Chapter 07 - Planning for Profit and Cost Control

Answers to Questions

Budgets are useful for large companies with complex activities as well as small companies. Budgets act as a vehicle for communication by formalizing management’s plans in a document that communicates company objectives. The benefits associated with this kind of planning apply to all sizes of companies operating at all levels of complexity.

The budget represents the companywide plans stated in financial terms as to how to coordinate operating activities to accomplish goals and objectives. Accordingly, its success depends upon the combined effort of all of the parties involved. A committee that includes representatives from all pertinent departments is necessary to formulate the master budget.

The three levels of planning are as follows:

(1)Strategic planning – the long-run planning activities that address issues such as overall company goals and objectives.

(2)Capital budgeting – the intermediate financial planning activities of the entire company that concern investments, product selection, and desired profitability.

(3)Operations budgeting – the short-run financial planning for the company’s different departments that culminates in the formation of a master budget.

The span of time is the primary factor that distinguishes the three levels of planning from each other. Strategic planning involves long-range decisions; capital budgeting is associated with intermediate-range plans; and operational budgeting is concerned with short-range plans.

The perpetual budget has the advantage of keeping management involved in the budget process. Too often budgets are prepared and forgotten. The perpetual budget forces management to maintain a constant focus on the company’s goals and objectives.

The primary advantages associated with budgeting are as follows:

Planning – formalizes management’s plans in a document that communicates company objectives.

Coordination – forces departments to coordinate their activities in a manner that ensures the attainment of the objectives of the whole company.

Performance measurement – represents specific, quantitative standards that can be used to evaluate performance.

Corrective action – acts as an early warning system that promotes corrective action.

Budgeted amounts represent management’s expectations regarding how the firm as a whole and individual departments within the firm should perform. By comparing actual performance with the expected performance (the budgeted amounts), managers can be effectively evaluated.

Mr. Shilov’s failure with budgets seems to stem from his misunderstanding of the human element. He states that “he made budgets.” Experience shows that, in general, employees are more willing to accept budget standards if they participate in the budgeting process. Further, Mr. Shilov appears to have used the budget as a tool for punishment – a basis for reprimanding employees. As a result, employees would resent the budget and would be unmotivated to accomplish budget standards.

A master budget consists of a series of detailed schedules and budgets that describe the overall financial plans for the forthcoming accounting period.

The sales forecast normally functions as the starting point for the development of the master budget. Clearly, production and other related activities depend upon the level of sales.

The desired level of ending inventory must be added to projected sales in order to determine the amount of goods that are needed during the period. The beginning inventory is subtracted from the amount of goods needed in order to determine the amount of goods to be produced. Managing inventory is important because an inventory shortage can result in customer dissatisfaction and loss of sales. Conversely, excess inventory ties up capital investment, creates unnecessary storage cost, and is subject to obsolescence or spoilage. Finding the balance between too much and too little inventory is essential to the profitability of a company.

The cash budget is composed of three major components:

(1)Cash receipts – expected cash inflows from sales, sale of investments, and borrowing activities, etc.

(2)Cash payments – expected cash outflows for inventory purchases, selling and administrative expenses, and purchases of investments, etc.

(3)Financing activities – expected borrowing and repayment activities.

Determining the amount of the cash balance to include on the budgeted balance sheet is an insignificant reason for preparing a cash budget. The real purpose of preparing a cash budget is to enable a company to effectively manage its financing and investing activities. If the company can foresee a cash surplus then investment opportunities can be investigated to earn interest or debt can be repaid to reduce interest. If the company anticipates a cash shortage, appropriate sources of financing can be investigated to avoid possible bankruptcy. When dealing with large amounts of money, investing, borrowing, and repayment activities that involve interest can be critical to profitability.

The pro forma income statement provides information about the expected profitability of the company. The completion of this statement is dependent on the departmental operating budgets. For example, the sales budget provides information about projected sales revenues, the purchases budget provides information as to projected cost of goods sold, the selling and administrative expenses budget provides information about projected operating expenses, and the cash budget provides information as to expected interest revenue and expense.

The cash budget, like the pro forma statement of cash flows, provides information as to expected cash receipts and cash payments, but in addition it shows how a firm plans to effectively manage its cash through financing and investing activities.

Exercise 7-1A

Ms. Weller appears to be a person with an attitude problem. She does not understand how to involve her colleagues in the budgeting process. She degrades their input and uses the budget as a tool for criticism. In so doing, Ms. Weller has failed to gain the support of upper-level management. The attitudes of upper-level management will have a significant impact on the effectiveness of the budget. Subordinates develop a keen awareness of management's expectations. If upper-level managers degrade, make fun of, or ignore the budget, subordinates will rapidly follow suit. If budgets are used to humiliate or embarrass subordinates, they will resent the treatment and the budgeting process that enables it. To be effective, upper-level management must accept and portray the budget as a sincere effort to express realistic goals that employees will be expected to accomplish. The proper atmosphere is essential to budgeting success. Once a negative pattern has been established, it is difficult to change. Perhaps the most effective solution in this case is to replace Ms. Weller.

Exercise 7-2A

Sales Budget
January / February / March
Cash sales / $ 60,000 / $ 66,000 / $ 72,600
Sales on account / 140,000 / 154,000 / 169,400
Total budgeted sales / $200,000 / $220,000 / $242,000

b.The amount of sales revenue appearing on the 1st quarter income statement is the sum of the monthly amounts ($200,000 + $220,000 + $242,000 = $662,000).

Exercise 7-3A

Schedule of Cash Receipts / July / August / September
Current cash sales / $ 80,000 / $ 85,000 / $ 90,000
Plus collections from accounts receivable / 100,000 / 90,000 / 108,000
Total budgeted collections / $180,000 / $175,000 / $198,000

b.The current month’s sales on account will be collected in the following month. Accordingly, the amount of accounts receivable at the end of September is equal to September’s sales on account ($129,600).

Exercise 7-4A

1st Quarter / 2nd Quarter / 3rd Quarter / 4th Quarter
East Div. / $150,000 / $156,000 / $162,240 / $168,730*
West Div. / 250,000 / 255,000 / 260,100 / 265,302
South Div. / 200,000 / 210,000 / 220,500 / 231,525
Total / $600,000 / $621,000 / $642,840 / $665,557

*Rounded

1st Quarter / 2nd Quarter / 3rd Quarter / 4th Quarter
Total / $600,000 / $621,000 / $642,840 / $665,557

Exercise 7-5A

a.Sales for January are expected to be $560,000 ($800,000 x 0.70)

Beginning accounts receivable balance / $120,000
January sales on account / 560,000
Available for collection / 680,000
Less: Ending accounts receivable balance / (82,000)
Cash collected / $598,000

b.It is reasonable to assume that sales will decline in January. Customers tend to buy merchandise in December for Christmas gifts and to cut back on buying in January immediately after Christmas.

Exercise 7-6A

Sales would likely be highest in late January or early February because of Valentine’s Day sales. October may also produce higher sales due to buying for Halloween. Other holiday seasons are also likely to boost sales. Accordingly, sales would be high in April for Easter, and November and December for Christmas and Hanukah. Months that would be lower would be May and June. Summer months may pick up due to children being out of school and in the malls. Similarly, sales would be expected to drop off in August and September when school reopens.

Exercise 7-7A

Inventory Purchases Budget
January / February / March
Budgeted cost of goods sold / $60,000 / $ 64,000 / $70,000
Plus:Desired ending inventory / 6,400 / 7,000 / 8,000
Total inventory needed / 66,400 / 71,000 / 78,000
Less:Beginning inventory / 6,000 / 6,400 / 7,000
Required purchases (on account) / $60,400 / $ 64,600 / $71,000

Exercise 7-7A (continued)

b.The amount of cost of goods sold appearing on the first quarter pro forma income statement is the sum of the monthly amounts ($60,000 +$64,000 + $70,000 = $194,000).

c.Since the quarter ends on March 31, the ending inventory for March is also the ending inventory for the quarter, $8,000.

Exercise 7-8A

Schedule of Cash Payments for Inventory Purchases
April / May / June
Payment for current accounts payable / $126,000 / $144,000 / $171,000
Payment for previous accounts payable / 8,000 / 14,000 / 16,000
Total budgeted payments for inventory / $134,000 / $158,000 / $187,000

b.Since 90% of the current purchases on account are paid in cash during the month of purchase, 10% will remain payable at the end of the month,$19,000 ($190,000 x 0.10).

Exercise 7-9A

a.Budgeted cost goods sold for July is $420,000($400,000 x 1.05)

Ending inventory balance / $ 32,000
Budgeted cost of goods sold / 420,000
Total inventory needed / 452,000
Less: Beginning inventory balance / (30,000)
Budgeted purchases / $422,000

June’s payables balance paid in July / $ 36,000
Cash paid for July purchases ($422,000 x 0.70) / 295,400
Projected cash payments for July / $331,400

Exercise 7-10A

a. An inventory purchases budget prepared with the sales manager's estimate:

1st Quarter / 2nd Quarter / 3rd Quarter / 4th Quarter
Sales / $450,000 / $360,000 / $320,000 / $540,000
Cost of goods sold / $270,000 / $216,000 / $192,000 / $324,000
Plus: Desired ending inventory / 21,600 / 19,200 / 32,400 / 36,000
Total inventory needed / 291,600 / 235,200 / 224,400 / 360,000
Less: Beginning inventory / 30,000 / 21,600 / 19,200 / 22,440
Required purchases / $261,600 / $213,600 / $205,200 / $337,560

b. An inventory purchases budget prepared with the marketing consultant's estimate:

1st Quarter / 2nd Quarter / 3rd Quarter / 4th Quarter
Sales / $600,000 / $480,000 / $420,000 / $700,000
Cost of goods sold / $360,000 / $288,000 / $252,000 / 420,000
Plus: Desired ending inventory / 28,800 / 25,200 / 42,000 / 36,000
Total inventory needed / 388,800 / 313,200 / 294,000 / 456,000
Less: Beginning inventory / 30,000 / 28,800 / 25,200 / 42,000
Required purchases / $358,800 / $284,400 / $268,800 / $414,000

Exercise 7-11A

Schedule of Cash Payments for S&A Expenses
Oct. / Nov. / Dec.
Equipment lease expense / $7,500 / $ 7,500 / $ 7,500
Prior month's salary expense, 100% / 0 / 8,200 / 8,700
Cleaning supplies / 2,800 / 2,730 / 3,066
Insurance premium / 7,200 / 0 / 0
Rent / 1,700 / 1,700 / 1,700
Miscellaneous expenses / 700 / 700 / 700
Total payments for S&A expenses / $19,900 / $20,830 / $21,666
Depreciation is a noncash charge.

Exercise 7-11A

b.Since salaries expense is paid in the month following the month it is incurred, the amount payable at the end of December will be the amount of salary expense incurred in December, $9,000.

c. Since the insurance premium is prepaid for 6 months on October 1, the amount of prepaid insurance at the end of December will be $3,600 [$7,200 – ($1,200 x 3)].

Exercise 7-12A

a.Budgeted payments for January:
Sales commissions / $40,000
Rent / 24,000
Miscellaneous / 2,000
Total* / $66,000

*The amount of utilities is not included because the cash payment will be made in February. The amount of depreciation is not included because the depreciation does not require a cash payment. Recall that cash is paid at the time of purchase rather than when the depreciation is recognized.

b.The full $8,000 balance for the utilities charge will remain payable at the end of January.

c.The problem implies that the monthly charge for depreciation is $4,000. Accordingly, the amount of depreciation to be recognized on an annual income statement would be $48,000 ($4,000 x 12).

Exercise 7-13A

Cash Budget / July / August / September
Section 1: Cash receipts
Beginning cash balance / $ 50,000 / $ 20,000 / $ 20,000
Add cash receipts / 180,000 / 200,000 / 240,600
Total cash available (a) / 230,000 / 220,000 / 260,600
Sections 2: Cash Payments
For inventory purchases / 165,500 / 140,230 / 174,152
For S&A expenses / 54,500 / 60,560 / 61,432
For interest exp at 1% per month / 0 / 1001 / 1092
Total budgeted disbursements (b) / 220,000 / 200,890 / 235,693
Sections 3: Financing Activities
Cash surplus (shortage) (a – b=c) / 10,000 / 19,110 / 24,907
Borrowing (repayment) (d–c) / 10,000 / 890 / (4,907)
Ending cash balance (d) / $ 20,000 / $ 20,000 / $ 20,000

110,000 x 1% = 100 (rounded)

2(10,000 + 890) x 1% = 109 (rounded). Note that $4,907 is repaid at the end of month, in addition to interest, that still has to be paid in September.

b.Cash flow from operating activities is equal to total (i.e., sum of the monthly amounts) cash receipts from customers minus the total (i.e., sum of the monthly amounts) of cash payments for inventory, S&A expense, and interest [i.e., $620,600 – ($220,000 + $200,890 + $235,693) = ($35,983) net cash outflow.]

c.Cash flow from financing activities is the amount borrowed less repayments (i.e., $10,000 + $890 – $4,907 = $5,983 net cash inflow.)

Exercise 7-14A

Cash Collections
Collections from May’s receivables balance / $ 80,000
Collections from June’s credit sales ($500,000 x .80) / 400,000
Cash sales from June / 200,000
Total cash receipts / $680,000
Desired cash balance / 30,000
Cash disbursements / 660,000
Total cash needs / 690,000
Cash shortage (amount needed to be borrowed) / $ 10,000

b.The interest expense for June is $0 because the loan is taken at the end of June.

c.The interest expense for July is $75 ($10,000 x 9% ÷ 12).

Exercise 7-15A

a. Pro forma income statement prepared with Mr. Meier’s estimate:

1st Quarter / 2nd Quarter / 3rd Quarter / 4th Quarter / Total
Sales revenue / $194,400 / $216,000 / $226,800 / $280,800 / $918,000
Cost of goods sold / 116,640 / 129,600 / 136,080 / 168,480 / 550,800
Gross profit / 77,760 / 86,400 / 90,720 / 112,320 / 367,200
S. & Adm. expenses / 19,440 / 21,600 / 22,680 / 28,080 / 91,800
Net income / $ 58,320 / $ 64,800 / $ 68,040 / $ 84,240 / $275,400

b. Pro forma income statement prepared with Ms. Odom's estimate:

1st Quarter / 2nd Quarter / 3rd Quarter / 4th Quarter / Total
Sales revenue / $189,000 / $210,000 / $220,500 / $273,000 / $892,500
Cost of goods sold / 113,400 / 126,000 / 132,300 / 163,800 / 535,500
Gross Profit / 75,600 / 84,000 / 88,200 / 109,200 / 357,000
S & A expenses / 18,900 / 21,000 / 22,050 / 27,300 / 89,250
Net income / $ 56,700 / $ 63,000 / $ 66,150 / $ 81,900 / $267,750

c.Forecasting is not likely to be 100% accurate. Therefore, different executive officers within the same company may have different estimates about the future. In addition to legitimate differences caused by honest opinions, self-interest may also contribute to differences. For example, AshleyOdom may want to establish low budgetary figures for sales because these figures will become the standards for the evaluation of Ashley's future performance. With low standards, she would have a better chance of reaching the standards.

Problem 7-16A

a.Pro forma income statement assuming 5% growth:

Budget
Sales revenue / $2,100,000
Cost of goods sold / 1,312,500
Gross profit / 787,500
Selling & administrativeexpenses / 472,500
Net income / $ 315,000

b.Pro forma income statement with 10% growth:

Actual Result
Sales revenue / $2,200,000
Cost of goods sold / 1,375,000
Gross profit / 825,000
Selling & administrativeexpenses / 495,000
Net income / $ 330,000

Excess of actual net income over budget:

$330,000 – $315,000 = $15,000

Bonus: $15,000 x15% = $2,250

c.Pro forma income statement assuming 15% growth:

Budget
Sales revenue / $2,300,000
Cost of goods sold / 1,437,500
Gross profit / 862,500
Selling & administrativeexpenses / 517,500
Net income / $ 345,000

d. Zero

Problem 7-16A (continued)

e.The process of participative budgeting is recommended. This process requires two-way communication between the president and divisional vice presidents. Any disagreement about the budget assumptions should be fully discussed and pros and cons well considered. If the president believes that the divisional budget is unrealistic, he should tell the vice president directly and explain the reasons. Participative budgeting is more than just a budget proposal from a subordinate and a review and final decision by the superior. The process described in the problem is nothing but gamesmanship.

Problem 7-17A

Sales Budget / January / February / March / Total
Sales on account / $240,000 / $252,000 / $264,600 / $756,600

b.Sales revenue for the quarter is equal to the sum of the monthly amounts ($240,000 + $252,000 + $264,600 = $756,600).

c.
Schedule of Cash Receipts / January / February / March
Receipts from January sales / $168,000
Receipts from January sales / $ 48,000
Receipts from January sales / $ 24,000
Receipts from February sales / 176,400
Receipts from February sales / 50,400
Receipts from March sales / 185,220
Total / $168,000 / $224,400 / $259,620

Schedule of Cash Receipts / January / February / March / April / May
Receipts from January sales / $168,000
Receipts from January sales / $ 48,000
Receipts from January sales / $ 24,000
Receipts from February sales / 176,400
Receipts from February sales / 50,400
Receipts from February sales / $25,200
Receipts from March sales / 185,220
Receipts from March sales / 52,920
Receipts from March sales / $26,460
Total / $168,000 / $224,400 / $259,620 / $78,120 / $26,460

The accounts receivable as of March 31, 2015 is equal to the amount due to be collected in April and May from the first quarter sales, $104,580($78,120 + $26,460).

Problem 7-18A

Inventory Purchases Budget / April / May / June
Budgeted cost of goods sold / $75,000 / $68,000 / $60,000
Plus desired ending inventory / 6,800 / 6,000 / 9,000
Inventory needed / 81,800 / 74,000 / 69,000
Less beginning inventory / 3,600 / 6,800 / 6,000
Required purchases (on account) / $78,200 / $67,200 / $63,000

b.Since the quarter ends on June 30, the ending inventory for June is also the ending inventory for the quarter (i.e., $9,000).

Schedule of Cash Payments / April / May / June
Payment of current accounts payable / $46,920 / $40,320 / $37,800
Payment of previous accounts payable / 14,800 / 31,280 / 26,880
Total budgeted payments for inventory / $61,720 / $71,600 / $64,680

d.Since 60% of the current purchases on account are paid in cash during the month of purchase, 40% will remain payable at the end of the month (i.e., $63,000 x .40 = $25,200).

Problem 7-19A

Schedule of Cash Payments for S&A Expenses
July / August / September
Salary expense / $24,000 / $24,000 / $24,000
Prior month's sales commissions, 100% / 0 / 2,000 / 2,000
Supplies expense / 360 / 390 / 420
Prior month's utilities, 100% / 0 / 1,100 / 1,100
Rent / 6,600 / 6,600 / 6,600
Miscellaneous / 690 / 690 / 690
Total payments for S&A expenses / $31,650 / $34,780 / $34,810
Depreciation is a noncash charge.

b.Since utilities are paid in the month following the month they are incurred, the amount payable at the end of September will be the amount of utilities expense incurred in September which is $1,100.

c.Since sales commissions are paid in the month following the month they are incurred, the amount payable at the end of September will be the amount of sales commissions expense incurred in September which is $2,000.

Problem 7-20A

This is a typical problem for what-if analysis. Students can use a computerized spreadsheet to try different possible scenarios.

The budgeted net income for the next year: $580,000x115%= $667,000

Assume x = Desired sales

Sales – Cost of goods sold – S&A = NI

X – 0.7 X – ($60,000 + .10 X) = $667,000

.20 X – $60,000 = $667,000

X = $3,635,000

Alternatively, you can use the contribution margin ratio to determine sales.

Contribution margin ratio = Sales (100%) – Variable costs (80%) = 20%

(Net income + Fixed cost) ÷ CM ratio

= ($667,000+$60,000)÷ 20% = $3,635,000

Pro Forma Income Statement
Sales revenue / $3,635,000
Cost of goods sold / 2,544,500
Gross profit / 1,090,500
Selling & admin. expenses / 423,500*
Net income / $ 667,000

*($3,635,000 x 10% + $60,000) = $423,500

% increase required: ($3,635,000 – $3,200,000) ÷ $3,200,000 = 13.59% (rounded)

Problem 7-20A (continued)

Budgeted cost of goods sold with a 2% cut: $2,240,000 x 98% = $2,195,200

Budgeted gross profit: $3,200,000 – $2,195,200= $1,004,800

The budgeted level of selling and administrative expenses:

$1,004,800– $667,000 = $337,800

Pro Forma Income Statement
Sales revenue / $3,200,000
Cost of goods sold / 2,195,200
Gross profit / 1,004,800
Selling & admin. expenses / 337,800*
Net income / $ 667,000

*The figure means that management has to cut the selling and administrative expenses by $42,200 ($380,000 – $337,800) in order to reach the president’s goal.

Projected sales revenue to increase by 15%:

$3,200,000 x 115%= $3,680,000

Projected cost of goods sold: $3,680,000 x 70% = $2,576,000

Pro Forma Income Statement
Sales revenue / $3,680,000
Cost of goods sold / 2,576,000
Gross profit / 1,104,000
Selling & admin. expenses / 460,000
Net income / $ 644,000

Since the projected net income under the given scenario will be only $644,000, which is short of the original $667,000, the company cannot reach its goal.