- Discuss what a master budget is
- Learn how to prepare a master budget 
- Steps in preparing the operating section of a master budget


[SLIDE 1]

The master budget is the set of budgeted financial statements and supporting schedules for the entire organization; it includes the operating budget, capital expenditures budget, and financial budget. Budgeted financial statements are financial statements based on budgeted amounts rather than actual amounts. The master budget is operational and static.  The master budget is based on various estimates and assumptions.  When preparing the master budget, management will ask some of these questions:<ul>
<li>How much sales revenue will we earn?</li>
<li>How much cash will we collect from customers?</li>
<li>How much raw material will we need to purchase?</li>
<li>How much manufacturing costs will we incur?</li>
<li>How much cash will we pay to our suppliers and our direct laborers, and how much cash will we pay for manufacturing resources?</li>
<li>What is the total cost that will be transferred from finished goods inventory to cost of goods sold?</li>
<li>How much selling and administrative expense will be incurred and how much cash will be paid related to those expenses?</li>
<li>How much money will we borrow from or repay to lenders- including interest?</li>
<li>How much operating income will we earn?</li>
<li>What will our balance sheet look like at the end of the budget period?</li>
</ul>
These questions will be answered in the 10 budgets that make up the master budget.  These budgets are:<ol>
<li>A sales budget, which includes a schedule of expected cash collections</li>
<li>A production budget</li>
<li>A direct materials budget, which includes a schedule of expected cash disbursements for material purchases</li>
<li>A direct labor budget</li>
<li>A manufacturing overhead budget</li>
<li>An ending finished goods inventory budget</li>
<li>A selling and administrative expense budget</li>
<li>A cash budget</li>
<li>A budgeted income statement</li>
<li>A budgeted balance sheet</li>
</ol>
Some of these 10 budgets are combined to make up the operating budget and financial budget. There is also one more budget that is prepared and that is the <strong>capital expenditure budget</strong> for organization improvements and asset purchases necessary during the course of the budget period.

The <strong>operating budget</strong> is the set of budgets that projects sales revenue, cost of goods sold, and selling and administrative expenses, all of which feed into the cash budget and then the budgeted financial statements. The first component of the operating budget is the sales budget, the cornerstone of the master budget. Why? Because sales affect most other components of the master budget. 

The <strong>financial budget</strong> includes the cash budget and the budgeted financial statements. The cash budget details how the business expects to go from the beginning cash balance to the desired ending cash balance. These budgeted financial statements look exactly like ordinary financial statements. The only difference is that they list budgeted (projected) amounts rather than actual amounts.

The capital expenditures budget is the budget that presents the company's plan for purchasing property, plant, equipment, and other long-term assets. 

Let's learn how to prepare a master budget.


[SLIDE 2]

The diagram on the slide shows the order in which managers prepare the components of the master budget for a manufacturing company. 

The diagram also shows that the master budget includes three types of budgets:<ul>
<li>The operating budget</li>
<li>The capital expenditures budget</li>
<li>The financial budget</
</ul>
Notice that the budgeting process starts with the sales budget.  All other budgets stem from the estimated number of units expected to be sold.  Also, note that the budgets described on the slide are typical for a manufacturing company. Manufacturing companies tend to have more budget schedules than other types of organizations because their operations are more complex. Once you understand budgeting in a manufacturing environment, you can easily modify the process to perform budgeting in other organizations.  

We will begin with how to prepare the sales budget and then move through each of the other budgets in the order they are prepared.


[SLIDE 3]

We begin the preparation of the master budget by completing the sales budget. The sales budget is an estimate of units of product the organization expects to sell multiplied by the expected sales price per unit. This is perhaps the most important budget as it drives most of the other budgets. For example, the production budget and related materials, labor, and overhead budgets are based on expected sales.

Forecasting sales often involves extensive research and numerous sources. Companies typically start with their sales staff since salespeople have daily contact with customers and direct information about customer demand. Some companies pay for market trend data to learn about industry and product trends. Many organizations hire market research consultants to obtain and review industry data and ultimately to predict customer demand. Larger companies sometimes employ economists to develop sophisticated models used to project sales. Smaller, less sophisticated organizations simply base their estimates on past trends. 

We will create our master budget for 2014 using the company Helen's Bathworks as an example. Helen's Bathworks began manufacturing hair and bath products in 2001.  Its biggest customer is a national retail chain that specializes in such products.  For the purpose of simplicity, we will prepare the budget by quarters for a year.  Based on communication with the sales team and past performance they expect sales to be the following for each quarter:

<table border=0 cellpadding=5 cellspacing=0><tr style="font-weight: bold;"><td>Q1</td><td>Q2</td><td>Q3</td><td>Q4</td></tr><tr><td>10,000</td><td>30,000</td><td>10,000</td><td>40,000</td></tr></table>

The company estimates the sales price to be $5.00 per unit.  With this information, we can complete the sales budget for the coming year as shown on the slide.  We take the estimated units to be sold and multiply by the expected sales price per unit.

<span style="color: red;">Total Budged Sales = Estimated Selling price per unit * Estimated Sales in Units</span>

After completing the sales budget, we then complete the Schedule of Expected Cash Collections.  Helen's Bathworks has a balance of $9,000 in accounts receivable at the beginning of the budget year. The company expects to collect 70% of sales in the quarter the sale occurred and 30% in the quarter after the sale.  The uncollected balance at the end of the fourth quarter will be the balance in accounts receivable on the end of year budgeted balance sheet that we will prepare further in the lesson. Based on this information, we can complete the Schedule of Cash Collections for the budget year as shown on the slide.

We take the beginning accounts receivable of $9,000 and add 70% of $50,000 in Sales for Q1.  We take the other 30% of Q1 sales and add 70% of the Q2 sales.  Continue this same step with Q3 and Q4 to get the total for the budget year.  

Now that we have the sales budget and Cash Collections schedule completed, we can create the production budget.  

[SLIDE 4]

Most companies, including Helen's Bathworks, maintain a certain level of finished goods inventory. Thus production is typically not the same as projected sales. The production budget is an estimate of units to be produced and is based on sales projections plus an estimate of desired ending finished goods inventory less beginning finished goods inventory, as summarized in the following: 

<span style="color: red;">Budgeted unit sales + Desired units of ending FG inventory = Total Units required - Units of beginning FG inventory = Required production in units</span>

The number of units desired in ending inventory is determined and specified by company management. Desired ending inventory balance is generally a function of the  quantity and timing of demand in the upcoming period as related to the firm's capacity and speed to produce particular units. Frequently, management stipulates that ending inventory be equal to a given percentage of the next period's projected sales. Other alternatives include a constant amount of inventory, a buildup of inventory for future high-demand periods, or near-zero inventory under a just-in-time system. The decision about ending inventory levels results from the consideration of whether a firm wants to have constant production with varying inventory levels or variable production with constant inventory levels. Managers should consider the high costs of stockpiling inventory before making a decision about how much inventory to keep on hand.   

For our example, Helen's Bathworks, management feels that the following assumptions are a good estimate for the production budget:<ul>
<li>Beginning Inventory (BI) of finished goods (in units) should be 10% of the current quarter's budgeted unit sales</li>
<li>Ending Inventory (EI) of finished goods (in units) should be 10% of next quarter's budgeted unit sales</li>
<li>Beginning inventory for Q1 is 1,000 units. Desired ending inventory of finished goods in Q4 is 1,500 units</li>
</ul>
Using the sales estimates from the sales budget and the assumptions with regard to beginning and ending inventory, we can create the production budget for Helen's Bathworks as shown on the slide.  

We take the sales units for the quarter and add the desired ending inventory units (10% of next quarter budgeted sales units) to get the units required to produce.  We then take and subtract the beginning inventory (10% of the current quarter's budgeted unit sales) from the units required to get the units that need to be produced for the quarter. As you can see, the desired ending inventory units are the beginning inventory units in the next quarter.

Once we know how many units must be produced each quarter, budgets are established for the individual components of production: direct materials, direct labor, and manufacturing overhead. Let's look at the direct materials budget next.


[SLIDE 5]

Direct material is essential to production and must be purchased each period in sufficient quantities to meet production needs. In addition, the quantities of direct material purchased must be in conformity with the company's desired ending inventory policies.  The direct materials budget is an estimate of raw materials needed to achieve a desired level of production. To prepare a direct materials purchases budget, managers must know what production needs will be in each accounting period in the budget. This information is provided by the production budget. They must also know the desired level of the direct materials inventory for each period and the per-unit cost of direct materials. The desired level of ending direct materials inventory is usually stated as a percentage of the next period's production needs.

For our example, Helen's Bathworks, management feels that the following assumptions are a good estimate for the Direct Materials budget:<ul>
<li>Beginning Inventory of materials (in ounces) should be 20% of the current quarter's budgeted production needs</li>
<li>Ending Inventory of materials (in ounces) should be 20% of next quarter's budgeted production needs</li>
<li>Beginning inventory for Q1 is 24,000 ounces; Desired ending inventory of finished goods in Q4 is 30,000 ounces</li>
<li>The estimated cost of raw material is $0.05 per ounce</li>
<li>The amount of raw material required per unit is 10 ounces</li>
</ul>
With this information, we can now establish a direct materials budget that answers the questions, "How many pounds of material must be purchased during each quarter to achieve this production," and "What is the cost of the materials?" To begin, we take the production units for the quarter and multiply by the amount of raw material required per unit to get the amount of raw material required for production in the quarter.  The next step is to determine the quantity of direct materials to be purchased for each quarter.  The formula for this is:
<span style="color: red;">
Total Units of Direct materials (DM) to be Purchased = Total Production needs in Units of DM + Desired Units of ending DM Inventory - Desired Units of beginning DM Inventory</span>

The third step is to calculate the cost of the direct materials purchases by multiplying the total number of unit purchases by the direct materials cost.  

Looking at our example, Helen's Bathworks, we determined that production for Q1 was 12,000 units.  We take the 12,000 units and multiply by 10 ounces of DM to get a total of 120,000 ounces needed to produce 12,000 units.  In the next step, we take the 120,000 ounces needed for production in Q1 and add our desired ending inventory amount (20% of the next quarter's budgeted production needs) to get the total ounces required for production.  We then subtract the beginning inventory (20% of the current quarter's budgeted production needs) to get the amount of raw material to be purchased for the quarter.  Once we have the amount needed to be purchased, we multiply by the cost per ounce to get the cost of direct materials purchases for the quarter.  Our completed budget for direct materials is on the slide.    

The next budget to complete is the Direct Labor Budget.


[SLIDE 6]

The direct materials purchases budget is the first of three supporting budgets for production. The second is the direct labor budget. The direct labor budget is an estimate of direct labor hours and related costs necessary to achieve a desired level of production. Production managers use estimated direct labor hours to plan how many employees will be required during the period and the hours that each will work, and accountants use estimated direct labor costs to plan for cash payments to the workers. Managers of human resources use the information in a direct labor budget in deciding whether to hire new employees or reduce the existing work force and also as a guide in training employees and preparing schedules of employee fringe benefits.

For our example, Helen's Bathworks, management feels that the following assumptions are a good estimate for the Direct Labor budget:<ul>
<li>Direct Labor hours is estimated at .10 hours per unit</li><li>Direct Labor cost is estimated at $6.00 per hour</li></ul>
To prepare the direct labor budget, we take the budgeted production units and multiply by the estimated direct labor hour per unit to get the total direct labor hours required to produce the budgeted production units.  Next, you take the total direct labor hours and multiply by the direct labor cost per hour to get the total budgeted direct labor cost.  Our completed direct labor budget is on the slide.

The third supporting budget for production is the manufacturing overhead budget.  


[SLIDE 7]

We have covered the first two of three supporting budgets for production. The last supporting budget is the manufacturing overhead budget. The manufacturing overhead budget is an estimate of all production costs, other than direct materials and direct labor, necessary to achieve a desired level of production. In estimating overhead, all fixed and variable costs must be specified and separated into their fixed and variable components. 

For our example, Helen's Bathworks, management feels that the following assumptions are a good estimate for the Manufacturing overhead budget:

Variable overhead costs are estimated as follows:<ul>
<li>Factory supplies is $.18 per production unit</li><li>Employee benefits is $.24 per production unit</li><li>Inspection is $.09 per production unit</li><li>Maintenance & repair is $.16 per production unit</li><li>Utilities is $.30 per production unit</li>
</ul>
Fixed overhead costs are estimated as follows:<ul>
<li>Depreciation, machinery is $2,810 per quarter</li><li>Depreciation, building is $2,335 per quarter</li><li>Supervision is $9,000 per quarter</li><li>Maintenance & repair is $2,150 per quarter</li><li>Other costs is $3,175 per quarter</li>
</ul>
To prepare the manufacturing overhead budget, we prepare the variable costs by taking the budgeted production units and multiplying by the estimated cost per unit for each expense associated with the variable overhead cost. Next, you take the amounts for fixed overhead and since it is the same for each quarter, we spread the same numbers across all quarters of the budget.  We then add total variable costs for each quarter to fixed overhead costs for the quarter to get the total budgeted manufacturing overhead for the year.

The next budget is the selling and administrative budget.


[SLIDE 8]

Now that we have created the direct materials, direct labor and manufacturing overhead budgets, let's combine the information in them to create the Cost of Goods Manufactured budget.  The Cost of Goods Manufactured budget will help us in getting the estimate for the cost per production unit that we need to complete the income statement budget. 

For our example, Helen's Bathworks, we have the following necessary information from the materials, labor and overhead budgets:<ul>
<li>Direct material cost $.05 per ounce</li><li>Beginning materials inventory is 24,000 ounces</li><li>Direct materials purchases for the period is $45,550</li><li>Ending materials inventory is 30,000 ounces</li><li>Direct labor cost for the period is $54,300</li><li>Manufacturing overhead for the period is $169,225</li><li>There is no work in process at the beginning or end of the period</li><li>Total units manufactured is 90,500</li>
</ul>
To prepare the cost of goods manufactured budget, we:<ol>
<li>take the beginning materials inventory and multiply by the estimated cost per ounce</li>
<li>add the beginning inventory materials cost to the direct materials purchases to get the direct materials available for use</li>
<li>take the ending materials inventory and multiply by the estimated cost per ounce and subtract this from the materials available for use to get the cost of direct materials used</li>
<li>add this to our direct labor costs and manufacturing overhead cost for the period to arrive at the total manufacturing costs for the period.  If we had beginning or ending work in process, you would add and subtract these from the manufacturing costs to get the total cost of goods manufactured.</li>
</ol>
To get the cost per production unit, you take the total cost of goods manufactured and divide by the units manufactured for the period.  In our example, the cost per unit is $2.969890.  We will use the cost per unit to calculate the cost of goods sold on the income statement budget.  This number also lets us know if our sales price is high enough to cover the cost of the product.

Let's look at the Cost of goods sold budget next.


[SLIDE 9]

The Cost of Goods Sold budget is an estimate of the costs for items sold during the period.  We need this information to complete the income statement budget.

For our example, Helen's Bathworks, we need the cost per unit information from the Cost of Goods Manufactured budget. The cost of goods sold statement:<ol>
<li>takes the beginning finished goods inventory and multiplies by the cost per unit to get the cost of the beginning inventory</li>
<li>takes the units produced for the period and multiplies by the cost per unit for the total cost of production for the period and adds this to the beginning inventory amount to get the cost of goods available for sale</li>
<li>takes the ending finished goods inventory and multiplies by the cost per unit and subtracts from the goods available for sale to get the total cost amount for the goods that were sold during the period</li>
</ol>
The next budget to create is the selling and administrative budget.


[SLIDE 10]

We have covered the production budgets and now let's review the remaining budgets to complete the master budget. A selling and administrative budget is a detailed plan of operating expenses, other than those related to production, that are needed to support sales and overall operations during an accounting period. Accountants use this budget to estimate cash payments for products or services not used in production-related activities.  Some companies group selling and administrative expenses into variable and fixed components for the purposes of cost behavior analysis, CVP analysis and profit planning. 

For our example, Helen's Bathworks, management feels that the following assumptions are a good estimate for the Selling and Administrative budget:

Variable Selling and Administrative costs are estimated as follows:<ul>
<li>Delivery expense is $.08 per production unit</li><li>Sales Commissions is $.10 per production unit</li><li>Accounting expense is $.07 per production unit</li><li>Other expenses is $.04 per production unit</li></ul>
Fixed Selling and Administrative costs are estimated as follows:<ul>
<li>Sales Salaries is $4,500 per quarter</li><li>Executive Salaries is $12,750 per quarter</li><li>Depreciation, Office Equipment is $925 per quarter</li><li>Taxes and Insurance is $1,700 per quarter</li></ul>
To prepare the selling and administrative budget, we prepare the variable costs by taking the budgeted production units and multiplying by the estimated cost per unit for each expense associated with the variable selling and administrative cost. Next, we take the amounts for fixed selling and administrative, and since it is the same for each quarter, we spread the same numbers across all quarters of the budget.  We then add total variable costs for each quarter to fixed costs for the quarter to get the total budgeted selling and administrative costs for the year.

This budget completes the operating section of the master budget.  In the next lesson, we will look at the financial section budgets and the capital expenditures budget.