Master Budget and Responsibility Accounting CHAPTER 6 Master Budget and Responsibility Accounting

CHAPTER 6 LEARNING OBJECTIVES Describe the master budget and explain its benefits Describe the advantages of budgets Prepare the operating budget and its supporting schedules Use computer-based financial planning models for sensitivity analysis Describe responsibility centers and responsibility accounting In Chapter 6, we will explore the budget process. On this slide are the first five of our 7 learning objectives: Describe the master budget and explain its benefits Describe the advantages of budgets Prepare the operating budget and its supporting schedules Use computer-based financial planning models for sensitivity analysis Describe responsibility centers and responsibility accounting

Chapter 6 learning objectives, concluded Recognize the human aspects of budgeting Appreciate the special challenges of budgeting in multinational companies Here are the last two of our seven learning objectives about budgeting. Recognize the human aspects of budgeting Appreciate the special challenges of budgeting in multinational companies

Budget Defined A budget is the quantitative expression of a proposed plan of action by management for a specified period. A budget is an aid to coordinating what needs to be done to implement that plan. A budget generally includes both the plan’s financial and nonfinancial aspects and serves as a blueprint for the company to follow in an upcoming period. A budget is the quantitative expression of a proposed plan of action by management for a specified period, and Also works as an aid to coordinating what needs to be done to implement that plan

Budgets help managers…. Communicate directions and goals to different departments of a company to help them coordinate the actions they must pursue to satisfy customers and succeed in the marketplace. Judge performance by measuring financial results against planned objectives, activities, and timelines to learn about potential problems. Motivate employees to achieve their goals. Budgets serve many purposes for firms including those seen here: Communicate directions and goals to different departments of a company to help them coordinate the actions they must pursue to satisfy customers and succeed in the marketplace Judge performance by measuring financial results against planned objectives, activities, and timelines to learn about potential problems Motivate employees to achieve their goals.

Strategic plans and operating plans To develop successful strategies, managers must consider questions such as the following: What are our objectives? How do we create value for our customers while distinguishing ourselves from our competitors? Are the markets for our products local, regional, national or global? What trends affect our markets? What organizational and financial structures serve us best? What are risks and opportunities of alternative strategies and what are our contingency plans if our preferred plan fails? As managers work to develop successful strategies, they must consider various questions including the risks and opportunities of alternative strategies, contingency plans if the preferred plan fails, how the economy, industry and competitors affect the business as well as, and in addition to, the questions shown here: To develop successful strategies, managers must consider questions such as the following: What are our objectives? How do we create value for our customers while distinguishing ourselves from our competitors? Are the markets for our products local, regional, national or global? What trends affect our markets? What organizational and financial structures serve us best?

Budgeting cycle: Before the start of a fiscal year, managers at all levels take into account past performance, market feedback, anticipated future changes and other indicators to initiate plans for the next period. Senior managers give subordinate managers a frame of reference against which they will compare actual results. Managers and management accountants investigate any deviations from the plan. Well managed companies usually cycle through these steps during the course of a fiscal year: Before the start of a fiscal year, managers at all levels take into account past performance, market feedback, anticipated future changes and other indicators to initiate plans for the next period. Senior managers give subordinate managers a frame of reference against which they will compare actual results. Managers and management accountants investigate, during the course of the year, changes.

Working document: Master Budget The master budget is at the core of the budgeting process. It expresses management’s operating and financial plans for a specified period: Operating decisions deal with how to best use the limited resources of an organization. (the operating budget) Financial decisions deal with how to obtain the funds to acquire those resources. (the financial budget) The working document at the core of the budget-related process is known as the master budget. It expresses management’s operating and financial plans for a specified period and includes a set of budgeted financial statements.

Advantages of Budgets Promotes coordination and communication among subunits within the company. Provides a framework for judging performance and facilitating learning. Motivates managers and other employees. Among the advantages of budgets are that it: Promotes coordination and communication among subunits within the company Provides a framework for judging performance and facilitating learning - as an example, budgets enable a company’s managers to measure actual performance against predicted performance. This information, then, can be used to guide future activity. Motivates managers and other employees

Challenges in administering a budget Top managers want lower-level managers to participate in the budgeting process because they have more specialized knowledge of day-to-day management, however… The budgeting process is time-consuming, and Upper-level management’s support is crucial Of course, challenges are also associated with budgets and the budget process. The budget process is time-consuming, requires lower-level managers “buy-in” and upper-level management support.

Time coverage of budgets The timeline for a budget is dependent on the motive for creating the budget. The most frequently used budget period is 1 year. Businesses may also use a rolling budget. This budget is always available for a specified future period, by continually adding a month, quarter, or year to the period just ended. The motive for creating a budget should guide a manager in choosing the period for the budget. As an example, if the purpose for the budget is cash-flow, you may look at a 6-month horizon whereas if you are looking at profitability of a new product line, you may need to look 3-years into the future.

To facilitate the budget process, use the 5-step decision making process Identify the problem and uncertainties Obtain information Make predictions about the future Make decisions by choosing among alternatives Implement the decision, evaluate performance and learn A company will go through the five-step decision-making process that was introduced in Chapter 1 and is shown here. Identify the problem and uncertainties Obtain information Make predictions about the future Make decisions by choosing among alternatives Implement the decision, evaluate performance and learn

Basic Operating Budget Steps Prepare the revenues budget (schedule 1; the starting point) Page 206 Prepare the production budget (schedule 2; in units). Page 207 Prepare the direct materials usage budget and direct materials purchases budget (schedule 3) Pages 207 and 208 Prepare the direct manufacturing labor budget (schedule 4) Page 208 The revenue budget is usually based on expected demand because demand for a company’s products is invariably the limiting factor for achieving profit goals. The logical next step is to plan the production so that the product is available when customers need it. The number of units to be produced is the key to computing the usage of direct materials in both quantity and dollars. This will be based on quantity required for each unit to be produced from the production budget To create the budget for direct manufacturing labor costs, managers estimate wage rates, production methods, process and efficiency improvements and hiring plans.

Basic Operating Budget Steps Prepare the manufacturing overhead costs budget (schedule 5) Page 210 Prepare the ending inventories budget (schedule 6A, units; schedule 6B, dollars) Pages 211 and 212 Prepare the cost of goods sold budget (schedule 7) Page 212 Prepare the operating expense (period cost) budget (schedule 8) Page 213 Prepare the budgeted income statement Exhibit 6-3 page 213 The next schedule to be created (schedule #5) is the manufacturing overhead costs budget. Managing overhead costs is both challenging and important because of the required understanding of the activities required for production and the cost driver of those activities. Inventories are essential for proper customer service and play an important role in the determination of the budget. The production budget already included a determination of the target ending finished goods inventory. Cost of Goods Sold are calculated by adding additional production costs to beginning finished goods inventory and subtracting ending finished goods inventory. Non-manufacturing costs are included in the operating expense budget. Formats differ for the budgeting income statement but generally, information from schedules 1, 7 and 8 are used to generate the budgeted income statement.

Basic Financial Budget Steps From Appendix Based on the operating budgets: Prepare the capital expenditures budget. Prepare the cash budget. Prepare the budgeted balance sheet. Prepare the budgeted statement of cash flows. Once the schedules just discussed and the budgeted income statement are complete, additional schedules need to be created to complete the budgeted balance sheet and the financial section of the master budget. Prepare the capital expenditures budget. Prepare the cash budget. Prepare the budgeted balance sheet. Prepare the budgeted statement of cash flows.

Overview of the Master Budget This illustration shows the relationship between the schedules that we discussed for both the operating and financial sections of the master budget. As is clearly demonstrated, the revenues budget begins the process and informs virtually all of the schedules that come later. Exhibit 6-2 page 204

Financial-planning models & sensitivity analysis: Financial planning models may be employed to conduct sensitivity (“what- if”) analysis to assist in the budgetary process. A “what-if” analysis or sensitivity analysis is a technique that examines how a result will change if the original predicted data or underlying assumption change. Financial planning models are mathematical representations of the relationships among operating activities, financing activities and other factors that affect the master budget.

Sensitivity Analysis Sensitivity analysis is used to assist managers in planning and budgeting. Sensitivity analysis is a “what if” technique that illustrates the impact of changes from the predicted data. Two scenarios are being considered for Stylistic Furniture’s (the company from the textbook) budget. As we learn from the table shown here, the master budget assumes a particular mix of product sales, selling price, material cost with the resulting budgeted operating income. In scenario #1, a what-if look at an alternative, the price has been reduced with no offsetting decrease in direct material cost or increase in units sold. This results in a 22% decrease in budgeted operating income. In scenario #2, we instead are looking at an increase in direct material costs, resulting in an 8% decrease in budgeted operating income. This kind of “advance notice” gives managers an idea of where they should focus efforts to ensure meeting the budgeted operating income. Exhibit 6-4 page 214

Budgeting and Responsibility Accounting Responsibility center—a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities. Responsibility accounting—a system that measures the plans, budgets, actions, and actual results of each responsibility center. Generally, we consider 4 levels of responsibility center. To attain the goals described in the master budget, top managers must coordinate the efforts of all the firm’s employees. Consequently, the way a firm is structured shapes how the coordination occurs. Here we see the definition of a responsibility center and responsibility accounting: Responsibility center—a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities. Responsibility accounting—a system that measures the plans, budgets, actions, and actual results of each responsibility center

Types of Responsibility Centers Cost—accountable for costs only Revenue—accountable for revenues only Profit—accountable for revenues and costs Investment—accountable for investments, revenues, and costs There are 4 types of responsibility center: Cost—accountable for costs only Revenue—accountable for revenues only Profit—accountable for revenues and costs Investment—accountable for investments, revenues, and costs

Budgets and Feedback Budgets offer feedback in the form of variances: actual results deviate from budgeted targets. Variances provide managers with: Early warning of problems A basis for performance evaluation A basis for strategy evaluation Budgets offer feedback in the form of variances and provide managers with early warning of problems. They can also be the basis for performance evaluations and are a basis for strategy evaluation.

Responsibility & Controllability Controllability is the degree of influence that a manager has over costs, revenues, or related items for which he or she is being held responsible. Responsibility accounting helps managers to first focus on whom they should ask to obtain information and not on whom they should blame. Responsibility accounting focuses on gaining information and knowledge, not only on control. The fundamental purpose of responsibility accounting is to enable future improvement. Managers should avoid thinking about controllability only in the context of performance evaluation. Responsibility accounting helps managers to first focus on whom they should ask to obtain information and not on whom they should blame. The fundamental purpose of responsibility accounting is to enable future improvement.

Human aspects of budgeting Budgetary slack is the practice of underestimating budgeted revenues or overestimating budgeted costs to make budgeted targets easier to achieve. Stretch targets are targets that are challenging but achievable to focus effort on achieving the targets. Kaizen Budgeting is a practice whereby each budget process incorporates continuous improvement from past results. Budgetary slack is a concern for firms when using budgets for performance evaluation. There are many techniques to avoid or minimize this negative aspect including the use of stretch targets and Kaizen budgeting.

Budgeting in multinational companies International companies face significant exchange rate uncertainty rendering budgets for traditional purposes of evaluating a firm’s performance moot but still very useful as a tool to help manager’s adapt plans and coordinate actions when conditions are volatile. Do managers of multinational companies find budgeting to be a helpful tool? A natural question when you consider the volatility of exchange rates, among other conditions. The answer is yes though the use of the budget is often modified to accommodate that volatility.

Terms to learn TERMS TO LEARN PAGE NUMBER REFERENCE Activity-based budgeting(ABB) Page 209 Budgetary slack Page 218 Cash budget Page 225 Continuous budget Page 202 Controllability Page 217 Controllable cost Cost center Page 216 Financial budget Page 203 Financial planning models Page 213 Investment center

Terms to learn, concluded PAGE NUMBER REFERENCE Kaizen budgeting Page 220 Master budget Page 199 Operating budget Page 203 Organization structure Page 216 Pro forma statements Profit center Responsibility accounting Responsibility center Revenue center Rolling budget Page 202 Rolling forecast