Managing Financial and Human Resources

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Topic Overview 8 – Budgeting, Financial Planning, Cash

budget and Decision Making

A Practical Example

In order to understand how all these budgets are put together, an example of Shims et

al. (2011) will be used. The focus is on a manufacturing company called the Putnam

Company, which produces and markets a single product.

The assumptions used are:

➢ The company uses a single material and one type of labor in the manufacture of

the product.

➢ It prepares a master budget on a quarterly basis.

➢ Work-in-process inventories at the beginning and end of the year are negligible

and are ignored.

➢ The company uses a single cost driver—direct labor hours (DLH)—as the

allocation base for assigning all factory overhead costs to the product.

Sales Budget

The sales budget is the starting point in preparing the master budget, since estimated

sales volume influences nearly all other items appearing throughout the master budget.

The sales budget should show total sales in quantity and value. The expected total sales

can be break-even or target income sales or projected sales. It may be analyzed further

by product, by territory, by customer, and, of course, by seasonal pattern of expected

sales.

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Generally, the sales budget includes a computation of expected cash collections from

credit sales, which will be used later for cash budgeting.

Schedule 1

Monthly Cash Collections from Customers

Frequently there are time lags between monthly sales made on account and their related

monthly cash collections. For example, in any month, credit sales are collected in this

manner: 15 percent in month of sale, 60 percent in the following month, 24 percent in the

month after, and the remaining 1 percent are uncollectible.

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Production Budget

After sales are budgeted, the production budget can be determined. The production

budget is a statement of the output by product and is generally expressed in units. It

should take into account the sales budget, plant capacity, whether stocks are to be

increased or decreased, and outside purchases. The number of units expected to be

manufactured to meet budgeted sales and inventory requirements is set forth in the

production budget.

Expected production volume = Planning sales + Desired ending inventory - Beginning

inventory

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Schedule 2

Inventory Purchases, Merchandising Firm

Putnam Company is a manufacturing firm, so it prepares a production budget, as shown

in Schedule 2. If the company were a merchandising (retailing or wholesaling) firm, then

instead of a production budget, it would develop a merchandise purchase budget showing

the amount of goods to be purchased from its suppliers during the period. The

merchandise purchases budget is in the same basic format as the production budget,

except that it shows goods to be purchased rather than goods to be produced:

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Direct Material Budget

When the level of production has been computed, a direct material budget should be

constructed to show how much material will be required for production and how much

material must be purchased to meet this production requirement.

The purchase will depend on both expected usage of materials and inventory levels.

The formula for computation of the purchase is:

Purchase in units = Usage + Desired ending material inventory units – Beginning

inventory units

The direct material budget is usually accompanied by a computation of expected cash

payments for materials.

Schedule 3

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Direct Labor Budget

The production requirements as set forth in the production budget also provide the

starting point for the preparation of the direct labor budget. To compute direct labor

requirements, expected production volume for each period is multiplied by the number of

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direct labor hours required to produce a single unit. The direct labor hours to meet

production requirements is then multiplied by the (standard) direct labor cost per hour to

obtain budgeted total direct labor costs.

Schedule 4

Factory Overhead Budget

The factory overhead budget should provide a schedule of all manufacturing costs other

than direct materials and direct labor. Using the contribution approach to budgeting

requires the cash budget, we must remember that depreciation does not entail a cash

outlay and therefore must be deducted from the total factory overhead in computing cash

disbursement for factory overhead.

Schedule 5

To illustrate the factory overhead budget, we will assume that:

➢ Total factory overhead budgeted = $18,300 fixed (per quarter), plus $2 per hour of

direct labor. This is one example of a cost-volume (or flexible budget) formula

(y = a + bx), developed via the least-squares method with a high R2.

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➢ Depreciation expenses are $4,000 each quarter.

➢ Overhead costs involving cash outlays are paid for in the quarter incurred.

Ending Finished Goods Inventory Budget

The ending finished goods inventory budget provides us with the information required

for the construction of budgeted financial statements. After completing Schedules 1 to 5,

sufficient data will have been generated to compute the per-unit manufacturing cost of

finished product. This computation is required for two reasons:

i. to help compute the cost of goods sold on the budgeted income statement,

ii. to give the dollar value of the ending finished goods inventory to appear on the

budgeted balance sheet.

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Schedule 6

Selling and Administrative Expense Budget

The selling and administrative expense budget lists the operating expenses involved in

selling the products and in managing the business. Just as in the case of the factory

overhead budget, this budget can be developed using the cost-volume (flexible budget)

formula in the form of y = a + bx.

If the number of expense items is very large, separate budgets may be needed for the

selling and administrative functions.

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Schedule 7

Cash Budget

The cash budget is prepared for the purpose of cash planning and control. It presents the

expected cash inflow and outflow for a designated time period. The cash budget helps

management keep cash balances in reasonable relationship to its needs. It aids in

avoiding unnecessary idle cash and possible cash shortages. The cash budget consists

typically of five major sections:

1. The cash receipts section, which is cash collections from customers and other cash

receipts, such as royalty income and investment income.

2. The cash disbursements section, which comprises all cash payments made by

purpose.

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3. The cash surplus or deficit section, which simply shows the difference between the

total cash available and the total cash needed including a minimum cash balance if

required. If there is surplus cash, loans may be repaid or temporary investments made.

4. The financing section, which provides a detailed account of the borrowings,

repayments, and interest payments expected during the budgeting period.

5. The investments section, which encompasses investment of excess cash and

liquidation of investment of surplus cash.

Schedule 8

To illustrate, we will make these assumptions:

• Putnam Company has an open line of credit with its bank, which can be used as

needed to bolster the cash position.

• The company desires to maintain a $10,000 minimum cash balance at the end of

each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall

and to provide for the minimum cash balance of $10,000.

• All borrowings and repayments must be in multiples of $1,000 amounts, and

interest is 10 percent per annum.

• Interest is computed and paid on the principal as the principal is repaid.

• All borrowings take place at the beginning of a quarter, and all repayments are

made at the end of a quarter.

• No investment option is allowed in this example. The loan is self-liquidating in the

sense that the borrowed money is used to obtain resources that are combined for

sale, and the proceeds from sales are used to pay back the loan.

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Note that:

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Budgeted Income Statement

The budgeted income statement summarizes the various component projections of

revenue and expenses for the budgeting period. However, for control purposes, the

budget can be divided into quarters or even months, depending on the need.

Schedule 9

Budgeted Balance Sheet

The budgeted balance sheet is developed by beginning with the balance sheet for the

year just ended and adjusting it, using all the activities that are expected to take place

during the budgeting period. Some of the reasons why the budgeted balance sheet must

be prepared are:

• It could disclose some unfavorable financial conditions that management might

want to avoid.

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• It serves as a final check on the mathematical accuracy of all the other

schedules.

• It helps management perform a variety of ratio calculations.

• It highlights future resources and obligations.

We can construct the budgeted balance sheet by using:

o The December 20A balance sheet (Schedule 10)

o The cash budget (Schedule 8)

o The budgeted income statement (Schedule 9)

Putnam’s budgeted balance sheet for December 31, 20B, is presented next.

Schedule 10

To illustrate, we will use this balance sheet for the year 20A.

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Bužinskienė (2019) perform a similar to the above analysis in the form of a case study on

the Snaige corporation. After the formation of the master budget to the “Snaige” company,

it was found that the company will have been expected to sell 204 thousand units of

product and it will be earned 38,958 thousand euros of turnover. Also, the company

should expect cash collections of 35,070 thousand euros from customers. To achieve

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these sales results the company would need to buy 1,041 thousand units of required

materials. It would cost about 30,603 thousand euros and it would need to pay

approximately 24,892 thousand euros. After an analysis of direct materials purchasing,

we indicate, that another cost would include the salary of workers 3,724 thousand euros,

the manufacturing overhead 6,539 thousand euros, selling and administrative expenses

1,806 thousand euros. It is important to note that the company last year incurred a loss

and this budgeting process shows the way to earn a profit of 1,210 thousand euros. The

most important budgeting process is the result of the cash budget. This budget indicates

that the company would need to search financing sources and it would need to prepare

new agreements conditions to customers for prepayment received. Another way to cover

cash deficiency it would be to borrow from financial institutions.

As it is supported by the case study of Bužinskienė (2019), effective budgeting could

significantly contribute to the optimal decision making safeguarding the interests of all

stakeholders, but especially the internal who directly benefit from a company’s

profitability.

References:

Bužinskienė, R., 2019. MASTER BUDGET FORMATION IN PRIVATE

COMPANIES. Professional Studies: Theory & Practice/Profesines Studijos: Teorija ir

Praktika, (21).

Shim, J.K., Siegel, J.G. and Shim, A.I., 2011. Budgeting basics and beyond (Vol. 574).

John Wiley & Sons.