Chapter 7

1. Chapter 7 The Budget Process

2. C7 Learning Objectives 1. What is the importance of the budgeting process? 2. How do the advantages and disadvantages of imposed budgets and participatory budgets compare?

3. C7 Continuing . . . Learning Objectives 3. Why does a budget manual facilitate the budgeting process? 4. What complicates the budgeting process in a multinational environment? 5. What is the starting point of a master budget and why is this item chosen?

4. C7 Continuing . . . Learning Objectives 6. How are the various master budget schedules prepared and how do they relate to one another? 7. Why is the cash budget so important in the master budgeting process?

5. C7 Continuing . . . Learning Objectives 8. How does the statement of cash flows relate to the income statement and the cash budget? 9. Why does actual revenue from a product differ from budgeted revenue? (Appendix)

6. C7 Continuing . . . Learning Objectives 10. How does traditional budgeting differ from zero-based budgeting? (Appendix)

7. Different Roles of Budgeting Process and Budgets • Planning • Motivation • Evaluation • Coordination • Communication • Education • Ritual

8. Participation in the Budgeting Process Imposed budgets Top Management Middle Management Participatory budgets Operational Management

9. Best Times to Use Imposed Budgets • In start-up organizations • In extremely small businesses • In times of economic crisis • When operating managers lack budgetary skills or perspective • When organizational units require precise coordination of efforts

10. Advantages of Imposed Budgets • Increase probability that organization’s strategic plans will be incorporated in planned activities • Enhance coordination among divisional plans and objectives • Use top management’s knowledge of overall resource availability • Reduce the possibility of input from inexperienced or uninformed lower-level employees • Reduce the time frame for the budgeting process

11. Disadvantages of Imposed Budgets • May result in dissatisfaction, defensiveness, and low morale among individuals who must work under the budget • Reduce the feeling of teamwork • May limit the acceptance of the stated goals and objectives • Limit the communication process among employees and management • May create a view of the budget as a punitive device • May result in unachievable budgets for international divisions if local operating and political environments are not adequately considered • May stifle the initiative of lower-level managers

12. Best Times to UseParticipatory Budgets • In well-established organizations • In extremely large businesses • In times of economic affluence • When operating managers have strong budgetary skills and perspectives • When organizational units are quite autonomous

13. Advantages of Participatory Budgets • Provide information from persons most familiar with the needs and constraints of organizational units • Integrate knowledge that is diffused among various levels of management • Lead to better morale and higher motivation • Provide a means to develop fiscal responsibility and budgetary skills of employees • Develop a high degree of acceptance of and commitment to organizational goals and objectives by operating management

14. Continuing . . . Advantages of Participatory Budgets • Are generally more realistic • Allow organizational units to coordinate with one another • Allow subordinate managers to develop operational plans that conform to organizational goals and objectives • Include specific resource requirements • Blend overview of top management with operating details • Provide a social contract that expresses expectations of top management and subordinates

15. Disadvantages ofParticipatory Budgets • Require significantly more time • Create a level of dissatisfaction with the process approximately equal to that occurring under imposed budgets in cases in which the effects of managerial participation are negated by top-management changes • Create an unachievable budget in cases in which managers may be ambivalent or unqualified to participate • May cause managers to introduce slack into the budget • May support “empire building” by subordinates • May start the process earlier in the year when there is more uncertainty about the future year

16. Budget Manual • Statements of the budgeting purpose and its desired results • A listing of specific budgetary activities to be performed • A calendar of scheduled budgetary activities • Sample budget forms • Original, revised, and approved budgets

17. Calendar Budget Period Year Quarter 1 Quarter 2 Quarter 3 Quarter 4 January February March April May June July August September October November December

18. The Master Budget A comprehensive set of an organization’s budgetary schedules and pro forma (projected) financial statements

19. Composition of the Master Budget Financial Budgets (dollars) Operating Budgets (units & dollars) Sales Budget Production Budget Purchases Budget Direct Labor Budget Overhead Budget Selling & Administrative Budget Cash Budget Capital Budget Schedule of Cost of Goods Manufactured Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows

20. Budget Example Sales budgets by month: January $200 February 300 March 400 Variable cost of goods sold will be 60 percent of sales dollars. Other variable costs will be 15 percent of sales dollars, paid one month later. Total fixed costs for the year will be $240, of which $10 per month is depreciation expense.

21. Balance Sheet, December 31, 19x0

22. Budgeted Income Statement for the Quarter Ending March 31, 19x1

23. Purchases Budget for the Three Months Ending March 31, 19x1

24. Cash Collections from Customers Collections are estimated to be 20 percent in the month of sale, 48 percent the month following, and 32 percent in the second month following. There are no uncollectible accounts.

25. Cash Receipts

26. Cash Disbursements for Purchases

27. Cash Disbursements–All Costs

28. Tentative Cash Budget

29. Minimum Cash Balance Policies Financial managers devote considerable attention to determining the needed minimum level of cash. As with most decisions, a trade off between two conflicting factors is involved. Too small a minimum balance would lead to a higher probability of running out of cash, while too large a minimum balance would lead to little or no return.

30. Continuing . . . Minimum Cash Balance Policies In this example, the desired minimum cash is $25,000. Cash can be borrowed in $5,000 increments at an interest rate of 12 percent per year.

31. Revised Cash Budget

32. Budgeted Income Statement for the Quarter Ending March 31, 19x1

33. Balance Sheet, March 31, 19x1

34. Total Revenue Variance Budgeted Sales (BSP x BV) Actual sales (ASP x AV) Total Revenue Variance* *Favorable or unfavorable

35. Sales Price Variance BSPx AV ASP x AV BSP x BV Sales Price Variance AV (ASP - BSP) * *Favorable or unfavorable

36. Sales Volume Variance BSP x AV ASP x AV BSP x BV Sales Volume Variance BSP (AV - BV) * *Favorable or unfavorable

37. Example The Maine Lobsters budget 1999 ticket sales at $70,000 per home game, which represent the sale of an estimated 10,000 tickets at a selling price of $7. At July’s first home game, actual gate ticket revenue was $66,000, creating a total unfavorable revenue variance of $4,000. The actual sales consisted of 12,000 tickets at $5.50.

38. Revenue Variance Calculations Total Revenue Variance equals: 70,000 - ($5.50 x 12,000) = $4,000 U Sales Price Variance equals: 12,000 x ($5.50 - $7.00) = $18,000 U Sales Volume Variance equals: $7.00 x (12,000 - 10,000) = $14,000 F

39. Traditional Budgeting • Starts with last year’s funding appropriation • Focuses on money • Does not systematically consider alternatives to current operations • Produces a single level of appropriation for an activity

40. Zero-Based Budgeting • Starts with a minimal (or zero) figure for funding • Focuses on goals and objectives • Directly examines alternative approaches to achieving similar results • Produces alternative levels of funding based on availability of funds and desired results