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Chapter 10 Budgetary Planning
Cost Analysis (Acct 355)
Athabasca University
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CHAPTER 10 Budgetary Planning The NavigatorChapter 10 Scan Study Objectives Read Feature Story Read Chapter Preview Read text and answer Before You Go On Work Using the Decision Toolkit Review Summary of Study Objectives Review Decision Toolkit—a Summary Work Comprehensive Do It 1 and 2! Answer Self-Study Questions Complete assignments Study objectives After studying this chapter, you should be able to do the following: 1. State the essentials of effective budgeting and the components of a master budget. 2. Prepare budgets for sales, production, and direct materials. 3. Prepare budgets for direct labour, manufacturing overhead, and selling and administrative expenses, and a budgeted income statement. 4. Prepare the cash budget and the budgeted balance sheet. 5. Explain the applicability of budgeting in non-manufacturing companies. BUDGETING FOR SMOOTH SKIES Pilots have long used flight simulators to test their decision-making in certain situations. What if airline managers used a model to simulate complex business conditions and used that for business decision-making? In a way, that's what budgetary planning does. Managers forecast revenues and expenses to predict future profits and take corrective action when the numbers deviate from the budgetary “flight path.” Toronto-based Porter Airlines, which serves 19 destinations in eastern Canada and the United States, used to use spreadsheets for tracking its chart of accounts, budget, and forecasting models. But as the airline grew, it adopted a sophisticated database that improves decision-making. The software generates real-time financial reports for Porter's cost centre managers, who can see when expenses and revenues differ from those in the budget, and take action when necessary. The variance reports show actual versus budget amounts, actual versus prior-year amounts, and current monthly and quarterly amounts versus those from the previous periods. Porter uses the software to develop two mathematical models. One looks at overall finances. The other examines the profitability of existing and potential routes, which allows managers to allocate and budget resources accordingly. “When we add certain dimensions to the financial model, they add automatically to the route profit model—we just have to select the allocation method,” said Scott Murray, Porter's Controller, Financial Reporting and Internal Control. “We're able to observe route by route and choose the level of allocation based on a predetermined method. Right up to the board level, we can easily present the data to identify the profitability of our routes.” Using information in the database regarding key performance indicators (KPIs), Porter can budget more accurately. “This will enable us to focus on additional KPIs—cost per employee, cost per aircraft landing, or available seat miles—because we can pinpoint any and all of the metrics that we hold to be important in the airline industry,” Mr. Scott said. In 2013, readers of the prestigious Condé Nast Traveler magazine voted Porter Airlines the best small airline in the world. Among passenger perks are spacious airport waiting areas and free alcohol on board—costs that Porter tracks carefully. The airline carried its 10 millionth passenger in 2013 after just seven years in business. Pending government approval, Porter was hoping to expand its routes by 2016 to serve destinations such as Miami, Los Angeles, and Vancouver with jets instead of its fleet of turboprops. This growth will require careful forecasting and budgetary planning to stay on course. Sources: Jason McBride, “The End of an Affair,” The Grid, January 22, 2014; “Porter Airlines Passes 10 Million Passengers,” news release, November 12, 2013; “Porter Is Best Small Airline in World: Condé Nast Traveler,” news release, October 30, 2013; “Porter Airlines: Prophix Case Study,” Prophix Software, 2012, prophix. Preview of Chapter 10 As the feature story about Porter Airlines indicates, budgeting is critical to financial well-being. As a student, you budget your study time and your money. Families budget income and expenses. Our focus in this chapter is budgeting for businesses—how management uses budgeting as a planning tool. Through budgeting, management should be able to have enough cash to pay creditors, enough raw materials to meet production requirements, and enough finished goods to meet expected sales. The chapter is organized as follows: THE BENEFITS OF BUDGETING Following are the primary benefits of budgeting: 1. 2. 3. 4. 5. 6. It requires all levels of management to plan ahead and to formalize goals on a recurring basis. It provides definite objectives for evaluating performance at each level of responsibility. It creates an early warning system for potential problems so that management can make changes before things get out of control. It makes it easier to coordinate activities within the business. It does this by fitting the goals of each segment with overall company objectives. Thus, production and sales promotion can be integrated with expected sales. It results in greater management awareness of the entity's overall operations and the impact on operations of external factors, such as economic trends. It motivates personnel throughout the organization to meet planned objectives. A budget is an aid to management; it is not a substitute for management. A budget cannot operate or enforce itself. Companies can realize the benefits of budgeting only when managers carefully administer their budgets. ESSENTIALS OF EFFECTIVE BUDGETING Effective budgeting depends on a sound organizational structure that clearly defines authority and responsibility for all phases of operations. Budgets based on research and analysis should result in realistic goals that will contribute to a company's growth and profitability. The effectiveness of a budget program is directly related to how well it is accepted by all levels of management. Once the budget has been adopted, it should be an important tool for evaluating performance. Variations between actual and expected results should be systematically and periodically reviewed to determine their cause(s). However, individuals should not be held responsible for variations that are beyond their control. LENGTH OF THE BUDGET PERIOD The budget period is not necessarily one year in length. A budget may be prepared for any period of time. Various factors influence the length of the budget period. These factors include the type of budget, the type of organization, the need for periodic appraisal, and actual business conditions. For example, cash may be budgeted monthly, whereas a plant expansion budget may cover a 10-year period. The budget period should be long enough to provide an attainable goal under normal business conditions. Ideally, the time period should be long enough that seasonal or cyclical fluctuations do not have a big impact on it. On the other hand, the budget period should not be so long that reliable estimates are impossible. The most common budget period is one year. The annual budget is then often supplemented by monthly and quarterly budgets. Many companies use continuous 12-month budgets. These budgets drop the month just ended and add a future month. One advantage of continuous budgeting is that it keeps management planning a full year ahead. THE BUDGETING PROCESS The development of the budget for the coming year generally starts several months before the end of the current year. The budgeting process usually begins with the collection of data from each organizational unit of the company. Past performance is often the starting point for setting future budget goals. The budget is developed within the framework of a sales forecast. This forecast shows potential sales for the industry and the company's expected share of these sales. In sales forecasting, various factors are considered: (1) general economic conditions, (2) industry trends, (3) market research studies, (4) anticipated advertising and promotion, (5) previous market share, (6) changes in prices, and (7) technological developments. The input of sales personnel and top management is essential to the sales forecast. In small companies, the budgeting process is often informal. In larger companies, responsibility for coordinating the preparation of the budget is assigned to a budget committee. The committee ordinarily includes the president, treasurer, chief accountant (controller), and management personnel from each of the major areas of the company, such as sales, production, and research. The budget committee acts as a review board where managers can defend their budget goals and requests. Differences are reviewed, modified if necessary, and reconciled. The budget is then put in its final form by the budget committee, and is approved and distributed. BUDGETING AND HUMAN BEHAVIOUR A budget can have a significant impact on human behaviour. It may inspire a manager to higher levels of performance. Or it may discourage additional effort and pull down a manager's morale. Why do these effects occur? The answer is found in how the budget is developed and administered. In developing the budget, each level of management should be invited to participate. This “bottom-up” approach is called participative budgeting. The advantages of participative budgeting are many. First, lower-level managers have more detailed knowledge of their specific area and thus should be able to provide more accurate budgetary estimates. Second, if lower-level managers are invited to participate in the budgeting process, they are more likely to see the resulting budget as fair. The overall goal is to reach agreement on a budget that the managers consider fair and achievable, but that also meets the corporate goals set by top management. When this overall goal is met, the budget will create positive motivation for the managers. In contrast, if the managers view the budget as being unfair and unrealistic, they may feel discouraged and uncommitted to budget goals. The risk of having unrealistic budgets is generally greater when the budget is developed from top management down to lower management than vice versa. Illustration 10-1 graphically displays the flow of budget data from bottom to top under participative budgeting. BUSINESS INSIGHTRolling Forecasts Replace Budgets Many organizations use annual budgets to help plan expenses and revenues, and monitor whether the actual amounts vary substantially from the expected amounts and take action if needed. But some observers caution that budgets are not always effective. For one thing, when management bonuses or performance ratings are tied to meeting budget targets, there's an incentive to do things like move money from one account to another, defer expenses to increase profits, or spend money in an account before year end in order not to lose it. A survey of more than 300 certified management accountants at Canadian firms found that a significant number of them said that such “gaming” with budgets sometimes happens in their companies. Another problem with budgeting is the time and resources it takes, only to have the numbers be out of date once the lengthy budgeting process is over. That's why multinational consumer giant Unilever did away with its annual budget in 2010. Instead, it uses an eight-quarter rolling forecast, updated regularly with input from the sales, supply chain, marketing, and finance departments. “Previously, the business units were committed to this arbitrary annual number in the budget and were of the mind-set that they had to stick to it. Now, every division has a target, and it is our job in finance to continually help them reach it,” says Neal Vorchheimer, Unilever's senior vice president of finance for North America. Sources: Theresa Libby and R. Murray Lindsay, “The Effects of Trust and Budget-Based Controls on Budget Gaming and Budget Value,” AAA 2013 Management Accounting Section (MAS) Meeting Paper, August 17, 2012; Christopher Hann, “Why You Should Ditch Your Annual Budget,” Entrepreneur, January 30, 2012; Russ Banham, “Let It Roll: Why More Companies Are Abandoning Budgets in Favor of Rolling Forecasts,” CFO Magazine, May 1, 2011; Jeff Buckstein, “A Fresh Approach to Budgeting,” CMA Magazine, September-October 2004. What are some reasons to continue using a budget? BUDGETING AND LONG-RANGE PLANNING Budgeting and long-range planning are not the same. One important difference is the time period involved. The maximum length of a budget is usually one year, and budgets are often prepared for shorter periods of time, such as a month or a quarter. In contrast, long-range planning usually covers a period of at least five years. A second significant difference is in emphasis. Budgeting focuses on achieving specific short-term goals, such as meeting annual profit objectives. Long-range planning, on the other hand, identifies long-term goals, selects strategies to achieve those goals, and develops policies and plans to implement the strategies. In long-range planning, management also considers anticipated trends in the economic and political environment and how the company should react to them. The final difference between budgeting and long-range planning pertains to the amount of detail presented. Budgets, as you will see in this chapter, can be very detailed. Long-range plans contain much less detail. The data in long-range plans are intended more for a review of progress toward longterm goals than as a basis of control for achieving specific results. The main objective of long-range planning is to develop the best strategy to maximize the company's performance over an extended future period. Helpful Hint When comparing a budget with a long-range plan, ask the following questions: 10-1. Which has more detail? 10-2. Which is done for a longer period of time? 10-3. Which is more concerned with short-term goals? THE MASTER BUDGET The term budget is actually a shorthand term to describe several budget documents. All of these documents are combined into a master budget. The master budget is a set of interrelated budgets that create a plan of action for a specified time period. Illustration 10-2 shows the individual budgets included in a master budget. expenditure budget, which is discussed under the topic Capital Budgeting in Chapter 13. BEFORE YOU GO ON… ▸Do It!Budget Terminology Use this list of terms to complete the sentences that follow. Long-range planning Participative budgeting Sales forecast Operating budgets Master budget Financial budgets (a)A ________ shows potential sales for the industry and a company's expected share of such sales. (b)________ are used as the basis to prepare the budgeted income statement. (c)The ________ is a set of interrelated budgets that constitutes a plan of action for a specified time period. (d)________ identifies long-term goals, selects strategies to achieve these goals, and develops policies and plans to implement the strategies. (e)Lower-level managers are more likely to perceive results as fair and achievable under a ________ approach. (f)________ focus primarily on the cash resources needed to fund expected operations and planned capital expenditures. Action Plan Understand the budgeting process, including the importance of the sales forecast. Understand the difference between an operating budget and a financial budget. Differentiate budgeting from long-range planning. Realize that the master budget is a set of interrelated budgets. Solution (a)Sales forecast (b)Operating budgets (c)Master budget (d)Long-range planning (e)Participative budgeting (f)Financial budgets Related exercise material: BE10-1, E10-16, and D10-11. Examples Key Topic Review Chapter 10, Part 1 - SO 1, 2, 3 Powerpoint 10 Copyright © 2015 John Wiley & Sons Canada, Ltd. Preparing the Sales, Production, and Direct Materials Budgets STUDY OBJECTIVE 2 Prepare budgets for sales, production, and direct materials. We use a case study of Hayes Company in preparing the operating budgets. Hayes manufactures and sells a single product, an ergonomically designed bike seat with multiple customizable adjustments, called the Rightride. The budgets are prepared by quarters for the year ending December 31, 2016. Hayes Company begins its annual budgeting process on September 1, 2015, and it completes the budget for 2016 by December 1, 2015. The company begins by preparing the budgets for sales, production, and direct materials. SALES BUDGET As shown in the master budget in Illustration 10-2, the sales budget is the first budget that is prepared. Each of the other budgets depends on the sales budget. The sales budget is derived from the sales forecast. It represents management's best estimate of sales revenue for the budget period. An inaccurate sales budget may adversely affect net income. For example, an overly optimistic sales budget may result in excessive inventories that may have to be sold at reduced prices. In contrast, an overly conservative budget may result in lost sales revenue due to inventory shortages. Forecasting sales is challenging. For example, consider Orca Bay Sports & Entertainment, the Vancouver-based entertainment company that owns and operates the Vancouver Canucks National Hockey League franchise and the team's home arena, Rogers Arena. Classified as a small market club under the current NHL economic environment, the Vancouver Canucks must rely on more than just ticket sales and league broadcast rights to generate revenue. Orca Bay is also a retailer, selling an array of Canucks-branded paraphernalia such as jerseys, banners, and posters at several stores at Rogers Arena and in downtown Vancouver. Unlike most retailers, Orca Bay has to drive the vast majority of its sales during a short time and mainly during games, which themselves are dependent on varying attendance, thus adding to the forecasting challenges. Or consider the challenges faced by Hollywood movie producers in predicting the complicated revenue stream produced by a new movie. Movie theatre ticket sales represent only 20% of total revenue. The bulk of revenue comes from global sales, DVDs, video-on-demand, merchandising products, and video games, all of which are difficult to forecast. The sales budget is prepared by multiplying the expected sales volume in units for each product by its anticipated selling price per unit. For Hayes Company, the sales volume is expected to be 3,000 units in the first quarter, with 500-unit increments in each quarter after that. Illustration 10-3 shows the sales budget for the year, by quarters, based on a sales price of $60 per unit. Il lustration 10-3 Sales budget Units of Finished Goods Inventory Beg. Inv. Required Sale s Prod. Units End. Inv. The production budget, in turn, becomes the basis for determining the budgeted costs for each manufacturing cost element, as explained in the following pages. DIRECT MATERIALS BUDGET The direct materials budget shows both the quantity and cost of direct materials that need to be purchased. The quantities of direct materials to purchase are determined with the formula in Illustration 10-6. Illustration 10-6 Formula for direct materials quantities The budgeted cost of direct materials to be purchased is then calculated by multiplying the required units of direct materials by the expected cost per unit. Units of Direct Materials Beg. Inv. Direct Materials to Purchase Direct Materials Required for Prod. End. Inv. The desired ending inventory is again a key component in the budgeting process. For example, inadequate inventories could result in temporary shutdowns of production. Because of its close proximity to suppliers, Hayes Company has found that an ending inventory of raw materials equal to 10% of the next quarter's production requirements is enough. The manufacture of each Rightride requires 2 kg of raw materials, and the expected cost per kilogram is $4. Illustration 10-7 shows the direct materials. Il lustration 10-7 Direct materials budget Units of Direct Materials (1st quarter) 620 6,300 6,200 720 BEFORE YOU GO ON… ▸Do It!Master Budget Soriano Company is preparing its master budget for 2016. Relevant data pertaining to its sales, production, and direct materials budgets are as follows: Sales: Sales for the year are expected to total 1 million units. Quarterly sales, as a percentage of total sales, are 20%, 25%, 30%, and 25%, respectively. The sales price is expected to be $50 per unit for the first three quarters and $55 per unit beginning in the fourth quarter. Sales in the first quarter of 2017 are expected to be 10% higher than the budgeted sales for the first quarter of 2016. Production: Management desires to maintain the ending finished goods inventories at 25% of the next quarter's budgeted sales volume. Direct materials: Each unit requires 3 kg of raw materials at a cost of $5 per kilogram. Management desires to maintain raw materials inventories at 5% of the next quarter's production requirements. Assume the production requirements for the first quarter of 2017 are 810,000 kg. Prepare the sales, production, and direct materials budgets by quarters for 2016. Action Plan Know the form and content of the sales budget. Prepare the sales budget first, as the basis for the other budgets. Determine the units that must be produced to meet anticipated sales. Preparing the Direct Labour, Manufacturing Overhead, and S&A Expense Budgets DIRECT LABOUR BUDGET STUDY OBJECTIVE 3 Prepare budgets for direct labour, manufacturing overhead, and selling and administrative expenses, and a budgeted income statement. As shown in Illustration 10-2, the operating budgets culminate with preparation of the budgeted income statement. Before we can do that, we need to prepare budgets for direct labour, manufacturing overhead, and selling and administrative (S&A) expenses. Like the direct materials budget, the direct labour budget contains the quantity (hours) and cost of direct labour that will be needed to meet production requirements. The total direct labour cost is calculated using the formula in Illustration 10-8. Illustration 10-8 Formula for direct labour cost Direct labour hours are determined from the production budget. At Hayes Company, two hours of direct labour are required to produce each unit of finished goods. The expected hourly wage rate is $10. Illustration 10-9 shows these data. The direct labour budget is critical in maintaining a labour force that can meet the expected levels of production. Il lustration 10-9 Direct labour budget Helpful Hint An important assumption in Illustration 10-9 is that the company can add to and subtract from its workforce as needed so that the $10 per hour labour cost applies to a wide range of possible production activity. MANUFACTURING OVERHEAD BUDGET The manufacturing overhead budget shows the expected manufacturing overhead costs for the budget period. As shown in Illustration 10-10, this budget distinguishes between variable and fixed overhead costs. Hayes Company expects variable costs to fluctuate with the production volume based on the following rates per direct labour hour: indirect materials $1; indirect labour $1; utilities $0; and maintenance $0. Thus, for the 6,200 direct labour hours required to produce 3,100 units, the budgeted indirect materials cost is , and the budgeted indirect labour cost is . Hayes also recognizes that some maintenance is fixed. The amounts reported for fixed costs are assumed in our example. The accuracy of budgeted fixed overhead cost estimates can be greatly improved by using activity-based costing. Illustration 10-10 Manufacturing overhead budget At Hayes Company, overhead is applied to production based on direct labour hours. Thus, as shown in Illustration 10-10, the annual rate is $8 per hour . SELLING AND ADMINISTRATIVE EXPENSES BUDGET Hayes Company combines its operating expenses into one budget, the selling and administrative expenses budget. This budget projects selling and administrative expenses for the budget period. In this budget, as in the preceding one, expenses are classified as either variable or fixed. In this case, the variable expense rates per unit of sales are $3 of sales commissions and $1 of freight out. Variable expenses per quarter are based on the unit sales from the sales budget (Illustration 10-3). For example, sales in the first quarter are expected to be 3,000 units. Thus, the sales commissions expense is , and freight out is . Fixed expenses are based on assumed data. Illustration 10-11 shows the selling and administrative expenses budget. individual operating budgets except the following: (1) interest expense is expected to be $100, and (2) income taxes are estimated to be $12,000. Illustration 10-13 shows the budgeted income statement. HAYES COMPANY Budgeted Income Statement Year Ending December 31, 2016 Sales (Illustration 10-3) $900,0 00 Cost of goods sold (15,000 × $44) 660,00 0 Gross profit 240,00 0 Selling and administrative expenses (Illustration 10-11) 180,00 0 Income from operations 60,000 Interest expense 100 Income before income taxes 59,900 Income tax expense 12,000 Net income $ 47,900 Illustration 10-13 Budgeted income statement DECISION TOOLKIT BEFORE YOU GO ON… ▸Do It!Budgeted Income Statement Soriano Company is preparing its budgeted income statement for 2016. Relevant data pertaining to its sales, production, and direct materials budgets can be found in the Do It! exercise. In addition, Soriano budgets 0 hours of direct labour per unit, labour costs at $15 per hour, and manufacturing overhead at $25 per direct labour hour. Its budgeted selling and administrative expenses for 2016 are $12 million. (a)Calculate the budgeted total unit cost. (b)Prepare the budgeted income statement for 2016. Ignore income taxes. Action Plan Recall that total unit cost consists of direct materials, direct labour, and manufacturing overhead. Recall that direct materials costs are included in the direct materials budget. Know the form and content of the income statement. Use the total unit sales information from the sales budget to calculate annual sales and cost of goods sold. Solution (a) Unit Cost Total 3 kg $ 5 $15 0 Direct labour 0 hours $15 7 Manufacturing overhead 0 hours $25 12 Total unit cost $35 0 Cost Element Direct materials Quanti ty (b) SORIANO COMPANY Budgeted Income Statement For the Year Ending December 31, 2016 Sales (1,200,000 units from sales budget) $61,500,0 00 Cost of goods sold (1,200,000 × $35/unit) 42,000,00 0 Gross profit 19,500,00 0 Selling and administrative expenses 12,000,00 0 Net income $
Chapter 10 Budgetary Planning
Course: Cost Analysis (Acct 355)
University: Athabasca University
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