LECTURE 11 COMM 2AB3

Chapter 6 Master Budget and Responsibility Accounting

March 19, 21, 24 2014
Budgets
Budget the quantification of an organizations expectations of the inflow and outflow of resources for a set time period of a proposed future plan of
action by management
o Quantification of a plan, in a dollar amount
o Budget can be based on what is going to happen or what has already happened
o Based on a purely estimated amount (future) master budget; static budget
o Based on the past flexible budget
o Not the same as a forecast
Forecast usually based on strategic options; take budget (master budget) and modify it; what would happen to it if strategic
option is applied
Any modification of a budget
o Eg/ Company already in operation, expect inflation of 1.5%, expect growth in product sales (internal) and market (external)
Labor, material, advertising costs
Budgeting the process of gathering information to assist in making those forecasts
Master Budget (Short Term Budget Application
o Coordinates and summarizes all the financial projections of all the organizations individual budgets in a single document for a set period
of time
o Includes operating estimates, a cash budget, and pro forma financial statements (balance sheet, income statement and statement of cash
flows)
o Embraces operating and financing activities and decisions
o Approaches start from:
Top line this is what we want to achieve in sales
Bottom line this is what we want to end up in profits
Advantages of Budgets
o Promotes planning, includes the implementation of plans
Links the budget with strategic analysis for the organization including overall objectives, trends, risks, alternative strategies
Promotes coordination and communication among subunits within the company
o Motivates managers and other employees
Helps to achieve a standard
Can be as minute; eg/ want to use 100 bottle tops; need to manufacture more than 100
Set a practical budget, as opposed to theoretical budget
o Apply and influence control
Assign responsibilities by allocating resources to managers
Set targets and goals
o Provide performance evaluation and feedback criteria
Comparing actual performance against a budget is better than comparing this years achievements to last years result including
corrective action
More revenue, less costs is not always better any deviation from budget is not good
Could have done a purposely understated revenue and get a bonus when achieved more
Extreme risk
Why did we make more money? Did someone take a risk?
If market grew by 100% and we made 10%? Made more than budget, but less than market
Strategic Planning
1. Selecting overall objectives
o Qualitative how to accomplish quantitative objective
o Quantitative
Increase revenues by 10% in coming year; increase dividend payout by 15%; increase cash flow profit margin, reduce operating
expense etc
Can be numerous and simultaneous
2. Choosing markets
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LECTURE 11 COMM 2AB3
o Where we are operating from; regional, national etc
3. Selecting products to produce
4. Determine price/quality mix
o Lower quality, cheaper price
5. Choosing technologies
o Will have direct impact on budgets
Short Term Budgets
1 year or less (eg/ next quarter)
Quantities to produce
o Inventory, spoilage and for sale
o Extra capacity
Quantities to sell
Supplies acquisitions
Financial resources needed
Long Term Budgets
Investing decisions
o Eg/ Expanding to another country; use Capital Budgets 25 years; looks at cash outflows from every year; based on growth, inflation, one
time revenues, costs
More than one year
Forecasts of large asset acquisitions
Financing plans
Research and development plans
Divisions of Master Budgets
Operating Budgets
o The set of budgets leading to the pro forma (budgeted) income statements
Financial Budgets
o The set of budgets that comprise and lead to the capital budget, cash budget, pro forma balance sheet and the pro forma statement of cash
flows
Basic Operating Budget Steps
1. Prepare the Revenue Budget (top line)
2. Prepare the Production Budget (in Units)
3. Prepare the Direct Materials Usage Budget and Direct Materials Purchases Budget
4. Prepare the Direct Manufacturing Labor Budget
5. Prepare the Manufacturing Overhead Costs Budget
6. Prepare the Ending Inventories Budget
o Eg/ If company has policy to have at least 10% of the next periods budgeted sales in stock
7. Prepare the Costs of Goods Sold Budget
8. Prepare the Operating Expense (Period Cost) Budget
9. Prepare the Budgeted Income Statement (bottom line)
Basic Financial Budget Steps
Based on the Operating Budgets
1. Prepare the capital expenditures budget
2. Prepare the cash budget
3. Prepare the budgeted balance sheet
4. Prepare the budgeted statement of cash flows
Types of Responsibility Centers
If deviation from budget, must be able to pinpoint where it occurred- not good or bad, but investigateable
Areas of responsibility if you are a cost center, your budget targets and goals will be different from other cost centers
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LECTURE 11 COMM 2AB3
Cost
o Accountable for costs only
o Cost, no revenue
o Eg/ Sonomax given bonus based on net profit of company, but have no control over revenues; how do you set around revenues when
youre a cost center? Budget has to be set according to the correct center
o Eg/ If running website or HR, how can you give a bonus based on revenues of the firm?
Revenue
o Accountable for revenues only
o Eg/ Sales center; no control over production, rent, utilities; only control over sales cannot be evaluate on profitability (includes cost);
Profit
o Accountable for revenues and costs
o Eg/ Midlevel management is responsible for profit budgets
Investment
o Accountable for investments, revenues, and costs
o Responsible for capital budgeting;
o D or C level (Directors, CEO etc)
Budgets and Feedback
Budgets offer feedback in the form of variances; actual results deviate from budgeted targets
Variance provide mangers with
o Early warning of problems
o A basis for performance evaluation
o A basis for strategy evaluation
Favorable or unfavorable not good or bad; relative term relative to bottom line; how did extra or less revenue affect the bottom line?
o Eg/ Less revenue than budgeted; but if market goes down a lot, not bad, because did not go down as much as market
Cannot compare a budget of 200,000 units of sales with a revenue of 220,000 units would have the wrong costs; level of activity is different; more
labor costs, packaging, materials etc
o Prepare budget for future (master)
o Live the term out
o Prepare flexible budget (what happened)
o Compare
o Remake budget
Controllability
Controllability the degree of influence that a manager has over cost, revenues, or related items for which he is being held responsible
o Eg/ Produce bottle of beer; takes bottle top, label, liquid which takes labor, material and overhead bottle of beer production costs $1; 100
produced, but cost $110 determine who is responsible
Were no broken bottles, torn labels; staff is high quality what happened?
Did purchasing manager purchase materials at a higher price?
Did material producers increase prices, and budget wasnt adjusted?
Did the waste from spoilage get reduced?
Did we save money on labor because of poor quality? Did this cause broken bottles and more spoilage?
Responsibility Accounting focuses on information sharing, not in laying blame on a particular manager
o Holding people who have control over costs responsible
o Must ensure that budget follows responsibility centers
Budgeting and Human behaviour
The budgeting process may be abused both by superiors and subordinates, leading to negative outcomes
o Employees or upper management
Superiors may dominate the budget process or hold subordinates accountable for events they have no control over
Subordinates may build budgetary slack in their budgets
o Budget slack overestimate of costs, underestimation of revenues
o Set lower standards for budget
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LECTURE 11 COMM 2AB3
o Budgetary Slack the practice of underestimating budgeted revenues, or overestimating budgeted expenses, in an effort to make the
resulting budgeted goals (profits) more easily attainable
Budget padding addition of irrelevant cost items in a budget
o Eg/ Center that uses hospital line so power never goes out, yet accounts for using diesel to power a generator generator never used
Master Budget for a Retailer
Master Budget for a Manufacturer
Only difference is production budget vs. purchase budget
The Master Budget tie-in to the Bash Budget
Advantages of Budgeting
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LECTURE 11 COMM 2AB3
Cash Budget
Expected cash inflows (recipients)
Expected cash outflows (disbursements)
Predicts cash position for specific level of activity
Predicts timing of bank loans and repayments
In Class Example 1)
Denominator level needed for fixed costs
o Eg/ Rent is $1 per student, with respect to 500 students; rent is $500
o Denominator level when fixed costs are expressed as per unit
Sales Commission = V S&A
Actual in November; December February are Budgeted
70% + 28% = 98% 2% of bad credit
Ending balance of cash $10,000 if excess, pay off loan; if less, get loan
Production budget prepared in units, not dollars
o Based on a sales budget or information given on sales
A) Production Budget (in units) for December and January
Need vs. want analysis what I need vs. what I have
December January
What I need:
Projected Sales
Min E. Inv.
50,000
1000 + 10% of 60,000
57,000
60,000
1000 + 10% of 30,000
64,000
What I have?
Beg. Inv (E. Inv of
previous month)
1000 + 10% of 50,000
= (6000) (7,000)
Produce 51,000 57,000
B) Direct Material Purchases Budget (in $)
December
What I need:
Production in Dec
Min DM End Inv in Dec
51,000 units x $5
$2000 + (30% of 57,000 units x $5)
What I have?
Beg Inv of Dec (E. Inv of
Nov)
$2000 + (30% of 51,000 units x $5)
$264,000
Another method (51,000 units x $5 x 70%) - $2000
Need Sales and Production Budgets to make DM Purchases Budget
C) Cash Budget in December ($)
December
Beginning Balance $15,000 (EB of Nov)
Add Cash Inflow
Collections from Dec Cash Sales
Collections from Dec Credit Sales
Collection from Nov Credit Sales
50,000 x $2 x 10%
50,000 x $42 x 90% x 70%
45,000 x $40 x 90% x 28%
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LECTURE 11 COMM 2AB3
Less Disbursements (Cash
Outflow)
DM Purchases
Direct Labor
VMOH
FMOH
Sales Commission
Fixed S&A
Purchase of Equipment
$264,000 from DM Purchase Budget
$8 x 51,000 units from Prod. Budget
$3 x 51,000 units from Prod. Budget
$4 x 40,000 from denominator level
10% x 50,000 x $42 from Sales Budget
$9 x 40,000 from denominator level
$400,000 due to down payment
Cash Surplus $46,600
Inflow
10% of all sales are made in cash
50,000 units x $42/unit x 10%
90% Accounts Receivable are collected; 70% within the month
90% of 50,000 units x $42/unit x 70%
Previous month; 90% of sales is on credit; 28% of credit sales are collected in the following month
90% x 28% x 45,000 units x $40/unit
Outflow
Buying $264,000 of DM but may have credit policy; multiple months will influence payment within a month
Fixed cost does not change unit fixed cost is based on denominator level (40,0000
Denominator level is not the relevant range it is within the relevant rage
Need $10,000 cash at all times other wise borrow loan or pay off loan
In this situation assume amortization is part of costs in the table
If this was not the case; 30% of FMOH is Cash Outflow and 60% of F S&A is Cash Outflow (other 60% and 40% are Amortization)
Cash Budget DEC
Beginning Balance 15,000
Add Cash Inflow 1,986,600
Less Disbursements (1,955,000)
Cash Surplus 46,600
Less Line of Credit (10,000) (IF LINE OF CREDIT IS IN SCENARIO)
36,000
Did not borrow money would have had a BB of $10,000 do not have to pay off any money
Also recall that borrowing and investing is different investing is long-term debt; cash budgets are for short-term
In Class Example 2)
Static budget can be prepared once the actual has prepared, looking backward
o (Static Budget) January ------------>December (Actual)
Learned static budgets look into future without knowledge of how internal or external factors will impact budget
o Eg/ Plan to sell 200,000 units at $1 = $200,000 revenue
Actual = $300,000 revenue why the difference?
150,000 units x $2 sold 50,000 units (25%) less than amount supposed to sell; if market decreased by 50%, he
only took sales down by 25%
Cannot compare a Static Budget with Actual because different level of activity
Flexible Budget budget for actual output; what already happened; assume knowledge of what happened, use it to create budget
o Combination between what happened and what was supposed to happen
Flexible Budget = % Budgeted x Actual Quantity of Output
Variance = |Actual Flexible|
Analysis Static Budget Actual Results Flexible Budget Variance U/F
Units 10,000 8,000 8,000 -
Total Revenues 200,000 128,000 200,000/10,000 x 8,000
=160,000
32,000 U
Total Variable Costs 120,000 80,000 120,000/10,000 x 8,000
= 96,000
16,000 F
Total Fixed Costs 20,000 18,000 20,000 2,000 F
Operating Profit 60,000 30,000 44,000 14,000 U
Fixed Cost does not depend on quantity just what you budgeted cost to be static budget carried forward
Variance inform whether the change hurt or helped the bottom line; Favorable (F) or Unfavorable (U) (not good or bad)
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LECTURE 11 COMM 2AB3
If actual cost < budgeted flexible cost; actual revenue > budgeted revenue favorable
Operating Income overall; made $14,000 less income than supposed to, because bad in sales (revenue U), good in costs (costs both F)
o Sales could have been affected by (caused to be unfavorable):
Sales-Price Variance (SPV) sold lower than should have
Budgeted Selling Price = 200,000/10,000 = 20
Actual Selling Prince = Actual Rev/Actual Units = 128,000/8,000 = 16
Market Size Variance market doing poorly
Sales Volume Variance sold less quantity
Market Share Variance share of market decreased; could be due to quality
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