OPERATIONAL BUDGETING Chapter 23 OPERATIONAL BUDGETING 2

Budgeting: The Basis for Planning and Control A budget is a comprehensive financial plan for achieving the financial and operational goals of an organization. Planning Developing objectives for acquisition and use of resources. Control Steps taken by management to ensure that objectives are attained.

Operating Cash Flows Cash Inventories DMWIPFG 166 days 247 Days Accounts Receivable 81 days 247 Days

Benefits Derived from Budgeting Enhanced managerial responsibility Coordination of activities Performance evaluation Benefits Assignment of decision making responsibilities

Establishing Budgeted Amounts: The “Behavioral” Approach Budget Problems Perceived unfair or unrealistic goals. Poor management-employee communications. Solution Reasonable and achievable budgets. Employee participation in budgeting process.

Participation in Budget Process Flow of Budget Data

The Budget Period The annual operating budget may be divided into quarterly or monthly budgets. 2005 2006 2007 2008 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 Master Budget Sales forecast Production budgets Cost of goods sold and ending inventory budgets Operating expense budgets Budgeted financial budgets: cash income balance sheet Capital expenditures budget

Preparing the Master Budget 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 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 The Sales Budget July is needed for June ending inventory computations.

The Production Budget Sales Budget Completed Production Budgets

Let’s prepare the production budget. The management of Basket 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 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 Production Budget

The Production Budget

The Production Budget Production Production Budget Budgets Units Completed Production Budgets Material Purchases

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

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 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 Production Budget Material Purchases

The Production Budget Material Purchases

Cash Payments for Material Purchases Materials used in production cost $0.40 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

Cash Payments for Material Purchases

Cash Payments for Material Purchases

Cash Payments for Material Purchases

The Production Budget Production Production Budget Budget Units Material Completed Production Budget Labor

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 also at $10 per hour.

Cash Payments for Direct Labor

Cash Payments for Direct Labor

Manufacturing Overhead The Production Budget Production Budget Units Material Labor Completed Production Budget Manufacturing Overhead

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.

Cash Payments for Manufacturing Overhead

Cash Payments for Manufacturing Overhead

Cash Payments for Manufacturing Overhead

Selling and Administrative (S&A) Expense Budget Production Budget Completed Selling and Administrative Expense Budget

Selling and Administrative (S&A) Expense Budget 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.

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.

Cash Payments for (S&A) Expenses

Cash Payments for (S&A) Expenses

Cash Receipts Budget All sales are on account. Basket’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

Cash Receipts Budget

Cash Receipts Budget

Cash Receipts Budget

Comprehensive 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.

$50,000 × .16 × 3/12 = $2,000

The Budgeted Income Statement Cash Budget Completed Budgeted Income Statement

The Budgeted Income Statement

The Budgeted Income Statement Computation of unit cost follows

The Budgeted Income Statement 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 Budgeted Income Statement

The Budgeted Balance Sheet Completed Budgeted Income Statement Budgeted Balance Sheet

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

25% of June sales of $300,000 11,500 lbs. @ $.40 per lb. 5,000 units @ $4.99 each 50% of June purchases of $56,800

Consider the following condensed example from Barton, Inc. . . . Flexible Budgeting Hmm! Comparing costs at different levels of activity is like comparing apples with oranges. Consider the following condensed example from Barton, Inc. . . . Performance evaluation is difficult when actual activity differs from the activity originally budgeted.

Flexible Budgeting

Flexible Budgeting U = Unfavorable variance – Barton, Inc. was unable to achieve the budgeted level of activity.

F = Favorable variance: actual costs are less than budgeted costs. Flexible Budgeting F = Favorable variance: actual costs are less than budgeted costs.

Flexible Budgeting Since cost variances are favorable, have we done a good job controlling costs?

I don’t think I can answer the question using the original budget. Flexible Budgeting How much of the favorable cost variance is due to lower activity, and how much is due to good cost control? I don’t think I can answer the question using the original budget.

I don’t think I can answer the question using the original budget. Flexible Budgeting How much of the favorable cost variance is due to lower activity, and how much is due to good cost control? I don’t think I can answer the question using the original budget. To answer the question, we must the budget to the actual level of activity.

Flexible Budgeting 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 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.

Flexible Budgeting 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. Variable Fixed

Flexible Budgeting Let’s prepare budgets Barton, Inc.

Variable costs are expressed as a constant amount per hour. 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.

Flexible Budgeting

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

Flexible Budgeting Fixed costs are expressed as a total amount that does not change within the relevant range of activity.

Flexible Budgeting Performance Report Now let’s prepare a budget performance report at 8,000 actual machine hours for Barton, Inc.

Flexible Budgeting Performance Report

Flexible Budgeting Performance Report Indirect labor and indirect material have unfavorable variances because actual costs are more than the flexible budget costs.

Flexible Budgeting Performance Report Power has a favorable variance because the actual cost is less than the flexible budget cost.

End of Chapter 23 4