CHAPTER TWO

MASTER BUDGET AND RESPONSIBILITY ACCOUNTING

What is budget?
Budget is the quantitative expression of a proposed plan of action by management for a specified
period, and an aid to coordinating what needs to be done to implement that plan may include
both financial and non-financial data.

The Ongoing Budget Process

1. Managers and accountants plan the performance of the company, taking into account past
performance and anticipated future changes

2. Senior managers distribute a set of goals against which actual results will be compared

3. Accountants help managers investigate deviations from budget. Corrective action occurs
at this point

4. Managers and accountants assess market feedback, changed conditions, and their own
experiences as plans are laid for the next budget period.

Strategy, Planning and Budgets, Illustrated

Choosing the Budget Period (Generally fiscal years)

The annual operating budget may be divided into quarterly and monthly budgets.

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 ADVANTAGES OF BUDGETS
 Provides a framework for judging performance

 Motivates managers and other employees

 Promotes coordination and communication among subunits within the company

MASTER BUDGET

 The master budget expresses the managements’ operating and financial plan for a
specified period and it includes a set of budgeted financial statements.

Components of Master Budgets

 Operating Budget – building blocks leading to the creation of the Budgeted Income
Statement

 Financial Budget – building blocks based on the Operating Budget that lead to the
creation of the Budgeted Balance Sheet and the Budgeted Statement of Cash Flows

Basic Operating Budget Steps

1. Prepare the Revenues Budget

2. Prepare the Production Budget (in Units)

3. Prepare the Direct Materials Usage Budget and Direct Materials Purchases Budget

4. Prepare the Direct Manufacturing Labor Budget

5. Prepare the Manufacturing Overhead Costs Budget

6. Prepare the Ending Inventories Budget

7. Prepare the Cost of Goods Sold Budget

8. Prepare the Operating Expense (Period Cost) Budget

9. Prepare the Budgeted Income Statement

Basic Financial Budget Steps

Based on the Operating Budgets:

1. Prepare the Capital Expenditures Budget

2. Prepare the Cash Budget

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 3. Prepare the Budgeted Balance Sheet

4. Prepare the Budgeted Statement of Cash Flows

Sample Master Budget, Illustrated

The Sales Budget

 The sales budget is the Key to the entire budgeting process because all other schedules
derive from it. Therefore, a mistake here makes the entire budget less effective.

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Where would you go to get accurate sales forecasting information?

 Forecasting includes the following sources: past history, backlog of unfulfilled orders,
marketing plans, competition, new products, availability of resources, economic
conditions, customer, sales force, industry trends

Budgeting Example
Royal Company is manufacturing business which produces and sold product X to its existing and
new customers. Royal company is preparing budgets for the quarter ending June 30, 2017.

Budgeted sales for the next five months will be:

April 20,000 units

May 50,000 units

June 30,000 units

July 25,000 units

August 15,000 units.

The selling price is $10 per unit. So based on the given information prepare the sales(revenue)
budget for the quarter end June 30,2017.

The Sales Budget

April May June Quarter

Budgeted
sales (units) 20,000 50,000 30,000 100,000
Selling price
per unit $ 10 $ 10 $ 10 $ 10
Total sales $ 200,000 $ 500,000 $ 300,000 $ 1,000,000

All sales are on account. Royal’s collection pattern is:

 70% collected in the month of sale, 25% collected in the month following
sale, 5% is uncollectible.

 The March 31 accounts receivable balance of $30,000 will be collected in

full.

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 Expected Cash Collections

April May June Quarter

Accounts rec. - 3/31 $ 30,000 $ 30,000
April sales
70% x $200,000 140,000 140,000
25% x $200,000 $ 50,000 50,000
May sales
70% x $500,000 350,000 350,000
25% x $500,000 $ 125,000 125,000
June sales
70% x $300,000 210,000 210,000
Total cash collections $ 170,000 $ 400,000 $ 335,000 $ 905,000

Note: The 25% of June sales ($75,000) to be collected in July becomes the Accounts
Receivable balance at the end of June.

The Production Budget information

 Production must be adequate to meet budgeted sales and provide for sufficient ending
inventory.

 The management at Royal Company wants ending inventory to be equal to 20% of the
following month’s budgeted sales in units. This is how much inventory that is required to
meet production needs in the next period.

 On March 31, 4,000 units were on hand.

The Production Budget

April May June Quarter

Budgeted sales 20,000 50,000 30,000 100,000
Add desired ending
inventory 10,000 6,000 5,000 5,000
Total needed 30,000 56,000 35,000 105,000
Less beginning
inventory 4,000 10,000 6,000 4,000

Required production 26,000 46,000 29,000 101,000

Ending inventory based on 20% of July sales (25,000)

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Manufacturing Cost Budgets
Now that we know production needs, we need to determine how much material; labor and
overhead will be required to meet those needs.

 To determine cost of goods manufactured, we also need to know ending WIP inventory.

The Direct Materials Budget information

 At Royal Company, five pounds of material are required per unit of product.

 Management wants materials on hand at the end of each month equal to 10% of the
following month’s production.

 On March 31, 13,000 pounds of material are on hand. Material cost is $0.40 per pound.

The Direct Materials Budget

April May June Quarter
Production 26,000 46,000 29,000 101,000
Materials per unit 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add desired
ending inventory 23,000 14,500 11,500 11,500
Total needed 153,000 244,500 156,500 516,500
Less beginning
inventory 13,000 23,000 14,500 13,000
Materials to be
purchased 140,000 221,500 142,000 503,500

Material cost per unit $0.4 $0.4 $0.4 $0.4

Material cost $56,000 $88,600 $56,800 $201,400

Ending inventory will be 10% of July production needs

Expected Cash Disbursement for Materials

 Royal pays $0.40 per pound for its materials.

 One-half of a month’s purchases are paid for in the month of purchase; the other half is
paid in the following month. The March 31 accounts payable balance is $12,000.

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 Expected Cash Disbursement for Materials
April May June Quarter
Accounts pay. 3/31 $ 12,000 $ 12,000
April purchases
50% x $56,000 28,000 28,000
50% x $56,000 $ 28,000 28,000
May purchases
50% x $88,600 44,300 44,300
50% x $88,600 $ 44,300 44,300
June purchases
50% x $56,800 28,400 28,400
Total cash
disbursements $ 40,000 $ 72,300 $ 72,700 $ 185,000

Note: The 50% of June purchases payable in July ($28,400) is the Accounts Payable balance at
the end of June.

The Direct Labor Budget

 At Royal, each unit of product requires 0.05 hours of direct labor.

 The Company has a “no layoff” policy so all employees will be paid for 40 hours of work
each week. In exchange for the “no layoff” policy, workers agreed to a wage rate of $10
per hour regardless of the hours worked (No overtime pay).

 For the next three months, the direct labor workforce will be paid for a minimum of 1,500
hours per month.

April May June Quarter

Production 26,000 46,000 29,000 101,000
Direct labor hours 0.05 0.05 0.05 0.05
Labor hours required 1,300 2,300 1,450 5,050
Guaranteed labor hours 1,500 1,500 1,500
Labor hours paid 1,500 2,300 1,500 5,300
Wage rate $ 10 $ 10 $ 10 $ 10
Total direct labor cost $ 15,000 $ 23,000 $ 15,000 $ 53,000

Note: Cash disbursement equals total direct labor cost since it is paid in period earned

Manufacturing Overhead Budget

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  Royal Company uses a variable manufacturing overhead rate of $1 per unit produced.

 Fixed manufacturing overhead is $50,000 per month and includes $20,000 of noncash
costs (primarily depreciation of plant assets).

April May June Quarter

Production in units 26,000 46,000 29,000 101,000
Variable mfg. OH rate $ 1 $ 1 $ 1 $ 1
Variable mfg. OH costs $ 26,000 $ 46,000 $ 29,000 $ 101,000
Fixed mfg. OH costs 50,000 50,000 50,000 150,000
Total mfg. OH costs 76,000 96,000 79,000 251,000

Less noncash costs 20,000 20,000 20,000 60,000

Cash disbursements
for manufacturing OH $ 56,000 $ 76,000 $ 59,000 $ 191,000

Note: - depreciation is non-cash expense

Ending Finished Goods Inventory Budget

 Now, Royal can complete the ending finished goods inventory budget.

 At Royal, manufacturing overhead is applied to units of product on the basis of direct

labor hours.

Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units
Unit product cost $ 4.99
Ending finished goods inventory ?

= $49.7/hr
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
8 $ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $ 24,950
Selling and Administrative Expense Budget

 At Royal, variable selling and administrative expenses are $0.50 per unit sold.

 Fixed selling and administrative expenses are $70,000 per month.

 The fixed selling and administrative expenses include $10,000 in costs – primarily
depreciation – that are not cash outflows of the current month.

April May June Quarter

Budgeted sales 20,000 50,000 30,000 100,000
Variable selling
and admin. rate $ 0.50 $ 0.50 $ 0.50 $ 0.50
Variable expense $ 10,000 $ 25,000 $ 15,000 $ 50,000
Fixed selling and
admin. expense 70,000 70,000 70,000 210,000
Total expense 80,000 95,000 85,000 260,000
Less noncash
expenses 10,000 10,000 10,000 30,000
Cash disburse-
ments for
selling & admin. $ 70,000 $ 85,000 $ 75,000 $ 230,000

The Cash Budget

Royal:

 Maintains a 16% open line of credit for $75,000.

 Maintains a minimum cash balance of $30,000.
 Borrows on the first day of the month and repays loans on the last day of the month.
 Pays a cash dividend of $49,000 in April.
 Purchases $143,700 of equipment in May and $48,300 in June paid in cash.
 Has an April 1 cash balance of $40,000.

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 April May June Quarter
Beginning cash balance $ 40,000
Add cash collections 170,000
Total cash available 210,000
Less disbursements
Materials 40,000
Direct labor 15,000
Mfg. overhead 56,000
Selling and admin. 70,000
Equipment purchase -
Dividends 49,000
Total disbursements 230,000
Excess (deficiency) of
cash available over
disbursements $ (20,000)

Because the company maintains a cash balance of $30,000, the company must borrow on its line
of credit. Financing and Repayment
April May June Quarter
Excess (deficiency)
of Cash available
over disbursements $ (20,000)
Financing:
Borrowing 50,000
Repayments -
Interest -
Total financing 50,000
Ending cash balance $ 30,000 $ 30,000 $ - $ -

April May June Quarter

Beginning cash balance $ 40,000 $ 30,000
Add cash collections 170,000 400,000
Total cash available 210,000 430,000
Less disbursements
Materials 40,000 72,300
Direct labor 15,000 23,000
Mfg. overhead 56,000 76,000
Selling and admin. 70,000 85,000
Equipment purchase - 143,700
Dividends 49,000 -
Total disbursements 230,000 400,000
Excess (deficiency) of
cash available over
disbursements $ (20,000) $ 30,000

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 Financing and Repayment
April May June Quarter
Excess (deficiency)
of Cash available
over disbursements $ (20,000) $ 30,000
Financing:
Borrowing 50,000 -
Repayments - -
Interest - -
Total financing 50,000 -
Ending cash balance $ 30,000 $ 30,000

Note:- Because the ending cash balance is exactly $30,000, Royal will not repay the loan this
month

The cash budget

April May June Quarter

Beginning cash balance $ 40,000 $ 30,000 $ 30,000 $ 40,000
Add cash collections 170,000 400,000 335,000 905,000
Total cash available 210,000 430,000 365,000 945,000
Less disbursements
Materials 40,000 72,300 72,700 185,000
Direct labor 15,000 23,000 15,000 53,000
Mfg. overhead 56,000 76,000 59,000 191,000
Selling and admin. 70,000 85,000 75,000 230,000
Equipment purchase - 143,700 48,300 192,000
Dividends 49,000 - - 49,000
Total disbursements 230,000 400,000 270,000 900,000
Excess (deficiency) of
cash available over
disbursements $ (20,000) $ 30,000 $ 95,000 $ 45,000

Financing and Repayment

April May June Quarter
Excess (deficiency)
of Cash available
over disbursements $ (20,000) $ 30,000 $ 95,000 $ 45,000
Financing:
Borrowing 50,000 - - 50,000
Repayments - - (50,000) (50,000)
Interest - - (2,000) (2,000)
Total financing 50,000 - (52,000) (2,000)
Ending cash balance $ 30,000 $ 30,000 $ 43,000 $ 43,000

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Note: - $50,000 × 16% × 3/12 = $2,000 Borrowings on April 1 and repayment of June 30.

The Budgeted Income Statement

After we complete the cash budget, we can prepare the budgeted income statement for Royal
based on the information available .from the above budgets.

Royal Company
Budgeted Income Statement
For the Three Months Ended June 30

Sales (100,000 units @ $10) $ 1,000,000

Cost of goods sold (100,000 @ $4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000
Operating income 241,000
Interest expense 2,000
Net income $ 239,000

The Budgeted Balance Sheet

Royal reported the following account balances prior to preparing its budgeted financial
statements:

 Land - $50,000

 Common stock - $200,000

 Retained earnings - $146,150

 Equipment - $175,000

 Add 143,700 in May and 48,300 in June for ending balance of $367,000

The budgeted balance sheet is prepared based on the information available from both operational
and financial budgets.

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