THE MASTER BUDGET-A NETWORK OF INTERRELATIONSHIPSThe 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 stepSince 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 policy3.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 BudgetTo 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 BudgetOnce 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 BudgetThe 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 1MEREDITH COMPANYSales Budget, For the Year Ended December 31, 49x4

Quarter

1234Year

Expected sales in units1,0001,8002,0001,2006,000

Selling price per unitx $150x $150x $150x $150x $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 ($150,000)60,000$ 90,000150,000

Second quarter sales ($270,000)108,000$162,000270,000

Third quarter sales ($300,000)120,000$180,000300,000

Fourth quarter sales ($180,000)72,00072,000

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 BudgetAfter 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.Schedule 2MEREDITH COMPANYProduction BudgetFor the Year Ended December 31, 19x1on units)

Quarter

1234Year

Expected sales (Schedule 1)1,0001,8002,0001,2006,000

Add: Desired ending inventory of finished goods*180200120300$300

Total needs 1,1802,0002,1201,5006,300

Less: Beginning inventory of finished goods**200180200120200

Units to be produced***9801,8201,9201,3806,100

*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 FirmMeredith 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 inventoryXXXXX

Total needsXXXXX

Less: Beginning merchandise inventoryXXXXX

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 BudgetReturning 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 scheduleXXXXX

Add desired ending inventory of raw materialsXXXXX

Total raw materials needsXXXXX

Less beginning inventory of raw materialsXXXXX

Raw materials to be purchasedXXXXX

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 3MEREDITH COMPANYDirect Materials Budget, For the Year Ended December 31, 19x1

Quarter

1234Year

a9801,8201,9201,3806,100

Raw material needs per unit (pounds)22222

Production needs (pounds)1,9603,6403,8402,76012,200

Add desired ending inventory of raw materials* (pounds)910960690520520

Total needs (pounds)2,8704,6004,5303,28012,720

Less beginning inventory of raw materials (pounds)490910960690490

Raw materials to be purchased (pounds)2,3803,6903,5702,59012,230

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 ($11,900)5,950$ 5,95011,900

Second-quarter purchases ($18,450)9,225$ 9,22518,450

Third-quarter purchases ($17,850)8,925$ 8,92517,850

Fourth-quarter purchases ($12,950)6,4756,475

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 BudgetThe 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 4MEREDITH COMPANYDirect Labor Budget, For the Year Ended December 31, 18z1

Quarter

1234Year

Units to be produced (Schedule 2)9801,8201,9201,3806,100

Direct labor time per unit (hours)55555

Total hours of direct labor time needed4,9009,1009,6006,90030,500

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 BudgetThe 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 5MEREDITH COMPANYManufacturing Overhead Budget, For the Year Ended December 31, 19x1

Quarter

1234Year

Budgeted direct labor-hours4,9009,1009,6006,90030,500

Variable overhead rate $2$2$2$2$2

Budgeted variable overhead$ 9,800$18,200$19,200$13,800$ 61,000

Budgeted fixed overhead18,30018,30018,30018,30073,200

Total budgeted overhead28,10036,50037,50032,100134,200

Less depreciation4,0004,0004,0004,00016,000

Cash disbursements for overhead$24,100$32,500$33,500$28,100$118,200

Cost of a Unit of ProductAfter 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 6MEREDITH COMPANYEnding Finished Goods Inventory Budget, For the Year Ended December 31, 19x1

ItemQuantityCoatTotal

Production cost per unit:

Direct materials2 pounds$5.00 per pound$10

Direct labor5 Hours$10.00 per hour50

Manufacturing overhead5 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 BudgetThe 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 7MEREDITH COMPANYSelling and Administrative Expense Budget, For the Year Ended December 31, 19x1

Quarter

1234Total

Budgeted sales in units1,0091,8002,0001,2006,000

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:

Advertising20,00020,00020,00020,00080,000

Executive salaries40,00040,00040,00040,000160,000

Insurance12,60012,600

Properly taxes7,4007,400

Total budgeted selling andadministrative 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 BudgetThe 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 StatementA 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 8Meredith CompanyCash Budget, For the year ended December 31, 191

Quarter

Schedule1234Total year

Cash balance beginning$19,000$10,675$10,000$10,350$19,000

Add receipts:

Collections from customers1160,000198,000282,000252,000892,000

Total cash available before current financing179,000208,675292,000262,350911,000

Less disbursements

Direct materials312,22515,17518,15015,40060,950

Direct labour449,00091,00096,00069,000305,000

Manufacturing overhead524,10032,50033,50028,100118,200

Selling and administrative763,00078,00066,00071,000278,000

Income taxes915,00015,00015,00015,00060,000

Equipment purchase30,00012,00042,000

Dividends5,0005,0005,0005,00020,000

Total disbursements198,325248,675233,650203,500884,150

Excess (deficiency) of cash available over disbursements(19,325)(40,000)58,35058,85026,850

Financing:

Borrowings (at beginning)30,000*50,00080,000

Repayments (at ending)(45,000)(35,000)(80,000)

Interest (at 10% per annum)(3,000)**(2,625)(5,625)

Total financing30,00050,000(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 750Total interest being paid $3,000Schedule 9MEREDITH COMPANYBudgeted 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)6492,000

Gross margin408,000

Less selling and administrative expense7278,000

Net operating income130,000

Less interest expense85,625

Income before taxes*124,375

Less income taxes60,000

Net income$ 64,375

* EstimatedThe Budgeted Balance SheetThe 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 COMPANYBalance 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 equipment250,000

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' equity337,575

Total liabilities and stockholders' equity$343,850

Schedule 10MEREDITH COMPANYBudgeted Balance Sheet, December 31, 19x1

Assets

Current assets:

Cash$ 21,225(a)

Accounts receivable108,000(b)

Raw materials inventory2,600(c)

Finished goods inventory24,600(d)

Total current assets$156,425

Plant and equipment:

Land30,000(e)

Buildings and equipment292,000(f)

Accumulated depreciation(90,000)(g)

Plaint and equipment, net232,000

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 earnings181,950(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$137,575Add net income, from schedule 9 64,375201,950Deduct dividends paid, from Schedule 8 20,000December 31, 19x1, balance $181,950

Illustration of Preparation of Master Budget for Non-manufacturing CompanyNow 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 ProblemTo 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, 19X1Assets

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 insurance1,800$75,800

Plant assets

Equipment, fixtures, and other$37,000

Accumulated depreciation12,80024,200

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' equity78,950

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 expenses5% of sales, paid as incurredRent$2,000, paid as incurredInsurance$200 expiration per monthDepreciation, including new fixtures$500 per monthThe 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 BudgetThe principal steps in preparing the master budget are:Operating Budget1.Using the data given, prepare the following detailed schedules for each of the months of the planning horizon:a)Sales budgetb)Cash collections from customersc)Purchases budgetd)Disbursements for purchasese)Operating expense budgetf)Disbursements for operating expenses2.Using these schedules, prepare a budgeted income statement for the 4 months ending July 31, 19X1 (Exhibit 7-3).Financial Budget3.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 BudgetYou should now be ready to trace the budgeting process.Step 1a: Sales BudgetThe 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 CollectionsIt 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.

MarchAprilMayJuneJulyApril-JulyTotal

Schedule a: Sales BudgetCredit sales, 40%$16,000$20,000$32,000$24,000$20,000

Plus cash sales, 60%24,00030,00048,00036,00030,000

Total sales$40,000$50,000$80,000$60,000$50,000$240,000

Schedule b: Cash CollectionsCash sales this month$30,000548,000$36,000$30,000

Plus 100% of last month's credit sales16,00020,00032,00024,000

Total collections$46,000$68,000$68,000$54,000

Step 1c: Purchases BudgetAfter 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 inventoryTrace the total purchases figure in the final column of Schedule c to the second row of Exhibit 7-3.MarchAprilMayJuneJulyApril-JulyTotal

Schedule c: Purchases BudgetDesired ending inventory$48,000*$64,800$ 53,600$48,000$42,400

Plus cost of goods sold**28,00035,00056,00042,00035,000$168,000

Total needed$76,000$99,800$109,600$90,000$77,400

Less beginning inventory42,400***48,00064,80053,60048,000

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

Schedule d: Disbursements for Purchases50% of last month's purchases$16,800$ 25,900$22,400$18,200

Plus 50% of this month's purchases25,90022,40018 20014 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 PurchasesSchedule 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 BudgetThe 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.MarchAprilMayJuneJulyApril-JulyTotal

Schedule e: Operating expense budgetWages (fixed)$2,500$ 2,500$ 2,500$ 2,500$ 2,500

Commissions (15% of current month's sales)6,0007,50012,0009,0007,500

Total wages and commissions$8,500$10,000$14,500$11,500$10,000$46,000

Miscellaneous expenses(5% of current sales)2,5004,0003,0002,50012,000

Rent (fixed)2,0002,0002,0002,0008,000

Insurance (fixed)200200200200800

Depreciation (fixed)5005005005002,000

Total operating expenses$15,200$21,200$17,200$15,200$68,800

Step 1f: Operating Expense DisbursementsDisbursements 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.MarchAprilMayJuneJulyApril-JulyTotal

Schedule f: Disbursementsfor Operating Expenses

Wages and commission 50% of last month's expenses$ 4,250$ 5,000$ 7,250$ 5,750

50% of this month's expenses5,0007,2505,7505,000

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

Miscellaneous expenses2,5004,0003,0002,500

Rent2,0002,0002,0002,000

Total disbursements$13,750$18,250$18,000$15,250

Step 2: Preparation of Budgeted Income StatementSteps 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, 19X1DataSource of Data

Sales$240,000Schedule a

Cost of goods sold168,000Schedule c

Gross margin$ 72,000

Operating expenses:Wages and commissions$46,000Schedule e

Rent8,000Schedule e

Miscellaneous12,000Schedule e

Insurance800Schedule e

Depreciation2,00068,800Schedule e

Income from operations$ 3,200

Interest expense675Exhibit 7-4

Net income$ 2,525

Step 3: Preparation of Financial BudgetThe 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 BudgetThe 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) for1.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 necessaryExhibit 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, 19X1AprilMayJuneJuly

Beginning cash balance$10,000$10,550$10,970$10,965

Cash receiptsCollections from customers (Schedule b)46,00068,00068,00054,000

Total cash available, before financing (w)*$56,000$78,550$78,970$64,965

Cash disbursementsMerchandise (Schedule d)42,70048,30040,60032,900

Operating expenses (Schedule f)13,75018,25018,00015,250

Purchase of new fixtures (given)3,000---

Total disbursements (x)$59,450$66,550$58,600$48,150

Minimum cash balance desired (y)10,00010,00010,00010,000

Total cash needed$ 69,450$76,550$68,600$58,150

Excess (deficiency) of total cash available overtotal cash needed before financing (w-x-y)$(13,450)$ 2,000$10,370$ 6,815

FinancingBorrowing (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 SheetThe 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 31,191Assets

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.