Profit Planning

Chapter 9

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 1

Understand why
organizations budget and
the processes they use to
create budgets.

McGraw-Hill/Irwin Slide 2
 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 activities is known
as budgetary control.

McGraw-Hill/Irwin Slide 3
 Planning and Control

Planning
Planning –– Control
Control ––
involves
involves developing
developing involves
involves thethe steps
steps taken
taken by
by
objectives
objectives and
and management
management to to increase
increase
preparing
preparing various
various the
the likelihood
likelihood that
that the
the
budgets
budgets to
to achieve
achieve objectives
objectives setset down
down while
while
those
those objectives.
objectives. planning
planning are are attained
attained and
and
that
that all
all parts
parts of
of the
the
organization
organization are are working
working
together
together toward
toward that
that goal.
goal.

McGraw-Hill/Irwin Slide 4
 Advantages of Budgeting

Define goals
and objectives
Communicate
plans

Advantages
Coordinate Means of allocating
activities resources

Uncover potential
bottlenecks

McGraw-Hill/Irwin Slide 5
 Responsibility Accounting

Managers should be held

responsible for those
items - and only those
items - that they can
actually control
to a significant extent.

McGraw-Hill/Irwin Slide 6
 Choosing the Budget Period

Operating Budget

2008 2009 2010 2011

Operating
Operating budgets
budgets ordinarily
ordinarily AA continuous
continuous budget
budget is
is aa
cover
cover aa one-year
one-year period
period 12-month
12-month budget
budget that
that rolls
rolls
corresponding to a company’s
corresponding to a company’s forward one month (or quarter)
fiscal year. Many companies forward one month (or quarter)
fiscal year. Many companies as the current month (or quarter)
divide their annual budget as the current month (or quarter)
divide their annual budget is
into four quarters. is completed.
completed.
into four quarters.

McGraw-Hill/Irwin Slide 7
 Self-Imposed Budget
Top M anagem ent

M id d le M id d le
M anagem ent M anagem ent

S u p e r v is o r S u p e r v is o r S u p e r v is o r S u p e r v is o r

A self-imposed budget or participative budget is a budget that is

prepared with the full cooperation and participation of managers
at all levels.

McGraw-Hill/Irwin Slide 8
 Advantages of Self-Imposed Budgets
1.
1. Individuals
Individuals at
at all
all levels
levels of
of the
the organization
organization are
are viewed
viewed as
as
members
members of of the
the team
team whose
whose judgments
judgments are
are valued
valued by
by top
top
management.
management.
2.
2. Budget
Budget estimates
estimates prepared
prepared by
by front-line
front-line managers
managers are
are
often
often more
more accurate
accurate than
than estimates
estimates prepared
prepared by
by top
top
managers.
managers.
3.
3. Motivation
Motivation isis generally
generally higher
higher when
when individuals
individuals participate
participate
in
in setting
setting their
their own
own goals
goals than
than when
when the
the goals
goals are
are
imposed
imposed from
from above.
above.
4.
4. A
A manager
manager who
who is
is not
not able
able to to meet
meet aa budget
budget imposed
imposed
from
from above
above can
can claim
claim that
that itit was
was unrealistic.
unrealistic. Self-imposed
Self-imposed
budgets
budgets eliminate
eliminate this
this excuse.
excuse.
McGraw-Hill/Irwin Slide 9
 Self-Imposed Budgets
Self-imposed budgets should be reviewed
by higher levels of management to
prevent “budgetary slack.”
Most companies issue broad guidelines in
terms of overall profits or sales. Lower
level managers are directed to prepare
budgets that meet those targets.

McGraw-Hill/Irwin Slide 10
 Human Factors in Budgeting
The success of a budget program depends on 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.

McGraw-Hill/Irwin Slide 11
 The Budget Committee

A
A standing
standing committee
committee responsible
responsible for
for
 overall
overall policy
policy matters
matters relating
relating to
to the
the budget
budget
 coordinating
coordinating the
the preparation
preparation of of the
the budget
budget
 resolving
resolving disputes
disputes related
related to
to the
the budget
budget
 approving
approving the
the final
final budget
budget

McGraw-Hill/Irwin Slide 12
 The Master Budget: An Overview
Sales
Sales budget
budget

Selling
Selling and
and
Ending
Ending inventory
inventory administrative
administrative
Production
Production budget
budget
budget
budget budget
budget

Direct
Direct materials
materials Direct
Direct labor
labor Manufacturing
Manufacturing
budget
budget budget
budget overhead
overhead budget
budget

Cash
Cash Budget
Budget

Budgeted
Budgeted Budgeted
Budgeted
income
income balance
balance sheet
sheet
statement
statement

McGraw-Hill/Irwin Slide 13
 Learning Objective 2

Prepare a sales budget,

including a schedule of
expected cash collections.

McGraw-Hill/Irwin Slide 14
 Budgeting Example

 Royal Company is preparing budgets for the

quarter ending June 30.
 Budgeted sales for the next five months are:
 April 20,000 units
 May 50,000 units
 June 30,000 units
 July 25,000 units
 August 15,000 units.
 The selling price is $10 per unit.

McGraw-Hill/Irwin Slide 15
 The Sales Budget

The individual months of April, May, and June are

summed to obtain the total budgeted sales in units
and dollars for the quarter ended June 30th

McGraw-Hill/Irwin Slide 16
 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.

McGraw-Hill/Irwin Slide 17
 Expected Cash Collections

McGraw-Hill/Irwin Slide 18
 Expected Cash Collections

From
From the
the Sales
Sales Budget
Budget for
for April.
April.

McGraw-Hill/Irwin Slide 19
 Expected Cash Collections

From
From the
the Sales
Sales Budget
Budget for
for May.
May.

McGraw-Hill/Irwin Slide 20
 Quick Check 

What will be the total cash collections for

the quarter?
a. $700,000
b. $220,000
c. $190,000
d. $905,000

McGraw-Hill/Irwin Slide 21
 Quick Check 

What will be the total cash collections for

the quarter?
a. $700,000
b. $220,000
c. $190,000
d. $905,000

McGraw-Hill/Irwin Slide 22
 Expected Cash Collections

McGraw-Hill/Irwin Slide 23
 Learning Objective 3

Prepare a
production budget.

McGraw-Hill/Irwin Slide 24
 The Production Budget

Sales Production
Budget Budget
ed
and l et
p
Expected
o m
C
Cash
Collections

The production budget must be adequate to

meet budgeted sales and to provide for
the desired ending inventory.
McGraw-Hill/Irwin Slide 25
 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.

McGraw-Hill/Irwin Slide 26
 The Production Budget

McGraw-Hill/Irwin Slide 27
 The Production Budget

Budgeted May sales 50,000

Desired ending inventory % 20%
March 31
Desired ending inventory 10,000
ending inventory
McGraw-Hill/Irwin Slide 28
 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

McGraw-Hill/Irwin Slide 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

McGraw-Hill/Irwin Slide 30
 The Production Budget

McGraw-Hill/Irwin Slide 31
 The Production Budget

Assumed ending inventory.

McGraw-Hill/Irwin Slide 32
 Learning Objective 4

Prepare a direct materials

budget, including a
schedule of expected cash
disbursements for
purchases of materials.

McGraw-Hill/Irwin Slide 33
 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.

McGraw-Hill/Irwin Slide 34
 The Direct Materials Budget

From
From production
production budget
budget

McGraw-Hill/Irwin Slide 35
 The Direct Materials Budget

McGraw-Hill/Irwin Slide 36
 The Direct Materials Budget

March 31 inventory

10% of following month’s Calculate the materials to

production needs. be purchased in May.
McGraw-Hill/Irwin Slide 37
 Quick Check 

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

McGraw-Hill/Irwin Slide 38
 Quick Check 

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

McGraw-Hill/Irwin Slide 39
 The Direct Materials Budget

McGraw-Hill/Irwin Slide 40
 The Direct Materials Budget

Assumed ending inventory

McGraw-Hill/Irwin Slide 41
 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.

McGraw-Hill/Irwin Slide 42
 Expected Cash Disbursement for Materials

McGraw-Hill/Irwin Slide 43
 Expected Cash Disbursement for Materials

Compute the expected cash

disbursements for materials
for the quarter.

140,000 lbs. × $0.40/lb. = $56,000

McGraw-Hill/Irwin Slide 44
 Quick Check 

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

McGraw-Hill/Irwin Slide 45
 Quick Check 

What are the total cash disbursements for the

quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400

McGraw-Hill/Irwin Slide 46
 Expected Cash Disbursement for Materials

McGraw-Hill/Irwin Slide 47
 Learning Objective 5

Prepare a direct
labor budget.

McGraw-Hill/Irwin Slide 48
 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.
 For purposes of our illustration assume that Royal has a
“no layoff” policy, workers are pay at the rate of $10 per
hour regardless of the hours worked.
 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.

McGraw-Hill/Irwin Slide 49
 The Direct Labor Budget

From production budget.

McGraw-Hill/Irwin Slide 50
 The Direct Labor Budget

McGraw-Hill/Irwin Slide 51
 The Direct Labor Budget

Greater
Greater of
of labor
labor hours
hours required
required
or
or labor
labor hours
hours guaranteed.
guaranteed.
McGraw-Hill/Irwin Slide 52
 The Direct Labor Budget

McGraw-Hill/Irwin Slide 53
 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

McGraw-Hill/Irwin Slide 54
 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 April ofMay
1,500June
hours Quarter
Labor hours required 1,300 2,300 1,450
in a month? Regular hours paid 1,500 1,500 1,500 4,500
a. $79,500 Overtime hours paid - 800 - 800

b. $64,500 Total regular hours 4,500 $10 $ 45,000

Total overtime hours 800 $15 $ 12,000
c. $61,000 Total pay $ 57,000

d. $57,000

McGraw-Hill/Irwin Slide 55
 Learning Objective 6

Prepare a
manufacturing
overhead budget.

McGraw-Hill/Irwin Slide 56
 Manufacturing Overhead Budget
 At
At Royal,
Royal, manufacturing
manufacturing overhead
overhead is is applied
applied toto units
units
of
of product
product on on the
the basis
basis of
of direct
direct labor
labor hours.
hours.
 The
The variable
variable manufacturing
manufacturing overhead
overhead rate
rate is
is $20
$20 per
per
direct
direct labor
labor hour.
hour.
 Fixed
Fixed manufacturing
manufacturing overhead
overhead is is $50,000
$50,000 per
per month,
month,
which
which includes
includes $20,000
$20,000 ofof noncash
noncash costs
costs (primarily
(primarily
depreciation
depreciation of of plant
plant assets).
assets).

 Let’s
Let’s prepare
prepare the
the manufacturing
manufacturing overhead
overhead budget.
budget.

McGraw-Hill/Irwin Slide 57
 Manufacturing Overhead Budget

Direct
Direct Labor
Labor Budget.
Budget.
McGraw-Hill/Irwin Slide 58
 Manufacturing Overhead Budget

Total mfg. OH for quarter $251,000

= $49.70 per hour *
Total labor hours required 5,050

* rounded

McGraw-Hill/Irwin Slide 59
 Manufacturing Overhead Budget

Depreciation
Depreciation is
is aa noncash
noncash charge.
charge.

McGraw-Hill/Irwin Slide 60
 Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $ 24,950

Direct
Direct materials
materials
budget
budget and
and information.
information.

McGraw-Hill/Irwin Slide 61
 Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $ 24,950

Direct
Direct labor
labor budget.
budget.

McGraw-Hill/Irwin Slide 62
 Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory ?

Total mfg. OH for quarter $251,000

= $49.70 per hour *
Total labor hours required 5,050

McGraw-Hill/Irwin Slide 63
 Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $ 24,950

Production
Production Budget.
Budget.

McGraw-Hill/Irwin Slide 64
 Learning Objective 7

Prepare a selling and

administrative
expense budget.

McGraw-Hill/Irwin Slide 65
 Selling and Administrative Expense Budget
 At Royal, the selling and administrative expense 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.

McGraw-Hill/Irwin Slide 66
 Selling and Administrative Expense Budget

Calculate the selling and administrative

cash expenses for the quarter.
McGraw-Hill/Irwin Slide 67
 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

McGraw-Hill/Irwin Slide 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

McGraw-Hill/Irwin Slide 69
 Selling Administrative Expense Budget

McGraw-Hill/Irwin Slide 70
 Learning Objective 8

Prepare a cash
budget.

McGraw-Hill/Irwin Slide 71
 Format of the Cash Budget
The cash budget is divided into four sections:
1. Cash receipts section lists all cash inflows excluding cash
received from financing;
2. Cash disbursements section consists of all cash payments
excluding repayments of principal and interest;
3. Cash excess or deficiency section determines if the
company will need to borrow money or if it will be able to
repay funds previously borrowed; and
4. Financing section details the borrowings and repayments
projected to take place during the budget period.

McGraw-Hill/Irwin Slide 72
 The Cash Budget

Assume the following information for 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 (both purchases paid in cash)
 Has an April 1 cash balance of $40,000

McGraw-Hill/Irwin Slide 73
 The Cash Budget

Schedule
Schedule of
of Expected
Expected
Cash
Cash Collections.
Collections.

McGraw-Hill/Irwin Slide 74
 The Cash Budget

Schedule
Schedule of
of Expected
Expected
Cash
Cash Disbursements.
Disbursements.
Direct Labor
Budget.
Manufacturing
Overhead Budget.

Selling and Administrative

Expense Budget.

McGraw-Hill/Irwin Slide 75
 The Cash Budget

Because Royal maintains

a cash balance of $30,000,
the company must borrow
$50,000 on its line-of-credit.

McGraw-Hill/Irwin Slide 76
 The Cash Budget

Because Royal maintains

a cash balance of $30,000,
the company must borrow
$50,000 on its line-of-credit.

Ending cash balance for April

is the beginning May balance.

McGraw-Hill/Irwin Slide 77
 The Cash Budget

McGraw-Hill/Irwin Slide 78
 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

McGraw-Hill/Irwin Slide 79
 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

McGraw-Hill/Irwin Slide 80
 The Cash Budget

$50,000 × 16% × 3/12 = $2,000

Borrowings on April 1 and
repayment on June 30.

McGraw-Hill/Irwin Slide 81
 The Budgeted Income Statement

Cash Budgeted
Budget Income
Statement
t ed
e
pl
om
C

With interest expense from the cash

budget, Royal can prepare the budgeted
income statement.

McGraw-Hill/Irwin Slide 82
 Learning Objective 9

Prepare a budgeted
income statement.

McGraw-Hill/Irwin Slide 83
 The Budgeted Income Statement

Sales
Sales Budget.
Budget.
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Ending
Ending Finished
Finished
Sales (100,000 units @ $10) $ 1,000,000 Goods
Cost of goods sold (100,000 @ $4.99) 499,000
Goods Inventory.
Inventory.
Gross margin 501,000
Selling and administrative expenses 260,000 Selling
Selling and
and
Operating income 241,000 Administrative
Administrative
Interest expense 2,000
Expense
Expense Budget.
Budget.
Net income $ 239,000

Cash
Cash Budget.
Budget.

McGraw-Hill/Irwin Slide 84
 Learning Objective 10

Prepare a
budgeted balance
sheet.

McGraw-Hill/Irwin Slide 85
 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 (April 1)
• Equipment - $175,000

McGraw-Hill/Irwin Slide 86
 Royal Company
Budgeted Balance Sheet
June 30
Assets:
Cash $ 43,000
Accounts receivable 75,000
Raw materials inventory 4,600
Finished goods inventory 24,950
Land 50,000
Equipment 367,000
Total assets 564,550

Liabilities and Stockholders' Equity

Accounts payable $ 28,400
Common stock 200,000
Retained earnings 336,150
Total liabilities and stockholders' equity $ 564,550

McGraw-Hill/Irwin Slide 87
 Royal Company
Budgeted Balance Sheet
June 30
Beginning balance $146,150
Assets: Add: net income 239,000
Cash $ 43,000
Deduct: dividends (49,000)
Accounts receivable 75,000
Ending balance $336,150
Raw materials inventory 4,600
Finished goods inventory 24,950
Land 50,000
Equipment 367,000
Total assets 564,550

Liabilities and Stockholders' Equity

Accounts payable $ 28,400
Common stock 200,000
Retained earnings 336,150
Total liabilities and stockholders' equity $ 564,550

McGraw-Hill/Irwin Slide 88
 End of Chapter 9

McGraw-Hill/Irwin Slide 89