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1 Page 1 8. Budgetingg In this chapter we discuss the process of budgeting. A business needs to plan for future contingencies, and it needs to make sure that it can handle them. A budget is an expression of a business plans and goals using dollar amounts. You begin by forecasting sales (in dollars and units) and from there you calculate: (i) the expenses that you will need in order to support your sales forecast, (ii) the capital expenditures that you will need to make to support your operations, and (iii) the cash inflows and outflows that your anticipated sales, expenses and expenditures will generate. By engaging in this process you can help make sure that you have the resources that your businesss will need in the future The budget process is also a tool that can be usedd in evaluating a business personnel. If sales are estimated to be a set amount and fewer sales are generated, then you can ask the personnel responsible for sales to explain why the saless fell short of expectations. Similarly, if expenses or expenditures are higher than anticipated, you can ask the personnel responsible for those outlays to explain why they were above expectations.

2 Page 2 The Master Budget The master budget is a comprehensive financial plan for a business. It is made up of the Operating and Financial budgets, which are in turn made up of supporting schedules (budgets). The Operating Budget The Operating Budget is a Budgeted Income Statement and all supporting schedules. As an example, you would do the following in order to construct a rough operating budget for a manufacturing operation: You plan on how many units you will sell. I will sell 100,000 units this year. Where will those units come from? How many units do I already have? Will I need any more units for inventory purposes? You plan on how many units you will produce this year. From this you calculate the cost to produce the units that you will need this year. You plan on how many salesman you will need, and the other marketing expenses you will need to incur this year in order to sell the units that you want to sell. This tells you how much you will spend on marketing this year. You plan on how many administrative support people you will need at this level of operation. This tells you how much you will spend on administrative expenses. From all of these numbers you can create a Budgeted Income Statement, which is also called a Pro Forma Income statement. You can break these numbers down by month or quarter in order to produce a quarterly Pro Forma Income Statement. to me at mconstas@csulb.edu

3 Page 3 Operating Budget for a Manufacturing Enterprise For a manufacturing operation, an Operating Budget will begin with a Sales Budget. A Sales Budget outlines the expected saless for each product in units and dollars: You would then prepare a Production Budget. The Production Budget describes how many units must be produced in order to meet your sales needs and satisfy ending inventory requirements.

4 Page 4 After the production budget is prepared, you can prepare budgets from direct materials, direct labor, and overhead. The Direct Materials Budget ties the production to the Direct be purchased in order to produce the estimated units: Materials that will need to

5 Page 5 The Direct Labor Budget ties the production to the direct laborr hours needed to produce the estimated units: The Overhead Budget shows the expected cost of all indirect manufacturing items. The Ending Finished Goods Inventory Budget supplies information needed for the budgeted balance sheet and also servess as an important input for the preparation of the cost of goods budget.

6 Page 6 You estimate all of your selling general and administrative General and Administrative Budget. expenses in one Selling,

7 Page 7 The Financial Budget The remaining budgets that appear in the Master Budget make up the Financial Budget. The Financial Budget typicallyy consists of the Cash Budget, the Budgetedd Balance Sheet, and the Budgeted Income Statement. From the prior supporting budgets, you can then produce the Budgeted Income Statement.

8 Page 8 The Cash Budget shows all of the cash inflows and outflows that tie into the numbers indicatedd in the Financial Budget. In addition, itt shows other inflows and outflows, including cash inflows and outflows from financing activities.

9 Page 9 From alll of the previous budgets, you can then prepare a Budgeted Balance Sheet.

10 Page 10 Static vs. Flexible Budgets Most Master Budgets suffer from the fact that theyy are static budgets. A static budget assumes that one level of activity is achieved. It probably would be more beneficial for a budget to assume that different levels are achieved when dealing with variable costs. The following chart indicates how a Flexible Production Budget might be shown:

11 Page 11 Budget Variances It is important to compare the budgeted performance with the business actual performance. This is done by calculating budget variances. This is the topic of the next two chapters. Calculating budget variances are important because it verifies the budgeted process. It will become evident that people are using unrealistic budget numbers because large budget variances will be consistently generated. Budget variances are also useful in evaluating the performance of departments and personnel. If your actual expenditure is different from your budgeted cost of materials, you will want to investigate the reason why. You may want to encourage the behavior that caused the budget variance, or you may wish to discourage it. It is important, however that you use budget variances for controllable costs when using them for performance evaluation.

12 Page 12 PROBLEMS E-1. Royco, Inc. contracted for the current year to purchase $425,000 worth of light fixtures from a retailer for $5 per unit. Royco keeps 12 1/2 percent of its annual purchases (in dollars) on hand at the end of each calendar year to avoid stockouts in early January, a period when most retailers are out of fixtures. If Royco purchased $725,000 worth of inventory last year at $7.50 per unit, what are the unit sales for the current year? Royco uses a FIFO inventory system. A 128,542 B 97,083 C 86,458 D 84,583 E-2. The Axel Company's contribution margin ratio is 25% and its total fixed costs are $80,000. Certain changes are planned that will increase total fixed costs by 10% but decrease variable expenses by 20% per unit. What sales volume will achieve a pre-tax income of $16,000? (Round your answer to the nearest $1,000.) A $149,000 B $173,000 C $260,000 D $347,000 E-3. The Sledge Hammer Company manufactures a line of high quality tools. The company sold 1,000,000 hammers at a price of $4 per unit in The company estimates that this volume represents a 20% share of the current hammers market. The market is expected to increase by 5%. Marketing specialists have determined that, as a result of a new advertising campaign and packaging, the company will increase its share of this larger market to 24%. Due to changes in prices, the new price for the hammer will be $4.30 per unit. This new price is expected to be in line with the competition and have no effect on the volume estimates. What are the estimated sales revenues in 1994? A $5,040,000 B $5,160,000 C $5,418,000 D $5,689,000 to me at mconstas@csulb.edu

13 Page 13 For the following question(s) refer to the information below. Each column is a separate situation) Sales 100,000 units 40,000 units $2,000,000? Production 110,000 units? 1,950,000 $55,000 Beg. Finished Goods 20,000 units 5,000 units? 7,000 Ending Finished Goods? 7,500 units 10,000 9,500 E-4. What is the ending finished goods inventory (in units) column 1? A 10,000 B 27,000 C 30,000 D 100,000 E-5. What is the production volume (in units) for column 2? A 50,000 B 42,500 C 35,000 D 12,500 E-6. What is the beginning finished goods in column 3? A $40,000 B $50,000 C $60,000 D $90,000 E-7. What are the sales in column 4? A $62,000 B $55,000 C $52,500 D $16,500 to me at mconstas@csulb.edu

14 Page 14 For the following question(s) refer to the information below. T. Jackson Retail seeks your assistance to develop cash and other budget information for May, June, and July. At April 30, the company had cash of $5,500, accounts receivable of $437,000, inventories of $309,400, and accounts payable of $133,055. The budget is to be based on the following assumptions: SALES: Each month's sales are billed on the last day of the month. Customers are allowed a 3% discount if payment is made within 10 days after the billing date. Receivables are recorded in the accounts at their gross amounts (not net of discounts). 55% of the billings are collected within the discount period; 30% are collected by the end of the month; 9% are collected by the end of the second month; and 6% turn out to be uncollectible. PURCHASES: 60% of all purchases of merchandise and selling, general, and administrative expenses are paid in the month purchased and the remainder in the following month. The number of units in each month's ending inventory is equal to 125% of the next month's units of sales. The cost of each unit of inventory is $30. Selling, general, and administrative expenses, of which $3,000 is depreciation, are equal to 15% of the current month's sales. Actual and projected sales are as shown below: Dollars Units March ,000 11,800 April ,000 12,100 May ,000 11,900 June ,000 11,400 July ,000 12,000 August ,000 12,200 to me at mconstas@csulb.edu

15 Page 15 E-8. What are the budgeted merchandise purchases (in dollars) for May? A $338,250 B $355,500 C $357,000 D $375,750 E-9. What are the budgeted merchandise purchases (in dollars) for June? A $319,500 B $342,000 C $364,500 D $375,000 E-10. What are the budgeted cash disbursements during the month of June? A $407,520 B $420,600 C $421,950 D $434,280 E-11. What are the budgeted cash collections during the month of May? A $445,894 B $453,880 C $472,114 D $474,934 E-12. What are the budgeted number of inventory units that need to be purchased in July? A 15,250 B 15,000 C 12,250 D 12,000 P-1 The Hi Fi Company has just made its sales forecast for 20X9. The marketing department estimates that the company will sell 720,000 units. In the past, management has found that inventories of finished goods should be maintained at approximately three months' sales. The inventory at the beginning of 1994 was 40,500 units. Sales take place evenly throughout the year. What is the estimated production level (in units) required for the coming year to meet these objectives? to me at mconstas@csulb.edu

16 Page 16 P-2 The Smart Company is preparing its cash budget for the month of June. The following information is available concerning its accounts receivable: Estimated credit sales for June $300,000 Actual credit sales for May 225,000 Estimated collections in June for credit sales in June 25% Estimated collections in June for credit sales in May 65% Estimated collections in June for credit sales prior to May $18,000 Estimated write-offs in June for uncollectible credit sales 12,000 Estimated provision for bad debts in June for credit sales in June 10,000 What are the estimated cash receipts from accounts receivable collections in June? P-3 The Richburn Manufacturing Company increased its ending inventory by $17,000 in 20X9. The company also granted its customers more liberal credit terms which increased the accounts receivable by $37,500. Sales were $975,000 in 20X9 and the accounts payable decreased by $27,500. The gross profit on sales is 45%. Selling and administrative expenses were $145,000; this included depreciation expense of $4,000. What was the cash disbursements for 20X9? P-4 A wholesale distributor for floor-covering materials prices such that retail prices are 250% of cost. Inventory on July 1st was $180,000 and the distributor wants the July 31st inventory to be 40% smaller. What are the budgeted July purchases if the estimated sales are $400,000? P-5 Rizzo Corporation had 17,000 units of brake calipers on hand at the end of 20X8. The company's inventory policy was to maintain an ending inventory equal to 15% of the current year's sales. During 20X9, Rizzo sold 210,000 units of calipers. How many units did Rizzo purchase in 20X9? SOLUTIONS E-1 ANSWER: C (725,000/7.50) ,000/ x = (425,000/5.00).125 E-2. ANSWER: C fixed costs = 80,000 (1.10) = 88, = (Sales VC/Sales) VC =.75 sales if VC decrease by 20%, then VA =.60 sales sales -.60 sales - 88,000 = sales = 88, ,000 = 104,000 Sales = 104,000/.4 = 260,000 to me at mconstas@csulb.edu

17 Page 17 E-3. E-4. E-5. E-6. E-7. E-8. E-9. ANSWER: C 1993 sales = 1,000,000 ($4) = $4,000, market size = 1,000,000/.20 = 5,000, sales volume = 5,000,000 (1.05) (.24) = 1,260, sales = 1,260,000 (4.30) = $5,418,000 ANSWER: C X = 20, , ,000 = 30,000 ANSWER: B 5,000 + x - 40,000 = 7,500 X = 7, ,000 5,000 = 42,500 ANSWER: C x + 1,950,000-2,000,000 = 10,000 x= 2,000,000 1,950,000 = 10,000 = 60,000 ANSWER: C 7, ,000 - x = 9,500 7, ,000-9,500 = x 52,500 = x ANSWER: A 1.25 (11,900) + x - 11,900 = 1.25 (11,400) X = 11,275 purchases = 11,275 (30) = $338,250 ANSWER: C 1.25 (11,400) + x - 11,400 = 1.25 (12,000) x = 12,150 purchases = 12,150(30) = $364,500 E-10. ANSWER: B merchandise purchases =.60 (364,500) +.40 (338,250) = $354,000 Expenses =.60 [(.15)(456,000) - $3,000] +.40[(.15) 476, ] = 66,600 Cash Disbursements = 354, ,600 = 420,600 E-11. ANSWER: A From April: 484,000 (.55) (97) + 484,000 (.30) = $403,414 From March: 472,000 (.09) = $42,480 Total Cash Collections = 403, ,480 = 445,894 to me at mconstas@csulb.edu

18 Page 18 E-12. ANSWER: C Beg Bal + purchases sales = ending balance 1.25 (12,000) + x - 12,000 = 1.25 (12,200) 15,000 + x -12,000 = 15,250 3,000 + x = 15,250 X = 12,250 P-1 40,500 + X - 720,000 = 720,000 (3/12). P-2 25 (300,000) +.65 (225,000) + 18,000 = $239,250 P-3 Cost of sales =.55 (975,000) = $536,250 plus decrease in A/Payable 27,500 plus increase inventory 17,000 selling & administrative 141, ,750. P-4 180,000 + x (400,000/2.5) =.60(180,000) = 88,000 P-5 210,000 + (.15(210,000)) -17,000 = $224,500 to me at mconstas@csulb.edu

January 10,000 units February 15,000 units. 15,000 units

In Class #9.1 Prepare the sales budget Royal Company is preparing budgets for the quarter ending June 30 th. Actual sales for January to March are as follows: Month Sales Budget January 10,000 units February