1. 11 - 1  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using Budgets to Achieve Organizational Objectives Chapter 11

2. 11 - 2  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Introduction u Ridgetown was a thriving and growing city. u In 2001, the projected city revenues were about $2.5 billion. u Proposed expenditures were approximately $2.7 billion.

3. 11 - 3  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Introduction u Mayor Sandra Moore and the city council were concerned about the projected deficit. 1 The city was not allowed to run deficits. 2 The mayor and the majority of council felt that residents expected to continue to enjoy the current level of services. u After reading this chapter, you will be able to...

4. 11 - 4  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objectives 1 Identify the primary role of budgets and budgeting in organizations. 2 Demonstrate the importance of each element of the budgeting process. 3 Explain the different types of operating budgets and financial budgets and their interrelationships.

5. 11 - 5  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objectives 4 Describe the way that organizations effectively use and interpret budgets. 5 Undertake what-if and sensitivity analysis – two important budgeting tools used by budget planners. 6 Identify the role of budgets in service and not-for-profit organizations. 7 Recognize the behavioral effects of budgeting on an organization’s employees.

6. 11 - 6  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 1 Identify the primary role of budgets and budgeting in organizations.

7. 11 - 7  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity-Related and Flexible Resources u What are flexible costs? u They are costs that vary with the activity level in the organization. u What are committed costs? u They are costs that do not change with changes in activity level. u The budgetary process determines the level of most committed costs.

8. 11 - 8  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Planning and Control and the Role of Budgets u What is a budget? u It is a quantitative expression of the money inflows and outflows that reveals whether a financial plan will meet organizational objectives. u What is budgeting? u It is the process of preparing budgets.

9. 11 - 9  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Planning and Control and the Role of Budgets u Budgets are a central part of the design and operation of management accounting systems. u Budgets also provide a way to communicate the organization’s short-term goals to its members. u Budgeting serves to coordinate the organization’s activities.

10. 11 - 10  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Planning and Control and the Role of Budgets u Budgeting is a tool that forces coordination of the organization’s activities and helps identify coordination problems. u Budgets are prepared for specific time periods. u Differences between actual results and the budget plan are called variances.

11. 11 - 11  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Planning and Control and the Role of Budgets Identify Organization Objectives and Short-Term Goals Develop Long-Term Strategy and Short-Term Plans Develop Master Budget Measure and Assess Performance Reevaluate Objectives, Goals, Strategy, and Plans Planning Control

12. 11 - 12  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Planning and Control and the Role of Budgets u Budgeting involves forecasting the demand for three types of resources. 1 Flexible resources that give rise to variable costs 2 Intermediate-term capacity resources that give rise to capacity-related costs 3 Long-term capacity resources that give rise to capacity-related costs

13. 11 - 13  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 2 Demonstrate the importance of each element of the budgeting process.

14. 11 - 14  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Budgeting u The budgeting process describes the broad activities performed during the budget period. u Planners can select any budget period, but usually choose one year.

15. 11 - 15  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Elements of Budgeting 1. Organization Goals 3. Capital Spending Plan 2. Sales Plan 5. Production Plan 8. Labor Hiring and Training Plan 10. Expected Financial Results 4. Inventory Policy 6. Productive Capacity 7. Materials Purchasing Plan 9. Administrative and Discretionary Spending Plan 11. Statement of Expected Cash Flows 12. Projected Financial Statements

16. 11 - 16  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 3 Explain the different types of operating budgets and financial budgets and their interrelationships.

17. 11 - 17  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Master Budget Outputs u The master budget includes two sets of outputs: The expected or projected financial results The plans or operating budgets

18. 11 - 18  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Operating Budgets u Operating budgets typically consist of six operating plans: 1 The sales plan identifies the planned level of sales for each product. 2 The capital spending plan specifies the long-term capital investments. 3 The production plan schedules all required purchasing activities.

19. 11 - 19  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Operating Budgets 4 The materials purchasing plan schedules all required purchasing activities. 5 The labor hiring and training plan specifies the number of people the organization must hire or release. 6 The administrative and discretionary spending plan includes administration, staffing, research and development, and advertising.

20. 11 - 20  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Financial Budgets u Planners usually present the projected financial results, or financial budgets, in three forms: 1 A statement of expected cash flows 2 The projected (pro forma) balance sheet 3 The projected (pro forma) income statement

21. 11 - 21  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Financial Budgets u Financial analysts use the statement of projected cash flows in two ways: 1 To plan when excess cash will be generated so that they can undertake short-term investments 2 To organize how to meet any cash shortages

22. 11 - 22  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 4 Describe the way that organizations effectively use and interpret budgets.

23. 11 - 23  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Budgeting Process u What is a demand forecast? u It is the estimate of the market demand, or sales potential, for a product given the specific product price. u This forecast drives the budgeting process. u What is the production plan? u It identifies the intended production during each sub-period of the annual budget.

24. 11 - 24  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Budgeting Process u How frequent can budget sub-periods be? – daily – weekly – monthly u Planners use the inventory policy along with the sales plan to develop the production plan.

25. 11 - 25  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Budgeting Process u What is aggregate planning? u It is an approximated determination of whether the organization has the capacity to undertake a proposed production plan. u What are spending plans? u They are tentative resource commitments.

26. 11 - 26  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Budgeting Process u What are examples of spending plans? Materials purchasing plans Labor hiring and training plan Administrative and discretionary spending plan Capital spending plan

27. 11 - 27  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Budgeting Process u What resources determine capacity levels? 1 Flexible resources that the organization can acquire in the short term 2 Committed resources that the organization must acquire for the intermediate term 3 Committed resources that the organization must acquire for the long term

28. 11 - 28  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Types and Commitment Time Term Flexible resources required in short term (less than several weeks) Type of Capacity Acquired Provides the ability to use existing capacity Examples Raw materials, supplies, casual labor

29. 11 - 29  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Types and Commitment Time Term Committed resources acquired for the intermediate term (up to six months) Type of Capacity Acquired General purpose capacity that is transferable between organizations Examples People, general purpose equipment, specialty raw materials

30. 11 - 30  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capacity Types and Commitment Time Term Committed resources acquired for the long-term (more than six months) Type of Capacity Acquired Special purpose capacity that is customized for the organization’s use Examples Buildings, special purpose equipment

31. 11 - 31  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Interpreting the Production Plan u Production is the minimum of demand and capacity. Production = Minimum (production capacity, total demand)

32. 11 - 32  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Financial Plans u Once planners have developed the production, staffing, and capacity plans, they can prepare a financial summary of the tentative operating plans. u What is a line of credit? u It is a short-term financing arrangement, with a pre-specified limit, between an organization and a financial institution.

33. 11 - 33  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Cash Flow Statement Projected Cash Flow Statement Cash inflows from sales and collections of receivables Cash outflows for: – Short-term flexible resources – Intermediate-term committed resources – Long-term committed resources Results of financing operations

34. 11 - 34  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Cash Flow Statement Format of Cash Flow Statement Cash inflows – Cash outflows = Net cash flow

35. 11 - 35  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Cash Flow Statement Format of Financing Section of Cash Flow Statement Net cash flow from operations + Opening cash ± Cash invested or withdrawn ± Cash provided or used in issuing or retiring stock or debt = Cash available before short-tem financing ± Cash used or provided by short-term financing = Ending cash

36. 11 - 36  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Using the Projected Results u Planners use budget information to... – identify broad resources requirements. – identify potential problems. – compare projected operating and financial results.

37. 11 - 37  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Cost-Volume-Profit Analysis u Conventional cost-volume-profit analysis rests on several assumptions. u What are some of these assumptions? – All of an organization’s costs are either flexible or capacity related. – Units made equals units sold. – Revenue per unit does not change as volume changes.

38. 11 - 38  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Cost-Volume-Profit Analysis u What is the contribution margin? u It is the selling price less all flexible costs. u What is the break-even point in units? Capacity-Related Costs Contribution Margin Per Unit

39. 11 - 39  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Cost-Volume-Profit Analysis u Assume Princeton Company manufactures three products: Plastic valves, metal valves, and specialty valves. u Capacity related costs are $20,400,000. Plastic Metal Specialty Unit Sales 500,000425,000 400,000 Contribution Margin $14 $15 $13

40. 11 - 40  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Cost-Volume-Profit Analysis u What is the weighted average contribution margin? u Plastic valves: $14 × 500,000 ÷ 1,325,000 + Metal valves: $15 × 425,000 ÷ 1,325,00 + Specialty valves: $13 × 400,000 ÷ 1,325,00 = $14.0189

41. 11 - 41  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Cost-Volume-Profit Analysis u What is the breakeven in units? u $20,400,000 ÷ $14.0189 = 1,455,178 u How many plastic valves? u 1,455,178 × 500,000 ÷ 1,325,000 = 549,124 u How many metal valves? u 1,455,178 × 425,000 ÷ 1,325,000 = 466,755

42. 11 - 42  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 5 Undertake what-if and sensitivity analysis – two important budgeting tools used by budget planners.

43. 11 - 43  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young What-If Analysis u What is “what-if” analysis? u It is a strategy that uses a model to predict the results of varying key parameters or estimates.

44. 11 - 44  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Sensitivity Analysis u What is sensitivity analysis? u It is the process of selectively varying a plan’s or a budget’s key estimates. u If small changes in parameters produce large changes in decisions or results, the plan is said to be sensitive to the estimates.

45. 11 - 45  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 6 Identify the role of budgets in service and not-for-profit organizations.

46. 11 - 46  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Role of Budgeting in Service and Not-For-Profit Organizations u The role for budgeting in planning and control is as important in not-for-profit and government organizations as it is in profit seeking organizations.

47. 11 - 47  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Role of Budgeting in Service and Not-For-Profit Organizations Organization Focus of Budgeting Type Process Manufacturing Sales and manufacturing activities Natural resources Sales, resource availability, and acquisition Service Sales activities, and staffing requirements Nonprofit Raising revenues and controlling expenditures

48. 11 - 48  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Role of Budgeting in Service and Not-For-Profit Organizations u What is an appropriation? u It is an authorized spending limit in a governmental department. u What is a periodic budget? – It is a budget prepared for a specified period of time. – usually one year

49. 11 - 49  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young The Role of Budgeting in Service and Not-For-Profit Organizations u What is continuous budgeting? u It is the process that organizes the budget into subintervals. u As each budget subinterval ends, the organization drops the completed subinterval from the budget and adds the next budget subinterval.

50. 11 - 50  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Discretionary Expenditures u Organizations use three general approaches to budget discretionary expenditures. Incremental Budgeting Zero-Based Budgeting Project Funding

51. 11 - 51  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Discretionary Expenditures u What is incremental budgeting? u It is an approach to developing appropriations for discretionary expenditures that assumes that the starting point for each discretionary expenditure item is the amount spent on it in the previous budget.

52. 11 - 52  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Discretionary Expenditures u What is zero-based budgeting? u It is an approach to developing appropriations for discretionary expenditures that assumes that the starting point for each discretionary expenditure item is zero.

53. 11 - 53  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Discretionary Expenditures u What is project funding? u It is an approach to developing appropriations for discretionary expenditures that organizes appropriations into a package that focuses on achieving some defined output.

54. 11 - 54  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Controlling Discretionary Expenditures u A recent phenomenon has been the rise of activity based budgeting. u Activity based budgeting uses knowledge about the relationship between production units and the activities required to produce those units to develop detailed estimates of activity requirements.

55. 11 - 55  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Learning Objective 7 Recognize the behavioral effects of budgeting on an organization’s employees.

56. 11 - 56  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Managing the Budget Process u Who should manage and oversee the budgeting process? u Many organizations use a budget team. u The budget team usually reports to a budget committee which generally includes the chief executive officer.

57. 11 - 57  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Behavioral Aspects of Budgeting u There are two interrelated behavioral issues in budgeting: 1 Designing the budget process 2 Influencing the budget process

58. 11 - 58  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Designing the Budget Process u What is authoritative budgeting? u It is a budget in which superiors tell subordinates what their budget will be. u What are stretch targets? u They are targets that exceed previous targets by a significant amount and usually require an enormous increase in a goal over the next budgeting period.

59. 11 - 59  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Designing the Budget Process u What is participative budgeting? u It is a method of budget setting that involves a joint decision making process in which all parties agree about setting the budget targets.

60. 11 - 60  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Designing the Budget Process u What is consultative budgeting? u It is a budgeting method whereby managers ask subordinates to discuss their ideas about the budget, but no joint decision making occurs.

61. 11 - 61  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Influencing the Budget Process u What is influencing the budget process? u It is when people try to influence or manipulate the budget to their own ends. u Managers have been known to play budgeting games in which they attempt to manipulate information and targets to achieve as high a bonus as possible.

62. 11 - 62  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Conclusion u Shawn Dawson, the senior analyst in the finance group of the city of Ridgetown, divided each cost element into three groups: 1 Committed 2 Discretionary 3 Reengineering or redesign program costs with a cost reduction potential

63. 11 - 63  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Conclusion u The immediate problem was to choose which discretionary expenditures would have to be cut in the short run. u The council members were strongly divided.

64. 11 - 64  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young End of Chapter 11