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Preparation Of Budgets; Master Budgets, Functional (Department Budgets, Cash Budgets), Proforma Financial Reports (Income Statements And Balance Sheets)

Master Budgets

All the functional division of the organization prepares the budget for the particular division. The master budget is the sum total of all the divisional budgets that is prepared by all the divisions. Further, it also includes the financial planning, cash-flow forecast and budgeted profit and loss account and balance sheet of the organization. It is the goal of the organization to reach a level in a particular period. Normally master budget is prepared for a year.

Sometimes, it may be misunderstood that master budget is one large budget of the organization. However, it is not the case. Master Budget is the summary of the divisional budget. It is a continuous financial plan.

 

Steps to Prepare Master BudgetSales Budget

The sales budget is the foundation of the master budget. All the procurements, staff requirements and administration cost are based on the sales. First and foremost, the number of units to be sold and price per unit are derived. On the basis of that, the value of sales is calculated. The sales budget is prepared based on considering the following factors:

• Market demand estimation
• Production capacity or an infrastructure facility
• Current supply facility
• Industry analysis

Market demand and production capacity are determined with the help of Marketing division and production division respectively.

 

Production Budget

The production budget is mainly based on the sales budget. However, following factors shall be considered;

• Inventory at the beginning of the year
• Inventory to be maintained at the end of the year
• Number of units manufactured
• Buffer stock to be maintained throughout the year

 

The production budget is divided into further three parts:

• Direct material budget
• Direct labor budget
• Manufacturing overhead budget

If the company is not having manufacturing unit, we require a number of units to purchase instead of the production budget.

 

Capital Asset Acquisition Budget

The plant, machinery, and equipment require periodical maintenance and replacement. If the sales target is higher than the previous period, new plant and machinery also need to be introduced.

Therefore, careful planning of the capital asset has to be done. A financial budget is an integral part of Master Budget.

 

Applications of Master Budget

a. Important Planning Tool

The master budget is considered one of the most important planning tools for an organization. While planning, top-level management discusses the overall profitability and the asset and liability position of the company. For which, the master budget is being used.

b. Measures Performance

Master budget measures the performance of the organization as a whole.  It helps in departmental control and setting in departmental accountability. It helps in improving the efficiency.

c. Interdivision Coordination:

The master budget is used for the interdivisional coordination amongst the divisions of the organization. It helps and ensures that coordination with the other divisions is properly made.

 

Advantages of Master Budget

 Motivation to Staff

The master budget serves as a motivation tool on the basis of which the employees can compare the actual performance with the budgeted performance. The Master Budget helps staff in getting job satisfaction as well as a good contribution to the growth of the business.

Summary of the Divisional Budget

Master budget works as a summary budget for the overview of the business owners and the management. The master budget indicates how much the organization is earning and what the expenses are incurred as a whole.

Planning in Advance

The master budget identifies the unusual problems in advance and fixes the same. For instance, one of the company divisions is not performing well and the expenses incurred are exceeding the set budget limit. This results in the lower profitability of the company.

Helps in the Achievement of Goal

The organization has short, medium and long-term goals. A master budget helps in achieving the long-term goal of the organization. All the resources of the organization are channelized and controlled for optimization of the profit.

Continuous Improvement

The master budget is a continuous process. Each year the organization prepares the master budget and it works as a tool of analytics. The variances are identified and the worked upon for better results on a continuous basis.

 

Disadvantages of Master Budget

Rigidity: Master budgets are typically prepared for a specific time period, such as a fiscal year, and are often fixed or static in nature. This rigidity can limit the organization’s ability to adapt to changing circumstances or unexpected events. If the business environment or operating conditions significantly deviate from what was originally anticipated, the master budget may become less relevant or less effective in guiding decision-making.

Time and Resource Intensive: Developing a comprehensive master budget requires significant time, effort, and resources. It involves collecting, analyzing, and synthesizing data from various departments or units within the organization. This process can be time-consuming and may divert attention and resources away from other important activities. Additionally, the need for coordination and collaboration among different stakeholders may create complexities and delays in the budgeting process.

Lack of Flexibility: Master budgets are typically prepared well in advance and are based on assumptions and forecasts. However, actual circumstances may differ from these projections. If there are significant deviations in sales volumes, production levels, or other key variables, the master budget may not accurately reflect the current situation. This lack of flexibility can make it challenging for managers to respond effectively to changing market conditions or unforeseen events.

Overemphasis on Financial Goals: Master budgets primarily focus on financial targets and objectives. While financial performance is important, an exclusive focus on financial metrics may overlook other crucial aspects of organizational performance, such as customer satisfaction, employee engagement, or innovation. Relying solely on a master budget to drive decision-making may lead to a narrow perspective and neglect other critical areas of the business.

Unrealistic Assumptions: Master budgets often require making assumptions about future market conditions, customer behavior, and competitive dynamics. These assumptions are based on forecasts and predictions, which can be subject to uncertainties and inaccuracies. If the assumptions underlying the master budget turn out to be unrealistic, it can undermine the effectiveness of the budget as a planning and control tool.

Limited Accountability: Since the master budget is a consolidated view of the organization’s financial plans, it may be challenging to attribute specific responsibilities and accountability to individual departments or managers. This lack of accountability can make it difficult to identify and address performance issues at the departmental or individual level.

Illustration

Mashauri limited operates a budget system. The following is the company’s profit forecast for a six month period ending 31 August 2019:

 

	March	April	May	June	July	August
	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’	Sh. ‘000’
Sales	440,000	460,000	420, 000	480, 000	440, 000	480, 000
Raw materials used	164, 000	152,000	166, 000	182, 000	106, 000	152,000
Rent	10, 000	10, 000	10, 000	10, 000	10, 000	10, 000
Wages	72, 000	64, 000	80, 000	88, 000	72, 000	72, 000
Factory expenses	14, 000	14, 000	14, 000	14, 000	14, 000	14, 000
Sales commission	16, 000	18, 000	20, 000	22, 000	26, 000	24, 000
Advertising expenses	24,000	28, 000	20, 000	32, 000	40, 000	44,000
Administration expenses	74, 000	78, 000	96, 000	70, 000	84, 000	94, 000
Depreciation	20, 000	20, 000	20, 000	20, 000	20, 000	20, 000
Provision for doubtful debts	8, 000	8, 000	10, 000	8, 000	8, 000	10, 000
Total expenses	402, 000	392,000	436,000	446,000	380,000	440,000
Net profit	38, 000	68, 000	(16, 000)	34, 000	60, 000	40, 000
Closing stocks of raw materials	150, 000	128, 000	112,000	164, 000	94, 000	118, 000

Additional information: 

1. The cash book showed an overdrawn balance of sh. 43,000,000 on 1 June 2019
2. Plant installation costs amounting to sh. 60,000,000 are due to in August 2019 while a loan repayment from a debtor of sh. 16,000,000 falls due in June 2019
3. Factory expenses are paid one month after they are incurred by the company
4. One eight of the wages amount is paid months in arrears
5. Three months’ rent is payable in advance on the first day of each quarter
6. Payment for raw materials is made two months after delivery
7. Two months credit is taken on advertising expense.
8. Administration expense are payable in the month in which they arise
9. A dividend and tax thereon will be paid in July 2019 amounting to sh. 50,000
10. Debtors are allowed three months credit
11. Sales commission is paid one month in arrears.

Required: 

1. Cash budget for the period between 1 June 2019 and 31 August 2019
2. State the control measures that the management should put in place in order to improve the cash position of the company.

 

Improving the cash position of a company is crucial for maintaining financial stability and ensuring ongoing operations. Here are eight control measures that management can implement to enhance the cash position:

1. Cash Flow Forecasting: Implement a robust cash flow forecasting system to accurately project cash inflows and outflows. This will help identify potential cash shortfalls or surpluses and enable proactive cash management.
2. Efficient Accounts Receivable Management: Implement effective credit policies and procedures to minimize overdue accounts and improve collections. Monitor customer payment trends, establish clear credit terms, and follow up promptly on overdue invoices to ensure timely cash inflows.
3. Streamlined Accounts Payable Processes: Optimize accounts payable processes to ensure timely payment of invoices while taking advantage of available payment terms. Negotiate favorable payment terms with suppliers and review expenses regularly to identify potential cost savings.
4. Tight Expense Control: Implement rigorous expense management practices to control costs and reduce unnecessary expenditures. Regularly review and analyze expenses to identify areas where cost reductions can be made without negatively impacting operations.
5. Working Capital Management: Monitor and manage working capital components, such as inventory levels, accounts receivable, and accounts payable, to optimize the cash conversion cycle. Strive to reduce inventory holding periods, improve collection times, and negotiate extended payment terms with suppliers.
6. Cash Flow Sensitivity Analysis: Perform sensitivity analysis to assess the impact of various scenarios on cash flow. This will help identify potential risks and enable proactive planning to mitigate cash flow fluctuations.
7. Capital Expenditure Control: Implement strict control measures for capital expenditures to ensure that investments align with strategic objectives and generate positive cash flows. Conduct thorough cost-benefit analyses before approving capital projects and monitor their progress to ensure they deliver the expected returns.
8. Cash Reserves and Contingency Planning: Maintain adequate cash reserves as a buffer for unforeseen events or emergencies. Develop contingency plans to address potential disruptions and establish a line of credit or alternative financing options to access additional funds if needed.

 

 

 

ii) How a Company can improve its cash balances

• Reducing the debts credit period
• Negotiating for longer credit period from creditors or suppliers
• Suspend capital expenditures
• Reduce level of stocks being held
• Paying expenses in arrears

 

Functional (Department Budgets, Cash Budgets) Cash Budget

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 lists all of the cash inflows, except for financing, expected during the budget period. Generally, the major source of receipts is from sales.

The disbursements section summarizes all cash payments that are planned for the budget period. These payments include raw materials purchases, direct labor payments, manufacturing overhead costs, and so on, as contained in their respective budgets.

Also, other cash disbursements such as equipment purchases and dividends are listed.

The budget is the forecast of expected cash receipts and cash disbursement during the budget period.

The importance of cash budget need not be overemphasized. Cash is the lifeblood of the business. Without sufficient cash, a business cannot be run smoothly.

 

Cash is required for the purchase of raw material, payment of wages and other expenses, acquisition of assets, fulfillment of commitment to investors and so on.

The preparation of functional budgets will be a useless job unless the requisite amount of cash is made available to implement them.

That is why; the cash budget has assumed enormous importance. It reflects possible receipts of cash from various sources and the expected requirement of cash for meeting various obligations.

In this way, it highlights well in advance neither the need for taking necessary measures to streamline the cash flows so that there is neither any cash shortage nor the surplus of cash.

A cash budget is prepared for the budget period, however, for effective cash management, it is generally divided monthly, weekly or even daily.

 

Purpose of Cash Budget

The principal purposes of the cash budget may be outlined as follows:

• It indicates the probable cash position as a result of planned operations.
• Indicates cash excess or shortages.
• It indicates the need to arrange for short-term borrowing, or the availability of idle cash for investment.
• It makes provision for the co-ordination of cash about (i) total working capital (ii) sales, (iii) investment, and debt.
• It establishes a sound basis for obtaining credit.
• It establishes a sound basis for current control of the cash position.

 

Difference Between Cash Budget and Cash Flow Statement

A cash flow analysis may be made based on past data or estimated data of a forthcoming period. When the cash flow analysis is done based on past data the statement of such analysis is usually called the cash flow statement.

 

The following are the various functional budgets,

Sales Budget: Sales figure is subject to market demand so it is mostly principal budget factor andhence sales budget is prepared before any other budget.

Expected sales demand (units) x selling price per unit

 

Factors must be considered in preparing the sales budget:

• The locality of the market i.e., domestic or export
• The target customers i.e., industry or trade or a section or group of general public etc.,
• The product portfolio i.e., the number of products offered and their popularity among the target customers.
• The market share of each product and its influence on the product portfolio and the total market
• The effectiveness of existing marketing policy on the current sales volume and value.
• The market share of competitor’s products and their effect on the company’s sales. Seasonal fluctuation in sales.
• Expenditure on advertisement and its impact on sales.

 

Illustration 1

Kikwetu Enterprises is a firm operating in the textile industry.

The budgeted sales for the fabric “S” for the month of August 2019 are 20,000 units at a selling price of Sh. 4,000 per unit. Additional information:

1. For the production of one unit of output of fabric “S”, the following two components of inputs are used:

Component	Number of units	Cost per component Sh.
A	10	40
B	6	20

2. Stocks at the beginning of August 2006 are budgeted as:

8,000 units of finished products at Sh2,100 per unit

Components: A – 32,000 units at Sh.40 per unit

B – 19,200  units at Sh.20 per unit

3. Production of each unit of fabric “S” requires the following labour hours

Department	Hours per unit	Labour rate per hour Sh.
Production	8	200
finishing	4	180

4. Factory overheads absorbed into unit cost on the basis of direct labour hours. The budgeted factory overheads for the month are given as Sh.3840, 000.
5. The administration, selling and distribution overheads for given month are budgeted at Sh.11,000,000.
6. The company plans a reduction on 50% in quantity of finished stock at the end of the month and decrease of 25% in the quantity of each input component.

Required:

• For the month of August 2019

(i).      Production quantity budget.

(ii).           Material usage budget

(iii).       Material purchase budget

(iv).          Direct labour cost budget.

• A budgeted profit and loss account

 

Production Budget: Production budget is prepared based on sales budget. But if production capacity is principal budgeting factor then production budget factor is prepared first. To find out whether production is principal budget factor consider the following:

• Availability of materials
• Availability of labour
• Machine capacity

Budgeted sales units + Closing stock – Opening stock Material Budget: Material budget are of two types:

Material usage budget:

=Budgeted number of units for production x material quantity required per unit

Material purchase budget; it equals to

=Material usage budget + Closing inventory of material – Opening inventory of material Labour budget: Labour budget is calculated simply by multiplying number of hours required forproduction to labour rate per hour.

Budgeted labour hours = budgeted production units x standard hours per unit Budgeted labour cost = Budgeted labour hours x standard hourly rate

Labour budget based on standard hour

Productivity is often described in terms of standard hour. A standard hour describes the amount of work that is achievable at standard efficiency level. This concept is particularly useful when dissimilar units are being produced in a factory and management is interested to determine the production level of each product.

If there is a shortfall of labour hours, management can take a number of steps to address the problem: ▪     Recruit more workers

• Offer better overtime rates
• Offer incentives for labour force for achieving production targets
• Address the causes of scrap output
• Reduce closing inventory requirement

Production overheads budget: Unlike non-production overheads budget for production overheadscan be set quite comfortably as production overheads are directly related to production. Non-production overheads: As non-production overheads are not related to production but ratherfixed in nature like administration overheads and research overheads. Fixed costs can be predicted in advance but the costs that incur subject to management decisions are harder to predict at the start of the period.

Factors to be considered in Production Budget:

1. Production plan:-

Production planning is an important part of the preparation of the production budget. Optimum utilisation of plant capacity is taken by eliminating or reducing the limiting factors and thereby effective production planning is made.

1. The capacity of the business concern:-
2. It is to be ensured that the capacity of the organisation will coincide the budgeted production or not. For this purpose, plant utilisation budget will also be necessary. The production budget must be based on normal capacity likely to be achieved and it should not be too high or too low.
3. Inventory Policy:-
4. While preparing the production budget it is also necessary to see to what extent materials are available for producing the budgeted production. For that purpose, a purchase budget or a purchase plan must also be studied. Similarly, on the other hand, it is also necessary to verify the extent to which the inventory of finished goods is to be carried.
5. Sales budgets must also be considered before preparing production budget because it may so happen that the entire production of the concern may not be sold. In such a case the production budget must be in line with the sales budget.
6. A plan of the sequence of operations of production for effective preparation of a production budget should always be there.
7. Last, but not the least, the policy of the management should also be considered before preparing the production budget.

Objectives and Advantages of Production budget:

• Optimum utilisation of the productive resources of the organisation;
• Maintaining low inventory which results in risk of deterioration and fall in prices;
• Focus on the factors that are necessary to frame policies and plan sequence of operations;
• Projection of policies framed, on the basis of past performance, into the future to get the desired results;
• Helps in scheduling of production so that delivery dates are met and customer satisfaction is gained;
• Helpful in preparation of projected profit and loss statement, which is useful in evaluation of performance and profitability.

 

Proforma Financial Reports (Income Statements And Balance Sheets)

Proforma financial reports, including income statements and balance sheets, are financial statements that provide a projected or estimated view of a company’s financial performance and position. They are typically prepared based on assumptions, forecasts, and future expectations. Proforma financial reports are useful for evaluating the potential impact of certain decisions, scenarios, or changes in the business environment.

Key points about Proforma Financial Reports (Income Statements and Balance Sheets):

Purpose: Proforma financial reports are prepared to assess the financial implications of future events, decisions, or changes. They provide a forward-looking view of the company’s financial performance and position.

Assumptions: Proforma financial reports rely on assumptions about future revenues, expenses, assets, liabilities, and other financial variables. These assumptions are typically based on historical data, market trends, industry analysis, and management’s expectations.

Projection Period: Proforma financial reports can cover different time periods depending on the specific purpose. They can be short-term projections, such as quarterly or annual forecasts, or long-term projections spanning multiple years.

Income Statement: The proforma income statement estimates future revenues, expenses, and profits or losses. It provides insights into the company’s expected profitability and helps assess the impact of changes in pricing, sales volume, cost structure, or other factors.

Balance Sheet: The proforma balance sheet estimates the company’s assets, liabilities, and equity at a specific point in the future. It provides a snapshot of the company’s projected financial position, including its liquidity, solvency, and overall financial health.

Scenario Analysis: Proforma financial reports can be used for scenario analysis, where different assumptions or variables are tested to evaluate their impact on financial outcomes. This allows management to assess the potential risks and opportunities associated with different courses of action.

Illustration:

Let’s consider an example of a retail company that is considering expanding its operations to a new market. The management wants to assess the financial feasibility of this expansion. They prepare a proforma financial report to estimate the potential impact on the company’s income statement and balance sheet.

The proforma income statement includes projected revenues from the new market, estimated costs of operations, and expected profits. It considers factors such as sales volume, pricing strategy, marketing expenses, and operating costs specific to the expansion. The proforma income statement helps the management evaluate the profitability of the expansion and make informed decisions.

The proforma balance sheet includes estimates of additional assets required for the expansion, such as inventory, equipment, and working capital. It also considers potential liabilities, such as loans or credit lines for funding the expansion. The proforma balance sheet provides insights into the company’s projected financial position, liquidity, and leverage after the expansion.

By analyzing the proforma financial reports, the management can determine whether the expansion is financially viable, understand the potential impact on cash flows and profitability, and assess the risks and rewards associated with the decision.

Purpose Of Budgetary Control; Operation Of A Budgetary Control System, Organisation And Coordination Of The Budgeting Function

Purpose Of Budgetary Control

Budgetary control is the process by which budgets are prepared for the future period and are compared with the actual performance for finding out variances, if any. The comparison of budgeted figures with actual figures will help the management to find out variances and take corrective actions without any delay.

Objectives of Budgetary Control

The main objectives of budgetary control are given below:

1. Defining the objectives of the enterprise.
2. Providing plans for achieving the objectives so defined.
3. Coordinating the activities of various departments.
4. Operating various departments and cost centres economically and efficiently.
5. Increasing the profitability by eliminating waste.
6. Centralizing the control system.
7. Correcting variances from sit standards.
8. Fixing the responsibility of various individuals in the enterprise.

Advantages of Budgetary Control

Budgetary control has become an important tool of an organization to control costs and to maximize profits. Some of the advantages of budgetary control are:

1. It defines the goals, plans and policies of the enterprise. If there is no definite aim then the efforts will be wasted in achieving some other aims.
2. Budgetary control fixes targets. Each and every department is forced to work efficiently to reach the target. Thus, it is an effective method of controlling the activities of various departments of a business unit.
3. It secures better co-ordination among various departments.
4. In case the performance is below expectation, budgetary control helps the management in finding up the responsibility.
5. It helps in reducing the cost of production by eliminating the wasteful expenditure.
6. By promoting cost consciousness among the employees, budgetary control brings in efficiency and economy.
7. Budgetary control facilitates centralized control with decentralized activity.
8. As everything is planned and provided in advance, it helps in smooth running of business enterprise.
9. It tells the management as to where action is required for solving problems without delay.

Disadvantages or Limitations of Budgetary Control The following are the limitations of budgetary control:

1. It is really difficult to prepare the budgets accurately under inflationary conditions.
2. Budget involves a heavy expenditure which small business concerns cannot afford.
3. Budgets are prepared for the future period which is always uncertain. In future, conditions may change which will upset the budgets. Thus, future uncertainties minimize the utility of budgetary control system.
4. Budgetary control is only a management tool. It cannot replace management in decision-making because it is not a substitute for management.
5. The success of budgetary control depends upon the support of the top management. If there is lack of support from top management, then this will fail.

Budgetary control is the use of budgets and budgeting reports throughout the period to coordinate evaluate and control day-to-day operations in accordance with the goals specified by the budget.

Organisation And Coordination Of The Budgeting Function

Coordination involves obtaining and organizing the needed personnel, equipment, and materials to carry out the business. A budget aids in coordination between separate activity units to ensure that all parts of the company are in balance with each other and know how they fit in. It discloses weaknesses in the organizational structure. The budget communicates to staff what is expected of them. It allows for a consensus of ideas, strategies, and direction.