What is a Master Budget?
Master budget can be defined as the aggregation of all the lower level budgets which are calculated by various functional areas of the business and is a strategy that documents the financial statements, cash flow forecast, financial plans and also capital investments.
Explained
Since in a company, there are various departments to carry on different functions, and each one of them prepares a budget, forecasting the expenses and revenues estimated to incur. It includes budgeted financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, forecasted cash flows, and financial planning estimates made by the company. Every company has set targets and goals for each year, and it is through these budgets that the company prepares the plan of action to achieve them.
- The various budgets which are ultimately rolled up within a master budget are Direct labor budget, Direct material budget, Finished goods budget, Manufacturing expenses budget, production budget, sales budget, cash budgetCash BudgetCash budget refers to cash inflows and outflows estimations made by a company's management over a given period to evaluate whether the business has adequate cash & cash equivalents to meet its operational needs in the coming future.read more, capital asset acquiring budget and selling, and administrative budget. It can be presented in the monthly or quarterly form as per the requirement and covers the entire fiscal year.
- The master budget is the planning tool that is used by the management to direct and judge the performance of the various responsibility centersResponsibility CentersThe term "Responsibility Center" refers to a specific segment or unit of an organization for which a specific manager, employee, or department is held accountable and responsible for its business goals and objectives.read more that reside within an organization to have proper control. This budget undergoes the multiple iterations before it gets approved by the senior management to allocated funds accordingly. This budget is prepared under the guidance of the Budget director, which is usually the Controller of the company.
- The central aspect to remember about this budget is that it is the sum of all the individual budgets made within separate departments, thus providing a vital link between sales, production, and costs. It helps to ensure that all the departments work together in coordination to achieve the common objective of the overall business.
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Example of the Master Budget
When a company undergoes the process of merger and acquisition, then the master budget is prepared to see what the company gains from the transaction of acquiring the target company. For instance, every company has an HR and Admin department. When a company is acquired, then this would result in two staffs in the same category. It is here where the company has to make the budget to decide who to keep and who to let go of for the betterment of the business. Thus, the management has to prepare this budget before making any expansion plans. Thus, the master budget has detailed information about the future financial statements and cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more estimated after considering current loan rates, cash flows, and debt limits.
Major parts of the Master Budget
It has two parts, mainly: the operating budget and the financial budget.
#1 – Operating Budget
It is related to the operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more of the firm and includes the revenues generated and expenses incurred. This is basically presented in the form of the budgeted income statementBudgeted Income StatementThe budgeted income statement or the Pro Forma income statement presents the forecasted financial performance of the entity for future years of operations. It involves designing and implementing new strategies to achieve the set financial goals and tracking the actual periodic performance with the forecasted numbers.read more representing the income-generating activities carried on within an organization.
#2 – Financial Budget
It shows information about the financial position of the firm. It represents the cash budget as well, which gives information about the cash availability. The financial budget is prepared by making a budgeted balance sheet which uses information from the operating budgets.
Advantages
- It acts as a motivation to the staff as they can judge the actual performance with the desired one and thereby know the areas of improvement.
- It serves as a summary budget for the owners as they know what the business is estimating to earn and what it would incur to reach the goals.
- Since the budget is an estimate for the entire year, it helps in identifying the problems in advance and thus provide the management with the time to fix the same. Therefore, it helps in overall planning in advance.
- With the proper budget, it helps to estimate the short term and long-term goals of the organization and achieve them with proper channelizing of the resources.
Master Budget Issues
- While estimating cash or making cash budget, it gets challenging to forecast the net change in working capital from one period to another. As when the company is in the growth phase, then the working capital could decline heavily, resulting in negative numbers due to cash outflow as investments increase. Thus, taking a steady number for working capital creates problems for management as it results in an unrealistic result in case the company is in the growth phase.
- A similar issue arises with an inventory. As if the company forecasts more sales, then this would lead to increasing inventory, thereby resulting in negative working capitalNegative Working CapitalNegative Working Capital refers to a scenario when a company has more current liabilities than current assets. It implies that the available short-term assets are not enough to pay off the short-term debts. read more.
- Generally, while compiling the budget, to achieve the set budget, the employees lower the sales and estimate the higher expenses as management forces the organization to adhere to the budget, thereby deviating from the organization’s goals.
- Having a master budget leads to additional overhead expenses, as the organization needs an additional financial analyst who could track the variances and prepare the detailed analytical report on deviations, if any.
- Managers are more focused towards achieving the budget goals, as their incentives are tied to it, they ignore any new opportunities coming their way.
- Another problem with the master budget is that it is not easy to modify. Even a small alteration requires a lot of steps, thereby shaking the entire organizational planning.
Conclusion
Thus, the master budget is a one-year planning document used as a tool for the management to identify its goals well in advance and channelize the organization resources towards it. It provides a rough guideline for the company’s near-term expectations. It should be noted that the budget should be prepared with the utmost caution as it affects the operational performance of the entire organization.
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