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THE MASTER BUDGET-A NETWORK OF INTERRELATIONSHIPS

The master budget is a network consisting of many separate budgets that are interdependent. This network is illustrated in Exhibit 8-2.
The sales budget: Nearly all other parts of the master budget are dependent in some way on the sales budget. A sales budget is a detailed
schedule of expected sales for coming periods; it is usually expressed in both dollars and units. Once the sales budget has been set; a decision
can be made on the level of production that will be needed to support sales, and the production budget can be set as well. The production
budget then becomes a key factor in the determination of other budgets, including the direct materials budget, the direct labor budget, and the
manufacturing overhead budget. These budgets, in turn, are needed to assist in formulating a cash budget for the budget.
Sales forecasting-a critical step
Since nearly all budgets are derived from it in some way, the sales budget is the key to the entire budgeting process. If the sales budget is
sloppily done, then the entire master budget will be worthless and a waste of time and effort.
The sales budget is prepared from the sales forecast. A sales forecast is broader than a sales budget, generally encompassing potential sales
for the entire industry, as well as potential sales for the firm preparing the forecast. Factors that are considered in making a sales forecast
include:
1. Past experience in terms f sales volume.
2. Prospective pricing policy
3. Unfilled order backlogs.
4. Market research studies.
5. General economic conditions.
6. Industry economic conditions.
7. Movements of economic indicators such as gross national product, employment, prices, and personal income.
8. Advertising and product promotion.
9. Industry competition.
10. Market share.
Sales results from prior years are used as-a starting point in preparing a sales forecast. Forecasters examine sales data in relation to various
factors, including prices, competitive conditions, availability of supplies, and general economic conditions. Projections are then made into the
future, based on those factors that the forecasters feel will be significant over the budget period. In-depth discussions generally characterize
the gathering and interpretation of all data going into the sales forecast. These discussions, held at all levels of the organization, develop
perspective and assist in assessing the significance and usefulness of data.
Statistical tools such as regression analysis, trend and cycle projection, and correlation analysis are widely used in sales forecasting. In
addition, some firms have found it useful to build econometric models of their industry or of the nation to assist in forecasting problems. Such
models hold great promise for improving the overall quality of budget data.
Preparing the Master Budget
To show how the separate budgets making up the master budget are developed and integrated, we focus now on Meredith Company. Meredith
Company produces and sells a single product that we will call product A. Each year the company prepares the following budget documents:
1. A sales budget, including a computation of expected cash receipts.
2. A production budget.
3. A direct materials budget, including a computation of expected cash payments for raw materials.
4. A direct labor budget.
5. A manufacturing overhead budget.
6. An ending finished goods inventory budget.
7. A selling and administrative expense budget.
8. A cash budget.
9. A budgeted income statement.
10. A budgeted balance sheet.
In essence, the sales budget triggers a chain reaction that leads to the development of many other budget figures in an organization.
Exhibit 8-2 The master budget interrelationships

As shown in the exhibit, the selling and administrative expense budget is both dependent on and a determinant of the sales budget. This
reciprocal relationship arises from the fact that sales will in part be determined by the funds available for advertising and sales promotion.
The Cash Budget
Once the operating budgets (sales, production, and so on) have been established, the cash budget and other financial budgets can be
prepared. A cash budget is a detailed plan showing how cash resources will be acquired and used over some specified time period. Notice
from Exhibit 8-2 that all of the operating budgets, including the sales budget, have an impact of some type on the cash budget. In the case of
the sales budget, the impact comes from the planned cash receipts to be received on sales. In the case of the other budgets, the impact comes
from the planned cash expenditures within the budgets themselves.
These budgets for the year 19x1 are illustrated in Schedules 1 through 10 following.
The Sales Budget
The sales budget is the starting point in preparing the master budget. As shown earlier in Exhibit 8-2, nearly all other items in the master
budget, including production, purchases, inventories, and expenses, depend on it in some way.
The sales budget is constructed by multiplying the expected sales in units by the sales price. Schedule 1 below contains the sales budget for
Meredith Company for 19x1, by quarters. Notice from the schedule that the company plans to sell 6,000 units during the year, with sales
peaking out in the third quarter.
Generally, the sales budget is accompanied by a computation of expected cash receipts for the forthcoming budget period. This computation is
needed to assist in preparing the cash budget for the year. Expected cash receipts are composed of collections on sales made to customers in
prior periods, plus collections on sales made in the current budget period. Schedule I below also- contains a computation of expected cash
collections for Meredith Company.
Schedule 1
MEREDITH COMPANY
Sales Budget, For the Year Ended December 31, 49x4
Quarter
1 2 3 4 Year
Expected sales in units 1,000 1,800 2,000 1,200 6,000
Selling price per unit x $150 x $150 x $150 x $150 x $150
Total sales $150,000 $270,000 $300,000 $180,000 $900,000
Schedule of Expected Cash Collections
Accounts receivable, 12/31/x0 $100,000 $100,000
First quarter sales ($150,000) 60,000 $ 90,000 150,000
Second quarter sales ($270,000) 108,000 $162,000 270,000
Third quarter sales ($300,000) 120,000 $180,000 300,000
Fourth quarter sales ($180,000) 72,000 72,000
Total cash collections $160,000 $198,000 $282,000 $252,000 $892,000
Note: Forty percent of a quarter's sales is collected in the quarter of sale; the remaining 60 percent is collected in the quarter following.
The Production Budget
After the sales budget has been prepared, the production requirements for the forthcoming budget period can be determined and organized in
the form of a production budget. Sufficient goods will have to be available to meet sales needs and provide for the desired ending inventory. A
portion of these goods will already exist in the form of a beginning inventory. The remainder will have to be produced. Therefore, production
needs can be determined by adding budgeted sales (in units or in dollars) to the desired ending inventory (in units or in dollars), and deducting
the beginning inventory (in units or in dollars) from this total. Schedule 2 below contains a production budget for Meredith Company.
Sales
Budget
Production
Budget
Direct Labour
Budget
Cash
Budget
Budgeted
Balance sheet
Ending Inventory
Budget
Direct material
budget
Manufacturing
overhead budget
Budgeted Income
Statement
Budgeted Statement
of Changes in
financial position
Long-range
Sales Forecast
Capital
Budget
Selling and
administrative
expenses budget
Schedule 2
MEREDITH COMPANY
Production Budget
For the Year Ended December 31, 19x1
on units)
Quarter
1 2 3 4 Year
Expected sales (Schedule 1) 1,000 1,800 2,000 1,200 6,000
Add: Desired ending inventory of finished goods* 180 200 120 300$ 300
Total needs 1,180 2,000 2,120 1,500 6,300
Less: Beginning inventory of finished goods** 200 180 200 120 200
Units to be produced*** 980 1,820 1,920 1,380 6,100
* Ten percent of the next quarter's sales.
** The same as the prior quarter's ending inventory.
*** Estimated.

Students are often surprised to learn that firms budget the level of their ending inventories. Budgeting of inventories is a common practice,
however. If inventories are not carefully planned, the levels remaining at the end of a period may be excessive, causing an unnecessary tie-up
of funds and an unneeded expense of carrying the unwanted goods. On the other hand, without proper planning, inventory levels may be too
small, thereby requiring crash production efforts in following periods, and perhaps loss of sales due to inability to meet shipping schedules.
Inventory Purchases-merchandising Firm
Meredith Company is a manufacturing firm, so it prepares a production budget, as shown in Schedule 2. If it were a merchandising firm, then
instead of a production budget it would prepare a merchandise purchases budget showing the amount of goods to be purchased from its
suppliers during the period. The merchandise purchases budget is in the same basic format as the production budget, except that it shows
goods to be purchased rather than goods to be produced, as shown below:


Budgeted cost of goods sold (in units or in dollars) XXXXX
Add: Desired ending merchandise inventory XXXXX
Total needs XXXXX
Less: Beginning merchandise inventory XXXXX
Required purchases (in units or in dollars) XXXXX

The merchandising firm would prepare an inventory purchases budget such as this one for each item carried in stock. Some large retail
organizations make such computations on a frequent basis (particularly at peak seasons) in order to ensure that adequate stocks are on hand
to meet customer needs.
The Direct Materials Budget
Returning to the Meredith Company example, after production needs have been computed, a direct materials budget should be prepared to
show the materials that will be required in the production process. Sufficient raw materials will have to be available to meet production needs,
and to provide for the desired ending raw materials inventory for the budget period. Part of this raw materials requirement will already exist in
the form of a beginning raw materials inventory. The remainder will have to be purchased from suppliers. In sum, the format for computing raw
materials needs is:
Raw materials needed to meet the production schedule XXXXX
Add desired ending inventory of raw materials XXXXX
Total raw materials needs XXXXX
Less beginning inventory of raw materials XXXXX
Raw materials to be purchased XXXXX
Preparing a budget of this kind is one step in a company's overall material requirements planning (MRP). MRP is an operations research tool
that employs the computer to assist the manager in overall materials and inventory planning. The objective of MRP is to ensure that the right
materials are on hand, in the right quantities, and at the right time to support the production process. The detailed operation of MRP is covered
in most operations research textbooks; for this reason, it will not be considered further here, other than to point out that the concepts we are
discussing are an important part of the overall MRP technique.
Schedule 3 contains a direct materials purchases budget for Meredith Company. Notice that materials requirements are first determined in
units (pounds, gallons, and so on) and then translated into dollars by multiplying by the appropriate unit cost.
The direct materials budget is usually accompanied by a computation of expected cash disbursements for raw materials. This computation is
needed to assist in developing a cash budget. Disbursements for raw materials will consist of payments for prior periods, plus payments for
purchases for the current budget period. Schedule 3 contains a computation of expected cash disbursements for Meredith Company.
Schedule 3
MEREDITH COMPANY
Direct Materials Budget, For the Year Ended December 31, 19x1
Quarter
1 2 3 4 Year
a 980 1,820 1,920 1,380 6,100
Raw material needs per unit (pounds) 2 2 2 2 2
Production needs (pounds) 1,960 3,640 3,840 2,760 12,200
Add desired ending inventory of raw materials* (pounds) 910 960 690 520 520
Total needs (pounds) 2,870 4,600 4,530 3,280 12,720
Less beginning inventory of raw materials (pounds) 490 910 960 690 490
Raw materials to be purchased (pounds) 2,380 3,690 3,570 2,590 12,230
Raw materials cost per pound $5 $5 $5 $5 $5
Cost of raw materials to be purchased $11,900 $18,450 $17,850 $12,950 $61,150
Schedule of Expected Cash Disbursements
Accounts payable, 12/31/x0 $ 6,275 $ 6,275
First-quarter purchases ($11,900) 5,950 $ 5,950 11,900
Second-quarter purchases ($18,450) 9,225 $ 9,225 18,450
Third-quarter purchases ($17,850) 8,925 $ 8,925 17,850
Fourth-quarter purchases ($12,950) 6,475 6,475
Total cash disbursements $12,225 $15,175 $18,150 $15,400 $60,950
Note: Fifty percent of a quarter's purchases are paid for in the quarter of purchase; the remaining 50 percent are paid for in the quarter
following.
*Twenty-five percent of the next quarter's production needs. For example, the second-quarter production needs are 3,640 pounds. Therefore,
the desired ending inventory for the first quarter would be 25 percent x 3,640 pounds = 910 pounds. The ending inventory of 520 pounds for the
fourth quarter is estimated.
The Direct Labor Budget
The direct labor budget is also developed from the production budget. Direct labor requirements must be computed so that the company will
know whether sufficient labor time is available to meet production needs. By knowing in advance just what will be needed in the way of labor
time throughout the budget year, the company can develop plans to adjust the labor force as the situation may require. Firms that neglect to
budget run the risk of facing labor shortages or having to hire and fire at awkward times. Erratic labor policies lead to insecurity and inefficiency
on the part of employees.
To compute direct labor requirements, the number of units of finished product to be produced each period (month, quarter, and so on) is
multiplied by the number of direct labor-hours required to produce a single unit. Many different types of labor may be involved. If so, then
computations should be by type of labor needed. The hours of direct labor time resulting from these computations can then be multiplied by the
direct labor cost per hour to obtain budgeted total direct labor costs. Schedule 4 following contains such computations for Meredith Company.

Schedule 4
MEREDITH COMPANY
Direct Labor Budget, For the Year Ended December 31, 18z1
Quarter
1 2 3 4 Year
Units to be produced (Schedule 2) 980 1,820 1,920 1,380 6,100
Direct labor time per unit (hours) 5 5 5 5 5
Total hours of direct labor time needed 4,900 9,100 9,600 6,900 30,500
Direct labor cost per hour
$
10

$
10

$
10

$
10

$
10
Total direct labor cost $49,000 $91,000 $96,000 $69,000 $305,000
The Manufacturing Overhead Budget
The manufacturing overhead budget should provide a schedule of all costs of production other than direct materials and direct labor. These
costs should be broken down by cost behavior for budgeting purposes, and a predetermined overhead rate developed. This rate will be used to
apply manufacturing overhead to units of product throughout the budget period. In the case of Meredith Company, the contribution approach to
costing is being used internally for planning purposes, so only variable overhead is included in the predetermined overhead rate.
A computation showing budgeted cash disbursements for manufacturing overhead should be made for use in developing the cash budget. The
critical thing to remember in making this computation is that depreciation is a non-cash charge. Therefore, any depreciation charges included in
manufacturing overhead must be deducted from the total in computing expected cash payments.
We will assume that the variable overhead rate is $2 per direct labor hour, and that fixed overhead costs are budgeted at $18,300 per quarter,
of which $4,000 represents depreciation. All overhead costs involving cash disbursements are paid for in the quarter incurred. The
manufacturing overhead budget, by quarters, and the expected cash disbursements, by quarters, are both shown in Schedule 5.
Schedule 5
MEREDITH COMPANY
Manufacturing Overhead Budget, For the Year Ended December 31, 19x1
Quarter
1 2 3 4 Year
Budgeted direct labor-hours 4,900 9,100 9,600 6,900 30,500
Variable overhead rate $2 $2 $2 $2 $2
Budgeted variable overhead $ 9,800 $18,200 $19,200 $13,800 $ 61,000
Budgeted fixed overhead 18,300 18,300 18,300 18,300 73,200
Total budgeted overhead 28,100 36,500 37,500 32,100 134,200
Less depreciation 4,000 4,000 4,000 4,000 16,000
Cash disbursements for overhead $24,100 $32,500 $33,500 $28,100 $118,200
Cost of a Unit of Product
After completing Schedules 1-5, sufficient data will have been generated to compute the cost of a unit of finished product. This computation is
needed for two reasons: first, to know how much to charge as cost of goods sold on the budgeted income statement; and second, to know what
value to place on the balance sheet for the ending finished goods inventory.
For Meredith Company, the cost of a unit of finished product is $82, consisting of $10 of direct materials, $50 of direct labor, and $22 of
manufacturing overhead. The computations behind these figures are shown below in Schedule 6.
Schedule 6
MEREDITH COMPANY
Ending Finished Goods Inventory Budget, For the Year Ended December 31, 19x1
Item Quantity Coat Total
Production cost per unit:
Direct materials 2 pounds $5.00 per pound $10
Direct labor 5 Hours $10.00 per hour 50
Manufacturing overhead 5 hours $4.40 per hour* 22
$82
Budgeted finished goods inventory:
Ending finished goods inventory in units (Schedule 2) 300
Total production cost per unit (see above) x $82
Ending finished goods inventory in dollars $24,600
* $134,200 = 30,500 hours = $4.40.
The Selling and Administrative Expense Budget
The s Ring and administrative expense budget contains a listing of anticipated expenses for the budget period that will be incurred in areas
other than manufacturing. The budget will be made up of many smaller, individual budgets submitted by various persons having responsibility
for cost control in selling and administrative matters. If the number of expense items is very large, separate budgets may be needed for the
selling and administrative functions.
Schedule 7
MEREDITH COMPANY
Selling and Administrative Expense Budget, For the Year Ended December 31, 19x1
Quarter
1 2 3 4 Total
Budgeted sales in units 1,009 1,800 2,000 1,200 6,000
Variable selling and administrative
expense per unit*

$3


$3


$3


$3


$3
Budgeted variable expense $ 3,000 $ 5,400 $ 6,000 $ 3,600 $ 18000
Fixed selling and administrative expense:
Advertising 20,000 20,000 20,000 20,000 80,000
Executive salaries 40,000 40,000 40,000 40,000 160,000
Insurance 12,600 12,600
Properly taxes 7,400 7,400
Total budgeted selling and
administrative expenses $63,000 $78,000 $66,000 $71,000 $278,000
* Commissions, clerical, and freight-out.
Schedule 7 contains the selling and administrative expense budget for Meredith Company for 19x1.
The Cash Budget
The cash budget pulls together much of the data developed in the preceding steps, as illustrated earlier in Exhibit 8-2. The reader should
restudy this exhibit before reading on.
The cash budget is composed of four major sections:
1. The receipts section.
2. The disbursements section.
3. The cash excess or deficiency section.
4. The financing section. ,
The receipts section consists of the opening cash balance added to whatever is expected in the way of cash receipts during the budget period.
Generally, the major source of receipts will be from sales, as discussed earlier.
The disbursements section consists of all cash payments that are planned for the budget period. These payments will include raw materials
purchases, direct labor payments, manufacturing overhead costs, and so on, as contained in their respective budgets. In addition, other cash
disbursements such as income taxes, capital equipment purchases, and dividend payments will also be included.
The cash excess or deficiency section consists of the difference between the cash receipts section totals and the cash disbursements section
totals. If a deficiency exists, the company will need to arrange for borrowed funds from its bank. If an excess exists, funds borrowed in previous
periods can be repaid or the idle funds can be placed in short-term investments.
The financing section provides a detailed account of the borrowings and repayments projected to take place during the budget period. It also
includes a detail of interest payments that will be due on money borrowed. Banks are becoming increasingly insistent that firms in need of
borrowed money give long advance notice of the amounts and times that funds will be needed. This permits the banks to plan and helps to
assure that funds will be ready when needed. Moreover, careful planning of cash needs via the budgeting process avoids unpleasant surprises
for companies as well. Few things are more disquieting to an organization than to run into unexpected difficulties in the Cash account. A well-
coordinated budgeting program eliminates uncertainty as to what the cash situation will be two months, six months, or a year from now.
The cash budget should be broken down into time periods that are as short as feasible. Many firms budget cash on a weekly basis, and some
larger firms go so far as to plan daily cash needs. The more common planning horizons are geared to monthly or quarterly figures. The cash
budget for Meredith Company for 19x1 is shown on a quarterly basis in Schedule 8.
The Budgeted Income Statement
A budgeted income statement can be prepared from the data developed in Schedules 1-8. The budgeted income statement is one of the key
schedules in the budget process. It is the document that tells how profitable operations are anticipated to be in the forthcoming period. After it
has been developed, it stands as a benchmark against which subsequent company performance can be measured. Schedule 9 below contains
a budgeted income statement for Meredith Company for 19x1
Schedule 8
Meredith Company
Cash Budget, For the year ended December 31, 191
Quarter
Schedule 1 2 3 4 Total year
Cash balance beginning $19,000 $10,675 $10,000 $10,350 $19,000
Add receipts:
Collections from customers 1 160,000 198,000 282,000 252,000 892,000
Total cash available before current financing 179,000 208,675 292,000 262,350 911,000
Less disbursements
Direct materials 3 12,225 15,175 18,150 15,400 60,950
Direct labour 4 49,000 91,000 96,000 69,000 305,000
Manufacturing overhead 5 24,100 32,500 33,500 28,100 118,200
Selling and administrative 7 63,000 78,000 66,000 71,000 278,000
Income taxes 9 15,000 15,000 15,000 15,000 60,000
Equipment purchase 30,000 12,000 42,000
Dividends 5,000 5,000 5,000 5,000 20,000
Total disbursements 198,325 248,675 233,650 203,500 884,150
Excess (deficiency) of cash available over disbursements (19,325) (40,000) 58,350 58,850 26,850
Financing:
Borrowings (at beginning) 30,000* 50,000 80,000
Repayments (at ending) (45,000) (35,000) (80,000)
Interest (at 10% per annum) (3,000)** (2,625) (5,625)
Total financing 30,000 50,000 (48,000) (37,625) 5,625()
Cash balance ending $10,675 $10,000 $10,350 $21,225 $21,225
* The company requires a minimum cash balance of $10,000. Therefore, borrowing must be sufficient to cover the cash deficiency of
$19,325 and to provide for the minimum cash balance of $10,000. All borrowings and all repayments of principal are in round $1,000
amounts.
** The interest payments relate only to the principal being repaid at the time it is repaid. For example, the interest in quarter 3 relates only to the interest
due on the $30,000 principal being repaid from quarter 1 borrowing and on the $15,000 principal being repaid from quarter 2 borrowing, as
follows:
$30,000 x 10% x 9 months $2,250
$15,000 X 10% X 6 months 750
Total interest being paid $3,000
Schedule 9
MEREDITH COMPANY
Budgeted Income Statement, For the Year Ended December 31, 19x1
Schedule
Sales (6,000 units at $150) 1 $900,000
Less cost of goods sold (6,000 units at $82) 6 492,000
Gross margin 408,000
Less selling and administrative expense 7 278,000
Net operating income 130,000
Less interest expense 8 5,625
Income before taxes * 124,375
Less income taxes 60,000
Net income $ 64,375
* Estimated
The Budgeted Balance Sheet
The budgeted balance sheet is developed by beginning with the current balance sheet and adjusting it for the data contained in the other
budgets. A budgeted balance sheet for Meredith Company for 19x1 is presented in Schedule 10. The company's beginning-of-year balance
sheet, from which the budgeted balance sheet in Schedule 10 has been derived in part, is presented below:
MEREDITH COMPANY
Balance Sheet, December 31, 19x0
Assets
Current assets:
Cash $ 19,000
Accounts receivable 100,000
Raw materials inventory (490 pounds) 2,450
Finished goods inventory (200 units) 16,400
Total current assets $137,850
Plant and equipment:
Land 30,000
Buildings and equipment 250,000
Accumulated depreciation (74,000)
Plant and equipment, net 206,000
Total assets $343,850
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable (raw materials) $ 6,275
Stockholders' equity:
Common stock, no par $200,000
Retained earnings 137,575
Total stockholders' equity 337,575
Total liabilities and stockholders' equity $343,850
Schedule 10
MEREDITH COMPANY
Budgeted Balance Sheet, December 31, 19x1
Assets
Current assets:
Cash $ 21,225 (a)
Accounts receivable 108,000 (b)
Raw materials inventory 2,600 (c)
Finished goods inventory 24,600 (d)
Total current assets $156,425
Plant and equipment:
Land 30,000 (e)
Buildings and equipment 292,000 (f)
Accumulated depreciation (90,000) (g)
Plaint and equipment, net 232,000
Total assets $388,425
Liabilities and Stockholders' Equity
Current liabilities $ 6,475 (h)
Accounts payable (raw materials)
Stockholders' equity:
Common stock, no par $200,000 (i)
Retained earnings 181,950 (j)
Total stockholders' equity 381,950
Total liabilities and stockholders' equity $388,425
Explanation of December 31, 19x1, balance sheet figures:
a) The ending cash balance, as projected by the cash budget in Schedule 8.
b) Sixty percent of fourth-quarter sales, from Schedule 1 ($180,000 x 60% = $108,000).
c) From Schedule 3, the ending raw materials inventory will be 520 pounds. This material costs $5 per pound. Therefore, the
ending inventory in dollars will be 520 pounds x$5 = $2.600.
d) From Schedule 6.
e) From the December 31, 19x0, balance sheet (no change).
f) The December 31, 19x0, balance sheet indicated a balance of $250,000. During 19x1
$42,000 additional equipment will be purchased (see Schedule 8), bringing the December 31, 19x1,
balance to $292.000.
g) The December 31, 190, balance sheet indicated a balance of $74,000. During 19x1, $16,000 of depreciation will be taken
(see Schedule 5), bringing the December 31, 19x1. balance to $90.000,
h) One half of the fourth-quarter raw materials purchases, from Schedule 3.
i) From the December 31. 19x0, balance sheet (no change).
j) December 31, 19x0, balance $137,575
Add net income, from schedule 9 64,375
201,950
Deduct dividends paid, from Schedule 8 20,000
December 31, 19x1, balance $181,950


Illustration of Preparation of Master Budget for Non-manufacturing Company
Now that you know what budgets are and why they are important, we can return to Exhibit 7-1 and trace the preparation of the master budget
components. Do not rush, follow each step carefully and completely. Although the process may seem largely mechanical, remember that the
master-budgeting process generates key decisions regarding pricing, product lines, capital expenditures, research and development, personnel
assignments, and so forth. Therefore, the first draft of the budget leads to decisions that prompt subsequent drafts before a final budget is
chosen. Because budget preparation is somewhat mechanical, many organizations use powerful spreadsheet or modeling software to prepare
and modify budget drafts. Appendix 7 discusses using personal computer spreadsheets for budgeting. You may want to refer to Chapter 17,
which describes basic knowledge of financial accounting processes, terms, and calculations we will use to prepare a master budget.
Description of Problem
To illustrate the budgeting process we will use as an example the Cooking Hut Company (CHC), a local retailer of a wide variety of kitchen and
dining room items. The company rents a retail store in a midsized community near a large metropolitan area. CHC's management prepares a
continuous budget to aid financial and operating decisions. For simplicity in this illustration, the planning horizon is only 4 months, April through
July. In the past, sales have increased during this season. Collections lag behind sales, and cash is needed for purchases, wages, arid other
operating outlays. In the past, the company has met this cash squeeze with the help of short-term loans from a local bank and will continue to
do so, repaying those loans as cash is available.
Exhibit 7-2 is the closing balance sheet for the fiscal year just ended. Sales in March were $40,000. Monthly sales are forecasted as follows:
April $50,000
May $80,000
June $60,000
July $50,000
August $40,000
Management expects future sales collections to follow past experience: 60% of the sales should be in cash and 40% on credit. All credit
accounts are collected in the month following the sales. The $16,000 of accounts receivable on March 31 represents credit sales made in
March (40% of $40,000). Uncollectible accounts are negligible and are to be ignored. Also ignore all local, state, and federal taxes for this
illustration.
Because deliveries from suppliers and customer demands are uncertain, at the end of each month, CHC wants to have on hand a basic
inventory of items valued at $20,000 plus 80% of the expected cost of goods sold for the following month. The cost of merchandise sold
averages 70% of sales. Therefore, the inventory on March 31 is $20,000 + .7(.8 April sales of $50,000) = $20,000 + $28,000 = $48A00. The
purchase terms available to CHC are net, 30 days. CRC pays for each month's purchases as follows: 50% during that month and 50% during
the next month. Therefore, the accounts payable balance on March 31 is 50% of March's purchases, or $33,600 .5 = $16,800.

Illustration-3 The Cooking Hut Company Balance Sheet March 31, 19X1
Assets
Current assets:
Cash $10,000
Accounts receivable, net (.4 x March sales of $40,000) 16,000
Merchandise inventory, $20,000 +.7 (.8 x April sales of $50,000) 48,000
Unexpired insurance 1,800 $75,800
Plant assets
Equipment, fixtures, and other $37,000
Accumulated depreciation 12,800 24,200
Total assets $100,000
Liabilities and Owners' Equity
Current liabilities
Accounts payable (.5 x March purchases of $33,600) $16,800
Accrued wages and commissions payable ($1,250 + $3,000) 4,250 $ 21,050
Owners' equity 78,950
Total liabilities and owners' equity $100,000

CHC pays wages and commissions semimonthly, half a month after they are earned. They are divided into two portions: monthly fixed wages
of $2,500 and commissions, equal to 15% of sales, which we will assume are uniform throughout each month. Therefore, the March 31 balance
of accrued wages and commissions payable is (.5 $2,500) + .5(.15 $40,000) = $1,250 + $3,000 = $4,250. CHC will pay this $4,250 on April
15.
In addition to buying new fixtures for $3,000 cash in April, CHC's other monthly expenses are as follows:
Miscellaneous expenses 5% of sales, paid as incurred
Rent $2,000, paid as incurred
Insurance $200 expiration per month
Depreciation, including new fixtures $500 per month
The company wants a minimum of $10,000 as a cash balance at the end of each month. To keep this simple, we will assume that CHC can
borrow or repay loans in multiples of $1,000. Management plans to borrow no more cash than necessary and to repay as promptly as possible.
Assume that borrowing occurs at the beginning and repayment at the end of the months in question. Interest is paid, under the terms of this
credit arrangement, when the related loan is repaid. The interest rate is 18% per year.
Steps in Preparation of Master Budget
The principal steps in preparing the master budget are:
Operating Budget
1. Using the data given, prepare the following detailed schedules for each of the months of the planning horizon:
a) Sales budget
b) Cash collections from customers
c) Purchases budget
d) Disbursements for purchases
e) Operating expense budget
f) Disbursements for operating expenses
2. Using these schedules, prepare a budgeted income statement for the 4 months ending July 31, 19X1 (Exhibit 7-3).
Financial Budget
3. Using the data given and the supporting schedules, prepare the following forecasted financial statements:
a) Cash budget including details of borrowings, repayments, and interest for each month of the planning horizon (Exhibit 7-4)
b) Budgeted balance sheet as of July 31, 19X1 (Exhibit 7-5)
You will need schedules 1a, 1c, and le to prepare the budgeted income statement (Exhibit 7-3), and schedules 1b, 1d, and 1f to prepare the
cash budget (Exhibit 7-4).
Organizations with effective budget systems have specific guidelines for the steps and timing of budget preparation. Although the details differ,
the guidelines invariably include the preceding steps. As we follow these steps to examine the schedules of this illustrative problem, be sure
that you understand the source of each figure in each schedule and budget. The logic of this manual example is Identical to the logic used to
prepare computerized budgeting models and systems (see Appendix 7).
Step 1: Preparation of Operating Budget
You should now be ready to trace the budgeting process.
Step 1a: Sales Budget
The sales budget (Schedule a in the table on page 262) is the starting point for budgeting because inventory levels, purchases, and operating
expenses are geared to the rate of sales activities (and other cost drivers that are not present in this example). Accurate sales and cost-driver
activity forecasting is essential to effective budgeting; sales forecasting is considered in a later section of this chapter. March sales are included
in Schedule a because they affect cash collections in April. Trace the final column in Schedule a to the first row of Exhibit 7-3 on page 264. In
nonprofit organizations, forecasts of revenue or some level of services are also the focal points for budgeting. Examples are patient revenues
and government reimbursement expected by hospitals and donations expected by churches. If no revenues are generated, as in the case of
municipal fire protection, a desired level of service is predetermined.
Step 1b: Cash Collections
It is easiest to prepare Schedule b, cash collections, at the same time as preparing the sales budget. Cash collections include the current
month's cash sales plus the previous month's credit sales. We will use total collections in preparing the cash budget-see Exhibit 7-4 on page
266.

March April May June July
April-July
Total
Schedule a: Sales Budget
Credit sales, 40% $16,000 $20,000 $32,000 $24,000 $20,000
Plus cash sales, 60% 24,000 30,000 48,000 36,000 30,000

Total sales $40,000 $50,000 $80,000 $60,000 $50,000 $240,000
Schedule b: Cash Collections
Cash sales this month $30,000 548,000 $36,000 $30,000
Plus 100% of last month's credit
sales
16,000 20,000 32,000 24,000

Total collections

$46,000 $68,000 $68,000 $54,000

Step 1c: Purchases Budget
After sales are budgeted, prepare the purchases budget (Schedule c). The total merchandise needed will be the sum of the desired ending
inventory plus the amount needed to fulfill budgeted sales demand. The total need will be partially met by the beginning inventory; the
remainder must come from planned purchases. These purchases are computed as follows:
Budgeted purchases = Desired ending inventory + Cost of goods sold Beginning inventory
Trace the total purchases figure in the final column of Schedule c to the second row of Exhibit 7-3.

March April May June July
April-July
Total
Schedule c: Purchases Budget
Desired ending inventory $48,000* $64,800 $ 53,600 $48,000 $42,400
Plus cost of goods sold** 28,000 35,000 56,000 42,000 35,000 $168,000
Total needed $76,000 $99,800 $109,600 $90,000 $77,400
Less beginning inventory 42,400*** 48,000 64,800 53,600 48,000

Purchases $33,600 $51,800 $ 44,800 $36,400 $29,400

Schedule d: Disbursements for Purchases
50% of last month's purchases $16,800 $ 25,900 $22,400 $18,200
Plus 50% of this month's purchases

25,900 22,400 18 200 14 700

Disbursements for purchases

$42,700 $ 48,300 $40,600 $32,900

* $20,000 + (.8 x April cost of goods sold) = $20,000 +.,8(f35,000) = f48,000.
** 7 X March sales of $40,000 = $28,000; .7 x April sales of $50,000 = $35,000, and so on.
*** $20,000 + (.8 x March cost of goods sold of $28,000) = &20,000 + $22,400 = $42,400.
Step 1d: Disbursements for Purchases
Schedule d, disbursements for purchases, is based on the purchases budget. Disbursements include 50% of the current month's purchases
and 50% of the previous month's purchases. We will use total disbursements in preparing the cash budget, Exhibit 7-4, for the financial budget.
Step 1e: Operating Expense Budget
The budgeting of operating expenses depends on various factors. Month-to-month fluctuations in sales volume and other cost-driver activities
directly influence many operating expenses. Examples of expenses driven by sales volume include sales commissions and many delivery
expenses. Other expenses are not influenced by sales or other cost-driver activity (such as rent, insurance, depreciation, and salaries) within
appropriate relevant ranges and are regarded as fixed. Trace the total operating expenses in the final column of Schedule e, which summarizes
these expenses, to the budgeted income statement, Exhibit 7-3.
March April May June July
April-July
Total
Schedule e: Operating expense budget
Wages (fixed) $2,500 $ 2,500 $ 2,500 $ 2,500 $ 2,500
Commissions (15% of
current month's sales)
6,000 7,500 12,000 9,000 7,500

Total wages and commissions $8,500
$10,000 $14,500 $11,500 $10,000 $46,000
Miscellaneous expenses
(5% of current sales) 2,500 4,000 3,000 2,500 12,000
Rent (fixed) 2,000 2,000 2,000 2,000 8,000
Insurance (fixed) 200 200 200 200 800
Depreciation (fixed)

500 500 500 500 2,000
Total operating expenses

$15,200 $21,200 $17,200 $15,200 $68,800
Step 1f: Operating Expense Disbursements
Disbursements for operating expenses are based on the operating expense budget. Disbursements include 50% of last month's and this
month's wages and commissions, and miscellaneous and rent expenses. We will use the total of these disbursements in preparing the cash
budget, Exhibit 7-4.
March April May June July
April-July
Total
Schedule f: Disbursements
for Operating Expenses

Wages and commission
50% of last month's expenses

$ 4,250 $ 5,000 $ 7,250 $ 5,750

50% of this month's expenses
5,000 7,250 5,750 5,000

Total wages and commissions
$ 9,250 $12,250 $13,000 $10,750

Miscellaneous expenses 2,500 4,000 3,000 2,500
Rent 2,000 2,000 2,000 2,000
Total disbursements $13,750 $18,250 $18,000 $15,250
Step 2: Preparation of Budgeted Income Statement
Steps 1a through 1f provide enough information to construct a budgeted income statement from operations (Exhibit 7-3). 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.
Exhibit 7-3 The Cooking Hut Company Budgeted Income Statement for 4 Months Ending July 31, 19X1
Data Source of Data
Sales $240,000 Schedule a
Cost of goods sold 168,000 Schedule c
Gross margin $ 72,000
Operating expenses:
Wages and commissions $46,000 Schedule e
Rent 8,000 Schedule e
Miscellaneous 12,000 Schedule e
Insurance 800 Schedule e
Depreciation 2,000 68,800 Schedule e
Income from operations $ 3,200
Interest expense 675 Exhibit 7-4
Net income $ 2,525
Step 3: Preparation of 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. This chapter focuses on the cash budget and the ending balance sheet. Chapters 11 and 12 discuss the capital budget. In our
illustration, the $3,000 purchase of new fixtures would be included in the capital budget.

Step 3a: Cash Budget
The cash budget is a statement of planned cash receipts and disbursements. The cash budget is heavily affected by the level of operations
summarized in the budgeted income statement. The cash budget has the following major sections, where the letters w, x, y, and z refer to the
lines in Exhibit 7-4 that summarize the effects of that section.
The total cash available before financing (w) equals the beginning cash balance plus cash receipts. Cash receipts depend on collections from
customers' accounts receivable and cash sales and on other operating income sources. Trace total collections from Schedule b to Exhibit 7-4.
Cash disbursements (x) for
1. Purchases depend on the credit terms extended by suppliers and the bill-paying habits of the buyer (disbursements for merchandise from
Schedule d should be traced to Exhibit 7-4).
2. Payroll depends on wage, salary, and commission terms and on payroll dates (wages and commissions from Schedule f should be
traced to Exhibit 7-4).
3. Some costs and expenses depend on contractual terms for installment payments, mortgage payments, rents, leases, and miscellaneous
items (miscellaneous and rent from Schedule f should be traced to Exhibit 7-4).
4. Other disbursements include outlays for fixed assets, long-term investments, dividends, and the like (the $3,000 expenditure for new
fixtures).
Management determines the minimum cash balance desired (y) depending on the nature of the business and credit arrangements.
Financing requirements (z) depend on how the total cash available, w in Exhibit 7-4, compares with the total cash needed. Needs include the
disbursements, x, plus the desired ending cash balance, y. If the total cash available is less than the cash needed; borrowing is necessary
Exhibit 7-4 shows that CHC will borrow $14,000 in April to cover the planned deficiency. If there is an excess, loans may be repaid$1,000,
$9,000, and $4,000 are repaid in May, June, and July, respectively. The pertinent outlays for interest expenses are usually contained in this
section of the cash budget. Trace the calculated interest expense to Exhibit 7-3, which then will be complete.
The ending cash balance is w - x + z. Financing, z, has either a positive (borrowing) or a negative (repayment) effect on the cash balance. The
illustrative cash budget shows the pattern of short-term, "self-liquidating" financing. Seasonal peaks often result in heavy drains on cash-for
merchandise purchases and operating expensesbefore the sales are made and cash is collected from customers. The resulting loan is "self-
liquidating"that is, the borrowed money is used to acquire merchandise for sale, and the proceeds from sales are used to repay the loan. This
"working capital cycle" moves from cash to inventory to receivables and back to cash.
Cash budgets help management to avoid having unnecessary idle cash, on the one hand, and unnecessary cash deficiencies, on the other. A
well managed financing program keeps cash balances from becoming too large or too small.
Exhibit 7-4 The Cooking Hut Company Cash Budget for 4 Months Ending July 31, 19X1
April May June July
Beginning cash balance $10,000 $10,550 $10,970 $10,965
Cash receipts
Collections from customers (Schedule b)
46,000 68,000 68,000 54,000
Total cash available, before financing (w)* $56,000 $78,550 $78,970 $64,965
Cash disbursements
Merchandise (Schedule d) 42,700 48,300 40,600 32,900
Operating expenses (Schedule f) 13,750 18,250 18,000 15,250
Purchase of new fixtures (given) 3,000 - - -
Total disbursements (x) $59,450 $66,550 $58,600 $48,150
Minimum cash balance desired (y) 10,000 10,000 10,000 10,000
Total cash needed $ 69,450 $76,550 $68,600 $58,150
Excess (deficiency) of total cash available over
total cash needed before financing (w-x-y)
$(13,450) $ 2,000 $10,370 $ 6,815
Financing
Borrowing (at beginning of month)
Repayments (at end of month)
$14,000**
- $(1,000) $(9,000) $(4,000)
Interest (at 18% per year)*** - (30) (405) (240)
Total cash increase (decrease) from financing (z) $ 14,000 $(1,030) S(9,405) $(4,240)
Ending cash balance (w-x+z) $ 10,550, $10,970 $10,965 $12,575
* Letters are keyed to the explanation in the text.
** Borrowing and repayment of principal are made in multiples of $1,000, at an interest rate of 18% per year.
*** Interest computations: .18 x $1,000 x 2/12; .18 x $9,000 x 3/12; .18 x $4,000 x 4/12.
Step 3b: Budgeted Balance Sheet
The final step in preparing the master budget is to construct the budgeted balance sheet (Exhibit 7-5) that projects each balance sheet item in
accordance with the business plan as expressed in the previous schedules. Specifically, the beginning balances at March 31 would be
increased or decreased in light of the expected cash receipts and cash disbursements in Exhibit 7-4 and in light of the effects of noncash items
appearing on the income statement in Exhibit 7-3. For example, unexpired insurance would decrease from its balance of $1,800 on March 31
to $1,000 on July 31, even though it is a noncash item.
When the complete master budget is formulated, management can consider all the major financial statements as a basis for changing the
course of events. For example, the initial formulation may prompt management to try new sales strategies to generate more demand.
Alternatively, management may explore the effects of various adjustments in the timing of receipts and disbursements. The large cash
deficiency in April, for example, may lead to an emphasis on cash sales or an attempt to speed up collection of accounts receivable. In any
event, the first draft of the master budget is rarely the final draft. As it is reworked, the budgeting process becomes an integral part of the
management process itself-budgeting is planning and communicating.
Exhibit 7-5 The Cooking Hut Company Budgeted Balance Sheet July 31,191
Assets
Current assets:
Cash (Exhibit 7-4) $12,575
Accounts receivable, net (.4 x July sales of $50,000, Schedule a) 20,000
Merchandise inventory (Schedule c) 42,000
Unexpired insurance ($1,800 $800) 1,000 $75,975
Plant assets
Equipment, fixtures, and other ($37,000 + $3,000 fixtures) $40,000
Accumulated depreciation ($12,800 + $2,000 depreciation expense) (14,800) 25,200
Total assets $101,175
Liabilities and Owners' Equity
Current liabilities
Accounts payable (.5 x July purchases of $29,400, Schedule c) $14,700
Accrued wages and commissions payable (.5 $10,000, Schedule e) 4,000 $ 19,700
Owners' equity ($78,950 + $2,525 net income) 81,475
Total liabilities and owners' equity $101,175
Note: Beginning balances are used as a start for the computations of unexpired insurance, plant, and owners' equity.