2/6/02W. Bentz1 A&MIS 212 Profit Planning: Budgeting Session 11 February 12, 2002

2/6/02W. Bentz2 Functions of Budgets--1 1.Formally communicates management objectives and priorities in financial terms 2.Represents authorization and approval to undertake activities 3.Guide to action by others both internal and external to the firm

2/6/02W. Bentz3 Functions of Budgets--2 4.Establishes expectations in quantitative terms 5.The planning process forces and facilitates communication among functional and operating groups

2/6/02W. Bentz4 Functions of Budgets--3 6.Budgets form a basis on which to evaluate both the effectiveness and efficiency of the achievement of agreed upon goals and objectives 7.Forces us to identify potential or likely problem areas and challenges to goals and targets

2/6/02W. Bentz5 Benefits of Effective Budgets  The benefits of profit planning depend on:  The environment in which the organization operates  The time and effort devoted to the planning process  The extent to which management goals and objectives are reflected in the plans  The extent to which management utilizes the plans

2/6/02W. Bentz6 Benefits of Effective Budgets  Improved performance relative to goals  Improved performance evaluation processes  Improved coordination & communication  Lower risk and lower cost of capital

2/6/02W. Bentz7 Perceived Costs of Budgeting  Executive time and effort  Management time and effort away from more valuable activites  Cost of staff time and software  Constraints on management  Reveals problems, weaknesses, etc.

2/6/02W. Bentz8 Steps in Budgeting Process 1.Forecast the markets for goods & services 2.Plan revenues (prices & quantities) 3.Prepare production budget in units 4.Prepare materials requirements budget 5.Prepare materials purchases budget 6.Prepare labor requirements budget 7.Prepare labor acquisition budget

2/6/02W. Bentz9 Steps in Budgeting Process 8.Prepare cost budgets for other expense categories 9.Determine billing and cost rates 10.Prepare more detailed sales and inventory budgets based on matching sales plans with production plans 11.Prepare cost of goods sold budgets 12.Prepare budgeted financial statements

2/6/02W. Bentz10 Risk factors  The predictability of demand is a key factor in the usefulness of financial budgets. Demand drives action.  Stability of suppliers, employees, and facilities influence risk  Financial health is key to the achievement of other objectives

2/6/02W. Bentz11 Other Considerations  Different budgets of the same areas may exist for different purposes. The revenue budget used for cash flow and financing purposes may be more conservative than the sales budgets (targets) given to the sales force, for example.

2/6/02W. Bentz12 Misuse of Budgets  Budgets get a bad name because they can be used by management to brow- beat subordinates and justify non- support of projects, etc.  I believe in open communication of budgets and fair, honest treatment of managers. People tend to be more suspicious than selfish!

2/6/02W. Bentz13 The Basic Framework of Budgeting Detail Budget Detail Budget Detail Budget Master Budget Summary of a company’s plans. Sales Production Materials

2/6/02W. Bentz14 Planning and Control Planning -- involves developing objectives and preparing various budgets to achieve these objectives. ControlControl -- involves the steps taken by management that attempt to ensure the objectives are attained.

2/6/02W. Bentz15 Advantages of Budgeting Advantages Communicating plans Think about and plan for the future Means of allocating resources Uncover potential bottlenecks Coordinate activities Define goal and objectives

2/6/02W. Bentz16 Responsibility Accounting Managers should be held responsible for those items — and only those items — that the manager can actually control to a significant extent.

2/6/02W. Bentz17 Choosing the Budget Period Operating Budget The annual operating budget may be divided into quarterly or monthly budgets.

2/6/02W. Bentz18 Choosing the Budget Period Continuous or Perpetual Budget This budget is usually a twelve-month budget that rolls forward one month as the current month is completed.

2/6/02W. Bentz19 Participative Budget System Flow of Budget Data

2/6/02W. Bentz20 The Budget Committee A standing committee responsible for –overall policy matters relating to the budget –coordinating the preparation of the budget

2/6/02W. Bentz21 The Master Budget Sales Budget Selling and Administrative Budget

2/6/02W. Bentz22 The Master Budget Direct Materials Budget Ending Inventory Budget Production Budget Selling and Administrative Budget Direct Labor Budget Manufacturing Overhead Budget Sales Budget

2/6/02W. Bentz23 The Master Budget Direct Materials Budget Ending Inventory Budget Production Budget Selling and Administrative Budget Direct Labor Budget Manufacturing Overhead Budget Cash Budget Sales Budget Budgeted Financial Statements

2/6/02W. Bentz24 The Sales Budget Detailed schedule showing expected sales for the coming periods expressed in units and dollars.

2/6/02W. Bentz25 Budgeting Example  Royal Company is preparing budgets for the quarter ending June 30.  Budgeted sales for the next five months are: April 20,000 units May 50,000 units June 30,000 units July 25,000 units August 15,000 units.  The selling price is $10 per unit.

2/6/02W. Bentz26 The Sales Budget

2/6/02W. Bentz27 The Sales Budget

2/6/02W. Bentz28 The Production Budget SalesBudget ProductionBudget Completed Production must be adequate to meet budgeted sales and provide for sufficient ending inventory.

2/6/02W. Bentz29 The Production Budget Royal Company wants ending inventory to be equal to 20% of the following month’s budgeted sales in units. On March 31, 4,000 units were on hand. Let’s prepare the production budget. Let’s prepare the production budget.

2/6/02W. Bentz30 The Production Budget Budgeted sales 50,000 Desired percent 20% Desired inventory 10,000 Budgeted sales 50,000 Desired percent 20% Desired inventory 10,000

2/6/02W. Bentz31 The Production Budget March 31 ending inventory March 31 ending inventory

2/6/02W. Bentz32 The Production Budget

2/6/02W. Bentz33 The Production Budget

2/6/02W. Bentz34 The Production Budget

2/6/02W. Bentz35 Expected Cash Collections All sales are on account. Royal’s collection pattern is: 70% collected in the month of sale, 25% collected in the month following sale, 5% is uncollectible. The March 31 accounts receivable balance of $30,000 will be collected in full. All sales are on account. Royal’s collection pattern is: 70% collected in the month of sale, 25% collected in the month following sale, 5% is uncollectible. The March 31 accounts receivable balance of $30,000 will be collected in full.

2/6/02W. Bentz36 Expected Cash Collections

2/6/02W. Bentz37 Expected Cash Collections

2/6/02W. Bentz38 Expected Cash Collections

2/6/02W. Bentz39 Expected Cash Collections

2/6/02W. Bentz40 The Direct Materials Budget At Royal Company, five pounds of material are required per unit of product. Management wants materials on hand at the end of each month equal to 10% of the following month’s production. Let’s prepare the direct materials budget.On March 31, 13,000 pounds of material are on hand. Material cost $0.40 per pound. Let’s prepare the direct materials budget. At Royal Company, five pounds of material are required per unit of product. Management wants materials on hand at the end of each month equal to 10% of the following month’s production. Let’s prepare the direct materials budget.On March 31, 13,000 pounds of material are on hand. Material cost $0.40 per pound. Let’s prepare the direct materials budget.

2/6/02W. Bentz41 The Direct Materials Budget From production budget From production budget

2/6/02W. Bentz42 The Direct Materials Budget

2/6/02W. Bentz43 The Direct Materials Budget 10% of the following month’s production 10% of the following month’s production

2/6/02W. Bentz44 The Direct Materials Budget March 31 inventory March 31 inventory

2/6/02W. Bentz45 The Direct Materials Budget

2/6/02W. Bentz46 The Direct Materials Budget

2/6/02W. Bentz47 Expected Cash Disbursement for Materials Royal pays $0.40 per pound for its materials. One-half of a month’s purchases are paid for in the month of purchase; the other half is paid in the following month. The March 31 accounts payable balance is $12,000. Let’s calculate expected cash disbursements. Let’s calculate expected cash disbursements. Royal pays $0.40 per pound for its materials. One-half of a month’s purchases are paid for in the month of purchase; the other half is paid in the following month. The March 31 accounts payable balance is $12,000. Let’s calculate expected cash disbursements. Let’s calculate expected cash disbursements.

2/6/02W. Bentz48 Expected Cash Disbursement for Materials

2/6/02W. Bentz49 Expected Cash Disbursement for Materials 140,000 lbs. × $.40/lb. = $56,000

2/6/02W. Bentz50 Expected Cash Disbursement for Materials

2/6/02W. Bentz51 Expected Cash Disbursement for Materials

2/6/02W. Bentz52 The Direct Labor Budget At Royal, each unit of product requires 0.05 hours of direct labor. The Company has a “no layoff” policy so all employees will be paid for 40 hours of work each week. In exchange for the “no layoff” policy, workers agreed to a wage rate of $10 per hour regardless of the hours worked (No overtime pay). For the next three months, the direct labor workforce will be paid for a minimum of 1,500 hours per month. Let’s prepare the direct labor budget. Let’s prepare the direct labor budget. At Royal, each unit of product requires 0.05 hours of direct labor. The Company has a “no layoff” policy so all employees will be paid for 40 hours of work each week. In exchange for the “no layoff” policy, workers agreed to a wage rate of $10 per hour regardless of the hours worked (No overtime pay). For the next three months, the direct labor workforce will be paid for a minimum of 1,500 hours per month. Let’s prepare the direct labor budget. Let’s prepare the direct labor budget.

2/6/02W. Bentz53 The Direct Labor Budget From production budget

2/6/02W. Bentz54 The Direct Labor Budget

2/6/02W. Bentz55 The Direct Labor Budget Higher of labor hours required or labor hours guaranteed. Higher of labor hours required or labor hours guaranteed.

2/6/02W. Bentz56 The Direct Labor Budget

2/6/02W. Bentz57 Manufacturing Overhead Budget producedRoyal Company uses a variable manufacturing overhead rate of $1 per unit produced. Fixed manufacturing overhead is $50,000 per month and includes $20,000 of noncash costs (primarily depreciation of plant assets). Let’s prepare the manufacturing overhead budget. Let’s prepare the manufacturing overhead budget.

2/6/02W. Bentz58 Manufacturing Overhead Budget From production budget

2/6/02W. Bentz59 Manufacturing Overhead Budget

2/6/02W. Bentz60 Manufacturing Overhead Budget Depreciation is a noncash charge.

2/6/02W. Bentz61 Ending Finished Goods Inventory Budget Now, Royal can complete the ending finished goods inventory budget. At Royal, manufacturing overhead is applied to units of product on the basis of direct labor hours. Let’s calculate ending finished goods inventory. Let’s calculate ending finished goods inventory. Now, Royal can complete the ending finished goods inventory budget. At Royal, manufacturing overhead is applied to units of product on the basis of direct labor hours. Let’s calculate ending finished goods inventory. Let’s calculate ending finished goods inventory.

2/6/02W. Bentz62 Ending Finished Goods Inventory Budget Direct materials budget and information

2/6/02W. Bentz63 Ending Finished Goods Inventory Budget Direct labor budget

2/6/02W. Bentz64 Ending Finished Goods Inventory Budget Total mfg. OH for quarter $251,000 Total labor hours required 5,050 hrs. = $49.70 per hr.* * rounded

2/6/02W. Bentz65 Ending Finished Goods Inventory Budget Production Budget

2/6/02W. Bentz66 Selling and Administrative Expense Budget At Royal, variable selling and administrative expenses are $0.50 per unit sold. Fixed selling and administrative expenses are $70,000 per month. The fixed selling and administrative expenses include $10,000 in costs – primarily depreciation – that are not cash outflows of the current month. Let’s prepare the company’s selling and administrative expense budget. At Royal, variable selling and administrative expenses are $0.50 per unit sold. Fixed selling and administrative expenses are $70,000 per month. The fixed selling and administrative expenses include $10,000 in costs – primarily depreciation – that are not cash outflows of the current month. Let’s prepare the company’s selling and administrative expense budget.

2/6/02W. Bentz67 Selling and Administrative Expense Budget

2/6/02W. Bentz68 Selling and Administrative Expense Budget

2/6/02W. Bentz69 The Cash Budget Royal: lMaintains a 16% open line of credit for $75,000. lMaintains a minimum cash balance of $30,000. lBorrows on the first day of the month and repays loans on the last day of the month. lPays a cash dividend of $49,000 in April. lPurchases $143,700 of equipment in May and $48,300 in June paid in cash. lHas an April 1 cash balance of $40,000. Royal: lMaintains a 16% open line of credit for $75,000. lMaintains a minimum cash balance of $30,000. lBorrows on the first day of the month and repays loans on the last day of the month. lPays a cash dividend of $49,000 in April. lPurchases $143,700 of equipment in May and $48,300 in June paid in cash. lHas an April 1 cash balance of $40,000.

2/6/02W. Bentz70 The Cash Budget Schedule of Expected Cash Collections Schedule of Expected Cash Collections Schedule of Expected Cash Disbursements Schedule of Expected Cash Disbursements

2/6/02W. Bentz71 The Cash Budget Direct Labor Budget Manufacturing Overhead Budget Selling and Administrative Expense Budget

2/6/02W. Bentz72 The Cash Budget Because Royal maintains a cash balance of $30,000, the company must borrow on its line-of-credit

2/6/02W. Bentz73 Financing and Repayment Ending cash balance for April is the beginning May balance.

2/6/02W. Bentz74 The Cash Budget

2/6/02W. Bentz75 Financing and Repayment Because the ending cash balance is exactly $30,000, Royal will not repay the loan this month.

2/6/02W. Bentz76 The Cash Budget

2/6/02W. Bentz77 The Cash Budget At the end of June, Royal has enough cash to repay the $50,000 loan plus interest at 16%. At the end of June, Royal has enough cash to repay the $50,000 loan plus interest at 16%.

2/6/02W. Bentz78 Financing and Repayment $50,000 × 16% × 3/12 = $2,000 Borrowings on April 1 and repayment of June 30.

2/6/02W. Bentz79 The Budgeted Income Statement Cash Budget Budgeted Income Statement Completed After we complete the cash budget, we can prepare the budgeted income statement for Royal.

2/6/02W. Bentz80 The Budgeted Income Statement

2/6/02W. Bentz81 The Budgeted Balance Sheet Royal reported the following account balances on June 30 prior to preparing its budgeted financial statements: –Land - $50,000 –Building (net) - $175,000 –Common stock - $200,000 –Retained earnings - $146,150 Royal reported the following account balances on June 30 prior to preparing its budgeted financial statements: –Land - $50,000 –Building (net) - $175,000 –Common stock - $200,000 –Retained earnings - $146,150

2/6/02W. Bentz82 25%of June sales of $300,000 25%of June sales of $300,000 5,000 units at $4.99 each 5,000 units at $4.99 each 11,500 lbs. at $0.40/lb. 11,500 lbs. at $0.40/lb. 50% of June purchases of $56,800 50% of June purchases of $56,800

2/6/02W. Bentz83

2/6/02W. Bentz84 Zero-Base Budgeting Managers are required to justify all budgeted expenditures, not just changes in the budget from the previous year. The baseline is zero rather than last year’s budget.

2/6/02W. Bentz85 International Aspects of Budgeting Multinational companies face special problems when preparing a budget. –Fluctuations in foreign currency exchange rates. –High inflation rates in some foreign countries. –Differences in local economic conditions. –Local governmental policies.

2/6/02W. Bentz86 End of Chapter 9

2/6/02W. Bentz87