Financial Budgets
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Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Where operating budgets focus on how many units to produce, financial budgets focus on the cash budget and pro forma financial statements — translating those production plans into dollars and cash flow.
What is the cash budget?
The cash budget answers a few key questions: What's our beginning cash balance? How much cash do we expect to receive? How much do we expect to pay out? How much ending cash do we need?
The tricky part is that expected costs and expected cash flows aren't the same thing, because of accrual timing. Say a company expects to spend $725,000 on direct materials and $3,500,000 on direct labor — that doesn't mean it disburses $4,225,000 in cash that period. Materials are typically bought on credit, increasing accounts payable rather than requiring immediate cash. Meanwhile, the company is paying off AP balances from prior periods in the current one.
The same logic applies to collections. If a company expects to sell $200 million worth of product, that doesn't mean it collects $200 million in cash that period either — sales on credit create accounts receivable, and the cash comes in later, while AR balances from prior periods get collected now.
What are pro forma financial statements?
Pro forma statements aren't built from actual results — they're projections of what a company expects to happen. Think of "pro forma" as "projected." A full set includes a pro forma balance sheet, pro forma income statement, and pro forma cash flow statement.
Practice question: the direct materials budget
Using the following data, what is the total direct materials purchasing budget?
| Item | Units | Notes |
|---|---|---|
| Number of units sold | 14,500 | — |
| Beginning finished goods inventory | 1,500 | — |
| Ending finished goods inventory | 3,000 | 1,500-unit increase in finished goods |
| Beginning direct materials inventory | 2,000 | — |
| Ending direct materials inventory | 1,500 | 500-unit decrease (used from prior period) |
| Direct materials cost per unit | $5 | — |
Budgets have to be built in order: sales budget, then production budget, then direct materials and direct labor budgets. You can't skip straight to materials.
Step 1: the sales and production budgets
The company plans to sell 14,500 units — but that's not the same as how many units it needs to produce. A finished unit sits in finished goods inventory until it's sold. Since ending finished goods inventory (3,000) is 1,500 units higher than beginning (1,500), the company needs to produce 1,500 more units than it sells:
Step 2: the direct materials budget
Producing 16,000 units doesn't mean buying materials for all 16,000, either. Beginning direct materials inventory (2,000 units' worth) was higher than ending (1,500 units' worth) — a 500-unit decrease, meaning the company used up materials it already had on hand from a prior period instead of buying new ones for those units:
| Budget | Units | Dollar Amount |
|---|---|---|
| Sales | 14,500 | — |
| Production | 16,000 | — |
| Direct Materials | 15,500 | $77,500 |
Every budget in the sequence adjusts for inventory you already have. Sales tells you what leaves the door; production adjusts for finished goods you're holding; materials purchases adjust again for raw materials you're holding. Skip either adjustment and the number is wrong.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.