Chapter 11: Budget & Flexible
Budget
1-1
Profit Rich, Yet Cash Poor
Conditions leading to cash
shortages when profits are high.
Large investments
in assets to support
rapid revenue growth.
Long operating cycles
(cash-to-cash cycles).
Consider the following cash-to-cash cycle.
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Profit Rich,Yet Cash Poor
The following profitability measures were taken from
NTI’s financial report for the year ended December
31, 2020.
1-3
Profit Rich,Yet Cash Poor (cont.)
Even though NTI appears to be profitable relative to
industry averages, it is plagued by severe cash flow
problems. The liquidity measures presented as follows
were also taken from NTI’s December 31, 2020, financial
report. Unlike the profitability measures, these measures
are all well below industry averages.
1-4
Profit Rich, Yet Cash Poor
As shown, NTI’s operating
cycle during 2020 averaged
247 days. In other words,
cash was tied up in inventory
and receivables for 247 days
before converting back into
cash. Throughout its
operating cycle, however,
payrolls, materials purchases,
debt service, and overhead
costs all required
disbursements of cash on a
timely basis (for example, 30
days). No wonder NTI’s 2020
statement of cash flows
reported a $250,000 negative
cash flow from operations!
Cash
Inventories
DM→WIP→FG
166 days
247 Days
Accounts Receivable
81 days
Cash
Even if sales are growing rapidly, cash is tied
up in inventory and receivables for so long that
a cash shortage will be the likely result.
1-5
Budgeting: The Basis for Planning
and Control
A budget is a comprehensive financial
plan for achieving the financial and
operational goals of an organization.
Planning
Control
Developing
objectives for
acquisition
and use of
resources.
Steps taken by
management to
ensure that
objectives are
attained.
1-6
Benefits Derived from Budgeting
Enhanced management
responsibility
Coordination
of activities
Benefits
Performance
evaluation
Assignment of decisionmaking responsibilities
1-7
Establishing Budgeted Amounts
 Comparisons of actual performance with budgeted
amounts are widely used in evaluating the
performance of departments and department
managers.
 Two basic philosophies prevail today that dictate the
levels at which budgeted amounts should be set. We
identify these philosophies as:
1. The behavioral approach.
2. The total quality management approach.
 We first discuss the behavioral approach, which
currently is the more widely used budgeting
philosophy.
1-8
Establishing Budgeted Amounts:
Behavioral Approach
Budget Problems
Solution
▪ Perceived unfair or
unrealistic goals.
▪ Reasonable and
achievable budgets.
▪ Poor managementemployee
communications.
▪ Employee
participation in
budgeting process.
1-9
Establishing Budgeted Amounts:
Total Quality Management Approach
A commitment to the
goal of completely
eliminating inefficiency.
Budgeted amounts set
at levels representing
absolute efficiency.
Small failures to
achieve budgeted
amounts direct
management to
areas where
improvement is
possible.
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Selecting and Using a Budgeting Approach:
Managers Should Participate Actively
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Flow of Budget Data
1-11
The Budget Period
The annual operating budget may be
divided into quarterly or monthly budgets.
2012
2013
2014
2015
Capital Budgets are for longer periods of time.
A rolling budget is usually a twelve-month budget
that adds one month as the current month
is completed.
1-12
The Master Budget
A typical master budget for a manufacturing company
would include the following:
1. Operating budgets
a. Sales budget
b. Production budgets including
 Units to produce
 Direct materials
 Direct labor
 Overhead
c. Cost of goods manufactured and sold budget
1-13
The Master Budget (cont.)
d. Selling and administrative expense budget
 Marketing
 Administrative expenses
 Research and development
e. Cash budget
2. Financial budgets
a. Budgeted income statement
b. Budgeted balance sheet
c. Budgeted cash flows statement
d. Capital expenditures budget
1-14
The Master Budget
1-15
Steps in Preparing a Master Budget
The following is the logical sequence of steps for
preparing the annual elements of the master
budget.
1. Prepare a sales forecast.
2. Prepare budgets for production, manufacturing
costs, and operating expenses.
3. Prepare a budgeted income statement.
4. Prepare a cash budget.
5. Prepare a budgeted balance sheet.
1-16
Preparing the Master Budget: An Illustration
We will now develop NTI’s master budget for 2021.
• A primary objective of this process is to help NTI
avoid the cash flow problems experienced during
2020.
• Sales of NTI’s product are expected to increase
throughout 2021. However, the company will
drastically cut back production during the first
quarter to liquidate some of the finished goods
inventory currently on hand.
• As of January 1, there is no work in process inventory.
• No capital expenditures are planned for 2021.
1-17
NTI’s Beginning Balance Sheet
1-18
Steps in Preparing a Master Budget
Sales
Budget
Estimated
Unit Sales
Estimated
Unit Price
Analysis of economic and market conditions
+
Forecasts of customer needs from
marketing personnel
1-19
Manufacturing Cost Estimates
In preparation for the budget process, Lisa Scott, NTI’s
cost accountant, has thoroughly analyzed the company’s
variable and fixed manufacturing costs.
• Direct materials consist of two specially coated disks
that cost $7.50 each.
• Direct labor is one-eighth hour per disk or onequarter hour per finished unit.
• She is confident that variable manufacturing costs per
unit will not increase during 2021.
• She also believes that fixed manufacturing overhead
will hold steady at approximately $15,000 per
quarter.
1-20
Preparing the Master Budget:
Manufacturing Cost Estimates
On the basis of her analysis, she compiled the
following manufacturing cost estimates.
1-21
The Sales Budget
Bob Poole, NTI’s marketing director, is optimistic that demand for
the company’s product will continue to grow in 2021. He estimates
that sales will reach 8,000 units in the first quarter and 10,000 units
in the second quarter. Sales estimates for the third and fourth
quarters are 30,000 units and 40,000 units, respectively. To keep its
product affordable to a wide range of users, NTI is committed to
holding its selling price per unit at $75 throughout the year.
8,000 units
to Production
Budget
1-22
The Production Budget: Units
Production must be adequate to meet budgeted
sales and to provide sufficient ending inventory.
Budgeted product sales in units
+ Desired product units in ending inventory
= Total product units needed
– Product units in beginning inventory
= Product units to produce
1-23
Production Budget: Units
Upon examining performance reports for 2020, Joe Reco, NTI’s
production manager, concluded that he had overreacted to the
rapid sales growth experienced in the fourth quarter. Based on
new inventory policies and estimates, the unit production budget
was created.
8,000 units
From Sales
Budget
1-24
The Production Budget:
Material Purchases
The material purchases budget is based
on production quantity and desired
material inventory levels.
×
=
+
=
–
=
Units to produce
Material needed per unit
Material needed for units to produce
Desired units of material in ending inventory
Total units of material needed
Units of material in beginning inventory
Units of material to purchase
1-25
The Production Budget:
Direct Labor & Overhead
Budgeted Production Direct Labor Budget
× Labor Hours per unit
= Total Hours needed for units to produce
X Cost per Labor Hour
= Budgeted Direct Labor Cost
Overhead Budget
Budgeted Production
× Variable overhead cost
= Budgeted Variable Overhead cost
+ Budgeted Fixed Overhead cost
= Total Budgeted Overhead
1-26
The Production Budget: Cost Budgets
From NTI 2021 Units of Production Budget
1-27
Cost of Goods Manufactured and
Sold Budget
The budget estimates for cost of goods
sold are computed using the beginning
finished goods inventory figure from the
beginning balance sheet and information
from the production budgets.
Beginning
Balance
Sheet
Production
Budget
Information
Cost of Goods
Manufactured and
Sold Budget
1-28
Cost of Goods Manufactured and
Sold Budget
A manufacturing company’s cost of goods sold is equal to its
beginning finished goods inventory, plus the cost of goods
manufactured during the period, less its ending finished goods
inventory.
1-29
Selling and Administrative
(S&A) Expense Budget
✓ Selling expense budgets contain both variable and
fixed items.
▪ Variable items: shipping costs and sales commissions.
▪ Fixed items: advertising and sales salaries.
✓ Administrative expense budgets contain mostly
fixed items.
▪ Executive salaries and depreciation on company offices.
1-30
Budgeted Income Statement
 The budgeted income statements are based on
estimates from:
◦ Sales budget.
◦ Cost of goods sold budget.
◦ Selling and administrative expense budget.
 Additionally, management must make estimates
related to:
◦ Interest expense.
◦ Income taxes.
1-31
The Budgeted Income Statement
1-32
Cash Budget Estimates
The estimates and data necessary to prepare
the cash budget and budgeted balance
sheets are called cash budget estimates.
These include budgeted disbursements for
payables, prepayments, debt service, and
taxes. In addition, NTI must budget cash
receipts from collection of receivables.
1-33
Current Payables Budget
 Our preparation of a cash budget begins with estimating
the portion of budgeted costs and expenses that will
require cash payment in the near future.
 Certain expenses will not require an outlay of cash. These
include:
1. Expenses that result from the expiration of prepaid
items (such as insurance policies) and
2. The depreciation of plant assets.
 However, only those costs and expenses financed by
current payables (which include immediate cash payments
as well as accounts payable and accrued expenses) will
require cash payments.
1-34
NTI: Budget for Current Payables and
Disbursements for 1st Quarter
1-35
Prepayments Budget
NTI prepays for its insurance policies. Therefore,
this must be considered when preparing the cash
budget.
1-36
Debt Service Budget
The purpose of this schedule is to summarize the cash
payments (both principal and interest) required to service
NTI’s debt each quarter. NTI has two notes payable
outstanding on January 1, 2021.
1. The 12 percent, $36,000 note payable is the loan from
Nancy Conrad, NTI’s president. The loan agreement calls
for quarterly payments of $9,000 plus interest accrued
on the outstanding balance at a quarterly rate of 3
percent. The debt service on this note in the first
quarter equals $9,000 in principal plus interest of
$1,080 ($36,000 × 3%), or a cash outlay of $10,080. The
note’s debt service in the second quarter equals $9,000
in principal plus interest of $810 ($27,000 × 3%), or a
cash outlay of $9,810.
1-37
Debt Service Budget (cont.)
2. The 14 percent, $246,000 note payable is to NTI’s
bank. The loan agreement calls for payment of the
entire $246,000 at the end of the first quarter of 2021,
plus interest accrued at a quarterly rate of 3.5 percent.
Thus, the debt service on this note in the first quarter
equals $246,000 plus interest of $8,610 ($246,000 ×
3.5%), or a cash outlay of $254,610. There is no debt
service cost associated with this note in the second
quarter.
1-38
Budgeted Income Taxes
Each quarter, NTI makes income tax payments equal to its
income tax liability at the beginning of that quarter. NTI’s
$64,000 liability at the beginning of the first quarter was taken
from its January 1, 2021, balance sheet. The $46,124 liability at
the beginning of the second quarter is simply the income tax
liability at the end of the first quarter.
1-39
Estimated Receipts from Customers
All of NTI’s sales are made on account. As such, the sole
source of cash receipts is the collection of accounts
receivable.
 In an attempt to improve cash flow performance in 2021,
NTI’s credit manager, Richard Baker, set the following goals
for his department:
1. To collect the entire $225,000 of accounts receivable
reported on the January 1, 2021, balance sheet by the end
of the first quarter
2. To collect 75 percent of quarterly sales during the
quarter in which they are made and collect the remaining
25 percent in the subsequent quarter.
 If successful, Baker estimates that NTI’s average collection
period will be reduced from 81 days to 30 days.

1-40
NTI: Budget for Accounts Receivable
Collections 1st Quarter
1-41
NTI: Cash Budget 1st Quarter
1-42
The Cash Budget
There is an improved cash position from 2020 to
2021 due to:
• A new policy of controlling inventory and
production schedules; and
• Goals to tighten credit policies.
1-43
The Budgeted Balance Sheet
1-44
Benefits of Budgeting
Advance warning and
assignment of responsibility
for conditions that require
corrective actions.
BUDGETS
Coordination of activities among
all departments within the
organization.
The creation of standards for
evaluating performance.
1-45
Flexible Budgeting
Hmm! Comparing
costs at different
levels of activity
is like comparing
apples with oranges.
Performance
evaluation is difficult
when actual activity
differs from the activity
originally budgeted.
1-46
Flexible Budgeting
 A flexible budget is one that can be adjusted
easily to show budgeted revenue, costs, and
cash flows at different levels of activity.
 Thus, if a change in volume lessens the
usefulness of the original budget, a new budget
may be prepared quickly to reflect the actual
level of activity for the period.
1-47
Flexible Budgeting
How can we
evaluate Joe
using the original
budget?
To answer the question, we must
the budget to the actual level of activity.
Central Concept: If you can tell me what your
activity was for the period, I will tell you what your
costs and revenue should have been.
1-48
Flexible Budgeting
Show expenses that should
have occurred at the actual
level of activity.
May be prepared for any activity
level in the relevant range.
Reveal variances due to cost
control or lack of cost control.
Improve performance
evaluation.
1-49
Flexible Budgeting
To
a budget for different activity
levels, we must know how costs behave
with changes in activity levels.
▪ Total variable costs change
in direct proportion to
changes in activity.
▪ Total fixed costs remain
unchanged within the
relevant range.
Fixed
1-50
Flexible Budgeting
1-51
Flexible Budgeting
1-52
Flexible Budgeting
Performance Report
1-53
Computers and Flexible Budgeting
 Adjusting the entire budget to reflect a different
level of sales or production would be a sizable task
in a manual system.
 In a computer-based system, however, it can be
done quickly and easily.
 Once the cost-volume-profit relationships have
been entered into a budgeting program, the
computer instantly performs the computations
necessary to generate a complete master budget
for any level of business activity.
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Ethics, Fraud, and Corporate
Governance
There is a growing concern in many states that
judicial budgetary requests have been denied
by governors and state legislatures in order to
free up resources for more politically popular
priorities.
Diverting financial resources for alternative
purposes results in shortfalls that jeopardize a
state’s ability to defend the indigent and
provide other services. Budgetary integrity,
political neutrality, and the prudent oversight
of resource allocations are as important in the
public sector as they are in the private sector.
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End of Week 11
McGraw-Hill/Irwin
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