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Chapter 8

Master Budgeting

Learning objectives

1. Understand why organizations budget


2. Prepare operating budgets

Sales budget
Production budget
Direct materials budget
Direct labor budget
Manufacturing overhead budget
Ending finished goods inventory budget
Selling and administrative budget

3. Prepare financial budgets


Budgeted income statement
Cash budget

Budget

A budget is a plan for using limited resources:


The goals were trying to achieve in a specific
period
How we plan to achieve these goals
The act of preparing a budget is called
budgeting
The use of budgets to control an organizations
activities is known as budgetary control

Three Purposes of Budgeting

Planning
Planning involves developing objectives and preparing various budgets
to achieve those objectives
Budgets force managers to think ahead regarding how to achieve
various financial goals
The budgeting process leads to the best way to use available resources

Coordination
Budgets highlight linkages among departments and force them to
communicate and to work toward company goals

Control
Budgets define goals and objectives that can serve as benchmark for
evaluating actual performance
Detect problem areas
Evaluate managers performance

Choosing a Budget Period

Annual operating budget covers a one-year period


corresponding to a companys fiscal year
Many companies divide their annual budget into four quarters

A continuous budget is a 12-month budget that rolls


forward one month (or quarter) as the current month (or
quarter) is completed
Operating Budget

2014

2015

2016

2017

Preparing the Master


Budget*

* master budget full package of operating


budgets for all areas of operations + financial
budgets

An Overview of Master Budget


Operating budgets
Sales
Sales budget
budget
Ending
Ending
inventory
inventory
budget
budget
Direct
Direct materials
materials
budget
budget

Production
Production budget
budget

Direct
Direct labor
labor
budget
budget

Selling
Selling and
and
administrative
administrative
budget
budget
Manufacturing
Manufacturing
overhead
overhead budget
budget

Cash
Cash Budget
Budget
Not required
Budgeted
Budgeted
income
income
statement
statement

Financial budgets
7

Budgeted
Budgeted
balance
balance sheet
sheet

Sales Budget

Starting point for master budget


How much sales revenue will we earning in the following year?

Based on:
The budgeted price you expect to charge
Expected future unit sales (estimates from Marketing)

Budgeted Sales Revenue = Budgeted price *


Budget unit sales

Example: Royal Company

Royal Company is preparing budgets for the quarter ending June


30th. Budgeted sales for the next five months are:
April
20,000 units
May
50,000 units
June
30,000 units
July
25,000 units
August 15,000 units
The budgeted selling price is $10 per unit.
The sales budget for the second quarter is
April

May

June

Quarter

Budgeted
sales in units

20,000

50,000

30,000

100,000

Selling price

$10

$10

$10

$10

Budget sales
revenue

$200,000

$500,000

$300,000

$1,000,000

Production Budget

How many units do we need to produce?


Budgeted production depends on:
expected sales in units (from the sales budget)
firms inventory policy for finished goods
Sales
Sales budget
budget

Production
Production budget
budget

Ending Inventory = Beginning Inventory for the following period

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Production Budget
Example: The management at Royal Company wants ending inventory
to be equal to 20% of the following months budgeted sales in units
Beginning Inventory in April = Ending Inventory in March = 20,000*20%=4,000
Budgeted sales in July is 25,000 units
April

11

May
50,000

June
30,000

Quarter

Sales in units

20,000

100,000

+Desired ending
inventory

50,000*20% 30,000*20%
=10,000
=6,000

25,000*20%
=5,000

=Total requirements

30,000

56,000

35,000

105,000

-beginning inventory

4,000

10,000

6,000

4,000

=Units to be produced

26,000

46,000

29,000

101,000

5,000

From the Sales


budget
based on
inventory policy

=ending inventory
from previous
quarter

Exercise: Production Budget


April
Desired ending inventory
Beginning inventory
Budgeted sales
Budgeted production

May

June

(1)

(4)

(6)

1,000

(3)

(5)

10,000

15,000

20,000

(2)

15,500

21,000

Inventory policy: desired ending inventory for current month = 10%


of expected sales for next month.

Required: Fill in the missing numbers

12

Budgets for Inputs (DL, DM and Overhead)

Direct Materials Budget


Based on estimates of materials per unit of product, and
prices of materials

Direct Labor Budget


Based on estimates of DL hours per unit of product, and
wage per hour

Manufacturing Overhead
Based on estimates of fixed overhead and variable
overhead per unit of product
Production
Production budget
budget

Direct
Direct materials
materials
budget
budget
13

Direct
Direct labor
labor
budget
budget

Manufacturing
Manufacturing
overhead
overhead budget
budget

Direct Materials Budget


The direct materials budget details
the raw materials that must be
purchased to fulfill the production
budget and to provide for adequate
inventories

Production
Production budget
budget

Direct
Direct materials
materials budget
budget

Example: at Royal Company, 5 pounds of materials are


required per unit of product.
Management wants materials on hand at the end of each
month equal to 10% of the following months production.
On March 31, 13,000 pounds of materials are on hand.
Material cost is $0.40 per pound.
14

Direct Materials Budget for Royal Company


April

May

June

Quarter

Units to be produced

26,000

46,000

29,000

101,000

Materials per unit (lbs)

Production needs

(26000*5) =
130,000

230,000

145,000

505,000

Add: Desired ending


Inventory

230,000*10%
=23,000

145,000*10%
=14,500

11,500
(assumed)

11,500

Total needed

153,000

244,500

156,500

516,500

Less: Beginning Inventory

13,000

23,000

14,500

13,000

Materials to be purchased

140,000

221,500

142,000

503,500

140,000*0.4
=56,000

221,500*0.4
=88,600

142,000*0.4=
56,800

503,500*0.4
=201,400

Cost of materials
purchased

Desired ending inventory = 10% of the following months production needs


On March 31, 13,000 pounds of materials are on hand.
Material cost is $0.40 per pound.
15

Direct Labor Budget


The direct labor budget shows the
direct labor-hours required to satisfy
the production budget

Production
Production budget
budget

Direct
Direct labor
labor budget
budget

At Royal, each unit of product requires 0.05 hours (3


minutes) of direct labor.
Because of no-layoff policy, the direct labor workforce
will be paid for a minimum of 1,500 hours per month for
the next three months
Workers are paid at the rate of $10 per hour regardless
of the hours worked.

16

Direct Labor Budget for Royal Company


April

May

June

Quarter

26,000

46,000

29,000

101,000

Direct Labor per unit (hrs)

0.05

0.05

0.05

0.05

Labor hours required

1,300

2,300

1,450

5050

Guaranteed labor hours

1,500

1,500

1,500

Labor hours paid

1,500

2,300

1,500

5,300

Hourly wage rate

$10

$10

$10

$10

1500*10=
$15,000

2300*010=
$23,000

1500*10=
$15,000

5300*10=
$53,000

Units to be produced

Total direct labor costs

17

Manufacturing Overhead Budget


The manufacturing overhead
budget includes budgeted variable
overhead cost and fixed overhead
cost

18

Production
Production budget
budget

Manufacturing
Manufacturing overhead
overhead
budget
budget

At Royal, manufacturing overhead is applied to units


of product on the basis of direct labor hours
The variable manufacturing overhead rate is $20 per
direct labor hour
Fixed manufacturing overhead is $50,000 per month
(primarily depreciation of plant assets)

Manufacturing Overhead Budget for Royal Company


April

May

June

Quarter

1,300 DLH

2,300 DLH

1,450 DLH

(1300+2300
+1450)=
5,050 DLH

$ 20 per DLH

$ 20 per DLH

$ 20 per DLH

$20 per DLH

Budgeted variable
manufacturing
overhead cost

$26,000

$46,000

$29,000

$101,000

Budgeted fixed
manufacturing
overhead cost

$50,000

$50,000

$50,000

$150,000

Budgeted total
manufacturing
overhead cost

$76,000

$96,000

$79,000

$251,000

Direct Labor Hours


Required
Variable manufacturing
overhead rate

19

Ending Finished Goods Inventory Budget

Ending finished goods inventory budget details the budgeted


unit product cost, ending finished goods inventory in units (the
number of unsold units), and ending finished goods inventory in
dollars (the cost of unsold units)

Ending finished goods inventory needed for two reasons


To determine the cost of goods sold on the budgeted income
statement
To value ending inventories on the budgeted balance sheet

Production
Production budget
budget

Ending
Ending finished
finished goods
goods
inventory
inventory budget
budget

20

Ending finished goods inventory budget for Royal Company


Production costs per unit

Quantity

Cost

Total

Direct materials

5.00 lbs.

$0.4

$2.00

Direct labor

0.05 hrs.

$10.0

$0.50

Manufacturing overhead

0.05 hrs.

$49.7

$2.49
$4.99

Budgeted finished goods inventory


Ending inventory in units
Unit product cost
Ending finished goods inventory

$4.99
???

Total mfg. OH for quarter $251,000


Total labor hours required 5,050 = $49.70 per hour

21

Ending finished goods inventory budget for Royal Company


Production costs per unit

Quantity

Cost

Total

Direct materials

5.00 lbs.

$0.4

$2.00

Direct labor

0.05 hrs.

$10.0

$0.50

Manufacturing overhead

0.05 hrs.

$49.7

$2.49
$4.99

Budgeted finished goods inventory


Ending inventory in units

5,000

Unit product cost

$4.99

Ending finished goods inventory

24,950

Production Budget

22

Selling and Administrative Expense Budget

23

Selling and Administrative


Budget lists nonmanufacturing expenses

Sales
Sales budget
budget

Selling
Selling &
& Administrative
Administrative
Budget
Budget

At Royal, the selling and administrative expense budget is divided


into variable and fixed components
The variable selling and administrative expenses are $0.50 per
unit sold
Fixed selling and administrative expenses are $70,000 per month
The fixed selling and administrative expenses include $10,000 in
costs primarily depreciation that are not cash outflows of the
current month

Selling and Administrative Budget for Royal Company


From Sales
Budget

April

May

June

Quarter

20,000

50,000

30,000

100,000

Budgeted Variable S&A


rate

0.5

0.5

0.5

0.5

Budgeted Variable S&A


expenses

10,000

15,000

15,000

50,000

Budgeted Fixed S&A


expenses

70,000

70,000

70,000

210,000

Budgeted Total S&A


expenses

80,000

95,000

85,000

260,000

Budgeted sales

24

Consolidate for Financial Budgets


Operating budgets
Sales
Sales budget
budget
Ending
Ending
inventory
inventory
budget
budget
Direct
Direct materials
materials
budget
budget

Financial budgets

25

Production
Production budget
budget

Direct
Direct labor
labor
budget
budget

Budgeted
Budgeted
income
income
statement
statement

Selling
Selling and
and
administrative
administrative
budget
budget

Manufacturing
Manufacturing
overhead
overhead budget
budget

Cash
Cash budget
budget

Budgeted Income Statement

Budgeted income statement shows the companys


target revenues, expenses and profit.
It summarizes the financial results of operation budgets,
including sales, production, direct materials, direct labor,
manufacturing overhead, and selling and administrative
budgets

Budgeted income statement serves as a benchmark


against which subsequent actual performance can be
measured
Detect the problematic areas in a firm
Evaluate the performance of managers

26

Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Sales (100,000 units @ $10)
Less: Cost of goods sold (100,000 @

$1,000,000
$499,000

$4.99)
Gross margin

27

Sales Budget
Ending Finished
Goods Inventory
Budget

$501,000

Selling and administrative expenses

$260,000

Operating income

$241,000

Selling and
Administrative
Expense Budget

Cash Budget

Cash Budget details cash inflows and outflows


Revenues and costs on the income statement differ
from actual cash inflows and outflows
revenues are recorded when the product was sold, not when
the $$$ was actually received
product costs are expensed when the product was sold
(matching of costs to revenues), not when the cost was actually
incurred
depreciation is a non-cash cost item (not a cash outflow)
special items

Firms use cash budget to determine whether they


will have enough cash on hand to sustain operations
Cash shortage can be managed by accelerating revenues,
deferring payments, or borrowing

28

Format of the Cash Budget

29

The cash budget is divided into four sections:

Cash receipts section lists all cash inflows excluding cash


received from financing

Cash disbursements section consists of all cash payments


excluding repayments of principal and interest

Cash excess or deficiency section determines if the


company will need to borrow money or if it will be able to repay
funds previously borrowed; Cash inflow cash outflow

Financing section details the borrowings and repayments


projected to take place during the budget period

Cash Inflows from Operations

The main cash inflow is proceeds from sales


To estimate cash inflows, sales revenue needs to be adjusted
for the firms credit policy:
if you offer credit to customers, some of them will pay you weeks or
months after the sale
sales revenue is recognized on the income statement when the sale
took place, not when you actually received the $$$

30

Example: Cash receipts from Credit Sales

Many of your customers buy on credit (i.e., part of sales


revenue is collected several months after the sale).
On average, you collect 60% of revenue in the month of sale,
35% of revenue in the following month, and 5% of revenue 2
months later. What are your cash inflows in May?
Month
March
April

Sales
$150
$100

May

$130

Month

March

April

May

March

150x60%1

150x35% =
52.5

150x5% =
7.5

100x60%=
60

100x35% =
35

April

31

May

130x60% =
78

Cash
Collection

78+35 +7.5
= 120.5

Exercise: Cash receipts from credit sales

Wallmarts budgeted sales are as follows:

32

January
$150,000
February
$160,000
March
$172,000
The company expects to collect 75% of a months
sales in the month of sale and 25% in the following
month.
Question: What are the cash receipts for February?

Example: Royal Companys Cash Receipts


Royal Companys Sales Budget
Budgeted sales in units
Selling price
Budget sales revenue

April

May

June

Quarter

20,000

50,000

30,000

100,000

$10

$10

$10

$10

$200,000

$500,000

$300,000

$1,000,000

At Royal Company, all sales are on account.


Royals credit policy is
70% collected in the month of sale
25% collected in the month following sale
5% uncollectible

33

In April, the March 31st accounts receivable balance of $30,000 will


be collected in full.

Royal Companys expected cash receipts


April
Accounts receivable 3/31

May

June

Quarter

$30,000

$30,000

$140,000

$140,000

April Sales
70% * $200,000
25% * $200,000

$50,000

$50,000

$350,000

$350,000

May Sales
70%*$500,000
25%*$500,000

$125,000

$125,000

$210,000

$210,000

$335,000

$905,000

June Sales
70%*$300,000

Total cash collections


34

$170,000

$400,000

Cash Outflows from Operations


Cash outflows from operations: purchases of direct
materials, payment to direct labor, expenditures on
manufacturing overhead and SG&A costs

adjust for credit terms with suppliers


adjust for non-cash items (e.g., depreciation)

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Example: Royal Companys Cash Disbursement


Royal Companys Direct Materials Budget
Materials to be purchased (lbs)
Materials price per pound
Cost of materials purchased

April

May

June

Quarter

140,000

221,500

142,000

503,500

$0.4

$0.4

$0.4

$0.4

$56,000

$88,600

$56,800

$201,400

Royal pays $0.4 per pound for its materials


Royal Companys cash payment policy
50% of a months purchase is paid for in the month of purchase;
50% is paid in the following month
The March 31 accounts payable balance is $12,000

36

Royal Companys expected cash disbursement for materials


April
Accounts payable 3/31

May

June

Quarter

$12,000

$12,000

$28,000

$28,000

April Purchases
50% * $56,000
50% * $56,000

$28,000

$28,000

$44,300

$44,300

May Purchases
50%*$88,600
50%*$88,600

$44,300

$44,300

$28,400

$28,400

$72,700

$185,000

June Purchases
50%*$56,800

37

Total cash disbursements


for materials

$40,000

$72,300

Royal Companys Cash Disbursement for labor, manufacturing


overhead, selling & administrative expenses

Royal Company - Non Cash Items


Fixed manufacturing overhead includes $20,000 of noncash costs
(primarily depreciation of plant assets)
Fixed selling and administrative expenses include $10,000 in costs
primarily depreciation that are not cash outflows of the current month
April

May

June

Quarter

Budgeted direct labor cost

$15,000

$23,000

$15,000

$53,000

Budgeted variable manufacturing


overhead

$26,000

$46,000

$29,000

$101,000

Budgeted fixed manufacturing


overhead

50,000-20,000

50,000-20,000

50,000-20,000

$90,000

=30,000

=30,000

Budgeted variable S&A expenses

10,000

15,000

15,000

$50,000

Budgeted fixed S&A expenses

70,000-10,000

70,000-10,000

70,000-10,000

=60,000

=60,000

=60,000

$180,000

Cash disbursement

38

=30,000

Special Items

Adjust for special items


Cash outflows: purchase of machines, payment of dividends, loan
payments
Cash inflows: sale of machines, sale of stock in capital market, loans
received

Special items in Royal Company


An April 1 cash balance of $40,000
Purchases $143,700 of equipment in May and $48,300 in June
(both purchases paid in cash)
Pays a cash dividend of $49,000 in April
Maintains a minimum cash balance of $30,000
Borrows on the first day of the month and repays loans one year
later

39

Royal Companys Cash Budget


April

May

June

Quarter

Beginning cash balance

$40,000

$30,000

$30,000

$40,000

Add: Cash collections

$170,000

$400,000

$335,000

$905,000

Total cash available

$210,000

$430,000

Materials

$40,000

$72,300

$72,700

$185,000

Direct labor

$15,000

$23,000

$15,000

$53,000

Manufacturing overhead

$56,000

$76,000

$59,000

$191,000

Selling and administrative

$70,000

$75,000

$75,000

$230,000

$143,700

$48,300

$192,000

$49,000

$49,000

Total disbursements

$230,000

$400,000

270,000

$900,000

Excess (deficiency)

$(20,000)

$30,000

95,000

$45,000

$50,000

$50,000

Total financing

$50,000

Ending cash balance

$30,000

$30,000

$95,000

Less: Cash disbursements

Equipment purchase
Dividend

Financing:
Borrowing
Repayments

40

$95,000