Chapter Profit Planning Learning Objectives LO1 LO2 LO3 LO4 LO5 LO6 LO7 LO8 LO9 LO10 Understand why organizations budget and the processes they use to create budgets Prepare a sales budget, including a schedule of expected cash receipts Prepare a production budget Prepare a direct materials budget, including a schedule of expected cash disbursements Prepare a direct labor budget Prepare a manufacturing overhead budget Prepare a selling and administrative expense budget Prepare a cash budget Prepare a budgeted income statement Prepare a budgeted balance sheet New in this Edition • Many new In Business boxes have been added Chapter Overview A The Basic Budgeting Framework A budget is a detailed plan outlining the acquisition and use of financial and other resources over a specified time period Planning and control A good budgeting system must provide for both planning and control Planning involves developing objectives and preparing budgets to achieve those objectives Control involves the steps taken by management to ensure that the objectives set down at the planning stage are attained and that all parts of the organization work together towards those objectives Advantages of budgeting Budgeting has many advantages, including: • Budgeting provides managers with a vehicle for communicating their plans in an orderly way throughout the entire organization • Budgeting requires managers to plan for the future • Budgeting provides a means of allocating resources to those parts of the organization where they can be used most effectively • Budgeting uncovers potential bottlenecks before they occur • Budgeting coordinates the activities of the entire organization • Budgets provide benchmarks for evaluating subsequent performance Responsibility accounting A manager should be held responsible for those items of revenues and costs—and only those items—that the manager can actually control to a significant extent The manager who is held responsible for a specific cost should have a 529 budget specifying a limit on how much can be spent This limit may be adjusted, depending on the activity during the period This idea will be developed in later chapters Choosing a budget period Budget periods vary in length Some may be as short as a month, whereas others may cover many years The most common budgeting period, however, is a year • Operating budgets ordinarily cover a one-year period Additionally, many companies divide their operating budgets into quarterly or monthly periods • A continuous or perpetual budget covers a 12-month period but adds a new month on the end as the current month is completed This approach stabilizes the planning horizon at one year Self-imposed participative budget The most successful budget programs usually involve lower-level managers in preparing their own budgets—although this point is in some dispute There are two basic reasons for favoring participative budgets: 1) lower-level managers are more familiar with the details of their own operations than top managers and 2) managers tend to be more committed to budgets that they have been able to influence Human relations Management must keep clearly in mind that budgeting involves coordinating and motivating people and the human dimension is of primary importance a Top managers must clearly convey the message in actions as well as in words that budgeting is important If top management appears to be ambivalent about the benefits of budgeting, others in the organization will be reluctant to commit their own time and energy to the budgeting process b If there is a preoccupation with getting every dollar and cent right or with placing blame, the budgeting process will be resented and managers will attempt to “game the system.” Budgets should not be used as a club They should be a way of ensuring that everyone understands what is expected Significant deviations from the budget should be investigated so that managers understand changing conditions and their implications for the organization Managers should not ordinarily be punished for deviations from the budget B Preparing the Master Budget (Exercise 9-1 through Exercise 9-7.) The master budget consists of a number of separate, but interrelated budgets The interrelationships among these various budgets are illustrated in Exhibit 9-2 in the text Schedules through 10 in the text present a comprehensive example of a master budget The Sales Budget (Exercise 9-1; Schedule in the text) The sales budget is a detailed schedule showing the expected sales for the coming period It is typically expressed in both dollars and units of the product The sales budget is usually accompanied by a schedule of expected cash receipts The schedule of expected cash collections should take into account delays in collecting credit sales The Production Budget (Exercise 9-2; Schedule in the text) The budgeted production for each period can be determined by adding together the budgeted sales and the desired ending inventory and then subtracting the beginning inventory The desired ending inventory in units for each period is usually a predetermined percentage of budgeted unit sales for the following period The production budget is typically expressed in terms of physical units rather than in dollars In a merchandising company, a merchandise purchases budget would replace the production budget The merchandise purchases budget shows the amount of goods to be 530 purchased from suppliers each period This can be determined by adding together the budgeted sales and the desired ending inventory and then subtracting the beginning inventory As in a manufacturing company, the desired ending inventory in units is usually some predetermined percentage of the unit sales for the following period The Direct Materials Budget (Exercise 9-3; Schedule in the text) Once production needs have been determined, a direct materials budget should be prepared This budget details the materials that will be required to fulfill the production budget and to ensure adequate inventory levels Sufficient amounts of raw material must be acquired to meet both production needs and to provide for desired ending inventories Materials purchases are determined by adding together the materials required for production needs and the desired ending materials inventories, and then subtracting the beginning inventory The desired ending inventory in units is usually a predetermined percentage of the number of units expected to be used in production the following period The direct materials budget is usually accompanied by a schedule of expected cash disbursements for raw materials This schedule should take into account any delays that are anticipated in paying for materials The Direct Labor Budget (Exercise 9-4; Schedule in the text) Once production needs are known, the direct labor budget must be prepared so that the company will know whether sufficient labor time is available to meet those needs The direct labor budget is typically expressed in both direct labor-hours and in dollars Translating the direct-labor requirements into spending can lead to complications if there is overtime or if there is some sort of guaranteed employment policy The Manufacturing Overhead Budget (Exercise 9-5; Schedule in the text) The manufacturing overhead budget lists all production costs other than direct materials and direct labor Manufacturing overhead costs should be broken down by cost behavior for budgeting purposes Typically, the variable portion of manufacturing overhead is assumed to be proportional to budgeted activity and the fixed portion is assumed to be constant in total Under the assumption that depreciation is the only significant non-cash manufacturing overhead expense, the manufacturing overhead expense can be converted to a cash flow basis by backing out of the total any depreciation charges Ending Finished Goods Inventory Budget (Schedule in the text) This budget details the amount and value of ending inventory on the budgeted balance sheet The unit product cost from this budget is also used to compute the cost of goods sold for the budgeted income statement The details of the computations will depend on whether variable or absorption costing is used Managers often want budgets on an absorption costing basis since that is the basis that will ordinarily be used to report results to outsiders Data for the computations in this schedule are found in the direct materials, direct labor, and manufacturing overhead budgets The Selling and Administrative Expense Budget (Exercise 9-6; Schedule in the text) The selling and administrative budget lists the anticipated non-manufacturing expenses for the budget period In practice this budget is usually made up of many smaller individual budgets negotiated with various managers having sales and administrative responsibilities Setting appropriate budget limits for selling and administrative functions is one of the most difficult problems in management accounting and is just beginning to be understood The Cash Budget (Exercise 9-7; Schedule in the text) The cash budget should be broken down into time periods that are as short as feasible so as to alert management to problems 531 that may occur due to fluctuations in cash flows As anyone with a checking account knows, it is quite possible to have a positive overall cash flow during a period and yet be overdrawn at some point during the period The cash budget is composed of four major sections: a The receipts section b The disbursements section c Cash receipts, plus the beginning cash balance, less cash disbursements results in cash excess or deficiency In the case of a deficiency, management must arrange to borrow additional funds In the case of excess cash, management can use the excess funds to repay previous borrowing or to make new investments d The financing section of the cash budget details the borrowing and repayments projected to take place during the budget period, including any interest payments Budgeted Financial Statements (Schedule in the text) The last components of the master budget consist of the budgeted income statement and the budgeted statement of financial position The balance sheet is perhaps the most difficult of the statements to construct in the examples we use It requires pulling together data from a variety of schedules and sources 532 Assignment Materials Assignment Exercise 9-1 Exercise 9-2 Exercise 9-3 Exercise 9-4 Exercise 9-5 Exercise 9-6 Exercise 9-7 Problem 9-8 Problem 9-9 Problem 9-10 Problem 9-11 Problem 9-12 Problem 9-13 Problem 9-14 Problem 9-15 Problem 9-16 Problem 9-17 Problem 9-18 Problem 9-19 Problem 9-20 Problem 9-21 Problem 9-22 Case 9-23 Case 9-24 Case 9-25 Level of Topic Difficulty Schedule of expected cash collections Basic Production budget Basic Materials purchases budget Basic Direct labor budget Basic Manufacturing overhead budget Basic Selling and administrative budget Basic Cash budget analysis Basic Evaluating a company’s budget procedures Basic Schedule of cash collections; cash budget Basic Behavioral aspects of budgeting; ethics and the manager Basic Production and purchases budgets Basic Direct materials and direct labor budgets Basic Direct labor and manufacturing overhead budgets Basic Schedules of expected cash collections and disbursements Basic Cash budget; income statement; balance sheet Basic Cash budget with supporting schedules Medium Integration of the sales, production, and purchases budgets Medium Cash budget with supporting schedules Medium Completing a master budget Medium Completing a master budget Medium Cash budget for one month Difficult Integrated operating budgets Difficult Evaluating a company’s budget procedures Difficult Master budget with supporting schedules Difficult Cash budget for a growing company Difficult Suggested Time 20 10 15 20 15 15 20 30 45 45 45 30 30 30 60 60 60 60 120 120 60 90 45 120 75 Essential Problems: Problem 9-11, Problem 9-13, Problem 9-14, Problem 9-15, Problem 9-19 or Problem 9-20 Supplementary Problems: Problem 9-8, Problem 9-9, Problem 9-10, Problem 9-12, Problem 916 or Problem 9-18, Problem 9-17, Problem 9-21, Problem 9-22, Case 9-23, Case 9-24, Case 9-25 533 534 Chapter Lecture Notes Helpful Hint: Before beginning the lecture, show students the ninth segment from the second tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library This segment introduces students to many of the concepts discussed in chapter The lecture notes reinforce the concepts introduced in the video I Chapter theme: This chapter focuses on the steps taken by businesses to achieve their planned levels of profits – a process called profit planning Profit planning is accomplished by preparing numerous budgets, which, when brought together, form an integrated business plan known as a master budget The basic framework of budgeting A Basic definitions i A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period The act of preparing a budget is called budgeting The use of budgets to control an organization’s activities is known as budgetary control 535 536 B Difference between planning and control i Planning involves developing objectives and preparing various budgets to achieve those objectives ii Control involves the steps taken by management to increase the likelihood that the objectives set down at the planning stage are attained and that all parts of the organization are working together toward that goal iii To be effective, a good budgeting system must provide for both planning and control Good planning without effective control is time wasted C Advantages of budgeting i Budgets communicate management’s plans throughout the organization ii Budgets force managers to think about and plan for the future “In Business Insights” While our focus in this chapter is on preparing operating budgets for a one-year time frame, longerterm budgets can also be very helpful to organizations from a planning standpoint For example: “Heading Off a Crisis” (page 380) • The Repertory Theatre of St Louis is a not-forprofit professional theatre that is supported by contributions from donors and ticket sales 537 538 TM 9-3 MASTER BUDGET INTERRELATIONSHIPS (Exhibit 9-2) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-4 COMPREHENSIVE BUDGETING EXAMPLE Royal Company is preparing budgets for the second quarter ending June 30 • Budgeted sales of the company’s only product for the next five months are: April May June July August 20,000 50,000 30,000 25,000 15,000 units units units units units • The selling price is $10 per unit • The following elements of the master budget will be prepared in this example: Sales budget (with a schedule of expected cash collections) Production budget Direct materials budget (with a schedule of expected cash disbursements for materials) Direct labor budget Manufacturing overhead budget Ending finished goods inventory budget Selling and administrative expense budget Cash budget Budgeted income statement 10 Budgeted balance sheet © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-5 SALES BUDGET Budgeted sales (units) Selling price per unit Total sales April 20,000 × $10 $200,000 May 50,000 × $10 $500,000 June 30,000 × $10 $300,000 Quarter 100,000 × $10 $1,000,000 SCHEDULE OF EXPECTED CASH COLLECTIONS Additional data: • All sales are on account • The company collects 70% of these credit sales in the month of the sale; 25% are collected in the month following sale; and the remaining 5% are uncollectible • The accounts receivable balance on March 31 was $30,000 All of this balance was collectible April Accounts receivable beginning balance $ 30,000 April sales 70% × $200,000 140,000 25% × $200,000 May sales 70% × $500,000 25% × $500,000 June sales 70% × $300,000 Total cash collections $170,000 May June Quarter $ 30,000 140,000 50,000 $ 50,000 350,000 $400,000 $125,000 350,000 125,000 210,000 $335,000 210,000 $905,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-6 PRODUCTION BUDGET Additional data: • The company desires to have inventory on hand at the end of each month equal to 20% of the following month’s budgeted unit sales • On March 31, 4,000 units were on hand Budgeted sales [TM 9-4] Add desired ending inventory Total needs Less beginning inventory Required production 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 July 25,000 3,000* 28,000 5,000 23,000 * Budgeted sales in August = 15,000 units Desired ending inventory in July = 15,000 units × 20% = 3,000 units © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-7 DIRECT MATERIALS BUDGET Additional data: • pounds of material are required per unit of product • Management desires to have materials on hand at the end of each month equal to 10% of the following month’s production needs • The beginning materials inventory was 13,000 pounds • The material costs $0.40 per pound Required production in units [TM 9-6] Raw materials per unit (pounds) Production needs (pounds) Add desired ending inventory (pounds)* Total needs (pounds) Less beginning inventory (pounds) Raw materials to be purchased (pounds) Cost of raw materials to be purchased at $0.40 per pound April May June Quarter 26,000 46,000 29,000 ×5 ×5 ×5 130,000 230,000 145,000 101,000 ×5 505,000 23,000 14,500 11,500 153,000 244,500 156,500 11,500 516,500 13,000 23,000 14,500 13,000 140,000 221,500 142,000 503,500 $56,000 $88,600 $56,800 $201,400 * For June: 23,000 units produced in July [TM 9-6] × pounds per unit = 115,000 pounds; 115,000 pounds × 10% = 11,500 pounds © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-8 SCHEDULE OF EXPECTED CASH DISBURSEMENTS FOR MATERIAL Additional data: • Half of a month’s purchases are paid for in the month of purchase; the other half is paid for in the following month • No discounts are given for early payment • The accounts payable balance on March 31 was $12,000 Accounts payable beginning balance $12,000 $ 12,000 April purchases 50% × $56,000 28,000 28,000 50% × $56,000 $28,000 28,000 May purchases 50% × $88,600 44,300 44,300 50% × $88,600 $44,300 June purchases 50% × $56,800 28,400 28,400 Total cash disbursements for materials $40,000 $72,300 $72,700 $185,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-9 DIRECT LABOR BUDGET Additional data: • Each unit produced requires 0.05 hour of direct labor • Each hour of direct labor costs the company $10 • Management fully adjusts the workforce to the workload each month April Units to be produced 26,000 [TM 9-6] Direct labor-hours per unit × 0.05 Total hours of direct labor time needed 1,300 Direct labor cost per hour × $10 Total direct labor cost $13,000 May June Quarter 46,000 × 0.05 29,000 × 0.05 101,000 × 0.05 2,300 × $10 $23,000 1,450 × $10 $14,500 5,050 × $10 $50,500 Note: Many companies not fully adjust their direct labor work force every month and in such companies direct labor behaves more like a fixed cost, with additional cost if overtime is necessary © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-10 MANUFACTURING OVERHEAD BUDGET Additional data: • Variable manufacturing overhead is $20 per direct labor-hour • Fixed manufacturing overhead is $50,500 per month This includes $20,500 in depreciation, which is not a cash outflow Budgeted direct labor-hours [TM 9-9] Variable manufacturing overhead rate Variable manufacturing overhead Fixed manufacturing overhead Total manufacturing overhead Less depreciation Cash disbursements for manufacturing overhead April May June Quarter 1,300 2,300 1,450 5,050 × $20 × $20 × $20 × $20 $26,000 $46,000 $29,000 50,500 50,500 50,500 76,500 96,500 79,500 20,500 20,500 20,500 $101,000 151,500 252,500 61,500 $56,000 $76,000 $59,000 $191,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-11 ENDING FINISHED GOODS INVENTORY BUDGET Additional data: • Royal Company uses absorption costing in its budgeted income statement and balance sheet • Manufacturing overhead is applied to units of product on the basis of direct labor-hours • The company has no work in process inventories Computation of absorption unit product cost: Quantity Direct materials pounds Direct labor 0.05 hours Manufacturing overhead 0.05 hours Unit product cost Cost $0.40 per pound $10.00 per hour $50.00 per hour* * Predetermined Total manufacturing overhead = overhead rate Total direct labor hours = $252,500 = $50.00 per hour 5,050 hours Budgeted ending finished goods inventory: Ending finished goods inventory in units [TM 9-6] Unit product cost [see above] Ending finished goods inventory in dollars 5,000 × $5 $25,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved Total $2.00 0.50 2.50 $5.00 TM 9-12 SELLING AND ADMINISTRATIVE EXPENSE BUDGET Additional data: • Variable selling and administrative expenses are $0.50 per unit sold • Fixed selling and administrative expenses are $70,000 per month and include $10,000 in depreciation Budgeted sales in units [TM 9-4] Variable selling and administrative expense per unit Variable selling and administrative expense Fixed selling and administrative expense Total selling and administrative expense Less depreciation Cash disbursements for selling and administrative expenses April May June Quarter 20,000 50,000 30,000 100,000 × $0.50 × $0.50 × $0.50 × $0.50 $10,000 $25,000 $15,000 $ 50,000 70,000 70,000 70,000 210,000 80,000 10,000 95,000 10,000 85,000 10,000 260,000 30,000 $70,000 $85,000 $75,000 $230,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-13 CASH BUDGET Additional data: A line of credit is available at a local bank that allows the company to borrow up to $75,000 a All borrowing occurs at the beginning of the month, and all repayments occur at the end of the month b Any interest incurred during the second quarter will be paid at the end of the quarter The interest rate is 16% per year Royal Company desires a cash balance of at least $30,000 at the end of each month The cash balance at the beginning of April was $40,000 Cash dividends of $51,000 are to be paid to shareholders in April Equipment purchases of $143,700 are scheduled for May and $48,800 for June This equipment will be installed and tested during the second quarter and will not become operational until July, when depreciation charges will commence © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-14 CASH BUDGET ROYAL COMPANY Cash Budget For the Quarter Ending June 30 April May June 400,000 430,000 335,000 365,000 905,000 945,000 40,000 13,000 72,300 23,000 72,700 14,500 185,000 50,500 56,000 76,000 59,000 191,000 70,000 Equipment purchases Dividends 51,000 Total disbursements 230,000 85,000 143,700 400,000 75,000 48,800 270,000 230,000 192,500 51,000 900,000 Excess (deficiency) of cash available over disbursements (20,000) 30,000 95,000 45,000 (50,000) ( 2,000) (52,000) 50,000 (50,000) ( 2,000) ( 2,000) Cash balance, beginning $ 40,000 Add receipts: Cash collections [TM 9-5] 170,000 Total cash available 210,000 Less disbursements: Direct materials [TM 9-8] Direct labor [TM 9-9] Manufacturing overhead [TM 9-10] Selling & administrative [TM 9-12] Financing: Borrowings Repayments Interest* Total financing 50,000 0 50,000 Cash balance, ending $ 30,000 $ 30,000 $ 30,000 0 0 $ 30,000 $ 43,000 * $50,000 × 16% × (3 months/12 months) = $2,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved Quarter $ 40,000 $ 43,000 TM 9-15 BUDGETED INCOME STATEMENT ROYAL COMPANY Budgeted Income Statement For the Quarter Ending June 30 Net sales [see below] Less cost of goods sold [see below] Gross margin Less selling & administrative expenses [TM 9-12] Net operating income Less interest expense [TM 9-14] Net income $950,000 500,000 450,000 260,000 190,000 2,000 $188,000 Computation of net sales: Sales $1,000,000 Less uncollectible amounts (5%) 50,000 Net sales $ 950,000 Computation of cost of goods sold: Budgeted sales (units) Unit product cost Cost of goods sold 100,000 × $5 $500,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 9-16 BEGINNING BALANCE SHEET ROYAL COMPANY Balance Sheet March 31 Current assets: Cash $ 40,000 (a) Accounts receivable 30,000 (b) Raw materials inventory 5,200 (c) Finished goods inventory 20,000 (d) Plant and equipment: Land 400,000 (e) Buildings and equipment 1,610,000 (f) Accumulated depreciation (750,000) (g) Total assets Liabilities: Accounts payable Stockholders’ equity: Common stock $ 200,000 (i) Retained earnings 1,143,200 (j) Total liabilities and stockholders’ equity (a) (b) (c) (d) (e) See TM 9-13 See TM 9-5 Given Given Given (f) (g) (h) (i) (j) Given Given See TM 9-8 Given Given © The McGraw-Hill Companies, Inc., 2006 All rights reserved $ 95,200 1,260,000 $1,355,200 $ 12,000 (h) 1,343,200 $1,355,200 TM 9-17 BUDGETED BALANCE SHEET ROYAL COMPANY Budgeted Balance Sheet June 30 Current assets: Cash $ 43,000 (a) Accounts receivable 75,000 (b) Raw materials inventory 4,600 (c) Finished goods inventory 25,000 (d) Plant and equipment: Land 400,000 (e) Buildings and equipment 1,802,500 (f) Accumulated depreciation (841,500) (g) Total assets Liabilities: Accounts payable Stockholders’ equity: Common stock $ 200,000 (i) Retained earnings 1,280,200 (j) Total liabilities and stockholders’ equity (a) (b) (c) (d) (e) See TM 9-14 $300,000 sales × 25% 11,500 pounds × $0.40 per pound See TM 9-11 See TM 9-16 $ 147,600 1,361,000 $1,508,600 $ 28,400 (h) 1,480,200 $1,508,600 (f) $1,610,000+ $143,700+ $48,800 (g) $750,000 + $61,500 + $30,000 (h) $56,800 purchases × 50% (i) (j) See TM 9-16 $1,143,200 + $188,000 – $51,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved [...]... responsibility accounting is that managers should be held responsible only for those items that they can control to a significant extent a Responsibility accounting systems enable organizations to react quickly to deviations from their plans and to learn from feedback obtained by comparing budgeted goals to actual results The point is not to penalize individuals for missing targets 5 ii 6 Responsibility accounting. .. accounting Choosing a budget period 1 Operating budgets ordinarily cover a one year period corresponding to a company’s fiscal year Many companies divide their annual budget into four quarters a In this chapter we focus on one-year operating budgets 2 A continuous or perpetual budget is a 12month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed a This approach... budget or participative budget is a budget that is prepared with the full cooperation and participation of managers at all levels It is a particularly useful approach if the budget will be used to evaluate managerial performance 543 8 9 544 8 9 2 The advantages of self-imposed budgets include: a Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by... the final budget a This committee may consist of the president, vice presidents in charge of various functions such as sales, production, and purchasing, and the controller 12 E The master budget: an overview i 13 The master budget consists of a number of separate but interdependent budgets 1 The sales budget shows the expected sales for the budget period expressed in dollars and units It is usually