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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.
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Chapter Overview
I. HOW STRATEGIC PLANNING INCREASES COMPETITIVENESS
II. OVERALL PLAN
• Organization Goals
III. HUMAN ELEMENT IN BUDGETING
• Value of Employee Participation
IV. DEVELOPING THE MASTER BUDGET: WHERE TO START?
• Sales Forecasting
o Sales Staff
o Market Researchers
o Delphi Technique
o Trend Analysis
o Econometric Model
V. COMPREHENSIVE ILLUSTRATION
• Forecasting Production
• Forecasting Production Costs
o Direct Materials
o Direct Labor
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
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Chapter Overview, continued
XII. BUDGETING IN RETAIL AND WHOLESALE ORGANIZATIONS
XIII. BUDGETING IN SERVICE ORGANIZATIONS
XIV. ETHICAL PROBLEMS IN BUDGETING
XV. BUDGETING UNDER UNCERTAINTY
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Chapter Outline
LO 13-1 Understand the role of budgets in overall organization plans.
• The budget is a financial plan of the resources needed to carry out activities and meet
financial goals.
o A recent study shows that small businesses rely on budgets to help manage cash flow,
HOW STRATEGIC PLANNING INCREASES COMPETITIVENESS
• Critical success factors are strengths of a company that enable it to outperform competitors.
o By identifying critical success factors and ensuring that they are incorporated into the
OVERALL PLAN
• A master budget is made up of three components:
o The organization goals
• Organization Goals
o Organization goals are a company’s broad objectives established by management that
employees work to achieve.
• Strategic Long-Range Profit Plan
o The strategic long-range profit plan is a statement detailing steps to take to achieve a
• Master Budget (Tactical Short-Range Profit Plan): Tying the Strategic Plan to the Operating
Plan
o 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.
o Budgeting is a dynamic process that ties together goals, plans, decision making, and
employee performance evaluation.
o Exhibit 13.1 shows the master budget and its relationship to other plans, accounting
reports, and management decision-making processes.
o Benchmarking is the continuous process of measuring products, services, or activities
against competitors’ performance.
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LO 13-2 Understand the importance of people in the budgeting process.
HUMAN ELEMENT IN BUDGETING
• Although budgets are often viewed in purely quantitative, technical terms, managers’
personal goals and values will affect their beliefs about the coming period.
• Value of Employee Participation
o 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
DEVELOPING THE MASTER BUDGET: WHERE TO START?
• All budgeting processes share some common elements.
o After organization goals, strategies, and long-range plans have been developed, work
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LO 13-3 Estimate sales.
• Sales Forecasting
o 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.
o Sales Staff
▪ 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
o Market Researchers
▪ Market researchers do not have the same incentives that sales personnel have to bias
the budget.
o Delphi Technique
▪ 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.
▪ Differences among individual forecasts can be addressed and reconciled without
involving the personality or position of individual forecasters.
o Trend Analysis
▪ 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.
o Econometric Model
▪ Econometric models are statistical methods of forecasting economic data using
regression models.
COMPREHENSIVE ILLUSTRATION
• To illustrate the discussion of the budgeting process, the budget for Santiago Pants, a
manufacturer, is developed.
o A manufacturing example because it includes most aspects of a firm’s operations.
Units in ending
Units in beginning
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LO 13-4 Develop production and cost budgets.
• Forecasting Production
o 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.
• 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
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• Forecasting Production Costs
o Direct Materials
▪ 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.
• 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
o Direct Labor
▪ 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.
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o Overhead
▪ Overhead is composed of many different types of costs with varying cost behaviors.
▪ Exhibit 13.5 presents a sample schedule of budgeted manufacturing overhead.
o 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.
• Completing the Budgeted Cost of Goods Sold
o 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
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• Revising the Initial Budget
o The budget usually undergoes a good deal of coordinating and revising before it is
considered final.
MARKETING AND ADMINISTRATIVE 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.
o 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.
PULLING IT TOGETHER INTO THE INCOME STATEMENT
• The budgeting process culminates in the projected operating profits reported in the budgeted
income statement, as shown in Exhibit 13.8.
o The budgeted income statement also includes estimated federal and other income taxes.
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KEY RELATIONSHIPS: THE SALES CYCLE
• The master budget is rooted in some key relations among sales, accounts receivable, and cash
flows in the sales cycle. That is,
Sales
Accounts receivable
Cash
BB
BB
LO 13-5 Estimate cash flows.
USING CASH FLOW BUDGETS TO ESTIMATE CASH NEEDS
• The cash budget refers to a statement of cash on hand at the start of the budget period,
expected cash receipts, expected cash disbursements, and the resulting cash balance at the
end of the budget period.
sales
sales
account
Other receipts
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• Multiperiod Cash Flows
o A more detailed analysis looks at multiperiod cash receipts (Exhibit 13.10) and cash
disbursements (Exhibit 13.11) to ensure that the company will not run out of cash during
the year. (See Business Application box “The Curse of Growth.”)
LO 13-6 Develop budgeted financial statements.
PLANNING FOR THE ASSETS AND LIABILITIES ON THE BUDGETED BALANCE
SHEETS
• Budgeted balance sheets are statements of budgeted financial position.
BIG PICTURE: HOW IT ALL FITS TOGETHER
• A model of the budgeting process for a manufacturing firm is presented in Exhibit 13.13.
LO 13-7 Explain budgeting in merchandising and service organizations.
BUDGETING IN SERVICE ORGANIZATIONS
• Budgeting is used extensively in different types of organizations.
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▪ Because of the critical importance of timing and seasonality in merchandising, special
attention is usually given to short-term budgets. The budget helps formalize an
ongoing process of coordinating buying and selling.
• A key difference in the master budget of a service enterprise is the absence of
product or material inventories. Neither a production budget (for manufacturing
firms) nor a merchandise purchases budget (for merchandising firms) is needed.
• Service businesses need to carefully coordinate sales with the necessary labor.
Managers must ensure that personnel with the right skills are available at the right
times.
o In governmental organizations, the budget serves as an expression of the legislature’s
desires and is a legally binding authorization. (See Business Application box “Budget Is
the Law in Government.”)
LO 13-8 Explain why ethical issues arise in budgeting.
ETHICAL PROBLEMS IN BUDGETING
• Budgeting creates serious ethical issues for many people.
• Managers and employees provide much of the information for the budget. Their performance
then is compared with the budget they help develop.
• The company must recognize the trade-off between encouraging unbiased reporting by local
managers and the use of this information in performance evaluation and reward.
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LO 13-9 Explain how to use sensitivity analysis to budget under uncertainty.
BUDGETING UNDER UNCERTAINTY
• Formal planning models allow many alternatives and options to be explored in the planning
process.
o Any projection of the future is uncertain.
▪ Managers often perform sensitivity analysis on their projections.
• By asking and answering hypothetical questions during the planning phase,
management can determine the risk of various phases of its operations and can
develop contingency plans.
o The incorporation of uncertainty into budget estimates can be quite useful.
▪ Spreadsheets are extremely useful in preparing budgets, which require considerable
what-if thinking.
Matching
A.
Budget
H.
Organization goals
B.
Budgeted balance sheets
I.
Participative budgeting
C.
Cash budget
J.
Production budget
D.
Critical success factors
K.
Profit plan
E.
Delphi technique
L.
Strategic long-range plan
F.
Econometric models
M
Trend analysis
G.
Master budget
_____ 1. A statement of cash on hand at the start of the budget period, expected cash receipts,
expected cash disbursements, and the resulting cash balance at the end of the budget
period.
_____ 2. A company’s broad objectives established by management that employees work to
achieve.
_____ 3. Strengths of a company that enable it to outperform competitors.
_____ 4. A forecasting method in which individual forecasts of group members are submitted
anonymously and evaluated by the group as a whole.
_____ 5. The financial plan of an organization for the coming year or other planning period.
_____ 6. The use of input from lower- and middle-management employees for budget
preparation.
_____ 7. The income statement portion of the master budget.
_____ 8. A forecasting method that ranges from simple visual extrapolation of points on a
graph to highly sophisticated computerized time series analysis.
_____ 9. Statistical methods of forecasting economic data using regression models.
_____ 10. A financial plan of the resources needed to carry out activities and meet financial
goals.
_____ 11. A statement detailing steps to take to achieve a company’s organization goals.
_____ 12. The production plan of resources needed to meet current sales demand and ensure
that inventory levels are sufficient for future sales.
_____ 13. Statements of budgeted financial position.
Matching Answers
1. C
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Multiple Choice
1. Which of the following statements is correct?
a. Critical success factors are strengths of a company that enable it to outperform
competitors.
b. The strategic long-range profit plan is a statement detailing steps to take to achieve a
company’s budget.
c. The master budget is a long-range financial plan of an organization.
d. Budgeting is a static process.
2. Which of the following method(s) can be used to extract sales forecast?
a. Delphi technique
b. Trend analysis
c. Econometric models
d. All of the above
3. Jim is preparing the production budget for his company. He estimates that 21,000 units have
to be produced to meet the sales forecast of 18,000 units and the desired ending inventory of
4,000 units. How many units should be in the beginning inventory?
a. 750 units
b. 800 units
c. 1,000 units
d. 1,200 units
4. For next year, 21,000 units of finished goods have to be produced, each consuming 3 units of
materials at $6. The expected beginning and ending materials inventories are 8,000 units and
12,000 units, respectively. How much is expected to be spent for materials purchases next
year?
a. $360,000
b. $372,000
c. $390,000
d. $402,000
5. For next year, 21,000 units of finished goods have to be produced, each requiring 1.5 hours
of labor. The prevailing hourly rate is expected to be $12 per hour. What is the direct labor
cost for next year?
a. $332,000
b. $356,000
c. $378,000
d. $412,000
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6. Which of the following statements is not correct?
a. To simplify the budgeting process, overhead costs are usually divided into fixed and
variable components.
b. Most companies estimate work-in-process inventories.
c. The budget usually undergoes a good deal of coordinating and revising.
d. Budgeting marketing and administrative costs is very difficult because managers have
discretion about how much money is spent and the timing of the expenditures.
7. The following information is available.
Cash collected from current month’s sales
40%
Cash collected from last month’s sales
55%
Uncollectible sales
5%
100%
The expected credit sales of the second quarter are:
April
$400,000
May
450,000
June
500,000
How much cash will be collected in May?
a. $360,000
b. $400,000
c. $420,000
d. $480,000
8. The following information is available.
Cash payment for current month’s purchases
30%
Cash payment for last month’s purchases
67%
Cash discount taken
3%
100%
The expected credit purchases of the second quarter are:
April
$180,000
May
250,000
June
300,000
How much cash will be paid in May?
a. $184,500
b. $195,600
c. $200,750
d. $221,400
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9. Which of the following statements is not correct?
a. A key difference in the master budget between a service enterprise and a manufacturing
firm is the absence of product or material inventories.
b. Service businesses need to carefully coordinate sales with the necessary labor.
c. The purchase budget in retail and wholesale businesses drives the rest of the budgeted
income statement.
d. A merchandiser has no production budget.
10. Which of the following statements is correct?
a. Managers and employees provide much of the information for the budget.
b. Performance of managers and employees is compared with the budget they help develop.
c. The company must recognize the trade-off between encouraging unbiased reporting by
managers and the use of this information in performance evaluation and reward.
d. All of the above.
11. Participative budgeting:
a. Relies on input from top management for budget preparation.
b. Is also called grass root budgeting.
c. Is efficient and expedient.
d. Prevents employees from accepting the goals of their organization.
12. Which of the following statements is correct?
a. Sales forecast can be done after sales budget is prepared.
b. Market researchers are concerned with short-term sales.
c. Salespeople have an incentive to bias their sales forecasts.
d. Delphi technique encourages participants to identify themselves and foster
communication.
Multiple Choice Answers
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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.
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Demonstration Problem 1 – 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
Units to be produced
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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:
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.
Demonstration Problem 2 – 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
Add: Desired ending inventory
3,200
Total direct materials needs
Less: Beginning inventory
Direct materials to be purchased
Unit cost
$ 30
Total cost of direct materials to be purchased
$1,626,000
Total materials cost
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Demonstration Problem 3
Emerson Manufacturing Company produces two products: Model S and Model Z. The following
income statement shows this year’s operating results.
Emerson Manufacturing Company
Income Statement
For the year ended December 31
Revenue:
Model S
$300,000
Model Z
200,000
$500,000
Cost of goods sold:
Model S
150,000
Model Z
120,000
(270,000)
Gross margin
$230,000
Operating costs:
Marketing
60,000
Distribution
50,000
Depreciation
21,000
Administration
30,000
(161,000)
Operating income
$ 69,000
Emerson’s management is in the process of preparing next year’s budget. The following
information is under consideration.
1. The selling price of Model S is expected to remain the same, but the units sold will
increase by 6 percent
2. The selling price and units of Model Z will increase by 5 percent and 10 percent,
respectively.
3. As indicated by the suppliers of key components, the cost of each unit sold will increase
by 3 percent.
4. Marketing costs are expected to increase by $20,000.
5. Distribution costs remain the same fixed percentage of total sales revenue.
6. Depreciation costs remain unchanged.
7. A new administrative aide will be hired part time for $25,000.
8. There is no beginning or ending inventory.
Required:
Prepare a budgeted income statement for next year.
Demonstration Problem 3 – Solution
Emerson Manufacturing Company
Budgeted Income Statement
For the budget year ended December 31
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Demonstration Problem 4
The management at Emerson Manufacturing Company is studying the cash inflow pattern in
preparation for its cash budget. The following information is available.
Cash collected from current month’s sales
40%
Cash collected from last month’s sales
55%
Cash discount taken
2%
Uncollectible sales
3%
100%
For the second quarter of next year, the beginning balance of accounts receivable ($23,000) is
expected to be collected in full in April. The expected credit sales of the second quarter are:
April
$40,000
May
45,000
June
50,000
Required:
Prepare a multi-period schedule of cash collections for the second quarter of next year.
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Demonstration Problem 4 – Solution
Emerson Manufacturing Company
Multiperiod Schedule of Cash Collections
For the quarter ended June 30