CHAPTER
5
Operating Budgets
Learning Objective 1
Describe different
types of budgeting
and identify the
purposes of
budgeting.
What is Budgeting?
Budget:
A quantitative expression of a plan of
action that shows how a firm or an
organization will acquire and use
resources over some specified period of
time.
The budget identifies and allocates
resources necessary to effectively and
efficiently carry out the mission of the
organization.
Successful budgeting is absolutely
critical to the success of a business.
Describe Three Types of Budgets
Strategic Plan: Broad, long-run planning, usually
prepared by top management.
Capital Budget: Systematic plan for long-term
investments in operating assets.
Operations (Master) Budget: Details the
immediate goals for revenues, production,
expenses, and cash for the next period. This
budget is the most detailed and the most heavily
used budget an organization has.
What are the Purposes of Budgeting ?
OVERALL PURPOSE:
To quantify a general plan so that performance in
relation to a goal can be carefully monitored.
TWOFOLD PURPOSE
FIRST:
To allow individuals or
companies to develop
a plan to meet a
specified goal.
SECOND:
To allow ongoing
comparison between actual
results and the plan in
order to control operations
or activities.
Example: Monthly Budget
Gross salary. . . . . . . . . . . . . . .
Withholdings:
Federal income taxes . . . . . . . $250
State income taxes . . . . . . . . .
150
Other withholdings. . . . . . . . . . 150
Net take-home pay . . . . . . .
Fixed expenses:
House mortgage expense. . . . $450
Car payment expense. . . . . . .
250
Insurance expense . . . . . . . . .
100
Disposable income. . . . . . . .
Utilities expense . . . . . . . . . . . . $ 65
Food expense. . . . . . . . . . . . . .
200
Miscellaneous expenses. . . . . . 350
Net surplus. . . . . . . . . . . . . .
$2,000
(550)
$1,450
(800)
$ 650
(615)
$ 35
List Reasons for Budgeting
1. Planning and setting objectives
2. Communication
3. Coordination
4. Authorization
5. Motivation
6. Conflict resolution
7. Performance measurement (evaluation)
Learning Objective 2
Describe the budgeting
process and its behavioral
implications.
Budgeting Process
Who or what is the budget committee?
- A management group responsible for
establishing budgeting policy and for
coordinating the preparation of budgets.
What are two issues of the budgeting
process?
- Behavioral considerations
- Delegation of responsibility
for preparing the budget-top-down versus bottom-up issue
List Behavioral Considerations
1. Top management support
2. Employee participation
3. Addressing budget
deviations
Describe the Top-Down Approach to
Budgeting
Top
Management
Manager
Top management
prepares the entire
budget and distributes it
to division managers.
Manager
Manager
Describe the Bottom-Up Approach to
Budgeting
Top
Management
Manager
Each manager prepares a
budget request, from
which management
creates an overall budget.
Manager
Manager
Learning Objective 3
Explain the master budget
and its components for
manufacturing firms,
merchandising firms, and
service firms.
Master Budget—Manufacturing
Sales Budget
Production
Budget
Direct Materials
Budget
Direct Labor
Budget
Selling/Admin.
Expense Budget
Manufacturing
Overhead Budget
Cash Budget
Pro-Forma Income
Statement
Pro-Forma
Balance Sheet
Pro-Forma
Cash Flows
Master Budget—Manufacturing
Define each budget.
Sales Budget
A schedule of
projected
sales over the
budget
period.
Example: Sales Budget
Selling price per bike . . . . . . $
Expected sales (units). . . . .
100
x 100
Expected revenues . . . . . . . $10,000
Master Budget—Manufacturing
Define each budget.
Sales Budget
Production
Budget
A schedule of production
requirements for the
budget period.
Example: Production Budget
Expected sales. . . . . . . . . . . . . . .
100
Add desired ending inventory. . . . 105
Total number of bikes needed . .
205
Less beginning inventory . . . . . . .
70
Bikes to be produced . . . . . . . . . .
135
Note: Ending inventory is estimated at 80%
of the next period’s sales.
Master Budget—Manufacturing
Define each budget.
Sales Budget
Production
Budget
Direct Materials
Budget
A schedule of direct
materials to be used
and purchased
during the budget
period.
Example: Direct Materials Budget
Direct materials usage:
Direct
Materials
Metal
Plastic
Amount
Required
2,700 lbs.
Unit
Cost
$2.00/ft.
Total
Cost
$5,400
405 lbs.
$1.00/ft.
$ 405
Example: Direct Materials Budget
Direct materials purchases:
Desired ending inventory. . . . .
Needed for production. . . . . . .
Total needed . . . . . . . . . . . . . .
Less beginning inventory. . . . .
Materials to be purchased . . . .
Unit cost. . . . . . . . . . . . . . . . . .
Total cost . . . . . . . . . . . . . . . .
Metal Plastic
2,100
315
2,700
405
4,800
720
2,800
210
2,000
510
x $2
x $1
$4,000
$ 510
Master Budget—Manufacturing
Define each budget.
Sales Budget
Production
Budget
Direct Materials
Budget
Direct Labor
Budget
A schedule of
direct labor
requirements for
the budget
period.
Example: Direct Labor Budget
Number of bikes to produce. . . .
Direct labor hours per bike. . . . .x
Total hours required. . . . . . . . .
Rate per hour. . . . . . . . . . . . . . . .x
135
3
405
$5
Total direct labor cost. . . . . . . . $2,025
Master Budget—Manufacturing
Define each budget.
Sales Budget
Production
Budget
Direct Materials
Budget
Direct Labor
Budget
A schedule of
production
costs other
than those for
direct labor
and direct
materials.
Manufacturing
Overhead
Budget
Example: Manufacturing Overhead
Budget
Variable costs:
Indirect materials costs. . . . . . . . .
Indirect labor costs . . . . . . . . . . . .
Total variable costs. . . . . . . . . . .
$ 220
600
$ 820
Fixed costs:
Insurance expense. . . . . . . . . . . .
Depreciation expense. . . . . . . . . .
Total fixed costs . . . . . . . . . . . . .
200
$ 600
$ 800
Total manufacturing overhead . . .
$1,620
Master Budget—Manufacturing
Define each budget.
A schedule of all
nonproduction
spending
expected to occur
during the budget
period.
Sales Budget
Production
Budget
Selling and
Administrative
Expense Budget
Direct Materials
Budget
Direct Labor
Budget
Manufacturing
Overhead
Budget
Example: Per-Unit Cost
Direct materials usage:
Input
Required
Cost
Inputs
Metal
$2.00/ft.
20
Plastic
$1.00/ft.
3
Direct labor
$5.00/hr.
3
Fixed OH
$1.98/hr.
3
Variable OH $2.02/hr.
3
Total unit cost. . . . . . . . . . . . . . . .
Cost
per Bike
$40.00
3.00
15.00
5.94
6.06
$70.00
Example: Selling and Administrative
Budget
Variable expenses:
Sales commissions . . . . . . . . . . . . . . $
Total variable expenses. . . . . . . . . . $
400
400
Fixed expenses:
Salaries expense . . . . . . . . . . . . . . .
Depreciation . . . . . . . . . . . . . . . . . . .
Advertising expense. . . . . . . . . . . . .
Total fixed expenses. . . . . . . . . . . .
Total selling and
administrative expenses. . . . . . . . .
$1,000
100
200
$1,300
$1,700
Master Budget—Manufacturing
Define each budget.
A schedule of
expected cash
receipts and
disbursements
during the
budget period.
Direct Materials
Budget
Sales Budget
Production
Budget
Selling and
Administrative
Expense Budget
Direct Labor
Budget
Manufacturing
Overhead
Budget
Cash Budget
Example: Cash Budget
Cash balance, beginning . . . . . . . . .
Add collections from customers . . . .
(1)Total cash available. . . . . . . . . .
Less disbursements for:
Direct materials . . . . . . . . . . . . .
$ 3,000
Direct labor. . . . . . . . . . . . . . . . .
2,000
Equipment purchase . . . . . . . . .
2,000
(2)Total disbursements. . . . . . . . . .
Minimum cash balance desired. . . . .
Total cash needed. . . . . . . . . . . . . . .
Excess (or deficiency) of cash available before financing. . . . .
(3) Financing needed . . . . . . . . . . .
Ending cash balance [(1) – (2) + (3)]
$ 4,900
10,100
$15,000
$ 7,000
6,000
$13,000
$ 2,000
0
$ 2,000
Master Budget—Merchandising
Define each budget.
Sales Budget
Purchases
Budget
Selling and
Administrative
Expense Budget
Cash Budget
A schedule of projected purchases
over the budget period.
Master Budget—Merchandising
Define each budget.
Pro-forma financial
statements
“budget” financial
information for the
coming period.
Sales Budget
Purchases
Budget
Selling and
Administrative
Expense Budget
Cash Budget
Pro-Forma
Income
Statement
Pro-Forma
Balance
Sheet
Pro-Forma
Statement of
Cash Flows
Master Budget—Service
Define each budget.
A service entity’s budget
that identifies how much
revenue will be
generated during a
period.
Supplies
Budget
Revenue Budget
Production
Budget
Wages and
Salaries Budget
Selling/Admin.
Expense Budget
Overhead
Budget
Cash Budget
Pro-Forma Income
Statement
Pro-Forma
Balance Sheet
Pro-Forma Statement
of Cash Flows
Expanded Material
Learning Objective 4
Prepare proforma financial
statements.
Example: Pro-Forma
Income Statement
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold:
Beginning finished goods inventory. . . . . . . .
Manufacturing costs:
Direct materials used. . . . . . . . . . . . . . . . . .
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . . . . .
Total cost of goods available for sale . . . . . .
Less ending finished goods inventory. . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . .
Gross margin. . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses. . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . .
Income before taxes . . . . . . . . . . . . . . . . . . .
$10,000
$ 4,900
$ 5,805
2,025
1,620
9,450
$14,350
(7,350)
(7,000)
$ 3,000
1,700
$ 1,300
0
$ 1,300
Example: Pro-Forma Balance Sheet
ASSETS
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 15,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . 3,000
Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . 7,350 $ 25,350
Long-term operating assets:
Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 12,000
Less accumulated depreciation. . . . . . . . . . . . . (3,300)
8,700
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 34,050
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . $ 8,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . .
7,000 $ 15,000
Stockholders’ equity:
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,850
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . .
7,200
19,050
Total liabilities and stockholders’ equity. . . . . . . . .
$ 34,050
Example: Pro-Forma Statement of Cash
Flows
Cash flows from operating activities:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . .
Add (subtract) adjustments:
Depreciation . . . . . . . . . . . . . . . . . . . . . . . $ 700
Increase in finished goods . . . . . . . . . . . . (2,450)
Increase in accounts receivable. . . . . . . . 5,550
Net cash provided by operating activities . .
3,800
$ 5,100
Cash flows from investing activities:
Purchase of equipment . . . . . . . . . . . . . . $(2,000)
Net cash used in investing activities . . . .
(2,000)
Cash flows from financing activities:
Cash obtained from borrowing . . . . . . . . $ 7,000
Net cash used in financing activities. . . .
7,000
Net increase in cash. . . . . . . . . . . . . . . . . .
$ 1,300
$ 10,100
Expanded Material
Learning Objective 5
Distinguish between
static and flexible
budgets.
Define Static versus
Flexible Budgeting
Static Budgeting:
 A quantified plan that projects revenues and costs for
only one level of activity.
 Not useful for controlling costs and measuring
performance because the actual level of activity may
have differed significantly from the planned level.
Flexible Budgeting:
 A quantified plan that projects revenues and costs for
varying levels of activity.
 More useful for control and performance evaluation
because it is not confined to one level of activity.
Static Budget
Cost per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . .
Direct labor. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Manufacturing overhead . . . . . . . . . . . . . . . . . .
Total unit cost . . . . . . . . . . . . . . . . . . . . . . . .
1.20
0.80
0.50
$2.50
Budgeting production (units) . . . . . . . . . . . . . . . 5,000
Budgeted manufacturing costs:
Direct materials. . . . . . . . . . . . . . . . . . . . . .
$ 6,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . .
4,000
Manufacturing overhead. . . . . . . . . . . . . . .
2,500
Total manufacturing costs. . . . . . . . . . . . $12,500
Static Budget—
Performance Report
Actual Budgeted Difference
Production (units)
4,800
5,000
(200)
Manufacturing costs:
Direct materials. . . . . . . . .$ 5,500 $ 6,000 $ (500)
Direct labor . . . . . . . . . . . . 3,800 4,000
(200)
Manufacturing overhead . 2,450 2,500
(50)
Total actual and budgeted
manufacturing costs . . . . $11,750 $12,500 $ (750)
Flexible Budget
What are the three steps to prepare a
flexible budget?
Determine a relevant range over which
production is expected to vary during the
coming period.
Analyze the projected manufacturing costs for
the coming period.
Using the per-unit costs for each element,
prepare a budget showing what costs are
expected to be incurred at several points within
the relevant range.
Flexible Budget
Manufacturing Range of Production (units)
Costs per Unit 4,800
5,000
5,200
Direct materials . $1.20
$ 5,760
$ 6,000
$ 6,240
Direct labor. . . . . . 0.80
3,840
4,000
4,160
Manufacturing
overhead. . . . . . 0.50
2,400
2,500
2,600
Total. . . . . . . . $2.50
$12,000
$12,500
$13,000
Flexible Budget—
Performance Report
Actual production (units) . . . . . . . . . . . . . . . . . .
Budgeted production (units) . . . . . . . . . . . . . . .
Difference. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Actual Budgeted
Direct materials. . . . . . . . . .
Direct labor . . . . . . . . . . . . .
Manufacturing overhead . .
Total costs . . . . . . . . . . . .
$ 5,500 $ 5,760
3,800
3,840
2,450
2,400
$11,750 $12,000
4,800
5,000
(200)
Difference
$ (260)
(40)
50
$ 250