Chapter 8: Master Budgeting

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Learning Objective 1: Understand why organizations budget and the processes they use to create budgets

Basic Framework of Budgeting:

Budget: A detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period

Budgeting: The act of preparing a budget

Budgetary control: The use of budgets to control an organization's activities

Differences Between Planning and Control:

Planning involves developing objectives and preparing various budgets to achieve those objectives

Control involves the steps taken by management to increase the likelihood that the objectives are met, and all parts of the organization are working together toward the goal

Advantages of Budgeting:

Define goals and objectives

Think about and plan for the future

Means of allocating resources

Uncover potential bottlenecks

Coordinate activities

Communicate plans

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Choosing the Budget Period:

Operating budgets usually cover a one-year period corresponding to a company's fiscal year

Many companies divide their annual budget into four quarters

Self-Imposed Budgets:

Self-imposed budget (participative budget): A budget that is prepared with the full cooperation and participation of managers at all levels

Advantages of self-imposed budgets

Individuals at all levels are viewed as members of the team

Budgets estimates prepared by front-line managers are often more accurate compared to estimates prepared by top managers

Motivation is generally higher

Self-imposed budgets eliminate the excuse of a budget being unrealistic if a manager is unable to reach it

These budgets should be reviewed by higher levels of management to prevent "budgetary slack"

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Human Factors in Budgeting:

Enthusiastic and committed top management

Budgeting must not be used to pressure employees or blame them when something goes wrong

Highly achievable budget targets are usually preferred when managers are rewarded based on meeting budgets targets

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The Master Budget:

The master budget includes many budget schedules

Direct materials, direct labor, manufacturing overhead

Sales, production, ending inventory

Selling & administrative

Cash

All the budgets flow among each other

The cash and sales budget are then used to prepare a budgeted income statement and a budgets balance sheet

A master budget is based on various estimated and assumptions

What are the budgeted unit sales?

What is the budgeted selling price per unit?

What percentage of accounts receivable will be collected in the current and subsequent periods?

Seeing the Big Picture:

Every schedule in the master budget is meant to answer 10 questions

How much sales revenue will we earn?

How much cash will we collect from customers?

How much raw material will we need to purchase?

How much manufacturing costs will we incur?

How much cash will we pay to our supplier and our direct laborers, and how much cash will we pay for manufacturing overhead resources?

What is the total cost that will be transferred from finished goods inventory to cost of goods sold?

How much selling and administrative expense will we incur and how much cash will we pay related to those expenses?

How much money will we borrow from or repay to lenders - including interest?

How much operating income will we earn?

What will our balance sheet look like at the end of the budget period?

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Learning Objective 2, 3, and 4: Prepare a sales budget, a production budget, and a direct materials budget

Sales budget example: Royal Company is preparing budgets for the quarter ending June 30th. The selling price is $10 per unit. Budgeted sales for the next five months are:

April: 20,000 units

May: 50,000 units

June: 30,000 units

July: 25,000 units

August: 15,000 units

Sales budget for each month = The month's budgeted sales x Selling Price

April's sale budget = 20,000 x $10 = $200,000

May's sale budget = 50,000 x $10 = $500,000

June's sale budget = 30,000 x $10 = $300,000

Sales budget for quarter ending = Sum of individual months' budgeted sales up to and including the ending month

Sales budget for quarter ending June 30th = $200,000 + $500,000 + $300,000 = $1,000,000

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Expected cash collections example: All sales are on account. Royal's collection pattern is:

70% collected in the month of sale

30% collected in the month following sale

In April, the March 31st accounts receivable balance of $30,000 is collected in full.

April Sales Budget: $140,000 ($200,000 x 70%) is collected in April; $60,000 ($200,000 x 30%) is collected in May.

May Sales Budget: $350,000 ($500,000 x 70%) is collected in May; $150,000 ($500,000 x 30%) is collected in June.

The total cash collections is the sum of all of the collected sales.

Total cash collections for the quarter ended June 30th = $140,000 + $60,000 + $350,000 + $150,000 = $940,000

Accounts Receivable for the quarter ended is 30% of the ending month's sales.

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Production budget example: The management at Royal Company wants ending inventory to be equal to 20% of the following month's budgeted sales in units. On March 31st, 4,000 units were on hand.

Budgeted sales + Desired ending inventory = Total needs

Desired ending inventory = Following month's budgeted units x desired percentage

Total needs - Beginning inventory = Required production

The desired ending inventory becomes the beginning inventory for the next month.

For the quarter ending:

Budgeted sales is the sum of budgeted sales

Desired ending inventory is the month ending's desired inventory

Total needs is the quarter's calculated needs

Beginning inventory is the first month's beginning inventory

Required production is the quarter's calculated production

Required production for May:

50,000 + (30,000 x 20%) = 50,000 + 6,000 = 56,000

56,000 - 10,000 = 46,000

Required production for June:

30,000 + (25,000 x 20%) = 30,000 + 5,000 = 35,000

35,000 - 6,000 = 29,000

Required production for the quarter:

100,000 + 5,000 = 105,000

105,000 - 4,000 = 101,000

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Direct materials budget example: At Royal Company, five pounds of material are required per unit of product. Management wants materials on hand at the end of each month equal to 10% of the following month's production On March 31st, 13,000 pounds of material are on hand. Material cost is $0.40 per pound.

Budgeted production x Materials per unit = Production needs

Production needs + Desired ending inventory = Total needed

Following month's production needs x 10% = Desired ending inventory

Total needed - Beginning inventory = Materials to be purchased

Like the production budget, the desired ending inventory becomes the next month's beginning inventory.

Materials to be purchased in May:

46,000 x 5 = 230,000

230,000 + (145,000 x 10%) = 230,000 + 14,500 = 244,500

244,500 - 23,000 = 221,500

Set-up for direct materials budget for the quarter is like the production budget.

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Expected cash disbursement for materials example: Royal pays $0.40 per pound for its materials. 50% of a month's purchases is paid for in the month of purchase, the other 50% is paid in the following month. The March 31st accounts payable balance is $12,000.

Total expected cash disbursement = Materials to be purchased in the month x price for each unit of material

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Learning objectives 5, 6, and 7

Direct labor budget example: At Royal, each unit of product requires 0.05 hours (3 minutes) of direct labor. Royal pays its workers at the rate of $10 per hour.

Units of production x Direct labor time per unit in hours = Labor hours required

Labor hours required x Hourly wage rate = Total direct labor costs

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Manufacturing overhead Budget example: At Royal, manufacturing overhead is applied to units of product on the basis of direct labor hours. The variable manufacturing overhead rate is $20 per direct labor hour. Fixed manufacturing overhead is $50,000 per month, which includes $20,000 of noncash costs.

Budgeted direct labor hours x Variable mfg. OH rate = Variable mfg. OH costs

Variable mfg. OH costs + Fixed mfg. OH costs = Total mfg. OH costs

Total mfg. OH costs - noncash costs = Cash disbursement for mfg. OH

Total mfg. OH for the quarter / Total labor hours required = Overall price per hour

Ending finished goods inventory budget:

Include information for quantity and cost of direct materials , direct labor, and manufacturing overhead (use overall price per hour). Figure out the price for each. The total of all prices id the unit product cost.

Ending inventory in units x Unit product cost = Ending finished goods inventory

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Selling and Administrative Expense budget example: At Royal, the selling and administrative expense budget is divided into variable and fixed components The variable selling and administrative expenses are $0.50 per unit sold. Fixed selling and administrative expenses are $70,000 per month. The expenses include $10,000 in costs that are not cash outflows of the current month.

Budgeted sales x Variable S&A rate = Variable expenses

Variable expenses + Fixed S&A expenses = Total S&A expenses

Total S&A expenses - noncash expenses = Cash S&A expenses