RIGOS CMA REVIEW

PART 2 - CHAPTER 1

BUDGETING

I. INTRODUCTION TO PLANNING AND CONTROL

     The material in this chapter is tested on the CMA exam at Level C, which means that the candidate is responsible for demonstrating knowledge, comprehension, application, analysis, synthesis, and evaluation.

     A. Planning and Control Cycle

     Planning is the selection of goals, predicting potential results under alternative means of achieving the goals, and a decision on which alternative to implement. Control is the performance evaluation that provides feedback of the results. Planning is the first step in control, and control is the last step in planning. Planning establishes the goals and objectives of the firm. Planning is oriented toward the future. It is the first part of the budget cycle to assign resources to operating units. Control tries to ensure that the objectives are met, thus it is both oriented toward both the present and the past. Planning and control are continuous and interdependent.

     B. Hierarchy of Planning

     There are many different lists of terms describing the hierarchy of planning. Very few companies would have plans labeled with all the levels given below. The major thing to remember is that planning is a continuum from long-term and large scale to immediate and detailed. All the parts of an organization's planning must fit together no matter what the various parts are called.

          1. Mission and Strategic Goals: The mission of an organization is its central purpose, the reason for its existence. It answers the questions "What business are we in?" or "What business do we want to be in?" This may seem like an obvious question, but it isn't always easy to answer. A company can meander from one thing to another on its way to failure if it doesn't know what business it is really in. Strategic goals are the major goals that relate to the company's mission. The mission defines the broad goals that are compatible with the company's mission. There are generally goals related to such things as profitability, market share, service and product quality, employee development, and community service.

          2. Strategic Objectives and Plans: Goals, objectives, plans, etc., are related terms that may vary from organization to organization. The process of translating long-range plans into short-term action is what is important. Strategic plans are company-wide plans with a long planning horizon, sometimes as much as ten to thirty years. Many companies have a "5-Year Plan" which is revised annually with a new year added each time. In for-profit companies, a major part of strategic planning would be profit related. Capital budgeting has a strategic component in that the decision whether or not to build a new factory will affect the company's profits for many years.

          3. Tactical Objectives and Plans: These plans translate overall strategy into shorter range specifics for each division, department, etc. They contain more detail and are more action-oriented.

          4. Operational Objectives and Plans: These plans are very detailed implementation of the company's strategy. They are annual plans with specific objectives for individual operating units. These plans include what we think of separately as budgets and financing plans. For some companies these may be the only parts of overall planning that are formal written documents.

          5. Contingency Plans: These plans are sometimes called disaster recovery plans to be implemented in case of fire, flood, power outages, etc. Planning before a catastrophe can result in a quicker response in the midst of chaos.

     C. Effective Control Systems

     An effective control system is necessary for an organization to realize its strategic, tactical, and operational goals. Control points that are placed so that potential problems are identified before they occur have much more strategic value than "after-the-fact" identification of problems. An effective control system:

          1. Measurement of Progress: Monitors activities and processes so that progress can be measured against established strategic goals and objectives,

          2. Corrective Action: Provides for identification of deviations from desired performance so that implementation of timely corrective action can occur, and

          3. Adaptation to Change: Has the flexibility to be updated to allow for changing conditions.

     D. Types of Controls

          1. Preliminary (Feedforward) Controls: These are used to control input resources prior to the organizational transition process. They are designed to prevent problems from occurring.

          2. Screening (Concurrent) Controls: These are used to monitor the ongoing transformation process to ensure that organizational standards and goals are being met.

          3. Post-Action (Feedback) Controls: These are used after completion of the transformation process to determine if and where corrective action needs to be taken.

     E. Benchmarking

     A benchmark is a point of reference from which measurements can be made. It serves as a standard of comparison. Benchmarking, therefore, is the process of identifying products and services, organizational activities, functions and processes that represent "best practice" (i.e., the benchmark) to be strived for and attained. It is a continuous evaluation process and is an essential element of quality audits and gap analysis. Benchmarks can be used in establishing reasonable goals when creating budgets.

II. BUDGETING OVERVIEW

     A. Formal Plan

     A budget is a formal statement of an organization's plans for a period of time expressed in quantitative terms. It is used to guide an entity toward reaching its operational goals and is, therefore, an important element of overall planning and control. Financial and qualitative issues must be considered along with the quantitative data to ensure that all aspects of company operations are included in profit planning.

     B. Communication and Coordination

     Budgets are an aid to communication, coordination, and implementation of the plan. Everyone knows what to expect and what is expected of them. The very process of budget development facilitates communication and coordination between departments such as marketing and production.

     C. Evaluation Tool - Budget Report

     The budget is an objective standard against which performance can be evaluated.

          1. Budget/Variance Report: A budget/variance report typically will show budgeted figures, actual results, and any differences between the two. These differences are variances which must be analyzed to determine why they arose, if significant. (Variances are studied in detail in Part 2, Chapter 5-Performance Measurement.) Variance analysis will help management determine whether budget figures need to be revised to meet changing conditions or whether corrective action needs to be taken to bring operations back into line.

          2. Motivation: Budgets should also have a motivating dimension. For more discussion on this topic, see the later section in this chapter, "Behavioral Aspects of Budgeting."

     D. Top Management Commitment

     To be effective, budgets require top management commitment. Many companies have a budget committee consisting of the president and heads of the major functional areas such as sales, production, marketing, distribution, and finance. This committee sets policy, coordinates the budget preparation process, and monitors variance reports. It may also approve the final budget and thus authorize the action necessary for its implementation.

     E. Essential Planning Element

     Small firms tend to control activities through direct observation by the owner, with a very informal budget process. The budget might not even be written. This lack of formal planning makes its contribution to small (and sometimes not-so-small) company failure. A major function of a formal budget process is that it forces management to plan. Planning helps anticipate problems so action can be taken before the situation reaches crisis proportions. If planning is not done, managers can find themselves spending all of their time "fire-fighting", while the business muddles its way into bankruptcy.

III. CONCEPTUAL ASPECTS OF BUDGETING

     A. Roles of Budgeting

     Budgets serve many purposes, not all of them in the same company, but at least some of them in each company, whether or not the participants are aware of them. (Use the acronym PREMECC to help to remember them.)

          1. Planning: Budgets make concrete the details of management's goals by assigning resources to them: time, labor and materials.

          2. Ritual: The budget can play an important role in the development of organizational cohesiveness. However, if management is only going through the motions, it is a waste of time and money.

          3. Evaluation: Budgets can assist in measuring the achievement of goals. Feedback is provided by comparing the actual results to the planned budget. When sales are not at the predicted level, flexible budgets should be used to compare actual results with the results that should have been achieved at that sales level.

          4. Motivation: Budgets can help develop the desire to achieve goals. This can depend on how employees are involved in the budget process and whether or not they feel the goals are achievable. (See Section IV - Behavioral Aspects of Budgeting.)

          5. Education: Participants in the budget process can learn about the interrelationships in the organization, in the production process, in cost behavior, etc.

          6. Coordination: The process of developing the budget itself facilitates coordination among departments such as marketing, production, purchasing, etc.

          7. Communication: The budget helps communicate plans and goals within the company. However, the budget must be a clear communications device. It will do no good if it is filed as soon as it is received, because the recipient doesn't understand what all the pages of numbers mean.

     B. Environments of Budgeting

     Budgeting is not done in a vacuum. It is affected by the environment inside and outside the company. Many facets of the environment can not be controlled by the company, but must be taken into account when developing the budget to be able to achieve the desired results.

          1. Economic: Many microeconomic and macroeconomic factors affect the budget process from outside the company. These must be taken into consideration when developing the sales budget. As we saw above, the sales budget is critical to the entire budget process.

          2. Organization: Under the law a corporation is an artificial person who can sue and be sued. Over time a company develops a "personality", a collection of ways of doing things, a "corporate culture". This must be considered when designing a budget system, just as it would be considered when trying to accomplish anything within the company.

          3. Behavior: People bring with them into the company their own personalities and ways of doing things. How they react determines the effectiveness of budgets in evaluation and motivation.

     C. Management Decisions on the Budget Process

     When developing the budget process, decisions need to be made as to which methods and procedures fit best with the overall management style of the company. The budget process needs to be consistent with the management style in order to have credibility. These choices are neither right nor wrong. Neither are they an either/or decision. Each is a continuum and the company needs to find the place on each where it is most comfortable.

          1. What to Budget?          Annual/Master versus Project

               a. Annual/Master Budget: An annual/master budget is the detailed financial blueprint, expressed in monetary terms, to plan for the future of the company during the next year, to achieve the goals and objectives established in the planning process.

               b. Project Budget: A project budget specifies the amount and distribution of resources allocated to a project. A project is a one-time undertaking having definable starting and ending points, with specified objectives. Project budgets include budgets for undertakings such as construction of a factory, design and implementation of new information technology, and research on a potential new product. Project budgets cover short or long time periods, depending on the project. For example, a capital budget might last five or more years.

          2. What Level of Detail?          Line Items versus Programs

               a. Line Items: This is the old familiar format where each expense, etc., has a dollar amount. This type of budgeting is high on control, leaving limited flexibility for the manager once the budget is approved.

               b. Programs: In this type of budget, a lump sum is allocated for a program and the manager has considerable freedom in spending it to carry out the program function. This type is very low on control, which could give top management hysterics, if they did not have the right kind of corporate culture.

          3. How to Estimate Budget Items?          Incremental versus Zero-Based

               a. Incremental: This is a relatively quick and simple method where a percentage increase or decrease is added to or subtracted from last year's budget. The problem with this method is that past over or underfunding is never corrected. For example, a person or department that no longer performs a useful function continues on indefinitely. Grossly overworked departments tend to scream loudly and may thus receive special adjustments outside of the regular budget process.

               b. Zero-Based: With this method each budget item must be prioritized and justified as if it were brand new. Each item is built up from a zero dollar basis. This can be very time consuming, if it is done correctly. It also requires a serious commitment from top management. Some companies do full zero-based budgeting only every five years, to gain some of the benefits without so much time and expense. Many federally-funded programs require the use of zero-based budgeting.

          4. Who Sets the Budget?          Authoritarian/Top-Down versus Participative

               a. Authoritarian/Top-Down/Imposed: Top management imposes the budget on the organization. Top management may feel this is quicker and gives them more control; however, the control may be illusory if lower level employees do not "buy" the budget goals. If they do not feel the budget is attainable, they may try to meet the goals only hard enough to avoid being adversely noticed by their supervisor.

               b. Participative/Bottom-Up: All levels of management are involved in the budget process. If the managers who are responsible for costs have a major part in planning those costs, they then have a stake in meeting the budget and will work harder to justify their planning. A drawback of participative budgeting is that budgets may not align between units or with organizational strategies.

     D. Kaizen Budgeting

     The Kaizen concept and its relationship to continuous improvement are included in Part 3, Chapter 1-Strategic Planning. In kaizen budgeting, continuous improvement is built into the budget figures. This is accomplished by incorporating targets into the budget that reflect expected cost reductions or increased productivity over the budget period. For example, the direct labor hours budget for a three-month period could include an expected reduction in standard labor hours per unit of product or production run. Thus, the standard input in the second month of the budget period would be less than in the first month, and so on.

     E. Continuous/Rolling Budgets

     Some companies use a continuous, or rolling, budget. At the end of an incremental budget period such as a month or a quarter, a budget is added for that corresponding period one year or more ahead. This process results in always having a budget on hand for the next 12 or more months. Continuous/rolling budgets force management to keep looking outward to a stable planning horizon and to engage in shorter planning cycles. As a result, management would be more likely to focus on increased growth or problem situations earlier than would otherwise be the case. Additionally, a continuous budget would reflect the latest outlook for the next budget period, thus making the budget a more realistic and achievable plan.

     F. Contingency Budgeting

     As its name implies, this is budgeting to provide resources should possible negative events occur, such as fire, flood, labor action, breakdown of equipment (particularly computers), etc. Contingency planning is a topic in Part 3, Chapter 1-Strategic Planning.

     G. Activity-Based Budgeting

     This is an approach to budgeting in which a budget for each identified activity is developed, each with its separate operational driver identified. Thus, a larger set of cost drivers is included in the budget.

IV. BEHAVIORAL ASPECTS OF BUDGETING

     A. Goal Congruence

     Budgets are effective in planning and control to the extent that there is unified understanding and acceptance of the objectives, the mechanics, and the uses of budgeting. Goal congruence is the alignment of employees' and management's attitudes and actions such that all parties are acting as a unified whole toward achieving the objectives of the organization. There are two aspects of this congruence.

          1. General Management Style: The budgeting procedures instituted should be congruent with the philosophy of the general management style present in the organization. For example, participatory budgeting procedures are not congruent with an authoritarian, top-down management style. Any attempt to institute participatory budgeting in such a situation would be doomed to failure as employees would be suspicious of management's motives and management would find it difficult to accept input from employees.

          2. Congruent Activities: Employees need to be encouraged to behave in such a way as to increase the likelihood that the organization's objectives will be met. This requires a budgeting environment and procedures that are based on respect for the input of all parties involved. For example, budgetary slack (or padding) is often introduced into a budget at departmental or program levels. This behavior is based on a history of across-the-board percentage cuts off the top of submitted budgets. This scenario sets up a "budgetary slack spiral," with more slack leading to more cuts leading, in turn, to more slack, etc. The actions of the budget participants are not congruent in the overall organizational objective of developing an effective budget that can be a reliable and usable planning and control tool.

          3. Management by Objective (MBO): Management by Objective (MBO) is a systematic method for linking organizational strategies and goals to their implementation. Managers negotiate a contract of individual goals, or key results/targets, with their subordinates. The subordinates are then responsible for developing and implementing activities to achieve the goals. Desirable characteristics of an MBO program include:

• Identification of Precise Objectives That Are Measurable
  
• Clear Relationship Between Individual and Organizational Goals
  
• Active Employee Participation in Setting Objectives
  
• Performance Evaluation Based on Goal Achievement

     B. Controllability and Performance Evaluation

     For budgets to be effective in motivating performance, managers should be held responsible for budget items over which they have control.

          1. Controllable Revenues and Costs: These are revenues and costs which can be incurred, changed, or influenced in some way by the management level being evaluated.

          2. Uncontrollable Revenues and Costs: These are revenues and costs which cannot be incurred, changed, or influenced in any way by the management level being evaluated.

     C. Participatory Budgeting

     Budgets are effective when those who are responsible for carrying out plans and whose performance will be measured against the outcomes of those plans participate in the process of budget development. Furthermore, the more employees participate in the budget process, the more they will be aware of the objectives of the organization and issues that affect the attainment of those objectives.

          1. Advantages: The following are potential advantages to be obtained from participatory budgeting methods and procedures:

               a. Internalization: There is an increased likelihood that a participant will internalize the objectives of the budget, leading to congruence with the organization's goals. Furthermore, as an employee's input is utilized, it is seen to be valued, morale is improved and a resulting enhanced self-image should spur productivity.

               b. Acceptance: Employees are more willing to accept and comply with a budget that they have helped to compile. Furthermore, they are more accepting of the evaluation process that is tied to the budget.

               c. Attainable Objectives: Participatory budgeting should allow for the development of more realistically attainable (practical) goals and standards. When goals are imposed from the top or are too rigid or rigorous (e.g., they are theoretical rather than practical goals), the employees are not motivated to perform to levels that they view as unattainable. Morale suffers and hostility and defeatist attitudes result.

          2. Disadvantages: Participatory budgeting works well in organizations where the corporate culture is committed to and encourages the interchange of ideas. Some potential disadvantages follow.

               a. Inefficiency: Employee participation is valuable to the extent it enhances the development of a realistic budget. Inclusion of more people than is useful in the process leads to inefficiency, delays, and the examination of irrelevant information. The process should not get out of control just for the sake of using the participatory style.

               b. Manipulation (Budgetary Slack and Decoy Projects): It is important that those involved in the budget should understand the need for willingness to compromise and to work as a team member. Individuals may be too enamored of their own individual agenda to be constructive in the budget process. Budgetary slack and adding decoy projects are two examples of manipulative tactics that individuals participating in the budget process may engage in to obtain an advantage.

               c. Loss of Control: As the budget process is opened up, there may be actual (or a sense of) a reduction in control. Implementation of participatory budgeting needs to be carefully planned and monitored so that essential controls are not lost.

     D. Departmental Budgeting

     Departmental budgeting is budgeting at the departmental level. It involves the allocation of resources to a department for use in meeting operational objectives as the department sees fit.

          1. Positive Impact on Behavior: When implemented appropriately, the following are likely positive behavioral issues related to departmental budgeting:

               a. Goal Congruence: Since each department will be involved in the planning process, there is likely to be better understanding and acceptance of overall goals, thereby improving the planning process.

               b. Communication and Coordination: Since departments are generally interdependent, the process of planning and preparing departmental budgets will necessitate greater communication and coordination among departments.

               c. Responsibility and Accountability: As planning becomes more formalized and goals and duties more clearly defined, lines of responsibility and accountability become more distinct.

          2. Negative Impact on Behavior: The following are potentially negative issues related to departmental budgeting:

               a. Fear of Punishment: If budgeted targets are not met, the increased accountability and responsibility that go hand in hand with departmental budgeting might generate fear of punishment. Departmental managers who have set the objectives against which they will be measured might be more inclined to pressure departmental employees to meet goals.

               b. Loss of Control: As in the previous discussion on participatory budgeting, there may be concerns over loss of control when budgeting is done at the departmental level.

     E. Implementation of New System

     When an organization implements a new budgeting procedure, there will be the normal apprehension about and resistance to change. The following steps can be taken to gain maximum acceptance of the new system:

          1. Management Support: Provide evidence that the new procedure has the commitment and support of top management.

          2. Communication: Increased communication with all affected employees explaining the reasons for the change.

          3. Feedback: Provide feedback channels and be responsive to employee questions and suggestions.

          4. Flexibility: Change budgetary restrictions when conditions change.

V. DEVELOPING AN ANNUAL/MASTER BUDGET

     A. Introduction

          1. Annual/Master Budget: The master budget is the detailed financial blueprint, expressed in monetary terms, to plan for the future of the company during the next year, to achieve the goals and objectives established in the planning process. It is driven by the sales forecast and management policy in such areas as how much inventory to keep on hand, how tight credit policies should be, how soon accounts payable should be paid, etc. The master budget is an interrelated set of budgets: sales, production, cash, capital expenditures, and pro forma financial statements.

          2. Order of Development: The order in which a budget is developed is of substantial importance. An inventory budget cannot be developed unless expected sales information is known. Likewise, a raw materials budget cannot be prepared unless production estimates have been determined. Also critical to the budgeting process is the ability to make reasonable estimates. Sales, production, and other estimates made in one budget will impact others. As a result, estimation errors may render much of the master budget unrealistic. A schematic of the budget development process is presented in Figure 2-1 of the text.

     B. Budget Development Process

          1. Sales Forecast and Budget: The rest of the budget is dependent upon the sales budget. Many factors are considered in forecasting the sales budget: the state of the economy, the level of competition, production capacity, management's policies on credit terms, pricing, advertising and sales promotions, etc.

               a. Many Factors: Because of the many varying factors that impact the sales forecast, the sales budget is considered to be the most difficult budget to do. Both qualitative and quantitative measures can be used. In selecting a forecasting technique, it is important to consider the cost of developing the forecast vs. the level of accuracy required. Sometimes, two techniques may be used independently to generate a forecast.

               b. Qualitative Measures: These are subjective analyses, based on judgment and opinion. They are useful when quantitative data are not available or are obsolete, or when there is insufficient time to prepare a quantitative forecast. Common techniques include:

                    1) Executive Opinions: Top management meets and collectively develops a forecast, drawing upon the expertise of each member.

                    2) Composite Opinion of Sales Staff: The sales staff prepares a forecast based on its contact with customers.

                    3) Consumer Surveys: A forecast is prepared based on results of surveys of consumer opinion.

                    4) Outside Opinion: The firm may seek expert opinions from outside consultants in specialized areas in order to prepare a forecast.

                    5) Managers' and Staff Opinions: A forecast may be developed from opinions solicited from managers and staff persons. The Delphi Method, whereby questionnaires are distributed to knowledgeable individuals whose replies remain anonymous, is sometimes used to eventually develop a consensus forecast. This method can utilize expertise of many individuals while eliminating the need to assemble and avoiding group pressure to conform. However, it may lead to a false consensus if questions are improperly designed so as to be ambiguous or misleading.

               c. Quantitative Measures: Quantitative measures involve objective analysis of numeric data. The two main approaches are Time Series and Associative Models. (Quantitative approaches to forecasting are discussed in more detail in Part 1, Chapter 5-Quantitative Methods.)

                    1) Time Series Models: These examine historical data and incorporate assumptions that the future can be predicted from the past. Fluctuations in data can be smoothed using moving averaging. Seasonal trend can be handled using exponential smoothing. This latter approach uses a double averaging technique to adjust the data for trend.

                    2) Associative Models: These use a mathematical equation that is developed to predict values of the variable of interest. Simple and Multiple Regression are the techniques most commonly used.

          2. Production Budget: Once the sales budget has been determined, a retail concern would develop a purchases budget to plan for acquisition of inventory. It is first done in units and then unit costs are applied to arrive at budgeted costs. In a manufacturing concern, the production budget must be calculated so that there will be sufficient goods available to sell and to maintain desired ending inventory levels. If management wants consistent utilization of production facilities, inventory may be increased during the year to allow for seasonal fluctuations in sales. The production budget is done in physical units. The basic format is ending inventory units desired plus units for current period's activity less units on hand at the beginning of the current period. This is demonstrated in Example 1 below.

          3. Direct Materials Budget: This budget provides for materials purchases to meet the production budget and to maintain the raw materials inventory. This budget is done first in units (pounds, pieces, gallons), then the units are multiplied by the cost per unit. The total cost flows to the cash budget.

          4. Direct Labor Budget: This is the labor required for the production budget. Again the budget is done first in units (hours) and then multiplied by the cost per unit for the cash budget.

          5. Factory Overhead Budget: This budget includes all of the costs to produce the goods, except for the direct materials and direct labor costs. This total will be analyzed into fixed and variable costs to be allocated to production (see Part 2, Chapter 3-Cost Assignment). The total costs will also be a part of the cash budget.

          6. Cost of Goods Sold Budget: This reflects the information provided by the manufacturing budgets identified above as well as the budgeted changes in finished goods inventories.

          7. Selling and Administrative Expense Budget: This budget contains all of the other costs to operate the company that are not included elsewhere. The selling expense part impacts the sales budget in the area of advertising and sales promotions. This budget would be done by department (accounting, personnel, president's office, marketing, research and development, etc.) and then summarized into the selling and administrative budget.

          8. Capital Expenditures Budget: This budget plans the purchasing of capital assets as they are needed. Capital budgeting is performed independently of other elements of the master budget. The results of the analysis of capital investment alternatives determine which capital acquisitions to make, however, and are incorporated into the overall budgeting process through the capital expenditures budget. So that the funds will be available when required, this budget is also coordinated with the cash budget. (For the decision analysis aspects, see Part 3, Chapter 5-Investment Decisions.)

          9. Cash Budget: This is arguably the most important budget and is certainly tested the most frequently on the examination. It consists of three schedules: cash receipts, cash disbursements, and summary balances.

               a. Cash Receipts Schedule: The major component of cash receipts are cash sales and receipts from credit sales made in previous and current months. Receipts from disposal of equipment, etc., could also be included.

               b. Cash Disbursements Schedule: This is made up of information derived from amounts incorporated in Schedules 3 through 8 above. A major component is payments to suppliers (reductions of accounts payable).

               c. Summary Schedule: This is the actual cash budget document itself. It starts with the beginning cash balance, adds the receipts, and subtracts the disbursements to give an ending cash balance. Management generally has policies about the desired level of ending cash, but in any case it needs to be a positive balance. Therefore, the last section will show borrowing and repayment of cash related to loan arrangements with the bank and the short-term investment of any cash in excess of the desired ending cash balance.

          10. Pro Forma Financial Statements: The last step in the budget development process is the presentation of pro forma financial statements. Pro forma is a Latin term meaning "as a matter of form", therefore, pro forma financial statements are projected or budgeted information in the form of financial statements.

          11. Budgeted Contribution Margin: As discussed further in Part 3, Chapter 4-Decision Analysis, many short-term business decisions require managers to estimate marginal costs. In many situations, marginal costs are estimated from the budgeted contribution margin, or budgeted revenue minus budgeted variable costs. When calculating contribution margin, it is necessary to determine which costs are fixed and which are variable. Variable production costs include direct materials, direct labor, and variable overhead. Variable nonproduction costs include any variable selling and administrative expenses, such as sales commissions. The CMA candidate must be able to calculate both unit and total contribution margin.

          12. Comprehensive Examples: The following three examples illustrate procedures for all the budgets and schedules described in Items 1 through 11 above.

Example 1: Purchases Budget Problem for Retailing Concern. Note that the format shown here is the same as would be used for the production and materials purchases budgets for a manufacturing concern.

     Lair Company is a retailer of leather handbags. The handbags are imported and are sometimes difficult to obtain on short notice. Therefore, the managers want to have 40% of the next month's estimated sales on hand at the end of the month. The Company's sales budget for the first quarter follows:

	Dollars	Units
January	$200,000	2,000
February	240,000	2,400
March	300,000	3,000

          The handbags cost $80 each and sell for $100. Prepare a purchases budget for February.

Answer:

	Units
Ending inventory desired 2/28. (3,000 units x 40%)	1,200
February budgeted sales	2,400
Total units needed	3,600
Less: Units on hand 2/1 (2,400 units x 40%)	960
Units to be purchased	2,640
Total budgeted cost of purchases: 2,640 units @ $80 per unit	$211,200

Example 2: Cash Budget

     Assuming the same details as in the purchases budget problem, prepare a cash budget for the month of February given the following information:

• The company pays for 50% of all purchases in the month of purchase and 50% in the following month. Purchases for the month of January were $208,000.
  
• All sales are on account. The Company has historically collected 40% in the month of sale and 55% in the following month. Five percent of all credit sales are normally uncollectible.
  
• The cash balance on February 1 was $20,000. The Company borrowed $50,000 on February 2 from the bank and paid interest of $500 to the bank in February.
  
• Out-of-pocket selling and administrative costs of $15,000 were paid in February. Also, furniture costing $5,000 was purchased with cash.
  
• No other transactions affecting cash occurred in February

Answer:

Beginning cash balance		$20,000
Cash receipts:
Receipts on account:
Jan $200,000 x 0.55	$110,000
Feb 240,000 x 0.40	96,000
Bank loan	50,000
Total receipts		+256,000
Cash disbursements:
Payments on account:
Jan $208,000 x 0.50	$104,000
Feb 211,200 x 0.50	105,600
Interest on loan	500
G & A expenses	15,000
Purchase of furniture	5,000
Total disbursements		-230,100
Ending cash balance		$ 45,900

Example 3: Master Budgets and Pro Forma Financial Statements. The following is a somewhat simplistic example. However, it demonstrates all the basic technical and mechanical aspects of developing a master budget.

     Garden Craft, Inc. makes clay figures for gardens. Its balance sheet as of June 30 is as follows:

Garden Craft, Inc.
  Balance Sheet
as of June 30, 20xx

Assets
Current Assets:
Cash	$    5
Accounts Receivable	30
DM Inventory	12
FG Inventory	36
Total Current Assets	83
PP&E (net)	50
Total Assets	$133
Liabilities and Equity
Current Liabilities:	$133
Accounts Payable	$    6
Long-Term Liabilities:
Loans Payable (L.T.)	47
Total Liabilities	53
Stockholders' Equity	80
Total Liab. & SE	$133

     Other Information:

• Garden wants a cash balance of $5 at the beginning of each month. It has a short-term borrowing arrangement with the bank so that a loan equal to any shortfall of the desired balance is made and the funds necessary to make up to a balance of $5 are deposited into the cash account. Any excess funds above $5 at the end of the month are first used to reduce outstanding principal on this arrangement. Additional excess cash not needed to reduce principal is invested. Interest at 1% per month on the outstanding month-end loan balance is deducted by the bank at the end of the following month.
  
• Two months' sales are kept in FG Inventory. The June 30 balance of $36 represents 12 units to be sold in July and August at a variable inventory cost of $3 per unit - $2 materials and $1 direct labor.
  
• One month's production in pounds is kept in DM Inventory. The June 30 balance of $12 represents the cost of 6 lbs. of material needed for July production at $2 per pound.
  
• Accounts Payable payment schedule: 50% in the current month, 50% in the following month. The June 30 $6 balance represents 50% of June's materials purchases [(6 lbs at $2 lb) x 50%]
  
• Accounts Receivable collections schedule: 25% in the current month, 50% in the first month following the sale, 25% in the second month following the sale. The June 30, $30 balance represents 75% of June's sales [(4 units at $5 per unit) x 75%] and 25% of May's sales [(12 units at $5 per unit) x 25%].
  

          Sales Forecast (in units):

May	12	September	6
June	4	October	8
July	8	November	10
August	4	December	4

          Sales Price (per clay figure): $5

           Costs:
          DM: $2 per pound (1 lb. = 1 clay figure)
          DL: $1 per clay figure - paid in month of production
          Other costs: $4 per month fixed manufacturing overhead, $2 per month fixed selling, general, & administrative costs

Required:

          Prepare the following for Garden Craft, Inc.:
          1. A master budget for the third quarter
          2. Pro forma income statement and balance sheet for July.

Solution:

          1. Master budget for the third quarter:

Sales Budget	July	August	September
Sales (units)	8	4	6
Sales $/Unit	$5	$5	$5
Sales $	$40	$20	$30

Production Budget (# Units)	July	August	September
Ending FG Inv. Desired	10	14	18
+ Monthly sales	8	4	6
Total units needed	18	18	24
- Beg. In. FG	-12	-10	-14
Production	6	8	10

Materials Purchases Budget	July	August	September
Ending DM Inv. Desired (lbs.)	8	10	4
+ Production (lbs.)	6	8	10
Total lbs needed	14	18	14
- Beginning Inventory (lbs.)	- 6	- 8	-10
Purchased (lbs)	8	10	4
Cost per lb.	$2	$2	$2
Purchases in $	$16	$20	$8

Direct Labor Budget	July	August	September
$1 x monthly production	$ 6	$ 8	$10

Manufacturing Overhead Budget	July	August	September
Monthly fixed overhead	$ 4	$ 4	$ 4

Cash Receipts Budget	July	August	September
AR Collections:
May Sales:
12 x $5 x .25	$15
June Sales:
4 x $5 x .5	10
4 x $5 x .25		$ 5
July Sales:
8 x $5 x .25	10
8 x $5 x .5		20
8 x $5 x .25			10
Aug. Sales:
4 x $5 x .25		5
4 x $5 x .5			10
Sept. Sales:
6 x $5 x .25			7.5
	$35	$30	$27.5

Other:

Bad debts: read information carefully. May be necessary to deduct from collections to be forthcoming in last month of collection period, or collectible receivables figure may need to be used (credit sales x percent collectible at monthly collection rate.

Discounts: adjust first month's collections for any early payment discounts.

Interest received on investments, cash sales, and sales of assets: add to above in month received

Cash Disbursements Budget	July	August	September
A/P Payments:
Purchases made:
June (A/P balance)	$6
July ($16 x .5)	8	$8
August ($20 x .5)		10	$10
Sept. ($24 x .5)			4
Total A/P Payments	$14	$18	$14
Other Disbursements:
DL Payroll (monthly prod. x $1)	6	8	10
Manufacturing overhead	4	4	4
Selling, Gen. and Admin Costs	2	2	2
Total cash disbursements	$26	$32	$30

Accounts Payable Early Payment Cash discounts: deduct from first payments

Add any payments needed for capital acquisitions or schedule repayments on borrowings to above

Disbursements for interest are computed when cash budget compiled

Combined Cash Budget	July	August	September
A/P Payments:
Beg. Bal. (required)	$5	$5	$5
+ Cash Receipts
(from Cash Receipts Budget)	35	30	27.5
- Cash Disbursements
(from Cash Disbursements Budget)	-26	-32	-30
Interest on month-end borrowing	0	0	-0.02
Tentative balance	14	3	2.48
Excess Invested	-9
Borrowed		2	2.52
Ending Balance (required)	$5	$5	$5

          2. Pro forma financial statements:

Garden Craft, Inc.
Income Statement (Contribution Margin Format)
For Month Ended July 31, 20xx

Sales (8 x $5)	$40
Variable Costs (8 x $3)	24
Contribution Margin	16
Fixed Cost	6
Income (before tax)	$10

Garden Craft, Inc.
Statement of Financial Condition
as of July 31, 20xx

Assets		Liabilities
Current Assets:		Current Liabilities:
Cash	$  5	Accounts Payable	$  8
Investment (ST)	9	Long Term Liabilities:
Accounts Rec.	35	Loan Payable (LT)	47
DM Inventory	16	Total Liabilities	55
FG Inventory	30
Total Current Assets	95
PP&E (net)	50	Stockholders' Equity	90
Total Assets	$145	Total Liab. & SE	$145

           Notes:
          Accounts Receivable: (4 x $5 x .25) + (8 x $5 x .75) = $35
          Accounts Payable: (July purchases $16 x .5 to be paid in August) = $8
          DM Inventory: August production 8 lbs at $2/lb
          FG Inventory: August and September sales (10 units) at $3/unit
          Depreciation: (omitted from this example for simplicity) Add Depreciation Expense to Income Statement and reduce net PE on Balance Sheet.
          Short-term Loan: Not incurred until August.

Garden Craft, Inc
Statement of Cash Flows
For Month Ended July 31, 20xx

Cash Flows from Operations:
Cash Receipts from Customers	$35
Cash Disbursements to Suppliers	(14)
Cash Disbursed for Payroll	( 6)
Cash Disbursed for Overhead	( 4)
Cash Disbursed for S. G & A Expenses	( 2)
Cash Net Cash Flows from Operations	9
Cash Flows from Investing Activities:
Short term investment	( 9)
Net Cash Flows from Investing Activities	( 9)
Cash Flows from Financing Activities:	0
Net Change in Cash Balance	0
Add Cash Balance July 1, 20xx	5
Cash Balance July 31, 20xx	$ 5

VI. STANDARD COST SYSTEMS

     Standard costs are designed to control the two components of the cost of producing something: the price paid per unit of input and the quantity of input units used. Price and quantity standards are set for materials, labor and overhead inputs. Standard cost is a unit concept. It represents the budget to produce one unit. A standard cost system results when standard costs are incorporated into the accounting system. Actual costs are accumulated in input accounts, but standard costs are assigned to Work-in-Process. Differences are reconciled using variance accounts.

     A. Setting Standard Costs

     Several issues and approaches are balanced in the process of setting standard costs.

          1. Activities Assigned Standard Costs: A determination of the costs for which standards should be set should include examination of each of the following criteria:

               a. Repetitive: Activities should be repetitive in nature.

               b. Measurable and Controllable: The input and the output of the activity should be measurable and controllable.

               c. Definable at Unit Level: The elements of cost for which standards are being set (direct materials, direct labor, and overhead) must be definable on a per unit basis.

               d. Processing Method: A predetermined processing method for the activity must have been established.

          2. Cost Behavior: Analyzing past cost behavior can give an indication of costs which may help predict future cost behavior. However, standards should reflect what costs should be not just what they have been.

          3. Engineering Estimates: Industrial engineers do work measurement studies that measure the time and materials required to produce one unit.

          4. Negotiation: The final standard should be negotiated between the line manager who will be evaluated on his performance in controlling costs and his supervisor.

     B. Level of Standards

          1. Ideal/Hypothetical Standards: These are standards that can be attained only under perfect conditions. There is no allowance for machinery breakdowns, or waiting for materials, etc., none of the delays that can be expected in a normal world. Ideal standards require at all times a level of effort and skill that would be expected from the very best employees at their best. Ideal standards are generally not used in practice, because they discourage the efforts of ordinary employees who know they can't make the standard, so "why bother?" Variances are useless because part of the variance is "normal," the expected difference from the standard. This obscures the actual variances that need to be investigated. Ideal standards are not used for normal planning purposes. They may, however, provide an ultimate target for kaizen budgeting.

          2. Attainable/Practical Standards: Practical standards are tight, but attainable. They can be achieved by normal employees working with reasonable, efficient effort, with a reasonable allowance for breakdowns, etc. Variances provide useful information because they represent abnormal conditions. Thus, variances need to be investigated. Attainable standards are useful in the planning and budget process.

     C. Advantages of Standard Costs

          1. Planning: Standard costs are useful when calculating the budget.

          2. Exception Reporting: Management by exception allows managers to focus on the variances and spend little or no time on things that are going right.

          3. Responsibility Accounting: Standard costs provide a standard against which performance can be evaluated.

          4. Motivation: Employees are aware of costs and thus are able to strive for economy and efficiency.

     D. Behavioral Issues in Standard Cost Systems

     Standard cost systems have the capacity to motivate and to enhance goal congruence if implemented and utilized with sensitivity. However, they can de-motivate if imposed by an autocratic management style to achieve high levels of control.

          1. Employee Participation: If employees affected by the standard costs do not participate in establishing the standard costs, they will be less likely to be motivated to meet the standard. When evaluation systems are implemented that are based on comparison with standards, managers are more likely to accept their evaluations if they had input into the standard-setting process.

          2. Levels and Motivation: Standards can be easy (loose), reasonable (tight but attainable), or unreasonable (ideal).

               a. Loose Standards: When standards are loose, employees are not motivated to work to their capabilities. They are not challenged and productive capacity of the organization is wasted.

               b. Unreasonable Standards: Standards that are too tight are also de-motivational as workers are frustrated in their attempts to perform to unrealistically high expectations. Efforts will fall off and morale will be undermined.

               c. Attainable Standards: These will motivate employees to achieve with the understanding that there is room for an occasional mistake (which is only human) and that there will be no accountability placed upon them for situations over which they have no control (e.g., machinery breakdowns or illness).

          3. Standards Developed by Consultant: When standards are imposed by parties outside the organization, there might be resentment or a tendency not to accept the standards. There is a danger that managers will perceive the consultant as someone who does not understand their particular process, price/cost structure, or the employees directly affected. A great deal of tact and sensitivity is needed in such circumstances. Encouraging the manager to work with the consultant may be helpful in overcoming resistance.

          4. Communication and Understanding: In the standard setting process it is valuable to explain to employees the need for and the objectives that the company hopes to accomplish through the use of a standard cost system. An understanding of how the system works, why it is used, and what each individual's role is in meeting the standards will help overcome resentment and enhance performance levels.

VII. FLEXIBLE BUDGET

     The annual/master budget is also referred to as a static or fixed budget because it is calculated for a single level of output (i.e. production and sales) activity. It seldom happens that sales or production occur exactly as planned.

     A. Actual Level of Activity

     In order to evaluate performance fairly, the budget needs to be adjusted to the actual level of activity. The flexible budget can be calculated at the same time as the master budget for several levels of activity within an expected range of sales or production. If the actual level of activity does not hit one of the calculated levels, or if the flexible budget was not calculated at the beginning of the period, it can easily be calculated at the end of the period when the actual level of activity is known.

     B. Use Standard Costs

     The flexible budget is calculated using standard costs. Thus, one is comparing the costs that should have been incurred for the actual level of production with the costs that were actually incurred.

     The master budget is an expanded, detailed form of the basic cost formula:

     TC = (VCs x Qs) + FCs
     Where:
     TC = Total Costs
     VCs = Standard Variable Costs
     Qs = Master Budget Standard Quantity
     FCs = Standard Fixed Costs

     The flexible budget uses the actual quantity:

     TC = (VCs x Qa) + FCs
     Where: Qa = Standard Quantity for Actual Activity.

     The actual results, the flexible budget and the master budget and their variances are related. Their relationship is depicted in Figure 2-2 (not shown here). (Note: Variances are addressed in Part 2, Chapter 5-Performance Measurement.)

VIII. EMPLOYEE BENEFITS

     A. Employee Benefit Statement

     An employee benefit statement is a report that communicates the cost of overall benefits incurred on behalf of individual employees beyond their salary or wages. The typical components of the employee benefit statement are:

• Salaries and wages
  
• Bonuses or other award payments
  
• Social Security and Medicare
  
• Federal and state unemployment
  
• Workers' compensation
  
• Defined benefit, 401(k), and other retirement plans
  
• Holiday pay
  
• Vacation, pay
  
• Sick pay
  
• Medical, dental, vision, disability, and life insurance
  
• Tuition reimbursements

Sometimes employers include additional benefits such as:

• Flexible spending accounts
  
• Optional life, long-term care, home, automobile, or other insurance
  
• College savings plans
  
• Employee product discounts
  
• Employee holiday or summer party
  
• On-site cafeteria
  
• Sports leagues
  
• Fitness club memberships or discounts
  
• Training programs

     B. Allocation of Employee Benefit Costs

     No single way exists to allocate employee benefit costs to production. Two common methods are:

          1. Assign as Part of Direct Labor: Benefit costs may be first allocated to direct labor, and then traced as part of direct labor costs to production.

          2. Allocate as Part of Overhead: Benefit costs may be included in the overhead cost pool, and then allocated as part of overhead to production.

          3. Financial Statement Effects: There will be no financial statement differences between these two methods if: (a) the company carries no inventory, or (b) overhead costs are allocated to production using direct labor costs as the allocation base (assuming that benefit costs were also allocated to direct labor costs based using wages as the allocation base). However, the balance sheet and income statement ARE affected if the company carries inventories and an allocation base other than direct labor cost is used to allocate overhead. Balance sheet and income statement values in a given year might be higher or lower under either method, depending on the circumstances.