Profit Planning

Chapter 8

McGraw-Hill/Irwin
9-2

Learning Objective 1

Understand why
organizations budget
and the processes they
use to create budgets.
9-3

The Basic Framework of Budgeting

A budget is a detailed quantitative plan for acquiring

and using financial and other resources over a specified
forthcoming time period.

1. The act of preparing a budget is called

budgeting.
2. The use of budgets to control an organization’s
activity is known as budgetary control.
9-4

Planning and Control

Planning – Control –
involves developing involves the steps
objectives and taken by
preparing various management that
budgets to achieve attempt to ensure the
these objectives. objectives are
attained.
9-5

Advantages of Budgeting

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

Advantages
Coordinate Means of allocating
activities resources

Uncover potential
bottlenecks
9-6

Responsibility Accounting

Managers should be held responsible for those

items — and only those items — that
the manager can actually control
to a significant extent.
 9-7

Choosing the Budget Period

Operating Budget

2005 2006 2007 2008

The annual operating budget A continuous budget is a

may be divided into quarterly 12-month budget that rolls
or monthly budgets. forward one month (or quarter)
as the current month (or quarter)
is completed.
9-8

Self-Imposed Budget

Top Management

Middle Middle
Management Management

Supervisor Supervisor Supervisor Supervisor

A budget is prepared with the full cooperation and
participation of managers at all levels. A
participative
budget is also known as a self-imposed budget.
 9-9

Advantages of Self-Imposed Budgets

1.
1. Individuals
Individuals at
at all
all levels
levels of
of the
the organization
organization are
are viewed
viewed
as
as members
members of of the
the team
team whose
whose judgments
judgments are
are valued
valued
by
by top
top management.
management.
2.
2. Budget
Budget estimates
estimates prepared
prepared by
by front-line
front-line managers
managers are
are
often
often more
more accurate
accurate than
than estimates
estimates prepared
prepared by
by top
top
managers.
managers.
3.
3. Motivation
Motivation isis generally
generally higher
higher when
when individuals
individuals
participate
participate in
in setting
setting their
their own
own goals
goals than
than when
when the
the
goals
goals are
are imposed
imposed from
from above.
above.
4.
4. AA manager
manager who
who is
is not
not able
able to
to meet
meet aa budget
budget imposed
imposed
from
from above
above can
can claim
claim that
that it
it was
was unrealistic.
unrealistic. Self-
Self-
imposed
imposed budgets
budgets eliminate
eliminate this
this excuse.
excuse.
9-10

Self-Imposed Budgets

Most companies do not rely exclusively upon self-

imposed budgets in the sense that top managers
usually initiate the budget process by
by issuing broad
guidelines in terms of overall profits or sales.
9-11

Human Factors in Budgeting

The success of budgeting depends upon three important

factors:
1. Top management must be enthusiastic and committed
to the budget process.
2. Top management must not use the budget to pressure
employees or blame them when something goes wrong.
3. Highly achievable budget targets are usually preferred
when managers are rewarded based on meeting budget
targets.
9-12

The Budget Committee

A standing committee responsible for

 overall policy matters relating to the budget
 coordinating the preparation of the budget
9-13

Learning Objective 2

Prepare a sales budget,

including a schedule of
expected cash
collections.
9-14

Budgeting Example

 Royal Company is preparing budgets for the quarter

ending June 30.
 Budgeted sales for the next five months are:
 April 20,000 units
 May 50,000 units
 June 30,000 units
 July 25,000 units
 August 15,000 units.
 The selling price is $10 per unit.
9-15

The Sales Budget

The individual months of April, May, and June are summed

to obtain the total projected sales in units and dollars for
the quarter ended June 30th
9-16

Expected Cash Collections

•• All
All sales
sales are
are on
on account.
account.
•• Royal’s
Royal’s collection
collection pattern
pattern is:
is:
 70%
70% collected
collected in
in the
the month
month of of sale,
sale,
 25%
25% collected
collected in
in the
the month
month following
following sale,
sale,
 5%5% uncollectible.
uncollectible.
•• The
The March
March 3131 accounts
accounts receivable
receivable balance
balance of
of
$30,000
$30,000 will
will be
be collected
collected inin full.
full.
9-17

Expected Cash Collections

9-18

Expected Cash Collections

From the Sales Budget for April.

9-19

Expected Cash Collections

From the Sales Budget for

May.
9-20

Quick Check 

What will be the total cash collections for the quarter?

a. $700,000
b. $220,000
c. $190,000
d. $905,000
9-21

Quick Check 

What
What will
will be
be the
the total
total cash
cash collections
collections for
for the
the quarter?
quarter?
a.
a. $700,000
$700,000
b.
b. $220,000
$220,000
c.
c. $190,000
$190,000
d.
d. $905,000
$905,000
9-22

Expected Cash Collections

9-23

Learning Objective 3

Prepare a production
budget.
9-24

The Production Budget

Sales Production
Budget Budget
and d
Expected e te
p l
Cash
m
Co
Collections

Production must be adequate to meet budgeted

sales and provide for sufficient ending inventory.
9-25

The Production Budget

• The management at Royal Company wants ending

inventory to be equal to 20% of the following month’s
budgeted sales in units.

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

 Let’s prepare the production budget.

9-26

The Production Budget

9-27

The Production Budget

Budgeted May sales 50,000

Desired ending inventory % 20%
March 31
Desired ending inventory 10,000
ending inventory
9-28

Quick Check 

What is the
the required production for May?
a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
9-29

Quick Check 

What is the
the required production for May?
a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
9-30

The Production Budget

9-31

The Production Budget

Assumed ending inventory.

9-32

Learning Objective 4

Prepare a direct
materials budget,
including a schedule of
expected cash
disbursements for
purchases of materials.
9-33

The Direct Materials Budget

•• At
At Royal
Royal Company,
Company, five five pounds
pounds of of material
material are
are
required
required per
per unit
unit of
of product.
product.
•• Management
Management wantswants materials
materials onon hand
hand at
at the
the end
end of
of
each
each month
month equal
equal to to 10%
10% ofof the
the following
following month’s
month’s
production.
production.
•• On
On March
March 31,
31, 13,000
13,000 pounds
pounds ofof material
material are
are on
on hand.
hand.
Material
Material cost
cost is
is $0.40
$0.40 per
per pound.
pound.
Let’s
Let’s prepare
prepare thethe direct
direct materials
materials budget.
budget.
9-34

The Direct Materials Budget

From production budget

9-35

The Direct Materials Budget

9-36

The Direct Materials Budget

March 31 inventory

10% of following Calculate the materials to

month’s production be purchased in May.
needs.
9-37

Quick Check 

How
How much
much materials
materials should
should be
be purchased
purchased in
in May?
May?
a.
a. 221,500
221,500 pounds
pounds
b.
b. 240,000
240,000 pounds
pounds
c.
c. 230,000
230,000 pounds
pounds
d.
d. 211,500
211,500 pounds
pounds
9-38

Quick Check 

How
How much
much materials
materials should
should be
be purchased
purchased in
in May?
May?
a.
a. 221,500
221,500 pounds
pounds
b.
b. 240,000
240,000 pounds
pounds
c.
c. 230,000
230,000 pounds
pounds
d.
d. 211,500
211,500 pounds
pounds
9-39

The Direct Materials Budget

9-40

The Direct Materials Budget

Assumed ending inventory

 9-41

Expected Cash Disbursement for Materials

•• Royal
Royal pays
pays $0.40
$0.40 per
per pound
pound forfor its
its materials.
materials.
•• One-half
One-half of
of aa month’s
month’s purchases
purchases is is paid
paid for
for in
in the
the month
month
of
of purchase;
purchase; the
the other
other half
half is
is paid
paid in in the
the following
following month.
month.
•• The
The March
March 3131 accounts
accounts payable
payable balance
balance is is $12,000.
$12,000.

Let’s
Let’s calculate
calculate expected
expected cashcash disbursements.
disbursements.
9-42

Expected Cash Disbursement for Materials

9-43

Expected Cash Disbursement for Materials

Compute the expected cash

disbursements for materials
for the quarter.

140,000 lbs. × $.40/lb. = $56,000

9-44

Quick Check 

What are the total cash disbursements for the quarter?

a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
9-45

Quick Check 

What are the total cash disbursements for the quarter?

a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
9-46

Expected Cash Disbursement for Materials

9-47

Learning Objective 5

Prepare a direct labor

budget.
 9-48

The Direct Labor Budget

•• At
At Royal,
Royal, each
each unit
unit of
of product
product requires
requires 0.05
0.05 hours
hours (3
(3
minutes)
minutes) of of direct
direct labor.
labor.
•• The
The Company
Company has has aa “no
“no layoff”
layoff” policy
policy so
so all
all employees
employees will
will
be
be paid
paid for
for 40
40 hours
hours of of work
work each
each week.
week.
•• In
In exchange
exchange for for the
the “no
“no layoff”
layoff” policy,
policy, workers
workers agree
agree to
to aa
wage
wage rate
rate of
of $10
$10 per
per hour
hour regardless
regardless ofof the
the hours
hours worked
worked
(no
(no overtime
overtime pay).
pay).
•• For
For the
the next
next three
three months,
months, thethe direct
direct labor
labor workforce
workforce will
will
be
be paid
paid for
for aa minimum
minimum of of 1,500
1,500 hours
hours per
per month.
month.
 Let’s
Let’s prepare
prepare the the direct
direct labor
labor budget.
budget.
9-49

The Direct Labor Budget

From production budget.

9-50

The Direct Labor Budget

9-51

The Direct Labor Budget

Greater
Greater of
of labor
labor hours
hours required
required
or
or labor
labor hours
hours guaranteed.
guaranteed.
9-52

The Direct Labor Budget

9-53

Quick Check 

What would be the total direct labor cost for

the quarter if the company follows its no lay-off
policy, but pays $15 (time-and-a-half) for
every hour worked in excess of 1,500 hours in
a month?
a. $79,500
b. $64,500
c. $61,000
d. $57,000
9-54

Quick Check 

What would be the total direct labor cost for the

quarter if the company follows its no lay-off policy,
but pays $15 (time-and-a-half) for every hour worked
in excess of 1,500 hours in a month?April May June Quarter
a. $79,500 Labor hours required 1,300 2,300 1,450
Regular hours paid 1,500 1,500 1,500 4,500
b. $64,500
Overtime hours paid - 800 - 800
c. $61,000
d. $57,000 Total regular hours 4,500 $10 $ 45,000
Total overtime hours 800 $15 $ 12,000
Total pay $ 57,000
9-55

Learning Objective 6

Prepare a
manufacturing
overhead budget.
9-56

Manufacturing Overhead Budget

• At Royal, manufacturing overhead is applied to units of

product on
on the basis of direct labor hours.
• The variable manufacturing overhead rate is $20 per
direct labor hour.
• Fixed manufacturing
manufacturing overhead is $50,000 per month and
includes $20,000 of noncash costs (primarily depreciation
of plant assets).

 Let’s prepare the manufacturing

manufacturing overhead
overhead budget.
9-57

Manufacturing Overhead Budget

Direct Labor Budget.

9-58

Manufacturing Overhead Budget

Total mfg. OH for quarter $251,000

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

* rounded
9-59

Manufacturing Overhead Budget

Depreciation
Depreciation is
is aa noncash
noncash charge.
charge.
9-60

Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

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

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct materials
budget and information.
9-61

Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $10.00 0.50
Manufacturing overhead

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct labor budget.

9-62

Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units
Unit product cost $ 4.99
Ending finished goods inventory ?

Total mfg. OH for quarter $251,000

Total labor hours required 5,050
= $49.70 per hour *
9-63

Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $10.00 0.50
Manufacturing overhead 0.05 hrs. $49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $24,950

Production Budget.
9-64

Learning Objective 7

Prepare a selling and

administrative expense
budget.
 9-65

Selling and Administrative Expense Budget

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

Let’s
Let’s prepare
prepare the
the company’s
company’s selling
selling and
and
administrative
administrative expense
expense budget.
budget.
9-66

Selling and Administrative Expense Budget

Calculate the selling and administrative

cash expenses for the quarter.
9-67

Quick Check 

What are the total cash disbursements for selling and

administrative expenses for the quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
9-68

Quick Check 

What are the total cash disbursements for selling and

administrative expenses for the quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
9-69

Selling and Administrative Expense Budget

9-70

Learning Objective 8

Prepare a cash budget.

9-71

Format of the Cash Budget

The cash budget is divided into four sections:

1. Cash receipts listing all cash inflows excluding
borrowing;
2. Cash disbursements listing all payments excluding
repayments of principal and interest;
3. Cash excess or deficiency; and
4. The financing section listing all borrowings, repayments
and interest.
 9-72

The Cash Budget

Royal:
Royal:
 Maintains
 Maintains aa 16%
16% open
open line
line of
of credit
credit for
for $75,000
$75,000

 Maintains
Maintains aa minimum
minimum cashcash balance
balance of
of $30,000
$30,000

 Borrows
Borrows onon the
the first
first day
day of
of the
the month
month and
and repays
repays
loans
loans on
on the
the last
last day
day of
of the
the month
month

 Pays
Pays aa cash
cash dividend
dividend ofof $49,000
$49,000 in
in April
April

 Purchases
Purchases $143,700
$143,700 of of equipment
equipment in in May
May and
and $48,300
$48,300
in
in June
June (both
(both purchases
purchases paid
paid in
in cash)
cash)

 Has
Has an
an April
April 11 cash
cash balance
balance of
of $40,000
$40,000
9-73

The Cash Budget

Schedule
Schedule of
of Expected
Expected
Cash
Cash Collections.
Collections.
9-74

The Cash Budget

Schedule
Schedule of
of Expected
Expected
Cash
Cash Disbursements.
Disbursements.

Direct Labor
Budget.

Manufacturing
Overhead Budget.

Selling and Administrative

Expense Budget.
9-75

The Cash Budget

Because Royal maintains

a cash balance of $30,000,
the company must borrow
$50,000 on its line-of-
credit.
9-76

The Cash Budget

Ending cash balance for April

is the beginning May balance.
9-77

The Cash Budget

9-78

Quick Check 

What is the excess (deficiency) of cash available over

disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
9-79

Quick Check 

What is the excess (deficiency) of cash available over

disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
9-80

The Cash Budget

$50,000 × 16% × 3/12 = $2,000

Borrowings on April 1 and
repayment on June 30.
9-81

The Budgeted Income Statement

Cash Budgeted
Budget Income
Statement
ed
et
pl
o m
C

After we complete the cash budget, we can

prepare the budgeted income statement for
Royal.
9-82

Learning Objective 9

Prepare a budgeted
income statement.
9-83

The Budgeted Income Statement

Sales
Sales Budget.
Budget.
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Ending
Ending Finished
Finished
Sales (100,000 units @ $10) $ 1,000,000 Goods
Goods Inventory.
Inventory.
Cost of goods sold (100,000 @ $4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000 Selling
Selling and
and
Operating income 241,000 Administrative
Administrative
Interest expense 2,000 Expense
Expense Budget.
Budget.
Net income $ 239,000

Cash
Cash Budget.
Budget.
9-84

Learning Objective 10

Prepare a budgeted
balance sheet.
9-85

The Budgeted Balance Sheet

Royal
Royal reported
reported the
the following
following account
account balances
balances prior
prior to
to
preparing
preparing its
its budgeted
budgeted financial
financial statements:
statements:

•• Land
Land -- $50,000
$50,000
•• Common
Common stock
stock -- $200,000
$200,000
•• Retained
Retained earnings
earnings -- $146,150
$146,150
•• Equipment
Equipment -- $175,000
$175,000
9-86
Royal Company
Budgeted Balance Sheet 25%
25% ofof June
June
June 30 sales
sales of
of
Current assets $300,000.
$300,000.
Cash $ 43,000
Accounts receivable 75,000 11,500
11,500 lbs.
lbs.
Raw materials inventory 4,600 at
at $0.40/lb.
$0.40/lb.
Finished goods inventory 24,950
Total current assets 147,550 5,000
5,000 units
units
Property and equipment at
at $4.99
$4.99 each.
each.
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550
50%
50% ofof June
June
Accounts payable $ 28,400 purchases
purchases
Common stock 200,000 of
of $56,800.
$56,800.
Retained earnings 336,150
Total liabilities and equities $ 564,550
9-87
Royal Company
Budgeted Balance Sheet
June 30
Current assets
Cash $ 43,000
Accounts receivable Beginning balance $ 146,150
75,000
Add: net income 239,000
Raw materials inventory 4,600
Deduct: dividends (49,000)
Finished goods inventory 24,950
Ending balance $ 336,150
Total current assets 147,550
Property and equipment
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550

Accounts payable $ 28,400

Common stock 200,000
Retained earnings 336,150
Total liabilities and equities $ 564,550
9-88

End of Chapter 8