Chapter 7
Profit Planning
McGraw-Hill /Irwin
© The McGraw-Hill Companies, Inc., 2007
Learning Objective
LO1
To understand why
organizations budget
and the processes
they use to create
budgets.
7-2
The Basic Framework of Budgeting
A budget is a detailed quantitative plan for
acquiring and using financial and other resources
over a specified forthcoming time period.
1. The act of preparing a budget is called
budgeting.
2. The use of budgets to control an
organization’s activity is known as
budgetary control.
7-3
Planning and Control
Planning –
involves developing
objectives and
preparing various
budgets to achieve
these objectives.
Control –
involves the steps
taken by
management that
attempt to ensure
the objectives are
attained.
7-4
Advantages of Budgeting
Define goal
and objectives
Communicate
plans
Think about and
plan for the future
Advantages
Coordinate
activities
Means of allocating
resources
Uncover potential
bottlenecks
7-5
Responsibility Accounting
Managers should be held responsible for
those items — and only those items —
that the manager can actually control
to a significant extent.
7-6
Choosing the Budget Period
Operating Budget
2003
2004
2005
2006
The annual operating budget
may be divided into quarterly
or monthly budgets.
7-7
Self-Imposed Budget
Top Management
Middle
Management
Supervisor
Supervisor
Middle
Management
Supervisor
Supervisor
A budget is prepared with the full cooperation and
participation of managers at all levels. A participative
budget is also known as a self-imposed budget.
7-8
Advantages of Self-Imposed Budgets
1. Individuals at all levels of the organization are viewed
as members of the team whose judgments are valued
by top management.
2. Budget estimates prepared by front-line managers are
often more accurate than estimates prepared by top
managers.
3. Motivation is generally higher when individuals
participate in setting their own goals than when the
goals are imposed from above.
4. A manager who is not able to meet a budget imposed
from above can claim that it was unrealistic. Selfimposed budgets eliminate this explanation.
7-9
Self-Imposed Budgets
Most companies do not rely exclusively upon
self-imposed budget in the sense that top
managers usually initiate the budget process
by issuing broad guidelines in terms of overall
profits or sales.
7-10
Human Factors in Budgeting
The success of budgeting depends upon three
important factors:
1. Top management must be enthusiastic and
committed to the budget process.
2. Top management must not use the budget to
pressure employees or blame them when
something goes wrong.
3. Highly achievable budget targets are usually
preferred when managers are rewarded based
on meeting budget targets.
7-11
Zero Based Budgeting
A zero-based budget requires managers to
justify all budgeted expenditures, not just
changes in the budget from the prior year.
Most managers argue that
zero-based budgeting is too
time consuming and costly to
justify on an annual basis.
7-12
The Budget Committee
A standing committee responsible for


overall policy matters relating to the budget
coordinating the preparation of the budget
7-13
The Master Budget: An Overview
Sales
Budget
Ending
Finished Goods
Budget
Direct
Materials
Budget
Production
Budget
Selling and
Administrative
Budget
Direct
Labor
Budget
Manufacturing
Overhead
Budget
Cash
Budget
Budgeted Financial Statements
7-14
Learning Objective
LO2
To prepare a sales budget,
including a schedule of
expected cash collections.
7-15
Budgeting Example
 Royal Company is preparing budgets for the
quarter ending June 30.
 Budgeted sales for the next five months are:
April
May
June
July
August
20,000 units
50,000 units
30,000 units
25,000 units
15,000 units.
 The selling price is $10 per unit.
7-16
The Sales Budget
The individual months of April, May, and June are
summed to obtain the total projected sales in units
and dollars for the quarter ended June 30th
7-17
Expected Cash Collections
 All sales are on account.
 Royal’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following sale,
5% uncollectible.
 The March 31 accounts receivable balance of
$30,000 will be collected in full.
7-18
Expected Cash Collections
7-19
Expected Cash Collections
From the Sales Budget for April.
7-20
Expected Cash Collections
From the Sales Budget for May.
7-21
Quick Check 
What will be the expected cash collections in
June from the June sales?
a. $125,000
b. $210,000
c. $335,000
d. $905,000
7-22
Quick Check 
What will be the expected cash collections in
June from the June sales?
a. $125,000
b. $210,000
c. $335,000
d. $905,000
7-23
Expected Cash Collections
7-24
The Production Budget
Sales
Budget
and
Expected
Cash
Collections
Production
Budget
Production must be adequate to meet budgeted
sales and provide for sufficient ending inventory.
7-25
Learning Objective
LO3
To prepare a
production budget.
7-26
The Production Budget
 The management at Royal Company wants
ending inventory to be equal to 20% of the
following month’s budgeted sales in units.
 On March 31, 4,000 units were on hand.
Let’s prepare the production budget.
7-27
The Production Budget
7-28
The Production Budget
March 31
ending inventory
Budgeted May sales
Desired ending inventory %
Desired ending inventory
50,000
20%
10,000
7-29
Quick Check 
What is the required production for May?
a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
7-30
Quick Check 
What is the required production for May?
a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
7-31
The Production Budget
7-32
The Production Budget
Assumed ending inventory.
7-33
Learning Objective
LO4
To prepare a direct
materials budget,
including a schedule
of expected cash
disbursements for
purchases of materials.
7-34
The Direct Materials Budget
 At Royal Company, five pounds of material
are required per unit of product.
 Management wants materials on hand at the
end of each month equal to 10% of the
following month’s production.
 On March 31, 13,000 pounds of material are
on hand. Material cost is $0.40 per pound.
Let’s prepare the direct materials budget.
7-35
The Direct Materials Budget
From production budget
7-36
The Direct Materials Budget
7-37
The Direct Materials Budget
March 31 inventory
10% of following month’s
production needs.
Calculate the materials to
by purchased in May.
7-38
Quick Check 
How much materials should be purchased in May?
a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds
7-39
Quick Check 
How much materials should be purchased in May?
a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds
7-40
The Direct Materials Budget
7-41
The Direct Materials Budget
Assumed ending inventory
7-42
Expected Cash Disbursement for
Materials
 Royal pays $0.40 per pound for its materials.
 One-half of a month’s purchases is paid for in
the month of purchase; the other half is paid in
the following month.
 The March 31 accounts payable balance is
$12,000.
Let’s calculate expected cash disbursements.
7-43
Expected Cash Disbursement for
Materials
7-44
Expected Cash Disbursement for
Materials
Compute the expected cash
disbursements for materials
for the quarter.
140,000 lbs. × $.40/lb. = $56,000
7-45
Quick Check 
What are the total cash disbursements for the
quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
7-46
Quick Check 
What are the total cash disbursements for the
quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
7-47
Expected Cash Disbursement for
Materials
7-48
Learning Objective
LO5
To prepare a
direct labor budget.
7-49
The Direct Labor Budget
 At Royal, each unit of product requires 0.05 hours (3
minutes) of direct labor.
 The Company has a “no layoff” policy so all employees will
be paid for 40 hours of work each week.
 In exchange for the “no layoff” policy, workers agree to a
wage rate of $10 per hour regardless of the hours worked
(No overtime pay).
 For the next three months, the direct labor workforce will be
paid for a minimum of 1,500 hours per month.
Let’s prepare the direct labor budget.
7-50
The Direct Labor Budget
From production budget
7-51
The Direct Labor Budget
7-52
The Direct Labor Budget
Greater of labor hours required
or labor hours guaranteed.
7-53
The Direct Labor Budget
7-54
Quick Check 
What would be the total direct labor cost for
the quarter if the company follows its no lay-off
policy, but pays $15 (time-and-a-half) for every
hour worked in excess of 1,500 hours in a
month?
a. $79,500
b. $64,500
c. $61,000
d. $57,000
7-55
Quick Check 
What would be the total direct labor cost for
the quarter if the company follows its no lay-off
policy, but pays $15 (time-and-a-half) for every
April
May
June
Quarter
hour workedLabor
in excess
of 1,500
in1,450
a
hours required
1,300 hours
2,300
Regular hours paid
1,500 1,500
1,500 4,500
month?
Overtime hours paid
800
800
a. $79,500
regular hours
4,500
$10 $ 45,000
b. $64,500 Total
Total overtime hours
800
$15 $ 12,000
c. $61,000 Total pay
$ 57,000
d. $57,000
7-56
Learning Objective
LO6
To prepare a manufacturing
overhead budget.
7-57
Manufacturing Overhead Budget
 At Royal manufacturing overhead is applied to
units of product on the basis of direct labor
hours.
 The variable manufacturing overhead rate is
$20 per direct labor hour.
 Fixed manufacturing overhead is $50,000 per
month and includes $20,000 of noncash costs
(primarily depreciation of plant assets).
Let’s prepare the manufacturing overhead
budget.
7-58
Manufacturing Overhead Budget
Direct Labor Budget
7-59
Manufacturing Overhead Budget
Total mfg. OH for quarter $251,000
= $49.70 per hour*
Total labor hours required 5,050
*rounded
7-60
Manufacturing Overhead Budget
Depreciation is a noncash charge.
7-61
Ending Finished Goods Inventory Budget
Production costs per unit
Direct materials
Direct labor
Manufacturing overhead
Quantity
Cost
5.00 lbs. $ 0.40
Total
$ 2.00
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Direct materials
budget and information
7-62
Ending Finished Goods Inventory Budget
Production costs per unit
Direct materials
Direct labor
Manufacturing overhead
Quantity
Cost
5.00 lbs. $ 0.40
0.05 hrs. $ 10.00
Total
$ 2.00
0.50
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Direct labor budget
7-63
Ending Finished Goods Inventory Budget
Production costs per unit
Direct materials
Direct labor
Manufacturing overhead
Quantity
Cost
5.00 lbs. $ 0.40
0.05 hrs. $ 10.00
0.05 hrs. $ 49.70
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Total
$ 2.00
0.50
2.49
$ 4.99
$
4.99
Total mfg. OH for quarter $251,000
= $49.70 per hour*
Total labor hours required 5,050
7-64
Ending Finished Goods Inventory Budget
Production costs per unit
Direct materials
Direct labor
Manufacturing overhead
Quantity
Cost
5.00 lbs. $ 0.40
0.05 hrs. $ 10.00
0.05 hrs. $ 49.70
Budgeted finished goods inventory
Ending inventory in units
Unit product cost
Ending finished goods inventory
Total
$ 2.00
0.50
2.49
$ 4.99
5,000
$ 4.99
$ 24,950
Production Budget
7-65
Learning Objective
LO7
To prepare a selling and
administrative expense
budget.
7-66
Selling and Administrative Expense
Budget
 At Royal, the selling and administrative expenses
budget is divided into variable and fixed components.
 The variable selling and administrative expenses are
$0.50 per unit sold.
 Fixed selling and administrative expenses are $70,000
per month.
 The fixed selling and administrative expenses include
$10,000 in costs – primarily depreciation – that are not
cash outflows of the current month.
Let’s prepare the company’s selling and
administrative expense budget.
7-67
Selling and Administrative Expense
Budget
Calculate the selling and administrative
cash expenses for the quarter.
7-68
Quick Check 
What are the total cash disbursements for
selling and administrative expenses for the
quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
7-69
Quick Check 
What are the total cash disbursements for
selling and administrative expenses for the
quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
7-70
Selling and Administrative Expense
Budget
7-71
Learning Objective
LO8
To prepare a
cash budget.
7-72
Format of the Cash Budget
The cash budget is divided into four sections:
1. Cash receipts listing all cash inflows excluding
borrowing;
2. Cash disbursements listing all payments
excluding repayments of principal and interest;
3. Cash excess or deficiency; and
4. The financing section listing all borrowings,
repayments and interest.
7-73
The Cash Budget
Royal:
 Maintains a 16% open line of credit for $75,000
 Maintains a minimum cash balance of $30,000
 Borrows on the first day of the month and repays
loans on the last day of the month
 Pays a cash dividend of $49,000 in April
 Purchases $143,700 of equipment in May and
$48,300 in June paid in cash
 Has an April 1 cash balance of $40,000
7-74
The Cash Budget
Schedule of Expected
Cash Collections
7-75
The Cash Budget
Schedule of Expected
Cash Disbursements
Direct Labor
Budget
Manufacturing
Overhead Budget
Selling and Administrative
Expense Budget
7-76
The Cash Budget
In the month of April will
expect to have a cash
deficiency of $20,000.
7-77
The Cash Budget
Because Royal maintains
a cash balance of $30,000,
the company must borrow
$50,000 on it line-of-credit.
Ending cash balance for April
is the beginning May balance.
7-78
The Cash Budget
7-79
Quick Check 
What is the excess (deficiency) of cash
available over disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
7-80
Quick Check 
What is the excess (deficiency) of cash
available over disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
7-81
The Cash Budget
$50,000 × 16% × 3/12 = $2,000
Borrowings on April 1 and
repayment on June 30.
7-82
Learning Objective
LO9
To prepare a budgeted
income statement.
7-83
The Budgeted Income Statement
Cash
Budget
Budgeted
Income
Statement
After we complete the cash budget,
we can prepare the budgeted income
statement for Royal.
7-84
The Budgeted Income Statement
Sales Budget
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ $10)
Cost of goods sold (100,000 @ $4.99)
Gross margin
Selling and administrative expenses
Operating income
Interest expense
Net income
$ 1,000,000
499,000
501,000
260,000
241,000
2,000
$ 239,000
Ending Finished
Goods Inventory
Selling and
Administrative
Expense Budget
Cash Budget
7-85
Learning Objective
LO10
To prepare a budgeted
balance sheet.
7-86
The Budgeted Balance Sheet
Royal reported the following account
balances prior to preparing its
budgeted financial statements:




Land - $50,000
Common stock - $200,000
Retained earnings - $146,150
Equipment - $175,000
7-87
Royal Company
Budgeted Balance Sheet
June 30
Current assets
Cash
Accounts receivable
Raw materials inventory
Finished goods inventory
Total current assets
Property and equipment
Land
Equipment
Total property and equipment
Total assets
Accounts payable
Common stock
Retained earnings
Total liabilities and equities
$
25% of June
sales of
$300,000
43,000
75,000
4,600
24,950
147,550
11,500 lbs.
at $0.40/lb.
5,000 units
at $4.99 each
50,000
367,000
417,000
$ 564,550
$
28,400
200,000
336,150
$ 564,550
50% of June
purchases
of $56,800
7-88
Royal Company
Budgeted Balance Sheet
June 30
Current assets
Cash
Accounts receivable
Raw materials inventory
Finished goods inventory
Total current assets
Property and equipment
Land
Equipment
Total property and equipment
Total assets
Accounts payable
Common stock
Retained earnings
Total liabilities and equities
$
43,000
Beginning balance
75,000
Add: net income
4,600
Deduct: dividends
24,950
Ending balance
147,550
$146,150
239,000
(49,000)
$336,150
50,000
367,000
417,000
$ 564,550
$
28,400
200,000
336,150
$ 564,550
7-89
End of Chapter 7
7-90