Introduction to Management Accounting | ICE 7 | Master Budgeting
Difficulty: Intermediate | Prerequisites: Basic understanding of income statements, balance sheets and the accounting equation. Familiarity with cost of goods sold and accounts receivable concepts.
Master budgeting ties together every major financial plan a company makes for an upcoming period: how much cash it expects to collect, what it needs to buy, what it will spend, and where it will end up financially. This exercise walks through the full cycle for a merchandising firm, from forecasting sales collections through to a budgeted balance sheet. If you can build these schedules from a set of assumptions, you can build any operating budget. The skill tested here is not just arithmetic, it is understanding how each schedule feeds the next.
A master budget for a merchandising company chains five schedules together: cash collections (when you receive money from sales), purchases budget (what inventory you need to buy), cash budget (will you have enough cash?), budgeted income statement (profit on an accrual basis) and budgeted balance sheet (where everything stands at period end). Each schedule pulls numbers from the one before it, so one wrong assumption cascades through the lot.
Schedule of expected cash collections
A month-by-month forecast of when credit sales will convert into actual cash received. It accounts for the timing lag between making a sale and collecting the money.
In simple terms, this is your answer to "when does the money from our sales land in the bank account?"
Merchandise purchases budget
A schedule that calculates how much inventory a company must purchase in a given period, based on expected cost of goods sold and desired ending inventory levels.
Think of it as: "how much stock do we need to buy this month so we don't run out next month?"
Cash budget
A summary of all expected cash inflows and outflows for a period, used to determine whether the company will have enough cash on hand or will need financing.
In simple terms, this is a bank-account forecast: money in, money out, what is left.
Budgeted income statement
A projected profit-and-loss statement prepared on an accrual basis. It includes non-cash expenses like depreciation and bad debts that do not appear in the cash budget.
Think of it as the "on paper" profit picture, which includes costs you have not physically paid yet.
Budgeted balance sheet
A projected snapshot of assets, liabilities and equity at the end of the budget period, built from the results of all other budget schedules.
In simple terms, this is where everything lands once you combine the cash budget, the income statement and the inventory figures.
Cost of goods sold (COGS)
The direct cost of the merchandise a company sells during a period, expressed here as a percentage of sales revenue (65% in this exercise).
Uncollectible accounts (bad debts)
The portion of credit sales the company expects never to collect. In this exercise, 5% of each month's sales are written off.
Ending merchandise inventory
The stock a company wants to have on hand at the end of a period. Here it is set at 80% of the following month's COGS, ensuring enough inventory is available to start the next month.
The assumptions driving collections:
75% of sales collected in the month of sale
20% collected in the month following the sale
5% uncollectible (written off as bad debts)
Sales figures: November $320,000, December $340,000, January $330,000.
How to build the schedule
For each month, you layer collections from multiple months' sales. November's cash receipts include:
20% of October's sales: 0.20 x $410,000 = $82,000 (October sales are implied from the answer)
75% of November's sales: 0.75 x $320,000 = $240,000
Total November collections: $322,000
December's cash receipts include:
20% of November's sales: 0.20 x $320,000 = $64,000
75% of December's sales: 0.75 x $340,000 = $255,000
Total December collections: $319,000
The key insight: each month's collections come from at least two different months' sales. You are stacking layers, not simply applying one percentage to one number.
November | December | |
|---|---|---|
From October sales | $82,000 | - |
From November sales | $240,000 | $64,000 |
From December sales | - | $255,000 |
Expected cash collections | $322,000 | $319,000 |
The goal is to figure out how much inventory to buy each month. The logic runs in four steps:
Calculate budgeted COGS for the month: Sales x 65%
November: $320,000 x 0.65 = $208,000
December: $340,000 x 0.65 = $221,000
Calculate desired ending inventory: next month's COGS x 80%
November ending inventory: $221,000 x 0.80 = $176,800
December ending inventory: ($330,000 x 0.65) x 0.80 = $214,500 x 0.80 = $171,600
Add COGS and desired ending inventory to get total needs
November: $208,000 + $176,800 = $384,800
December: $221,000 + $171,600 = $392,600
Subtract beginning inventory (which equals the previous month's ending inventory)
November: $384,800 - $166,400 = $218,400
December: $392,600 - $176,800 = $215,800
Critical link: November's ending inventory becomes December's beginning inventory. This is where students most often lose the thread.
November | December | |
|---|---|---|
Budgeted COGS | $208,000 | $221,000 |
+ Desired ending inventory | $176,800 | $171,600 |
= Total needs | $384,800 | $392,600 |
- Beginning inventory | ($166,400) | ($176,800) |
Budgeted purchases | $218,400 | $215,800 |
The cash budget brings collections and disbursements together to show whether the company has enough cash. Two important details from the problem:
Merchandise is paid for in the month after purchase (so November's disbursement of $199,000 is for October's purchases, and December's $218,400 is for November's purchases)
Other monthly cash expenses: $21,000
Depreciation ($16,000/month) is not a cash outflow and does not appear in the cash budget
Building the cash budget
Start with beginning cash, add receipts (from the collections schedule), subtract disbursements, and see what remains.
November | December | |
|---|---|---|
Cash disbursement for merchandise | $199,000 | $218,400 |
Other monthly cash expenses | $21,000 | $21,000 |
Total cash disbursements | $220,000 | $239,400 |
Beginning cash balance | $22,000 | $124,000 |
+ Cash receipts | $322,000 | $319,000 |
= Total cash available | $344,000 | $443,000 |
- Cash disbursements | $220,000 | $239,400 |
= Excess of cash available | $124,000 | $203,600 |
Financing | 0 | 0 |
Ending cash balance | $124,000 | $203,600 |
Notice November's ending cash ($124,000) becomes December's beginning cash. The company needs no financing in either month because cash available exceeds disbursements.
The income statement works on an accrual basis, so it includes items the cash budget ignores:
Bad debts: 5% of each month's sales (November: 0.05 x $320,000 = $16,000; December: 0.05 x $340,000 = $17,000)
Depreciation: $16,000 per month (a non-cash expense)
Note: The source answer shows December bad debts as $16,000 rather than $17,000. This appears to be a rounding or simplification in the original. Strictly, 5% of $340,000 = $17,000.
November | December | |
|---|---|---|
Sales | $320,000 | $340,000 |
Less: COGS | $208,000 | $221,000 |
Gross margin | $112,000 | $119,000 |
Less: Monthly expense | $21,000 | $21,000 |
Less: Bad debts | $16,000 | $16,000 |
Less: Depreciation | $16,000 | $16,000 |
Net operating income | $59,000 | $65,000 |
The income statement shows profit, but profit is not cash. November's net operating income is $59,000, yet the company's cash balance grew by $102,000 ($124,000 - $22,000). The difference comes from non-cash charges, timing of collections and timing of payments.
The balance sheet pulls together the results of every other schedule. Each line traces back to a specific source:
Cash: ending cash balance from the December cash budget ($203,600)
Accounts receivable: December sales not yet collected. 20% of $340,000 = $68,000 (the 75% was collected in December; 5% is uncollectible and written off)
Merchandise inventory: desired ending inventory for December ($171,600, from the purchases budget)
PPE: prior balance minus two months of depreciation. Starting PPE of $1,170,000 - (2 x $16,000) = $1,138,000
Assets | |
|---|---|
Cash | $203,600 |
Accounts receivable | $68,000 |
Merchandise inventory | $171,600 |
PPE (net) | $1,138,000 |
Total assets | $1,581,200 |
Liabilities and stockholders' equity | |
|---|---|
Accounts payable | $215,800 |
Common stock | $840,000 |
Retained earnings | $525,400 |
Total liabilities and SE | $1,581,200 |
Accounts payable equals December's budgeted purchases ($215,800), because merchandise is paid in the month following purchase.
Retained earnings equals the prior balance plus November and December net operating income ($59,000 + $65,000 = $124,000). The implied prior retained earnings: $525,400 - $124,000 = $401,400.
Cash collections for month M:
Collections = (Prior month's sales x Carryover %) + (Month M sales x Current-month %)
Budgeted COGS:
COGS = Sales x COGS percentage
Desired ending inventory:
Ending inventory = Next month's COGS x Inventory policy %
Budgeted purchases:
Purchases = COGS + Desired ending inventory - Beginning inventory
Cash budget ending balance:
Ending cash = Beginning cash + Cash receipts - Cash disbursements +/- Financing
Accounts receivable on the balance sheet:
AR = Most recent month's sales x (percentage not yet collected, excluding uncollectible)
This is how any business with seasonal sales or credit terms manages its cash. A company that sells on credit (30-day terms, for example) needs a collections schedule to avoid running out of cash between making the sale and receiving payment. Retailers and wholesalers use the purchases budget logic to decide how much inventory to order each month, balancing the cost of carrying too much stock against the risk of stockouts.
Students often include depreciation as a cash outflow in the cash budget. Depreciation is a non-cash expense. It appears on the income statement but never in the cash budget.
Students sometimes forget that collections in a given month come from multiple months' sales. November's cash includes money from October's sales, not just November's.
A common error is using the same month's COGS as both the ending inventory base and the current month's COGS. Ending inventory is based on the following month's COGS.
Students frequently confuse budgeted purchases with COGS. They are different: purchases account for inventory build-up or draw-down, while COGS reflects only what was sold.
⚠️ You will almost certainly be asked to prepare at least one of these schedules from a set of assumptions. Practise building them from scratch, not just reading completed ones.
⚠️ The cash budget vs. income statement distinction is a favourite exam topic. Know which items appear where: depreciation and bad debts on the income statement only; actual cash payments on the cash budget only.
⚠️ Watch for the one-month payment lag on merchandise purchases. The amount paid in cash this month is last month's purchases, not this month's.
⚠️ Ending inventory policy is a common setup for calculation questions. Make sure you read whether it is based on the current month's or the following month's COGS.
True or false: Depreciation appears as a cash outflow in the cash budget.
Answer: False. Depreciation is a non-cash expense.
Fill in the blank: If December sales are $340,000 and 75% are collected in the month of sale, cash collected from December sales in December is ______.
Answer: $255,000.
True or false: Beginning inventory for December equals ending inventory for November.
Answer: True.
Fill in the blank: If COGS is 65% of sales and sales are $320,000, COGS equals ______.
Answer: $208,000.
True or false: Accounts payable on the budgeted balance sheet equals the current month's COGS.
Answer: False. It equals the current month's budgeted purchases (since purchases are paid in the following month).
Q: If January sales are $330,000, what is January's budgeted COGS?
A: $330,000 x 0.65 = $214,500.
Q: What is the desired ending merchandise inventory for December, given that January COGS is $214,500 and the inventory policy is 80% of the following month's COGS?
A: $214,500 x 0.80 = $171,600.
Q: Why does the cash budget for November show a merchandise disbursement of $199,000 when November's budgeted purchases are $218,400?
A: Because merchandise is paid for in the month following purchase. The $199,000 paid in November is for October's purchases. November's purchases of $218,400 will be paid in December.
Q: A company collects 75% of sales in the month of sale and 20% the following month. If November sales are $320,000 and December sales are $340,000, how much of November's sales are collected in December?
A: 20% of $320,000 = $64,000.
Q: Explain why net operating income ($59,000 in November) differs from the increase in cash ($102,000 in November).
A: Net operating income is calculated on an accrual basis and includes non-cash charges (depreciation of $16,000 and bad debts of $16,000). The cash increase reflects actual cash collected (including collections from prior months' sales) minus actual cash paid out (including payments for prior months' purchases). The timing differences between accrual recognition and cash movement cause the two figures to diverge.
This material connects directly to cost-volume-profit (CVP) analysis, because the COGS percentage is a variable cost ratio applied to sales. If you change the sales forecast, every downstream schedule changes with it.
The cash budget links to topics on short-term financing and working capital management. When the cash budget shows a shortfall, the company must arrange a line of credit or short-term loan, which connects to the financing section of many courses.
The distinction between accrual income and cash flow is foundational for understanding the statement of cash flows, which reconciles net income back to actual cash generated.
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