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FINANCIAL &

MANAGERIAL
ACCOUNTING for MBAs
Peter D. Easton Robert F. Halsey Mary Lea McAnally Al L. Hartgraves Wayne J. Morse
Fourth Edition

MODULE 21
Operational Budgeting and
Profit
Planning

Cambridge Business Publishers,


Learning Objective 1

Discuss the importance


of budgets.

Cambridge Business Publishers, 2015 2


Reasons for Budgeting

Budgets
Require people to think about the
future
Move a company from a reactive to a
proactive style of management
Improve communication and
coordination
Provide a guide to action
Provide a basis of performance
evaluation
Aid in risk management
Cambridge Business Publishers, 3
Management by Exception

Management compares results with


budgeted amounts
Attention is directed only to those
activities not proceeding as planned
Saves time by not requiring
management to examine every past
activity

Cambridge Business Publishers, 4


Risk Management
RISK is the danger that things will
not go according to plan.

Risk can be associated with positive


impact:
Increase in sales volume
Increase in selling prices
Risk is more commonly associated with
negative impact:
Work stoppage at a key supplier
Fire
Hackers
Cambridge Business Publishers, 5
Aid in Risk Management

Risk management, or enterprise risk


management, is the process of identifying,
evaluating, and planning possible
responses to risks.

Useful tools to manage risk:


An organizations budget model can:
Evaluate the financial impact of risk
Determine best response from a financial perspective
Performance evaluation procedures, if completed
on a timely basis, assist in monitoring risk
Cambridge Business Publishers, 6
Aid in Risk Management
RISK IDENTIFICATION
Identify possible risks and their implications.

RISK ASSESSMENT AND QUANTIFICATION


Predict each risks probability and impact, including financial impacts.
Classify risks by importance to the organization.

RISK RESPONSE
Select a response to each risk:
Avoid risk, e.g. do not accept project
Transfer risk, e.g. purchase insurance
Mitigate risk, e.g. contingency plans
Accept risk, e.g. risk low, risk will not have a significant impact, or risk
unavoidable

RISK MONITORING
Develop procedures to continuously monitor important risks with the goal of
facilitating a timely response.
Alan J. Chilcott, Risk Management A Developing Field of Study and
Application, Cost Engineering September 9, 2010, pp. 9-16; Neville Turbit,
Basics of Managing Risk, The Project Perfect White Paper Collection,
Cambridge Business Publishers, www.projectperfect.com.au. 7
Learning Objective 2

Describe basic approaches


to budgeting.

Cambridge Business Publishers, 2015 8


Approaches to Budgeting

Cambridge Business Publishers, 9


Output/Input Approach to Budgeting

Budgets physical inputs and costs as a


function of planned input (unit-level)
activities
Often used for service, merchandising,
manufacturing and distribution
activities
Works effectively with activities that
have defined relationships between
effort and accomplishment
Starts with the planned outputs
Works backward to budget the inputs
Cambridge Business Publishers, 10
Activity-Based Approach to Budgeting

Type of output/input method


Reduces distortions in the transformation
Emphasis placed on the expected costs of
the planned activities that will be
consumed by the cost objective
How it works
Overhead costs are budgeted based on
anticipated consumption of activities
Consumption of activity cost drive determined
Budgeted activity cost based on units of
activity and related cost per unit of activity
cost driver
Cambridge Business Publishers, 11
Incremental Approach to Budgeting

Budgets costs for a coming period as a


dollar or percentage change from the
amount budgeted for a previous period
Used when relationship between inputs
and outputs is weak or nonexistent
Widely used in government and not-for-
profit organizations
Advantage
Simplifies the budget process by
considering only the increments
Cambridge Business Publishers, 12
Minimum Level Approach to Budgeting

Establishes a base amount for budget


items and requires explanation or
justification for any budgeted amount
above the minimum base
Corrects deficiencies in the
incremental approach
Questions the necessity for costs
included in the base budget of the
incremental approach
Very time consuming
Cambridge Business Publishers, 13
Variations of the
Minimum Level Approach
Zero-based budgeting
Every dollar of expenditures must be
justified
Breaks total budget into program
packages wit related costs
Budgeting for objectives
Combines elements of activity-based and
zero-based budgeting with a need to live
within fixed financial constraints

Cambridge Business Publishers, 14


Learning Objective 3

Explain the relations among


elements of a master budget and
develop a basic budget.

Cambridge Business Publishers, 2015 15


The Master Budget

The culmination of the budgeting


process
Groups all budgets and supporting
schedules together
Coordinates all financial and
operational activities placing them into
an organization-wide set of budgets for
A Major Goal
a given time period
Ensure the smooth functioning of a business
throughout the budget period and the
organizations operation cycle

Cambridge Business Publishers, 16


Operating Cycle of a Manufacturing
or Merchandising Operation

Involves the conversion of cash into other


assets, which are intended to produce
revenues in excess of their costs
Cambridge Business Publishers, 17
Budget Process for a Merchandiser
Sales
Budget

Selling General &


Purchases
Expense Administrative
Budget
Budget Expense
Budget

Cash
Special Budget
Budgets Pro Forma
Statements
Income Statement
Cambridge Business Publishers, Balance Sheet 18
Sales Budget

Starting point for the budgeting


process
Includes a forecast of sales revenue
Normally includes a forecast of unit
sales
Best available information used to
forecast
Future market conditions
Merchandise available
Promotion and advertising plans
Expected pricing policies
Cambridge Business Publishers, 19
Sales Budget Example

BC Carts distributes plastic carts to retailers.


For June, estimated sales are 9,000 carts at a
selling price of $10 each with an estimated
cost of $4 per cart.
BC Carts
Sales Budget
For Month of June 2015
Sales in units 9,000
Selling price per unit $ 10.00
Sales revenue $90,000

Budget revenue for June is $90,000

Cambridge Business Publishers, 20


Purchases Budget

Indicates the merchandise to be


purchased to meet sales needs and
ending inventory requirements
Often referred to as merchandise
purchases budget
Considers
Budgeted sales
Desired ending inventory
Planned beginning inventory

Cambridge Business Publishers, 21


Purchases Budget Example
BC Carts desires to have 20% of the carts needed for the
next months sales in stock at the end of each month. At
the beginning of June, 1,800 carts are on hand. Each cart
costs $4. Sales are planned to increase 10% per month.

BC Carts
Purchases Budget
For Month of June 2015
Units Dollars
Sales needs 9,000. $36,000.
Desired ending inventory 1,980. 7,920.
Total 10,980. 43,920.
Less beginning inventory (1,800) (7,200)
Purchases 9,180. $36,720.

Sales for July: 9,000 + (9,000 0.10) = 9,900 carts Number of units times
Ending inventory = 9,900 0.20 = 1,980 carts
the cost per unit of $4
Cambridge Business Publishers, 22
Selling Expense Budget

Presents the expenses the organization


plans to incur in connection with sales
and distribution
Costs are broken into variable and
fixed costs
Variable selling costs
Developed as a percent of sales or an
amount per unit sold
Fixed selling costs
Often based on an estimate obtained from
the sales manager
Cambridge Business Publishers, 23
Selling Expense Budget Example
BC Carts desires to BC Carts
have 20% of the Selling Expense Budget
For Month of June 2015
carts needed for Budgeted sales $90,000
the next months Variable selling expenses
sales in stock at Commissions (4%) $3,600
the end of each Miscellaneous (1.5%) 1,350
month. Total variable expenses 4,950
At the beginning of Fixed selling expenses
June, 1,800 carts Depreciation 3,500
are on hand. Advertising 2,000
Miscellaneous 1,200
Each cart costs $4. Total fixed expenses 6,700
Sales are planned Total selling expenses $11,650
to increase 10% Commissions: $90,000 x 0.04 = $3,600
Miscellaneous: $90,000 x 0.015 = $1,350
per month.
Cambridge Business Publishers, 24
General and Administrative Expense
Budget
Presents the expenses planned in
connection with the general
administration of the organization
Includes expenses for
Compensation
Insurance
Depreciation
Utilities
Miscellaneous
Most often the costs are fixed
Because they do not vary with unit-level cost
drivers
Cambridge Business Publishers, 25
General and Administrative Expense
Budget Example
BC Carts estimates the following monthly general
and administrative costs: $5,000 for salaries,
$800 for insurance, $1,100 for depreciation, $600
for utilities, and $900 for miscellaneous.
BC Carts
General and Administrative Expense Budget
For Month of June 2015
Salaries $5,000
Insurance 800
Depreciation 1,100
Utilities 600
Miscellaneous 900
Total general and administrative expenses $8,400

Cambridge Business Publishers, 26


Cash Budget

Summarizes all cash receipts and


disbursements expected to occur during the
budget period
Because of issues related to the timing of
sales and collections on account
Collections on sales may not equal sales revenue
Because of issues related to the timing of
payments for purchases and other expense
items
Disbursements may not equal expenses

Cash is critical to survival.

Cambridge Business Publishers, 27


Cash Receipts Budget Example
BC Carts budgeted its June sales at $90,000. It
estimates that 40% of sales are cash and 60% are
on credit. 30% of credit sales are collected in the
month of sale and 70% are collected in the
following month. Beginning cash balance is
$15,000 and sales during May were $86,000.
40% Cash 40% Cash
Sales 30% Collected current
Sale
month
s 60% Credit 70% Collected following
Sales month
Cash Receipts Budget for
June 2015
Collections on sales $90,000 x 0.40
Cash sales $36,000
$90,000 x 0.60 x 0.30 = $16,200
Credit sales
Current month (30% of credit sales) 16,200
Prior month (70% of credit sales) 36,120 $86,000 x 0.60 x 0.70 = $36,120
Total $88,320
Cambridge Business Publishers, 28
Cash Disbursements Budget Example
BC Carts estimates that 25% of its current month
inventory purchases will be paid during the month
incurred and 75% are paid in the following month. During
May, purchases were $32,000. Budgeted purchases for
June are $36,720 (from the purchases budget.)

Inventory purchases section of the cash


disbursements section of the cash budget:

Cash Disbursements Budget for


June 2015
Disbursements
$36,720 x 0.25 = $9,180
Purchases
Current month (25% of purchases) $ 9,180
Prior month (75% of purchases) 24,000 $32,000 x 0.75 = $24,000
Total $33,180
Continued
Cambridge Business Publishers, 29
Cash Disbursements Budget Example cont.
BC Carts general and administrative costs were
$8,200 during May, and $8,400 during June, $1,100 of
each which is depreciation. Income taxes were $15,500
during May. The company pays for selling costs in the
month incurred, and 60% of the general and
administrative costs in the month incurred with the
remaining 40% the following month. Income taxes are
taxed at 30% of income before taxes and are paid the
Cash following
month Disbursements
accrual. Budget for
Selling expenses $ 8,150
June 2015
General and administrative expenses
Current month (60%) $4,380
Prior month (40%) 2,840
Income taxes 15,500
General and administrative expenses
0.60 x ($8,400 - $1,100) = $4,380
$22,720
0.40 x ($8,200 - $1,100) = $2,840

Cambridge Business Publishers, Continued


30
Financing Section of Cash Budget

BC Carts repays $5,000 of the principal on its


bank loan on June 30 and December 31, and
any accrued interest.
Cash Disbursements Budget for
June 2015
Short-term financing
Loan repayments $5,000
Interest 750
Net cash used for financing $5,750

$25,000 x 0.60 x 1/2

Continued
Cambridge Business Publishers, 31
Complete Cash Budget
BC Carts
Cash Budget
For Month of June 2015

Cash balance, beginning $15,000.

Cash receipts Collections on sales

section Cash sales (40%) $36,000.

Credit sales

Current month (30% of credit sales) 16,200.

Prior month (70% of credit sales) 36,120.

Cash disbursements Total 88,320.


section Cash available for operations 103,320.

Disbursements

Purchases

Current month (25% of purchases) 9,180.


Financing
section Prior month (75% of purchases) 24,000.

Total 33,180.

Cambridge Business Publishers, Selling expenses 8,150. 32


Budgeted Financial Statements

Are pro forma statements that reflect


the as-if effects of the budgeted
activities on the actual financial
position of organization
Reflect the actual results if all
budgetary projections are correct
Include
Budgeted income statement
Budgeted balance sheet

Cambridge Business Publishers, 33


Budgeted Income Statement Example
Beginning inventory totaled $7,200 and
ending inventory totaled $7,920.
BC Carts
Budgeted Income Statement
For Month of June 2015
Sales Sales Budget $90,000.
Cost of goods sold
Beginning inventory Purchases Budget $ 7,200.
Purchases 36,720.
Cost of merchandise available 43,920.
Ending inventory (7,920) (36,000)
Gross profit Selling and General & 54,000.
Administrative Budget
Other expenses:
Selling expenses 25,000 x 6%11,650.
x 1/12
General and administrative expenses 8,400. (20,050)
30% of income before taxes
Income from operations 33,950.
Interest expense (125)
Cambridge Business Publishers, 34
Budgeted Income Statement Example
Beginning balance sheet amounts at May 31 and where
to find information for the June 30 balance sheet:

Cash $15,000 In addition to the beginning


balance sheet:
Accounts receivable 36,120
Inventory 7,200 Cash budget
Equipment, net 95,000 Cash receipts, sales budgets
Total assets $153,320 Purchases budget, income statement
Accounts payable $24,000 Income statement
Income taxes payable 15,500
Accrued expenses 2,840 Cash disbursements and purchases budget
Accrued Interest 625 Income statement and cash disbursements
Notes payable 25,000 Income statement and cash disbursements
Common stock 22,000 Cash disbursements
Retained earnings 63,355 Only the beginning balance sheet
Calculated from prior retained earnings and
Total liabilities & equities $153,320 net income
Cambridge Business Publishers, 35
Budgeted Balance Sheet
BC Carts
Budgeted Balance Sheet
June 30, 2015
Assets
Current assets Cash $90,000 x 0.60 x 0.70
Budget
Cash $33,520
Accounts receivable Given 37,800
Inventory 7,920 $ 79,240 $95,000 - $3,500 - $1,100

Fixed assets
Equipment, net 90,400
$36,720 x 0.75
Total assets $169,640
Liabilities and Income
Stockholders' Equity
Stmt. ($8,400 - $1,100) x 0.40
Current liabilities
Accounts payable $27,540
Income taxes payable 10,148 $25,000 - $5,000
Accrued expenses 2,920 $ 40,608
Given
Long-term liabilities
$63,355 + $23,678
Notes payable 20,000
Total liabilities 60,608
Cambridge Business Publishers, 36
Finalizing the Budget

Before finalizing the budget, two


questions must be addressed
Is the
Is the proposed
proposed budget
budget acceptabl
feasible? e?

Cambridge Business Publishers, 37


Learning Objective 4

Explain and develop a basic


manufacturing budget.

Cambridge Business Publishers, 2015 38


Production Budget

Additional steps are required to


develop master budgets for
manufacturing organizations
Due to conversion of raw materials
into finished goods
Must determine production volume
To support sales
To meet finished goods inventory

Cambridge Business Publishers, 39


Budget Assembly for a Manufacturer

Cambridge Business Publishers, 40


Production Budget Example
BC Carts produces plastic carts and has
estimated sales of 9,000 carts for June and
9,900 for July. BC wants to have 10% of the
materials needed for the next months
production and 20% of the carts needed for
the next months sales in stock at the end of
each month. BC Carts
Production Budget
For Month of June 2015
Sales in units 9,000.
Desired ending inventory of carts 1,980. 0.20 x 9,900 (July sales)
Total cart requirements 10,980.
Less beginning inventory of carts (1,800) 0.20 x 9,000 (June sales)
Budgeted production 9,180.

Cambridge Business Publishers, 41


Purchases Budget Example - Resin
Assume BC Carts plans to produce 10,098 carts in July. It
wants to have 10% of the materials needed for the next
months production in stock at the end of each month.
Each cart requires 6 pounds of plastic resin and two
wheels. At June 1, BC had 5,508 pounds of resin and
1,836 wheels on hand. Wheels cost $0.30 each and resin
costs $0.21 per pound.

BC Carts
Purchases Budget
For Month of June 2015
Resin:
Pounds of resin needs (6 lbs. x 9,180 carts) 55,080. 6 x 10,098 x 0.10
Desired ending resin inventory 6,059.
Total resin requirements in pounds 61,139.
Less beginning resin inventory (5,508)
Given
Resin purchases in pounds 55,631.
Continued
Cambridge Business Publishers, 42
Purchases Budget Example - Wheels
BC Carts plans to produce 10,098 carts in July. It wants
to have 10% of the materials needed for the next
months production in stock at the end of each month.
Each cart requires 6 pounds of plastic resin and two
wheels. At June 1, BC had 5,508 pounds of resin and
1,836 wheels on hand. Wheels cost $0.30 each and
resin costs $0.21 per pound.

Wheels:
Number of wheels needed (2 x 9,180 carts) 18,360. 2 x 10,098 x 0.10
Desired ending wheel inventory 2,020.
Total wheel requirements 20,380.
Less beginning wheel inventory (1,836) Given
Wheels purchases 18,544.

Continued
Cambridge Business Publishers, 43
Purchases Budget Example
Complete materials purchases budget:
BC Carts
Purchases Budget
For Month of June 2015
Resin:
Pounds of resin needs (6 lbs. x 9,180 carts) 55,080.
Desired ending resin inventory 6,059.
Total resin requirements in pounds 61,139.
Less beginning resin inventory (5,508)
Resin purchases in pounds 55,631.
Wheels:
Number of wheels needed (2 x 9,180 carts) 18,360.
Desired ending wheel inventory 2,020.
Total wheel requirements 20,380.
$0.21 x 55,631
Less beginning wheel inventory (1,836)
= $11,683
Wheels purchases 18,544.

Purchases (Dollars): $0.30 x 18,544


Resin at $0.21 per pound $11,683. = $5,563
Wheels at $0.30 each 5,563.
Total purchases in dollars $17,246.
Cambridge Business Publishers, 44
Manufacturing Cost Budget Example
BC Carts have the following costs per unit:
Direct materials
Resin: 6 pounds @ $0.21 a pound
Wheels: 2 @ $0.30 each
Direct labor 0.075 hrs. @ $10 per hour
Variable overhead $0.43 per unit
Fixed overhead $8,262

BC Carts
Manufacturing Cost Budget
For Month of June 2015
Direct materials
Resin used in production (9,180 6 lbs. $0.21) $11,567
Wheels used in production (9,180 2 $0.30) 5,508
Total direct materials 17,075
Direct labor (9,180 0.075 $10) 6,885
Manufacturing overhead
Variable ($0.43 per unit) 3,947
Fixed 8,262
Total manufacturing costs $36,169
Cambridge Business Publishers, 45
Learning Objective 5

Describe the relationship


between budget development
and manager behavior.

Cambridge Business Publishers, 2015 46


Employee Participation
Budgets used to promote productive
employee behavior directed toward
meeting goals
Two approaches to employee involvement
Top-Down Bottom-Up
Budget Budget
Known also as an Known also as a
imposed budget participative budget
Top management Managers at all levels
identifies primary are involved in budget
preparation
goals and objectives Ensures that employees
and communicates to understand their roles
lower management in meeting goals

Cambridge Business Publishers, 47


Budgetary Slack

The tendency of some managers to


intentionally understate revenues or
overstate expenses
Why might managers do this?
To make it easier to obtain favorable
performance reviews
A disadvantage of participative
budgeting

Cambridge Business Publishers, 48


Budgeting Periods

Fixed-length periods
Most companies use a one-year budget
period; some shorter and longer
Life-cycle budgeting
Developing a budget for a projects entire life
Continuous budgeting
Based on a moving time frame
When one period passes, one more period is
added
Sometimes called a rolling budget
Managers forced to focus on future

Cambridge Business Publishers, 49


Forecasts

Budget preparation requires forecasts


Based on a variety of factors
Historical trends
Product innovation
Economic conditions
Industry conditions
Companys strategic position for
competing Forecast
Industry forecast is often
the starting point for
forecasting.

Cambridge Business Publishers, 50


Types of Forecasts Used in Budgeting

The collection period for sales on


account
Percent of uncollectible sales on
account
Cost of materials, supplies, utilities,
etc.
Employee turnover
Time required to perform activities.
Forecast
Interest rates
Development time for new products or
services
Cambridge Business Publishers, 51
Ethics

Falsifying budgets is grounds for dismissal


Building slack into budgets
Padding the budget
Including unneeded expense categories in
budgets
Subsequently using these to pad other
budget categories
Unethical tactics in performance reporting
Misclassification of expenses
Overstating revenues
Understating expenses
Postponing or accelerating recording of
activities

Cambridge Business Publishers, 52


Open Book Management

Obtain employee support for the


budget
The sharing of financial and related
information with employees
Teaching employees to understand financial
numbers
Encouraging employees to use the
information in their work
Sharing financial results with employees
Properly used, an operating budget is an effective
Bonus program
mechanism for motivating employees to higher levels
of performance and productivity.
Cambridge Business Publishers, 53
The End