The Master Budget and Responsibility Accounting Chapter 22 The Master Budget and Responsibility Accounting

Why Managers Use Budgets 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

How Managers Use Budgets

Benefits of Budgeting

Performance Report Identifies areas where the actual results differed from the budget

Steps Managers Take To Prepare A Budget 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

Master Budget

S22-2: Understanding the components of the master budget The following are some of the components included in the master budget. Budgeted balance sheet Sales budget Capital expenditures budget Budgeted income statement Cash budget Inventory, purchases, and cost of goods sold budget Budgeted statement of cash flows List in order of preparation the items of the master budget. ______ B F D C E A G

Prepare an operating budget First three components Sales budget Inventory, purchases, and cost of goods sold budget Operating expenses Feed into the budgeted income statement

Sales Budget Cornerstone of master budget Level of sales affect all other elements Projected sales are calculated as: Each product multiplied by expected units sold

Inventory, Purchases, and Cost of Goods Sold Budget 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

Inventory, Purchases, and Cost of Goods Sold Budget 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)

Operating Expense Budget 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

Operating Expense Budget

Budgeted Income Statement

Budgeted Income Statement

The Budgeted Income Statement Prepared after sales budget, cost of goods sold budget and operating expense budget

S22-3: Preparing an operating budget 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. Grippers Sales Budget January February Total Sales price per pair $ 180 $ 190 Number of pairs × 8,500 × 3,500 Total sales $1,530,000 $665,000 $2,195,000

S22-4: Preparing an operating budget 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. Grippers Inventory, Purchases, and Cost of Goods Sold Budget January February Cost of goods sold (0.60 × sales from S 21-3) $ 918,000 $ 399,000 + Desired ending inventory ($10,000 + 0.50× Cost of goods sold for next month) 209,500 329,800 = Total inventory required 1,127,500 728,800 − Beginning inventory (469,000) (209,500) = Purchases $ 658,500 $ 519,300

Financial Budget 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

Cash Budget 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

Budgeted Cash Collections from Customers Cash sales from the sales budget Collections of prior month’s credit sales

Budgeted Cash Payments for Purchases Payments for operating expenses Payments during the month of purchase—assume 50% Payments following the month of purchase—assume 50% x 50%

Budgeted Cash Payments for Operating Expenses 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 Depreciation is a non-cash expense Insurance was prepaid in the prior quarter

The Cash Budget 8. 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.

Budgeted Balance Sheet

Budgeted Statement of Cash Flows

Getting Employees to Accept the Budget 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

S22-5: Preparing a financial budget 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 $425,000. 50% 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.

S22-5: Preparing a financial budget Grippers Budgeted Cash Collections from Customers January February Cash sales (50% of current month ) $ 765,000 $ 332,500 Collection of sales: 30% of prior month credit sales 127,500 459,000 18% of sales two months ago 72,000 76,500 Total cash collections $ 964,500 $ 868,000

S22-6: Preparing a financial budget 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. Grippers Budgeted Cash Payments for Purchases January February 50% of last month $ 293,250 $ 329,250 50% of current month 329,250 259,650 Total cash payments $ 622,500 $ 588,900

S22-7: Preparing a financial budget 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?

S22-7: Preparing a financial budget Grippers Cash Budget January and February 2012 January February Beginning cash balance $ 12,500 $ 402,300   Cash collections from customers 1,077,600 827,400 Cash available 1,090,100 1,229,700 Cash payments Purchases of inventory 622,500 588,900 Operating expenses 65,300 56,650 Total cash payments 687,800 645,550 Ending cash balance 402,300 584,150 Less: Minimum cash balance desired (10,000) Cash excess (deficiency) $ 392,300 $ 574,150

Using Information Technology for Sensitivity Analysis and Rolling Up Unit Budgets 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

Sensitivity Analysis and Rolling Up Unit Budgets 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

Rolling Up Individual Budgets

Rolling Up Individual Budgets 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

S22-9: Using sensitivity analysis in budgeting Maplehaven Sporting Goods Store has the following sales budget: Suppose June sales are expected to be $80,000 rather than $64,000. Riverbed Sporting Goods Store Sales Budget April - July April May June July April-July Total Cash sales, 80% $40,800 $64,000 $51,200 Credit sales, 20% 10,200 16,000 12,800 Total sales, 100% $51,000 $80,000 $246,000 Riverbed Sporting Goods Store Revised Sales Budget April - July April May June July April-July Total Cash sales, 80% $40,800 $64,000 Credit sales, 20% 10,200 16,000 Total sales, 100% $51,000 $80,000 $262,000

Responsibility Accounting 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

Responsibility Centers Goal is to control cost Goal is to increase revenues Goal is to increase profits Goal is to increase ROI, EVA, & residual income

Partial Organization Chart

Responsibility Accounting Performance Reports 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

Learn about Service Departments 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

Traceable Fixed Costs 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

Example Traceable service costs = $30,000 Base is number of orders $30,000 / $400,000 equals $0.075 cost per order

Example $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) = $0.05

Responsibility Accounting Reports Show the results of the segment or division for which a particular manager is responsible