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Chapter 08 - Lecture Notes
8-1
Chapter 8
Lecture Notes
Chapter theme: This chapter describes how organizations
define their financial goals by preparing numerous budgets
that collectively form an integrated business plan known
as a master budget. The master budget communicates
management’s plans throughout the organization, allocates
resources, and coordinates activities.
I. The basic framework of budgeting
Learning Objective 1: Understand why organizations
budget and the processes they use to create budgets.
A. Basic definitions
i. A budget is a detailed quantitative plan for
acquiring and using financial and other resources
over a specified forthcoming time period.
1. The act of preparing a budget is called
budgeting.
2. The use of budgets to control an
organization’s activities is known as
budgetary control.
B. Difference between planning and control
i. Planning involves developing objectives and
preparing various budgets to achieve those
objectives.
ii. Control involves the steps taken by management to
increase the likelihood that the objectives set down
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at the planning stage are attained and that all parts
of the organization are working together toward
that goal.
iii. To be effective, a good budgeting system must
provide for both planning and control. Good
planning without effective control is time wasted.
C. Advantages of budgeting
i. Budgets communicate management’s plans
throughout the organization.
ii. Budgets force managers to think about and plan
for the future.
iii. The budgeting process provides a means of
allocating resources to those parts of the
organization where they can be used most
effectively.
iv. The budgeting process can uncover potential
bottlenecks before they occur.
v. Budgets coordinate the activities of the entire
organization by integrating the plans of its various
parts.
vi. Budgets define goals and objectives that can serve
as benchmarks for evaluating subsequent
performance.
Helpful Hint: Mention to students that budgets are
prepared for reasons other than projecting income
statement and balance sheet account balances. Ask
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students to think about some other information that
might be provided by budgets, such as determining the
need for short-term borrowing or estimating raw
material needs.
D. Other terminology/concepts related to budgeting
i. Responsibility accounting
1. The premise of responsibility accounting is
that managers should be held responsible
only for those items that they can control to
a significant extent.
a. Responsibility accounting systems
enable organizations to react quickly
to deviations from their plans and to
learn from feedback obtained by
comparing budgeted goals to actual
results. The point is not to penalize
individuals for missing targets.
ii. Choosing a budget period
1. Operating budgets ordinarily cover a one-
year period corresponding to a company’s
fiscal year. Many companies divide their
annual budget into four quarters.
a. In this chapter we focus on one-year
operating budgets.
2. A continuous or perpetual budget is a 12-
month budget that rolls forward one month
(or quarter) as the current month (or quarter)
is completed.
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a. This approach keeps managers
focused on the future at least one
year ahead.
iii. The self-imposed budget
1. A self-imposed budget or participative
budget is a budget that is prepared with the
full cooperation and participation of
managers at all levels. It is a particularly
useful approach if the budget will be used to
evaluate managerial performance.
2. The advantages of self-imposed budgets
include:
a. Individuals at all levels of the
organization are viewed as members
of the team whose judgments are
valued by top management.
b. Budget estimates prepared by front-
line managers (who have intimate
knowledge of day-to-day operations)
are often more accurate than
estimates prepared by top managers.
c. Motivation is generally higher
when individuals participate in
setting their own goals than when the
goals are imposed from above.
d. A manager who is not able to meet a
budget imposed from above can
claim that it was unrealistic. Self-
imposed budgets eliminate this
excuse.
3. Self-imposed budgets should be reviewed by
higher levels of management. Without such
a review, self-imposed budgets may have
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too much “budgetary slack,” or may not be
aligned with overall strategic objectives.
4. Most companies do not rely exclusively
upon self-imposed budgets in the sense that
top managers usually initiate the budget
process by issuing broad guidelines in terms
of overall target profits or sales. Lower level
managers are directed to prepare budgets
that meet those targets.
Helpful Hint: Ask students if they ever worked in an
organization with a management-imposed budget or a
participative budget. Solicit the reactions of students to
these kinds of budgets and the effects they had on
motivation and performance.
iv. Human factors in budgeting
1. The success of a budget program depends on
three important factors:
a. Top management must be
enthusiastic and committed to the
budgeting process; otherwise nobody
will take it seriously.
b. Top management must not use the
budget to pressure employees or
blame them when something goes
wrong. This breeds hostility and
mistrust rather than cooperative and
coordinated efforts.
c. Highly achievable budget targets
are usually preferred (rather than
“stretch budget” targets) when
managers are rewarded based on
meeting budget targets.
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E. The master budget: an overview
i. The master budget consists of a number of separate
but interdependent budgets.
1. The sales budget shows the expected sales
for the budget period expressed in dollars
and units. It is usually based on a company’s
sales forecast.
a. All other parts of the master budget
are dependent on the sales budget.
2. The production budget is prepared after the
sales budget. It lists the number of units that
must be produced during each budget period
to meet sales needs and to provide for the
desired ending inventory. The production
budget in turn directly influences the direct
materials, direct labor, and
manufacturing overhead budgets, which
in turn enable the preparation of the ending
finished goods inventory budget.
a. These budgets are then combined
with data from the sales budget and
the selling and administrative
expense budget to determine the
cash budget.
3. The cash budget is a detailed plan showing
how cash resources will be acquired and
used over a specified time period.
a. All of the operating budgets have an
impact on the cash budget.
4. The last step of the process is to prepare a
budgeted income statement and a
budgeted balance sheet.
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ii. To help you see the “big picture” keep in mind that
the 10 schedules in a master budget are designed to
answer the 10 questions as shown on the next two
slides.
iii. It also bears emphasizing that a master budget is
based on various estimates and assumptions. For
example, the sales budget requires three
estimates/assumptions as follows:
1. What are the budgeted unit sales?
2. What is the budgeted selling price per unit?
3. What percentage of accounts receivable will
be collected in the current and subsequent
periods?
iv. When Microsoft Excel is used to create a master
budget, these types of assumptions can be depicted
in a Budgeting Assumptions tab, thereby enabling
the Excel-based budget to answer “what-if”
questions.
Helpful Hint: Budgets—particularly in large
organizations—can be very complex. To keep the
complexity within bounds, we have simplified the
budgets. Even so, these simplified budgets are intricate,
and the level of detail may be overwhelming to some
students. Emphasize that each step in the process is
fairly simple, but the budgets must fit together for the
plan to be successful. Return to Exhibit 9-2 from time to
time to review the master budget interrelationships.
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II. Preparing the master budget
Learning Objective 2: Prepare a sales budget,
including a schedule of expected cash collections.
A. The sales budget
i. Assume the facts as shown for the Royal Company.
1. The sales budget multiplies the budgeted
sales in units for each month by the selling
price per unit.
a. The total sales budget for the quarter
($1,000,000) is calculated by
multiplying the budgeted sales in
units for the quarter (100,000) by the
selling price per unit ($10).
ii. Assume the information as shown regarding
Royal’s expected cash collections.
1. The first step in calculating Royal’s cash
collections is to insert the beginning
accounts receivable balance ($30,000) into
the April column of the cash collections
schedule.
a. This balance will be collected in full
in April.
2. The second step is to calculate the April
credit sales that will be collected during
each month of the quarter.
a. $140,000 ($200,000 × 70%) will be
collected in April and $50,000
($200,000 × 25%) will be collected
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in May. $10,000 ($200,000 × 5%)
will be uncollectible.
3. The third step is to calculate the May credit
sales that will be collected during each
month of the quarter.
a. $350,000 ($500,000 × 70%) will be
collected in May and $125,000
($500,000 × 25%) will be collected
in June. $25,000 ($500,000 × 5%)
will be uncollectible.
Quick Check – calculating cash collections
4. The fourth step is to calculate the June
credit sales that will be collected during the
month of June.
a. $210,000 ($300,000 × 70%) will be
collected in June.
5. The fifth step is to calculate the total for
each column in the schedule and the total for
the quarter ($905,000).
Learning Objective 3: Prepare a production budget.
B. The production budget (must be adequate to meet
budgeted sales and to provide for the desired ending
inventory)
i. Assume the information as shown to enable the
preparation of Royal’s production budget (If Royal
was a merchandising company it would prepare a
merchandise purchases budget instead of a
production budget).
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1. The first step in preparing the production
budget is to insert the budgeted sales in units
from the sales budget.
2. The second step is to calculate the required
production in units for April (26,000 units).
a. Notice, the desired ending inventory
in units for April (10,000 units) and
the beginning inventory in units for
April (4,000 units).
Quick Check – Calculating required production
3. The third step is to calculate the required
production for May (46,000 units).
a. Notice, April’s desired ending
inventory (10,000 units) becomes
May’s beginning inventory.
4. The fourth step is to calculate the required
production for June (29,000 units).
a. Notice, we are assuming a desired
ending inventory of 5,000 units
(which implies that projected sales in
July are 25,000 units).
5. The fifth step is to complete the “Quarter”
column.
a. Notice, April’s beginning inventory
and June’s ending inventory are
carried over to this column.
Helpful Hint: Many students have a tendency to add up
the inventory amounts instead of using the ending or
the beginning figure. Pointing this out early might
reduce confusion on the part of students.
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