Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 7 - 1

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 7 Introduction to Budgets and Preparing the Master Budget

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 7 Learning Objectives When you have finished studying this chapter, you should be able to: 1. Explain how budgets facilitate planning and coordination. 2. Anticipate possible human relations problems caused by budgets. 3. Explain potentially dysfunctional incentives in the budget process.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Chapter 7 Learning Objectives 4. Explain the difficulties of sales forecasting. 5. Explain the major features and advantages of a master budget. 6. Follow the principal steps in preparing a master budget. 7. Prepare the operating budget and the supporting schedules. 8. Prepare the financial budget. 9. Use a spreadsheet to develop a budget (Appendix 7).

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Budgets and the Organization Budgets facilitate planning and coordination. A budget is a quantitative expression of a plan of action that imposes the formal structure of an organization. Learning Objective 1 Managers use budgeting as an effective cost-management tool.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Benefits of Budgets Provide an opportunity to reevaluate existing activities and evaluate new ones. Aid managers in communicating objectives and coordinating actions across the organization. Compel managers to think ahead Provide benchmarks to evaluate subsequent performance.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Zero-based Budget Requires justification of expenditures for every activity, including continuing activities. Starts with the assumption that current activities will not automatically be continued; every activity starts at zero budget. A zero-based budget:

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Possible Human Relations Problems Problems in implementing budgets: - Low level of participation in the budget process, - Lack of acceptance of responsibility for the final budget, - Incentives to lie and cheat in the budget process, - Difficulties in obtaining accurate sales forecasts Learning Objective 2

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Possible Human Relations Problems The advantages of budgeting: - The perceived attitude of top management, -The level of participation in the budget process, -The degree of alignment between the budget and other performance goals. An environment where there is a two-way flow of information reduces negative attitudes. Participative budgets are formulated with the active participation of all affected employees.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Message conveyed by the budget system may be misaligned with incentives provided by the compensation system. Misalignment between performance goals stressed in budgets versus performance measures the company uses to reward employees and managers can limit advantages of budgeting. Possible Human Relations Problems

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Dysfunctional Incentives Dysfunctional incentives lead managers to make poor decisions – lying if the budget process creates incentives to bias budget information. And one more complication—managerial bonuses based on making budget. Budgetary slack (budget padding) - an over- statement or understatement of budgeted revenue to create an easier goal to achieve. Learning Objective 3

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales Forecasting A sales forecast is a prediction of sales under a given set of conditions. Sales forecasts are usually prepared under the direction of the top sales executive. Learning Objective 4 The sales budget is the result of decisions to create conditions that will generate a desired level of sales.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Competitors’ actions Past patterns of sales Estimates made by sales force General economic conditions Factors to Consider When Forecasting Sales Changes in the firm’s prices Changes in product mix Market research studies Advertising and sales promotion plans

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Types of Budgets Strategic plan Long-range planning Capital budget Master budget Continuous budget

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Strategic Plan The most forward-looking budget is the strategic plan, which sets the overall goals and objectives of the organization. The strategic plan leads to long-range planning, which produces forecasted financial statements for five- to ten-year periods.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Long-range plans… are coordinated with capital budgets, which detail the planned expenditures for facilities, equipment, new products, and other long-term investments. Long-Range Plans Master budgets link to both long-range plans and short-term budgets.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Master Budget SalesPurchasesDistribution The master budget is a detailed and comprehensive analysis of the first year of the long-range plan. It summarizes the planned activities of all subunits of an organization. Learning Objective 5 Production

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Continuous Budget Rolling budgets... are a common form of master budgets that add a month in the future as the month just ended is dropped.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating budget (profit plan)... Financial budget... Master Budget Focuses on the income statement and supporting schedules or budgeted expenses. Focuses on the effects that the operating budget and other plans will have on cash balances.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Steps in Preparing the Master Budget 1. Supporting data 2. Operating budget 3. Financial budget Learning Objective 6

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Steps in Preparing the Master Budget 1. Basic data a.Sales budget b.Cash collections from customers c.Purchases and cost-of-goods sold budget d.Cash disbursements for purchases e.Operating expense budget f.Cash disbursements for operating expenses The principal steps in preparing the master budget:

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Steps in Preparing the Master Budget 3. Financial Budget: Prepare forecasted financial statements: a.Capital budget b.Cash budget c.Budgeted balance sheet 2. Operating Budget: Prepare budgeted income statement using basic data in step 1.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating Budget Sales budget Cash collections from customers Disbursements for purchases Disbursements for operating expenses Purchases budget Operating expenses budget Learning Objective 7

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cash Collections It is easiest to prepare budgeted cash collections at the same time as the sales budget. Cash collections include the current month’s cash sales plus the previous month’s credit sales.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Purchases Budget and Cash Disbursements Budget cost of goods sold by multiplying the cost of merchandise sold percentage by budgeted sales. The total merchandise needed is the sum of budgeted cost of goods sold plus the desired ending inventory.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Purchases Budget and Cash Disbursements Finally, compute required purchases by subtracting beginning inventory from total merchandise needed: Budgeted purchases: = Desired ending inventory + Cost of goods sold – Beginning inventory Purchases Use the budgeted purchases to budget cash disbursements.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating Expense Budget The budgeting of operating expenses depends on several factors. Month-to-month changes in sales volume and other cost-driver activities directly influence many operating expenses. Expenses driven by sales volume include sales commissions and many delivery expenses.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Other expenses are not influenced by sales or other cost-driver activity and are regarded as fixed, within appropriate relevant ranges. Rent Insurance Depreciation Salaries Operating Expense Budget

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating Expense Disbursements Disbursements for operating expenses are based on the operating expense budget. Disbursements may include 50% of last month’s and this month’s wages and commissions plus miscellaneous and rent expenses. The total of these disbursements is then used in preparing the cash budget.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Budgeted Income Statement The income statement will be complete after addition of the interest expense, which is computed after the cash budget has been prepared. Budgeted income from operations is often a benchmark for judging management performance.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall The cash budget is a statement of planned cash receipts and disbursements that contains these major sections: available cash balance, net cash receipts, and disbursement financing. Financial Budget Learning Objective 8 The second major part of the master budget is the financial budget, which consists of the capital budget, cash budget, and ending balance sheet.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cash Budget Available cash balance = Beginning cash balance – Minimum cash balance desired. Cash receipts depend on collections from:  customers’ accounts receivable, cash  sales, and other operating income sources.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cash Budget Cash disbursements for purchases depend on the credit terms extended by suppliers and the bill-paying habits of the buyer. Payroll depends on wage, salary, and commission terms and on payroll dates.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cash Budget Other disbursements include outlays for fixed assets, long-term investments, dividends, and the like. Disbursements for some costs and expenses depend on:  contractual terms for installment  payments,  mortgage payments, rents, leases, and  miscellaneous items.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cash Budget Ending cash balance = Beginning cash balance + Receipts – Disbursements + Cash from financing The cash from financing can be either positive (borrowing) or negative (repayment).

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Budgeted Balance Sheet The final step in preparing the master budget is to construct the budgeted balance sheet that projects each balance sheet item in accordance with the business plan. Beginning balances would be increased or decreased in light of the expected cash receipts and disbursements and the effects of noncash items on the income statement.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Strategy and the Master Budget The master budget is an important management tool for evaluating and revising strategy. The first draft of a master budget is rarely the final draft. As managers revise strategy, the budgeting process becomes an integral part of the management process itself—budgeting is planning and communicating.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Activity-Based Master Budgets An activity-based budgetary system emphasizes the planning and control purpose of cost management. Functional budgeting focuses on preparing budgets for various functions such as production, selling, and administrative support.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Financial Planning Models Financial models are only as good as the assumptions and the inputs used to build and manipulate them. Financial planning models are mathematical models that can incorporate the effects of alternative assumptions about sales, costs, or product mix.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Spreadsheets for Budgeting Arithmetic errors are virtually nonexistent. Spreadsheet software for personal computers, a powerful and flexible tool for budgeting, can be used to prepare mathematical models. Learning Objective 9 Models can be applied with a variety of assumptions that reflect changes in expected sales, cost drivers, cost functions, etc.

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