Operational Budgeting

Chapter 23

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright 2012 The McGraw-Hill Companies, Inc. 23-1

Learning Objective 1

To understand budgeting process

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Budgeting: The Basis for Planning and Control

A budget is a comprehensive financial plan for achieving the financial and operational goals of an organization.

Planning
Developing objectives for acquisition and use of resources.

Control
Steps taken by management to ensure that objectives are attained.
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Benefits Derived from Budgeting

Enhanced management responsibility

Coordination of activities

Benefits

Performance evaluation

Assignment of decisionmaking responsibilities

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Establishing Budgeted Amounts: Behavioral Approach

Budget Problems
Perceived unfair or unrealistic goals. Poor managementemployee communications.

Solution
Reasonable and achievable budgets. Employee participation in budgeting process.

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Participation in Budget Process

Top Management

Middle Management

Middle Management

Supervisor

Supervisor

Supervisor

Supervisor

Flow of Budget Data

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Learning Objective 2

To prepare a comprehensive budget

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The Budget Period

The annual operating budget may be divided into quarterly or monthly budgets.

2008

2009

2010

2011

Capital Budgets are for longer periods of time.

A continuous budget is usually a twelve-month budget that adds one month as the current month is completed.
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The Master Budget

Sales budget Production budgets Cost of goods manufactured and sold budget

Financial budgets: cash flow income stmt. balance sheet capital

Cash budget

Selling and administrative budget

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Steps in Preparing a Master Budget

Sales Budget
Estimated Unit Sales Estimated Unit Price

Analysis of economic and market conditions

+
Forecasts of customer needs from marketing personnel
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Preparing the Master Budget

Basket, Inc. is preparing budgets for the quarter ending June 30. The sales price is $10 per magnet. Budgeted sales for the next four months are:

April 20,000 magnets @ $10 = $200,000 May 50,000 magnets @ $10 = $500,000 June 30,000 magnets @ $10 = $300,000 July 25,000 magnets @ $10 = $250,000

The Sales Budget

July is needed for June ending inventory computations.

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The Production Budget

Production must be adequate to meet budgeted sales and to provide sufficient ending inventory. Budgeted product sales in units + Desired product units in ending inventory = Total product units needed Product units in beginning inventory = Product units to produce

The management of Basket wants ending inventory to be 20 percent of the next months budgeted sales in units.
4,000 units were on hand March 31. Lets prepare the production budget.

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The Production Budget

Budgeted unit sales Desired ending inventory Total units needed Less beginning inventory Units to produce April 20,000 10,000 30,000 4,000 26,000 May 50,000 6,000 56,000 10,000 46,000 June 30,000 5,000 35,000 6,000 29,000

Ending inventory = 20% of next month's sales needs. June ending inventory = .20 25,000 July units = 5,000 units. Beginning inventory is last month's ending inventory.

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The Production Budget Material Purchases

The material purchases budget is based on production quantity and desired material inventory levels.
= + = =
Units to produce Material needed per unit Material needed for units to produce Desired units of material in ending inventory Total units of material needed Units of material in beginning inventory Units of material to purchase
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The Production Budget Material Purchases

Five pounds of material are needed for each unit produced.

The management at Basket wants to have materials on hand at the end of each month equal to 10 percent of the following months production needs.
The materials inventory on March 31 is 13,000 pounds. July production is budgeted for 23,000 units.
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The Production Budget Material Purchases

Units to produce Pounds per unit Material needs (lbs.) Desired ending inventory Total material needs (lbs.) Less beginning inventory Material purchases (lbs.) April 26,000 5 130,000 23,000 153,000 13,000 140,000 May 46,000 5 230,000 14,500 244,500 23,000 221,500 June 29,000 5 145,000 11,500 156,500 14,500 142,000

Ending inventory = 10% of next month's material needs. June ending inventory = .10 (23,000 units 5 lbs. per unit). June ending inventory = 11,500 lbs. Beginning inventory is last month's ending inventory.
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Cash Payments for Material Purchases

Materials used in production cost $0.40 per pound. One-half of a months purchases are paid for in the month of purchase; the other half is paid for in the following month.
No discount terms are available. The accounts payable balance on March 31 is $12,000.
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Cash Payments for Material Purchases

Material purchases (lbs.) Cost per pound Total cost Payables from March April purchases May purchases June purchases Total payments in month $56,000 = $28,000 $88,600 = $44,300 $56,800 = $28,400
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April 140,000 $ 0.40 $ 56,000 $ 12,000 28,000

May 221,500 $ 0.40 $ 88,600 $ 28,000 44,300 $ 72,300

June 142,000 $ 0.40 $ 56,800

$ 40,000

$ 44,300 28,400 $ 72,700

The Production Budget Direct Labor

Each unit produced requires 3 minutes (.05 hours) of direct labor. Basket employs 30 persons for 40 hours each week at a rate of $10 per hour. Any extra hours needed are obtained by hiring temporary workers also at $10 per hour.
April 26,000 0.05 1,300 $ 10 $ 13,000 May 46,000 0.05 2,300 $ 10 $ 23,000 June 29,000 0.05 1,450 $ 10 $ 14,500
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Units to produce Hours per unit Total hours required Wage rate per hour Direct labor cost

The Production Budget Manufacturing Overhead

Variable manufacturing overhead is $1 per unit produced and fixed manufacturing overhead is $50,000 per month. Fixed manufacturing overhead includes $20,000 in depreciation which does not require a cash outflow.

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Cash Payments for Manufacturing Overhead

April Units to produce 26,000 Variable overhead rate $ 1.00 Variable overhead cost $ 26,000 Fixed overhead 50,000 Total mfg. overhead cost $ 76,000 Deduct depreciation 20,000 Manufacturing overhead - cash $ 56,000 May 46,000 $ 1.00 $ 46,000 50,000 $ 96,000 20,000 $ 76,000 June 29,000 $ 1.00 $ 29,000 50,000 $ 79,000 20,000 $ 59,000

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Selling and Administrative (S&A) Expense Budget

Selling expense budgets contain both variable and fixed items.
Variable items: shipping costs and sales commissions.

Fixed items: advertising and sales salaries.

Administrative expense budgets contain mostly fixed items.

Executive salaries and depreciation on company offices.
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Cash Payments for (S&A) Expenses

Variable selling and administrative expenses are $0.50 per unit sold and fixed selling and administrative expenses are $70,000 per month.

Fixed selling and administrative expenses include $10,000 in depreciation which does not require a cash outflow.

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Cash Payments for (S&A) Expenses

Budgeted unit sales Variable S&A per unit Variable S&A expense Fixed S&A expense Total S&A expense Deduct depreciation S&A expense - cash April 20,000 $ 0.50 $ 10,000 70,000 $ 80,000 10,000 $ 70,000 May 50,000 $ 0.50 $ 25,000 70,000 $ 95,000 10,000 $ 85,000 June 30,000 $ 0.50 $ 15,000 70,000 $ 85,000 10,000 $ 75,000

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Cash Receipts Budget

All sales are on account.
Baskets collection pattern is: 70 percent collected in month of sale

25 percent collected in month after sale

5 percent will be uncollectible

Accounts receivable on March 31 is $30,000, all of which is collectible.

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Cash Receipts Budget

Budgeted unit sales Price per unit Budgeted sales revenue Receipts from March sales Receipts from April sales Receipts from May sales Receipts from June sales Total cash receipts April 20,000 $ 10 $ 200,000 $ 30,000 140,000 May 50,000 $ 10 $ 500,000 $ 50,000 350,000 $ 400,000 June 30,000 $ 10 $ 300,000

$ 170,000

$ 125,000 210,000 $ 335,000

April: .70 $200,000 = $140,000 and .25 $200,000 = $50,000 May: .70 $500,000 = $350,000 and .25 $500,000 = $125,000 June: .70 $300,000 = $210,000
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Comprehensive Cash Budget Additional Information

Basket Company: Has a $100,000 line of credit at its bank, with a zero balance on April 1. Maintains a $30,000 minimum cash balance. Borrows at the beginning of a month and repays at the end of a month. Pays interest at 16 percent when a principal payment is made. Pays a $51,000 cash dividend in April. Purchases equipment costing $143,700 in May and $48,800 in June. Has a $40,000 cash balance on April 1.
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Comprehensive Cash Budget

Beginning cash balance Cash receipts Cash available Cash payments: Materials budget Labor budget Manufacturing OH budget S&A expense budget Equipment purchases Dividends Total cash payments Balance before financing Borrowing Principal repayment $50,000 Interest Ending cash balance April $ 40,000 170,000 $ 210,000 $ 40,000 13,000 56,000 70,000 0 51,000 $ 230,000 $ (20,000) 50,000 0 .16 3/12 0 $ 30,000 May $ 30,000 400,000 $ 430,000 $ 72,300 23,000 76,000 85,000 143,700 0 $ 400,000 $ 30,000 0 0 $2,000 0 $ 30,000 June $ 30,000 335,000 $ 365,000 $ 72,700 14,500 59,000 75,000 48,800 0 $ 270,000 $ 95,000 0 (50,000) (2,000) $ 43,000
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The Budgeted Income Statement

Basket Company Budgeted Income Statement For the Three Months Ended June 30 Sales (100,000 units @ $10) Cost of goods sold (100,000 @ $4.99) Gross margin Selling and administrative expenses Computation of unit cost Operating income follows after we complete Interest expense the income From statement S&A Expense Budget Net income
April May June Total $ 80,000 95,000 85,000 $ 260,000

$ 1,000,000 499,000 $ 501,000 260,000 $ 241,000 2,000 $ 239,000

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The Budgeted Income Statement

Production costs per unit Direct materials Direct labor Manufacturing overhead Total unit cost Quantity Cost 5.00 lbs. $ 0.40 0.05 hrs. $ 10.00 0.05 hrs. $ 49.70 Total $ 2.00 0.50 2.49 $ 4.99

Total mfg. OH for quarter $251,000 = = $49.70 per hr. Total labor hours required 5,050 hrs.
From labor and Mfg. OH budgets April May June Total Labor Hours 1,300 2,300 1,450 5,050 Mfg. OH $ 76,000 96,000 79,000 $ 251,000

Manufacturing overhead is applied based on direct labor hours.

23-30

The Budgeted Balance Sheet

Basket reports the following account balances on June 30, prior to preparing its budgeted financial statements:
Land - $50,000 Building (net) - $174,500 Common stock - $200,000 Equipment (net) - $192,500 Retained earnings - $148,150 Paid dividends of $51,000
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Basket Company 25% of June Budgeted Balance Sheet sales of June 30, 2009 $300,000 Current assets Cash $ 43,000 Accounts receivable 75,000 Raw materials inventory 4,600 Finished goods inventory 24,950 11,500 lbs. Total current assets $ 147,550 @ $.40 per lb. Property and equipment 5,000 units Land $ 50,000 @ $4.99 each Building 174,500 Equipment 192,500 Total property and equipment $ 417,000 Beginning balance $ 148,150 Total assets $ 564,550 50% of June Add: net income 239,000 purchases Deduct: dividends (51,000) Liabilities and Equities of $56,800 Ending balance $ 336,150 Accounts payable $ 28,400 Common stock Retained earnings Total liabilities and equities 200,000 336,150 $ 564,550
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Learning Objective 3

Advanced budgeting: Flexible budget

23-33

Flexible Budgeting
Hmm! Comparing costs at different levels of activity is like comparing apples with oranges.

Performance evaluation is difficult when actual activity differs from the activity originally budgeted.

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Flexible Budgeting
Original Budget Units of Activity 10,000 Actual Results 8,000 Variances 2,000 U $6,000 F 4,500 F 1,200 F 0 0 $11,700 F

Variable costs U = Unfavorable variance $ Barton, Indirect labor $ 40,000 34,000 was unable to achieve the Indirect Inc. materials 30,000 25,500 budgeted level of activity. 3,800 Power 5,000 Fixed costs we done area less good than job budgeted controlling costs. costs? Depreciation 12,000 12,000 Insurance 2,000 2,000 Total overhead costs $ 89,000 $ 77,300

Since F =cost Favorable variances variance: are favorable, actual costs have

23-35

Flexible Budgeting
I dont think I can answer the question using the original budget. How much of the favorable cost variance is due to lower activity, and how much is due to good cost control?

To answer the question, we must the budget to the actual level of activity.
Central Concept: If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been.
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Flexible Budgeting
To a budget for different activity levels, we must know how costs behave with changes in activity levels.
Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range.
Fixed

23-37

Deficiencies of the Static Planning Budget

The relevant question is . . .
How much of the cost variances is due to higher activity, and how much is due to cost control?

To answer the question, we must the budget to the actual level of activity.

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Prepare a report showing activity (volume) variances. Planning budget VS Flexible budget

23-39

Activity Variances
Larrys Flexible Budget Compared with the Planning Budget

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Activity Variances
Larrys Flexible Budget Compared with the Planning Budget
Activity and revenue increase by 10 percent, but net operating income increases by more than 10 percent due to the presence of fixed costs.

23-41

Prepare a report showing revenue and spending variances. Flexible Budget VS Actual

23-42

Revenue and Spending Variances

Flexible budget revenue Actual revenue

The difference is a revenue variance.

Flexible budget cost

Actual cost

The difference is a spending variance.

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Revenue and Spending Variances Larrys Flexible Budget Compared with the Actual Results
$1,750 favorable revenue variance

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Revenue and Spending Variances Larrys Flexible Budget Compared with the Actual Results
Spending variances

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Prepare a performance report that combines activity variances and revenue and spending variances.

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A Performance Report Combining Activity and Revenue and Spending Variances

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End of Chapter 23

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