Answer

A master budget is a detailed and comprehensive budget that is made up of several other budgets like the operating budget, financial or capital expenditure budget that is made up of all the income generating processes including all expenses and revenues. Several methods can be used to develop a master budget; however, the two common ones include: top down and down up approaches have been discussed in this paper. The paper covers the differences between the two methods of developing a master budget and its application in 3D Oil Company. The most suitable method for developing the company’s budget is also discussed and justified.

A master Budget

Companies make use of financial budgets to assist in planning and operations control in a company or business enterprise. A master budget allows the management of a company to evaluate the performance of the organization in respect to the original plans when the budget was made. It is a document that outlines the financial plans of a company for a particular financial year. It may have an additional month for continuity purposes and referred to as a continuous budget (Peavler, 2018).

Elements of a Master Budget

A master budget refers to a document that is based on other individual specialized subjects which fall under three major categories;

a). Operating budgets

b). Capital expenditures budget

c). Financial budgets

Operating Budgets

These are budgets that are used to plan and maintain regular business activities of a company such as sales, general and administrative expenses and selling expenses. The sales budget records estimated expected income and expenses that directly relates to the company’s sales. It provides an estimate of the amount of earnings available to meet the company’s goals. The sales budget is based on sales forecasts (Peavler, 2018).

Selling expense budget is estimated from the projected expenses based on expected income and the sale of goods. Example of such expenses include sales manager’s salaries, sales expenses, sales commission, advertising and marketing expenses (Peavler, 2018).

The production budget is determined from the units that the company intends to sell in a particular financial year. The inventory requirements are taken into consideration when determining the production budget.

Other expenses not directly related to particular sales items are recorded under general expenses and administrative budget. Such costs include rent, depreciation expenses and other shared utilities. A master budget in accounting is a detailed and comprehensive budgetary plan that is usually made up of several other budgets like the operating budget that is made up of all the income generating processes including all expenses and revenues. It finally culminates into a document referred to as the income statement. Another budget that makes up the master budget is the financial budget and it shows all the cash inflows and outflows in a company or business enterprise. The details are drawn from the cash budget (Peavler, 2018).

Financial Budget

The financial budget is made up of the cash budget, capital expenditures budget and the budgeted balance sheet. The cash budget ignores costs that are in cash form such as depreciation. The budgeted statement of financial position provides the ending balances for all liabilities, equity accounts and assets (Peavler, 2018).

Capital Expenditures Budget

Capital expenditures budget is a financial document that has budgetary figures for assets that are fixed and are very large and expensive. Capital expenditure budgets are used within the master budget in most business firms. Some firms utilize some of the budgets while most use all the budget types.

Methods of Developing a Master Budget

There are two ways of developing a master budget:

Top Down Budget Approach

This is a process where the development of the budget stars with the top budget or the total budget and later broken into major components within the budget.

Bottom Up Budget Approach

This is a process where the development of the budget starts with a list or schedule of all items that would be required to make up the budget. The cost of the items are listed and added to get the total budget.

Figure 1 below shows the different decision making structure between top up and down up budget decision making processes.

Figure 1. Differences in Top Down and Down-Up Budget Approaches

 (Corporate Finance Institute, 2019).

In down up budget approach, the managers participate and provide input to the budget process. They own the process as they participated in its formation and find it easy to convince their teams on why they should work hard to achieve the targets of the budget processes but the lower level managers in top down budget approach do not participate in the decision making process and they may find it difficult to convince their teams on issues that they have not participated in not provided any input. However according to Kim and Park (2006) top down approach is the most convenient and the best budget approach to use. Kim and Park (2006) posit that;

“…top-down budgeting is the most efficient way of budget formulation and it is by no means a definite conclusion – the bottom-up approach still enjoys widespread use as the common budget formulation method in many countries…”(p. 89).

Top down budget approach allows the management to set a ceiling for all the lower managers’ not to surpass their expenditure goals when creating their budgets that must conform to the one provided.

Advantages of Top up Budget Process

Top-down budget approach starts with the company’s senior executives who make decisions on annual company objectives and goals. They discuss and come up with high-level targets for different departments that would affect sales, expenses and the company profits. The managers and lower level staff are not consulted nor participate when making the targets. However, the top executives may rely on the department’s previous performance or allocation (Corporate Finance Institute, 2019). The objective and overall framework for the budget is then passed on to the respective department. The major advantages of the top down approach are;

The budget reflects the company’s overall functional strategy as senior management focus on the company’s overall growth. Top down approach allows top management to allocate resources to all departments while prioritizing the order of importance (Corporate Finance Institute, 2019).

Top-down budgeting concentrates on the development of a single budget at a time while allowing the departments to work within a certain budget ceiling before combining all the budgets from different departments. The process is less tedious and allows budgets to be made only on set targets. It is quicker when compared with down up approach where lower level managers start from nothing (Corporate Finance Institute, 2019).

Top-Down Budget Disadvantages

Motivational levels are very low in top down budget process as lower level managers are supposed to implement budgetary decisions that they can fully explain to their subordinates as they never participated in the creation hence they do not own the processes making it difficult for them to own and fully support the processes. They lack incentives and motivation to execute the budgets successfully to their completion (Corporate Finance Institute, 2019).

The senior executives are not directly involved in the company’s daily activities and their view may deviate from the realistic expectations relating to expenses and revenues. The risks of overstating or understating resources required may be very high as the senior executives may make inaccurate targets that are not realistic or attainable. The lower level senior managers may find it very difficult to support and implement such budgets (Corporate Finance Institute, 2019).

Advantages of Bottom Up Budgeting

The bottom up budget creation process starts at the lower level manager’s office and moves upwards to the company’s top management. The departmental heads create the budgets based on past and present information while using past experience to create the provisions that would cushion the company in case the actual budget does not work out as expected. All the items found on the budget are explained and the necessary information included (Corporate Finance Institute, 2019).

Disadvantages of Bottom Up Budgeting

Bottom up budgeting process is time consuming as it requires lower level managers to start from scratch and create a budget that is within the company’s requirement. It may take several reviews before the budget is approved (Kim & Park, 2006).

3D Oil Limited

3D Oil Limited (TDO) is involved in oil and gas exploration in Australia. Its major property is the Melbourne’s Morning Star Gold mining project in Victoria (Yahoo Finance, 2018). 3D Oil Limited is an Australian company that operates from 41 Exhibition Street in Melbourne. The company has gas and oil assets in Gippsland Basin in Victoria with its exploration permit covering over 4,960 square kilometers off the shore of Otway Basin, Tasmania. It holds 100% in another exploration permit WA/527-P that covers over 6,580 square kilometers off the shore of Roebuck basin. 3D company was established in Melbourne in the year 2003. The company’s market capitalization amounted to 23.337 million in 2018 while the earnings per share for the same period was negative -0.005. The average shares traded amounted to 127,369 (3D Oil Limited Company, 2018).

                                        Table 1 Budgeted Income Statement for 2019

Source: (3D Oil Limited Company, 2018)

3D Oil Limited Budgetary Application Processes

3D Oil Limited operates in the energy industry which has a high volatility rate and the prices fluctuate constantly (Yahoo Finance, 2018). The company’s beta for the last three months was 3.23 and its shares were trading at AUD 0.088 per share in the Australian stock exchange. The best approach is to use is the Down up approach as that company’s shares are very volatile and material changes in prices of goods are very common. The materials used in the exploration and mining of Gold have constant prices but the high positive beta indicates that any changes in the stock market are replicated 3.23 times on the 3D share prices. The managers of 3D Oil Limited prepare budgets for various segments and departments in the oil and gas exploration and drilling operations. The company’s financial controller and his department prepare budgets based on information that has been provided from all the managers from different departments and sectors (3D Oil Limited Company, 2018).

The company’s budget committee is mandated to approve it but the preparation and estimates are done by the financial department. The company can either use the bottom up or the top-down budgeting approach however various departments like administrative budgets, exploration and finance budgets can be motivated to allow participatory budgeting as most executives believe that bottom-up budget approach is relatively successful due to its convenience and easiness to attract lower level managers who are not skilled in financial accounting and also they would be more cooperative to implement the budget since they also contributed to its some input on its preparation. 3D Oil limited annual report (2018) states that;

“…Exploration expenditure incurred is accumulated in respect of each identifiable area of interest. These costs are only carried forward in relation to each area of interest to the extent…” p.31.

The exploration costs cannot be predicted and they have to be prepared by the employees dealing in particular areas of concern. Bottom up budgeting is suitable for the company as oil exploration is made up of many projects that require different exploration permits at different exploration and mining periods. Bottom up budgetary approach is mostly applicable when budget items are not static and each budgetary allocation has to be started from scratch. Top down budgetary approach uses historical figures to build up a budget. The items change by percentages but ostensibly most items remain the same.

The following is the budgeted income statement for 3D Oil limited. Compared to the actual income statement, the budgeted income statement is a little different but the revenues reflect a constant increasing trend as reflected in table 1 below. The gross profit follows the same increasing trend but the selling and administrative expenses indicate that the budget expenses will increase unlike the historical cost patterns that indicate a different perspective.

              Table 2 Budgeted Income Statement for 2019 and Actual Income Statement

Source: (3D Oil Limited Company, 2018)

Table 2 Trend Analysis for the Years 2018 and 2019 Forecast

Source: (3D Oil Limited Company, 2018)

                            3D Oil Limited (TDO) Historical Trend Analysis for Revenues & Expenses

Figure 2. 3D Oil Limited (TDO) Historical Trend Analysis for Revenues & Expenses

Source: (3D Oil Limited Company, 2018)

The budgetary allocation for 2019 as viewed from the historical trend analysis would deviate from the pattern forecasted from historical records. The total expenses net indicate that the trend would certainly increase and not decrease while the same case has been reflected for gross profit however the operating income, selling and general administrative expenses would follow a similar pattern as indicated by the budgeted income statement. The operating would improve as well as the selling and general expenses as shown on figure 2 above. Other options that may work well with 3D Oil Limited would be to apply top down budget option when preparing the details for the sales and production budgets while for exploration budgets the down up approach can be used to compile the budget. For the energy industry, generally the best method that can work well with companies like 3D Oil limited is the bottom up.

The company is mainly engaged in oil and gas exploration in different parts of Australia and other parts of the world that the company is still targeting. The best approach is the bottom up as the managers on the ground are aware of the requirements and conditions on the ground. It would take more time for senior executives to come to the ground to make accurate estimates hence its easier if the lower managers are allowed to take part in the budget making process before the master budget for the company is rolled out for every financial year. It is difficult to apply the top down budget concept in companies operating in the oil sector as most of the work is prospective and the amounts to be spent depends on the lower level managers on the ground. Motivated lower level managers would have the incentives to execute the budget in a way that the company can remain profitable despite the resources set aside for prospective and exploration activities.                           

Conclusion

The best budgeting approach depends on the decisions of the management and the industry that the company is operating in. For the energy industry, the best method for companies like 3D Oil limited is the bottom up. The company is engaged in oil and gas exploration in different parts of Australia and other parts of the world that the company is still targeting. The best approach is the bottom up as the managers on the ground are aware of the requirements and conditions on the ground. It would take more time for senior executives to come to the ground to make accurate estimates, hence its easier if the lower managers are allowed to take part in the budget making process before the master budget for the company is rolled out for every financial year. Top-down budget approach starts with the company’s senior executives who make decisions on annual company objectives and goals. It involves discussions and coming up with high-level targets for different departments that would affect sales, expenses and the company profits.