Chapter 9 BUDGETING A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms Control Device & Planning Tool

BUDGETING BASICS Benefits of Budgeting Requires all levels of management to plan ahead and formalize goals on a recurring basis Provides definite objectives for evaluating performance at each level of responsibility Creates an early warning system for potential problems

BUDGETING BASICS Benefits of Budgeting Facilitates coordination of activities within the business Results in greater management awareness of the entity’s overall operations and the impact of external factors Motivates personnel throughout organization to meet planned objectives

BUDGETING BASICS Length of Budget Period May be prepared for any period of time Most common - one year Supplement with monthly and quarterly budgets Different budgets may cover different time periods Continuous twelve-month budget Drops the month just ended and adds a future month This keeps management planning a full year ahead

BUDGETING BASICS Budgeting Process Base budget goals on past performance Collect data from organizational units Begins several months before the end of the current year Start with the Sales Budget

BUDGETING BASICS Budgeting Process Factors considered in Sales Forecasting: General economic conditions Industry trends Market research studies Anticipated advertising and promotion Previous market share Price changes Technological developments

BUDGETING BASICS Budgeting Process The budgeting process is usually informal in small companies Assigned to a budget committee in larger companies

BUDGETING BASICS Budgeting and Human Behavior Participative Budgeting “bottom-to-top” approach is called Participative Budgeting Advantages: Leads to more accurate budget estimates because lower level managers have more detailed knowledge of their area Employees perceive the process as fair due to involvement of lower level management Overall goal - produce a budget considered fair and achievable by managers while still meeting corporate goals

BUDGETING BASICS Budgeting and Human Behavior Participative Budgeting Disadvantages: Can be time consuming and costly Can foster budgetary “gaming” through budgetary slack This is a situation where managers intentionally underestimate budgeted revenues or overestimate budgeted expenses so that budget goals are easier to meet

BUDGETING BASICS - The Master Budget A set of interrelated budgets that constitutes a plan of action for a specified time period Contains two classes of budgets: Operating budgets: Individual budgets that result in the preparation of the budgeted income statement Financial budgets: The capital expenditures budget, the cash budget, and the budgeted balance sheet – focus primarily on cash needs to fund operations and capital expenditures

BUDGETING BASICS - The Master Budget - Components

OPERATING BUDGETS: Sales Budget The sales budget is the first budget prepared It is derived from the sales forecast The sales forecast is management’s best estimate of sales revenue for the budget period Every other budget depends on the sales budget

OPERATING BUDGETS: Sales Budget Example – Hayes Company Expected sales volume: 3,000 units in the first quarter with 500-unit increment increases for each following quarter Sales price: $60 per unit Hayes Company Sales Budget For the Year Ending December 31, 2005 Expected unit sales Unit selling price Total sales 1 3,000 x $60 $180,000 2 3,500 x $60 $210,000 3 4,000 x $60 $240,000 4 4,500 x $60 $270,000 Year 15,000 x $60 $900,000 Quarter

OPERATING BUDGETS: Production Budget The production budget shows the units that must be produced to meet anticipated sales It is derived from sales budget plus the desired finished goods Required production in units formula:

OPERATING BUDGETS: Production Budget Example – Hayes Company Hayes Co. believes it can meet future sales needs with an ending inventory of 20% of next quarter’s sales

OPERATING BUDGETS: Direct Materials Budget The direct materials budget shows both the quantity and cost of direct materials to be purchased It is derived from the direct materials units required for production (from the production budget) and desired ending materials inventory Budgeted cost of direct materials to be purchased = required units of direct materials X anticipated cost per unit

OPERATING BUDGETS: Direct Materials Budget Example – Hayes Company Desires an ending inventory of 10% of the next quarter’s production requirements The manufacturing of each unit requires 2 pounds of raw materials at an expected price of $4 per pound

OPERATING BUDGETS: Direct Materials Budget Example – Hayes Company

OPERATING BUDGETS: Direct Labor Budget The direct labor budget shows both the quantity of hours and cost of direct labor necessary to meet production requirements The total direct labor cost formula is:

OPERATING BUDGETS: Direct Labor Budget Example – Hayes Company Direct labor hours from the production budget Two hours of direct labor required for each unit Hourly wage rate $10

OPERATING BUDGETS: Manufacturing Overhead Budget The manufacturing overhead budget shows the expected manufacturing overhead costs for the budget period It distinguishes between fixed and variable overhead costs Example – Hayes Company Fixed cost amounts are assumed Expected variable costs per direct labor hour: Indirect materials: $1.00 Indirect labor: $1.40 Utilities: $0.40 Maintenance: $0.20

Hayes Company Manufacturing Budget For the Year Ending December 31, 2005 Quarter 1 $ 6,200 8,680 2,480 1,240 18,600 20,000 3,800 9,000 5,700 38,500 $57,100 2 $ 7,200 10,080 2,880 1,440 21,600 20,000 3,800 9,000 5,700 38,500 $60,100 3 $ 8,200 11,480 3,280 1,640 24,600 20,000 3,800 9,000 5,700 38,500 $63,100 4 $ 9,200 12,880 3,680 1,840 27,600 20,000 3,800 9,000 5,700 38,500 $66,100 Year $ 30,800 43,120 12,320 6,160 92,400 80,000 15,200 36,000 22,800 154,000 $246,400 Variable Costs Indirect materials ($1.00 per DLH) Indirect labor ($1.40 per DLH) Utilities ($ .40 per DLH) Maintenance ($.20 per DLH) Total variable Fixed costs Supervisory salaries Depreciation Property tax and insurance Maintenance Total fixed Total manufacturing overhead Direct Labor hours 6,200 7,200 8,200 9,200 30,800 Manufacturing overhead rate per direct labor hour ($246,400  30,800) $8.00

OPERATING BUDGETS: Selling & Administrative Expense Budget Is a projection of anticipated operating expenses Distinguishes between fixed and variable costs Example – Hayes Company Fixed cost amounts are assumed Expected variable costs per unit sold (from sales budget): Sales commissions: $3.00 Freight-out: $1.00

Hayes Company Selling & Administrative Budget For the Year Ending December 31, 2005 Quarter Variable Costs Sales commissions ($3 per unit) Freight-out ($1 per unit) Total variable Fixed costs Advertising Sales salaries Office Salaries Depreciation Property taxes and insurance Total Fixed Expenses Total Selling/Admin. Expenses 1 $ 9,000 3,000 12,000 5,000 15,000 7,500 1,000 1,500 30,000 $42,000 2 $ 10,500 3,500 14,000 5,000 15,000 7,500 1,000 1,500 30,000 $44,000 3 $ 12,000 4,000 16,000 5,000 15,000 7,500 1,000 1,500 30,000 $46,000 4 $ 13,500 4,500 18,000 5,000 15,000 7,500 1,000 1,500 30,000 $48,000 Year $ 45,000 15,000 60,000 20,000 60,000 30,000 4,000 6,000 120,000 $180,000

OPERATING BUDGETS: Budgeted Income Statement The budgeted income statement is prepared from the operating budgets Sales Budget Production Budget Direct Materials Budget Direct Labor Budget Manufacturing Overhead Budget Selling and Administrative Expense Budget

FLEXIBLE BUDGETS Projects budget data for various levels of activity Essentially, a series of static budgets at different activity levels The budgetary process is more useful if it is adaptable to changes in operating conditions Flexible budgets can be prepared for each type of budget in the master budget Flexible budgets are static budgets at different activity levels

DEVELOPING THE FLEXIBLE BUDGET Steps Identify the activity level and the relevant range of activity Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost Identify the fixed costs and determine the budgeted amount for each cost Prepare the budget for selected increments of the activity level within the relevant range

FLEXIBLE BUDGET – A CASE STUDY Example – Fox Manufacturing Co. Monthly comparisons of actual and budgeted manufacturing overhead costs for Finishing Department 2007 master budget Expected annual operating capacity of 120,000 direct labor hours Overhead costs:

FLEXIBLE BUDGET – A CASE STUDY Example – Fox Manufacturing Co. Identify the activity level and the relevant range activity level: direct labor hours relevant range: 8,000 – 12,000 direct labor hours per month Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost

FLEXIBLE BUDGET – A CASE STUDY Example – Fox Manufacturing Co. Identify the fixed costs and determine the budgeted amount for each cost Three fixed costs per month: depreciation $15,000 property taxes $5,000 supervision $10,000 Prepare the budget for selected increments of activity within the relevant range Prepared in increments of 1,000 direct labor hours

FLEXIBLE BUDGET – A CASE STUDY Example – Fox Manufacturing Co. Formula to determine total budgeted costs from the budget at any level of activity: * Total variable cost per unit X activity level Determine total budgeted costs for Fox Manufacturing Company with fixed costs of $30,000 and total variable cost $4 per unit At 9,000 direct labor hours : $30,000 + ($4 X 9,000) = $66,000 At 8,622 direct labor hours: $30,000 + ($4 X 8,622) = $64,488