1. CHAPTER 10: STATIC AND FLEXIBLE BUDGETS Cost Management, Canadian Edition © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 1

2. Learning Objectives © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 2 Q1: What are the relationships among budgets, long-term strategies, and short-term operating plans? Q2: What is a master budget and how is it prepared? How are operating budgets prepared? Q3: How is the cash budget developed? Q4: What are budget variances and how are they calculated? Q5: What are the differences between static and flexible budgets? Q6: How are budgets used to monitor and motivate performance? Q7: What are other approaches to budgeting?

3. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 3 Q1: What are the relationships among budgets, long-term strategies, and short-term operating plans?

4. Budgets, Strategies, & Operating Plans A budget is –A formalized financial plan. –A translation of an organization’s strategies. –A method of communicating. –A way to define areas of responsibility and decision rights. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 4 The budget cycle is the series of sequential steps followed to create and use budgets.

5. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 5 Q2: What is a master budget and how is it prepared? How are operating budgets prepared?

6. Master Budgets A master budget is –A comprehensive plan for the upcoming accounting period. –Usually prepared for a one-year period. –Is based on a series of budget assumptions. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 6 The master budget consists of several subsidiary budgets, in two categories: –Operating budgets –Financial budgets

7. Operating Budgets –Revenue budget –Production budget –Direct materials budget –Direct labour budget –Manufacturing overhead budget –Inventory and cost of goods sold budget –Support department budgets –Budgeted income statement © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 7 The operating budget is created by preparing the following individual budgets, in this order:

8. Financial Budgets –Capital budget –Long-term financing budget –Cash budget –Budgeted balance sheet –Budgeted statement of cash flows © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 8 The financial budget is created by preparing the following individual budgets, in this order:

9. Operating Budget Example Stanley J, Inc., makes a tool used by auto mechanics that sells for $68/unit. It expects to sell 6,000 units in April and 7,000 units in May. Stanley J prefers to end each period with a finished goods inventory equal to 10% of the next period’s sales in units and a direct materials inventory equal to 20% of the direct materials required for the next period’s production. The company never has any beginning or ending work-in-process inventories. There were 400 units in finished goods inventory on April 1. Prepare the revenue and production budgets for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 9

10. Operating Budget Example Stanley J’s product uses 0.3 kg of direct material per unit, at a cost of $4/kg. There were 220 kg of direct material on hand on April 1. Assume that budgeted production for May is 6,500 units. Prepare the direct materials budget for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 10

11. Operating Budget Example Stanley J’s product uses 0.2 hours of direct labour at a cost of $12/hr. Prepare the direct labour budget for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 11

12. Operating Budget Example Stanley J’s budgeted fixed manufacturing overhead for April is $167,000, and variable manufacturing overhead is budgeted at $6 per direct labour hour. Prepare the manufacturing overhead budget for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 12

13. Operating Budget Example Assume that Stanley J’s April 1 direct materials inventory had a cost of $1,560. Prepare the April ending inventories budget for direct materials. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 13

14. Operating Budget Example Prepare the April ending inventories budget for finished goods. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 14

15. Operating Budget Example Assume that Stanley J’s April 1 finished goods inventory had a cost of $12,146. Prepare the cost of goods sold budget for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 15

16. Operating Budget Example Stanley J’s budget for April includes $22,000 for administrative costs, $34,000 for fixed distribution costs, $18,000 for research and development, and $13,000 for fixed marketing costs. Additionally, the budgeted variable costs for distribution are $0.75/unit sold and the budgeted variable costs for marketing are 4% of sales revenue. Prepare the support department budget for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 16

17. Operating Budget Example Suppose that Stanley J’s income tax rate is 28%. Prepare the budgeted income statement for April. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 17

18. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 18 Q3: How is the cash budget developed?

19. Cash Budgets Cash budgets are prepared after the operating budgets. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 19 The cash budgets include the following individual budgets: –Cash receipts budget –Cash disbursements budget –Short-term borrowings and investments budget

20. Cash Budget Example Bryce Manufacturing is preparing a cash budget for a new division that will begin operations on January 1, 2010. Bryce expects sales to be 40% cash and 60% on account, with 45% of credit sales are collected in the month of the sale. In the month after the sale, 50% of credit sales should be collected, with the remainder collected two months after the sale. Budgeted sales for the first three months are $100,000, $150,000 and $200,000. Prepare a cash receipts budget for the first three months of 2010. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 20

21. Cash Budget Example Bryce Manufacturing budgets direct labour costs to be 30% of sales revenue and expects to pay this in the month the costs are incurred. Direct materials purchases will be on account, and paid as follows: 40% in the month of the purchase, 50% the following month, and 10% in the second month following the purchase. Budgeted direct material purchases for the first 3 months of 2010 are $20,000, $35,000 and $45,000. Compute the budgeted cash disbursements for direct materials and labour for the first 3 months of 2010. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 21

22. Cash Budget Example Bryce Manufacturing budgets other variable costs at 4% of sales revenue and will be paid in the month after the costs are incurred. Other budgeted fixed costs are $6,000 per month and will be paid in the month incurred. Prepare a cash disbursements budget for all costs, including direct materials and labour. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 22

23. Cash Budget Example Using the information from the prior slides, prepare a schedule of budgeted cash flows for Bryce Manufacturing’s new division for the first three months of 2010. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 23

24. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 24 Q4: What are budget variances and how are they calculated?

25. Budget Variances Managers compare actual results to budgeted results in order to –Monitor operations, and –Motivate appropriate performance. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 25 Differences between budgeted and actual results are called budget variances. –Variances are stated in absolute value terms, and labeled as Favourable or Unfavourable.

26. Budget Variances Reasons for budget variances are investigated. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 26 The investigation may find: –Inefficiencies in actual operations that can be corrected. –Efficiencies in actual operations that can be replicated in other areas of the organization. –Uncontrollable outside factors that require changes to the budgeting process.

27. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 27 Q5: What are the differences between static and flexible budgets?

28. Static Budgets A budget prepared for a single level of sales volume is called a static budget. Static budgets are prepared at the beginning of the year. Differences between actual results and the static budget are called static budget variances. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 28

29. Flexible Budgets A budget prepared for a multiple levels of sales volume is called a flexible budget. Flexible budgets are prepared at the beginning of the year for planning purposes and at the end of the year for performance evaluation. Differences between actual results and the flexible budget are called flexible budget variances. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 29

30. Flexible Budget Example Tina’s Trinkets is preparing a budget for 2010. The budgeted selling price per unit is $10, and total fixed costs for 2010 are estimated to be $5,000. Variable costs are budgeted at $3/unit. Prepare a flexible budget for the volume levels 1,000, 1,100, and 1,200 units. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 30

31. Static Budget Variances Example Suppose that Tina’s 2010 static budget was for 1,100 units of sales. The actual results are given below. Compute the static budget variances for each row and discuss. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 31

32. Flexible Budget Variances Example Compute the flexible budget variances for Tina and discuss the results. Compare the flexible budget variances to the static budget variances on the prior page. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 32

33. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 33 Q6: How are budgets used to monitor and motivate performance?

34. Performance Evaluation A static budget variance includes effects from output volume. A flexible budget variance removes these output volume effects. Other adjustments to the year-end flexible budget may be made for a fair performance evaluation, such as –Input price changes outside the control of the manager under evaluation –Fixed cost increases outside the control of the manager under evaluation –Note that it is important that managers have control over amounts they are held accountable for © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 34

35. Performance Evaluation Participative Budgeting – Occurs when managers are responsible for setting their own budgets which creates “buy-in” in the budgeting process – Must be careful that budgets are not set unrealistically low as this would offer little motivation to perform well Zero-based budgeting – Does not rely on adjusting prior years’ budgets – Managers must be able to justify all budget amounts – This encourages cost cutting, however is time- consuming © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 35

36. © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide 36 Q7: What are other approaches to budgeting?

37. Other Budgeting Approaches Rolling budgets are prepared frequently for overlapping time periods and actual results may be used to update the budget for the next period. Activity based budgets use more cost pools and cost drivers. Kaizen budgets plan cost reductions over time. Extreme programming can be used to budget long-term projects that contain a large amount of uncertainty. –Often used for information technology projects –Projects begin with little up-front planning © John Wiley & Sons, 2009 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al Slide # 37

38. Copyright Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. © John Wiley & Sons, 2009Slide 38 Chapter 10: Static and Flexible Budgets Cost Management, Cdn Ed, by Eldenburg et al