Budgeting is a critical function of any business, as it is required for both financial planning and growth. A master budget consolidates a company’s lower-level budgets into a single central document for ease of reference. Continue reading to learn more about what a master budget entails and how to use it.
What is the Purpose of a Master Budget?
Master budgets are created as part of small business accounting, typically monthly or quarterly to cover the entire fiscal year. Companies may add extra months to the end of the budget to keep it rolling, a process known as continuous budgeting.
The master budget includes a financing plan and a cash flow forecast in addition to the budgeted financial statements. Some companies will include a statement of purpose to explain how the master budget fits into the company’s long-term financial objectives. The document is highly adaptable because it is used by the company’s management to make planning decisions. The budget director is in charge of updating this document with input from various departments and employees.
What is a Master Budget?
A master budget is a financial document that outlines how much an organization expects to earn and spend over the course of a fiscal year, usually divided into quarters or months. It may also include text explanations of how the budget will assist the company in meeting its strategic objectives. You can use it to track an organization’s expenses and income, as well as to combine budgets for individual departments or projects. The master budget remains constant throughout the year, allowing the company to perform variance analysis, which compares actual income and expenses to the company’s forecast.
The master budget process in many companies involves feedback and revision from employees at various levels, but senior management usually has the final say in approval.
What a Master Budget Encompasses
These are the most common elements in a company’s master budget. Some businesses may not use one or more of the budgets, but the majority do. Service businesses, for example, rarely use production budgets.
#1. Budget for Sales
The sales budget, which is based on the sales forecast, is the first schedule to be created. The sales budget is usually different from the sales forecast and is adjusted based on managerial judgment and other data.
#2. Production Timetable
The production schedule is the second budget planning schedule. The company must determine how many sales it expects to make in the coming year. The company must then budget how many sales in units it needs to make in order to meet the sales budget and end-of-year inventory requirements. Most businesses have an ending inventory that they want to meet every month or quarter in order to avoid stocking out.
#3. Budget for Direct Materials, Labor, and Overhead
The direct materials include the purchase budget, which refers to the raw materials used in the company’s manufacturing process; the direct labor budget, which estimates how many hours of work and how many workers a company requires; and the overhead budget, which includes both fixed and variable overhead costs.
#4. Budget for Finished Goods Inventory and Cost of Goods Sold
The budget for ending finished goods inventory is required to complete the cost of goods sold budget and the balance sheet. Based on raw materials, direct labor, and overhead, this budget assigns a value to each unit of product produced.
#5. Budget for Administration
Non-manufacturing costs such as freight or supplies are covered by the selling and administrative expense budget.
#6. Budget for Cash
The cash budget, usually on a monthly basis, states cash inflows and outflows, expected borrowing, and expected investments. The cash budget ignores any item that is not in cash, such as depreciation.
#7. Budgeted Balance Sheet
If budgeting plans are followed during the budgeting period, the budgeted balance sheet shows the ending balances of the asset, liability, and equity accounts.
#8. Capital Investments
The capital expenditures budget includes budgetary figures for the business firm’s large, expensive fixed assets.
How to Create a Master Budget for Your Company
To prepare a master budget, you must first prepare all of the smaller budgets, beginning with the sales budget, because the numbers in your sales budget will have a direct impact on the others.
Before you begin budget preparation, you must decide whether you will prepare master budget components on a monthly or quarterly basis.
Step 1: Make a sales budget.
Your sales budget is the foundation for all of the other budgets you’ll need to create. Here are a few examples of items that directly affect your sales budget:
- Levels of production
- Costs of materials
- Demand from customers
- Personnel numbers
- Overhead expenses
- Revenue
Making the sales budget first will cut down on the amount of work required for many of the other budgets.
Step 2: Create a budget for production.
The production budget, which is closely related to the sales budget, delves a little deeper into production, covering details such as the number of items you intend to produce or sell.
For example, how much will the materials cost if you plan to produce 12,000 rocking chairs? What about the cost of labor? If you are not manufacturing items, you can skip the production budget and instead concentrate on the materials budget.
Step 3: Make a budget for materials.
Whether you’re producing products to sell or simply purchasing them for resale, you’ll need to develop a materials budget that is directly related to your sales budget. Because you’ve already estimated your sales totals for the coming year, creating your materials budget will be much easier.
Step 4: Establish a direct labor budget.
Creating a direct labor budget is a necessary step for manufacturing companies. You can skip this step if you are purchasing goods for resale.
Step 5: Establish an overhead budget.
This step will assist you in accounting for both fixed and variable production costs while excluding direct materials and direct labor, as each has its own budget.
Step 6: Deduct the cost of goods sold.
Using information from the sales budget, materials budget, and production budget will simplify the creation of the cost of goods sold budget. You must also include budgeted beginning and ending inventory in the cost of goods sold budget.
Step 7: Make a budget for administrative expenses.
Once the manufacturing steps are complete, you can begin working on your administrative budget. It should include all non-manufacturing costs your company will incur, such as supplies, sales, and shipping or freight costs, as well as front office salaries.
Step 8: Make a financial budget.
If you’ve been in business for a while, you can use the previous year’s totals to guide you through the financial projections required to create the financial budget. If you’re just starting, all of the figures in your operational and financial budgets will be estimates.
The financial budget includes a cash budget that shows cash inflows and outflows based on the operational budgets created earlier; a budgeted balance sheet based on operational totals; and a budget for any capital expenditures expected in the upcoming fiscal year.
Step 9: Make a master budget.
The final step is to combine the details from the smaller budgets to create a master budget. Remember that your master budget will be into two sections: the budgeted income statement, which is the result of your smaller budgets, and your financial budget, which was created in Step 8.
Master budgets typically reflect totals for the following fiscal year, with budgeted amounts entered into a standard monthly or quarterly budget format.
Tips for Creating a Master Budget
Here are some pointers to consider as you create a master budget:
#1. Include other people.
Making sure that all departments and levels of employees have a say in the budget can help to make the process more democratic and the final budget more equitable. Finding new perspectives can also help employees feel valued by the company, and can result in unexpected solutions or compromises. When all departments understand how the company’s goals translate into its budget, motivation to stick to that budget increases.
#2. Avoid evaluating employees based on budget compliance.
Employee behavior may be affected if their job performance is dependent on their ability to work within the master budget on a personal or departmental level. They may make decisions based on what is best for the budget rather than what is best for the department. Also, they may raise their cost estimates while decreasing their sales estimates in order to be more likely to meet those targets. Budget adherence can also encourage employees to avoid risks that could benefit the company. Consider using different performance indicators to assess employee success.
#3. Make use of the budget as a guideline.
Whether you ask in-house accountants to spend their time measuring variances or hiring external financial analysts, strictly enforcing your master budget can consume significant resources. Because the master budget is a large-scale strategic document, reviewing it while keeping any changes in the company’s position and strategy in mind can be more beneficial than constant itemized comparison. This is a significant difference from some of the individual spending budgets, such as the manufacturing budget or the purchases budget, where itemized tracking may assist you in avoiding overspending.
#4. Combine the master budget and a flexible budget.
The master budget remains constant throughout the year to be useful for comparison. If a company experiences impressive growth or unexpected economic circumstances, the master budget may need to be adjusted to account for the changes, whether it’s higher income and corresponding material costs or higher administrative costs as the company recovers from a natural disaster. Companies may create new flexible budgets to create new standards for their financial performance throughout the year because a flexible budget creates projections for these changes.
The Master Budget Challenges
When a company implements a master budget, senior management has a strong tendency to force the organization to closely adhere to it by incorporating budget goals into employee compensation plans. This has the following consequences:
- Employees tend to estimate low sales and high expenses when creating the budget so that they can easily meet the budget and achieve their compensation plans.
- To compel the organization to adhere to the budget, a team of financial analysts must track and report on deviations from the plan. This increases the company’s unnecessary overhead costs.
- Managers frequently overlook new business opportunities because all resources have already been allocated toward meeting the budget, and their personal incentives are tied to the budget.
As a result, enforcing a master budget can skew a company’s operational performance. Because of this issue, it may be preferable to use the master budget as a rough guideline for management’s near-term business expectations.
Conclusion
A master budget is not required for every business. However, if you manufacture products and must manage multiple areas, creating a master budget may be a good idea.
Keep in mind that creating a master budget is a collaborative effort between owners and management to create a document that can serve as a financial blueprint for the coming year.
Master Budget FAQs
What is part of master budget?
A master budget’s major components include income and expenses, overhead and production costs, and monthly, annual, average, and projection totals.
What is the first thing an accountant should do to develop a master budget?
Displays the planned sales units as well as the expected sales dollars. Because most departments’ plans are linked to sales, it is the starting point in the budgeting process.
How do you calculate master budget variance?
Simply subtract the actual amount spent from the budgeted amount for each line item to compute budget variances.
