Chapter 9:
Profit Planning
Cornerstones of Managerial Accounting, 4e
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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.
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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.
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Planning, Control, and Budgets
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Advantages of Budgeting
A budgetary system gives an organization
several advantages.
Planning
Information for Decision Making
Standards for Performance
Evaluation
Improved Communication
& Coordination
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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.
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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.
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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.
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The Master Budget and
Its Interrelationships
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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
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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.
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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)
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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:
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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.
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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.
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Ending
Finished
Goods
Inventory
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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.
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Cost of Goods Sold Budget
►The cost of goods sold budget reveals
the expected cost of the goods to be
sold.
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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.
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Budgeted Income Statement
►With the completion of the budgeted cost of
goods sold schedule and the budgeted selling
and administrative expenses budget, Texas
Rex has all the operating budgets needed to
prepare an estimate of operating income.
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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
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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:
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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.
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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.
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Participative Budgeting
► Rather than imposing budgets on subordinate managers,
participative budgeting allows subordinate managers
considerable say in how the budgets are established.
► The increased responsibility and challenge inherent in the
process provide nonmonetary incentives that lead to a higher
level of performance.
► However, participative budgeting has three potential
problems:
► setting standards that are either too high or too low
► building slack into the budget (often referred to as padding the
budget)
► pseudoparticipation
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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.
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Multiple Measures of Performance
►Often, organizations make the mistake of using budgets
as their only measure of managerial performance.
►While financial measures of performance are important,
overemphasis can lead to a form of dysfunctional
behavior called milking the firm or myopia.
►Myopic behavior occurs when a manager takes actions
that improve budgetary performance in the short run but
bring long-run harm to the firm.
►Budgetary measures alone cannot prevent myopic
behavior.
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