Chapter 13 – Planning and Budgeting
13-1
Chapter 13
Planning and Budgeting
Learning Objectives
1. Understand the role of budgets in overall organization plans.
2. Understand the importance of people in the budgeting process.
3. Estimate sales.
4. Develop production and cost budgets.
5. Estimate cash flows.
6. Develop budgeted financial statements.
7. Explain budgeting in merchandising and service organizations.
8. Explain why ethical issues arise in budgeting.
9. Explain how to use sensitivity analysis to budget under uncertainty.
Chapter Outline
I. HOW STRATEGIC PLANNING INCREASES COMPETITIVENESS
II. OVERALL PLAN
A. Organization goals
B. Strategic long-range profit plan
C. Master budget (Tactical short-range profit plan): Tying the strategic plan to the
operating plan
III. HUMAN ELEMENT IN BUDGETING
♦ Value of employee participation
IV. DEVELOPING THE MASTER BUDGET: WHERE TO START?
♦ Sales forecasting
1. Sales staff
2. Market researchers
3. Delphi technique
4. Trend analysis
5. Econometric model
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V. COMPREHENSIVE ILLUSTRATION
A. Forecasting production
B. Forecasting production costs
1. Direct materials
2. Direct labor
3. Overhead
C. Completing the budgeted cost of goods sold
D. Revising the initial budget
VI. MARKETING AND ADMINISTRATIVE BUDGET
VII. PULLING IT TOGETHER INTO THE INCOME STATEMENT
VIII. KEY RELATIONSHIPS: THE SALES CYCLE
IX. USING CASH FLOW BUDGETS TO ESTIMATE CASH NEEDS
♦ Multiperiod Cash Flows
X. PLANNING FOR THE ASSETS AND LIABILITIES ON THE BUDGETED
BALANCE SHEETS
XI. BIG PICTURE: HOW IT ALL FITS TOGETHER
XII. BUDGETING IN RETAIL AND WHOLESALE ORGANIZATIONS
XIII. BUDGETING IN SERVICE ORGANIZATIONS
XIV. ETHICAL PROBLEMS IN BUDGETING
XV. BUDGETING UNDER UNCERTAINTY
XVI. SUMMARY
Key Concepts
LO 13-1 Understand the role of budgets in overall organization plans.
♦ Critical success factors are strengths of a company that enable it to outperform competitors.
• By identifying critical success factors and ensuring that they are incorporated into the
strategic plan, companies are able to maintain an edge over competitors.
• Important critical success factors can be exploited to improve the company’s overall
competitiveness.
♦ The budget is a financial plan of the resources needed to carry out activities and meet financial
goals.
• A recent study shows that small businesses rely on budgets to help manage cash flow,
among things (see In-Action item for more information).
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• The budgeting process is widely used and necessary for success. The usual problems
with budgeting are the use of budgets as targets and the dysfunctional effects caused by
that use.
• An overall organization plan is made up of three components:
(1) The organization goals,
(2) The strategic long-range profit plan, and
(3) The master budget (i.e., the tactical short-range profit plan).
• Organization goals are a company’s broad objectives established by management that
employees work to achieve.
• The strategic long-range profit plan is a statement detailing steps to take to achieve a
company’s organization goals. The plan provides a general framework for guiding
management’s operating decisions.
• Strategic plans discuss the major capital investments required to maintain present
facilities, increase capacity, diversify products and/or processes, and develop particular
markets.
• The master budget (also known as the static budget, the budget plan, or the planning
budget) is the financial plan of an organization for the coming year or other planning
period.
• The profit plan is the income statement portion of the master budget.
• The master budget indicates the sales levels, production and cost levels, income, and
cash flows anticipated for the coming year. In addition, these budget data are used to
construct a budgeted balance sheet.
• Budgeting is a dynamic process that ties together goals, plans, decision making, and
employee performance evaluation.
• Exhibit 13.1 shows the master budget and its relationship to other plans, accounting
reports, and management decision-making processes.
• The master budget is derived from the long-range plan in consideration of conditions
expected during the coming period. Such plans are subject to change as the events of the
year unfold.
• Benchmarking is the continuous process of measuring products, services, or activities
against competitors’ performance.
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• Competitive intelligence can be part of a benchmarking activity in which some
companies gather information by speaking to their competitors, customers, and suppliers.
LO 13-2 Understand the importance of people in the budgeting process.
♦ Although budgets are often viewed in purely quantitative, technical terms, managers’ personal
goals and values will affect their beliefs about the coming period.
• Budget preparation rests on human estimates of an unknown future. People’s forecasts
are likely to be greatly influenced by their experiences with various segments of the
company.
• One challenge of budgeting is to identify who in the organization is best able to provide
the most accurate information about particular topics.
• Participative budgeting (also called grass roots budgeting) is the use of input from
lower- and middle-management employees for budget preparation.
• Participative budgeting is time consuming, yet it enhances employee motivation and
acceptance of goals, and provides information that enables employees to associate
rewards and penalties with performance. It also serves a training or development role for
managers.
• Studies have found that managers often provide inaccurate data when asked to give
budget estimates. Managers who believe that the budget will be used as a norm for
evaluating their performance could provide an estimate that will not be too hard to
achieve.
• Ideally, the budget will motivate people and facilitate their activities so that the
organization can achieve its goals.
LO 13-3 Estimate sales.
♦ All budgeting processes share some common elements.
• After organization goals, strategies, and long-range plans have been developed, work
begins on the master budget, a detailed budget for the coming fiscal year with some less-
detailed figures for subsequent years.
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• The bulk of the work preparing the master budget is usually done in the six months
immediately preceding the beginning of the coming fiscal year.
• Final budget approvals by the chief executive and board of directors are made one
month to six weeks before the beginning of the coming fiscal year.
♦ Beginning with a sales forecast, the firm can plan the activities over which it has more control.
As better information about sales becomes available, it is reasonably easy to adjust the rest of the
budget.
• In most firms, forecasting sales is the most difficult aspect of budgeting because it is
most uncertain.
• If, on the other hand, production is more uncertain than sales because of unpredictable
supply of materials, the firm may want to begin with a raw material and production
forecast.
♦ Salespeople are in the unique position of being close to the customers, and they may possess
the best information and the best local knowledge in the company about customers’ immediate
and near-term needs.
• Salespeople realize that they will be evaluated based, in part, on the budget. As a result,
they have an incentive to bias their sales forecasts.
• Incentive compensation plans can be designed to motivate different behaviors, each
with their own strengths and weaknesses.
♦ Market researchers do not have the same incentives that sales personnel have to bias the budget.
• Market researchers have a different perspective on the market. That is, they can predict
long-term trends in attitudes and the effects of social and economic changes on the
company’s sales, potential markets, and products.
♦ The Delphi technique is a forecasting method in which individual forecasts of group members
are submitted anonymously and evaluated by the group as a whole.
• Each group member obtains a copy of all forecasts but is unaware of their sources.
• Differences among individual forecasts can be addressed and reconciled without
involving the personality or position of individual forecasters.
• After the differences are discussed, the process is repeated until the forecasts converge
on a single best estimate of the coming year’s sales level.
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♦ Trend analysis is a forecasting method that ranges from simple visual extrapolation of points
on a graph to highly sophisticated computerized time series analysis.
• Time series techniques use only past observations of the data series to be forecasted.
• This approach is relatively economical.
• Forecasting techniques based on trend analysis often requires long series of past data to
derive a suitable solution. When used in accounting applications, monthly data are
required to obtain an adequate number of observations.
♦ Econometric models are statistical methods of forecasting economic data using regression
models.
• Econometric models can include many relevant predictors. Manipulating the
assumed values of the predictors makes it possible to examine a variety of hypothetical
conditions and relate them to the sales forecast.
♦ No model removes the uncertainty surrounding sales forecasts. Cost-benefit tests should be
used to determine which methods are most appropriate.
LO 13-4 Develop production and cost budgets.
♦ The production budget is the production plan of resources needed to meet current sales
demand and ensure that inventory levels are sufficient for future sales.
• It is necessary to determine the required inventory level for the beginning and end of the
budget period.
• The basic cost flow equation (also known as the basic inventory formula) can be
adapted for inventories, production, and sales to solve for the required production. Recall
from Chapter 6 the inventory equation:
Beginning balance (BB) + Transfer in (TI) – Transfer out (TO) = Ending balance (EB).
• Rearranging the terms, this revised equation states that production equals the sales
demand plus or minus an inventory adjustment.
Required
production (units)
=
Budgeted
sales (units)
+
Units in ending
inventory
–
Units in beginning
inventory
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• Another way to solve the required production is to go through the following T-account:
Finished goods Inventory
Units in beginning inventory
Required production (?)
Units in ending inventory
• Production and inventory are stated in equivalent finished units.
• Exhibit 13.2 presents a production budget example.
• Management of the production facilities reviews the production budget to ascertain
whether the budgeted level of production can be reached with the capacity available.
• One benefit of the budgeting process is that it facilitates the coordination of activities.
======================
Demonstration Problem 1
East Mountain Bike expects to sell 25,000 electronic bicycles next year. The management
estimates that the beginning and ending inventory will be 2,000 units and 3,500 units,
respectively.
Required:
Prepare a production budget for next year.
Solution:
East Mountain Bike
Production Budget
For the budget year ended December 31
(in units)
Expected sales
25,000
Add: Desired ending inventory of finished goods
3,500
Total needs
28,500
Less: Beginning inventory of finished goods
(2,000)
Units to be produced
26,500
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======================
♦ Once the sales and production budgets have been developed and the efforts of the sales and
production groups have been coordinated, the next step is to estimate costs of direct materials,
direct labor, and manufacturing overhead at budgeted levels of production so the budgeted cost
of goods sold can be prepared.
♦ Direct materials purchases needed for the budget period are derived from the equation:
Required material
purchases
=
Materials to
be used in
production
+
Estimated ending
materials
inventory
–
Estimated
beginning materials
inventory
• Another way to solve the required materials purchases is to go through the following T–
account:
Materials Inventory
Estimated beginning inventory
Required purchases (?)
Estimated ending inventory
Required usage = Required production × Materials needed per unit of output.
Cost of materials to be purchased = Required purchases × Cost of materials per unit.
• Exhibit 13.3 shows the direct materials budget.
======================
Demonstration Problem 2
(Continued from Demonstration Problem 1)
Each electronic bicycle produced at East Mountain Bike requires two major parts (frame and
tires) and an electronic subassembly from its suppliers as inputs. The following information is
available:
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Frame
Tires
Electronic subassembly
Material per bike
1
2
1
Unit cost
$900
$30
$420
Beginning inventory
1,100
2,000
950
Ending inventory
2,500
3,200
1,800
Required:
Prepare the direct material budget for next year.
Solution: East Mountain Bike
Direct Materials Budget
For the budget year ended December 31
Units to be produced next year (from the production budget above): 26,500
Frame
Tires
Electronic
subassembly
Direct material needed per bike
1
2
1
Total production needs
26,500
53,000
26,500
Add: Desired ending inventory
2,500
3,200
1,800
Total direct materials needs
29,000
56,200
28,300
Less: Beginning inventory
(1,100)
(2,000)
(950)
Direct materials to be purchased
27,900
54,200
27,350
Unit cost
$900
$30
$420
Total cost of direct materials to be purchased
$25,110,000
$1,626,000
$11,487,000
Total materials cost
$38,223,000
======================
♦ Estimates of direct labor costs often are obtained from engineering and production
management.
Direct labor usage = Required production × Labor hours needed per unit of output.
Direct labor cost = Direct labor usage × Direct labor cost per hour.
• Exhibit 13.4 shows a direct labor budget.
♦ Overhead is composed of many different types of costs with varying cost behaviors.
• Budgeting overhead requires an estimate based on production levels, management
discretion, long-range capacity and other corporate policies, and external factors such as
increases in property taxes.
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• To simplify the budgeting process, overhead costs are usually divided into fixed and
variable components, with discretionary and semi-fixed costs treated as fixed costs within
the relevant range.
• Exhibit 13.5 presents a sample schedule of budgeted manufacturing overhead.
♦ The total manufacturing costs can be determined by adding materials, labor, and overhead
together. Exhibit 13.6 shows the calculation for the budgeted statement of cost of goods sold.
• In most companies, estimates of work–in-process inventories are omitted from the
budget because they have a minimal impact on the budget.
• The calculation of the cost of goods sold follows the equation:
Estimated cost of
goods sold
=
Estimated
beginning finished
goods inventory
+
Estimated cost of
goods
manufactured
–
Estimated ending
finished goods
inventory
• Another way to determine the estimated cost of goods sold is to go through the finished
goods T-account:
Finished goods Inventory
Beginning inventory
Cost of goods manufactured
Ending inventory
• This part of the budgeting effort can be extremely complex for manufacturing
companies. It can be very difficult to coordinate production schedules among numerous
plants; it is also difficult to coordinate production schedules with sales forecasts.
♦ The budget usually undergoes a good deal of coordinating and revising before it is considered
final.
• Not part of the budget is really formally adopted until the board of directors finally
approves the master budget.
♦ Budgeting marketing and administrative costs is very difficult because managers have
discretion about how much money is spent and the timing of the expenditures.
• The budgeting objective is to estimate the amount of marketing and administrative costs
required to operate the company at its projected level of sales and production, and to
achieve long-term company goals.