Budgeting Concepts & Forecasting Techniques Patricia Burnett, CMA

Budgeting Concepts & Forecasting Techniques Patricia Burnett, CMA
Part 1 Study Unit 9 Budgeting Concepts & Forecasting Techniques Patricia Burnett, CMA

SU 5 - Introduction The Budget is a planning tool, a control tool, a communication tool and a motivational tool For the CMA exam, budget is a composite of theory and calculations Exam questions require calculations that have many steps, and therefore are the most missed questions of the CMA exam It is very important to pay attention to detail as you work the calculations.

SU 9.1 -Role of Budget and the Budgeting Process
Planning tool: set clear goals for the Organization and clear metrics of Performance (Revenue Forecast, investments, CAPEX, Headcount, Production Capacity, purchases…) A written plan for the future A way to anticipate problems and hopefully means to deal with them before they happen Quantifies operational steps

Control tool: Setting cost guidelines (financial limitations) Reveal efficiency (or inefficient) of resources usage Accountability of controllable costs and rational for exceeding Reveal things that are done correctly; it can be positive thing Budget can also be a way for self-evaluation tool for Managers Employees should not view the budget negatively Budgetary slack = overestimation of expenses Consider budgetary slack and the motivation behind it Continued

Control tool: To control costs A way to discover efficiency and inefficiency Budget process must be integrated into the Accounting Process (Actuals), that way variances can be assigned correctly Do you see any other way that it is a control tool?

Motivational tool: Helps employees to do a good job and manage Employees get motivated when they are involved in the preparation of it Budget must be realistic and not seen as a restriction = flexible Budget is not always viewed in a positive manner Communication tool: help to communicate clear objectives/goals Can communicate what goals the firm is attempting to accomplish

Goal congruence = make sure all the Departments are working toward the same goals (inventory, sales, profits, margins, hiring, savings…) Starting point for an organization  Mission Statement Next is the Strategic Plan (10 years)  set priorities and long-term vision Awareness is crucial for allocation of limited resources Shot-term objectives and specific action plans (3 years)

How to evaluate “progress”? Budget is one way to measure this progress Comparing Actuals / Budget / Historical and new Forecast Month over month seasonality of some businesses (Monthly Budget) Importance of the phasing of expenses and activities (Commitment) Study Unit 10 = variances Role of the budget is to measure favorable/unfavorable variances Coordination of the activities in the entire Organization

Budgeting as: Quantification of Management’s Plans Role in the overall Planning and Evaluation Process To Evaluate progress Formulating and Controlling Short-term objectives Measuring against established goals Monitoring and Controlling Enhancing Coordination

Budgeting’s Role in Formulating and Controlling Short-term Objectives Goal of increasing market share Making a steady dividend payout Only be achieved through the completion of incremental steps Lays out specific revenue targets and expense limitations on a month-to-month basis

Role of Budgets in Measuring Performance Against Established Goals Provide guideposts for the assessment of success or failure The Role of Budgets Monitoring and Controlling Expenditures Budget reports are produced periodically during the year Variance: reveals the efficient or inefficient use of company resources

Characteristics of a successful Budgeting Process Sufficient lead time Budget must be finalized when the fiscal year begins Budge planning calendar: schedule of activities for the development and adoption of the budget Budget manual Buy-in at all levels

Participation in the Budget Process Begins with the mission statement formulated by the board of directors Senior management Budget committee/department Middle and lower management Top-down (authoritative) budgeting Bottom-up (participative) budgeting

Time Framers for Budgets- each phase of the organization’s planning cycle has its own budget with an appropriate time frame Strategic: senior managers with time frames of up to 10 years or more Intermediate: middle managers with time frames of up to 2 years Operational: lower-level managers with time frames of 1 month – 1 year

Effects of External Factors on the budgeting Process General economic decisions based on firm’s strategy and budget Expected trends Availability of financial resources The concept of Controllability Key concept in the use of budgets and other standards to evaluate performance Can be difficult to isolate because few costs or revenues are under the sole influence of one manager

SU 9.1 Question 1 All of the following are advantages of the use of budgets in a management control system except that budgets A. Force management planning. B. Provide performance criteria. C. Promote communication and coordination within the organization. D. Limit unauthorized expenditures.

SU 9.1 Question 1 Answer Correct Answer: D Budgets serve many roles. They force management to plan ahead, communicate organizational goals throughout the organization, and provide criteria for future performance evaluations. Incorrect Answers: A: Forcing management planning is an advantage of using budgets. B: Providing performance criteria is an advantage of using budgets. C: Promoting communication and coordination within the organization is an advantage of using budgets.

SU 9.1 Question 2 Ineffective budget control systems are characterized by A. Use of budgets as a planning but not a control tool. B. Use of budgets for harassment of individuals rather than motivation. C. Lack of timely feedback in the use of the budget. D. All of the answers are correct.

SU 9.1 Question 2 Answer Correct Answer: D Ineffective budget control systems are characterized by each of the items noted. The use of budgets for planning only is a problem that must be resolved through the education process. Management must be educated to use the budget documents for control, not just planning. Management must learn that budgets can motivate and help individuals achieve professional growth as well as the goals of the firm. Ignoring budgets obviously contributes to the ineffectiveness of the budget system. Finally, feedback must be timely or lower management and employees will soon recognize that budget feedback is so late it provides no information, making the budget a worthless device. Incorrect Answers: A: This is not the only item listed that characterizes ineffective budget control systems. B: This is not the only item listed that characterizes ineffective budget control systems. C: This is not the only item listed that characterizes ineffective budget control systems.

SU 9.1 Question 3 When comparing performance report information for top management with that for lower-level management, A Top management reports are more detailed. B Lower-level management reports are typically for longer time periods. C Top management reports show control over fewer costs. D Lower-level management reports are likely to contain more quantitative data and less financial data.

SU 9.1 Question 3 Answer Correct Answer: D Information sent to top management is ordinarily more highly aggregated and less timely than that communicated to managers at operational levels. Top managers are concerned with the organization’s overall financial results and long-term prospects and are responsible for the strategic planning function. Lower-level reports contain more quantitative information of an operational nature, e.g., production data. Incorrect Answers: A Top management reports are less detailed. Top management usually practices management by exception. B Lower-level reports are typically more timely. Rapid feedback is necessary to solve operating problems. C Top management is responsible for all costs incurred within the organization, including those incurred in lower level departments.

SU 9.1 Question 4 Each organization plans and budgets its operations for slightly different reasons. Which one of the following is not a significant reason for planning? A Providing a basis for controlling operations. B Forcing managers to consider expected future trends and conditions. C Ensuring profitable operations. D Checking progress toward the objectives of the organization.

SU 9.1 Question 4 Answer Correct Answer: C This question is apparently directed toward budgeting. A budget is a realistic plan for the future that is expressed in quantitative terms. It is a planning, control, motivational, and communications tool. A budget promotes goal congruence and coordination among operating units. Unfortunately, a budget does not ensure profitable operations. Incorrect Answers: A Control of operations is a goal of planning. B Forcing managers to consider expected future trends and conditions is a goal of planning. D Checking progress toward objectives is a goal of planning.

SU 9.2 – Budgeting and Standard Costing
Predetermined expectations Of input, output or given activity (should cost) Provide an alert to differences May be based on accounting, engineering or statistical Activity analysis identifies, describes, and evaluates the activities to go into product Historical data may be a surrogate for companies lacking resources to study the activities

Direct Materials – direct relationship between unit price and quality. Inferior (cheaper) products (input) = higher consumption, higher labor use Direct Labor – difficult to est. standard cost for labor May rely on a team development approach

Theoretical vs. Practical Standards Ideal (theoretical) standards – optimal conditions, also ref. as perfection or maximum efficiency standards. Most skilled labor, no waste or spoilage Also call “tight” standards Sometimes used in a continuous improvement process Usually replaced by attainable standards for most budgets and estimates (i.e. product cost) Continue

Currently attainable (practical) standards – expected to be achieved Reasonably well trained workers Allowance for spoilage, waste and downtime Alternative is “difficult-to-attain” results.

SU 9.2 – Budgeting and Standard Costing (not in text)
Controllability is a key concept to evaluate performance Budget can be flexible to allow for changes Establishing standards of performance (KPIs) Measuring actual performance Analyzing and comparing with standards (variances) Devising and implementing corrective actions Reviewing and revising the standards Use of Standard costing  baseline (t =0)

Remember, to develop standards: Activity analysis: ABC step 1 Review of historical data to assess trend or base Calculate estimated cost: for example direct materials, there is a relationship between price and quality

SU 9.2 – Budgeting and Standard Costing (not in text)
Incorporate potential cost savings based on assumptions Identify risks and opportunities on realizable events Ideal (theoretical) standards / Practical standard

SU Question 1 All of the following statements concerning standard costs are correct except that A Time and motion studies are often used to determine standard costs. B Standard costs are usually set for one year. C Standard costs can be used in costing inventory accounts. D Standard costs are usually stated in total, while budgeted costs are usually stated on a per-unit basis.

SU Question 1 Answer Correct Answer: D Standard costs can be used at the per-unit level and any level of aggregation above. Incorrect Answers: A Time and motion studies are often used to determine standard costs. B Standard costs are usually set for one year. C Standard costs can be used in costing inventory accounts.

SU Question 2 Jura Corporation is developing standards for the next year. Currently XZ-26, one of the material components, is being purchased for $36.45 per unit. It is expected that the component’s cost will increase by approximately 10% next year and the price could range from $38.75 to $44.18 per unit, depending on the quantity purchased. The appropriate standard for XZ-26 for next year should be set at the A Current actual cost plus the forecasted 10% price increase. B Lowest purchase price in the anticipated range to keep pressure on purchasing to always buy in the lowest price range. C Highest price in the anticipated range to ensure that there are only favorable purchase price variances. D Price agreed upon by the purchasing manager and the appropriate level of company management.

SU Question 2 Answer Correct Answer: D Standard prices are designed for internal performance measurement. Standards should be attainable, but not so easily as to not provide motivation. Management should decide its objectives and set a standard that will achieve that objective when the standard is met. For example, the lowest price might not be selected if the company is using a JIT system, for which the primary objective is the minimization of inventories.

SU Question 3 After performing a thorough study of Michigan Company’s operations, an independent consultant determined that the firm’s labor standards were probably too tight. Which one of the following facts would be inconsistent with the consultant’s conclusion? A A review of performance reports revealed the presence of many unfavorable efficiency variances. B Michigan’s budgeting process was well-defined and based on a bottom-up philosophy. C Management noted that minimal incentive bonuses have been paid in recent periods. D Production supervisors found several significant fluctuations in manufacturing volume, with short-term increases on output being followed by rapid, sustained declines.

SU Question 4 Answer Correct Answer: B It is highly unlikely that workers familiar with their own processes would set too-tight standards. Incorrect Answers: A Many unfavorable efficiency variances would be an indicator of too-tight standards. C The widespread failure for expected bonuses to be earned would be an indicator of too-tight standards. D The situation described is indicative of rush jobs being too common, which is a result of poor production planning, not tight labor standards.

SU 9.2 Question 5 Jura Corporation is developing standards for the next year. Currently XZ-26, one of the material components, is being purchased for $36.45 per unit. It is expected that the component’s cost will increase by approximately 10% next year and the price could range from $38.75 to $44.18 per unit, depending on the quantity purchased. The appropriate standard for XZ-26 for next year should be set at the A. Current actual cost plus the forecasted 10% price increase. B. Lowest purchase price in the anticipated range to keep pressure on purchasing to always buy in the lowest price range. C. Highest price in the anticipated range to ensure that there are only favorable purchase price variances. D. Price agreed upon by the purchasing manager and the appropriate level of company management.

SU 9.2 Question 5 Answer Correct Answer D. Standard prices are designed for internal performance measurement. Standards should be attainable, but not so easily as to not provide motivation. Management should decide its objectives and set a standard that will achieve that objective when the standard is met. For example, the lowest price might not be selected if the company is using a JIT system, for which the primary objective is the minimization of inventories. Incorrect Answer Explanations: A. The actual cost could be more or less depending in the quantity purchased. B. The lowest price may not always be in the company’s best interests if the quantity required to obtain the lowest price would lead to much higher carrying costs. C. Standards should be set tightly enough to provide motivation to purchasing management.

SU 9.2 Question 6 When compared with ideal standards, practical standards A. Produce lower per-unit product costs. B. Result in a less desirable basis for the development of budgets. C. Incorporate very generous allowance for spoilage and worker inefficiencies. D. Serve as a better motivating target for manufacturing personnel.

SU 9.2 Question 6 Answer Correct Answer D. Practical standards, also called attainable standards, are more likely to meet with worker acceptance than standards based on an unachievable ideal. Incorrect Answer Explanations: A. The effect of one type of standard over another cannot guarantee lower costs. B. Practical standards are more appropriate in most cases than ideal standards in the development of budgets. C. An acceptance of high levels of spoilage and worker inefficiencies cannot be overcome through the use of standards.

SU 9.2 Question 7 All of the following statements concerning standard costs are correct except that A. Time and motion studies are often used to determine standard costs. B. Standard costs are usually set for one year. C. Standard costs can be used in costing inventory accounts. D. Standard costs are usually stated in total, while budgeted costs are usually stated on a per-unit basis.

SU 9.2 Question 7 Answer Correct Answer D. Standard costs can be used at the per-unit level and any level of aggregation above. Incorrect Answer Explanations: A. Time and motion studies are often used to determine standard costs. B. Standard costs are usually set for one year. C. Standard costs can be used in costing inventory accounts.

SU 9.2 Question 8 Granger Company is reviewing its standard machine hours per unit to use in its budget for the upcoming year. The machine manufacturer’s specifications indicated a unit could be made in 0.75 hours, and a benchmarking study showed a competitor produced at a speed of 0.78 machine hours per unit. Granger’s actual results from last year averaged 0.83 machine hours per unit even though a standard of 0.80 machine hours per unit had been established using engineering studies. The standard Granger should use in its upcoming budget is A machine hours per unit. B machine hours per unit. C machine hours per unit. D machine hours per unit.

SU 9.2 Question 8 Answer Correct Answer C. Standard costs are predetermined expectations about how much a given activity should cost. Standards should be based on accounting, engineering, or statistical control studies. Incorrect Answer Explanations: A. The machine manufacturer’s specifications are the ideal standards set for production under optimal conditions. This is not the best alternative for setting Granger’s standard costs. B. While benchmarking can be a useful tool in helping companies with productivity management and business process reengineering, it is unrealistic for setting Granger’s standard costs. D. A standard cost is not just an average of pasts costs but an objectively determined estimate of what a cost should be. Historical data may be used to set standards by firms that lack the resources to engage in the complex task of activity analysis. However, it is not the best option in this case.

SU 9.3 – The Master Budget Annual Profit Plan
Operating Budget – emphasis is on current resources Sales budget Production budget Direct material budget Manufacturing overhead budget Ending finished goods inventory budget Cost of goods sold budget Continued

SU 9.3 – The Master Budget Nonmanufacturing budget
Research and development budget Design budget Marketing budget Distribution budget Customer service budget Administrative budget Pro forma income statement

SU 9.3 – The Master Budget Financial Budget – emphasis on funds needed to purchase operating assets. Sales Budget Production Budget Purchase Budget Expense Budget Continued

SU 9.3 – The Master Budget Capital budget Cash budget
Projected cash disbursement Projected cash collection schedule Pro forma income statement Pro forma balance sheet Pro forma statement of cash flows

SU 9.3 – Question 1 Pro forma financial statements are part of the budgeting process. Normally, the last pro forma statement prepared is the A Capital expenditure plan. B Income statement. C Statement of cost of goods sold. D Statement of cash flows.

SU 9.3 – Question 1 answer Correct Answer: D The statement of cash flows is usually the last of the listed items prepared. All other elements of the budget process must be completed before it can be developed.

SU 9.3 – Question 2 Which one of the following may be considered an independent item in the preparation of the master budget? A Ending inventory budget. B Capital investment budget. C Pro forma income statement. D Pro forma statement of financial position.

SU 9.3 – Question 2 answer Correct Answer: B The capital investment budget may be prepared more than a year in advance, unlike the other elements of the master budget. Because of the long-term commitments that must be made for some types of capital investments, planning must be done far in advance and is based on needs in future years as opposed to the current year’s needs.

SU 9.3 – Question 3 The Yummy Dog Bone Company is anticipating that a major supplier might experience a strike this year. Because of the nature of the product and emphasis on quality, extra production cannot be stored as finished goods inventory. When developing a contingency budget that would anticipate a direct materials buildup, the two most significant items that will be affected are A Production volume and direct material. B Sales and ending inventory. C Production and cash flow. D Direct materials and cash flow.

SU 9.3 – Question 3 answer Correct Answer: D The most significant items are those that will vary between the contingency budget and the regular budget. The company cannot increase its finished goods inventory, but it can increase its inventory of the direct materials provided by the supplier. Thus, the items most affected will be direct materials and cash. The cash budget will be affected because of the need to pay for direct materials prior to their usage.

Let’s review the process again!
9.3 - Budgeting Process Let’s review the process again!

Master Budget Operational Budget Financial Budget

9.3 The Master Budget Also called comprehensive budget or annual profit plan (operating + financial) Operating Budget (Sales, Production, DM, DL, MOH, COGS, R&D, Marketing…) Financial Budget (Capital or CAPEX, Cash flows, Pro-Forma B/S, Pro-Forma CF)

Budgeting Process (not in text)
Sufficient lead time Budget planning calendar Detailed procedures for preparing and submitting the budget Buy-in at all levels: support and transparency of Top management is crucial Top-down Vs. Bottom-up budgeting Authoritative vs. participative approach Strategic/10 Intermediate/2 Operational/1

Time Frames for Budgets Strategic – up to 10 yrs. Intermediate – up to 2 yrs. Operational – 1 mo. – 1 yr.

External Factors General Economic environment Competitors (Review Michael Porter) Regulation and Governmental initiatives Industry specific situation Input cost rising Continued

External Factors Shareholders = merger & acquisition R&D: different stage of product develop. Technology / Software / Applications

Controllability Key concept in the use of budgets Under the discretion of a particular manager Can be difficult to isolate

Revisions to the Budget Significant internal and external changes since the original budget was created Control loop: The budget Measurement Analyzing and comparing Development and implementing corrective actions Reviewing and revising the standards

Budgeting Process - Question 1
A planning calendar in budgeting is the A. Calendar period covered by the budget. B. Schedule of activities for the development and adoption of the budget. C. Calendar period covered by the annual budget and the long-range plan. D. Sales forecast by months in the annual budget period.

Budgeting Process - Question 1 Answer
Correct Answer: B The budget planning calendar is the schedule of activities for the development and adoption of the budget. It should include a list of dates indicating when specific information is to be provided by each information source to others. The preparation of a master budget usually takes several months. For instance, many firms start the budget for the next calendar year some time in September in hopes of having it completed by December 1. Because all of the individual departmental budgets are based on forecasts prepared by others and the budgets of other departments, it is essential to have a planning calendar to ensure the proper integration of the entire process. Incorrect Answers: A: The period covered by the budget precedes the events in the planning calendar. C: The period covered by the budget precedes the events in the planning calendar. D: The planning calendar is not associated with sales.

The primary role of the budget director and the budgeting department is to A. Settle disputes among operating executives during the development of the annual operating plan. B. Develop the annual profit plan by selecting the alternatives to be adopted from the suggestions submitted by the various operating segments. C. Justify the budget to the executive committee of the board of directors. D. Compile the budget and manage the budget process.

Correct Answer: D The budget department is responsible for compiling the budget and managing the budget process. The budget director and department are not responsible for actually developing the estimates on which the budget is based. This role is performed by those to whom the resulting budget will be applicable. The budget director has staff, not line, authority. (S)he has a technical and advisory role. The final decision-making responsibility rests with line management. Incorrect Answers: A: The budget director has staff, not line, authority. (S)he has a technical and advisory role. The final decision-making responsibility rests with line management. B: The budget director has staff, not line, authority. (S)he has a technical and advisory role. The final decision-making responsibility rests with line management. C: The budget director has staff, not line, authority. (S)he has a technical and advisory role. The final decision-making responsibility rests with line management.

The following sequence of steps is employed by a company to develop its annual profit plan: Planning guidelines are disseminated downward by top management after receiving input from all levels of management. A sales budget is prepared by individual sales units reflecting the sales targets of the various segments. This provides the basis for departmental production budgets and other related components by the various operating units. Communication is primarily lateral with some upward communication possible. A profit plan is submitted to top management for coordination and review. Top management’s recommendations and revisions are acted upon by middle management. A revised profit plan is resubmitted for further review to top management. Top management grants final approval and distributes the formal plan downward to the various operating units. This outline of steps best describes which one of the following approaches to budget development? A. Imposed budgeting by top management. B. Bottom-up approach. C. Top-down approach. D. Total justification of all activities by operating units.

Correct Answer: B A bottom-up approach is characterized by general guidance from the highest levels of management, followed by extensive input from middle and lower management. This sequence of steps aptly describes this process. Incorrect Answers: A: Top management has received extensive input and cooperation from lower levels through performing these steps. C: These steps describe the opposite of a top-down approach. D: Top management is not demanding justification of all activities in the steps described; such a demand would be consistent with a system known as zero-based budgeting.

The budgeting technique that is most likely to motivate managers is A Top-down budgeting. B Zero-based budgeting. C Program budgeting and review technique. D Bottom-up budgeting.

Correct Answer: D Bottom-up budgeting is the best way of motivating managers to meet budget estimates because it permits participation in the budget process. Lower level managers who take part in budgeting decisions are more likely to support the result and less likely to feel that the budget has been imposed from above. Incorrect Answers: A A top-down budget is less likely to motivate lower level managers who have not participated in its formation. B Zero-based budgeting is a means of adding objectivity to the budget process; employee motivation is not a particular goal. C Program budgets are formulated by objective rather than function.

SU 9.4 - Budget Methodologies
Project Budget Activity-Based Budget p. 297 Zero-Based Budget (Manager must justify the entire budget every year/cycle) Different from Incremental budgeting Continuous budgeting More accurate and keep Managers thinking ahead – time consuming

9.4 – Budget Methodologies
Remember Static & Flexible Budgeting: Static Budget = based on only one level of sales or production Flexible Budget = series of budgets prepared for many levels of activity Also remember – You must know how to both apply and select a specific budgeting method, as well explain why it should be selected.

SU 9.4 – Question 1 Which one of the following is not an advantage of activity-based budgeting? A. Better identification of resource needs. B. Linking of costs to outputs. C. Identification of budgetary slack. D. Reduction of planning uncertainty.

SU 9.4 – Question 1 Answer Answer Explanations for Question 1:
A. Better identification of resource needs is an advantage of any kind of budgeting. B. Linking costs to outputs is a feature of a cost accumulation system, such as job-order or process costing. C. Identification of budgetary slack can be built into any budget system, not just an activity-based one. D. *Correct Answer* Activity-based budgeting applies activity-based costing principles to budgeting. It focuses on the numerous activities necessary to produce and market goods and services and requires analysis of cost drivers. Activity-based budgeting cannot reduce the level of uncertainty to which any large organization is subject.

SU 9.4 – Question 2 An advantage of incremental budgeting when compared with zero-based budgeting is that incremental budgeting A. Encourages adopting new projects quickly. B. Accepts the existing base as being satisfactory. C. Eliminates functions and duties that have outlived their usefulness. D. Eliminates the need to review all functions periodically to obtain optimum use of resources.

SU 9.4 – Question 2 Answer Answer Explanations for Question 2: A. Both types of budgets treat new projects in the same manner. B. *Correct Answer* Incremental budgeting simply adjusts the current year’s budget to allow for changes planned for the coming year; a manager is not asked to justify the base portion of the budget. ZBB, however, requires a manager to justify the entire budget for each year. Incremental budgeting offers to managers the advantage of requiring less managerial effort to justify changes in the budget. C. Reexamining functions and duties that may have outlived their usefulness is an advantage of ZBB. D. Periodic review of functions is essential regardless of the budgetary system used.

SU 9.4 – Question 3 A systemized approach known as zero-based budgeting (ZBB) A. Presents the plan for only one level of activity and does not adjust to changes in the level of activity. B. Presents a statement of expectations for a period of time but does not present a firm commitment. C. Divides the activities of individual responsibility centers into a series of packages that are prioritized. D. Classifies budget requests by activity and estimates the benefits arising from each activity.

SU 9.4 – Question 3 Answer Answer Explanations for Question 3: A. A static budget does not adjust for changes in activity levels. B. ZBB does present a firm commitment. C. *Correct Answer* Zero-based budgeting is a planning process in which each manager must justify a department’s entire budget every year (or period). Different levels of service (work effort) are evaluated for each activity, measures of work and performance are established, and activities are ranked (prioritized) according to their importance to the entity. For each budgetary unit, decision packages are prepared that describe various levels of service that may be provided, including at least one level lower than the current one. D. Each activity is prepared as a series of packages.

SU 9.4 – Question 4 Medico has found that its annual budgets are quickly outdated once actual data is recorded. Sometimes actual preparations have already begun for the period being budgeted by the time the annual budget is finished, which leaves no time to react to changing factors. Medico wants the budget to be as up-to-date as possible, and management is willing to revise budgets as needed. Which budgeting solution would be most appropriate for Medico? A. Flexible budgeting. B. Activity-based budgeting. C. Zero-based budgeting. D. Continuous budgeting.

SU 9.4 – Question 4 Answer Answer Explanations for Question 4: A. Flexible budgeting is the calculation of the quantity and cost of inputs that should have been consumed given the achieved level of production. These are primarily used at the end of a period to compare actual results with expected (budgeted) results. B. Activity-based budgeting applies activity-based costing principles to budgeting. It focuses on the numerous activities necessary to produce and market goods and services and requires analysis of cost drivers. Activity-based budgeting is used primarily used to properly allocate indirect costs, not to manage costs. C. Zero-based budgeting requires a manager to justify the entire budget for each year. The major limitation of zero-based budgeting is that it requires more time and effort to prepare than a traditional budget. This would not meet the needs of Medico. D. *Correct Answer* A continuous (rolling) budget is one that is revised monthly or quarterly by dropping one period and adding a new one. Thus, a company desiring a budget that is always as up-to-date as possible will benefit from using this type of budget.

SU 9.5 - Operating Budget Calculation
Sales Budget: Sales forecast x Selling Price Production Budget: concerned with Units only (no impact from Pricing strategy) Projected Units (Volume) Desired Ending Inventory (Safety Stock) Projection on BGN Inventory  Units to be produced (include % spoilage)

SU 9.5 - Operating Budget Calculation
Direct Materials Budget Follow directly from the production budget Concerned with units and input prices Objective is to minimize raw inventory carrying cost, obsolesces Closely

SU 9.5 Question 1 Wellfleet Company manufactures recreational equipment and prepares annual operational budgets for each department. The Purchasing Department is finalizing plans for the fiscal year ending June 30, Year 2, and has gathered the information regarding two of the components used in both tricycles and bicycles. Wellfleet uses the first-in, first-out inventory method. A19 B12 Tricycles Bicycles Beginning inventory, July 1, Year 1 3,500 1,200 800 2,150 Ending inventory, June 30, Year 2 2,000 1,800 1,000 900 Unit cost $1.20 $4.50 $54.50 $89.60 Projected fiscal year unit sales -- 96,000 130,000 Component usage: 2/unit 1/unit 4/unit

SU 9.5 Question 1 (cont.) If the economic order quantity of Component B12 is 70,000 units, the number of times that Wellfleet Company should purchase this component during the fiscal year ended June 30, Year 2, is A. Four times. B. Five times. C. Eight times. D. Nine times.

SU 9.5 Question 1 Answer Correct Answer: D The number of tricycles to be produced is 96,200. Each requires one unit of B12. The number of bicycles to be produced is 128,750. Each requires four units of B12, a total of 515,000. Combining the 96,200 units needed for tricycles with the 515,000 units needed for bicycles results in a total demand of 611,200 units. An additional 600 units (1,800 – 1,200) will have to be ordered to permit the increase in the inventory of B12. Dividing the annual requirement of 611,800 units by the 70,000-unit EOQ results in 8.74 orders per year. Because partial orders are not possible, nine orders will have to be placed. Incorrect Answers: A: Ordering four times will meet the need for tricycle but not bicycle production. B: Ordering five times will meet the need for tricycle but not bicycle production. C: Eight orders will suffice only for the bicycles.

SU 9.5 Question 2 Rokat Corporation is a manufacturer of tables sold to schools, restaurants, hotels, and other institutions. The table tops are manufactured by Rokat, but the table legs are purchased from an outside supplier. The Assembly Department takes a manufactured table top and attaches the four purchased table legs. It takes 20 minutes of labor to assemble a table. The company follows a policy of producing enough tables to ensure that 40% of next month’s sales are in the finished goods inventory. Rokat also purchases sufficient direct materials inventory to ensure that direct materials inventory is 60% of the following month’s scheduled production. Rokat’s sales budget in units for the next quarter is as follows: July 2,300 August 2,500 September 2,100 Rokat’s ending inventories in units for June 30 are Finished goods 1,900 Direct materials (legs) 4,000

SU 9.5 Question 2 Answer Correct Answer: A The August production of 1,600 units will require 6,400 table legs. September’s production of 1,800 units will require 7,200 table legs. Thus, inventory at the end of August should be 4,320 legs (7,200 legs × 60%). The total of legs needed during August is 10,720 (6, ,320), of which 4,200 are available from the July 31 ending inventory. The remaining 6,520 legs must be purchased during August. Incorrect Answers: B: The figure of 9,400 legs is based on an ending inventory of 100% of September’s production. C: Failing to consider the legs needed for the ending inventory results in 2,200 legs. D: The amount needed for August production is 6,400 legs.

SU 9.6 – Operating Budget Calculations
Direct Labor Budget Employee Fringe Benefits Variable OH: Manufacturing OH budget reflects the nature of OH as a mixed cost (VC + FC) VOH contains elements that vary with level of production: indirect materials, indirect labor, variable factory operating costs Fixed OH: real estate taxes, insurance, depreciations = easy to project

SU 9.6 – Operating Budget Calculations
Ending Finished Goods Inventory Budget COGS Budget (materials, labor, overhead) Variable Costing & Contribution Margin Nonmanufacturing Budget Pro Forma Operating Income

9.6 - Question 1 Which one of the following statements regarding selling and administrative budgets is most accurate? A. Selling and administrative budgets are usually optional. B. Selling and administrative budgets are fixed in nature. C. Selling and administrative budgets are difficult to allocate by month and are best presented as one number for the entire year. D. Selling and administrative budgets need to be detailed in order that the key assumptions can be better understood.

9.6 - Question 1 Answer A. Selling and administrative budgets are no more optional than any other component of the master budget. B. Selling and administrative budgets have both variable and fixed components. C. Selling and administrative budgets should be prepared on the same basis as the remainder of the budget, typically on at least a monthly basis. D. *Correct Answer* Sales and administrative budgets are prepared after the sales budget. Like the other budgets, they constitute prospective information based on the preparer’s assumptions about conditions expected to exist and actions expected to be taken.

9.6 - Question 2 Harvin Co. pays out sales commissions to its sales team in the month the company receives cash for payment. These commissions equal 5% of total (monthly) cash inflows as a result of sales. Harvin has budgeted sales of $300,000 for August, $400,000 for September, and $200,000 for October. Approximately half of all sales are on credit, and the other half are cash sales. Experience indicates that 70% of the budgeted credit sales will be collected in the month following the sale, 20% the month after that, and 10% of the sales will be uncollectible. Based on this information, what should be the total amount of sales commissions paid out by Harvin in the month of October? A. $8,500 B. $13,500 C. $17,000 D. $22,000

9.6 - Question 2 Answer A. Failure to consider the cash sales made during October results in $8,500. B. *Correct Answer* Cash sales for Harvin for the month of October are budgeted at $100,000 (half of $200,000 overall sales). Projections for collections of credit sales in August indicate that 20% will be cash inflows in October, or ($150,000 × 20%) = $30,000. Projections for collections of credit sales in September indicate that 70% will be cash inflows in October, or ($200,000 × 70%) = $140,000. Therefore, total cash inflows projected for the month of October equal $100,000 + $30,000 + $140,000 = $270,000. Because sales commissions are set at 5% of monthly cash inflows, the sales commissions for October equal ($270,000 × 5%) = $13,500. C. The amount of $17,000 is based on total sales for August and September rather than credit sales. D. Using total sales rather than credit sales results in $22,000.

SU 9.7 – Projecting Cash Collections
Capital Budget: CAPEX = major expenditures for long-term assets (equipment, furniture, software, hardware…) Ranking projects: NPV, IRR, Payback  Part 2 Cash Collections Schedule: estimate the inflows of cash from customer payments Cash Budget = Lynchpin of Budget Process It is the part of Financial budget cycle that ties together all the schedules from the operating budget

SU 9.7 Question 1 DeBerg Company has developed the following sales projections for the calendar year. May $100,000 June 120,000 July 140,000 August 160,000 September 150,000 October 130,000 Normal cash collection experience has been that 50% of sales are collected during the month of sale and 45% in the month following sale. The remaining 5% of sales is never collected. DeBerg’s budgeted cash collections for the third calendar quarter are A. $427,500 B. $422,500 C. $414,000 D. $450,000

SU 9.7 Question 1 Answer Correct Answer: C If 50% of sales are collected in the month of sale and 45% in the next month, with the balance uncollectible, collections during the third quarter will be based on sales during June, July, August, and September. As calculated below, total budgeted collections are $414,000. June: $120,000 × 45% = $ 54,000 July: 140,000 × (50% + 45%) 133,000 August: 160,000 × (50% + 45%) 152,000 September: 150,000 × 50% 75,000 Total $414,000

SU 9.7 Question 2 Historically, Pine Hill Wood Products has had no significant bad debt experience with its customers. Cash sales have accounted for 10% of total sales, and payments for credit sales have been received as follows: 40% of credit sales in the month of the sale 30% of credit sales in the first subsequent month 25% of credit sales in the second subsequent month 5% of credit sales in the third subsequent month The forecast for both cash and credit sales is as follows: Month Sales January $95,000 February 65,000 March 70,000 April 80,000 May 85,000

SU 9.7 Question 2 (cont.) What is the forecasted cash inflow for Pine Hill Wood Products for May? A. $70,875 B. $76,500 C. $79,375 D. $83,650

SU 9.7 Question 2 Answer Correct Answer: C The cash inflows for May will come from May cash sales of $8,500 ($85,000 × 10%), May credit sales of $30,600 ($85,000 × 90% × 40%), April sales of $21,600 ($80,000 × 30% × 90%), March sales of $15,750 ($70,000 × 25% × 90%), and February sales of $2,925 ($65,000 × 5% × 90%). The total is $79, Incorrect Answers: A: The amount of $70,875 omits May cash sales. B: May credit sales equals $76,500. D: The amount of $83,650 includes 5% of January’s credit sales.

SU 9.8 – Cash Budget Cash budget projects cash receipts and disbursements for planning and control purposes. It helps prevent not only cash emergencies but also identifies excessive idle cash. Part of the financial budget cycle that ties together all the schedules from the operating budget. Vital because an organization must have adequate cash. Particularly important for seasonal organizations Must consider collection policies, bad debt est., changes in the economy, etc.

SU 9.8 – Cash Budget Cash Disbursements Schedule (example page 307*)
Cash Budget Preparation (example page 308*)

Question 1 Monroe Products is preparing a cash forecast based on the following information: Monthly sales: December, $200,000; January, $200,000; February, $350,000; March, $400,000. All sales are on credit and collected the month following the sale. Purchases are 60% of next month’s sales and are paid for in the month of purchase. Other monthly expenses are $25,000, including $5,000 of depreciation. If the January beginning cash balance is $30,000, and Monroe is required to maintain a minimum cash balance of $10,000, how much short-term borrowing will be required at the end of February? Loans are repaid in the following month, even though that might require additional borrowing at the end of the month. A. $60,000 B. $70,000 C. $75,000 D. $80,000

9.8 - Question 1 Answer Beginning cash balance $ 30,000
$ 30,000 Collections on December sales (in January) 200,000 Collections on January sales (in February) Disbursements for inventory (in January) (210,000) Disbursements for inventory (in February) (240,000) Disbursements for other expenses (in January) (20,000) Disbursements for other expenses (in February) Minimum balance requirement (10,000) Shortfall $ (70,000)

Question 2 Which one of the following best represents a factor that should be considered for medium- and long-term cash forecasting? A. Pre-tax cost of capital projects. B. Current monthly depreciation. C. Impact of stock split. D. Non-routine property sales.

Question 2 Answer A. The pre-tax cost of capital projects represents a sunk cost and is not relevant to medium- and long-term cash forecasting. B. The current monthly depreciation represents a sunk cost and is not relevant to medium- and long-term cash forecasting. C. A stock split does not impact cash. Thus, it is not relevant to medium- and long-term cash forecasting. D. *Correct Answer* Non-routine property sales could result in large fluctuations of cash and should be considered for medium- and long-term forecasting.

9.9 – Sales Forecast and Pro Forma Financial Statements
Begin by looking at historical trends Using regression analysis to forecast next year’s sales Determining the AAGR (Average Annual Growth Rate) See example on page 308

SU 9.9 – Sales Forecasts Percent of sales method
After sales are forecasted, future financial statements must be forecasted Common method is the percent of sales method Items on the income statement and balance sheets assumed to increase proportionately to sales Other items based off historical data and forecasted net sales

SU 9.9 – Pro Forma Financial Statements
Pro forma: Latin phrase meaning “according to form.” Referred to when financial statements reflect projected, rather than actual, results Used to decide whether budget activities will result in acceptable level of income Also observed is target gross margin percentage and the interest coverage ratio

Pro Forma Balance Sheet: Using cash and capital budgets And the pro forma income statement Beginning-of-the-period balance sheet

Pro Forma Statement of Cash Flow Normally last statement prepared Classifies cash receipts and disbursements Direct presentation reports the major classes of gross cash operating receipts, payments, and difference between them Indirect presentation reconciles net income with net operating c ash flow

Financial Projections and Ratio Analysis Help the bank asses debt covenants To see whether company anticipates satisfying requirements Typically debt ratio < than a certain threshold Coverage ratio > than a threshold Satisfactory levels of these ratios provide the bank assurance

9.9 – Question 1 In November, a company finalized its budget for the upcoming calendar year. In December, the decision was made to acquire new equipment in January by trading in old equipment and financing the amount due by a loan with principal and interest due at the end of 3 years. Out-of-pocket costs to operate the machinery would not change. This decision would change which of the company’s budgeted financial statements for the upcoming year? A. The budgeted balance sheet only. B. Both the budgeted balance sheet and the income statement. C. The budgeted balance sheet, the income statement, and the statement of cash flows. D. Both the budgeted income statement and the statement of cash flows.

9.9 – Question 1 Answer A. The budgeted balance sheet is not the only statement that would change. B. The budgeted balance sheet and the income statement are not the only statements that would change. C. *Correct Answer* The budgeted balance sheet, the income statement, and the statement of cash flows would all change. D. The budgeted income statement and the statement of cash flows are not the only statements that would change.

9.9 – Question 2 A production plan should be based on A. A sales forecast adjusted for projected inventory levels. B. Economic order quantities and reorder points. C. Exponential smoothing. D. Linear regression.

9.9 – Question 2 Answer A. *Correct Answer* A production plan depends on the sales budget and anticipated inventory levels. Inventory serves to balance seasonal fluctuations in sales with the need for stable and efficient use of productive resources. B. EOQs and reorder points are considered only after it has decided how many units are needed. C. Exponential smoothing is a technique used to level or smooth variations encountered in a forecast. A production plan should be based on the variations expected. D. Regression analysis explains the correlation of a dependent variable with one or more independent variables. It is based on linearity of costs.

9.9 – Question 3 One of the final steps in completing a master budget is the preparation of a pro forma cash flow statement. This statement is intended to help users of financial statements A. Evaluate a firm’s economic resources and obligations. B. Evaluate a firm’s liquidity, solvency, and financial flexibility. C. Determine a firm’s components of income from operations. D. Determine whether or not accounts receivable are collectible.

9.9 – Question 3 Answer A. The pro forma balance sheet, not the pro forma statement of cash flows, will better evaluate a firm’s economic resources and obligations. B. *Correct Answer* The pro forma statement of cash flows classifies cash receipts and disbursements depending on whether they are from operating, investing, or financing activities. Thus, it will help users evaluate a firm’s liquidity, solvency, and financial flexibility by analyzing the different cash disbursements and receipts. C. A pro forma statement of income, not the pro forma statement of cash flows, will better determine a firm’s components of income from operations. D. The pro forma statement of cash flows is not intended to determine whether or not accounts receivables are collectible. This is best determined by performing ratio analysis.

Service Cost Allocations By Ronald Schmidt, CMA, CFM
Part 1 Study Unit 8 Service Cost Allocations By Ronald Schmidt, CMA, CFM

Allocation of Service Department Costs Overview
Many companies in all sectors of the economy, and not-for-profit and governmental organizations as well, allocate service department costs to “production” or user departments, and ultimately to the products and services that they provide. Example, hospitals use sophisticated methods for allocating costs of service departments such as Housekeeping, Patient Admissions, and Medical Records to patient wards and outpatient services, and then to individual patients. Allocations were important to hospitals because Medicare reimbursement was based on actual costs. To the extent that the hospital allocated service department costs to Medicare patients, Medicare covered these costs.

Companies that allocate service department costs do so for one or more of the following reasons: To provide more accurate product cost information. Allocating service department costs to production departments, and then to products, recognizes that these services constitute an input in the production process. To improve decisions about resource utilization. By imposing on division managers the cost of the service department resources that they use, division managers are encouraged to use these resources only to the extent that their benefit exceeds their cost. To ration limited resources. When production departments have some discretion over their utilization of a service department resource, charging production departments for the resource usually results in less demand for it than if the resource were “free” to the production departments.

The motivation for the first reason, to provide more accurate product cost information, can be to improve decision-making within the organization, to improve the quality of external financial reporting, or to comply with contractual agreements in regulatory settings where cost-based pricing is used. The distinction between the second and third reasons is important in the context of fixed versus variable costs. In connection with the second reason, to improve decisions about resource utilization, from the company’s perspective, a division manager making a short-term decision about whether to utilize service department resources should incorporate into that decision the service department’s marginal costs, which are usually the variable costs. The manager should ignore the service department’s fixed costs if these costs will not be affected by the manager’s decision. This reasoning suggests that only the service department’s variable costs should be charged out. However, in connection with the third reason, to ration a scarce resource, if the service department controls a fixed asset, and if demand for the asset exceeds capacity, charging users a fee for the asset allows the service department to balance demand with supply. The fee need not relate to the cost of obtaining the asset; rather, it is a mechanism for managing demand. Examples would be charging departments a “rental fee” for their use of vehicles from the motor pool, or for their use of a corporate conference facility.

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure that all service department costs are allocated. Budgeted rates provide service department managers incentives to control costs, and also provide user departments more accurate information about service department billing rates for planning purposes. In either case, service department costs should be allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible. Here are some examples: Allocate building maintenance costs based on square footage; Allocate costs of the company airplane based on miles flown; Allocate costs of the data processing department based on CPU time. In some cases, companies benefit from allocating fixed costs using a different allocation base than variable costs. For example, fixed costs might be allocated based on an estimate of long-term usage by the production departments.

Historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they account for the fact that service departments provide services to other service departments as they will as to production departments: Direct Method Step-down Method Reciprocal Method

Allocation of Service Department Costs Direct Method
The Direct Method is the most widely-used method. This method allocates each service department’s total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments. Example: Machining and Assembly are the only production departments that used the services of the Human Resources Department in March. Costs from Human Resources are allocated based on the number of new hires. Machining hired seven employees in March and Assembly hired three employees. Human Resources incurred total costs of $93,000 in March. Allocation of H.R. Department costs to Machining: 70% of $93,000 = $65,100 Allocation of H.R. Department costs to Assembly: 30% of $93,000 = $27,900 The characteristic feature of the direct method is that no information is necessary about whether any service departments utilized services of the Human Resources Department. It does not matter whether no other service department hired anybody, or whether three other service departments each hired five employees (implying that more than 50% of the hiring occurred in the service departments). Under the direct method, service department to service department services are ignored, and no costs are allocated from one service department to another.

Allocation of Service Department Costs Step-down Method
The Step-down Method is also called the Sequential Method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it. The choice of which department to start with is important. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence. The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other: Total Cost Service Dept % of services provided by the service department listed at left to: H.R. D.P. R.M. Machining Assembly $ 80,000 -- 20% 10% 40% 30% 120,000 8% 7% 55% 40,000 50% $240,000

The amounts in the far left column are the costs incurred by each service department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department are charged out. The company decides to allocate the costs of Human Resources first, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. However, a case could be made to allocate Data Processing first, because it has greater total costs than either of the other two service departments. In any case, the company decides to allocate Data Processing second.

In the table below, the row for each service department allocates the total costs in that department (the original costs incurred by the department plus any costs allocated to it from the previous allocation of other service departments) to the production departments as well as to any service departments that have not yet been allocated. H.R. D.P. R.M. Machining Assembly Costs prior to allocation $ 80,000 $120,000 $40,000 -- Allocation of H.R. ($ 80,000) 16,000 8,000 $32,000 $24,000 Allocation of D.P. (136,000) 10,348 44,348 81,304 Allocation of R.M. (58,348) 29,174 $105,522 $134,478

After the first service department has been allocated, in order to derive the percentages to apply to the production departments and any remaining service departments, it is necessary to “normalize” these percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P. can be allocated back to H.R. The percentages for the remaining service and production departments sum to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages are normalized as follows: Risk Management: 7% ÷ 92% = 7.61% Machining: 30% ÷ 92% = 32.61% Assembly: 55% ÷ 92% = 59.78% Total: % For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to Assembly, not 55%.

The characteristic feature of the step-down method is that once the costs of a service department have been allocated, no costs are allocated back to that service department. As can be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations.

Allocation of Service Department Costs Reciprocal Method
The Reciprocal Method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations. Using the data from the step-down method example, the simultaneous equations are: H.R. = $ 80,000 + (0.08 x D.P.) D.P. = $120,000 + (0.20 x H.R.) R.M. = $ 40,000 + (0.10 x H.R.) + (0.07 x D.P.) Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of these service departments. For example, Human Resources receives services from Data Processing, but not from Risk Management. 8% of the services that Data Processing provides, it provides to Human Resources. Therefore, the total costs allocated from Human Resources should include not only the $80,000 incurred in that department, but also 8% of the costs incurred by Data Processing. Solving for the three unknowns (which can be performed using spreadsheet software): H.R. = $ 91,057 D.P. = $138,211 R.M. = $ 58,781

Allocation of Service Department Costs Reciprocal Method
Hence, costs are allocated as follows: To illustrate the derivation of the amounts in this table, the $36,423 that is allocated from Human Resources to Machining is 40% of H.R.’s total cost of $91,057. H.R. D.P. R.M. Machining Assembly Costs prior to allocation $80,000 $120,000 $40,000 -- Allocation of H.R. ($91,057) 18,211 9,106 $36,423 $ 27,317 Allocation of D.P. 11,057 (138,211) 9,675 41,463 76,016 Allocation of R.M. (58,781) 29,390 29,390 $ 0 $ 0 $ 0 $107,276 $132,723

Allocation of Service Department Costs Summary
The direct method and step-down method have no advantages over the reciprocal method except for their simplicity, and the step-down method is sometimes not very simple. Nevertheless, the reciprocal method is not widely used. Given advances in computing power, the reciprocal method would seem to be accessible to many companies that are not using it. Presumably, these companies believe that the benefits obtained from more accurate service department cost allocations do not justify the costs required to implement the reciprocal method. In fact, many companies do not allocate service department costs at all, either because they do not think these allocations are beneficial, or because they do not believe that the benefits justify the costs.

Allocation of Service Department Costs Dysfunctional Incentives from Service Department Cost Allocations The incentives that service department cost allocations impose on managers and employees should be carefully considered. In some cases, these allocations have unintended and undesirable consequences. For example: At one university, professors are “charged” for office telephone usage, which includes a fixed monthly fee similar to the flat fee that is charged for residential telephone service. The “charge” comes out of the professor’s “research allowance,” which can otherwise be used for professional expenses such as journal subscriptions, professional organization dues, and travel to conferences. Since the flat fee (as opposed to the long distance charges) is unavoidable, it does not affect the professors’ behavior, but it is viewed negatively, because the research allowance is effectively several hundred dollars a year less than “advertised” by the administration. At another university, state-of-the-art computer equipment in the classrooms is purchased out of student fees. Consequently, this equipment is readily available and “free” to the faculty when they teach. However, when a professor reserves a room for a non-teaching purpose, such as a research presentation to fellow faculty, the Instructional Technology service center “charges” the professor’s department approximately $50 to use the equipment, which is far in excess of the equipment’s marginal cost (the depreciation on the bulb in the projector). The $50 charge is sufficient to dissuade many departments from using the equipment for non-instructional purposes, so the equipment sits idle, and the professors use a “low tech” solution: an overhead projector and transparencies.

Cost And Variance Measures By Ronald Schmidt, CMA, CFM
Part 1 Study Unit 10 Cost And Variance Measures By Ronald Schmidt, CMA, CFM

Variance Analysis and overview
A budget communicates to employees the organization’s operational and strategic objectives Considerations: Evaluations system must be used to monitor progress Feedback must be timely

Variance analysis is the basis of any performance evaluation system. On the cost side, a favorable variance occurs when actual costs are less than standard costs. An unfavorable variance occurs when actual costs are greater than standard costs. On the revenue side, a favorable variance occurs when actual revenues are greater than budgeted revenues. An unfavorable variance occurs when actual revenues are less than budgeted revenues.

The significance of variances depends not only on their amount but also on their direction, frequency, and trend. It enables management by exception – the practice of giving attention primarily to significant deviations from expectations. Assignment of responsibility = Budget owner Cost centers = cost drivers = controllable costs Allocation / indirect costs Crucial part of variance analysis is the assignment of responsibility to those most likely to have information that will help find solutions. Constructive approach is to promote learning and continuous in manufacturing, not to assign blame.

Variance Analysis overview
Objectives of the budget: performance? Budget vs. Actual, evaluate the trend, and develop a rolling Forecast

Flexible budget and sales-volume variance
Static budget = flexible budget and sales volume variance Flexible budget variance – Diff. between the actual results and the budgeted amount for the actual activity level. The costs that should have been incurred given the actual level of production. The actual level of production is based on the actual output while still using the standard level of inputs. Variance could be due to: Selling Price Input costs Input quantities

The sales-volume variance is the difference between the flexible budget and static budget amounts if selling prices and costs are constant.

See page 343 ACTUAL RESULTS = ACTUAL INPUTS x ACTUAL PRICE FLEXIBLE BUDGET = ACTUAL INPUTS x STANDARD PRICE STATIC BUDGET = BUDGETED INPUTS x STANDARD PRICE

SU 10.1 Practice Question 1 The purpose of identifying manufacturing variances and assigning their responsibility to a person/department should be to A Use the knowledge about the variances to promote learning and continuous improvement in the manufacturing operations. B Trace the variances to finished goods so that the inventory can be properly valued at year-end. C Determine the proper cost of the products produced so that selling prices can be adjusted accordingly. D Pinpoint fault for operating problems in the organization.

SU 10.1 Practice Question 1 Answer
Correct Answer: A The purpose of identifying and assigning responsibility for variances is to determine who is likely to have information that will enable management to find solutions. The constructive approach is to promote learning and continuous improvement in manufacturing operations, not to assign blame. However, information about variances may be useful in evaluating managers’ performance.

SU 10.1 Practice Question 2 A difference between standard costs used for cost control and the budgeted costs of the same manufacturing effort can exist because A Standard costs represent what costs should be, whereas budgeted costs are expected actual costs. B Budgeted costs are historical costs, whereas standard costs are based on engineering studies. C Budgeted costs include some slack, whereas standard costs do not. D Standard costs include some slack, whereas budgeted costs do not.

Correct Answer: A In the long run, these costs should be the same. In the short run, however, they may differ because standard costs represent what costs should be, whereas budgeted costs are expected actual costs. Budgeted costs may vary widely from standard costs in certain months, but, for an annual budget period, the amounts should be similar.

SU 10.1 Practice Question 3 The controller of a company holds a monthly meeting where any department that has a 10% unfavorable variance to budget must explain the variance and develop a plan to remedy the situation. This is an example of A Activity-based management. B Cost management. C Continuous improvement. D Management by exception.

Correct Answer: D Variance analysis is an important tool for the management accountant. It enables management by exception, which is the practice of giving attention primarily to significant deviations from expectations. Managers must use their judgment to determine the most efficient use of their limited time. Concentrating on operations that are not performing within expected limits is likely to yield the best ratio of benefits to costs.

Flexible budget = Actual level of production x standard costs
Remember Flexible budget = Actual level of production x standard costs

Components of the flexible Budget
DM variance Price variance Quantity or usage variance Materials mix variance / yield variance DL variance Rate variance Efficiency variance Labor mix variance / yield variance MOH variance (By Jim Clemons) 4 way analysis VOH spending variance VOH efficiency variance FOH spending variance (budget variance) FOH production-volume variance

Flexible budget Remember a flexible budget adjusts for changes in the volume of activity. It can be adapted to any level of production. Flexible budget variances result from variations in the efficiency and effectiveness of producing actual output. They are the differences between actual results and flexible budget amounts. See example on page 343

SU 10.2 Question 1 A manufacturing firm planned to manufacture and sell 100,000 units of product during the year at a variable cost per unit of $4.00 and a fixed cost per unit of $2.00. The firm fell short of its goal and only manufactured 80,000 units at a total incurred cost of $515,000. The firm’s manufacturing cost variance was A. $85,000 favorable. B. $35,000 unfavorable. C. $5,000 favorable. D. $5,000 unfavorable.

SU 10.2 Question 1 Answer Correct Answer: C The company planned to produce 100,000 units at $6 each ($4 variable + $2 fixed cost), or a total of $600,000, consisting of $400,000 of variable costs and $200,000 of fixed costs. Total production was only 80,000 units at a total cost of $515,000. The flexible budget for a production level of 80,000 units includes variable costs of $320,000 (80,000 units × $4). Fixed costs would remain at $200,000. Thus, the total flexible budget costs are $520,000. Given that actual costs were only $515,000, the variance is $5,000 favorable.

SU 10.2 Question 2 To monitor total cost, total revenue, and net profit based upon production levels, a manager should use A. Both flexible budgeting and standard costing. B. Static budgeting but not standard costing. C. Standard costing but not flexible budgeting. D. Static budgeting and standard costing.

SU 10.2 Question 2 Answer Correct Answer: A A flexible budget is a set of static budgets prepared in anticipation of varying levels of activity. Unlike a static budget, the use of a flexible budget permits effective evaluation of actual results when actual and expected production differ. Setting cost standards facilitates preparation of a flexible budget. For example, a standard unit variable cost is useful in determining the total variable cost for a given output.

DM / DL variances DL rate variance DL efficiency variance
AQ x (AP – SP) DL efficiency variance SP x (AQ – SQ) Mix and yield variances Substitutable products Weighted average standard price Standard mix of inputs (SPSM) Actual mix of inputs (SPAM) Mix variance = ATQ x (SPSM – SPAM) Yield variance = (STQ – ATQ) x SPSM MIX + YIELD variances = EFFICIENCY variance

SU 10.3 Question 1 Blaster, Inc., a manufacturer of portable radios, purchases the components from subcontractors to use to assemble into a complete radio. Each radio requires three units each of Part XBEZ52, which has a standard cost of $1.45 per unit. During May, Blaster experienced the following with respect to Part XBEZ52. Units Purchases ($18,000) 12,000 Consumed in manufacturing 10,000 Radios manufactured 3,000

SU 10.3 Question 1 (cont.) During May, Blaster incurred a purchase price variance of During May, Blaster incurred a purchase price variance of A. $450 unfavorable. B. $450 favorable. C. $500 favorable. D. $600 unfavorable

SU 10.3 Question 1 Answer Correct Answer: D Blaster’s purchase price variance is calculated as follows: Purchase price variance = AQ × (SP – AP) = 12,000 parts × ($1.45 – $1.50) = 12,000 × –$0.05 = $600 unfavorable Incorrect Answers: A: The standard quantity needed for the actual output times the $.05 unfavorable price variance per part equals $450 unfavorable. B: The variance is unfavorable, and $450 is the amount of the variance that relates only to the standard input for the actual output. C: The variance is unfavorable. Furthermore, the variance is based on the quantity purchased, not the quantity consumed. [Note: The materials price variance is sometimes isolated at the time of transfer to production.]

SU 10.3 Question 2 Blaster, Inc., a manufacturer of portable radios, purchases the components from subcontractors to use to assemble into a complete radio. Each radio requires three units each of Part XBEZ52, which has a standard cost of $1.45 per unit. During May, Blaster experienced the following with respect to Part XBEZ52. Units Purchases ($18,000) 12,000 Consumed in manufacturing 10,000 Radios manufactured 3,000

SU 10.3 Question 2 (cont.) During May, Blaster incurred a materials efficiency variance of A. $1,450 unfavorable. B. $1,450 favorable. C. $4,350 unfavorable. D. $4,350 favorable.

SU 10.3 Question 2 Answer Correct Answer: A Standard usage was three parts per radio at $1.45 each. For a production level of 3,000 units, the total materials needed equaled 9,000 parts, but materials actually used totaled 10,000 parts. Thus, the variance is $1,450 unfavorable {SP × (AQ – SQ) = [$1.45 standard cost per part × (10,000 actually used – 9,000 standard usage)]}. Incorrect Answers: B: The variance is unfavorable. The actual quantity used exceeded the standard input allowed. C: Assuming that 12,000 parts were consumed results in $4,350 unfavorable. D: Assuming that 12,000 parts were consumed and that the variance is favorable results in $4,350 favorable.

SU 10.4 Question 1 Under a standard cost system, direct labor price variances are usually not attributable to A. Union contracts approved before the budgeting cycle. B. Labor rate predictions. C. The use of a single average standard rate. D. The assignment of different skill levels of workers than planned.

SU 10.4 Question 1 Answer Correct Answer: A The direct labor price (rate) variance is the actual hours worked times the difference between the standard rate and the actual rate paid. This difference may be attributable to (1) a change in labor rates since the establishment of the standards, (2) using a single average standard rate despite different rates earned among different employees, (3) assigning higher-paid workers to jobs estimated to require lower-paid workers (or vice versa), or (4) paying hourly rates, but basing standards on piecework rates (or vice versa). The difference should not be caused by a union contract approved before the budgeting cycle because such rates would have been incorporated into the standards. Incorrect Answers: B: Predictions about labor rates may have been inaccurate. C: Using a single average standard rate may lead to variances if some workers are paid more than others and the proportions of hours worked differ from estimates. D: Assigning higher paid (and higher skilled) workers to jobs not requiring such skills leads to an unfavorable variance.

SU 10.4 Question 2 Zazoo, Inc. specializes in reviewing and editing technical magazine articles. Zazoo sets the following standards for evaluating the performance of the professional staff: Annual budgeted fixed costs for normal capacity level of 10,000 articles reviewed and edited $600,000 Standard professional hours per 10 articles 200 hours Flexible budget of standard labor costs to process 10,000 articles $10,000,000 The following data apply to the 9,500 articles that were actually reviewed and edited during the current year. Total hours used by professional staff 192,000 hours Flexible costs $9,120,000 Total cost $9,738,000 Zazoo’s labor efficiency variance for the year is

SU 10.4 Question 2 (cont.) Zazoo’s labor efficiency variance for the year is A. $100,000 unfavorable. B. $238,000 unfavorable. C. $380,000 favorable. D. $500,000 favorable

SU 10.4 Question 2 Answer Correct Answer: A The labor efficiency variance is the standard cost per hour times the difference between standard and actual hour. The standard labor rate is $50 per hour, and the standard time allowed for 9,500 articles is 190,000 hours (9,500 × 20). Actual hours worked totaled 192,000. Thus, an unfavorable variance of 2,000 hours occurred. The unfavorable labor efficiency variance is therefore $100,000 (2,000 hours × $50). Incorrect Answers: B: The difference between the standard labor cost ($9,500,000) and total actual (fixed + variable) cost ($9,738,000) is $238,000. C: The variance is unfavorable. D: The efficiency variance is based on standard hours for actual production levels--in this case, 190,000 hours.

Conclusion – key take away
What could explain favorable / unfavorable variances? Better purchase price (supplier concentration) Lower quality input (outsource other country) Better technology = more efficiency (turnaround, bottleneck) Higher-skilled workers (PhD, training, turnover, benefits, union) Less scrap / spoilage = Lean sigma (waste) Economies of scale (volume) Inflation – cost of living (tax, insurance, rent) Cost of capital, risk, exchange rate External factors (competitors, demand, distribution) Components of the product (spare parts)

Budgeting Concepts & Forecasting Techniques Patricia Burnett, CMA

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Budgeting Concepts & Forecasting Techniques Patricia Burnett, CMA

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