Budgetary Planning PDF

Budget A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms. It represents the primary method of communicating agreed-upon objectives throughout the organization. Once adopted, a budget becomes an important basis for evaluating...

Budget A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms. It represents the primary method of communicating agreed-upon objectives throughout the organization. Once adopted, a budget becomes an important basis for evaluating performance. It promotes e iciency and serves as a deterrent to waste and ine iciency. Budgeting and Accounting Accounting information makes major contributions to the budgeting process. From the accounting records, companies can obtain historical data on revenues, costs, and expenses. These data are helpful in formulating future budget goals. Normally, accountants have the responsibility for presenting management’s budgeting goals in financial terms. In this role, they translate management’s plans and communicate the budget to employees throughout the company. They prepare periodic budget reports that provide the basis for measuring performance and comparing actual results with planned objectives. The budget itself, and the administration of the budget, however, are entirely management responsibilities. The Benefits of Budgeting The primary benefits of budgeting are: 1. It requires all levels of management to plan ahead and to formalize goals on a recurring basis. 2. It provides definite objectives for evaluating performance at each level of responsibility. 3. It creates an early warning system for potential problems so that managment can make changes before things get out of hand. 4. It facilitates the coordination of activities within the business. It does this by correlating the goals of each segment with overall company objectives. Thus, the company can integrate production and sales promotion with expected sales. 5. It results in greater management awareness of the entity’s overall operations and the impact on operations of external factors, such as economic trends. 6. It motivates personnel throughout the organization to meet planned objectives. A budget is an aid to management; it is not a substitute for management. A budget cannot operate or enforce itself. Companies can realize the benefits of budgeting only when managers carefully administer budgets. 1 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso Essentials of E ective Budgeting E ective budgeting depends on a sound organizational structure. In such a structure, authority and responsibility for all phases of operations are clearly defined. Budgets based on research and analysis are more likely to result in realistic goals that will contribute to the growth and profitability of a company. And, the e ectiveness of a budget program is directly related to its acceptance by all levels of management. Once adopted, the budget is an important tool for evaluating performance. Managers should systematically and periodically review variations between actual and expected results to determine their cause(s). However, individuals should not be held responsible for variations that are beyond their control. Length of the Budget Period The budget period is not necessarily one year in length. A budget may be prepared for any period of time. Various factors influence the length of the budget period. These factors include the type of budget, the nature of the organization, the need for periodic appraisal, and prevailing business conditions. The budget period should be long enough to provide an attainable goal under normal business conditions. Ideally, the time period should minimize the impact of seasonal or cyclical fluctuations. On the other hand, the budget period should not be so long that reliable estimates are impossible. The most common budget period is one year. The annual budget, in turn, is often supplemented by monthly and quarterly budgets. Many companies use continuous 12-month budgets. These budgets drop the month just ended and add a future month. One advantage of continuous budgeting is that it keeps management planning a full year ahead. The Budgeting Process The development of the budget for the coming year generally starts several months before the end of the current year. The budgeting process usually begins with the collection of data from each organizational unit of the company. Past performance is often the starting point from which future budget goals are formulated. The budget is developed within the framework of a sales forecast. This forecast shows potential sales for the industry and the company’s expected share of such sales. Sales forecasting involves a consideration of various factors: (1) general economic conditions, (2) industry trends, (3) market research studies, (4) anticipated advertising and promotion, (5) previous market share, (6) changes in prices, and (7) technological developments. The input of sales personnel and top management is essential to the sales forecast. In larger companies, a budget committee has responsibility for coordinating the preparation of the budget. The committee ordinarily includes the president, treasurer, chief accountant (controller), and management personnel from each of the major areas of the company, such as sales, production, and research. The budget committee serves as a review board where managers can defend their budget goals and requests. Di erences are reviewed, modified if necessary, and reconciled. The budget is then put in its final form by the budget committee, approved, and distributed. Budgeting and Human Behavior A budget can have a significant impact on human behavior. If done well, it can inspire managers to higher levels of performance. However, if done poorly, budgets can discourage additional e ort and pull down the morale of managers. Why do these diverse e ects occur? The answer is found in how the budget is developed and administered. In developing the budget, each level of management should be invited to participate. This “bottom- to-top” approach is referred to as participative budgeting. One advantage of participative budgeting is that lower- level managers have more detailed knowledge of their specific area and thus are able to provide more accurate budgetary estimates. Also, when lower-level managers participate in the budgeting process, they are more likely to perceive the resulting budget as fair. The overall goal is to reach agreement on a budget that the managers consider fair and achievable, but which also meets the corporate goals set by top management. When this goal is met, the budget will provide positive motivation for the managers. In contrast, if managers view the budget as unfair and 2 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso unrealistic, they may feel discouraged and uncommitted to budget goals. The risk of having unrealistic budgets is generally greater when the budget is developed from top management down to lower management than vice versa. Participative budgeting does, however, have potential disadvantages. First, the “give and take” of participative budgeting is time-consuming (and thus more costly). Under a “top-down” approach, the budget is simply developed by top management and then dictated to lower-level managers. A second disadvantage is that participative budgeting can foster budgetary “gaming” through budgetary slack. Budgetary slack occurs when managers intentionally underestimate budgeted revenues or overestimate budgeted expenses in order to make it easier to achieve budgetary goals. To minimize budgetary slack, higher-level managers must carefully review and thoroughly question the budget projections provided to them by employees whom they supervise. For the budget to be e ective, top management must completely support the budget. The budget is an important basis for evaluating performance. It also can be used as a positive aid in achieving projected goals. The e ect of an evaluation is positive when top management tempers criticism with advice and assistance. In contrast, a manager is likely to respond negatively if top management uses the budget exclusively to assess blame. A budget should not be used as a pressure device to force improved performance. In sum, a budget can be a manager’s friend or a foe. Budgeting and Long-Range Planning Budgeting and long-range planning are not the same. One important di erence is the time period involved. The maximum length of a budget is usually one year, and budgets are often prepared for shorter periods of time, such as a month or a quarter. In contrast, long-range planning usually encompasses a period of at least five years. A second significant di erence is in emphasis. Budgeting focuses on achieving specific short-term goals, such as meeting annual profit objectives. Long range planning, on the other hand, identifies long-term goals, selects strategies to achieve those goals, and develops policies and plans to implement the strategies. In long-range planning, management also considers anticipated trends in the economic and political environment and how the company should cope with them. The final di erence between budgeting and long-range planning relates to the amount of detail presented. Budgets, can be very detailed. Long-range plans contain considerably less detail. The data in long range plans are intended more for a review of progress toward long-term goals than as a basis of control for achieving specifi c results. The primary objective of long-range planning is to develop the best strategy to maximize the company’s performance over an extended future period. The Master Budget The term “budget” is actually a shorthand term to describe a variety of budget documents. All of these documents are combined into a master budget. The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period. The master budget contains two classes of budgets. Operating budgets are the individual budgets that result in the preparation of the budgeted income statement. These budgets establish goals for the company’s sales 3 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso and production personnel. In contrast, financial budgets focus primarily on the cash resources needed to fund expected operations and planned capital expenditures. Financial budgets include the capital expenditure budget, the cash budget, and the budgeted balance sheet. Preparing the Operating Budgets The sales budget is derived from the sales forecast. It represents management’s best estimate of sales revenue for the budget period. An inaccurate sales budget may adversely a ect net income. For example, an overly optimistic sales budget may result in excessive inventories that may have to be sold at reduced prices. In contrast, an unduly pessimistic sales budget may result in loss of sales revenue due to inventory shortages. The sales budget is prepared by multiplying the expected unit sales volume for each product by its anticipated unit selling price. Hayes Company expects sales volume to be 3,000 units in the first quarter, with 500-unit increases in each succeeding quarter. Illustration shows the sales budget for the year, by quarter, based on a sales price of $60 per unit. 4 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso Production Budget The production budget shows the number of units of a product to produce to meet anticipated sales demand. Production requirements are determined from the following formula A realistic estimate of ending inventory is essential in scheduling production requirements. Excessive inventories in one quarter may lead to cutbacks in production and employee layo s in a subsequent quarter. On the other hand, in adequate inventories may result either in added costs for overtime work or in lost sales. Hayes Company believes it can meet future sales requirements by maintaining an ending inventory equal to 20% of the next quarter’s budgeted sales volume. For example, the ending finished goods inventory for the first quarter is 700 units (20% x anticipated second-quarter sales of 3,500 units). Illustration the production budget. The production budget, in turn, provides the basis for the budgeted costs for each manufacturing cost element, as explained in the following topic. Direct Materials Budget The direct materials budget shows both the quantity and cost of direct materials to be purchased. The quantities of direct materials are derived from the following formula After the company determines the number of units to purchase, it can compute the budgeted cost of direct materials to be purchased. It does so by multiplying the required units of direct materials by the anticipated cost per unit. The desired ending inventory is again a key component in the budgeting process. For example, inadequate inventories could result in temporary shut downs of production. Because of its close proximity to suppliers, Hayes Company maintains an ending inventory of raw materials equal to 10% of the next quarter’s production requirements. The manufacture of each Rightride requires 2 pounds of raw materials, and the expected cost per pound is $4. Illustration shows the direct materials budget. Assume that the desired ending direct materials amount is 1,020 pounds for the fourth quarter of 2014. 5 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso Direct Labor Budget Like the direct materials budget, the direct labor budget contains the quantity (hours) and cost of direct labor necessary to meet production requirements. The total direct labor cost is derived from the following formula. Direct labor hours are determined from the production budget. At Hayes Company, two hours of direct labor are required to produce each unit of finished goods. The anticipated hourly wage rate is $10. Illustration shows these data. The direct labor budget is critical in maintaining a labor force that can meet the expected levels of production. Manufacturing Overhead Budget The manufacturing overhead budget shows the expected manufacturing overhead costs for the budget period. As Illustration shows, this budget distinguishes between variable and fixed overhead costs. Hayes Company expects variable costs to fluctuate with production volume on the basis of the following rates per direct labor hour: indirect materials $1.00, indirect labor $1.40, utilities $0.40, and maintenance $0.20. Thus, for the 6,200 direct labor hours to produce 3,100 units, budgeted indirect materials are $6,200 (6,200 x $1), and budgeted indirect labor is $8,680 (6,200 x $1.40). Hayes also recognizes that some maintenance is fixed. The amounts reported for fixed costs are assumed for our example. The accuracy of budgeted overhead cost estimates can be greatly improved by employing activity-based costing. 6 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso  At Hayes Company, overhead is applied to production on the basis of direct labor hours. Thus, as Illustration shows, the budgeted annual rate is $8 per hour ($246,400 / 30,800). Selling and Administrative Expense Budget Hayes Company combines its operating expenses into one budget, the selling and administrative expense budget. This budget projects anticipated selling and administrative expenses for the budget period. This budget also classifies expenses as either variable or fixed. In this case, the variable expense rates per unit of sales are sales commissions $3 and freight-out $1. Variable expenses per quarter are based on the unit sales from the sales budget. For example, Hayes expects sales in the first quarter to be 3,000 units. Thus, Sales Commissions Expense is $9,000 (3,000 x $3), and Freight-Out is $3,000 (3,000 x $1). Fixed expenses are based on assumed data. Budgeted Income Statement The budgeted income statement is the important end-product of the operating budgets. This budget indicates the expected profitability of operations for the budget period. The budgeted income statement provides the basis for evaluating company performance. Budgeted income statements often act as a call to action. 7 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso  Hayes Company then determines cost of goods sold by multiplying the units sold by the unit cost. Its budgeted cost of goods sold is $660,000 (15,000 x $44). All data for the income statement come from the individual operating budgets except the following: (1) interest expense is expected to be $100, and (2) income taxes are estimated to be $12,000. Illustration shows the budgeted income statement. Preparing the Financial Budgets Cash Budget The cash budget shows anticipated cash flows. Because cash is so vital, this budget is often considered to be the most important financial budget. The cash budget contains three sections (cash receipts, cash disbursements, and financing) and the beginning and ending cash balances, as shown in Illustration. The cash receipts section includes expected receipts from the company’s principal source(s) of revenue. These are usually cash sales and collections from customers on credit sales. This section also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investments, plant assets, and the company’s capital stock. The cash disbursements section shows expected cash payments. Such payments include direct materials, direct labor, manufacturing overhead, and selling and administrative expenses. This section also includes projected payments for income taxes, dividends, investments, and plant assets. 8 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso  The financing section shows expected borrowings and the repayment of the borrowed funds plus interest. Companies need this section when there is a cash deficiency or when the cash balance is below management’s minimum required balance. Data in the cash budget are prepared in sequence. The ending cash balance of one period becomes the beginning cash balance for the next period. Companies obtain data for preparing the cash budget from other budgets and from information provided by management. In practice, cash budgets are often prepared for the year on a monthly basis. To minimize detail, we will assume that Hayes Company prepares an annual cash budget by quarters. Its cash budget is based on the following assumptions. 1. The January 1, 2014, cash balance is expected to be $38,000. Hayes wishes to maintain a balance of at least $15,000. 2. Sales 60% are collected in the quarter sold and 40% are collected in the following quarter. Accounts receivable of $60,000 at December 31, 2013, are expected to be collected in full in the first quarter of 2014. 3. Short-term investments are expected to be sold for $2,000 cash in the first quarter. 4. Direct materials: 50% are paid in the quarter purchased and 50% are paid in the following quarter. Accounts payable of $10,600 at December 31, 2013, are expected to be paid in full in the first quarter of 2014. 5. Direct labor: 100% is paid in the quarter incurred. 6. Manufacturing overhead and selling and administrative expenses: All items except depreciation are paid in the quarter incurred. 7. Management plans to purchase a truck in the second quarter for $10,000 cash. 8. Hayes makes equal quarterly payments of its estimated annual income taxes. 9. Loans are repaid in the earliest quarter in which there is su icient cash (that is, when the cash on hand exceeds the $15,000 minimum required balance). In preparing the cash budget, it is useful to prepare schedules for collections from customers (assumption No. 2) and cash payments for direct materials (assumption No. 4). These schedules are shown in Illustrations. 9 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso  Illustration shows the cash budget for Hayes Company. The budget indicates that Hayes will need $3,000 of financing in the second quarter to maintain a minimum cash balance of $15,000. Since there is an excess of available cash over disbursements of $22,500 at the end of the third quarter, the borrowing, plus $100 interest, is repaid in this quarter. A cash budget contributes to more e ective cash management. It shows managers when additional financing is necessary well before the actual need arises. And, it indicates when excess cash is available for investments or other purposes. Budgeted Balance Sheet The budgeted balance sheet is a projection of financial position at the end of the budget period. This budget is developed from the budgeted balance sheet for the preceding year and the budgets for the current year. Pertinent data from the budgeted balance sheet at December 31, 2013, are as follows: 10 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso Illustration shows Hayes Company’s budgeted balance sheet at December 31, 2014. The computations and sources of the amounts are explained below. Cash: Ending cash balance $37,900, shown in the cash budget (Illustration, page 10). Accounts receivable: 40% of fourth-quarter sales $270,000, shown in the schedule of expected collections from customers (Illustration, page 9). Finished goods inventory: Desired ending inventory 1,000 units, shown in the production budget (Illustration, page 5) times the total unit cost $44 (shown in Illustration, page 8). Raw materials inventory: Desired ending inventory 1,020 pounds, times the cost per pound $4, shown in the direct materials budget (Illustration, page 6). Buildings and equipment: December 31, 2013, balance $182,000, plus purchase of truck for $10,000 (Illustration, page 10). Accumulated depreciation: December 31, 2013, balance $28,800, plus $15,200 depreciation shown in manufacturing overhead budget (Illustration, page 7) and $4,000 depreciation shown in selling and administrative expense budget (Illustration, page 7). Accounts payable: 50% of fourth-quarter purchases $37,200, shown in schedule of expected payments for direct materials (Illustration, page 9). Common stock: Unchanged from the beginning of the year. Retained earnings: December 31, 2013, balance $46,480, plus net income $47,900, shown in budgeted income statement (Illustration, page 8). After budget data are entered into the computer, Hayes prepares the various budgets (sales, cash, etc.), as well as the budgeted financial statements. Using spreadsheets, management can also perform “what if” (sensitivity) analyses based on di erent hypothetical assumptions. For example, suppose that sales managers project that sales will be 10% higher in the coming quarter. What impact does this change have on the rest of the budgeting process and the financing needs of the business? The impact of the various assumptions on the budget is quickly determined by the spreadsheet. Armed with these analyses, managers make more informed decisions about the impact of various projects. They also anticipate future problems and business opportunities. Budgeting in Nonmanufacturing Companies 11 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso  Budgeting is not limited to manufacturers. Budgets are also used by merchandisers, service companies, and not-for-profit organizations. Merchandisers As in manufacturing operations, the sales budget for a merchandiser is both the starting point and the key factor in the development of the master budget. The major di erences between the master budgets of a merchandiser and a manufacturer are these: 1. A merchandiser uses a merchandise purchases budget instead of a pro duction budget. 2. A merchandiser does not use the manufacturing budgets (direct materials, direct labor, and manufacturing overhead). The merchandise purchases budget shows the estimated cost of goods to be purchased to meet expected sales. The formula for determining budgeted merchandise purchases is To illustrate, assume that the budget committee of Lima Company is preparing the merchandise purchases budget for July 2014. It estimates that budgeted sales will be $300,000 in July and $320,000 in August. Cost of goods sold is expected to be 70% of sales—that is, $210,000 in July (.70 x $300,000) and $224,000 in August (.70 x $320,000). The company’s desired ending inventory is 30% of the following month’s cost of goods sold. Required merchandise purchases for July are $214,200, computed as follows When a merchandiser is departmentalized, it prepares separate budgets for each department. For example, a grocery store prepares sales budgets and purchases budgets for each of its major departments, such as meats, dairy, and produce. The store then combines these budgets into a master budget for the store. When a retailer has branch stores, it prepares separate master budgets for each store. Then, it incorporates these budgets into master budgets for the company as a whole. Service Companies In a service company, such as a public accounting firm, a law o ice, or a medical practice, the critical factor in budgeting is coordinating professional sta needs with anticipated services. If a fi rm is oversta ed, several problems may result: Labor costs are disproportionately high. Profits are lower because of the additional salaries. Sta turnover sometimes increases because of lack of challenging work. In contrast, if a service company is understa ed, it may lose revenue because existing and prospective client needs for service cannot be met. Also, professional sta may seek other jobs because of excessive work loads. Service companies can obtain budget data for service revenue from expected output or expected input. When output is used, it is necessary to determine the expected billings of clients for services provided. In a public accounting fi rm, for example, output is the sum of its billings in auditing, tax, and consulting services. When input data are used, each professional sta member projects his or her bill able time. The fi rm then applies billing rates to billable time to produce expected service revenue. 12 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso Not-For-Profit Organizations Budgeting is just as important for not-for-profit organizations as for profit-oriented businesses. The budget process, however, is di erent. In most cases, not-for-profit entities budget on the basis of cash flows (expenditures and receipts), rather than on a revenue and expense basis. Further, the starting point in the process is usually expenditures, not receipts. For the not-for-profi t entity, management’s task generally is to fi nd the receipts needed to support the planned expenditures. The activity index is also likely to be significantly di erent. For example, in a not-for-profit entity, such as a university, budgeted faculty positions may be based on full-time equivalent students or credit hours expected to be taught in a department. For some governmental units, voters approve the budget. In other cases, such as state governments and the federal government, legislative approval is required. After the budget is adopted, it must be followed. Overspending is often illegal. In governmental budgets, authorizations tend to be on a line-by-line basis. That is, the budget for a municipality may have a specified authorization for police and fi re protection, garbage collection, street paving, and so on. The line-item authorization of governmental budgets significantly limits the amount of discretion management can exercise. The city manager often cannot use savings from one line item, such as street paving, to cover increased spending in another line item, such as snow removal. EXERCISES 1.1 Molly Packing Company estimates that 2024 unit sales will be 12,000 in quarter 1, 16,000 in quarter 2, and 20,000 in quarter 3, at a unit selling price of Php 300.00. Management desires to have ending finished goods inventory equal to 15% of the next quarter’s expected unit sales. Prepare a production budget by quarter for the first six months of 2024. 1.2 Barry Company is preparing its master budget for 2024. Relevant data pertaining to its sales, production, and direct materials budgets are as follows. Sales. Sales for the year are expected to total 1,200,000 units. Quarterly sales, as a percentage of total sales, are 20%, 25%, 30%, and 25%, respectively. The sales price is expected to be Php 500 per unit for the first three quarters and Php 550 per unit beginning in the fourth quarter. Sales in the first quarter of 2015 are expected to be 10% higher than the budgeted sales for the first quarter of 2014. Production. Management desires to maintain the ending finished goods inventories at 25% of the next quarter’s budgeted sales volume. Direct materials. Each unit requires 3 pounds of raw materials at a cost of Php 50 per pound. Management desires to maintain raw materials inventories at 5% of the next quarter’s production requirements. Assume the production requirements for the first quarter of 2015 are 810,000 pounds. Prepare the sales, production, and direct materials budgets by quarters for 2014. Production. Management desires to maintain the ending finished goods inventories at 25% of the next quarter’s budgeted sales volume. Direct materials. Each unit requires 3 pounds of raw materials at a cost of Php 50 per pound. Management desires to maintain raw materials inventories at 5% of the next quarter’s production requirements. Assume the production requirements for the first quarter of 2025 are 810,000 pounds. Prepare the sales, production, and direct materials budgets by quarters for 2024. 1.3 Barry Company is preparing its budgeted income statement for 2024. Relevant data pertaining to its sales, production, and direct materials budgets can be found in the exercise 1.2. In addition, Barry budgets 0.5 hours of direct labor per unit, labor costs at Php 150 per hour, and manufacturing overhead at Php 250 per direct labor hour. Its budgeted selling and administrative expenses for 2024 are $12,000,000. (a) Calculate the budgeted total unit cost. (b) Prepare the budgeted income statement for 2024. 13 Reference: Managerial Accounting by Weygandt, Kimmel and Kieso