Profit Planning and Budgeting

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Learning Objectives
1. Define budgeting and discuss its role in planning, control,
and decision making.
2. Define and prepare the operating budget, identify its
major components, and explain the interrelationships of
its various components.
3. Define and prepare the financial budget, identify its major
components, and explain the interrelationships of its
various components.
4. Describe the behavioral dimension of budgeting.
 Description of Budgeting

• All businesses should prepare budgets.

• Budgets help business owners and managers to plan ahead, and later,
exercise control by comparing what actually happened to what was expected
in the budget.
• Budgets formalize managers’ expectations regarding sales, prices, and costs.
• Even small businesses and nonprofit entities can benefit from the planning
and control provided by budgets.
 Budgeting and Planning and Control
• Planning and control are linked.
• Planning is looking ahead to see what actions should be taken to
realize particular goals.
• Control is looking backward, determining what actually happened
and comparing it with the previously planned outcomes.
• Budgets are financial plans for the future and are a key component
of planning. They identify objectives and the actions needed to
achieve them.
• Before preparing a budget, an organization should develop a
strategic plan.
• The strategic plan plots a direction for an organization’s future
activities and operations; it generally covers at least five years.
Planning, Control, and Budgets
Advantages of Budgeting
A budgetary system gives an organization
several advantages.

Planning

Information for Decision Making

Standards for Performance

Evaluation

Improved Communication
& Coordination
 The Master Budget
• The master budget is the comprehensive financial plan
for the organization as a whole.
• Typically, the master budget is for a one-year period,
corresponding to the fiscal year of the company.
• Yearly budgets are broken down into quarterly and
monthly budgets.
• The use of smaller time periods allows managers to
compare actual data with budgeted data more
frequently, so problems may be noticed and resolved
sooner.
 The Master Budget
(continued)

• Some organizations have developed a continuous

budgeting philosophy.
• A continuous budget is a moving 12-month budget.
• As a month expires in the budget, an additional month in
the future is added so that the company always has a 12-
month plan on hand.
• Proponents of continuous budgeting maintain that it
forces managers to plan ahead constantly.
 Master Budget:
Directing and Coordinating
• Most organizations prepare the master budget for the
coming year during the last four or five months of the
current year.
• The budget committee reviews the budget, provides
policy guidelines and budgetary goals, resolves
differences that arise as the budget is prepared, approves
the final budget, and monitors the actual performance of
the organization as the year unfolds.
• The controller usually serves as the budget director, the
person responsible for directing and coordinating the
organization’s overall budgeting process.
 Master Budget:
Major Components
►A master budget can be divided into operating and financial
budgets:
►Operating budgets describe the income-generating activities of a
firm: sales, production, and finished goods inventories. The ultimate
outcome of the operating budgets is a pro forma or budgeted income
statement.
►Financial budgets detail the inflows and outflows of cash and the
overall financial position. Planned cash inflows and outflows appear
in the cash budget. The expected financial position at the end of the
budget period is shown in a budgeted, or pro forma, balance sheet.
►Since many of the financing activities are not known until
the operating budgets are known, the operating budget is
prepared first.
The Master Budget and
Its Interrelationships
 Preparing the Operating Budget
►The operating budget consists of a budgeted income
statement accompanied by the following supporting
schedules:
►sales budget
►production budget
►direct materials purchases budget
►direct labor budget
►overhead budget
►selling and administrative expenses budget
►ending finished goods inventory budget
►cost of goods sold budget
 Sales Budget
• The sales budget is approved by the budget committee
and describes expected sales in units and dollars.
• Because the sales budget is the basis for all of the other
operating budgets and most of the financial budgets, it is
important that it be as accurate as possible.
• The first step in creating a sales budget is to develop the
sales forecast.
• The sales forecast is just the initial estimate, and it is
often adjusted by the budget committee.
Preparing a Sales Budget
 Production Budget
• The production budget tells how many units must be
produced to meet sales needs and to satisfy ending
inventory requirements.
• To compute the units to be produced, both unit sales and
units of beginning and ending finished goods inventory
are needed:

Units to be produced = Expected unit sales + Units in

desired ending inventory (EI) – Units in beginning
inventory (BI)
Preparing a Production Budget
Preparing a Production Budget (continued)
 Direct Materials Purchases Budget
• After the production budget is completed, the budgets
for direct materials, direct labor, and overhead can be
prepared.
• The direct materials purchases budget tells the amount
and cost of raw materials to be purchased in each time
period.
• The formula used for calculating purchases is as follows:
Preparing a Direct Materials Purchases
Budget
Preparing a Direct Materials Purchases Budget
(continued)
Preparing a Direct Materials Purchases Budget
(continued)
 Direct Labor Budget
• The direct labor budget shows the total direct labor hours and the direct
labor cost needed for the number of units in the production budget.
• As with direct materials, the budgeted hours of direct labor are determined
by the relationship between labor and output.
Preparing a Direct Labor Budget
 Overhead Budget
• The overhead budget shows the expected cost of all
production costs other than direct materials and
direct labor.
• Many companies use direct labor hours as the driver
for overhead.
• Then costs that vary with direct labor hours are
pooled and called variable overhead.
• The remaining overhead items are pooled into fixed
overhead.
 Preparing an Overhead Budget
Information:
Refer to the direct labor budget below. The variable overhead rate is $5
per direct labor hour. Fixed overhead is budgeted at $1,645 per quarter
(this amount includes $540 per quarter for depreciation).

Required:
Prepare an overhead budget.
 Preparing an Overhead Budget (continued)

Solution:
 Ending Finished Goods Inventory Budget

• The ending finished goods inventory budget supplies

information needed for the balance sheet and also
serves as an important input for the preparation of
the cost of goods sold budget.
• To prepare this budget, the unit cost of producing
finished goods must be calculated by using
information from the direct materials, direct labor,
and overhead budgets.
 Preparing an Ending
Finished Goods Inventory Budget
Information:
Refer to the direct materials, direct labor,
and overhead budgets prepared previously
and shown here.
 Preparing an Ending
Finished Goods Inventory Budget (continued)
 Cost of Goods Sold Budget
•Assuming that the beginning finished
goods inventory is valued at $1,251, the
budgeted cost of goods sold schedule can
be prepared using information from the
previous budgets (from direct materials to
ending inventory).
•The cost of goods sold budget reveals the
expected cost of the goods to be sold.
Preparing a Cost of Goods Sold Budget
Selling and Administrative
Expenses Budget
• The selling and administrative expenses budget
outlines planned expenditures for nonmanufacturing
activities.
• As with overhead, selling and administrative expenses
can be broken down into fixed and variable
components.
• Such items as sales commissions, freight, and supplies
vary with sales activity.
 Preparing a Selling and Administrative
Expenses Budget
Information:
Refer to the sales budget below. Variable expenses are $0.10 per unit sold. Salaries
average $1,420 per quarter; utilities, $50 per quarter; and depreciation, $150 per
quarter. Advertising for Quarters 1 through 4 is $100, $200, $800, and $500,
respectively.

Required:
Prepare a selling and administrative expenses budget.
Preparing a Selling and Administrative
Expenses Budget (continued)
 Budgeted Income Statement
• With the completion of the budgeted cost of goods sold schedule and
the budgeted selling and administrative expenses budget, a company
has all the operating budgets needed to prepare an estimate of
operating income.
 Preparing a Budgeted Income Statement
Information:
Refer to Cornerstones 9-1, 9-7, 9-8, and 9-12 for the sales budget, the cost of
goods sold budget, the selling and administrative expenses budget, and the cash
budget. Assume that the tax rate is 40 percent.

Required:
Prepare a budgeted income statement.
Preparing the Financial Budget
►The remaining budgets found in the master budget are the financial
budgets.
►The usual financial budgets prepared are:
►cash budget
►budgeted balance sheet
►budget for capital expenditures
 Cash Budget
• Understanding cash flows is critical in managing a business.
• Often, a business successfully produces and sells products but fails
because of timing problems associated with cash inflows and outflows.
• Because cash flow is the lifeblood of an organization, the cash budget is
one of the most important budgets in the master budget.
• The basic structure of a cash budget includes cash receipts,
disbursements, any excess or deficiency of cash, and financing as shown
below:
 Cash Budget: Cash Available
• Cash available consists of the beginning cash balance and the
expected cash receipts. Expected cash receipts include all
sources of cash for the period being considered.
• The principal source of cash is from sales.
• Since a large proportion of sales is usually on account, a major
task of an organization is to determine the pattern of collection
for its accounts receivable.
• If a company has been in business for a while, it can use past
experience to determine what percentage of credit sales are
paid in the month of and months following sales.
• This is used to create a schedule of cash collections on accounts
receivable.
 Preparing a Schedule for Cash Collections
on Accounts Receivable
Information:
From past experience, Texas Rex expects that, on average, 25 percent of total sales
are cash and 75 percent of total sales are on credit. Of the credit sales, Texas Rex
expects that 90 percent will be paid in cash during the quarter of sale, and the
remaining 10 percent will be paid in the following quarter. Recall from Cornerstone
9-1 that Texas Rex expects the following total sales:

Quarter 1 $10,000
Quarter 2 $12,000
Quarter 3 $15,000
Quarter 4 $20,000

The balance in accounts receivable as of the last quarter of 2011 was $1,350. This
will be collected in cash during the first quarter of 2012.
Required:
1. Calculate cash sales expected in each quarter of 2012.
2. Prepare a schedule showing cash receipts from sales expected in each quarter of
2012.
Preparing a Schedule for Cash Collections
on Accounts Receivable (continued)
 Cash Budget:
Cash Disbursements
• The cash disbursements section lists all planned cash outlays
for the period.
• All expenses that do not require a cash outlay are excluded
from the list (e.g., depreciation is never included in the
disbursements section).
• Just as sources of cash may require a schedule of cash
collections on accounts receivable to calculate cash expected
from credit sales, the disbursements section may require care
in handling payments on account.
Determining Cash Payments
on Accounts Payable
Determining Cash Payments
on Accounts Payable (continued)
 Cash Budget:
Cash Excess or Deficiency
• Some companies expand the basic cash budget format by
adding lines to show any borrowing or repayment necessary to
achieve a minimum desired cash amount.
• When this is done, the preliminary ending cash balance is
called cash excess or deficiency.
• The cash excess or deficiency line is compared to the minimum
cash balance (or lowest amount of cash acceptable as noted by
company policy).
• If a cash deficiency exists with less cash on hand than is
needed, the company usually obtains a short-term loan.
• A cash excess is usually used to repay loans or used to make
temporary investments.
 Cash Budget: Borrowings and Repayments, Ending
Cash Balance
• Borrowings and Repayments: If a company converts its
preliminary cash balance line to a cash excess (deficiency) line,
it may be borrowing or repaying money. If there is a deficiency,
this section shows the necessary amount to be borrowed.
When excess cash is available, this section shows planned
repayments, including interest expense.
• Ending Cash Balance: The last line of the cash budget is the
ending cash balance. This is the planned amount of cash to be
on hand at the end of the period after all receipts and
disbursements, as well as borrowings and repayments, are
considered.
Preparing a Cash Budget
Preparing a Cash Budget (continued)
Budgeted Balance Sheet
• The budgeted balance sheet depends on information contained in the
current balance sheet and in the other budgets in the master budget.
• Explanations for the budgeted figures are typically provided in the
footnotes.
 Using Budgets for Performance Evaluation
• Budgets are often used to judge the performance of managers.
• Bonuses, salary increases, and promotions are all affected by a
manager’s ability to achieve or beat budgeted goals.
• Positive behavior occurs when the goals of each manager are
aligned with the goals of the organization and each manager
has the drive to achieve them.
• The alignment of managerial and organizational goals is often
referred to as goal congruence.
• If the budget is improperly administered, subordinate
managers may subvert the organization’s goals.
• Dysfunctional behavior is individual behavior that is in basic
conflict with the goals of the organization.
 Frequent Feedback on Performance
• Managers need to know how they are doing as the year progresses.
• Frequent, timely performance reports allow managers to know how
successful their efforts have been, to take corrective actions, and to
change plans as necessary.
 Realistic Standards
►Budgets should reflect operating realities, including the
following:
►Actual Levels of Activity: Flexible budgets are used to ensure that budgeted
costs can be realistically compared with costs for actual levels of activity.
►Seasonal Variations: Interim budgets should reflect seasonal effects. Toys ‘‘R’’
Us, for example, would expect much higher sales in the quarter that includes
Christmas than in other quarters.
►Efficiencies: Budgetary cuts should be based on planned increases in efficiency
and not simply arbitrary across-the-board reductions. Across-the-board cuts
without any formal evaluation may impair the ability of some units to carry out
their missions.
►General Economic Trends: General economic conditions also need to be
considered. Budgeting for a significant increase in sales when a recession is
projected is not only foolish but also potentially dangerous.
 Controllability of Costs
• Ideally, managers are held accountable only for costs
that they can control.
• Controllable costs are costs whose level a manager
can influence.
• If noncontrollable costs are put in the budgets of
subordinate managers to help them understand that
these costs also need to be covered, then they should
be separated from controllable costs and labeled as
noncontrollable.