation of thecash received from customers, which is calculated as:

The closing balance of cash is the figure which is the "balancing item" andwhich is the final figure which binds all the various budgets together.


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The Master Budget - A Simplified Example The Personal SoftwareFactory Pty Ltd

Introduction

In this section we can show the overall budget for the Software Factoryfor the year ended 31 December 19x1. It commences with a summary ofthe budget position for each of the four quarters and then shows the firstand fourth quarters of the detailed budgets.


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Budget overview and financials for the 19x1 year

Sales budget


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Production budget

Expenses budget


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Budgeted cash flow


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Budgeted Income Statement

Budgeted Balance Sheet


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Flexing the budget

Introduction

As we discussed in the previous topic, a budget may go through severaliterations. It is important for the master budget to be built in such a wayas to allow the analysis of the budget under all its various differentassumptions. Some issues that may be important for a company are:

What will be the impact on profits and on financing of changes in thesales volume of products?

What will be the impact on profits and on financing of changes in thesales mix of products?

What will be the impact on profits and on financing of changes in theraw materials cost of products?

What will be the impact on profits and on financing of changes in thevalue of the local currency in foreign exchange markets?

What will be the impact on profits and on financing of changes inassumptions on the cost of labour?

What will be the impact on profits and on financing of changes inassumptions on the level of capital expenditure?

The budget should flex to allow us to view the consequences of the

What if at the Software Factory

It would be very desirable for general, marketing, production and financialmanagement to be able to review a number of budget assumptions. As wediscussed above, there are many assumptions that could be built into abudget model but we will focus on just two:

The level of sales activity The level of the cost of raw materials

Of these two, the level of sales activity is clearly the most important driverof the overall results of the company. Nonetheless changes in the cost ofraw materials can make quite a difference to the standing of the company.So we have presented three scenarios to management

The "base case" which is the generally agreed position for the company

The "absolute best case" which assumes a ten per cent increase in

sales $ revenue over the base case and a five Per cent reduction inthe amount the company has to pay for raw materials


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The "absolute worst case" which assumes a ten per cent reduction insales $ revenue over the base case and a five Per cent increase inthe amount the company has to pay for raw materials

What difference does that make to the level of profitability and cash

generation ability of the company?

Base Case

First, let's remind ourselves of what the "base case" looks like. There is, ofcourse, no change from the master budget in the level of sales and rawmaterial costs.

What follows is a summarised version of the income Statement, BalanceSheet and Cash Flow of the Software Factory. The company budgets toearn an after tax profit of $491,970 for the year and have $338,676 incash at the end of the period.

Very Best Case

The "Very Best Case" shows a 10% improvement in the level of sales and

5% improvement in the cost of raw materials from the master budget.


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The company under the "Very Best Case" scenario would expect to earnan after tax profit of $799,585 for the year and have $930,770 in cash atthe end of the period.

Worst Case

The "Very Best Case" shows a 10% reduction in the level of sales and 5%increase in the cost of raw materials from the master budget.

The company under the "Very Worst Case" scenario would expect to earnan after tax profit of $211,077 for the year and have just $56,412 in cashat the end of the period.


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Analysis of the What If Scenarios

We can also put a summary of the what if scenarios in a table and showeach case against some key variables such as the Sales Revenue and Net

Profit after Tax for the period and Cash on Hand

Worst Case Base Case Best case

Change inSales Volume

-10% - +10

Change in RawMaterials Prices

+ 5 % - - 5 %

Sales Revenue $2.2m $2.7m $3.1m

Net Profit afterTax

$0.2m $0.5m $0.8m

Cash on Hand $56,412 $338,676 $647,770

We can see that moving from the Very Worst to the Very Best case givesrise to major changes in all major variables. Sales would increase by 41%but Net Profit after Tax increases by 300% and Cash on Hand by 1,048%!.


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Using a Spreadsheet to Build the Budget

Introduction

You will have noticed that the analyses in the previous section changedsignificant variables such as Sales Revenue and yet the Balance Sheetflexed and still balanced. That was because the Budget model for thecompany was built in a spreadsheet which was designed to be fully

integrated and support flexing.

Microcomputer spreadsheets are very useful tools in the support of thepreparation of Budgets. With the multi dimensional spreadsheets nowavailable such as Lotus 1-2-3 Release 4.0 and the workbook feature ofMicrosoft Excel, we can build spreadsheets that contain key elements ofinformation in smaller, easy to audit and maintain spreadsheets. We uselinking between the smaller spreadsheets to build an overall spreadsheetthat is completely integrated and flexible. A suite of spreadsheets thatmight make up the overall package and some of the many ways in which

they might be linked are shown below:


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Logical Formulae

Some of the formulae that might be used include "IF" statements and

formulae that choose some value based upon a predetermined value suchas "CHOICE" and "VLOOKUP" and "HLOOKUP".

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Master Budget Course