Operational and Financial Budgeting

1. 6 Operational and Financial Budgeting Prepared by Douglas Cloud Pepperdine University

2. Objectives • Explain how budgeting relates to the major functions of management. • Describe the components and organization of a comprehensive budget. • Describe several methods managers use to forecast sales and some of the problems of using each method. • Describe two approaches to setting budget allowances for costs and the types of costs for which each is appropriate. After reading this chapter, you should be able to: Continued

3. Objectives • Describe behavioral problems associated with budgeting. • Prepare a budgeted income statement, a purchases budget, a cash budget, and a budgeted balance sheet. • Describe the leads and lags that complicate the budgeting of cash receipts and disbursement. Continued

4. Objectives • List several ways that managers might resolve cash deficiencies revealed by a cash budget. • Describe similarities and differences between budgeting in for-profit and not-for-profit entities. • State how zero-based-budgeting and program budgeting differ from other budgeting processes.

5. Budgets often reveal incompatibilities and conflicts.

6. Comprehensive Budget A comprehensive budget or master budget is a set of financial statements and other schedules showing the expected, or pro forma, results for a future period.

7. Comprehensive Budget Assumptions about cost behavior Pro forma income statement Sales forecast + + Assumptions about levels of inventory, collections of receivables, and payments of expenses and liabilities Budgets for purchases and production Balance sheet at beginning of budget period + Budgets for cash and requirements for short-term financing Pro forma balance sheet + Plans for long-term financing and for capital spending

8. Continuous Budgets Continuous budgets are maintained by adding a budget for a month (or quarter) as one of these periods goes by. Thus, a 12-month budget exists at all times. 2006

9. Sales Forecasters • External Indicators • Historical Analysis • Judgment

10. Interim Period Forecasts Three distinct types of sales forecasting methods: 1. Annual forecasts 2. Longer-term forecasts (three to five years) 3. Quarterly or monthly forecasts Once a forecast for the year has been approved as a basis for planning, it is necessary to break it down into interim periods.

11. Indirect labor $2,400 $0.40 Supplies 200 0.40 Maintenance 1,600 0.20 Depreciation 1,200 0.00 Miscellaneous 700 0.10 Total $6,100 $1.10 Expense Budget Direct Labor per Hour Fixed Amount per Month Cost

12. Flexible budget allowance direct labor hours variable cost per hour fixed cost per month = x + Flexible budget allowance = $6,100 + (1,000 x $1.10) $7,200 Expense Budget Example: Indirect labor

13. Direct labor hours 1,000 1,300 Indirect labor $2,800 $2,920 $2,870 $50 Supplies 600 720 705 15 Maintenance 1,800 1,860 1,900 (40 ) Depreciation 1,200 1,200 1,200 0 Miscellaneous 800 830 840 (10 ) Total $7,200 $7,530 $7,515 $15 Production Performance Report Month____________________ Department________________ Manager__________________ March Mixing E. Jones Budget Allowances Budgeted Actual Actual Costs HoursHoursIncurredVariance

14. Budgeting and Behavior Behavioral problems arise when: • When managers’ interests conflict • When budgets are imposed from above • When stretch goals are used • When budgets are viewed as checkup devices Conflict

15. Imposed Budgets Imposed budgets are when senior managers set performance goals (budgets) without consulting the individuals who will be responsible for meeting those goals. Serious behavioral problems can arise (or be avoided) depending on the attitudes of managers imposing the performance goals.

16. Stretch Goals S t r e t c h g o a l sare exceptionally ambitious targets not likely to be achieved without making fundamental changes in the way a job is done.

17. “Checkup” Devices Behavioral problems arise when managers compare budgeted and actual results and subsequently evaluate the performance of their subordinates.

18. “Spend IT or Lose It” Expense budgets set limits on levels of costs to be incurred, allowances managers are not supposed to exceed. If managers view their budget allowances as strict limits on spending, they may spend either too little or too much.

19. Budgeting and Ethics • Managers in some areas might consider preparing—and ask management accountants to help them in doing so—budgets with a great deal of slack so that managers will be able to meet them with minimum effort. • Top-level management impose budgets on subordinates so tight that there is little chance of achieving them. • Ethical issues also arise about the reporting of actualresults for a budget period.

20. January $400 February 500 March 800 April 700 May 600 Cost of goods sold will be 60% of sales dollars. Total fixed costs will be $150, of which $15 per month is depreciation expense. Exhibit 6-3 MonthSales Budget

21. Sales $400 $500 $800 $1,700 Cost of goods sold 240 300 480 1,020 Gross profit and contribution margin 160 200 320 680 Fixed costs 150 150 150 450 Income $ 10 $ 50 $170 $ 230 Exhibit 6-4 Budgeted Income Statement Three-Month JanuaryFebruaryMarchTotal

22. Cost of goods sold $ 240 $ 300 $ 480 $1,020 Budgeted ending inven. 780 900 780 780 Total requirements 1,020 1,200 1,260 1,800 Beginning inventory 540 780 900 540 Purchases $ 480 $ 420 $ 360 $1,260 Exhibit 6-5 Purchases Budget Three-Month JanuaryFebruaryMarchTotal

23. Exhibit 6-6 Cash Receipts Budget Three-Month JanuaryFebruaryMarchTotal Sales $400 $500 $800 $1,700 Collections: From prior years, 30% $310 $120 $150 $ 580 From current month, 70% 280 350 560 1,190 Total receipts $590 $470 $710 $1,770

24. Exhibit 6-7 Cash Disbursements for Purchases Three-Month JanuaryFebruaryMarchTotal From prior month, 40% $195 $192 $168 $ 555 From current month, 60% 288 252 216 756 Total $483 $444 $384 $1,311

25. Exhibit 6-8 Cash Disbursements Budget Three-Month JanuaryFebruaryMarchTotal For merchandise, see Exhibit 6-7 $483 $444 $384 $1,311 Fixed costs requiring cash 135 135 135 405 $618 $579 $519 $1,716

26. Exhibit 6-9 Cash Budget Three-Month JanuaryFebruaryMarchTotal Beginning balance, Exhibit 6-3 $ 80 $ 52 $ 50 $ 80 Cash receipts, Exhibit 6-6 590 470 710 1,770 Total available $670 $522 $760 $1,850 Cash disbursements, Exhibit 6-8 618 579 519 1,716 Indicated balance $ 52 $(57 ) $241 $ 134 Excess (deficiency) 2 (107 ) 191 Borrow 107 107 Repay 107 107 Ending balance $ 52 $ 50 $134 $ 134

27. Exhibit 6-10 Pro Forma Balance Sheet As of March 31, 20X6 Assets Cash (Exhibit 6-9) $ 134 Accounts receivable (March sales x 30%) 240 Inventory (Exhibit 6-5) 780 Fixed assets (beginning balance less $45 depreciation for 3 months) 1,535 Total assets $2,689 Equities Accounts payable (March purchases x 40%) $ 144 Stockholders’ equity 2,545 Total equities $2,689

28. Zero-based budgeting means that managers must justify every dollar they request in a budget proposal for a given year.

29. Program budgeting requires that a budget indicate not only how the requested funds are to be spent, but also why the funds are to be spent in those ways.

30. Chapter 6 The End