CHAPTER M8
The Operating Budget
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Learning Objective 1:
Describe some of the
benefits of the
operating budget.
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Operating Budget
 The operating budget, (also called the
master operating budget, or simply the
master budget) is a plan that focuses on
the day-to-day operations of a firm.
 It is usually prepared for a one-year time
period, but could be for prepared for
several years at a time.
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What is It?
 The operating budget is essentially a set of
forecasted financial statements. It also
includes several detailed schedules that
provide the backup documentation for the
financial statements.
 Forecasted financial statements are also
called pro forma statements.
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Benefits of Budgeting
Budgeting serves as a guide.
 Budgeting helps allocate resources.
 Budgeting encourages communication and
coordination.
 Budgeting sets performance standards or
benchmarks.

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Serves as a Guide
 A budget is a plan, and a plan can help
guide you through the future.
 A household budget can be a great aide in
helping a family control its spending.
 Likewise, an operating budget will help a
business to anticipate and handle the little
bumps in the road as they occur.
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Helps Allocate Resources
 An operating budget helps the managers
to determine the best possible allocation of
the company’s scarce resources (such as
money, materials, labor, etc.).
 The budgeting process may lead to the
discovery of potential bottlenecks before
they occur, thus allowing managers to take
action to alleviate the bottleneck.
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Encourages Communication
and Coordination
 An effective budgeting process requires that
managers from all of the functional areas
within the firm work together as a whole.
 The manufacturing department needs to
know what the marketing department is doing
and vice versa. By preparing the operating
budget, managers become more aware of the
firm’s other functional areas.
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Sets Performance Standards
 A budget can also be thought of as a goal.
After a goal has been set, you can then
measure your success in meeting that
goal.
 Managers are often rewarded for meeting
or exceeding their budgeted performance
standards.
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Learning Objective 2:
Describe the three budgeted
financial statements
contained in the operating
budget and the other budgets
that support the budgeted
financial statements.
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Contents of Operating
Budget
Sales Forecast
Cash Budget
Sales Budget
Production
(Purchases)
Budget
Cost of Goods Sold
(Cost of Services)
Budget
Selling and
Administrative
Expense Budget
Budgeted
Income
Statement
Budgeted
Balance
Sheet
Budgeted
Statement of
Cash Flows
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Sales Budget
 The first budget prepared is the sales
budget. The sales budget is based upon
the sales forecast.
 Information from the
sales budget has an
impact upon almost
every other aspect of
the operating budget.
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Production/Purchases
Budget
 A manufacturing firm needs to prepare a
Production Budget as well as a Purchases
Budget for the materials used in production.
 A merchandising firm needs to prepare a
purchases budget for the inventory items that
they sell.
 The production and purchases budgets are
very similar in format.
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Cost of Goods Sold
Budget
 The Cost of Goods Sold Budget is an
integral part of the budgeted income
statement for a manufacturing or
merchandising firm.
 There is nothing unusual about preparing this
budget, it looks just like a normal cost of
goods sold schedule. The only difference is
the use of estimated amounts. A service
company uses a Cost of Services Budget.
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Selling and Administrative
Expense Budget
 Another important part of the budgeted
income statement is the Selling and
Administrative Expense Budget.
 Items included in this budget are advertising
and promotion, administrative and sales
salaries, and the expenses related to the
corporate and sales offices.
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Budgeted Income
Statement
 The Budgeted Income Statement looks
very much like any other income
statement. The main difference is that the
numbers being reported are expected
future results, rather than historical data.
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Cash Budget
 The Cash Budget shows an analysis of
the expected cash receipts and cash
disbursements for the company. Only the
cash flows from operating activities would
typically appear in the cash budget.
 For example, the cash outflow for a capital
budgeting project would not be shown on
the cash budget.
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Budgeted Balance Sheet
 A Budgeted Balance Sheet is prepared in
exactly the same manner as a standard
balance sheet, with the only exception being
the use of estimated future amounts rather
than historical amounts for assets, liabilities,
and owners’ equity.
 Most of the numbers in the budgeted balance
sheet come from the other budgets.
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Budgeted Statement of
Cash Flows
 The Budgeted Statement of Cash Flows is
a comprehensive projection of all the cash
flows for the company during the period
covered by the operating budget.
 Expected cash flows from operating
activities, investing activities, and financing
activities would all be shown in this budget.
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Budget Interrelationships
Sales Forecast
Cash Budget
Sales Budget
Production
(Purchases)
Budget
Cost of Goods Sold
(Cost of Services)
Budget
Selling and
Administrative
Expense Budget
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Budgeted
Income
Statement
Budgeted
Balance
Sheet
Budgeted
Statement of
Cash Flows
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Learning Objective 3:
Compare and contrast
various approaches to
the preparation and use
of the operating budget.
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Different Approaches to
Budgeting
 There are many different approaches and
theories that have been used for the
budgeting process. Not any one approach
is always best. What works well for one
company may not work well for the next.
 We will look at seven different approaches
to budgeting.
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Perpetual Budgeting
 The first budgeting approach is perpetual
budgeting, also called continual
budgeting.
 With this approach, the operating
budget is continually updated
and extended. As one month or
quarter ends, another month or
quarter is added to the end of the
budget.
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Incremental Budgeting
 The second approach is called incremental
budgeting. In this case, the prior year’s
budget is used as a starting point for the
current year. Only the changes (increments)
need to be justified.
 Incremental budgets are often used by
governmental agencies, including colleges
and universities.
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Zero-Based Budgeting
 The third approach is zero-based
budgeting. This is an alternative to
incremental budgeting. The prior year’s
budget is NOT used as a starting point for
the current year.
 Each year, the full amount of each budget
item needs to be justified. This is much
more time consuming, but probably leads
to a better budget.
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Top-Down Budgeting
 The fourth approach to budgeting
is known as top-down
budgeting.
 Top-down budgeting occurs
when the budget is prepared by
the top managers of the firm, and
the budget is implemented by the
lower-level managers in the firm.
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Imposed Budget
 Many top-down budgets are also imposed
budgets. This fifth approach to budgeting
occurs when top managers set the budget
amounts without any input from the lower
level managers.
 Low- and middle-level managers must strive
to meet the goals set forth by the budget,
not matter how unreasonable they might be.
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Bottom-Up Budgeting
 The sixth approach to budgeting
is known as bottom-up
budgeting. As the name implies,
this is a budget prepared by the
lower-level managers of the firm.
 These managers then
communicate their ideas to the
higher levels of management for
final approval.
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Participative Budgeting
 The seventh approach to budgeting is known
as a participative budget. In this approach,
managers and employees at all levels are
included in the budgeting process.
 A bottom-up budget is also participatory in
nature. However, you can have a top-down
budget that is participatory if the top
managers seek input from the lower levels.
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Learning Objective 4:
Describe the role of the
sales forecast in the
budgeting process.
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Sales Forecast
 A sales forecast is an informed prediction
of the level of sales that can be achieved in
future periods.
 A reasonably accurate sales forecast is
crucial to the overall operating budget. All
of the different parts of the operating budget
depend upon the sales forecast, thus it is
often called the cornerstone of the budget.
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Sales Forecast Accuracy
 Factors that influence the accuracy of the
sales forecast include:
General economy: inflation, recession, etc.?
 Industry conditions: strength or weakness?
 Actions of competitors: increase or decrease
market share?
 Technological developments: are you on the
cutting edge or being left behind?

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Learning Objective 5:
Prepare the budgets
included in the
operating budget.
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Preparing the
Operating Budget
 To illustrate the preparation of the operating
budget, let’s use the example of a merchandising
company that sells baseball caps. This is their
only product.
 We will prepare the monthly operating budgets for
the first quarter of 2007. We will start with the
actual balance sheet for Dec. 31, 2006, and then
the sales forecast and sales budget for the first
quarter of 2007.
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The Cap Company
Budgeted Balance Sheet
December 31, 2006
ASSETS
Current assets:
Cash
Accounts receivable
Inventory
$ 12,000
25,000
5,250
Total current assets
Property, plant, and equipment:
Equipment
Less: Accum. Depr.
$ 42,250
$ 19,520
(5,000)
Total assets
14,520
$ 56,770
LIABILITIES
Accounts payable
STOCKHOLDERS' EQUITY
Common stock
$ 15,000
Retained earnings
8,470
Total liabilities and equity
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$ 33,300
23,470
$ 56,770
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Sales Forecast and
Sales Budget
The Cap Company
Sales Forecast
For the Quarter Ending March 31, 2007
Forecasted sales in units
January February
3,000
4,000
March
5,000
Total
12,000
The Cap Company
Sales Budget
For the Quarter Ending March 31, 2007
Expected unit sales
Expected selling price
January February March
3,000
4,000
5,000
$
12 $
12 $
12
Total
12,000
$
12
Budgeted sales dollars
$ 36,000
$ 144,000
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$ 48,000
$ 60,000
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Cost of Goods Sold Budget
 The Cap Company purchases the baseball
caps for $7.00 each.
The Cap Company
Cost of Goods Sold Budget
For the Quarter Ending March 31, 2007
January February March
Expected unit sales
3,000
4,000
5,000
Expected purchase cost $
7 $
7 $
7
Total
12,000
$
7
Budgeted sales dollars
$ 84,000
$ 21,000
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$ 28,000
$ 35,000
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Selling and Administrative
Expense Budget
 The Cap Company incurs selling and
administrative expenses as shown below:
The Cap Company
Selling and Administrative Expense Budget
For the Quarter Ending March 31, 2007
Salaries and wages
Office rent & utilities
Depreciation
Other sell/admin expenses
Total
January February March
$ 7,600 $ 8,800 $ 10,000
1,800
1,800
1,800
300
300
300
4,300
4,900
5,500
Total
$ 26,400
5,400
900
14,700
$ 14,000
$ 47,400
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$ 15,800
$ 17,600
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Budgeted Income
Statement
 Using the information from the three
previous budgets, we can prepare the
budgeted income statement.
 Notice how the sales forecast drives the
budgeted income statement. If we change
the sales forecast, all of the other budgets
would need to be changed also.
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Budgeted Income
Statement
The Cap Company
Budgeted Income Statement
For the Quarter Ending March 31, 2007
Sales
Cost of goods sold
January February March
$ 36,000 $ 48,000 $ 60,000
21,000
28,000
35,000
Total
$ 144,000
84,000
Gross profit
$ 15,000
Selling and admin. expenses
14,000
$ 20,000
15,800
$ 25,000
17,600
$ 60,000
47,400
Net income
$ 4,200
$ 7,400
$ 12,600
$ 1,000
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Purchases Budget
 The purchases budget was not needed to
prepare the budgeted income statement.
However, it is needed to prepare the
budgeted balance sheet.
 In particular, the budgeted purchases will
have an impact on three major balance
sheet items: cash, inventory, and accounts
payable.
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Purchases Budget
 Let’s assume that The Cap Company tries to
maintain an inventory equal to 25% of the
next month’s budgeted sales volume.
 In other words, at the end of December
they should have had an inventory equal to
25% of the caps they expected to sell in
January.
 The ending inventory for March will be 25%
of the expected April sales of 4,400 units.
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Purchases Budget
The Cap Company
Purchases Budget
For the Quarter Ending March 31, 2007
January February
Forecasted sales in units
3,000
4,000
Desired ending inventory
1,000
1,250
March
5,000
1,100
Total
12,000
1,100
Total units needed
Beginning inventory
4,000
750
5,250
1,000
6,100
1,250
13,100
750
Units to be purchased
3,250
4,250
4,850
12,350
Cost per unit
$
Cost of purchases
$ 22,750
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$
7
$ 29,750
$
7
$ 33,950
$
7
$ 86,450
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Budgeting Cash Flows
 We need to determine an estimated
ending cash balance before we can
prepare the budgeted balance sheet.
 Another factor that could impact the
balance sheet is the possibility of needing
some short-term financing due to a
shortage of cash.
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Cash Budget
 The preparation of a cash budget is an
important step in the operating budget
process.
 The cash budget provides information not
readily available on the other budgets
previously prepared. Keep in mind that the
budgeted income statement is based on
accrual accounting concepts, not cash flows.
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Cash Budget
 For The Cap Company, let’s make the
following assumptions about cash flows:
Cash receipts from sales tend to be collected
50% in the month of sale and 50% in the
following month.
 Cash disbursements for purchases are always
made in the month following the purchase.
 Other cash disbursements are made in the
month that the expense is incurred.

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Cash Budget
 Additional information needed about The
Cap Company:
A minimum balance of $10,000 should be
maintained. Any shortfall can be borrowed
from the local bank at 12% annual interest.
 December purchases totaled $33,300.
 December sales totaled $50,000.

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The Cap Company
Cash Budget
For the Quarter Ending March 31, 2007
Beginning cash balance
Budgeted cash receipts:
In month of sale
In month after sale
January February March
$ 12,000 $ 10,000 $ 11,730
Total
$ 12,000
18,000
25,000
24,000
18,000
30,000
24,000
72,000
67,000
$ 43,000
$ 42,000
$ 54,000
$ 139,000
55,000
52,000
65,730
151,000
33,300
13,700
22,750
15,500
29,750
17,300
85,800
46,500
Total cash payments
$ 47,000
$ 38,250
$ 47,050
$ 132,300
Balance before borrowing
Borrowing (Repayment)
$ 8,000
2,000
$ 13,750 $ 18,680
(2,020)
-
$ 18,700
(20)
Budgeted cash balance
$ 10,000
$ 11,730
$ 18,680
Total cash receipts
Cash available
Budgeted cash payments:
For purchases
Sell/Admin. (minus depr.)
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$ 18,680
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Building the Balance Sheet
 We now have enough information to prepare
the budgeted balance sheet for The Cap
Company. We can determine the accounts
receivable and accounts payable balances
from the information used to prepare the
cash budget.
 Information about owners’ equity and
equipment comes from the Dec. 31 balance
sheet.
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The Cap Company
Budgeted Balance Sheet
March 31, 2007
ASSETS
January
Current assets:
Cash
Accounts receivable
Inventory
Total current assets
February
March
$
10,000
18,000
7,000
$
11,730
24,000
8,750
$
18,680
30,000
7,700
$
35,000
$
44,480
$
56,380
Property, plant, and equipment:
Equipment
$
Less: Accum. Depr.
19,520 $
(5,300)
19,520 $
(5,600)
19,520
(5,900)
Total assets
49,220
$
58,400
$
70,000
LIABILITIES
$
22,750
2,000
$
29,750
-
$
33,950
-
$
29,750
$
33,950
$
15,000
13,650
$
15,000
21,050
Accounts payable
Short-term note payable
Total liabilities
Common stock
Retained earnings
$
$
24,750
OWNERS' EQUITY
$
15,000
9,470
Total owners' equity
$
24,470
$
28,650
$
36,050
Total liabilities and equity
$
49,220
$
58,400
$
70,000
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Discussion Questions
 Can you verify the accounts receivable
balance for March 31? Where do you find
the necessary information?
 Can you verify the accounts payable
balance for March 31? Where do you find
the necessary information?
 Can you verify the accumulated
depreciation for all three months?
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Discussion Questions
 Question: Can you verify the retained
earnings balance for January 31, 2007?
 Answer: Take the Dec. 31 balance of $8,470
and add the $1,000 January income.
 Question: Can you verify the retained
earnings balance for February 28, 2007?
 Hint: There is a “little” item in the cash budget
that you need to include.
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Learning Objective 6:
Describe the appropriate
use of the operating
budget in the overall
management process.
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Using the Budget
 The budget has an impact on all areas of
management performance.
 Preparing the budget is part of the
planning process.
 Day-to-day efforts to achieve budgeted
amounts are part of the operating
process.
 Comparison of actual results with budgeted
results is part of the control process.
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Performance to Budget
Evaluation
 A major part of the control function of
management is the performance to
budget evaluation.
 The main instrument used in this evaluation
is the budget performance report. This
report indicates any variances between
actual results and budgeted results.
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The Cap Company
Budget Report
 Assume the following results for The Cap
Company for the first quarter of 2007.
The Cap Company
January - March, 2007
Budget Performance Report
Description
Sales
Salaries/Wages
Other sell/admin
Budget
144,000
26,400
14,700
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Actual Variance
148,000 4,000 F
28,000 1,600 U
14,000
700 F
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Three Truths About
Budgeting
 Since all of the budgets are interrelated and
all of the budgets stem from the sales
forecast, there are three truths about
budgeting that should be kept in mind:
 1. If the sales forecast is inaccurate, the
operating budget will be inaccurate.
 2. The sales forecast will be inaccurate.
 3. The operating budget will be inaccurate.
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End of Chapter M8
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