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Comprehensive Master Budget: A Combination of Forecasting & Profit Planning

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To you who have been waiting for “budgeting process guide”, now I am coming with a comprehensive guiding on how to construct a budget for businesses purposes, with a single case example (for easier understanding). But before that, let’s talk about the main resources of every types of budget be called “Master Budget”.

A comprehensive master budget is a formal statement of management’s expectation regarding sales, expenses, volume, and other financial transactions for the coming period. It consists basically of a pro-forma income statement, pro-forma balance sheet, and cash budget.

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At the beginning of the period, the budget is a plan or standard. At the end, it serves as a control device to help management measure its performance against the plan so that future performance may be improved.

The budget is classified broadly into two categories:

 

[A]. OPERATING BUDGET

The “Operating Budgetconsists of:

  1. Sales budget
  2. Production budget
  3. Direct materials budget
  4. Direct labor budget
  5. Factory overhead budget
  6. Selling and administrative expense budget
  7. Pro forma income statement

 

[B]. FINANCIAL BUDGET

The “Financial Budgetconsists of:

  1. Cash budget
  2. Pro forma balance sheet

 
Five major steps in preparing the budget are:

  1. Prepare a sales forecast.
  2. Determine expected production volume.
  3. Estimate manufacturing costs and operating expenses.
  4. Determine cash flow and other financial effects.
  5. Formulate projected financial statements.

 
Comprehensive Sales Planning

The initiating management decisions in developing the plan were the statements of broad objectives, specific goals, basic strategies, and planning premises. The sales planning process is a necessary part of profit planning and control because:

  1. It provides for the basic management decisions about marketing.
  2. Based on those decisions, it is an organized approach for developing a comprehensive sales plan.

 

If the sales plan is not realistic, most if not all of the other parts of the overall profit plan also are not realistic.

Therefore, if the management believes that a realistic sales plan cannot be developed, there is little justification for profit planning and control. Despite the views of a particular management, such a conclusion may be an implicit admission of incompetence. Simply, if it is really impossible to assess the future revenue potential of a business, there would be little incentive for investment in the business initially or for continuation of it except for purely speculative ventures that most managers and investors prefer to avoid.

The primary purposes of a sales plan are:

  1. To reduce uncertainty about the future revenues.
  2. To incorporate management judgments and decisions into the planning process (e.g., in the marketing plans).
  3. To provide necessary information for developing other elements of a comprehensive profit plan.
  4. To facilitate management’s control of sales activities.

 

 
Sales Planning Compared with Forecasting

Sales planning and forecasting often are confused. Although related, they have distinctly different purposes. A forecast is not a plan; rather it is a statement and/or a quantified assessment of future conditions about a particular subject (e.g., sales revenue) based on one or more explicit assumptions. A forecast should always state the assumptions on which it is based. A forecast should be viewed as only one input into the development of a sales plan. The management of a company may accept, modify, or reject the forecast. In contrast, a sales plan incorporates management decisions that are based on the forecast, other inputs, and management judgments about such related items as sales volume, prices, sales effects, production, and financing.

 
The Top Line

Most companies do not really manage top-line growth. They allocate resources to businesses they think will be most productive and hope the economy cooperates. But a growing number of companies are taking a less passive approach and studying revenue growth more carefully. They argue that quantifying the sources of revenue can yield a wealth of information, which results in more targeted and more effective decision-making. With the right discipline and analysis, they say, growing revenues can be as straightforward as cutting costs. Some companies go so far as to link the two efforts. The idea is to bring the same systematic analysis to growing revenue that we have brought to cost cutting.

A “Sources of Revenue Statement (SRS)” is useful in this effort. The information on revenue captured by traditional financial statements is woefully inadequate. Sorting revenues by geographic market, business unit, or product line tells the source of sales. But it does not explain the underlying reason for those sales.

The SRS model breaks revenue into five categories:

  1. Continuing sales to established customers (known as base retention)
  2. Sales won from the competition (share gain)
  3. New sales from expanding markets
  4. Moves into adjacent markets where core capabilities can be leveraged

 

Note: Entirely new lines of business unrelated to the core

To produce an SRS statement, 5 (five) steps are required in addition to establishing total revenues for comparable periods, as is commonly done for purposes of completing an income statement:

  1. Determine revenue from the core business by establishing the revenue gain or loss from entry to or exit from adjacent markets and the revenue gain from new lines of business, and subtracting this from total revenue.
  2. Determine growth attributable to market positioning by estimating the market growth rate for the current period and multiplying this by the prior period’s core revenue.
  3. Determine the revenue not attributable to market growth by subtracting the amount determined in Step 2 from that determined in Step 1.
  4. To calculate base retention revenue, estimate the customer churn rate, multiply it by the prior period’s core revenue, and deduct this from the prior period’s core revenue.
  5. To determine revenue from market-share gain, subtract retention revenue, growth attributable to market positioning, and growth from new lines of business and from adjacent markets from core revenue.

 

Example:

To illustrate how all these budgets are put together, we will focus on a manufacturing company called the Royal Bali Cemerlang, which produces and markets a single product. We will make these assumptions:

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.

Here is how a master budget works:

Mater Budget
This master budget will bring us through the next step of budgeting process, here is the outline:

Sales Budget, will be the first budget to be generated, sales budget will supply the following budgets with basic information:

  1. Desired Ending Inventory Budget
  2. Production Budget
  3. Selling Expense Budget
  4. Cash Budget

 

Next….

Desired Ending Inventory Budget use the Sales Budget’s information as a base to construct. This budget will generate bottom line information to supply the following budgets with information:

  1. Production Budget
  2. Cost of Goods Sold Budget

 

Next….

Production Budget uses the “sales budget” and “desired ending inventory budget” as main resources of information. Production Budget will generate “Expected Unit to be Produced” to supply the following budgets with information:

  1. Direct Material Budget
  2. Direct Labor Budget
  3. Factory Overhead Budget

 

Now, you can go on yourself.

On my next post, we will talk about “Sales Budget”, how a sales budget is constructed, in detail.

5 Comments

5 Comments

  1. Apr 19, 2009 at 4:07 pm

    Could you please help me with a homework assinment for a master budget sheet?

  2. Mar 22, 2010 at 12:09 pm

    Churn rate is applicable for subscription or account based revenue. what would be applicable for the retail company

  3. anton kop

    Jul 22, 2010 at 11:42 am

    could you please, assist me with a sample schedule showing the differential costs ( cost schedule)

  4. Jul 27, 2010 at 2:57 am

    Hi! Can you please help me find a case study with answer? I badly need it as a requirement in school. Thank you.

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