© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Operational Budgeting Chapter 22

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Control Steps taken by management to ensure that objectives are attained. Planning Developing objectives for acquisition and use of resources. A budget is a comprehensive financial plan for achieving the financial and operational goals of an organization. Budgeting: The Basis for Planning and Control

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Benefits Coordination of activities Performance evaluation Enhanced managerial responsibility Assignment of decision making responsibilities Benefits Derived from Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Budget Problems Perceived unfair or unrealistic goals. Poor management- employee communications. Solution Reasonable and achievable budgets. Employee participation in budgeting process. Establishing Budgeted Amounts: The “Behavioral” Approach

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flow of Budget Data Participation in Budget Process

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin C a p i t a l B u d g e t s A continuous budget is usually a twelve-month budget that adds one month as the current month is completed. The annual operating budget may be divided into quarterly or monthly budgets. The Budget Period

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Sales forecast Production schedule Budgeted financial budgets: cash income balance sheet Capital expenditures budget Operating expense budgets Cost of goods sold and ending inventory budgets The Master Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin That’s enough talking about budgets, now show me an example! Preparing the Master Budget: An Illustration

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Sales Budget Estimated Unit Sales Estimated Unit Price Analysis of economic and market conditions + Forecasts of customer needs from marketing personnel Preparing the Master Budget: An Illustration

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Ellis Magnet Co. is preparing budgets for the quarter ending June 30. The sales price is $10 per magnet. Budgeted sales for the next four months are: April20,000 $10 =$200,000 May50,000 $10 =$500,000 June30,000 $10 =$300,000 July25,000 $10 =$250,000 The Sales Budget July is needed for June ending inventory computations. Preparing the Master Budget: An Illustration

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Sales Budget Completed Production Budget The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Ellis wants ending inventory to be 20 percent of the next month’s budgeted sales in units. 4,000 units were on hand March 31.  Let’s prepare the production budget. The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Production Budget Material Purchases Production Budget Units Completed The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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 The Production Budget Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Five pounds of material are needed for each unit produced. Ellis wants to have materials on hand at the end of each month equal to 10 percent of the following month’s production needs. The materials inventory on March 31 is 13,000 pounds. July production is budgeted for 23,000 units. Five pounds of material are needed for each unit produced. Ellis wants to have materials on hand at the end of each month equal to 10 percent of the following month’s production needs. The materials inventory on March 31 is 13,000 pounds. July production is budgeted for 23,000 units. The Production Budget Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Production Budget Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Production Budget Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Production Budget Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Materials used in production cost $.40 per pound. One-half of a month’s purchases are paid for in the month of purchase; the other half is paid for in the following month. No discount terms are available. The accounts payable balance on March 31 is $12,000. Materials used in production cost $.40 per pound. One-half of a month’s purchases are paid for in the month of purchase; the other half is paid for in the following month. No discount terms are available. The accounts payable balance on March 31 is $12,000. Cash Payments for Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Material Purchases

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Production Budget Labor Production Budget Units Material Completed The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Each unit produced requires 3 minutes (.05 hours) of direct labor. Ellis 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 also at $10 per hour. The Production Budget Direct Labor

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Direct Labor

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Direct Labor

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Production Budget Units Material Labor Completed Production Budget Manufacturing Overhead The Production Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 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. The Production Budget Manufacturing Overhead

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Manufacturing Overhead

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Manufacturing Overhead

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for Manufacturing Overhead

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Production Budget Completed Selling and Administrative Expense Budget Selling and Administrative (S&A) Expense Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Selling expense budgets contain both variable and fixed items.  Variable items: shipping costs and sales commissions.  Fixed items: advertising and sales salaries. Administrative expense budgets contain mostly fixed items.  Executive salaries and depreciation on company offices. Selling and Administrative (S&A) Expense Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Variable selling and administrative expenses are $.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. Cash Payments for (S&A) Expenses

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for (S&A) Expenses

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Payments for (S&A) Expenses

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin I have seen a lot of cash payments but no cash receipts. Show me some cash receipts! Cash Receipts Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin All sales are on account. Ellis’s 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. All sales are on account. Ellis’s 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. Cash Receipts Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Receipts Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Receipts Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Receipts Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Cash Receipts Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin With just a little more information we will be able to prepare a comprehensive cash budget. Comprehensive Cash Budget

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Ellis Magnet 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. Comprehensive Cash Budget Additional Information

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin $50,000 ×.16 × 3/12 = $2,000

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Budgeted Income Statement Cash Budget Completed The Budgeted Income Statement

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Budgeted Income Statement

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Computation of unit cost follows The Budgeted Income Statement

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Total mfg. OH for quarter $251,000 Total labor hours required 5,050 hrs. = $49.70 per hr. Manufacturing overhead is applied based on direct labor hours. The Budgeted Income Statement

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Budgeted Income Statement

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin The Budgeted Income Statement

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Budgeted Balance Sheet Completed Budgeted Income Statement The Budgeted Balance Sheet

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Ellis 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 Ellis 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 The Budgeted Balance Sheet

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 25% of June sales of $300,000 11,500 $.40 per lb. 50% of June purchases of $56,800 5,000 $4.99 each

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Let’s change topics. Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Performance evaluation is difficult when actual activity differs from the activity originally budgeted. Flexible Budgeting Hmm! Comparing costs at different levels of activity is like comparing apples with oranges. Consider the following condensed example from the Cheese Company...

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin U = Unfavorable variance – Cheese Company was unable to achieve the budgeted level of activity. Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin F = Favorable variance: actual costs are less than budgeted costs. Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Since cost variances are favorable, have we done a good job controlling costs? Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin I don’t think I can answer the question using the original budget. How much of the favorable cost variance is due to lower activity, and how much is due to good cost control? Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting I don’t think I can answer the question using the original budget. How much of the favorable cost variance is due to lower activity, and how much is due to good cost control? To answer the question, we must the budget to the actual level of activity.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Central Concept If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been. Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Improve performance evaluation. May be prepared for any activity level in the relevant range. Show expenses that should have occurred at the actual level of activity. Reveal variances due to good cost control or lack of cost control. Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin To 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 Variable Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Let’s prepare budgets for the Cheese Company. Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting Variable costs are expressed as a constant amount per hour. In the original budget, indirect labor was $40,000 for 10,000 hours resulting in a rate of $4.00 per hour.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting Total variable cost = $7.50 per unit × budget level in units

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting Fixed costs are expressed as a total amount that does not change within the relevant range of activity.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Now let’s prepare a budget performance report at 8,000 actual machine hours for the Cheese Co. Flexible Budgeting Performance Report

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Flexible Budgeting Performance Report

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Indirect labor and indirect material have unfavorable variances because actual costs are more than the flexible budget costs. Flexible Budgeting Performance Report

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Power has a favorable variance because the actual cost is less than the flexible budget cost. Flexible Budgeting Performance Report

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin I would be happy to assist you with your cash budget! End of Chapter 22