Chapter 9 BUDGETING

1. 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

2. BUDGETING BASICSBenefits of Budgeting • Requires all levels of management to plan aheadand formalize goals on a recurring basis • Providesdefinite objectivesfor evaluating performance at each level of responsibility • Creates anearly warning systemfor potential problems

3. BUDGETING BASICSBenefits of Budgeting • Facilitatescoordination of activitieswithin the business • Results ingreater management awarenessof the entity’s overall operations and the impact of external factors • Motivates personnelthroughout organization to meet planned objectives

4. BUDGETING BASICSLength of Budget Period • May be prepared forany 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

5. BUDGETING BASICSBudgeting 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

6. 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

7. BUDGETING BASICSBudgeting Process • The budgeting process is usually informal in small companies • Assigned to a budget committee in larger companies

8. BUDGETING BASICSBudgeting and Human BehaviorParticipative Budgeting “bottom-to-top” approach is called Participative Budgeting Advantages: • 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

9. BUDGETING BASICSBudgeting and Human BehaviorParticipative 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

10. 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

11. BUDGETING BASICS -The Master Budget - Components

12. 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

13. Hayes CompanySales BudgetFor the Year Ending December 31, 2005 Quarter Expected unit salesUnit selling price Total sales 13,000 x $60 $180,000 23,500 x $60 $210,000 34,000 x $60 $240,000 44,500 x $60 $270,000 Year15,000 x $60 $900,000 OPERATING BUDGETS:Sales BudgetExample – 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

14. 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:

15. OPERATING BUDGETS:Production BudgetExample – Hayes Company Hayes Co. believes it can meet future sales needs with an ending inventory of 20% of next quarter’s sales

16. 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

17. 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

18. OPERATING BUDGETS:Direct Materials BudgetExample – Hayes Company

19. OPERATING BUDGETS:Direct Labor Budget • The direct labor budget shows both the quantity of hours and cost of direct labornecessary to meet production requirements • The total direct labor cost formula is:

20. OPERATING BUDGETS:Direct Labor BudgetExample – Hayes Company • Direct labor hours from the production budget • Two hours of direct labor required for each unit • Hourly wage rate $10

21. OPERATING BUDGETS:Manufacturing Overhead Budget • The manufacturing overhead budget shows the expected manufacturing overhead costs for the budget period • It distinguishes between fixedandvariable 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

22. Manufacturing overhead rate per direct labor hour ($246,400  30,800) $8.00 Hayes CompanyManufacturing BudgetFor the Year Ending December 31, 2005 Quarter 1 $ 6,2008,6802,480 1,240 18,60020,0003,8009,000 5,700 38,500 $57,100 2 $ 7,20010,0802,880 1,440 21,60020,0003,8009,000 5,700 38,500 $60,100 3 $ 8,20011,4803,280 1,640 24,60020,0003,8009,000 5,700 38,500 $63,100 4 $ 9,20012,8803,680 1,840 27,60020,0003,8009,000 5,700 38,500 $66,100 Year $ 30,80043,12012,320 6,160 92,40080,00015,20036,000 22,800 154,000 $246,400 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 fixed Total manufacturing overhead Direct Labor hours 6,200 7,200 8,200 9,200 30,800

23. OPERATING BUDGETS:Selling & Administrative Expense Budget • Is a projection of anticipated operating expenses • Distinguishes between fixed and variablecosts 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

24. Year$ 45,000 15,000 60,00020,00060,00030,0004,000 6,000 120,000 $180,000 1 $ 9,000 3,000 12,0005,00015,0007,5001,000 1,500 30,000 $42,000 2 $ 10,500 3,500 14,0005,00015,0007,5001,000 1,500 30,000 $44,000 3 $ 12,000 4,000 16,0005,00015,0007,5001,000 1,500 30,000 $46,000 4 $ 13,500 4,500 18,0005,00015,0007,5001,000 1,500 30,000 $48,000 Hayes CompanySelling & Administrative BudgetFor the Year Ending December 31, 2005 Quarter Variable Costs Sales commissions ($3 per unit) Freight-out ($1 per unit) Total variableFixed costs Advertising Sales salaries Office Salaries Depreciation Property taxes and insurance Total Fixed Expenses Total Selling/Admin. Expenses

25. 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

26. 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

27. DEVELOPING THE FLEXIBLE BUDGETSteps • 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

28. 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:

29. 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

30. 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 $15,000 property taxes $5,000 supervision $10,000 • Prepare the budget for selected increments of activity within the relevant range • Prepared in increments of 1,000 direct labor hours

31. 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