Master Budgeting and Financial Planning

3. Manufacturing Cost Budgets

After determining production volume, the company must budget for the specific costs required to make those goods. These are categorized as product costs.

• Direct Materials Budget: This plans the quantity and cost of raw materials to be purchased. $\begin{aligned} \text{Materials to purchase} = &\text{ materials needed for production} \\ &+ \text{ desired ending materials} \\ &- \text{ beginning materials} \end{aligned}$
• Direct Labor Budget: This calculates the labor cost required to convert materials into finished goods. $\begin{aligned} \text{Direct labor cost} = &\text{ units to produce} \\ &\times \text{ direct labor hours per unit} \\ &\times \text{ direct labor rate} \end{aligned}$
• Manufacturing Overhead (MOH) Budget: This includes all manufacturing costs other than direct materials and direct labor (such as indirect materials, indirect labor, and factory utilities). MOH is often calculated using an activity base, such as direct labor hours.

4. Selling & Administrative (S&A) Budget

Unlike product costs, which are attached to inventory, S&A costs are period costs. These include non-manufacturing expenses like marketing, sales commissions, and administrative salaries. These costs are charged directly to the income statement in the period they occur and never enter inventory.

5. The Budgeted Income Statement

The culmination of the operating budget is the budgeted income statement. This document uses the sales and cost budgets to project the company's net income. It is important to note that because of accrual accounting, profit is not cash. For example, uncollectible expenses reduce reported income even though no cash is actually paid out.

The Financial Budget: Managing Liquidity

While the operating budget shows how a company makes a profit, the financial budget shows how the company funds those operations and maintains liquidity.

1. Capital Asset Budget

Before looking at cash flow, companies must plan for long-term investments. The capital asset budget plans for the purchase of major long-term assets (like machinery or copiers), which significantly impact future cash needs.

2. Cash Schedules and the Cash Budget

To ensure the company can pay its bills, it must forecast its cash inflows and outflows.

• Cash Collections Schedule: This predicts when cash will actually be received from sales. Because many companies sell on credit, collections often happen in a different period than the actual sale.
• Cash Payments Schedule: This predicts when cash will be paid to suppliers and other vendors.
• Cash Budget: This is the master plan for cash. It calculates the expected cash balance by taking the beginning balance, adding receipts, and subtracting disbursements.

$\begin{aligned} \text{Ending Cash Balance} = &\text{ Beginning cash balance} \\ &+ \text{ Cash receipts (collections)} \\ &- \text{ Cash disbursements (payments)} \end{aligned}$

Critical Warning: Do not confuse revenue with cash collections, and do not confuse expenses with cash payments. For example, depreciation is an expense on the income statement, but it is a non-cash item and must be removed when calculating cash disbursements.

3. The Budgeted Balance Sheet

The final piece of the master budget is the budgeted balance sheet, which projects the company's financial position at the end of the period. It pulls data from all previous schedules:

• Cash comes from the cash budget.
• Accounts Receivable comes from the collections schedule.
• Inventory comes from the production and materials budgets.
• Machinery & Equipment comes from the capital asset budget.
• Accounts Payable comes from the cash payments schedule.
• Retained Earnings is derived from the budgeted income statement.

Summary Checklist for Success

To master the master budget, follow this flow:

1. Start with the Sales Budget (Units and Dollars).
2. Determine Production Needs (Units).
3. Convert production needs into DM, DL, and MOH (Product Costs).
4. Add Selling & Administrative (Period Costs).
5. Prepare the Budgeted Income Statement.
6. Build the Cash Schedules, Cash Budget, and Budgeted Balance Sheet.