Strategy and the Master Budget Chapter 8 Strategy and the Master Budget

Learning Objectives Describe the role of a budget in planning, communicating, motivating, controlling, and evaluating performance Discuss the importance of strategy and its role in budgeting and identify factors common to successful budgets Outline the budgeting process

Learning Objectives Prepare a master budget and explain the interrelationships among its supporting schedules Identify unique budgeting characteristics of service and international firms and not-for-profit organizations

Learning Objectives Apply zero-base, activity-based, and kaizen budgeting Discuss the roles of ethics and behavioral concerns in budgeting

Strategy and the Master Budget Business continually deals with the future and uncertainty Planning is a process of charting the future course in this uncertain and dynamic world to attain desired goals Successful organizations are the result of careful planning and diligent implementation The budget is one aspect of planning used by many organizations

Learning Objective One Describe the role of a budget in planning, communicating, motivating, controlling, and evaluating performance

Role of a Budget A budget is an organization’s operation plan for a specified period; it identifies the resources and commitments required to fulfill the organization’s goals for the period.

The Budget is . . . a plan of operations. a basis for allocating resources. a communication and authorization device. a device for motivating and guiding implementation. a guideline for operations and gauge for controlling operations. a basis for performance evaluation.

Budgeting Budgeting is the process of preparing a budget Budgeting systems accomplish many purposes beyond achieving planning and control Budgeting system are at once forms and sources of power, and they serve as a political advocacy device used by both budgeters and budgetees in the internal resource allocation process

Learning Objective Two Discuss the importance of strategy and its role in budgeting and identify factors common to successful budgets

Importance of Strategy A firm’s strategy is the path it chooses for attaining its long-term goals and mission It is the starting point in preparing its plans and budgets The process of determining a firm’s strategy begins by assessing external factors that affect operations and evaluating internal factors that can be its strengths and weaknesses

Importance of Strategy An organization’s internal factors include operating characteristics such as financial strength, managerial expertise, functional structure, and organizations culture Matching the organization’s strengths with its identified opportunities and threats enables it to form its strategy

Formulation of Strategy Insert Exhibit 8.1

Strategic Goals and Long-Term Objectives The long-range plan identifies actions over a 5- to 10-year period to attain the firm’s strategic goal Capital budgeting is a process for evaluating proposed major projects and planning for resource requirements Capital budgets are prepared to bring an organization’s capabilities into line with the needs of its long-range plan and long-term sales forecast An organization’s capacity is a result of capital investments made in prior budgeting periods

Translating Strategy with the Balanced Scorecard Insert Exhibit 8.2

Short-Term Objectives and the Master Budget A master budget is an organization’s operating and financing plans for a specified period Operating budgets are plans that identify resources needed in operating activities and the acquisition of these resources Financial budgets identify sources and uses of funds for the budgeted operations, present budgeted operating result, and delineate financial position at the end of the budgeted period

Budget Relationships Strategic Goals Long-Term Objectives Capital Budgeting Long-Range Plan Short-Run Objectives Feedback Master Budgets Controls Operations

Successful Budgets Successful budgets share many common factors Most important among them is the acceptance and support of the budget by all managers and employees A budget is more likely to be successful if employees perceive it as a planning and coordinating tool to help them to do their jobs, not as a pressure device to squeeze the last drop of their energy out of them

Successful Budgets A successful budget is a motivating device that helps people work toward the goal of the organization and a better operating result A successful budget has technically correct and reasonably accurate numbers

Learning Objective Three Outline the budgeting process

The Budgeting Process The budgeting process can range from the informal simple processes small firms use that take only days or weeks to complete to elaborate, lengthy procedures large firms or governments employ that span over months The budget committee oversees all budget matters and often is the highest authority in an organization for all matters related to the budget

The Budgeting Process The budget usually is prepared for a set time, most commonly one year with subperiod budgets for each of the quarters or months A continuous (rolling) budget maintains a budget for a set number of months, quarters or years at all times The budget committee is responsible for providing initial budget guidelines that set the tone for the budget and govern its preparation

Budget Revision Strictly implementing a budget as prescribed even when the actual events differ significantly from those expected certainly is not a desirable behavior In such cases, managers should be encouraged not to rely on the budget as the absolute guideline in operations Systematic, periodic revision of the approved budget or the use of a continuous budget can be an advantage in dynamic operations

Learning Objective Four Prepare a master budget and explain the interrelationships among its supporting schedules

Master Budget A master budget is a comprehensive budget for a specific period It consists of many interrelated operating and financial budgets A sales budget often is regarded as the cornerstone of the entire budget The starting point in preparing a sales budget is sales forecasts

The Master Budget Insert Exhibit 8.4

Sales Forecasting Current sales levels and sales trends of the past few years General economic and industry conditions Competitors’ actions and operating plans Pricing policies Credit policies Advertising and promotional activities Unfilled back-orders

Sales Budget A sales budget shows expected sales in units at their expected selling prices A firm prepares the sales budget for a period based on the forecasted sales level, production capacity for the budget period, and long-term plan and short-term goal of the firm A sales budget is the cornerstone of budget preparation because a firm can complete the plan for other activities only after it identifies the expected sales level

Sales Budget April May June Quarter Sales in units 20,000 Kerry Industrial Products Company Sales Budget For the First Quarter Ended June 30, 2007 April May June Quarter Sales in units 20,000 Selling price per unit x $30 Total sales $600,000

Sales Budget April May June Quarter Sales in units 20,000 25,000 Kerry Industrial Products Company Sales Budget For the First Quarter Ended June 30, 2007 April May June Quarter Sales in units 20,000 25,000 Selling price per unit x $30 x $30 Total sales $600,000 $750,000

Sales Budget April May June Quarter Kerry Industrial Products Company Sales Budget For the First Quarter Ended June 30, 2007 April May June Quarter Sales in units 20,000 25,000 35,000 Selling price per unit x $30 x $30 x $30 Total sales $600,000 $750,000 $1,050,000

Sales Budget April May June Quarter Kerry Industrial Products Company Sales Budget For the First Quarter Ended June 30, 2007 April May June Quarter Sales in units 20,000 25,000 35,000 80,000 Selling price per unit x $30 x $30 x $30 x $30 Total sales $600,000 $750,000 $1,050,000 $2,400,000

Production Budget A firm prepares a production budget after determining the number of units that it expects to sell A production budget is a plan for acquiring the resources needed to carry out the manufacturing operations to satisfy the expected sales and maintain the desired ending inventory

Production Budget The total number of units to be produced depends on the budgeted sales, the desired units of finished goods ending inventory, and the units of finished goods beginning inventory. Determining the budgeted units of production: Budgeted Budgeted Desired Beginning Production Sales Ending Inventory (in units) (in units) Inventory (in units) (in units) = + –

Production Budget Kerry expects to have 5,000 units on hand on April 1 and wants to have 30% of the following month’s projected unit sales on hand at the end of each month. Determining the budgeted units of production: Budgeted Budgeted Desired Beginning Production Sales Ending Inventory (in units) (in units) Inventory (in units) (in units) = + –

Production Budget Kerry expects to have 5,000 units on hand on April 1 and wants to have 30% of the following month’s projected unit sales on hand at the end of each month. Determining the budgeted units of production: Budgeted Desired Beginning Production 20,000 Ending Inventory (in units) Inventory (in units) (in units) = + – From the Sales Budget

Production Budget Step 1: Determine the desired ending level at April 30: 30% x 25,000 units for May sales = 7,500 units Determining the budgeted units of production: Budgeted Beginning Production 20,000 7,500 Inventory (in units) (in units) = + –

Step 2: Apply inventory from April 1: Production Budget Step 2: Apply inventory from April 1: 5,000 units Determining the budgeted units of production: Budgeted Production 20,000 7,500 5,000 (in units) = + –

Step 3: Determine projected production for April Production Budget Step 3: Determine projected production for April Determining the budgeted units of production: 22,500 20,000 7,500 5,000 = + –

Production Budget

30% of June’s budgeted sales Production Budget 30% of June’s budgeted sales

Production Budget July sales are budgeted at 40,000 units, so 30% × 40,000 = 12,000 units.

Direct Materials Budget The information in the production budget becomes the basis for preparing several manufacturing-related budgets A direct materials usage budget shows the direct materials required for production and their budgeted cost

Direct Materials Budget Each unit produced requires 3 pounds of alloy at a cost of $2.45 per pound. Kerry expects to manufacture 36,000 units in July. On April 1, 7,000 pounds of alloy were in inventory. Total direct Desired direct Total direct Direct materials materials materials materials beginning needed in ending inventory purchase for inventory production the period + =

Direct Materials Budget Each unit produced requires 3 pounds of alloy at a cost of $2.45 per pound. Kerry expects to manufacture 36,000 units in July. On April 1, 7,000 pounds of alloy were in inventory. Total direct Desired direct Total direct materials materials materials 7,000 needed in ending inventory purchase for production the period + =

Direct Materials Budget Budgeted unit production in April is 22,500. At 3 pounds per unit direct material needs are 67,500 pounds. Desired direct Total direct 67,500 materials materials 7,000 ending inventory purchase for the period + =

Direct Materials Budget Desired ending inventory is 10 % of the next period’s production needs. In May production needs will be 28,000 units, so 28,000 × 3 pounds = 84,000 × 10% = 8,400 pounds. Total direct 67,500 8,400 materials 7,000 purchase for the period + = 68,900 pounds

Direct Materials Budget Insert Exhibit 8.7

Direct Materials Budget Insert Exhibit 8.8

Direct Labor Budget To prepare the direct labor budget, a company would use its production budget The direct labor budget enables the personnel department to plan for hiring and repositioning of employees A good labor budget helps the firm to avoid emergency hiring, prevent labor shortages, and reduce or eliminate the need to lay off workers

Direct Labor Budget Each unit of output requires .5 hours of semi-skilled labor at an average cost of $8.00 per hour, and .2 hours of skilled labor at an average cost of $12.00 per hour. 22,500 × .5 × $8.00 = $90,000 22,500 × .2 × $12.00 = $54,000

Factory Overhead Budget A factory overhead budget often includes all production costs other than direct materials and direct labor Unlike direct materials and direct labor, manufacturing overhead costs include costs that vary in direct proportion with the units manufactured as well as costs that vary with either the kind of facilities the firm has or the way in which the firm carries out it operations

Factory Overhead Budget The variable overhead rate is $4.40 per direct labor hour. Fixed factory overhead is $44,300 during April and May, and $54,300 in June. Fixed overhead includes depreciation expense of $30,000 for April and May, and $40,000 in June.

Cost of Goods Manufactured and Sold Budget The cost of goods manufactured production cost and the cost of goods sold budget reports the total budgeted cost of units sold for a period Upon completion of the cost of goods manufactured and sold budget for a period, two items in this budget appear in other budgets for the same period The income statement budget uses the cost of goods sold to determine the gross margin of the period, and the balance sheets includes the finished goods ending inventory it total assets

Cost of Goods Manufactured and Sold Budget Insert Exhibit 8.11

Selling and General Administrative Expense Budget A selling and general administrative expense budget delineates plans for all non-manufacturing expenses This budget serves as a guideline for selling and administrative activities during the budget period Many selling and general administrative expenditures are discretionary

Selling and General Administrative Expense Budget Firms are known to reduce or eliminate selling and administrative expenses to increase operating income for the period Firms must be wary of taking a short-term perspective when preparing a selling and administrative expense budget

Selling and General Administrative Expense Budget Insert Exhibit 8.12

Cash Budget A cash budget depicts effects of all budgeted activities on cash By preparing a cash budget, management can: take steps to ensure having sufficient cash on hand to carry out the planned activities allow sufficient time to arrange for additional financing that may be needed during the budget period (and thus avoid high costs of emergency borrowing) plan for investments of excess cash on hand to earn the highest possible return

Cash Budget A cash budget includes all items that affect cash flows and pulls data from almost all parts of the master budget A cash budget generally includes three major sections: Cash available Cash disbursements Financing

Cash Budget: Receipts Management at Kerry expects 70% of all sales to be for cash and credit card sales, of which 40% are credit card sales that result in a 3% processing fee. Of the company’s accounts receivable 80% are paid in the month following the month of sale, and 60% of these are paid within the discount period (2% discount allowed). Of the remaining accounts receivable, 15% are collected in the second month following the month of sale, and 5% of accounts receivable eventually prove uncollectible. Sales during March were $450,000.

Cash Budget $600,000 × 70% = $420,000 $420,000 × 60% = $252,000

Cash Budget $420,000 × 40% × 97% = $162,960 $450,000 × 30% × 80% × 60% x 98% = $63,504

Cash Budget $450,000 × 30% × 80% × 40% = $43,200 $400,000 × 30% × 15% = $18,000

Cash Budget Insert Exhibit 8.14 (Cash Budget) Here

Budgeted Income Statement The budgeted income statement estimates the expected operating income from the budgeted operations A budgeted income statement allows management a glimpse of the likely operating result upon completion of the budgeted operation Once the budget income statement has been approved, it becomes the benchmark against which the performance of the period is evaluated

Budgeted Income Statement Insert Exhibit 8.15

Budgeted Balance Sheet The last step in a budget preparation cycle usually is to prepare the budget balance sheet The starting point in preparing the budget balance sheet is the expected financial positions at the end of the current operating period--the beginning balances of the budget period

Budgeted Balance Sheet Insert Exhibit 8.16 (Budget Balance Sheet) Here

Budgeted Balance Sheet Starting with the beginning balance, the budget balance sheet incorporates the effects of operations during the budget period and shows the balances at the end of the budget period

Budgeting in Service Industries Insert Exhibit 8.17 (Budget Balance Sheet) Here

Learning Objective Five Identify unique budgeting characteristics of service and international firms and not-for-profit organizations

Budgeting in Service Industries Similar to budgeting for manufacturing or merchandising firms, budgeting for service firms plans for the resources available from operations and the required resources in operations to fulfill budgeted goals The difference is in the absence of production or merchandise purchase budgets and their ancillary budgets

Budgeting in Service Industries An important focal point in its budgeting is personnel planning A service firm must ensure that it has personnel with the appropriate skills to perform the services required for the budgeted service revenue

Budgeting in Service Industries Insert Exhibit 8.18

Budgeting in Not-for-Profit Organizations The master budget of a not-for-profit organization often becomes an authorization document for allowable expenditures and activities In effect, the budget for a not-for-profit organization often becomes the source of both the power and limitations of the budgeted unit

Budgeting in Not-for-Profit Organizations A not-for-profit organization begins its budget preparation by estimating the total revenues for the budget period The organization must often decide how to best allocate limited resources to competing activities and subunits

Learning Objective Six Apply zero-base, activity-based, and kaizen budgeting

Alternative Budgeting Approaches Over the years many alternative approaches have been proposed to improve budget preparation Zero-based budgeting is a budgeting process that requires managers to prepare budgets from a zero base A zero-base budgeting process allows no activities or functions to be included in the budget unless managers can justify their need Zero-based budgeting requires managers or budgeting teams to perform in-depth reviews and analyses of all budget items

Activity-Based Budgeting Activity-based budgeting is a budgeting process based on activities and cost drivers of operations It starts with the budgeted output and segregates costs required for the budgeted output into homogeneous activity cost pools (such as unit, batch, product-sustaining, and facility-sustaining activity cost pools)

Activity-Based Budgeting Activity-based budgeting can be a simple extension of a firm’s activity-based costing system that has grouped its costs into activity cost pools The firms needs to review the appropriateness of its activity cost pools and accuracy of its activity costs for the budget period before employing them in budgeting

Factory Overhead Budget Using Activity-Based Budgeting Insert Exhibit 8.19

Traditional versus Activity-Based Budgeting Insert Exhibit 8.20

Kaizen Budgeting Kaizen budgeting is a budgeting approach that explicitly demands continuous improvement and incorporates the expected improvements in the budget A firm using kaizen budgeting prepares budgets based on the desired future operating processes for the budget period This is an improvement over the current operating processes, rather than the continuation of the current practices as is often the case in traditional budgeting

Kaizen Budgeting Kaizen budgeting begins by analyzing practices to identify areas for improvement and determine expected changes needed to attain the desired improvements Budgets are prepared based on improved practices or procedures Kaizen budgeting is not limited to internal improvements (could involve improvements of their suppliers)

Kaizen Budgeting A kaizen budget decrease is not the same as the budget cuts often seen made by firms or governments when facing a budget crunch because of diminishing revenues A budget cut often is a reluctant passive response accomplished by reducing activities or services In contrast, kaizen budgeting promotes active engagement in reforming or altering practices

Learning Objective Seven Discuss the roles of ethics and behavioral concerns in budgeting

Ethics in Budgeting In order to encourage persons responsible for budget preparation and implementation to attain the organization’s goals, management must take into consideration ethical and behavioral factors in budgeting For example, too often people believe that it is better to promise too little and deliver more than to promise too much and deliver less

Ethics in Budgeting Spending the budget is another serious ethical issue in budgeting Managers might believe that their future budgets will be reduced if they do not use up all the budget amounts As a result, managers might resort to wasteful spending to exhaust the remaining budgeted amount before the end of the period

Difficulty Level of the Budget Target An easy budget target may fail to encourage the employees to give their best efforts A budget target that is very difficult to achieve can, however, discourage mangers from even trying to attain it Ideally, budget targets should be challenging yet attainable

Budget Difficulty and Effort Easy Difficult Budget Difficulty Effort High Low

Highly Achievable Budget Target The advantages of using a highly achievable budget target include: Increasing managers’ commitment to achieving the budget target Maintaining managers’ confidence in the budget Decreasing organizational control cost Reducing the risk that managers will engage in harmful earnings management practices or violate corporate ethical standards Allowing effective and efficient managers greater operating flexibility

Authoritative or Participative Budgeting Budgeting processes are either top down or bottom up In a top-down budgeting process, management prepares budgets for the entire organization (including those for lower-level operations) This process is often referred to as authoritative budgeting

Authoritative or Participative Budgeting In a bottom-up budgeting process, the people affected by the budget, including lower-level employees, are involved in the budget preparation process This process is often referred to as participative budgeting

Authoritative or Participative Budgeting An effective budgeting process often combines both top-down and bottom-up budgeting approaches The final budget usually is reached after several rounds of negotiations

End of Chapter Eight