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    Describe How and Why Managers Use Budgets – Principles of Accounting, Volume 2: Managerial Accounting


    Implementation of a company’s strategic plan often begins by determining management’s basic expectations about future economic, competitive, and technological conditions, and their effects on anticipated goals, both long-term and short-term. Many firms at this stage conduct a situational analysis that involves examining their strengths and weaknesses and the external opportunities available and the threats that they might face from competitors. This common analysis is often labeled as SWOT.

    After performing the situational analysis, the organization identifies potential strategies that could enable achievement of its goals. Finally, the company will create, initiate, and monitor both long-term and short-term plans.

    An important step in the initiation of the company’s strategic plan is the creation of a budget. A good budgeting system will help a company reach its strategic goals by allowing management to plan and to control major categories of activity, such as revenue, expenses, and financing options. As detailed in Accounting as a Tool for Managers, planning involves developing future objectives, whereas controlling involves monitoring the planning objectives that have been put into place.

    There are many advantages to budgeting, including:


    Budgeting is a formal method to communicate a company’s plans to its internal stakeholders, such as executives, department managers, and others who have an interest in—or responsibility for—monitoring the company’s performance.

    Budgeting requires managers to plan for both revenues and expenses.


    Preparing a budget requires managers to consider and evaluate

    The assumptions used to prepare the budget.

    Long-term financial goals.

    Short-term financial goals.

    The company’s position in the market.

    How each department supports the strategic plan.

    Preparing a budget requires departments to work together to

    Determine realizable sales goals.

    Compute the manufacturing or other requirements necessary to meet the sales goals.

    Solve bottlenecks that are predicted by the budget.

    Allocate resources so they can be used effectively to meet the sales and manufacturing goals.

    Compare forecasted or flexible budgets with actual results.


    When compared to actual results, budgets are early alerts and they forecast:

    Cash flows for various levels of production.

    When loans may be required or when loans may be reduced.

    Budgets show which areas, departments, units, and so forth, are profitable or meet their appropriate goals. Similarly, they also show which components are unprofitable or do not reach their anticipated goals.

    Budgets set defined benchmarks that may be used for evaluating company and management performance, including raises and bonuses, as well as negative consequences, such as firing.

    To understand the benefits of budgeting, consider Big Bad Bikes, a company that manufactures high-end mountain bikes. The company will begin producing and selling trainers this year. Trainers are stands that allow a rider to ride their bike indoors similar to the way bikes are used in spinning classes. Big Bad Bikes has a 5-year plan and has always been successful in managing its budget. Managers participate in developing the budget and are aware that all expenses must be related to the company’s strategic plan. They know that managing their departments is much easier when the budget is developed to support the strategic plan.

    The plan for Big Bad Bikes is to introduce itself to the trainer market with a sales price of $70 for the first two quarters of the year and then raise the price to $75 per unit. The marketing department estimates that sales will be 1,000 units for the first two quarters, 1,500 for the third quarter, and 2,500 per quarter through the second year. Management will work with each department to communicate goals and build a budget based on the sales plan. The resulting budget can be evaluated by all departments involved.

    Break-Even Analysis and Profitability

    In the long run, proper budget reporting assists management in making good decisions. Management uses budgets to evaluate the performance of employees and their department. They can also use budgets to evaluate and benchmark the performance of a business unit in a large business organization or of the entire performance of a small company. They can also use budgets to evaluate separate projects. In budgeting situations, employees may feel a tension between reporting actual results and reporting results that reach the predetermined goals created by the budget. This creates a situation where managers may choose to act unethically and pressure accountants to report favorable financial results not supported by the operations.

    Accountants need to be aware of this circumstance and use ethical standards when assisting the development and creation of budgets. After a proper budget has been created, the reporting of the actual results will assist in creating a realistic and honest picture of the actual operations for the managers reviewing the budget. The budget accountant needs to take steps to ensure that employees are not trying to misreport the budget results; for example, managers might be tempted to set artificially low standards to ensure that targets are hit and significantly exceeded. Such results could lead to what might be considered as excessive bonuses paid to managers.

    Source : opentextbc.ca

    Preparing a Master Budget

    Preparing a Master Budget

    Preparing a Master Budget What you’ll learn to do: Illustrate the use of accounting data in a prepared master budget

    Master budgets can be based off of historical accounting data for established companies or forecasts for new companies.  The accounting data is a crucial component of a master budget as it can provide historical information in order to build a budget with attainable goals.

    Let’s go through the sequence of budget preparation and see how accounting data can assist us in the process.c


    Summarize the impact of the sales forecast on the master budget

    Outline the sequence of components of the master budget

    Create a production budget

    Create a direct materials budget

    Create direct labor budget

    Create a manufacturing overhead budget

    Create an ending inventory budget

    Create a selling and administrative expense budget

    Create a cash budget

    Create a budgeted income statement

    Create a budgeted balance sheet

    Sales Forecast and the Master Budget

    It is December again, and you know your supervisor is going to start asking you to work on the annual budget. It is such a pain to try to accumulate all of the numbers he is requesting, and you don’t understand why he is so picky about the whole process. Begrudgingly you begin putting together the seemingly endless spreadsheets, and accounting documents he is asking for, but why? How can what feels like a waste of time be so important to the company?

    The master budget will offer guidance to every department in the company, knowing, starting at the sales forecast, where product needs to be priced, how to manage floor space and staff each step of the process. It can be hard to see the benefit of this large process, if you only work in one department of a company, so let’s take a look, from the first step forward.

    The master budget contains multiple components, so let’s take a look at each one of them individually first, then we will start putting the pieces together.

    What would you, as a manager, think is the most important number to know, before you start any budgeting process?

    If you answered sales, you are right! We can’t do anything from a budgeting standpoint until we have the sales forecast as a beginning number. We are going to call this forecast, the sales budget, and it is the first piece of a somewhat large puzzle.

    Having accurate sales figures is the key to the entire budgeting process. If this budget is inaccurate, it kind of rolls downhill and the rest of the budgets will be off as well. In big companies, there might be mathematical models and statistics involved in figuring out these numbers. Don’t worry. We won’t be doing that in this course, but knowing the importance of this information is the key.

    This budget will affect the variable portions of the selling and administrative budgets and will also feed into the production budget. The production budget is needed to figure out direct materials, direct labor and manufacturing overhead budgets. Once these are all done, then comes the finished goods inventory budget.

    Once all of these budgets are done, we can do a cash budget, income statement and balance sheet to finish off the process. Information from all of the previous budgets go into creating the cash budget, so you can see the importance of an effective and accurate sales budget!

    So let’s get started with our Sales Budget! Our company, Hupana Running Company makes the best running shoe ever. They have tasked you with creating a sales budget for the shoe. Let’s start with some basic assumptions, so we can start to build a budget.

    Hupana plans to sell 2,000 pairs of shoes this year. The selling price of the shoes is $100 per pair. For simplicity, we are going to assume that all of the sales are cash sales, and that sales is even each quarter.

    So armed with that information, here is the sales budget for Hupana Running Company!

    All 4 Quarters Q1 Q2 Q3 Q4

    Budgeted sales in pairs 2000 500 500 500 500

    Selling price per pair $100 $100 $100 $100 $100

    Sales in $ $200,000 $50,000 $50,000 $50,000 $50,000

    What is next? On to the production budget!


    Components of the Master Budget

    So, the sales budget is the starting point, as we discussed in the previous section. We also discussed some of the other components of the master budget that can happen once we have solid sales numbers to work from.

    The components of the master budget interrelate, and it is important to prepare them in order, as information from one component is needed to complete the next! Take a look at this crazy flow chart for a manufacturing business!

    So this gives you an overview of how each of the components of the entire budget work together. As a reminder, that this is a master budget for a manufacturing business.  Also note, that we would be setting up the budgets in an Excel workbook with a sheet for each budget.

    Now let’s look at the production budget!


    Production Budget

    Once we get the sales budget prepared, you can see on the flow chart that the next budget we need to work on is the production budget. This budget is necessary to provide all of the details we need to prepare direct materials, direct labor and manufacturing overhead budgets that come next.

    Source : courses.lumenlearning.com

    Master budget definition — AccountingTools

    The master budget is the aggregation of all lower-level budgets produced by a company's various functional areas, and also includes budgeted financial statements, a cash forecast, and a financing plan.


    AccountingTools Master budget definition

    June 28, 2021

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    What is a Master Budget?

    The master budget is the aggregation of all lower-level budgets produced by a company's various functional areas, and also includes budgeted financial statements, a cash forecast, and a financing plan. The master budget is typically presented in either a monthly or quarterly format, and usually covers a company's entire fiscal year. An explanatory text may be included with the master budget, which explains the company's strategic direction, how the master budget will assist in accomplishing specific goals, and the management actions needed to achieve the budget. There may also be a discussion of the headcount changes that are required to achieve the budget.

    A master budget is the central planning tool that a management team uses to direct the activities of a corporation, as well as to judge the performance of its various responsibility centers. It is customary for the senior management team to review a number of iterations of the master budget and incorporate modifications until it arrives at a budget that allocates funds to achieve the desired results. Hopefully, a company uses participative budgeting to arrive at this final budget, but it may also be imposed on the organization by senior management, with little input from other employees.

    The budgets that roll up into the master budget include:

    Direct labor budget

    Direct materials budget

    Ending finished goods budget

    Manufacturing overhead budget

    Production budget Sales budget

    Selling and administrative expense budget

    The selling and administrative expense budget may be further subdivided into budgets for individual departments, such as the accounting, engineering, facilities, and marketing departments.

    Once the master budget has been finalized, the accounting staff may enter it into the company's accounting software, so that the software can issue financial reports comparing budgeted and actual results.

    Smaller organizations usually construct their master budgets using electronic spreadsheets. However, spreadsheets may contain formula errors, and also have a difficult time constructing a budgeted balance sheet. Larger organizations use budget-specific software, which does not have these two problems.

    Example of a Master Budget

    Many lower-level budgets have specific formats that are used to arrive at certain outcomes, such as the fully absorbed cost of the finished goods inventory, or the number of units of products to be manufactured. This is not the case for the master budget, which looks very much like a standard set of financial statements. The income statement and balance sheet will be in the normal format mandated by Generally Accepted Accounting Principles or International Financial Reporting Standards. The primary difference is the cash budget, which does not usually appear in the standard format of the statement of cash flows. Instead, it serves the more practical purpose of identifying specific cash inflows and outflows that will result from the rest of the budget model. Here is an example of the cash budget:

    Alpha Intergalactic Corporation

    Cash Budget

    For the Year Ended December 31, 20XX

    Quarter 1 Quarter 2 Quarter 3 Quarter 4

    Beginning cash $100,000 $98,000 $95,000 $38,000

    +/- Net profit (loss)  +25,000  +12,000 +40,000 +23,000

    + Depreciation  +15,000 +15,000 +22,000 +24,000

    - Capital expenditures

    -28,000 0 -80,000 -35,000

    +/- Working capital changes  -14,000 -30,000

    -39,000 -21,000

    = Ending cash $98,000 $95,000 $38,000 $29,000

    The most difficult item to estimate in the cash budget is the net change in working capital from period to period. During periods of rapid growth, working capital can be a strongly negative number, since the company must invest in more accounts receivable than usual. If the amount of working capital appears to be holding steady despite rapid growth, then it is quite likely that management has built an unrealistic expectation into the budget to be able to collect accounts receivable more quickly than has been the case in the past.

    A similar problem can arise with inventory, which is another component of working capital. It generally takes more inventory to support more sales, so the portion of working capital comprised of inventory can be expected to increase in conjunction with more sales. Thus, it is extremely likely that a company experiencing any amount of growth will forecast negative cash flows, because of the need to fund additional working capital.

    Other Master Budget Issues

    Another document sometimes included in the master budget is a set of key performance metrics that are calculated based on the information in the budget. For example, it may show accounts receivable turnover, or inventory turnover, or earnings per share. These metrics are useful for testing the validity of the budget model against actual results in the past. For example, if the accounts receivable turnover metric is much lower than historical results, that could mean that the company is over-estimating its ability to collect accounts receivable promptly, which means that the amount of accounts receivable shown in the balance sheet may be understated and the amount of cash may be overstated.

    Source : www.accountingtools.com

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