MANAGEMENT ACCOUNTING Pearson Education Limited 2008 Cheryl S

MANAGEMENT ACCOUNTING © Pearson Education Limited 2008 Cheryl S. Mc. Watters, Jerold L. Zimmerman, Dale C. Morse

8 -2 Management Accounting Budgeting (Planning and control) Chapter 8 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -3 Objectives • Use budgeting for planning purposes • Use budgeting for control purposes • Identify the conflicts that exist between planning and control in the budgeting process • Describe the benefits of having both short-term and long-term budgets • Explain the responsibility implications of a line-item budget • Identify the costs and benefits of budget lapsing • Develop flexible budgets and identify when flexible budgeting should be used instead of static budgeting • Explain the costs and benefits of using zero-based budgeting • Create a master budget for an organisation • Create pro-forma financial statements based on data provided Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -4 The Purpose of Budgets are a key component of the organization’s planning and control system Budgets are forecasts of future revenues and expenses Budgeting is the process of gathering information to assist in making forecasts Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -5 Budgeting for Planning Decisions Budgets play an integral role in making planning decisions Budgets are a used to transfer information to individual decision makers in the organization Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -6 Budgeting for Planning Decisions Encourage top-down flow of information and plans Budgets attempt to Encourage bottom-up flow of information Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -7 Budgeting for Control Budgets are often used to assign responsibilities by allocating resources to managers Budgeted amounts can be used as goals to motivate Budgeted amounts can be used as targets by which performance is evaluated and rewarded Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -8 Variances The difference between budgeted performance and actual performance is called the variance An adverse variance occurs when Actual costs > Budgeted costs or Actual revenues < Budgeted revenues A favorable variance occurs when Actual costs < Budgeted costs or Actual revenues > Budgeted revenues Variances are commonly calculated on a monthly basis to identify how successfully an organization is meeting its goals Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -9 Variances Numerical Example Budgeted (£) Actual (£) Variance (£) Revenues 450, 000 453, 000 F Cost of goods sold (235, 000) (248, 000) 13, 000 A General administration (80, 000) (132, 000) 52, 000 A Selling expenses (100, 000) (90, 000) 10, 000 F Profit 35, 000 (17, 000) 52, 000 A Administration Costs differ greatly from those expected and would be investigated Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -10 Conflict between Planning and Control For control, budgets serve as the benchmark for performance measurement For planning, budgets communicate specialized knowledge from one area to another Over reliance on performance measurement will lead to a reduction in knowledge transfer Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -11 Conflict between Planning and Control To manage the conflict between planning and control many organizations put the Chief Executive in change of the budgeting process and the chief financial officer in charge of the collection and preparation of data The budget is an informal set of contracts between the units of the organization Most budgets are set in a negotiation process Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -12 Participative Budgeting is a bottom-up process With Participative Budgeting the person ultimately being held responsible for meeting the target makes the initial budget forecast Motivation to achieve the target is higher Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -13 How Budgeting Helps Resolve Organizational Problems Links knowledge with responsibility to make planning decisions Measures and rewards performance for control Budgeting Systems An administrative device to resolve organizational problems Management Accounting Mc. Watters, Zimmerman, Morse Distributes Responsibilities © Pearson Education Limited 2008

8 -14 Short-Term versus Long-Term Budgets Strategic Planning Long-term Budgets 1. Selecting overall objectives (more than one year) 2. Choosing markets Short-term Budgets 3. Selecting products to produce Forecasts of large asset acquisitions (1 year or less) Financing plans 4. Determining price/quality mix Quantities to produce Research and development plans 5. Choosing technologies Quantities to sell Supplies acquisitions Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -15 Line-Item Budgets • Budgets that authorize the manager to spend only up to the specified amount on each line item • Managers cannot spend savings from one line item on another line item • The manager does not have the responsibility to substitute resources among line items as circumstances change • Impose more control on Managers • Prevalent in government organizations Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -16 Line-Item Budgets Numerical Example Line item budgets reduce management incentives to search for cost savings and reduce the organisation flexibility Line item Salaries Office supplies Amount (£) 185, 000 12, 000 Office equipment 3, 000 Postage 1, 900 Maintenance Utilities 350 1, 200 Rent 900 Total 204, 350 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -17 Budget Lapsing • Funds that have not been spent at year-end do not carry over to the next year • Managers have incentive to spend at the end of each year • Operating efficiency is reduced • Managers have less discretion in the timing of expenditures Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -18 Static versus Flexible Budgets Static budgets do not vary with volume and are used when a manager has control over volume or the consequences thereof Flexible budgets are adjusted for changes in volume and are used mainly in manufacturing where the manager does not have control over volume Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -19 Static versus Flexible Budgets Numerical Example Each line item in the budget varies with volume. Then a budget is prepared at different volume levels Ticket Sales (€) (Formula) 3, 000 4, 000 5, 000 € 18 N* 54, 000 72, 000 90, 000 Band € 20, 000 + 0. 15 N (28, 100) (30, 800) (33, 500) Auditorium € 5, 000 + 0. 05 N (7, 700) (8, 600) (9, 500) € 80(N/200) (1, 600) (2, 000) € 28, 000 (28, 000) (11, 000) 3, 000 17, 000 Revenues Security Other costs Profit/Loss *N is the number of tickets sold Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -20 Static versus Flexible Budgets Show revenues and expenses that should have occurred at the actual level of activity Flexible Budgets May be prepared for any activity level in the relevant range Reveal variances due to good cost control or lack of cost control Improve performance evaluation Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -21 Static versus Flexible Budgets Central Concept If you can tell me what your activity was for the period, I will tell you what your costs and revenue should have been Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -22 Incremental versus Zero-Base Budgets Incremental Budgets § Base budget is the previous budget § Only incremental changes from the previous budget are examined in detail Management Accounting Mc. Watters, Zimmerman, Morse Zero-Base Budgets § Each line item is set at zero each year § Every line item must be justified and renewed each year © Pearson Education Limited 2008

8 -23 Zero-Base Budgets • ZBB Motivates managers to maximize firm value by identifying and eliminating those expenditures whose total costs exceed total benefits • Incremental expenditures are deleted when their costs exceed their incremental benefits • Inefficient base budgets are not eliminated • In practice ZBB is used infrequently • Most useful when new top-level management come from outside the firm • Costly to conduct Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -24 The Master Budget Integrates the estimates from each department to predict production requirements, financing, cash flows and financial statements at the end of the period. Serves as a guide and benchmark for the entire organization Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -25 Comprehensive Master Budget Illustration The following slides provide an illustration of the Master Budget The Master Budget is prepared for a simple firm Natur. Apples (an apple processor) Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -26 Master Budget Illustration Budgeting process - Natur. Apples Production budget Sales budget Factory overhead budget Selling and administrative budget Direct labour budget Apple procurement Direct materials budget Capital investment budget Financial Budget Beginning balance sheet Budgeted profit and loss Statement Management Accounting Mc. Watters, Zimmerman, Morse Budgeted cash flows Budgeted Balance Sheet © Pearson Education Limited 2008

8 -27 Master Budget Numerical Example Expected beginning Balance Sheet Assets £ £ Cash 100, 000 Accounts receivable 200, 000 Inventory Sauce (13, 500 cases x £ 58/case) 783, 000 Pie Filling (2, 500 cases x £ 48/case) 120, 000 Property, plant and equipment (net) 903, 000 2, 300, 000 3, 503, 000 Liabilities and shareholders equity Accounts payable Long-term debt Shareholders equity 100, 000 1, 000 2, 403, 00 3, 503, 000 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -28 Master Budget Numerical Example Sales Budgeted cases Sauce Pie Filling Budgeted price/case (£) Budgeted revenue (£) 140, 000 68 9, 520, 000 60, 000 53 3, 180, 000 Total Management Accounting Mc. Watters, Zimmerman, Morse 12, 700, 000 © Pearson Education Limited 2008

8 -29 Master Budget Numerical Example Production Budget – Production volume Beginning inventory + Production = Sales + Desired ending inventory or Production = Sales + Desired ending inventory – beginning inventory Product Sales Ending inventory Beginning inventory Production Sauce 140, 000 5, 000 13, 500 131, 500 Pie Filling 60, 000 1, 000 2, 500 58, 500 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -30 Master Budget Numerical Example Production Budget Raw Materials Product Kilograms per case x Cases = Kilograms x Cost Per Kilogram (£) = Sauce 25 131, 500 3, 287, 500 0. 80 2, 630, 000 Pie Filling 20 58, 500 1, 170, 000 0. 80 936, 000 Total 4, 457, 500 Cost (£) 3, 566, 000 Direct Labour Product Hours per case x Cases = Hours x Cost Per hour (£) = Cost (£) Sauce 0. 60 131, 500 78, 900 10 789, 000 Pie Filling 0. 50 58, 500 29, 250 10 292, 500 Total Management Accounting Mc. Watters, Zimmerman, Morse 108, 150 1, 081, 500 © Pearson Education Limited 2008

8 -31 Master Budget Numerical Example Production Budget Overhead Product Direct labour cost x Overhead per £ of direct labour = Cost (£) Sauce £ 789, 000 2 1, 578, 000 Pie Filling £ 292, 500 2 585, 000 Total 2, 163, 000 Product Costs Product Total product cost (£) Materials + Labour + Overhead / Cases = Cost per case (£) Sauce 4, 997, 000 131, 500 38 Pie Filling 1, 813, 500 58, 500 31 Total 6, 810, 500 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -32 Production Budget Raw Materials Product Kilograms per case x Cases = Kilograms x Cost Per Kilogram (£) = Cost (£) Sauce 25 131, 500 3, 287, 500 0. 80 2, 630, 000 Pie Filling 20 58, 500 1, 170, 000 0. 80 936, 000 Total 4, 457, 500 3, 566, 000 Direct Labour Product Hours per case x Cases = Hours x Cost Per hour (£) = Cost (£) Sauce 0. 60 131, 500 78, 900 10 789, 000 Pie Filling 0. 50 58, 500 29, 250 10 292, 500 Total 108, 150 1, 081, 500 Overhead Product Direct labour cost x Overhead per £ of direct labour = Cost (£) Sauce £ 789, 000 2 1, 578, 000 Pie Filling £ 292, 500 2 585, 000 Total 2, 163, 000 Product Costs Product Total product cost (£) Materials + Labour + Overhead / Cases = Cost per case (£) Sauce 4, 997, 000 131, 500 38 Pie Filling 1, 813, 500 58, 500 31 Total 6, 810, 500 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -33 Master Budget Numerical Example Selling and Administration Budget Selling and administrative areas £ Marketing 470, 000 Finance 160, 000 Shipping 380, 000 Chairman's office 180, 000 Total selling and administration Management Accounting Mc. Watters, Zimmerman, Morse 1, 190, 000 © Pearson Education Limited 2008

8 -34 Master Budget Numerical Example Capital Investment Budget Capital investment project Purchase date Cost (£) Coring machine 05/10/2008 40, 000 Dicing machine 05/10/2008 80, 000 Total Management Accounting Mc. Watters, Zimmerman, Morse 120, 000 © Pearson Education Limited 2008

8 -35 Master Budget Numerical Example Financial Budget Financial transactions Date Amount (£) Loan from bank 05/10/2008 100, 000 Repayment of bank loan 05/04/2009 (100, 000) Retirement of long-term debt 01/06/2009 (200, 000) Payment of interest 31/12/2009 (50, 000) Payment of interest 30/06/2009 (50, 000) Payment of dividends 30/09/2009 (2, 000) Net cash flow from financial transactions Management Accounting Mc. Watters, Zimmerman, Morse (2, 300, 000) © Pearson Education Limited 2008

8 -36 Master Budget -Numerical Example Budgeted profit and loss statement Revenues (Sales budget) £ £ Cost of goods sold £ 12, 700, 000 Beginning inventory (Beg, balance sheet) 903, 000 + Production costs (production budget) 6, 810, 500 - Ending inventory (Production budget) Sauce (£ 38/case x 5, 000 cases) 190, 000 Pie Filling (£ 31/case x 1, 000 cases) 31, 000 Gross Margin Selling and administrative expenses (Selling and admin. budget) (221, 000) (7, 492, 500) 5, 207, 500 (1, 190, 000) Interest expense (Financial budget) (100, 000) Net profit before taxes 3, 917, 500 Taxes (£ 3, 917, 500 x 0. 40) 1, 567, 000 Net Profit 2, 350, 500 Beginning shareholders’ equity (Beg Balance sheet) 2, 403, 000 + Net Profit 2, 350, 500 -Dividends 2, 000 Ending shareholders equity 2, 753, 500 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -37 Master Budget -Numerical Example Cash Flow from Operations Budgeted cash flow statement £ £ Net Income (Income Statement) 2, 350, 500 Add: Depreciation 400, 000 Inventory Decrease 682, 000 Accounts Payable Increase 50, 000 Less: Accounts Receivable Increase (100, 000) Total Cash Flow from Operations 3, 382, 500 Cash Flow from Investments Coring Machine Purchase (Capital Investment Budget) (40, 000) Dicing Machine Purchase (Capital Investment Budget) (80, 000) (120, 000) Cash Flow from Financial Transactions Bank Loan (Financial Budget) 100, 000 Bank Loan Repayment (Financial Budget) (100, 000) (200, 000) Long-term Debt Retirement (Financial Budget) Dividend Payment (Financial Budget) (2, 000) (2, 200, 000) Change in Cash Balance 1, 062, 500 100, 000 1, 162, 500 Beginning Cash Balance (Beginning Balance Sheet) Ending Cash Balance Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -38 Master Budget - Numerical Example Assets Cash (Cash Flow Statement) £ Budgeted Balance Sheet £ 1, 162, 500 300, 000 Inventory: Applesauce 5, 000 cases @ £ 38 190, 000 Apple Pie filling 1, 000 cases @ £ 31 31, 000 221, 000 2, 300, 000 120, 000 Accounts Receivable (Predicted) Property, Plant and Equipment (net) Beginning Balance (Beginning Balance Sheet) Capital Investments (Capital Investment Budget) Depreciation for the Year (400, 000) 2, 020, 000 Total Assets 3, 703, 500 Liabilities and Stockholders' Equity Accounts Payable (Predicted) 150, 000 Long-Term Debt 1, 000 Beginning Balance (Beginning Balance Sheet) Retirement (Financial Budget) (200, 000) 800, 000 Total Liabilities 950, 000 Stockholders' Equity (Income Statement) 2, 753, 500 3, 703, 500 Total Liabilities and Stockholders' Equity Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008

8 -39 Management Accounting Budgeting (Planning and controlling) End of Chapter 8 Management Accounting Mc. Watters, Zimmerman, Morse © Pearson Education Limited 2008