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CHAPTER 7 COVERAGE OF LEARNING OBJECTIVES

LEARNING OBJECTIVE LO1: Explain how budgets facilitate planning and coordination. LO2: Anticipate possible human relations problems caused by budgets. LO3: Explain potentially dysfunctional incentives in the budget process. LO4: Explain the difficulties of sales forecasting. LO5: Explain the major features and advantages of a master budget. LO6: Follow the principal steps in preparing a master budget. LO7: Prepare the operating budget and the supporting schedules. LO8: Prepare the financial budget. LO9: Use a spreadsheet to develop a budget (Appendix 7).

FUNDAMENTAL ASSIGNMENT MATERIAL A1,B1

CRITICAL THINKING EXERCISES AND EXERCISES

CASES, EXCEL, COLLAB. & INTERNET PROBLEMS EXERCISES

25 22 23 A1,B1 A1,B1 A1,B1 A1,B1 24,26 29 28,29,30,31 27,29,32,33, 34,35

40 39, 40 42 39 40 40 36,37,38 41,42 43,45 43,45,46,48 43,44,47,48 49

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CHAPTER 7 The Master Budget 7-A1 (60-90 min.) Note: The first printing of the text has an error. The following four accounts should be changed to the following: Inventory $ 434,000 Total assets 1,000,000 Accounts payable 489,000 Total liabilities and owners equities 1,000,000

1.

Exhibit I BETTERBUY ELECTRONICS, INC. Mall of America Store Budgeted Income Statement For the Three Months Ending August 31, 20X8 $1,500,000 930,000 $ 570,000

Sales Cost of goods sold (.62 x $1,500,000) Gross profit Operating expenses: Salaries, wages, commissions $300,000 Other expenses 60,000 Depreciation 7,500 Rent, taxes and other fixed expenses 165,000 Income from operations. Interest expense* Net income * See schedule g for calculation of interest.

532,500 $ 37,500 6,640 $ 30,860

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Exhibit II BETTERBUY ELECTRONICS, INC. Mall of America Store Cash Budget For the Three Months Ending August 31, 20X8 June July August Beginning cash balance $29,000 $25,000 $25,443 Minimum cash balance desired 25,000 25,000 25,000 (a) Available cash balance $ 4,000 $ 0 $ 443 Cash receipts & disbursements: Collections from customers (schedule b) $ 376,000 $ 607,000 $454,000 Payments for merchandise (schedule d) (434,000) (248,000) (248,000) Fixtures (purchased in May) (55,000) Payments for operating expenses (schedule f) (223,000) (151,000) (151,000) (b) Net cash receipts & disbursements $(336,000 )$ 208,000 $55,000 Excess (deficiency) of cash before financing (a + b) (332,000) 208,000 55,443 Financing: Borrowing, at beginning of period$ 332,000 $ - $ Repayment, at end of period - (202,000) (54,000) Interest, 10% per annum (5,557)* (1,083)* (c) Total cash increase (decrease) from financing $332,000 $(207,557) $(55,083) (d) Ending cash balance (beginning balance + b + c) $ 25,000 $ 25,443 $ 25,360 * See schedule g

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Exhibit III BETTERBUY ELECTRONICS, INC. Mall of America Store Budgeted Balance Sheet August 31, 20X8 Assets Cash (Exhibit II) $ 25,360 Accounts receivable* 432,000 Merchandise inventory 186,000 Total current assets $643,360 Net fixed assets: $168,000 less depreciation of $7,500 160,500 Total assets $803,860 Liabilities and Owners Equity Accounts payable Notes payable Total current liabilities Owners' equity: $511,000 plus net income of $30,860 Total equities $186,000 76,000** $262,000

541,860 $803,860

*July sales, 20% x 90% x $400,000 $ 72,000 August sales, 100% x 90% x $400,000 360,000 Accounts receivable (to Exhibit III) $432,000 ** See schedule g

June Schedule a: Sales Budget Credit sales (90%) $630,000 Cash sales (10%) 70,000 Total sales (to Exhibit I) $700,000

July

August

Total

$360,000 $360,000 $1,350,000 40,000 40,000 150,000 $400,000 $400,000 $1,500,000

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Schedule b: Cash Collections June Cash sales $ 70,000 On accounts receivable from: April sales 54,000 May sales 252,000 June sales July sales Total collections (to Exhibit II) $376,000 July $ 40,000 63,000 504,000 $607,000 August $ 40,000 126,000 288,000 $454,000

Schedule c: Purchases Budget May June July August Desired purchases: 62% x next month's sales $434,000 $248,000 $248,000 $186,000 Schedule d: Disbursements for Purchases June July August Last month's purchases (to Exhibit II) $434,000 $248,000 $248,000 Other required items related to purchases Accounts payable, August 31, 2008 (62% x September sales - to Exhibit III) $186,000 Cost of goods sold (to Exhibit I) $434,000 $248,000 $248,000 Schedule e: Operating Expense Budget June July August Salaries, wages, commissions $140,000 $80,000 $80,000 Other Variable expenses 28,000 16,000 16,000 Fixed expenses 55,000 55,000 55,000 Depreciation 2,500 2,500 2,500 Total operating expenses $225,500 $153,500 $153,500

Total $300,000 60,000 165,000 7,500 $532,500

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Schedule f: Payments for Operating Expenses June July August Variable expenses $168,000 $ 96,000 $ 96,000 Fixed expenses 55,000 55,000 55,000 Total payments for operating expenses $223,000 $151,000 $151,000 Schedule g: Interest calculations June July August Beginning balance $ 332,000 $ 334,767 $130,000 Monthly interest expense @ 10% 2,767 2,790 1,083 Ending balance before repayment $ 334,767 337,557 131,083 Principal repayment (from statement of receipts and disbursements) (202,000) (54,000) Interest payment (5,557) (1,083) Ending balance $ 130,000 $ 76,000 2. This is an example of the classic short-term, self-liquidating loan. The need for such a loan often arises because of the seasonal nature of a business. The basic source of cash is proceeds from sales to customers. In times of peak sales, there is a lag between the sale and the collection of the cash, yet the payroll and suppliers must be paid in cash right away. When the cash is collected, it in turn may be used to repay the loan. The amount of the loan and the timing of the repayment are heavily dependent on the credit terms that pertain to both the purchasing and selling functions of the business.

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7-B1 (60-120 min.) $ refers to New Zealand dollars. 1. 2. See Exhibits I, II, and III and supporting schedules a, b, c, d. The cash budget and balance sheet clearly show the benefits of moving to just-in-time purchasing (though the transition would rarely be accomplished as easily as this example suggests). However, the company would be no better off if it left much of its capital tied up in cash -- it has merely substituted one asset for another. At a minimum, the excess cash should be in an interest bearing account -- the interest earned or forgone is one of the costs of inventory. January February $62,000 $70,000 March $38,000

Schedule a: Sales Budget Total sales (100% on credit)

Schedule b: Cash Collections 60% of current month's sales $37,200 30% of previous month's sales 7,500 10% of second previous month's sales 2,500 Total collections $47,200 December Schedule c: Purchases Budget Desired ending inventory $39,050 Cost of goods sold 12,500 Total needed $51,550 Beginning inventory 16,000 Purchases $35,550

$42,000 $22,800 18,600 21,000 2,500 6,200 $63,100 $50,000 March $ 6,000 19,000 $25,000 6,000 $19,000

January February $ 6,000* $ 6,000 31,000 35,000 $37,000 $41,000 39,050 8,050 $ - $32,950

* Actual ending January (and beginning February) inventory level is 8,050, as inventory levels are drawn down toward desired level of $6,000.

Schedule d: Disbursements for Purchases 100% of previous month's purchases $35,550 March 31 accounts payable
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$32,950 $19,000

Exhibit I VICTORIA KITE Cash Budget For the Three Months Ending March 31, 2008 January February Cash balance, beginning $ 5,000 Minimum cash balance desired 5,000 (a) Available cash balance 0 Cash receipts and disbursements: Collections from customers (Schedule b) 47,200 Payments for merchandise (Schedule d) (35,550) Rent (8,050) Wages and salaries (15,000) Miscellaneous expenses (2,500) Dividends (1,500) Purchase of fixtures (b) Net cash receipts & disbursements $ (15,400) Excess (deficiency) of cash before financing (a + b) $(15,400) Financing: Borrowing, at beginning of period $ 15,500 Repayment, at end of period Interest, 10%, compounded monthly (c) Total cash increase (decrease) from financing $ 15,500 (d) Cash balance, end (beginning balance + c + b) $ 5,100 $ 5,100 5,000 100 March $34,692 5,000 29,692

63,100 (250) (15,000) (2,500) $ 45,350 $ 45,450 $

50,000 (32,950) (250) (15,000) (2,500) (3,000) $(3,700) $25,992 -

- $ (15,500) (258)

$(15,758) $ $ 34,692

$30,992

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Exhibit II VICTORIA KITE Budgeted Income Statement For the Three Months Ending March 31, 2008 Sales (Schedule a) Cost of goods sold (Schedule c) Gross margin Operating expenses: Rent* Wages and salaries Depreciation. Insurance Miscellaneous Net income from operations Interest expense Net income $170,000 85,000 $ 85,000 $16,750 45,000 750 375 7,500

70,375 $ 14,625 258 $ 14,367

*(January-March sales less $10,000) x .10 plus 3 x $250

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Exhibit III VICTORIA KITE Budgeted Balance Sheet March 31, 2008 Assets Current assets: Cash (Exhibit I) $30,992 Accounts receivable* 22,200 Merchandise inventory (Schedule c) 6,000 Unexpired insurance 1,125 Fixed assets, net: $12,500 + $3,000 - $750 Total assets Liabilities and Stockholders' Equity Liabilities: Accounts payable (Schedule d) $19,000 Rent payable. 16,000 Dividends payable 1,500 Stockholders' equity** Total liabilities and stockholders' equity.

$60,317 14,750 $75,067

$36,500 38,567 $75,067

*February sales (.10 x $70,000) plus March sales (.40 x $38,000) = $22,200 **Balance, December 31, 2007 $25,700 Add: Net income. 14,367 Total $40,067 Less: Dividends declared. 1,500 Balance, March 31, 2008 $38,567

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7-1 Budgeting 1) provides an opportunity for managers to reevaluate existing activities and evaluate possible new activities, 2) compels managers to think ahead by formalizing their responsibilities for planning, 3) aids managers in communicating objectives to units and coordinating actions across the organization, and 4)provides benchmarks to evaluate subsequent performance. 7-2 Budgeting is primarily attention directing because it helps managers to focus on operating or financial problems early enough for effective planning or action. 7-3 Strategic planning covers no specific time period, is quite general, and often is not built around financial statements. Longrange planning usually has a 5- or 10-year horizon and consists of financial statements without much detail. Budgeting usually has a horizon of one year or less, and consists of financial statements with much detail. 7-4 Continuous budgets add a month (or quarter) in the future as the month (or quarter) just ended is dropped. Therefore, the continuous budget provides a continually updated budget looking twelve months ahead. When the new month (or quarter) is added, the budget for the remainder of the current year may also be revised. When companies revise the budgets for the remainder of the current year, they usually compare subsequent results to the original budget (a fixed target) in addition to comparing them to the latest revised budget. 7-5 If the measures used to reward employees in the performance evaluation system are not aligned with the goals of the company, the incentives from the evaluation system may lead employees to take actions that conflict with the interests of the company.

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7-6 Lower-level managers bias their forecasts to create budgetary slack or padding. Upper-level managers adjust for this bias in creating a revised budget. Therefore, lower-level managers introduce additional bias to compensate for the adjustment that will be made by upper-level managers, and upper-level managers introduce additional adjustments. This cycle can quickly destroy the potential benefits of budgets. 7-7 A manager may make short-run decisions to increase profits that are not in the companys best long-run interests, such as offering customers excessively favorable credit terms or cutting discretionary expenditures such as R&D and advertising, trading future sales for current profits. In the extreme, manager might choose to falsely report inflated profits. 7-8 First, by moving this year's sales into next year or moving next year's expenses into this year, the manager ensures a higher level of reported profit (and probably a higher bonus) next year. Second, by decreasing this year's income, the manager avoids ratcheting up of performance expectations in setting the bonus target for the next year. 7-9 Budgeted performance is better than past performance as a basis for judging current performance because the budget contains no hidden inefficiencies and can be founded on current rather than past economic conditions. 7-10 Budgets are especially important in environments that are rapidly changing. They force managers to look forward and plan for change. Budgets force analysis of the factors that are bringing about the changes.

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7-11 No. When budgeting in done correctly, it is an important aid to managers. Managers need time to plan and coordinate their various activities. Budgeting forces them to take time from the dayto-day problems and focus on longer-term issues. 7-12 The sales forecast is the starting point for budgeting because all other operating activities of the company are affected by the volume of sales. 7-13 The sales forecast is influenced by past patterns of sales, estimates made by the sales force, general economic conditions, competitors' actions, changes in prices, market research studies, and advertising and sales promotion plans. 7-14 An operating budget is used as a guide for production and sales and it focuses on the income statement. A financial budget is used to control the receipt and disbursement of funds and it focuses on the statement of cash receipts and disbursements. 7-15 Operating expenses are costs charged to the income statement in a particular period. Some operating expenses may be associated with the sales of the period, and others may be costs of being in business for the period. Disbursements for these operating expenses, that is, the cash payments for them, may come in a previous period (assets purchased in one period and depreciated over future periods) or a future period (wages accrued in a period but paid in the next period), as well as during the period. 7-16 A cash budget is an attempt to regulate the flow of cash in optimum fashion.

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7-17 Budgeting will be effective only if it is accepted by those managers who are responsible for controlling costs. Since their performance will be measured against the budget, they must be educated in the assumptions underlying the budget and convinced of its objectivity and relevance. 7-18 Both functional and activity-based master budgets begin with the forecasted demand for products or services. However, whereas functional budgets then determine the inventory, materials, labor, and overhead budgets, the activity-based budget focuses on determining the demand for key activities. This demand is measured by the cost-driver unit for each activity. Then the budgeted resource consumption rates are used to set the budgets for resources such as materials, labor, and overhead. The focus on activities and consumption rates in activity-based budgeting is what managers believe offers value from an operational control perspective. 7-19 No. Financial planning models are mathematical statements of the relationships in the organization among all the operating and financial activities and of other major internal and external factors that may affect the financial results of decisions. But financial planning models are only as good as the assumptions and inputs used to build them. Managers must understand the models to provide appropriate assumptions and inputs. If managers do not understand budgeting, using financial planning models can result in GIGO (garbage in, garbage out).

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7-20 Setting up the master budget on a spreadsheet is timeconsuming -- the first time. However, if it is done properly, with maximum flexibility, then the ease of subsequent use probably will more than offset that initial cost. Ultimately, though, the master budget system must meet the cost-benefit test. Improved budgeting systems are only worthwhile if they offer net benefits. It is also a fact that all large, well-managed companies have computerized master budget systems. Preparing and revising the master budget of a large company just would not be feasible without the aid of a computer. 7-21 Spreadsheets can be used to make a mathematical model of an organization. It may take much effort to create the model, but once it is in place it can be used over and over again with minimal effort. Such a model is especially useful for sensitivity analysis, which is the asking of "what if" questions. 7-22 Budgets that are used primarily for limiting spending provide incentives for game playing. Accurate forecasts and estimates give way to strategies designed to avoid budget cuts or to justify increased budgets. Budgets should have a much larger role in the effective and efficient management of an organization. A budget should be a decision tool. It helps managers project the results of their decisions, thereby aiding them in making the right decisions. It also provides a base for adapting to change. Anything that results in loss of budget accuracy will limit the decision usefulness of the budget.

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7-23 Accurate sales forecasts are essential to budgeting. Sales personnel are often closest to the action and therefore in the best position to make accurate forecasts. They are in direct contact with customers, and often they are the first to notice trends. A central staff function, such as market research, can set parameters for forecasting and give some common ground rules. But usually it is important to get sales personnel heavily involved because they have information that no one else has. Most importantly, the more involved sales personnel are, the more committed they will be to achieving budgeted sales goals. 7-24 The planning that comes through a good budget process is important to all segments of an organization. Segments with both revenues and expenses can show a budgeted profit. Other segments, those that have only expenses such as a research and development department, still have to plan their operations. It is important to predict the resources needed to meet the segments objectives so that required resources can be obtained. Budgeting provides a formal channel for communication between the segment and top management about what activities the segment is to undertake. 7-25 A key to employee acceptance of a budget is participation. Budgets created with the active participation of all affected employees are generally more effective than budgets imposed on subordinates. If a budget is to help direct future activities, employees must accept the budget. Acceptance means believing that the budget reflects a desired future path for the organization. If a manager has been a participant in determining the future path that is, helped develop the budget he or she is more likely to accept it as a desirable objective.

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7-26 (5 min.) 1. a. Budgeted income statement b. Budgeted balance sheet c. Cash budget d. Capital budget 7-27 (10-15 min.) Education Solutions will be using cash until the beginning of 2010, at which time cash receipts will begin to exceed cash disbursements. Therefore, the following amount of venture capital is needed to carry the firm to the beginning of 2010: Initial capital investment $380,000 First year cash outflow (12 x $35,000) 420,000 Second year cash outflow [12 x ($35,000 - $30,000)] 60,000 Total $860,000 2. Sales budget (or operating budget) 3. Continuous (rolling) 4. Overall goals of the organization

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7-28 (10-15 min.) 1. Cost + (.25 x Cost) = Sales 1.25 x Cost = $2,060,000 Cost = $1,648,000 Use the familiar identity, Beginning Inventory plus Purchases equals Cost of Goods Sold plus Ending Inventory. To compute required purchases, compute the inventory needed (Cost of Goods Sold plus Ending Inventory) and then subtract the amount that will come from Beginning Inventory: July Merchandise Purchases Cost of goods sold ($2,210,000 1.25) $1,768,000 Add: Target ending inventory (.30 x $2,360,000 1.25) 566,400 Cost of goods needed $2,334,400 Less: Beginning inventory (.30 x $2,210,000 1.25) 530,400 Required Purchases $1,804,000

2.

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7-29 (25-30 min.) 1. July collections include: May sales billed June 5, .18 x .5 x $750,000 June sales billed June 20, .18 x .5 x $800,000 June sales billed July 5, .80 x .5 x $800,000 x .98 July sales billed July 20, .80 x .5 x $900,000 x .98 Total 2. .60 x .25 x $800,000 = $120,000 3. Ending inventory, .60 x .25 x $900,000 Merchandise needed for current month's sales, .60 x $800,000 Total needs Beginning inventory, .60 x .25 x $800,000 Required Purchases

$ 67,500 72,000 313,600 352,800 $805,900

$135,000 480,000 615,000 120,000 $495,000 August $ 90,000 540,000 630,000 135,000 $495,000 $517,500

4. July Ending inventory, .60 x .25 x next month's sales $135,000 Merchandise needed for current month's sales, .60 x sales 540,000 Total needs 675,000 Beginning inventory, .60 x .25 x current month's sales 135,000 Required Purchases $540,000 Payments, 1/2 of current purchases, 1/2 of preceding month's purchases, .5 x $540,000 + .5 x $495,000

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7-30 (15 min.) This illustration is straightforward and follows the chapter example closely. All amounts are in dollars. June Sales budget Credit sales, 30% Cash sales, 70% Total sales, 100% 123,000 287,000 410,000 July 132,000 308,000 440,000 August 150,000 350,000 500,000

Cash collections budget Cash sales this month 287,000 100% of last month's credit sales 105,000 Total collections 392,000

308,000 123,000 431,000

350,000 132,000 482,000

7-31 (15-25 min.) This problem is slightly more complex than 7-30. All amounts are in thousands of Japanese yen. January February March Sales budget Credit sales, 80% Cash sales, 20% Total sales Cash collections budget Cash sales this month 50% of this month's credit sales 40% of last month's credit sales 10% of next-to-last month's credit sales Total collections 160,000 40,000 200,000 40,000 80,000 62,400 18,000 200,400 176,000 192,000 44,000 48,000 220,000 240,000 44,000 48,000 88,000 96,000 64,000 70,400 15,600 16,000 211,600 230,400

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7-32 (10-15 min.) Collections from: January sales: $360,000 x 12% February sales: $400,000 x 10% x 99% February sales: $400,000 x 25% March sales: $450,000 x 50% x 98% Total cash collections

$ 43,200 39,600 100,000 220,500 $403,300

7-33 (15-20 min.) This is straightforward. It follows the illustration in the chapter very closely. All amounts are in dollars. Some students need to be reminded that merchandise inventories are carried at cost, not at selling prices. ADOBO LIGHTING EMPORIUM Purchases and Disbursements Budgets June Purchases budget Ending inventory Cost of goods sold, 60% of sales Total needed Beginning inventory Purchases Disbursements for purchases 10% of this month's purchases 80% of last month's purchases 10% of second-last month's purchases
*.80 x 180,000 = 144,000 **.10 x 250,000 = 25,000

July 270,000 210,000 480,000 220,000 260,000

August 240,000 252,000 492,000 270,000 222,000

220,000 264,000 484,000 275,000 209,000

20,900 26,000 144,000* 167,200 25,000** 18,000 189,900 211,200

22,200 208,000 20,900 251,100

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7-34 (20-25 min.) This is straightforward. Except for requirement 1, it follows the illustration in the chapter very closely. All amounts are in euros. 1. 210,000 - [15,000 + .9(.6 x 300,000)] = 210,000 - [15,000 + .9(180,000)] = 210,000 - 177,000 = 33,000 LINKENHEIM GMBH Purchases and Disbursements Budgets June Purchases budget Ending inventory* Cost of goods sold, 60% of sales Total needed Beginning inventory Purchases Disbursements for purchases 80% of last month's purchases 20% of this month's purchases Disbursements for purchases 171,600 180,000 351,600 210,000 141,600 July 198,600 174,000 372,600 171,600 201,000 August 231,000 204,000 435,000 198,600 236,400

2.

120,000 28,320 148,320

113,280 40,200 153,480

160,800 47,280 208,080

*Inventory targets, end of month: June: 15,000 + .9(0.6 x 290,000) = 15,000 + .9(174,000) = 171,600 July: 15,000 + .9(0.6 x 340,000) = 15,000 + .9(204,000) = 198,600 August: 15,000 + .9(0.6 x 400,000) = 15,000 + .9(240,000) = 231,000

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7-35 (20 min.) This is a straightforward exercise. CARLSON COMPANY Cash Budget For the Month Ended June 30, 20X4 (in thousands) Beginning Cash, May 31, 20X4 Cash Receipts: Collections from customers from: June sales (.80 x $290) May sales (.5 x 24)* April sales Total cash available during June Cash Disbursements: On accounts payable of May 31 On June purchases, .25 x $192 Wages Utilities Advertising Office expenses Ending Cash, June 30, 20X4 $ 15

$232 12 20

264 $279

$145 48 36 5 10 4

248 $ 31

*$24,000 = 20% of May sales, 10% of which or half the remainder will be collected in June. All of April's remaining sales will be collected in June.

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7-36 (20-25 min.) The collections from March sales are a bit tricky. Note that the receivable balance from March sales at March 31 is $450,000; therefore, four fifths (because 40/50 will be collected in April and 10/50 will be collected in May) will be received in April. MERRILL NEWS AND GIFTS Budgeted Statement of Cash Receipts and Disbursements For the Month Ending April 30, 20X7 Cash balance, March 31, 20X7 $ 100,000 Add receipts, collections from customers: From April sales, 1/2 x $1,000,000 $500,000 From March sales, 4/5 x $450,000 360,000 From February sales 80,000 940,000 Total cash available before current financing $1,040,000 Less disbursements: Merchandise purchases, $450,000 x 40% $180,000 Payment on accounts payable 460,000 Payrolls 90,000 Insurance premium 1,500 Other expenses 45,000 Repayment of loan and interest 97,200 873,700 Cash balance, April 30, 20X7 $ 166,300

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7-37 (40-60 min.) BOTANICA COMPANY Statement of Estimated Cash Receipts and Disbursements For the Month Ended October 31, 20X7 Cash balance, September 30, 20X7 Receipts, collections of receivables (Schedule 1) Total cash available Less disbursements: Merchandise purchases (Schedule 2) $17,000 Variable expenses (Schedule 3) 3,125 Fixed expenses (Schedule 3) 900 Cash balance, October 31, 20X7 $ 4,800 29,340 $34,140

21,025 $13,115

Schedule 1, Collections of Accounts Receivable: Collected in October Sales $12,000 $36,000 $30,000 Percent Amount 6% $ 720 30% 10,800 60% x 99% 17,820 $29,340 October $ 6,600* 18,000 $24,600 9,000* $15,600 $10,400 6,600 $17,000

From August sales From September sales From October sales Total October collections

Schedule 2, Payments for Merchandise: September Target ending inventory $ 9,000* Goods sold 21,600 Total needs $30,600 Beginning inventory 10,800* Purchases $19,800 Payments, 2/3 x $15,600 October purchases Accounts payable, end of September, 1/3 x $19,800 purchases Total payments in October

* (12/20)(.5)(30,000) = $9,000; (12/20)(.5)(36,000) = $10,800; (12/20)(.5)(22,000) = $6,600


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Schedule 3, Selling and General Administrative Expenses: Total selling and general administrative expenses Less fixed expenses Total variable expenses for year (vary with sales) October variable expenses: $37,500 x (October sales Year's sales) = $37,500 x ($30,000 $360,000) Total fixed expenses Less depreciation (no current cash outlay) Total cash required for fixed expenses for year October cash required for fixed expenses: $10,800 12 $61,500 24,000 $37,500

$ 3,125 $24,000 13,200 $10,800

900

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7-38 (30 - 40 min.) 1. The Ritz-Carltons monthly cash budget is:


January February March April May $2,479,500 $2,479,500 $2,218,500 $2,218,500 $1,827,000 694,260 1,487,700 247,950 2,429,910 256,500 400,000 694,260 1,487,700 221,850 2,403,810 256,500 400,000 694,260 1,331,100 221,850 2,247,210 229,500 400,000 621,180 1,331,100 182,700 2,134,980 229,500 400,000 621,180 1,096,200 182,700 1,900,080 189,000 400,000 June $1,827,000 511,560 1,096,200 182,700 1,790,460 189,000 400,000 120,000 3,600,000 4,309,000 ($2,518,540)

Revenues Collections: Previous Mo. Sales This Mo. Sales Next Mo. Sales Total collections Disbursements: Variable costs ($30/room) Fixed salaries Fixed operating costs Interest payments Total disbursements Net cash inflow

120,000 120,000 120,000 120,000 120,000 _________ _________ _________ _________ _________ 776,500 776,500 749,500 749,500 709,000 $1,653,410 $1,627,310 $1,497,710 $1,385,480 $1,191,080

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July August September October November $1,827,000 $1,827,000 $1,827,000 $1,827,000 $2,218,500 511,560 1,096,200 182,700 1,790,460 189,000 400,000 511,560 1,096,200 182,700 1,790,460 189,000 400,000 511,560 1,096,200 182,700 1,790,460 189,000 400,000 511,560 1,096,200 221,850 1,829,610 189,000 400,000 511,560 1,331,100 247,950 2,090,610 229,500 400,000

December $2,479,500

Total $25,056,000 $0 621,180 7,015,680 1,487,700 15,033,600 247,950 2,505,600 2,356,830 24,554,880 256,500 400,000 2,592,000 4,800,000 1,440,000 7,200,000 16,032,000 $ 8,522,880

120,000 120,000 120,000 120,000 120,000 _________ _________ _________ _________ _________ 709,000 709,000 709,000 709,000 749,500 $1,081,460 $1,081,460 $1,081,460 $1,120,610 $1,341,110

120,000 3,600,000 4,376,50 0 ($2,019,670)

2.

Increase in revenues: 6 mo. x .05 x 300 rooms x $290 x 30 days x .98 collected = $767,340 Increase in costs: 6 mo. x .05 x 300 rooms x $30 x 30 days = $81,000 Increase in profit = $767,340 - $81,000 = $686,340

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7-39 ( 15 min.) 1. Cost-saving actions would probably focus on one or more of the activities of the Shipping and Receiving Department. Steele might start with the non-value added activities, handling and record-keeping. For example, the activity-based budget data suggest that the cost per move is $10 ($112,000 / 11,200 moves). Assuming that handling costs are variable with respect to the number of moves, reducing the number of moves by 4,334 moves (about 40%), would provide the required savings. Reorganizing the warehouse is one way to try to achieve such savings. Steele might also focus on activities that cost the most (and have the most potential for cost savings). For example, the activity-based budget shows that the highest-cost activity is shipping, so that might be the best place to look for potential cost savings from changing processes. 2. Regardless of what methods are selected to achieve cost savings, the activity-based budget seems to be a better starting point. The traditional budget does not show how changes in activities might affect costs, whereas the activity-based budget does.

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7-40 (25-30 min.) 1. An optimistic preliminary budget might be as follows, assuming level sales volume, a $.94 per pound price, and a 2% decrease in variable costs. Sales, 1.6 million pounds @ $.94/pound Variable costs Fixed costs, primarily depreciation Pretax profit $1,504,000 (862,400) (450,000) $ 191,600

This budget does not meet the $209,000 profit goal. Stark has a dilemma of submitting a realistic budget that does not meet Philp's goal or preparing an unrealistic budget. The following budget, which assumes that prices will not fall, sales levels will be maintained, and some fixed costs will be saved, would meet the profit target. Although Stark does not believe the assumptions, she might feel pressure to submit it (or something similar) to headquarters: Sales, 1.6 million pounds @ $.95/pound Variable costs, .98 x $880,000 Fixed costs, primarily depreciation Pretax profit
*$1,520,000 - $862,400 - $209,000

$1,520,000 (862,400) (448,600)* $ 209,000

2.

Two major problems are the arbitrary setting of budget targets by top management without regard to whether the targets can be achieved and the draconian measures used when a budget is not met, even if the shortfall is small or reasonable explanations for the shortfall are given.

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3.

Apparently the preliminary financial results are as follows: Sales, 1.6 million pounds @ $.945/pound $1,512,000 Variable costs, .98 x $880,000 (862,400) Fixed costs, primarily depreciation (450,000) Pretax profit $ 199,600 Extending the depreciable lives of fixed assets by 2 years could increase this profit by $15,000 to $214,600, well above the target. But doing so would be manipulating the accounting system to achieve desirable results. When the estimates of depreciable lives were first made, there may have been much uncertainty in the estimates. However, changing the accounting method to make the financial results look better is an ethical violation. Managers should not change accounting methods just to make their performance look better (or in this case, to save their job). Although changing the depreciation schedule is not ethical, it is easy to see how the budgeting process creates an incentive for such unethical behavior. If the budget and reporting process makes excellent performance appear deficient, there may be great temptation for managers to cheat the system.

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7-41 (50-90 min.) This spreadsheet is constructed so that only formulas are entered in the disbursements and operating income schedules. You can compare the total operating income figures at the bottom of each spreadsheet to assess the effects of each scenario. Amounts are in dollars. 1 and 2. Table of Budget Data Sales forecasts Growth Cost of goods sold percentage Misc. expense percentage Sales commissions Employee salaries per month Rent per month Insurance expense per month Depreciation per month Disbursements for Operating Expenses (2a) Cost of goods sold 262,500 Commissions 37,500 Salaries 22,000 Miscellaneous 22,500 Rent 6,000 231,000 33,000 22,000 19,800 6,000
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June 375,000 0% 375,000

July 330,000 0% 330,000

August 420,000 0% 420,000 70% 6% 10% 22,000 6,000 450 2,850 294,000 42,000 22,000 25,200 6,000 787,500 112,500 66,000 67,500 18,000

Total

350,500

311,800

389,200 1,051,500

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Operating Income (2b) Sales Cost of goods sold Gross margin Operating expenses Commissions Salaries Miscellaneous Rent Insurance Depreciation Total Operating income

June 375,000 262,500 112,500 37,500 22,000 22,500 6,000 450 2,850 91,300 21,200

July 330,000 231,000 99,000 33,000 22,000 19,800 6,000 450 2,850 84,100 14,900

August Total 420,000 1,125,000 294,000 787,500 126,000 337,500 42,000 22,000 25,200 6,000 450 2,850 98,500 27,500 112,500 66,000 67,500 18,000 1,350 8,550 273,900 63,600

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3a. Table of Budget Data Sales forecasts Growth Cost of goods sold percentage Misc. expense percentage Sales commissions Employee salaries per month Rent per month Insurance expense per month Depreciation per month

June 375,000 5% 393,750

July 330,000 5% 346,500

August 420,000 5% 441,000 70% 6% 10% 22,000 6,000 450 2,850

Disbursements for Operating Expenses Cost of goods sold 275,625 Commissions 39,375 Salaries 22,000 Miscellaneous 23,625 Rent 6,000 Total 366,625

242,550 34,650 22,000 20,790 6,000 325,990

308,700 44,100 22,000 26,460 6,000 407,260

Total 826,875 118,125 66,000 70,875 18,000 1,099,875

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Operating Income Sales Cost of goods sold Gross margin Operating expenses Commissions Salaries Miscellaneous Rent Insurance Depreciation Total Operating income

June 393,750 275,625 118,125 39,375 22,000 23,625 6,000 450 2,850 94,300 23,825

July 346,500 242,550 103,950 34,650 22,000 20,790 6,000 450 2,850 86,740 17,210

August 441,000 308,700 132,300 44,100 22,000 26,460 6,000 450 2,850 101,860 30,440

Total 1,181,250 826,875 354,375 118,125 66,000 70,875 18,000 1,350 8,550 282,900 71,475

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3b. Table of Budget Data Sales forecasts Growth Cost of goods sold percentage Misc. expense percentage Sales commissions Employee salaries per month Rent per month Insurance expense per month Depreciation per month

June 375,000 -2% 367,500

July 330,000 -2% 323,400

August 420,000 -2% 411,600 70% 6% 0% 52,500 6,000 450 2,850

Disbursements for Operating Expenses Cost of goods sold 257,250 Commissions 0 Salaries 52,500 Miscellaneous 22,050 Rent 6,000 Total 337,800

226,380 0 52,500 19,404 6,000 304,284

288,120 0 52,500 24,696 6,000 371,316

Total 771,750 0 157,500 66,150 18,000 1,013,400

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Operating Income Sales Cost of goods sold Gross margin Operating expenses Commissions Salaries Miscellaneous Rent Insurance Depreciation Total Operating income

June 367,500 257,250 110,250 0 52,500 22,050 6,000 450 2,850 83,850 26,400

July 323,400 226,380 97,020 0 52,500 19,404 6,000 450 2,850 81,204 15,816

August 411,600 288,120 123,480 0 52,500 24,696 6,000 450 2,850 86,496 36,984

Total 1,102,500 771,750 330,750 0 157,500 66,150 18,000 1,350 8,550 251,550 79,200

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7-42 (50-90 min.) These spreadsheets contain data from the problem in the top of the spreadsheet space. Computations of operating expenses are accomplished with formulas that reference the table. Comparing the summary calculations of operating expenses (labeled TOTAL OPERATING EXPENSE) allows the user to assess the effects of alternate scenarios. 1. Table of Budget Data Cost behavior Cost 37 Displays 25 Displays Indirect Packaging Shipping TOTAL OPERATING EXPENSE

Fixed

Variable

$100 $40 $40,000 $16/compone nt $8,000 $4 / display $8,000 $2 / display $19,206,000

Quantity / display 5 5

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Sales forecasts Month 1 October 2 November 3 December 4 January 5 February 6 March 7 April 8 May Sales mix Sales growth 3,200 2,400 5,600 3,200 3,200 2,400 2,400 2,800

37 Displays 25 Displays 1 1.25 1 1 3,200 4,000 2,400 3,000 5,600 7,000 3,200 4,000 3,200 4,000 2,400 3,000 2,400 3,000 2,800 3,500 Indirect $616,000 472,000 1,048,000 616,000 616,000 472,000 $3,840,000 Packaging $36,800 29,600 58,400 36,800 36,800 29,600 $228,000 Shipping $22,400 18,800 33,200 22,400 22,400 18,800 $138,000 Total $3,075,200 2,320,400 5,339,600 3,075,200 3,075,200 2,320,400 $19,206,000

Operating expenses Month Components 1 October $2,400,000 2 November 1,800,000 3 December 4,200,000 4 January 2,400,000 5 February 2,400,000 6 March 1,800,000 Totals $15,000,000

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2. Table of Budget Data Cost behavior Cost 37 Displays 25 Displays Indirect Packaging Shipping TOTAL OPERATING EXPENSE Sales forecasts Sales mix Month 1 November 2 December 3 January 4 February 5 March 6 April 7 May

Fixed

Variable $100 $40 $16 / component $4 / display $2 / display

Quantity / display 5 5

$40,000 $8,000 $8,000 $16,639,680

Sales growth 2,400 5,600 3,200 3,200 2,400 2,400 2,800

37 Displays 1 0.9 2,160 5,040 2,880 2,880 2,160 2,160 2,520

25 Displays 1.25 0.9 2,700 6,300 3,600 3,600 2,700 2,700 3,150

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Operating expenses Month Components 1 November $1,620,000 2 December 3,780,000 3 January 2,160,000 4 February 2,160,000 5 March 1,620,000 6 April 1,620,000 Totals $12,960,000 3. Table of Budget Data Cost behavior Cost 37 Displays 25 Displays Indirect Packaging Shipping TOTAL OPERATING EXPENSE

Indirect $428,800 947,200 558,400 558,400 428,800 428,800 $3,350,400

Packaging $27,440 53,360 33,920 33,920 27,440 27,440 $203,520

Shipping $17,720 30,680 20,960 20,960 17,720 17,720 $125,760

Total $2,093,960 4,811,240 2,773,280 2,773,280 2,093,960 2,093,960 $16,639,680

Fixed

Variable $100 $40 $16 / component $4 / display $2 / display

Quantity / display 5 5

$40,000 $8,000 $8,000 $18,240,600

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Sales forecasts Sales mix Month 1 December 2 January 3 February 4 March 5 April 6 May 7 8 Operating expenses Month 1 December 2 January 3 February 4 March 5 April 6 May Totals

Sales growth 5,600 3,200 3,200 2,400 2,400 2,800 0 0

37 Displays 25 Displays 1 1.5 0.9 0.9 5,040 7,560 2,880 4,320 2,880 4,320 2,160 3,240 2,160 3,240 2,520 3,780 0 0 0 0

Components $4,032,000 2,304,000 2,304,000 1,728,000 1,728,000 2,016,000 $14,112,000

Indirect $1,048,000 616,000 616,000 472,000 472,000 544,000 $3,768,000

Packaging $58,400 36,800 36,800 29,600 29,600 33,200 $224,400

Shipping $33,200 22,400 22,400 18,800 18,800 20,600 $136,200

Total $5,171,600 2,979,200 2,979,200 2,248,400 2,248,400 2,613,800 $18,240,600

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7-43 (80-100 min.) 1. On January 1, Salt Lake Light Opera needs to borrow $2,057,000, on April 1 it needs an additional $562,000, on September 31 it can repay $2,014,000, but on October 1 it must again borrow $726,000. This can be seen from the following analysis (in thousands of dollars): Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4 208 200 200 200 200 200 200 200 8 0 0 0 883 1,893 4,504 2,024 (780) (200) (30) (30) (30) (30) (2,046) (2,100) (2,100) (2,100) (100) (300) (60) (60) (60) (60) (125) (125) (140) (135) (32) (2,065) (562) 2,014 (726) (2,057) 2,057 (562) 2,014 562 (2,014) 2,057 200 562 (2,014) 200 200 726 200 (726) 726

Beginning cash balance Minimum cash balance desired Available cash balance Cash receipts & disbursement: Collections from customers (1) Payments for supplies (2) Other expenses (3) Payments for payroll (4) Major equipment (5) Small equipment (6) Mortgage principal (7) Mortgage interest (8) Interest on working capital (9) Net cash receipts & disbursements Excess (deficiency) of cash before financing Financing: Borrowing (at beginning of quarter) Repayment (at end of quarter) Total cash increase (decrease) from financing Ending cash balance

Explanations (see next page):


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(1) Collections are revenues for the quarter less the increase (or plus the decrease) in accounts receivable. (2) Payments for supplies in the first quarter are the accounts payable carried over from 20X4 and in the third quarter (July) are the purchases in June. Decembers purchases will be paid for in 20X6. (3) Other expenses are $10,000 per month, paid as incurred. (4) Payroll payments in the first quarter are those of December 20X4 ($646,000) plus the $700,000 from each of January and February. Each other quarter they are three $700,000 payments. (5) $100,000 of major equipment payments are made in September, October, November, and December. (6) Small equipment payments are $20,000 each month. (7) The mortgage payments semi-annually are $4,000,000 32 = $125,000. (8) $3,500,000 x .04 = $140,000; $3,375,000 x .04 = $135,000. (9) The $32,000 payment is the interest that was payable at the end of 20X4. The result of 20X5 operations will be an increase in the working capital loan from $1,588,000 (without the accrued interest) to $3,308,000, an increase of $1,720,000: Qtr. 1 Beginning loan $1,588 Accrued interest (rounded*) 91 Additional borrowing 2,057 Ending loan $3,736 Qtr. 2 $3,736 108 562 $4,406 Qtr. 3 $4,406 110 (2,014) $2,502 Qtr. 4 $2,502 80 726 $3,308

*The unrounded amounts of quarterly interest expense @8% are: Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4 Total $91,125 $107,453 $110,139 $80,693 $389,410

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2. Salt Lake Light Operas projected income statement and balance sheet for 20X5 are (in thousands): SALT LAKE LIGHT OPERA Income Statement For the Year Ended December 31, 20X5 $11,059 $8,400 800 500 120 9,820 1,239 275 389 $ 575 SALT LAKE LIGHT OPERA Balance Sheet December 31, 20X5 Assets Cash $ 200 Receivables 6,195 Supplies inventory 600 Total current assets 6,995 Fixed assets 5,949 Total assets $12,944 Liabilities & Equities Loan payable $ 2,919 Accrued interest payable 389 Accounts payable 700 Payroll payable 700 Current mortgage 250 Total current liabilities 4,958 Mortgage payable 3,000 Total liabilities 7,958 Owners Equity 4,986 Total liabilities & equities $12,944
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Revenues Expenses: Salary & wages Supplies Depreciation Other Total expenses Operating margin Interest: Mortgage Loan Net income

664

3. This requirement asks for a Statement of Cash Flows. Such a statement is not shown in Chapter 7, but it is covered in Chapter 16. Students who do not have a background in financial accounting might be directed to skip this requirement. Amounts are in thousands. SALT LAKE LIGHT OPERA Statement of Cash Flows For the Year Ended December 31, 20X5 Cash flows from operating activities: Cash receipts Cash disbursements: Supplies Payroll Interest Other Net cash provided (used) by operations Cash flows from investing activities: Investment in plant and equipment Net cash used for investing activities Cash flows from financing activities: Principal payments on mortgage Receipts from bank loan Net cash provided by financing activities Net increase (decrease) in cash Beginning cash balance, 1/1/20X5 Ending cash balance, 12/31/20X5

$9,304 [11,059 1,755] (980) [780 + 200] (8,346) [2,046 + (3 x 2,100)] (307) [32 + 140 + 135] (120) (449)

(640) (640)

(250) 1,331 1,081 (8) 208 $ 200

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4. Salt Lake Light Opera has a net income of $575,000 but a shortfall in cash requiring borrowing of $1,720,000 (1,331,000 borrowed plus accrued interest of 389,000). This is not uncommon for a growing organization. However, it is borrowing on a shortterm basis via a working capital loan, while the need seems to be a long-term need. The $640,000 of investment is clearly long-term, but the $449,000 needed for operations also appears to be a longterm need unless receivables can be collected more quickly. Therefore, SLLO should consider additional long-term borrowing, possibly a second mortgage. The organization is in danger of defaulting on its loan because it cannot meet the condition that the loan must be paid off at least once a year, so it needs a loan without such a stipulation.

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7-44 (40-60 min.) 1. HIGHLINE HOSPITAL Budgeted Cash Receipts For the Quarter Ending September 30, 20X7 (in thousands)

Calculation July August September May: 3rd-party billings .9 x 6000 x .2 $1,080 May: patient billings .1 x 6000 x .4 240 June: 3rd-party billings .9 x 6000 x .2 $1,080 June: patient billings .1 x 6000 x .4 240 June: 3rd-party billings .9 x 6000 x .5 2,700 June: patient billings .1 x 6000 x .4 240 July: 3rd-party billings .9 x 5800 x .2 $ 1,044 July: patient billings .1 x 5800 x .4 232 July: 3rd-party billings .9 x 5800 x .5 2,610 July: patient billings .1 x 5800 x .4 232 July: 3rd-party billings .9 x 5800 x .2 1,044 July: patient billings .1 x 5800 x .1 58 August: 3rd-party billings .9 x 6000 x .5 2,700 August: patient billings .1 x 6000 x .4 240 August: 3rd-party billings .9 x 6000 x .2 1,080 August: patient billings .1 x 6000 x .1 60 Sept: 3rd-party billings .9 x 6600 x .2 1,188 Sept: patient billings .1 x 6600 x .1 66 Total receipts from billings $5,362 $5,302 $5,470 Endowment fund income 210 210 210 Total cash receipts $5,572 $5,512 $5,680

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2.

Budgeted Cash Disbursements For the Quarter Ending September 30, 20X7 (in thousands) July $2,960 August September $3,000 1,500 $4,500 $3,120 1,800 540 $5,460

Salaries:

$1,800 + (.2 x $5,800) $1,800 + (.2 x $6,000 ) $1,800 + (.2 x $6,600) Purchases, previous month 1,450 Interest Total cash disbursements $4,410 3.

Budgeted Cash Receipts and Disbursements For the Third Quarter, 20X7 (in thousands) 350 16,764 (14,370) $ 2,744 (220) $ 2,524 (4,000) $ (1,476) $

Beginning cash balance Budgeted cash receipts ($5,572 + $5,512 + $5,680) Less budgeted cash disbursements ($4,410 + $4,500 + $5,460) Budgeted cash balance, September 30, 2007 Minimum cash balance (.1 x $2,200) Cash available for capital expenditures Budgeted capital expenditures Borrowing needed on October 1, 2007

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7-45 (50-60 min.) 1. MINNESOTA STATE UNIVERSITY Projected Enrollment, Credits, and Faculty Academic Year 2007-08 Undergraduate Graduate Expected enrollmenta 3,528 1,890 Average credit hours 25 20 b Total credit hours 88,200 37,800 Full-time-equivalent enrollmentc 2,940 1,575 Credit hours per faculty memberd 720 360 e Total faculty needed 122.5 105
a

Total 5,418 126,000 4,515 1,080 227.5

98% x 3,600 = 3,528; 105% x 1,800 = 1,890 25 x 3,528 = 88,200; 20 x 1,890 = 37,800 c 88,200 / 30 = 2,940; 37,800 / 24 = 1,575 d 24 x 30 = 720; 18 x 20 = 360 e 88,200 / 720 = 122.5; 37,800 / 360 = 105
b

2.

MINNESOTA STATE UNIVERSITY Faculty Salaries Budget Academic Year 2007-08 Total Faculty Salaries $ 7,531,300 6,455,400 $13,986,700

Undergraduate Graduate Total

Faculty Needed 122.5 105.0 227.5

Average Salary $61,480 61,480

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3.

MINNESOTA STATE UNIVERSITY Tuition and Legislative Revenue Budget Academic Year 2007-08 Graduate Division Total 37,800 126,000 1,200 2,100 36,600 123,900 x $92 x $92 $3,367,200 $11,398,800 1,575 4,515 x $780 $1,228,500 x $780 $3,521,700

Undergrad Division Total credit hours 88,200 Less: Scholarship credit hours* 900 Tuition paying credit hours 87,300 Tuition per credit hour x $92 Total tuition budget $8,031,600 Full time equivalent students 2,940 Legislative apportionment per full-time equivalent student x $780 Total legislative apportionment $2,293,200
*30 x 30 = 900; 50 x 24 = 1,200

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4.

MINNESOTA STATE UNIVERSITY Annual Budget Shortfall Academic Year 2007-08

Budgeted operating expenditures: Faculty salaries $13,986,700 Operation and maintenance of facilities: Salaries and wages (1.06 x $240,000) 254,400 Other ($260,000 + $12,000) 272,000 General Administrative 525,000 Library: Acquisitions 155,000 Operations 200,000 Health Services 50,000 Intramural athletics 60,000 Intercollegiate athletics 245,000 Insurance and retirement 560,000 Interest 75,000 Total budgeted operating expenditures $16,383,100 Budgeted revenues: Tuition $ 11,398,800 Legislative apportionment 3,521,700 Endowment income 210,000 Auxiliary services 335,000 Intercollegiate athletics 300,000 Total budgeted operating revenues $15,765,500 Deficit from operations $ 617,600 Budgeted capital expenditures 575,000 Total cash needed from fund-raising $ 1,192,600

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7-46 (30 min.) 1. 10% revenue increase 10% revenue decrease Revenue $ 16,450 $ 13,459 Cost of Sales 9,212 7,537 Gross Margin 7,238 5,922 S&A Expense 4,918 4,024 Income before income taxes 2,320 1,898 Income tax expense 812 664 Net income $ 1,508 $ 1,234 2. 10% revenue increase 10% revenue decrease Revenue $ 16,450 $ 13,459 Cost of Sales 9,212 7,537 Gross Margin 7,238 5,922 S&A Expense 4,478 4,478 Income before income taxes 2,760 1,444 Income tax expense 966 505 Net income $ 1,794 $ 939 In part 1, where all costs are variable, budgeted net income increases or decreases by 10% in proportion to the 10% change in revenue. In part 2, where some costs are fixed, budgeted net income increases or decreases by a larger percentage than the 10% change in revenue. 3. 45% Gross margin Revenue $ 14,955 Cost of Sales 8,225 Gross Margin 6,730 S&A Expense 4,478 Income before income taxes 2,252 Income tax expense 788 Net income $ 1,464 43% gross margin $ 14,955 8,524 6,431 4,478 1,953 684 $ 1,269

Note how a small change in the gross margin percentage translates into a large change in budgeted net income.
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7-47 For the solution, see the Prentice Hall Web site, www.prenhall.com/ 7-48 (30-60 min.) The purpose of this exercise is to prepare a budget for an organization (an individual student) that is familiar to all students and to see the effect of assumptions on the budget. Each student will have some ideas about both the revenue and expense budgets of a typical student, but these ideas will likely vary across students. They will experience the process of negotiation needed to get a budget that the group can agree on. When the groups get together and compare budgets, it will be instructive to see how different groups make different assumptions that lead to different budgets. This should reinforce the importance of assumptions to the budget process and show how decisions made during the budget process affect the resulting budget.

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7-49 (30-45 min.) NOTE TO INSTRUCTOR. This solution is based on the 2006 10-K which was the most recent set of annual results available on the web site in early 2007 when the book went to press. Be sure to examine the current web site before assigning this problem, as the information there may have changed. 1. There are 12 brand lines under the corporation shell. They are Carnival Cruise Lines, Holland America Line, Princess Cruises, Seabourn Cruise Line and Windstar Cruises in North America; P&O Cruises, Cunard Line, Ocean Village and Swan Hellenic in the United Kingdom; AIDA in Germany; Costa Cruises in southern Europe; and P&O Cruises in Australia. Each brand has a slightly different focus. Each of the lines focuses on a different part of the world or offers a different class of cruise. Different names allow for the association or branding of a particular line with a particular type of cruise. For instance, Windstar focuses on the exotic locations and the sailing ship experience while Carnival focuses on more of a festive atmosphere on board ship that is, fun times. The corporation also operates 3 riverboats on the Danube River and several tour companies. 2. Total revenues in fiscal 2006 were $11,839 million. The occupancy percentage was 106%. Notice that occupancy is greater than 100%. How can one explain this? For Carnival, it means that capacity is defined as two persons per room, so when more than two persons occupy a room capacity utilization is greater than 100%.

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3. According to managements estimate, capacity will increase 5.8% per year for the next three years. Assuming that revenue increases in proportion to capacity, budgeted revenue for the next two years would be: 2007: 1.058 x 11,839 million = $12,526 million 2008: 1.058 x 12,526 million = $13,252 million Of course, with added revenue from additional cruise days there would be added costs. If added cruise days were achieved by making better use of existing capacity, costs would probably not increase proportionately with the volume. Some fixed costs would not be likely to change. However, since the added volume requires adding capacity, costs would probably increase nearly proportionally to the increase in volume. A few fixed costs, for example corporate headquarters costs, might not increase much, but even costs that are fixed for a given level of capacity will increase if capacity needs to be increased. 4. The prices for cruises of the same length to the same location are not all the same. They differ according to when the cruise dates are high season or low season and also according to the level of capacity utilization that the particular cruise has achieved. The firms goal is to have the maximum capacity utilization possible for each cruise. If demand is high for a particular cruise, then the firm will be able to command a higher price and still fill the cabins. Since much of the cost of the cruise is likely to be fixed in nature, the firm will incur the cost even if they dont fill the cabins. Thus, a price that covers variable cost and contributes to fixed costs will be preferred to an empty cabin. Destinations or dates that are less popular are cheaper because once the company schedules the cruise, it is in its best interests to fill as many cabins as possible as long as the price is above the variable costs. Last-minute deals can be especially cheap if a particular cruise looks like it is likely to have excess capacity.
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