College of San Mateo

Accounting 131

Rosemary Nurre


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Chapter 9

 Profit Planning

 Learning Objectives

1. Understand why organizations budget and the processes they use to create budgets.
2. Prepare a sales budget, including a schedule of expected cash receipts.
3. Prepare a production budget.
4. Prepare a direct materials budget, including a schedule of expected cash disbursements.
5. Prepare a direct labor budget.
6. Prepare a manufacturing overhead budget.
7. Prepare an ending finished goods inventory budget.
8.Prepare a selling and administrative expense budget.
9. Prepare a cash budget.
10. Prepare a budgeted income statement and a budgeted balance sheet.
Lecture Notes

A. The Basic Budgeting Framework. A budget is a detailed plan outlining the acquisition and use of financial and other resources over a specified time period.

1. Planning and control. A good budgeting system must provide for both planning and control. Planning involves developing objectives and preparing various budgets to achieve those objectives. Control involves the steps taken by management to ensure that the objectives set down at the planning stage are attained and that all parts of the organization work together towards those objectives.

2.Advantages of budgeting. There are many advantages to budgeting, including:

  • Budgeting provides managers with a vehicle for communicating their plans in an orderly way throughout the entire organization.
  • Budgeting requires managers to give planning top priority.
  • Budgeting provides a means of allocating resources to those parts of the organization where they can be most effectively used.
  • Budgeting uncovers potential bottlenecks before they occur.
  • Budgeting coordinates the activities of the entire organization by integrating the plans and objectives of the various parts.
  • Budgets provide benchmarks for evaluating subsequent performance.

3. Responsibility accounting. A manager should be held responsible for those items of revenues and costs-and only those items-that the manager can actually control to a significant extent. The manager who is held responsible for a specific cost should have a budget specifying a limit on how much can be spent. This limit may be adjusted, depending upon the activity during the period. This idea will be developed in later chapters.

4. Choosing a budget period. Budget periods vary in length. Some may be as short as a month, whereas others may cover many years. The most common budgeting period, however, is a year.

  • Operating budgets ordinarily cover a one-year period. Additionally, many companies divide their operating budgets into quarterly or monthly periods.
  • A continuous or perpetual budget is one that covers a 12-month period but which adds a new month on the end as the current month is completed. This approach stabilizes the planning horizon at one year.

 5. Self-imposed participative budget. The most successful budget programs involve lower-level managers in preparing their own budgets. There are two basic reasons: 1) lower-level managers are more familiar with the details of their own operations than top managers and 2) managers tend to be more committed to budgets that they have been able to influence.

6. Human relations. Management must keep clearly in mind that budgeting involves coordinating and motivating people and the human dimension is of primary importance.

  • Top managers must clearly convey the message in actions as well as in words that budgeting is important. If top management appears to be ambivalent about the benefits of budgeting, others in the organization will be reluctant to commit their own time and energy to the budgeting process.
  • If there is a preoccupation with getting every dollar and cent right or with placing blame, the budgeting process will be resented and managers will attempt to "game the system." Budgets should not be used as a club. They should be a way of ensuring that everyone understands what is expected. Significant deviations from the budget should be investigated so that managers understand changing conditions and their implications for the organization. Managers should not ordinarily be punished for deviations from the budget.

B. Preparing the Master Budget. The master budget consists of a number of separate, but interrelated budgets. The interrelationships among these various budgets are illustrated in Exhibit 9-2 in the text. Schedules 1 through 10 in the text present a comprehensive example of a master budget.

 NOTE: Budgets in large organizations can be very complex. The budgets in the text are substantially simplified. Even so, these simplified budgets are quite intricate and the level of detail may appear overwhelming. Each step in the process is fairly simple, but the budgets must fit together. Return to Exhibit 9-2 from time to time to provide the context for each of the separate budgets making up the master budget.

1. The Sales Budget (Schedule 1 in the text). The sales budget is a detailed schedule showing the expected sales for the coming period. It is typically expressed in both dollars and units of the product. The sales budget is usually accompanied by a schedule of expected cash receipts. The schedule of expected cash collections should take into account delays in collecting credit sales.

2. The Production Budget (Schedule 2 in the text). The budgeted production for each period can be determined by adding together the budgeted sales and the desired ending inventory and then subtracting the beginning inventory. The desired ending inventory in units for each period is usually a predetermined percentage of budgeted unit sales for the following period. The production budget is typically expressed in terms of physical units rather than in dollars.

In a merchandising firm, a merchandise purchases budget would replace the production budget. The merchandise purchases budget shows the amount of goods to be purchased from suppliers each period. This can be determined by adding together the budgeted sales and the desired ending inventory and then subtracting the beginning inventory. As in a manufacturing firm, the desired ending inventory in units is usually some predetermined percentage of the unit sales for the following period.

 3. The Direct Materials Budget (Schedule 3 in the text). Once production needs have been determined, a direct materials budget should be prepared. This budget details the materials that will be required to fulfill the production budget and to ensure adequate inventory levels. Sufficient amounts of raw material must be acquired to meet both production needs and to provide for desired ending inventories. Materials purchases can be determined by adding together the materials required for production needs and the desired ending materials inventories and then subtracting the beginning inventory. The desired ending inventory in units is usually a predetermined percentage of the number of units that are expected to be used in production the following period. The direct materials budget is usually accompanied by a schedule of expected cash disbursements for raw materials. This schedule should take into account any delays that are anticipated in paying for materials.

 4. The Direct Labor Budget (Schedule 4 in the text). Once production needs are known, the direct labor budget must be prepared so that the company will know whether sufficient labor time is available to meet those needs. The direct labor budget is typically expressed in both direct labor-hours and in dollars. Translating the direct-labor requirements into spending can lead to complications if there is overtime or if there is some sort of guaranteed employment policy.

5. The Manufacturing Overhead Budget (Schedule 5 in the text). The manufacturing overhead budget lists all production costs other than direct materials and direct labor. Manufacturing overhead costs should be broken down by cost behavior for budgeting purposes. Typically, the variable portion of manufacturing overhead is assumed to be proportional to budgeted activity and the fixed portion is assumed to be constant in total. Under the assumption that depreciation is the only significant non-cash manufacturing overhead expense, the manufacturing overhead expense can be converted to a cash flow basis by backing out of the total any depreciation charges.

 6. Ending Finished Goods Inventory Budget (Schedule 6 in the text). This budget details the amount and value of ending inventory on the budgeted balance sheet. The unit product cost from this budget is also used to compute the cost of goods sold for the budgeted income statement. The details of the computations will depend upon whether variable or absorption costing is used. Managers often want budgets on an absorption costing basis since that is the basis that will ordinarily be used to report results to outsiders. Data for the computations in this schedule are found in the direct materials, direct labor, and manufacturing overhead budgets.

 7. The Selling and Administrative Expense Budget (Schedule 7 in the text). The selling and administrative budget lists the anticipated non-manufacturing expenses for the budget period. In practice this budget is usually made up of many smaller individual budgets negotiated with various managers having sales and administrative responsibilities. Setting appropriate budget limits for selling and administrative functions is one of the most difficult problems in management accounting and is just beginning to be understood.

 8. The Cash Budget (Schedule 8 in the text). The cash budget should be broken down into time periods that are as short as feasible in order to alert management to problems that may occur due to fluctuations in cash flows. As anyone with a checking account knows, it is quite possible to have a positive overall cash flow during a period and yet be overdrawn at some point during the period. The cash budget is composed of four major sections:

a. The receipts section.

b. The disbursements section.

c. Cash receipts, plus the beginning cash balance, less cash disbursements results in cash excess or deficiency. If a deficiency exists, additional funds must be arranged for. If an excess exists, previous borrowing can be repaid or short-term investments made.

d. The financing section of the cash budget provides a detailed account of the borrowing and repayments projected to take place during the budget period. It also includes a detailing of interest payments.

 NOTE: For simplicity, all of the interest calculations in the text, transparencies, and problems assume simple interest is used with no compounding.

 9. Budgeted Financial Statements (Schedule 9 in the text). The last components of the master budget consist of the budgeted income statement and the budgeted statement of financial position. The balance sheet is perhaps the most difficult of the statements to construct in the examples we use. It requires pulling together data from a variety of schedules and sources.

NOTE: After reviewing the makeup of each budget within the master budget, return to Exhibit 9-2 and think of how the order in which the various budgets are prepared could be altered. This process helps to clarify in your mind the interrelationships of these various budgets.