BUS 215; Banfield, Ch 8 Week 6 Notes
BUS 215; Banfield, Ch 8 Week 6 Notes BUS 215
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Date Created: 05/11/16
BUS 215 CH 8 Master Budgeting I. What is a Budget? ● A budget is a detailed plan for the future that is usually expressed in formal quantitative terms. ● Budgets are used for two distinct purposesplanning and control. To be effective, a good budgeting system must provide for both planning and control ○ Planning involves developing goals and preparing various budgets to achieve those goals. ○ Control involves gathering feedback to ensure that the plan is being properly executed or modified as circumstances change. ● Advantages of Budgeting 1. Budgets communicate management’s plans throughout the organization. 2. Budgets force managers to think abou and plan for the future. In the absence of the necessity to prepare a budget, many managers would spend all of their time dealing with daytoday emergencies. 3. The budgeting process provides a means ofallocating resource to those parts of the organization where they can be used most effectively. 4. The budgeting process can uncover potentiabottlenecks before they occur. 5. Budgets coordinate the activities of the entire organizatintegratin the plans of its various parts. Budgeting helps to ensure that everyone in the organization is pulling in the same direction. 6. Budgets define goals and objectives that can serve benchmarks for evaluating subsequent performance. ● Responsibility Accounting ○ responsibility accounting is that a manager should be held responsible for those items—anonl those items—that the manager can actually control to a significant extent. ■ responsibility accountipersonalizes accounting information by holding individuals responsible for revenues and costs. ■ This concept is central to any effective planning and control system. Someone must be held responsible for each cost or else no one will be responsible and the cost will inevitably grow out of control. ○ What happens if actual results do not measure up to the budgeted goals? ■ The manager not penalized. However, should take the initiative to understand the sources of significant favorable or unfavorable discrepancies, & take steps to correct unfavorable discrepancies and replicate favorable discrepancies, and should be prepared to explain discrepancies and the steps taken to correct or exploit them to higher management. ■ The point of an effective responsibility accounting system is to make sure that nothing “falls through the cracks,” that the organization reacts quickly and appropriately to deviations from its plans, and that the organization learns from the feedback it gets by comparing budgeted goals to actual results ■ The point inot to penalize individuals for missing targets. ● Choosing a Budget Period ○ Many companies divide their budget year into four quarters. ■ This approach has the advantage of requiring periodic review and reappraisal of budget data throughout the year. ○ Continuous orperpetual budgets are sometimes used. A continuous orperpetual budget is a 12month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. ■ one month (or quarter) is added to the end of the budget as each month (or quarter) comes to a close. ■ This approach keeps managers focused at least one year ahead so that they do not become too narrowly focused on shortterm results. ● Selfimposed Budget ○ A selfimposed budget orparticipative budget is a budget that is prepared with the full cooperation and participation of managers at all levels. ■ Selfimposed budgets have a number of advantages: 1. Individuals at all levels of the organization are recognized as members of the team whose views and judgments are valued by top management. 2. Budget estimates prepared by frontline managers are often more accurate and reliable than estimates prepared by top managers who have less intimate knowledge of markets and daytoday operations. 3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. Selfimposed budgets create commitment. 4. A manager who is not able to meet a budget that has been imposed from above can always say that the budget was unrealistic and impossible to meet. With a selfimposed budget, this claim cannot be made ○ Selfimposed budgeting has two important limitations. ■ First, lowerlevel managers may make suboptimal budgeting recommendations if they lack the broad strategic perspective possessed by top managers. ■ Second, selfimposed budgeting may allow lowerlevel managers to create too muchbudgetary slack. Because the manager who creates the budget will be held accountable for actual results that deviate from the budget, the manager will have a natural tendency to submit a budget that is easy to attain. ○ Unfortunately, many companies do not use selfimposed budgeting. ■ Instead, top managers often initiate the budgeting process by issuing profit targets. Lowerlevel managers are directed to prepare budgets that meet those targets. ■ The difficulty is that the targets set by top managers may be unrealistically high or may allow too much slack. If the targets are too high and employees know they are unrealistic, motivation will suffer. If the targets allow too much slack, waste will occur. ■ Unfortunately, top managers are often not in a position to know whether the targets are appropriate. Admittedly, a selfimposed budgeting system may lack sufficient strategic direction and lowerlevel managers may be tempted to build slack into their budgets. ■ Nevertheless, because of the motivational advantages of selfimposed budgets, top managers should be cautious about imposing inflexible targets from above. ● Human Factors in Budgeting ○ The success of a budget program also depends on whether top management uses the budget to pressure or blame employees. ■ Using budgets to blame employees breeds hostility, tension, and mistrust rather than cooperation and productivity. ■ Rather than being used as a weapon, the budget should be used as a positive instrument to assist in establishing goals, measuring operating results, and isolating areas that need attention. ○ The budgeting process is also influenced by the fact that bonuses are often based on meeting and exceeding budgets. ■ Typically, no bonus is paid unless the budget is met. The bonus often increases when the budget target is exceeded, but the bonus is usually capped out at some level. ■ highly achievable budgets may help build a manager’s confidence and generate greater commitment to the budget while also reducing the likelihood that a manager will engage in undesirable behavior at the end of budgetary periods to secure bonus compensation ■ while some experts argue that budget targets should be very challenging and should require managers to stretch to meet their goals, in practice, most companies set their budget targets at “highly achievable” levels. II. The Master Budget An overview ● The master budget consists of a number of separate but interdependent budgets that formally lay out the company’s sales, production, and financial goals. The master budget culminates in a cash budget, a budgeted income statement, and a budgeted balance sheet ○ The first step in the budgeting process is the preparation sales budget, which is a detailed schedule showing the expected sales for the budget period ■ The sales budget is based on the company’s sales forecast ○ The sales budget influences the variable portion of the selling and administrative expense budget and it feeds into the production budget ■ Production budget : defines how many units need to be produced during the budget period. ○ The production budget in turn is used to determine direct materials, direct labor, and manufacturing overhead budgets. ○ Once a company has prepared these three manufacturing cost budgets, it can prepare the ending finished goods inventory budget. ○ The master budget concludes with the preparation of a cash budget, income statement, and balance sheet. Information from the sales budget, selling and administrative expense budget, and the manufacturing cost budgets all influence the preparation ofash budget. ■ Acash budget is a detailed plan showing how cash resources will be acquired and used ● The budgeted income statement provides an estimate of net income for the budget period and it relies on information from the sales budget, ending finished goods inventory budget, selling and administrative expense budget, and the cash budget. ■ The final schedule of the master budget is the balance sheet, which estimates a company’s assets, liabilities, and stockholders’ equity at the end of a budget period. ■ ● Seeing the Big Picture ○ Questions answered from budgeting ■ How much sales revenue will we earn? ■ How much cash will we collect from customers? ■ How much raw material will we need to purchase? ■ How much manufacturing cost (including direct materials, direct labor, and manufacturing overhead) will we incur? ■ How much cash will we pay to our suppliers and our direct laborers, and how much will we pay for manufacturing overhead resources? ■ What is the total cost that will be transferred from finished goods inventory to cost of goods sold? ■ How much selling and administrative expense will we incur and how much cash will we pay related to those expenses? ■ How much money will we borrow from or repay to lenders—including interest? ■ How much net operating income will we earn? ■ What will our balance sheet look like at the end of the budget period? ○ important to understand that many of the schedules in a master budget hinge on a variety of estimates and assumptions that managers mustmake when preparing those schedules. ○ Exhibit 8–2summarizes the questions that underlie these estimates and assumptions for seven of the schedules included in a master budget. As you study the forthcoming budget schedules, keep these two “big picture” insights in mind—that the budget is designed to answer 10 key questions and that it is based on various estimates and assumptions—because they will help you understandwhy andhow a master budget is created. ○ ○ Before reading further, it is important to understand why Larry created the Budgeting Assumptions tab shown inxhibit 8–4. ■ He did it because it simplifies the process of using a master budget to answer “whatif” questions. For example, assume that Larry wanted to answer the question: Whatif we increase the selling price per unit by $2 and expect sales to drop by 1,000 units per quarter, what would be the impact on profits? ■ With a properly constructed Budgeting Assumptions tab, Larry would only need to make a few adjustments to the data within this tab and the formulas embedded in each of the budget schedules would automatically update the projected financial results. This is much simpler than attempting to adjust data inputs within each of the master budget schedules. ● Sales Budget ○ ■ Schedule 1 contains Hampton Freeze’s sales budget for 2014. ● keep in mind that all of its numbers are derived from cell references to the Budgeting Assumptions tab and formulas—none of the numbers appearing in the schedule were actually keyed into their respective cells. ● Furthermore, it bears emphasizing that all remaining schedules in the master budget are prepared in the same fashion—they rely almost exclusively on cell references and formulas. ■ For the year, Hampton Freeze expects to sell 100,000 cases of popsicles at a price of $20 per case for total budgeted sales of $2,000,000. The budgeted unit sales for each quarter (10,000, 30,000, 40,000, and 20,000) come from cells C7 through F7 in the Budgeting Assumptions tab shown in Exhibit 8–4, and the selling price per case ($20.00) comes from cell B8 in the Budgeting Assumptions tab. ■ Schedule 1 also shows that the company’s expected cash collections for 2014 are $1,970,000. The accounts receivable balance of $90,000 that is collected in the first quarter comes from cell B8 of the beginning balance sheet shown inExhibit 8–3. All other cash collections rely on the estimated cash collection percentages from cells B9 and B10 of the Budgeting Assumptions tab. ■ For example,Schedule 1 shows that the budgeted sales for the first quarter equal $200,000. In the first quarter, Hampton Freeze expects to collect 70% of this amount, or $140,000. In the second quarter, the company expects to collect the remaining 30% of this amount, or $60,000. ● The Production Budget ○ The production budget is prepared after the sales budget. ○ The production budget lists the number of units that must be produced to satisfy sales needs and to provide for the desired ending finished goods inventory. ■ Production needs can be determined as follows: ■ ■ Note the production requirements are influenced by the desired level of the ending finished goods inventory. Inventories should be carefully planned. Excessive inventories tie up funds and create storage problems. Insufficient inventories can lead to lost sales or lastminute, highcost production efforts. ○ Schedule 2 contains the production budget for Hampton Freeze. ■ ● The budgeted sales data come from cells B7 through E7 of the sales budget. The desired ending finished goods inventory for the first quarter of 6,000 cases is computed by multiplying budgeted sales from the second quarter (30,000 cases) by the desired ending finished goods inventory percentage (20%) shown in cell B13 of the Budgeting Assumptions tab. ○ The total needs for the first quarter (16,000 cases) are determined by adding together the budgeted sales of 10,000 cases for the quarter and the desired ending inventory of 6,000 cases. ○ As discussed above, the ending inventory is intended to provide some cushion in the event that problems develop in production or sales increase unexpectedly. ○ Because the company already has 2,000 cases in beginning finished goods inventory (as shown in the beginning balance sheet iExhibit 8–3), only 14,000 cases need to be produced in the first quarter. ● Pay particular attention to the Year column to the right of the production budget in Schedule 2 . ○ In some cases (e.g., budgeted sales, total needs, and required production), the amount listed for the year is the sum of the quarterly amounts for the item. In other cases, (e.g., desired units of ending finished goods inventory and units of beginning finished goods inventory), the amount listed for the year is not simply the sum of the quarterly amounts. ○ From the standpoint of the entire year, the beginning finished goods inventory is the same as the beginning finished goods inventory for the first quarter—inot the sum of the beginning finished goods inventories for all four quarters. ○ Similarly, from the standpoint of the entire year, the ending finished goods inventory, which Larry Giano assumed to be 3,000 units, is the same as the ending finished goods inventory for the fourth quarter—itnot the sum of the ending finished goods inventories for all four quarters. It is important to pay attention to such distinctions in all schedules that follow. ○ Inventory Purchases Merchandising Company ■ Hampton Freeze prepares a production budget because it is a manufacturing company. If it were a merchandising company, instead it would prepare amerchandise purchases budget showing the amount of goods to be purchased from suppliers during the period. ■ The format of the merchandise purchases budget is shown below: ● ○ Direct Materials Budget ■ A direct materials budge is prepared after the production requirements have been computed. The direct materials budget details the raw materials that must be purchased to fulfill the production budget and to provide for adequate inventories. The required purchases of raw materials are computed as follows: ■ ■ Schedule 3 contains the direct materials budget for Hampton Freeze. ● ○ Direct Labor Budget ■ The direct labor budget shows the direct laborhours required to satisfy the production budget. ● By knowing in advance how much labor time will be needed throughout the budget year, the company can develop plans to adjust the labor force as the situation requires. ● Companies that neglect the budgeting process run the risk of facing labor shortages or having to hire and lay off workers at awkward times. Erratic labor policies lead to insecurity, low morale, and inefficiency. ■ The direct labor budget for Hampton Freeze is shown iSchedule 4 . ● ● The first line in the direct labor budget consists of the required production for each quarter, which is taken directly from cells B14 through E14 of the production budSchedule 2 ). ● the minimum direct labor cost for a quarter would be computed as follows: ○ ○ Note that in this case the direct costs shown in the first and fourth quarters of Schedule 4 would have to be increased to $180,000. ● Manufacturing Overhead Budget ○ The manufacturing overhead budget lists all costs of production other than direct materials and direct labor ○ Schedule 5 shows the manufacturing overhead budget for Hampton Freeze. At Hampton Freeze, manufacturing overhead is separated into variable and fixed components. ○ ○ The last line oSchedule 5 for Hampton Freeze shows the budgeted cash disbursements for manufacturing overhead. Because some of the overhead costs are not cash outflows, the total budgeted manufacturing overhead costs must be adjusted to determine the cash disbursements for manufacturing overhead. At Hampton Freeze, the only significant noncash manufacturing overhead cost is depreciation, which is $15,000 per quarter (see cell B29 in the Budgeting Assumptions tab). These noncash depreciation charges are deducted from the total budgeted manufacturing overhead to determine the expected cash disbursements. ■ company’s predetermined overhead rate for the year is $10 per direct laborhour, which is determined by dividing the total budgeted manufacturing overhead for the year by the total budgeted direct laborhours for the year. ● The ending finished goods inventory budget ○ After completingSchedules 1– 5, Larry Giano had all of the data he needed to compute the unit product cost for the units produced during the budget year. ○ This computation was needed for two reasons: ■ first, to help determine cost of goods sold on the budgeted income statement; and ■ second, to value ending inventories on the budgeted balance sheet. The cost of unsold units is computed on the ending finished goods inventory budget ○ ● Selling and Administrative Expense Budget ○ The selling and administrative expense budget lists the budgeted expenses for areas other than manufacturing. In large organizations, this budget would be a compilation of many smaller, individual budgets submitted by department heads and other persons responsible for selling and administrative expenses. ■ For example, the marketing manager would submit a budget detailing the advertising expenses for each budget period. ○ Schedule 7 contains the selling and administrative expense budget for Hampton Freeze. Like the manufacturing overhead budget, the selling and administrative expense budget is divided into variable and fixed cost components. Consequently, budgeted sales in cases for each quarter are entered at the top of the schedule. ■ ● The Cash Budget ○ The cash budget is composed of four major sections: 1. The receipts section. 2. The disbursements section. 3. The cash excess or deficiency section. 4. The financing section. ○ Generally, the major source of receipts is from sales.The disbursements section summarizes all cash payments that are planned for the budget period. ■ These payments include raw materials purchases, direct labor payments, manufacturing overhead costs, and so on, as contained in their respective budgets. ■ In addition, other cash disbursements such as equipment purchases and dividends are listed. ○ The cash excess or deficiency section is computed as follows: ■ ■ If excess cash → the company can invest the excess funds or repay principal and interest to lenders. ■ If cash is deficient → borrow ○ ■ The financing section of the cash budget details the borrowings and principal and interest repayments projected to take place during the budget period. ● In this chapter, we’ll always assume that all borrowings take place on the first day of the borrowing period and all repayments take place on the last day of the final period included in the cash budget. ■ To calculate borrowings and interest payments, you’ll need to pay attention to the company’s desired minimum cash balance and to the terms of the company’s loan agreement with the bank. For example, Hampton Freeze’s desired minimum cash balance is $30,000 (see cell B42 in the Budgeting Assumptions tab). ● Furthermore, we are going to assume that Hampton Freeze’s loan agreement stipulates that it must borrow money in increments of $10,000 and that it must pay simple interest of 3% per quarter (as shown in cell B43 of the Budgeting Assumptions tab) ■ The cash balances at both the beginning and end of the year may be adequate even though a serious cash deficit occurs at some point during the year. Consequently, the cash budget should be broken down into time periods that are short enough to capture major fluctuations in cash balances. ● While a monthly cash budget is most common, some organizations budget cash on a weekly or even daily basis. At Hampton Freeze, Larry Giano has prepared a quarterly cash budget that can be further refined as necessary. This budget appears iSchedule 8 ■ The beginning cash balance in the first quarter of $42,500 agrees with cell B7 of the beginning balance sheet inExhibit 8–3. ● Each quarter’s beginning cash balance plus the collections from customers equals the total cash available ○ The disbursements section of the cash budget includes six types of cash disbursements. Each quarter’s cash disbursements for direct materials come from cells B27 through E27 of the schedule of expected cash disbursements for materials (see Schedule 3 ). ■ The quarterly cash payments for direct labor were calculated in cells B11 through E11 of the direct labor budget (see Schedule 4 ), whereas the quarterly cash payments related to manufacturing overhead were calculated in cells B13 through E13 of the manufacturing overhead budget (see Schedule 5 ). ■ The quarterly cash payments for selling and administrative expenses come from cells B19 through E19 of the selling and administrative expense budget (seeSchedule 7 ). ■ So putting it all together, in the first quarter, the cash disbursements for direct materials ($49,500), direct labor ($84,000), manufacturing overhead ($68,000), and selling and administrative expenses ($107,000), plus equipment purchases of $50,000 and a dividend of $8,000 (see cells C43 and B44 from the Budgeting Assumptions tab) equals the total cash disbursements of $366,500. ○ Each quarter’s total cash available minus its total disbursements equals the excess (deficiency) of cash available over disbursements. ○ The first row in the financing section of the cash budget relates to projected borrowings ■ the company wants to maintain a minimum cash balance of $30,000; therefore, it will not need to borrow money in any quarter where its excess of cash available over disbursements is greater than $30,000. ■ However, in the first quarter of 2014 Hampton Freeze estimates that it will have a cash deficiency of $94,000; consequently, the company’s minimum required borrowings at the beginning of the first quarter would be computed as follows ● Again, recall that the bank requires that loans be made in increments of $10,000. Because Hampton Freeze needs to borrow at least $66,100 at the beginning of the second quarter, the company will have to borrow $70,000 from the bank. ■ third and fourth quarters, Hampton Freeze has an excess of cash available over disbursements that is greater than $30,000, so it will not need to borrow money in these two quarters. ● we always assume that the company will, as far as it is able, repay the loan plus accumulated interest on thelast day of the final per included in the cash budget. ● Because Hampton Freeze has excess cash of $263,300 in the fourth quarter, on the last day of the fourth quarter, it would be able to repay the $200,000 that it borrowed from the lender plus $21,900 of interest computed as follows: ● The ending cash balance for each period is computed by taking the excess (deficiency) of cash available over disbursements plus the total financing. ● The Budgeted Income Statement ○ Schedule 9 contains the budgeted income statement for Hampton Freeze. All of the revenues and expenses shown on the budgeted income statement come from the data in the beginning balance sheet and the data developed iSchedules 1– . ○ Schedule 9 ○ The budgeted income statement is one of the key schedules in the budget process. It shows the company’s planned profit and serves as a benchmark against which subsequent company performance can be measured ■ Because Larry Giano created a Budgeting Assumptions tab in his Excel file and linked all of his budget schedules together using properly constructed Excel formulas, he can make changes to his underlying budgeting assumptions and instantly see the impact of the change on all of the schedules and on net income. ■ For example, if Larry wanted to estimate the profit impact if fourth quarter sales are 18,000 cases instead of 20,000 cases, he would simply change the 20,000 cases shown in cell F7 of his Budgeting Assumptions worksheet to 18,000 cases. The revised net income of $87,045 would instantly appear in cell C12 of the budgeted income statement. ● The Budgeted Balance Sheet ○ The budgeted balance sheet is developed using data from the balance sheet from the beginning of the budget period (seeExhibit 8–) and data contained in the various schedules. Hampton Freeze’s budgeted balance sheet accompanied by explanations of how the numbers were derived is presenteSchedule 10. ○ Schedule 10 ○ Explanations of December 31, 2014, balance sheet figures: ○
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