Chapter 9BUDGETING

A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms

Control Device & Planning Tool

BUDGETING BASICS Benefits of Budgeting

Requires all levels of management to plan ahead and formalize goals on a recurring basis

Provides definite objectives for evaluating performance at each level of responsibility

Creates an early warning system for potential problems

BUDGETING BASICS Benefits of Budgeting

Facilitates coordination of activities within the business

Results in greater management awareness of the entity’s overall operations and the impact of external factors

Motivates personnel throughout organization to meet planned objectives

BUDGETING BASICS Length of Budget Period

May be prepared for any period of time Most common - one year Supplement with monthly and quarterly

budgets Different budgets may cover different time

periods Continuous twelve-month budget

Drops the month just ended and adds a future month

This keeps management planning a full year ahead

BUDGETING BASICS Budgeting Process

Base budget goals on past performance

Collect data from organizational units

Begins several months before the end of the current year

Start with the Sales Budget

BUDGETING BASICS Budgeting Process

Factors considered in Sales Forecasting: General economic conditions Industry trends Market research studies Anticipated advertising and promotion Previous market share Price changes Technological developments

BUDGETING BASICS Budgeting Process

The budgeting process is usually informal in small companies

Assigned to a budget committee in larger companies

BUDGETING BASICS Budgeting and Human Behavior

Participative Budgeting

“bottom-to-top” approach is called

Participative BudgetingAdvantages:

Leads to more accurate budget estimates because lower level managers have more detailed knowledge of their area

Employees perceive the process as fair due to involvement of lower level management

Overall goal - produce a budget considered fair and achievable by managers while still meeting corporate goals

BUDGETING BASICS Budgeting and Human Behavior

Participative Budgeting

Disadvantages:

Can be time consuming and costly

Can foster budgetary “gaming” through budgetary slack

This is a situation where managers intentionally underestimate budgeted revenues or overestimate budgeted expenses so that budget goals are easier to meet

BUDGETING BASICS -The Master Budget

A set of interrelated budgets that constitutes a plan of action for a specified time period

Contains two classes of budgets:

Operating budgets:

Individual budgets that result in the preparation of the budgeted income statement

Financial budgets:The capital expenditures budget, the cash budget, and the budgeted balance sheet – focus primarily on cash needs to fund operations and capital expenditures

BUDGETING BASICS -The Master Budget - Components

OPERATING BUDGETS:Sales Budget

The sales budget is the first budget prepared

It is derived from the sales forecast The sales forecast is management’s

best estimate of sales revenue for the budget period

Every other budget depends on the sales budget

OPERATING BUDGETS:Sales Budget

Example – Hayes Company

Expected sales volume: 3,000 units in the first quarter with 500-unit increment increases for each following quarter

Sales price: $60 per unit

Hayes CompanySales Budget

For the Year Ending December 31, 2005

Expected unit salesUnit selling price

Total sales

1 3,000

x $60

$180,000

2 3,500

x $60

$210,000

3 4,000

x $60

$240,000

4 4,500

x $60

$270,000

Year 15,000

x $60

$900,000

Quarter

OPERATING BUDGETS:Production Budget

The production budget shows the units that must be produced to meet anticipated sales

It is derived from sales budget plus the desired finished goods

Required production in units formula:

OPERATING BUDGETS:Production Budget

Example – Hayes Company

Hayes Co. believes it can meet future sales needs with an ending inventory of 20% of next quarter’s sales

Hayes Company Production Budget

For the Year Ending December 31, 2005

Quarter 1 2 3 4 Year

Expected unit sales 3,000 3,500 4,000 4,500 Add: Desired ending finished goods units* 700 800 900 1,000 Total required units 3,700 4,300 4,900 5,500 Less: Beginning finished goods inventory ** 600 700 800 900 Required production units 3,100 3,600 4,100 4,600 15,400 *20% of next quarter’s sales **20% of estimated first-quarter 2005 sales

OPERATING BUDGETS:Direct Materials Budget

The direct materials budget shows both the quantity and cost of direct materials to be purchased

It is derived from the direct materials units required for production (from the production budget) and desired ending materials inventory

Budgeted cost of direct materials to be purchased = required units of direct materials X anticipated cost per unit

OPERATING BUDGETS:Direct Materials BudgetExample – Hayes Company

Desires an ending inventory of 10% of the next quarter’s production requirements

The manufacturing of each unit requires 2 pounds of raw materials at an expected price of $4 per pound

OPERATING BUDGETS:Direct Materials BudgetExample – Hayes Company

Hayes Company

Direct Materials Budget For the Year Ending December 31, 2005

Quarter

1 2 3 4 Year Units to be produced 3,100 3,600 4,100 4,600 Direct materials per unit x 2 x 2 x 2 x 2 Total pounds needed for production 6,200 7,200 8,200 9,200 Add: Desired ending direct materials* 720 820 920 1,020** Total materials required 6,920 8,020 9,120 10,220 Less: Beginning direct materials*** 620 720 820 920 Direct materials purchases 6,300 7,300 8,300 9,300 Cost per pound x $4 x $4 x $4 x $4 Total cost direct materials purchased $25,200 $29,200 $33,200 $37,200 $124,800 *10% of next quarter’s production requirements **Estimated 2006 first-quarter pounds need for production – 10,200 x 10% ***10% of estimated first-quarter pounds needed for production

OPERATING BUDGETS:Direct Labor Budget

The direct labor budget shows both the quantity of hours and cost of direct labor necessary to meet production requirements

The total direct labor cost formula is:

OPERATING BUDGETS:Direct Labor Budget

Example – Hayes Company Direct labor hours from the production budget

Two hours of direct labor required for each unit

Hourly wage rate $10

Hayes Company Direct Labor Budget

For the Year Ending December 31, 2005 Quarter 1 2 3 4 Year Units to be produced 3,100 3,600 4,100 4,600 Direct labor hours per unit x 2 x 2 x 2 x 2 Total required direct labor hours 6,200 7,200 8,200 9,200

Direct labor cost per hour x $10 x $10 x $10 x $10 Total direct labor cost $62,000 $72,000 $82,000 $92,000 $308,000

OPERATING BUDGETS:Manufacturing Overhead Budget

The manufacturing overhead budget shows the expected manufacturing overhead costs for the budget period

It distinguishes between fixed and variable overhead costs

Example – Hayes Company Fixed cost amounts are assumed

Expected variable costs per direct labor hour: Indirect materials: $1.00 Indirect labor: $1.40 Utilities: $0.40 Maintenance: $0.20

Hayes CompanyManufacturing Budget

For the Year Ending December 31, 2005

Variable Costs Indirect materials ($1.00 per DLH) Indirect labor ($1.40 per DLH) Utilities ($ .40 per DLH) Maintenance ($.20 per DLH) Total variableFixed costs Supervisory salaries Depreciation Property tax and insurance Maintenance Total fixedTotal manufacturing overhead

1 $ 6,200

8,6802,480

1,240 18,600

20,0003,8009,000

5,700 38,500

$57,100

Quarter

2 $ 7,20010,080

2,880 1,440 21,600

20,0003,8009,000

5,700 38,500

$60,100

3 $ 8,20011,480

3,280 1,640 24,600

20,0003,8009,000

5,700 38,500

$63,100

4 $ 9,20012,880

3,680 1,840 27,600

20,0003,8009,000

5,700 38,500

$66,100

9,200

8,2007,2006,200 30,800Direct Labor hours

Manufacturing overhead rate per direct labor hour ($246,400 30,800) $8.00

Year $ 30,800

43,12012,320

6,160 92,400

80,00015,20036,000

22,800 154,000

$246,400

OPERATING BUDGETS:Selling & Administrative Expense

Budget Is a projection of anticipated operating expenses Distinguishes between fixed and variable costs

Example – Hayes Company Fixed cost amounts are assumed

Expected variable costs per unit sold (from sales budget):

Sales commissions: $3.00

Freight-out: $1.00

Hayes CompanySelling & Administrative Budget

For the Year Ending December 31, 2005

Variable Costs Sales commissions ($3 per unit) Freight-out ($1 per unit) Total variableFixed costs Advertising Sales salaries Office Salaries Depreciation Property taxes and insuranceTotal Fixed Expenses

Total Selling/Admin. Expenses

1 $ 9,000

3,000 12,000

5,00015,000

7,5001,000

1,500 30,000

$42,000

Quarter

2

$ 10,500 3,500 14,000

5,00015,000

7,5001,000

1,500 30,000

$44,000

3 $ 12,000 4,000 16,000

5,00015,000

7,5001,000

1,500 30,000

$46,000

4 $ 13,500 4,500 18,000

5,00015,000

7,5001,000

1,500 30,000

$48,000

Year $ 45,000 15,000 60,000

20,00060,00030,000

4,000 6,000

120,000

$180,000

OPERATING BUDGETS:Budgeted Income Statement

The budgeted income statement is prepared from the operating budgets Sales Budget Production Budget Direct Materials Budget Direct Labor Budget Manufacturing Overhead Budget Selling and Administrative Expense Budget

FLEXIBLE BUDGETS

Projects budget data for various levels of activity

Essentially, a series of static budgets at different activity levels

The budgetary process is more useful if it is adaptable to changes in operating conditions

Flexible budgets can be prepared for each type of budget in the master budget

Flexible budgets are static budgets at different activity levels

DEVELOPING THE FLEXIBLE BUDGET

Steps

Identify the activity level and the relevant range of activity

Identify the variable costs and determine the budgeted variable cost per unit of activity for each cost

Identify the fixed costs and determine the budgeted amount for each cost

Prepare the budget for selected increments of the activity level within the relevant range

FLEXIBLE BUDGET – A CASE STUDYExample – Fox Manufacturing Co.

Monthly comparisons of actual and budgeted manufacturing overhead costs for Finishing Department

2007 master budget Expected annual operating capacity of 120,000 direct

labor hours Overhead costs:

FLEXIBLE BUDGET – A CASE STUDYExample – Fox Manufacturing Co.

Identify the activity level and the relevant range activity level: direct labor hours relevant range: 8,000 – 12,000 direct labor hours per

month

Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost

FLEXIBLE BUDGET – A CASE STUDYExample – Fox Manufacturing Co.

Identify the fixed costs and determine the budgeted amount for each cost Three fixed costs per month:

depreciation $15,000property taxes $5,000supervision $10,000

Prepare the budget for selected increments of activity within the relevant range Prepared in increments of 1,000 direct labor

hours

FLEXIBLE BUDGET – A CASE STUDYExample – Fox Manufacturing Co.

Formula to determine total budgeted costs from the budget at any level of activity:

* Total variable cost per unit X activity level

Determine total budgeted costs for Fox Manufacturing Company with fixed costs of $30,000 and total variable cost $4 per unit At 9,000 direct labor hours : $30,000 + ($4 X 9,000) = $66,000 At 8,622 direct labor hours: $30,000 + ($4 X 8,622) = $64,488