Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 22 1

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 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

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Learn why managers use budgets 1 1 3

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. To plan and control actions and the related revenues and expenses To incorporate management’s strategic and operational plans Planning technology upgrades Planning capital asset replacements, improvements, or expansions Compare actual results with budgeted amounts to determine corrective actions 4

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Identifies areas where the actual results differed from the budget 7

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Understand the components of the master budget 2 2 8

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Master budget—the set of budgeted financial statements and supporting schedules for the entire organization Budget includes three types of budgets: The operating budget Projects sales revenue, cost of goods sold, and operating expenses The capital expenditures budget The plan for purchasing property, plant, equipment, and other long-term assets The financial budget Plans for raising cash and paying debts Contain projected amounts, not actual amounts 9

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The following are some of the components included in the master budget. a.Budgeted balance sheet b.Sales budget c.Capital expenditures budget d.Budgeted income statement e.Cash budget f.Inventory, purchases, and cost of goods sold budget g.Budgeted statement of cash flows List in order of preparation the items of the master budget ______ 2.______ 3.______ 4.______ 5.______ 6.______ 7.______ B F D C E A G

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Prepare an operating budget

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. First three components Sales budget Inventory, purchases, and cost of goods sold budget Operating expenses Feed into the budgeted income statement 13

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Cornerstone of master budget Level of sales affect all other elements Projected sales are calculated as: Each product multiplied by expected units sold 14

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Budget determines: Cost of goods sold for the budgeted income statement Ending inventory for the budgeted balance sheet Purchases for the cash budget Familiar equation is used Beginning inventory + Purchases – Ending inventory = Cost of goods sold Rearrange equation to solve for unknowns Purchases = Cost of goods sold + Ending inventory – Beginning inventory 15

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 70% cost of goods sold figure uses sales budget created earlier Desired ending inventory is derived from company policies Desired ending inventory becomes beginning inventory for next period (month, quarter, or year) 16

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Prepared after sales budget and cost of goods sold budget Shows estimated expenses for the period Includes fixed and/or variable expenses Examples: Fixed and variable salaries, commissions Rent Insurance Advertising Miscellaneous Look at prior income statements 17

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 21 Prepared after sales budget, cost of goods sold budget and operating expense budget

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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 $190 each in February. All sales are cash only. Prepare the sales budget for January and February. 22 Grippers Sales Budget JanuaryFebruaryTotal Sales price per pair$ 180$ 190 Number of pairs× 8,500 × 3,500 Total sales$1,530,000$665,000$2,195,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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 $10,000 plus 50% of the next month’s cost of goods sold. Use this information and the sales budget prepared in S22-3 to prepare Grippers’ inventory, purchases, and cost of goods sold budget for January and February. 23 Grippers Inventory, Purchases, and Cost of Goods Sold Budget JanuaryFebruary Cost of goods sold (0.60 × sales from S 21-3)$ 918,000$ 399,000 + Desired ending inventory ($10, × Cost of goods sold for next month)209,500329,800 = Total inventory required1,127,500728,800 − Beginning inventory (469,000) (209,500) = Purchases$ 658,500$ 519,300

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Prepare a financial budget

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Cash budget Project cash receipts and payments Budgeted balance sheet Project each asset, liability, and stockholders’ equity account Budgeted statement of cash flows Project cash flows from operating, investing, and financing activities 25

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Statement of budgeted cash receipts and payments Details how to go from the beginning cash balance to the desired ending balance Four major parts: Cash collections from customers Cash payments for purchases Cash payments for operating expenses Cash payments for capital expenditures Depends on operating budget 26

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Cash collections from customers Cash sales from the sales budget Collections of prior month’s credit sales 27

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Payments for operating expenses Payments during the month of purchase—assume 50% Payments following the month of purchase—assume 50% 28 x 50%

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the operating expenses budget and payment information to compute cash payments for operating expenses Payment of 50% of current month’s salary and commissions Payment of 50% of prior months salary and commissions Payment for rent and miscellaneous expenses in the same month 29 Insurance was prepaid in the prior quarter Depreciation is a non-cash expense

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall 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.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Most important part of the budgeting system Getting managers and employees to accept the budget Managers must motivate employees to accept the budget’s goals How? 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 Do not build in slack–becomes less accurate 33

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 34

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Grippers Budgeted Cash Collections from Customers JanuaryFebruary Cash sales (50% of current month )$ 765,000$ 332,500 Collection of sales: 30% of prior month credit sales127,500459,000 18% of sales two months ago 72,000 76,500 Total cash collections$ 964,500$ 868,000 35

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 36 Grippers Budgeted Cash Payments for Purchases JanuaryFebruary 50% of last month$ 293,250$ 329,250 50% of current month329,250259,650 Total cash payments$ 622,500$ 588,900

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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? 37

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Grippers Cash Budget January and February 2012 JanuaryFebruary Beginning cash balance$ 12,500$ 289,200 Cash collections from customers964,500868,000 Cash available977,0001,157,200 Cash payments Purchases of inventory622,500588,900 Operating expenses65,30056,650 Total cash payments687,800645,550 Ending cash balance289,200511,650 Less: Minimum cash balance desired(10,000) Cash excess (deficiency)$ 279,200$ 501,650 38

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use sensitivity analysis in budgeting

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Technology makes it more cost-effective for managers to: Conduct sensitivity analysis on their own unit’s budget Combine individual unit budgets to create the companywide master budget Master budget models the company’s planned activities Must support key strategies 40

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Sensitivity analysis What-if technique that determines the result if predicted amounts differ from those budgeted Spreadsheet programs used for budgeting make sensitivity analysis cost-effective What-if budget questions easily changed within Excel with a few keystrokes Makes it cost-effective to perform more comprehensive sensitivity analyses Managers react quickly if key assumptions underlying the master budget (such as sales price or quantity) turn out to be wrong 41

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Individual operating units roll up budgets to prepare company-wide budget Budget management software is used Often part of Enterprise Resource Planning (ERP) system Allows management to conduct sensitivity analysis on unit data Managers can spend less time compiling and summarizing data and more time analyzing it 43

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Maplehaven Sporting Goods Store has the following sales budget: Suppose June sales are expected to be $80,000 rather than $64, Riverbed Sporting Goods Store Sales Budget April - July AprilMayJuneJuly April-July Total Cash sales, 80%$40,800$64,000$51,200$40,800 Credit sales, 20% 10,200 16,000 12,800 10,200 Total sales, 100%$51,000$80,000$64,000$51,000$246,000 Riverbed Sporting Goods Store Revised Sales Budget April - July AprilMayJuneJuly April-July Total Cash sales, 80%$40,800$64,000 $40,800 Credit sales, 20% 10,200 16,000 10,200 Total sales, 100%$51,000$80,000 $51,000$262,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Prepare performance reports for responsibility centers and account for traceable and common shared fixed costs

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A system for evaluating the performance of each responsibility center and its manager A responsibility center is the part of the organization for which a particular manager is responsible Is a part of the organization for which a manager has decision-making authority and accountability Four types: Cost center Revenue center Profit center Investment center Decentralization highlights the need for reports on individual segments 46

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 47 Goal is to control cost Goal is to increase revenues Goal is to increase profits Goal is to increase ROI, EVA, & residual income

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Performance reports compare budgeted and actual amounts Reporting at all levels: Division (investment centers) Product lines (profit centers) Production (cost centers) Sales (revenue centers) Management by exception Shows variances between actual and budgeted amounts 49

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Departments that provide services to multiple departments or divisions for the company Usually do not generate revenues Similar to the shared production overhead Nonproduction related service departments Examples: Payroll and Human Resources Accounting Copying/Graphic Services Physical Plant (repairs and maintenance) Advertising (companywide, not specific products) Mail and Shipping Services Shared Facilities (meeting rooms used by various departments) Legal Services Travel Booking Services 50

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Costs directly associated with an individual product, division, or business segment Would disappear if the company discontinued the product, division or segment Assigning traceable fixed costs Splitting the cost equally–not fair Based on use of the services–fair Small users charged less Larger users charged more Identify cost drivers (ABC costing) suitable for assigning traceable service department charges Common service departments listed on next slide 51

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Traceable service costs = $30,000 Base is number of orders $30,000 / $400,000 equals $0.075 cost per order 53

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. $30,000 / $400,000 equals $0.075 cost per order Apply to divisions based upon number of orders The DVD division can further split the traceable cost between Excel DVDs and Specialty DVDs $10,500 - $3,500 known untraceable = $7,000 Calculate a cost per order as ($7,000/140,000) = $

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Show the results of the segment or division for which a particular manager is responsible 55

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 56

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 57

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 58

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 59

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 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. 60

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Responsibility 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. 61

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 63 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.