Chapter 22 Master Budgets

Chapter 22 Master Budgets

© 2016 Pearson Education, Inc.
Learning Objectives Describe budgeting objectives, benefits, and procedures and how human behavior influences budgeting Define budget types and the components of the master budget © 2016 Pearson Education, Inc.

Learning Objectives Prepare an operating budget for a manufacturing company Prepare a financial budget for a manufacturing company Describe how information technology can be used in the budgeting process © 2016 Pearson Education, Inc.

Why Do Managers Use Budgets?
A budget is a financial plan that managers use to coordinate a business’s activities. Managers use budgets to: Develop strategies. Plan and budget for specific actions to achieve goals. Implement the plan. Take corrective action. A budget is a financial plan that managers use to coordinate a business’s activities. Managers use budgets in fulfilling their major responsibilities. First, they develop strategies—overall business goals, such as a goal to expand international operations or a goal to be a value leader in one market while diversifying into markets. Companies then plan for specific actions to achieve those goals. The next step is to act—to carry out the plans. After acting, managers compare actual results with the budget and use the information to make control decisions. The feedback allows them to determine what, if any, corrective action to take. © 2016 Pearson Education, Inc.

Budgeting Objectives After acting, managers compare actual results with the budget and use the information to make control decisions. The feedback allows them to determine what, if any, corrective action to take. If, for example, the company spent more than expected in one area of operations, managers must cut other costs or increase revenues. These decisions then affect the company’s future strategies and plans. Notice that the process is a loop: The control step is not an end but an input into the develop strategies step. Successful companies use current period results to help make decisions regarding the company’s future. © 2016 Pearson Education, Inc.

Budgeting Objectives Budgeting requires managers to plan for the company’s future. The budget coordinates a company’s activities. A budget provides a benchmark that motivates employees and helps managers evaluate performance. One benefit of budgeting is that it requires managers to plan for the company’s future. Decisions are then based on this formalized plan, which helps prevent haphazard decision making. Keep in mind, however, that budgets are plans for future activities and may need to be modified. Another benefit is that a budget coordinates a company’s activities. Creating a budget facilitates coordination and communication by requiring managers at different levels and in different functions across the entire value chain to work together to make a single, unified, comprehensive plan for the business. A third benefit is that budgets provide a benchmark that motivates employees and helps managers evaluate performance. In most companies, part of the manager’s performance evaluation depends on how actual results compare to the budget. This can be done through a performance report. © 2016 Pearson Education, Inc.

Benchmarking Exhibit 22-2 illustrates a performance report for a service company. This report identifies variances—the areas where the actual results differed from the budget. Looking at the report, we see that actual Service Revenue account was $11,000 less than budgeted. This was caused by two factors. The company was able to sell at a higher average price per service. The actual price per service is calculated as $31 per service, or $589,000 divided by 19,000 services, whereas the planned price was $30 per service, or $600,000 divided by 20,000 services. However, the company sold 1,000 fewer services than it planned to sell (19,000 actual services less 20,000 budgeted services). The increase in price per service was not enough to make up for the decrease in the number of services sold. Variable expenses were less than budgeted for both Server Space Expense and Advertising Expense, which creates a favorable variance. Actual Server Space Expense was less than budgeted Server Space Expense because the company sold 1,000 fewer services and because the company reduced the Server Space Expense per service from $2.25 per budgeted service ($45,000 / 20,000 services) to $2.00 per actual service ($38,000 / 19,000 services). Commission Expense remained constant at 5% of revenues, but due to the $11,000 reduction in revenues, Commission Expense was $550 less ($11,000 × 5%). Actual fixed expenses were exactly the same as budgeted fixed expenses. Considering this company’s fixed expenses, one wouldn’t expect these to change unless the company changed the pay rate or number of employees or unless the company negotiated a new contract with its Internet service provider. © 2016 Pearson Education, Inc.

Budgeting Procedures Budgeting procedures vary from company to company. Budgeting should include input from all levels within the organization. Budgeting usually begins several months before the beginning of the budget period. The budgeting process varies from company to company. For a small company, the process may be relatively simple and somewhat informal. In larger companies, however, the process can be very complex, with a budget committee coordinating the process. To achieve the benefit of motivating employees, the budget should include input from all levels. This requires significant coordination among the company’s various business segments. Therefore, the budgeting process usually begins several months before the beginning of the budget period. © 2016 Pearson Education, Inc.

Budgeting and Human Behavior
Managers must: Support the budget Show employees how budgets can help them achieve better results Require that employees participate in developing the budget Budgetary games: Budgetary slack occurs when managers intentionally understate expected revenues or overstate expected expenses. Spend it or lose it. The most important part of a budgeting system is getting managers and employees to accept the budget so the company can reap the planning, coordination, and control benefits illustrated in Exhibit If managers use the budget as a benchmark to evaluate employees’ performance, managers must first motivate employees to accept the budget’s goals. Managers must support the budget themselves, or no one else will. Managers must show employees how budgets can help them achieve better results. Managers must have employees participate in developing the budget so that employees feel the goals are realistic and achievable. Managers’ performance is also evaluated by comparing actual results to the budget. When they develop the company’s budget, they may be tempted to participate in budgetary “gaming” and build in budgetary slack. Budgetary slack occurs when managers intentionally understate expected revenues or overstate expected expenses. This increases the chance that actual performance will be better than the budget and that they will receive a good evaluation. But adding slack into the budget makes it less accurate and less useful for planning and control. Another budgetary game is referred to as “spend it or lose it.” In many companies, if a business segment has a budgeted expense item and does not spend as much as expected for the item, there is a fear the budgeted item will have a lower amount in future budget periods. © 2016 Pearson Education, Inc.

Are There Different Types of Budgets?
Strategic budget Long-term financial plan Long-term goals Operating budget Short-term financial plan Short-term goals There are many different purposes for budgeting; therefore, there are many different types of budgets. The term strategic generally indicates a long-term goal. A company will develop strategies such as becoming the cost leader in a particular market or expanding into international markets. A strategic budget is a long-term financial plan used to coordinate the activities needed to achieve the long-term goals of the company. Strategic budgets often span 3 to 10 years. Because of their longevity, they often are not as detailed as budgets for shorter periods. The term operational generally indicates a short-term goal. After the company develops strategies and creates a strategic budget, the next step is to plan for shorter periods. An operational budget is a short-term financial plan used to coordinate the activities needed to achieve the short-term goals of the company. Operational budgets are most often one year in length but may also span only a week, a month, or a quarter, depending on the company’s needs. Operational budgets are generally much more detailed than strategic budgets. © 2016 Pearson Education, Inc.

Static and Flexible Budgets
A static budget is a budget prepared for only one level of sales volume. A flexible budget is a budget prepared for various levels of sales volume. A static budget is a budget prepared for only one level of sales volume. For example, Smart Touch Learning, the fictitious company we have used to illustrate accounting concepts throughout the textbook, may prepare a budget based on annual sales of 2,000 touch screen tablet computers. All revenue and expense calculations would be based on sales of 2,000 tablets. A flexible budget is a budget prepared for various levels of sales volume. This type of budget is useful for what if analysis. Smart Touch Learning may expect to sell 2,000 tablet computers, but a flexible budget showing results for selling 1,600 tablets, 1,800 tablets, 2,000 tablets, 2,200 tablets, and 2,400 tablets allows managers to plan for various sales levels. Flexible budgets are covered in detail in the next chapter. © 2016 Pearson Education, Inc.

Master Budgets The master budget is the set of budgeted financial statements and supporting schedules for the entire organization. The capital expenditures budget presents the company’s plan for purchasing long-term assets. A financial budget includes the cash budget and the budgeted financial statements. The cash budget details how the business expects to go from the beginning cash balance to the ending cash balances. The master budget is the set of budgeted financial statements and supporting schedules for the entire organization; it includes the operating budget, capital expenditures budget, and financial budget. Budgeted financial statements are financial statements based on budgeted amounts rather than actual amounts. The master budget is operational and static. The operating budget is the set of budgets that projects sales revenue, cost of goods sold, and selling and administrative expenses, all of which feed into the cash budget and then the budgeted financial statements. The first component of the operating budget is the sales budget, the cornerstone of the master budget. Why? Because sales affect most other components of the master budget. The capital expenditures budget is the budget that presents the company’s plan for purchasing property, plant, equipment, and other long-term assets. Another type of budget is the financial budget. The financial budget includes the cash budget and the budgeted financial statements. The cash budget details how the business expects to go from the beginning cash balance to the desired ending cash balance. These budgeted financial statements look exactly like ordinary financial statements. The only difference is that they list budgeted (projected) amounts rather than actual amounts. © 2016 Pearson Education, Inc.

Master Budgets Exhibit 22-3 shows the order in which managers prepare the components of the master budget for a manufacturing company such as Smart Touch Learning. The exhibit shows that the master budget includes three types of budgets: • The operating budget • The capital expenditures budget • The financial budget © 2016 Pearson Education, Inc.

How Are Operating Budgets Prepared for a Manufacturing Company?
The master budget includes the following budgets: Sales budget Production budget Direct materials budget Direct labor budget Manufacturing overhead budget Cost of goods sold budget Selling and administrative budget The budgeting process starts by completing the sales budget. All other budgets stem from the estimated number of units expected to be sold. © 2016 Pearson Education, Inc.

How Are Operating Budgets Prepared for a Manufacturing Company?
To illustrate the preparation of the master budget, we use Smart Touch Learning. As you recall, the company manufactures its own brand of touch screen tablet computers that are preloaded with the company’s e-learning software. The master budget is for 2019, prepared by quarter. The balance sheet for December 31, 2018, as shown in Exhibit 22-4, provides some of the data we use in preparing the master budget. © 2016 Pearson Education, Inc.

Sales Budget The forecast of sales revenue is the cornerstone of the master budget. The first step in preparing the master budget is the sales budget. The forecast of sales revenue is the cornerstone of the master budget because the level of sales affects expenses and almost all other elements of the master budget. Budgeted total sales for each product equals the sales price multiplied by the expected number of units sold. The sales and marketing teams at Smart Touch Learning project that the company will sell 500 tablet computers in the first quarter of 2019, with sales increasing by 50 tablets each quarter. The tablets sell for $500 each. Exhibit 22-5 shows the sales budget for Smart Touch Learning for Budgeted total sales for each product equals the sales price multiplied by the expected number of units sold. The total sales for the year will be carried to the budgeted income statement. The quantity of products sold is also important so that Smart Touch Learning can determine production needs for the future. © 2016 Pearson Education, Inc.

Production Budget The production budget is the basis for product costs budgets, direct materials budget, direct labor budgets, and manufacturing overhead budgets. The production budget determines the number of tablets to be produced during the year and is the basis for the production costs budgets: direct materials budget, direct labor budget, and manufacturing overhead budget. In addition, the information is used to complete the cost of goods sold budget. To calculate the number of tablets to be produced, start with the number of tablets projected to be sold. Add to this amount the desired number of tablets for ending Finished Goods Inventory to calculate the total number of tablets needed. Keep in mind that Smart Touch Learning does not want to end the period with zero inventory; it wants to have enough tablets on hand to begin the next period. The company should have the minimum amount of inventory to be sure the company balances providing goods to customers with turning over the inventory efficiently. Keeping inventory at the minimum level that meets these needs helps reduce inventory storage costs, insurance costs, and warehousing costs, and it reduces the potential for inventory to become obsolete. After determining the number of tablets needed, subtract the number of tablets already on hand in beginning Finished Goods Inventory. The difference is the number of tablets to be produced. © 2016 Pearson Education, Inc.

Production Budget Exhibit 22-6 illustrates the production budget for Smart Touch Learning. Note that one period’s ending inventory becomes the next period’s beginning inventory. © 2016 Pearson Education, Inc.

Direct Materials Budget
After completing the production budget, Smart Touch Learning needs to determine the product costs for the tablets. Smart Touch Learning has determined the number of tablets to be produced each quarter. The next step is to determine the production costs for the tablets, beginning with direct materials costs. The purchasing department has projected that the cost of direct materials is $150 per unit. The company now needs to determine the amount of materials to purchase each quarter. The amount of indirect materials needed for the production of tablet computers has been determined to be insignificant and will therefore not be considered in the calculation. This means that the amount of materials in the Raw Materials Inventory account is assumed to be only direct materials. Just as the Finished Goods Inventory account must be considered when calculating the number of tablets to produce, the Raw Materials Inventory account must be considered when calculating the amount of materials to be purchased. The number of units to be produced is multiplied by the direct materials cost per unit to determine the direct materials needed for production. Direct materials needed for production plus the desired ending inventory gives us the total direct materials needed. By then subtracting the direct materials in ending inventory, we arrive at the budgeted purchases of direct materials. © 2016 Pearson Education, Inc.

Direct Materials Budget
Exhibit 22-7 illustrates the direct materials budget for Smart Touch Learning. Note that the purchasing department has projected the cost of direct materials to be $150 per unit, which is used to determine the cost of the direct materials needed for production. As with the production budget, note that one period’s ending inventory becomes the next period’s beginning inventory. © 2016 Pearson Education, Inc.

Direct Labor Budget Exhibit 22-8 shows the direct labor budget for Smart Touch Learning for To calculate the direct labor cost, multiply the number of tablets to be produced by the number of projected direct labor hours. Then multiply that total by the average direct cost per hour. The personnel manager for Smart Touch Learning projects direct labor cost at $25 per hour. © 2016 Pearson Education, Inc.

Manufacturing Overhead Budget
The predetermined overhead allocation rate is used to allocate the indirect overhead costs to the tablets produced by Smart Touch Learning. As a reminder, the formula to calculate the predetermined overhead allocation rate is calculated as Total estimated overhead costs / Total estimated quantity of the overhead allocation base. © 2016 Pearson Education, Inc.

Manufacturing Overhead Budget
Exhibit 22-9 shows the manufacturing overhead budget for Smart Touch Learning for 2019. © 2016 Pearson Education, Inc.

Cost of Goods Sold Budget
The cost of goods sold budget for Smart Touch Learning for 2019 is shown in Exhibit Smart Touch Learning uses the first-in, first-out (FIFO) inventory costing method. The production budget illustrated in Exhibit 22-6 shows that the company starts 2019 with 200 tablets in Finished Goods Inventory, and the balance sheet in Exhibit 22-4 shows that beginning Finished Goods Inventory has a total cost of $55,000, which is $275 per tablet. All other tablets sold in 2019 will assume the budgeted production cost of $294 per tablet, as calculated above. Referring to the sales budget in Exhibit 22-5, the company projected sales of 500 tablets in the first quarter. Therefore, using FIFO, 200 tablets will be assigned the beginning inventory costs of $55,000, and the remaining 300 tablets will be assigned the cost of $294 per tablet. © 2016 Pearson Education, Inc.

Selling and Administrative Expense Budget
The completed selling and administrative expense budget for Smart Touch Learning for 2019 is shown in Exhibit Cost behavior is also considered for this budget, with costs designated as variable or fixed. © 2016 Pearson Education, Inc.

How Are Financial Budgets Prepared for a Manufacturing Company?
The financial budgets include the cash budget and the budgeted financial statements: Budgeted income statement Budgeted balance sheet Budgeted statement of cash flows The financial budgets include the cash budget and the budgeted financial statements: budgeted income statement, budgeted balance sheet, and budgeted statement of cash flows. However, before we begin the cash budget, we have to complete the capital expenditures budget. © 2016 Pearson Education, Inc.

Capital Expenditures Budget
The purchase of long-term assets is part of a strategic plan. Capital expenditures are purchases of long-term assets, such as: Delivery trucks Computer systems Office furniture Manufacturing equipment Capital expenditures are purchases of long-term assets, such as delivery trucks, computer systems, office furniture, and manufacturing equipment. The decision to purchase these expensive, long-term assets is part of a strategic plan, and this decision-making process is covered in detail in a later chapter. For now, we will assume Smart Touch Learning plans to purchase additional manufacturing equipment on January 2, The equipment will cost $160,000 and will be paid in two equal installments during the first and second quarters of The installment payments will be included in the cash budget. © 2016 Pearson Education, Inc.

Cash Budget The cash budget pulls information from the other budgets previously prepared. The cash budget has three sections: Cash receipts Cash payments Short-term financing The cash budget pulls information from the other budgets previously prepared and has three sections: cash receipts, cash payments, and short-term financing. © 2016 Pearson Education, Inc.

Cash Receipts Cash receipts result from cash received from customers. Exhibit shows the calculations for cash receipts from customers. Smart Touch Learning projects that 30% of the sales will be cash sales, which indicates cash will be collected immediately. The remaining 70% of the sales are expected to be on account. The company expects to collect 60% of the credit sales in the quarter of the sale and 40% in the quarter following the sale. The balance sheet for December 31, 2018, shows Accounts Receivable has a balance of $70,000, and this amount is expected to be collected in the first quarter of The total cash receipts from customers for each quarter will be carried to the cash budget. © 2016 Pearson Education, Inc.

Cash Payments Capital expenditures Product costs: Direct materials purchases Direct labor costs Manufacturing overhead costs Selling and administrative expenses Smart Touch Learning has cash payments for capital expenditures, product costs (direct materials purchases, direct labor costs, and manufacturing overhead costs), and selling and administrative expenses. Therefore, the calculations for cash payments require reference to several previously developed budgets. © 2016 Pearson Education, Inc.

Short-Term Financing Exhibit shows the calculations for cash payments. The calculation of cash payments for direct materials uses information from the direct materials budget shown in Exhibit Reference to the December 31, 2018, balance sheet shown in Exhibit 22-4 indicates Accounts Payable has a balance of $20,000. This amount will be paid in the first quarter of 2019. The information for cash payments for direct labor comes from Exhibit Smart Touch Learning pays direct labor costs in the quarter incurred. The information for cash payments for manufacturing overhead comes from Exhibit Smart Touch Learning makes cash payments for these costs in the quarter incurred. Keep in mind that we are calculating cash payments. Therefore, non-cash expenses are not included in the cash budget. The most common non-cash expense is depreciation. Remember that deprecation is the allocation of an asset’s cost to an expense account over the life of the asset. The cash outflow for long-term assets, such as manufacturing equipment, is at the time of purchase. We use Exhibit to determine the cash payments for selling and administrative expenses, which Smart Touch Learning pays in the quarter incurred. Cash payments for capital expenditures include the manufacturing equipment purchased on January 2, 2019, for $160,000 that will be paid in two $80,000 installments in the first and second quarters of Note that the total cash payments for each quarter will be carried to the cash budget. The December 31, 2019, balance in Accounts Payable will be carried to the budgeted balance sheet. © 2016 Pearson Education, Inc.

Short-Term Financing The December 31, 2018, balance sheet shown in Exhibit 22-4 shows Cash has a balance of $15,000. Smart Touch Learning’s financial accountant recommends maintaining a larger cash balance in the future. The recommended minimum cash balance for 2019 is $30,000. The company has arranged short-term financing through a local bank. The company borrows cash as needed at the beginning of each quarter, in increments of $1,000, in order to maintain the minimum cash balance. Interest is paid on any outstanding principal balance at the beginning of the following quarter at 3% per quarter. Repayments on the principal balance are also made at the beginning of the quarter, in increments of $1,000, as cash is available. Now that we have compiled the information needed for cash receipts and cash payments, let’s insert those amounts into the cash budget so we can determine the amount of short-term financing needed during Exhibit shows the partially completed cash budget for 2019. Notice that the cash payment for interest expense for the first quarter is $0. The December 31, 2018, balance sheet from Exhibit 22-5 does not show Notes Payable or Interest Payable as liabilities. Therefore, no interest is owed at the beginning of the first quarter of Exhibit shows a cash balance before financing of negative $15,715, which is the cash available of $265,000 less the cash payments of $280,715. This amount is less than the minimum cash balance desired and creates a cash deficiency of $45,715. © 2016 Pearson Education, Inc.

Short-Term Financing The ending cash balance for the first quarter, then, becomes the beginning cash balance for the second quarter. Because the projected cash balance is a deficiency, Smart Touch Learning financed $46,000 so that the ending cash balance is at least the $30,000 minimum cash balance. Exhibit shows the cash budget completed for the second quarter. © 2016 Pearson Education, Inc.

Short-Term Financing When the interest payment is recorded for the second quarter, it is determined that Smart Touch Learning again has a cash deficiency and must borrow funds to maintain the minimum cash balance of $30,000. Carefully examine Exhibit 22-16, which shows the first and second quarters after financing and the third quarter before financing. © 2016 Pearson Education, Inc.

Short-Term Financing After the third quarter interest payment is calculated and the ending cash balance before financing is determined, Smart Touch Learning shows a projected cash excess for the third quarter, as shown in Exhibit The cash excess can be used to repay a portion of the amount previously borrowed, again in increments of $1,000. Exhibit shows the completed cash budget. Note that the principal repayment in the fourth quarter is only $41,000, even though the company has $60,590 in excess cash. At the beginning of the fourth quarter, the balance on the note is $41,000, which is the total of the amounts borrowed in the first and second quarters less the repayment made in the third quarter ($46,000 + $42,000 ‒ $47,000). Smart Touch Learning will only repay what has been borrowed and now has excess cash to be used for other purposes. Also, pay special attention to the Total column of the cash budget. You cannot simply add across each row to determine these amounts because this is a summary for the entire year. For example, the beginning cash balance for the year is the same as the beginning cash balance for the first quarter, but not the sum of the beginning balances for each quarter. The budgeted financial statements are the next step in the budgeting process, and the cash budget provides several amounts needed. The interest expense calculations are carried to the budgeted income statement, and the ending cash balance is carried to the budgeted balance sheet. Smart Touch Learning repaid all amounts borrowed during the year. If those amounts had not been repaid in full, the balance would be carried to the budgeted balance sheet as the balance for Notes Payable. © 2016 Pearson Education, Inc.

Budgeted Income Statement
Below is a summary of the sources used to calculate the budgeted income statement. Smart Touch Learning has now determined all amounts needed to calculate the budgeted net income for Be sure not to confuse revenues earned with cash received from customers or expenses incurred with cash payments. The accrual-based income statement reports revenues earned and expenses incurred. The statement of cash flows reports cash receipts and cash payments. © 2016 Pearson Education, Inc.

Budgeted Balance Sheet
The budgeted balance sheet for Smart Touch Learning for December 31, 2019, pulls amounts from the various budgets previously completed. One remaining calculation is for Retained Earnings. Retained Earnings is increased by the amount of net income earned and decreased by the amount of dividends declared. The net income is shown in Exhibit 22-18, and the company does not project dividends for the year. A summary of the sources for the balance sheet figures is in the slide. Take the time to look at each exhibit referenced to ensure you know where each figure came from. © 2016 Pearson Education, Inc.

Budgeted Statement of Cash Flows
The last step in the preparation of the master budget is the budgeted statement of cash flows. The information comes from the cash budget, illustrated in Exhibit All cash receipts and disbursements are designated as operating activities, investing activities, or financing activities. The direct method is used and illustrated in Exhibit © 2016 Pearson Education, Inc.

How Can Information Technology Be Used in the Budgeting Process?
To conduct sensitivity analysis To combine individual unit budgets to create the companywide master budget Exhibits 22-5 through show that managers must prepare many calculations to develop the master budget for a small company such as Smart Touch Learning. Technology makes it more cost-effective for managers to conduct sensitivity analysis and combine individual unit budgets to create the companywide master budget. The master budget models the company’s planned activities. Actual results, however, often differ from plans. Management, therefore, wants to know how budgeted income and cash flows would change if key assumptions turned out to be incorrect. We previously defined sensitivity analysis as a what-if technique that asks what a result will be if a predicted amount is not achieved or if an underlying assumption changes. Many companies use computer spreadsheet programs like Excel to prepare master budget schedules and statements. Today, what if budget questions are easily answered using a few keystrokes in Excel. Companies with multiple business segments must combine the budget data from each of the segments to prepare the companywide budgeted financial statements. This process can be difficult for companies whose business segments use different spreadsheets to prepare the budgets. Software also allows managers to conduct sensitivity analyses on data from their own segments. When a manager is satisfied with his or her budget, he or she can easily enter it in the companywide budget. His or her segment’s budget automatically integrates with budgets from all other business segments—from around the building, around the state, around the country, or around the world. © 2016 Pearson Education, Inc.

How Are Operating Budgets Prepared for a Merchandising Company?
So far, this chapter has illustrated the preparation of the master budget for a manufacturing company. Appendix 22A illustrates the process for a merchandising company. Many of the calculations and budgets are the same, but in some ways, completing the master budget for a merchandising company is easier. Merchandising companies purchase the products they sell rather than manufacture them. Therefore, the inventory, purchases, and cost of goods sold budget replaces the production budget, direct materials budget, direct labor budget, manufacturing overhead budget, and cost of goods sold budget. Exhibit 22A-1 shows the master budget components for a merchandising company. © 2016 Pearson Education, Inc.

Sales Budget We will use Greg’s Games, a fictitious company, to illustrate the preparation of the master budget. Greg’s Games is a retail chain store that carries a complete line of music CDs and DVDs. We will prepare the master budget for one of the stores in the chain for April, May, June, and July—the main selling season. Exhibit 22A-2 shows the balance sheet for Greg’s Games for March 31, The balance sheet provides some of the data that we use in preparing the master budget. © 2016 Pearson Education, Inc.

Sales Budget In a merchandising company, just as with a manufacturing company, the forecast of sales revenue is the cornerstone of the master budget because the level of sales affects expenses and almost all other elements of the master budget. Budgeted total sales for each product equals the sales price multiplied by the expected number of units sold. Sales in March were $40,000. Projected sales are given for April through August. Sales are 60% cash and 40% on account. Greg’s Games collects all credit sales the month after the sale. The $16,000 balance in Accounts Receivable at March 31, 2018, is March’s sales on account, or 40% of $40,000. There are no other Accounts Receivable. Uncollectible accounts are immaterial and thus aren’t included in the master budget. Exhibit 22A-3 shows the sales budget for Greg’s Games for the four months. The April through July total budgeted sales of $240,000 is carried to the budgeted income statement. © 2016 Pearson Education, Inc.

Inventory, Purchases, and Cost of Goods Sold Budget
The cost of goods sold computation shows the relationship between inventory, purchases, and ending inventory: The equation can be rearranged to find the amount of purchases required: The inventory, purchases, and cost of goods sold budget determines cost of goods sold for the budgeted income statement, ending Merchandise Inventory for the budged balance sheet, and merchandise inventory purchases for the cash budget. After the sales budget, we next need to prepare the inventory, purchases, and cost of goods sold budget. This budget determines cost of goods sold for the budgeted income statement, ending merchandise inventory for the budgeted balance sheet, and merchandise inventory purchases for the cash budget. Beginning merchandise inventory is known from last month’s balance sheet. Budgeted cost of goods sold averages 70% of sales. Desired ending merchandise inventory should be equal to $20,000 plus 80% of next month’s cost of goods sold. To prepare the inventory, purchases, and cost of goods sold budget, we need to calculate the amount of inventory that needs to be purchased. To do this, we begin with the equation for cost of goods sold. Then we can rearrange the equation to isolate purchases on the left side. © 2016 Pearson Education, Inc.

Inventory, Purchases, and Cost of Goods Sold Budget
How much inventory does Greg’s Games need to purchase? Greg’s Games should have the minimum amount of merchandise inventory to be sure the company balances providing goods to customers with turning over the merchandise inventory efficiently. Keeping merchandise inventory at the minimum level that meets these needs helps reduce inventory storage costs, insurance costs, and warehousing costs and reduces the potential for merchandise inventory to become obsolete. Exhibit 22A-4 shows the merchandise inventory, purchases, and cost of goods sold budget for Greg’s Games. The beginning balance of merchandise inventory for April is the ending balance from the March 31 balance sheet. © 2016 Pearson Education, Inc.

Selling and Administrative Expense Budget
The monthly payroll for Greg’s Games is salaries of $2,500 plus sales commissions equal to 15% of sales. This is a mixed cost, with both fixed and variable components. The monthly expenses are as follows: Rent Expense is $2,000, Depreciation Expense is $500, Insurance Expense is $200, and Miscellaneous Expense is 5% of sales, which is paid as incurred. This information will be used to prepare the selling and administrative expense budget. The selling and administrative expense budget for Greg’s Games is shown in Exhibit 22A-5. © 2016 Pearson Education, Inc.

How Are Financial Budgets Prepared for a Merchandising Company?
The budgets for a merchandising company include: Capital expenditures budget Cash budget Budgeted income statement Budgeted balance sheet Budgeted statement of cash flows We continue the budgeting process for Greg’s Games by preparing the capital expenditures budget, cash budget, and budgeted financial statements—the budgeted income statement, the budgeted balance sheet, and the budgeted statement of cash flows. © 2016 Pearson Education, Inc.

Cash Receipts The primary source of cash is from customers. The sales budget illustrated in Exhibit 22A-3 shows the total sales for the period. Recall that the company’s sales are 60% cash and 40% on credit. The 40% credit sales are collected the month after the sale is made. Exhibit 22A-6 shows that April’s budgeted cash collections consist of two parts. The first is April’s cash sales of $30,000 from the sales budget in Exhibit 22A-3. The second is the collections of March’s credit sales, which is the $16,000 Accounts Receivable from the March 31 balance sheet in Exhibit 22A-2. This process is repeated for all four months. © 2016 Pearson Education, Inc.

Cash Payments Greg’s Games pays for merchandise inventory purchases 50% during the month of purchase and 50% the month after purchase. We use the inventory, purchases, and cost of goods sold budget from Exhibit 22A-4 to compute budgeted cash payments for purchases of inventory. April’s cash payments for purchases consist of two parts. The first is the payment of 50% of March’s purchases, which is the $16,800 Accounts Payable balance from the March 31 balance sheet in Exhibit 22A-2. The second is the payment for 50% of April’s purchases, or 50% of $51,800 which equals $25,900. This process is repeated for all four months and is illustrated in Exhibit 22A-7. © 2016 Pearson Education, Inc.

Cash Payments We next use the selling and administrative expense budget in Exhibit 22A-5 and payment information for Greg’s Games to compute cash payments for selling and administrative expenses. Greg’s Games pays half the salary in the month incurred and half in the following month. Therefore, at the end of each month, Greg’s Games reports Salaries and Commissions Payable equal to half the month’s payroll. The $4,250 balance in Salaries and Commissions Payable in the March 31 balance sheet in Exhibit 22A-2 is half the March payroll of $8,500. Recall that the company’s selling and administrative expenses also include $2,000 rent, $500 depreciation, $200 of insurance expense, and miscellaneous expenses of 5% of sales for the month. Greg’s Games pays all those expenses in the month incurred except for insurance and depreciation. Recall that the insurance was prepaid insurance, so the cash payment for insurance was made before this budget period; therefore, no cash payment is made for insurance during April through July. Depreciation is a non-cash expense, so it’s not included in the budgeted cash payments for selling and administrative operating expenses. April’s cash payments for selling and administrative expenses consist of the items listed here. Exhibit 22A-8 shows the cash payments for selling and administrative expenses for Greg’s Games. © 2016 Pearson Education, Inc.

Short-Term Financing Companies often borrow funds to maintain a minimum cash balance. For example, Greg’s Games borrows cash in $1,000 increments at an annual interest rate of 12%. Because Greg’s Games requires a minimum ending cash balance of $10,000, April’s $2,950 budgeted cash balance before financing falls $7,050 short of the minimum required. Recall that when Greg’s Games borrows, the amount borrowed is to be paid back in $1,000 installments plus interest at 12% annually. Note that in May, the company begins to pay the $8,000 borrowed in April. Greg’s Games must also pay interest at 12%. For May, the interest paid is calculated as $8,000 owed times 12% times 1/12 of the year, or $80 interest. For June, the company’s interest owed will change because the principal of the note has been paid down by $1,000 in May. June interest is calculated as $7,000 owed times 12% times 1/12 of the year, or $70 interest. For July, interest is $6,000 owed times 12% times 1/12 of the year, or $60 interest. © 2016 Pearson Education, Inc.

Short-Term Financing Greg’s Games requires a minimum cash balance of $10,000 at the end of each month. The store can borrow money in $1,000 increments at an annual interest rate of 12%. Management borrows no more than the amount needed to maintain the $10,000 minimum ending cash balance. Total interest expense will vary as the amount of borrowing varies from month to month. Notes payable require $1,000 payments of principal, plus monthly interest on the unpaid principal balance. This is an installment loan; therefore, payments of principal are $1,000 per month even if there is additional excess cash on hand. Borrowing and all principal and interest payments occur at the end of the month. Exhibit 22A-9 shows the cash budget for April, May, June, and July. To prepare the cash budget, we started with the beginning cash balance from the March 31 balance sheet in Exhibit 22A-2 and added the budgeted cash receipts from Exhibit 22A-6 to determine the cash available. Then we subtracted cash payments for purchases calculated in Exhibit 22A-7, selling and administrative expenses calculated in Exhibit 22A-8, and any capital expenditures. This yields the ending cash balance before financing. The cash balance at the end of July of $24,440 is the cash balance on the July 31 budgeted balance sheet. © 2016 Pearson Education, Inc.

Exhibit 22A-10 shows the budgeted income statement for Greg’s Games. It is prepared by using information from the sales budget in Exhibit 22A-3; the inventory, purchases, and cost of goods sold budget in Exhibit 22A-4; and the selling and administrative expenses budget in Exhibit 22A-5. The computation of interest expense as part of the cash budget is also used in the budgeted income statement. Income taxes are ignored in order to simplify the process. © 2016 Pearson Education, Inc.

To prepare the budgeted balance sheet, project each asset, liability, and stockholders’ equity account based on the plans outlined in the previous exhibits. Determine the balance of each account as of July 31, The slide is a summary of the sources for the budgeted balance sheet figures. © 2016 Pearson Education, Inc.

Budgeted Statement of Cash Flows
The final step in the master budget process is preparing the budgeted statement of cash flows. The information comes from the cash budget in Exhibit 22A-9. All cash receipts and disbursements are designated as operating activities, investing activities, or financing activities. Exhibit 22A-12 shows the direct method for a budgeted statement of cash flows for Greg’s Games. © 2016 Pearson Education, Inc.

Chapter 22 Master Budgets

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