Companies use budgeting to facilitate planning and control within the business firm in order that they can manage the financial aspects of their business and plan for new product expansion in the future. Budgeting also allows for the evaluation of performance of companies during the planning period.
Before the budgeting planning process can begin, the firm should develop a strategic plan and a series of objectives based on that strategic plan covering the next five years. The strategic plan forms the basis for the various budgets that the firm will put together.
What is the Master Budget
The master budget is a one-year budget planning document for the firm encompassing all other budgets. It coincides with the fiscal year of the firm and may be broken down into quarters and, further, into months. If the firm plans for the master budget to be an ongoing document, rolling from year to year, then normally a month is added to the end of the budget to facilitate planning. This is called continuous budgeting.
The budget committee usually develops the master budget for each year, guided by the Budget Director, who is usually the Controller of the company.
What are the Major Parts of the Master Budget?
Depending on the size of the firm, the master budget is a comprehensive budget planning document. It usually has two parts, the operating budget and the financial budget. The operating budget shows the income-generating activities of the firm, including revenues and expenses. The result is a budgeted income statement.
The financial budget shows the inflows and outflows of cash and other elements of the firm's financial position. The inflows and outflows of cash come from the cash budget. As such, the result of the financial budget is the budgeted balance sheet. Operating budgets are prepared first as information from the operating budgets is needed for the financial budgets.
The operating budget is actually composed of eight supporting budget planning schedules. They are inter-related and come together to develop a budgeted income statement based on the operating budget.
The first schedule to develop is the sales budget, which is based on the sales forecast. The sales budget is not usually the same as the sales forecast but is adjusted based on managerial judgement and other data.
The second schedule for budget planning is the production schedule. After determining the amount of sales the company expects to make in the next year, then the company budgets how many sales in units the company has to make in order to meet the sales budget and meet ending inventory requirements. Most companies have an ending inventory they want to meet every month or quarter in order that they don't stock out.
The next schedules are the direct materials purchases budget which refers to the raw materials the firm uses in its production process, the direct labor budget, and the overhead budget. The overhead budget includes both fixed and variable overhead costs.
The ending finished goods inventory budget is necessary to complete the cost of goods sold budget and the balance sheet. This budget assigns a value to every unit of product produced based on raw materials, direct labor, and overhead.
The selling and administrative expense budget deals with non-manufacturing costs such as freight or supplies.
The budgeted income statement is the result of the schedules above. Take note that operating income is not the same as net income. In order to get net income, you have to subtract out taxes and interest.
Overview of the Financial Budget
There are three remaining budgets found in the financial budget portion of the master budget. These are the cash budget, the budgeted balance sheet, and the budget for capital expenditures. The cash budget states cash inflows and outflows, expected borrowing, and expected investing, usually on a monthly basis. Any item that is not in cash, such as depreciation, is ignored by the cash budget.
The budgeted balance sheet gives the ending balances of the asset, liability, and equity accounts if budgeting plans hold true during the budgeting time period.
The budget for capital expenditures contains budgetary figures for the large, expensive fixed assets for the business firm.
These are the most often used budgets within the master budget of business firms. Some firms may not use one or another of the budgets, but most use some form of all of them. Service firms, for example, do not typically use production budgets.