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Accounting Principles II:
Budgets
Complete Study Guide
Introduction to Budgets
Budgets are part of a company's long‐range planning system. While some portions of a long‐range plan are concerned with the organization in five to ten years, the budget is the short‐range portion of the plan. Most budgets are prepared for a twelve‐month period, sometimes on a rolling basis. A rolling budget is updated quarterly (or as often as management requires the data) by dropping the three months just ended and adding one quarter's data to the end of the remaining nine months already budgeted (see following figure). Rolling budgets require management to keep looking forward and to anticipate changes.
The master budget consists of all the individual budgets required to prepare budgeted financial statements. Although different textbooks group the budgets differently, the main components of a budget are operating budgets for revenues and expenses, capital expenditures budget, cash budget, and finally the budgeted financial statements, which include the income statement, balance sheet, and cash flow statement.
Operating Budgets
The operating budgets include the budgets for sales, manufacturing costs (materials, labor, and overhead) or merchandise purchases, selling expenses, and general and administrative expenses. Sales budget The sales budget is the starting point in putting together a comprehensive budget for a business. It includes the number of units to be sold and the selling price per unit. It is important to agree to the sales budget first because many other budgets are based on this data. Although its components are simple, getting a management team to agree on the number of units to be sold and the selling price per unit, the two items needed to prepare the budget, is often difficult and time‐ consuming. The Pickup Trucks Company, which makes toy trucks, has just completed its budgeting process for next year. Total expected sales are 100,000 toy trucks at a price of $15.00 each. Its sales budget has been prepared on a quarterly basis as follows:
raw materials purchases. The Pickup Trucks Company requires 10% of next quarter's production requirement for raw materials to be in its ending inventory. For example, because it takes five tires to make the special toy pickup truck (four plus the spare tire mounted on the side), at a cost of $0.50 per tire, the raw materials purchases budget calculates 501,890 tires required at a cost of $250,945. The units in the production budget are adjusted for units in ending and beginning inventories, multiplied by five (number of tires per pick up) to determine total tires to be purchased and then multiplied by $0.50 to determine the cost of the tires needed. As a reminder, the production budget showed the following units for 20X1:
Selling expenses budget The budget for selling expenses includes the variable and fixed selling expenses. The variable expenses in the selling expenses budget are usually based on sales dollars. Assume the Pickup Trucks Company's variable expenses are sales commissions and delivery expense. Sales commissions are 4% of sales dollars, and delivery expense, also called freight out by some companies, is $0.10 per unit sold. The company also has fixed sales salaries of $50,000. The calculations for sales commissions and delivery expense, followed by the selling expenses budget, are shown in the following tables.
The general and administrative expenses budget details the variable and fixed operating expenses for the general and administrative areas of the company. The Pickup Trucks Company has no variable administrative expenses. Its fixed expenses include salaries of $60,000, rent expense of $15,000, and office supplies of $6,000.
Capital Expenditures Budget
The capital expenditures budget identifies the amount of cash a company will invest in projects and long‐term assets. Although funds for expenditures may be identified and approved in total during the budget process, most companies have a separate process for approving funds for the specific items included in a capital expenditures budget. The process includes a financial evaluation to determine whether the company's return on investment targets are met and, once the targets are known to be met, a qualitative review by a top management team. Many companies include long‐term assets, such as joint ventures, purchases of other companies, and purchases or leases of fixed assets, as well as new products, new markets, research and development, significant marketing programs, and information technology items in their capital expenditures budgets.
Cash Budget
The cash budget is prepared after the operating budgets (sales, manufacturing expenses or merchandise purchases, selling expenses, and general and administrative expenses) and the capital expenditures budget are prepared. The cash budget starts with the beginning cash balance to which is added the cash inflows to get cash available. Cash outflows for the period are then subtracted to calculate the cash balance before financing. If this balance is below the company's required balance, the financing section shows the borrowings needed. The financing section also includes debt repayments, including interest payments. The cash balance before financing is adjusted by the financing activity to calculate the ending cash balance. The ending cash balance is the cash balance in the budgeted or pro forma balance sheet. In keeping with the budgets previously discussed for the Pickup Trucks Company, the cash budget in this example will be prepared on a quarterly basis. In addition to the information in the budgets previously prepared, the following information is needed to complete the cash budget.
- The company is expected to end the current year with $20,000 cash, $162,000 in accounts receivable, and $24,862 in accounts payable.
- The company's sales are all made on credit, with 70% of the balance collected in the quarter of the sale and 30% in the quarter after the sale.
- The company plans to sell a piece of land in the third quarter for $15,000, its book value.
- The total cost of raw materials to be purchased (including tires) are: $31,270 in quarter one; $39,530 in quarter two; $60,936 in quarter three; and $69,021 in quarter four.
- Raw materials purchases are paid for 60% in the quarter of the purchase and 40% in the quarter after the purchase.
- All other cash expenses are paid for in the quarter they are incurred.
- Capital expenditures for 20X1 include the purchase of machines for $20,000 in quarter two and $56,000 in quarter three.
- Income taxes for the current year are paid quarterly with the final payment being made in the first quarter of the following year.
- The company requires a cash balance of $20,000 at the end of each quarter. Arrangements have been made with the bank to borrow if needed in even increments of $1,000. Assume all borrowings are made at the beginning of the quarter. Borrowings are paid back at the end of the next quarter with interest of 8%. Before preparing the cash budget, the collections from customers and payments for raw materials purchases must be calculated.
Budgeted Income Statement
The budgeted or pro forma income statement is prepared after the operating budgets have been completed. The cost of goods sold on the income statement is calculated using the per unit cost of $11.25, which consists of $1.40 per unit for direct materials, $7.00 per unit for direct labor, and a manufacturing overhead rate of $2.85. The overhead rate is calculated by multiplying the predetermined overhead rate of $5.70 per direct labor hour times the direct labor hours per unit of one‐half hour.
Explanations for each balance are as follows: Cash: Ending balance per the cash budget. Accounts receivable: 30% of fourth quarter sales ($600,000 × 30%). Finished goods inventory: 2,475 units (15% of next quarter's sales of 16,500) times $11.25 per unit cost. See production budget and cost of goods sold calculation for further information. Raw materials inventory: Materials for 1,683 units (10% of next quarter's production of 16,830 units) times $1.40 per unit cost of materials. See direct materials budget and cash budget for units and costs. Land : Sale of land with a cost of $15,000 (per cash budget information) deducted from beginning balance of $45,000. Building: No activity during the year. Equipment: Beginning balance of $60,000 plus purchases totaling $76,000. Accumulated depreciation: Beginning balance of $50,000 plus $15, additional depreciation per the manufacturing overhead budget. Notes payable: $72,000 in borrowings during the year minus $50,000 principal repayments per the cash budget. Accounts payable: 40% of fourth quarter purchases ($69,021 × 40%). See cash payments for raw materials in cash budget and its calculation spread sheet. Income taxes payable: Balance owed for current year taxes. Difference between estimated taxes paid (per cash budget for quarters two, three, and four) and the expense per budgeted income statement. The company did not make a payment of its 20X1 taxes in quarter one of 20X0; the payment in the cash budget quarter one is for 20X0 taxes. Common stock: No stock activity during the year. Additional paid ‐ in ‐ capital: No stock activity during the year. Retained earnings: Beginning balance $89,799 plus net income for the year of $102,672 per the budgeted income statement. Dividends were not declared and paid, and therefore none are deducted.
Merchandising Company Budgets
In a merchandising company, the production budget and the three manufacturing budgets—direct materials, direct labor, and manufacturing overhead—are replaced with the merchandise purchases budget. This budget is prepared using the same three components as the production budget—sales, required ending merchandise inventory, and beginning merchandise inventory. As with the production budget, the required ending inventory is added to the expected sales to determine total amount of merchandise needed, and beginning inventory is subtracted from the total to determine the amount of inventory that needs to be purchased. The number of units is multiplied by cost of the merchandise to complete the merchandise purchases budget. For example, assume The Sunny Beach T‐Shirt Company plans to sell 25,000 T‐shirts
