Cornerstones

CORNERSTONES of Managerial Accounting, 5e

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CHAPTER 9:PROFIT PLANNINGCornerstones of Managerial Accounting, 5e


Learning Objectives

1. Define budgeting and discuss its role in planning, control, and decision making.

2. Define and prepare the operating budget, identify its major components, and explain the interrelationships of its various components.

3. Define and prepare the financial budget, identify its major components, and explain the interrelationships of its various components.

4. Describe the behavioral dimension of budgeting.


Description of Budgeting

All businesses should prepare budgets.Budgets help business owners and managers to plan ahead, and later, exercise control by comparing what actually happened to what was expected in the budget.

Budgets formalize managers’ expectations regarding sales, prices, and costs.

Even small businesses and nonprofit entities can benefit from the planning and control provided by budgets.

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Budgeting and Planning and Control

Planning and control are linked.Planning is looking ahead to see what actions should be taken to realize particular goals.

Control is looking backward, determining what actually happened and comparing it with the previously planned outcomes.

Budgets are financial plans for the future and are a key component of planning. They identify objectives and the actions needed to achieve them.

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Budgeting and Planning and Control (cont.)

Before preparing a budget, an organization should develop a strategic plan.

The strategic plan plots a direction for an organization’s future activities and operations; it generally covers at least 5 years.

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Planning, Control, and Budgets

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Advantages of Budgeting

PlanningInformation for

Decision Making

Standards for Performance

Evaluation

Improved Communication & Coordination

A budgetary system gives an organization several advantages.

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The Master Budget

The master budget is the comprehensive financial plan for the organization as a whole.

Typically for a 1-year period, corresponding to the fiscal year of the company.

Yearly budgets are broken down into quarterly and monthly budgets.

The use of smaller time periods allows managers to compare actual data with budgeted data more frequently, so problems may be noticed and resolved sooner.

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The Master Budget (cont.)

Some organizations have developed a continuous budgeting philosophy.

A continuous budget is a moving 12-month budget.

As a month expires in the budget, an additional month in the future is added so that the company always has a 12-month plan on hand.

Proponents of continuous budgeting maintain that it forces managers to plan ahead constantly.

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Master Budget: Directing and Coordinating Most organizations prepare the master budget for the coming year during the last 4 or 5 months of the current year.

The budget committee: reviews the budget provides policy guidelines and budgetary goals resolves differences that arise as the budget is prepared approves the final budget monitors the actual performance of the organization as the year

unfolds. The controller usually serves as the budget director, the person responsible for directing and coordinating the organization’s overall budgeting process.

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Master Budget: Major Components

A master budget can be divided into operating and financial budgets: Operating budgets describe the income-generating

activities of a firm: sales, production, and finished goods inventories. Outcome is a pro forma or budgeted income statement.

Financial budgets detail the inflows and outflows of cash and the overall financial position.

Planned cash inflows and outflows appear in the cash budget. The expected financial position at the end of the budget period is shown in a budgeted, or pro forma, balance sheet. LO-1


Master Budget: Major Components (cont.)

Since many of the financing activities are not known until the operating budgets are known, the operating budget is prepared first.

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The Master Budget and Its Interrelationships

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Preparing the Operating Budget

The operating budget consists of a budgeted income statement accompanied by the following supporting schedules: sales budget production budget direct materials purchases budget direct labor budget overhead budget selling and administrative expenses budget ending finished goods inventory budget cost of goods sold budget LO-2


Sales Budget

The sales budget is approved by the budget committee and describes expected sales in units and dollars.

The sales budget is the basis for all of the other operating budgets and most of the financial budgets.

It is important that it be as accurate as possible.The first step in creating a sales budget is to develop the sales forecast.

The sales forecast is just the initial estimate, and it is often adjusted by the budget committee.

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Preparing a Sales BudgetCornerstone 9.1


Budgeting in a Service Industry

You are the controller for a large, regional medical center. The chief of cardiology has been pushing to have a free-standing heart hospital built on the medical center campus. However, you are concerned that taking the heart cases away from the main hospital will hurt its bottom line. While the medical center is nonprofit, it does need to cover all of its costs to stay in business. You also wonder whether the heart hospital will break even.

What information do you need to forecast revenues and costs of the heart hospital?This is a two part problem. The first question, what impact will the heart hospital have on the main hospital’s revenues, requires knowledge of the number and types of heart cases seen at the main hospital each year. This information could come from the sales revenue budget from the previous year, assuming that the total number of patient days and procedures are broken out by type of case and procedure. Since so many of the costs of a hospital are fixed, there will probably be little decrease in costs as those heart patients leave for the freestanding heart hospital. The second question requires a forecast of the number of patients and probably reimbursement rates expected for procedures to be performed by the heart hospital. This information can be compared with budgeted operating costs to see if the heart hospital’s revenues can cover its costs.Forecasts of sales revenues and costs are dependent on detailed information provided by sources like the marketing or sales department and past accounting information and need to be revised and updates as new information or circumstances dictate. LO-2


Production Budget

The production budget tells how many units must be produced to meet sales needs and to satisfy ending inventory requirements.

To compute the units to be produced, both unit sales and units of beginning and ending finished goods inventory are needed:Units to be produced = Expected unit sales

+ Units in desired ending inventory (EI) – Units in beginning inventory (BI)

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Preparing a Production BudgetCornerstone 9.2


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Preparing a Production Budget (cont.)

Cornerstone 9.2


Direct Materials Purchases Budget

After the production budget is completed, the budgets for direct materials, direct labor, and overhead can be prepared.

The direct materials purchases budget tells the amount and cost of raw materials to be purchased in each time period.

The formula used for calculating purchases is as follows:

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Preparing a Direct Materials Purchases Budget

Cornerstone 9.3


Direct Labor Budget

The direct labor budget shows the total direct labor hours and the direct labor cost needed for the number of units in the production budget.

The budgeted hours of direct labor are determined by the relationship between labor and output.

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Preparing a Direct Labor BudgetCornerstone 9.4


Overhead Budget

The overhead budget shows the expected cost of all production costs other than direct materials and direct labor.

Many companies use direct labor hours as the driver for overhead.

Then costs that vary with direct labor hours are pooled and called variable overhead.

The remaining overhead items are pooled into fixed overhead.

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Preparing an Overhead BudgetCornerstone 9.5

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Ending Finished Goods Inventory Budget

The ending finished goods inventory budget: Supplies information needed for the balance sheet Serves as an important input for the preparation of the

cost of goods sold budget. To prepare this budget, the unit cost of producing finished goods must be calculated by using information from the direct materials, direct labor, and overhead budgets.

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Preparing an Ending Finished Goods Inventory Budget

Cornerstone 9.6


Cost of Goods Sold Budget

Assuming that the beginning finished goods inventory is valued at $1,251, the budgeted cost of goods sold schedule can be prepared using information from Cornerstones 9.3 to 9.6.

The cost of goods sold budget reveals the expected cost of the goods to be sold.

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Preparing a Cost of Goods Sold Budget

Cornerstone 9.7


Selling and Administrative Expenses Budget

The selling and administrative expenses budget outlines planned expenditures for nonmanufacturing activities.

Selling and administrative expenses can be broken down into fixed and variable components.

Items as sales commissions, freight, and supplies vary with sales activity.

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Preparing a Selling and Administrative Expenses Budget

Cornerstone 9.8


Preparing a Selling and Administrative Expenses Budget (cont.)

Cornerstone 9.8

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Budgeted Income Statement

With the completion of the budgeted cost of goods sold schedule and the budgeted selling and administrative expenses budget, a company has all the operating budgets needed to prepare an estimate of operating income.

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Preparing a Budgeted Income Statement

Cornerstone 9.9


Preparing the Financial Budget

The remaining budgets found in the master budget are the financial budgets.

The usual financial budgets prepared are: cash budget budgeted balance sheet budget for capital expenditures

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Cash Budget

Understanding cash flows is critical in managing a business.

Often, a business successfully produces and sells products but fails because of timing problems associated with cash inflows and outflows.

Because cash flow is the lifeblood of an organization, the cash budget is one of the most important budgets in the master budget.

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Cash Budget (cont.)

The basic structure of a cash budget includes cash receipts, disbursements, any excess or deficiency of cash, and financing as shown below:

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Cash Budget: Cash Available

Cash available consists of the beginning cash balance and the expected cash receipts. Expected cash receipts include all sources of cash for the period being considered.

The principal source of cash is from sales. Since a large proportion of sales is usually on account, a major task of an organization is to determine the pattern of collection for its accounts receivable.

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Cash Budget: Cash Available (cont.)

If a company has been in business for a while, it can use past experience to determine what percentage of credit sales are paid in the month of and months following sales.

This is used to create a schedule of cash collections on accounts receivable.

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Preparing a Schedule for Cash Collections on Accounts Receivable

Cornerstone 9.10

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Preparing a Schedule for Cash Collections on Accounts Receivable (cont.)

Cornerstone 9.10

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Cash Budget: Cash Disbursements

The cash disbursements section lists all planned cash outlays for the period.

All expenses that do not require a cash outlay are excluded from the list (e.g., depreciation is never included in the disbursements section).

Just as sources of cash may require a schedule of cash collections on accounts receivable to calculate cash expected from credit sales, the disbursements section may require care in handling payments on account.

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Determining Cash Payments on Accounts Payable

Cornerstone 9.11

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Determining Cash Payments on Accounts Payable (cont.)

Cornerstone 9.11

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Cash Budget: Cash Excess or Deficiency

Some companies expand the basic cash budget format by adding lines to show any borrowing or repayment necessary to achieve a minimum desired cash amount.

When this is done, the preliminary ending cash balance is called cash excess or deficiency.

The cash excess or deficiency line is compared to the minimum cash balance (or lowest amount of cash acceptable as noted by company policy).

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Cash Budget: Cash Excess or Deficiency (cont.)

If a cash deficiency exists with less cash on hand than is needed, the company usually obtains a short-term loan.

A cash excess is usually used to repay loans or used to make temporary investments.

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Cash Budget: Borrowings and Repayments, Ending Cash Balance

Borrowings and Repayments: If a company converts its preliminary cash balance line to a cash excess (deficiency) line, it may be borrowing or repaying money. If there is a deficiency, this section shows the necessary amount to be borrowed. When excess cash is available, this section shows planned repayments, including interest expense.

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Cash Budget: Borrowings and Repayments, Ending Cash Balance

Ending Cash Balance: The last line of the cash budget is the ending cash balance.

This is the planned amount of cash to be on hand at the end of the period after all receipts and disbursements, as well as borrowings and repayments, are considered.

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Preparing a Cash BudgetCornerstone 9.12

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Preparing a Cash Budget (cont.)Cornerstone 9.12

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Cash Budgeting for a Small Painting CompanyYou are the accountant for a number of small businesses in your town, one of which is Ramon’s Paint and Plaster. Ramon has been through a tough year as construction in the town has been down. However, new home construction is picking up and Ramon has been asked to bid on twice as many jobs in the past month as he was last year at this time. Ramon needs to know what his cash flow will be for the coming year. You are starting to amass information to help you forecast monthly cash inflows and outflows for the next six months.

What information do you need to forecast cash inflows and outflows for the paint and plaster business for the next six months?

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Cash Budgeting for a Small Painting Company (cont.)This is a two part problem. The first question, what inflows of cash are expected, depends on the number and size of the jobs Ramon can successfully bid on. Ramon’s business has been primarily residential, so you’ll need to know the number of housing starts (or the number of building permits applied for) and the number of remodeling jobs expected. You will also need to consider the price Ramon charges as well as the probability of prompt payment. Some builders have a good reputation for paying promptly in the first ten days of the month following work by Ramon’s crew. Others lag behind. While you can encourage Ramon to work primarily with the better builders, he may be forced to accept some jobs with contractors who frequently pay later. LO-3


Cash Budgeting for a Small Painting Company (cont.)The second question requires a forecast of the potential cash outflows. Ramon has a crew of six workers and the hourly rate is known. He also can figure out the cost of the paint and plaster materials fairly accurately, once the size of the job is known. It will be difficult to forecast the cash inflows and outflows too far in advance. As a result, you will probably want to set up the cash budget for one to three months in advance and then update the forecasted numbers as the year progresses.

Forecasts of cash inflows and outflows depend on the economic conditions, the reputation of the payment patterns of the customers, and the prices charged both for the jobs obtained as well as for the supplies used. Information from the past year can be used as a baseline, however, changing economic conditions will affect future amounts. LO-3


Budgeted Balance Sheet

The budgeted balance sheet depends on information contained in the current balance sheet and in the other budgets in the master budget.

Explanations for the budgeted figures are typically provided in the footnotes.

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Using Budgets for Performance Evaluation

Budgets are often used to judge the performance of managers.

Bonuses, salary increases, and promotions are all affected by a manager’s ability to achieve or beat budgeted goals.

Positive behavior occurs when the goals of each manager are aligned with the goals of the organization and each manager has the drive to achieve them.

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Using Budgets for Performance Evaluation (cont.)

The alignment of managerial and organizational goals is often referred to as goal congruence.

If the budget is improperly administered, subordinate managers may subvert the organization’s goals.

Dysfunctional behavior is individual behavior that is in basic conflict with the goals of the organization.

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Positive Behavior

Key features that promote a reasonable degree of positive behavior include: frequent feedback on performance monetary and nonmonetary incentives participative budgeting realistic standards controllability of costs multiple measures of performance

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Frequent Feedback on Performance

Managers need to know how they are doing as the year progresses.

Frequent, timely performance reports allow managers to know how successful their efforts have been, to take corrective actions, and to change plans as necessary.

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Monetary and Nonmonetary Incentives

Incentives are the means an organization uses to influence a manager to exert effort to achieve an organization’ s goal.

Traditional organizational theory assumes that employees are primarily motivated by monetary rewards, they resist work, and they are inefficient and wasteful.

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Monetary and Nonmonetary Incentives (cont.)

Thus, monetary incentives are used to control a manager’s tendency to shirk and waste resources by relating budgetary performance to salary increases, bonuses, and promotions.

Nonmonetary incentives, including job enrichment, increased responsibility and autonomy, and recognition programs can be used to enhance a budgetary control system.

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Participative Budgeting

Rather than imposing budgets on subordinate managers, participative budgeting allows subordinate managers considerable say in how the budgets are established.

The increased responsibility and challenge inherent in the process provide nonmonetary incentives that lead to a higher level of performance.

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Participative Budgeting (cont.)

However, participative budgeting has three potential problems: setting standards that are either too high or too low building slack into the budget (often referred to as

padding the budget) pseudoparticipation

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Standard Setting

Some managers may tend to set the budget either too loose or too tight.

Since budgeted goals tend to become the manager’s goals when participation is allowed, making this mistake in setting the budget can result in decreased performance levels.

The trick is to get managers in a participative setting to set high but achievable goals.

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Budgetary Slack

The second problem with participative budgeting is the opportunity for managers to build slack into the budget.

Budgetary slack (or padding the budget) exists when a manager deliberately underestimates revenues or overestimates costs in an effort to make the future period appear less attractive in the budget than they think it will be in reality.

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Budgetary Slack (cont.)

Either approach increases the likelihood that the manager will achieve the budget and consequently reduces the risk that the manager faces.

The act of padding the budget is questionable when considering what is viewed as ethical professional practice.

It is not communicating information fairly and objectively and constitutes a violation of the credibility standard.

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Pseudoparticipation

The third problem with participation occurs when top management assumes total control of the budgeting process, seeking only superficial participation from lower-level managers.

This practice is termed pseudoparticipation. Top management is simply obtaining formal acceptance of the budget from subordinate managers, not seeking real input.

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Realistic Standards

Budgets should reflect operating realities, including the following: Actual Levels of Activity: Flexible budgets are used to

ensure that budgeted costs can be realistically compared with costs for actual levels of activity.

Seasonal Variations: Interim budgets should reflect seasonal effects. Toys ‘‘R’’ Us, for example, would expect much higher sales in the quarter that includes Christmas than in other quarters.

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Realistic Standards (cont.) Efficiencies: Budgetary cuts should be based on

planned increases in efficiency and not simply arbitrary across-the-board reductions. Across-the-board cuts without any formal evaluation may impair the ability of some units to carry out their missions.

General Economic Trends: General economic conditions also need to be considered. Budgeting for a significant increase in sales when a recession is projected is not only foolish but also potentially dangerous.

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Controllability of Costs

Ideally, managers are held accountable only for costs that they can control.

Controllable costs are costs whose level a manager can influence.

If noncontrollable costs are put in the budgets of subordinate managers to help them understand that these costs also need to be covered, then they should be separated from controllable costs and labeled as noncontrollable.

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Multiple Measures of Performance

Often, organizations make the mistake of using budgets as their only measure of managerial performance.

While financial measures of performance are important, overemphasis can lead to a form of dysfunctional behavior called milking the firm or myopia.

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Multiple Measures of Performance (cont.)

Myopic behavior occurs when a manager takes actions that improve budgetary performance in the short run but bring long-run harm to the firm.

Budgetary measures alone cannot prevent myopic behavior.

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Cornerstones

Documents

Transcript of Cornerstones