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McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Fourteen Planning for Profit and Cost Control

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McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Fourteen

Planning for Profit andCost Control

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Learning Objective 1

• Describe the budgeting process and the benefits it provides.

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Three Levels of Planning

1.1. Strategic planningStrategic planning involves making long-term involves making long-term decisions such as defining the scope of the decisions such as defining the scope of the business, determining which products to business, determining which products to develop or discounting, and identifying the develop or discounting, and identifying the most profitable markets.most profitable markets.

2.2. Capital budgetingCapital budgeting focuses on intermediate focuses on intermediate range planning and involves decisions as range planning and involves decisions as whether to buy or lease equipment, whether to whether to buy or lease equipment, whether to stimulate sales, or whether to increase stimulate sales, or whether to increase company assets.company assets.

3.3. Master budgetMaster budget describes short-term objectives describes short-term objectives in specific sales targets, production goals, and in specific sales targets, production goals, and financing plans.financing plans.

1.1. Strategic planningStrategic planning involves making long-term involves making long-term decisions such as defining the scope of the decisions such as defining the scope of the business, determining which products to business, determining which products to develop or discounting, and identifying the develop or discounting, and identifying the most profitable markets.most profitable markets.

2.2. Capital budgetingCapital budgeting focuses on intermediate focuses on intermediate range planning and involves decisions as range planning and involves decisions as whether to buy or lease equipment, whether to whether to buy or lease equipment, whether to stimulate sales, or whether to increase stimulate sales, or whether to increase company assets.company assets.

3.3. Master budgetMaster budget describes short-term objectives describes short-term objectives in specific sales targets, production goals, and in specific sales targets, production goals, and financing plans.financing plans.

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Advantages of Budgeting

BudgetingBudgetingBudgetingBudgeting

PromotesPromotesPlanningPlanningPromotesPromotesPlanningPlanning

EnhancesEnhancesPerformance Performance MeasuremenMeasuremen

tt

EnhancesEnhancesPerformance Performance MeasuremenMeasuremen

tt

EnhancesEnhancesCorrective Corrective

ActionsActions

EnhancesEnhancesCorrective Corrective

ActionsActions

PromotesPromotesCoordinationCoordination

PromotesPromotesCoordinationCoordination

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Cashpaymentsfor S & A

Cashpayments

for inventory

Inventorypurchases

budget

IncomeStatement

S & Aexpensebudget

BalanceSheet

Cashreceipts

Salesbudget

Cashbudget

Statement ofCash Flows

Cash Receiptsand Payments

Schedules

OperatingBudgets

Pro formaFinancial

StatementsStartStart

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Learning Objective 2

• Explain the relationship between budgeting and human behavior.

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Budgeting and Human Behavior

Upper management must be sensitive to the impact of the budgeting process on employees.

Budgets are Budgets are constraining. constraining.

They limit They limit individual individual

freedom in favor freedom in favor of an established of an established

plan.plan.

Budgets are Budgets are constraining. constraining.

They limit They limit individual individual

freedom in favor freedom in favor of an established of an established

plan.plan.

Many people find Many people find evaluation based evaluation based

on budget on budget expectations expectations

stressful. Think of stressful. Think of students and students and

exams.exams.

Many people find Many people find evaluation based evaluation based

on budget on budget expectations expectations

stressful. Think of stressful. Think of students and students and

exams.exams.Upper management must demonstrate Upper management must demonstrate

that budgets are sincere efforts to that budgets are sincere efforts to express realistic goals employees are express realistic goals employees are

expected to meet.expected to meet.

Upper management must demonstrate Upper management must demonstrate that budgets are sincere efforts to that budgets are sincere efforts to

express realistic goals employees are express realistic goals employees are expected to meet.expected to meet.

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Learning Objective 3

• Prepare a sales budget and related schedule of cash receipts.

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Sales Budget

A detailed schedule prepared by the marketing department showing expected sales for the coming periods and expected collections on those sales. It is critical to the success of the entire master budgeting process.

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Sales Budget

Hampton Hams (HH) is preparing a sales Hampton Hams (HH) is preparing a sales budget for the last quarter of the year. Ham budget for the last quarter of the year. Ham sales are expected to peak in the months of sales are expected to peak in the months of

October, November, and December (the October, November, and December (the holiday seasons). The store sales for October holiday seasons). The store sales for October are expected to total $160,000 ($40,000 in are expected to total $160,000 ($40,000 in

cash sales, and $120,000 in sales on account). cash sales, and $120,000 in sales on account). Sales are expected to increase by 20% per Sales are expected to increase by 20% per

month for November and December.month for November and December.

Let’s prepare a sales budget.Let’s prepare a sales budget.

Hampton Hams (HH) is preparing a sales Hampton Hams (HH) is preparing a sales budget for the last quarter of the year. Ham budget for the last quarter of the year. Ham sales are expected to peak in the months of sales are expected to peak in the months of

October, November, and December (the October, November, and December (the holiday seasons). The store sales for October holiday seasons). The store sales for October are expected to total $160,000 ($40,000 in are expected to total $160,000 ($40,000 in

cash sales, and $120,000 in sales on account). cash sales, and $120,000 in sales on account). Sales are expected to increase by 20% per Sales are expected to increase by 20% per

month for November and December.month for November and December.

Let’s prepare a sales budget.Let’s prepare a sales budget.

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Sales Budget

$40,000 $40,000 × 120% = $48,000× 120% = $48,000$40,000 $40,000 × 120% = $48,000× 120% = $48,000$120,000 $120,000 × 120% = $144,000× 120% = $144,000$120,000 $120,000 × 120% = $144,000× 120% = $144,000

Accounts receivable at December 31Accounts receivable at December 31stst are are $172,800, the uncollected sales on $172,800, the uncollected sales on

account.account.

Accounts receivable at December 31Accounts receivable at December 31stst are are $172,800, the uncollected sales on $172,800, the uncollected sales on

account.account.

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Schedule of Cash Receipts

Hampton Hams (HH) will collect cash sales in Hampton Hams (HH) will collect cash sales in the month of sale. Past experience shows that the month of sale. Past experience shows that the company will collect cash from its credit the company will collect cash from its credit

sales in the month following the month of the sales in the month following the month of the sale (October credit sales will be collected in sale (October credit sales will be collected in

full in November).full in November).

Let’s prepare the cash receipts budget.Let’s prepare the cash receipts budget.

Hampton Hams (HH) will collect cash sales in Hampton Hams (HH) will collect cash sales in the month of sale. Past experience shows that the month of sale. Past experience shows that the company will collect cash from its credit the company will collect cash from its credit

sales in the month following the month of the sales in the month following the month of the sale (October credit sales will be collected in sale (October credit sales will be collected in

full in November).full in November).

Let’s prepare the cash receipts budget.Let’s prepare the cash receipts budget.

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Schedule of Cash Receipts

Sales revenue on the income statement Sales revenue on the income statement will be the sum of the monthly sales will be the sum of the monthly sales

($582,400).($582,400).

Sales revenue on the income statement Sales revenue on the income statement will be the sum of the monthly sales will be the sum of the monthly sales

($582,400).($582,400).

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Learning Objective 4

• Prepare an inventory purchases budget and related schedule of cash payments.

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Inventory Purchases Budget

The total amount of inventory needed for each month is equal to the amount of the cost of budgeted sales plus the desired

ending inventory.

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Inventory Purchases Budget

HH maintains a policy that ending inventory HH maintains a policy that ending inventory should be equal to 25% of the next month’s should be equal to 25% of the next month’s projected cost of goods sold. At HH, cost of projected cost of goods sold. At HH, cost of

goods sold normally equal 70% of sales.goods sold normally equal 70% of sales.

Suppliers require HH to pay 60% of inventory Suppliers require HH to pay 60% of inventory purchases in the month goods are purchased purchases in the month goods are purchased and the remaining 40% in the month after the and the remaining 40% in the month after the

purchase.purchase.

Let’s prepare the inventory purchases budget Let’s prepare the inventory purchases budget and the schedule of cash payments for and the schedule of cash payments for

inventory purchases.inventory purchases.

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Inventory Purchases Budget

$134,400 × 25% = $33,600$134,400 × 25% = $33,600

$155,960 × 40% = $62,384 Accounts Payable

$155,960 × 40% = $62,384 Accounts Payable

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$145,600 × 40% = $58,240

$145,600 × 40% = $58,240$145,600 × 60% = $87,360$145,600 × 60% = $87,360

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Learning Objective 5

• Prepare a selling and administrative expense budget and related schedule of cash payments.

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Selling and Administrative Expense Budget

The details of the Selling and Administrative (S&A) Budget are shown on the next two screens. It is important to note that sales

commissions (based on 2% of sales) are paid in the month following the sale, while supplies

expense, based on 1% of sales) are paid in the month of the sale. The utility expense is paid in the month following the usage of the

electricity, gas, and water.

The details of the Selling and Administrative (S&A) Budget are shown on the next two screens. It is important to note that sales

commissions (based on 2% of sales) are paid in the month following the sale, while supplies

expense, based on 1% of sales) are paid in the month of the sale. The utility expense is paid in the month following the usage of the

electricity, gas, and water.

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Selling and Administrative Expense Budget

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Learning Objective 6

• Prepare a cash budget.

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Cash Budget

HH plans to purchase, for cash, store fixtures HH plans to purchase, for cash, store fixtures with a cost of $130,000 in October. HH with a cost of $130,000 in October. HH

borrows or repays principal and interest on the borrows or repays principal and interest on the last day of each month. Any monies borrowed last day of each month. Any monies borrowed from the bank bear interest at an annual rate from the bank bear interest at an annual rate of 12% (1% per month). The management at of 12% (1% per month). The management at HH wants to maintain an end of month cash HH wants to maintain an end of month cash

balance of at least $10,000.balance of at least $10,000.

HH plans to purchase, for cash, store fixtures HH plans to purchase, for cash, store fixtures with a cost of $130,000 in October. HH with a cost of $130,000 in October. HH

borrows or repays principal and interest on the borrows or repays principal and interest on the last day of each month. Any monies borrowed last day of each month. Any monies borrowed from the bank bear interest at an annual rate from the bank bear interest at an annual rate of 12% (1% per month). The management at of 12% (1% per month). The management at HH wants to maintain an end of month cash HH wants to maintain an end of month cash

balance of at least $10,000.balance of at least $10,000.

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Cash Budget

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Cash Budget

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Check Yourself

Astor Company expects to incur the following Astor Company expects to incur the following operating expenses during September: Salary operating expenses during September: Salary Expense, $25,000; Utility Expense, $1,200; Expense, $25,000; Utility Expense, $1,200; Depreciation Expense, $5,400; and Selling Expense, Depreciation Expense, $5,400; and Selling Expense, $14,000. It pays operating expenses in cash in the $14,000. It pays operating expenses in cash in the month in which it incurs them. Based on this month in which it incurs them. Based on this information, the total amount of cash outflow information, the total amount of cash outflow reported in the Operating Activities section of the pro reported in the Operating Activities section of the pro format Statement of Cash Flows would be:format Statement of Cash Flows would be:

a.a. $45,600.$45,600.

b.b. $31,600.$31,600.

c.c. $40,200.$40,200.

d.d. $44,400$44,400

Depreciation Expense is a non-cashDepreciation Expense is a non-cashcharge to income and will not appearcharge to income and will not appear

on the Statement of Cash Flows.on the Statement of Cash Flows.

Depreciation Expense is a non-cashDepreciation Expense is a non-cashcharge to income and will not appearcharge to income and will not appear

on the Statement of Cash Flows.on the Statement of Cash Flows.

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Learning Objective 7

• Prepare a pro forma income statement, balance sheet, and statement of cash flows.

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Pro Forma Income Statement

The pro forma income statement gives management an estimate of the expected

profitability of HH. If the project appears to be unprofitable, management can make the

decision to abandon it. Although managers remain responsible for data analysis and

decision making, computer technology offers powerful tools to asset in those tasks.

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Pro Forma Income Statement

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Pro Forma Balance Sheet

This new store has no contributed capital because its operations will be financed

through debt (line-of-credit) and earnings. The amount of retained earnings will be equal to the net income because there are no prior periods. The fixtures purchased in October will be depreciated for a full three months.

Total accumulated depreciation will be $3,000.

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Pro Forma Statement of Cash Flows

Almost all the information for the Pro Forma Statement of Cash Flows can be

found on the Cash Budget.

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End of Chapter Fourteen