MODULE 2 – PROFIT PLANNING: OPERATION
BUDGET PART 1 production budget.
2.1 DESCRIPTION
Define and Role
BUDGETING - the creation of a plan of action
expressed in financial terms.
- process where an entity translates
their operations in quantitative terms
to represent it as its planned
operations, activities, and production
for a specific time period in
consideration.
- plays a key role in planning,
controlling and decision making.
Objectives:
1. Provide a realistic estimate of income and
expenses.
2. Provide a coordinated plan of action for the entity.
3. Serve as a control mechanism that can be used in
performance evaluation by being able to check
results and suggest future corrective actions.
4. Provide guidance to the management.
5. Help in decision-making.
6.Provide communication, coordination, and
harmonious operations within the entity.
Benefits:
1. Compels managers to think ahead.
2. Provides an opportunity to re-evaluate existing
activities and evaluate new ones.
3. Aids managers in communicating objectives and
coordinating actions across the organization.
4. Provides benchmarks to evaluate subsequent
performance.
-Budgets serve to improve communication and
coordination, a role that becomes increasingly
important as organizations grow in size.
-The MASTER BUDGET, which is the comprehensive
financial plan of an organization, is made up of the
operating and financial budgets.
2.2 PREPARING THE OPERATIONAL BUDGET
OPERATING BUDGET - the budgeted income
statement and all supporting budgets.
1. SALES BUDGET - consists of the anticipated
quantity and price of all products to be sold. It is
done first, and the results feed directly into the
2.PRODUCTION BUDGET - gives the expected
production in units to meet forecasted sales and
desired ending inventory goals.
- Expected production is supplemented by beginning
inventory. The results of the production budget are
needed for the direct materials purchases budget
and the direct labor budget.
3. DIRECT MATERIAL PURCHASES BUDGET - gives
the necessary purchases during the year for every
type of raw material to meet production and desired
ending inventory goals.
4. DIRECT LABOR BUDGET - shows the number of
labor hours, and the direct labor cost needed to
support production. The resulting direct labor hours
are needed to prepare the overhead budget.
5. OVERHEAD BUDGET - may be broken down into
fixed and variable components to facilitate
preparation of the budget.
6. SELLING AND ADMINISTRATIVE BUDGET - gives
the forecasted costs for these functions.
7. FINISHED GOODS INVENTORY BUDGET & COST
OF GOODS SOLD BUDGET - detail production costs
for the expected ending inventory and the units sold,
respectively.
Leads to the creation of -> BUDGETED INCOME
STATEMENT
- The budgeted income statement outlines the net
income to be realized if budgeted plans come to
realize.
2.3 PREPARING THE FINANCIAL BUDGET
FINANCIAL BUDGET - includes the cash budget, the
capital expenditure budget, and the budgeted
balance sheet.
1. CASH BUDGET - the beginning balance in the cash
account, plus anticipated receipts, minus anticipated
disbursements, plus or minus any necessary PLANNING, CONTROL AND BUDGETS
borrowing.

2. CAPITAL ACQUISITIONS BUDGET

3. BUDGETED FINANCIAL STATEMENTS

BUDGETED BALANCE SHEET - gives the anticipated
ending balances of the asset, liability, and equity
accounts if budgeted plans hold.

2.4 USING BUDGETS FOR PERFORMANCE

EVALUATION
Behavioral dimensions
- The success of a budgetary system depends on how
seriously human factors are considered.
- To discourage dysfunctional behavior,
organizations should avoid overemphasizing budgets ADVANTAGES:
as a control mechanism. - compels periodic planning
- Budgets can be improved as performance - enhances coordination, cooperation, and
measures by using: communication
- forces qualification plans and proposals
(1) participative budgeting and other nonmonetary
- provides a framework for performance evaluation
incentives - enables members of the organization to be aware
(2) providing frequent feedback on performance of business costs
(3) using flexible budgeting - satisfies some legal and contractual requirements
(4) ensuring that the budgetary objectives reflect - directs the firm’s activities toward the achievement
reality of organizational goals
(5) holding managers accountable for only
LIMITATIONS:
controllable costs. - budgets per se are merely estimates involving risk
and uncertainty
BUDGET - requiring a certain amount of judgment
- is a financial plan of the resources needed to carry - for some, the costs involved in developing a budget
out tasks and meet financial goals and implementing a budgetary program maybe
- quantitative expression of the goals more than the benefits that may be derived
therefrom
- usually monetary – terms of a desired future result
MASTER BUDGET – the comprehensive financial plan
Purposes: for the organization as a whole
a. Communicating approved future plans
b. Coordinating operations
c. Motivating managers
d. Setting a standard or basis of evaluation against
which actual performance can be measured.
Types of Budgets: (Major Composition of the MODULE 3 – PROFIT PLANNING: CASH-VOLUME-
Master Budget) PROFIT- ANALYSIS PART 2
a. Operating Budget
b. Financial Budget
3.1 BREAKEVEN IN UNITS AND IN PESOS
c. Capital Budget
Cost-Volume-Profits (CVP) Analysis
OPERATING BUDGET - Estimates how CHANGES in COSTS (both variable
1. Budgeted Income Statement and fixed), SALES VOLUME and PRICE affect a
a. Sales Budget company’s profit.
b. Production Budget - Powerful tool for planning and decision making
1) Materials Cost Budget Break-even-point – is the point where total revenue
2) Direct Labor Cost Budget
EQUALS cost (...the point of ZERO profit) no loss, no
3) Factory Overhead Budget
profit
4) Inventory Levels
c. Cost of Sales Budget - Helps managers pinpoint problems and find
d. Selling and Administrative Budget solutions
- Addresses many other issues:
FINANCIAL BUDGET  The number of units that must be sold to
1. Budgeted Balance Sheet breakeven
2. Cash Budgeted
 The impact of a given reduction in fixed costs
3. Budgeted Statements of Sources and Uses of
Funds on the break-even point
 The impact of an increase in price on profit
CAPITAL BUDGET
- contains planned acquisitions of major items like - Allows managers to do sensitivity analysis by
PLANT and EQUIPMENT . examining the impact of various price or cost levels
- involves some of the most critical budgeting
on profit.
decisions in an organization because capital
expenditure projects usually require LARGE cash
outlays and cover longer time periods. Using Operating Income in Cost-Volume-Profit
Analysis
Budgeting Terminologies:  OPERATING INCOME = Total revenue – Total
Fixed Budget – projection of cost at a particular or expenses
one level of production (usually at normal capacity) -Expenses are classified according to function:
for a definite time period. (1) manufacturing function, (2) selling function and
the (3) administrative function
Flexible Budget – projection of cost at different - All product and period costs do end up as expenses
levels of production for a definite period of time. on the income statement
Physical Budget - budget that is expressed in units of - Assumed that all units produced are sold
materials, number of employees, or number of
manhours or service units rather than in pesos.  CVP
- Organize costs into fixed and variable components
Planning Budget – (static budget) another - Focus is on the firm as a whole
term for master budget. - Cost – refer to all costs of the company –
production, selling and administrative
Zero based budget – a system of establishing  Variable cost – direct materials, direct labor,
financial plans beginning with an assumption of no variable overhead, variable
activity and justifying each program or activity level. selling and administrative cost
 Fixed cost – fixed costs, fixed selling and
administrative expenses
 Contribution Margin Income Statement Contribution margin ratio = 1 – variable cost ratio
- Based on the separation of costs into fixed and
variable components  Break-even sales in pesos:
FORMAT for the Contribution Margin Income Statement: Break-even sales = Total fixed costs .
Sales P xxxx Contribution margin ratio
Total Variable cost xxxx
Total CONTRIBUTION MARGIN xxxx 3.2 UNITS AND PESO SALES TO ACHIEVE A TARGET
Total fixed cost xxxx INCOME
Operating income xxxx
SALES REVENUE to achieve a TARGET INCOME:
Contribution margin - the difference between sales
and variable expense. It is the amount of sales
Sales in Pesos = Fixed cost + Target Income
revenue left over after all the variable expenses
Contribution Margin ratio
are covered that can be used to contribute to fixed
expense and operating income.
Assuming fixed cost remain unchanged:
Change in profit = Contribution margin ratio x Change in
 Break-even point in units sales
Operating Income = Sales – Total variable expenses – Total fixed
expenses
Margin of safety – difference between actual or
budgeted sales and break-even sales. This is the
Operating income = (Price x Number of units sold) – (Variable cost amount that represents at how much can sales go
per unit x Number of units sold) - Total fixed cost down before the entity can anticipate losses.

Operating Income = Contribution Margin – Total fixed expenses

Margin of safety ratio – is MOS divided by the actual
Break-even units = ___Total Fixed cost___ or budgeted sales or by dividing profit ratio by the
Price – Variable cost per unit contribution margin ratio.

 Break-even point in Sales Pesos Sales mix – is the combination of products that, in
 Variable Cost Ratio: total, will compose the reported sales of an entity,
- Is the proportion of each peso sales that must be applicable to multiple product line companies.
used to cover variable costs.
Key assumptions in CVP Analysis:
Sales revenue = Unit selling price x Units sold 1. Costs are classified as variable or fixed.
2. Variable costs change at a linear rate.
Price per unit – Variable cost per unit = Contribution margin per 3. Fixed costs remains unchanged within the
unit relevant rage.
4. Selling prices do not change as sales volume
VARIABLE COST RATIO = Variable cost per unit changes.
PRICE 5. For multiple product companies, sales mix usually
remain constant.
 Contribution Margin Ratio: 6. Inventory remains constant and is not focused too
- The percentage of peso sales remaining after much in CVP analysis.
variable costs are covered. 7. Volume is the greatest factor affecting costs.
- Is the proportion of each peso sales available to
cover fixed costs and provide for profit.
3.3 GRAPHS CVP RELATIONSHIPS
CMR = Total Contribution margin
Total Sales
 GRAPH OF COST-VOLUME-PROFIT
RELATIONSHIPS
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3.4 MULTIPLE PRODUCT ANALYSIS

3.5 COST-VOLUME-PROFIT-ANALYSIS AND RISK

AND UNCERTAINTY