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Profit Planning

Learning Objectives
1. Understand why organizations budget and the processes they use to create budgets.
2. Prepare a sales budget, including a schedule oI expected cash receipts.
3. Prepare a production budget.
4. Prepare a direct materials budget, including a schedule oI expected cash
disbursements.
5. Prepare a direct labor budget.
6. Prepare a manuIacturing overhead budget.
7. Prepare an ending Iinished goods inventory budget.
8.Prepare a selling and administrative expense budget.
9. Prepare a cash budget.
10. Prepare a budgeted income statement and a budgeted balance sheet.
Lecture Notes
A. The Basic Budgeting Framework. A budget is a detailed plan outlining the
acquisition and use oI Iinancial and other resources over a speciIied time period.
1. Planning and control. A good budgeting system must provide Ior both planning
and control. Planning involves developing objectives and preparing various budgets to
achieve those objectives. Control involves the steps taken by management to ensure
that the objectives set down at the planning stage are attained and that all parts oI the
organization work together towards those objectives.
2.Advantages of budgeting. There are many advantages to budgeting, including:
O udgeting provides managers with a vehicle Ior communicating their
plans in an orderly way throughout the entire organization.
O udgeting requires managers to give planning top priority.
O udgeting provides a means oI allocating resources to those parts oI the
organization where they can be most eIIectively used.
O udgeting uncovers potential bottlenecks beIore they occur.
O udgeting coordinates the activities oI the entire organization by
integrating the plans and objectives oI the various parts.
O udgets provide benchmarks Ior evaluating subsequent perIormance.
. Responsibility accounting. A manager should be held responsible Ior those items
oI revenues and costs-and only those items-that the manager can actually control to a
signiIicant extent. The manager who is held responsible Ior a speciIic cost should
have a budget speciIying a limit on how much can be spent. This limit may be
adjusted, depending upon the activity during the period. This idea will be developed
in later chapters.
. Choosing a budget period. udget periods vary in length. Some may be as short
as a month, whereas others may cover many years. The most common budgeting
period, however, is a year.
O perating budgets ordinarily cover a one-year period. Additionally,
many companies divide their operating budgets into quarterly or monthly
periods.
O A continuous or perpetual budget is one that covers a 12-month period
but which adds a new month on the end as the current month is
completed. This approach stabilizes the planning horizon at one year.
. Self-imposed participative budget. The most successIul budget programs involve
lower-level managers in preparing their own budgets. There are two basic reasons: 1)
lower-level managers are more Iamiliar with the details oI their own operations than
top managers and 2) managers tend to be more committed to budgets that they have
been able to inIluence.
6. Human relations. Management must keep clearly in mind that budgeting involves
coordinating and motivating people and the human dimension is oI primary
importance.
O Top managers must clearly convey the message in actions as well as in
words that budgeting is important. II top management appears to be
ambivalent about the beneIits oI budgeting, others in the organization
will be reluctant to commit their own time and energy to the budgeting
process.
O II there is a preoccupation with getting every dollar and cent right or
with placing blame, the budgeting process will be resented and managers
will attempt to "game the system." udgets should not be used as a club.
They should be a way oI ensuring that everyone understands what is
expected. SigniIicant deviations Irom the budget should be investigated
so that managers understand changing conditions and their implications
Ior the organization. Managers should not ordinarily be punished Ior
deviations Irom the budget.
B. Preparing the Master Budget. The master budget consists oI a number oI
separate, but interrelated budgets. The interrelationships among these various budgets
are illustrated in Exhibit 9-2 in the text. Schedules 1 through 10 in the text present a
comprehensive example oI a master budget.
%. Budgets in large organi:ations can be very complex. The budgets in the text
are substantially simplified. Even so, these simplified budgets are quite intricate and
the level of detail may appear overwhelming. Each step in the process is fairly simple,
but the budgets must fit together. Return to Exhibit 9-2 from time to time to provide
the context for each of the separate budgets making up the master budget.
1. The Sales Budget (Schedule 1 in the text). The sales budget is a detailed schedule
showing the expected sales Ior the coming period. It is typically expressed in both
dollars and units oI the product. The sales budget is usually accompanied by a
schedule oI expected cash receipts. The schedule oI expected cash collections should
take into account delays in collecting credit sales.
2. The Production Budget (Schedule 2 in the text). The budgeted production Ior each
period can be determined by adding together the budgeted sales and the desired
ending inventory and then subtracting the beginning inventory. The desired ending
inventory in units Ior each period is usually a predetermined percentage oI budgeted
unit sales Ior the Iollowing period. The production budget is typically expressed in
terms oI physical units rather than in dollars.
In a merchandising Iirm, a merchandise purchases budget would replace the
production budget. The merchandise purchases budget shows the amount oI goods to
be purchased Irom suppliers each period. This can be determined by adding together
the budgeted sales and the desired ending inventory and then subtracting the
beginning inventory. As in a manuIacturing Iirm, the desired ending inventory in units
is usually some predetermined percentage oI the unit sales Ior the Iollowing period.
. The Direct Materials Budget (Schedule 3 in the text). nce production needs
have been determined, a direct materials budget should be prepared. This budget
details the materials that will be required to IulIill the production budget and to ensure
adequate inventory levels. SuIIicient amounts oI raw material must be acquired to
meet both production needs and to provide Ior desired ending inventories. Materials
purchases can be determined by adding together the materials required Ior production
needs and the desired ending materials inventories and then subtracting the beginning
inventory. The desired ending inventory in units is usually a predetermined percentage
oI the number oI units that are expected to be used in production the Iollowing period.
The direct materials budget is usually accompanied by a schedule oI expected cash
disbursements Ior raw materials. This schedule should take into account any delays
that are anticipated in paying Ior materials.
. The Direct Labor Budget (Schedule 4 in the text). nce production needs are
known, the direct labor budget must be prepared so that the company will know
whether suIIicient labor time is available to meet those needs. The direct labor budget
is typically expressed in both direct labor-hours and in dollars. Translating the direct-
labor requirements into spending can lead to complications iI there is overtime or iI
there is some sort oI guaranteed employment policy.
. The Manufacturing Overhead Budget (Schedule 5 in the text). The
manuIacturing overhead budget lists all production costs other than direct materials
and direct labor. ManuIacturing overhead costs should be broken down by cost
behavior Ior budgeting purposes. Typically, the variable portion oI manuIacturing
overhead is assumed to be proportional to budgeted activity and the Iixed portion is
assumed to be constant in total. Under the assumption that depreciation is the only
signiIicant non-cash manuIacturing overhead expense, the manuIacturing overhead
expense can be converted to a cash Ilow basis by backing out oI the total any
depreciation charges.
6. Ending Finished Goods Inventory Budget (Schedule 6 in the text). This budget
details the amount and value oI ending inventory on the budgeted balance sheet. The
unit product cost Irom this budget is also used to compute the cost oI goods sold Ior
the budgeted income statement. The details oI the computations will depend upon
whether variable or absorption costing is used. Managers oIten want budgets on an
absorption costing basis since that is the basis that will ordinarily be used to report
results to outsiders. Data Ior the computations in this schedule are Iound in the direct
materials, direct labor, and manuIacturing overhead budgets.
7. The Selling and Administrative Expense Budget (Schedule 7 in the text). The
selling and administrative budget lists the anticipated non-manuIacturing expenses Ior
the budget period. In practice this budget is usually made up oI many smaller
individual budgets negotiated with various managers having sales and administrative
responsibilities. Setting appropriate budget limits Ior selling and administrative
Iunctions is one oI the most diIIicult problems in management accounting and is just
beginning to be understood.
8. The Cash Budget (Schedule 8 in the text). The cash budget should be broken
down into time periods that are as short as Ieasible in order to alert management to
problems that may occur due to Iluctuations in cash Ilows. As anyone with a checking
account knows, it is quite possible to have a positive overall cash Ilow during a period
and yet be overdrawn at some point during the period. The cash budget is composed
oI Iour major sections:
a. The receipts section.
b. The disbursements section.
c. Cash receipts, plus the beginning cash balance, less cash disbursements results in
cash excess or deIiciency. II a deIiciency exists, additional Iunds must be arranged
Ior. II an excess exists, previous borrowing can be repaid or short-term investments
made.
d. The Iinancing section oI the cash budget provides a detailed account oI the
borrowing and repayments projected to take place during the budget period. It also
includes a detailing oI interest payments.
%. For simplicity, all of the interest calculations in the text, transparencies, and
problems assume simple interest is used with no compounding.
. Budgeted Financial Statements (Schedule 9 in the text). The last components oI
the master budget consist oI the budgeted income statement and the budgeted
statement oI Iinancial position. The balance sheet is perhaps the most diIIicult oI the
statements to construct in the examples we use. It requires pulling together data Irom
a variety oI schedules and sources.
%. After reviewing the makeup of each budget within the master budget, return to
Exhibit 9-2 and think of how the order in which the various budgets are prepared
could be altered. This process helps to clarify in your mind the interrelationships of
these various budgets.