1. CHAPTER 14 COST ANALYSIS FOR PLANNING McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

2. Learning Objectives 1.What is the cost terminology that relates to the budgeting process? 2.Why are budgets useful, and how does management philosophy influence the budget process? 3.How are alternative budget time frames used? 4.What is the significance of the sales forecast (or revenue budget) to the overall operating budget? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

3. Learning Objectives 5.How is the purchases/production budget developed? 6.What is the importance of cost behavior patterns in developing the operating expense budget? 7.Why are a budgeted income statement and balance sheet prepared? 8.How is the cash budget developed? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

4. Learning Objectives 9.Why and how are standards useful in the planning and control process? 10.How is the standard cost of a product developed? 11.How are standard costs used in the cost accounting system? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

5. Learning Objective 1 What is the cost terminology that relates to the budgeting process? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

6. Planning and Budgeting Planning is the initial part of the planning and control cycle A budget is a plan in financial terms The results of an organization’s activities will be reported in terms of income, cash flow, and financial position – the financial statements McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

7. Strategic, Operational, and Financial Planning Planning and Control Cycle Performance Analysis: Plans vs. Actual Results (Controlling) Executing Operational Activities (Managing) Revisit Plans Implement Plans Data Collection and Performance Feedback McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

8. Usefulness of Budgets The preparation of a budget forces management to plan The budget provides a benchmark against which to compare actual performance The budgeting process requires communication and coordination among functional areas of a firm McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

9. Standard Costs A standard cost is a budget for each component – materials, labor, and overhead – of a product Standard costs are used in the planning and control processes of manufacturing and other types of companies McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

10. Cost Classifications Classifying costs based on the relationship of total cost to volume of activity results in categories of variable, fixed, and mixed costs Classifying costs according to a time-frame perspective results in committed and discretionary costs –A committed cost is incurred to execute a long-range policy decision –A discretionary cost is one that can be adjusted in the short term at management’s discretion McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

11. Learning Objective 2 Why are budgets useful, and how does management philosophy influence the budget process? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

12. The Budgeting Process in General In a highly structured organization, the budget is seen as carved in stone Management philosophy is reflected in whether the budget is prepared using a top- down, dictated, approach or a participative, managers involved, approach Most budgets are based on current budgets with revisions – the incremental approach McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

13. Learning Objective 3 How are alternative budget time frames used? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

14. The Budget Time Frame Budgets can be prepared for a single period or for several periods A single-period budget is prepared in the months preceding the beginning of the year and is used the entire year A multi-period or rolling budget involves planning for segments of a year on a repetitive basis The advantage of a continuous budget is that it will be more accurate, but it takes more effort McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

15. The Budgeting Process First, develop and communicate assumptions about the economy, the industry, and the organization’s strategy The operating budget is made up of a number of detailed budgets: –Sales/revenue budget –Purchases/production budget –Operating expense budget –Income statement budget –Cash budget –Balance sheet budget McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

16. Learning Objective 4 What is the significance of the sales forecast (or revenue budget) to the overall operating budget? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

17. Sales Forecast The sales forecast is the key to developing a reasonable budget The most challenging component since there is so little control over the variables that influence sales Need to consider the past experience of managers, production capacity, pricing policy, and advertising effectiveness The other budgeted items are a function of the sales budget McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

18. Learning Objective 5 How is the purchases/production budget developed? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

19. Purchases/Production Budget By using the cost of goods sold model with units, the quantity of merchandise to be manufactured or purchased can be determined – after the sales budget The firm’s inventory policy determines the amounts to be used in the computation The inventory policy should take into consideration such factors as lead time and forecast errors The ending inventory for one period is the beginning inventory for the next period McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

20. Budget Calculations as a Guide If a production budget calls for vastly different quantities to be manufactured each period, the production may be planned at a constant level If materials can be purchased in certain quantities, the purchase quantities nearest to the calculated value will be used Budget calculations provide a guide to action – not absolute amounts McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

21. Cost of Goods Sold Budget Once the sales budget and the purchases/production budgets have been prepared, the cost of goods sold budget can be prepared Cost of goods sold consists of: –Raw materials budget –Direct labor budget –Overhead budget McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

22. Learning Objective 6 What is the importance of cost behavior patterns in developing the operating expense budget? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

23. Operating Expense Budget Some operating expenses are variable expenses: –Sales commissions Some operating expenses are fixed: –Depreciation Therefore, operating expenses are budgeted according to their cost behavior patterns Budget slack occurs when managers larger budgets than necessary McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

24. Learning Objective 7 Why are a budgeted income statement and balance sheet prepared? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

25. Budgeted Income Statement Use the sales forecast, the cost of goods sold budget, and the operating expense budget to prepare budgeted income statement An important step in determining profitability and overall satisfactory results McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

26. Budgeted Balance Sheet A budgeted balance sheet is prepared after the impact of all the other budgets has been determined Depreciation, amortization, inventory, cash, liabilities, and owners’ equity are all affected by the other budgets McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

27. Learning Objective 8 How is the cash budget developed? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

28. Cash Budget Like a budgeted cash flow statement – but with a short time frame Must anticipate short-term borrowing needs Must know when excess cash can be invested for interest revenue Must make assumptions about collection of accounts receivable and sales through a cash receipts budget Must make assumptions about cash payments McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

29. Learning Objective 9 Why and how are standards useful in the planning and control process? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

30. Standard Costs Used in: –Planning and control process of management –Value inventory for financial reporting Has two inputs: –Quantity of input –Cost per unit of input Is a unit budget McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

31. Using Standard Costs Standard costs are used to compare to actual costs Differences are called variances The variances may be due to either differences in input quantity or differences in cost per input unit Appropriately developed, standard costs can be used in the cost accounting system McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

32. Learning Objective 10 How is the standard cost of a product developed? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

33. Developing Standards Ideal standards – assumes operating conditions will be ideal; maximum efficiency at all times; usually will have unfavorable variances Attainable standards – recognizes there will be some operating inefficiencies; will have both favorable and unfavorable variances Past experience standards – includes all inefficiencies from past operations; does not contain a challenge McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

34. Learning Objective 11 How are standard costs used in the cost accounting system? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

35. Costing Products with Standard Costs Must aggregate the individual standard costs for each of the inputs: –Raw materials –Direct labor –Overhead Purchasing agent provides information about materials costs Human resources will provide information about labor costs McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

36. Overhead Standard Costs Overhead costs are classified as fixed or variable Variable overhead will be expressed in terms that reflect the causes of overhead expenditures Fixed overhead will be expressed as a total cost per accounting period and allocated to individual products McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

37. Other Uses of Standards Can be used for planning and control of period costs Can be used with quantitative goals of the organization The development of goals can be expressed as standards Do not have to be expressed in dollars McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

38. Budgeting for Other Analytical Purposes Service firms can use budgeting techniques for financial and nonfinancial resources such as time budgets Can also be used in manufacturing firms in areas not related to production such as customer service McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002