Budgeting

Budgeting

Fall 2011

Introduction

tool for planning and controlling organizations.

A budget is the quantitative expression of a proposed plan of action by management for a future time period and an aid to the coordination and implementation of the plan.

Budgeting Mugan 2/?

Budgeting Cycle

– Planning the performance of the organization

– Providing a frame of reference, a set of specific expectations against which actual results can be compared

– Investigating variations from plans– Correcting action follows, if necessary– Planning again

Budgeting Mugan 3/?

Budget Quantitative plans

Static –Master Budget For a certain level

Flexible Adjusted for different levels and actual level

Short term or long term Capital budgets Operational budgets

Financial and nonfinancial data

Budgeting Mugan 4/?

Uses of Budgets

Goal congruence Enhance communication and

coordination Among different units of the business Among managers, and subunits

Performance evaluation Determining possible bottlenecks

Budgeting Mugan 5/?

Budgets and Feedback

Feedback through variance analysis Variance= deviations from the budget;

both negative and positive; the amount of deviation is important

Variances provide managers with Early warning of problems A basis for performance evaluation-who’s

responsible A basis for strategy evaluation

Budgeting Mugan 6/?

Budgeting and Human Behavior Top-down and bottom-up approach Participative budgeting Superiors may dominate the budget

process or hold subordinates accountable for events they have no control over

Subordinates may build “budgetary slack” into their budgets By underestimating budgeted revenues, or

overestimating budgeted expenses, in an effort to make the resulting budgeted goals (profits) more easily attainable

Budgeting Mugan 7/?

Comparison Top-down budgets:

Top management makes the aggregate forecasts then disaggregates down to lower levels Decision control more important than decision

managementBottom-up budgets (participative budgeting):

Lower levels know better what they are doing They make initial forecasts therefore can be held

responsible Decision management more important than decision

control Top executive officers of firms have final decision

rights over the entire budget process and resolve disputes

After adoption, the budget acts as a set of contracts among the various units of the firm

Budgeting Mugan 8/?

Responsibility Centers

a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities

Responsibility Accounting – a system that measures the plans, budgets, actions, and actual results of each Responsibility Center

Budgeting Mugan 9/?

Types of Responsibility Centers

1. Cost – accountable for costs only- evaluated based on actual and budgeted costs

2. Revenue – accountable for revenues only-evaluated based on actual and budgeted revenues

3. Profit – accountable for revenues and costs-evaluated on the profit

4. Investment – accountable for investments, revenues, and costs – return on investment; residual income; EVA

Budgeting Mugan 10/?

Controllability

What items are under the control of the manager? Allocated? Avoidable? Unavoidable?


Budget Process

Based on historical data and changing conditions develop estimates

Goals and budgets are made known to key personnel

Deviations from budgets are investigated and corrective action taken – managers and accountants



Components of Master Budgets Operating Budget – leads to budgeted income

statement Sales budget Production budget

Direct Materials budget Direct Labor budget Manufacturing overhead budget

Financial Budget – leads to balance sheet and cash flow statement Cash collections Cash payments Purchase of assets Payment of dividends Borrowing and lending


Time Coverage of Budgets Strategic planning requires long-term

budgets (2, 5, or 10 years) Many firms require managers to prepare

both short-term and long-term budgets as part of the periodic budget review

Operating budgets-usually prepared on monthly, quarterly, annually basis

Usually the master budget or the static budget is prepared on yearly basis

Flexible budgets – rolling budgets


Master Budget


Basic Operating Budget Steps

1. Prepare the Sales Budget2. Prepare the Production Budget (in

Units)3. Prepare the Direct Materials Usage

Budget and Direct Materials Purchases Budget

4. Prepare the Direct Labor Budget


Basic Operating Budget Steps

5. Prepare the Manufacturing Overhead Budget

6. Prepare the Cost of Goods Sold Budget

7. Prepare the Selling and Administrative Expense Budget

8. Prepare the Budgeted Income Statement


Basic Financial Budget Steps

Based on the Operating Budgets:1. Prepare the Cash Budget2. Prepare the Budgeted Balance Sheet3. Prepare the Budgeted Statement of

Cash Flows


Cash Budget

A cash budget shows expected cash receipts and disbursements; it indicates the months having cash shortages and excesses.


Sales Budget First budget prepared since most

budgets cannot be prepared without an estimate of sales

A variety of methods are used to estimate sales: Economic models Sales trends Trade journals Sales force estimates


Production Budget

Quantity to be produced based on following formula:


Example Exercise #1Example Exercise #1 VitaPup produces a vitamin-enhanced dog

food that is sold in Kansas. The company expects sales to be 12,600 bags in January, 14,500 bags in February, and 19,000 bags in March. There are 1,260 bags on hand at the start of January. VitaPup desires to maintain monthly ending inventory equal to 10% of next month’s expected sales.

Prepare the production budget for VitaPup for the months of January and February.


Example Exercise #1 SolutionExample Exercise #1 Solution Production Budget for January

Expected Sales 12,600+Desired Ending Inventory 1,450- Beginning Inventory (1,260)

Total Production 12,790

Production Budget for FebruaryExpected Sales 14,500

+ Desired Ending Inventory 1,900- Beginning Inventory (1,450)

Total Production 14,950


Direct Material Purchase Budget

Depends upon the amount needed for production and the amount needed for ending inventory

The following formula can be used:


Direct Labor Budget

Direct labor can be calculated using the following formula: Number of units produced x Labor hours

per unit x Rate per hour

Once calculated, can be used to determine the approximate number of employees needed


Manufacturing Overhead Budget

Variable Costs Multiply variable cost per unit by

quantity produced

Fixed Costs Remain relatively constant Depreciation could fluctuate based on

planned acquisitions


Selling and Administrative Expense Budget

Includes the following: Salaries

Advertising

Office Expenses

Other General Expenses


Budgeted Income Statement

Compilation of information provided by previously prepared budgets Sales Budget Direct Materials Budget Direct Labor Budget Manufacturing Overhead Budget Selling and Administrative Expense

Budget


Capital Acquisitions Budget

Acquisitions include: Property Plant Equipment

Must be carefully planned due to the large amounts of cash that could be used


Cash Receipts and Disbursements Budget

Managers must plan for two items: Amount of Cash Flows Timing of Cash Flows

Importance Differences between cash flows and

income Anticipate cash shortages or surpluses


Example Exercise #2Example Exercise #2 The Warrenburg Antique Mall budgeted

credit sales in the first quarter of 2009 to be as follows:

January $150,000February $160,000March $172,000

Credit sales in December of 2008 are expected to be $200,000. The company expects to collect 75% of a month’s sales in the month of sale and 25% in the following month.

Estimate the cash receipts for January and February.


Example Exercise #2 SolutionExample Exercise #2 Solution January Estimated Cash Receipts

December (200,000 x 25%) $50,000January (150,000 x 75%) $112,500Total $162,500

February Estimated Cash ReceiptsJanuary (150,000 x 25%) $37,500February (160,000 x 75%) $120,000Total $157,500


Budgeted Balance Sheet

Last budget prepared

Sometimes referred to as the pro forma balance sheet

Used to assess the effect of planned decisions on the future financial position of the firm


Budgeting Overview Flowchart

Revenues Budget

Production Budget

Direct Manufacturing Labor Costs

Budget

Ending Inventory Budget

Manufacturing Overhead

Costs Budget

Direct Materials

Costs Budget

Cost of Goods Sold Budget

Operating Expense Budget

Budgeted Income

Statement

Capital Expenditures

Budget

Cash Budget

Budgeted Balance Sheet

Budgeted Statement of Cash Flows

Operating Budget Financial Budget


MASTER BUDGET EXAMPLERecent and anticipated sales:September October November December January

Current Assets $40.000 $48.000 $60.000 $80.000 $36.000 Cash $12.000 Accounts Receivable 10.000 Inventory 63.600 Equipment -- net 100.000 Liabilities as of September 30 None

Credit sales: 75% cash 25% creditGross margin percentage 30%Salaries and wages (as % of revenues) 15%Rent (as % of revenues) 5%Other operating costs (as % of revenues) 4%Monthly depreciation $1.000Minimum inventory level $30.000October purchases (light fixtures) $600November purchases (light fixtures) $400December purchases $0Minimum cash balance $8.000Annual interest rate on borrowings 18%

Newport Stationery StoreBalance Sheet as of September 30, 2007


Fill in the schedules

Item September October November December total Q3Total sales 40.000$ 48.000$ 60.000$ 80.000$ 188.000$ Credit sales 10.000 12.000 15.000 20.000 47.000$ Cash sales (total sales - credit sales) 30.000$ 36.000$ 45.000$ 60.000$ 141.000$

Receipts: Cash sales 36.000$ 45.000$ 60.000$ 141.000$ Collections on accounts receivable (past month's credit sales) 10.000 12.000 15.000 37.000$ Total 46.000$ 57.000$ 75.000$ 178.000$

Schedule ABudgeted Monthly Cash Receipts



Item October November December 4th QuarterPurchases 42.000$ 56.000$ 25.200$ 123.200$ Deduct 2% cash discount 840 1.120 504 2.464 Disbursements 41.160$ 54.880$ 24.696$ 120.736$

Schedule B

Budgeted Monthly Cash Disbursements for Purchases



Item October November December 4th QuarterSalaries and wages 7.200$ 9.000$ 12.000$ 28.200$ Rent 2.400 3.000 4.000 9.400 Other cash operating costs 1.920 2.400 3.200 7.520 Total disbursements for operations 11.520$ 14.400$ 19.200$ 45.120$

Schedule CBudgeted Monthly Cash Disbursements for Operations



Item October November December 4th Quarter

Purchases (from Schedule B) 41.160$ 54.880$ 24.696$ 120.736$

Cash operating costs (from Schedule C) 11.520 14.400 19.200 45.120 Light fixtures 600 400 0 1.000 Total disbursements 53.280$ 69.680$ 43.896$ 166.856$

Schedule DBudgeted Total Monthly Cash Disbursements



Item October November December 4th QuarterTotal reciepts (from Schedule A) 46.000$ 57.000$ 75.000$ 178.000$ Total disbursements (from Schedule D) 53.280 69.680 43.896 166.856 Net cash increase (decrease) (7.280)$ (12.680)$ 31.104$ 11.144$

Schedule EBudgeted Cash Receipts and Disbursements



Item September October November December 4th QuarterBeginning cash balance (prior month's ending cash balance) 12.000$ 8.720$ 8.040$ 12.000$ Net cash increase (decrease) (from Schedule E) (7.280) (12.680) 31.104 11.144 Cash position before borrowing 4.720 (3.960) 39.144 23.144 Minimum cash balance required 8.000 8.000 8.000 8.000 Cash excess (deficiency) (3.280) (11.960) 31.144 15.144 Borrowing required (multiples of $1,000) 4.000 12.000 0 16.000 Interest payments 540 540 Borrowing repaid 16.000 16.000 Ending cash balance 12.000$ 8.720$ 8.040$ 22.604$ 22.604$

Schedule FFinancing Required



Revenues (schedule A) 188.000$ Cost of goods sold 131.600 Gross margin 56.400 Operating costs Salaries and wages (Schedule C) 28.200$ Rent (Schedule C) 9.400 Other cash operating costs (Schedule C) 7.520 Depreciation 3.000 48.120

Operating income 8.280 Deduct interest expense (Schedule F) (540) Add purchase discounts (Schedule B) 2.464 Net income before taxes 10.204$

Newport Stationery Store

Budgeted income Statement for quarter ending December 31, 2007



AssetsCurrent assets Cash (Schedule F) 22.604$ Acounts receivable (December credit sales from Schedule A) 20.000

Inventory (buffer inventory + Dec. inventory purchases from Sch. B) 55.200 Total current assets 97.804$ Equipment and fixtures

Equipment -- net (Sept 30 balance - depreciation for quarter) 97.000$ Fixtures (Schedule D) 1.000 98.000

Total 195.804$

Liabilities and Owner's Equity Liabilities None Owners' Equity (Sept. 30 owners' equity + net income for quarter) 195.804$

195.804$

Newport Stationery StoreBalance Sheet as of December 31, 2007


Use of Computers in the Budget Planning Process

Extremely useful in budgeting process Excel Spreadsheet Other specialized program

Allows for company to determine effects of a decision on entire budget “What if” Analysis


Budgetary Control Budgets as a Standard for Evaluation

Actual amounts are compared with budgeted amounts

Differences between actual and budgeted amounts are referred to as budget variances

Budget variances should be investigated when they are material


Budgetary Control Management must make sure the level of

activity in the budget is equal to the actual level of activity

Static Budget Not adjusted for the actual level of production

Flexible Budget A set of budget relationships that can be

adjusted for various production activity levels


Investigating Budget Variances

Causes of Budget Variances Budget may not have been well

conceived

Conditions may have changed

Managers may have performed particularly well or poorly


Investigating Budget Variances

Management by Exception Economical approach

Only exceptional variances are investigated

Must investigate both unfavorable and favorable exceptional variances


Variances

If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future

If the factors causing actual costs to be higher than expected can be identified, then actions may be taken to prevent those factors from recurring in the future

If cost changes are likely to be permanent, cost information can be updated for future jobs


First-Level Variances The first-level variance for a cost item is

the difference between the actual costs and the master budget costs for that cost item

Variances are favorable (F) if the actual costs are less than estimated master budget costs

Unfavorable (U) variances arise when actual costs exceed estimated master budget costs


Planning Variances A flexible budget adjusts the master

budget to reflect the actual volume by using standard costs Standard costs are budgeted unit costs Standards are established per unit of product as

well as per unit of input Cost differences between the master and the

flexible budget are called planning variances Reflect the difference between planned output

and actual output Arise entirely because the planned volume of

activity was not realized


Flexible Budget Variances Flexible budget variances are the

differences between the flexible budget and the actual results

Flexible budget variances reflect: Quantity variances -- the difference

between the planned and the actual usage of inputs per unit of output

Cost variances -- the difference between the planned and the actual price or cost per unit of the various cost items


Second & Third-Level Variances The second-level variances are the

planning variance and the flexible budget variance

The direct material flexible budget variances and direct labor flexible budget variances can be decomposed further into third-level variances: Efficiency variances Price variances


Direct Material Variances

The material quantity variance is calculated as: Quantity variance = (AQ-SQ) x SP

Where:AQ = actual quantity of materials usedSQ = standard (estimated) quantity of

materials requiredSP = standard (estimated) price of

materials


Direct Material Variances

The material price variance is calculated as: Price variance = (AP-SP) x AQ

Where:AP = actual price of materials

SP = standard (estimated) price of materials AQ = actual quantity of materials used

The price variance may, however, be calculated using the quantity purchased rather than the quantity used


Direct Labor Variances

Efficiency variance = (AH-SH) x SRRate variance = (AR-SR) x AH

Where:AH = actual number of direct labor hoursAR = actual wage rate & SR = standard rateSH = standard (estimated) number of direct labor

hours The sum of the rate variance and the efficiency variance

equals the total flexible budget direct labor variance Standard hours of DL reflects the total hours allowed for the

actual output level given standard direct labor hours per output unit


Overhead Variances

Variable Fixed The quantity of capacity-related costs

may not change from period to period, but the spending on them may fluctuate

Monitoring spending variances on capacity-related resources is possible and desirable


Variable Overhead Cost Variances

consist of a quantity component called the efficiency

variance and a price component called spending variance

Variable overhead cost variances may be analyzed in a manner similar to direct material or direct labor variances when they are assigned to products in the traditional way – by the direct labors


Fixed Overhead variances Since fixed costs are flexed to reflect the

actual capacity level; but fixed within a range there is no price variance but a budget variance Actual fixed costs – budgeted fixed costs

And Volume variance to reflect the change in

capacity Fixed overhead rate per driver unit=(actual

driver units – driver units allowed for the actual output level)


Variances

Short summary

Static BudgetsStatic Budgets

A A static budgetstatic budget ( master budget) is prepared for only ( master budget) is prepared for only one level of a given type of activity.one level of a given type of activity.

All actual results are compared with the All actual results are compared with the original budgeted amounts, even if sales original budgeted amounts, even if sales

volume is more or less than originally planned.volume is more or less than originally planned.


Master Budget Variance: SalesMaster Budget Variance: Sales

The variances of actual results The variances of actual results from the master budget are called from the master budget are called master (static) budget variances.master (static) budget variances.


Master Budget Variance: Master Budget Variance: ExpensesExpenses

Actual expenses that are less than Actual expenses that are less than budgeted expenses result in budgeted expenses result in favorable expense variances.favorable expense variances.

Actual expenses that exceed Actual expenses that exceed budgeted expenses result in budgeted expenses result in

unfavorable expense variances.unfavorable expense variances.


Flexible BudgetFlexible Budget

AA flexible budgetflexible budget (variable budget) is a (variable budget) is a budget that adjusts for changes in sales budget that adjusts for changes in sales volume and other cost-driver activitiesvolume and other cost-driver activities..


Flexible Budget FormulasFlexible Budget Formulas

To develop a flexible budget, managers To develop a flexible budget, managers determine revenue and cost behavior determine revenue and cost behavior

(within the relevant range) with (within the relevant range) with respect to cost drivers.respect to cost drivers.


Evaluation of Financial Evaluation of Financial PerformancePerformance

Units 7,000 9,000 2,000 U Sales $217,000 $279,000 $62,000 U Variable costs 152,600 196,200 43,600 F Contribution margin $ 64,400 $ 82,800 $18,400 U Fixed costs 70,000 70,000 – Operating income $ (5,600) $ 12,800 $18,400 U

Master Master budgetbudget

Flexible Flexible budget budget

for actual for actual sales sales

activityactivity

Sales- Sales- activity activity

variancesvariances


Isolating the Causes of Isolating the Causes of VariancesVariances

EffectivenessEffectiveness is the degree to which is the degree to which a goal, objective, or target is met.a goal, objective, or target is met.

Performance may be effective, Performance may be effective, efficient, both, or neither.efficient, both, or neither.

EfficiencyEfficiency is the degree to which inputs are is the degree to which inputs are used in relation to a given level of outputs.used in relation to a given level of outputs.


Flexible-Budget VariancesFlexible-Budget Variances

Total flexible-budget variance Total flexible-budget variance = Total actual results = Total actual results – – Total flexible-budget planned resultsTotal flexible-budget planned results

Flexible-budget variances Flexible-budget variances

Actual Actual results results

$(11,570)$(11,570)

Flexible Flexible budget budget $(5,600)$(5,600)

$5,970 Unfavorable$5,970 Unfavorable


Sales-Activity VariancesSales-Activity Variances

Total sales-activity varianceTotal sales-activity variance

==

Actual sales unit – Master budgeted sales unitsActual sales unit – Master budgeted sales units

××

Budgeted contribution margin per unitBudgeted contribution margin per unit


Sales price and Sales Volume Variances

Sales prices fluctuations cause variance: The sales-price variances arises because a company increased or decreased its sales price when compared with the budgeted sales price.

SPV = (Act. Sale Price – Exp. Sale Price) X Act. Sales Volume

Volume fluctuations cause variance: The sales-volume variance, which arises from an increase or decrease in units sold.

SVV = (Act. Sales Vol. – Bud. Sale Vol.) X Unit Contribution Margin


Variances from Material and Variances from Material and Labor StandardsLabor Standards

Flexible budget or total Flexible budget or total standard cost allowedstandard cost allowed

Units of good output achievedUnits of good output achieved

Input allowed per unit of outputInput allowed per unit of output

Standard unit price of inputStandard unit price of input××

××

==

Standard Direct-Materials Cost Allowed:Standard Direct-Materials Cost Allowed:


Price and Usage VariancesPrice and Usage Variances

(Actual quantity – Standard quantity) (Actual quantity – Standard quantity) × Standard price× Standard price

(Actual price – Standard Price) (Actual price – Standard Price) × Actual quantity × Actual quantity


Variable-OverheadVariable-OverheadEfficiency VarianceEfficiency Variance

When actual cost-driver activity differs from When actual cost-driver activity differs from the standard amount allowed for the actual the standard amount allowed for the actual

output achieved, a output achieved, a variable-overhead variable-overhead efficiency varianceefficiency variance will occur. will occur.


Variable-OverheadVariable-OverheadSpending VarianceSpending Variance

This is the difference between the actual This is the difference between the actual variable overhead and the amount variable overhead and the amount

of variable overhead budgeted for the of variable overhead budgeted for the actual level of cost-driver activity.actual level of cost-driver activity.


AH × AR

Spending variance = AH(AR - SVR)

Efficiency variance = SVR(AH - SH)

Spending Variance

EfficiencyVariance

Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours

AH × SVR

SH × SVR

Variable Overhead Variances


Budget Variance

VolumeVariance

Predetermined FOVH= Budgeted Fixed OVH/ normal activity level of cost driver

Cost driver = units produced, direct labor hours, machine hours etc.

cost driver × predet.overhead rate

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

Fixed Overhead Variances


Variance example 1

Requirement 1

Actual BudgetUnits (pounds) 450.000 400.000 50.000 F

Revenues $3.555.000 $3.200.000 355.000 FDirect materials 865.000 580.000 285.000 UDirect manufacturing labor 348.000 336.000 12.000 USelling price per pound of cookie $7,90 $8,00 $0,10 USelling-price variance 45.000,00$ U

Performance Report, April 2004Variance


Variance example 1Requirements 2, 3 and 4

Price Actual Input Quantity × EfficiencyActual Costs Incurred Variance Budgeted Price Variance Flexible Budget

(1) (2) = (1) - (3) (3) (4) = (3) - (5) (5)

Direct Materials Cookie mix $93.000 $0 $93.000 $3.000 U $90.000 Milk chocolate 532.000 133.000 U 399.000 61.500 U 337.500 Almonds 240.000 0 240.000 15.000 U 225.000

$865.000 133.000 U $732.000 $79.500 U $652.500

Direct manufacturing labor Mixing $108.000 $0 $108.000 $0 $108.000 Baking 240.000 0 240.000$ 30.000 F 270.000

$348.000 $0 $348.000 $30.000 F $378.000


Variance example 2

Requirement 1Actual Flexible Budget Static Budget

Production and sales in units 110.000 110.000 120.000 Machine hours 30.000 33.000 36.000 Fixed manuf. Overhead (FMOH) $440.000 $450.000 $450.000Variable manuf. Overhead (VMOH) $960.000 $990.000 $1.080.000VMOH per machine hour $32,00 $30,00 $30,00FMOH allocated per machine hour $12,50


Variance example 2

Variable Manufacturing Overhead Actual Costs

Actual Input Qty.

× Budgeted

Rate Flexible Budget

$960.000 $900.000 $990.000

$60.000 U $90.000 F

Spending variance

Efficiency variance


Variance Example 2

Requirement 2

Fixed Manufacturing Overhead Actual Costs

Static/Flexible Budget Lump

Sum Allocated$440.000 $450.000 $375.000

$10.000 F $75.000 UProduction volume varianceSpending variance


Variance Example 2

Requirement 3Actual Flexible Budget Static Budget

Production and Sales in Units 110.000 110.000 150.000 Machine hours 30.000 33.000 45.000 Fixed manuf. Overhead (FMOH) $440.000 $450.000 $450.000Variable manuf. Overhead (VMOH) $960.000 $990.000 $1.350.000VMOH per machine hour $32,00 $30,00 $30,00FMOH allocated per machine hour $10,00


Variance Example 2

Variable Manufacturing Overhead Actual Costs

Actual Input Qty. ×

Budgeted Rate

Flexible Budget

$960.000 $900.000 $990.000

$60.000 U $90.000 F

Spending variance Efficiency variance


Variance Example 2

Fixed Manufacturing Overhead Actual Costs

Static/Flexible Budget Lump

Sum Allocated$440.000 $450.000 $300.000

$10.000 F $150.000 USpending variance Production volume variance


THE END


Documents

Budgeting