ACCT301 presentation

CHAPTER10
Static and Flexible Budgets
In Brief
Organizations communicate and advance their vision and strategies through short-term and long-term budgets. Managers use budgets in their
control systems to measure, monitor, and motivate employees to achieve organizational goals. They evaluate organizational performance by
comparing actual operations to budgeted plans, with an aim to improve operations and increase planning accuracy. Some organizations
provide employee incentives for meeting or exceeding budget-based benchmarks. When developing and using budgets, managers must
consider the business risks that might cause organizational performance to deviate from plans, and also identify and adjust for potential
biases that could result in poor forecasts.
This Chapter Addresses the Following Questions:
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Q1 How do budgets contribute to the strategic management process?
Q2 What is a master budget, and how is it prepared?
Q3 What are flexible budgets, and how can they be used for sensitivity analysis?
Q4 How are budget variances calculated and used as performance measures?
Q5 How do behavioral tensions influence the budgeting process?
Q6 What approaches exist for addressing the problems of traditional budgeting?
PLANNING FOR A MOVING TARGET
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n October 2006, The National Association of Realtors reported the largest drop in home prices since 1968, when the trade group began
collecting price data (Hagerty, 2006). Not surprisingly, changes in the housing industry affect the entire economy. For example, Arizona
State Universityprofessor Jay Q. Butler estimated that construction accounted for 10% of salaried jobs in the Phoenix area. Prices for
products such as gypsum, copper electrical wire, and lumber dropped quickly as new home construction slowed. Commercial construction
companies were also affected because a strong link exists between the construction of homes and retail buildings (Frangos, 2006).
Phoenix real estate prices continued to decline over the next several years as a worldwide financial crisis unfolded. Median asking prices for
Phoenix homes fell from $333,800 in April 2006 to $168,120 in May 2010 (www.housingtracker.net). Throughout this time period,
considerable uncertainty existed about short-term as well as long-term real estate and construction industry trends. Each year, some experts
predicted a rebound while others anticipated further declines. But by 2010, many experts were cautious; some believed that prices had
reached the bottom but would not recover for several more years (e.g., Buchholz, 2010).
If you worked as an accountant or a manager for a business linked to the construction industry, what could you do to manage risk and plan
business operations? First, you would evaluate how the changing economy was likely to affect current and future operations. For such a
large business decline, you might need to make immediate changes to ensure continued operations, such as altering budgets to plan for the
slowdown, and possibly reassessing long-term goals and strategies. In this chapter we explore the effect of the housing decline on Unique
Sinks, a company that sells sinks to residential contractors. At the beginning of the budget year, the housing industry was booming. Then
came the slowdown, and now the company must revisit its plans.
SOURCES: J. R. Hagerty, “Home Prices Keep Sliding; Buyers Sit Tight,” The Wall Street Journal, October 26, 2006; A. Frangos, “Housing
Decline Sparks Slowdown in Construction,” The Wall Street Journal, October 27, 2006; and J. Buchholz, “Real Estate Experts Forecast
Metro Phoenix Market Recovery in 2014,” Phoenix Business Journal, February 19, 2010.
BUDGETS AND THE STRATEGIC MANAGEMENT PROCESS
Q1 How do budgets contribute to the strategic management process?
You may not realize it, but you probably already have experience in strategically using budgets. For example, think about how many college
students must routinely anticipate both school-related expenditures, such as tuition and books, and living expenses, such as rent and food. So
before each term begins, they develop financial plans. These plans consider expenses as well as incoming funds such as scholarships, loans,
and wages. At the end of each month or term, students might compare their actual expenditures to those they had planned and then adjust
their plans for future spending or financing. For example, if expenses are outpacing revenues, students have several choices. They can lower
their living expenses. They might transfer to a less expensive college, switch from full-time to part-time status, or take fewer courses. They
might also increase funds by applying for more scholarships or loans or by increasing their work hours.
Organizations face similar budgetary risks. In the upcoming fiscal period, plans must be developed to anticipate revenues, expenses, and
cash flows. At the end of the period, actual results are compared to the plan to identify gaps, or variances, from the plan. A budget is a
formalized financial plan for operations of an organization for a specified future period. A budget is an organization’s financial roadmap; it
reflects management’s forecast of the financial effects of an organization’s plans for one or more future time periods.
As shown in Exhibit 10.1, organizations use budgets as part of their strategic management process. Budgets for capital expenditures and
long-term financing help managers implement organizational strategies. Budgets for revenues, costs, and cash flows help managers carry out
and control short-term operating plans. To monitor organizational performance and to motivate employees, managers compare actual results
to budgets and use variance information to improve operations.
BUDGETS AND LEVERS OF CONTROL
Exhibit 10.2 summarizes several ways in which budgets serve as part of control systems to measure, monitor, and motivate performance.
Budgets enhance belief systems by communicating organizational strategies and goals. Budgets also encourage managers throughout the
organization to clarify their plans and to coordinate activities such as sales and production. In addition, budgets provide a mechanism for
defining the responsibilities and financial decision-making authority, or decision rights, of individual managers. For example, separate
budgets are often developed for each department within an organization. The manager of each department is then given authority to use the
organization’s resources in accordance with the budget (a boundary system) and is also responsible for meeting budgeted goals (a diagnostic
control system). Managers may use comparisons of budgeted to actual results to identify changes in the business environment that might
require revisions to strategies or operating plans (an interactive control system).
CURRENT PRACTICE
See Chapter 1 for details about the four levers of control and Chapter 15 for responsibility accounting.
EXHIBIT 10.1 Budgeting and the Strategic Management Process
EXHIBIT 10.2 Budgets and Levers of Control
MASTER BUDGET
Q2 What is a master budget, and how is it prepared?
A master budget is a comprehensive plan for an upcoming financial period, usually a year. As shown in Exhibit 10.3, the master budget for
a manufacturing organization begins with organizational strategies and operating plans, which lead to an operating budget—management’s
plan for revenues, production, and operating costs. The master budget also includes a financial budget—management’s plan for capital
expenditures, long-term financing, cash flows, and short-term financing. Master budgets are often summarized in a set of budgeted
financial statements. These statements are forecasts of the future income statement, balance sheet, and cash flows.
DEVELOPING A MASTER BUDGET
The master budget is developed using a set of budget assumptions, which are plans and predictions about next period’s operating activities.
Budget assumptions often begin with a sales forecast and pricing plans, leading to the revenue budget. The volume of production is next
forecast using beginning inventory levels, sales forecasts, and desired ending inventory levels. The production budget leads to budgets for
direct materials, direct labor, and manufacturing overhead. These budgets are used to create budgets for ending inventory and cost of goods
sold. The operating budget also includes budgets for costs of nonproduction departments such as sales, human resources, research and
development, and general administration. Expected operating cash receipts and disbursements are combined with planned capital
expenditures and long-term financing to develop a short-term financing budget. Finally, the components of all the preceding budgets are
combined to create budgeted financial statements.
CURRENT PRACTICE
Consultant John Bailey argues that managers face a dilemma when planning desired inventory levels. Sales can be lost if inventory is too
low, but high inventory levels often cause waste and require more cash.1
Master budgets are often broken down into monthly or quarterly time periods to allow managers to monitor cash flows and operating results
throughout the year. Some businesses, such as retail stores, may prepare budgets for weekly time periods.
CHAPTER REFERENCE
See Chapter 12 for details about capital budgeting.
FORECASTING
Accountants assist managers in the process of developing budget assumptions. They may analyze past revenue and cost trends and behavior,
gather information from personnel throughout the organization about possible revenue and cost changes, or obtain estimates from operating
personnel about the effects of planned production changes.
EXHIBIT 10.3
Developing a Manufacturer’s
Master Budget
ALTERNATIVE TERMS
Some people use the terms pro forma financial statements, predicted financial statements, or forecasted financial statements instead
of budgeted financial statements.
Sales Forecasting Because production and other resource decisions often rely on the volume of goods or services to be sold, accurate sales
forecasts greatly improve the efficient use of resources. Sales may be forecast assuming an estimated percentage change from the prior year.
Alternatively, managers may use one or more of these techniques:
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Project past sales trends into the future using judgmental or statistical methods.
Estimate sales based on industry data for similar businesses.
Construct a financial model to predict sales based on one or more forecasted economic variables.
Gather sales predictions from sales and other personnel.
Conduct market research to estimate customer demand.
Managers can improve sales forecast accuracy by using multiple forecasting techniques. They can also improve accuracy by considering the
many factors that influence sales, such as general and industry economic conditions, direct and indirect competition, customer tastes and
expectations, seasonality, and planned changes such as new product or service offerings, pricing adjustments, promotional efforts,
distribution method revisions, and credit policy modifications.
Cost Forecasting Managers sometimes budget individual costs as a percentage of revenues or as a percentage change from the prior year.
They may also forecast costs using techniques similar to those used for sales. Managers can improve cost forecasts by carefully evaluating
cost behavior, as discussed in Chapter 2. Some costs, such as advertising and research and development, are discretionary. Managers rely on
their strategic and operating plans to establish desired levels for these costs.
RISK OF BIASED DECISIONS
Recency Effect
The recency effect is a bias in which people rely too heavily on recent experiences or information. This bias may cause managers to
disregard evidence of change and believe inappropriately that current business conditions will continue. When analyzing information about
changes in the economic environment, the recency effect causes managers to weigh the most recently received information more heavily
than information received earlier. The recency effect increases the risk of overly optimistic or pessimistic budgets. For example, a manager
who has recently experienced an unsuccessful capital project may reject a proposed capital project that should be accepted. Organizations
can reduce the risk of poor decisions by seeking independent sources of information and by varying the sequence in which information is
presented.
Cash Flow Forecasting Accurate cash flow forecasts can be critical to financial viability, particularly for small organizations. For example,
Glen Herriman, the owner of Herriman’s Stationary Supplies, blamed his past financial troubles on a failure to manage finances. He stated
in a radio interview, “I figured that the finance could sort itself out as long as I was making the sales and the profit was right.”2
Cash flow forecasting includes not only identifying the expected sources and uses of cash, but also estimating the timing of receipts and
disbursements. To forecast cash flows, managers consider questions such as these: How quickly will customers pay their bills? How quickly
must we pay our vendors, employees, other suppliers, and tax authorities? Are our business plans or other economic changes likely to alter
the cash flow patterns? When do we plan to purchase new equipment, pay dividends, issue stock, or buy back stock? Should we arrange to
borrow money, as needed, to cover short-term cash shortages? Should excess cash be invested?
In the following budgeting illustration, the accountant develops a master budget by gathering data, adopting budget assumptions, and
creating individual budgets in the following order:
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Revenue budget
Production budget (units)
Direct materials and direct labor budgets
Manufacturing overhead budget
Budgeted statement of cost of goods manufactured and sold
Selling and administration budget
Cash receipts and disbursements budget
Short-term financing budget
Budgeted income statement and retained earnings
Budgeted balance sheet
UNIQUE SINKS (PART 1)
DEVELOPING A MASTER BUDGET
Unique Sinks is a family-owned manufacturing business specializing in sinks; it does not produce any of the faucets or plumbing needed for
installation. The company focuses on the new housing market, which has been quite strong for over ten years. Unique Sinks’ core
competencies include a relatively low-cost but high-quality manufacturing process for sinks. During the last several years, demand for large
houses with three to four bathrooms was strong, and homebuyers were particularly interested in sinks that were distinctive yet utilitarian.
Jordan Kovacik, the company’s owner, is beginning to plan for the next year. First, he reviews past performance, reads industry publications,
and discusses the new housing market with several contractors. Although some economists have warned of an impending decline in the
housing market, Jordan’s customers believe that the boom in new housing construction is far from over. Jordan concludes that high sales
volumes are likely to continue. He also decides that no changes in vision or strategy will be needed for the next year.
As in prior years, Jordan will submit budgeted financial statements to his bank as part of his annual line-of-credit loan application.3 He also
plans to compare quarterly results to budgeted revenues and costs so that he can monitor whether operations are under control. Jordan
provides the company’s accountant, Ana Fernandez, with the following housing start estimates and asks her to begin developing a master
budget for the next period.
Quarter
Housing Starts
First
6,000
Second
24,000
Third
12,000
Fourth
4,000
DEVELOPING THE REVENUE BUDGET
Ana prepares the revenue budget first because she needs information from the volume of sink sales to develop the production and variable
cost budgets. Based on her discussion with Jordan, Ana anticipates that the sinks will sell for $85 each and that the company will continue to
garner 35% of the new housing sink market. In addition, she calls several developers regarding the number of sinks they expect to install in
each house. Ana develops the revenue budget.
REVENUE BUDGET
DEVELOPING THE PRODUCTION BUDGET
From this year’s accounting records, Ana expects the first quarter beginning inventory to consist of 600 units. She knows that the sales
manager wants to end each quarter with inventory levels at 10% of the following quarter’s sales to provide a cushion for increases in
demand.4 Ana calculates the number of sinks that will be manufactured each quarter, factoring in the sales forecast and both beginning and
targeted ending inventory levels.
PRODUCTION BUDGET (UNITS)
DEVELOPING THE DIRECT MATERIALS AND DIRECT LABOR BUDGET
According to Jordan, material and labor requirements for next year should be about the same as in the past. From prior years’ experience,
Ana assumes that each sink will require about 40 pounds of material and 3 hours of direct labor. Based on expected production, she develops
a budget for the amount of materials and labor resources required for each quarter.
DIRECT MATERIAL AND DIRECT LABOR RESOURCE REQUIREMENTS
Ana expects that 20,000 pounds of material will be on hand at the beginning of the year. She knows that Jordan prefers to have 10% of the
next quarter’s production on hand at the end of each quarter.5 Given the inventory and materials usage requirements, she estimates the
quantity of direct materials that will be purchased each quarter.
DIRECT MATERIALS PURCHASES (POUNDS)
Ana calls the direct materials vendor, who tells her that the price should remain at $0.50 per pound over the next six months. Because the
vendor is unsure whether price changes will occur later in the year, she budgets $0.50 per pound for the entire year. She next examines
payroll records and considers possible changes in labor rates. Given this information, she expects to pay $12 per hour for labor throughout
the next year. She combines the direct labor usage requirements and the direct labor purchases with the cost information to develop the
direct materials and direct labor budget.
DIRECT MATERIALS AND DIRECT LABOR BUDGET
DEVELOPING THE MANUFACTURING OVERHEAD BUDGET
The accounting system includes four types of manufacturing overhead costs: indirect labor, supplies, depreciation, and “other” (everything
else). Ana believes that cost behavior will remain the same as in past years. The only fixed overhead production cost is depreciation, which
is calculated using the straight-line method. Because Jordan does not plan to purchase any new equipment next year, she estimates that
depreciation will remain at $9,000 per quarter. Ana assumes that indirect labor, supplies, and other costs are strictly variable. She uses
regression analysis to estimate the variable cost, assuming direct labor as the cost driver. Ana is satisfied with the quality of the statistics, so
she relies on the regression results to estimate these costs.
CHAPTER REFERENCE
Chapter 2 provides details for using regression analysis to estimate a cost function.
HELPFUL HINT
Amounts in the budget schedules are rounded to the nearest dollar. Because of rounding errors, some amounts appear to add incorrectly. The
Excel spreadsheet used to create these schedules is available on the Wiley Web site at www.wiley.com/college/eldenburg.
Ana combines the variable and fixed costs to create the manufacturing overhead budget. She multiplies the direct labor hours needed for
production by the variable cost per direct labor hour to determine the variable costs for each quarter. For example, she expects production to
use 24,408 direct labor hours during the first quarter at $0.3000 per hour, resulting in indirect labor cost of $7,322. Ana also calculates the
fixed overhead allocation rate by dividing the annual budgeted fixed overhead costs by the annual budgeted volume of the predetermined
allocation base, direct labor hours.
MANUFACTURING OVERHEAD BUDGET
DEVELOPING THE BUDGETED STATEMENT OF COST OF GOODS MANUFACTURED AND SOLD
Now that Ana has developed budgets for all of the production costs, she can complete a budget for the cost of goods manufactured and sold.
Based on an examination of current year accounting records, she expects the beginning inventory of finished goods to consist of 600 units at
a cost per unit of $50.4167, or $30,250, and beginning direct material inventory to consist of 20,000 pounds at a cost of $0.50 per pound, or
$10,000 total. The company usually has no work in process at the end of each quarter. The first-in, first-out inventory cost flow assumption
is used for financial reporting, so ending inventory is valued at the current year’s production cost per unit:
Using the ending inventory costs shown above and information from the preceding budgets, Ana prepares the Budgeted Statement of Cost of
Goods Manufactured and Sold.
BUDGETED STATEMENT OF COST OF GOODS MANUFACTURED AND SOLD
DEVELOPING THE SELLING AND ADMINISTRATION BUDGET
Ana reviews past records for selling and administration and considers possible changes in those costs. She estimates that depreciation should
be $2,400 per quarter, salaries will be $40,000 per quarter, and commissions will remain at 10% of revenues. Based on prior experience, she
estimates bad debt expense at 2% of revenues. Other miscellaneous costs will be budgeted at amounts similar to the last year, with a small
increment for inflation. Now Ana develops the selling and administration budget.
SELLING AND ADMINISTRATION BUDGET
DEVELOPING THE CASH RECEIPTS AND DISBURSEMENTS BUDGET
Based on past experience, Ana expects Unique Sinks to be short of cash during some quarters. More houses are started in the spring and
summer, so demand is high in the second and third quarters and is much lower in the first and fourth quarters. She develops a cash receipts
and disbursements budget to plan for the company’s borrowing needs.
After reviewing the current year’s cash collection patterns, Ana estimates that 66% of each quarter’s sales will be received in cash during the
quarter and 32% will be received during the following quarter. She also estimates that $110,622 ($118,000 less allowance for uncollectible
accounts of $7,378) of the current year’s sales will be collected during the first quarter.6 She uses this information combined with amounts
from the revenue budget to estimate the cash collections during each quarter.
Employees are paid on the 15th and last day of each month, so cash is required for labor costs incurred during each quarter. The company’s
materials vendor requires payment within 30 days, so Ana estimates that one-third of each quarter’s purchases is paid during the following
quarter. She also estimates that $72,370 of the prior year purchases will be paid during the first quarter. All other costs are paid during the
quarter incurred except for income taxes. The company’s tax accountant told Ana that a final payment on prior year taxes of approximately
$7,000 will be due during the first quarter, and the company should make estimated payments of $40,000 each during the fourth, sixth, ninth,
and twelfth months of the year. According to Jordan, the company will probably pay a dividend of about $370,000 during the fourth quarter.
Ana combines the preceding information with the planned direct material and labor cost information, manufacturing overhead, and selling
and administration data to develop the cash receipts and disbursements budget.
CASH RECEIPTS AND DISBURSEMENTS BUDGET
DEVELOPING THE SHORT-TERM FINANCING BUDGET
Ana estimates that the company will begin next year with a cash balance of $45,820, which will not be sufficient to cover the excess of
budgeted disbursements over receipts during the first part of the year. In addition, Jordan wants to maintain a cash balance of at least
$30,000 at the end of each quarter. Thus, Ana calculates the amounts of borrowing needed during the first part of the year, expected
repayments during the later part of the year, and interest costs. Ana believes that the annual interest rate will be 8%, or 2% per quarter.7 To
be conservative, Ana does not budget any earnings on cash balances, even though Jordan sometimes invests excess cash in short-term
securities. Ana summarizes this information in the short-term financing budget.
SHORT-TERM FINANCING BUDGET
DEVELOPING THE BUDGETED STATEMENT OF INCOME AND RETAINED EARNINGS
Ana uses the previous budgets for revenue, cost of goods sold, selling and administration costs, interest expense on short-term financing, and
an estimated income tax rate of 30% to prepare the budgeted income statement. In addition, she combines estimated beginning retained
earnings of $165,322 with budgeted net income and the expected dividend payment to estimate ending retained earnings.
BUDGETED STATEMENT OF INCOME AND RETAINED EARNINGS
DEVELOPING THE BUDGETED BALANCE SHEET
To prepare the budgeted balance sheet, Ana begins with an estimated beginning balance sheet for next year based on the most recent
information for the current period. She then estimates next year’s ending balance sheet amounts based on the assumed transactions in the
preceding budgets.
BUDGETED BALANCE SHEET
APPROVING AND USING THE MASTER BUDGET
Once Ana completes the master budget, she prints the various budgets for Jordan’s review and approval. He is pleased that the company
should have no debt at the end of the year, be able to pay a $370,000 dividend, and still have a healthy cash balance of over $50,000. Ana
has worked for him for many years, so he is confident that her estimates reflect current business conditions.
Given these strong results, Jordan wonders whether he should reduce the dividend and use the extra cash to invest in some new
manufacturing equipment that could reduce spoilage rates and labor costs. He asks Ana to develop an analysis of the costs and benefits of
the potential purchase before he makes a final decision. Otherwise, he tells Ana that he approves the budget.
STRATEGIC RISK MANAGEMENT Unique Sinks (Part 1)
BUDGETS AS CONTROLS.
The owner of Unique Sinks planned to compare quarterly results to budgeted revenues and costs so that he could monitor whether operations
were under control–that is, he planned to use the master budget primarily as a diagnostic control to ensure that operations proceed according
to plan. Could the master budget also be used as part of a belief system, boundary system, and/or interactive control system? The owner
seemed to have a limited view of the strategic uses of a master budget.
BUDGET ASSUMPTIONS AND BUSINESS RISKS
The master budget was based on a series of assumptions including sales volumes and prices, cost behaviors, direct material prices, and
customer payment patterns. How confident could the owner be that these assumptions would match actual conditions? Operations are more
likely to deviate from budget assumptions when the economic environment changes. Thus, a key issue for Unique Sinks was whether the
new housing construction boom would continue.
BIAS IN OPERATIONAL PLANNING
The master budget was particularly sensitive to assumptions regarding the volume of sales. Were the owner’s housing start estimates
influenced by a recency effect bias? Did the owner place undue weight on the recent housing boom and ignore economists’ warnings of an
impending decline? A drop in sales volume would reduce revenues, variable costs, profits, and cash flows.
BUDGETING IN NONMANUFACTURING ORGANIZATIONS
The individual budgets shown previously in this chapter are for a manufacturing organization. The specific types of budgets that comprise a
master budget depend on the nature of an organization’s goods or services and its accounting system. For example, some service
organizations do not carry inventory; the direct costs of producing services are recognized as period costs in the income statement. Thus,
budgets for these organizations generally would not include inventory computations and might not include direct materials. Other service
organizations, such as retailers, would carry inventory. The categories chosen for individual budgets are based on the categories that
managers use to plan and monitor operations.
In the not-for-profit sector, budgets are often a primary source of information about the operations of the organization. Although donors
request financial statements, budgets provide much of the operating information used by managers. In governmental organizations, budgets
must often be legally adopted, placing restrictions on spending authority.
BUDGETING IN INTERNATIONAL ORGANIZATIONS
Budgeting is often more complex for international organizations. Communication can be more time consuming because international
business segments participate in the budgeting process. Cultural and legal differences influence both internal and external operations and
need to be considered. The economies of different countries rarely move in tandem, and forecasting sales is more difficult. In addition,
currency translations and differences in inflation and deflation rates greatly increase business risk in the planning and budgeting process.
FLEXIBLE BUDGETS
Q3 What are flexible budgets, and how can they be used for sensitivity analysis?
The master budget illustrated in Unique Sinks (Part 1) is a static budget, or a budget based on forecasts of specific volumes of production or
services. All variable costs are calculated for a specific volume of operations. The information in a static budget is biased when compared to
results for a different volume of operations. In particular, budgeted variable costs and budgeted cash inflows are overstated when fewer units
or services are produced than budgeted. Similarly, budgeted variable costs and budgeted cash inflows are understated if more units or
services are produced.
In contrast to a static budget, a flexible budget is a set of cost relationships that can be used to estimate costs and cash flows for any level of
operations, within the relevant range. As such, a flexible budget uses the variable cost information from the master budget but adjusts sales
information and variable costs to reflect actual volumes. Because fixed costs are not expected to change, these values are carried over from
the static budget.
BUDGET SENSITIVITY ANALYSIS
One benefit of creating a flexible budget is that managers and accountants can easily perform sensitivity analysis to estimate the effects of
deviations from budget assumptions. For example, the owner of Unique Sinks might want to know how profits or cash flows would be
affected if direct material prices increase or if sales volumes fall. Budget sensitivity analysis can be performed using spreadsheets with an
input area containing budget assumptions. Similar spreadsheets were shown for cost-volume-profit analysis in Chapter 3.
CHAPTER REFERENCE
Chapters 2 and 3 emphasize the importance of the relevant range for estimating a cost function and evaluating the effects of volume on costs
and profits.
Unique Sinks (Part 2) illustrates the preparation of a flexible budget and its use in performing sensitivity analysis.
UNIQUE SINKS (PART 2)
DEVELOPING AND USING A FLEXIBLE BUDGET
Unique Sinks is now operating in May of the budget year. Rumors suggest that new housing starts will decline. Although sales to date are
close to the volumes predicted in the master budget, Jordan asks Ana to analyze the potential effects if sales are only 10,000 units or, in the
worst-case scenario, 7,000 units.
DEVELOPING A FLEXIBLE BUDGET
Ana decides to create a third-quarter flexible budget, which will allow Jordan to easily anticipate the financial effects of different levels of
sales. She also decides to create a spreadsheet for the flexible budget that will allow changes to other budget assumptions. She inserts the
third-quarter assumptions from the master budget into the input section of the spreadsheet.
Ana assumes that the cost function does not change as sales volumes decline (i.e., that operations remain within a relevant range). This
assumption means that changes in sales volume will cause total variable costs to change but will have no effect on fixed costs. She
summarizes the fixed and variable costs, which will allow the spreadsheet to calculate a breakeven point.
THIRD-QUARTER FIXED AND VARIABLE COSTS
FLEXIBLE BUDGET OPERATING INCOME AND BREAKEVEN POINT
Ana now programs the spreadsheet to allow computation of operating income for different levels of sales. She also programs it to compute
the breakeven point. She performs two analyses–one at sales of 10,000 units and one at sales of 7,000 units. She leaves all other assumptions
unchanged.8
CHAPTER REFERENCE
Breakeven point calculations are demonstrated in Chapter 3
OPERATING INCOME AND BREAKEVEN POINT–SENSITIVITY ANALYSIS
From these analyses, Ana estimates that operating income would decrease by almost $50,000 if sales drop to 10,000 units and by almost
$100,000 if only 7,000 units are sold. Although sales of either 10,000 or 7,000 units would be substantially higher than the breakeven point
of 3,608 units, Ana knows that a large decline in sales might cause cash flow problems.
FLEXIBLE BUDGET CASH RECEIPTS AND DISBURSEMENTS
Ana next prepares a flexible budget for cash receipts and disbursements. Direct material purchases and production schedules are set before
the quarter begins, and the company has not yet experienced lost sales. Therefore, she assumes that purchases and production will remain
unchanged.
CASH RECEIPTS AND DISBURSEMENTS–7,000 UNITS SOLD
Ana is pleased to see that cash flows are expected to remain positive even in the worse-case scenario of 7,000 units sold. However, the
company would not be able to fully repay the loans of $183,875 that had been borrowed during the first and second quarters. Also, the
company would probably be unable to pay the $370,000 dividend that is scheduled for the fourth quarter.
USING THE FLEXIBLE BUDGET FOR PLANNING
Ana provides Jordan with her analyses and shows him how to make changes to the spreadsheet. He is pleased to have this new planning
model. He can use it to anticipate the effects of changes in sales and to investigate the effects of potential tactics.
STRATEGIC RISK MANAGEMENT Unique Sinks (Part 2)
FLEXIBLE BUDGET AND QUALITY OF INFORMATION.
Ana created a flexible budget. How was the quality of information in the flexible budget better than the information in the static budget? The
flexible budget provided a better target against which to compare actual results. The static budget would overestimate revenues, variable
costs, and cash inflows if the sales volume dropped. The flexible budget will improve the owner’s ability to effectively monitor whether
costs are under control.
BUDGETS AS PERFORMANCE BENCHMARKS
Q4 How are budget variances calculated and used as performance measures?
Managers and accountants use budgets to monitor operations by comparing actual results to budget forecasts. These comparisons serve
as benchmarks, or standards, against which performance may be measured and evaluated, helping managers assess how well strategies and
operations are meeting expectations. For example, managers learn whether desired sales volumes are achieved or whether costs are under
control. In addition, accountants monitor budgets to improve the quality of the strategic management process (Exhibit 10.1) over time, thus
improving the organization’s ability to achieve its vision, strategies, and operating plans.
BUDGET VARIANCES AND ANALYSES
Differences between budgeted and actual results are called budget variances. If actual revenues are larger than the budget, or actual costs
are lower than the budget, the variance is categorized as afavorable variance. Conversely, an unfavorable variance occurs when actual
costs are greater than budgeted or actual revenues are less than budgeted.
Budget variances occur for two general reasons. First, actual activities might not follow plans. For example, in 2005 Hurricane Katrina shut
down four Folgers coffee production facilities in New Orleans. These closures would cause actual revenues to be much lower than
budgeted, while actual costs would be higher than budgeted due to clean-up. All employees in the region continued to receive pay and health
benefits, even though revenues stopped. At the same time, other coffee producers experienced unanticipated increases in volumes to cover
the shortage from Folgers, causing their actual revenues and variable costs to be higher than budgeted.9
Second, unanticipated increases or decreases in the purchase prices of direct materials or other input factors can cause the budget to be an
inappropriate benchmark for performance. Each time gasoline and fuel costs increase unexpectedly, airline budgets become poor predictors
of fuel costs. Accordingly, revisions of the budget benchmark would take into account new information about expected prices.
CHAPTER REFERENCE
In Chapter 11, we learn more about the reasons for variances and the actions that managers take, if any, after analyzing variances.
As indicated in Exhibit 10.2, variances are used to monitor actual results compared to the budget. Managers and accountants gain improved
understanding of the organization’s progress toward objectives and goals when they investigate the reasons for variances. Variances can also
be part of a diagnostic control system used to evaluate and reward performance. In addition, variances can be part of an interactive control
system; as managers investigate factors causing variances, they might reassess the organization’s vision and core competencies, reconsider
strategies, and develop improved operating plans.
CHAPTER REFERENCE
See Chapters 1 and 15 for more details about diagnostic and interactive control systems.
Variances may be calculated by comparing actual results to a static budget, a flexible budget, or a budget that has been adjusted to create a
better benchmark for performance. As shown in Unique Sinks (Part 3), different benchmarks are appropriate for different purposes.
UNIQUE SINKS (PART 3)
DEVELOPING A VARIANCE REPORT
Unique Sinks has now finished the third quarter of the budget year. Sales during the third quarter were poor. The dramatic drop in housing
prices caused local contractors to cancel construction projects and rescind orders for sinks. Fortunately, Jordan responded quickly to
changing conditions and cut back production to 7,000 units. By October, he believes that the low level of new house construction might
continue. He asks Ana to prepare a cost variance analysis for the third quarter as he considers ways to cut production costs.
STATIC VERSUS FLEXIBLE BUDGET VARIANCES
To focus on production costs, Ana creates a variance report for the third quarter based on the number of units produced (instead of the
number of units sold). She designs the report to show both static budget variances and flexible budget variances. Both budgets use the
variable production costs per unit calculated in Unique Sinks (Part 2, p. 387).
STATIC AND FLEXIBLE PRODUCTION BUDGET VARIANCE REPORT FOR THIRD QUARTER
The static budget variances give the impression that operations during the third quarter were very efficient. Total costs were far less than
budgeted. However, Ana knows that she would expect to see favorable static budget variances because the actual production volume of
7,000 was much lower than planned. All of the variable costs would be overstated in the static budget. Therefore, this report provides poorquality information for analyzing production costs.
From the flexible budget variances, Ana learns that direct labor costs were significantly higher than expected. She knows that Jordan was
reluctant to lay workers off when sales orders dropped. Thus, more workers were on hand than needed for the volume of production. None
of the other variances were large, so Ana decides to focus Jordan’s attention on the direct labor variance.
RELEVANT VARIANCE INFORMATION
As Jordan studies the flexible budget variances, he realizes that he may need to lay off some of the production workers. He does not believe
that the housing market will recover soon, and the company cannot afford the cost overruns. But he does not want to lay off workers, so he
first considers other ways to contain costs or to increase sales volumes.
STRATEGIC RISK MANAGEMENT Unique Sinks (Part 3)
VARIANCES IN A DIAGNOSTIC CONTROL SYSTEM.
The cost variances helped Ana see that direct labor costs were significantly higher than they should have been; they appeared to be out of
control. How might this diagnosis lead to improved management? By sharing this information with Jordan, he can more rapidly identify and
evaluate options for bringing costs back under control.
VARIANCES AND THE DEGREE OF BUSINESS RISK
Because budgets are based on forecasts about the future, it is impossible to prevent variances by exactly achieving budgeted revenues and
costs. The degree of forecast accuracy varies across organizations and across time. For example, forecasting became more difficult for the
owner of Unique Sinks when the boom in new housing construction ended. Some organizations operate in stable business environments and
have fairly predictable revenues and costs. Other organizations have greater business risk, leading to more volatile or unpredictable revenues
and costs. Significant variances are more likely to occur in highly competitive industries, when selling newly developed goods and services,
or when subject to fluctuating raw material costs such as petroleum prices.
PEOPLE: THE CENTER OF THE BUDGETING PROCESS
Q5 How do behavioral tensions influence the budgeting process?
In the Unique Sinks illustrations, the owner and accountant were the main participants in the budgeting process. It was relatively easy for the
owner and accountant to share information and coordinate their planning efforts. The budget reflected the owner’s vision and strategies, and
he could personally ensure that operating plans were carried out.
As organizations grow in size, it becomes increasingly difficult for top managers to control planning and operations. Large organizations
benefit from the wide range of expertise held by employees. However, top managers find it challenging to gather knowledge that is spread
throughout the organization and to ensure that employees work toward common goals.
BUDGET RESPONSIBILITY AND PERFORMANCE EVALUATION
As discussed earlier in the chapter, budgets give managers decision rights over the use of an organization’s resources. To hold managers
accountable for this authority, performance measurement systems often include budget variances. For example, a sales manager may be held
responsible for variances from budgeted revenues. To motivate even better performance, bonuses may be given to managers who meet or
exceed budget goals. Sometimes broader employee groups receive profit sharing, cash, or other bonuses based on achieving or exceeding
budgeted income levels. Sales representatives who meet target sales volumes may be rewarded with family trips to resort destinations or
award dinners to celebrate their good performance.
PARTICIPATION IN BUDGETING
Accurate budgeting relies on the accuracy of revenue, cost, cash flow, and other forecasts. Ideally, individuals with the most knowledge in
each area should develop budget forecasts. In small organizations, top managers might have the most knowledge about factors influencing
revenues, costs, and cash flows. Knowledge tends to become more dispersed as organizations grow, increasing the need to gather forecast
information more broadly. When budgets are used as benchmarks for performance, additional motivational factors must be considered.
Different organizations adopt different budgeting approaches based on differences in philosophy, knowledge dispersion, and motivational
issues.
Budget plans can be developed from the top down, using information that has been gathered from the bottom up. In other words, top
management provides strategies and suggested organizational targets for the coming period. These strategies and targets are communicated
“top-down” to division and department managers who incorporate them into the budgeted operating plans. Departmental budget requests are
then communicated “bottom-up” to members of top management who are responsible for final budget approval. Although top managers
approve the final budget, they rely on the knowledge and experience of individual managers to help them establish reasonable departmental
budgets.
When managers in the field have more knowledge about future operations than top management, budgets are often developed from the
bottom up. For example, sales representatives at Unique Sinks could provide individual sales volume forecasts, which could be combined
into an overall company forecast. Participative budgeting occurs when managers who are responsible for meeting budgets also prepare the
initial budget forecasts, setting targets for themselves. Theoretically, participative budgeting motivates employees to meet budget targets
because they buy into the target-setting process. However, when employees set targets, incentives exist to set them low so that goals can be
met easily, a practice called budgetary slack. In contrast, when top management sets targets, incentives exist to raise targets to induce
greater productivity. This practice is called budget ratcheting. If targets are either easily met or unachievable, employees have little
motivation to improve performance. Therefore, negotiations are often required over a period of time prior to setting the final budget. If the
targets set by top management appear to be unreasonable to middle management, a great deal of tension arises. These goals also create
pressure on all of the employees within the firm. These pressures can lead to unethical behavior and loss of talented employees because
targets cannot be met or the pressure just becomes too great.10
BUDGET MANIPULATION
When performance evaluations and bonuses are based on achieving budgeted results, managers have incentives to build in budgetary slack
by intentionally setting revenue budgets too low and cost budgets too high. This practice hampers organizations when more precise
information would result in better strategies and operating plans. For example, if sales targets are set too low, an organization could lose
sales because it lacks the resources to increase production of goods or services over the short term.
Because business risks prevent absolute accuracy when forecasting future revenues and costs, top managers, shareholders, and others cannot
easily identify and remedy budgets that have been manipulated. However, several methods are used to minimize budgetary slack. For
example, independent sources such as consultants or market experts may prepare forecasts. These forecasts are compared to budgeted
estimates so that employees providing budget information realize their estimates are being scrutinized. Also, bonuses can be given for
accurate forecasts as well as for operating within the budget. Incentives to manipulate budgets often increase in larger organizations where
managers tend to focus only on the resources and performance of their own departments. As a result, they are less likely to consider the
organization as a whole and tend to submit biased budget requests. These requests lead to misallocations of resources among competing
departments or projects. To address this problem, some organizations give bonuses based on a combination of department results and overall
organization profitability, which reduces incentives to build in slack while motivating managers to support each other by directing resources
toward the best projects.
ZERO-BASED BUDGETING
Some managers simply add an adjustment, such as increasing last year’s budget for expected growth or inflation to plan for the next period.
This type of budgeting practice discourages them from seeking ways to use the organization’s resources more efficiently. In addition, many
organizations adopt policies so that departments lose authority over unspent budgeted costs and receive lower future budgets if actual costs
are lower than the current budget. This policy encourages department managers to spend all of their budgeted funds to avoid future cutbacks.
To reduce these types of problems, organizations may adopt zero-based budgeting, in which managers justify budget amounts as if no
information about budgets or costs from prior budget cycles was available. This system encourages managers to cut costs and improve
budget quality. A disadvantage is that it is time consuming, and the benefits may not be worth the extra time involved.
CURRENT PRACTICE
As an alternative to zero-based budgeting, some managers use a technique based on Theory of Constraints calledstrategic budgeting. All
departmental budget requests are reduced by 50%, with the excess placed in a “group budget buffer.” Department managers are allowed to
request funds from the buffer as needed, subject to open discussions with other department managers. This method encourages managers to
use resources more efficiently and reduces budgetary slack.11
FOCUS ON ETHICAL DECISION MAKING:
Timely Reporting of Budget Problems
Suppose a CPA firm establishes a budget of professional hours for a particular audit job. The hours are broken down by audit area, and one
area is the valuation of inventory and cost of goods sold. During the last year, the audit client adopted new procedures for assigning product
costs to individual units. The audit budget includes extra hours for the estimated time needed to document and assess the reasonableness of
the new method. Many factors could cause this part of the audit to be over budget. Consider the following two scenarios:
1. The client failed to establish appropriate records needed to easily audit the new method, and this part of the audit will require more
than the budgeted time to complete.
2. The auditor assigned to this part of the audit is inexperienced and is unable to complete the work in the budgeted time.
Regardless of the reason for the overage, managers in charge of the audit need to be notified as soon as possible so that they can consider
possible ways to realign staff and complete the job on time. In addition, in the first scenario the audit firm might be able to bill the client for
the extra work involved if the audit contract includes a provision for such price adjustments. However, this scenario would most likely
require the client to be notified promptly, while the work is still being performed. In the second scenario, the firm’s profitability will be
lower than planned. The time overage may also result in a poor performance evaluation, especially if the auditor has similar problems in
other audit areas. Yet the overage may be considered reasonable in light of the auditor’s inexperience. Even so, the auditor should be able to
accomplish the following elements of the AICPA’s Project Management competency:
•
•
Develop alternative estimates of time and resource requirements for a project.
Effectively facilitate and control the project process and take corrective action as needed.
The auditor must quickly recognize an impending overage and formulate appropriate strategies for completing the task as efficiently as
possible. The auditor also needs to keep her supervisor apprised of the situation and seek help, when needed.
SOURCE: AICPA Core Competency Framework, available at www.aicpa-eca.org.
BUDGETS, TEAMWORK, AND ETHICS
Some people might believe that the preceding scenario is unrelated to ethical decision making. However, when we work in a team, we
assume a moral obligation to other members of the team. Consider these questions: Have you or others ever failed to meet a deadline on a
group project? If so, what were the reasons for the delay? When and how was the delay reported to other team members? How did late work
affect the quality of work product and the well-being of other team members?
BEYOND TRADITIONAL BUDGETING
Q6 What approaches exist for addressing the problems of traditional budgeting?
The traditional budgeting practices introduced earlier in the chapter are used widely. Seventy percent of the 1,995 firms responding to a
2003 IMA survey reported using traditional budgeting techniques.12However, critics point out that these budget practices are plagued by
several key problems.13 First, budget assumptions are typically outdated by the time the budgets are used. Change in the business
environment make it difficult to develop accurate forecasts and necessitate modifications to strategies and operating plans more frequently
than the traditional annual budget cycle. Time is wasted and the budgets have little value. Second, budgets have traditionally been used
primarily as diagnostic control systems. Managers and other employees are rewarded for ensuring that operations proceed according to plan.
This focus often stifles innovation, prevents employees from pursuing new opportunities, andfocuses attention primarily on short-term
financial goals. Finally, traditional budgets impede cooperation across departments and business units. Given decision authority and
responsibility for their own budgets, managers engage in suboptimal behaviors. Traditional practices are incompatible with flatter,
networked organization structures. To address these criticisms, managers and accountants are increasingly exploring new options by either
improving upon or abandoning the traditional budget process. Following are more recent budgeting techniques that overcome some of the
problems mentioned above.
ACTIVITY-BASED BUDGETS
Traditional budget models are developed around a few cost drivers that are primarily output based. In our earlier illustration, the accountant
of Unique Sinks separated production costs into direct materials, direct labor, and variable and fixed overhead. Costs were budgeted for two
activities—production and selling and administration. Activity-based budgeting uses numerous cost pools and their related cost drivers to
anticipate costs for individual activities. A budget is developed for each activity in an organization’s activity-based system.
Activity-based budgeting provides a number of advantages over traditional budgeting methods. When operational budgets are prepared
before financial budgets, managers are assured that the budget is operationally feasible. Under traditional budgeting systems, the operational
budget is usually prepared separately from the financial budget. In budget systems such as the one illustrated for Unique Sinks, the
accountant might inadvertently base the financial budget on a forecast of production volume exceeding the company’s capacity. Also,
activity-based budgets incorporate more factors, such as unit, batch, facility, and customer drivers, into the planning process. These
additional factors improve the quality of information for planning, promoting better allocation of resources. Finally, activity-based budgets
improve communication with lower-level operating personnel, who are more likely to understand budgets set in operational terms.
The disadvantages of activity-based budgeting are similar to those for activity-based costing (ABC) as discussed in Chapter 7. To use
activity-based budgeting, organizations must have an activity-based information system in place. Such systems can be costly to develop and
maintain. In the 2003 IMA study, only about 15% of the respondents placed high priority on adopting new ABC or customer profitability
systems.14 Thus, this chapter does not provide a detailed example. However, details about ABC are available in Chapter 7, and you can
explore activity-based budgeting by completing end-of-chapter Problem 10.34.
GPK AND RCA BUDGETS
Although activity-based budgets can lead to improved planning, a problem with ABC is that some fixed costs are treated as variable once
activity pools and cost drivers have been identified. This practice introduces measurement error into budget estimates.
In contrast, GPK and RCA identify cost functions for fixed and variable costs at the resource center level. Firms that use GPK and RCA cost
accounting systems typically use these systems to develop flexible budgets based on resource usage. Accordingly, compared to traditional
and ABC budgets, GPK and RCA systems are likely to provide more accurate cost forecasts. However, GPK and RCA systems are
expensive to implement, and benefits from added accuracy in planning may not be worth the costs of implementing and maintaining these
systems. See Chapter 7 for more details about the strengths and weaknesses of GPK and RCA.
BEYOND BUDGETING: RELATIVE PERFORMANCE EVALUATION
Some business groups believe that planning should be separate from performance evaluation because the adverse behavioral effects of
traditional budgeting are so severe.15 Promoters of an approach calledbeyond budgeting argue that manager or employee performance
should be evaluated relative to internal or external benchmarks. Internal benchmarks might include actual performance of other departments
or business units. External benchmarks might include performance of close competitors. About 55% of respondents to the 2003 IMA survey
reported that benchmarking was an extensively used tool.16
EXHIBIT 10.4
Relative Performance
Compared to Static and
Flexible Budget Variances
As shown in Exhibit 10.4, relative performance evaluation differs from flexible budget variances, which are based on actual sales or
production volumes.17 When managers are evaluated under a relative performance system, they may still use traditionally developed budgets
and variances as part of an interactive control system to search for challenges and opportunities arising from changing economic conditions.
Benchmarks have several advantages over static or flexible budget variances for performance evaluation. The most important advantage is
that benchmarks focus manager attention on creating value rather than on manipulating the budget or taking inappropriate actions to achieve
budget targets. Benchmarks also increase the accuracy and fairness of performance evaluation. Relative performance evaluation
automatically removes uncontrollable changes, such as general or industry economic conditions. The benchmark approach also holds
managers accountable for initiatives by competing firms such as the adoption of new business opportunities or cost-reduction practices.
Relative performance evaluation might also increase motivation, if benchmarks are perceived as challenging but achievable.
A major drawback of relative performance evaluation systems is that organizations may lack the necessary benchmark data. Insufficient data
is most likely to be a problem in the rapidly changing environments that would benefit most from this approach. In addition, as discussed
in Chapter 15, simpler approaches may be available for reducing the dysfunctional behaviors associated with traditional budgeting practices.
BEYOND BUDGETING: DYNAMIC FORECASTING (ROLLING BUDGETS)
The business environment has become increasingly dynamic, requiring managers to respond quickly to change. A rolling budget is prepared
monthly or quarterly and reflects planning changes going forward, often through the next 12 to 16 months. Many organizations use rolling
budgets because they incorporate more current information than either static or flexible budgets. Rolling budgets reflect the most recent
results and also incorporate significant changes in business strategy, operating plans, and the economy. Some managers are concerned that
rolling budgets merely add time spent on budgeting tasks. To address this concern, rolling budgets might focus only on key drivers of
strategic success—that is, on items that managers should monitor regularly.
ALTERNATIVE TERMS
The terms continuous budget and revolving budget are often used instead of rolling budget.
KAIZEN BUDGETS
Kaizen costing is a system developed in Japan for products that tend to have decreasing prices or increasing quality across time, such as
home entertainment centers, cell phones, and computers.Kaizen budgets set targeted cost reductions or quality improvements across time,
anticipating market price reductions across the life of a product. Under kaizen budgeting, cost reduction and quality improvement goals are
explicitly embedded in the budgets. Additional details about kaizen costing are available in Chapter 13, and you can explore this method by
completing end-of-chapter Problem 10.34.
TECHNOLOGY AND BUDGETING
Currently, many organizations use “home-grown” software that is usually based on spreadsheets for budgeting and analysis.18 However,
spreadsheets suffer from several problems. Software firm Host Analytics argues that spreadsheets19
•
•
•
Often contain errors in data and formulas
Are difficult to modify
Inhibit collaboration
•
May poorly document assumptions
Some organizations prefer to purchase systems from software developers. The most recent trend in performance management software is to
combine budgeting, planning, and forecasting software with operational and financial data. This combination allows for deeper analysis and
better business intelligence.
CURRENT PRACTICE
Some organizations prepare forecasts five or ten years into the future to improve long-term planning and to motivate performance consistent
with long-term strategic goals. The major benefit of such forecasts is to assist in planning for long-term projects, such as production
facilities.
Some of these products are accessible to managers via the Internet. For example, Microsoft sells Forecaster, a budgeting and forecasting
product that is accessible over the Internet to managers at all levels. A report module distributes information based on users’ needs. Sensitive
budget information is available only to authorized users. Those managers higher in the company can generally access more information than
managers below them. These types of products allow managers to produce monthly forecasts for rolling budgets.20
SUMMARY
Q1 How Do Budgets Contribute to the Strategic Management Process?
Budgeting and the Strategic Management Process
Budgets As Levers of Control
See Exhibit 10.2.
Decision Rights
Q2 What Is a Master Budget, and How Is it Prepared?
Master Budget Overview
Budget Assumptions
Nonmanufacturing Organizations
International Organizations
Forecasting
•
•
•
Sales Forecasting
Cost Forecasting
Cash Flow Forecasting
Q3 What Are Flexible Budgets, and How Can They Be Used for Sensitivity Analysis?
Static Budget
A specific volume
Flexible Budget
Any volume within a relevant range
Budget Sensitivity Analysis
Alternative budget assumptions
Q4 How Are Budget Variances Calculated and Used as Performance Measures?
Budget Variances
•
•
Differences between budgeted and actual results
Used to monitor progress toward goals and objectives
Static Budget Variances
•
•
Variances based on the budget for a specific volume of production or services
Variable cost variances may be misleading
Flexible Budget Variances
•
•
Variances based on the budget adjusted for actual sales or production volume
Variable costs are adjusted for actual volume of activity
Budgets As Benchmarks
Standards for measuring and evaluating performance
Degree of Business Risk
Major Reasons for Variances
•
•
Actual activities do not follow plans
Budget may be an inappropriate benchmark (i.e., budget assumptions may be incorrect)
Favorable Variances
Unfavorable Variances
Q5 How Do Behavioral Tensions Influence the Budgeting Process?
Decision Rights and Accountability
Budget Variances as Performance Measures
Participative Budgeting
Budgetary Slack
Budget Ratcheting
Zero-Based Budgeting
Q6 What Approaches Exist for Addressing the Problems of Traditional Budgeting?
Problems of Traditional Budgeting
•
•
•
Change causes budget assumptions to become outdated
Performance according to plan may stifle innovation and focus attention on short-term rather than long-term goals
Budgets often impede cooperation among departments and business units
Activity-Based Budgeting
GPK and RCA Budgets
Beyond Budgeting
•
•
Relative Performance Evaluation
Dynamic Forecasting (Rolling budgets)
Kaizen Budgets
Technology and Budgeting
Move away from spreadsheets to software that integrates budgeting, planning, and forecasting with operational and financial data
KEY TO SYMBOLS
•
•
•
•
•
This question requires students to extend knowledge beyond the applications shown in the textbook.
This question requires the ability to identify problems involving business risks, ethical dilemmas, or uncertainties
This question requires the ability to identify problems and also explore perspectives, biases, strengths and weaknesses, etc.
This question requires the ability to identify and explore problems and also prioritize among competing alternatives.
This question requires the ability to identify, explore, and prioritize and also envision ways to address ongoing risks and
opportunities.
See Appendix 1A for more information about identifying, exploring, prioritizing, and envisioning skills.
SELF-STUDY PROBLEMS
Self-Study Problem 1 Constructing a Master Budget
Q2
Refer to the budget schedules shown in Unique Sinks (Part 1) on pages 380 to 385.
REQUIRED:
•
•
•
A. Create a spreadsheet to replicate the master budget for Unique Sinks (Part 1). Include an input section at the top of the
spreadsheet for the assumptions needed to complete all master budget schedules. Assumptions should include information about
projected housing starts, prices, costs, and cash flows. When calculating the cost of goods manufactured and ending inventory, use the
budgeted allocation rates of $2.001 per unit for variable overhead cost and $0.7558 per unit for fixed overhead cost. Use cell
referencing in the budgets and schedules so that changes in the assumption section will be reflected throughout the spreadsheet. Check
the accuracy of your spreadsheet calculations by comparing your budget results to those shown in Unique Sinks (Part 1). (Hint: The
short-term financing budget requires programming to determine the amount to be borrowed or repaid each quarter given beginning
cash, cash receipts and disbursements, interest paid on any loan balances from the prior quarter, and a minimum ending cash balance
of $30,000. If you do not know how to program this item, you may wish to include the borrowings and repayments as assumptions in
the input area of your spreadsheet.)
B. Assume that the management of Unique Sinks anticipated a decline in sales during the second half of the year when preparing the
master budget. Estimated housing starts for the first two quarters were unchanged, but housing starts were expected to drop to 7,000 in
the third quarter and 2,000 in the fourth quarter. Change these numbers in the data input cells of your spreadsheet so that the master
budget reflects the new assumptions in all schedules. Compare the total production cost per unit in Parts A and B. Explain any
differences. Will Unique Sinks still be profitable with this large decrease in demand?
C. Continue with the budget assumptions from part (B). Analyze the cash receipts and disbursement budget and the short-term
financing budget to determine whether a dividend can be awarded and also whether additional funds will need to be borrowed.
(Hint: If you did not program the spreadsheet to automatically calculate the loan borrowing and repayment amounts, you will need to
manually alter the input assumptions for these variables to ensure that ending cash remains at $30,000 or higher.)
Solution to Self-Study Problem 1
1.
Verify that all budget schedules match those shown in Unique Sinks (Part 1).
2. Given the new assumptions for housing starts, the company is expected to remain profitable during the third quarter but to incur a loss
during the fourth quarter. Total profit for the year should remain positive.
BUDGETED STATEMENT OF INCOME AND RETAINED EARNINGS
REFLECTING DECLINE IN DEMAND DURING THIRD AND FOURTH QUARTERS
The cost per unit was $58.7559 in the original budget (p. 382) and increased to $58.8952 in the revised budget. The change was
caused by the smaller number of units used to allocate fixed production overhead. Notice that the change was relatively small because
most of the production costs were variable.
3.
The cash receipts and disbursements budget and short-term financing budget show that the firm will be able to pay off its debt during
the third quarter. However, the company will need to either reduce its dividend payment or borrow approximately $52,000 during the fourth
quarter.
CASH RECEIPTS AND DISBURSEMENTS BUDGET
REFLECTING DECLINE IN DEMAND DURING THIRD AND FOURTH QUARTERS
SHORT-TERM FINANCING BUDGET
REFLECTING DECLINE IN DEMAND DURING THIRD AND FOURTH QUARTERS
KEY TERMS
For each of these terms, write a definition in your own words. For starred terms, list at least one example that is different from the ones
given in this textbook.
Activity-based budgeting (p. 394)
*Benchmark (p. 389)
Beyond budgeting (p. 394)
Budget (p. 376)
*Budget assumptions (p. 377)
*Budget ratcheting (p. 392)
*Budget variance (p. 389)
*Budgetary slack (p. 392)
Budgeted financial statements (p. 377)
Decision rights (p. 376)
*Favorable variance (p. 389)
Financial budget (p. 377)
Flexible budget (p. 386)
Kaizen budgets (p. 396)
Master budget (p. 377)
Operating budget (p. 377)
Participative budgeting (p. 392)
*Recency effect (p. 379)
Rolling budget (p. 395)
*Static budget (p. 386)
*Unfavorable variance (p. 389)
*Zero-based budgeting (p. 392)
QUESTIONS
10.1
Explain how the following budgets relate to each other: revenue budget, production budget, and direct materials budget.
10.2
Explain the relationship between an organization’s budget and its vision, core competencies, risk preferences, strategies,
and operating plans.
10.3
What are the objectives of participative budgeting?
10.4
Define in your own words budgetary slack and budget ratcheting.
10.5
How are the master budget and flexible budget related?
10.6
10.7
What methods do organizations use to reduce budgetary slack?
How is a static budget adjusted to develop a flexible budget?
10.8
Explain how budgets are used to reinforce organizational belief systems.
10.9
Winter Tools company produces and sells snowblowers. Production levels are high in the summer and fall and then taper
off through the winter. Sales are high in the fall and early winter and then taper off in the spring. Explain why preparing a
cash budget might be particularly important for Snow Blowers.
10.10
Describe the types of information that managers use to develop budgets.
10.11
Discuss the similarities and differences between annual budgets and rolling budgets.
10.12
Why does preparation of a master budget often begin with the sales forecast?
10.13
How are budgets used as levers of control?
10.14
Is it better for managers to be pessimistic or optimistic when preparing a budget? Explain your reasoning.
10.15
What tensions could arise if top management sets unrealistically high profit goals?
EXERCISES
10.16
Q2
Revenue budget, services The Evergreen Children’s Clinic provided 20,000 doctor visits and 15,000
flu vaccinations last year. The average fee per doctor visit was $20, and the average fee for flu shots was
$10. The manager of the clinic believes that by advertising in local Parent Teacher Association bulletins,
doctor visits could increase by 10%, but flu shots would probably be unaffected.
REQUIRED:
1.
2.
10.17
Q2
Production budget The sales forecast for birdhouses built by Ryan Enterprises follows. Beginning
inventory for the year is expected to be 10,000 birdhouses, and the production manager prefers to
maintain an ending inventory of 20% of the next quarter’s sales.
Quarter
Number of Birdhouses
REQUIRED:
Prepare a revenue budget assuming that no advertising will be done.
Prepare a revenue budget assuming that the advertising campaign will be undertaken.
First
10,000
Second
30,000
Third
35,000
Fourth
50,000
Prepare a quarterly production budget. Assume that the sales forecast for the first quarter of the
following year is the same as the first quarter forecast for this year.
10.18
Q2
Retail inventory purchases budget Chang’s Jeans ‘n Tees is a retailer specializing in designer jeans
and T-shirts. The company expects to sell 10,000 pairs of jeans each quarter in the first two quarters,
20,000 pairs in the third quarter, and 15,000 in the fourth quarter. For T-shirts, sales are expected to be
20,000 each quarter for the first two quarters, 35,000 in the third quarter, and 25,000 in the fourth
quarter. Managers would like to maintain an ending inventory equal to 25% of next quarter’s sales, but
they expect to have only 2,000 pairs of jeans and 3,000 T-shirts in beginning inventory.
REQUIRED:
Prepare a quarterly purchases budget for jeans and T-shirts. Assume that the sales forecast for the first
quarter of the following year is the same as the first quarter forecast for this year.
10.19
Q2
Direct materials purchases budget The manager of Parton’s Pottery Company believes that the
company will sell 800 place settings of pottery dinnerware next month. She expects to have 100 place
settings in finished goods inventory at the beginning of the month and would like to have 200 place
settings in ending inventory. Each place setting requires three pounds of clay. The manager expects to
have 700 pounds of clay on hand at the beginning of the month, but she would like to decrease ending
inventory to 600 pounds.
REQUIRED:
How many pounds of material will need to be purchased to meet these requirements?
10.20
Q2
Production budget, resource requirements Seer Company has projected product sales for the next
six months as follows:
January
40 units
February
90 units
March
100 units
April
80 units
May
30 units
June
70 units
The product sells for $100 per unit, variable costs are $70 per unit, and fixed costs are $1,500 per month. The
finished product requires 3 units of raw material and 10 hours of direct labor. The company tries to maintain
an ending inventory of finished goods equal to the next two months of sales and an ending inventory of raw
materials equal to half of the current month’s usage.
REQUIRED:
1.
Prepare a production budget for February, March, and April.
2. Prepare a direct materials requirements and purchases budget for February, March, and April.
3.
Prepare a schedule of the direct labor hour requirements for February, March, and April.
10.21
Q2
Sales forecasts Golden Oldies sells CDs of formerly popular singers and groups. Its customers tend to
be middle age or older, so the firm advertises on TV, in magazines, and through direct mailing of
catalogs. On average, it sells to four customers for every 1,000 people watching a TV commercial. These
customers reply within two weeks of the time the commercial is shown. Catalogs are always sent out at
the end of each month because people tend to pay their bills at that time. Research shows that 0.5% of
the catalogs will result in a purchase during the month following the mailing. Magazine advertisements
generate about 25 responses per 10,000 subscribers in the month the magazine is published, 6
responses per 10,000 subscribers in the month after publication, and 1 response per 10,000 in the
second month following publication.
Golden Oldies is currently marketing the rock group “Beancounters.” Advertisements will be placed in the
February issue of magazines having total subscribers of 6,500,000. It will also send out 800,000 catalogs in
February. In addition, 20 late-night TV commercials will air in the first two weeks of February. The
commercials should reach 18 million viewers.
REQUIRED:
Calculate the budgeted number of Beancounters CDs sold per month for February through April,
assuming no other sales in March and April.
10.22
Q2, Q3, Q4
Static and flexible budgets, variances, information quality The photocopying department in a
community college has budgeted monthly costs at $40,000 per month plus $7 per student. Normally
800 students are enrolled. During January there were 730 students (which is within the relevant
range). At the end of the month, actual fixed costs were $42,000, and variable costs were $3,650.
REQUIRED:
•
•
•
•
•
10.23
Q3
A. Develop a static budget for photocopying costs based on 800 students.
B. Calculate the January static budget variance for fixed and variable photocopying costs.
C. Develop a flexible budget for the actual volume of students in January.
D. Calculate the January flexible budget variance for fixed and variable photocopying costs.
E. Which variance information—part (B) or (D)—is of higher quality? Explain.
Cumulative Exercise (Chapter 2): Flexible budget, regression analysis The CEO of Central
Industries has requested a forecast for next month’s maintenance costs. Three possible levels of
operations and potential cost drivers are as follows (all within the relevant range):
Refer to the information in Exercise 2.33. Data are available on the Wiley Web site
atwww.wiley.com/college/eldenburg.
REQUIRED:
•
•
10.24
Q5, Q6
REQUIRED:
A. If you have not already done so, perform a regression analysis using the most appropriate cost
driver for estimating maintenance costs. Write the cost function.
B. Use the cost function from Part A to develop a flexible budget for the three possible levels of
operations.
Meals budget, zero-based budgeting Explore your personal meals costs by examining your bank
account records, credit card bills, or other financial information for the last month.
•
•
•
A. Use your last month’s financial information to develop an estimate for the cost of meals
(groceries and meals eaten away from home) for next month.
B. Develop an estimate for next month’s meals costs using zero-based budgeting. Decide the
kinds of food and types of meals you will eat and then develop estimated costs for the groceries
and meals eaten away from home.
C. Explain what happened to your budget when you used zero-based budgeting. List one
advantage and one disadvantage of using zero-based budgeting for your meals costs.
10.25
Q2
Cash receipts budget Celina is developing a forecast for cash receipts for the first quarter of the year.
Credit sales for the quarter are estimated to be $640,000. The Accounts Receivable balance from the
fourth quarter of the prior year is $600,000. All other accounts receivable from the prior year have
been collected or written off. On average, collections of 50% occur during the quarter, 30% in the next
quarter, and 15% two quarters after a sale. At the end of the year, 5% are written off as uncollectible.
REQUIRED:
Calculate the budgeted cash receipts for the first quarter from credit sales.
10.26
Q2
Direct materials disbursements, purchase discounts New Ventures intends to start business on
January 1. Production plans for the first four months of operations are as follows:
January
20,000 units
February
50,000 units
March
70,000 units
April
70,000 units
Each unit manufactured requires 2 pounds of material. The firm would like to end each month with enough
raw material inventory to cover 25% of the following month’s production needs. The material costs $7 per
pound. Management anticipates paying for 40% of its purchases in the month of purchase. They will receive a
10% discount for these early payments. They anticipate having to defer payment to the next month on 60% of
their purchases. No discount will be taken on these late payments. There are no inventories on January 1.
REQUIRED:
10.27
Q2
•
Prepare a cash disbursements budget for materials for each of the first three months of
operations.
(CPA adapted) Purchases, cost of goods sold, and cash receipts budgets The Zel Company operates
at local flea markets and has budgeted sales as follows for the next three months.
Zel’s success in this specialty market is due mostly to the extension of credit terms and the budgeting
techniques implemented by the firm’s owner, Barbara Zel. Ms. Zel is a recycler; she collects her merchandise
daily at neighborhood garage sales and sells the merchandise weekly at regional flea markets. All
merchandise is marked up to sell at its purchase cost plus 25%. Stated differently, cost is 80% of the selling
price. Merchandise inventories at the beginning of each month are 30% of that month’s forecasted cost of
goods sold. With respect to sales on account, 40% of receivables are collected in the month of sale, 50% are
collected in the month following, and 10% are never collected.
REQUIRED:
1.
What is the anticipated cost of goods sold for June?
2. What is the beginning inventory for July expected to be?
3. What are the July purchases expected to be?
4.
What are the forecasted July cash collections?
10.28
Q2
Cash receipts and disbursements budget, customer discounts Myrna Manufacturing is located in
France and has projected sales in units for its first four months of operations as follows:
January
25,000
February
30,000
March
32,000
April
35,000
The product sells for €18 per unit. Twenty-five percent of the customers are expected to pay in the month of
sale and take a 3% discount; 70% are expected to pay in the month following sale. The remaining 5% will
never pay.
It takes 2 pounds of materials to produce a unit of product. The materials cost €0.75 per pound. In January
there are no raw materials in beginning inventories, but managers want to end each month with enough
materials for 20% of the next month’s production. The firm pays for 60% of its materials purchases in the
month of purchase and 40% in the following month. It takes one-half hour of labor to produce each unit.
Labor is paid €15 per hour and is paid in the same month as worked. Overhead is estimated to be €2 per unit
plus €25,000 per month (including depreciation of €12,000). Overhead costs are paid as incurred.
Myrna will begin January with no finished goods or work-in-process inventory. The managers wish to end
each month with 25% of the following month’s sales in finished goods inventory and no work in process.
REQUIRED:
10.29
Q3
•
Prepare a cash receipts and disbursements budget for February.
Flexible budget and variances, reasons for variances Play Time Toys is organized into two major
divisions: marketing and production. The production division is further divided into three
departments: puzzles, dolls, and video games. Each production department has its own manager.
The company’s management believes that all costs must be covered by sales of the three product lines.
Therefore, a portion of production division costs are allocated to each product line. The company’s accountant
prepared the following variance report for the dolls production department.
REQUIRED:
•
•
•
•
10.30
Q3, Q4
A. Is Play Time Toys using a static budget or a flexible budget to calculate variances? Explain.
Do you agree with this approach? Why or why not?
B. Develop a flexible budget for the actual sales of 1,100 units.
C. Use the benchmark you created in part (B) to calculate variances.
D. Review the variances from part (C). Briefly describe the types of operating or budgeting
problems that might have caused these variances.
Cash receipts and disbursements budget, purchase discounts, customer discounts, financing
need A college student, Brad Worth, plans to sell atomic alarm clocks with MP3 players over the
Internet and by mail order to help pay his expenses during the fall semester. He buys the clocks for $32
and sells them for $50. If payment by check accompanies the mail orders (estimated to be 40% of
sales), he gives a 10% discount. If customers include a credit card number for either Internet or mail
order sales (30% of sales), customers receive a 5% discount. The remaining collections are estimated
to be:
One month following
15%
Two months following
6%
Three months following
4%
Uncollectible
5%
Sales forecasts are as follows:
September
120 units
October
220 units
November
320 units
December
400 units
January
Out of business
Brad plans to pay his supplier 50% in the month of purchase and 50% in the month following. A 6% discount
is granted on payments made in the month of purchase; however, he will not be able to take any discounts on
September purchases because of cash flow constraints.
All September purchases will be paid for in October. He has 50 clocks on hand (purchased in August and to
be paid for in September) and plans to maintain enough end-of-month inventory to meet 70% of the next
month’s sales.
REQUIRED:
•
•
•
A. Prepare schedules for monthly budgeted cash receipts and cash disbursements for this
venture.
B. During which months will Brad need to finance purchases? (Hint: Prepare a short-term
financing budget.)
C. Brad planned simply to write off the uncollectibles. However, his accounting professor
suggested he turn them over to a collection agency. How much could Brad let the collection
agency keep so that he would be no worse off?
10.31
Q2
Production budget, direct material resource requirements Ryan Manufacturing must budget a
particular direct material very carefully because of its scarcity and its cost. One unit of this material is
used to produce one unit of finished product, and all direct material is added at the beginning of
production. Beginning inventory data are as follows:
Direct materials
1,200 units
Work in process
400 units
Finished goods
2,000 units
The CEO developed a strategic plan to increase sales this period to 14,000 units. To protect against inventory
shortages, she would like to double finished goods, work-in-process, and direct materials inventories.
REQUIRED:
•
•
•
•
10.32
Q2
A. How many units must be completed to achieve these goals?
B. How many units must be placed into production to achieve these goals?
C. How many units of direct materials must be purchased to achieve these goals?
D. Assume that Ryan’s purchasing agent is certain that only 12,000 units of this material can
be acquired next period. If the firm holds to its goal for ending inventories, how many units can
be sold?
Production, labor, materials, and revenue budgets (CMA adapted) Bullen & Company makes and
sells glare filters for microcomputer monitors. John Crane, controller, is responsible for preparing
Bullen’s master budget and has assembled the data below for next year.
The direct labor rate includes wages and all employee-related benefits and payroll taxes. Labor-saving
machinery will be fully operational by March. Also, as of March 1, the company’s union contract calls for an
increase in direct labor wages that is included in the direct labor rate.
Bullen expects to have 10,000 glare filters in beginning inventory and has a policy of carrying 50 percent of
the following month’s projected sales in inventory. Budgeted sales and cost data are as follows.
REQUIRED:
•
•
•
10.33
Q3, Q4
A. Prepare the following budgets for the first quarter. Be sure to show supporting calculations:
(1) production budget in units, (2) schedule of direct labor hours required, (3) schedule of the
cost of direct materials used, and (4) revenue budget.
B. Calculate the total budgeted contribution margin for the first quarter. Be sure to show
supporting calculations.
C. Describe at least three behavioral considerations in the profit-planning and budgeting
process.
Flexible budget variance analysis Cardinal Products hired a new marketing manager early this year.
After an informal consumer survey, the marketing manager decided to lower the firm’s selling price by
10% and increase television advertising. The operating results at year end were disappointing. The
marketing manager prepared the following analysis for the president. He assumed that direct materials
and direct labor were variable costs and that advertising was a fixed cost.
“As you can see,” the marketing manager reported, “the major problem is due to inefficiencies in production.
My plan would have worked if production had kept its costs in line.”
REQUIRED:
•
A. Prepare a flexible budget report.
•
B. What is the real source of the disappointing results? Explain.
PROBLEMS
10.34
Q6
Activity-based and kaizen budgeting, business risks Shenandoah Hills Clinic is located in a small rural
town and provides services for residents from three neighboring small towns, as well as many farmers in
the area. Part of the clinic’s cost is covered by funding from the county. The clinic director has developed
the following activity-based budget for first-quarter indirect costs.
REQUIRED:
•
•
•
•
•
10.35
Q6
A. What is the total ABC allocation budgeted for Preventative Health for the first quarter?
B. What is the total ABC allocation budgeted for Medical Problems for the first quarter?
C. The clinic director is concerned about funding for the first quarter. She expects funding from
the county to be cut by 2%. She has read about kaizen budgeting and would like to set some targets
for cost reduction. Assuming that the number of activities remains about the same as the budget
and that costs will be reduced by 2%, develop new budgeted cost allocation rates.
D. Explain how the use of activity-based budgeting might help the clinic’s managers respond to
a decrease in funding.
E. Identify several business risks and other factors that might influence the clinic’s ability to
achieve targeted cost reductions.
Performance benchmark, variances and analysis Central County Public Clinic is a free outpatient
clinic for public assistance patients. Among other services, the clinic provides visiting nurses for elderly
patients in their homes. A homemaker who cleans and performs other household tasks accompanies
each nurse. When the nurses are not visiting clients, they work at the office preparing for visits. When
the homemakers complete their visits, they go home.
Each year, the clinic receives a budget allotment from Central County. The county does not allow the clinic to
spend more than this allotment. The clinic, in turn, allocates its budget among its various programs. The
visiting nurse program was authorized (and spent) $229,583 in 20X8 and $258,281 in 20X9.
The nursing staff received a 5% increase in salary one-third of the way through 20X9. The homemakers did not
receive an increase in wages in 20X8 or in 20X9. The prices of medical supplies increased about 2% during
20X9 compared to 20X8. The prices of cleaning supplies were relatively constant across the two years.
Transportation is provided by the nurses, who are reimbursed $0.40 per mile.
REQUIRED:
•
•
•
•
10.36
Q2
A. In this problem you are not given a budget for 20X9. If you want to evaluate performance of
the 20X9 clinic, what can you use as the basis of a flexible budget to develop a benchmark?
B. Prepare a schedule to evaluate the performance of this program in 20X9 using the
benchmark suggested in part (A).
C. If you were the general manager of the clinic, what would you like to discuss with the head of
the Visiting Nurse Program concerning the 20X9 results? Explain.
D. How many patients should have been served in 20X9 for $258,281 if costs had been under
control?
Cumulative Problem (Chapter 3): Budgeted financial statements, bad debts, breakeven Walker
Products fell behind in paying its vendors, and it now has a poor credit rating. Consequently, all suppliers
demand cash on delivery (even employees are paid on a daily basis). The firm has a note payable on
which principal payments have been suspended. The firm must pay interest on this note at the rate of
1.5% of the beginning balance. If Walker misses even one interest payment, the bank will initiate
bankruptcy proceedings. The following is Walker’s balance sheet as of October 1.
Walker sells its product for $25 per unit. The purchase cost is $15 per unit. Budgeted sales for October are
2,500 units, and ending budgeted inventory is 2,000 units. Typically, 60% of Walker’s customers pay in the
month of sale, 35% in the month following purchase, and 5% never pay.
Walker’s employees are paid strictly on commission based on 10% of sales. The firm depreciates its fixed
assets at the rate of $2,000 per month. All other selling and administrative costs amount to $15,000 per month.
REQUIRED:
•
•
•
•
10.37
Q2
A. Prepare a cash receipts and disbursements budget for October.
B. Prepare a budgeted income statement for October.
C. Prepare the budgeted balance sheet as of the end of October.
D. Is the firm operating at a profit or loss? What level of sales is needed to break even?
(Hint: Treat commissions and expected bad debts as variable costs.)
Master budget, budgeted financial statements, solve for unknown Anchor Manufacturing has
forecasted sales of 5,000 units of its product at $75 each for the next month. Beginning inventory
consists of 800 pounds of direct materials and 300 units of finished goods. The managers would like to
end the month with 1,200 pounds of raw materials, no units in work in process, and 500 units in finished
goods. The firm accounts for inventory using the first-in, first-out (FIFO) method.
Three pounds of materials are required per unit of product manufactured. Each unit also requires two hours of
direct labor time. Materials cost $0.50 per pound, and labor is paid $15 per hour. Forecasted overhead is
$20,000 plus $2 per unit manufactured. Sales commissions are paid at the rate of $1 per unit, and administrative
costs are estimated to be $15,000 for the month.
The firm’s customers usually pay 25% of their bill in the month of the sale and 73% in the next month (the
other 2% are generally uncollectible). The firm pays its materials suppliers 70% in the month of purchase and
30% in the following month. Laborers, sales personnel, administrators, and all overhead purchases are paid in
the month that services are received. Overhead costs include $5,000 of depreciation on plant and equipment.
Sales last month were $240,000, and direct materials purchases were $6,000. A partially complete balance
sheet as of the beginning of the month is given here.
REQUIRED:
•
•
•
10.38
Q3, Q4
A. Complete the beginning balance sheet.
B. Prepare a master budget, including budgeted financial statements, for next month.
C. Analyze the income statement, cash budgets, and balance sheet, particularly the changes in
receivables and inventory. What changes would you suggest to improve Anchor’s performance?
Budget sensitivity analysis, strategic and operating plans, business risks Jordan, the owner of
Unique Sinks, realizes that if he withdraws the full amount of dividend, and if the slump in housing starts
continues into the next year, he may need to borrow more money than he can easily repay. He would like
to alter strategies or operating plans during the fourth quarter so that he could pay at least a $50,000
dividend and end the year with $300,000 in cash to cover potential shortfalls in the next year. Refer to
the data and solution for the fourth-quarter flexible budget developed in Self-Study Problem 1 (pages
398–400). The Excel spreadsheet solution to the Self-Study Problem is available on the Wiley Web site
at www.wiley.com/college/eldenburg.
REQUIRED:
•
A. Modify the assumptions and perform sensitivity analyses to identify a set of cost reductions
and/or payment deferrals that would allow Jordan to meet his goals. Leave all other assumptions
unchanged.
•
1. List the changes in your final sensitivity analysis, and explain why you chose this set of
changes.
•
2. Briefly explain what Jordan would need to do to implement each of these changes.
3. List several business risks or other factors that could influence whether the company
would be able to achieve the desired results.
B. Return to the original assumptions. Now modify the assumptions and perform sensitivity
analyses to determine what changes to volumes, prices, and/or customer collection patterns would
provide the desired dividend. Leave all other assumptions unchanged.
•
1. List the changes in your final sensitivity analysis, and explain why you chose this set of
changes.
•
2. Briefly explain what Jordan would need to do to implement each of these changes.
•
•
3. List several factors that could influence whether the company would be able to achieve
the desired results.
C. Write a memo to Jordan providing him with your recommendation for a best overall solution.
Also explain to Jordan the limitations of your recommendation.
•
•
10.39
Q2
Prepare cash budget from budgeted financial statements The Red Midget Company processes and
distributes beans. The beans are packed in 1-pound plastic bags and sold to grocery chains for $0.50 each
in boxes of 100 bags. Sales in February were 14,000 boxes, and the firm anticipates selling 16,000 boxes
during March. Typically, 80% of the firm’s customers pay within the month of sale, 18% of the customers
pay the month after, and 2% of sales are never collected.
The firm buys beans from local farmers. The farmers are paid $0.20 per pound, cash. Most of the processing is
done automatically. Consequently, most ($80,000) of the firm’s factory overhead is depreciation expense.
The firm advertises heavily and will publish $75,000 worth of advertisements in popular magazines during
March. This is up from February’s $60,000 for advertisements. The firm pays for 10% of its advertising in the
month the advertisements are run and 90% in the next month. Following are March’s budgeted Income
Statement and Statement of Cost of Goods Manufactured and Sold. All costs and expenses are paid for as
incurred unless specifically indicated otherwise above. The firm will begin March with a cash balance of
$25,000 and pays a monthly dividend of $15,000 to the owners.
REQUIRED:
10.40
Q4, Q5, Q6
•
From the information provided, prepare a cash receipts and disbursements budget for March.
Traditional budget versus relative performance evaluation Games ‘N More operates a chain of retail
stores that sell primarily puzzles, board games, and video games. The manager of each store receives a
bonus based on annual store results. The company’s CEO, Amanda Hargrove, is currently evaluating last
year’s performance. Most stores experienced lower than expected sales because of increasing
competition from Internet retail companies. In the past, the managers were evaluated based on store
results compared to budgets. However, the company’s CFO recently attended a seminar on relative
performance evaluation and recommended that Amanda consider evaluating manager performance
based on how well each store performed relative to other stores in the chain.
Managers are required to place all inventory orders through the corporate purchasing department to enable the
company to take advantage of quantity discounts. However, managers make their own decisions about selling
prices, product mix, sales promotions, and staffing levels. The corporate office conducts marketing research,
and the store managers meet quarterly to discuss customer purchasing trends and competition. Amanda
negotiates with each store manager to develop annual budgets, but she insists on setting challenging budget
targets to encourage managers to continuously improve store results. For example, the current year’s budgets
assumed a 10% increase in sales over the prior year even though the company faced greater com…