# CHAPTER THREE: MASTER BUDGET — Complete Study Notes

---

## LEARNING OBJECTIVES

After completing this chapter you will be able to:

- Define budgeting and explain its advantages
- Provide an overview of the budgeting process
- Prepare a master budget and explain the interrelationships among its supporting
schedules
- Describe the role of budgets in the overall management process
- Discuss the importance of strategy and its role in the master budgeting process
- Identify the reasons for sales forecast
- Understand the difficulties of sales forecasting

---

## 3.1 THE OVERALL PLAN AND CHARACTERISTICS OF BUDGET

### What is a Budget?

A **budget** is a plan expressed in quantitative (usually monetary) terms, covering

a specific period of time (usually one year).

In other words, a budget is a **systematic plan** for the utilization of manpower

and natural resources. In a business, a budget represents an estimate of future
costs and revenues.

- **Finance** is the lifeblood of a business, so financial planning is of utmost

importance.
- Budget is an important tool for **financial planning and control**.
- Financial planning is concerned with raising funds and effectively utilizing them
to **maximize the wealth** of the organization.
- Even with a good financial plan, desired results may not be achieved without
**effective control** to ensure implementation.
- The budget represents a set of **yardsticks and guidelines** for controlling
internal operations of an organization.
- The **discrepancy** between planned performance and actual performance is
highlighted through budgets.

### What is a Master Budget?

A **Master Budget** is a comprehensive expression of management's **operating and

financial plans** for a future time period (usually one year), summarized in a set
of **budgeted financial statements**.

- It embraces the impact of both **operating decisions** (use of scarce resources)

and **financing decisions** (how to obtain funds to acquire those resources).
- It is the **aggregation of all lower-level budgets** produced by a company's
various functional areas.
- It includes **budgeted financial statements**, cash forecasts, and a financing
plan.
- Typically presented in **monthly or quarterly format**, covering the company's
entire fiscal year.
- A master budget is the **central planning tool** that management uses to direct
the activities of a corporation and judge the performance of its various
**responsibility centers**.
### Two Main Components of the Master Budget

```
MASTER BUDGET
├── OPERATING BUDGET → How to utilize the funds raised (use of resources)
└── FINANCIAL BUDGET → How to raise funds for the activities
```

**Operating Budget** includes:

- Budgeted income statement
- Its supporting schedules

**Financial Budget** comprises:

- Capital budget
- Cash budget
- Budgeted balance sheet
- Budgeted statement of cash flows

### Characteristics of a Budget

1. It is **prepared in advance** and is derived from the **long-term strategy** of

the organization.
2. It relates to a **future period** for which objectives or goals have already
been laid down.
3. It is expressed in **quantitative form** — physical, monetary, or both.

---

## 3.2 ADVANTAGES OF BUDGETING

**Budgeting** is the act/process of **formulating an organization's plan**. It is

most useful when **integrated with a company's strategy**.

### 6 Major Advantages:

1. **Coordination and Communication**

- **Coordination** = interconnecting and balancing all aspects of
production/service and all departments so the company meets its goals.
- **Communication** = making sure goals are understood and accepted by all
employees.
- The budgeting process forces managers to think of the relationship of their
function with other departments and how to coordinate to achieve the overall plan.
- Communication is essential for coordination — the purchasing manager must know
the production plan; the production manager must know the sales plan, etc.
- Budget is a **formal document** used to communicate a consistent set of plans
to the organization as a whole.

2. **Resource Allocation**
- Because resources are limited, businesses need some type of **allocation** for
operation.
- Budgeting helps determine which activities should receive the limited
resources of the company.
- Through budgeting, companies can analyze activities to determine if they **add
value** for the company.

3. **Performance Measurement (Evaluation and Control)**

- Evaluation and control = comparing **actual performance** to the **budget** to
determine deviated areas and make corrective actions.
- A budget is a financial plan to **control future operations and results**.
 - It is expressed in numbers (dollars, units, pounds, hours, manpower, etc.).
- A budget serves as a useful **benchmark** against which to evaluate and
control actual performance.

4. **Motivation**
- Most employees are **motivated to work harder to avoid failure** than to
achieve success.
- As employees get closer to a goal, they work harder to achieve it.
- Executives like to set **demanding but achievable goals** for their
subordinate managers.
- Involvement of lower management in budget preparation promotes **common
understanding and acceptance** of organizational goals.
- Setting challenging and achievable targets encourages initiative,
responsibility, and commitment.

5. **Identifying Potential Constraints** (before they become problems)

6. **Facilitating Congruence** between organizational and personal goals

7. **Defining goals numerically** against which actual performance can be evaluated

---

## Strategy and Budgeting

**Strategy** specifies how an organization matches its own capabilities with the
**opportunities in the marketplace** to accomplish its objectives.

Key strategic questions:

- What are our objectives?
- How do we create value for customers while distinguishing ourselves from
competitors?
- Are the markets local, regional, national, or global?
- What trends affect our markets?
- How are we affected by the economy, our industry, and our competitors?
- What organizational and financial structures serve us best?
- What are the risks and opportunities of alternative strategies?
- What are our contingency plans if our preferred plan fails?

### Budgeting Strategies

**Budgeting strategy** is the **starting point** in preparing plans and budgets.

The four budgeting strategies are:

| Strategy | Description |
|---|---|
| **Mandated (Top-Down) Budgeting** | Developed by **top management** and passed
down to lower levels for implementation |
| **Participative (Bottom-Up) Budgeting** | Developed by **lower-level managers**
and passed upward to top management |
| **Incremental Budgeting** | Uses the **current period's budget** as the starting
point for the next period's budget |
| **Zero-Based Budgeting** | Company begins **from zero** in each budget period |

---

## 3.3 TYPES OF BUDGETS

Budgets are classified in different ways:

### 1. Based on Capacity

| Type | Description |
|---|---|
| **Fixed Budget** | Remains **unchanged** regardless of the level of activity.
Prepared for fixed expenses. Rigid and does not change with volume of activity.
Prepared for a particular level of activity under the premise that there will be no
change in outside conditions. |
| **Flexible Budget** | **Changes with the level of activity.** Prepared for
various levels of activity. Expenses are classified as fixed, variable, and semi-
variable. Not rigid. |

### 2. Based on Time

- **Long-range budgets** — cover long periods

- **Short-range budgets** — the most frequently used is **one year (annual)**
- The annual budget is often subdivided by **months** for the first quarter and
by **quarters** for the remainder of the year.
- **Rolling (Revolving/Continuous) Budgets** — Always available for a specified
future period by **adding a new period** in the future as the period just ended is
dropped.
- Example: A 12-month rolling budget always covers the next 12 months regardless
of where you are in the year.

### 3. Based on Coverage

| Type | Description |
|---|---|
| **Functional Budgets** | Relate to the various **functional activities** of an
organization (physical budgets, profit budgets, cost budgets, financial budgets) |
| **Master Budget** | **Consolidated summary** of all various functional budgets.
The "grand plan of action" for an upcoming period. |

---

## 3.4 DEVELOPING THE MASTER BUDGET

The master budget expresses management's operating and financial plans for a
specified period (usually one year) and comprises a set of **budgeted financial
statements**.

### Components of the Operating Budget (in order of preparation):

**IMPORTANT NOTE:** Preparation of the master budget begins with the **operating
budget**. The **production budget** (or inventory purchase budget) is set **after**
the sales budget is completed.

```
1. Sales Budget
↓
2. Schedule of Budgeted Cash Collections
↓
3. Inventory (Merchandise) Purchase Budget
↓
4. Schedule of Expected Cash Disbursements for Purchases
↓
5. Operating Expense Budget
 ↓
6. Schedule of Expected Cash Disbursements for Operating Expenses
↓
7. Budgeted Income Statement
```

### Components of the Financial Budget:

```
8. Cash Budget (Capital Budget info used here)
↓
9. Budgeted Balance Sheet
↓
10. Budgeted Statement of Cash Flows
```

---

### (a) Sales Budget

- The **starting point** of all budgeting.

- Includes both **cash and credit sales**.
- A detailed schedule showing the expected sales for the budgeted period.
- Sales forecast accuracy is **critical** because it is the data source for ALL
other budgets.

**Format:**
```
Sales Budget
Jan Feb Mar Quarter
Cash Sales (X%) xxx xxx xxx xxx
Credit Sales (Y%) xxx xxx xxx xxx
Total Budgeted Sales xxx xxx xxx xxx
```

---

### (b) Schedule of Budgeted Cash Collections

- Prepared to show how much cash is expected to be received from customers.

- Includes:
- **Current month's cash sales** PLUS
- **The previous month's credit sales** expected to be collected in the current
month (if credit sales are collected in the following month)

**Format:**
```
Cash Collection Budget
Jan Feb Mar Quarter
A/R beginning balance xxx - - xxx
January sales (cash + credit) xxx xxx - xxx
February sales (cash + credit) - xxx xxx xxx
March sales (cash only) - - xxx xxx
Total Cash Collections xxx xxx xxx xxx
```

> **Key rule:** Cash sales are collected in the **current month**. Credit sales are
collected in the **following month** (unless stated otherwise).
---

### (c) Inventory (Merchandise) Purchase Budget

- Prepared to show the amount of goods to be purchased from suppliers.

- The total inventory needed comes from two sources: **Beginning inventory** and
**planned purchases**.

**Formula:**
```
Budgeted Cost of Goods Sold xxxx
+ Desired Ending Inventory xxxx
= Total Inventory Needed xxxx
- Beginning Inventory xxxx
= Required Purchases xxxx
```

> **Note:** "Desired ending inventory" is usually given as a **% of the following
month's cost of goods sold (COGS)**.
> **Note:** Cost of Goods Sold = Sales × (1 - Gross Profit %). If Gross Profit =
40%, then COGS = 60% of Sales.

---

### (d) Schedule of Expected Cash Disbursements for Purchases

- A disbursement for inventory consists of:

- **Payments for prior period purchases** on account (accounts payable beginning
balance)
- **Payments for current period purchases** (based on payment terms, e.g., 50% in
month of purchase, 50% in following month)

**Format:**
```
Schedule of Cash Disbursements for Purchases
Jan Feb Mar Quarter
A/P beginning balance xxx - - xxx
January purchases (50%, 50%) xxx xxx - xxx
February purchases (50%, 50%) - xxx xxx xxx
March purchases (50%) - - xxx xxx
Total Disbursements for Purchases xxx xxx xxx xxx
```

---

### (e) Operating Expense Budget

- All **budgeted selling and administrative expenses** are compiled and listed.
- **Important:** The amount of **interest expense cannot be determined** until the
amount of expected borrowing is established through the **cash budget**. That is
why interest expense is added to the income statement **after** the cash budget is
prepared.

**Format:**
```
Operating Expense Budget
Jan Feb Mar Quarter
Salaries and wages xxx xxx xxx xxx
Advertising expense xxx xxx xxx xxx
Shipping expense (% sales) xxx xxx xxx xxx
Depreciation expense xxx xxx xxx xxx
Other expenses (% sales) xxx xxx xxx xxx
Total Operating Expenses xxx xxx xxx xxx
```

---

### (f) Schedule of Expected Cash Disbursements for Operating Expenses

- Cash expenses are **paid as incurred**.

- **IMPORTANT: Depreciation expense is NOT included** in cash disbursements because
depreciation is a **non-cash expense**.

**Format:**
```
Cash Disbursements for Operating Expenses
Jan Feb Mar Quarter
Salaries and wages xxx xxx xxx xxx
Advertising expense xxx xxx xxx xxx
Shipping expense xxx xxx xxx xxx
Other expenses xxx xxx xxx xxx
Total Cash Disbursements xxx xxx xxx xxx
(Note: Depreciation excluded — non-cash)
```

---

### (g) Budgeted Income Statement

- Shows the company's **planned profit** for the upcoming budget period.
- It will be **complete only after** interest expense is added (which is computed
after the cash budget is prepared).
- The **main reason** the budgeted income statement is prepared before the cash
budget is to show the ultimate output of the operating budget.

**Format:**
```
Budgeted Income Statement
Sales xxx
Less: Cost of Goods Sold (xxx)
Gross Profit xxx
Less: Operating Expenses:
Salaries and wages xxx
Advertising expense xxx
Shipping expense xxx
Depreciation expense xxx
Other expenses xxx
Total Operating Expenses (xxx)
Net Operating Income xxx
Less: Interest Expense (xxx)
Net Income xxx
```

---

### (h) Cash Budget

- Prepared to advise management of anticipated **cash shortages or excessive cash

balances**.
- Pulls together much of the data developed in the preceding steps.
- Composed of **four sections**:

**Section 1 — Receipts (Cash Collection):** All cash inflows

**Section 2 — Disbursements (Cash Payments):** All planned cash payments including:

- Inventory purchases
- Direct labor payments
- Equipment purchases
- Dividends
- Manufacturing costs
- Operating expenses

**Section 3 — Cash Excess or Deficiency:**

```
Beginning Cash Balance xxx
+ Receipts (Cash Collections) xxx
= Total Cash Available Before Financing xxx
- Disbursements (xxx)
= Excess (Deficiency) of Cash xxx
```

**Section 4 — Financing:** Includes borrowings, repayments, and interest payments.

**Complete Cash Budget Format:**

```
Cash Budget
Jan Feb Mar Quarter
Cash balance, beginning xxx xxx xxx xxx
Add: Receipts xxx xxx xxx xxx
Total Cash Available xxx xxx xxx xxx

Less: Disbursements:
Purchase of inventory (xxx) (xxx) (xxx) (xxx)
Operating expenses (xxx) (xxx) (xxx) (xxx)
Purchase of equipment (-) (xxx) (xxx) (xxx)
Cash dividends (xxx) (-) (-) (xxx)
Total Disbursements (xxx) (xxx) (xxx) (xxx)

Excess (Deficiency) of Cash xxx xxx xxx xxx

Financing:
Borrowings (beginning) xxx - - xxx
Repayments (end) (-) (-) (xxx) (xxx)
Interest paid (-) (-) (xxx) (xxx)
Total Financing xxx - (xxx) xxx

Cash Balance, Ending xxx xxx xxx xxx

```

> **Rules for borrowing (typical exam conditions):**

> - All borrowing is made at the **beginning** of a month
> - All repayments are made at the **end** of a month
> - Borrowings and repayments must be in **multiples of $1,000**
> - A **minimum cash balance** must be maintained
> - Interest is paid **only at the time of repayment of principal**
> - Interest rate is typically given per **year** (divide by 12 for monthly)
**Interest calculation:** Interest = Principal × Annual Rate × (Months/12)

---

### (i) Budgeted Balance Sheet

**Format:**
```
Budgeted Balance Sheet
ASSETS
Current Assets:
Cash xxx
Accounts Receivable xxx
Inventory xxx
Total Current Assets xxx

Plant Assets:
Building and Equipment (net) xxx
Total Assets xxx

LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities:
Accounts Payable xxx

Stockholders' Equity:
Capital Stock xxx
Retained Earnings xxx
Total Liabilities and SE xxx
```

> **How to calculate Retained Earnings for budgeted balance sheet:**

> Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

> **How to calculate Building and Equipment (net):**

> Beginning Balance + Purchases - Depreciation = Ending Balance

> **Accounts Receivable** = Last month's credit sales (the ones not yet collected)

> **Inventory** = Desired ending inventory from the purchase budget

> **Accounts Payable** = Last month's purchases not yet paid (50% of last month's
purchases if 50% paid in following month)

---

### (j) Budgeted Statement of Cash Flows

**Format:**
```
Budgeted Statement of Cash Flows

Cash flow from operating activities:

Cash collections from customers xxx
Cash disbursements for inventory (xxx)
Cash disbursements for operating exp. (xxx)
Net cash flow from operating activities xxx

Cash flow from investing activities:

Cash outflow to purchase equipment (xxx)
Net cash flow from investing activities (xxx)

Cash flow from financing activities:

Cash disbursements for dividends (xxx)
Cash disbursements for interest (xxx)
Inflow from borrowing xxx
Outflow for repayment (xxx)
Net cash flow from financing activities (xxx)

Net change in cash (increase/decrease) xxx

Plus: Beginning cash balance xxx
Ending cash balance xxx
```

---

## 3.4.1 MASTER BUDGET FOR MERCHANDISING FIRMS — COMPREHENSIVE EXAMPLE

### GIVEN INFORMATION (Aman Company)

Aman Company is a merchandising firm in Addis Ababa. They prepare a master budget
on a **quarterly basis**. The following data is for the **first quarter of 2005**
(January, February, March).

**Opening Balance Sheet (December 31, 2004):**

| Account | Debit | Credit |

|---|---|---|
| Cash | $48,000 | |
| Accounts Receivable | $224,000 | |
| Inventory | $60,000 | |
| Building and Equipment | $370,000 | |
| Accounts Payable | | $93,000 |
| Capital Stock | | $500,000 |
| Retained Earnings | | $109,000 |
| **TOTAL** | **$702,000** | **$702,000** |

**Sales Data:**

| Month | Sales |
|---|---|
| December 2004 (actual) | $280,000 |
| January 2005 | $400,000 |
| February 2005 | $600,000 |
| March 2005 | $300,000 |
| April 2005 | $200,000 |

**Key Assumptions:**
- Sales: **20% cash, 80% credit**
- All credit sales collected **in the month following sale**
- A/R at Dec 31 = result of December's credit sales ($280,000 × 80% = $224,000 ✓)
- **Gross Profit = 40% of sales** → Cost of Goods Sold = **60% of sales**
- Desired ending inventory = **25% of next month's COGS**
- **50% of inventory purchases paid in month of purchase**, 50% paid in following
month
- Equipment purchase: $1,700 in February; $84,500 in March
- Cash dividends: $45,000 declared and paid in January
- **Minimum cash balance: $30,000**
- Borrowing/repayment in **multiples of $1,000**
- Borrowing at the **beginning** of month; repayment at the **end** of month
- Annual interest rate: **12%**

**Monthly Operating Expenses:**

| Expense | Amount |
|---|---|
| Salaries and wages | $27,000 per month |
| Advertising | $70,000 per month |
| Shipping | 5% of sales |
| Depreciation | $14,000 per month |
| Other expenses | 3% of sales |

> All cash expenses paid as incurred.

---

### SOLUTION 1 — OPERATING BUDGET

---

#### STEP 1: Sales Budget

**Logic:** Split total budgeted sales into 20% cash and 80% credit.

| | January | February | March | Quarter |

|---|---|---|---|---|
| Cash Sales (20%) | $80,000 | $120,000 | $60,000 | $260,000 |
| Credit Sales (80%) | $320,000 | $480,000 | $240,000 | $1,040,000 |
| **Total Budgeted Sales** | **$400,000** | **$600,000** | **$300,000** |
**$1,300,000** |

**Calculations:**
- January: $400,000 × 20% = $80,000 (cash); $400,000 × 80% = $320,000 (credit)
- February: $600,000 × 20% = $120,000 (cash); $600,000 × 80% = $480,000 (credit)
- March: $300,000 × 20% = $60,000 (cash); $300,000 × 80% = $240,000 (credit)
- Quarter totals: Sum of the three months

---

#### STEP 2: Schedule of Budgeted Cash Collections

**Logic:**
- A/R beginning ($224,000) = December's credit sales → collected in January
- Each month's cash sales collected immediately
- Each month's credit sales collected the following month
- March credit sales ($240,000) are collected in April → NOT shown in Q1

| | January | February | March | Quarter |

|---|---|---|---|---|
| A/R beginning balance | $224,000 | — | — | $224,000 |
| January sales (cash $80K, credit collected in Feb $320K) | $80,000 | $320,000 | —
| $400,000 |
| February sales (cash $120K, credit collected in Mar $480K) | — | $120,000 |
$480,000 | $600,000 |
| March sales (cash only $60K) | — | — | $60,000 | $60,000 |
| **Total Cash Collections** | **$304,000** | **$440,000** | **$540,000** |
**$1,284,000** |
**Calculations:**
- January total: $224,000 + $80,000 = $304,000
- February total: $320,000 + $120,000 = $440,000
- March total: $480,000 + $60,000 = $540,000
- Quarter: $224,000 + $400,000 + $600,000 + $60,000 = $1,284,000

> **Note:** March's credit sales ($240,000) are collected in **April** — outside
the quarter, so excluded.

---

#### STEP 3: Inventory (Merchandise) Purchase Budget

**Logic:**
- COGS = 60% of sales (since gross profit is 40%)
- Desired ending inventory = 25% of **next month's** COGS
- Required Purchases = COGS + Desired Ending Inventory − Beginning Inventory

**First, calculate COGS:**

- Jan COGS: $400,000 × 60% = $240,000
- Feb COGS: $600,000 × 60% = $360,000
- Mar COGS: $300,000 × 60% = $180,000
- Apr COGS: $200,000 × 60% = $120,000 (needed for March's ending inventory
calculation)

**Calculate Desired Ending Inventory (25% of next month's COGS):**

- Jan ending: 25% × $360,000 = $90,000
- Feb ending: 25% × $180,000 = $45,000
- Mar ending: 25% × $120,000 = $30,000

**Beginning Inventory each month:**

- Jan beginning: $60,000 (from opening balance sheet)
- Feb beginning: $90,000 (= Jan's ending inventory)
- Mar beginning: $45,000 (= Feb's ending inventory)
- Quarter beginning: $60,000 (same as Jan — beginning of quarter)

| | January | February | March | Quarter |

|---|---|---|---|---|
| Budgeted COGS (60% of sales) | $240,000 | $360,000 | $180,000 | $780,000 |
| + Desired Ending Inventory | $90,000 | $45,000 | $30,000 | $30,000* |
| = Total Inventory Needed | $330,000 | $405,000 | $210,000 | $810,000 |
| − Beginning Inventory | $60,000 | $90,000 | $45,000 | $60,000** |
| **= Required Purchases** | **$270,000** | **$315,000** | **$165,000** |
**$750,000** |

> *Quarter ending inventory = March's ending inventory = $30,000

> **Quarter beginning inventory = January's beginning inventory = $60,000

---

#### STEP 4: Schedule of Cash Disbursements for Inventory Purchases

**Logic:**
- 50% of each month's purchases paid in the **month of purchase**
- 50% paid in the **following month**
- A/P beginning ($93,000) = unpaid portion of December purchases → paid in January

| | January | February | March | Quarter |

|---|---|---|---|---|
| A/P beginning balance | $93,000 | — | — | $93,000 |
| Jan purchases ($270,000 × 50%, 50%) | $135,000 | $135,000 | — | $270,000 |
| Feb purchases ($315,000 × 50%, 50%) | — | $157,500 | $157,500 | $315,000 |
| Mar purchases ($165,000 × 50%) | — | — | $82,500 | $82,500 |
| **Total Disbursements for Purchases** | **$228,000** | **$292,500** |
**$240,000** | **$760,500** |

**Calculations:**
- January: $93,000 + $135,000 = $228,000
- February: $135,000 + $157,500 = $292,500
- March: $157,500 + $82,500 = $240,000
- Quarter: $93,000 + $270,000 + $315,000 + $82,500 = $760,500

> Note: March's 50% unpaid = $82,500 → will be paid in April (not in Q1)

---

#### STEP 5: Operating Expense Budget

**Calculations:**
- Shipping = 5% of sales: Jan = $400,000×5% = $20,000; Feb = $600,000×5% = $30,000;
Mar = $300,000×5% = $15,000
- Other expenses = 3% of sales: Jan = $400,000×3% = $12,000; Feb = $600,000×3% =
$18,000; Mar = $300,000×3% = $9,000
- Depreciation = $14,000/month; Quarter total = $42,000 (not $14,000 — that's a
typo in the original)

| | January | February | March | Quarter |

|---|---|---|---|---|
| Salaries and wages | $27,000 | $27,000 | $27,000 | $81,000 |
| Advertising expense | $70,000 | $70,000 | $70,000 | $210,000 |
| Shipping (5% of sales) | $20,000 | $30,000 | $15,000 | $65,000 |
| Depreciation | $14,000 | $14,000 | $14,000 | $42,000 |
| Other expenses (3% of sales) | $12,000 | $18,000 | $9,000 | $39,000 |
| **Total Operating Expenses** | **$143,000** | **$159,000** | **$135,000** |
**$437,000** |

---

#### STEP 6: Schedule of Cash Disbursements for Operating Expenses

> **Depreciation is excluded** because it is a **non-cash expense**.

| | January | February | March | Quarter |

|---|---|---|---|---|
| Salaries and wages | $27,000 | $27,000 | $27,000 | $81,000 |
| Advertising expense | $70,000 | $70,000 | $70,000 | $210,000 |
| Shipping (5% of sales) | $20,000 | $30,000 | $15,000 | $65,000 |
| Other expenses (3% of sales) | $12,000 | $18,000 | $9,000 | $39,000 |
| **Total Cash Disbursements** | **$129,000** | **$145,000** | **$121,000** |
**$395,000** |

> Total operating expense ($437,000) − Depreciation ($42,000) = Cash disbursements

($395,000) ✓

---

#### STEP 7: Budgeted Income Statement

**(For the Quarter Ended March 31, 2005)**

| | Amount |
|---|---|
| Sales | $1,300,000 |
| Less: Cost of Goods Sold | ($780,000) |
| **Gross Profit** | **$520,000** |
| **Less: Operating Expenses:** | |
| Salaries and wages | $81,000 |
| Advertising expense | $210,000 |
| Shipping expense | $65,000 |
| Depreciation expense | $42,000 |
| Other expenses | $39,000 |
| **Total Operating Expenses** | **($437,000)** |
| **Net Operating Income** | **$83,000** |
| Less: Interest Expense | ($2,400) |
| **Net Income** | **$80,600** |

> Interest expense is filled in **after** the cash budget is prepared (see below).

---

### SOLUTION 2 — FINANCIAL BUDGET

---

#### STEP 8: Cash Budget

**(For the Quarter Ended March 31, 2005)**

**Pre-work — Determine if borrowing is needed:**

**January:**
- Beginning cash: $48,000
- + Receipts: $304,000
- Total available: $352,000
- − Disbursements: $228,000 (purchases) + $129,000 (operating) + $0 (equipment) +
$45,000 (dividends) = **$402,000**
- Excess/(Deficiency): $352,000 − $402,000 = **($50,000)** ← DEFICIENCY
- Minimum balance needed: $30,000
- Total need: $50,000 + $30,000 = $80,000 → **Borrow $80,000** (already a multiple
of $1,000)
- Ending cash: ($50,000) + $80,000 = **$30,000** ✓ (equals minimum)

**February:**
- Beginning cash: $30,000
- + Receipts: $440,000
- Total available: $470,000
- − Disbursements: $292,500 (purchases) + $145,000 (operating) + $1,700 (equipment)
+ $0 (dividends) = **$439,200**
- Excess/(Deficiency): $470,000 − $439,200 = **$30,800** ← Surplus (no borrowing
needed)
- No financing needed
- Ending cash: **$30,800**

**March:**
- Beginning cash: $30,800
- + Receipts: $540,000
- Total available: $570,800 (note: book shows $570,000 — rounding to match
textbook: $570,000)
- − Disbursements: $240,000 (purchases) + $121,000 (operating) + $84,500
(equipment) = **$445,500**
- Excess: $570,800 − $445,500 = **$125,300** ← Large surplus, can repay loan
- Repay $80,000 principal + interest $2,400
- After repayment: $125,300 − $82,400 = **$42,900**

**Interest Calculation:**
- Loan: $80,000 borrowed at start of January, repaid at end of March = 3 months
- Monthly interest: $80,000 × 12% ÷ 12 = **$800 per month**
- Total interest for 3 months: $800 × 3 = **$2,400**

| | January | February | March | Quarter |

|---|---|---|---|---|
| Cash balance, beginning | $48,000 | $30,000 | $30,800 | $48,000 |
| **Add: Receipts** | | | | |
| Collections from customers | $304,000 | $440,000 | $540,000 | $1,284,000 |
| **Total Cash Available** | **$352,000** | **$470,000** | **$570,800** |
**$1,332,000** |
| **Less: Disbursements** | | | | |
| Purchase of inventory | ($228,000) | ($292,500) | ($240,000) | ($760,500) |
| Operating expenses | ($129,000) | ($145,000) | ($121,000) | ($395,000) |
| Purchase of equipment | — | ($1,700) | ($84,500) | ($86,200) |
| Cash dividends | ($45,000) | — | — | ($45,000) |
| **Total Disbursements** | **($402,000)** | **($439,200)** | **($445,500)** |
**($1,286,700)** |
| **Excess (Deficiency) of Cash** | **($50,000)** | **$30,800** | **$125,300** |
**$45,300** |
| **Financing:** | | | | |
| Borrowings (at beginning) | $80,000 | — | — | $80,000 |
| Repayments (at end) | — | — | ($80,000) | ($80,000) |
| Interest (12% per year) | — | — | ($2,400) | ($2,400) |
| **Total Financing** | **$80,000** | **—** | **($82,400)** | **($2,400)** |
| **Cash Balance, Ending** | **$30,000** | **$30,800** | **$42,900** | **$42,900**
|

---

#### STEP 9: Budgeted Balance Sheet

**(As of March 31, 2005)**

**Working out each figure:**

- **Cash:** $42,900 (from cash budget ending balance)

- **Accounts Receivable:** March credit sales = $300,000 × 80% = **$240,000**
(collected in April)
- **Inventory:** March ending inventory = **$30,000** (from purchase budget)
- **Building and Equipment (net):**
- Beginning: $370,000
- + February purchase: $1,700
- + March purchase: $84,500
- − Depreciation 3 months: 3 × $14,000 = $42,000
- = $370,000 + $1,700 + $84,500 − $42,000 = **$414,200**
- **Accounts Payable:** March purchases unpaid = $165,000 × 50% = **$82,500**
- **Capital Stock:** $500,000 (unchanged)
- **Retained Earnings:**
- Beginning: $109,000
- + Net Income: $80,600
 - − Dividends: $45,000
- = $109,000 + $80,600 − $45,000 = **$144,600**

| ASSETS | | LIABILITIES & EQUITY | |

|---|---|---|---|
| **Current Assets** | | **Current Liabilities** | |
| Cash | $42,900 | Accounts Payable | $82,500 |
| Accounts Receivable | $240,000 | | |
| Inventory | $30,000 | **Stockholders' Equity** | |
| Total Current Assets | $312,900 | Capital Stock | $500,000 |
| **Plant Assets** | | Retained Earnings | $144,600 |
| Building & Equipment (net) | $414,200 | | |
| **Total Assets** | **$727,100** | **Total Liabilities & SE** | **$727,100** |

✓ Balance sheet balances: $727,100 = $727,100

---

#### STEP 10: Budgeted Statement of Cash Flows

**(For the Quarter Ended March 31, 2005)**

| | Amount |
|---|---|
| **Cash Flow from Operating Activities:** | |
| Cash collections from customers | $1,284,000 |
| Cash disbursements for purchase of inventory | ($760,500) |
| Cash disbursements for operating expenses | ($395,000)* |
| **Net Cash Flow from Operating Activities** | **$128,500** |
| **Cash Flow from Investing Activities:** | |
| Cash outflow to purchase equipment | ($86,200) |
| **Net Cash Flow from Investing Activities** | **($86,200)** |
| **Cash Flow from Financing Activities:** | |
| Cash disbursements for dividends | ($45,000) |
| Cash disbursements for interest expense | ($2,400) |
| Inflow from borrowing | $80,000 |
| Outflow for repayment | ($80,000) |
| **Net Cash Flow from Financing Activities** | **($47,400)** |
| Net Change in Cash (decrease) | ($5,100) |
| Plus: Beginning Cash Balance | $48,000 |
| **Ending Cash Balance** | **$42,900** ✓ |

> *Operating expense cash disbursements = $395,000 (from schedule). Note: the
textbook shows $397,500, which includes interest — the difference may reflect
different classification of interest. The ending balance remains $42,900
regardless.

**Verification:** $48,000 − $5,100 = $42,900 ✓ Matches cash budget ending balance.

---

## 3.5 DIFFICULTIES OF SALES FORECASTING

Sales forecasting is the **starting point** for the entire budgeting process. If
the sales figures are unreliable, the **entire budget process is a waste of time**.

All companies have two things in common when it comes to forecasting sales:
1. Sales forecasting is a **critical step** in the budgeting process.
2. It is very **difficult to do accurately**.
**Sales forecasting** = the process of predicting sales of goods or services.

- Various procedures are used in sales forecasting, and the final forecast usually
**combines information from many different sources**.
- The **marketing department** normally coordinates the effort to establish the
sales forecast.
- Many firms have a **top-management-level market research staff** to coordinate
sales forecasting efforts.
- The **starting point** in sales forecasting is generally the **sales level of the
prior year**.

### Key Factors in Sales Forecasting:

1. **Past sales levels and trends** — for the company and for the entire industry
2. **General economic trends** — Is the economy growing? How fast? Is a recession
expected?
3. **Economic trends in the company's industry** — e.g., in petroleum, is personal
travel likely to increase?
4. **Other factors expected to affect sales** in the industry
5. **Political and legal events** — changes in political power and legislation
6. **Intended pricing policy** of the company
7. **Planned advertising and product promotion**
8. **Expected actions of competitors**
9. **New product development** (substitutes or complements) by the company or other
firms
10. **Market research studies**
11. **Internal capacity and situation** of the company

> A slightly inaccurate sales forecast, coming at the very beginning of the budget
process, will **throw off all the other schedules** that make up the master budget.

---

## QUICK SUMMARY — KEY FORMULAS AND RULES

| Formula/Rule | Detail |
|---|---|
| COGS | = Sales × (1 − Gross Profit %) |
| Gross Profit | = Sales × Gross Profit % |
| Required Purchases | = COGS + Desired Ending Inventory − Beginning Inventory |
| Interest | = Principal × Annual Rate × (Months/12) |
| Ending Retained Earnings | = Beginning RE + Net Income − Dividends |
| Building & Equipment (net) | = Beginning + Purchases − Depreciation |
| Accounts Receivable (ending) | = Last month's credit sales (not yet collected) |
| Accounts Payable (ending) | = Last month's purchases not yet paid |
| Cash disbursements for operating expenses | Exclude depreciation (non-cash) |
| Order of budget preparation | Sales → Cash Collections → Purchases → Cash for
Purchases → Operating Expenses → Cash for Operating Expenses → Budgeted Income
Statement → Cash Budget → Balance Sheet → Statement of Cash Flows |

---

*End of Chapter 3 — Master Budget Complete Notes*