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

Learning Outcomes

  • 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!

Practice Questions

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!

The sales budget is used for the production budget and the selling and administrative expense budget. The selling and administrative budget is used for the budgeted income statements. The production budget is used for the finished goods budget, the direct materials budget, the direct labor budget, and the manufacturing overhead budget. The finished goods budget is used for the production budget. The direct materials budget, the direct labor budget, and the manufacturing overhead budget, the selling and administrative expense budget, and the budgeted income statement are all used for the cash budget. The cash budget is used for the budgeted balance sheet and the budgeted income statement. The budgeted income statement is used for the budgeted balance sheet and the sales budget. 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!

Practice Questions

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.

The production budget outlines the number of units that we need to produce to meet the requirements we put together in the sales budget. This information needs to be completed prior to moving forward. Without knowing how many of our products we need to make, it would be impossible to move forward with the remaining budgets!

So remember our sales numbers for Hupana Running Company from our sales budget. We plan to sell 2,000 pairs of shoes, evenly distributed between the four quarters of the year. Armed with this information, we can create our production budget.

We had 100 pairs of shoes in our finished goods inventory at the end of the previous year, so we can use that number as we start our production budget. We also want to always have at least 50 pair in our finished goods inventory at the end of each quarter, but would like to end the year with 150 pair in inventory to start the next year.

Hupana Running Company Production Budget
Quarter Q1 Q2 Q3 Q4 Totals
Budgeted unit sales (pairs) 500 500 500 500 2000
Desired finished goods inventory 50 50 50 150 300
Total need 550 550 550 650 2300
Less beginning finished goods inventory 100 50 50 50 250
Required production units 450 500 500 600 2050
So taking a look at our production budget, what do you notice?

Even though we intend to sell 2000 pairs of shoes this year, we are producing 2050! Why? Because we would like to have a larger ending inventory at the end of this year. This could be for a few reasons. Perhaps we anticipate higher sales in the first quarter, or maybe we want to have a plant shut down in the early part of the year. This higher ending finished goods inventory would allow us to cover those two situations.

Also notice, that in the first and fourth quarters, we are actually producing either fewer or more pairs of shoes than we intend to sell. This is to adjust for finished goods inventory.

Note: So Hupana Running Company is a manufacturer. What might be different if they were a merchandising company who simply purchased finished goods to sell?  Well, instead of a production budget, they would have a merchandise purchases budget. It would be similar in layout to the production budget, but the wording would be different.  Rather than a required production in units, we would simply have required purchases. Oh, and we could skip some of the additional budgets, like production, direct labor and manufacturing overhead! Why? Well, if we aren’t actually manufacturing anything, those budgets aren’t needed. A merchandising company is a bit easier to budget for, but let’s keep plugging away at our manufacturing company!
Now let’s practice!

Practice Questions

Direct Materials Budget

Hupana Running Company is off to a great budgeting start!! We have put together a sales budget, so we know how many pairs of our amazing running shoes we intend to sell, then we created a production budget, so now we know how many we need to produce each quarter to meet sales and finished inventory needs!

Ok, so next, we will need to figure out, based off the information in our production budget, what we need for direct materials! Remember, the number of pairs of shoes we sell each quarter, does not necessarily match the number of pairs we need to produce each quarter. Keeping that information in mind, let’s move on to our direct materials budget.

In order to complete this budget, let’s look at a few pieces of important information.

  1. How many units of raw materials are required for each pair of shoes?
  2. How many units do we need to meet our production budget?
  3. How many units of raw materials would we like to have in our ending inventory?
  4. What do we currently have in our raw materials inventory?
  5. How many units of raw materials do we need to purchase?
  6. How much does each unit of raw material cost?

Let’s assume we are showing 250 units of raw material in our ending inventory coming into the new year.  Each pair of shoes we make requires 5 units of raw materials. Let’s also note that our buyer has secured a price for our raw material of $2 per unit for the entire year! Yeah to our buyer for doing great work on an annual contract! This will certainly help us in our budgeting process right?

This information will help our buyers to purchase raw materials, especially if it has a long lead time to receive, or if we like to receive it close to needing it (this might be called JIT or just-in-time inventory!).

Hupana Running Company Direct Materials Budget
Quarter Q1 Q2 Q3 Q4 Total
Required production in pairs 450 500 500 600 2050
Units of raw material needed per pair 5 5 5 5 5
Units of raw material needed to meet production 2250 2500 2500 3000 10250
Plus desired ending raw material inventory 500 500 500 500 500
Total units of raw materials needed 2750 3000 3000 3500 10750
Less units in beginning raw material inventory 250 500 500 500 250
Units of raw materials to be purchases 2500 2500 2500 3000 10500
Cost of raw material per unit $2 $2 $2 $2 $2
Cost of raw material to be purchased $5,000 $5,000 $5,000 $6,000 $21,000
What information is helpful? We now know how much money we need to have each quarter to cover the cost of our raw materials. Our buyer is happy and so is our production manager, knowing that we will have raw material in stock for production!

We can use this information to start working on the next part of our budget! What comes next? Well labor of course!

Practice Questions

Direct Labor Budget

Ok, so Hupana Running Company is getting all set for the new year. We have our sales budget, and know how many pairs of shoes we plan to sell. From that information we created our production budget, so we know how many pairs we need to produce each quarter, and how many we want in finished goods inventory at the end of each quarter. We also then figured out how much raw materials we need to bring in each quarter to keep our production facilities humming along.

So now we need to determine our direct labor needs. Direct labor includes all of the employees who are required to actually manufacture the shoes. These are the people working on the production floor. This information is important, so they don’t run into a labor shortage and can plan for potential adjustments in their labor needs. Another use for this budget is to schedule plant shutdowns for cleaning and maintenance. Without the completion of the other budgets we have done, we couldn’t fill in all the blanks in the direct labor budget!

So what new information might we need to complete this budget? Well the biggest one is how much time does it take to complete a pair of shoes? Then we need to know our cost per hour for our direct labor. This cost per hour includes wages, payroll taxes and fringe benefits for each of our production employees. Don’t forget those things, as they can make a huge impact on the cost of an employee per hour!

So let’s figure out our labor information.

One pair of shoes takes .5 labor hours @ $20/ hour average

We already know how many pairs we need to make each quarter, so let’s get started on our direct labor budget!

Hupana Running Company Direct Labor Budget
Quarter Q1 Q2 Q3 Q4 Total
Required production in pairs 450 500 500 600 2050
Direct labor hours-pair 0.5 0.5 0.5 0.5 0.5
Total direct labor hours needed 225 250 250 300 1025
Direct labor cost per hour $20 $20 $20 $20 $20
Total direct labor cost $4,500 $5,000 $5,000 $6,000 $20,500
So we used the required production in pairs from our previous budgets. We noted above the time needed and the cost per hour for our manufacturing employees. With that information in hand, we can calculate our direct labor costs. We now know, how much we will spend each quarter on labor, and can staff properly!

Is all this budgeting fun starting to make sense? Let’s go over what we know so far.

We know our sales, production schedule, raw materials cost, direct labor cost and what we will have in finished goods and raw materials inventory at the end of the year! Are we having fun yet?

Practice Questions

On to manufacturing overhead!

Manufacturing Overhead Budget

Well, we are working through these budgets, but now we got to an interesting one. There is more that goes in to the production of our shoes that just the raw materials and the people working. We have equipment, and small supplies, as well as repairs and utilities. These things can get costly, so we need to make sure we are on top of them as we work through this budget!

Manufacturing overhead includes all the costs of production other than labor and raw materials. This can include some variable and some fixed components.

Variable manufacturing overhead is based on direct labor hours. This can include things like electricity, production supplies (perhaps needles for the machines that sew together the shoe components) and other miscellaneous items needed to produce the shoes.

Fixed manufacturing overhead includes depreciation on the equipment, rent or mortgage on the facility and costs to process purchase orders, customer calls and such. There may come a point where the current facility, equipment or customer reps can’t handle the volume. If this occurs, the fixed costs may change. For our purposes, let’s assume that the current facility and equipment can handle the budgeted output!

So let’s assume our variable manufacturing overhead to be $3 per labor hour. Let’s further assume our monthly fixed manufacturing overhead is $2050 per month. So, included in our fixed overhead is $500 of depreciation. Remember depreciation is not a cash outlay, so we can deduct it from our total manufacturing overhead for cash purposes!! We will talk more about that when we get to our cash budget in a bit.

So plugging the information above into our manufacturing overhead budget, we can come up with a predetermined overhead rate for the year. We also have figured out the cash outlay, as well as the total manufacturing overhead.

Hupana Running Company Manufacturing Overhead Budget
Quarter Q1 Q2 Q3 Q4 Total
Budgeted direct labor hours 225 250 250 300 1025
Variable manufacturing overhead rate $3 $3 $3 $3 $3
Variable manufacturing overhead $675 $750 $750 $900 $3,075
Fixed manufacturing overhead $2,050 $2,050 $2,050 $2,050 $8,200
Total manufacturing overhead $2,725 $2,800 $2,800 $2,950 $11,275
Minus depreciation $500 $500 $500 $500 $2,000
Cash disbursements for manufacturing overhead $2,225 $2,300 $2,300 $2,450 $9,275
A. Total manufacturing overhead $11,275
B. Budgeted direct labor hours $1,052
Predetermined overhead rate for the year A/B $11
So if you look at our previous budget for direct labor, the hours shown here on our manufacturing overhead budget come directly from that budget! The variable manufacturing overhead total is simply the hours multiplied by the rate. We now have the information needed to continue moving forward in our budgeting process! We also calculated our predetermined overhead rate for the year. Since manufacturing overhead i s an indirect cost, we can’t assign it to a particular product or job. Because we are using our direct labor hours as our allocation base, dividing the entire manufacturing overhead by the direct hours, gives us a dollar amount we can use, as an addition to the direct labor cost, for each hour worked.

So, as an example, our direct labor cost per hour is $20 (as you remember from our direct labor budget). We an now add the $11 per hour manufacturing overhead to each hour worked as we price our products. This is a helpful calculation to spread out those costs that we cannot directly tie to a given product. This comes in very handy when more than one product line is manufactured. So if Hupana Running Company had 12 lines of shoes with varying labor and material costs, we could use this standard amount per hour of labor to allocate all of the manufacturing overhead costs!

Okay, so now we can move on!! We have all kinds of information now to complete our budgeting tasks!

Practice Questions

Ending Inventory Budget

As the senior accountant at Hupana, it is your job to oversee the preparation of the master budget. You have been waiting on the manufacturing overhead budget, so you can complete the finished goods inventory budget. Having the balance for finished goods inventory is needed before you can move on to the budgeted financial statements that are part of your job! Luckily, you now have all of the information needed to move forward. Your managers have provided you with the details to fill in all of the blanks in this finished goods inventory budget!

Ok, so we have completed the first five budgets needed to help us figure out the value of our ending inventory among other things!

Calculating the per unit cost of our finished goods inventory is an important figure. We will need it to calculate the cost of goods sold. How much was spent to manufacture the remaining items in inventory will also give us the value of what we still have in our stock. This is an asset on our balance sheet, so getting the calculation right is important.

Hupana Running Company Ending Finished Goods Inventory Budget
Item Quantity Cost Total
Production cost per pair 5 unit $2 unit $10
Direct materials (from direct materials budget) 0.5 hour $20 hour $10
Direct labor (from direct labor budget) 0.5 hour $11 hour $6
Manufacturing overheard (from manufacturing overhead budget) $26
Unit production
Budgeted finished goods inventory
Ending finished goods inventory (in pairs)-from production budget 150
Unit product cost (from above) $26
Ending finished goods inventory in dollars $3,825
The finished goods inventory budget, references several other budgets we have prepared. Without those budgets, we would not have had a good number to use for our balance sheet that included all of the costs involved in the manufacture of the shoes left in our ending inventory.

So we now have a ton of information about our production schedule, our costs of manufacturing and a really good handle on our inventory. This is a great start, but there is a lot more to the overall business than what happens in manufacturing. There are costs relating to administration  and selling expenses that are necessary to get the orders to make the products that we sell.

Let’s get started!

Practice Questions

Selling and Administrative Budget

So Hupana Running Company knows all about production, and we have a good handle on how many pairs of shoes we are going to make, and how much raw materials and overhead go into each pair. But how do we get those orders? Well, there are sales commissions, marketing plans, data entry personnel, insurance, property taxes and all the other stuff that goes into operating a business.

Some of these expenses are variable, like sales commissions, and data entry personnel, while other expenses, like insurance and property taxes happen no matter how many pairs of shoes we make or sell. These are our fixed expenses.  So we are going to make some assumptions so we can start work on this budget.

  1. Based on prior year’s actual expenses, let’s assume that the variable selling and administrative expenses are $5 per pair of shoes.
  2. Let’s assume that executive salaries, insurance,marketing, property taxes and depreciation are our fixed expenses.
  3. All of the expenses are equally distributed over the four quarters of the year.

Hupana Running Company Selling and Administrative Expense Budget
Quarter Q1 Q2 Q3 Q4 Total
Budgeted unit sales 500 500 500 500 2000
Variable selling and administrative expense per case $5 $5 $5 $5 $5
Variable selling and administrative expense-total $2,500 $2,500 $2,500 $2,500 $10,000
Fixed selling and administrative expense
Marketing $1,500 $1,500 $1,500 $1,500 $6,000
Executive salaries $5,000 $5,000 $5,000 $5,000 $20,000
Insurance $500 $500 $500 $500 $2,000
Property taxes $250 $250 $250 $250 $1,000
Depreciation expense $500 $500 $500 $500 $2,000
Total fixed selling and administrative expenses $7,750 $7,750 $7,750 $7,750 $31,000
Total selling and administrative expenses $10,250 $10,250 $10,250 $10,250 $41,000
Less depreciation $500 $500 $500 $500 $2,000
Cash disbursements for selling and administrative expense $9,750 $9,750 $9,750 $9,750 $39,000
Note: because depreciation expense is a non-cash expense, we can subtract it for our cash budget preparation, but we still need the number for our overall budget and financial statements to get an overall picture of the health of our company!
What do you notice about our selling and administrative budget? First, we use the budgeted unit sales off of the sales budget we created first! So you can start to see how everything is tied together.

Practice Questions

Cash Budget

The cash budget will look a lot like a budget you would do for your personal budget. It includes income and expenses, as well as any cash overages or deficiencies. If you borrow money to purchase equipment you may also have a financing section. In your personal budget, this would be things like mortgages and car loans.

Hupana Running Company doesn’t have any outstanding loans, so we don’t need to worry about that section, but just be aware that it might exist. There also may be instances where a company has a short term cash flow issue. This can occur when a huge production run may be needed prior to a big selling season. So, if Hupana needed to make 1000 pair of shoes in October for December sales, they may run short of operating cash due to needing to bring in raw materials, labor and the other manufacturing costs prior to receiving the income for the shoes.

When this happens, it is possible to take out what is called a working capital line of credit to cover those short term shortfalls of cash. These are typically very short term notes, where the money is used to pay expenses until the revenue comes from the sales and then immediately repaid. Unlike a mortgage or equipment loan with set monthly payments, these short term notes can be paid off quickly with large payments. They are helpful to even out cash flow.

So back to our cash budget. We are going to need a bunch of information from our previous work to complete this one! If you haven’t already, you might want to either print those prior budgets or have them pulled up in multiple tabs. It will make it much easier to find the information you need!

Practice Questions

Budgeted Income

“How much money will we make this year, if we meet all of our budgets?” asked your supervisor. Well, we still don’t have that number, even with all of the work we have done so far to create budgets for each area of our company. We do know that cash flow looks good, and it feels like we have our pricing and production in a good place. So you tell your supervisor, “Let me finish up a couple of things here, and I will get you that information. It looks like we are in for a good year though!” As your supervisor walks out of your office, you begin to compile all of the details needed to complete a budgeted income statement.

Ok, wow, we have all the information we need to see what our income statement will look like if how we have budgeted our income and expenses happens. This is kind of like the frosting on the cake! Seeing it all put together, and finding out if we have done a good job of costing our products.

So what numbers are we going to need off our other budgets?

Hupana Running Company Budgeted Income Statement
Sales $200,000
Cost of goods sold $52,000
Gross margin $148,000
Selling and administrative expenses $41,000
Net operating income $107,000
Interest expense $ -
Net income $107,000
*Cost of goods sold = 2000 pairs at #26 per pair (assuming same costs on the 100 beginning balance in inventory as this year's production costs

Did you print the budgets yet? If you did, let’s go back through and see where all of our numbers are coming from!

  • Sales: Sales Budget
  • Cost of Goods Sold: The beginning inventory of 100 pair (assuming a cost per pair of $26 each), plus 1900 produced this year at a cost of $26 per pair from our finished goods inventory budget unit production cost. So 2000 × $26 = $52,000

The gross margin is simply the difference between our sales and our cost of goods sold.

The selling and administrative expenses come off the budget of the same name. We subtract those from our gross margin to come to a net operating income.

If we would have needed to borrow money, we may have had interest expense! We had an awesome year at Hupana Running Company, so no loans needed!

Think about how this income statement might look different, if competition stepped in and we had to drop the cost of our shoes to $60 per pair?

Practice Questions

Budgeted Balance Sheet

Ok, one more piece of our puzzle to finish up! The balance sheet gives us a snapshot in time. In this case, a snapshot in our budgeted time. There are lots of pieces of the puzzle, so let’s take a few minutes to review:

One more reminder:
assets=liabilities+stockholder’s equity\text{assets}=\text{liabilities}+\text{stockholder's equity}

This accounting equation may come in handy as we work through this process.

If sales, costs and expenses all follow the budget, here is what our year end balance sheet will look like!

Hupana Running Company Budgeted Balance Sheet
Current Assets
Cash $112,275
Raw Materials Inventory $1,000
Finished Goods Inventory $3,825
Total Current Assets $117,050
Plant and Equipment
Land $25,000
Buildings and Equipment $50,000
Accumulated Depreciation $(4,000)
Plant and Equipment, Net $71,000
Total Assets $188,050
Liabilities and Owner's Equity
Current Liabilities
Accounts payable $ -
Stockholder's Equity
Common stock $50,000
Retained earning $138,050
Total stockholder's equity $188,050
Total liabilities and stockholder's equity $188,050
Note: We made some beginning balance assumptions here: the land and buildings were already there, along with the stock and a beginning retained earnings of $31,050.
So overall, Hupana Running Company is in great shape if the budget goes as planned. But, budgets don't always go as planned, so having a cash cushion is a great thing! They could have reduced sales, or price reductions and still be ok. They did a great job of creating a cushion, where if things happen, they will still be fine.

Most businesses make some changes during the year to the budget. The budget is a guide, and must be considered a fluid document, that can be changed as new information or situations occur.

Practice Questions

Licenses and Attributions