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BUDGETING AND PROFIT PLANNING
Key Terms and Concepts to Know
Profit Planning and Budgeting: Profit plan is the steps taken by the business to achieve their planned levels of profits. Budget is a quantitative plan for acquiring and using resources over a specific time period to achieve its goals and objectives. Budget is used for two distinct purposes: o Planning which is developing goals and preparing various budgets to achieve those goals o Control which involves steps taken by management to increase the likelihood that all parts of the organization are working together to achieve the goals set down at the planning stage Budgets help to: o Communicate management’s plans throughout the organizations o Force managers to think and plan for future o Allocate resources where they can be used most effectively o Uncover potential bottlenecks. o Coordinate the activities of the entire organization o Serve as benchmarks for evaluating subsequent performance. Operating budgets ordinarily cover a one-year period corresponding to the company’s fiscal year. Organization may also divide their budget year into quarters and the quarters into months with operating budgets for each period.
Master Budget: Includes a number of separate but interdependent budgets that formally report the company’s sales, production, and financial goals. The starting point of the master budget is the sales budget. The ending point of the master budget is the budgeted financial statements. Since the budgeted financial statements include both an income statement and balance sheet, each step in the master budget has both an income statement and balance sheet component. Sometimes they are presented in the same budget and other times they are presented as separate budgets.
Key Topics to Know
Sales and Cash Collections Budget
The foundation and starting point for the master budget. Determines the anticipated unit and dollar sales for the budgeted income statement. May also include a schedule of expected cash collections that determines the amount of expected cash collections from customers for each period based on an expected collections pattern.
Example #
Company A is expecting to sell 10,000 cases in July, 20,000 cases in August, and 30, in September of Year 2. Selling price per case is $30. All sales are on account. The sales are collected 70% in the month of sale and 30% in the month following sale. June sales totaled $200,000. Bad debts are negligible and can be ignored.
Required: a) Prepare a sales budget. b) Prepare a schedule of expected cash collections from sales, by month and in total, for the third quarter. c) Assume that the company will prepare a budgeted balance sheet as of September 30. Determine the accounts receivable as of that date.
Solution #
a) Sales budget:
July August September
Quarter Total Budgeted Sales 10,000 20,000 30,000 60, x Selling price per unit $30 $30 $30 $ Total Sales $300,000 $600,000 $900,000 $1,800,
Example #
Bell Telecom has budgeted sales of its innovative mobile phone for next four monthS as follows: Sales Budget in Units July 30, August 45, September 60, October 50,
The company is now in the process of preparing a production budget for the third quarter. Ending inventory level must equal 10% of the next month’s sales.
Required: a) Calculate the ending inventory as of June 30. b) Prepare a production budget for the third quarter showing the number of units to be produced each month and for the quarter in total.
Solution #
a) Ending inventory: Since the ending inventory level must equal 10% of the next month’s sales, the ending inventory for the month of June must be 10% of July’s sales of 30, or 3,000 units.
b) Production Budget
July August September
Quarter Total October Budgeted sales in units 30,000 45,000 60,000 135,000 50,
- ending inventory 4,500 6,000 5,000 5, = Total needs 34,500 51,000 65,000 140,
- beginning inventory 3,000 4,500 6,000 3,000 5, = Required production 31,500 46,500 59,000 137,
Budgeted Cost per Unit
Budgeted cost per unit for finished goods produced has three components: direct materials, direct labor and variable and fixed overhead. Each type of cost requires a separate budget in the master budget.
Direct Materials Budget
Direct Material Budget: Determines the quantity of direct raw materials that must be purchased each period to meet anticipated production needs (from the production budget) and to provide for adequate levels of direct raw materials inventories. Remember that raw materials inventory may also include indirect materials. This budget addresses only the direct materials portion of raw materials inventory. The indirect materials portion is addressed as part of the overhead budget. Production needs are stated in units of finished goods and multiple units of direct materials may be required to produce one unit of finished goods. The first step in the direct materials budget is to convert units of finished goods produced into direct materials needed to produce them by multiplying the number of units produced by the direct materials required to produce one unit of finished goods. The final step in the direct materials budget to to determine the cost of the direct materials purchased by multiplying the quantity to be purchased by the purchase price per unit. May also include a schedule of expected cash disbursements which determines the amount of expected cash payments to suppliers and vendors for each period based on an expected payment pattern.
Example #
Texas Products has developed a very powerful electronic calculator. Each calculator requires three small chips that cost $2.00 each and are purchased from an overseas supplier. Texas Products has prepared a production budget for the calculator by quarters for Year 2 and for the first quarter of Year 3, as follows:
Year 2 Year 3 First Second Third Fourth First Budgeted productions, in calculators 60,000 90,000 150,000 100,000 80,
The inventory of the chips at the end of a quarter must be equal to 20% of the following quarter’s production needs. There will be 36,000 chips on hand to start the first quarter of Year 2.
Required: Prepare direct materials budget for the chips, by quarter and in total, for Year 2 including the dollar amount of purchases for each quarter and for the year in total.
Solution #
First Second Third Fourth Required production – units 10,000 8,000 8,500 9, X Direct labor hours per unit 0.6 0.6 0.6 0. = Total direct labor-hours needed 6,000 4,800 5,100 5, X Direct labor cost per hour $15.00 $15.00 $15.00 $15. = Total direct labor cost $90,000 $72,000 $76,500 $81,
Manufacturing Overhead Budget
The manufacturing overhead budget has two components – variable and fixed overhead. Budgeted variable overhead expenses depend on the number of units produced from the production budget and a budgeted variable overhead cost per unit. Budgeted fixed overhead expenses depend on the total cost expected to be incurred for each type of fixed overhead cost. Any noncash fixed manufacturing overhead costs, such as depreciation expense, is deducted from the total manufacturing overhead to determine the cash disbursements for manufacturing overhead. (Remember that depreciation expense is a non-cash expense. The cash was spent when the depreciable asset was acquired and not when the asset is depreciated.)
Example #
Company C’s variable manufacturing overhead rate is $2.00 per direct labor-hour and the company’s fixed manufacturing overhead is $40,250 per quarter. The only non-cash expense included in the fixed overhead is depreciation of $12,000 per quarter.
The budgeted direct labor-hours for each quarter are as followed:
First Second Third Fourth Budgeted direct labor hours 5,000 6,500 6,000 5,
Required: a) Construct company’s manufacturing overhead budget for the year. b) Compute the company’s variable, fixed and total manufacturing overhead rates for the year.
Solution #
a) Overhead budget First Second Third Fourth Year Budgeted direct labor-hours 5,000 6,500 6,000 5,500 23, X Variable overhead rate $2.00 $2.00 $2.00 $2.00 $2. = Variable overhead $10,000 $13,000 $12,000 $11,000 $46,
- Fixed overhead 40,250 40,250 40,250 40,250 161, = Total overhead $50,250 $53,250 $52,250 $51,250 $207,
- Deprecation 12,000 12,000 12,000 12,000 48, = Cash disbursements $38,250 $41,250 $40,250 $39,250 $159,
b) Overhead rate Overhead Direct Labor Hours Overhead Rate Variable overhead $46,000 / 23,000 = $2. Fixed overhead $161,000 / 23,000 = $7. Total overhead $207,000 / 23,000 = $9.
Selling and Administrative Expense Budget
Selling and Administrative (S&A) expense budget is similar to the manufacturing overhead budget as it includes variable and fixed expenses. Budgeted variable S&A expenses depend on the number of units sold or sales dollars from the sales budget. Budgeted fixed S&A expenses depend on the total cost expected to be incurred for each type of fixed S&A cost. Any noncash fixed S&A costs, such as depreciation expense, is deducted from the total S&A expenses to determine the cash disbursements for S&A expenses. (Remember that depreciation expense is a non-cash expense. The cash was spent when the depreciable asset was acquired and not when the asset is depreciated.)
Cash Budget
Cash budget is composed of four major sections: o Cash Receipts o Cash Disbursements o Cash Excess or Deficiency o Financing
Practice Problems
Practice Problem #
Peak sales for J & J Products, a wholesale distributor of leaf rakes, occur in August. Sales the company’s planning budget for the third quarter are shown below:
July August September Total Budgeted Sales on account $600,000 $900,000 $500,000 $2,000,
From past experience, the company has learned that 20% of a month’s sales are collected in the month of sale, another 70% are collected in the month following sale and the remaining 10% are collected in the second month following sale. Bad debts are negligible and can be ignored. May sales totaled $430,000 and June sales totaled $540,000.
Required: a) Prepare a schedule of expected cash collections from sales, by month and in total, for the third quarter. b) Compute the accounts receivable as September 30.
Practice Problem #
Micro Corporation has budgeted sales of its microchips for next four month as follows:
Units Sold April 20, May 25, June 35, July 40,
The company is preparing a production budget for the third quarter. Ending inventory level must equal 20% of the next month’s sales.
Required: a) Calculate the ending inventory as of March 31. b) Prepare a production budget for the third quarter by month and in total.
Practice Problem #
Company A sells a single product. Each unit takes two pounds of material and costs $3.00 per pound. Company A has prepared a production budget by quarters for Year 2 and for the first quarter of Year 3, as follows:
Year 2 Year 3 First Second Third Fourth First Budgeted production 30,000 60,000 90,000 100,000 50,
The ending inventory at the end of a quarter must be equal to 25% of the following quarter’s production needs. 26,000 pounds of material are on hand to start the first quarter of Year 2.
Required: Prepare direct materials budget for the chips by quarter and in for Year 2 in total including the dollar amount of purchases.
Practice Problem #
The production department of the Hampton Freeze, Inc. has submitted the following forecast of units to be produced by quarter for the upcoming fiscal year.
First Second Third Fourth Units to be produced 8,000 7,500 7,000 9,
Each unit requires 0.4 direct labor-hours. Direct labor rate is $10.00 per hour.
Required: Prepare the direct labor budget for the upcoming fiscal year.
Practice Problem #
The budgeted direct labor-hours for the Texaco Company are as followed:
First Second Third Fourth Budgeted direct labor hours 15,000 16,500 16,000 15,
Texaco Company’s variable manufacturing overhead rate is $1.5 per direct labor-hour and the company’s fixed manufacturing overhead is $60,000 per quarter. The only non- cash item included in the fixed mfg. overhead is depreciation, which is $18,000.
True / False Questions
- A short-term objective is a specific action managers use to reach their long- term goals. True False
- The strategic plan is management's vision of what they desire the organization to achieve over the long term. a)True False
- An advantage of budgeting is that it requires managers to evaluate why things did not progress according to the plan. True False
- Participative budgeting allows employees throughout the organization to have input into the budget-setting process. True False
- Budgets that are tight but attainable are less likely to motivate people than budgets that are easy to achieve. True False
- Operating budgets focus on the financial resources needed to support operations. True False
- The direct labor budget is based on budgeted sales levels. True False
- Budgeted manufacturing overhead includes indirect manufacturing costs, but not selling or administrative costs. True False
- Cash budget is a detailed plan showing how the cash will be acquired and used over a specific time period. True False
- A short-term objective is a specific action managers use to reach their long- term goals. a)True False
- The strategic plan is management's vision of what they desire the organization to achieve over the long term. True False
- Merchandising companies prepare the production budget after preparing the sales budget. True False
- Budget preparation is best determined in a top-down managerial approach. True False
- Past performance is the best overall basis for evaluating current performance and assessing the need for corrective action. True False
- What is the proper preparation sequencing of the following budgets?
1 - Budgeted Balance Sheet 2 - Sales Budget 3 - Selling and Administrative Budget 4 - Budgeted Income Statement a) 1, 2, 3, 4 b) 2, 3, 1, 4 c) 2, 3, 4, 1 d) 2, 4, 1, 3
- Albertville Inc. produces leather handbags. The production budget for the next four months is: July 6,000 units, August 8,000, September 7,500, October 8,000. Each handbag requires 0.5 square meters of leather. Albertville Inc's leather inventory policy is 30% of next month's production needs. On July 1 leather inventory was expected to be 2,000 square meters. Leather is expected to cost $5.00 per square meter in June, but go up to $6.00 per square meter in July. What is the expected cost of leather purchases in July? a) $13, b) $13, c) $16, d) $16,
- Albertville Inc. produces leather handbags. The production budget for the next four months is: July 5,000 units, August 8,000, September 9,500, October 10,800. Each handbag requires 1.3 hours of unskilled labor (paid $8 per hour) and 2.2 hours of skilled labor (paid $15 per hour). How many unskilled and skilled labor hours will be budgeted for August? a) 10, b) 17, c) 28, d) 28,
- Albertville Inc produces leather handbags. The production budget for the next four months is: July 6,000 units, August 7,000, September 7,500, October 8,000. Each handbag requires 1.3 hours of unskilled labor (paid $8 per hour) and 2.2 hours of skilled labor (paid $15 per hour). How much will be paid to skilled labor during the Quarter 3 (July-September)? a) $292, b) $676, c) $677, d) $742,
- Brimson has forecast production for the next three months as follows: July 5,000 units, August 6,600 units, September 7,500 units. Monthly manufacturing overhead is budgeted to be $17,000 plus $5 per unit produced. What is budgeted manufacturing overhead for July? a) $24, b) $41, c) $42, d) $47,
- Tomi has forecast sales for the next three months as follows: July 7,000 units, August 8,000 units, September 8,500 units. Tomi's policy is to have an ending inventory of 40% of the next month's sales needs on hand. July 1 inventory is projected to be 1,500 units. Selling and administrative costs are budgeted to be $15,000 per month plus $5 per unit sold. What are budgeted selling and administrative expenses for July? a) $24, b) $38, c) $49, d) $50,
- Echo has forecast sales to be $120,000 in February, $145,000 in March, $170,000 in April, and $180,000 in May. The average cost of goods sold is 60% of sales. All sales are on made on credit and sales are collected 60% in the month of sale, and 40% the month following. What are budgeted cash receipts in March? a) $131, b) $135, c) $94, d) $91,
- Carlton has forecast sales to be $215,000 in February, $260,000 in March, $300,000 in April, and $310,000 in May. All sales are made on credit and sales are collected 50% in the month of sale, 30% the month following and the remainder two months after the sale. What are budgeted cash receipts in April? a) $174, b) $217, 000 c) $271, d) $371,
- A department store has budgeted sales of 12,000 men's suits in September. Management wants to have 6,000 suits in inventory at the end of the month to prepare for the winter season. Beginning inventory for September is expected to be 4,000 suits. What is the dollar amount of purchase of suits? Each suit has a cost of $75. a) $750, b) $900, c) $1,050, d) $1,200,
- Northern Company is preparing a cash budget for June. The company has $12,000 cash at the beginning of June and anticipates $30,000 in cash receipts and $34,500 in cash disbursements during June. Northern Company has an agreement with its bank to maintain a cash balance of at least $10,000. As of May 31, the company owes $15,000 to the bank. To maintain the $10,000 required balance, during June the company must: a) Borrow $4, b) Borrow $2, c) Borrow $10, d) Borrow $7,
Solutions to Practice Problems
Practice Problem #
a) Schedule of Cash Collections: July August September Total May sales ($430,000 X 10%)
June sales ($540,000 X 70%, 10%)
July sales ($600,000 X 20%, 70%, 10%)
August sales ($900,000 X 20%, 70%)
September sales ($500, X 20%)
Total cash collections $541,000 $654,000 $790,000 $1,985,
b) Account receivable at September 30:
From August sales: $900,000 X 10% $90, From September sales: $500,000 X (70% + 10%) 400, Total account receivable $490,
Practice Problem #
a) Since the ending inventory for the month of March must be 20% of April’s sales of 20,000 units, ending inventory = 4,000 units.
b) Production Budget: April May June Quarter Budgeted sales in units 20,000 25,000 35,000 80, Add desired ending inventory* 5,000 7,000 8,000** 8, Total needs 25,000 32,000 43,000 88, Less beginning inventory 4,000 5,000 7,000 4, Required production 21,000 27,000 36,000 84,
*10% of the following month's unit sales **July sales = 40,000 X 20% = 8,
