Chapter 7. Chapter 7-1. Learning Objective. The Basic Framework of Budgeting. Profit Planning LO1

Chapter 7-1 Chapter 7 Profit Planning © The McGraw-Hill Companies, Inc., 2007 McGraw-Hill /Irwin Learning Objective LO1 To understand why organiza...
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Chapter 7-1

Chapter 7 Profit Planning

© The McGraw-Hill Companies, Inc., 2007

McGraw-Hill /Irwin

Learning Objective LO1 To understand why organizations budget and the processes they use to create budgets.

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The Basic Framework of Budgeting A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period. 1. The act of preparing a budget is called budgeting. 2. The use of budgets to control an organization’s activity is known as budgetary control.

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Chapter 7-2

Planning and Control Planning – involves developing objectives and preparing various budgets to achieve these objectives.

Control – involves the steps taken by management that attempt to ensure the objectives are attained.

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Advantages of Budgeting Define goal and objectives Communicate plans

Think about and plan for the future

Advantages Coordinate activities

Means of allocating resources Uncover potential bottlenecks

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Responsibility Accounting Managers should be held responsible for those items — and only those items — that the manager can actually control to a significant extent.

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Chapter 7-3

Choosing the Budget Period

Operating Budget

2003

2004

2005

2006

The annual operating budget may be divided into quarterly or monthly budgets.

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Self-Imposed Budget Top Management

Middle Management

Supervisor

Supervisor

Middle Management

Supervisor

Supervisor

A budget is prepared with the full cooperation and participation of managers at all levels. A participative budget is also known as a self-imposed budget. 7-8

Advantages of Self-Imposed Budgets 1. Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management. 2. Budget estimates prepared by front-line managers are often more accurate than estimates prepared by top managers. 3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. 4. A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Selfimposed budgets eliminate this explanation. 7-9

Chapter 7-4

Self-Imposed Budgets Most companies do not rely exclusively upon self-imposed budget in the sense that top managers usually initiate the budget process by issuing broad guidelines in terms of overall profits or sales.

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Human Factors in Budgeting The success of budgeting depends upon three important factors: 1. Top management must be enthusiastic and committed to the budget process. 2. Top management must not use the budget to pressure employees or blame them when something goes wrong. 3. Highly achievable budget targets are usually preferred when managers are rewarded based on meeting budget targets. 7-11

Zero Based Budgeting A zero-based budget requires managers to justify all budgeted expenditures, not just changes in the budget from the prior year. Most managers argue that zero-based budgeting is too time consuming and costly to justify on an annual basis.

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Chapter 7-5

The Budget Committee A standing committee responsible for overall policy matters relating to the budget coordinating the preparation of the budget

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The Master Budget: An Overview Sales Budget Ending Finished Goods Budget

Direct Materials Budget

Production Budget

Selling and Administrative Budget

Direct Labor Budget

Manufacturing Overhead Budget

Cash Budget

Budgeted Financial Statements 7-14

Learning Objective LO2

To prepare a sales budget, including a schedule of expected cash collections.

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Chapter 7-6

Budgeting Example Royal Company is preparing budgets for the quarter ending June 30. Budgeted sales for the next five months are: April May June July August

20,000 units 50,000 units 30,000 units 25,000 units 15,000 units.

The selling price is $10 per unit. 7-16

The Sales Budget The individual months of April, May, and June are summed to obtain the total projected sales in units and dollars for the quarter ended June 30th

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Expected Cash Collections All sales are on account. Royal’s collection pattern is: 70% collected in the month of sale, 25% collected in the month following sale, 5% uncollectible.

The March 31 accounts receivable balance of $30,000 will be collected in full.

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Chapter 7-7

Expected Cash Collections

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Expected Cash Collections

From the Sales Budget for April.

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Expected Cash Collections

From the Sales Budget for May.

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Chapter 7-8

Quick Check What will be the expected cash collections in June from the June sales? a. $125,000 b. $210,000 c. $335,000 d. $905,000

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Quick Check What will be the expected cash collections in June from the June sales? a. $125,000 b. $210,000 c. $335,000 d. $905,000

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Expected Cash Collections

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Chapter 7-9

The Production Budget Sales Budget ed and et pl Expected m Co Cash Collections

Production Budget

Production must be adequate to meet budgeted sales and provide for sufficient ending inventory. 7-25

Learning Objective LO3

To prepare a production budget.

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The Production Budget The management at Royal Company wants ending inventory to be equal to 20% of the following month’s budgeted sales in units. On March 31, 4,000 units were on hand.

Let’s prepare the production budget.

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Chapter 7-10

The Production Budget

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The Production Budget

March 31 ending inventory

Budgeted May sales Desired ending inventory % Desired ending inventory

50,000 20% 10,000 7-29

Quick Check

What is the required production for May? a. 56,000 units b. 46,000 units c. 62,000 units d. 52,000 units

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Chapter 7-11

Quick Check

What is the required production for May? a. 56,000 units b. 46,000 units c. 62,000 units d. 52,000 units

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The Production Budget

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The Production Budget

Assumed ending inventory. 7-33

Chapter 7-12

Learning Objective LO4 To prepare a direct materials budget, including a schedule of expected cash disbursements for purchases of materials.

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The Direct Materials Budget At Royal Company, five pounds of material are required per unit of product. Management wants materials on hand at the end of each month equal to 10% of the following month’s production. On March 31, 13,000 pounds of material are on hand. Material cost is $0.40 per pound. Let’s prepare the direct materials budget.

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The Direct Materials Budget

From production budget 7-36

Chapter 7-13

The Direct Materials Budget

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The Direct Materials Budget

March 31 inventory

10% of following month’s production needs.

Calculate the materials to by purchased in May. 7-38

Quick Check How much materials should be purchased in May? a. 221,500 pounds b. 240,000 pounds c. 230,000 pounds d. 211,500 pounds

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Chapter 7-14

Quick Check How much materials should be purchased in May? a. 221,500 pounds b. 240,000 pounds c. 230,000 pounds d. 211,500 pounds

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The Direct Materials Budget

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The Direct Materials Budget

Assumed ending inventory 7-42

Chapter 7-15

Expected Cash Disbursement for Materials Royal pays $0.40 per pound for its materials. One-half of a month’s purchases is paid for in the month of purchase; the other half is paid in the following month. The March 31 accounts payable balance is $12,000. Let’s calculate expected cash disbursements.

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Expected Cash Disbursement for Materials

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Expected Cash Disbursement for Materials

Compute the expected cash disbursements for materials for the quarter. 140,000 lbs. × $.40/lb. = $56,000 7-45

Chapter 7-16

Quick Check

What are the total cash disbursements for the quarter? a. $185,000 b. $ 68,000 c. $ 56,000 d. $201,400

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Quick Check

What are the total cash disbursements for the quarter? a. $185,000 b. $ 68,000 c. $ 56,000 d. $201,400

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Expected Cash Disbursement for Materials

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Chapter 7-17

Learning Objective LO5

To prepare a direct labor budget.

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The Direct Labor Budget At Royal, each unit of product requires 0.05 hours (3 minutes) of direct labor. The Company has a “no layoff” policy so all employees will be paid for 40 hours of work each week. In exchange for the “no layoff” policy, workers agree to a wage rate of $10 per hour regardless of the hours worked (No overtime pay). For the next three months, the direct labor workforce will be paid for a minimum of 1,500 hours per month. Let’s prepare the direct labor budget.

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The Direct Labor Budget

From production budget

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Chapter 7-18

The Direct Labor Budget

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The Direct Labor Budget

Greater of labor hours required or labor hours guaranteed. 7-53

The Direct Labor Budget

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Chapter 7-19

Quick Check What would be the total direct labor cost for the quarter if the company follows its no lay-off policy, but pays $15 (time-and-a-half) for every hour worked in excess of 1,500 hours in a month? a. $79,500 b. $64,500 c. $61,000 d. $57,000 7-55

Quick Check What would be the total direct labor cost for the quarter if the company follows its no lay-off policy, but pays $15 (time-and-a-half) for April May June Quarter every hour worked inrequired excess of 1,500 Labor hours 1,300 2,300 hours 1,450 in 1,500 1,500 4,500 Regular hours paid 1,500 a month? Overtime hours paid 800 800 a. $79,500 regular hours 4,500 $10 $ 45,000 b. $64,500 Total Total overtime hours 800 $15 $ 12,000 c. $61,000 Total pay $ 57,000 d. $57,000 7-56

Learning Objective LO6

To prepare a manufacturing overhead budget.

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Chapter 7-20

Manufacturing Overhead Budget At Royal manufacturing overhead is applied to units of product on the basis of direct labor hours. The variable manufacturing overhead rate is $20 per direct labor hour. Fixed manufacturing overhead is $50,000 per month and includes $20,000 of noncash costs (primarily depreciation of plant assets). Let’s prepare the manufacturing overhead budget. 7-58

Manufacturing Overhead Budget

Direct Labor Budget 7-59

Manufacturing Overhead Budget

Total mfg. OH for quarter $251,000 = $49.70 per hour* Total labor hours required 5,050 *rounded 7-60

Chapter 7-21

Manufacturing Overhead Budget

Depreciation is a noncash charge. 7-61

Ending Finished Goods Inventory Budget Production costs per unit Direct materials Direct labor Manufacturing overhead

Quantity Cost 5.00 lbs. $ 0.40

$

Total 2.00

Budgeted finished goods inventory Ending inventory in units Unit product cost Ending finished goods inventory

Direct materials budget and information

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Ending Finished Goods Inventory Budget Production costs per unit Direct materials Direct labor Manufacturing overhead

Quantity Cost 5.00 lbs. $ 0.40 0.05 hrs. $ 10.00

$

Total 2.00 0.50

Budgeted finished goods inventory Ending inventory in units Unit product cost Ending finished goods inventory

Direct labor budget

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Chapter 7-22

Ending Finished Goods Inventory Budget Production costs per unit Direct materials Direct labor Manufacturing overhead

Quantity Cost 5.00 lbs. $ 0.40 0.05 hrs. $ 10.00 0.05 hrs. $ 49.70

Budgeted finished goods inventory Ending inventory in units Unit product cost Ending finished goods inventory

$

Total 2.00 0.50 2.49 4.99

$

4.99

$

Total mfg. OH for quarter $251,000 = $49.70 per hour* Total labor hours required 5,050

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Ending Finished Goods Inventory Budget Production costs per unit Direct materials Direct labor Manufacturing overhead

Quantity Cost 5.00 lbs. $ 0.40 0.05 hrs. $ 10.00 0.05 hrs. $ 49.70

$

$ Budgeted finished goods inventory Ending inventory in units Unit product cost Ending finished goods inventory

Total 2.00 0.50 2.49 4.99

5,000 $ 4.99 $ 24,950

Production Budget

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Learning Objective LO7

To prepare a selling and administrative expense budget.

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Chapter 7-23

Selling and Administrative Expense Budget At Royal, the selling and administrative expenses budget is divided into variable and fixed components. The variable selling and administrative expenses are $0.50 per unit sold. Fixed selling and administrative expenses are $70,000 per month. The fixed selling and administrative expenses include $10,000 in costs – primarily depreciation – that are not cash outflows of the current month.

Let’s prepare the company’s selling and administrative expense budget. 7-67

Selling and Administrative Expense Budget

Calculate the selling and administrative cash expenses for the quarter. 7-68

Quick Check What are the total cash disbursements for selling and administrative expenses for the quarter? a. $180,000 b. $230,000 c. $110,000 d. $ 70,000

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Chapter 7-24

Quick Check What are the total cash disbursements for selling and administrative expenses for the quarter? a. $180,000 b. $230,000 c. $110,000 d. $ 70,000

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Selling and Administrative Expense Budget

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Learning Objective LO8

To prepare a cash budget.

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Chapter 7-25

Format of the Cash Budget The cash budget is divided into four sections: 1. Cash receipts listing all cash inflows excluding borrowing; 2. Cash disbursements listing all payments excluding repayments of principal and interest; 3. Cash excess or deficiency; and 4. The financing section listing all borrowings, repayments and interest. 7-73

The Cash Budget Royal: Maintains a 16% open line of credit for $75,000 Maintains a minimum cash balance of $30,000 Borrows on the first day of the month and repays loans on the last day of the month Pays a cash dividend of $49,000 in April Purchases $143,700 of equipment in May and $48,300 in June paid in cash Has an April 1 cash balance of $40,000

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The Cash Budget

Schedule of Expected Cash Collections

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Chapter 7-26

The Cash Budget Schedule of Expected Cash Disbursements Direct Labor Budget Manufacturing Overhead Budget Selling and Administrative Expense Budget 7-76

The Cash Budget

In the month of April will expect to have a cash deficiency of $20,000.

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The Cash Budget

Because Royal maintains a cash balance of $30,000, the company must borrow $50,000 on it line-of-credit.

Ending cash balance for April is the beginning May balance.

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Chapter 7-27

The Cash Budget

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Quick Check What is the excess (deficiency) of cash available over disbursements for June? a. $ 85,000 b. $(10,000) c. $ 75,000 d. $ 95,000

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Quick Check What is the excess (deficiency) of cash available over disbursements for June? a. $ 85,000 b. $(10,000) c. $ 75,000 d. $ 95,000

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Chapter 7-28

The Cash Budget

$50,000 × 16% × 3/12 = $2,000 Borrowings on April 1 and repayment on June 30.

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Learning Objective LO9

To prepare a budgeted income statement.

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The Budgeted Income Statement Cash Budget

m Co

ed et pl

Budgeted Income Statement

After we complete the cash budget, we can prepare the budgeted income statement for Royal. 7-84

Chapter 7-29

The Budgeted Income Statement Sales Budget Royal Company Budgeted Income Statement For the Three Months Ended June 30 Sales (100,000 units @ $10) Cost of goods sold (100,000 @ $4.99) Gross margin Selling and administrative expenses Operating income Interest expense Net income

$ 1,000,000 499,000 501,000 260,000 241,000 2,000 $ 239,000

Ending Finished Goods Inventory Selling and Administrative Expense Budget

Cash Budget

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Learning Objective LO10

To prepare a budgeted balance sheet.

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The Budgeted Balance Sheet Royal reported the following account balances prior to preparing its budgeted financial statements: Land - $50,000 Common stock - $200,000 Retained earnings - $146,150 Equipment - $175,000

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Chapter 7-30

Royal Company Budgeted Balance Sheet June 30 Current assets Cash Accounts receivable Raw materials inventory Finished goods inventory Total current assets Property and equipment Land Equipment Total property and equipment Total assets Accounts payable Common stock Retained earnings Total liabilities and equities

$

25% of June sales of $300,000 43,000 75,000 4,600 24,950 147,550

11,500 lbs. at $0.40/lb. 5,000 units at $4.99 each

50,000 367,000 417,000 $ 564,550 $

28,400 200,000 336,150 $ 564,550

50% of June purchases of $56,800 7-88

Royal Company Budgeted Balance Sheet June 30 Current assets Cash Accounts receivable Raw materials inventory Finished goods inventory Total current assets Property and equipment Land Equipment Total property and equipment Total assets Accounts payable Common stock Retained earnings Total liabilities and equities

$

43,000 Beginning balance 75,000 Add: net income 4,600 Deduct: dividends 24,950 Ending balance 147,550

$146,150 239,000 (49,000) $336,150

50,000 367,000 417,000 $ 564,550 $

28,400 200,000 336,150 $ 564,550 7-89

End of Chapter 7

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