Master Budget

The master budget is the aggregation of all lower-level budgets produced by a company's various
functional areas, and also includes budgeted financial statements, a cash forecast, and a financing
plan. The master budget is typically presented in either a monthly or quarterly format, and
usually covers a company's entire fiscal year. An explanatory text may be included with the
master budget, which explains the company's strategic direction, how the master budget will
assist in accomplishing specific goals, and the management actions needed to achieve the budget.
There may also be a discussion of the headcount changes that are required to achieve the budget.
A master budget is the central planning tool that a management team uses to direct the activities
of a corporation, as well as to judge the performance of its various responsibility centers. It is
customary for the senior management team to review a number of iterations of the master budget
and incorporate modifications until it arrives at a budget that allocates funds to achieve the
desired results. Hopefully, a company uses participative budgeting to arrive at this final budget,
but it may also be imposed on the organization by senior management, with little input from
other employees.
The budgets that roll up into the master budget include:

Direct labor budget

Direct materials budget

Ending finished goods budget

Manufacturing overhead budget

Production budget

Sales budget

Selling and administrative expense budget

The selling and administrative expense budget may be further subdivided into budgets for
individual departments, such as the accounting, engineering, facilities, and marketing
departments.
Once the master budget has been finalized, the accounting staff may enter it into the company's
accounting software, so that the software can issue financial reports comparing budgeted and
actual results.
Smaller organizations usually construct their master budgets using electronic spreadsheets.
However, spreadsheets may contain formula errors, and also have a difficult time constructing a

budgeted balance sheet. Larger organizations use budget-specific software, which does not have
these two problems.
Example of the Master Budget
Many lower-level budgets have specific formats that are used to arrive at certain outcomes, such
as the fully absorbed cost of the finished goods inventory, or the number of units of products to
be manufactured. This is not the case for the master budget, which looks very much like a
standard set of financial statements. The income statement and balance sheet will be in the
normal format mandated by Generally Accepted Accounting Principles or International Financial
Reporting Standards. The primary difference is the cash budget, which does not usually appear in
the standard format of the statement of cash flows. Instead, it serves the more practical purpose
of identifying specific cash inflows and outflows that will result from the rest of the budget
model. Here is an example of the cash budget:
Alpha Intergalactic Corporation
Cash Budget
For the Year Ended December 31, 20XX
Quarter 1

Quarter 2

Quarter 3

Quarter 4

$100,000

$98,000

$95,000

$38,000

+/- Net profit (loss)

+25,000

+12,000

+40,000

+23,000

+ Depreciation

+15,000

+15,000

+22,000

+24,000

- Capital expenditures

-28,000

-80,000

-35,000

+/- Working capital changes

-14,000

-30,000

-39,000

-21,000

= Ending cash

$98,000

$95,000

$38,000

$29,000

Beginning cash

The most difficult item to estimate in the cash budget is the net change in working capital from
period to period. During periods of rapid growth, working capital can be a strongly negative
number, since the company must invest in more accounts receivable than usual. If the amount of
work capital appears to be holding steady despite rapid growth, then it is quite likely that
management has built an unrealistic expectation into the budget to be able to collect accounts
receivable more quickly than has been the case in the past.
A similar problem can arise with inventory, which is another component of working capital. It
generally takes more inventory to support more sales, so the portion of working capital
comprised of inventory can be expected to increase in conjunction with more sales. Thus, it is
extremely likely that a company experiencing any amount of growth will forecast negative cash
flow, because of the need to fund additional working capital.

Other Master Budget Issues

Another document sometimes included in the master budget is a set of key performance metrics
that are calculated based on the information in the budget. For example, it may show accounts
receivable turnover, or inventory turnover, or earnings per share. These metrics are useful for
testing the validity of the budget model against actual results in the past. For example, if the
accounts receivable turnover metric is much lower than historical results, that could mean that
the company is over-estimating its ability to collect accounts receivable promptly, which means
that the amount of accounts receivable shown in the balance sheet may be understated, and the
amount of cash may be overstated.
Master Budget Problems
When a company implements a master budget, there is a strong tendency for senior management
to force the organization to closely adhere to it by including budget goals in employee
compensation plans. Doing so has the following effects:

When compiling the budget, employees tend to estimate low revenues and high expenses,
so that they can easily meet the budget and achieve their compensation plans.

Forcing the organization to follow the budget requires a group of financial analysts who
track down and report on variances from the plan. This adds unnecessary overhead
expense to the business.

Managers tend to ignore new business opportunities, because all resources are already
allocated toward attaining the budget, and their personal incentives are tied to the budget.

Thus, enforcing a master budget can skew the operational performance of a business. Because of
this problem, it may be better to employ the master budget as just a rough guideline for
management's near-term expectations for the business.