Strategy and the Master Budget

2

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3

• Describe the role of budgets in the overall management process

• Discuss the importance of strategy and its role in the master budgeting process

• Provide an overview of the budgeting process

• Prepare a master budget and explain the interrelationships among its supporting schedules

Learning Objectives

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• Identify unique budgeting characteristics of service firms, international firms, and not-for-profit organizations

• Understand zero-base, activity-based, and kaizen approaches to budgeting

• Discuss the application of integrated budgeting and planning tools

• Discuss the role of ethics and behavioral considerations in budgeting

Learning Objectives (continued)

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A budget:

– is a financial or nonfinancial expression of a plan of action for a specified period

– identifies the resources and commitments required to achieve the organization’s goals for an upcoming period

Budgeting:

– The process of preparing a budget is called budgeting

Basic Terminology

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• The starting point in the budget-preparation process is specification of the organization’s strategy

• An organization expresses its strategic goals and long-term objectives in its capital and master budgets

• Long-range planning often entails capital budgeting, which is a process for evaluating, selecting, and financing major projects, such as purchases of new factory equipment and construction of a new factory

Strategic Goals and Long-term Objectives

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The master budget:

– Represents the “grand plan of action” for an upcoming period

– Translates the organization’s short-term objectives into action steps

– Culminates in the preparation of a set of pro-forma financial statements

– Communicates to employees and managers alike the expectations of top management

– Helps coordinate subunit activities

The Master Budget

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The master budget is made up of operating and financial budgets:

– Operating budgets are plans that identify resources needed to carry out the budgeted activities, such as sales and services or production

• Operating budgets include production, purchase, personnel, and marketing budgets

– Financial budgets identify sources and uses of funds for the budgeted operations

• Financial budgets include the cash budget, budgeted statement of cash flows, the budgeted balance sheet, and the capital expenditures budget

The Master Budget (continued)

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The Budgeting Process

• The budget committee is the highest authority in an organization for all matters related to the budget

• Determination of the budget period:

–Generally, a fiscal year with sub-period budgets prepared for each quarter or month

–A continuous (rolling) budget is a budget system that has a budget for a set number of months, quarters, or years at all times–as one period ends another is added

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Three-step process:

(1) Define the “bottom-line” information contained in the budget (e.g., sales for the upcoming period)

(2) Determine what this information is a function of (e.g., budgeted unit sales, budgeted selling price/unit)

(3) Put together information in a user-friendly way

Preparing Individual Budgets

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The sales budget is often referred to as the cornerstone of the entire master budget

The sales budget has two components:

– Forecasted sales volume

– Budgeted selling prices

Sales Budget

12

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13

Sales Budget (continued)

April May June Quarter

Sales in units 20,000 25,000 35,000 80,000

Selling price

per unit x $30 x $30 x $30 x $30

Total sales $600,000 $750,000 $1,050,000 $2,400,000

Kerry Industrial CompanySales Budget

For the Quarter Ended June 30, 2007

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• After the sales budget, we prepare a production budget, which shows planned production for a given period

• Budgeted production can be calculated through use of the following formula:

Production Budget

Budgeted Budgeted Desired BeginningProduction Sales Ending Inventory(in units) (in units) Inventory (in units) (in units)

Budgeted Budgeted Desired BeginningProduction Sales Ending Inventory(in units) (in units) Inventory (in units) (in units)

= + –

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Production Budget (continued)

Kerry example:

(1) Beginning inventory (April 1) = 5,000 units

(2) Desired ending inventory (April 30th) = 30% of the following month’s projected unit sales

(3) The sales budget has total sales for May at 25,000 units.

Kerry example:

(1) Beginning inventory (April 1) = 5,000 units

(2) Desired ending inventory (April 30th) = 30% of the following month’s projected unit sales

(3) The sales budget has total sales for May at 25,000 units.

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Production Budget (continued)

22,500 20,000 7,500 5,000

22,500 20,000 7,500 5,000

= + –

Desired ending level at April 30:

30% x 25,000 units (May sales) = 7,500 units Desired ending level at April 30:

30% x 25,000 units (May sales) = 7,500 units

Inventory from April 1: 5,000 units

Inventory from April 1: 5,000 units

From theSales Budget

Budgeted production for AprilBudgeted production for April

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Production Budget (continued)

April May June QuarterBudgeted sales in units 20,000 25,000 35,000 80,000 Desired ending inventory 7,500 10,500 12,000 12,000 Units needed 27,500 35,500 47,000 92,000 Beginning inventory 5,000 7,500 10,500 5,000 Budgeted production 22,500 28,000 36,500 87,000

Kerry Industrial CompanyProduction Budget

For the Quarter Ended June 30,2007April May June Quarter

Budgeted sales in units 20,000 25,000 35,000 80,000 Desired ending inventory 7,500 10,500 12,000 12,000 Units needed 27,500 35,500 47,000 92,000 Beginning inventory 5,000 7,500 10,500 5,000 Budgeted production 22,500 28,000 36,500 87,000

Kerry Industrial CompanyProduction Budget

For the Quarter Ended June 30,2007

30% of June’s budgeted sales30% of June’s budgeted sales

July sales are budgeted at 40,000 units: 30% × 40,000 = 12,000 units.

July sales are budgeted at 40,000 units: 30% × 40,000 = 12,000 units.

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Direct Materials Budgets

The direct materials usage budget:

– Shows the amount (and cost) of direct materials required for budgeted production

– The last line of the production budget = first line of the direct materials usage budget

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Direct Materials Budgets (continued)

The direct materials purchases budget:

– Contains budgeted purchases, in units and dollars, of direct materials for the upcoming period

– Is needed to complete the direct materials usage budget (i.e., provides unit cost data)

– Is a function of: materials required for production (from materials usage budget), target ending inventory of materials, beginning-of-period materials inventory, budgeted purchase price per unit of raw material

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Materials Purchases Budget: Kerry Company

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Direct Labor Budget

• Enables the personnel department to plan for hiring & repositioning of employees, based on production needs

• Is prepared for each class (type) of labor, e.g., skilled and semi-skilled

• Is a function of:

– Budgeted output (from production budget)

– Standard labor hours per unit of output

– Standard wage rate per hour

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Direct Labor Budget (continued)

• Kerry uses 0.5 hours of semiskilled labor and 0.2 hours of skilled labor per unit @ standard wage rates of $8

and $12 per hour, respectively

23

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24

Direct Labor Budget: Kerry Company

Each unit of output requires 0.5 hours of semi-skilled labor @ $8.00/hour, and 0.2 hours of skilled labor @ $12.00/hourEach unit of output requires 0.5 hours of semi-skilled labor @ $8.00/hour, and 0.2 hours of skilled labor @ $12.00/hour

April May June QuarterBudgeted production 22,500 28,000 36,500 87,000 Semi-skilled labor costs 90,000$ 112,000$ 146,000$ 348,000$ Skilled labor costs 54,000 67,200 87,600 208,800 Total labor costs 144,000$ 179,200$ 233,600$ 556,800$

Kerry Industrial CompanyDirect Labor Budget

For the Quarter Ended June 30, 2007

22,500 × 0.5 × $8.00 = $90,000 22,500 × 0.2 × $12.00 = $54,000

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Cost of Goods Manufactured & CGS Budgets

• The cost of goods manufactured and CGS budgets are prepared after the factory overhead budget is prepared

• The income statement budget and the balance sheet use information from this budget

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Kerry Company: Cost of Goods Manufactured & CGS Budgets,

April 2007

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The selling and general administrative expenses

budget is now prepared:

– This budget includes all the planned expenditures for selling and general administrative activities

– Many of the expenses included in this budget are considered discretionary and are a likely place for spending cuts

– Managers must be careful not to focus solely on short-term affects when making cuts in these areas (e.g., customer-service expenditures)

Selling & Administrative Expense Budget

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Kerry Company--Cash Receipts Budget: April 2007

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The cash budget brings together the cash effects of all budgeted activities--to ensure that the firm has adequate cash on hand:

–This budget generally has three sections:– Cash available– Cash disbursements, and – Financing

–Preparation of this budget involves careful review of all other budgets to identify cash inflows and outflows

Cash Budget

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Kerry Company—Cash Budget: April 2007

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The budgeted income statement (I/S) and

budgeted balance sheet (B/S) can then be

prepared using all the aforementioned budgets:

– The budgeted I/S describes the expected operating income for the upcoming period

– The budgeted B/S, the last budget in the budget-preparation process, incorporates the effects of all operations and cash flows during the budget period and shows projected ending balances in asset, liability, and equity accounts

Budgeted I/S and B/S

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• These firms have different operating characteristics, operating environments, and considerations than those of manufacturing and merchandising firms

• Service firms are different due to the absence of production or merchandise purchase budgets and their ancillary budgets–the focus of the budgeting process must be personnel planning:

– Does the firm have sufficient staff and resources to provide the expected level of service output in the upcoming period?

– Do staff members have the appropriate skills?

Budgeting in Service Companies

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• International firms face additional challenges due to cultural and language differences, dissimilar political and legal environments, fluctuating monetary and exchange rates, and discrepancies in inflation rates of different countries

• NFPs have no single bottom-line that serves as a verifiable goal in budgeting; there is no clear standard by which to measure performance

– The budget shows estimated revenues and planned activities–the budget must show the organization can at least break-even

Budgeting in International Firms and Not-for-Profit (NFP) Organizations

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Zero-base budgeting (ZZB) is a budgeting process that requires managers to prepare budgets from a zero base

– This type of budgeting allows no activities or functions to be included in the budget unless managers can justify their needs

– In-depth reviews and analyses of all budget items make managers aware of activities and functions that have outlived their usefulness

– Can be a difficult and time-consuming process

Alternative Budgeting Approaches

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• Activity-based budgeting (ABB) is a budgeting process based on activities and cost drivers of operations:– Starts with the budgeted output and segregates costs

required for the budgeted output into homogeneous cost pools

– Can be a simple extension of a firm’s ABC system • Kaizen (Continuous improvement) budgeting:

– Incorporates continuous improvement expectations into the budgets

– Promotes active engagement in reforming and altering business practices and processes

Alternative Budgeting Approaches (continued)

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• Budgetary slack, or padding the budget, is the practice of managers knowingly including a higher amount of expenditures or a lower amount of revenue in a budget

• Spending the budget is another issue; managers often feel if they do not use all the resources they receive, next year’s budget may be cut

• Goal congruence is a term that refers to the degree of consistency between goals of the firm, its subunits, and its employees

– Involving employees in the budgeting process fosters goal congruence

Behavioral Issues in Budgeting

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• Difficulty level of the budget target?– An easy budget may fail to encourage employees to give their

best efforts, while a very difficult target can be discourage managers from even trying

– A “highly achievable target” is suggested with incentives for exceeding the budgeted figures

• Authoritative or participative budgeting?– Top-down budgeting is referred to as authoritative

budgeting– Bottom-up budgeting is referred to as participative

budgeting– Effective budgeting processes often combine the two types

Behavioral Issues in Budgeting (continued)

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• A budget is a financial or nonfinancial expression of an organization’s plan of action for a specified period; it identifies the resources and commitments required to achieve the organization’s goals for the period identified

• Strategy is the starting point in preparing its plans and budgets

• The “grand plan of action” for an upcoming period is the organization’s Master Budget

Summary

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Components of a master budget for a manufacturing firm include: – Sales budget– Production budget– Direct materials usage budget– Direct materials purchases budget– Direct labor budget– Factory overhead budget– Budgeted cost of goods manufactured/cost of goods sold

budgets– Selling and general administrative expenses budget– Cash receipts budget– Cash budget– Budgeted income statement (I/S), and – Budgeted balance sheet (B/S)

Chapter Summary (continued)

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Summary (continued)

• Service companies, international firms, and not-for-profit (NFP) firms have different operating characteristics, operating environments, and considerations than those of manufacturing and merchandising firms

• ZBB, ABB, and kaizen are three alternative approaches to budgeting that can improve budgeting effectiveness

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Summary (continued)

Budgets are only as effective as those responsible for their preparation and implementation

– Managers must be aware of the potential for budgetary slack and “budget spending”

– Participative budgeting often increases motivation in employees

42

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.

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• CONTACT:• 0322-3385752• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

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