CHAPTER 7
COVERAGE OF LEARNING OBJECTIVES
LEARNING OBJECTIVE / FUNDA-MENTAL
ASSIGN-MENT
MATERIAL / CRITICAL THINKING EXERCISES AND EXERCISES / PROBLEMS / CASES, EXCEL, COLLAB. & INTERNET EXERCISES
LO1: Explain how budgets facilitate planning and coordination. / A1,B1
LO2: Anticipate possible human relations problems caused by budgets. / 25 / 40
LO3: Explain potentially dysfunctional incentives in the budget process. / 22 / 39, 40
LO4: Explain the difficulties of sales forecasting. / 23 / 42 / 49
LO5: Explain the major features and advantages of a master budget. / A1,B1 / 24,26 / 39
LO6: Follow the principal steps in preparing a master budget. / A1,B1 / 29 / 40 / 43,45
LO7: Prepare the operating budget and the supporting schedules. / A1,B1 / 28,29,30,31 / 40 / 43,45,46,48
LO8: Prepare the financial budget. / A1,B1 / 27,29,32,33, 34,35 / 36,37,38 / 43,44,47,48
LO9: Use a spreadsheet to develop a budget (Appendix 7). / 41,42
CHAPTER 7
The Master Budget
7-A1 (60-90 min.)
Note: The first printing of the text has an error. The following four accounts should be changed to the following:
Inventory $ 434,000
Total assets 1,000,000
Accounts payable 489,000
Total liabilities and owners’ equities 1,000,000
1. Exhibit I
BETTERBUY ELECTRONICS, INC.
Mall of America Store
Budgeted Income Statement
For the Three Months Ending August 31, 20X8
Sales $1,500,000
Cost of goods sold (.62 x $1,500,000) 930,000
Gross profit $ 570,000
Operating expenses:
Salaries, wages, commissions $300,000
Other expenses 60,000
Depreciation 7,500
Rent, taxes and other fixed expenses 165,000 532,500
Income from operations. $ 37,500
Interest expense* 6,640
Net income $ 30,860
* See schedule g for calculation of interest.
Exhibit II
BETTERBUY ELECTRONICS, INC.
Mall of America Store
Cash Budget
For the Three Months Ending August 31, 20X8
June July August
Beginning cash balance $29,000 $25,000 $25,443
Minimum cash balance desired 25,000 25,000 25,000
(a) Available cash balance $ 4,000 $ 0 $ 443
Cash receipts & disbursements:
Collections from customers
(schedule b) $ 376,000 $ 607,000 $454,000
Payments for merchandise
(schedule d) (434,000) (248,000) (248,000)
Fixtures (purchased in May) (55,000) - -
Payments for operating
expenses (schedule f) (223,000) (151,000) (151,000)
(b) Net cash receipts & disbursements $(336,000 ) $ 208,000 $55,000
Excess (deficiency) of cash before
financing (a + b) (332,000) 208,000 55,443
Financing:
Borrowing, at beginning of period $ 332,000 $ - $ -
Repayment, at end of period - (202,000) (54,000)
Interest, 10% per annum - (5,557)* (1,083)*
(c) Total cash increase (decrease)
from financing $332,000 $(207,557) $(55,083)
(d) Ending cash balance (beginning
balance + b + c) $ 25,000 $ 25,443 $ 25,360
* See schedule g
Exhibit III
BETTERBUY ELECTRONICS, INC.
Mall of America Store
Budgeted Balance Sheet
August 31, 20X8
Assets Liabilities and Owners’ Equity
Cash (Exhibit II) $ 25,360 Accounts payable $186,000
Accounts receivable* 432,000 Notes payable 76,000**
Merchandise inventory 186,000 Total current liabilities $262,000
Total current assets $643,360
Net fixed assets: Owners' equity:
$168,000 less $511,000 plus net
depreciation of $7,500 160,500 income of $30,860 541,860
Total assets $803,860 Total equities $803,860
*July sales, 20% x 90% x $400,000 $ 72,000
August sales, 100% x 90% x $400,000 360,000
Accounts receivable (to Exhibit III) $432,000
** See schedule g
June July August Total
Schedule a: Sales Budget
Credit sales (90%) $630,000 $360,000 $360,000 $1,350,000
Cash sales (10%) 70,000 40,000 40,000 150,000
Total sales (to Exhibit I) $700,000 $400,000 $400,000 $1,500,000
Schedule b: Cash Collections
June July August
Cash sales $ 70,000 $ 40,000 $ 40,000
On accounts receivable from:
April sales 54,000 - -
May sales 252,000 63,000 -
June sales - 504,000 126,000
July sales - - 288,000
Total collections (to Exhibit II) $376,000 $607,000 $454,000
Schedule c: Purchases Budget May June July August
Desired purchases:
62% x next month's sales $434,000 $248,000 $248,000 $186,000
Schedule d: Disbursements for Purchases June July August
Last month's purchases (to Exhibit II) $434,000 $248,000 $248,000
Other required items related to purchases
Accounts payable, August 31, 2008
(62% x September sales - to Exhibit III) $186,000
Cost of goods sold (to Exhibit I) $434,000 $248,000 $248,000
Schedule e: Operating Expense Budget
June July August Total
Salaries, wages, commissions $140,000 $80,000 $80,000 $300,000
Other Variable expenses 28,000 16,000 16,000 60,000
Fixed expenses 55,000 55,000 55,000 165,000
Depreciation 2,500 2,500 2,500 7,500
Total operating expenses $225,500 $153,500 $153,500 $532,500
Schedule f: Payments for Operating Expenses
June July August
Variable expenses $168,000 $ 96,000 $ 96,000
Fixed expenses 55,000 55,000 55,000
Total payments for operating expenses $223,000 $151,000 $151,000
Schedule g: Interest calculations
June July August
Beginning balance $ 332,000 $ 334,767 $130,000
Monthly interest expense @ 10% 2,767 2,790 1,083
Ending balance before repayment $ 334,767 337,557 131,083
Principal repayment (from
statement of receipts and disbursements) (202,000) (54,000)
Interest payment (5,557) (1,083)
Ending balance $ 130,000 $ 76,000
2. This is an example of the classic short-term, self-liquidating loan. The need for such a loan often arises because of the seasonal nature of a business. The basic source of cash is proceeds from sales to customers. In times of peak sales, there is a lag between the sale and the collection of the cash, yet the payroll and suppliers must be paid in cash right away. When the cash is collected, it in turn may be used to repay the loan. The amount of the loan and the timing of the repayment are heavily dependent on the credit terms that pertain to both the purchasing and selling functions of the business.
7-B1 (60-120 min.) $ refers to New Zealand dollars.
1. See Exhibits I, II, and III and supporting schedules a, b, c, d.
2. The cash budget and balance sheet clearly show the benefits of moving to just-in-time purchasing (though the transition would rarely be accomplished as easily as this example suggests). However, the company would be no better off if it left much of its capital tied up in cash -- it has merely substituted one asset for another. At a minimum, the excess cash should be in an interest bearing account -- the interest earned or forgone is one of the costs of inventory.
Schedule a: Sales Budget January February March
Total sales (100% on credit) $62,000 $70,000 $38,000
Schedule b: Cash Collections
60% of current month's sales $37,200 $42,000 $22,800
30% of previous month's sales 7,500 18,600 21,000
10% of second previous month's sales 2,500 2,500 6,200
Total collections $47,200 $63,100 $50,000
December January February March
Schedule c: Purchases Budget
Desired ending inventory $39,050 $ 6,000* $ 6,000 $ 6,000
Cost of goods sold 12,500 31,000 35,000 19,000
Total needed $51,550 $37,000 $41,000 $25,000
Beginning inventory 16,000 39,050 8,050 6,000
Purchases $35,550 $ - $32,950 $19,000
* Actual ending January (and beginning February) inventory level is 8,050, as inventory levels are drawn down toward desired level of $6,000.
Schedule d: Disbursements for Purchases
100% of previous month's purchases $35,550 $ - $32,950
March 31 accounts payable $19,000
Exhibit I
VICTORIA KITE
Cash Budget
For the Three Months Ending March 31, 2008
January February March
Cash balance, beginning $ 5,000 $ 5,100 $34,692
Minimum cash balance desired 5,000 5,000 5,000
(a) Available cash balance 0 100 29,692
Cash receipts and disbursements:
Collections from customers
(Schedule b) 47,200 63,100 50,000
Payments for merchandise
(Schedule d) (35,550) - (32,950)
Rent (8,050) (250) (250)
Wages and salaries (15,000) (15,000) (15,000)
Miscellaneous expenses (2,500) (2,500) (2,500)
Dividends (1,500) -
Purchase of fixtures - - (3,000)
(b) Net cash receipts & disbursements $ (15,400) $ 45,350 $(3,700)
Excess (deficiency) of cash before
financing (a + b) $(15,400) $ 45,450 $25,992
Financing:
Borrowing, at beginning of period $ 15,500 $ - $ -
Repayment, at end of period - (15,500)
Interest, 10%, compounded monthly - (258)
(c) Total cash increase (decrease)
from financing $ 15,500 $(15,758) $ -
(d) Cash balance, end (beginning
balance + c + b) $ 5,100 $ 34,692 $30,992
Exhibit II
VICTORIA KITE
Budgeted Income Statement
For the Three Months Ending March 31, 2008
Sales (Schedule a) $170,000
Cost of goods sold (Schedule c) 85,000
Gross margin $ 85,000
Operating expenses:
Rent* $16,750
Wages and salaries 45,000
Depreciation. 750
Insurance 375
Miscellaneous 7,500 70,375
Net income from operations $ 14,625
Interest expense 258
Net income $ 14,367
*(January-March sales less $10,000) x .10 plus 3 x $250
Exhibit III
VICTORIA KITE
Budgeted Balance Sheet
March 31, 2008
Assets
Current assets:
Cash (Exhibit I) $30,992
Accounts receivable* 22,200
Merchandise inventory (Schedule c) 6,000
Unexpired insurance 1,125 $60,317
Fixed assets, net: $12,500 + $3,000 - $750 14,750
Total assets $75,067
Liabilities and Stockholders' Equity
Liabilities:
Accounts payable (Schedule d) $19,000
Rent payable. 16,000
Dividends payable 1,500 $36,500
Stockholders' equity** 38,567
Total liabilities and stockholders' equity. $75,067
*February sales (.10 x $70,000) plus March sales (.40 x $38,000) = $22,200
**Balance, December 31, 2007 $25,700
Add: Net income. 14,367
Total $40,067
Less: Dividends declared. 1,500
Balance, March 31, 2008 $38,567
7-1 Budgeting 1) provides an opportunity for managers to reevaluate existing activities and evaluate possible new activities, 2) compels managers to think ahead by formalizing their responsibilities for planning, 3) aids managers in communicating objectives to units and coordinating actions across the organization, and 4)provides benchmarks to evaluate subsequent performance.
7-2 Budgeting is primarily attention directing because it helps managers to focus on operating or financial problems early enough for effective planning or action.
7-3 Strategic planning covers no specific time period, is quite general, and often is not built around financial statements. Long-range planning usually has a 5- or 10-year horizon and consists of financial statements without much detail. Budgeting usually has a horizon of one year or less, and consists of financial statements with much detail.
7-4 Continuous budgets add a month (or quarter) in the future as the month (or quarter) just ended is dropped. Therefore, the continuous budget provides a continually updated budget looking twelve months ahead. When the new month (or quarter) is added, the budget for the remainder of the current year may also be revised. When companies revise the budgets for the remainder of the current year, they usually compare subsequent results to the original budget (a fixed target) in addition to comparing them to the latest revised budget.
7-5 If the measures used to reward employees in the performance evaluation system are not aligned with the goals of the company, the incentives from the evaluation system may lead employees to take actions that conflict with the interests of the company.
7-6 Lower-level managers bias their forecasts to create budgetary slack or padding. Upper-level managers adjust for this bias in creating a revised budget. Therefore, lower-level managers introduce additional bias to compensate for the adjustment that will be made by upper-level managers, and upper-level managers introduce additional adjustments. This cycle can quickly destroy the potential benefits of budgets.
7-7 A manager may make short-run decisions to increase profits that are not in the company’s best long-run interests, such as offering customers excessively favorable credit terms or cutting discretionary expenditures such as R&D and advertising, trading future sales for current profits. In the extreme, manager might choose to falsely report inflated profits.
7-8 First, by moving this year's sales into next year or moving next year's expenses into this year, the manager ensures a higher level of reported profit (and probably a higher bonus) next year. Second, by decreasing this year's income, the manager avoids ratcheting up of performance expectations in setting the bonus target for the next year.
7-9 Budgeted performance is better than past performance as a basis for judging current performance because the budget contains no hidden inefficiencies and can be founded on current rather than past economic conditions.
7-10 Budgets are especially important in environments that are rapidly changing. They force managers to look forward and plan for change. Budgets force analysis of the factors that are bringing about the changes.
7-11 No. When budgeting in done correctly, it is an important aid to managers. Managers need time to plan and coordinate their various activities. Budgeting forces them to take time from the day-to-day problems and focus on longer-term issues.
7-12 The sales forecast is the starting point for budgeting because all other operating activities of the company are affected by the volume of sales.
7-13 The sales forecast is influenced by past patterns of sales, estimates made by the sales force, general economic conditions, competitors' actions, changes in prices, market research studies, and advertising and sales promotion plans.
7-14 An operating budget is used as a guide for production and sales and it focuses on the income statement. A financial budget is used to control the receipt and disbursement of funds and it focuses on the statement of cash receipts and disbursements.
7-15 Operating expenses are costs charged to the income statement in a particular period. Some operating expenses may be associated with the sales of the period, and others may be costs of being in business for the period. Disbursements for these operating expenses, that is, the cash payments for them, may come in a previous period (assets purchased in one period and depreciated over future periods) or a future period (wages accrued in a period but paid in the next period), as well as during the period.
7-16 A cash budget is an attempt to regulate the flow of cash in optimum fashion.
7-17 Budgeting will be effective only if it is accepted by those managers who are responsible for controlling costs. Since their performance will be measured against the budget, they must be educated in the assumptions underlying the budget and convinced of its objectivity and relevance.
7-18 Both functional and activity-based master budgets begin with the forecasted demand for products or services. However, whereas functional budgets then determine the inventory, materials, labor, and overhead budgets, the activity-based budget focuses on determining the demand for key activities. This demand is measured by the cost-driver unit for each activity. Then the budgeted resource consumption rates are used to set the budgets for resources such as materials, labor, and overhead. The focus on activities and consumption rates in activity-based budgeting is what managers believe offers value from an operational control perspective.