BU8101 Accounting: A User Perspective Lecture 11

Budgeting

Compulsory Reading WHB Chapter 23

Lecture Date: 1 April 2013

11-1

Lecture Outline
Definition and Concepts

Behavioral Aspects
Preparation of a Master Budget Static Budget vs. Flexible Budget Flexible Budgets

11-2

Budgets The Basis for Planning and Control

A budget is a comprehensive financial plan that specifies how resources will be acquired and used during a specified period of time.

Planning
Developing objectives for acquisition and use of resources.

Control
Steps taken by management to ensure that objectives are attained.
11-3

Purposes of Budgeting
Provide standards used for performance evaluation and control
Provide information that can be used to improve decision making

Purposes
Force managers to plan for resource requirements.

Improve communication and coordination

11-4

The Budgetary Process

Budget expresses the companys strategic goals in quantitative terms

Vision (Strategic Goal) Formulate strategies to achieve vision

Prepare long-term budgets

Prepare short-term budgets (Operating Budgets) Assign decision rights
variance

Rewards / Punishments

Compare actual results to budgets

11-5

Budget Periods
Operating Budget

2008

2009

2010

2011

Operating budgets ordinarily cover a oneone-year period corresponding to a companys fiscal year. Many companies divide their annual budget into quarterly & monthly budgets.
Operating budgets are more operational than strategic in nature, done by lower-level managers.
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Budgeting Behavioral Aspects

Budget Problems Perceived unfair or unrealistic goals. Solutions Reasonable and achievable budgets.

Poor managementemployee communications.

Employee participation in budgeting process.

11-7

Participative Budgeting
Top Management Middle Management Supervisor Supervisor Middle Management Supervisor Supervisor

Flow of Budget Data

A participative budget is a budget that is prepared with the full cooperation and participation of managers at all levels.
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Types of Budgets
Master Budget
Covering all phases of a companys operations.

Detail Budget

Detail Budget Production

Detail Budget

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The Master Budget

Sales budget Production budget
Operating Budgets

Selling and administrative budget

Manufacturing overhead budget

Direct materials budget

Direct labor budget

Cash budget Budgeted income statement Budgeted balance sheet

11-10

Financial Budgets

The Sales 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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The Sales 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

July is needed for Junes ending inventory computations

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The Production Budget

Sales Budget

Production Budget

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The Production Budget

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

Lets prepare the production budget.

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The Production Budget Units to Produce

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
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The Production Budget Units to Produce

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 = 0.2 25,000 July units = 5,000 units. Beginning inventory is last month's ending inventory.

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The Production Budget

Production Budget Units Production Budget Material Purchases

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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
11-18

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.

11-19

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

Production Budget Materials Production Budget
Direct Labor

11-23

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 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

Units to produce Hours per unit Total hours required Wage rate per hour Direct labor cost

11-24

The Production Budget

Production Budget Production Budget
Manufacturing Overhead

Materials / Direct Labor

11-25

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.
April 26,000 $ 1.00 $ 26,000 50,000 $ 76,000 20,000 $ 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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Units to produce Variable overhead rate Variable overhead cost Fixed overhead Total mfg. overhead cost Deduct depreciation Manufacturing overhead - cash

Selling and Administrative (S&A) Expense Budget

Production Budget
Selling and Administrative Expense Budget

11-27

Selling and Administrative (S&A) Expense Budget

Selling expense budget contain both variable and fixed items.
Variable items: shipping costs and sales commissions. Fixed items: advertising and sales salaries. Administrative expense budget contain mostly fixed items. Executive salaries and depreciation on office equipment.

11-28

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.
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 Budget
Selling and Administrative Expense Budget

Cash Budget

11-30

Format of the Cash Budget

The cash budget is divided into four sections: 1. Cash receipts section lists all cash inflows excluding cash received from financing; 2. Cash disbursements section consists of all cash payments excluding repayments of principal and interest; 3. Cash excess or deficiency section determines if the company will need to borrow money or if it will be able to repay funds previously borrowed; and

4. Financing section details the borrowings and repayments projected to take place during the budget period.
11-31

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.

11-32

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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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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Cash Budget
Beginning cash balance Cash receipts Total cash receipts 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 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 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 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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$50,000 .16 3/12 = $2,000

The Budgeted Income Statement

Cash Budget Budgeted Income Statement

11-36

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 $ 1,000,000 499,000 $ 501,000

Computation of unit cost follows

11-37

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 Total labor hours required

From labor and OH budgets April May June Total Labor Hours 1,300 2,300 1,450 5,050

$251,000 5,050 hrs.

= $49.70 per hr.

Overhead $ 76,000 96,000 79,000 $ 251,000

Manufacturing overhead is applied based on direct labor hours.

11-38

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 Operating income Interest expense From S&A Expense Budget Net income April $ 80,000
May June Total 95,000 85,000 $ 260,000

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

Cash Budget
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The Budgeted Balance Sheet

Budgeted Income Statement Budgeted Balance Sheet

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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 Budgeted Balance Sheet June 30, 2009 Current assets Cash Accounts receivable Raw materials inventory Finished goods inventory Total current assets Property and equipment Land Building Equipment Total property and equipment Total assets Liabilities and Equities Accounts payable Common stock Retained earnings Total liabilities and equities

25% of June sales of $300,000

$ 43,000 75,000 4,600 24,950 $ 147,550 $ 50,000 174,500 192,500 $ 417,000 $ 564,550 $ 28,400 200,000 336,150 $ 564,550

June End Inv. 11,500 lbs. @ $.40 per lb. June End Inv. 5,000 units @ $4.99 each

50% of June purchases of $56,800

Beginning balance Add: net income Deduct: dividends Ending balance $ 148,150 239,000 (51,000) $ 336,150
11-42

Static vs. Flexible Budgets

Static Budgets Traditional Budgets are prepared for a fixed activity level (e.g. Sales budget prepared for 500,000 units).
What if actual sales volume is 800,000 units?

Flexible Budgets Flexible Budgets are prepared for multiple activity levels (e.g. Sales budget prepared for 500,000 units, 800,000 units, 1,000,000 units etc).
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Drawbacks of Static Budgets

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.

11-44

Flexible Budgeting
U = Unfavorable variance Barton, Inc. was unable to achieve the budgeted level of activity.
Original Budget Units of Activity Variable costs Indirect labor Indirect materials Power Fixed costs Depreciation Insurance Total overhead costs 10,000 $ 40,000 30,000 5,000 12,000 2,000 $ 89,000 Actual Results 8,000 $ 34,000 25,500 3,800 12,000 2,000 $ 77,300 Variances 2,000 U $6,000 F 4,500 F 1,200 F 0 0 $11,700 F
11-45

Flexible Budgeting
Original Budget Units of Activity Variable costs Indirect labor Indirect materials Power 10,000 $ 40,000 30,000 5,000 Actual Results 8,000 $ 34,000 25,500 3,800 Variances 2,000 U $6,000 F 4,500 F 1,200 F 0 0 $11,700 F

F = Favorable variance: actual costs Fixed costs are less than budgeted Depreciation 12,000 costs. 12,000 Insurance 2,000 2,000
Total overhead costs $ 89,000 $ 77,300

Q: Since cost variances are favorable, has Barton done a good job controlling costs?

11-46

Flexible Budgeting
How much of the favorable cost variance is due to lower activity, and how much is due to good cost control? Shouldnt variable costs be lower if actual activity is below budgeted activity?

I dont think I can answer the question using the original budget.

To answer the question, we must flex the budget to the actual level of activity.
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Flexible Budgeting
Show expenses that should have occurred at the actual level of activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. Improve performance evaluation.
11-48

Flexible Budgeting
To flex 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

11-49

Flexible Budgeting
Cost Formula Per Hour Units of Activity Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 Hours Hours 12,000 Hours

$ 32,000 In the 24,000 original budget, labor was $40,0004,000 for 10,000 hours resulting $ 60,000

10,000 12,000 Variable8,000 costs are expressed as a constant amount per hour.

in a rate of $4.00 per hour.

$12,000 2,000

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Flexible Budgeting
Cost Formula Per Hour Units of Activity Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 $ 32,000 24,000 4,000 $ 60,000 $12,000 $ 12,000 2,000 2,000 $ 14,000 $ 74,000 10,000 $ 40,000 30,000 5,000 $ 75,000 $ 12,000 2,000 $ 14,000 $ 89,000 12,000 $ 48,000 36,000 6,000 $ 90,000 $ 12,000 2,000 $ 14,000 $ 104,000

Total variable cost = $7.50 per unit budget level in units

11-51

Flexible Budgeting
Cost Formula Per Hour Units of Activity Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 Hours Hours 8,000 10,000 12,000 Hours 12,000

Fixed costs are expressed total $ 32,000 $ 40,000 as $ a 48,000 24,000 30,000 amount that does not change 36,000 within 4,000 5,000 6,000 the relevant range of activity.
$ 60,000 $ 75,000 $ 90,000 $12,000 2,000 $ 12,000 2,000 $ 14,000 $ 74,000 $ 12,000 2,000 $ 14,000 $ 89,000 $ 12,000 2,000 $ 14,000 $ 104,000
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Indirect labor and indirect material have unfavorable variances because actual costs are more than the flexible budget costs.
Cost Formula Per Hour Units of Activity Variable costs Indirect labor Indirect material Power Total variable costs Fixed Costs Depreciation Insurance Total fixed costs Total overhead costs $ 4.00 3.00 0.50 7.50 $12,000 2,000 Total Fixed Costs Flexible Budget 8,000 $ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000 Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,000 $ 14,000 $ 77,300

Variances 0 $ 2,000 U 1,500 U 200 F $ 3,300 U 0 0 0 $ 3,300 U

11-53

Review Questions
1. A store has budgeted sales of $36,000 in July. The store manager wants to have $7,000 in inventory at the end of July. Its beginning inventory is expected to be $6,000. What is the budgeted amount of merchandise purchases? a. $36,000. b. $37,000. c. $42,000. d. $43,000. 2. A company predicts its production and sales will be 24,000 units. At that level of activity, its fixed costs are budgeted at $12.50 per unit, and its variable costs are budgeted at $10.25. If its activity level declines to 20,000 units, what will be its fixed costs and its variable costs? a. Total fixed costs $300,000; Total variable costs $246,000. b. Total fixed costs $250,000; Total variable costs $205,000. c. Total fixed costs $300,000; Total variable costs $205,000. d. Total fixed costs $250,000; Total variable costs $246,000.
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Check List
Do you have a good understanding of:

Preparation of various budgets (focus: operating budgets)

Limitations of static budgets

Flexible budgets: preparation & analysis

END

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