Needles Powers Crosson Principles of Accounting 12e The Budgeting Process 22 C H A P T E R © human/iStockphoto

NeedlesPowersCrosson

Principles of Accounting

12e

The Budgeting Process22C H A P T E R

© human/iStockphoto

LEARNING OBJECTIVES

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LO1: Define budgeting and describe how it relates to the concepts of comparability and understandability.

LO2: Identify the elements of a master budget in different types of organizations and the guidelines for preparing budgets.

LO3: Prepare the operating budgets that support the financial budgets.

LO4: Prepare a budgeted income statement, a cash budget, and a budgeted balance sheet.

LO5: Explain why budgeting is essential to the management process.

SECTION 1: CONCEPTS


Comparability: the convention of presenting information in a way that enables decision makers to recognize similarities, differences, and trends over different periods in the same company and among different companies

Understandability: the qualitative characteristic of information that enables users to comprehend the meaning of the information they receive

Concepts Underlying the Budgeting Process

Budgeting is the process of identifying, gathering, summarizing, and communicating financial and nonfinancial information about an organization’s future activities.– Budgets are plans of action based on forecasted

transactions, activities, and events.– Budgeting provides managers the opportunity to

match their organizational goals with the resources necessary to accomplish those goals. It empowers all in the organization to understand the goals in terms of their responsibilities and be held accountable for budget plans and results, since they can be compared.


The Master Budget(slide 1 of 3)

A master budget consists of a set of operating budgets and a set of financial budgets that detail an organization’s financial plans for a specific period, generally a year.

Operating budgets are plans used in daily operations. They include:– sales budget– production budget– direct materials purchases budget– direct labor budget



– overhead budget– selling and administrative expenses budget– cost of goods manufactured budget

The sales budget is prepared first because it is used to estimate sales volume and revenues. – Once managers know the quantity of

products or services to be sold and how many sales dollars to expect, they can develop other budgets that will enable them to manage their resources so that they can generate profits on those sales.



Operating budgets are the basis for preparing the financial budgets, which are projections of financial results for the period. They include:– a budgeted income statement– a capital expenditures budget– a cash budget– a budgeted balance sheet

The budgeted income statement and budgeted balance sheet are also called pro forma financial statements, meaning that they show projections rather than actual results.



SECTION 2: ACCOUNTING APPLICATIONS

Prepare operating budgets– Sales budget– Production budget– Direct materials purchases budget– Direct labor budget– Overhead budget– Selling and administrative expenses budget– Cost of goods manufactured budget

Prepare financial budgets– Budgeted income statement– Cash budget– Budgeted balance sheet


Preparation of a Master Budget

The next three slides display the elements of a master budget for a manufacturing, a retail, and a service organization, respectively. – As these illustrations indicate, the process of

preparing a master budget is similar in all three types of organizations in that each prepares a set of operating budgets that serve as the basis for preparing the financial budgets.

– The process differs mainly in the kinds of operating budgets that each type of organization prepares.


Preparation of a Master Budget for a Manufacturing Organization


Preparation of a Master Budget for a Retail Organization


Preparation of a Master Budget for a Service Organization


Budget Procedures(slide 1 of 2)

There is no standard format for budget preparation, but budgets should communicate the appropriate information in a clear and understandable manner.

Managers can improve the quality of budgets by:– Knowing the purpose of the budget, and clearly

identifying who is responsible for carrying out the activities of the budget.

– Identifying the user group and its information needs.– Identifying sources of accurate, meaningful budget

information.


Budget Procedures(slide 1 of 2)

– Establishing a clear format for the budget. The budget should begin with a clearly stated heading

that includes the organization’s name, the type of budget, and the accounting period under consideration.

The budget’s components should be clearly labeled, and the unit and financial data should be listed in an orderly manner.

– Using appropriate formulas and calculations in deriving the quantitative information.

– Revising the budget until it includes all planning decisions. Several revisions may be required before the final version is ready for distribution.



The Sales Budget(slide 1 of 4)

The first step in preparing a master budget is to prepare a sales budget.– A sales budget shows expected sales during

a period, expressed in both units and dollars.– Sales managers use this information to plan

sales- and marketing-related activities and to determine their human, physical, and technical resource needs.

– The following equation is used to determine the total budgeted sales:

Total Budgeted Sales = Estimated Selling Price per Unit X Estimated Sales in Units



– Although the calculation is easy, selecting the best estimates for the selling price per unit and the sales demand in units can be difficult.

– To help estimate sales volume, managers often use a sales forecast, which is a projection of the estimated sales in units, based on an analysis of external and internal factors.

– External factors include: the state of the local and national economies the state of the industry’s economy the nature of the competition and its sales volume

and selling price



– Internal factors include: the number of units sold in prior periods the organization’s credit policies the organization’s collection policies the organization’s pricing policies any new products that the organization plans to

introduce to the market the capacity of the organization’s manufacturing

facilities

– The next slide shows Framecraft’s sales budget. The budget shows the estimated number of unit sales

and dollar revenue amounts for each quarter and for the entire year. It indicates highly seasonal sales activity.




The Production Budget(slide 1 of 3)

A production budget shows the number of units that a company must produce to meet budgeted sales and inventory needs.– Production managers use this information to

plan for the materials and human resources that production-related activities will require.

– To prepare a production budget, managers must know the budgeted number of unit sales (from the sales budget) and the desired level of ending finished goods inventory for each period in the budget year.



– The following formula identifies the production needs for each period:

– The next slide shows Framecraft’s production budget. Framecraft’s desired level of ending finished goods

inventory is 10 percent of the next quarter’s budgeted unit sales.

Notice that each quarter’s desired total units of ending finished goods inventory become the next quarter’s desired total units of beginning finished goods inventory.

Because unit sales of 15,000 are budgeted for the 1st quarter of next year, the ending finished goods inventory for the 4th quarter of the year is 1,500 units.




The Direct Materials Purchases Budget(slide 1 of 4)

The direct materials purchases budget identifies the quantity of purchases required to meet budgeted production and inventory needs and the costs associated with those purchases.– To prepare a direct materials purchases budget,

managers must know what production needs will be in each period (from the production budget). They must also know the desired level of the direct materials inventory for each period and the per-unit cost of direct materials. Framecraft’s desired level of ending direct materials

inventory is 20 percent of the next quarter’s budgeted production needs.



– The following steps are involved in preparing a direct materials purchases budget: Step 1: Calculate each period’s total production

needs in units of direct materials using the following formula:

Step 2: Determine the quantity of direct materials to be purchased during each accounting period in the budget using the following formula:



Step 3: Calculate the cost of the direct materials purchases using the following formula:

– The next slide shows Framecraft’s direct materials purchases budget for the year. Plastic is the only direct material used in Framecraft’s

picture frames. Each picture frame requires 10 ounces of plastic.

Framecraft’s Purchasing Department has estimated the cost of the plastic used in the picture frames at $0.05 per ounce.

Notice that each quarter’s desired units of ending direct materials inventory become the next quarter’s desired units of beginning direct materials inventory.




The Direct Labor Budget(slide 1 of 3)

A direct labor budget shows the direct labor hours needed during a period and the associated costs.– Production managers use estimated direct labor

hours to plan how many employees will be required during the period and the hours that each will work.

– Accountants use estimated direct labor hours to plan for cash payments to the workers.

– Managers of human resources use the direct labor budget in deciding whether to hire new employees or reduce the existing work force.



– The following two steps are used to prepare a direct labor budget: Step 1: Estimate the total direct labor hours using

the following formula:

Step 2: Calculate the total budgeted direct labor cost using the following formula:

– The next slide shows Framecraft’s direct labor budget.




The Overhead Budget(slide 1 of 3)

An overhead budget shows the anticipated manufacturing costs, other than direct materials and direct labor costs, that must be incurred to meet budgeted production needs.– It has two purposes:

To integrate the overhead cost budgets developed by the managers of production and production-related departments.

To group information for the calculation of overhead rates for the next accounting period.

– The next slide shows Framecraft’s overhead budget.





– As the previous slide shows, Framecraft prefers to group overhead information into variable and fixed costs to facilitate CVP analysis.

– The single overhead rate is computed using the following formula:

Estimated Total Overhead Costs ÷ Estimated Total Direct Labor Hours

– Framecraft’s predetermined overhead rate is:$171,045 ÷ 9,050 direct labor hours = $18.90 per direct labor

hour

or$18.90 per direct labor hour x 0.10 direct labor hour per unit =$1.89 per unit produced


The Selling and Administrative Expenses Budget (slide 1 of 2)

A selling and administrative expenses budget shows the operating expenses, other than those related to production, that are needed to support sales and overall operations during a period.– The next slide shows Framecraft’s selling and

administrative expenses budget. Framecraft groups its selling and administrative

expenses into variable and fixed components for purposes of cost behavior analysis, CVP analysis, and profit planning.

The number of units sold, not produced, are used to compute this budget since selling and administrative costs are triggered by sales, not production.


The Selling and Administrative Expenses Budget (slide 2 of 2)


The Cost of Goods Manufactured Budget(slide 1 of 2)

A cost of goods manufactured budget summarizes the estimated costs of production during a period. – The sources of information for total

manufacturing costs are the direct materials, direct labor, and overhead budgets.

– The next slide summarizes Framecraft’s estimated costs of production for the year. The budgeted, or standard, product unit cost for one

picture frame is computed as follows:

Cost of Goods Manufactured ÷ Units Produced$270,595 ÷ 90,500 units = $2.99


The Cost of Goods Manufactured Budget(slide 2 of 2)



Financial Budgets

With revenues and expenses itemized in the operating budgets, an organization is able to prepare the financial budgets, which are projections of financial results for the period.

Financial budgets include:– a budgeted income statement– a capital expenditures budget– a cash budget– a budgeted balance sheet


The Budgeted Income Statement(slide 1 of 2)

A budgeted income statement projects an organization’s net income for a period based on the revenues and expenses estimated for that period.– The next slide shows Framecraft’s budgeted

income statement for the year. The company’s expenses include 8 percent

interest paid on a $70,000 note payable and income taxes paid at a rate of 30 percent.

Information about projected sales and costs comes from several operating budgets.


The Budgeted Income Statement(slide 2 of 2)


The Capital Expenditures Budget

A capital expenditures budget outlines the anticipated amount and timing of capital outlays for long-term assets during a period.– Managers rely on the information in a capital

expenditures budget when making decisions about such matters as buying equipment or building a new plant.

– Framecraft’s capital expenditures budget for the year includes $30,000 for the purchase of a new framemaking machine. The company plans to pay $15,000 in the first

quarter of the year, when the order is placed, and $15,000 in the second quarter of the year, when it receives the machine.


The Cash Budget

A cash budget is a projection of the cash that an organization will receive and pay out during a period. It summarizes the cash flow prospects of all transactions considered in the master budget.– It excludes planned noncash transactions, such

as depreciation and amortization expense, issuance and receipt of stock dividends, uncollectible accounts expense, and gains and losses on sales of assets.

– The following formula is used in preparing a cash budget:


Elements of a Cash Budget


Cash Collections

The schedule on the next page shows the cash that Framecraft expects to collect from customers during the year. – Cash sales represent 20 percent of the company’s

expected sales; the other 80 percent are credit sales.

– Experience has shown that Framecraft collects payments for 60 percent of all credit sales in the quarter of sale, 30 percent in the quarter following sale, and 10 percent in the 2nd quarter following sale.

– The information in this schedule is summarized in the cash receipts section of the company’s cash budget.


Schedule of Expected Cash Collections from Customers


Cash Payments

The next slide shows Framecraft’s schedule of expected cash payments for direct materials during the year.– Framecraft pays 50 percent of the invoices

it receives in the quarter of purchase and the other 50 percent in the following quarter.

– The information in this schedule is summarized in the first line of the cash payments section of the company’s cash budget.


Schedule of Expected Cash Payments for Direct Materials


Cash Budget(slide 1 of 2)

Framecraft’s cash budget for the year appears on the next slide.– It shows the estimated cash receipts and cash

payments for the period, as well as the cash increase or decrease.

– The cash increase or decrease plus the period’s beginning cash balance equals the ending cash balance anticipated for the period.

– Each quarter’s budgeted ending cash balance becomes the next quarter’s beginning cash balance.


Cash Budget(slide 2 of 2)


Minimum Cash Balance

Many organizations maintain a minimum cash balance to provide a margin of safety against uncertainty.– If the ending cash balance on the cash budget

falls below the minimum level required, short-term borrowing may be necessary to cover planned cash payments during the year.

– If the ending cash balance is significantly larger than the organization needs, it may invest the excess in short-term securities to generate additional income.


The Budgeted Balance Sheet

A budgeted balance sheet projects an organization’s financial position at the end of a period.– It uses all estimated data compiled in

preparing a master budget and is the final step in the budgeting process.

– The next slide shows Framecraft’s budgeted balance sheet at the end of the year.


Budgeted Balance Sheet



SECTION 3: BUSINESS APPLICATIONS

Planning Performing Evaluating Communicating


Budgeting and the Management Process

Budgets are essential to accomplishing an organization’s strategic plan.

They are used to communicate understandable information, coordinate activities and resource usage, motivate employees, and provide comparative information to evaluate performance.

Budgets are also used to manage and account for cash.


Advantages of Budgeting

Budgeting is advantageous because budgets:

– foster organizational communication

– ensure a focus both on future events and on resolving day-to-day issues

– assign resources and the responsibility to use them wisely to managers who are held accountable for their results

– can identify potential constraints before they become problems

– facilitate congruence between organizational and personal goals

– define organizational goals and objectives numerically, against which actual performance results can be evaluated


Budgeting and Goals(slide 1 of 2)

Budgeting helps managers achieve both long-term and short-term goals.– Long-Term Goals

Strategic planning is the process by which management establishes an organization’s long-term goals.

These goals define the direction that an organization will take and are the basis for making annual operating plans and preparing budgets.

Long-term goals must set specific tactical targets and timetables and assign responsibility to specific personnel.


Budgeting and Goals(slide 2 of 2)

– Short-Term Goals Annual operating plans involve every part of an

enterprise and are much more detailed than long-term strategic plans.

To formulate an annual operating plan, an organization must restate its long-term goals in terms of what it needs to accomplish during the next year.

The process entails making decisions about sales and profit targets, human resource needs, and the introduction of new products or services.

The short-term goals identified in an annual operating plan are the basis of an organization’s operating budgets for the year.


Budgeting Basics

Once long- and short-term goals have been decided, the organization’s management plays a central role in coordinating the budgeting process.

Managers set the basics of the budgeting process, including assigning budget authority, inviting employee participation, selecting the budget period, and implementing the budget.


Assigning Budget Authority

Every budget and budget line item is associated with a specific role or job in an organization.

Since manager responsibilities and budget authority are linked, managers must explain or take corrective action for any deviations between budget and actual results.– If managers do not have budget authority over

what they need to accomplish in their job responsibilities, they lack the control necessary to accomplish their duties and cannot be held accountable for results.


Inviting Employee Participation

The key to a successful budget is participative budgeting, a process in which personnel at all levels of an organization actively engage in making decisions about the budget.– If individuals at all levels have a voice in setting

the budget targets, they will be motivated to ensure that their departments attain those targets and stay within the budget.

– If they do not have a role in the budgeting process, motivation will suffer, and budget targets may be unrealistic and impossible to attain.


Selecting the Budget Period

Budgets generally cover a one-year period, but may be divided further into monthly or quarterly periods.– Static budgets are prepared once a year and do not

change during the annual budget period.– A continuous budget is a forward-rolling budget that

summarizes budgets for the next 12 months. Each month managers prepare a budget for that month, 12 months hence.

– Traditional budgeting requires managers to justify only budget changes over the past year.

– Zero-based budgeting requires that every budget item be justified annually, thus building the budget from scratch.


Implementing the Budget(slide 1 of 2)

The budget committee, which includes the controller and many of the organization’s top management, has overall responsibility for budget implementation. The budget committee– Oversees each stage in the preparation of

the organization’s overall budget.– Mediates any departmental disputes that

arise in the process.– Gives final approval to the budget.


Implementing the Budget(slide 2 of 2)

Successful budget implementation depends on two factors—clear communication and the support of top management.– The budget committee must communicate

clearly the performance expectations and budget targets.

– Top management must show support for the budget and encourage its implementation. Many organizations have employee incentive plans

that tie the achievement of budget targets to bonuses and other types of compensation.


Budgeting and the Management Process

Budgeting is not only an essential part of planning; it also helps managers command, control, evaluate, and report on operations, as summarized in the graphic below.



Documents

Needles Powers Crosson Principles of Accounting 12e The Budgeting Process 22 C H A P T E R © human/iStockphoto