Account 2 part question SLEEK -WRITER

Chapter 6 Budgeting for Operations Management In an office, a computer tablet calendar application is utilized by a set of hands. Javier Larrea/age footstock/SuperStock Learning Objectives After studying Chapter 6, you will be able to: Identify the major elements of a financial planning and control system. Explain the major purposes of budgeting. Define responsibility accounting, including cost, profit, and investment centers. Understand the role of flexible budgeting in planning and control. Identify the major human behavior factors that affect budgets and the budgeting process. Identify independent and dependent budget variables. Understand the basic format and calculation sequences necessary for preparation of budgets and supporting schedules. Prepare and format schedules for all elements of the master budget. Budgeting: The Negatives and the Positives! If you mention the words "plans" or "budgets" to Ann Davis, president of Internet Pathways, you get a reaction ranging from disdain to outright hostility. She has been heard to say: "How can I plan? Things always change so fast!" "My business isn' t suited to anything so formal. My managers and I need to be flexible, fast on our feet, and ready to change direction overnight, if we have to do so." "The budget always says we can't do it. I just say, 'Do it!'" "The budget reports tell me where I've been, never where I'm going." "That' s the accountant's budget; it doesn't tell me what my problems are and what to do about them!" "We can't wait for approvals and reports. Budgets hold us back!" Ann even has a coffee cup with "Budgets Are For Wimps!" printed on it. She believes that intuition and drive, not reports, got the company to where it is today. "The easiest way to lose our edge is to start acting like paper shufflers!" she exclaims. Each of her comments has some truth in it; however, the comments together reflect serious deficiencies in the firm's management process—little or no planning, and little ability to measure performance. A close friend says plans and budgets strike terror in Ann because her "style" is threatened. She likes to operate quickly, often keeping others in the dark. The friend says that she's afraid to admit that she has little idea where the company is going. Recently, a situation arose in which Ann thought employees were making too many "bad calls" on key decisions. She was surprised by the responses she got when she asked several department managers what was wrong. Each complained about lack of direction at the top, how management kept changing its mind, that there was no plan of action, and how employees felt they could not judge how each of them, and the company as a whole, was progressing. Introduction A simple concept is a key to budgeting: Planning is not deciding what to do in the future; it is deciding what to do now to assure a future. This chapter discusses concepts, tools, and processes used in a planning and control system and illustrates an integrated master budget. 6.1 Budgeting: A Planning and Control System Planning and control comprise an overall management system. Planning can be viewed as a framework within which managers anticipate future events, develop a plan of action, and estimate future revenues and costs. Control is the process of using feedback on actual operating results to compare to the plan, to evaluate performance in achieving the plans and goals, and to make changes. A budget is a plan showing what and how resources are to be used over a specified time period. A plan, act, control, and evaluate cycle is shown in Figure 6.1. The master plan is prepared, decisions are made and actions taken, reports are prepared and analyzed, and the plan is reviewed and updated. Figure 6.1: The planning and control cycle Figure depicting the planning and control cycle. The figure is circular in nature and has an inner (planning) and outer (controlling) ring of boxes. In the inner ring, four boxes are placed as follows: "plan" at the top, "act" to the right, "control" on the bottom, and "evaluate" on the left. An arrow points from plan to act, from act to control, from control to evaluate, and from evaluate to plan (making a clockwise flow cycle). In the outer ring, boxes are placed as follows: "prepare the master plan" above and connected to the "plan" box, "record transactions" to the right of and connected to the "act" box, "report on actual vs. plan" below and connected to the "control" box, and "review and update plan" to the left of and connected to the "evaluate" box. An arrow points from "prepare the master plan" to "record transactions", from "record transactions" to "report on actual vs. plan", from "report on actual vs. plan" to "review and update plan", and from "review and update plan" to "prepare the master plan" (making a clockwise flow cycle). A mission statement sets the purpose of the organization. Goals and objectives are statements about its future position and its long-term direction. They describe specific performance targets within certain timeframes. A profit goal might be, for example, to earn an annual 15 percent aftertax return on shareholders' equity or to generate sales of $1 billion by 2016. Once goals (direction and motivations) and objectives (quantified performance targets) are set, action plans can be defined. The budgeting process determines the inputs needed to achieve the forecast outputs. A planning and control system includes tools, methods, and attitudes. The following set of common elements appears: Strategic planning process. This long-range planning effort defines the firm's mission (why the firm exists), the long-range goals (what level of achievement it expects), and a strategic plan (what markets, price policies, resource needs, and production capabilities the firm will have). Business plan and personal goal setting. Creating the annual business plan is the task of evaluating the firm's strengths, weaknesses, opportunities, and tactics to build firm-wide priorities for the coming year. Also, each manager develops a personal set of goals and a plan of achievements that are consistent with the firm's business plan. Planning process and timetable. A budgeting schedule includes when to start the process, submit budgets, and review and approve budgets at various management levels—who does what and when. Responsibility accounting system. This is a planning and control system that combines responsibility centers, control reports, and cost drivers. Reward or incentive system. Rewards can provide incentives for managers who achieve their unit's budget goals and/or MBO targets. Tying performance to compensation appears to be an increasingly common practice. Financial modeling. Ability to evaluate alternative or "what if" scenarios is now an expected part of any financial planning system. Simulation can test a plan to assess goal achievement and evaluate alternative actions. Participatory budgeting. It is assumed that every manager in the firm is involved in planning and control. Often, budget objectives are set at the executive level, but budgets are constructed from the bottom up—sometimes called "grass roots" budgeting. A budget period may be a week, month, quarter, year, or longer. But normally, a master budget is for a year's activities and is divided into months or quarters. Long-term budgets may be for five or more years. 6.2 Responsibility Accounting Responsibility accounting has no universal definition but does link authority and control. A key aspect of responsibility accounting is that managers prepare plans for their areas of responsibility and exert control over those activities by making decisions and evaluating results. A responsibility accounting system brings discipline to planning and control tasks. The same basic elements remain visible in the accounting systems of small firms as in the sophisticated planning systems of large, complex organizations. The basic elements of responsibility accounting are: Responsibility center designations – to segment the organization into small sets of similar activities. Control reports – to compare actual versus plan for expenses, revenues, and other financial and activity measures, such as cost drivers. Roll-up reporting capability – to summarize lower level activities at higher levels along responsibility channels. Strictly speaking, managers put more effort towards managing people who incur costs rather than actually controlling costs themselves. Controllable costs are tied to organizational structure, activities management, and performance assessment. Responsibility Centers From a firm's perspective, planning and control focus on responsibility centers. A responsibility center is an organizational unit that has a specific manager with authority and control over spending, earning, or investing. Responsibility centers can be subdivided into three groups: cost centers, profit centers, and investment centers. Figure 6.2 illustrates these responsibility centers. Figure 6.2: Responsibility centers: investment, profit, and cost centers Figure displaying the relationship and flow between responsibility centers. The figure consists of six horizontal rows of boxes. The first row contains one box labeled "President, 1000)". The second row consists of investment centers. The three boxes that sit next to each other in this row are labeled "Vice-President, Group A, 2000", "Vice-President, Group B, 3000" and "Vice-President, Group C, 4000". The third row consists of profit centers. The three boxes that sit next to each other in this row are labeled "Director, Division 1, 3100", "Director, Division 2, 3200" and "Director, Division 3, 3300". The fourth and fifth rows consist of cost or activity centers. The three boxes that sit next to each other in the fourth row are labeled "Manager, Accounting, 3220", "Manager, Manufacturing, 3240" and "Manager, Sales, 3260". The three boxes that sit next to each other in the fourth row are labeled "Supervisor, Stamping, 3242", "Supervisor, Assembly, 3244" and "Supervisor, Logistics, 3246". The sixth and final row consists of more cost or activity centers (as needed). The two boxes that sit next to each other in this row are labeled "Handling, Activity, 3247" and "Shipping, Activity, 3248". A line connects the "President" box at the top of the figure to a bracket that connects all investment center boxes. Lines connect each of these boxes to a bracket that connects to all profit center boxes. Lines connect each of these boxes to a bracket that connects to all boxes in the fourth row (cost or activity center boxes). Lines connect of each these boxes to a bracket that connects to all boxes in the fifth row (cost or activity center boxes). A final line connects the "Supervisor, Logistics, 3246" box to a bracket that connects to the two boxes in the final row (more cost or activity centers as needed boxes). A cost center is a responsibility center where control exists over incurring costs. Often, cost centers are defined by an organization chart and may be further subdivided into more cost centers if costs and activities can be better linked for cost determination and management purposes. A cost center is the smallest unit of an organization within which costs and activities are measured. Activity centers, discussed in Chapter 5, are like cost centers. A profit center is a responsibility center where control exists over generating revenue and incurring its related costs. Often, sales organizations are profit centers—with product revenues, cost of sales, and marketing expenses. Managers with product-line responsibility might include both manufacturing and marketing departments. Branch or regional managers often have sales and expense control. The term revenue center can be used where a manager has revenue responsibility but controls few expenses, such as in a regional sales office. An investment center is a responsibility center where control exists over costs, revenues, and investments in assets used or managed. Managers must have the authority to acquire or dispose of assets. Typically, divisions of large firms are considered to be investment centers and are viewed by top management essentially as separate business entities. Identifying Cost Centers In many cases, cost centers parallel the boxes on the organization chart. Figure 6.2 illustrates the link between a firm's organization and its cost center coding. Activity groupings should be studied before cost centers are defined. Logical groupings are often created by a numbering system—defining different parts of the organization, levels of management, and superior/subordinates links. For example, the first digit indicates a group; the second, a division; the third, a functional area; and the last digit provides even greater detail if needed. Design of the cost system is critical. If activities are segmented too finely, too many cost centers are created, and key cost information is subdivided too finely. However, data aggregation and summarization start here, and a greater danger is losing important cost relationships if cost and activity detail are too summarized. Cost centers defined too broadly lose detail needed in later analyses, and this detail can be recreated only at great cost. Contemporary Practice 6.1 Different Organizations and Adjusting the Accounting Planning and Control System Traditionally, organizations have been structured around a functional organizational chart: operations, marketing, accounting, human resources, and research and development. As companies grow, they frequently move to a divisional structure, organized around product lines, world geography, or different customer groupings. Functional activities are part of each division. To gain efficiencies, a hybrid structure evolves where certain activities are centralized at corporate levels (e.g., finance and R & D) and others are decentralized within divisional groups (e.g., marketing and after-market customer service). Matrix organizations evolve to combine the advantages of both functional and divisional organizations. Marketing may be done at the divisional level but coordinated across all divisions by a corporate marketing function. Now, in specific situations, a manager has both functional and divisional responsibility. The accounting system must be designed to provide relevant information from both perspectives to make good choices at that decision point, consistent with corporate goals. Accountants must "go back to the drawing board" as we seek to design accounting planning and control systems to serve new organizational approaches (Ritson, 2000). Control Reports and Roll-Up Reporting Control reports are prepared routinely for each cost center for a specific time period. Figure 6.3 is a cost center report from a metal-forming factory. This is from Cost Center 3242 in Figure 6.2 and uses an account numbering system set up to detail the types of costs that will be tracked. This factory has nearly 40 cost centers and uses approximately four hundred different expense accounts. Several points should be made about the control report in Figure 6.3. The breakdown among controllable, semicontrollable, and allocated expenses is an excellent approach to signal which costs and variances are the responsibility of that cost center's manager. Monthly and year-to-date comparisons of actual to budget costs report the current situation, annual trends, and magnitude and direction of variances from budget. Activity measures, including cost drivers that relate overhead costs to outputs, are reported at the bottom of the report. Figure 6.3: Example of a cost center control report Cost Center: Stamping Period: September Cost Center No.: 3242 Supervisor: Tatso Kannisoni Monthly Year-to-Date Actual Budget Fav./ (Unfav.) Actual Budget Fav./ (Unfav.) 6110 Total direct labor 23465 24192 727 206211 209520 3309 6160 Total direct materials 79560 80000 440 712344 715000 2656 6211 Machine setup 6212 Downtime 6215 Maintenance labor 6245 Hourly overtime premium 6271 Hourly fringe benefits 6330 Repairs-dies & fixtures 6441 Rework 6443 Scrap 6490 Miscellaneous expenses 3703 1076 430 761 11222 10671 68 1247 118 3424 1680 639 0 12000 7319 22 1242 160 (279) 604 209 (761) 778 (3352) (46) (5) 42 29920 13357 4205 3094 106112 78971 479 8730 1901 30608 13286 3016 0 103506 77446 206 13827 1434 688 (71) (1189) (3094) (2606) (1525) (273) 5097 (467) Total controllable o/h expenses 29296 26486 (2810) 246769 243329 (3440) 6220 Other indirect labor 6260 Salaries 6272 Salaried benefits 6320 Repairs-equipment 6420 Factory utilities 2498 2107 424 7066 337 2389 2045 518 10069 139 (109) (62) 94 3003 (198) 21111 16914 4138 82987 2564 20732 18105 4812 80253 3888 (379) 1191 674 (2734) 1324 Total semicontrollable o/h expenses 12432 15160 2728 127714 127790 76 6510 Depreciation-building 6520 Depreciation-equipment 6540 Property taxes 6780 Administrative allocations 271 4070 1342 33945 267 4070 1342 27503 (4) 0 0 (6442) 1588 36630 12078 260230 962 36630 12078 244201 (626) 0 0 (16029) Total allocated o/h expenses 39628 33182 (6446) 310526 293871 (16655) Total cost center overhead 81356 74828 (6528) 685009 664990 (20019) Total cost center expenditures 184381 179020 (5361) 1603564 1589510 (14054) Activity measures: Workers Direct labor hours Number of stampings (000) Operating machine hours 12.0 1920.0 179.7 1145 12.0 2016.0 175.0 1209.6 Diff 0.0 96.0 4.7 64.6 11.7 16450.0 1563.0 10419 11.8 17460.0 1575.0 10476 Diff 0.1 1010.0 12.0 57 The overall performance of supervisor Kannisoni in controllable and semicontrollable categories was close to budget for September. But because of an extra large administrative allocation in account 6780, the cost center's total overhead expenses appear to be about $6,000 over budget. While including allocated expenses may be useful for other purposes, it has little beneficial budget impact and violates a basic responsibility accounting rule: Account for what you control. Roll-up reporting aggregates results for each higher management level. Middle and upper levels of management receive reports containing summarized results for all cost centers under their control. The report in Figure 6.3 is reviewed by supervisor Kannisoni and his superior. Results from this cost center are summarized at the next higher level—in the control report for the manufacturing manager in Cost Center 3240 from Figure 6.2. All cost centers in Division 2, Profit Center 3200, are summarized in the director's control report. Division 2 is then summarized in Group B vice-president's Investment Center 3000 control report, along with all divisions reporting to the Group B vice-president. All responsibility center reports are eventually summarized into one firm-wide control report for the president. 6.3 Why Budget? Advantages of budgeting nearly always outweigh the costs and efforts required by the process. Although many reasons exist for budgeting, several key purposes are now discussed. Formalize the Planning Process. Perhaps the foremost purpose of budgeting is to compel managers to think about the future. This forces them to set goals, consider future problem areas, and formulate strategies. Budgeting motivates managers to anticipate opportunities, problems, and actions, rather than to merely react. Create a Plan of Action. The planning process brings together ideas, forecasts, resource availability, and financial realities to create a course of action to achieve the firm's goals and objectives. Build the plan, then use it! Create a Basis for Performance Evaluation. Actual results lack meaning unless they are compared to some target or a budgeted number. A budget is a benchmark against which actual results are measured and managers' performances are evaluated. Significant variances between actual and planned require explanations and, often, corrective actions. Promote Continuous Improvement. Redesigning processes, increasing productivity expectations, eliminating nonvalue-adding activities, and erasing quality problems are integral parts of planning for future performance. The budgeting system is where these improvement processes are quantified and locked into operating plans. Coordinate and Integrate Management's Efforts. Budgeting processes open lines of communication within the organization: (1) up and down organizational lines of subordinates and supervisors and (2) across organizational lines to integrate functional tasks. Aid in Resource Allocation. "We'll do it, if we get budget approval to hire another person." This is a typical comment about resources and budgets. Many resources are allocated during budget preparation time. Create an "Aura of Control." The expression "in control" can mean many things; however, in a management sense, effective controls ensure that managers understand their authority, responsibilities, and limits. A budget system can serve as a fiscal disciplinarian or a "money cop." Motivate Managers and Employees Positively. The motivational "good news" is: People who help to prepare budgets for their domain will have a commitment to the budget and take pride in achieving "our" plans. Through the budget, managers can see how their parts of the puzzle fit together to form a whole—the firm-wide plan. Promotions, raises, and incentives are based on job performance, which includes achieving budget targets. Budgeting systems can promote improved teamwork, more involvement in process improvement, and greater goal congruency throughout the organization. If management, from the president down, treats budgets as important, each manager and employee will too. 6.4 Behavioral Side of Budgeting While the goal is to motivate managers positively, budgeting can have a variety of impacts on people and organizations. Budgets have the potential of motivating workers to reach higher levels of efficiency and productivity or creating artificial barriers to progress. Top-Management Support Intense top-management involvement in planning and control processes is correlated with budgeting success at middle and lower management levels. Nothing will destroy the effectiveness of the budgeting process quicker than managers' perceptions that their superiors do not support the process. Top-management actions must cement the impression that a major commitment exists for planning and budget-related performance evaluations. Demonstration of support involves at least five important steps. First, establish clearly delineated lines of authority and responsibility. Second, involve managers in the planning process. Third, set appropriate goals and objectives that can be easily translated into plans and actions at lower management levels. Fourth, review, critique, and approve budgets thoroughly. And fifth, follow-up and review budget reports with the intent of encouraging budget updates and goal-oriented actions. Budget Slack Budget slack, also called "padding the budget," occurs when managers intentionally request more resources than needed. If lower level managers know from past experience that their budget requests will be cut by upper-level managers, the response is to inflate certain expenses or to "low-ball" revenue estimates. In turn, upper-level managers, knowing that lower-level managers pad their budgets, automatically raise estimated revenues and cut budgeted expenses. The result is a vicious circle of lack of trust and counter-productivity. Another problem arises during budget downsizing when upper management requires all segments to cut expenses by some arbitrary percentage, say 10 percent. Managers may make noneconomic decisions or resort to gamesmanship for self-preservation, perhaps creating protective slack for the next cuts. This approach suffers from three weaknesses: (1) organizational differences are ignored, (2) specific resource reallocations needed to support the firm's long-run goals are obliterated, and (3) executive management is viewed as capricious and uncaring. In its defense, if everyone "shares" the pain of budget reductions, a feeling of "together we can solve the problem" can be encouraged. The most effective weapon against "slack" and "across the board" budget cutting is a careful and rigorous review of budgets by line managers. To be effective, reviewers must know the inner workings of the activities reporting to them. Nonaccounting managers must be able to read and interpret budget data and control reports. Human Factors and Budget Stress Budgets are bases for directing activities and establishing a discipline within an organization. The tightness of budgets necessarily depends on a number of factors, including the ability to predict future results for a given function, the manager's experience, and the closeness of supervision. Some people need close guidance and a "fear of God" approach, while others operate best with broad degrees of freedom. Supervisors and upper-level managers must make careful judgments about how tight budget standards should be for each manager. Remember, the objectives are to generate the greatest benefit from each manager's area of responsibility and to maximize goal achievement for the whole organization. Ethics of Budgeting "Gamesmanship" often rears its head in budgeting. Budgets are future estimates. Management judgment is heavily involved. We expect ethical behavior, objective allocations of resources based on need and returns, and a managerial attitude of fairness and equity to permeate the organization. We have already mentioned the problem of budget slack—budgeting expenses too high or revenues too low to cover anticipated budget cuts. Other problems involve misstating to earn approval of projects, hiding over spending on one project by charging expenses to another project, blaming controllable budget variances on noncontrollable events, and pressuring subordinates, which encourages them to act unethically "to meet the budget." In the public sector where budgets are legislated, spending unused appropriations near the end of a fiscal year on nonessential or wasteful activities to help justify budget requests for the next fiscal year is common and borders on unethical use of public funds. Executive management must be alert to messages that the budget system sends to all employees. The discussions of "aura of control," top-management support, budget slack, and human factors all combine to highlight the importance of a structured control system with clear responsibilities and feedback. Planning and control systems can move a firm to a higher ethical plane and also create more dilemmas. Managers involved in the budget-setting process and in the control reporting process are the most effective weapons in upholding the integrity of the planning and control system. 6.5 Master Budget—An Overview The annual budgeting effort is commonly called the master budget or, in some firms, the profit plan or financial plan. Although a master budget usually covers a one-year period in detail, it may be prepared on a month-by-month basis for the year and may be extended in summary form for several years. Master Budget Components Master budget terminology and classifications may differ among organizations, but a common set is shown in flowchart format in Figure 6.4 to describe it and its supporting schedules. A comprehensive example follows to illustrate each schedule and its format. Figure 6.4 references the appropriate master budget schedules shown later in the chapter. Operating Budgets. The operating budget is a formal document that takes a sales forecast and converts it into a plan of action. Planned operating results are summarized in a cash-flow forecast and forecast financial statements. The day-to-day activities of any business are the interdependent parts of an operating cycle. The operating cycle is a circular sequence of events from purchasing on account, paying those bills, generating sales, and collecting cash for the sales. The cycle can be viewed as a "cash-to-cash" process. The cycle continuously repeats itself. Cash-Flow Forecast. Cash-flow forecasting is a key to cash management. Cash management is planning and controlling cash balances over time. Often, three timeframes can be identified: long term, annual, and short term (which may be daily or weekly). Each fits into the firm's planning process. Project Budgets. While much budgeting uses a 12-month timeframe to plan repetitive activities, a number of activities are project-related and have project budgets. Examples include capital spending for new construction and equipment, research and development programs, and information systems development projects. Project costs are planned around resources and the project's time line. Project budgets, however, are integrated into annual plans as well. Forecast (Pro Forma) Financial Statements. Forecast balance sheets and income statements summarize the financial results from operating, cash-flow, and project budgets for managers. Forecast income statements and balance sheets provide managers with information needed to judge how adequately the master plan achieves the firm's financial goals and objectives. Most financial goals are expressed as ratios of balance sheet and income statement numbers. The forecast financial data then become the basis for management's evaluation of actual results. Information from internal planning processes to be released to stockholders and others external to the firm is carefully structured, must meet external reporting requirements, and is called "financial forecasts" or "financial projections." Figure 6.4: Master budget components and their relationships Flow chart for sales forecasting and budget components. The top box is labeled "sales forecast, (schedule 3)" and is connected to a bracket that flows down by arrows to three separate boxes: a box labeled "supporting schedules (sch. 9, 10, 11); a box labeled "production plan (schedule 4)", and a bracket that connects boxes labeled "administrative expense budget (schedule 13)" and "selling expense budget (schedule 13)". A dashed line flows from this "selling expense budget" box and flows back into the "sales forecast" box. The "production plan" box flows down into a bracket that connects the three following boxes: "materials requirements budget (schedule 5)", "direct labor budget (schedule 6)", and "manufacturing overhead budgets (schedules 7 & 8)". These three boxes are connected by a lower bracket that flows into both: a box labeled "cost of goods manufactured and sold (schedule 12)"; and into the line that connects the "sales forecast" and "supporting schedules" boxes. The "cost of goods manufactured and sold" box connects to a box below labeled "cash-flow forecasts (schedule 15)". Two previously discussed boxes, "administrative expense budget" and "selling expense budget" are connected by a lower bracket and flow into the line that connects the "cost of goods manufactured and sold" and "cash-flow forecasts" boxes. The "supporting schedules" box flows into the "cash-flow forecasts" box. All of the above boxes are sectioned off as operating budgets in the figure. Two boxes (sectioned off as project boxes in the figure), "capital expenditures budget (schedule 14)" and "research and development budget (schedule 14)", are connected by a bracket and flow into the "cash-flow forecasts" box. Finally, the "cash-flow forecasts" box flows into a bracket that connects two boxes labeled "forecast income statements" and "forecast balance sheets", both of which are sectioned off as forecast financial statements in the figure. Master Budget for Nonmanufacturing Organizations How does a master budget differ for a merchandising or service organization? The basic budgeting concepts are essentially the same; however, variations do exist. Merchandising Organizations. A merchandiser replaces production with purchases in Figure 6.4. The budget cycle for merchandisers will have the following different traits: Often, multiple locations exist and have individual budgets. Budgets for all segments are consolidated into one sales and operating expense budget. Revenue and expense budgets for store operations are created. If distribution systems and warehousing are involved, these budgets must be linked to sales forecasts and store budgets. A greater proportion of managers are profit center managers (product lines, branches, or departments) with both revenue and expense responsibilities. Most merchandising companies will concentrate on a gross margin or contribution margin plan, which combines sales and cost of sales budgets. Operating expenses may differ in nature in merchandising firms, but the functional classifications of selling and administrative expenses remain. Service Organizations. A service organization often depends heavily on human resources. Planning personnel capacity and staffing levels is critical. In many service organizations, personnel expenses, which include salaries and benefits, account for well over 75 percent of all expenses. This is the case, for example, in school systems and accounting, legal, and consulting firms. Here personnel may be organized by type of service, skill, customer, or project. Staffing plans using headcounts may be more valuable for planning and control than dollar plans. In complex organizations such as hospitals and banks, budgets develop around services provided. Forecasts of customer or patient work volumes, equipment used, support services required, and revenue generated are developed in responsibility centers and are combined vertically and linked horizontally. In financial institutions, for example, interest income from loans and investments is forecast along with interest expense paid on deposits, yet operating expenses for the people who make loans and get deposits require traditional expense budgeting. Nonprofit Organizations. Many nonprofit organizations operate similar to merchandising and service firms. However, two characteristics of nonprofit organizations require special attention: (1) lack of clearly defined outputs and (2) fixed or legislated inputs or revenues. These commonly arise with governmental, educational, and philanthropic services. Budgets are determined by a legislative process with legal constraints placed on how much can be spent and what type of spending can be incurred. The outputs might be better fire protection, natural resource conservation, or national defense. In certain areas, workloads can be defined, such as in issuing drivers licenses or processing tax returns. Given the legislated revenue side, the budgeter's tasks are to work with managers to define desirable goals and outcomes, to allocate resources (people and dollars) to the programs that generate the greatest benefit, and to evaluate performance based on comparisons of predefined goals and results for given benchmarks. 6.6 The Starting Point and Beyond The executive team meets to set goals, targets, and assumptions. If executives emphasize planning, updating budgets, and evaluating performances using budget comparisons, all managers see that financial planning and control are major parts of the "corporate culture." The controller sets the wheels in motion by providing time schedules, forecast support data, and forms. But given these basics, where is the starting point of the planning cycle? What is planned first? Finding the Controlling Constraint The starting point of the budget effort should always be the most constraining variable. Generally, this is sales. Most managers work to generate more sales. But other constraining variables might be: Machine capacity in a specialized area (plastic extruding equipment in a plastic bottle plant). Floor space in a retail outlet (the first floor in a major downtown department store). Salespersons' time to make calls on customers (sales reps who must decide which clients to visit). Tables in a restaurant (where demand for reservations cannot be met). When a variable other than sales limits growth, it becomes the starting point for planning. But, for most firms, sales units or revenue is the limiting "resource." Sales Forecasting A realistic sales budget is the foundation of a master budget. The sales forecast is based on a variety of interlocking factors, such as pricing policy, economic outlook, industry conditions, advertising, historical patterns, and the firm's strategic market position. A sales forecast is built using data from many sources, including: Analysis of historical trends to create a momentum forecast. Grass-roots forecasts, by product and by customer, prepared by salespersons. Statistical analysis of sales and economic data. Market research analysis of promotion, sales efforts, and market share. These approaches are not independent. More likely, all are involved in solving the forecasting problem. Each method tests the assumptions and the data of the others. The marketing plan and the sales forecast are interdependent. Figure 6.4 shows the reciprocal relationship by solid and dotted lines. Using Activity-Based Costing Relationships Activity-based costing sets formal links among resource inputs and their costs, operating activities, and outputs. The budgeting process must include these relationships in converting expected sales volumes into production and operating expense budgets. A carefully developed ABC system will greatly simplify the budgeting process by using the cost functions developed for product costing to plan expenses. From ABC studies come a much greater understanding of cost-causing relationships. Quality assessment, JIT performance, and employee involvement and empowerment measures are parts of planning and evaluation processes. These are predominately nonmonetary indicators but still part of budgeting. Financial modeling can include these linkages in a computer-based simulation of operations and operating budgets. Independent and Dependent Variables The planning assumptions, management inputs, product cost and price data, sales forecasts, and all the formula-driven relationships are called independent variables; they can be changed by the planner or budget analyst. Most remaining values in budgets come from mathematical relationships, using the independent variables. These calculated values are called dependent variables. Independent variables are used to calculate dependent variables. For example, sales units, prices, and the percentage of sales collected in the month of sale are independent variables that can be combined to find cash collected, a dependent variable. In spreadsheet software logic, independent variables are constants or external inputs. The dependent variables are found by creating a cell formula. "What if" changes to independent variables will allow alternative scenarios to be tested through modeling. The impacts of the changes can be seen on the dependent variables—for example, net income. Preparing and Formatting Budget Schedules Budget preparation uses forecasts, planning assumptions, basic logical and mathematical relationships, and management experience and judgment. A few calculation guidelines help, such as: While budgeting does not follow debit and credit rules, a final test of the master budget is whether the forecast balance sheet balances. Budget relationships are defined quantitatively to allow the same formulas to be repeated in later time periods, such as in spreadsheet cell formulas. Ideally, initial planning assumptions, management inputs, and beginning values (the independent variables) should be sufficiently complete to calculate all other variables. Prepare schedules in the order of the sequential chain of events, such as the sales forecast, production plan, and then the purchases schedule. Align time periods by columns—month by month or quarter by quarter. This pattern allows repetitive calculations to be duplicated easily. Put independent variables in an initial schedule for easy access when making "what if" changes for later analyses. Avoid circular reasoning. For example, sales may be a function of advertising. Yet, the advertising budget may be a percentage of sales. Structure and format simplify budget preparation. Frequently, data from one period are needed in the prior or next period. Or, data in one schedule are used in a following schedule. A structure keeps data and calculations organized. Assume that: Sales for the first four months of 2015 are forecast to be $50,000, $60,000, $80,000, and $70,000, respectively. Cost of sales is forecast to be 60 percent of sales. Beginning inventory is $18,000. Ending inventory is expected to be 40 percent of next month's cost of sales. Cash from sales will be collected as follows: 60 percent in the month of sale and 40 percent in the month after the sale. Uncollectibles are ignored here. Beginning accounts receivable is $40,000, all from December sales. The format and data for cash receipts forecasting for 2015's first quarter are: January February March Sales $50,000 $60,000 $80,000 Cash collections of receivables from: December sales ($40,000 receivables) $40,000 January sales ($50,000 x .6 and x .4) 30,000 $20,000 February sales ($60,000 x .6 and x .4) 36,000 $24,000 March sales ($80,000 x .6) 48,000 Total cash collected from sales $70,000 $56,000 $72,000 The January column contains all data needed to find cash collections for January. The sales row provides the data to find cash collections for January, February, and March. This column/row format can be used in all master budget schedules. The format and data for forecasting purchases for the first quarter are: January February March April Sales $50,000 $60,000 $80,000 $70,000 Cost of sales (60 %) 30,000 36,000 48,000 42,000 Product needs: Cost of sales $30,000 $36,000 $48,000 $42,000 Ending inventory (40 % of next month's cost of sales) 14,400 19,200 16,800 Total needs $44,400 $55,200 $64,800 Product available: Less beginning inventory 18,000 14,400 19,200 Required purchases $26,400 $40,800 $45,600 As can be seen from the arrows, organizing data by columns and rows sets a repeating pattern for calculations. Also, an important pattern is established: sales plus ending inventory set the total amount needed, while beginning inventory and purchases meet the need. Contemporary Practice 6.2 What If the Sales Budget is Wrong? While many marketing managers can quote their company's forecast accuracy, most cannot quantify value of accurate sales forecasts. Now, managers are looking at quantifying the costs of forecast errors in both operations and in marketing itself. Different costs result from over-forecasting and under-forecasting. Having estimates of these costs places greater priority on investing in quality forecasts at the very beginning of the budget process. Operations costs include the following (Kahn, 2003): producing the wrong product causes inventory levels and inventory storing costs to increase; changing production schedules will increase production costs due to personnel and equipment changes; expediting raw materials creates higher inbound raw material costs; shipping to the wrong location incurs extra logistics costs for storing product in the wrong location; inaccurate shipping furthermore necessitates transshipment costs to get product to the right location; and discounting the price may be required to get the product sold. Marketing costs include the following (Kahn, 2003): inefficient use of marketing resources; improper allocation of resources across products; reduced or even lost revenue from inability to deliver; and lost sales opportunities. 6.7 Other Budgeting Techniques So far we have discussed budgeting in terms of a master budget and its components. The concept of budgeting can incorporate other tools where needed. Flexible Budgeting In Chapter 1, we introduced cost functions. We suggested that expense budgets can be based on a variable rate and a fixed amount of costs. By knowing the cost function, we can plan costs for any activity level within our relevant range. This is a flexible budget. Initially, when the master budget is prepared, an expected activity level is the basis for the expense budget. For example, Fred Bleiberg provides local area delivery services. He is developing a home delivery service for local restaurants to be called Your Favorite Foods. This would utilize the unused capacity in his delivery services. Activity is the number of deliveries. Following are expense items, which include variable, fixed, and semivariable behaviors. Expense item Fixed expenses Variable expenses Driver payments $1.50 per delivery Supplies expense .15 Added management expenses $3,000 Depreciation expense 1,000 Added communications expenses 600 .10 Miscellaneous expenses 400 .05 Totals $5,000 $1.80 per delivery The cost function is: $5,000 + ($1.80 × deliveries). Fred thought he would handle about 10,000 deliveries this year, but he only made 9,000. Figure 6.5 presents his original budget, a flexible budget for the actual 9,000 deliveries, and a comparison of his actual expenses to the adjusted budget. The original budget is based on 10,000 deliveries, and, therefore, cannot be used to evaluate actual results. The flexible budget is based on the actual activity level: 9,000 deliveries. Remember: Fixed expenses are fixed, and variable expenses adjust to the actual activity level. For example, miscellaneous expenses are $400 plus 10,000 times $0.05, or $900, in the original budget, and are $400 plus 9,000 times $0.05, or $850, in the flexible budget. The manager is expected to spend no more than $850 for miscellaneous expenses since only 9,000 deliveries were made. Figure 6.5: Flexible budgeting performance report for Your Favorite Foods Original Expense Budget Flexible Budget Based on Actual Deliveries Actual Expenses Budget Variances Fav. (Unfav.) Variable expenses: Driver payments Supplies expense $15,000 1,500 $13,500 1,350 $14,050 1,300 $(550) 50 Fixed expenses: Added management expenses Depreciation 3,000 1,000 3,000 1,000 3,000 1,000 (100) 0 Semivariable expenses: Added communication expenses Miscellaneous expenses 1,600 900 1,500 850 1,900 750 (400) 100 Total expenses $23,000 $21,200 $22,100 $(900) Flexible budgeting can also be tied to applying overhead in product costing. In Chapter 3, we developed rates to apply factory overhead to products. Applied overhead was found by using the cost function and actual activity. Actual overhead minus applied overhead produces either an overapplied or underapplied overhead variance. (See the master budget example later in this chapter.) This variance includes any spending variance and any mismatch in applying fixed overhead. These variances are discussed in detail in Chapter 7. Project Budgeting Project budgets are oriented to specific events or tasks and use time schedules to do annual operating budgets. Project budget examples include construction projects, information systems projects, engineering and design projects, entertainment events, and government defense contracts. Project management has been a source of many cost and time overruns. Many projects are unique, one-time efforts. Research projects often present another management dilemma: working in technologically unknown areas with no predictable output or timetable. Project budgets link stages and segments of work, timetables, deadlines or decision points, and spending authorizations. Actual costs are compared with budget time and dollar amounts to monitor the project periodically and at specific review points. Two management concerns exist. How did we do? And, what should we do now? The first is control oriented, and the second is planning oriented. One looks back at resources used, and the other looks forward to completing the project. As an example, assume that a systems development project is budgeted at $90,000 and should take six months to complete. It is now three months into the project, and $40,000 has been spent. The manager in charge estimates that it is one-third done and will take another six months and $80,000 to complete. How should the current status be evaluated? If the project is now one-third complete, the manager is over budget in both time and money as follows: Performance to date Total project Original budget Original budget Resources used to date For portion completed Budget overrun to date Revised projected budget Projected budget overrun Costs $90,000 $40,000 $30,000 ($10,000) $120,000 ($30,000) Time 6 months 3 months 2 months (1 month) 9 months (3 months) Using the original budget, at this point the project is a month behind schedule and overspent by $10,000. If the total project budget is revised for time and dollars, the project will be $30,000 and three months over budget. Careful monitoring of project status (costs and accomplishment) is needed to meet time and dollar targets. Probabilistic Budgeting Probabilities reflect the likelihood that certain business conditions will occur. When risk exists that a particular variable may move within a range of values, probabilistic expressions of those outcomes help the budget to be more realistic. The sensitivity of profits to changes in variables, such as sales volume and prices, can be tested, and then management can focus on sensitive variables. Eric Paul, controller of YA Industries, can calculate expected values of sales, costs, and any other budgeted variable from probabilities assigned by senior managers in marketing, production, and other areas. Assume, for example, that YA plans to sell a product next year for $20 a unit, with a variable cost of $14. Probability estimates have been made for three sales volume levels. Sales volume (units) Probabilities Expected value (units) Conservative 150,000 × .20 = 30,000 Most likely 200,000 × .70 = 140,000 Optimistic 250,000 × .10 = 25,000 1.00 Expected sales volume (units) 195,000 The calculation of expected contribution margin is as follows: Expected sales (195,000 units × $20) $3,900,000 Expected variable costs (195,000 units × $14) 2,730,000 Expected contribution margin $1,170,000 Price, volume, variable cost, fixed costs, and many other variables can be assigned probabilities in many combinations reflecting the levels of uncertainty. Past experience coupled with a careful analysis of the future can serve as a basis for establishing probability estimates. Admittedly, probability estimates will not be precise, but they should represent the best inputs managers can generate and be more accurate than rough approximations or intuitive estimates. 6.8 A Master Budget Example To illustrate the master budget sequence of planning activity and schedule formats, a comprehensive example is presented. The firm is Schwartzben Products Company, a small manufacturer of wood-based products. In recent years, its primary product is a speaker's podium, which is sold to chapters of the Effective Speakers Society of America (ESSA). Graduates of the Society's speaker training programs are awarded a wooden podium as a symbol of public speaking prowess. Schwartzben produces a high-quality product at a very competitive price. The product is called the "EXEC." In the Schwartzben Products factory, wood is cut and assembled, a polyurethane finish is applied, and packing and shipping are done. A small sales office and administrative staff completes the organization. Each year, Schwartzben Products prepares a master budget on a quarterly basis and generally follows the structure shown in Figure 6.3. As in most budgeting situations, Schwartzben Products' dollar amounts are rounded to the nearest dollar. The model used to prepare the budget will track decimal places. When amounts are rounded throughout the budget example, certain columns or rows may appear to add incorrectly; however, overall accuracy is maintained. Annual Goals and Planning Assumptions Schwartzben Products begins its planning process with a meeting organized by the controller at a local resort each August. All managers discuss their areas of responsibility and present strengths, opportunities, problems, and last year's results. Financial and operating goals for 2015 are set, and planning guidelines are agreed upon. Planning Assumptions. Certain data and relationships are needed to begin the planning process. These planning assumptions include beginning balances, product costs and prices, operating assumptions, and financing assumptions. Product Cost and Pricing Data. The first planning data are EXEC quantities and costs. Materials, labor, and overhead are listed by each resource used. A list of materials is often called a bill of materials. Direct labor shows costs and hours. Schedule 1 shows these quantities and amounts. Amounts that are bold are independent variables throughout the example. Schedule 1: Product quantities, costs, and prices Product costs Cost Quantity Per unit Materials: Plywood (square feet) $0.275 15.00 $ 4.125 Trim (feet) 0.085 18.00 1.530 Total materials $ 5.655 Direct labor: Preparation and finishing hours $12.00 1.00 $12.000 Factory overhead: Variable – Based on direct labor hours $ 6.50 1.00 $ 6.500 Fixed – Based on machine hours 12.00 0.60 7.200 Total manufacturing overhead $13.700 Total product cost $31.355 Sales price $49.00 Manufacturing overhead is identified as fixed or variable. After analyses of activities and cost behaviors, direct labor hours was selected as the variable overhead cost driver. Much activity in the plant is linked to labor-intensive processes that generate the majority of variable overhead costs. The fixed overhead cost driver is machine hours, because most fixed overhead is generated by equipment costs. Operating and Financing Assumptions. A variety of planning details are needed to prepare budget schedules. Most come from past experience, estimates of beginning balances, and 2015 forecasts. Schedule 2 presents the initial assumptions. Operating assumptions include percentages, specific budgeted amounts for certain accounts to prepare overhead rates, and any other constant that will be needed in calculations. Borrowing details, cash policies, taxes, dividends, and beginning balance sheet figures are the independent variables for financing assumptions. These starting points are needed to complete the cash-flow forecast and pro forma (or forecast) financial statements. Schedule 2: Operating and financing assumptions Inventory data: Plywood (sq feet) Trim (feet) EXEC December 31, 2014, inventory 10,000 6,000 700 Ending inventory (part of next quarter's usage) 20% 10% 25% Accounts receivable: Sales percentage collected this quarter 75% Cash discount percentage for receipt of this quarter's sales 2% Accounts payable: Purchases percentage paid this quarter 60% Manufacturing activity base: Normal labor hour activity rounded to the nearest 500 hours 11,500 Normal machine hour activity rounded to the nearest 500 hours (See Schedule 7 for budgeted variable rates and annual fixed amounts.) 7,000 Selling and administrative expense data: Sales commissions: 4%; Shipping expenses (See Schedule 13 for annual budgeted selling and administrative expense amounts): $1.30 per unit Financial assumptions and balances: Cash balance: Minimum balance $5,000 Maximum balance: $10,000 Borrowing and investment incremental amount 5,000 Quarterly principal payment on notes payable 3,000 Capital stock – Outstanding shares 24,000 Paid-in-capital 240,000 Dividend rate – per share per quarter $0.05 Income tax rate (federal, state, and local) 40% Interest rate on bank borrowings and investments (annual) (See December 31, 2014, Balance Sheet for beginning balances.) 9% Project expenditures: First quarter Second quarter Third quarter Fourth quarter Equipment purchases $8,000 $0 $10,000 $12,000 Research and development 0 0 0 4,000 Sales Forecast The sales forecast is the only remaining independent variable necessary. It is prepared using a rolling five-quarter timeframe. A fifth quarter of sales data is needed to complete a number of fourth quarter schedules. Physical quantities are independent variables. Dollar amounts are found by using the physical units and prices from Schedule 1. From the sales dollars in Schedule 3 through the end of the master budget, all numbers are calculated using data and instructions in Schedules 1, 2, and 3. All values from this point are dependent variables using the independent variables. Schedule 3: Sales forecast First quarter Second quarter Third quarter Fourth quarter Total Fifth quarter Unit sales 2,400 2,800 3,000 3,200 11,400 3,000 Sales dollars $117,600 $137,200 $147,000 $156,800 $558,600 $147,000 Production Plan A production plan, Schedule 4, is prepared using the beginning finished podium inventory, the sales forecast, and the desired ending inventory levels. In this example, work in process inventory is assumed to be so small and unchanging that it is immaterial to both planning and product costing tasks. Key relationships in this production plan are the percentages of sales that should be on hand at the end of each quarter. Note the format of Schedule 4. Sales plus required ending inventory equal units needed. Then, by subtracting beginning inventory, the needed production volume is found. This sequence is common to many budgeting calculations. Schedule 4: Production plan First quarter Second quarter Third quarter Fourth quarter Total Fifth quarter Unit sales 2,400 2,800 3,000 3,200 11,400 3,000 Ending finished goods 700 750 800 750 750 Total units needed 3,100 3,550 3,800 3,950 12,150 (750) Beginning finished goods (700) (700) (750) (800) (700) Production needed 2,400 2,850 3,050 3,150 11,450 Materials Requirements and Purchases Budget. Quantities of materials used in each unit (the bill of materials) are specified in Schedule 1. Estimated quantities are based on experience or engineering studies and help set standard costs, which are discussed in Chapter 7. Quantities of materials needed to meet production requirements are determined by multiplying the units to be made by the quantities of materials required for each unit. Schedule 5: Materials requirements and purchases budget Plywood requirements (sq ft): First quarter Second quarter Third quarter Fourth quarter Total Fifth quarter Ending inventory 8,550 9,150 9,450 8,850 12,195 3,000 Production requirements 36,000 42,750 45,750 47,250 171,750 44,250 Total needs 44,550 51,900 55,200 56,100 180,600 Beginning inventory (10,000) (8,550) (9,150) (9,450) (10,000) (750) Purchases in square feet 34,550 43,350 46,050 46,650 170,600 Dollar cost of plywood purchases $9,501 $11,921 $12,664 $12,829 $46,915 Trim requirements (linear ft): Ending inventory 5,130 5,490 5,670 5,310 5,310 Production requirements 43,200 51,300 54,900 56,700 206,100 53,100 Total needs 48,330 56,790 60,570 62,010 211,410 Beginning inventory (6,000) (5,130) (5,490) (5,670) (6,000) Purchases in linear feet 42,330 51,660 55,080 56,340 205,410 Dollar cost of trim purchases $3,598 $4,391 $4,682 $4,789 $17,460 Total materials purchases $13,099 $16,312 $17,346 17,618 $64,375 Ending plywood inventory for the first quarter of 8,550 square feet is 20 percent (Schedule 2) of the second quarter's production needs of 42,750 square feet. The 36,000 square feet of plywood needed for production in the first quarter is found by multiplying 15 square feet per unit (Schedule 1) times the 2,400 units to be produced (Schedule 4). Thus, the rules from Schedules 1 and 2 and the quantities from Schedule 4 determine all amounts needed to calculate the purchases requirements in Schedule 5. In more complex production situations, the accumulation of parts and materials needs is called a bill of materials explosion. All uses of the same part in different products are summed to find the total usage across the entire product line for a time period. Computer software for production planning, such as Materials Requirements Planning (MRP), is used to calculate needs and to issue purchase orders when inventory levels reach certain points. Direct Labor Budget. The direct labor budget is estimated first by the direct labor time required per unit (Schedule 1) times the units to be made (Schedule 4). Hours per podium are set by past experience or industrial engineering studies. At one hour per EXEC, the hours per quarter equal the units to be produced per quarter. Labor cost per hour can be the "straight" wage rate, with all payroll taxes and fringe benefits included in manufacturing overhead. Or the rate could be a "loaded" wage rate, which includes most fringes and expected overtime premiums. Schedule 6: Direct labor requirements First quarter Second quarter Third quarter Fourth quarter Total Total direct labor hours needed 2,400 2,850 3,050 3,150 11,450 Total direct labor payroll expense $28,800 $34,200 $36,600 $37,800 $137,400 Factory Overhead Budgets. Planning factory overhead takes two forms: creating the expected overhead spending patterns (using a flexible budget) and budgeting spending and applied overhead levels. Cost Estimation Using ABC and Statistical Techniques. Detailed cost estimates come from several sources already discussed in prior chapters. Cost estimation techniques presented in Chapter 2 (regression analysis, high-low method, etc.) are used by managers and accountants to budget expenses that track well against one or more activity variables. More commonly, the same cost drivers used in Chapters 3 and 5 to build cost functions and assign costs to cost objectives are now applied to another cost objective—budgeting. Factory Overhead Flexible Budget. Selecting activity bases for applying overhead, setting normal activity levels, planning variable and fixed overhead items, and setting the overhead rates are all part of the annual budgeting process. Schedule 7 is the result. Independent variables (in bold) are the variable overhead rates and the fixed overhead annual amounts. Separate cost drivers were selected for variable and fixed overhead. The variable overhead cost driver is direct labor hours. Fixed overhead is applied using machine hours. Annual normal direct labor and machine hours are rounded (11,500 labor hours and 7,000 machine hours). Budgets are prepared for various ranges of activity, in both cases in increments of 500 hours around normal levels. Using budgeted expenses and normal activity levels given in Schedule 2, variable and fixed overhead rates are set. These are calculated on Schedule 7 and added to product costs in Schedule 1. Schedule 7: Factory overhead flexible budget Cost driver activity levels normal Variable cost driver: Direct labor hours 11,000 11,500 12,000 Fixed cost driver: Machine hours 6,500 7,000 7,500 Variable expenses: Rate/hour Supplies and other variable expenses $ 1.40 $15,400 $16,100 $16,800 Indirect labor and benefits expenses 5.10 56,100 58,650 61,200 Total variable overhead expenses $ 6.50 $71,500 $74,750 $78,000 Fixed expenses: Amount Depreciation expense $20,000 $20,000 $20,000 $20,000 Supervision salaries 41,000 41,000 41,000 41,000 Other fixed overhead expenses 23,000 23,000 23,000 23,000 Total fixed overhead expenses $84,000 $84,000 $84,000 $84,000 Total manufacturing overhead expenses $155,500 $158,750 $162,000 Overhead Rates: Variable rate per direct labor hour $ 6.50 $ 6.50 $ 6.50 Fixed rate per machine hour $12.00 Factory Overhead Operating Budget. With overhead rates and budgeted activity levels, quarterly budgets for manufacturing overhead and applied overhead are prepared. Again, direct labor and machine hour activity levels come from the hours per unit in Schedule 1 and the production plan. Variable expense budgets for each quarter are the expected spending levels given that activity level. First quarter's supplies and other variable expenses of $3,360 in Schedule 8 result from multiplying $1.40 per direct labor hour (Schedule 7) times 2,400 hours (Schedule 6). Budgeted fixed costs are merely divided equally among four quarters. Near the bottom of Schedule 8 is the planned applied overhead. This will differ from the budgeted spending level because of the difference between budgeted fixed cost and applied fixed overhead. The quarter's planned activity level for machine hours (1,440 hours) does not equal one quarter of the annual normal activity level (7,000 hours ÷ 4 quarters). Fixed overhead is budgeted at $21,000 for the quarter (one-fourth of $84,000). Using the fixed overhead rate of $12.00 per machine hour developed in Schedule 7, the applied fixed overhead is $17,280. Budgeted fixed overhead is underapplied by $3,720, which is $21,000 minus $17,280 ($12 per hour × 310 hours). Variable overhead is budgeted and applied at $6.50 per direct labor hour. Therefore, no budgeted overapplied or underapplied variable overhead exists. Schedule 8: Factory overhead operating budget First quarter Second quarter Third quarter Fourth quarter Budgeted direct labor hour activity 2,400 2,850 3,050 3,150 11,450 Budgeted machine hour activity 1,440 1,710 1,830 1,890 6,870 Budgeted variable overhead expenses $15,600 $18,525 $19,825 $20,475 $74,425 Budgeted fixed overhead expenses 21,000 21,000 21,000 21,000 84,000 Total budgeted factory overhead $36,600 $39,525 $40,825 $41,475 $158,425 Budgeted factory overhead cash outflow $31,600 $34,525 $35,825 $36,475 $138,425 Applied factory overhead: Variable overhead applied $15,600 $18,525 $19,825 $20,475 $74,425 Fixed overhead applied 17,280 20,520 21,960 22,680 82,440 Total applied overhead $32,880 $39,045 $41,785 $43,155 $156,865 Overapplied/(Underapplied) overhead $(3,720) $(480) $960 $ 1,680 $(1,560) Overapplied/(Underapplied) overhead $(3,720) $(4,200) $(3,240) $ 1,560 $(1,560) YTD Supporting Schedules Several supporting schedules are prepared by the accounting staff and are important to various forecasts and calculations. Assumptions about collections, payments, and ending balances were given in Schedule 2. We can now develop forecasts for accounts receivable (Schedule 9), inventories (Schedule 10), and accounts payable (Schedule 11). Schedule 9: Accounts receivable First quarter Second quarter Third quarter Fourth quarter Beginning balance $ 40,000 $ 29,400 $ 34,300 $ 36,750 Net sales 1,440 1,710 1,830 156,800 Total receivables 21,000 21,000 21,000 $193,550 Decreases in receivables: Collections of prior quarter's sales $ 40,000 $ 29,400 $ 34,300 $ 36,750 Collections of this quarter's sales 86,436 100,842 108,045 115,248 Total cash collections of receivables $126,436 $130,242 $142,345 $151,998 Cash discounts 1,764 2,058 2,205 2,352 Total credits to receivables $128,200 $132,300 $144,550 $154,350 Ending balance $ 29,400 $ 34,300 $ 36,750 $ 39,200 Schedule 10: Ending inventories – cost basis Dec. 31, 2014 First quarter Second quarter Third quarter Fourth quarter Materials inventory: Plywood (square feet) $ 2,750 $ 2,351 $ 2,516 $ 2,599 $ 2,434 Trim (linear feet) 510 436 467 482 451 Total materials inventory $ 3,260 $ 2,787 $ 2,983 $ 3,081 $ 2,885 EXEC finished goods inventory 21,949 21,949 23,516 25,084 23,516 Total inventories $25,209 $24,736 $26,499 $28,165 $26,401 Schedule 11: Accounts payable First quarter Second quarter Third quarter Fourth quarter Beginning balance $ 6,000 $ 5,240 $ 6,525 $ 6,938 Purchases on account 13,099 16,312 17,346 17,614 Total payables $19,099 $21,552 $23,870 $24,556 Decreases in payables: Payments of prior quarter's $ 6,000 $ 5,240 $ 6,525 $ 6,938 purchases Payments of prior quarter's 7,860 9,787 10,407 10,571 purchases Total cash payments $13,860 $15,027 $16,932 $17,509 Ending balance $ 5,240 $ 6,525 $ 6,938 $ 7,047 For accounts receivable, the percentage of net sales collected in the current quarter is 75 percent and cash discounts are 2 percent of collections of the current quarter's net sales. Inventory values use quantities from Schedules 4 and 5 and costs from Schedule 1. For accounts payable, Schedule 2 indicates that 60 percent of purchases are paid in the current quarter. Cost of Products Manufactured and Sold Schedule Now all the elements are in place to prepare a schedule of the cost of goods manufactured and sold. These costs are forwarded in summary form to the income statement. Schedule 12: Cost of podiums manufactured and sold First quarter Second quarter Third quarter Fourth quarter Total Materials inventory: Plywood (square feet) $ 9,900 $11,756 $12,581 $12,994 $ 47,231 Trim (linear feet) 3,672 4,361 4,667 4,820 17,519 Total materials used $13,572 $16,117 $17,248 $17,813 $ 64,750 Direct labor 28,800 34,200 36,600 37,800 137,400 Factory overhead applied 32,880 39,045 41,785 43,155 156,865 Cost of EXECs manufactured $75,252 $89,362 $95,633 $98,768 $359,015 Plus: Beginning inventory 21,949 21,949 23,516 25,084 21,949 Less: Ending inventory (21,949) (23,516) (25,084) (23,516) (23,516) Cost of EXECs sold $75,252 $87,794 $94,065 $100,336 $357,447 Overapplied/(Underapplied) (3,720) (480) 960 1,680 (1,560) overhead Adjusted cost of EXECs sold $78,972 $88,274 $93,105 $98,656 $359,007 Using Schedule 12, a useful proof can be made. With product costs from Schedule 1 and sales from Schedule 3, total costs of EXECs sold can be calculated quickly: $357,447. These numbers can be checked against the sums of materials, labor, applied overhead, and the changes in inventories. For each product in each quarter these numbers should match. Selling and Administrative Expense Budgets Expenses of promoting, selling, and distributing the products are budgeted by combining the costs into a selling or marketing expenses budget (Schedule 13). Administrative expenses are fixed costs and are allocated to the four quarters. Schedule 13: Selling and administrative expenses budget First quarter Second quarter Third quarter Fourth quarter Total Selling expenses: Sales commission expenses $ 4,704 $ 5,488 $ 5,880 $ 6,272 $22,344 Advertising and other sales 4,000 4,000 4,000 4,000 16,000 expenses Sales salaries expenses 7,500 7,500 7,500 7,500 30,000 Shipping expenses 3,120 3,640 3,900 4,160 14,820 Total selling expenses $19,324 $20,628 $21,280 $21,932 $83,164 Administrative expenses: Wage and salaries expense $15,000 $15,000 $15,000 $15,000 $ 60,000 Other administrative 3,500 3,500 3,500 3,500 14,000 expenses Total administrative 18,500 18,500 18,500 18,500 74,000 expenses Total selling and $37,824 $39,128 $39,780 $40,432 $157,164 administrative expenses Project Budgets Few project budgets exist in this example. Schwartzben Products has a small capital investment and research and development budget, which is shown in Schedule 14. Equipment purchases are capitalized, and research and development costs are expensed. Schedule 14: Capital investment project budget First quarter Second quarter Third quarter Fourth quarter Total Projects: Equipment purchases $ 8,000 $ 0 $10,000 $12,000 $30,000 Research and 0 0 0 4,000 4,000 development expenses Total project $ 8,000 $ 0 $10,000 $16,000 $34,000 expenditures Cash-Flow Forecasts Now that all operating and project budgets are in place, the time for summarizing has arrived. The first summary is the preparation of the cash-flow forecast. Nearly every schedule impacts cash. The basic structure is to list receipts and disbursements, sum to a cash balance, and show any planned investing or borrowing activities. In Schedule 15, a source document for each cash-flow item is cited. Schedule 15: Cash-flow forecast First quarter Second quarter Third quarter Fourth quarter Total Cash inflows: Collections from Schedule 9 $126,436 $130,242 $142,345 $151,998 $551,021 sales Interest received Balance 0 0 0 0 0 sheet Total cash inflows $126,436 $130,242 $142,345 $151,998 $551,021 Cash outflows: Purchases Schedule 11 $ 13,860 $ 15,027 $ 16,932 $ 17,509 $ 63,328 payments Direct labor payroll Schedule 6 28,800 34,200 36,600 37,800 137,400 Factory overhead Schedule 8 31,600 34,525 35,825 36,475 138,425 Selling& Schedule 13 37,824 39,128 39,780 40,432 157,164 administrative exp Interest payments Balance 1,125 1,125 1,058 1,103 4,410 sheet Income taxes Balance 2,000 (834) 2,673 4,323 8,162 payments sheet Dividend payments Schedule 2 1,200 1,200 1,200 1,200 4,800 Project budget Schedule 14 8,000 0 10,000 16,000 34,000 payments Note payable Schedule 2 3,000 3,000 3,000 3,000 12,000 repayments Total cash outflows $127,409 $127,371 $147,068 $157,841 $559,689 Cash inflows minus $ (973) $ 2,871 $ (4,723) $ (5,843) $ (8,668) outflows Plus: Beginning 6,000 5,027 7,898 8,176 6,000 cash Cash available $ 5,027 $ 7,898 $ 3,176 $ 2,332 $ (2,668) Less: Excess cash 0 0 0 0 0 on hand Plus: New 0 0 5,000 5,000 10,000 borrowing needed Ending cash $ 5,027 $ 7,898 $ 8,176 $ 7,332 $ 7,332 balance Cumulative $ 0 $ 0 $ 5,000 $10,000 $10,000 borrowings Cumulative $ 0 $ 0 $ 0 $ 0 $ 0 investments A key part of cash-flow forecasting is to anticipate cash deficits or surpluses. If the cash balance falls below the minimum desired level (given in Schedule 2), bank borrowings or investment sales are needed. If the cash balance exceeds the maximum level, excess cash should be invested to ensure maximum earnings. Calculations at the bottom of Schedule 15 forecast that Schwartzben Products will need to borrow cash. The Completed Example: Forecast Financial Statements The operating data presented determine the forecast financial results. Consolidation of operating numbers into forecast financial statements is frequently the controller's responsibility. These statements are reviewed carefully by the firm's executives. In this example, the source schedule for each account balance is listed to help explain the income statement and balance sheet numbers. Forecast Income Statements. The forecast or pro forma income statement is a summary of the expected revenue and expense budgets. Management can compare its actual income statements with the forecast statements as the year progresses. If budgeted profits are to be realized, adjustments may have to be made. Perhaps the budget itself requires revision. Schwartzben Products Company – forecast income and expense statements First quarter Second quarter Third quarter Fourth quarter Total Source Sales $117,600 $137,200 $147,000 $156,800 $558,600 Schedule 3 Cost of goods sold $ 75,252 $ 87,794 $ 94,065 $100,336 $357,447 Schedule 12 Factory variances (3,720) (480) 960 1,680 (1,560) Schedule 8 Net cost of goods sold $ 78,972 $ 88,274 $ 93,105 $ 98,656 $359,007 Gross margin on sales $ 38,628 $ 48,926 $ 53,895 $ 58,144 $199,593 Selling & $ 37,824 $ 39,128 $ 39,780 $ 40,432 $157,164 Schedule administrative expense 13 Research & 0 0 0 4,000 4,000 Schedule development expense 14 Total operating $ 37,824 $ 39,128 $ 39,780 $ 44,432 $161,164 expenses Operating income $ 804 $ 9,798 $ 14,115 $ 13,712 $ 38,429 Schedule 11 Other: Interest income $ 0 $ 0 $ 0 $ 0 $ 0 Calculated Interest expense (1,125) (1,058) (1,103) (1,148) (4,433) Calculated Sales cash discounts (1,764) (2,058) (2,205) (2,352) (8,379) Schedule 9 Total other items $ (2,889) $ (3,116) $ (3,308) $ (3,500) $(12,812) Net income before $ (2,085) $ 6,683 $ 10,808 $ 10,213 $ 25,618 taxes Income tax expense (834) 2,673 4,323 4,085 10,247 Calculated Net income $ (1,251) $ 4,010 $ 6,485 $ 6,128 $ 15,371 As can be seen, most amounts are summarized from earlier schedules. Only the interest income and expense and income tax expense are computed here from data in Schedule 2 and from amounts already calculated. All other amounts were taken from other budget schedules. Forecast Balance Sheets. The forecast or pro forma balance sheet indicates the firm's financial position at a future date. Like the income statement, it is a summary statement that depends on individual budgets that have been prepared. The forecast balance sheet also serves as a point of reference during the year. Interim statements prepared at various dates can be compared with corresponding budget statements. Schwartzben Products Company – forecast balance sheets Dec 31, 2014 Mar 31, 2015 June 30, 2015 Sept 30, Dec 31, Source Assets: Cash $ 6,000 $ 5,240 $ 7,898 $ 8,176 $ 7,332 Schedule 15 Short-term 0 0 0 0 0 Schedule investments 15 Accounts receivable 40,000 29,400 34,300 36,750 39,200 Schedule 9 Inventories 25,209 24,736 26,499 28,165 26,401 Schedule 10 Interest receivable 0 0 0 0 0 Income Stmt Total current assets $ 71,209 $ 59,163 $ 68,697 $ 73,090 $ 72,934 Building and $360,000 $368,000 $368,000 $378,000 $390,000 Schedule equipment 14 Accumulated (100,000) (105,000) (110,000) (115,000) (120,000) Schedule depreciation 8 Total assets $331,209 $322,163 $326,697 $336,090 $342,934 Liabilities and equity: Accounts payable $ 6,000 5,240 $ 6,525 $ 6,938 $ 7,047 Schedule 11 Taxes payable 2,000 (834) 2,673 4,323 4,085 Income Stmt Bank borrowings 0 0 0 5,000 10,000 Schedule 15 Interest payable 1,125 1,125 1,058 1,103 1,148 Income Stmt Total current $ 9,125 $ 5,531 $ 10,255 $ 17,364 $ 22,280 liabilities Long-term notes 50,000 47,000 44,000 41,000 38,000 Schedule payable 15 Total liabilities $ 59,125 $ 52,531 $ 54,255 $ 58,364 $ 60,280 Capital stock $240,000 $240,000 $240,000 $240,000 $240,000 Schedule 3 Retained earnings 32,084 29,633 32,442 37,727 42,654 Schedule 15, Income Stmt Total equity $272,084 $269,633 $282,442 $277,727 $282,654 Total liabilities and $331,209 $322,163 $326,697 $336,090 $342,934 equity Master Budget Summary Several observations should be made about the master budget example. The budget should be tested for reasonableness, including: A review of the reasonableness of critical independent variables (most often the sales forecast) as a key evaluation step. A sensitivity analysis to determine whether small changes in key variables will cause major changes in profitability or cash flows. "What if" analyses to determine whether a better combination of resource inputs could produce a stronger plan. A budget review and approval by each manager involved in the planning effort. An analysis to determine whether the management's goals and objectives are realized. Many iterations may be needed to arrive at a budget that managers can accept, meets management's goals, and pushes the firm toward its long-range goals. 6.9 Impacts of Contemporary Manufacturing Approaches The evolution of manufacturing approaches has, in some cases, had major impacts on budgeting. The following observations can be made: Just-in-time systems reduce inventory needs and may even eliminate their role in production budgeting. Some firms have reduced major component inventories to under two hours of production requirements. Shorter lead times place greater pressure on production planning. Small mistakes or delays can cause entire plants to stop—incurring nonproductive costs and lost output. Activity-based costing will likely increase the number of cost drivers and cost centers. Budgeting may actually be easier since costs and activity are more closely related. Flexible manufacturing and team production activities change the collection of cost data—where, how, and what. Costs will be regrouped for improved planning and control. Also, greater emphasis is placed on certain costs, such as costs of quality, manufacturing cycle times, value-added labor, and manufacturing throughput. The reduction of lead times and buffers throughout the production process means planning grows in importance. Chapter Summary One major management function is to plan and control the activities of an organization. A planning and control system includes a strategic plan, a responsibility accounting system, a master budget, and financial modeling. Cost or activity, profit, and investment centers define a manager's sphere of responsibility. The glue that holds planning activities together is the budget. Purposes of budgeting are outlined. The master budget is an integrated set of schedules; it ties operating, project, and financial budgets together. The operating budget begins with the constraining variable, most commonly the sales forecast. All operating budgets are integrated into the cash-flow budget and forecast financial statements. Understanding how to organize budget data and to format budget schedules can ease the assimilation of the huge amount of budget data brought together to create an operating plan. A master budget example was developed to show the integrative nature of the various budget schedules. Other budgeting approaches were presented. Flexible budgeting allows managers to be evaluated according to the actual activity they experience. Project budgeting prepares plans that span normal annual timeframes or are nonroutine in nature. Probabilistic budgeting gives managers an opportunity to bring into the budgeting process a range of estimates for key variables. Consideration is given to managers' budget-related behavior and the impacts that budgets have on people. Areas of particular importance are top-management's support of the budget, budgetary slack, budget stress, and ethical issues. Problem for Review The production manager of Riley Enterprises maintains an inventory of materials equal to production needs for the next month because of the possibility of delays in shipments from his Korean supplier. Each unit takes 4 pounds of materials, which cost $3 per pound. The target for finished goods inventory is 20 percent of the following month's sales. Budgeted sales in units for the first five months of 2015 are: Month Budgeted sales Month Budgeted sales January 12,000 April 16,000 February 16,000 May 20,000 March 15,000 At December 31, 2014, 60,000 pounds of materials and 3,000 units of finished goods were on hand. Question: Prepare a budget for production in units and a budget for purchases in pounds and dollars for the first three months of 2015. Solution: Production plan in units: January February March April May Sales 12,000 16,000 15,000 16,000 20,000 Ending inventory (20 % of next month) 3,200 3,000 3,200 4,000 Total units needed 15,200 19,000 18,200 20,000 Beginning inventory available 3,000 3,200 3,000 3,200 Production required 12,200 15,800 15,200 16,800 Purchases budget: January February March April Production required 12,200 15,800 15,200 16,800 Pounds per unit × 4 × 4 × 4 × 4 Pounds required 48,800 63,200 60,800 67,200 Ending inventory (next month's production 63,200 60,800 67,200 requirements) Total pounds needed 112,000 124,000 128,000 Beginning inventory available 60,000 63,200 60,800 Materials purchases in pounds 52,000 60,800 67,200 Cost per pound × $3 × $3 × $3 Materials purchases in dollars $156,000 $182,400 $201,600 Key Terms Click on each key term to see the definition. benchmark bill of materials bill of materials explosion budget budget slack cash management control expected value financing assumptions flexible budget goals and objectives investment center long-range goals master budget mission statement operating assumptions operating budget operating cycle planning planning assumptions pro forma (or forecast) financial statements profit center profit plan project budget responsibility accounting responsibility center revenue center roll-up reporting sales forecast strategic plan Questions for Review and Discussion Reread the vignette about Ann Davis at the beginning of the chapter. Respond to each of her comments about budgeting. Give a possible reason for why she thinks that way. What retort could you give to each comment? Identify and explain at least five purposes of budgeting. What are the similarities and differences among an activity center, a cost center, a profit center, and an investment center? What is the difference between an independent variable and a dependent variable in the budgeting process? Give three examples of each. For what kinds of business activities are project budgets useful? Why are the human behavioral concerns important in budgeting? Identify and explain the concerns. If Schwartzben Products Company were a wholesaler and not a manufacturer, how would the master budget sequence as presented change? From the master budget example, identify the independent variables. Which schedules contain only dependent variables? Explain why preparing the cash-flow forecast requires that all operating and project budget schedules be completed first. In the Schwartzben Products Company example, trace the following numbers back to independent variables: Schedule 5, first-quarter ending plywood inventory: 8,550 square feet. On Schedule 6, third-quarter direct labor hours: 3,050 hours. On Schedule 8, second-quarter indirect labor and fringe benefits expenses: $14,535. On Schedule 11, third-quarter payment of prior quarter's purchases: $6,525. Exercises 6-1. Types of Responsibility Centers. The list below describes a variety of business situations: The parts department of an automobile dealership. A convenience store that is owned by a chain organization. The goods to be sold and the selling prices are all determined by the corporate office. The wing assembly department of a private airplane manufacturer. The janitorial department of an office furniture manufacturer. The women's shoe department in a large retail store. The buyer, an assistant department manager, decides which styles, sizes, etc., are purchased. The department supervisor sets selling prices. The marketing department of a local TV station. The purchasing department for a large electronics company. The PC product line of a major computer manufacturer that is organized by product lines. The technical support department for a large computer software company. Customers call an 800 number and ask questions about problems they are experiencing with software purchased from the company. The car pool operation for a city government. City officials needing cars check them out for the days of travel. Question: For each business segment, indicate how it is most likely to be organized: as a cost center, a profit center, or an investment center. State any additional assumptions you feel are necessary to clarify a situation. 6-2. Forecast Cash Payments. Jaret's Shoe Shop is preparing its cash budget for the month of November. The following information is available about its operation: November beginning inventory $18,000 Estimated November cost of goods sold 90,000 Estimated November ending inventory 16,000 Estimated November payments for purchases made prior to November 21,000 Estimated November payments for purchases made in November 80 % Question: What are the estimated cash payments in November for Jaret's Shoe Shop? 6-3. Cash Receipts. Hampshire Company, located in Manchester, U. K., prepared the following sales budget for the first six months: January February March April May June Sales units 6,000 7,000 7,500 8,500 7,800 8,300 Units sell for £20 each. Twenty percent of sales is for cash, and the remainder is on account. The firm forecasts collection of sales on account to be 60 percent in the month of sale with the remainder collected in the next month. Beginning receivables at January 1 is £40,000. Questions: Find the forecast cash receipts for each month. If more customers use credit cards, causing cash sales to increase to 40 percent of total sales, by how much is cash increased in the second quarter? 6-4. Purchases and Payments. Cumberland Company sells course note packets for classes with high enrollments at Prestige University. Each packet sells for $10, and the purchase cost is $6 per packet. The firm keeps an inventory of 40 percent of next month's forecast sales. Each month, it pays suppliers 70 percent of the current month's purchases, and the remainder is paid in the following month. The Spring semester's sales budget is: January February March April May Sales $6,000 $4,000 $3,000 $6,000 $1,000 Questions: Calculate Cumberland's budgeted purchases per month through April. Show Cumberland's cash payments to suppliers per month from February through April. 6-5. Flexible Budgeting. P.W.'s Bicycle Co. operates a repair shop on Mayfield Road. PeeWee, the owner, has calculated his overhead costs per year to be $10,000 plus $10 per bicycle repaired. In late 2014, he prepared a budget for repairing 500 bikes in 2015. He actually repaired 550 bikes in 2015 and spent $15,200 for overhead expenses. Question: Comment on each of the following statements about 2015 activities. His cost function is ($10,000/500) + $10, or $30 per bike. His spending was $300 under his adjusted budget; therefore, he did control costs well. His original budget for 2015 (prepared in late 2014) was $15,500. His spending was $200 over his original budget; therefore, he did not control costs well. 6-6. Performance Report with a Budget Formula. Desert Rat Rentals, operating in Quartzite, Arizona, has one department totally dedicated to dune buggies. The company rents them at a daily rate plus mileage. The company's accountant, Dusty Aire, developed the following annual budget formula for each cost related to the dune buggies and the actual costs for this season, which just ended: Cost item Formula This season's actual costs Fuel and oil $0.40 per mile $ 9,735 Chassis and other 0.05 per mile plus $1,000 2,190 lubricants Repairs 0.06 per mile plus 1,200 2,705 Depreciation 2,500 2,500 Licenses, taxes, and fees 2,600 2,930 Insurance expenses 1,600 1,735 Total budget formula $0.51 per mile plus $8,900 $21,795 During the season, records of Desert Rat Rentals show that the dune buggies were driven 24,000 miles. Question: Prepare a responsibility performance report for Dusty that will show the budget, actual results, and variances for the Dune Buggy Department for this season. 6-7. Budget Comments. Comment briefly on the following quotes about budgeting from a financial planning textbook: "One major criticism of budgeting is that it is used as a 'cost reduction' tool rather than a 'cost control' tool. The objective of the budget is to control costs at an efficient level of operation." "There are generally three benefits from allowing employees to participate in developing the budget: (1) Employees tend to accept the budget as their own plan of action. (2) Participation tends to increase morale among employees and toward management. (3) Employee cohesiveness is increased, and productivity will also increase if dictated by the group norm." "Even though budgets are quantitative tools, considerable emotion is connected to budgeting. The individual in control often sees the budget as a means of getting things done. People being controlled often have feelings of anxiety because their success and promotion are tied directly to the budget." 6-8. Purchases and Cash Payments. A production plan by quarter for ADS Company is: First quarter 24,000 units Third quarter 32,000 units Second quarter 30,000 Fourth quarter 42,000 Four units of materials are used in producing each unit of product. Each unit of materials costs $0.60. Ending materials inventory is to be equal to 25 percent of production requirements for the next quarter. This requirement was met at the beginning of the year. Production for the first quarter following the budget year is estimated at 28,000 units. Accounts payable for materials purchased is estimated at $38,400 at the beginning of the current budget year. Forecast accounts payable at the end of the quarter should equal 40 percent of the purchases during the quarter. Questions: Determine the units of materials to be purchased each quarter. Determine the cost of materials purchases by quarter. Estimate the payments to be made each quarter for materials. 6-9. Various Budget Schedules. JRS Candies is preparing a budget for the second quarter of the current calendar year. The March ending inventory of merchandise was $106,000, which was higher than expected. The company prefers to carry ending inventory amounting to the expected sales volume of the next two months. Purchases of merchandise are paid half in the month of purchase and half in the month following purchase, and the balance due on accounts payable at the end of March was $24,000. Budgeted sales are as follows: April $50,000 July $72,000 May 48,000 August 56,000 June 60,000 September 60,000 Questions: Assume that a 25 percent gross profit margin is budgeted. Prepare a budget schedule that shows the following for April, May, and June: Cost of goods sold. Purchases required. Cash payments for merchandise. Assume that the accounts receivable balance on April 1 was $35,000 and that three-fourths of all customers pay in the month of sale and one-fourth in the month following the sale. Prepare a budget showing the cash receipts from accounts receivable for April, May, and June. 6-10. Adequacy of Cash Flow with "What Ifs." Marcy Lynn is preparing a budget of cash receipts and disbursements for Gourmet Food Services, Inc. Some sales are for cash, and the remainder is billed on a contract basis. Sales for April to August are: Cash sales Billed sales Total sales April $65,000 $40,000 $105,000 May 72,000 46,000 118,000 June 84,000 68,000 152,000 July 88,000 72,000 160,000 August 86,000 70,000 156,000 Of the billed sales, 65 percent is collected during the month of sale; the other 35 percent is collected the next month. Food costs amounting to 75 percent of sales must be paid during the month of sales. Monthly operating costs are $24,000. The cash balance at May 1 amounted to $7,000. If the cash balance is over $20,000 on August 31, Marcy and the other shareholders will receive the excess as dividends. Questions (use of spreadsheet software is recommended): Prepare a budget of cash receipts and disbursements for each month, May to August, inclusive. Compute the amount, if any, that can be paid in dividends at the end of August. What is the impact on possible dividend payments in the following situations? "What if" competitive pressures cause food costs to increase to 80 percent of sales? "What if" collections of billed sales slow to 50 percent in the month of sale and 50 percent in the next month? 6-11. Managerial Behavior and Budget Ethics. Freid Corporation has seen a new revision of the budget system each year for the past five years. Bonuses followed strong budget performances. The following are changes made during the past few years: Change 1: One year top management felt that, since wages were 60 percent of total expenses, the budget should simply focus on keeping next year's headcounts equal to or below the current year's level. Most managers did this by shifting work to outside contractors. Change 2: Concern over customer service caused top management to budget the number of back orders issued because an item was not available from existing inventory. A trip to Tahiti was given to managers with zero actual back orders. Change 3: Because corporate expenses were viewed as being too high, the president decided to allocate all home office expenses to the nine divisions. Each division head budgeted down to "net income" and was evaluated on the comparison of actual to planned "net income." Change 4: Also, at the final budget approval stage for the last several years, the president forced each division to reduce its total expenses by an even five percent across the board. This year, the president increased the across-the-board cuts to 10 percent. Question: Comment on Freid Corporation's approach to budgeting and the possible impacts each change might have on the budget process and managers' behavior. Problems 6-12. Responsibility Accounting and Roll-up Reporting. Greenblatt Packaging Corporation has two plants, one in Los Angeles and one in Singapore. Each plant has a forming and a packing department. Production for the forming department of the Los Angeles Plant is estimated at 1,600 tons for June. The budgeted costs per ton are as follows: Direct materials $8 Direct labor 15 Factory overhead (half fixed and half variable). 10 Total per ton. $33 Total budgeted production costs for the packing department are $33,000 for June. Budgeted costs for the plant manager's office are $57,000. Budgeted costs for the Singapore plant total $67,000. The vice-president of production is responsible for both plants and has $54,000 of budgeted expenses. Budgeted expenses for the company's vice-president of marketing's office are $112,600. The president's office budget is $60,000. In June, 1,500 tons were produced, and actual expenses were as follows: President's office $62,300 Los Angeles plant: Vice-president of marketing 109,800 Plant manager's office $58,300 Vice-president of production 55,500 Packing department 34,900 Singapore plant – total costs 70,100 Forming department: Direct materials 10,600 Direct labor 23,400 Overhead 13,200 Question: Prepare responsibility reports showing the appropriate budget, actual expenses, and variances from budget for each of the following: Forming department in Los Angeles plant. Plant manager for the Los Angeles plant. Vice-president of production. President of the company. 6-13. Responsibility Reporting. The following accounts and amounts (with 000s omitted) for Waitzman Company were taken from the accounting and budgeting records for June: June Year-to-date Acct. no. Account name Actual Budget Actual Budget 5110 Advertising $125 $135 $833 $810 5120 Bad Debt Expense 37 36 218 216 5130 Sales Commissions 109 111 754 670 6100 Direct Materials 1,319 1,388 8,178 8,328 6200 Direct Labor 749 751 4,599 4,506 6310 Depreciation – Factory Machinery 45 45 275 280 6320 Factory Rent 244 244 1,464 1,464 6330 Factory Utilities 34 33 237 218 6340 Indirect Labor 176 174 1,056 1,044 6350 Property Taxes – Factory Machinery 19 21 114 126 6360 Repairs and Maintenance – Factory 47 50 351 320 7120 Property Taxes – Office Equipment 7 8 42 48 7130 Salaries of Administrative Personnel 1,687 1,601 9,122 9,606 Question: Prepare a responsibility performance report for manufacturing operations. Use a format you think will best show budget performance. 6-14. Budgeted Income Statement for a Service Organization. The Ole Route 66 Motel is a low-priced motel in Winslow, Arizona, along Interstate 40. It has 50 rooms, each with two double beds. The rates are $18 for one person, $10 for the second person, and $3 each for the third and fourth persons. Rollaway beds are available for $2 per night. During April, the motel manager expects an 80 percent occupancy rate. Past experience suggests that 20 percent of the rooms rented will be to only 1 person, 20 percent to 2 persons, 30 percent to 3 persons, and 20 percent to 4 persons. Ten percent will have 5 persons and use rollaway beds. Laundry costs average $1.00 per person per night. Cleaning workers earn $6.00 per hour, and it takes 30 minutes to clean each room. Other variable operating costs (utilities, for example) are $4 per occupied room per night. Maintenance and grounds personnel costs are about $1,500 per month. Two clerks each have a salary of $1,200 per month. Depreciation is $2,000 per month. Other cash fixed expenses are $3,500 per month. Questions: Prepare a budgeted income statement for April. Suggest an average occupancy percentage needed to break even if the average number of people staying in a room is three. 6-15. Production and Inventories. Freedman Company has irregular sales volume during the year, and management is planning to produce at a uniform rate with inventories increasing or decreasing throughout the year. A sales budget in product units is forecast for the first six months of the year, as follows: Months Units Months Units January 40,000 April 25,000 February 25,000 May 40,000 March 20,000 June 50,000 The production cycle is short, and work in process inventories are insignificant. An inventory of 10,000 units was on hand at January 1, and 20,000 units of inventory are planned for June 30. Question: Prepare a production schedule that will have level production each month while showing the expected inventories at the end of each month. Comment on the problems this approach creates. Why is it attractive? 6-16. Project Management. In the Hurwitz Corporation, an advertising project is forecast to cost $100,000, generate $200,000 in additional variable contribution margin, and take 6 months to complete. It is now 4 months into the project, and $60,000 has been spent. Hurwitz estimates that it is one-third done and that it will take another 8 months and $100,000 to complete the project. Current estimates now show that the forecast additional variable contribution margin will be $160,000. Hurwitz is at a "go" or "no go" point on this project. Questions: How does Hurwitz report the project relative to the budget? How does Hurwitz report this project in its "plan of action," if approved for continuation? Should the project be "canned" or continued at this "go" or "no go" point? Explain. 6-17. Expected Cash Flow. Gartner Equipment Company is planning to expand beyond the industrial market of its materials handling equipment to produce trailers for the sports and recreation markets. The president, Bruce Gartner, estimates that the company must invest $1,800,000 in new equipment up front. He wants to know how much cash flow can be provided by operations next year to apply toward acquiring the equipment and how much of the cost will have to be financed. His sales staff estimates revenue next year at $8,500,000. However, if economic conditions deteriorate, sales revenue may be only $6,500,000. Cost of goods sold has historically been 70 percent of revenue. A possibility exists that the company will have to absorb cost increases that cannot be passed along to customers. In this case, the cost of goods sold will be 80 percent of revenue. With sales down to $6,500,000, the cost of goods sold will definitely be 80 percent of revenue. Probabilities of occurrence have been estimated for each of three alternatives as follows: Operating revenues and cost of goods sold Expenses Probabilities Sales at $8,500,000, cost of goods sold at 70 percent $1,050,000 30% Sales at $8,500,000, cost of goods sold at 80 percent 1,200,000 50% Sales at $6,500,000, cost of goods sold at 80 percent 1,100,000 20% Depreciation of $280,000 is included in operating expenses under each alternative, and depreciation of $350,000 is included in cost of goods sold for each alternative. Income taxes are estimated at 40 percent of income before income taxes. In making the transition, equipment will be sold for $600,000, net of income taxes. A payment of $350,000 must be made on long-term notes payable. Bruce wants dividends of $300,000 to be paid under each alternative. Question: What is the "worst case" cash-flow scenario that Bruce could face? Prepare a statement to show the forecast cash flow provided by operations under each assumption and the expected value of cash flows. Continue the forecast statement to show how much additional cash will be needed to finance the new project after considering the information given. Show the impact of all three assumptions on expected cash flows. 6-18. Budgeted Cost of Goods Manufactured. Ayal Plastic Products had inventories of 75,000 pounds of raw materials and 25,000 units of finished product on January 1. Sales forecasts for the first six months are as follows: January 40,000 units April 70,000 units February 55,000 May 60,000 March 50,000 June 70,000 Ayal maintains a finished goods inventory equal to 40 percent of the forecast sales of the next month and a raw materials inventory equal to 30 percent of the next month's production requirements. Each unit of product requires 3 pounds of raw materials at $5 per pound. The budgeted direct labor cost is $8 per hour, and each finished unit requires 30 minutes. Variable factory overhead is 40 percent of raw materials costs. Fixed factory overhead, including depreciation of $10,000, totals $90,000 per month and is applied using units. Normal volume is 60,000 units per month. Questions (use of spreadsheet software is recommended): Prepare a budgeted cost of goods manufactured schedule. Include supporting schedules needed to calculate product cost components and unit costs. Analyze the overhead flexible budget and amounts applied. Comment on the following: "What if" beginning inventory of raw materials was only 15,000 pounds? "What if" finished goods inventory level is only 20 percent of next month's sales? "What if" normal capacity is 50,000 units per month? 6-19. Cash Flows and "What If." Dennis Christopher, a member of the board of directors of Italy Markets, Inc., is concerned about the ability of the company to repay a loan in the amount of $250,000 that matures on June 30, 2015. In addition to the principal of the loan, the company must pay interest of $50,000. The cash balance at January 1, 2015, is $82,000. Sales for December 2014 through June 2015 are budgeted as follows: Net sales December 2014 $236,000 January 2015 137,000 February 142,000 March 182,000 April 170,000 May 156,000 June 148,000 Cash sales each month are equal to approximately 30 percent of net sales. Collections on accounts receivable are expected as follows: 60 percent collected during the month of sale. 40 percent collected in the following month. Total cash disbursements are estimated at $115,000 each month. Questions (use of spreadsheet software is recommended): Prepare a cash budget for each month and in total for the six months of 2015. Will the company be able to pay the loan with interest and still maintain a cash balance of no less than $60,000 on June 30? Explain. If actual sales are 10 percent lower than the forecast each month while cash expenses drop by only $5,000 per month, what will happen to the company's ability to pay off the loan and keep the cash balance at the desired level? If the sales and expenses fall as in Part (3) and collections patterns change to 40 percent collected in the current month and 60 percent in the following month, what will happen to the company's cash situation? 6-20. Product Cost Budget. The management of Burin Glass Products is aware of increased competition in the industry and has taken steps to improve cost control. Product costs on a per unit basis for last year are as follows: Product lines Red White Blue Direct materials $6 $3 $5 Direct labor 3 2 3 Applied factory overhead 3 2 3 Total unit cost $12 $ 7 $11 Units produced last year 300,000 240,000 340,000 The direct materials are manufactured by another division of the company which agreed to lower its price by 10 percent for this year. Direct labor cost will increase from $12 to $15 an hour, but increased productivity is planned. The revision of the production process will make it possible to manufacture 6 units of Red per hour, 8 units of White, or 10 units of Blue. Fixed overhead cost will, however, increase by $100,000 a year. This year's planned volumes are the same as last year's actual output. Last year the company operated at a normal activity level set at 200,000 direct labor hours with budgeted and actual factory overhead costs of $2,400,000. This year, normal activity is to be reset at 150,000 direct labor hours with factory overhead amounting to $2,100,000 (including the fixed overhead increase). Questions: Determine the cost of production this year in total and on a per unit basis. Compute the expected cost savings in total. Comment on the impact of the changes. 6-21. Forecast Balance Sheet. Ira Electronics, Inc. designs and assembles electronic systems used by a variety of organizations. Its principal products are medical measurement systems and instrumentation systems for chemical analyses. As a member of the budgeting team, your assignment is to prepare the budgeted balance sheet, based on information provided by other team members. The latest actual balance sheet shows: Beginning balance sheet, December 31 (in millions) Current assets: Current liabilities: Cash $479 Accounts payable $249 Accounts receivable 590 Accrued income taxes 132 Inventories 511 Other liabilities 280 $661 Prepaid expenses 30 Long-term debt 143 Total current assets $1,610 Total liabilities $804 Plant and equipment $1,397 Shareholders' equity: Less: depreciation 462 Common stock $356 Net plant and equipment 935 Retained earnings 1,385 1,741 Total assets $2,545 Total liabilities&equity $2,545 Cindy Feuer, another member of the team, has given you the following budgeted income statement for the coming year: Forecast income statement (in millions) Sales revenue $3,253 Cost of goods sold 1,583 Gross profit $1,670 Operating expenses: $1,670 Marketing $590 General and administrative 358 Research and development 343 1,291 Net income before taxes $379 Provision for income taxes 134 Net income after taxes $245 The controller has also furnished you with a number of assumptions, policies, and other information as follows: The company has made arrangements to acquire plant and equipment during the year for $339 million. Long-term debt will finance $18 million, and cash will be used for the remainder. All sales are on credit. Collections on credit sales for the year are scheduled to be $3,218 million. Changes in several account balances are planned. Inventories will decrease by $15 million. Other accrued liabilities will increase by $70 million. Prepaid expenses will increase by $10 million. Depreciation expense in the forecast income statement totals $105 million. Payments of accounts payable will total $2,682 million and on accrued income taxes will be $179 million. Common stock will be sold to employees in a special stock purchase plan for $34 million. Dividends of $29 million will be declared and paid during the year. Questions: Prepare a forecast yearend balance sheet. Does the proposed financing of new plant and equipment strain the cash position? Explain. Identify several danger areas in the forecast that might cause the asset acquisition to be difficult to finance. What other sources of cash might exist? 6-22. Ethical Use of Modeling. Jack Horowitz, a personal financial planning consultant, uses a "personal wealth builder" financial model to help evaluate his clients' current financial positions and desired retirement and estate goals. Most clients are relatively naive about financial matters. He represents a national life insurance company, a set of mutual fund companies, and other investment programs such as real estate and energy partnerships, precious metals, and annuities. He is properly licensed to provide counsel and to sell these products. He derives the majority of his income from insurance and mutual fund sales. He also does personal advising on a fee-only basis, a minor part of his business. Jack's model has numerous assumptions built in to allow quick evaluation of a person's wealth potential given that person's current investment program and income levels. Jack knows about these assumptions, many of which he can change given the client situation and need. Much data must be provided by the client, mostly current and historical data and some forecast or desired future needs and goals. From the model comes a set of suggestions for financial planning. These suggestions identify (1) serious gaps in current financial protection, such as disability insurance and accidental death coverage; (2) changes in current investments to increase rates of return or safety; (3) actions needed to achieve near-term financial goals, such as paying for college tuition; (4) retirement planning to ensure adequate income and financial safety to enjoy the "golden years" and (5) estate planning to ensure that the client's heirs receive their maximum entitlements. Question: Jack has found that the "personal wealth builder" financial model has great credibility with clients. They see it as a "black box" that provides financial answers to difficult questions. Identify possible ethical problems with using this model in Jack's normal client contracts. Give suggestions to Jack about how he can assure his clients of a fair evaluation. Case: Chester & Wayne Chester & Wayne is a regional food distribution company. Mr. Chester, CEO, has asked your assistance in preparing cash-flow information for the last three months of this year. Selected accounts from an interim balance sheet dated September 30, have the following balances: Cash $142,100 Accounts payable $354,155 Marketable securities 200,000 Other payables 53,200 Accounts receivable 1,012,500 Inventories 150,388 Mr. Wayne, CFO, provides you with the following information based on experience and management policy. All sales are credit sales and are billed the last day of the month of sale. Customers paying within 10 days of the billing date may take a 2 percent cash discount. Forty percent of the sales is paid within the discount period in the month following billing. An additional 25 percent pays in the same month but does not receive the cash discount. Thirty percent is collected in the second month after billing; the remainder is uncollectible. Additional cash of $24,000 is expected in October from renting unused warehouse space. Sixty percent of all purchases, selling and administrative expenses, and advertising expenses is paid in the month incurred. The remainder is paid in the following month. Ending inventory is set at 25 percent of the next month's budgeted cost of goods sold. The company's gross profit averages 30 percent of sales for the month. Selling and administrative expenses follow the formula of 5 percent of the current month's sales plus $75,000, which includes depreciation of $5,000. Advertising expenses are budgeted at 3 percent of sales. Actual and budgeted sales information is as follows: Actual: Budgeted: August $750,000 October $826,800 September 787,500 November 868,200 December 911,600 January 930,000 The company will acquire equipment costing $250,000 cash in November. Dividends of $45,000 will be paid in December. The company would like to maintain a minimum cash balance at the end of each month of $120,000. Any excess amounts go first to repayment of short-term borrowings and then to investment in marketable securities. When cash is needed to reach the minimum balance, the company policy is to sell marketable securities before borrowing. Questions (use of spreadsheet software is recommended): Prepare a cash budget for each month of the fourth quarter and for the quarter in total. Prepare supporting schedules as needed. (Round all budget schedule amounts to the nearest dollar.) You meet with Mr. Chester and Mr. Wayne to present your findings and happen to bring along your PC with the budget model software. They are worried about your findings in Part 1. They have obviously been arguing over certain assumptions you were given. Mr. Wayne thinks that the gross margin may shrink to 27.5 percent because of higher purchase prices. He is concerned about what impact this will have on borrowings. Comment. Mr. Chester thinks that "stock outs" occur too frequently and wants to see the impact of increasing inventory levels to 30 and 40 percent of next quarter's sales on their total investment. Comment on these changes. Mr. Wayne wants to discontinue the cash discount for prompt payment. He thinks that maybe collections of an additional 20 percent of sales will be delayed from the month of billing to the next month. Mr. Chester says "That's ridiculous! We should increase the discount to 3 percent. Twenty percent more would be collected in the current month to get the higher discount." Comment on the cash-flow impacts.