4Learning Objectives Learn why managers use budgets Understand the components of the master budgetPrepare an operating budgetPrepare a financial budgetUse sensitivity analysis in budgetingPrepare performance reports for responsibility centers and account for traceable and common shared fixed costsThe objectives of this chapter include to:Learn why managers use budgets.Understand the components of the master budget.Prepare an operating budget.Prepare a financial budget.Use sensitivity analysis in budgeting.Prepare performance reports for responsibility centers and account for traceable and common shared fixed costs.
5Learn why & how managers use budgets 1Learn why & how managers use budgetsThe first learning objective explains why managers use budgets.
6How & Why Managers Use Budgets Build a PlanFirst, they develop strategies—overall business goals like Amazon’s goal to expand its international operations, or Gateway’s goal to be a value leader in the personal computer market while diversifying into other markets. Companies then plan and budget for specific actions to achieve those goals. The next step is to act. After acting, managers compare actual results with the budget. This feedback allows them to determine what, if any, corrective action to take. These decisions affect the company’s future strategies and plans.
7Advantages of Budgeting Beginnings of the firm’s structure & beyond Think about andplan for the futureBenchmark for measuring performance and responsibilityDefine goalsand objectivesAdvantagesOver-ripe to ship produce uses? Salinas Valley 8, aka SV8: The freshest 100% vegetable juice on the planet. Seasonal product, limited availability, premium pricing.Goals: V8’s sales are approximate $1billion, we want 1% of that, or $10,000,000At $1 per can, that’s 10,000,000 cans to sell in a year.We can’t do that in our garage with blenders, crock pots, and trips to the super market.We need purchasing people, receiving people, cooking equipment, bottling equipment, and shipping facilitiesEach person in charge of above areas needs to see what volume they are dealing with, amounts to spend, and other information.Once we get underway, we need to see how we are performing to plan, sales, expenses, profits, output. How does it all measure up?What’s next????Negotiation/argument points:Defining goals and objectives – padding to ensure adequate resources and/or easy of achieving goalsAllocate resources – fighting for your share. Sometime the best negotiator takes more than their fair share of resources. What tool can you use to evaluate managers claimed profit increases from extra budget allocations?Control point: To be useful in measuring performance, the budget has to be RUMBA. It cannot be based on overoptimistic assumptions or people won’t follow it and won’t respect it for a guiding tool, nor as a control benchmark of against actual performance.Uncover potentialbottlenecksCommunicateplansCoordinateactivities & allocate resources
8Participative Budget System: Building Commitment to the Budget Top Down?Bottom Up?From the bottom: Workers committed to the numbers. Market based numbers. Workers are part of the team. They matter. They pad the numbers to make their evaluation easier.From the top: Numbers matched with the mission of the company – to earn more money. Numbers are stretched to higher levels that workers may not feel are realistic. What happens when you just KNOW you can’t achieve a goal?Watch for: Overzealous editing of bottom up projections – just as bad as top-down imposition.Padding from bottom up. Bigger padding from your pears that leads to inequities in achievability of your goals.Flow of Budget Datafrom the bottom, from the top, what to watch for
9Human Factors in Budgeting The success of budgeting depends upon:Commitment to the budget: plan & useThe quality of the inputsThe way management uses budgeted data.What about new ideas?Commitment to the budget:Use quality numbers – justify increases in profits, don’t just make an unrealistic change to sales forecast to make numbers look better. GIGOTop management following the budget, don’t overspend on pet projects. Hold everyone to the numbers.Where do you draw the line when it comes to good discipline of following the budget and stupidity of walking away from a great unbudgeted profit opportunity?Use of budget data:It is not a hammer with which to punish individuals. It is a tool to direct attention to shortfalls for repair and toward high achievement to learn.If it is used as a hammer – employees will not submit realistic numbers – they will pad and fight for their case to ensure they don’t get in trouble later.
10Getting Employees to Accept the Budget Most important part of the budgeting systemBuilding manager and employee acceptance of budgetHow?Managers must support the budget themselves, or no one else willManagers must show employees how budgets can help them achieve better resultsEmployees participate in developing the budgetA healthy budget process minimizes slackSlack filled budgets cannot be achieved, are not followed, and waste effortWhat is the most important part of Greg’s Tunes’ budgeting system? Despite all the numbers we have crunched, it is not the mechanics. It is getting managers and employees to accept the budget so Greg’s can reap the planning, coordination, and control benefits illustrated in Exhibit 22-3.Few people enjoy having their work monitored and evaluated. So, if managers use the budget as a benchmark to evaluate employees’ performance, managers must first motivate employees to accept the budget’s goals. Here is how they can do it.● Managers must support the budget themselves, or no one else will.● Managers must show employees how budgets can help them achieve better results.● Managers must have employees participate in developing the budget.
11Performance ReportIdentifies areas where the actual results differed from the budgetLet’s return to Smart Touch’s e-learning business. Suppose that comparing actual results to the budget in Exhibit 22-1 leads to the performance report in Exhibit This report identifies areas where the actual results differed from the budget.The differences are itemized below:Actual service revenue was $11,000 less than budgeted service revenue. This was caused by two factors. First, Smart Touch sold 1,000 fewer services than it planned to sell (19,000 actual – 20,000 budgeted). Second, Smart Touch was able to sell at a higher average price per service $31 ($589,000/19,000 services) than the $30 per service it planned.2. Variable expenses were less than budgeted for both server space expense and advertising expense. Actual server space expense was less than budgeted server space expense because Smart Touch sold 1,000 fewer services and because Smart Touch reduced the server space expense per service from $2.25 budgeted to $2.00 ($38,000/19,000 services) actual per service. Advertising expense remained constant at 5% of revenues, but due to the $11,000 reduction in revenues, advertising expense was $550 less ($11,000 5%).3. Actual fixed expenses were exactly the same as budgeted fixed expenses. Although not common, considering Smart Touch’s fixed expenses, one wouldn’t expect these to change unless Smart Touch changed the pay rate or number of employees or unless Smart Touch negotiated a new contract with its Internet service provider.After management reviews the variances, Smart Touch will want to consider how it can implement new strategies to meet its goals.
12Understand the components of the master budget 2Understand the components of the master budgetThe second learning objective is to understand the components of the master budget.
13Steps To Prepare A Budget Master budget—the set of budgeted financial statements and supporting schedules for the entire organizationMaster budget includes three types of budgets:The operating budgetProjects sales revenue, cost of goods sold, and operating expensesThe capital expenditures budgetThe plan for purchasing property, plant, equipment, and other long-term assetsThe financial budgetCash, Balance Sheet, Statement of Cash FlowsContain projected amounts, not actual amountsExhibit 22-5 shows the order in which managers prepare the components of the master budget.Sales budgetInventory, purchases, and cost of goods sold budgetOperating expenses budgetBudgeted income statementCash budgetCapital expenditures budgetBudgeted balance sheetBudgeted statement of cash flows
14S22-2: Understanding the components of the master budget The following are some of the components included in the master budget.Budgeted balance sheetSales budgetCapital expenditures budgetBudgeted income statementCash budgetInventory, purchases, and cost of goods sold budgetBudgeted statement of cash flowsList in order of preparation the items of the master budget.______BFDCEAGShort exercise 22-2 reviews the components of the master budget.
15Prepare an operating budget 3Prepare an operating budgetThe third learning objective is to prepare an operating budget.
16Prepare an operating budget First three componentsSales budgetInventory, purchases, and cost of goods sold budgetOperating expensesThose feed the budgeted income statementThe first three components of the operating budget as shown in Exhibit 22-5 are as follows:1. Sales budget (Exhibit 22-7)2. Inventory, purchases, and cost of goods sold budget (Exhibit 22-8)3. Operating expenses budget (Exhibit 22-9)The results of these three budgets feed into the fourth element of the operating budget—the budgeted income statement.
17How important are these numbers? Sales BudgetefffabcdHow important are these numbers?Cornerstone of master budgetLevel of sales drive and feed all other elementsProjected sales are calculated as:Average price multiplied by expected units soldThe forecast of sales revenue is the cornerstone of the master budget because the level of sales affects expenses and almost all other elements of the master budget. Budgeted total sales for each product are the sales price multiplied by the expected number of units sold.
18Your Firm’s Sales Budget How to convert your multiple products at different prices into a single product/single price budget.Consider this example:Item A: Sell = $350,000Item B: Sell = $300,000Item C: Sell = $350,000Totals: , = $1,000,000What will your sales budget look like?
19Your Firm’s Sales Budget Or, you could base it on a “basket of goods” approach, using 1 average customer as your unit of sales:The average customer buys:1.5 Hot dog = $4.50½ bag o’ chips = $0.501 beverage = $2.50Revenue per 1 customer = $7.50What will your sales budget look like?
20A note on the Sales Budget Reality vs. wishful thinkingValid sources of data:Market history, trends, anticipationInternal history review & projectionsRealistic assessment of life cycle positionCompetition analysisAsk: Are we doing anything to justify our growth?
21Your company Sketch out your sales budget on paper Units Customers, cases, individual units, basket of goodsAverage sales priceIs credit a factor?
22Inventory, Purchases, and Cost of Goods Sold Budget Budget determines:Cost of goods sold for the budgeted income statementEnding inventory for the budgeted balance sheetPurchases for the cash budgetBasic account math equation:Beginning inventory + Purchases = Ending inventory + Cost of goods soldRearrange equation to solve for purchasesCost of goods sold + Ending inventory – Beginning inventory = PurchasesThis budget determines cost of goods sold for the budgeted income statement, ending inventory for the budgeted balance sheet, and purchases for the cash budget. The familiar cost of goods sold computation specifies the relations among these items:Beginning inventory + Purchases – Ending inventory = Cost of goods soldBeginning inventory is known from last month’s balance sheet, budgeted cost of goods sold averages a percentage of sales, and budgeted ending inventory is a computed amount. You must solve for the budgeted purchases figure. To do this, rearrange the previous equation to isolate purchases.Purchases = Cost of goods sold + Ending inventory – Beginning inventoryCompanies should have the minimum amount of inventory to be sure the company balances providing goods to customers with turning over (selling) the inventory efficiently. Keeping inventory at the minimum level that meets these needs helps reduce inventory storage costs, insurance costs, and warehousing costs, and reduces the potential for inventory to become obsolete (not sellable).
23Inventory, Purchases, and Cost of Goods Sold Budget Exhibit 22-8 shows Greg’s inventory, purchases, and cost of goods sold budget. Trace the total budgeted cost of goods sold from Exhibit 22-8 of $168,000 to the budgeted income statement in Exhibit We will use the budgeted inventory and purchases amounts later.70% cost of goods sold figure uses sales budget created earlier. The desired ending inventory is derived from company policies and desired ending inventory becomes beginning inventory for next period (month, quarter, or year).Cost of goods sold is linked to the sales budget numbersDesired ending inventory is driven by future sales needsDesired ending inventory becomes beginning inventory for next period (month, quarter, or year)
24Your inventory, Purchases, COGS Budget Percent of sales &/or derived support for dollarsUnits & subsidiary schedule for manufacturersEnding inventory targetsPurchases/productionServices company – no ending inventory
25Operating Expense Budget Prepared after sales budget and cost of goods sold budgetPlans for non-product costs for the periodIncludes fixed and/or variable expensesExamples:Fixed and variable salaries, commissionsRentInsuranceAdvertisingMiscellaneousAfter projecting sales revenue and cost of goods sold, the operating expenses budget is calculated. The operating budget, with the sales budget and cost of goods sold budget is then used to produce the budgeted income statement that projects operating income for the period.The operating expense budget shows estimated expenses for the period. Some expenses are fixed, like rent. Others are variable, like sales commissions.
26Operating Expense Budget Exhibit 22-9 shows the operating expenses budget. Study each expense to make sure you know how it is computed. For example, sales commissions and miscellaneous expenses fluctuate with sales (variable). Salary, rent, depreciation, and insurance are the same each month (fixed).Volume drives variable expenses, % or sales, or per unit rateDeriving variable per unit costs is if allocating fixed costsFixed costs assigned or derived from table, eg depreciation tableIncome statement, vs. cash paid
27Your Operating Budget Variable costs Fixed costs Driven by sales dollars or units% of sales or per unit rateSupport with detail, but not too much detailFixed costsAll non production expensesInclude non-cash expenses, eg depreciationBuild a depreciation table, not full schedule
28Budgeted Income Statement Review the sales budget and inventory, purchases, and cost of goods sold budget for Greg’s Tunes.
29Budgeted Income Statement Now, review the operating expenses budget for Greg’s Tunes, Inc.
30The Budgeted Income Statement Example: Gregg’s TunesYour choice: Functional vs. Contribution MarginSales BudgetCOGS BudgetOperating BudgetOperating BudgetUse the sales budget (Exhibit 22-7); the inventory, purchases, and cost of goods sold budget (Exhibit 22-8); and the operating expenses budget (Exhibit 22-9) to prepare the budgeted income statement in ExhibitNotice that the income statement highlights the contribution margin, which you learned about in Chapter 19. Recall that the contribution margin is Revenue minus Variable costs. The contribution margin should be large enough to cover fixed expenses and to make a profit.Operating BudgetOperating BudgetOperating BudgetOperating BudgetCash Budget
31The Budgeted Income Statement Gregg’s Tunes is a merchandiserContribution format is not required, but it is an optionFunctional/tradition income statement is more common.Still must included driven costs so they change when you update inputs.Note: Do not include your full manufactured product costs as a purely variable cost.Why not?
32Your Income Statement Sketch it out on paper Account namesSource of numbers, but don’t try to get #’s yetFinalize your format and clear it with meWhat is missing?Where are you going to get it?
33S22-3: Preparing an operating budget Grippers sells its rock-climbing shoes worldwide. Grippers expects to sell 8,500 pairs of shoes for $180 each in January, and 3,500 pairs of shoes for $190 each in February. All sales are cash only.Prepare the sales budget for January and February.GrippersSales BudgetJanuaryFebruaryTotalSales price per pair$$Number of pairs× 8,500× 3,500Total sales$1,530,000$665,000$2,195,000Short exercise 22-3 reviews preparation of an operating budget.
34S22-4: Preparing an operating budget Review your results from S22-3. Grippers expects cost of goods sold to average 60% of sales revenue, and the company expects to sell 4,100 pairs of shoes in March for $260 each. Grippers’ target ending inventory is $10,000 plus 50% of the next month’s cost of goods sold.Use this information and the sales budget prepared in S22-3 to prepare Grippers’ inventory, purchases, and cost of goods sold budget for January and February.GrippersInventory, Purchases, and Cost of Goods Sold BudgetJanuaryFebruaryCost of goods sold(0.60 × sales from S 21-3)$ 918,000$ 399,000+ Desired ending inventory($10, × Cost of goodssold for next month)209,500329,800= Total inventory required1,127,500728,800− Beginning inventory(469,000)(209,500)= Purchases$ 658,500$ 519,300Short exercise 22-4 also focuses on preparing an operating budget.
35Prepare a financial budget 4Prepare a financial budgetThe fourth learning objective is to prepare a financial budget.
36Financial Budget Cash budget Pull cash receipts and payments from each budgetBudgeted balance sheetLink each account cell to the source budgetWhich item will you pull from the income statement?Budgeted statement of cash flows – not required, but okay if you wantProject cash flows from operating, investing, and financing activitiesThe financial budget includes the cash budget, the budgeted balance sheet, and the budgeted statement of cash flows.Cash budget projects cash receipts and payments. The budgeted balance sheet project each asset, liability, and stockholders’ equity account. The budgeted statement of cash flows project cash flows from operating, investing, and financing activities.
37Cash BudgetFeeds from the cash collected/paid segments of operating budgetsDetails how to go from the beginning cash balance to the desired ending balanceFour major parts:Cash collections from customersCash payments for purchases/manufacturingCash payments for operating expensesCash payments for capital expendituresBonus requirement:Put your financing cash flows in it tooThe cash budget, or statement of budgeted cash receipts and payments, details how the business expects to go from the beginning cash balance to the desired ending balance. The cash budget has four major parts:• Cash collections from customers• Cash payments for purchases• Cash payments for operating expenses• Cash payments for capital expendituresCash collections and payments depend on revenues and expenses, which appear in the operating budget. This is why you cannot prepare the cash budget until you have finished the operating budget.
38Budgeted Cash Collections from Customers Cash collections from customers come from two sources—cash sales and collections of accounts receivable. These amounts can be found on the sales budget.Recall that Greg’s sales are 60% cash and 40% on credit. The 40% credit sales are collected the month after the sale is made. Exhibit shows that April’s budgeted cash collections consist of two parts: (1) April’s cash sales from the sales budget in Exhibit 22-7 ($30,000) plus (2) collections of March’s credit sales ($16,000 from the March 31 balance sheet, Exhibit 22-6). Trace April’s $46,000 ($30,000 + $16,000) total cash collections to the cash budget in Exhibit on page 1066.Cash collections from customersBuild a “cash tail” onto each budgetCash sales from the sales budgetNote: Uncollected sales revenue goes where?
39Budgeted Cash Payments for Purchases Payments for operating expensesPayments during the month of purchase—assume 50%Payments following the month of purchase—assume 50%Demo: help me build one in Excel?The data for cash payment for purchases comes from the inventory and cost of goods sold budget.Recall that Greg’s pays for inventory purchases 50% during the month of purchase and 50% the month after purchase. Exhibit uses the inventory, purchases, and cost of goods sold budget from Exhibit 22-8 to compute budgeted cash payments for purchases of inventory. April’s cash payments for purchases consist of two parts: (1) payment of 50% of March’s purchases ($16,800 accounts payable balance from the March 31 balance sheet, Exhibit 22-6) plus (2) payment for 50% of April’s purchases (50% $51,800 = $25,900). Trace April’s $42,700 ($16,800 + $25,900) cash payment for purchases to the cash budget in Exhibit
40Budgeted Cash Payments for Operating Expenses Use the operating expenses budget and payment expectations to compute cash payments for operating expensesLet’s assume for this one that expenses are paid when incurredBack out any non-cash depreciation expenses.Help me build Tremont’s cash payments for operating expenses!Exhibit uses the operating expenses budget (Exhibit 22-9) and Greg’s payment information to compute cash payments for operating expenses. Greg’s pays half the salary in the month incurred and half in the following month. Recall that Greg’s operating expenses also include $2,000 rent, $500 depreciation, $200 of insurance expense, and miscellaneous expenses of 5% of sales for the month (from item 7 on page 1057). Greg’s pays all those expenses in the month incurred except for insurance and depreciation. Recall that the insurance was prepaid insurance, so the cash payment for insurance was made before this budget period; therefore, no cash payment is made for insurance during April–July. Depreciation is a noncash expense, so it’s not included in the budgeted cash payments for operating expenses.
41The Cash Budget8. Greg’s plans to purchase a used delivery truck in April for $3,000 cash.9. Greg’s requires a minimum cash balance of $10,000 before financing at the end of each month.To prepare the cash budget in Exhibit 22-14, start with the beginning cash balance (Exhibit 22-6) and add the budgeted cash collections from Exhibit to determine the cash available. Then, subtract cash payments for purchases (Exhibit 22-12), operating expenses (Exhibit 22-13), and any capital expenditures. This yields the ending cash balance before financing.Item 9 on page 1057 states that Greg’s Tunes requires a minimum cash balance before financing of $10,000. April’s $2,950 budgeted cash balance before financing falls $7,050 short of the minimum required ($10,000 – $2,950). To be able to access short-term financing, Greg’s must have secured an existing line of credit with the company’s bank. Securing this credit in advance is crucial to having the credit available to draw upon when cash shortages arise. Because Greg’s borrows in $1,000 increments, the company will have to borrow $8,000 to cover April’s expected shortfall. The budgeted ending cash balance equals the “ending cash balance before financing,” adjusted for the total effects of the financing (an $8,000 inflow in April). Exhibit shows that Greg’s expects to end April with $10,950 of cash ($2,950 + $8,000). Recall additionally that when Greg’s borrows, the amount borrowed is to be paid back in $1,000 installments plus interest at 12% annually. Note that in May, Greg’s begins to pay the $8,000 borrowed in April. Greg’s must also pay interest at 12%. For May, the interest paid is calculated as $8,000 owed times 12% times 1⁄12 of the year, or $80 interest. For June, Greg’s interest owed will change because the principal of the note has been paid down $1,000 in May. June interest is calculated as ($8,000 – $1,000) owed times 12% times 1⁄12 of the year, or $70 interest. For July, interest is ($8,000 – $1,000 – $1,000) owed times 12% times 1⁄12 of the year, or $60 interest. Exhibit also shows the cash balance at the end of May, June, and July.
42Example: E22-17 Your beginning cash balance? ZeroYour cash collections & paymentsAll cash tails from all budgetsInclude capital asset purchasesBorrowingBeginning to end
43Sketch out your cash budget Your beginning cash balance?ZeroOperating cash inflow/outflowsYour cash collections & paymentsAll cash tails from all budgetsInvesting cash flowsInclude capital asset purchasesFinancing cash flowsAll borrowing and repayment and related interest.Where go: Interest expense & accrued interest?Beginning to endAll owner investment, all dividends
44Budgeted Balance Sheet Cash budget ending balanceSales budgetInventory, Production, and COGS budget, unsold inventoryWhere did these numbers come from?What must these numbers do when inputs are changed on other budget elements?Cash budgetCOGS sub-schedule and operating expense sub-scheduleCOGS sub-schedule and operating expense sub-schedulePurchase, COGS budget & Maybe Operating expense budgetTo prepare the budgeted balance sheet, project each asset, liability, and stockholders’ equity account based on the plans outlined in the previous exhibits. Study the budgeted balance sheet in Exhibit to make certain you understand the computation of each figure. For example, on the budgeted balance sheet as of July 31, 2014, budgeted cash equals the ending cash balance from the cash budget in Exhibit Accounts receivable as of July 31 equal July’s credit sales of $20,000, shown in the sales budget (Exhibit 22-7). July 31 inventory of $42,400 is July’s desired ending inventory in the inventory, purchases, and cost of goods sold budget in Exhibit Detailed computations for each of the other accounts appear in ExhibitOperating expense budgetCash budgetCash budgetIncome statement
45Budgeted Statement of Cash Flows The final step is preparing the budgeted statement of cash flows. Use the information from the schedules of cash collections and payments, the cash budget, and the beginning balance of cash to project cash flows from operating, investing, and financing activities. Take time to study Exhibit on the next page and make sure you understand the origin of each figure.
46S22-5: Preparing a financial budget Refer to the Grippers sales budget that you prepared in S22-3. Now assume that Grippers’ sales are collected as follows: November sales totaled $400,000 and December sales were $425, % in the month of the sale 30% in the month after the sale 18% two months after the sale 2% never collected Prepare a schedule for the budgeted cash collections for January and February. Round answers to the nearest dollar.Short exercise 22-5 reviews preparation of the financial budget.
47S22-5: Preparing a financial budget GrippersBudgeted Cash Collections from CustomersJanuaryFebruaryCash sales (50% of current month )$ 765,000$ 332,500Collection of sales:30% of prior month credit sales127,500459,00018% of sales two months ago72,00076,500Total cash collections$ 964,500$ 868,000The exercise continues on this slide.
48S22-6: Preparing a financial budget Refer to the Grippers inventory, purchases, and cost of goods sold budget your prepared in S22-4. Assume Grippers pays for inventory purchases 50% in the month of purchase and 50% in the month after purchase. Prepare a schedule for the budgeted cash payments for purchases for January and February.GrippersBudgeted Cash Payments for PurchasesJanuaryFebruary50% of last month$ 293,250$ 329,25050% of current month329,250259,650Total cash payments$ 622,500$ 588,900Short exercise 22-6 also reviews preparing a financial budget.
49S22-7: Preparing a financial budget Grippers has $12,500 in cash on hand on January 1. Refer to S22-5 and S22-6 for cash collections and cash payment information. Assume Grippers has cash payment for operating expenses including salaries of $50,000 plus 1% of sales, all paid in the month of sale. The company requires a minimum cash balance of $10,000. Prepare a cash budget for January and February. Will Grippers need to borrow cash by the end of February?Finally, Short exercise 22-7 addresses preparation of a financial budget.
50S22-7: Preparing a financial budget GrippersCash BudgetJanuary and February 2012JanuaryFebruaryBeginning cash balance$ 12,500$ 402,300Cash collections from customers1,077,600827,400Cash available1,090,1001,229,700Cash paymentsPurchases of inventory622,500588,900Operating expenses65,30056,650Total cash payments687,800645,550Ending cash balance402,300584,150Less: Minimum cash balance desired(10,000)Cash excess (deficiency)$ 392,300$ 574,150The exercise continues on this slide.
51Use sensitivity analysis in budgeting 5Use sensitivity analysis in budgetingThe fifth learning objective is to use sensitivity analysis in budgeting.
52Rolling Up Individual Budgets Company headquarters must roll up the budget data from each of the stores to prepare the companywide master budgeted income statement. This roll-up can be difficult for companies in which units use different spreadsheets to prepare the budgets.
53Rolling Up Individual Budgets Individual operating units roll up budgets to prepare company-wide budgetBudget management software is usedOften part of Enterprise Resource Planning (ERP) systemAllows management to conduct sensitivity analysis on unit dataManagers can spend less time compiling and summarizing data and more time analyzing itIndividual operating units of a company need to roll up their budgets to prepare a company-wide budget. Companies often turn to budget-management software to solve this problem. Often designed as a component of the company’s Enterprise Resource Planning (ERP) system (or data warehouse), this software helps managers develop and analyze budgets.Across the globe, managers sit at their desks, log into the company’s budget system, and enter their numbers. The software allows them to conduct sensitivity analyses on their own unit’s data. When the manager is satisfied with the budget, he or she can enter it in the companywide budget with the click of a mouse. This unit’s budget automatically rolls up with budgets from all other units around the world. Whether at headquarters or on the road, top executives can log into the budget system and conduct their own sensitivity analyses on individual units’ budgets or on the companywide budget. Managers can spend less time compiling and summarizing data and more time analyzing it, to ensure that the budget leads the company to achieve its key strategic goals.
54Using Information Technology for Sensitivity Analysis and Rolling Up Unit Budgets Technology makes it more cost-effective for managers to:Conduct sensitivity analysis on their own unit’s budgetCombine individual unit budgets to create the companywide master budgetMaster budget models the company’s planned activitiesMust support key strategiesExhibits 22-7 through show that managers must prepare many calculations to develop the master budget for just one of the retail stores in the Greg’s Tunes merchandising chain. Technology makes it more cost-effective for managers to:● conduct sensitivity analysis on their own unit’s budget, and● combine individual unit budgets to create the companywide master budget.The master budget models the company’s planned activities. Top management pays special attention to ensure that the results of the budgeted income statement (Exhibit 22-10), the cash budget (Exhibit 22-14), and the budgeted balance sheet (Exhibit 22-15) support key strategies.
55Your budgets, all rolled up Monte Car Low Auto Dealership ExampleNote, there are formatting differences that were done according to the student group’s preferences.Note how budgets link togetherLet’s do the break even case and best case using goal-seek
56S22-9: Using sensitivity analysis in budgeting Maplehaven Sporting Goods Store has the following sales budget: Suppose June sales are expected to be $80,000 rather than $64,000.Riverbed Sporting Goods StoreSales BudgetApril - JulyAprilMayJuneJulyApril-JulyTotalCash sales, 80%$40,800$64,000$51,200Credit sales, 20%10,20016,00012,800Total sales, 100%$51,000$80,000$246,000Riverbed Sporting Goods StoreRevised Sales BudgetApril - JulyAprilMayJuneJulyApril-JulyTotalCash sales, 80%$40,800$64,000Credit sales, 20%10,20016,000Total sales, 100%$51,000$80,000$262,000Short exercise 22-9 uses sensitivity analysis in budgeting.
576 Prepare performance reports for responsibility centers and account for traceable and commonshared fixed costsThe sixth learning objective is to prepare performance reports for responsibility centers and account for traceable and common shared fixed costs.
58Do it wrong and you make some really silly (expensive!) mistakes. How do we know where responsibility lies without an army of middle managers?We separate the business into segments, then measure the performance of each segment separately.Do it right and you get a useful picture of each segment’s performance.Do it wrong and you make some really silly (expensive!) mistakes.
59Decentralization and Segment Reporting A Sales PersonA segment is any partition of an organization about which a manager seeks to manage costs, revenues, or investment. A segment can be . . .An Individual StoreA Market Territory
60Segment Types: Cost, Profit, or Investment Centers Cost CenterA segment whose manager has control over costs,but not over revenues nor investment funds.Eg: distribution center
61Cost, Profit, and Investments Centers Profit CenterA segment whose manager has control over both costs and revenues,but no control over investment funds.Eg: retail store operations management
62Cost, Profit, and Investments Centers Profit CenterA segment whose manager has control over both costs and revenues,but no control over investment funds.Eg: store manager
63Cost, Profit, and Investments Centers Investment CenterA segment whose manager has control over costs, revenues, and investments in operating assets.Eg: New business developmentCorporate Headquarters
64Segments as Responsibility Centers CostCenterProfitCenterInvestmentCenterOnce we have the segments settled, we know where responsibility lies.ResponsibilityCenter
65Reporting on SegmentsWe have to consider a few principles of responsibility accounting first:A segment should be measured on what it controls.Cost center = costsProfit center = costs and salesInvestment center costs, sales, assetsSuper, but which costs?
66Traceable and Common Costs Don’t allocatecommon costs in segment analysis.TraceableCosts arise becauseof the existence ofa particular segmentDo include traceable fixed costs in segment analysis.FixedCostsCommonA cost that supports more than one segment and would not go away if any particular segment were eliminated.
67Identifying Traceable Fixed Costs Traceable costs would disappear over time if the segment itself disappeared.Outsourcing solar panel manufacturing means….…..Manufacturingdivision manager.
68Identifying Common Fixed Costs Common costs arise because of overall operation of the company and are not due to the existence of a particular segment.We still have acompany president.No manufacturing segment costs….I’M NOT
69Traceable and Common Costs FixedCostsTraceableCommonAllocating costs to people responsible for them makes evaluation of segments possible. Arbitrarily allocating common costs makes for a less meaningful segment evaluation.
70Segmented Income Statement Example Our approach to segment reporting uses the contribution format.This line is different somehow from earlier chapters….
71Segmented Income Statement Example Our approach to segment reporting uses the contribution format.Division (Segment) marginis My Division’scontributionto corporate profits.I am responsible for it. I should be measured by it.
72Segmented Income Statement Royal Lawncare Supply Let’s see how the Weedban and Greengrow divisions fit into the company evaluation for Royal Lawncare
73Royal Sells $90,000 of Weedban, and $210,000 of Greengrow
74Weedban has a contribution margin ratio of 60% Greengrow’s is 30%
75What do these two stacks of figures already tell us? Royal Lawn care SupplyWhat do these two stacks of figures already tell us?
76What does “Traceable” mean, and why are these fixed costs in here? The company incurs $99,000 in total fixed costs: $45,000 in fixed costs are directly traceable to Weedban $21,000 in fixed costs are directly traceable to GreengrowWhat does “Traceable” mean, and why are these fixed costs in here?
77All costs within the control of Weedban and Greengrow’s management are charged to their business segments. No costs outside of their control are assigned to these segments. Their reporting is complete.Do we have everything we need to evaluate the profitability of these two segments?
78Why are common costs treated differently than traceable fixed costs? The $33,000 in common fixed costs are not charged to the business segments because they are not under the control of the business segmentsWhy are common costs treated differently than traceable fixed costs?
80Reminder NoteAllocating common fixed costs to the segments those fixed costs support is a recipe for disaster
81Royal Lawncare Bonus: Traced fixed costs vs. allocated fixed costs Note fixed cost treatment here in the proper case
82Royal Lawncare Bonus: Traced fixed costs vs. allocated fixed costs These fixed costs are allocated using a “fair share” argument, that every division needs to cover their arbitrarily designated share of overhead.How different is our perception of performance now?
83Issues Involving Allocating Costs Among Segments Failure to tracecosts directlyArbitrarily dividingcommon costsamong segmentsInappropriateallocation baseSegment1Segment2Segment3Segment4
84Omission of CostsCosts assigned to a segment should include all costs attributable to that segment from the company’s entire value chain.Business FunctionsMaking Up TheValue ChainProduct CustomerR&D Design Production Marketing Distribution ServiceSubliminal message: “Hey, this is using my activity based costing knowledge, cool !”
85Responsibility Accounting A system for evaluating the performance of each responsibility center and its managerA responsibility center is the part of the organization for which a particular manager is responsibleIs a part of the organization for which a manager has decision-making authority and accountabilityFour types:Cost centerRevenue centerProfit centerInvestment centerDecentralization highlights the need for reports on individual segmentsA responsibility center is a part of the organization for which a manager has decision-making authority and accountability for the results of those decisions. Lower-level managers are often responsible for budgeting and controlling costs of a single value-chain function. For example, one manager is responsible for planning and controlling the production of Smart Touch’s DVDs at the plant, while another manager is responsible for planning and controlling the distribution of the product to customers. Lower-level managers report to higher-level managers, who have broader responsibilities. Managers in charge of production and distribution report to senior managers responsible for profits earned by an entire product line.Responsibility accounting is a system for evaluating the performance of each responsibility center and its manager. The goal of these reports is to provide relevant information to those managers empowered to make decisions. This decentralization highlights the need for reports on individual segments, which are parts of the company for which managers need reports.
86Responsibility Centers In a cost center, managers are accountable for costs (expenses) only. Manufacturing operations are cost centers. The line foreman controls costs by ensuring that employees work efficiently. The foreman is not responsible for generating revenues because he is not involved in selling the product. The plant manager evaluates the foreman on his ability to control costs by comparing actual costs to budgeted costs. All else being equal, the foreman is likely to receive a more favorable evaluation if actual costs are less than budgeted costs.In a revenue center, managers are primarily accountable for revenues. An example would be a sales region of a business. These managers of revenue centers may also be responsible for the costs of their own sales operations. Revenue center performance reports compare actual with budgeted revenues and may include the costs incurred by the revenue center itself. All else being equal, the manager is likely to receive a more favorable evaluation if actual revenues exceed the budget.In a profit center, managers are accountable for both revenues and costs (expenses) and, therefore, profits. The (higher-level) manager responsible for an entire product line would be accountable for increasing sales revenue and controlling costs to achieve the profit goals. Profit center reports include both revenues and expenses to show the profit center’s income. Superiors evaluate the manager’s performance by comparing actual revenues, expenses, and profits to the budget. All else being equal, the manager is likely to receive a more favorable evaluation if actual profits exceed the budget.In an investment center, managers are accountable for investments, revenues, and costs (expenses). Examples include the Saturn division of General Motors. Managers of investment centers are responsible for (1) generating sales, (2) controlling expenses, and (3) managing the amount of investment required to earn the income (revenues minus expenses). Top management often evaluates investment center managers based on return on investment (ROI), residual income, or economic value added (EVA). All else being equal, the manager will receive a more favorable evaluation if the division’s actual ROI, residual income, or EVA exceeds the amount budgeted.Goal is to control costGoal is to increase revenuesGoal is to increase profitsGoal is to increase ROI, EVA, & residual income
87Partial Organization Chart Exhibit shows how an organization like Smart Touch may assign responsibility. At the top level, the CEO oversees each of the three divisions. Division managers generally have broad responsibility, including deciding how to use assets to maximize ROI. Most companies classify divisions as investment centers.
88Responsibility Accounting Performance Reports Performance reports compare budgeted and actual amountsReporting at all levels:Division (investment centers)Product lines (profit centers)Production (cost centers)Sales (revenue centers)Management by exceptionShows variances between actual and budgeted amountsEach division manager supervises all the product lines in that division. Product lines are generally considered profit centers. Thus, the manager of a product line is responsible for evaluating lower-level managers of both:• Cost centers (such as plants that make products), and• Revenue centers (such as managers responsible for selling products)Reports are used so that the CEO can evaluate divisions; the divisional VPs can evaluate individual product lines; and the product-line managers can evaluate the development, production, marketing, and distribution of their products. At each level, the reports compare actual results with the budget. Variances aid management by exception, which directs executives’ attention to important differences between actual and budgeted amounts.
89Learn about Service Departments Departments that provide services to multiple departments or divisions for the companyUsually do not generate revenuesSimilar to the shared production overheadNonproduction related service departmentsExamples:Payroll and Human ResourcesAccountingCopying/Graphic ServicesPhysical Plant (repairs and maintenance)Advertising (companywide, not specific products)Mail and Shipping ServicesShared Facilities (meeting rooms used by various departments)Legal ServicesTravel Booking ServicesIn most companies, there are departments that provide services to multiple departments or divisions for the company. These shared resources are often called service departments because they provide services to other departments at the same company. Another common characteristic of service departments is that they usually do not generate revenues. This is similar to the shared production overhead we allocated in the activity-based costing chapter, only now we are talking about nonproduction related service departments. Some examples of servicedepartments follow:● Payroll and Human Resources● Accounting● Copying/Graphic Services● Physical Plant (repairs and maintains administrative and production facilities)● Advertising (companywide, not specific products)● Mail and Shipping Services● Shared Facilities (such as meeting rooms used by various departments)● Legal Services● Travel Booking ServicesThis list is not all-inclusive, but merely some common centralized functions. For example, at your college or university, there are many similar shared services that support academic departments such as the library, admissions, counseling center and information technology. The key is that a service department is a centralized, nonrevenue generating department that provides services to many departments within a company.
90Traceable Fixed CostsCosts directly associated with an individual product, division, or business segmentWould disappear if the company discontinued the product , division or segmentAssigning traceable fixed costsSplitting the cost equally–not fairBased on use of the services–fairSmall users charged lessLarger users charged moreIdentify cost drivers (ABC costing) suitable for assigning traceable service department chargesCommon service departments listed on next slideIt is clear these service costs provide value to other parts of the company. But should we charge these costs to those divisions, products, or segments? The key to that question is to determine if the cost is traceable to a particular product, division, or business segment. If the costs are purely variable, tracing those costs to a specific product, division, or segment is easily identifiable. If the costs are fixed, it becomes a bit more challenging.Traceable fixed costs are fixed costs that can be directly associated with an individual product, division, or business segment. A traceable fixed cost would disappear if the company discontinued making the product or discontinued operating the division or the segment. For example, Smart Touch’s DVD manager’s salary is traceable to the DVD product line. Untraceable fixed costs (or common fixed costs) are those fixed costs that cannot be directly associated with an individual product, division, or business segment. For example, the salary of Sheena Bright, President of Smart Touch, is not traceable to a specific product line, division, or business segment. Therefore, her salary would be an untraceable fixed cost.So, how do companies charge various departments for their use of service departments? Let’s start with an example. Suppose Smart Touch incurs $40,000 per month to operate the Centralized Ordering Department. $30,000 is considered traceable fixed costs of the three divisions: CDs, DVDs, and e-Learning. $10,000 of the total $40,000 of Centralized Ordering Department costs are considered untraceable (common). How should the company assign the $30,000 traceable fixed cost among the three divisions? Splitting the cost equally—charging each division $10,000—may not be fair. Ideally, the company should assign the $30,000 traceable fixed costs based on each division’s use of centralized ordering services. The company should use the primary activity that drives (increases or decreases) the cost of central ordering services as the assignment base. As you may recall from Chapter 18, companies identify cost drivers when they implement activity-based costing (ABC). Therefore, a company that has already implemented ABC should know what cost drivers would be suitable for assigning traceable service department charges.
91Exhibit 22-21 lists some of the more common service departments.
92Example Traceable service costs = $30,000 Base is number of orders $30,000 / $400,000 equals $0.075 cost per orderSo, how do companies charge various departments for their use of service departments? Let’s start with an example. Suppose Smart Touch incurs $40,000 per month to operate the centralized Ordering Department. $30,000 is considered traceable fixed costs of the three divisions—CDs, DVDs, and e-Learning. $10,000 of the total $40,000 of Centralized Ordering Department costs are considered untraceable (common). How should the company assign the $30,000 traceable fixed cost among the three divisions?Ideally, the company should assign the $30,000 traceable fixed costs based on each division’s use of centralized ordering services. The company should use the primary activity that drives (increases or decreases) the cost of central ordering services as the assignment base. For example, order processing cost may be driven by the number of orders placed. Exhibit provides several examples of centralized services and common assignment bases.Based on the data in Exhibit 22-20, Smart Touch would probably chose the “number of orders” as the cost driver for assigning the $30,000 in traceable fixed ordering costs as this would closely match how much each division uses the Order Processing Department. First, Smart Touch would calculate a cost per order of $0.075 ($30,000/400,000 orders).
93Example $30,000 / $400,000 equals $0.075 cost per order Apply to divisions based upon number of ordersThe DVD division can further split the traceable cost between Excel DVDs and Specialty DVDs$10,500 - $3,500 known untraceable = $7,000Calculate a cost per order as ($7,000/140,000) = $0.05The assignment of the Order Processing Department’s traceable costs for Smart Touch can be further broken down by product line. We determined in Exhibit that the DVD division was allocated $10,500 of the total $30,000 traceable Order Processing Department costs when we used number of orders as an activity base. From earlier chapters we know that Smart Touch’s DVD division mainly produces two types of DVDs—Excel DVDs and Specialty DVDs. Of the $10,500 in traceable order processing costs of the DVD division, only $7,000 of those costs are traceable to the two products and $3,500 of those costs are untraceable (common). We need to assign the $7,000 in traceable order processing costs for the DVD division to the two product lines within the DVD division to determine the profit from each product line. First, Smart Touch would calculate a cost per order of $0.05 ($7,000 divided by 140,000 orders). Then, Smart Touch would assign the $7,000 traceable order processing costs between Excel and Specialty DVDs as before and as shown in Exhibit Step 3 would calculate income by division and by product line after assigning all traceable costs.
94Responsibility Accounting Reports Show the results of the segment or division for which a particular manager is responsibleExhibit illustrates responsibility accounting reports for each of the levels of management shown in Exhibit Responsibility accounting reports show the results of the segment or division for which a particular manager is responsible. This is illustrated in Exhibit for the divisions and the whole company, and in Exhibit for the DVD division and its products only.
95Chapter 22 SummaryA budgeted income statement shows estimated amounts, whereas the income statement shows actual results. Managers use budgets to develop strategies (overall business goals) and to create plans and follow actions that enable them to achieve those goals. They also review results against the goals (control), often using a performance report that compares budgeted amounts to actual amounts.A budgeted income statement shows estimated amounts, whereas the income statement shows actual results. Managers use budgets to develop strategies (overall business goals) and to create plans and follow actions that enable them to achieve those goals. They also review results against the goals (control), often using a performance report that compares budgeted amounts to actual amounts.
96Chapter 22 SummaryThe master budget is the set of budgeted financial statements and supporting schedules for the entire organization. It contains the operating budget, the capital expenditures budget, and the financial budget. There are many budgets that compose each of the three types. Each budget provides a portion of the plan that maps the company’s planned direction and goals for a period of time.The master budget is the set of budgeted financial statements and supporting schedules for the entire organization. It contains the operating budget, the capital expenditures budget, and the financial budget. There are many budgets that compose each of the three types. Each budget provides a portion of the plan that maps the company’s planned direction and goals for a period of time.
97Chapter 22 SummaryThe first three components of the operating budget include the sales budget; the inventory, purchases, and cost of goods sold budget; and the operating expenses budget. The sales budget depicts the breakdown of sales based on the terms of collection. The inventory, purchases, and cost of goods sold budget aids in planning for adequate inventory to meet sales (COGS) and for inventory purchases. The operating expenses budget captures the planned variable and fixed operating expenses necessary for normal operations. The three budgets help to form the budgeted income statement. Together these form the operational budget that depicts the company’s operational strategy for a period of time.The first three components of the operating budget include the sales budget; the inventory, purchases, and cost of goods sold budget; and the operating expenses budget. The sales budget depicts the breakdown of sales based on the terms of collection. The inventory, purchases, and cost of goods sold budget aids in planning for adequate inventory to meet sales (COGS) and for inventory purchases. The operating expenses budget captures the planned variable and fixed operating expenses necessary for normal operations. The three budgets help to form the budgeted income statement. Together these form the operational budget that depicts the company’s operational strategy for a period of time.
98Chapter 22 SummaryThe cash budget details how the business expects to go from the beginning cash balance to the desired ending balance each period. The cash budget has four major parts—cash collections from customers, cash payments for purchases, cash payments for operating expenses, and cash payments for capital expenditures. The results of these budgets are combined to form the cash budget. After preparing the cash budget, the rest of the financial statement budgets are prepared, including the budgeted balance sheet and budgeted statement of cash flows. These budgets depict the financial plan that implements the strategic goals of the company.The cash budget details how the business expects to go from the beginning cash balance to the desired ending balance each period. The cash budget has four major parts: cash collections from customers, cash payments for purchases, cash payments for operating expenses, and cash payments for capital expenditures. The results of these budgets are combined to form the cash budget. After preparing the cash budget, the rest of the financial statement budgets are prepared, including the budgeted balance sheet and budgeted statement of cash flows. These budgets depict the financial plan that implements the strategic goals of the company.
99Chapter 22 SummarySensitivity budgeting was once a time-consuming task. Now, with technology, modifying the budget assumptions is easy. Individual managers can easily modify the budgets of their specific units, and that data is automatically updated in the companywide budget plans. Being able to modify this data easily allows managers to be more responsive to business changes and plan better; thus, better, more timely decisions that benefit the company may be made.Sensitivity budgeting was once a time-consuming task. Now, with technology, modifying the budget assumptions is easy. Individual managers can easily modify the budgets of their specific units, and that data is automatically updated in the companywide budget plans. Being able to modify this data easily allows managers to be more responsive to business changes and plan better; thus, better, more timely decisions that benefit the company may be made.
100Chapter 22 SummaryResponsibility centers are parts of the company for which managers have decision-making authority and accountability. Responsibility accounting is performance reporting for those responsibility centers. There are four types of responsibility centers—cost centers, revenue centers, profit centers, and investment centers. Traceable fixed costs are those costs that would disappear if a company quit making a particular product or discontinued a division or segment. Common fixed costs (untraceable) are those costs that aren’t traceable to a specific product, division, or segment.Responsibility centers are parts of the company for which managers have decision-making authority and accountability over. Responsibility accounting is performance reporting for those responsibility centers. There are four types of responsibility centers: cost centers, revenue centers, profit centers, and investment centers. Traceable fixed costs are those costs that would disappear if a company quit making a particular product or discontinued a division or segment. Common fixed costs (untraceable) are those costs that aren’t traceable to a specific product, division, or segment.
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