1. Financial Planning and Analysis: The Master Budget
Chapter 9
Financial Planning and Analysis: The Master Budget
Chapter 9: Financial Planning and Analysis: The Master Budget
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2. Financial Planning and Analysis (FP&A) Systems
A financial planning and analysis (FP&A) system helps managers assess the company’s future and know if they are reaching their performance goals. A complete FP&A system includes subsystems for (1) planning, (2) measuring and recording results, and (3) evaluating performance.
The planning component of the FP&A system is called the master budget. It is intended to help ensure that plans are consistent and yield a result that makes sense for the organization.
A financial planning and analysis (FP&A) system helps managers assess the company’s future and know if they are reaching their performance goals. A complete FP&A system includes subsystems for (1) planning, (2) measuring and recording results, and (3) evaluating performance.
The planning component of the FP&A system is called the master budget. It is intended to help ensure that plans are consistent and yield a result that makes sense for the organization. (LO1)
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3. Purposes of Budgeting Systems
a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a specified period of time.
Planning
Facilitating Communication and Coordination
Allocating Resources
Controlling Profit and Operations
Evaluating Performance and Providing Incentives
A budget is a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a specified period of time. The procedures used to develop a budget constitute a budgeting system. Budgeting systems have five primary purposes: (1) planning, (2) facilitating communication and coordination, (3) allocating resources, (4) controlling profit and operations and (5) evaluating performance and providing incentives. (LO2)
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4. Sales of Services or Goods
Ending
Inventory
Budget Work in Process
and Finished
Goods
Production
Budget
Ending
Inventory
Budget Direct Materials
Direct
Materials
Budget
Direct
Labor Budget
Overhead
Budget
Selling and
Administrative
Budget
Cash Budget
The master budget comprises many separate budgets, or schedules, that are interdependent. Based on the sales budget, a company develops a set of operational budgets that specify how its operations will be carried out to meet the demand for its goods or services. A manufacturing company develops a production budget, which shows the number of product units to be manufactured and ending inventory budgets. From the production budget, a manufacturer develops budgets for the direct materials, direct labor, and overhead that will be required in the production process. A budget for selling and administrative expenses also is prepared. The operational portion of the master budget is similar in a merchandising firm, but instead of a production budget for goods, a merchandiser develops a budget for merchandise purchases. A merchandising firm will not have a budget for direct materials. Based on the sales budget for its services, a service industry firm develops a set of budgets that show how the demand for those services will be met. Every business prepares a cash budget. This budget shows expected cash receipts, as a result of selling goods or services, and planned cash disbursements, to pay the bills incurred by the firm. The final portion of the master budget includes a budgeted income statement, a budgeted balance sheet, and a budgeted statement of cash flows. (LO3)
Budgeted Income Statement
Budgeted Balance Sheet
Budgeted Statement of Cash Flows
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5. Activity-Based Costing versus Activity-Based Budgeting
Resources
Resources
Activity-Based Costing (ABC)
Activities
Activities
Activity-Based Budgeting (ABB)
Cost objects: products and services produced, and customers served.
Applying ABC concepts to the budgeting process yields activity-based budgeting or ABB. Under ABB, the first step is to specify the products or services to be produced and the customers to be served. Then the activities that are necessary to produce these products and services are determined. Finally, the resources necessary to perform the specified activities are quantified. Conceptually, ABB takes the ABC model and reverses the flow of the analysis. ABC assigns resource costs to activities, and then it assigns activity costs to products and services produced and customers served. ABB, on the other hand, begins by forecasting the demand for products and services as well as the customers to be served. These forecasts then are used to plan the activities for the budget period and to allocate the resources necessary to carry out the activities. (LO4)
Forecast of products and services to be produced and customers served.
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6. Sales Budget
Breakers, Inc. is preparing budgets for the quarter ending June 30.
Budgeted sales for the next five months are:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units.
The selling price is $10 per unit.
We will prepare each type of budget that make up the master budget.
Breakers, Inc. is preparing budgets for the quarter ending June 30. The unit sales are projected for the months of April through August. The selling price per unit is budgeted at $10. (LO5)
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7. Sales Budget
The projected units are multiplied by $10 for each month to determine the budgeted revenue for the months of April, May, June and the quarter. (LO5)
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8. Production Budget
The management of Breakers, Inc. wants ending inventory to be equal to 20% of the following month’s budgeted sales in units.
On March 31, 4,000 units were on hand.
Let’s prepare the production budget.
Now that the sales budget is complete, the production budget can be prepared. The purpose of the production budget is to ensure that production meets budgeted sales and provides sufficient ending inventory. Production must be adequate to meet budgeted sales and provide for sufficient ending inventory.
Management has determined that the ending inventory should be equal to 20% of the sales for the following month. At the end of March, there were 4,000 units on hand. (LO6)
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9. Ending inventory becomes beginning inventory the next month
Production Budget
From sales
budget
Ending inventory becomes beginning inventory the next month
The number of units projected to be sold in the first month is obtained from the sales budget.
The desired ending inventory is calculated by multiplying the projected sales for the next month, May, by 20%. This is added to the projected sales to determine the units needed for April.
The ending inventory for the previous month, March, is deducted from the amount needed to determine the number of units that must be produced.
The ending inventory for the first month, April, becomes the beginning inventory for the second month. The May and June production budget are prepared in the same manner as April.
Sales in units for the quarter is the sum of April, May and June sales. Since the end of June is also the end of the quarter, the ending inventory for the quarter is the same as the ending inventory for June. Since the beginning of April is also the beginning of the quarter, the beginning inventory for the quarter is the same as April’s beginning inventory. Total units needed for the quarter is the sum of the sales units and the ending inventory. The beginning inventory is subtracted from the total units needed to arrive at the units to be produced for the quarter. (LO6)
March 31
ending inventory
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10. Direct-Material Budget
At Breakers, five pounds of material are required per unit of product.
Management wants materials on hand at the end of each month equal to 10% of the following month’s production.
On March 31, 13,000 pounds of material are on hand. Material cost $.40 per pound.
Let’s prepare the direct materials budget.
Five pounds for materials are required to produce one unit. Management has determined that direct materials ending inventory should be 10% of the next month’s production. There are 31,000 pounds of direct materials in March’s ending inventory. The cost is 40 cents per pound. (LO6)
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11. Direct-Material Budget
From our production
budget
The first row in the direct materials budget is the units to be produced each month and for the quarter. This information is obtained from the production budget.
For each month, the units to be produced needs to be multiplied by 5 pounds to determine the amount of direct materials needed in each month. The ending inventory for April is 10% of May’s direct material needs. The desired ending inventory for April is added to the production needs for April.
The beginning inventory is subtracted from the total direct material needed for the month to arrive at the materials to be purchased.
The calculations are the same for each month. As in the production budget, the ending inventory for the quarter is the same as the ending inventory for June and the beginning inventory for the quarter is the same as the beginning inventory in April. (LO6)
March 31
inventory
10% of the following
month’s production
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12. Direct-Material Budget
The ending direct material inventory for June requires a bit more explanation. The projections for July must be expanded to determine the production budget for July, which will provide the information necessary to calculate the materials needed for June’s ending inventory. (LO6)
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13. Let’s prepare the direct labor budget.
At Breakers, each unit of product requires 0.1 hours of direct labor.
The Company has a “no layoff” policy so all employees will be paid for 40 hours of work each week.
In exchange for the “no layoff” policy, workers agreed to a wage rate of $8 per hour regardless of the hours worked (No overtime pay).
For the next three months, the direct labor workforce will be paid for a minimum of 3,000 hours per month.
Let’s prepare the direct labor budget.
Each unit can be produced in one tenth of an hour. Breaker’s pays employees for 40 hours each week. The wage rate is $8 per hour and there is no overtime pay. Management has projected that direct laborers will be paid for a minimum of 3,000 hours per month for the next three months. (LO5)
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14. labor hours required or labor hours guaranteed.
Direct-Labor Budget
The direct labor budget starts with the units to be produced from the production budget.
The production for each month and the quarter is multiplied by one tenth of an hour to determine the labor hours required.
The labor hours required is compared to the number of guaranteed labor hours. The labor hours to be paid is the greater of the two for each month. The labor hours to be paid for the quarter is the sum of the labor hours paid for the three months.
The labor hours paid is multiplied by the $8 wage rate to determine the total direct labor cost. (LO5)
From our
production
budget
This is the greater of
labor hours required or
labor hours guaranteed.
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15. Here is Breakers’ Overhead Budget for the quarter.
The manufacturing-overhead budget shows the cost of overhead expected to be incurred in the production process during the budget period. Breaker’s manufacturing overhead budget lists the expected cost of each overhead item by month. At the bottom of the schedule, the total budgeted overhead for each month is shown. (LO5)
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16. Selling and Administrative Expense Budget
At Breakers, variable selling and administrative expenses are $0.50 per unit sold.
Fixed selling and administrative expenses are $70,000 per month.
The $70,000 fixed expenses include $10,000 in depreciation expense that does not require a cash outflow for the month.
Management at Breaker’s has projected the variable selling and administrative expenses to by 50 cents per unit sold. The fixed selling and administrative costs are projected to be $70,000 per month. Each month, $10,000 of the fixed expenses is for depreciation, which does not require a cash outflow. This information will be important when the cash disbursements budget is prepared. (LO5)
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17. Selling and Administrative Expense Budget
Once again, we start with the unit sales for each month and the quarter from the sales budget.
The sales for each month and the quarter are multiplied by the variable selling and administrative cost rate of 50 cents per unit to determine the variable S&A costs. This is added to the fixed S&A costs of $70,000 for each month to arrive at the total S&A expenses for each month. Don’t forget that the fixed S&A expenses for the quarter is the sum of fixed S&A expenses for the three months.
The noncash expenses are deducted from the total expenses to determine the amount of cash disbursements required for each month and the quarter for selling and administrative expenses. (LO5)
From our
Sales budget
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18. Cash Receipts Budget At Breakers, all sales are on account.
The company’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following the sale,
5% is uncollected.
The March 31 accounts receivable balance of $30,000 will be collected in full.
All sales at Breakers are on account. The company has experienced the following collection pattern: 70% collected in the month of the sale, 25% is collected in the month following the sale, 5% becomes uncollectible. The accounts receivable balance at the end of March is $30,000 and is expected to be collected in full in April. (LO5)
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19. Cash Receipts Budget
During April, the remainder of March’s sales will be collected, which is the $30,000 accounts receivable balance on March % of April’s sales are also expected to be collected in April. Therefore, the total collections expected in April is $170,000.
May’s collections will be 25% of April’s sales and 70% of May’s sales. June’s collections will be 25% of May’s sales and 70% of June’s sales. The collections for the quarter is the sum of the collections for the three months. (LO5)
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20. Cash Disbursement Budget
Breakers pays $0.40 per pound for its materials.
One-half of a month’s purchases are paid for in the month of purchase; the other half is paid in the following month.
No discounts are available.
The March 31 accounts payable balance is $12,000.
Breakers pays 40 cents per pound for its materials. The company pays for half of its materials purchases in the month of the purchase and the remaining half is paid for in the following month. There are no discounts available to Breakers. The balance in accounts payable is $12,000 at the end of March. (LO5)
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21. Cash Disbursement Budget
The purchases for each month is multiplied by 40 cents per pound to determine the cost of materials purchased for the month. This cost is then multiplied by 50%. 50% of April’s materials purchases will be paid for in April, the remaining 50% will be paid in May. This pattern is followed in May and June to determine the cash disbursements for materials for each month.
The cash disbursements for each month are added together to determine the cash disbursements for the quarter. (LO5)
140,000 lbs. × $.40/lb. = $56,000
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22. Cash Disbursement Budget
Breakers:
Maintains a 12% open line of credit for $75,000.
Maintains a minimum cash balance of $30,000.
Borrows and repays loans on the last day of the month.
Pays a cash dividend of $25,000 in April.
Purchases $143,700 of equipment in May and $48,300 in June paid in cash.
Has an April 1 cash balance of $40,000.
Breakers will also make cash disbursements for payments on an open line of credit, loans, a cash dividend, and equipment purchases. All borrowings and repayments occur on the last day of each month. (LO5)
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23. Cash Budget (Collections and Disbursements)
From our Cash
Receipts Budget
From our Cash Disbursements
Budget
From our Direct Labor Budget
From our Overhead Budget
From our Selling and Administrative Expense Budget
The cash budget is a combination of the cash receipts budget, the cash disbursements for materials budget and other cash disbursements required, such as for direct labor and overhead. The cash budget starts with the beginning cash balance for April. This is also the beginning cash balance for the quarter. The cash collections for the month are found on the cash receipts budget and added to the beginning cash balance to arrive at the total cash available.
The cash outflow for materials is found on the cash disbursements budget.
The cash outflow for wages can be found on the direct labor budget.
Cash outflow requirements for manufacturing overhead can be found on the overhead budget.
Cash outflow for S&A costs can be found on the selling and administrative expense budget.
There are no equipment purchases made in April, but dividends are paid. The disbursements are totaled and them subtracted from the total cash available for the month. In April, there is a cash deficit. (LO5)
To maintain a cash
balance of $30,000,
Breakers must borrow
$35,000 on its line of credit.
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24. Cash Budget (Collections and Disbursements)
Breakers must
borrow an
addition $13,800
to maintain a
cash balance
of $30,000.
Cash collections and disbursements are determined in the same manner for the month of May. Although there is not a cash deficit at the end of May, the $16,200 available is still below the $30,000 minimum balance requirement by $13,800. (LO5)
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25. Cash Budget (Collections and Disbursements)
At the end of June, Breakers has enough cash to repay
the $48,800 loan plus interest at 12%.
June’s collections and disbursements budget follows the same format. There will be enough cash at the end of June to repay the amounts borrowed in April and May plus the 12% interest. (LO5)
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26. Cash Budget (Collections and Disbursements)
The beginning cash balance for the quarter is April’s beginning cash balance. The cash collections for the quarter are added to determine the total cash available for the quarter. Each item’s cash disbursements are totaled for the quarter and then added together to determine the total cash disbursements for the quarter. The disbursements for the quarter are then deducted from the collections for the quarter. There is a $37,200 cash surplus for the quarter. (LO5)
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27. Cash Budget (Financing and Repayment)
Ending cash balance for April
is the beginning May balance.
Now let’s discuss the financing and repayment needs.
Because there is a cash deficit in April, Breakers must borrow $35,000 to maintain the $30,000 minimum balance required. The ending cash balance for April becomes the beginning cash balance for May.
Cash collections and disbursements are determined in the same manner for the month of May. Although there is not a cash deficit at the end of May, the $16,200 available is still below the $30,000 minimum balance requirement by $13,800; therefore, Breakers must borrow an additional $13,800 at the end of May to have a $30,000 cash balance for the beginning of June.
The $35,000 borrowed at the end of April requires a $700 interest payment and the $13,800 borrowed at the end of May requires an interest payment of $138. The total to be repaid for principle and interest is $49,638. The ending cash balance for June is also the ending cash balance for the quarter.
The borrowings for the quarter is the sum of the borrowings in April and May. The repayments and interest for the quarter occurred in June. The ending cash balance for the quarter is the ending cash balance for June since the end of June is also the end of the quarter. (LO5)
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28. Cost of Goods Manufactured
The cost of goods manufactured schedule is prepared from the direct materials budget, the direct labor budget and the overhead budget. The ending work-in-process inventory amounts are estimates provided by management. The amounts for direct materials are in dollars, not units. The direct materials beginning inventory, purchases, and ending inventory amounts were taken from the direct materials budget. These amounts were multiplied by the cost of 40 cents per pound to arrive at the dollar amounts. (LO6)
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29. Cost of Goods Sold
The cost of goods sold schedule starts where the cost of goods manufactured left off. The cost of goods manufactured at the beginning of April can be divided by the units manufactured, 26,000, to arrive at a unit cost of $ The 4,000 units in finished goods inventory at the beginning of April is multiplied by the unit cost to determine the beginning inventory cost. The ending inventory for each month is also multiplied by $4.60 to determine the cost of the ending inventory. Remember, the ending inventory for one month becomes the beginning inventory for the following month. The beginning inventory for the quarter is the same as the beginning inventory for April and the ending inventory for the quarter is the same as the ending inventory for June. (LO6)
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30. Budgeted Income Statement
Now that the cost of goods manufactured and cost of goods sold schedules are complete, the budgeted income statement can be prepared.
A budgeted income statement for the quarter ending June 30 can now be prepared for Breakers. Revenue is taken from the sales budget. Cost of goods sold is taken from the cost of goods sold schedule. Gross margin is revenue less cost of goods sold. The operating expenses is taken from the selling and administrative expense budget and the cash budget. Net income is gross margin less total operating expenses. (LO5)
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31. Budgeted Statement of Cash Flows
The information for the budgeted statement of cash flows can be taken from the cash budget. (LO5)
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32. Budgeted Balance Sheet
Breakers reports the following account balances on March 31 prior to preparing its budgeted financial statements for June 30:
Land - $50,000
Building (net) - $148,000
Common stock - $217,000
Retained earnings - $46,400
Account balances for property, plant, and equipment and stockholders’ equity accounts are needed before preparing the budgeted balance sheet. (LO6)
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33. 25%of June sales of $300,000 11,500 lbs. at $.40 per lb.
5,000 units at
$4.60 per unit.
50% of June
purchases
of $56,800
The budgeted balance sheet is prepared for the date June 30. Cash is taken from the cash budget or the budgeted statement of cash flows. Accounts receivable is 25% of June sales. (Recall the collections pattern from the cash collections schedule.) The raw materials, work-in-process, and finished goods inventory amounts can be taken from the cost of goods manufactured and costs of goods sold schedules. The amount for equipment can be taken from the cash disbursements budget or the budgeted statement of cash flows.
The accounts payable balance is 50% of June’s purchases for direct materials. (Recall the cash disbursements pattern for direct materials.) The ending retained balance is the beginning balance plus net income less dividends paid. (LO6)
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34. Sales of Services or Goods
Ending
Inventory
Budget Work in Process
and Finished
Goods
Production
Budget
When the interactions of the elements of the master budget are expressed as a set of mathematical relations, it becomes a financial planning model that can be used to answer “what if” questions about unknown variables.
Ending
Inventory
Budget Direct Materials
Direct
Materials
Budget
Direct
Labor Budget
Overhead
Budget
Selling and
Administrative
Budget
Cash Budget
Managers must make assumptions and predictions in preparing budgets because organizations operate in a world of uncertainty. One way of coping with that uncertainty is to supplement the budgeting process with a financial planning model. A financial planning model is a set of mathematical relationships that express the interactions among the various operational, financial, and environmental events that determine the overall results of an organization’s activities. A financial planning model is a mathematical expression of all the relationships expressed in a master budget flow chart. In a fully developed financial planning model, all of the key estimates and assumptions are expressed as general mathematical relationships. Then the model is run on a computer many times to determine the impact of different combinations of these unknown variables. “What if” questions can be answered about such unknown variables as inflation, interest rates, the value of the dollar, demand, competitors’ actions, union demands in forthcoming wage negotiations, and a host of other factors. The widespread availability of personal computers and electronic-spreadsheet software has made financial planning models a more common management tool. (LO7)
Budgeted Income Statement
Budgeted Balance Sheet
Budgeted Statement of Cash Flows
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35. Budget Administration
The Budget Committee is a standing committee responsible for . . .
overall policy matters relating to the budget.
coordinating the preparation of the budget.
In small organizations, the procedures used to gather information and construct a master budget are usually informal. In contrast, larger organizations use a formal process to collect data and prepare the master budget. Such organizations usually designate a budget director or chief budget officer, which is often the controller. A budget committee, consisting of key senior executives, often is appointed to advise the budget director during the preparation of the budget. This committee is responsible for policy matters relating to the budget and coordinating the preparation of the budget. The authority to give final approval to the master budget usually belongs to the board of directors. By exercising its authority to make changes in the budget and grant final approval, the board of directors can have considerable influence on the overall direction the organization takes.
E-budgeting is an increasingly popular, Internet-based budgeting tool that can help streamline and speed up an organization’s budgeting process. The e in e-budgeting stands for both electronic and enterprisewide; employees throughout an organization, at all levels and around the globe, can submit and retrieve budget information electronically via the Internet. Managers in organizations using e-budgeting have found that it greatly streamlines the entire budgeting process. In the past, these organizations have compiled their master budgets on hundreds of spreadsheets, which had to be collected and integrated by the corporate controller’s office. (LO8)
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36. Behavioral Impact of Budgets
Budgetary Slack: Padding the Budget
People often perceive that their performance will look better in their superiors’ eyes if they can “beat the budget.”
When a supervisor provides a departmental cost projection for budgetary purposes, there is an incentive to overestimate costs. When the actual cost incurred in the department proves to be less than the inflated cost projection, the supervisor appears to have managed in a cost-effective way. At least that is the perception of many managers, and, in the behavioral area, perceptions are what count most. These illustrations are examples of padding the budget. Budget padding means underestimating revenue or overestimating costs. The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack. (LO9)
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37. Participative Budgeting
Most people will perform better and make greater attempts to achieve a goal if they have been consulted in setting the goal. The idea of participative budgeting is to involve employees throughout an organization in the budgetary process. Such participation can give employees the feeling that “this is our budget,” rather than the all-too-common feeling that “this is the budget you imposed on us.” While participative budgeting can be very effective, it also can have shortcomings. Too much participation and discussion can lead to uncertainty and delay. Also, when those involved in the budgeting process disagree in significant and irreconcilable ways, the process of participation can accentuate those differences. Finally, the problem of budget padding can be severe unless incentives for accurate projections are provided. (LO9)
Flow of Budget Data
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