Budgeting and Planning
Budgeting and Planning
Budgeting and Planning
1. Profit Planning 2. Participative or Self Imposed budgeting 3. Human Factors in Budgeting 4. Zero Based Budgeting (ZBB) 5. Budget Committee 6. Master Budget 7. Sales Budget 8. Production Budget 9. Inventory Purchases Budget for a Merchandising Firm 10. Material Budgeting | Direct Materials Budget 11. Labor Budget 12. Manufacturing Overhead Budget 13. Ending Finished Goods Inventory Budget 14. Selling and Administrative Expense Budget 15. Cash Budget 16. Budgeted Income Statement 17. Budgeted Balance Sheet 18. International Aspects of Budgeting
Profit Planning:
Learning Objectives:
1. Define and explain the terms "profit planning" and "budgeting". 2. What is the difference between planning and control? 3. What are the advantages and disadvantages of budgeting?
Contents:
1. 2. 3. 4. 5.
Definition and Explanation of Profit Planning and Budgeting Difference Between Planning and Control Advantages and Disadvantages of Budgeting Responsibility Accounting Budget Period
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Budgeting:
A budget is a detailed plan for acquiring and using financial and other resources over a specified period of time. It represents a plan for the future expressed in formal quantitative terms. The act of preparing a budget is called budgeting. The use of budgeting to control a firm's activities is called budgetary control. Master budget is a summary of a company's plan that sets specific targets for sales, production, distribution, and financing activities. It generally culminates in cash budget, a budgeted income statement, and a budgeted balance sheet. In short, it represents a comprehensive expression of management's plans for the future and how these plans are to be accomplished.
2. Budgets force managers to think about and plan for the future. In the 3. 4. 5. 6.
absence of the necessity to prepare a budget, many mangers would spend all of their time dealing with daily emergencies. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively The budgeting process can uncover many potential bottlenecks before they occur . Budgets coordinates the activities of the entire organization by integrating the plans of the various parts of the organization. Budgeting helps to ensure that everyone in the organization is pulling in the same direction. Budgets provide goals and objectives that can serve as benchmark for evaluating subsequent performance.
Disadvantages / Limitations of Budgeting: Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms. Budgets can be seen as pressure devices imposed by management, thus resulting in:
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a) bad labor relations b) inaccurate record-keeping. Departmental conflict arises due to: a) disputes over resource allocation b) departments blaming each other if targets are not attained. It is difficult to reconcile personal/individual and corporate goals. Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with "empire building" in order to enhance the prestige of a department. Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs. Managers may overestimate costs so that they will not be blamed in the future should they overspend. In Business | Bringing Order Out of Chaos: Consider the following situation encountered by one of the authors at a mortgage banking firm: For years, the company operated with virtually no system of budgets whatever. Management contented that budgeting was not well suited to the firm's type of operation. Moreover, management pointed out that the firm was already profitable. Indeed, outward the company gave every appearance of being a well managed, smoothly operating organization. A careful look within, however, disclosed that day to day operation were far from smooth, and often approached chaos. The average day was nothing more than an exercise in putting out one brush fire after another. The cash account was always at crisis levels. At the end of a day, no one ever knew whether enough cash would be available the next day to cover required loan closings. Departments were uncoordinated, and it was not uncommon to find that one department was pursuing a course that conflicted with the course pursued by another department. Employee morale was low, and turnover was high. Employees complained bitterly that when a job was well done, nobody ever knew about it. The company was bought out by a new group of stockholders who required that an integrated budgeting system be established to control operations. Within one year's time, significant changes were evident. Brush fires were rare. Careful planning virtually eliminated the problems that had been experienced with cash, and departmental efforts were coordinated and directed toward predetermined overall company goals. Although the employees were wary of the new budgeting program initially, they became" converted" when they saw the positive effects that it brought about. The more efficient operations caused profits to jump dramatically. Communication increased throughout the organization. When a job was well done, every body was knew about it. As one employee stated," For the first time, we know what the company expects of us"
Responsibility Accounting:
The concept of responsibility accounting is very important in profit planning. The basic idea behind responsibility accounting is that a manager should
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be responsible for those items that the managers can actually control to a significant extent. Each line item (i.e., revenue or cost) in the budget is made the responsibility of a manager, and that manager is held responsible for subsequent deviations between budgeted goals and actual results. Someone must be held responsible for each cost or else no one will be responsible, and the cost will inevitably grow out of control. Being held responsible for costs does not mean that the manager is penalized if the actual results do not measure up to the budgeted goals. However, the manager should take the initiative to correct any unfavorable discrepancies, should understand the source of significant favorable or unfavorable discrepancies, and should be prepared to explain the reasons for discrepancies to higher management. The point of an effective responsibility system is to make sure that nothing "falls through the cracks" that the organization reacts quickly and appropriately to deviations from its plans, and that the organization learns from the feedback it gets by comparing budgeted goals to actual results. The point is not to penalize individuals for missing targets. In Business | A Little Coordination Please! Budgeting plays and important role in coordinating activities in large organizations. Jerome York, the chief financial officer at IBM, discovered at one budget meeting that "the division that makes As/400 workstations planned to churn out 10,000 more machines than the marketing division was promising to sell. He asked nicely that the two divisions agree on how many they would sell for the sake of consistency (and to cut down on the inventory problem). The rival executives said it could not be done. Mr. York got tougher, saying it could. Ultimately, it was."
Source: Laurie Hays, "Blue Blood: IBM's finance chief, Ax in Hand, Scours Empire for Costs to Cut," The wall Street Journal, January 26, 1994, pp. A1, A6
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2. Explain the importance and use of a participative or self imposed budget in 3. What are advantages and disadvantages of self imposed budgeting?
The success of a budget program will be determined in large part by the way in which the budget is developed. In the most successful budget programs, managers with cost control responsibilities actively participate in preparing their own budgets. This is in contrast to the approach in which budgets are imposed from above. The participative approach to preparing budgets is particularly important if the budget is to be used to control and evaluate a manager's performance. If a budget is imposed on a manager from above, it will probably generate resentment and ill will rather than cooperation and commitment.
Middle Management
Middle Management
Supervisor
Supervisor
Supervisor
Supervisor
The initial flow of budget data in a participative system is from lower levels of responsibility to higher levels of responsibility. Each person with responsibility for cost control will prepare his or her own budget estimates and submit them to the next higher level of management. These estimates are reviewed and consolidated as they move upward in the organization.
Once self imposed budgets are prepared, are they subject to any kind of review? The answer is yes. Budget estimates prepared by lower-level managers should be scrutinized by higher levels of management. Without such a review, self imposed budgets may be too loose and allow much "budgetary slack." The result will be
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inefficiency and waste. Therefore before budgets are accepted, they must be carefully reviewed by immediate superiors. If changes from the original budget seem desirable, the items in question are discussed and modified as necessary. All level of an organization should work together to produce the budget. Since top management is generally unfamiliar with detailed, day to day operations, it should rely on subordinates to provide detailed budget data. On the other hand, top management has an overall strategic perspective that is also vital. Each level of responsibility in an organization should contribute in the way that it best can in a cooperative effort to develop an integrated budget. In Business | Cutting Slack in Ireland: A study of budgeting in four Irish businesses provides some interesting insights into controlling budgetary slack. It appears that one of the best ways to control budgetary slack is to have management accountants who fully understand the operational side of the business. As one operating manager put it, "Finance [i.e., management accountants] understand my budget completely. There is no slack or opportunity for slack." In contrast, budgetary slack was greatest in a subsidiary of a company headquarter in North America whose management accountants least understood the operating side of the business and yet always insisted that the budget be met. In fact, in this particular organization, corporate headquarters had previously ordered the Irish subsidiary midway through a year to deliver additional cost savings to make up for poor performance elsewhere in the corporation. Not surprisingly, the managers of the Irish subsidiary now routinely pad their budgets in case this happens again.
Source: Paul Prendergast, "Budget Padding: Is is a job for the finance police?" Management Accounting (UK) November 1997, pp. 44-46.
Participative or Self imposed budgeting is an ideal budgetary process. However most companies deviate from this ideal budgetary process. Typically top managers initiate the budget process by issuing broad guidelines in terms of overall target profits or sales. Lower level managers are desired to prepare budgets that meet those targets. The difficulty is that the target set by top managers may be unrealistically high or may allow too much slack. If the budgets are too high and employees know they are unrealistic, motivation will suffer. If the targets allow too much slack, waste will occur. And unfortunately top management is often not in a position to know whether the targets they have set are appropriate. Admittedly, however, a pure self imposed budgeting system is not without limitations. It may lack sufficient strategic direction and lower level managers may be tempted to build into their budgets a great deal of budgetary slack. Nevertheless, because of the motivational advantages of self imposed budgets, top managers should be cautious about setting inflexible budgets.
2. Budget estimates prepared by front line managers can be more accurate and
reliable than estimates prepared by top managers who are more remote from
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3. 4.
day to day activities and who have less intimate knowledge of markets and operating conditions. Motivation is generally higher when an individual participates in setting his or her own goal then when the goals are imposed from above. Self imposed budgets create commitments. If a manager is not able to meet the budget and it has been imposed from above, the manager can always say that the budget was unreasonable or unrealistic to start and, therefore, was impossible to meet. With a self imposed budget this excuse is not available.
1. Time consuming and costly. 2. May foster budgetary gaming through budgetary slack
1. The degree to which top management accepts the budget program as a vital
part of the company's activities.
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Preoccupation with the dollars and cents in the budget, or being rigid and inflexible, can only lead to frustration of these purposes. In Business | Who Cares About Budgets? Towers Perrin, a consulting firm, reports that the bonuses of more than two out of three corporate managers are based on meeting targets set in annual budgets." Under this arrangement, managers at the beginning of a year all too often argue that their targets should be lowered because of tough business conditions, when in fact conditions are are better than projected. If their arguments are successful, they can easily surpass the targets." Source: Ronald Fink and Towers Perrin, "Riding the Bull: The 2000 compensation survey, " CFO, June 2000, pp. 45-60. In establishing a budget, how challenging should budget targets be? In practice, companies typically set their budgets either at a "stretch" level or a "highly achievable" level. A stretch level budget is one that has only a small chance of being met and in fact may be met less than half the time by even the most capable managers. A highly achievable budget is one that is challenging, but which can be met through hard work. Managers usually prefer highly achievable budgets. Such budgets are generally coupled with bonuses that are given when budget targets are met, along with added bonuses when these targets are exceeded. Highly achievable budgets are believed to build a manager's confidence and to generate commitment to the budget program.
1. Define and explain the term "zero based budgeting" and "incremental 2. 3.
budgeting" in managerial accounting. Explain the importance and use of zero based budgeting in business. What are advantages and disadvantages of zero based budgeting?
Contents:
1. Definition and explanation of zero based budgeting ZBB 2. Advantages and disadvantages of zero based budgeting 3. An example of zero based budgeting
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In traditional approach of budgeting, the managers start with last year's budget and add to it (or subtract from it) according to anticipated needs. This is an incremental approach to budgeting in which the previous year's budget is taken for granted as a baseline. This approach is called incremental budgeting. Zero based budgeting approach requires considerable documentation. In addition to all of the schedules in the usual master budget, the manager must prepare a series of decision packages in which all of the activities of the department are ranked according to their relative importance and the cost of each activity is identified. Higher level managers can then review the decision packages and cut back in those areas that appear to be less critical or whose costs do not appear to be justified. Zero based budgeting is a good idea. The only issue is the frequency with which a ZBB review is carried out. Under zero based budgeting (ZBB) ,the review is performed every year. Critics of such type of budgeting charge that properly executed zero based budgeting is too time consuming and too costly to justify on an annual basis. In addition, it is argued that annual reviews soon become mathematical and that the whole purpose of zero based budgeting is then lost. Whether or not a company should use annual reviews is a matter of judgment. In some situations, annual zero based reviews may be justified; in other situations they may not because of the time and cost involved. However, most managers would at least agree that on occasion zero based reviews can be very helpful.
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4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details. 5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.
Budget Committee:
Learning Objective of the Article:
1. What is a budget committee? 2. What are the functions and responsibilities of a budget committee?
Definition:
Budget committee is a group of key management persons who are responsible for overall policy matters relating to the budget program and for coordinating the preparation of the budget.
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Master Budget:
Learning Objective of the Article:
2. What are the parts / components of master budget? 3. What are its advantages and disadvantages? Give example of master budget.
1. Sales Budget 2. Production Budget 3. Material Budgeting | Direct Materials Budget 4. Labor Budget 5. Manufacturing Overhead Budget 6. Ending Finished Goods Inventory Budget 7. Cash Budget 8. Selling and Administrative Expense Budget 9. Purchases Budget for a Merchandising Firm 10. Budgeted Income Statement 11. Budgeted Balance Sheet
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Budgeted Income Statement
Overhead Budget
Production Budget
Cash Budget
Budgeted Balance Sheet
Sales Budget:
Learning Objectives:
1. Define and explain sales budget. 2. Give and example of sales budget.
Contents:
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Percentage of sales collected in the period of the sales Percentage of sales collected in the period after the sales 70% 30%
70% 30%
1 2
$90,000 200,000
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3 4 5 6 1 2 3 4 5 6
Second quarter sales Third quarter sales Fourth quarter sales ----------Total cash collections $230,000 ====== Cash collections from last years fourth-quarter sales. $200,000 70%; $200,000 30% $600,000 70%; $600,000 30% $800,000 70%; $800,000 30% $400,000 70%
420,000
----------$480,000 ======
----------$740,000 ======
-----------
Uncollected fourth quarter sales appear as accounts receivable on the company's end of year balance sheet.
Production Budget:
Learning Objective of the article:
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Production requirements for a period are influenced by the desired level of ending inventory. Inventories should be carefully planned. Excessive inventories tie up funds and create storage problems. Insufficient inventories can lead to lost sales or crash production efforts in the following period.
*Twenty percent of the next quarters sales. The ending inventory of 3,000 cases is assumed **The beginning inventory in each quarter is the same as the prior quarter's ending inventory
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the quarterly amounts. From the standpoint of the entire year, the beginning inventory of finished goods is the same as the beginning inventory of finished goods for the first quarter--it is not the sum of the beginning inventories of the finished goods for all quarters. Similarly, from the standpoint of the entire year, the ending inventory of finished goods is the same as the ending inventory of finished goods for the fourth quarter--it is not the sum of the ending inventories of finished goods for all four quarters.
1. Define and explain an inventory budget. 2. Prepare an inventory budget or merchandising purchase budget.
Manufacturing firms prepare production budget but merchandising firms prepare merchandising purchase budget instead. Merchandising purchase budget shows the amount of goods to be purchased from its suppliers during the period. The merchandising purchase budget has the same basic format as the production budget, as shown below:
Example:
Inventory Purchase Budget for Merchandising Firms Budgeted cost of goods sold units or dollars Add desired ending merchandising inventory Total needs Less beginning merchandising inventory Required purchases units or dollars xxxx xxxx -------xxxx xxxx --------xxxx =====
1. Define and explain direct materials budget or Materials Budgeting. 2. Prepare a direct material budget including a schedule of expected cash
disbursements for purchases of materials.
Direct materials budget is prepared after computing production requirements by preparing a production budget. Direct materials budget or materials budgeting details the raw materials that must be purchased to fulfill the production requirements and to provide for adequate inventories. The required purchases of raw materials are computed as follows:
Raw materials needed to meet the production schedule Add desired ending inventory of raw materials Total raw materials needs Less beginning inventory of raw materials Raw materials to be purchased XXXX XXXX -------XXXX XXXX -------XXXX ======
Preparing a budget of this kind is one step in a company's overall material requirements planning (MRP). MRP is an operations management tool that uses a computer to help manage materials and inventories, The objective of material requirements planning (MRP) is to ensure that the right materials are on hand, in the right quantities, and at the right time to support the production budget. The detailed operation of materials requirements planning is covered in most operations management books.
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2 3 4 5 6
Accounts payable, beginning balance First-quarter purchase Second-quarter purchases Third-quarter purchase Fourth-quarter purchase
$25,800 23,700 $23,700 48,600 $48,600 51,450 $51,450 27,900 ------------------$72,300 ---------$100,050 ---------$79,350
$49,500
1 2 3 4 5 6
Ten percent of the next quarter's needs. For example, the second-quarter production needs are 480,000 pounds. Therefore, the desired ending inventory for the first quarter would be 10% 480,000 pounds = 48,000 pounds. The ending inventory of 22,500 pounds for the quarter is assumed Cash payments for the last year's fourth-quarter materials purchases. $47,500 50%; $47,500 50%. $97,200 50%; $97,200 50%. $102,900 50%; $102,900 50%. $55,800 50%. Unpaid fourth quarter's purchases appear as accounts payable on the company's end of year balance sheet
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Direct materials budget is usually accompanied by a schedule of expected cash disbursements for raw materials. This schedule is needed to prepare the overall cash budget. Disbursement of raw materials consist of payments for purchases on account in prior periods plus any payments for purchases in the current budget period. Direct materials budget in our example includes such a schedule of expected cash disbursements. Ordinarily, companies do not immediately pay their suppliers. At Hampton Freeze Inc. the policy is to pay for 50% of purchases in the quarter in which the purchase is made and 50% in the following quarter, so while the company intends to purchase $47,400 worth of sugar in the first quarter, the company will only pay for half, $23,700, in the first quarter and the other half will be paid in the second quarter. The company will also pay $25,800 for sugar acquired in the previous quarter, but not yet paid for. This is the beginning balance in the accounts payable. Therefore, the total cash disbursements for sugar in the first quarter are $49,500--the $25,800 payment for sugar acquired in the previous quarter plus the $23,700 payment for sugar acquired during the first quarter.
1. Define and explain direct labor budget. 2. Prepare direct labor budget. 1. Definition and explanation of direct labor budget 2. Example
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$84,000 =====
* This schedule assumes that the direct labor work force will be fully adjusted to the total direct labor hours needed each quarter.
1. Define and explain manufacturing overhead budget. 2. Prepare a manufacturing overhead budget.
The manufacturing overhead budget provides a schedule for all costs of production other than direct materials and direct labor.
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(.Freeze
Inc
.Hampton Freeze Inc Manufacturing Overhead Budget For the Year Ended December 31, 2003 Quarters Year 40,400 $4.00 --------$161,600 242,400 --------404,000 60,000 --------$344,000 ======= 4 7,600 $4.00 --------$30,400 60,600 --------91,000 15,000 --------$76,000 ======= 3 14,400 $4.00 --------$57,600 60,600 --------118,200 15,000 --------$103,200 ======= 2 12,800 $4.00 --------$51,200 60,600 --------111,800 15,000 --------$96,800 ======= 1 5,600 $4.00 --------$22,400 60,600 --------83,000 15,000 --------$68,000 ======= Cash disbursement for manufacturing overhead Total manufacturing overhead Less depreciation Variable manufacturing overhead Fixed manufacturing overhead (Budgeted direct labor hours (see direct labor budget Variable overhead rate
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level of fixed costs at budget time, an activity based costing system may be very helpful. It can help answer questions like, "How many clerks will we need to hire to process the anticipated the number of purchase orders next year?" For simplicity, we assume in all of the budgeting examples that appropriate fixed costs has already been determined for the budget with the aid of activity based costing system or some other method. The last line in the manufacturing overhead budget for Hampton Freeze Inc. shows that its budgeted cash disbursement for manufacturing overhead. Since, some of the overhead costs are not cash outflows, the total budgeted manufacturing overhead costs must be adjusted to determine the cash disbursements for manufacturing overhead. At Hampton Freeze, the only significant non-cash manufacturing overhead cost is depreciation, which is $15,00 per quarter. These non-cash depreciation charges are deducted from the total budgeted manufacturing overhead to determine the expected cash disbursements. Hampton Freeze Inc. pays all overhead costs involving the cash disbursements in the quarter incurred. Note that the company's predetermined overhead rate for the year will be $10 per direct labor hour, which is determined by dividing the total budgeted manufacturing overhead for the year by the total budgeted direct labor hours for the year.
1. Define and explain ending finished goods inventory budget. 2. Prepare a manufacturing overhead budget.
After preparing sales budget, production budget, direct materials budget, direct labor budget, and manufacturing overhead budget the management has all the data needed to calculate unit product cost. This calculation is needed for two reasons: first, to determine cost of goods sold on the budgeted income statement; and second, to know what amount to put on the balance sheet inventory account for unsold units. The carrying cost of unsold units is calculated on the ending inventory finished goods budget.
Example:
The unit product cost calculations for Hampton Freeze Inc. are shown below: (see explanation)
Hampton Freeze Inc. Ending Finished Goods Inventory Budget Absorption Costing Bases For the Year Ended December 31, 2009 Item Production Cost Per Case: Direct materials Direct labor Manufacturing overhead 15 Pounds 0.40 hours 0.40 hours $0.20 per pound 15.00 per hour 10.00 per hour $3.00 6.00 4.00 Quantity Cost Total
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--------Unit product cost $13.00 ====== Budgeted finished goods inventory: Ending finished goods inventory (see production budget) Unit production cost (see above) 3,000 $13.00 ----------Ending finished goods inventory in dollars $39.00 ======
Explanation of Ending Finished Goods Inventory Budget for Hampton Freeze Inc.
For Hampton Freeze Inc. the absorption costing unit product cost is $13 per case of popsicles (finished goods of Hampton Freeze Inc.)--costing of $3 of direct materials, $6 of direct labor, and $4 of manufacturing overhead. The manufacturing overhead is applied to units of product on the basis of direct labor-hours at the rate of $10 per direct labor-hour. The budgeted carrying cost of the expected inventory is $39,000.
1. Define and explain selling and administrative budget. 2. Prepare selling and administrative budget.
Example:
Following is the selling and administrative expense budget for Hampton Freeze Inc. (See explanation of this budget)
Hampton Freeze Inc. Selling and Administrative Expense Budget For the Year Ended December 31, 2009 Quarter
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1 Budgeted sales in cases (see sales budget) Variable selling and administrative expenses per case 10,000 $1.80 ----------Budgeted variable expense $ 18,000 ====== Budgeted fixed selling and administrative expenses: Advertising Executive salaries Insurance Property taxes Depreciation 10,000 -----------Total budgeted fixed selling and administrative exp. 85,000 -----------Total budgeted selling and administrative expenses Less depreciation 103,000 10,000 -----------Cash disbursements for selling and administrative exp. $93,000 ====== 20,000 55,000
20,000 55,000
18,150 10,000 -----------86,900 -----------140,900 10,000 -----------$130,900 ====== 10,000 -----------122,750 -----------194,750 10,000 -----------$184,750 ====== 10,000 -----------103,150 -----------139,150 10,000 -----------$129,150 ======
Explanation of Selling and Administrative Expense Budget for Hampton Freeze Inc.
Like the manufacturing overhead budget the selling and administrative expense budget is divided into variable and fixed cost components. In the above example the variable selling and administrative expense is $1.80 per case. Consequently, budgeted sales in cases for each quarter are entered at the top of the schedule. These data are taken from the sales budget (see sales budget). The budgeted variable selling and administrative expenses are determined by multiplying the budgeted sales in cases by the variable selling and administrative expense per case. For example, the budgeted variable selling and administrative expense for the first quarter is $18,000 (10,000 cases $1.80 per case). The fixed selling and administrative expenses (all given data) are then added to the variable selling and administrative expenses to arrive at the total budgeted selling and administrative expenses. Finally, to determine the cash disbursement for selling and administrative items, total budgeted selling and administrative expense is adjusted by adding back non-cash selling and administrative expenses (in this case, just depreciation).
1. Define and explain a cash budget. 2. What is the purpose of a cash budget 3. How to prepare a cash budget.
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Cash budget is a detailed plan showing how cash resources will be acquired and used over some specific time period. Cash budget is composed of four major sections. 1. The receipts section. 2. The disbursements section 3. The cash excess or deficiency section 4. The financing section The cash receipts section consists of a listing of all of the cash inflows, except for financing, expected during the budgeting period. Generally, the major source of receipts will be from sales. The disbursement section consists of all cash payment that are planned for the budgeted period. These payments will include raw materials purchases, direct labor payments, manufacturing overhead costs, and so on as contained in their respective budgets. In addition, other cash disbursements such as equipment purchase, dividends, and other cash withdrawals by owners are listed. The cash excess or deficiency section is computed as follows:
Cash balance beginning Add receipts Total cash available Less disbursements Excess (deficiency) of cash available over disbursements XXXX XXXX -------XXXX XXXX -------XXXX
If there is a cash deficiency during any period, the company will need to borrow funds. If there is cash excess during any budgeted period, funds borrowed in previous periods can be repaid or the excess funds can be invested. The financing section deals the borrowings and repayments projected to take place during the budget period. It also include interest payments that will be due on money borrowed. Generally speaking, the cash budget should be broken down into time periods that are as short as feasible. Considerable fluctuations in cash balances may be hidden by looking at a longer time period. While a monthly cash budget is most common, many firms budget cash on a weekly or even daily basis.
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Less disbursements: Direct materials Direct labor Manufacturing overhead Selling and Administrative Equipment purchases Dividends material budget Labor budget Overhead budget sell. & adm. budget 49,500 84,000 68,000 93,000 50,000 8,000 -----------Total disbursements 352,500 -----------Excess/deficiency of cash available over disbursements (80,000) 72,300 192,000 96,800 130,900 40,000 8,000 100,050 216,000 103,200 184,750 20,000 8,000 79,350 114,000 76,000 129,150 20,000 8,000 301,200 606,000 344,000 537,800 130,000 32,000
Financing: Borrowings (at beginning)* Payments (at beginning) Interest** 120,000 -----------Total financing 1200,000 -----------Cash balance, ending $40,000 ====== 60,000 180,000
------------ ------------ ------------ -----------$40,000 ====== $40,500 ====== $47,500 ====== $47,500 ======
*The company requires a minimum cash balance of $40,000. Therefore, borrowing must be sufficient to cover the cash deficiencies of $80,000 in quarter 1 and to provide for the minimum cash balance of $40,000. All borrowings and repayments of principal are in round $1,000 amount. **The interest payment relate only to the the principle being repaid at the time it is repaid. For example, the interest in quarter 3 relates only to the interest due on the $100,000 principle being repaid from quarter 1 borrowing: $100,000 10% per year 3/4 year = $7,500 The interest paid in quarter 4 is computed as follows: $20,000 10% per year 1 year $60,000 10% per year 3/4 year Total interest paid $2,000 4,500 --------$6,500 ======
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Management plans to spend $130,000 during the year on equipment purchases: $50,000 in the first quarter; $40,000 in the second quarter; $20,000 in the third quarter; $20,000 in the fourth quarter. The board of directors has approved cash dividends of $8,000 per quarter. Management would like to have a cash balance of at least $40,000 at the beginning of each quarter for contingencies. Assume Hampton Freeze will be able to get agreement from a bank for an open line of credit. This would enable the company to borrow at an interest rate of 10% per year. All borrowings and repayments would be in round $1,000 amount. All borrowings would occur at the beginning of the quarters and all repayments are made and only on the amount of principal that is repaid.
The cash budget is prepared one quarter at a time, starting with the first quarter. Management began the cash budget by entering the beginning balance of cash for the first quarter of $42,500--a number that is given above. Receipts--in this case, just the $230,000 in cash collection from customers--are added to the beginning balance to arrive at the total cash available of $272,500. Since the total disbursements are $352,500 and the total cash available is only $272,500, there is short fall of $80,000. Since management would like to have a beginning cash balance of at lease $40,000 for the second quarter, the company would need to borrow $120,000. Required borrowing at the end of the first quarter Desired ending cash balance Plus deficiency of cash available over disbursements Required borrowings
The second quarter of cash budget is handled similarly. Note that the ending cash balance of the first quarter is brought forward as the beginning cash balance for the second quarter. Also note that additional borrowing is required in the second quarter because of the continued cash shortfall. Required borrowing at the end of the second quarter Desired ending cash balance Plus deficiency of cash available over disbursements Required borrowings
In third quarter, the cash flow situation improves dramatically and the excess of cash available over disbursement is $148,000. This makes it possible for the company to repay part of its loan from the bank, which now totals $180,000. How much can be repaid? The total amount of the principle and interest that can be repaid is determined as follows: Total maximum feasible loan payments at the end of the third quarter Excess of cash available over disbursement Less desired ending cash balance $148,000 40,000 -------------
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$108,000 ======
The next step--figuring out the exact amount of loan payment--is tricky since interest must be paid on the principle amount that is repaid. In this example, the principle amount that is repaid must be less than $108,000, so we know that we would be paying of part of the loan that was taken out at the beginning of the first quarter. Since the repayment would be made at the end of the third quarter, interest would have accrued for three quarters. So the interest owed would be 3/4 of 10% or 7.5%. Either a trial and error or an algebraic approach will lead to the conclusion that the maximum principle repayment that can be made is $100,000. The interest payment would be 7.5% of this amount, or $7,500--making the total payment $107,500. In the fourth quarter, all of the loan and accumulated interest are paid off. If all loans are not repaid at the end of the year and budgeted financial statements are prepared, then interest must be accrued on the unpaid loans. This interest will not appear on the cash budget (since it has not yet been paid), but it will appear as interest expense on the budgeted income statement and as a liability on the budgeted balance sheet. As with the production budget and raw materials budget, the amounts under the year column in the cash budget are not always the sum of the amounts for the four quarters. In particular, the beginning cash balance for the year is the same as the beginning cash balance for the first quarter and the ending cash balance for the year is the same as the ending cash balance for the fourth quarter.
Burlington Northern Fe (BNSF) operates the second largest railroad in the United States. The company's senior vice president, CFO, and treasure is Tom Hunt, who reports that "as a general theme, we have become very cash-flow oriented." After the manager of the Burlington Northern and Santa Fe railroads, the company went through a number of years in which they were investing heavily and consequently had negative cash flow. To keep on top of the company's cash position, Hunt has a cash forecast prepared every month. "Everything falls like dominoes from free cash flows," Hunt says. "It provides us with alternatives." Right now, the alternative of choice is buying back our own stock...[b]ut it could be increasing dividends or making acquisitions. All those things are not even on the radar screen if you don't have free cash flow."
Source: Randy Myers, "Cash Crop: The 2000 working capital survey," CFO, August 2000, pp. 59-82.
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Cash budget
The budgeted income statement is one of the key schedules in the budget process. It shows the company's planned profit for the upcoming budget period, and it stands as a benchmark against which subsequent company performance can be measured.
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3 4
Total current assets Plant and equipment: Land Building and equipment Accumulated depreciation 5 6 7 80,000 830,000 (392,000) -------------Plant and equipment, net
$211,000
$518,000 --------------
Total assets
Current liabilities: Accounts payable (raw materials) Stockholders' equity: Common stock, no par Retained earnings 9 10 $175,000 526,000 -------------Total stock holders' equity 701,100 -------------Total liabilities and stockholders equity $729,000 ======= 8 $27,000
Hampton Freeze, Inc. Balance Sheet December 31, 2008 Assets Current Assets: Cash Accounts receivable Raw materials inventory (21,000 pounds) Finished goods inventory (2,000 cases) $42,500 90,000 4,200 26,000 ------------Total current assets Plant and Equipment: Land Building and equipment Accumulated depreciation 80,000 700,000 (292,000) $162,700
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------------Plant and equipment, net $488,000 ------------Total assets Liabilities and Stockholders' Equity Current Liabilities: Accounts payable (raw materials) Stockholders' Equity: Common stock, no par Retained earnings $175,000 449,900 ------------Total stock holders' equity 624,000 ------------Total liabilities and stockholders' equity $650,700 ======= $25,800 $650,700
1. The ending cash balance, as projected by the cash budget on cash budget
page.
2. Thirty percent of fourth quarter sales, from sales budget ($400,000 30% =
$120,000)
3. From direct materials budget, ending raw materials inventory will be 22,500 4. 5. 6. 7.
pounds. This material costs $0.20 per pound. Therefore, the ending inventory in dollars will be 22,500 pounds $0.20 = $4,500. From ending finished goods inventory budget. From December 2008 balance sheet (no change). The December 2008 balance sheet indicated a balance of $700,000. During 2009, $130,000 of additional equipment will be purchased (see cash budget), bringing the December 31, 2009, balance to $830,000. The December 31, 2008 balance sheet indicated a balance of $292,000. During 2009, $100,000 depreciation will be taken ($60,000 from manufacturing overhead budget, and $40,000 selling and administrative expense budget), bringing the December 2009, balance to $392,000. One half of the fourth quarter raw materials purchase, from direct materials budget. From the December 2008 balance sheet (no change). $449,900 108,200 ------558,100 32,000 ------$526,100 ======
8. 9.
Deduct dividend paid from cash budget December 31, 2009, balance
A multinational company faces special problems when preparing a budget. The problems arise because of fluctuations in foreign currency exchange rates, the high inflation rates found in some countries, and local economic conditions and governmental policies that affect everything from labor costs to marketing practices. Fluctuations in foreign currency exchange rates create unique budgeting problems. Exporters may be able to predict with some accuracy their sales in the local foreign currency such as South African rand or Swiss francs. However, the amounts they eventually receive in their own currency will depend on the currency exchange rates that prevail at the time. If, for example, the currency exchange rates are less favorable than expected, the company will ultimately receive in its own currency less than it had anticipated. Companies that are heavily involved in export operations often hedge their exposure to exchange rate fluctuations by buying and selling sophisticated financial contracts. These hedges ensure that if the company loses money in its exporting operations because of exchange rate fluctuations, it will make up that loss with gain on its financial contracts. The details of such hedging operations are covered in financial text books and websites. When a multinational company uses hedging operations, the costs of those activities should be budgeted along with other expenses. Some multinational companies have operations in countries with very high inflation rates--sometimes exceeding 100% a year. Such high inflation rates--called hyperinflation--can render a budget obsolete very quickly. A common budgeting tactic in such countries is to reduce the lead time for preparing the budget and to revise the budget frequently throughout the year in the light of the actual inflation experienced to date. In addition to problems with exchange rates and inflation, multinational companies must be sensitive to government policies in the countries in which they operate that might affect labor costs, equipment purchases, cash management, or other budget items.
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