Master Budget and Responsibility Accounting CHAPTER 6 Master Budget and Responsibility Accounting

The Budget A budget is a quantified statement of an entity’s plans for some period of time. It can be financial (budgeted sales activity) or non-financial (budgeted production levels). It allows companies to formally set goals for performance. The budget provides a means of performance review.

Planning and the Use of Budgets Companies spend a lot of time on strategic planning. Setting goals and objectives. Long and short term. Developing strategies to achieve those goals. Budgets show how resources will be used to implement the strategy.

For Example,... What plans did you make with respect to your college career? School to go to? Possible field of study? Costs? What budgeting decisions had to be made? Resources available? Scholarships, parent’s paying?, Job needed

Advantages of Budgets Compel strategic thinking and planning Identify goals Know critical success factors The strengths of the company that enable it to outperform competitors Know markets and the economic situations Evaluate risks

Advantages of Budgets Provide performance criteria Compare actual results to the budget (chapter 7) and assign responsibility. Motivate managers and employees. Goals must be challenging but achievable. Promote communication and coordination within the organization. Goals must be communicated. Provides coordination of activities across departments. Sales, production, and distribution

Things to Watch for All levels of the company should buy into the budget. Without this commitment, some managers will rebel. If goals are not reasonable employees may give up or manipulate the reported results to meet budgeted goals. The budget has to have some flexibility built into it. Conditions are not static, and the company must be able to respond to unforeseen events.

Time Horizon for Budgeting The appropriate length of time will depend on the events being budgeted. Single event (stockholder meeting). On-going activities – short-term. Annually, quarterly, monthly. On-going activities – long-term. 5 year business plan. Rolling budgeting. Budget is always available for specified period.

Master Budgets Master budgets consist of the following elements: Operating budgets Budgeted income statement and all the Supporting budget schedules Financial budgets Capital budget and the cash budget which lead to Budgeted balance sheet and cash flow statements

Sales or Revenues Budget All other budgets flow from this first one. Important to set accurate sales estimates. Budgeted revenue = units sold*price. Who would set the sales budget? Marketing/Sales department. What are the constraints on sales? Demand and productive capacity.

Information Used to Prepare the Sales Budget Past sales patterns Predictions of future sales based on market research, customer contact, and demographics changes General economic conditions and competitive pressures New products, price changes and advertising

Production Budgets What production levels must be achieved to support the sales budget? Production = Sales + FG(end) – FG(beg) Production costs include: Materials costs Direct labor Manufacturing overhead We will need budgets for each of these

Direct Materials How much material do we need to support the production level? How much do we need to purchase to maintain desired inventory level? Units purchased = (material usage) + ending inventory level – beginning inventory. Calculate in units first, then convert to cost.

Direct Labor Budget Direct labor costs will depend on the units to be produced and the time allowed for each unit in the various departments. Figure the time to complete the units and then convert them to costs.

Indirect Cost Budgeting Using the relationships which exist and the estimated cost functions, determine what overhead costs will be incurred in producing the number of units needed. Variable overhead costs per unit. Fixed overhead costs per period.

Inventory Levels We can attach cost to the target levels of ending inventory for direct material, work in process and finished goods. We used these units in previous calculations. You simply attach cost to each of these items.

Other Elements of Operating Budgets Calculate budgeted COGS based on the other budgeted items you have already calculated. Calculate the budgeted non-manufacturing costs R & D, Marketing, Distribution, Customer Service and Administrative costs Complete the budgeted income statement.

Financial Budget Components Capital Budgeting - chapter 21 Cash Budget - appendix to chapter 6 Budgeted Balance Sheet Budgeted Cash Flow Statement - not covered here

Cash Budgeting Purpose of the cash budget is to determine whether or not there will be excess cash to invest and/or deficiencies of cash requiring short term borrowing. Beginning balance + expected collections - budgeted disbursements = excess or deficiency

Financing Needed If we are predicting a deficiency, then borrowing must take place to cover the shortfall. Beginning borrowing + additional loans required - payments of principal - payments of interest = effects of financing Excess(deficiency) +/-- financing effect = ending cash balance.

Information Needed for Cash Budgeting What sales are for cash? For credit? When will credit sales be collected? When do we disburse cash for costs incurred? What disbursements are planned for purchases of fixed assets, payment of interest costs, loan principal and income taxes?

Budgeted Balance Sheet The budgeted account balances will depend on previous budget schedules cash balance: cash budget accounts receivable balance: sales budget and pattern of collections inventory amounts: operating budgets borrowing: cash budget retained earnings: effects of income and dividends

Budget Process Budgeting is a company-wide effort goals often come from the top different parts of the organization participate to budget specific activities/units. All this information must be tied together in the master budget. This is where the accountants come in.

The Accountant’s Role Accountants assist in the development of the goals and the budget itself at the unit level at the company-wide level They must assure that all the pieces tie together (coordination). They assist in communication of the goals and in the feedback provided. They provide evaluation of performance.

Other Budgeting Topics Kaizen Budgeting - base future budget information on continuous improvement time to produce product will decrease quality of product should improve Process should be improved Activity Based Budgeting (ABB) budget by activity and then work your way to budgeted overhead costs for the period. Part of the ABM movement

Responsibility Accounting Responsibility accounting involves assigning responsibility for meeting goals to various units within a business. Performance is then evaluated by responsibility centers.

Types of Responsibility Centers Cost center accountable for costs only Revenue center accountable only for revenues Profit center manager is accountable for operating profit of the unit Investment center manager is accountable for return on investment of the unit. Broad-based concept.

Controllability Assume we are trying to evaluate the managers of two different divisions. We notice that the costs are much higher for one division than the other (labor or materials for example) What factors affect these costs and can the manager necessarily control these factors?

Behavioral Implications If your performance is being measured by how well you are able to achieve the budget targets, what would the inclination be for setting these targets? The inclination might be to set the revenue targets (expense targets) too low (high), so that the goal can be achieved. This is referred to as budgetary slack.

Behavioral Implications… What happens if the budgeted targets are too lofty? May give up if they believe the target levels are too hard to reach. Having middle and lower level management participate in the budgeting process may help but then you run the risk of budgetary slack.

Incentive Schemes In order to meet company goals, we want to assign responsibilities and devise appropriate incentives that align the individual’s goals with those of the company. Use external benchmark performance measures. Set “stretch” targets Relate bonus to accuracy and level of forecasted activity.

The end!