Cornerstones of Managerial Accounting, 6e

Chapter 9: Profit Planning Cornerstones of Managerial Accounting, 6e © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Description of Budgeting All businesses should prepare budgets. Budgets help business owners and managers to plan ahead, and later, exercise control by comparing what actually happened to what was expected in the budget. Budgets formalize managers’ expectations regarding sales, prices, and costs. Small businesses and nonprofit entities can benefit from the planning and control provided by budgets. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3

Budgeting and Planning and Control Planning and control are linked. Planning is looking ahead to see what actions should be taken to realize particular goals. Control is looking backward, determining what actually happened and comparing it with the previously planned outcomes. Budgets are financial plans for the future and are a key component of planning. They identify objectives and the actions needed to achieve them. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4

Budgeting and Planning and Control (cont.) Before preparing a budget, an organization should develop a strategic plan. The strategic plan plots a direction for an organization’s future activities and operations; it generally covers at least five years. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

Planning, Control, and Budgets LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6

Advantages of Budgeting A budgetary system gives an organization several advantages: Planning Information for decision making Standards for performance evaluation Improved Communication & Coordination LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7

The Master Budget The master budget is the comprehensive financial plan for the organization as a whole. Typically for a one-year period, corresponding to the fiscal year of the company. Yearly budgets are broken down into quarterly and monthly budgets. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8

The Master Budget (cont.) The use of smaller time periods allows managers to compare actual data with budgeted data more frequently, so problems may be noticed and resolved sooner. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9

Master Budget: Directing and Coordinating Most organizations prepare the master budget for the coming year during the last four or five months of the current year. The budget committee: reviews the budget provides policy guidelines and budgetary goals resolves differences that arise as the budget is prepared approves the final budget monitors the actual performance of the organization as the year unfolds. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10

Master Budget: Directing and Coordinating (cont.) The controller usually serves as the budget director, the person responsible for directing and coordinating the organization’s overall budgeting process. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11

Master Budget: Major Components A master budget can be divided into operating and financial budgets: Operating budgets describe the income-generating activities of a firm: sales, production, and finished goods inventories. The ultimate outcome of the operating budgets is a pro forma or budgeted income statement. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12

Master Budget: Major Components (cont.) Financial budgets detail the inflows and outflows of cash and the overall financial position. Planned cash inflows and outflows appear in the cash budget. The expected financial position at the end of the budget period is shown in a budgeted, or pro forma, balance sheet. Since many of the financing activities are not known until the operating budgets are known, the operating budget is prepared first. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13

The Master Budget and Its Interrelationships LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14

Preparing the Operating Budget The operating budget consists of a budgeted income statement accompanied by the following supporting schedules: sales budget production budget direct materials purchases budget direct labor budget overhead budget selling and administrative expenses budget ending finished goods inventory budget cost of goods sold budget LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15

Sales Budget The sales budget is approved by the budget committee and describes expected sales in units and dollars. The sales budget is the basis for all of the other operating budgets and most of the financial budgets. It is important that it be as accurate as possible. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16

Sales Budget (cont.) The first step in creating a sales budget is to develop the sales forecast. The sales forecast is just the initial estimate, and it is often adjusted by the budget committee. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17

Production Budget The production budget tells how many units must be produced to meet sales needs and to satisfy ending inventory requirements. To compute the units to be produced, both unit sales and units of beginning and ending finished goods inventory are needed: Units to be produced = Expected unit sales + Units in desired ending inventory (EI) – Units in beginning inventory (BI) LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18

Direct Materials Purchases Budget After the production budget is completed, the budgets for direct materials, direct labor, and overhead can be prepared. The direct materials purchases budget tells the amount and cost of raw materials to be purchased in each time period. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19

Direct Materials Purchases Budget (cont.) The formula used for calculating purchases is as follows: LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20

Direct Labor Budget The direct labor budget shows the total direct labor hours and the direct labor cost needed for the number of units in the production budget. The budgeted hours of direct labor are determined by the relationship between labor and output. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21

Overhead Budget The overhead budget shows the expected cost of all production costs other than direct materials and direct labor. Many companies use direct labor hours as the driver for overhead. Then costs that vary with direct labor hours are pooled and called variable overhead. The remaining overhead items are pooled into fixed overhead. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22

Ending Finished Goods Inventory Budget The ending finished goods inventory budget: Supplies information needed for the balance sheet Serves as an important input for the preparation of the cost of goods sold budget. To prepare this budget, the unit cost of producing finished goods must be calculated by using information from the direct materials, direct labor, and overhead budgets. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23

Cost of Goods Sold Budget The cost of goods sold budget reveals the expected cost of the goods to be sold. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24

Selling and Administrative Expenses Budget The selling and administrative expenses budget outlines planned expenditures for nonmanufacturing activities. As with overhead, selling and administrative expenses can be broken down into fixed and variable components. Such items as sales commissions, freight, and supplies vary with sales activity. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25

Budgeted Income Statement With the completion of the budgeted cost of goods sold schedule and the budgeted selling and administrative expenses budget, Texas Rex has all the operating budgets needed to prepare an estimate of operating income. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26

Preparing the Financial Budget The remaining budgets found in the master budget are the financial budgets. The usual financial budgets prepared are: cash budget budgeted balance sheet budget for capital expenditures LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27

Cash Budget Understanding cash flows is critical in managing a business. Often, a business successfully produces and sells products but fails because of timing problems associated with cash inflows and outflows. LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28

Cash Budget Because cash flow is the lifeblood of an organization, the cash budget is one of the most important budgets in the master budget. The basic structure of a cash budget includes cash receipts, disbursements, any excess or deficiency of cash, and financing as shown here: LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29

Budgeted Balance Sheet The budgeted balance sheet depends on information contained in the current balance sheet and in the other budgets in the master budget. Explanations for the budgeted figures are typically provided in the footnotes. LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30

Using Budgets for Performance Evaluation Budgets are often used to judge the performance of managers. Bonuses, salary increases, and promotions are all affected by a manager’s ability to achieve or beat budgeted goals. Positive behavior occurs when the goals of each manager are aligned with the goals of the organization and each manager has the drive to achieve them. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31

Using Budgets for Performance Evaluation (cont.) The alignment of managerial and organizational goals is often referred to as goal congruence. If the budget is improperly administered, subordinate managers may subvert the organization’s goals. Dysfunctional behavior is individual behavior that is in basic conflict with the goals of the organization. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32

Participative Budgeting Rather than imposing budgets on subordinate managers, participative budgeting allows subordinate managers considerable say in how the budgets are established. The increased responsibility and challenge inherent in the process provide nonmonetary incentives that lead to a higher level of performance. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33

Participative Budgeting (cont.) However, participative budgeting has three potential problems: setting standards that are either too high or too low building slack into the budget (padding the budget) pseudoparticipation LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34

Controllability of Costs Managers are held accountable only for costs that they can control. Controllable costs are costs whose level a manager can influence. If noncontrollable costs are put in the budgets of subordinate managers to help them understand that these costs also need to be covered Should be separated from controllable costs and labeled as noncontrollable. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35

Multiple Measures of Performance Organizations make the mistake of using budgets as their only measure of managerial performance. While financial measures of performance are important, overemphasis can lead to a form of dysfunctional behavior called milking the firm or myopia. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36

Multiple Measures of Performance (cont.) Myopic behavior occurs when a manager takes actions that improve budgetary performance in the short run but bring long-run harm to the firm. Budgetary measures alone cannot prevent myopic behavior. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37