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CHAPTER 10CHAPTER 10CHAPTER 10CHAPTER 10

Using Budgets for Planning and Coordination

Using Budgets for Planning and Coordination

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Budgets and Budgeting Budgets and Budgeting ProcessProcess

Budgets and Budgeting Budgets and Budgeting ProcessProcess

Formal documents that quantify a company’s plans for achieving its goals

Budgeting process enhances communication and coordination by forcing managers to consider their goals and objectives carefully and specify means of achieving goals and objectives.

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The Master BudgetThe Master BudgetThe Master BudgetThe Master Budget

The master budget includes: Sales budget Production budget Direct materials purchases budget Direct labor budget Manufacturing overhead budget Selling and administrative expense budget Capital acquisitions budget Cash budget

See handout for details.

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Master BudgetMaster BudgetMaster BudgetMaster Budget

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Sales BudgetSales BudgetSales BudgetSales Budget

First budget prepared since most budgets cannot be prepared without an estimate of sales P6 in handout: Bottled Water Company

part 1

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Production BudgetProduction BudgetProduction BudgetProduction Budget Quantity to be produced based on

following formula:

Expected sales in unitsAdd: Desired ending inventory of finished goodsSubtract: Beginning inventory of finished unitsEquals Finished units to be produced

Desired ending inventory of finished goods becomes beginning inventory for the next period

Bottled Water Company part 2

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Direct Material Purchases Direct Material Purchases BudgetBudget

Direct Material Purchases Direct Material Purchases BudgetBudget

Depends upon amount needed for production and ending inventory The following formula can be used:

Bottled Water Company part 3

Materials required for productionAdd: Desired ending inventory of direct materialsSubtract: Beginning inventory of direct materials= Required purchases of direct materials

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Budgeted production: Q1= 50,000; Q2= 60,000Parts/unit= 3 , cost/part= $5 Ending inventory = 20% of next month’s production

Number of parts required for Q1 production is:a. 50,000b. 150,000c. 60,000d. 180,000

Answer: bQ1 production 50,000 x 3 parts/unit = 150,000

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Budgeted production: Q1= 50,000; Q2= 60,000Parts/unit= 3, cost/part= $5 Ending inventory = 20% of next month’s required parts

Desired ending inventory of parts for Q1 in units is:a. 10,000b. 12,000c. 30,000d. 36,000

Answer: dQ2 parts = 60,000 x 3 = 180,000 x 20% = 36,000

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Budgeted production: Q1= 50,000; Q2= 60,000Parts/unit= 3, cost/per part= $5Ending inventory = 20% of next month’s required partBeginning parts inventory, Q1= 30,000 units

Budgeted cost of purchases for Q1 is:a. $750,000b. $900,000c. $780,000d. $1,650,000

Answer: c150,000 (review 2) + 36,000 (review 3) – 30,000 =156,000 parts to purchase x $5 cost = $780,000

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Direct Labor BudgetDirect Labor BudgetDirect Labor BudgetDirect Labor Budget

Direct labor cost can be budgeted using the following formulas:- Units to be produced* direct labor

hours per unit * labor rate Bottled Water Company part 4 (no

calculation required)

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Manufacturing Overhead Manufacturing Overhead BudgetBudget

Manufacturing Overhead Manufacturing Overhead BudgetBudget

Separate costs into fixed and variable: Variable costs

cost/unit * units produced Fixed costs

- Identical each period except for depreciation

- Depreciation may vary due to planned acquisitions or disposals

- Bottled Water Company part 5 (no calculation required)

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Selling & Administrative Expenses Selling & Administrative Expenses BudgetBudget

Selling & Administrative Expenses Selling & Administrative Expenses BudgetBudget

Separate costs into fixed and variable: Variable costs

cost/unit * units sold Fixed costs

- Identical each period

- Bottled Water Company part 6 (no calculation required)

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Budgeted Income Budgeted Income StatementStatement

Budgeted Income Budgeted Income StatementStatement

Compilation of information provided by previously prepared budgets:

Sales from Sales Budget Cost of goods sold calculated from:

- Direct Materials Budget- Direct Labor Budget- Manufacturing Overhead Budget

Other expenses from Selling and Administrative Expense Budget

Bottled Water Company part 8 ((no calculation required))

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Capital Acquisitions BudgetCapital Acquisitions BudgetCapital Acquisitions BudgetCapital Acquisitions Budget

Decisions with respect to long lived assets- Use present value concepts to make

capital acquisition decisions Must be carefully planned since it

may substantially reduce cash reserves

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Cash Receipts and Cash Receipts and Disbursements BudgetDisbursements Budget

Cash Receipts and Cash Receipts and Disbursements BudgetDisbursements Budget

Managers must plan for amount and timing of cash flows

Careful planning of receipts and disbursements necessary to:- Anticipate cash shortages and

arrange to borrow funds- Anticipate cash surpluses and seek

productive uses

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Estimate Cash Collections and Estimate Cash Collections and Cash DisbursementsCash Disbursements

Estimate Cash Collections and Estimate Cash Collections and Cash DisbursementsCash Disbursements

Cash collections- Estimate % of credit sales collected in the

period of sale and subsequent periods

Cash disbursements- Estimate % of materials purchases paid in

the period of purchase and subsequent periods

Handout: E10-11 & 12; E10-13 & 14

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Budgeted Balance SheetBudgeted Balance SheetBudgeted Balance SheetBudgeted Balance Sheet

Last component of master budget prepared

Sometimes referred to as the pro forma balance sheet

Used to assess the effect of planned decisions on the future financial position of the firm

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Budgetary ControlBudgetary ControlBudgetary ControlBudgetary Control

Budgets as a Standard for Evaluation

- The standard is the budgeted amount- Standards for DM and DL are usually set up at

unit level

- Differences between budgeted and actual amounts are called budget variances

- Budget variances should be investigated when they are material

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Investigating Budget Investigating Budget VariancesVariances

Investigating Budget Investigating Budget VariancesVariances

Variances are differences between budgeted and actual amounts

Causes of Budget Variances- Budget may not have been well

conceived- Conditions may have changed- Managers may have performed

particularly well or poorly

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A General Approach to A General Approach to Variance AnalysisVariance Analysis

A General Approach to A General Approach to Variance AnalysisVariance Analysis

Variance analysis: an analysis of the difference between a standard and an actual cost. The process breaks down the difference into two components: price (spending) and quantity (efficiency) variance.

Direct material variances- Material price variance- Material quantity variance

Direct labor variances- Labor rate variance-Labor efficiency variance

Manufacturing overhead variances- Controllable overhead variance- Overhead volume variance

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A General Approach to A General Approach to Variance AnalysisVariance Analysis

A General Approach to A General Approach to Variance AnalysisVariance Analysis

AQ = Actual quantity SQ = Standard quantity allowed for actual outputAP = Actual price SP = Standard price

StandardCost

SQ X SP

Price variance Quantity variance

Actual CostAQ X AP

Actual Quantityat Standard Price

AQ X SP

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Material VariancesMaterial VariancesMaterial VariancesMaterial Variances

AQp X SP

AQp = Actual quantity purchasedAQu = Actual quantity usedAP = Actual priceSQ = Standard quantity allowed for actual outputSP = Standard price

Purchased Used

Actual Quantityat Standard Price

AQu X SP

StandardCost

SQ X SP

Price variance Quantity variance

Actual Cost ofMaterial Purchased

AQp X AP

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Material VariancesMaterial VariancesMaterial VariancesMaterial Variances Standard for 1 unit: 400 lbs @ $10 per lb Materials purchased: 200,000 lbs @ $9.90 per lb Materials used: 181,000 lbs to produce 450 units

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Data for chips used in the production of computersStandard: 3 chips per computer @ $6.50 per chipQuantity purchased: 200 chips for total of $1,350 Quantity used: 123 chips for production of 40 units

Calculate the material price variance:

$1,350 - $1,300 = $50Unfavorable price variance

200 X $6.75$1,350

200 X $6.50$1,300

Actual Cost ofMaterial Purchased

AQp X AP

Actual Quantity of Material Purchased at Standard Price

AQp X SP

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Data for chips used in the production of computersStandard: 3 chips per computer @ $6.50 per chipQuantity purchased: 200 chips for $1,350 totalQuantity used: 123 chips for production of 40 units

Calculate the material quantity variance:

$800 - $780 = $20Unfavorable quantity variance

Actual Quantity of Material Used at Standard Price

AQu X SPStandard Cost

SQ X SP123 X $6.50

$800(40 X 3) X $6.50

$780

Learning objective 2: Calculate and interpret variances for direct material

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Direct Labor VariancesDirect Labor VariancesDirect Labor VariancesDirect Labor Variances

AQ = Actual quantity of labor usedAP = Actual labor rate per hourSP = Standard labor rate per hourSQ = Standard quantity of labor allowed for actual output

Standard LaborCost

SQ X SP

Rate variance Efficiency variance

Actual Labor Cost

AQ X AP

Actual Quantity of Labor at Standard Price

AQ X SP

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A favorable labor efficiency variance means:a. Labor rates were higher than called for by

standardsb. Inexperienced labor was used, causing the

rate to be lower than standardc. More labor was used than called for by

standardsd. Less labor was used than called for by

standards

Answer: dLess labor was used than called for by standards

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Direct Labor VariancesDirect Labor VariancesDirect Labor VariancesDirect Labor Variances Standard for 1 unit: 4 hours @ $15 per hour Actual labor: 1,700 hours @ $15.50 per hour

to produce 450 units

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Data for labor used in the production of sneakersStandard: .25 hours per sneaker at $12.00 per hourActual quantity produced: 24,500 sneakersQuantity used: 6,000 hours, total cost $69,000

Calculate the labor rate variance:

$69,000 - $72,000 = ($3,000)Favorable rate variance

Actual LaborAH X AR

Actual Quantity of Labor at Standard Rate

AH X SR6,000 X $11.50

$69,0006,000 X $12.00

$72,000

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Data for labor used in the production of sneakersStandard: .25 hours per sneaker at $12.00 per hourActual quantity produced: 24,500 sneakersQuantity used: 6,000 hours, total cost $69,000

Calculate the labor efficiency variance:Actual Quantity of Labor at

Standard RateAH X SR

Standard Labor CostSH X SR

$72,000 - $73,500 = ($1,500)Favorable efficiency variance

6,000 X 12$72,000

(24,500 X .25) X $12.00$73,500

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““Favorable” Variances May Be Favorable” Variances May Be UnfavorableUnfavorable

““Favorable” Variances May Be Favorable” Variances May Be UnfavorableUnfavorable

A variance that is “favorable” should not be exempt from investigation. It could indicate poor management decision

E.g. Suppose inferior, low-priced materials are ordered. On one hand, a favorable price variance will arise. On the other hand, most likely there will be

substantially more scrap and rework, and thus a higher quantity variance.

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You Get What You Measure!You Get What You Measure!You Get What You Measure!You Get What You Measure!

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Incremental VS. Zero Base Incremental VS. Zero Base Budgeting (ZBB)Budgeting (ZBB)

Incremental VS. Zero Base Incremental VS. Zero Base Budgeting (ZBB)Budgeting (ZBB)

Incremental Budgeting: budgeting with a starting point from previous period revenues and costs (e.g. + or -10% )

ZBB requires budgeted amounts to be justified each period- Provides fresh consideration for

validity of budgeted amounts- Time consuming and expensive process- Not widely used by business

enterprises