11th Edition

Chapter 9

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 Profit Planning

Chapter Nine

McGraw-Hill/Irwin Copyright © 2006, The McGraw-Hill Companies, Inc.

 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 activity is known as
budgetary control.

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 Planning and Control

Planning
Planning –– Control
Control ––
involves
involves developing
developing involves
involves the
the steps
steps
objectives
objectives and
and taken
taken by
by
preparing
preparing various
various management
management that that
budgets
budgets to
to achieve
achieve attempt
attempt to
to ensure
ensure
these
these objectives.
objectives. the
the objectives
objectives are
are
attained.
attained.

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 Advantages of Budgeting

Define goal
and objectives
Communicate Think about and
plans plan for the future

Advantages
Coordinate Means of allocating
activities resources

Uncover potential
bottlenecks

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 Responsibility Accounting

Managers
Managers should
should bebe held
held responsible
responsible for
for those
those
items
items — — and
and only
only those
those items
items —
— that
that
the
the manager
manager cancan actually
actually control
control
to
to aa significant
significant extent.
extent.

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 Choosing the Budget Period

Operating Budget

2003 2004 2005 2006

The annual operating budget A continuous budget is a 12-

may be divided into quarterly
or monthly budgets.
McGraw-Hill/Irwin
month budget that rolls forward
one month (or quarter) as the
current month (or quarter) is
completed.
Copyright © 2006 The McGraw-Hill Companies, Inc.
 Self-Imposed Budget

Top M an ag em en t

M id d le M id d le
M an ag em en t M an ag em en t

S u p ervis or S u p ervis or S u p ervis or S u p ervis or

A budget is prepared with the full cooperation and

participation of managers at all levels. A participative
budget is also known as a self-imposed budget.
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 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. AA 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-
Self-
imposed
imposed budgets
budgets eliminate
eliminate thisthis excuse.
excuse.
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 Self-Imposed Budgets

Most companies do not rely exclusively upon

self-imposed budget in the sense that top
managers usually initiate the budget process
by issuing broad guidelines in terms of overall
profits or sales.

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 Human Factors in Budgeting

The
The success
success of
of budgeting
budgeting depends
depends uponupon three
three
important
important factors:
factors:
1.
1. Top
Top management
management mustmust be
be enthusiastic
enthusiastic and
and
committed
committed toto the
the budget
budget process.
process.
2.
2. Top
Top management
management mustmust not
not use
use the
the budget
budget toto
pressure
pressure employees
employees or or blame
blame them
them when
when
something
something goes
goes wrong.
wrong.
3.
3. Highly
Highly achievable
achievable budget
budget targets
targets are
are usually
usually
preferred
preferred when
when managers
managers areare rewarded
rewarded based
based
on
on meeting
meeting budget
budget targets.
targets.

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 Zero Based Budgeting

A zero-based budget requires managers to

justify all budgeted expenditures, not just
changes in the budget from the prior year.

Most
Most managers
managers argue
argue that
that
zero-based
zero-based budgeting
budgeting is
is too
too
time
time consuming
consuming and
and costly
costly to
to
justify
justify on
on an
an annual
annual basis.
basis.

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 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

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 The Master Budget: An Overview

Sales
Budget
Ending
Finished Goods
Budget Selling and
Production
Administrative
Budget
Budget

Direct Direct Manufacturing

Materials Labor Overhead
Budget Budget Budget

Cash
Budget

Budgeted Financial Statements

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 Budgeting Example

 Royal
Royal Company
Company is is preparing
preparing budgets
budgets for
for the
the
quarter
quarter ending
ending June
June 30.30.
 Budgeted
Budgeted sales
sales for
for the
the next
next five
five months
months are:
are:
 April
April 20,000
20,000 units
units
 May
May 50,000
50,000 units
units
 June
June 30,000
30,000 units
units
 July
July 25,000
25,000 units
units
 August
August 15,000
15,000 units.
units.
 The
The selling
selling price
price is
is $10
$10 per
per unit.
unit.

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 The Sales Budget

The individual months of April, May, and June are

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

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 Expected Cash Collections

•• All
All sales
sales are
are on
on account.
account.
•• Royal’s
Royal’s collection
collection pattern
pattern is:
is:
 70%
70% collected
collected in
in the
the month
month of
of sale,
sale,
 25%
25% collected
collected in
in the
the month
month following
following sale,
sale,
 5%
5% uncollectible.
uncollectible.
•• The
The March
March 3131 accounts
accounts receivable
receivable balance
balance of
of
$30,000
$30,000 will
will be
be collected
collected in
in full.
full.

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 Expected Cash Collections

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 Expected Cash Collections

From the Sales Budget for April.

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 Expected Cash Collections

From the Sales Budget for May.

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 Quick Check 

What
What will
will be
be the
the total
total cash
cash collections
collections for
for the
the
quarter?
quarter?
a.
a. $700,000
$700,000
b.
b. $220,000
$220,000
c.
c. $190,000
$190,000
d.
d. $905,000
$905,000

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 Quick Check 

What
What will
will be
be the
the total
total cash
cash collections
collections for
for the
the
quarter?
quarter?
a.
a. $700,000
$700,000
b.
b. $220,000
$220,000
c.
c. $190,000
$190,000
d.
d. $905,000
$905,000

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 Expected Cash Collections

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 The Production Budget

Sales Production
Budget Budget
ed
andl et
p
Expected
om
C
Cash
Collections

Production must be adequate to meet budgeted

sales and provide for sufficient ending inventory.

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 The Production Budget

• The
The management
management at
at Royal
Royal Company
Company wants
wants
ending
ending inventory
inventory to
to be
be equal
equal to
to 20%
20% of of the
the
following
following month’s
month’s budgeted
budgeted sales
sales in
in units.
units.

• On
On March
March 31,
31, 4,000
4,000 units
units were
were on
on hand.
hand.

 Let’s
Let’s prepare
prepare the
the production
production budget.
budget.

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 The Production Budget

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 The Production Budget

Budgeted May sales 50,000

Desired ending inventory % 20%
March 31
Desired ending inventory 10,000
ending inventory
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 Quick Check 

What
What is
is the
the required
required production
production for
for May?
May?
a.
a. 56,000
56,000 units
units
b.
b. 46,000
46,000 units
units
c.
c. 62,000
62,000 units
units
d.
d. 52,000
52,000 units
units

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 Quick Check 

What
What is
is the
the required
required production
production for
for May?
May?
a.
a. 56,000
56,000 units
units
b.
b. 46,000
46,000 units
units
c.
c. 62,000
62,000 units
units
d.
d. 52,000
52,000 units
units

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 The Production Budget

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 The Production Budget

Assumed ending inventory.

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 The Direct Materials Budget

•• At
At Royal
Royal Company,
Company, fivefive pounds
pounds of of material
material
are
are required
required per
per unit
unit of
of product.
product.
•• Management
Management wants
wants materials
materials on on hand
hand at
at
the
the end
end of
of each
each month
month equal
equal to to 10%
10% ofof the
the
following
following month’s
month’s production.
production.
•• On
On March
March 31,
31, 13,000
13,000 pounds
pounds of of material
material
are
are on
on hand.
hand. Material
Material cost
cost is
is $0.40
$0.40 per
per
pound.
pound.
Let’s
Let’s prepare
prepare the
the direct
direct materials
materials budget.
budget.
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 The Direct Materials Budget

From production budget

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 The Direct Materials Budget

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 The Direct Materials Budget

March 31 inventory

10% of following months Calculate the materials to

production needs. by purchased in May.
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 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 Copyright © 2006 The McGraw-Hill Companies, Inc.

 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

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 The Direct Materials Budget

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 The Direct Materials Budget

Assumed ending inventory

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 Expected Cash Disbursement for Materials

•• Royal
Royal pays
pays $0.40
$0.40 per
per pound
pound for
for its
its materials.
materials.
•• One-half
One-half of of aa month’s
month’s purchases
purchases is is paid
paid for
for in
in
the
the month
month ofof purchase;
purchase; the
the other
other half
half is
is paid
paid
in
in the
the following
following month.
month.
•• The
The March
March 31 31 accounts
accounts payable
payable balance
balance is is
$12,000.
$12,000.

Let’s
Let’s calculate
calculate expected
expected cash
cash disbursements.
disbursements.

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 Expected Cash Disbursement for Materials

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 Expected Cash Disbursement for Materials

Compute the expected cash

disbursements for materials
for the quarter.

140,000 lbs. × $.40/lb. = $56,000

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 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 Copyright © 2006 The McGraw-Hill Companies, Inc.

 Quick Check 

What are the total cash disbursements for the

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

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 Expected Cash Disbursement for Materials

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 The Direct Labor Budget

•• At
At Royal,
Royal, each
each unit
unit of
of product
product requires
requires 0.05
0.05 hours
hours (3
(3
minutes)
minutes) ofof direct
direct labor.
labor.
•• The
The Company
Company has has aa “no
“no layoff”
layoff” policy
policy so
so all
all employees
employees
will
will be
be paid
paid for
for 40
40 hours
hours of of work
work each
each week.
week.
•• In
In exchange
exchange for for the
the “no
“no layoff”
layoff” policy,
policy, workers
workers agree
agree to
to
aa wage
wage rate
rate of
of $10
$10 perper hour
hour regardless
regardless of of the
the hours
hours
worked
worked (No(No overtime
overtime pay).
pay).
•• For
For the
the next
next three
three months,
months, thethe direct
direct labor
labor workforce
workforce will
will
be
be paid
paid for
for aa minimum
minimum of of 1,500
1,500 hours
hours per
per month.
month.
 Let’s
Let’s prepare
prepare the the direct
direct labor
labor budget.
budget.

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 The Direct Labor Budget

From production budget

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 The Direct Labor Budget

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 The Direct Labor Budget

Greater
Greater of
of labor
labor hours
hours required
required
or
or labor
labor hours
hours guaranteed.
guaranteed.
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 The Direct Labor Budget

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 Quick Check 

What
What would
would be be the
the total
total direct
direct labor
labor cost
cost for
for the
the
quarter
quarter ifif the
the company
company follows
follows its
its no
no lay-off
lay-off policy,
policy,
but
but pays
pays $15$15 (time-and-a-half)
(time-and-a-half) for for every
every hour
hour
worked
worked in in excess
excess ofof 1,500
1,500 hours
hours inin aa month?
month?
a.
a. $79,500
$79,500
b.
b. $64,500
$64,500
c.
c. $61,000
$61,000
d.
d. $57,000
$57,000

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 Quick Check 

What
What would
would be be the
the total
total direct
direct labor
labor cost
cost for
for the
the
quarter
quarter ifif the
the company
company follows
follows itsits no
no lay-off
lay-off policy,
policy,
but
but pays
pays $15$15 (time-and-a-half)
(time-and-a-half) for for every
every hour
hour
worked
worked in in excess
excess of of 1,500
1,500 hours April in
hours in a
a month?
Maymonth?
June Quarter
Labor hours required 1,300 2,300 1,450
a.
a. $79,500
$79,500 Regular hours paid 1,500 1,500 1,500 4,500
b.
b. $64,500
$64,500 Overtime hours paid - 800 - 800

c.
c. $61,000
$61,000 Total regular hours 4,500 $10 $ 45,000
d. $57,000 Total overtime hours 800 $15 $ 12,000
d. $57,000
Total pay $ 57,000

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 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 raterate is
is $20
$20 per
per
direct
direct labor
labor hour.
hour.
• Fixed
Fixed manufacturing
manufacturing overhead
overhead is is $50,000
$50,000 perper month
month
and
and includes
includes $20,000
$20,000 ofof noncash
noncash costs
costs (primarily
(primarily
depreciation
depreciation ofof plant
plant assets).
assets).

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

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 Manufacturing Overhead Budget

Direct Labor Budget

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 Manufacturing Overhead Budget

Total mfg. OH for quarter $251,000

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

*rounded
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 Manufacturing Overhead Budget

Depreciation
Depreciation is
is aa noncash
noncash charge.
charge.

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 Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor
Manufacturing overhead

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct materials
budget and information

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 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

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct labor budget

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 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
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

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 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 Budget

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 Selling and Administrative Expense Budget

•• At
At Royal,
Royal, thethe selling
selling and
and administrative
administrative expenses
expenses budget
budget is
is
divided
divided into
into variable
variable and
and fixed
fixed components.
components.
•• The
The variable
variable selling
selling and
and administrative
administrative expenses
expenses are are $0.50
$0.50
per
per unit
unit sold.
sold.
•• Fixed
Fixed selling
selling andand administrative
administrative expenses
expenses are
are $70,000
$70,000 per
per
month.
month.
•• The
The fixed
fixed selling
selling and
and administrative
administrative expenses
expenses include
include
$10,000
$10,000 in in costs
costs –– primarily
primarily depreciation
depreciation –– that
that are
are not
not cash
cash
outflows
outflows of of the
the current
current month
month..

Let’s
Let’s prepare
prepare the
the company’s
company’s selling
selling and
and administrative
administrative
expense
expense budget.
budget.

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 Selling and Administrative Expense Budget

Calculate the selling and administrative

cash expenses for the quarter.
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 Quick Check 

What
What are
are the
the total
total cash
cash disbursements
disbursements for
for selling
selling
and
and administrative
administrative expenses
expenses for
for the
the quarter?
quarter?
a.
a. $180,000
$180,000
b.
b. $230,000
$230,000
c.
c. $110,000
$110,000
d.
d. $$ 70,000
70,000

McGraw-Hill/Irwin Copyright © 2006 The McGraw-Hill Companies, Inc.

 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

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 Selling and Administrative Expense Budget

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 Format of the Cash Budget

The cash budget is divided into four sections:

1. Cash receipts listing all cash inflows excluding
borrowing
2. Cash disbursements listing all payments
excluding repayments of principal and interest
3. Cash excess or deficiency
4. The financing section listing all borrowings,
repayments and interest

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 The Cash Budget

Royal:
Royal:

Maintains
Maintains aa 16%
16% open
open line
line ofof credit
credit for
for $75,000
$75,000

Maintains
Maintains aa minimum
minimum cashcash balance
balance of of $30,000
$30,000

Borrows
Borrows on
on the
the first
first day
day ofof the
the month
month andand repays
repays
loans
loans on
on the
the last
last day
day of
of the
the month
month

Pays
Pays aa cash
cash dividend
dividend ofof $49,000
$49,000 in in April
April

Purchases
Purchases $143,700
$143,700 of of equipment
equipment in in May
May and
and
$48,300
$48,300 in
in June
June paid
paid in
in cash
cash

Has
Has an
an April
April 11 cash
cash balance
balance of of $40,000
$40,000
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 The Cash Budget

Schedule
Schedule of
of Expected
Expected
Cash
Cash Collections
Collections

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 The Cash Budget

Schedule
Schedule of
of Expected
Expected
Cash
Cash Disbursements
Disbursements

Direct Labor
Budget

Manufacturing
Overhead Budget

Selling and Administrative

Expense Budget

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 The Cash Budget

Because Royal maintains

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

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 The Cash Budget

Ending cash balance for April

is the beginning May balance.

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 The Cash Budget

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 Quick Check 

What
What is is the
the excess
excess (deficiency)
(deficiency) of
of cash
cash available
available
over
over disbursements
disbursements for
for June?
June?
a.
a. $$ 85,000
85,000
b.
b. $(10,000)
$(10,000)
c.
c. $$ 75,000
75,000
d.
d. $$ 95,000
95,000

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 Quick Check 

What
What is is the
the excess
excess (deficiency)
(deficiency) of
of cash
cash available
available
over
over disbursements
disbursements for
for June?
June?
a.
a. $$ 85,000
85,000
b.
b. $(10,000)
$(10,000)
c.
c. $$ 75,000
75,000
d.
d. $$ 95,000
95,000

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 The Cash Budget

$50,000 × 16% × 3/12 = $2,000

Borrowings on April 1 and
repayment on June 30.

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 The Budgeted Income Statement

Cash Budgeted
Budget Income
Statement
t ed
e
pl
om
C

After we complete the cash budget,

we can prepare the budgeted income
statement for Royal.

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 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

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 The Budgeted Balance Sheet

Royal
Royal reported
reported the
the following
following account
account
balances
balances prior
prior to
to preparing
preparing its
its budgeted
budgeted
financial
financial statements:
statements:
 Land
Land -- $50,000
$50,000
 Common
Common stock
stock -- $200,000
$200,000
 Retained
Retained earnings
earnings -- $146,150
$146,150
 Equipment
Equipment -- $175,000
$175,000

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 Royal Company
Budgeted Balance Sheet 25%
25% of
of June
June
June 30 sales
sales of
of
Current assets $300,000
$300,000
Cash $ 43,000
Accounts receivable 75,000 11,500
11,500 lbs.
lbs.
Raw materials inventory 4,600 at
at $0.40/lb.
$0.40/lb.
Finished goods inventory 24,950
Total current assets 147,550 5,000
5,000 units
units
Property and equipment at
at $4.99
$4.99 each
each
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550
50%
50% of of June
June
Accounts payable $ 28,400
purchases
purchases
Common stock 200,000
of
of $56,800
$56,800
Retained earnings 336,150
Total liabilities and equities $ 564,550
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 Royal Company
Budgeted Balance Sheet
June 30
Current assets
Cash $ 43,000
Accounts receivable Beginning balance
75,000 $146,150
Add: net income 239,000
Raw materials inventory 4,600
Deduct: dividends (49,000)
Finished goods inventory 24,950
Ending balance $336,150
Total current assets 147,550
Property and equipment
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550

Accounts payable $ 28,400

Common stock 200,000
Retained earnings 336,150
Total liabilities and equities $ 564,550
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 International Aspects of Budgeting

• When a multinational company enters into the

budgeting process there are at least three
major problems that must be dealt with . . .
1. Fluctuations in foreign currency
exchange rates.
2. High inflation rates.
3. Local economic conditions and
governmental policies.

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 End of Chapter 9

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