Logistics

• Midterm solution: check the videos on

Canvas
• Homework on Chapter 7 & 8: due after
the spring break
• Quiz 3 on Chapter 6 & 7: in-class after
the spring break
 Chapter 6: dealing with excess supply and
excess demand
 Chapter 7: budgeting

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 Chapter 7

Operating Budgets
 Budget
• A budget is a plan for using limited resources
• The goals we are trying to achieve in a specific
period
• How we plan to achieve these goals

• Firms use budgets for

• Planning
• Coordination
• Control

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 Planning
• Budgets force managers to think ahead and find the best
way to use available resources
 Long-term strategic goals => short-term decisions to achieve these
goals, captured in short-term operating budgets

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 Coordination
• In decentralized companies, many decisions are delegated to
lower-level managers. Therefore, different departments must
communicate and coordinate with each other
• Budgets highlight linkages among departments and force
them to communicate and to work toward company goals
• Budgets are prepared by cross-functional teams of employees
from multiple departments

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 Control
• Budgets provide a benchmark for evaluating actual
performance
• Compare actual vs budgeted performance to
 Detect problem areas
 Evaluate managers’ performance
 Identify unrealistic assumptions made during planning

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 Preparing the Master Budget*

* master budget – full package of operating budgets

for all areas of operations + financial budgets
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 Road map

Selling, general &

admin. costs

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 Revenue Budget
• Starting point for master budget

• Based on:
 the price you expect to charge
 expected future sales (estimates from Market Research)

Budgeted price = $50 per unit.

Sales estimates are: 500 units in the 1st quarter, 400 in the 2nd
quarter, 600 in 3d quarter, 500 in 4th quarter.

Q1 Q2 Q3 Q4 Total
Sales in units 500 400 600 500 2,000
Price per unit $50 $50 $50 $50
Revenue $25,000 $20,000 $30,000 $25,000 $100,000

9 =sales*price
 Production Budget
Budgeted production depends on
• expected sales from the revenue budget
• inventory policy for finished goods
Btw, why do firms carry inventory?
e.g., your inventory policy is to have ending
inventory equal to 20% of next quarter’s sales.

Q1 Q2 Q3 Q4 Total from the

revenue budget
Sales in units 500 400 600 500
+ desired ending based on
80 120 100 120 inventory policy
inventory (=0.2*400) (=0.2*600)
=total requirements 580 520 700 620
− beginning inventory 100 80 120 100 =ending inventory
from previous
= budgeted production 480 440 580 520 2,020 quarter

budgeted production = expected sales + desired ending inventory

− beginning inventory
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 Exercise: Production Budget
April May June
Desired ending inventory (1) (5) (7)
Beginning inventory (2) (4) (6)
Budgeted sales 10,000 15,000 20,000
Budgeted production (3) 15,500 21,000
Inventory policy: desired ending inventory for current month = 10% of
expected sales for next month.
Fill in the missing numbers

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 Budgets for Inputs (DL, DM, overhead)
• Direct Materials Usage Budget
• Based on estimates of materials per unit of output
and prices of materials
• Direct Labor Usage Budget
• Based on estimates of DL hours per unit of output
and wage per hour
• Overhead Budget
• Based on estimates of fixed overhead and variable
overhead per unit of output

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 Direct Materials Usage Budget
You budgeted to use 2 pounds of materials per unit, at a
budgeted cost of $5 per pound.
Q1 Q2 Q3 Q4 Total from
production
budgeted production 480 440 580 520 budget
materials per unit, lb 2 2 2 2
cost of materials, per lb $5 $5 $5 $5
total cost of direct $4,800 $4,400 $5,800 $5,200 $20,200
materials (=480*2
*$5)

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 Direct Labor Usage Budget
You budgeted to use 2 hours of direct labor per unit, at a
budgeted cost of $10 per hour.
Q1 Q2 Q3 Q4 Total from
production
budgeted production 480 440 580 520 budget
labor hours per unit 2 2 2 2
cost of labor, per hour $10 $10 $10 $10
total cost of direct labor $9,600 $8,800 $11,600 $10,400 $40,400
(=480*2
*$10)

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 Overhead Budget
Budgeted variable overhead rate is $5 per unit.
Budgeted fixed manufacturing overhead is $2,250 per quarter.

Q1 Q2 Q3 Q4 Total
VARIABLE OVERHEAD from
production
budgeted production 480 440 580 520 budget
variable overhead rate $5 $5 $5 $5
per unit
Total variable overhead $2,400 $2,200 $2,900 $2,600 $10,100
(=480*$5)
FIXED OVERHEAD
Total fixed overhead $2,250 $2,250 $2,250 $2,250 $9,000

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 Selling, General & Administrative Costs
(SG&A Costs) Budget
• Linked to revenue budget

• Budgeted variable SG&A costs are $3/unit, budgeted fixed

SG&A costs are $3,000 per quarter

Q1 Q2 Q3 Q4 Total
Variable SG&A costs
from
Sales in units 500 400 600 500 revenue
budget
Var. SG&A/unit $3 $3 $3 $3
Total variable SG&A $1,500 $1,200 $1,800 $1,500 $6,000
Fixed SG&A costs
Total fixed SG&A $3,000 $3,000 $3,000 $3,000 $12,000

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 Budgeted Contribution Margin
Statement
combine annual totals from previous budgets:
Budgeted sales in units 2,000
Revenue $100,000
Variable costs:
variable COGS $70,000
variable SG&A $6,000
Contribution margin $24,000
Fixed costs:
fixed manuf. overhead $9,000
fixed SG&A $12,000
Profit before taxes $3,000

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 Cash Budget
Measures cash inflows and outflows from operating, investing,
and financing activities
 cash inflows and outflows differ from revenues and costs on the
income statement:
 revenue is recognized when the product was sold, not when the
cash was collected
 product costs are expensed when the product was sold (matching
of costs to revenues), not when the cost was incurred
 depreciation is a non-cash cost item (not a cash outflow)
 investing and financing activities
=> use cash budget to determine whether you will have enough cash on
hand to sustain operations

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 Cash Inflows from Operations
• The main cash inflow is proceeds from sales
• To estimate cash inflows, sales revenue needs to be adjusted
for the firm’s credit policy:
 if you offer credit to customers, some of them will pay you weeks or
months after the sale
 sales revenue is recognized on the income statement when the sale
took place, not when you actually received the $$$

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 Example: Cash Inflows from Sales
Many of your customers buy on credit (i.e., part of sales revenue is collected
as cash several months after the sale).
On average, you collect 60% of revenue in the month of the sale, 35% of
revenue in the following month, and 5% of revenue two months later.
Compute cash inflows for May.
Month Sales
March $150
April $100
May $130

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 Exercise: Cash Inflows from Sales
Wallmart’s budgeted sales are as follows:
January $150,000
February $160,000
March $172,000
The company expects to collect 75% of a month’s sales in
the month of the sale and 25% in the following month.
Compute cash inflows for February.

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 (continued) Cash Flows
Cash outflows from operations: purchases of direct
materials, payment to direct labor, expenditures on
manufacturing overhead and SG&A costs
adjust for credit terms with suppliers
adjust for non-cash items (e.g., depreciation)
• Cash flows from investing and financing activities
• Cash outflows: purchase of machines, payment of dividends, loan
payments
• Cash inflows: sale of machines, sale of stock in capital market, loans
received

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 Exercise: Managing a Cash Shortage
According to the income statement for the current quarter, the firm is
profitable. According to the cash budget, the firm is likely to run out of
cash by the end of the quarter. Which of the following are
reasonable ways to deal with this cash shortage?
• borrow money from a bank  YES  NO
• pay the suppliers later than usual (and incur a small penalty for late
payment)  YES  NO
• invest in new equipment that reduces direct labor costs
 YES  NO
• postpone purchases of new equipment  YES  NO
• encourage customers to pay their bills early (e.g., offer them a small
discount for early payment)  YES  NO
• trick question: a profitable company cannot run out of cash
 YES  NO
• offer a discount to customers who pay in cash  YES  NO
• buy a new information system to have better data on the day-to-day
operations of the firm  YES  NO
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 Gaming the System and Budgetary Slack
Scenario 1: You are a sales manager. During the budgeting process, your
boss asked you for your best estimate of next year’s sales (you
understand the market much better than your boss). The sales budget will
be based on the number that you provide. You will get a bonus at the end
of the year only if actual sales are higher than budgeted. A realistic sales
estimate is 10,000 units.
You really want to get a bonus. Which sales estimate will you give to
your boss?

 9,000 units
 10,000 units
 11,000 units

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 Gaming the System and Budgetary Slack
Scenario 2: You are a production manager. During the budgeting process,
your boss asked you for your best estimate of direct labor hours per unit
for next year (you understand the production process much better than
your boss). The direct labor budget will be based on the number that you
provide. You will get a bonus at the end of the year only if actual direct
labor per unit is less than budgeted (i.e., only if labor is used more
efficiently than budgeted). A realistic estimate is 5 direct labor hours per
unit.
You really want to get a bonus. Which estimate will you give to your
boss?

 4 hours per unit

 5 hours per unit
 6 hours per unit

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