This chapter explains the importance of budgeting and describes the master budget and its preparation. It also discusses the value of the master budget to the planning of future business activities
There are many advantages to budgeting. The most important advantages are displayed on your screen. One of the advantages that we may not think of right away is that budgeting provides a way to communicate plans throughout the business.
Most large companies have a standing budget committee that is responsible for budgeting policies and for coordinating the efforts of all participants in the budgeting process.
In a participatory budgeting process, information flows upward from lower levels of the business to top management. Lower-level managers have more detailed knowledge because they are closer to the day-to-day activities and operations of the business.
We need to choose a budgeting period. The normal operating budget for a business is one year. Generally, we break the year into quarters and then further into monthly budgets, which accumulate into our annual totals.
Many companies use a continuous or rolling twelve-month budget that drops off the immediate past month and adds one future month as the year progresses. A rolling budget allows a company to continuously work with a full one-year budget in place.
A company’s budgeting process begins with a sales budget. The success of all subsequent steps in the process depends on an accurate sales forecast. This slide describes the components of the master budget for a merchandser. The final result of the budgeting process is a set of budgeted financial statements.
The marketing department is usually responsible for developing the sales budget. Sales personnel forecast sales volume for the budget period by analyzing customer needs. Companies may also take a broader view by using economic forecasting models.
To illustrate the budgeting process, we are going to prepare a detailed budget for Hockey Den, a retailer of youth hockey sticks. We will begin with the sales budget.
Hockey Den sold seven hundred hockey sticks at one hundred dollars each in September 2008. Using this pricing information and the forecasted unit sales for the colder months of the fall season, the sales budget for the remaining three months of the year can be prepared. The sales budget includes January 2009 because the purchasing department relies on estimated January sales to plan December 2008 inventory purchases.
A company’s inventory policy will affect the quantity and frequency of purchases. Managers of just-in-time systems keep just enough inventory on hand to satisfy immediate demand. Some companies maintain a safety stock of inventory to meet unexpected demand or to protect against delays in receiving inventory shipments.
Once we have completed the sales budget, we can prepare the merchandise purchases budget that will incorporate Hockey Den’s sales demand and inventory policy. To prevent potential stock-outs of inventory items, and to have a good selection of merchandise on hand for customers, Hockey Den always wants its ending inventory for a month to be equal to ninety percent of the next month’s sales. On September 30, nine hundred hockey sticks were on hand, an amount equal to ninety percent of the one thousand hockey sticks budgeted for October sales.
We begin the purchases budget by computing the desired ending inventory for each of the three months. Recall that Hockey Den always wants its ending inventory for a month in units to be equal to ninety percent of the next month’s unit sales. The unit sales figures are from the sales budget.
Next we add the unit sales for each month to the desired ending inventory to get the total needs for each month.
Now, let’s complete the month of October. Total needs for October are one thousand seven hundred and twenty units. Hockey Den can partially meet these needs from the beginning inventory of nine hundred units. Subtracting nine hundred units from one thousand seven hundred and twenty units, we find that Hockey Den must purchase eight hundred twenty units in October. Multiplying the eight hundred twenty units by Hockey Den’s sixty dollars cost per unit converts the purchase amount to forty nine thousand two hundred dollars. Next, we will complete the purchases budget.
Here’s our completed purchases budget. Notice that the ending inventory for each month becomes the beginning inventory for the next month.
We use the sales budget to prepare a selling expense budget for Hockey Den. Sales commissions are variable, based on a percentage of sales revenue. The sales manager’s salary is a fixed expense.
We begin the selling expense budget with sales revenues amounts taken from the sales budget. Next, we compute sales commissions for each month by multiplying sales revenue for each month times ten percent. The sales manager’s salary of two thousand dollars per month is then added to sales commissions to get the total selling expense for each month.
Now we are ready to complete the general and administrative expense budget. Both expenses in this budget are fixed amounts per month.
The general and administrative expense budget for each month is the sum of administrative salaries and equipment depreciation. The total amount is the same each month since both of these amounts are fixed expenses.
The capital expenditures budget lists dollar amounts to be received from plant asset disposals and spent on additional plant assets. Since Hockey Den only plans one capital expenditure and no disposals of plant assets, this information will be incorporated in the cash budget.
Now that we have completed the budgets for sales, material purchases, selling expenses, and general and administrative expenses, we are ready to prepare budgets for cash receipts and disbursements. Our ultimate objective is budgeted financial statements.
We use the sales budget to prepare the cash receipts budget. Forty percent of Hockey Den’s sales are for cash. The remaining sixty percent of sales are on account. None of the sales on account are collected in the month of sale, but all sales on account are collected in the month following sale.
We begin the cash receipts budget with sales revenues amounts taken from the sales budget. September sales revenue is included because sixty percent of September sales will be collected in October.
The accounts receivable balance at the end of each month is sixty percent of that month’s budgeted sales. Cash sales are forty percent of each month’s sales.
The accounts receivable balance at the end of each month is collected in full during the next month. Cash sales are added to accounts receivable collections to get total cash receipts for the month.
We’re now ready to budget cash disbursements. We will begin with cash disbursements for purchases. Hockey Den makes all purchases of merchandise on account and pays the entire balance of accounts payable in the month following purchase. We will need to refer to the merchandise purchases budget to complete the cash disbursements budget.
The accounts payable balance at the end of September is fifty eight thousand, two hundred dollars and that amount is paid in October. Note that each month’s cash disbursement is the amount of the previous month’s purchase of merchandise.
Now that we have completed the cash receipts budget and the cash disbursements budget for merchandise purchases, we are ready to complete the cash budget. Some additional events affecting cash are displayed on your screen. You may need to make make a few notes from this information to keep from referring back to this screen as we use this information.
Here is the remainder of the information needed to complete Hockey Den’s cash budget. Again, you my find it helpful to take a few notes summarizing this information.
We begin the cash budget with October. Hockey Den’s cash balance at the beginning of October is twenty thousand dollars. Budgeted cash receipts for October are eighty two thousand dollars resulting in a total of one hundred two thousand dollars available for the month.
Our first cash disbursements are for merchandise purchases. These amounts come from the cash disbursements for purchases budget.
Next, we enter the disbursement amounts from Hockey Den’s selling expense budget.
Next, we enter the administrative salaries from Hockey Den’s general and administrative budget. Equipment depreciation was included in the general and administrative budget, but we do not include in the cash budget because depreciation is a non-cash expense.
Now we are ready to use some of the additional information affecting cash. Hockey Den has a ten thousand dollars loan and pays interest at the rate of one percent per month. The preliminary cash balance for October is seven thousand, two hundred dollars. Hockey Den has an agreement with its bank for loans at the end of each month to provide a minimum cash balance of twenty thousand dollars. The minimum cash balance policy will require Hockey Den to borrow twelve thousand, eight hundred dollars.
After borrowing twelve thousand, eight hundred dollars, Hockey Den’s ending cash balance is twenty thousand dollars. The total loan amount is now the original ten thousand dollars plus the additional twelve thousand, eight hundred dollars for a total of twenty two thousand, eight hundred dollars.
Here we see the completed cash budget for November. Hockey Den plans to pay a three thousand dollar cash dividend in November. The loan loan balance is twenty-two thousand dollars, resulting in an interest payment of two hundred twenty-eight dollars using the one percent per month interest rate. The preliminary cash balance for November is forty-five thousand, seventy two dollars which will allow Hockey Den to repay its twenty-two thousand, eight hundred dollar loan and still have an ending cash balance above its twenty thousand dollar minimum.
The expected loan repayment is deducted from the preliminary cash balance. The ending cash balance is twenty-two thousand, two hundred seventy-two dollars and the loan balance is now zero.
The cash budget is completed with the December cash information. Hockey Den plans to pay twenty-five thousand dollars in December to purchase new equipment. This large cash disbursement will reduce the December preliminary cash balance to three hundred seventy-two dollars, requiring Hockey Den to borrow again to meet its twenty thousand dollar minimum cash balance policy.
Hockey Den will need to borrow nineteen thousand, six hundred twenty-eight dollars to increase it cash balance to twenty thousand dollars.
Now that we have completed the cash budget, we are ready to prepare a budgeted income statement for the quarter.
Recall that Hockey Den plans to sell one thousand units in October, eight hundred units in November, and one thousand, four hundred units in December, for a total of three thousand, two hundred units for the quarter. The sales price is one hundred dollars per unit.
Hockey Den pays sixty dollars per unit for its merchandise.
Sales commissions are ten percent of sales revenue. Sales salaries are two thousand dollars per month for the three months.
Administrative salaries are four thousand, five hundred dollars per month and equipment depreciation is one thousand, five hundred dollars per month for the three months. Recall that even though depreciation does not result in a cash disbursement, it is an expense that is included in the income statement.
Hockey Den paid one hundred dollars in interest in October and two hundred twenty-eight dollars in November.
Hockey Den’s income tax rate is forty percent.
Now that we have completed the income statement for the quarter, we can prepare the balance sheet.
At this point, we have almost all of the information we need to prepare the balance sheet. However, we do need the account balances on your screen from September 30 to complete our work.
Here we see the completed balance sheet. On the next several screens we will review the sources of the amounts used to prepare this statement.
Hockey Den ends the month of December with a cash balance of twenty thousand dollars. Recall that borrowing was necessary to increase the cash balance to twenty thousand dollars minimum desired amount.
The accounts receivable balance is sixty percent of the one hundred forty thousand dollars credit sales for December.
The ending inventory is ninety percent of January expected sales of nine hundred units. Hockey Den’s cost per unit for merchandise is sixty dollars.
On September 30, Hockey Den’s equipment account showed a balance of two hundred thousand dollars. Budgeted equipment purchases are twenty-five thousand dollars in the month of December.
The accumulated depreciation balance on September 30 was thirty-six thousand dollars. Depreciation expense is budgeted at one thousand, five hundred dollars per month for the quarter.
Hockey Den makes all purchases of merchandise on account and pays the entire balance of accounts payable in the month following purchase. Budgeted purchases of fifty seven thousand dollars in December will be paid in January.
Hockey Den’s income tax payable is forty percent of its pretax income for the quarter.
Hockey Den will borrow nineteen thousand, six hundred twenty-eight dollars in December to increase its cash balance to the twenty thousand dollar minimum.
When we add the budgeted net income to the beginning balance for retained earnings, and deduct the budgeted dividend payment, we find Hockey Den’s ending retained earnings balance of eighty one thousand, eight hundred three dollars. The balance sheet is now complete.
Activity-based budgeting is based on expected activities instead of the traditional budget categories that we normally see. Activity-based budgets enable management to more easily plan resource consumption to match related changes in activity.
Now that we have mastered some of the basic concepts and principles of flexible budgets, variance analysis, and standard costs, we are ready to move onto the next chapter- “Flexible Budgets and Standard Costing”.