Solution manual cost accounting 8th by kinney chapter 08

Why is the cash budget so important in the master budgeting process?. Terminology Budget: a financial plan for the future based on a single level of activity; the quantitative expression

Learning Objectives

After reading and studying Chapter 8, you should be able to answer the following questions:

1 How are strategic planning and tactical planning related to budgeting?

2 What is the starting point of a master budget and why?

3 What are the various components of a master budget, and how are they prepared?

4 Why is the cash budget so important in the master budgeting process?

5 How and why are budgeted financial statements prepared at the end of the budgeting

process?

6 What benefits are provided by a budget?

7 (Appendix) How does a budget manual facilitate the budgeting process?

THE MASTER BUDGET CHAPTER

8

Terminology

Budget: a financial plan for the future based on a single level of activity; the quantitative expression of a

company’s commitment to planned activities and resource acquisition and use

Budgeting: the process of formalizing plans and translating qualitative narratives into a documented

quantitative format

Budget manual: a detailed set of documents that provides information and guidelines about the

budgetary process

Budget slack: an intentional underestimation of revenues and/or overestimation of expenses in a

budgeting process

Continuous budget: an on-going 12-month budget maintained by successively adding a new budget

month (12 months into the future) as each current month expires

Financial budget: a plan that combines the monetary details from the operating budgets; includes the

cash and capital budgets of a company as well as the pro forma financial statements

Imposed budget: a budget developed by top management with little or no input from operating

personnel; operating personnel are then informed of the budget goals and constraints

Master budget: the comprehensive set of budgets, budgetary schedules, and pro forma organizational

financial statements

Operating budget: a budget expressed in both units and dollars; includes components of the various pro

forma financial statements such as a sales budget, production budget, purchases budget, direct labor budget, overhead budget, and selling and administrative budget

Participatory budget: a budget that has been developed through a process of joint decision making by

top management and operating personnel

Rolling budget: (see continuous budget)

Strategic planning: top-level management planning on a long-range basis (5 to 10 years) that produces

a statement of long-range organizational goals and the strategies and policies that will help achieve those goals

Tactical planning: Short-term planning (1 – 18 months) that determines how the organization’s strategic

plans will be achieved

Lecture Outline LO.1: How are strategic planning and tactical planning related to budgeting?

A Introduction

1 Planning is the cornerstone of effective management and in complex situations successful planning requires that managers predict, with reasonable precision, the key variables that affect company performance

a A goal without a plan is just a wish

2 This chapter covers the budgeting process and preparation of the master budget

B The Budgeting Process

1 Budgeting is the process of formalizing plans and translating qualitative narratives into a

documented, quantitative format

a A budget is the quantitative expression of a company’s commitment to planned activities and

resource acquisition and use

b A budget is a type of standard that allows variances to be computed and feedback about those variances to be given to the appropriate managers

c Budgets can be viewed from a long-term (strategic) or short-term (tactical) perspective

2 Strategic Planning

a Strategic planning is the process of developing a statement of long-range (5–10 years)

goals for the organization and defining the strategies and policies that will help the

organization achieve those goals

b Key variables that are believed to be the direct causes of the achievement or

nonachievement of organizational goals and objectives should be identified (see text Exhibit 8-1)

i Internal factors are those under the control of management (e.g., access to resources and core competencies)

ii External factors are noncontrollable variables such as competitor actions and the

political/regulatory climates in which the company operates

c During the strategic planning process, managers agree on organizational goals and

objectives and how to achieve them

i This requires organizing complex activities, managing diverse resources, and formalizing plans

3 Tactical Planning

a Tactical planning is the process of determining the specific means or objectives by which

the strategic plans of the organization will be achieved; it is short range in nature (usually 1–

18 months)

i Such short-term tactical plans are considered “single use” plans and have been

developed to address a given set of circumstances or a specific time frame

ii The annual budget is an example of a single use tactical plan

b Text Exhibit 8-2 illustrates the relationships between strategic planning, tactical planning,

and budgeting

c A well-prepared budget can effectively communicate objectives, constraints, and

expectations to personnel throughout an organization about:

i what is to be accomplished;

ii how those accomplishments are to be achieved; and

iii the manner in which resources are to be allocated

d Employee participation is needed in the budget process to integrate necessary information from various sources as well as to obtain individual managerial commitment to the resulting budget

i The greater the employee participation in the budgeting process, the greater the time and cost involved

ii Budgets developed with significant employee participation are said to be built from the bottom of the organization upward

e A well-prepared budget translates a company’s strategic and tactical plans into usable

guidelines for company activities

i Management must review the budget prior to its approval and implementation in order to determine if the forecasted results are acceptable

f A budget, having been accepted, is then implemented and becomes a performance

benchmark

i Control functions include making actual-to-budget comparisons, determining variances, investigating variance causes, taking necessary corrective action, and providing feedback

to operating managers

ii Feedback, both positive and negative, is essential to the control process and must be

provided in a timely manner as illustrated in text Exhibit 8-3

g The budgeting process results in the preparation of a master budget

i The master budget is a comprehensive set of budgets, budgetary schedules, and

budgeted (pro forma) organizational financial statements

LO.2: What is the starting point of a master budget and why?

C The Master Budget

1 The master budget includes both the operating and financial budgets as illustrated in text Exhibit 8-4

a An operating budget is a budget that is expressed in both units and dollars

i It includes components of the various pro forma financial statements:

 Sales budget;

 Production budget;

 Purchases budget;

 Direct labor budget;

 Overhead budget; and

 Selling and administrative budget

b A financial budget is a budget that aggregates monetary details from the operating budgets

i It includes the following components:

 Capital expenditures budget;

 Cash budget;

 Pro forma balance sheet;

 Pro forma income statement;

 Pro forma statement of cash flows; and

 Pro forma statement of retained earnings

2 The master budget is prepared for a specific time period and is static (rather than flexible) in the sense that it is based on a single level of output demand

a The budget is typically prepared for a year and then subdivided into quarterly and monthly periods

3 The budgetary process begins with sales

a The output level of sales or service quantities selected for use in the master budget

preparation affects all other organizational components; it is essential that all the components interrelate in a coordinated manner

i Text Exhibit 8-5 illustrates the budgetary process showing how the various functional

areas of a manufacturing organization interrelate

b The process begins with the sales department’s estimates of the types, quantities, and timing

of sales

c The production manager combines sales estimates with information from purchasing, human resources, operations, and facilities to develop a production budget

d The treasurer combines the sales estimates with cash collection patterns and the production requirements information with cash payment patterns to develop a cash budget

LO.3: What are the various components of a master budget, and how are they prepared?

D The Master Budget Illustrated

1 Text Exhibit 8-6 presents the beginning balance sheet for Lewis & Clark Corp., which is used in

the text to illustrate the preparation of the master budget

a The sales budget is prepared in both units and sales dollars; dollar sales figures are

calculated by multiplying sales quantities by product selling prices (see text Exhibit 8-7)

2 Production Budget

a The production budget follows naturally from the sales budget and uses information regarding

the type, quantity, and timing of units to be sold (see text Exhibit 8-8)

b Sales information is combined with information on beginning and ending inventories so that managers can schedule the necessary production:

Units to be sold + desired ending units = total needs – beginning units = Units to be produced

c Ending inventory policy is generally specified by company management, and desired ending inventory is usually a function of the quantity and timing of demand in the upcoming period as related to the capacity and speed of the firm to produce particular units

i Other alternatives include a constant amount of inventory, a buildup of inventory for future high-demand periods, or near-zero inventory under a just-in-time system

ii Managers should consider the high costs of stockpiling inventory before making a

decision about how much inventory to keep on hand

3 Purchases Budget

a Direct material must be purchased each period in quantities sufficient to meet production needs and to conform to the company’s desired ending inventory policies

b Companies may have different policies for the direct material associated with different

products or for different seasons of the year

c The purchases budget for direct and indirect materials is first stated in whole units of finished

products (see text Exhibit 8-9)

d The budget is subsequently converted to individual direct material component requirements and following that, to cost of purchases amounts as illustrated in text Exhibit 8-9

4 Personnel Budget

a The personnel budget reports labor requirements for the factory, sales force, and office staff

i Budgets are prepared in terms of total number of people, specific number of worker types (skilled laborers, setup helpers, salespeople, clerical personnel, etc.), production hours needed, and vacation time provided

ii Labor costs are computed from items such as union labor contracts, minimum wage laws, fringe benefit costs, payroll taxes, and commission and bonus arrangements

5 Direct Labor Budget

a The direct labor budget consists of direct labor cost estimates that are based on the standard hours of production needed to produce the number of units shown in the production budget

(see text Exhibit 8-10)

b The average wage rate includes the direct labor payroll rate, payroll taxes, and fringe

benefits; these items usually add between 25 and 30 percent to the base labor cost

6 Overhead Budget

a The overhead budget shows the estimated cost of each overhead item for the period(s) (see

text Exhibit 8-11)

b All fixed and variable overhead costs must be specified, and mixed costs must be separated into their fixed and variable components so that budgeted overhead can be computed using the equation of a straight line:

Total budgeted overhead = Total budgeted fixed overhead + (budgeted unit variable overhead cost x budgeted number of units)

7 Selling and Administrative Budget

a The selling and administrative (S&A) budget includes the estimated selling and administrative

expenses for the period(s) (see text Exhibit 8-12)

b The operating expenses for each month can be predicted in the same fashion as overhead costs

i Sales figures rather than production levels are used as the measure of activity in

preparing this budget

8 The Capital Budget

a Capital budgeting is the process of assessing an economic entity’s long-term needs in the area of plant and equipment purchases and budgeting for those expenditures

b Although the capital budget (see text Exhibit 8-13) is prepared separately from the master

budget, capital expenditures affect the master budgeting process because such purchases affect depreciation expense and cash payments

LO.4: Why is the cash budget so important in the master budgeting process?

9 The Cash Budget

a The cash budget might be the most important schedule prepared during the budgeting process because a company cannot survive without cash

i A basic model for the cash budget is provided in the text at the beginning of this section

b Cash Receipts and Accounts Receivable

i Managers translate sales revenue information into actual cash receipts through the use

of an expected collection pattern This is illustrated in the text using the Lewis & Clark

Corp example and text Exhibits 8-14 and 8-15

ii The balances of the Accounts Receivable, Allowance for Uncollectibles, and Sales Discounts accounts can be projected once such a schedule of cash collections has been prepared (refer to the T-accounts in the text)

c Cash Disbursements and Accounts Payable

i Management can prepare an estimated cash disbursements schedule for accounts payable using the purchases information

ii Purchases are translated into actual cash disbursements through the use of an expected payment pattern This is illustrated in the text using the Lewis & Clark Corp example and

text Exhibits 8-16 and 8-17

iii The activity in the Accounts Payable account is illustrated in a T-account in the text

d Cash budgets can be used to: predict seasonal fluctuations in any potential cash flow, indicating a need for short-term borrowing and a potential schedule of repayments; show the possibility of surplus cash that could be used for investment; and measure the performance

of the accounts receivable and accounts payable departments by comparing actual to scheduled collections, payments, and discounts taken

i Cash flow provides the short-run source of power in a business to negotiate and act

ii Text Exhibit 8-18 provides ten ways for a small business to improve its cash flow

LO.5: How and why are budgeted financial statements prepared at the end of the budgeting process?

10 Budgeted Financial Statements

a Budgeted financial statements are prepared for the period(s) and reflect the results that will

be achieved if the estimates and assumptions used for all previous budgets actually occur

i The statements allow management to determine if the predicted results are acceptable for the period; management then has the opportunity to change and adjust items before beginning the new period if the predicted results are not acceptable

b Cost of Goods Manufactured Schedule

i Management must prepare a schedule of cost of goods manufactured in order to

determine cost of goods sold expense for the pro forma income statement

ii Text Exhibit 8-19 provides the formula for computing cost of goods manufactured

c Income Statement

i A pro forma (projected) income statement can now be prepared using much of the information previously developed in determining the revenues and expenses for the period

ii Text Exhibit 8-20 provides a pro forma income statement for Lewis & Clark Corp

d Balance Sheet

i A budgeted balance sheet showing the company’s pro forma financial position at the end

of the budgeting period is prepared next

ii Text Exhibit 8-21 presents the expected ending asset, liability, and stockholders’ equity

balances for Lewis & Clark Corp

e Statement of Cash Flows

i A pro forma statement of cash flows (SCF) can now be prepared using information found

in the income statement, balance sheet, and cash budget

ii Text Exhibit 8-22 presents the budgeted cash flow statement for Lewis & Clark Corp

iii The budgeted cash flow statement can assist managers in performing the following functions:

 Judging the company’s ability to handle fixed cash outflow commitments;

 Adapting to adverse changes in business conditions;

 Undertaking new commitments; and

 Assessing the quality of company earnings by indicating the relationship between net income and net cash flow from operations

iv Whereas the cash budget is essential to current cash management, the budgeted SCF gives managers a more comprehensive view of cash flows by rearranging them into three distinct major activities (operating, investing, and financing) thus enabling them to judge whether the specific anticipated flows are consistent with the company’s strategic plans

LO.6: What benefits are provided by a budget?

E Concluding Comments

1 Benefits of a well-prepared budget

a Budgets are guides to help managers align resource activities and resource allocations with organizational goals

b Budgets are a vehicle to promote employee participation, cooperation, and departmental coordination

c Budgets help managers carry out their managerial functions of planning, controlling, problem solving, and performance evaluating

d Budgets provide a basis on which to sharpen management’s responsiveness to changes in both internal and external factors

e Budgets serve as a model that provides a rigorous view of future performance of a business

in time to consider alternative measures

2 Demand must be predicted as accurately and with as many details as is possible because of its fundamental importance in the budgeting process

a Sales forecasts should indicate type and quantity of products to be sold, geographic locations

of the sales, types of buyers, and times when the sales are to be made

b Such detail is necessary because different products require different production and

distribution facilities; different customers have different credit terms and payment schedules; and different seasons or months may require different shipping schedules or methods

3 Estimated sales demand has a pervasive impact on the master budget

a Managers use as much information as is available and may combine several estimation approaches in arriving at a valid prediction

b The combining of prediction methods provides managers with a technique to confirm

estimates and reduce uncertainty

c Ways of estimating future demand include:

i canvassing sales personnel for a subjective consensus;

ii making simple extrapolations of past trends;

iii using market research; and

iv employing statistical and other mathematical models

4 Care should be taken to use realistic, rather than optimistic or pessimistic forecasts of revenues and costs

a Computer models can be utilized that allow repetitive simulations to be run after changes are made to one or more factors