1. 1 CHAPTER M8 The Operating Budget © 2007 Pearson Custom Publishing

2. 2 Learning Objective 1: Describe some of the benefits of the operating budget. © 2007 Pearson Custom Publishing

3. 3 Operating Budget The operating budget, (also called the master operating budget, or simply the master budget) is a plan that focuses on the day-to-day operations of a firm. The operating budget, (also called the master operating budget, or simply the master budget) is a plan that focuses on the day-to-day operations of a firm. It is usually prepared for a one-year time period, but could be for prepared for several years at a time. It is usually prepared for a one-year time period, but could be for prepared for several years at a time. © 2007 Pearson Custom Publishing

4. 4 What is It? The operating budget is essentially a set of forecasted financial statements. It also includes several detailed schedules that provide the backup documentation for the financial statements. The operating budget is essentially a set of forecasted financial statements. It also includes several detailed schedules that provide the backup documentation for the financial statements. Forecasted financial statements are also called pro forma statements. Forecasted financial statements are also called pro forma statements. © 2007 Pearson Custom Publishing

5. 5 Benefits of Budgeting  Budgeting serves as a guide.  Budgeting helps allocate resources.  Budgeting encourages communication and coordination.  Budgeting sets performance standards or benchmarks. © 2007 Pearson Custom Publishing

6. 6 Serves as a Guide A budget is a plan, and a plan can help guide you through the future. A budget is a plan, and a plan can help guide you through the future. A household budget can be a great aide in helping a family control its spending. A household budget can be a great aide in helping a family control its spending. Likewise, an operating budget will help a business to anticipate and handle the little bumps in the road as they occur. Likewise, an operating budget will help a business to anticipate and handle the little bumps in the road as they occur. © 2007 Pearson Custom Publishing

7. 7 Helps Allocate Resources An operating budget helps the managers to determine the best possible allocation of the company’s scarce resources (such as money, materials, labor, etc.). An operating budget helps the managers to determine the best possible allocation of the company’s scarce resources (such as money, materials, labor, etc.). The budgeting process may lead to the discovery of potential bottlenecks before they occur, thus allowing managers to take action to alleviate the bottleneck. The budgeting process may lead to the discovery of potential bottlenecks before they occur, thus allowing managers to take action to alleviate the bottleneck. © 2007 Pearson Custom Publishing

8. 8 Encourages Communication and Coordination An effective budgeting process requires that managers from all of the functional areas within the firm work together as a whole. An effective budgeting process requires that managers from all of the functional areas within the firm work together as a whole. The manufacturing department needs to know what the marketing department is doing and vice versa. By preparing the operating budget, managers become more aware of the firm’s other functional areas. The manufacturing department needs to know what the marketing department is doing and vice versa. By preparing the operating budget, managers become more aware of the firm’s other functional areas. © 2007 Pearson Custom Publishing

9. 9 Sets Performance Standards A budget can also be thought of as a goal. After a goal has been set, you can then measure your success in meeting that goal. A budget can also be thought of as a goal. After a goal has been set, you can then measure your success in meeting that goal. Managers are often rewarded for meeting or exceeding their budgeted performance standards. Managers are often rewarded for meeting or exceeding their budgeted performance standards. © 2007 Pearson Custom Publishing

10. 10 Learning Objective 2: Describe the three budgeted financial statements contained in the operating budget and the other budgets that support the budgeted financial statements. © 2007 Pearson Custom Publishing

11. 11 Contents of Operating Budget © 2007 Pearson Custom Publishing

12. 12 Sales Budget The first budget prepared is the sales budget. The sales budget is based upon the sales forecast. The first budget prepared is the sales budget. The sales budget is based upon the sales forecast.   Information from the sales budget has an impact upon almost every other aspect of the operating budget. © 2007 Pearson Custom Publishing

13. 13 Production/Purchases Budget A manufacturing firm needs to prepare a Production Budget as well as a Purchases Budget for the materials used in production. A manufacturing firm needs to prepare a Production Budget as well as a Purchases Budget for the materials used in production. A merchandising firm needs to prepare a purchases budget for the inventory items that they sell. A merchandising firm needs to prepare a purchases budget for the inventory items that they sell. The production and purchases budgets are very similar in format. The production and purchases budgets are very similar in format. © 2007 Pearson Custom Publishing

14. 14 Cost of Goods Sold Budget The Cost of Goods Sold Budget is an integral part of the budgeted income statement for a manufacturing or merchandising firm. The Cost of Goods Sold Budget is an integral part of the budgeted income statement for a manufacturing or merchandising firm. There is nothing unusual about preparing this budget, it looks just like a normal cost of goods sold schedule. The only difference is the use of estimated amounts. A service company uses a Cost of Services Budget. There is nothing unusual about preparing this budget, it looks just like a normal cost of goods sold schedule. The only difference is the use of estimated amounts. A service company uses a Cost of Services Budget. © 2007 Pearson Custom Publishing

15. 15 Selling and Administrative Expense Budget Another important part of the budgeted income statement is the Selling and Administrative Expense Budget. Another important part of the budgeted income statement is the Selling and Administrative Expense Budget. Items included in this budget are advertising and promotion, administrative and sales salaries, and the expenses related to the corporate and sales offices. Items included in this budget are advertising and promotion, administrative and sales salaries, and the expenses related to the corporate and sales offices. © 2007 Pearson Custom Publishing

16. 16 Budgeted Income Statement The Budgeted Income Statement looks very much like any other income statement. The main difference is that the numbers being reported are expected future results, rather than historical data. The Budgeted Income Statement looks very much like any other income statement. The main difference is that the numbers being reported are expected future results, rather than historical data. © 2007 Pearson Custom Publishing

17. 17 Cash Budget The Cash Budget shows an analysis of the expected cash receipts and cash disbursements for the company. Only the cash flows from operating activities would typically appear in the cash budget. The Cash Budget shows an analysis of the expected cash receipts and cash disbursements for the company. Only the cash flows from operating activities would typically appear in the cash budget. For example, the cash outflow for a capital budgeting project would not be shown on the cash budget. For example, the cash outflow for a capital budgeting project would not be shown on the cash budget. © 2007 Pearson Custom Publishing

18. 18 Budgeted Balance Sheet A Budgeted Balance Sheet is prepared in exactly the same manner as a standard balance sheet, with the only exception being the use of estimated future amounts rather than historical amounts for assets, liabilities, and owners’ equity. A Budgeted Balance Sheet is prepared in exactly the same manner as a standard balance sheet, with the only exception being the use of estimated future amounts rather than historical amounts for assets, liabilities, and owners’ equity. Most of the numbers in the budgeted balance sheet come from the other budgets. Most of the numbers in the budgeted balance sheet come from the other budgets. © 2007 Pearson Custom Publishing

19. 19 Budgeted Statement of Cash Flows The Budgeted Statement of Cash Flows is a comprehensive projection of all the cash flows for the company during the period covered by the operating budget. The Budgeted Statement of Cash Flows is a comprehensive projection of all the cash flows for the company during the period covered by the operating budget. Expected cash flows from operating activities, investing activities, and financing activities would all be shown in this budget. Expected cash flows from operating activities, investing activities, and financing activities would all be shown in this budget. © 2007 Pearson Custom Publishing

20. 20 Budget Interrelationships © 2007 Pearson Custom Publishing

21. 21 Learning Objective 3: Compare and contrast various approaches to the preparation and use of the operating budget. © 2007 Pearson Custom Publishing

22. 22 Different Approaches to Budgeting There are many different approaches and theories that have been used for the budgeting process. Not any one approach is always best. What works well for one company may not work well for the next. There are many different approaches and theories that have been used for the budgeting process. Not any one approach is always best. What works well for one company may not work well for the next. We will look at seven different approaches to budgeting. We will look at seven different approaches to budgeting. © 2007 Pearson Custom Publishing

23. 23 Perpetual Budgeting The first budgeting approach is perpetual budgeting, also called continual budgeting. The first budgeting approach is perpetual budgeting, also called continual budgeting. 4 4 With this approach, the operating budget is continually updated and extended. As one month or quarter ends, another month or quarter is added to the end of the budget. © 2007 Pearson Custom Publishing

24. 24 Incremental Budgeting The second approach is called incremental budgeting. In this case, the prior year’s budget is used as a starting point for the current year. Only the changes (increments) need to be justified. The second approach is called incremental budgeting. In this case, the prior year’s budget is used as a starting point for the current year. Only the changes (increments) need to be justified. Incremental budgets are often used by governmental agencies, including colleges and universities. Incremental budgets are often used by governmental agencies, including colleges and universities. © 2007 Pearson Custom Publishing

25. 25 Zero-Based Budgeting The third approach is zero-based budgeting. This is an alternative to incremental budgeting. The prior year’s budget is NOT used as a starting point for the current year. The third approach is zero-based budgeting. This is an alternative to incremental budgeting. The prior year’s budget is NOT used as a starting point for the current year. Each year, the full amount of each budget item needs to be justified. This is much more time consuming, but probably leads to a better budget. Each year, the full amount of each budget item needs to be justified. This is much more time consuming, but probably leads to a better budget. © 2007 Pearson Custom Publishing

26. 26 Top-Down Budgeting The fourth approach to budgeting is known as top-down budgeting. The fourth approach to budgeting is known as top-down budgeting. Top-down budgeting occurs when the budget is prepared by the top managers of the firm, and the budget is implemented by the lower-level managers in the firm. Top-down budgeting occurs when the budget is prepared by the top managers of the firm, and the budget is implemented by the lower-level managers in the firm. © 2007 Pearson Custom Publishing

27. 27 Imposed Budget Many top-down budgets are also imposed budgets. This fifth approach to budgeting occurs when top managers set the budget amounts without any input from the lower level managers. Many top-down budgets are also imposed budgets. This fifth approach to budgeting occurs when top managers set the budget amounts without any input from the lower level managers. Low- and middle-level managers must strive to meet the goals set forth by the budget, not matter how unreasonable they might be. Low- and middle-level managers must strive to meet the goals set forth by the budget, not matter how unreasonable they might be. © 2007 Pearson Custom Publishing

28. 28 Bottom-Up Budgeting The sixth approach to budgeting is known as bottom-up budgeting. As the name implies, this is a budget prepared by the lower-level managers of the firm. The sixth approach to budgeting is known as bottom-up budgeting. As the name implies, this is a budget prepared by the lower-level managers of the firm. These managers then communicate their ideas to the higher levels of management for final approval. These managers then communicate their ideas to the higher levels of management for final approval. © 2007 Pearson Custom Publishing

29. 29 Participative Budgeting The seventh approach to budgeting is known as a participative budget. In this approach, managers and employees at all levels are included in the budgeting process. The seventh approach to budgeting is known as a participative budget. In this approach, managers and employees at all levels are included in the budgeting process. A bottom-up budget is also participatory in nature. However, you can have a top-down budget that is participatory if the top managers seek input from the lower levels. A bottom-up budget is also participatory in nature. However, you can have a top-down budget that is participatory if the top managers seek input from the lower levels. © 2007 Pearson Custom Publishing

30. 30 Learning Objective 4: Describe the role of the sales forecast in the budgeting process. © 2007 Pearson Custom Publishing

31. 31 Sales Forecast A sales forecast is an informed prediction of the level of sales that can be achieved in future periods. A sales forecast is an informed prediction of the level of sales that can be achieved in future periods. A reasonably accurate sales forecast is crucial to the overall operating budget. All of the different parts of the operating budget depend upon the sales forecast, thus it is often called the cornerstone of the budget. A reasonably accurate sales forecast is crucial to the overall operating budget. All of the different parts of the operating budget depend upon the sales forecast, thus it is often called the cornerstone of the budget. © 2007 Pearson Custom Publishing

32. 32 Sales Forecast Accuracy Factors that influence the accuracy of the sales forecast include: Factors that influence the accuracy of the sales forecast include: General economy: inflation, recession, etc.? General economy: inflation, recession, etc.? Industry conditions: strength or weakness? Industry conditions: strength or weakness? Actions of competitors: increase or decrease market share? Actions of competitors: increase or decrease market share? Technological developments: are you on the cutting edge or being left behind? Technological developments: are you on the cutting edge or being left behind? © 2007 Pearson Custom Publishing

33. 33 Learning Objective 5: Prepare the budgets included in the operating budget. © 2007 Pearson Custom Publishing

34. 34 Preparing the Operating Budget To illustrate the preparation of the operating budget, let’s use the example of a merchandising company that sells baseball caps. This is their only product. To illustrate the preparation of the operating budget, let’s use the example of a merchandising company that sells baseball caps. This is their only product. We will prepare the monthly operating budgets for the first quarter of 2007. We will start with the actual balance sheet for Dec. 31, 2006, and then the sales forecast and sales budget for the first quarter of 2007. We will prepare the monthly operating budgets for the first quarter of 2007. We will start with the actual balance sheet for Dec. 31, 2006, and then the sales forecast and sales budget for the first quarter of 2007. © 2007 Pearson Custom Publishing

35. 35 © 2007 Pearson Custom Publishing

36. 36 Sales Forecast and Sales Budget © 2007 Pearson Custom Publishing

37. 37 Cost of Goods Sold Budget The Cap Company purchases the baseball caps for $7.00 each. The Cap Company purchases the baseball caps for $7.00 each. © 2007 Pearson Custom Publishing

38. 38 Selling and Administrative Expense Budget The Cap Company incurs selling and administrative expenses as shown below: The Cap Company incurs selling and administrative expenses as shown below: © 2007 Pearson Custom Publishing

39. 39 Budgeted Income Statement Using the information from the three previous budgets, we can prepare the budgeted income statement. Using the information from the three previous budgets, we can prepare the budgeted income statement. Notice how the sales forecast drives the budgeted income statement. If we change the sales forecast, all of the other budgets would need to be changed also. Notice how the sales forecast drives the budgeted income statement. If we change the sales forecast, all of the other budgets would need to be changed also. © 2007 Pearson Custom Publishing

40. 40 Budgeted Income Statement © 2007 Pearson Custom Publishing

41. 41 Purchases Budget The purchases budget was not needed to prepare the budgeted income statement. However, it is needed to prepare the budgeted balance sheet. The purchases budget was not needed to prepare the budgeted income statement. However, it is needed to prepare the budgeted balance sheet. In particular, the budgeted purchases will have an impact on three major balance sheet items: cash, inventory, and accounts payable. In particular, the budgeted purchases will have an impact on three major balance sheet items: cash, inventory, and accounts payable. © 2007 Pearson Custom Publishing

42. 42 Purchases Budget Let’s assume that The Cap Company tries to maintain an inventory equal to 25% of the next month’s budgeted sales volume. Let’s assume that The Cap Company tries to maintain an inventory equal to 25% of the next month’s budgeted sales volume. In other words, at the end of December they should have had an inventory equal to 25% of the caps they expected to sell in January. In other words, at the end of December they should have had an inventory equal to 25% of the caps they expected to sell in January. The ending inventory for March will be 25% of the expected April sales of 4,400 units. The ending inventory for March will be 25% of the expected April sales of 4,400 units. © 2007 Pearson Custom Publishing

43. 43 Purchases Budget © 2007 Pearson Custom Publishing

44. 44 Budgeting Cash Flows We need to determine an estimated ending cash balance before we can prepare the budgeted balance sheet. We need to determine an estimated ending cash balance before we can prepare the budgeted balance sheet. Another factor that could impact the balance sheet is the possibility of needing some short-term financing due to a shortage of cash. Another factor that could impact the balance sheet is the possibility of needing some short-term financing due to a shortage of cash. © 2007 Pearson Custom Publishing

45. 45 Cash Budget The preparation of a cash budget is an important step in the operating budget process. The preparation of a cash budget is an important step in the operating budget process. The cash budget provides information not readily available on the other budgets previously prepared. Keep in mind that the budgeted income statement is based on accrual accounting concepts, not cash flows. The cash budget provides information not readily available on the other budgets previously prepared. Keep in mind that the budgeted income statement is based on accrual accounting concepts, not cash flows. © 2007 Pearson Custom Publishing

46. 46 Cash Budget For The Cap Company, let’s make the following assumptions about cash flows: For The Cap Company, let’s make the following assumptions about cash flows: Cash receipts from sales tend to be collected 50% in the month of sale and 50% in the following month. Cash receipts from sales tend to be collected 50% in the month of sale and 50% in the following month. Cash disbursements for purchases are always made in the month following the purchase. Cash disbursements for purchases are always made in the month following the purchase. Other cash disbursements are made in the month that the expense is incurred. Other cash disbursements are made in the month that the expense is incurred. © 2007 Pearson Custom Publishing

47. 47 Cash Budget Additional information needed about The Cap Company: Additional information needed about The Cap Company: A minimum balance of $10,000 should be maintained. Any shortfall can be borrowed from the local bank at 12% annual interest. A minimum balance of $10,000 should be maintained. Any shortfall can be borrowed from the local bank at 12% annual interest. December purchases totaled $33,300. December purchases totaled $33,300. December sales totaled $50,000. December sales totaled $50,000. © 2007 Pearson Custom Publishing

48. 48 © 2007 Pearson Custom Publishing

49. 49 Building the Balance Sheet We now have enough information to prepare the budgeted balance sheet for The Cap Company. We can determine the accounts receivable and accounts payable balances from the information used to prepare the cash budget. We now have enough information to prepare the budgeted balance sheet for The Cap Company. We can determine the accounts receivable and accounts payable balances from the information used to prepare the cash budget. Information about owners’ equity and equipment comes from the Dec. 31 balance sheet. Information about owners’ equity and equipment comes from the Dec. 31 balance sheet. © 2007 Pearson Custom Publishing

50. 50 © 2007 Pearson Custom Publishing

51. 51 Discussion Questions Can you verify the accounts receivable balance for March 31? Where do you find the necessary information? Can you verify the accounts receivable balance for March 31? Where do you find the necessary information? Can you verify the accounts payable balance for March 31? Where do you find the necessary information? Can you verify the accounts payable balance for March 31? Where do you find the necessary information? Can you verify the accumulated depreciation for all three months? Can you verify the accumulated depreciation for all three months? © 2007 Pearson Custom Publishing

52. 52 Discussion Questions Question: Can you verify the retained earnings balance for January 31, 2007? Question: Can you verify the retained earnings balance for January 31, 2007? Answer: Take the Dec. 31 balance of $8,470 and add the $1,000 January income. Answer: Take the Dec. 31 balance of $8,470 and add the $1,000 January income. Question: Can you verify the retained earnings balance for February 28, 2007? Question: Can you verify the retained earnings balance for February 28, 2007? Hint: There is a “little” item in the cash budget that you need to include. Hint: There is a “little” item in the cash budget that you need to include. © 2007 Pearson Custom Publishing

53. 53 Learning Objective 6: Describe the appropriate use of the operating budget in the overall management process. © 2007 Pearson Custom Publishing

54. 54 Using the Budget The budget has an impact on all areas of management performance. The budget has an impact on all areas of management performance. Preparing the budget is part of the planning process. Preparing the budget is part of the planning process. Day-to-day efforts to achieve budgeted amounts are part of the operating process. Day-to-day efforts to achieve budgeted amounts are part of the operating process. Comparison of actual results with budgeted results is part of the control process. Comparison of actual results with budgeted results is part of the control process. © 2007 Pearson Custom Publishing

55. 55 Performance to Budget Evaluation A major part of the control function of management is the performance to budget evaluation. A major part of the control function of management is the performance to budget evaluation. The main instrument used in this evaluation is the budget performance report. This report indicates any variances between actual results and budgeted results. The main instrument used in this evaluation is the budget performance report. This report indicates any variances between actual results and budgeted results. © 2007 Pearson Custom Publishing

56. 56 The Cap Company Budget Report Assume the following results for The Cap Company for the first quarter of 2007. Assume the following results for The Cap Company for the first quarter of 2007. © 2007 Pearson Custom Publishing

57. 57 Three Truths About Budgeting Since all of the budgets are interrelated and all of the budgets stem from the sales forecast, there are three truths about budgeting that should be kept in mind: Since all of the budgets are interrelated and all of the budgets stem from the sales forecast, there are three truths about budgeting that should be kept in mind: 1. If the sales forecast is inaccurate, the operating budget will be inaccurate. 1. If the sales forecast is inaccurate, the operating budget will be inaccurate. 2. The sales forecast will be inaccurate. 2. The sales forecast will be inaccurate. 3. The operating budget will be inaccurate. 3. The operating budget will be inaccurate. © 2007 Pearson Custom Publishing

58. 58 End of Chapter M8 © 2007 Pearson Custom Publishing