Using Budgets for Planning and Coordination CHAPTER 10 Using Budgets for Planning and Coordination

Budgets and Budgeting Process Formal documents that quantify a company’s plans for achieving its goals Budgeting process enhances communication and coordination by forcing managers to consider their goals and objectives carefully and specify means of achieving goals and objectives.

The Master Budget The master budget includes: See handout for details. Sales budget Production budget Direct materials purchases budget Direct labor budget Manufacturing overhead budget Selling and administrative expense budget Capital acquisitions budget Cash budget See handout for details.

Master Budget

Sales Budget First budget prepared since most budgets cannot be prepared without an estimate of sales P6 in handout: Bottled Water Company part 1

Production Budget Quantity to be produced based on following formula: Desired ending inventory of finished goods becomes beginning inventory for the next period Bottled Water Company part 2

Direct Material Purchases Budget Depends upon amount needed for production and ending inventory The following formula can be used: Bottled Water Company part 3

Review 1 Budgeted production: Q1= 50,000; Q2= 60,000 Parts/unit= 3 , cost/part= $5 Ending inventory = 20% of next month’s production Number of parts required for Q1 production is: 50,000 150,000 60,000 180,000 Answer: b Q1 production 50,000 x 3 parts/unit = 150,000

Review 2 Budgeted production: Q1= 50,000; Q2= 60,000 Parts/unit= 3, cost/part= $5 Ending inventory = 20% of next month’s required parts Desired ending inventory of parts for Q1 in units is: 10,000 12,000 30,000 36,000 Answer: d Q2 parts = 60,000 x 3 = 180,000 x 20% = 36,000

Review 3 Budgeted production: Q1= 50,000; Q2= 60,000 Parts/unit= 3, cost/per part= $5 Ending inventory = 20% of next month’s required part Beginning parts inventory, Q1= 30,000 units Budgeted cost of purchases for Q1 is: $750,000 $900,000 $780,000 $1,650,000 Answer: c 150,000 (review 2) + 36,000 (review 3) – 30,000 = 156,000 parts to purchase x $5 cost = $780,000

Direct Labor Budget Direct labor cost can be budgeted using the following formulas: - Units to be produced* direct labor hours per unit * labor rate Bottled Water Company part 4 (no calculation required)

Manufacturing Overhead Budget Separate costs into fixed and variable: Variable costs cost/unit * units produced Fixed costs - Identical each period except for depreciation Depreciation may vary due to planned acquisitions or disposals Bottled Water Company part 5 (no calculation required)

Selling & Administrative Expenses Budget Separate costs into fixed and variable: Variable costs cost/unit * units sold Fixed costs Identical each period Bottled Water Company part 6 (no calculation required)

Budgeted Income Statement Compilation of information provided by previously prepared budgets: Sales from Sales Budget Cost of goods sold calculated from: - Direct Materials Budget - Direct Labor Budget - Manufacturing Overhead Budget Other expenses from Selling and Administrative Expense Budget Bottled Water Company part 8 ((no calculation required))

Capital Acquisitions Budget Decisions with respect to long lived assets - Use present value concepts to make capital acquisition decisions Must be carefully planned since it may substantially reduce cash reserves

Cash Receipts and Disbursements Budget Managers must plan for amount and timing of cash flows Careful planning of receipts and disbursements necessary to: - Anticipate cash shortages and arrange to borrow funds - Anticipate cash surpluses and seek productive uses

Estimate Cash Collections and Cash Disbursements Estimate % of credit sales collected in the period of sale and subsequent periods Cash disbursements Estimate % of materials purchases paid in the period of purchase and subsequent periods Handout: E10-11 & 12; E10-13 & 14

Budgeted Balance Sheet Last component of master budget prepared Sometimes referred to as the pro forma balance sheet Used to assess the effect of planned decisions on the future financial position of the firm

Budgetary Control Budgets as a Standard for Evaluation The standard is the budgeted amount Standards for DM and DL are usually set up at unit level Differences between budgeted and actual amounts are called budget variances Budget variances should be investigated when they are material

Investigating Budget Variances Variances are differences between budgeted and actual amounts Causes of Budget Variances - Budget may not have been well conceived - Conditions may have changed - Managers may have performed particularly well or poorly

A General Approach to Variance Analysis Variance analysis: an analysis of the difference between a standard and an actual cost. The process breaks down the difference into two components: price (spending) and quantity (efficiency) variance. Direct material variances - Material price variance Material quantity variance Direct labor variances - Labor rate variance -Labor efficiency variance Manufacturing overhead variances Controllable overhead variance Overhead volume variance

A General Approach to Variance Analysis

Material Variances

Material Variances Standard for 1 unit: 400 lbs @ $10 per lb Materials purchased: 200,000 lbs @ $9.90 per lb Materials used: 181,000 lbs to produce 450 units Slide 11-24

Exercise 1 Data for chips used in the production of computers Standard: 3 chips per computer @ $6.50 per chip Quantity purchased: 200 chips for total of $1,350 Quantity used: 123 chips for production of 40 units Calculate the material price variance:

Exercise 1 continued Data for chips used in the production of computers Standard: 3 chips per computer @ $6.50 per chip Quantity purchased: 200 chips for $1,350 total Quantity used: 123 chips for production of 40 units Calculate the material quantity variance: Learning objective 2: Calculate and interpret variances for direct material

Direct Labor Variances

Review 4 A favorable labor efficiency variance means: Labor rates were higher than called for by standards Inexperienced labor was used, causing the rate to be lower than standard More labor was used than called for by standards Less labor was used than called for by standards Answer: d

Direct Labor Variances Standard for 1 unit: 4 hours @ $15 per hour Actual labor: 1,700 hours @ $15.50 per hour to produce 450 units Slide 11-29

Exercise 2 Data for labor used in the production of sneakers Standard: .25 hours per sneaker at $12.00 per hour Actual quantity produced: 24,500 sneakers Quantity used: 6,000 hours, total cost $69,000 Calculate the labor rate variance:

Exercise 2 continued Data for labor used in the production of sneakers Standard: .25 hours per sneaker at $12.00 per hour Actual quantity produced: 24,500 sneakers Quantity used: 6,000 hours, total cost $69,000 Calculate the labor efficiency variance:

“Favorable” Variances May Be Unfavorable A variance that is “favorable” should not be exempt from investigation. It could indicate poor management decision E.g. Suppose inferior, low-priced materials are ordered. On one hand, a favorable price variance will arise. On the other hand, most likely there will be substantially more scrap and rework, and thus a higher quantity variance.

You Get What You Measure! Slide 11-33 33

Incremental VS. Zero Base Budgeting (ZBB) Incremental Budgeting: budgeting with a starting point from previous period revenues and costs (e.g. + or -10% ) ZBB requires budgeted amounts to be justified each period - Provides fresh consideration for validity of budgeted amounts - Time consuming and expensive process - Not widely used by business enterprises