CHAPTER 6 OPERATIONAL AND FINANCIAL BUDGETING 6-1 Sales Forecasting (a) The most critical factors for a high-fashion

clothier are the state of the economy and the tastes of consumers. Sales for this type of company are probably hardest to forecast because changes in taste are so hard to forecast. Athletic shoes were selling very well into 1998, then slowed considerably as the "brown shoes" typified by Timberland's offerings became more fashionable. (b) A manufacturer of carpeting must pay special attention to leading indicators such as housing starts and building permits issued. Carpet is a derived demand product, though the replacement market is certainly significant. (c) A grocery chain is concerned about the growth of areas it serves, whether competitors are moving in, and general economic conditions. The grocery business holds up in bad times, but the sales of other items typically stocked by a grocery chain will fall off during recessions. (d) Advertising revenues for a TV station depend on such factors as the ratings of its programs and economic conditions, both national and local. Some advertising is national, some local, so both matter. 6-2 Sales ForecastingEffects of External Events

Note to the Instructor: Answering this question is complicated somewhat because the indicated event may (1) affect the sales forecast in quantity, (2) prompt a change in prices or a change in sales mix, or (3) produce some combination of these changes. The following answers emphasize the effects on the forecast of quantities. (a) You would revise the forecast downward because the cut in the government program will result in fewer families buying homes and, therefore, appliances. (b) The forecast would probably be revised upward. Jewelry is a luxury item, and spending on luxury items is likely to increase as disposable personal income increases. Some individuals will enter the market who previously would not have, and some individuals will purchase more expensive jewelry than they might have before. (c) You would revise the sales forecast upward. Decreases in computer prices will lead to people buying more computers, and to your selling more parts to the makers. (d) Two possibilities arise. First, the higher the prices of energy, the more likely people and businesses will replace old, inefficient equipment. This effect will increase your sales. However, to the extent that heating (say in Miami) and air conditioning (say in Minnesota) are luxury items and bought at the margin, sales might decline. (e) The sales forecast should probably be adjusted upward. Improved insulation should reduce the requirements for energy to heat (or cool), and the rising energy costs should generate some additional insulation sales.

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(f) Sales forecasts for future years should be revised downward. High school students are an important group of prospective college students. However, the decline could be partially offset if a larger proportion of high school graduates continues in education and/or there is an increase in the number of persons entering college after several years away from school. (If the forecasted number of total students declines, the company might be expected to adopt higher prices to partially offset the smaller market.) 6-3 What's Happening Here? being careful about travel under budget if he continued at the year if he did not spend his place in December.

Cal probably went through the year expenditures, then saw that he would be same pace. Fearing a cut the following allowance, Cal sent people all over the 6-4

Cash BudgetingEffects of New Information

(a) A slowdown in collections can be expected, so cash receipts expectations must be revised. Perhaps, in those months where projected cash balances are relatively close to the desired minimum, borrowing will be indicated. The cash disbursements budget may also need revision if interest rates have risen beyond those expected at the time of the original budget. (b) The effects of an increase in the sales budget would be a lagged increase in the cash receipts budget, revision of the production and purchases budgets, and a corresponding revision of the cash disbursements budgets. (c) The cash disbursements budget must be revised to speed up the payments to suppliers. This revision may indicate the need for additional short-term financing. (d) The change in inventory policy will affect the purchases budget and, therefore, the cash disbursements budget. It is not possible, however, to be specific about the direction of the change without some idea of the month-to-month swings in sales levels. 6-5 Relationships of Profit and Cash This question draws attention to normal lead/lag situation for cash flows. The stated changes in cash balances are in line with the stated changes in sales volumes, given the normal expectations about cash outflows for merchandise purchases preceding cash inflows from sales. As a company grows, its cash receipts tend to lag behind its cash disbursements as long as the time to pay for purchases is less than the time a unit spends in inventory plus the time that customers take to pay. Only exceptional terms from suppliers will allow receipts to keep pace with disbursements. The reverse is true when sales are declining. The company is then paying for fewer units than it is collecting for, so receipts do not fall as fast as disbursements. 6-6 Are Budgets Bad at GE?

Welch apparently believes that sales budgets are set without regard to conditions in a particular industry and followed despite changes in external circumstances. Nothing in the chapter suggests that budgets should follow such principles. Rather the chapter points out that one benefit of budgets is that they help managers to determine whether changes during the period

6- 2

indicate permanent or temporary differences. not believe that participation is important.

It also appears that Welch does

Welchs views were reported by Thomas J. Martin, Managing: Ideas % Solutions, Fortune, May 29, 1995, 145-7. 6-7 Budgeted Income Statements and Purchases Budget (15 minutes) June $220,000 132,000 88,000 22,000 66,000 22,000 $ 44,000

Sales Cost of goods sold at 60% Gross profit Other variable costs at 10% Contribution margin Fixed costs Income Cost of goods sold ($250,000 x 60%) Desired ending inventory ($220,000 x 60%) Total requirements Beginning inventory Purchases 6-8 Cash Budget, Continuation of 6-7

May $250,000 150,000 100,000 25,000 75,000 22,000 $ 53,000 $150,000 132,000 282,000 95,000 $187,000

(20 minutes) May $250,000 $ 50,000 22,000 $2%2,000 June $220,000 $ !2,000 00,000 $2!2,000

Cash receipts budget Sales budget Collections from: Current month, 60% "rior month, #0% $otals Cash disbursements budget Purchases of prior month (6-7) Variable costs at 10% of sales Fixed costs ($22,000 - $3,000) Total cash disbursements Cash budget Beginning balance Receipts Total available Disbursements (requirement 1) Ending balance 6-9 1. May $ 30,000 272,000 302,000 224,000 $ 78,000 June $ 78,000 232,000 310,000 228,000 $ 82,000 (20 minutes) May $180,000 25,000 19,000 $224,000 June $187,000 22,000 19,000 $228,000

Budgeted Income Statement and Purchases Budget

Budgeted income statement for first three months of 20X9 Sales ($70,000 + $70,000 + $90,000) Cost of sales at 60% Gross profit Fixed costs ($12,000 x 3) $230,000 138,000 92,000 36,000

6- 3

Income

$ 56,000

6- 4

2.

Purchases budget Cost of sales* Desired ending inventory** Total requirements Beginning inventory Purchases January $ 42,000 63,000 105,000 55,000 $ 50,000 February $ 42,000 81,000 123,000 63,000 $ 60,000 March $ 54,000 72,000 126,000 81,000 $ 45,000 Total $138,000 72,000 210,000 55,000 $155,000

* 60% of month's sales **1.5 x coming month's cost of sales; $63,000 = 1.5 x $42,000; $81,000 = 1.5 x $54,000; $72,000 = 1.5 x $80,000 x .60 (April cost of sales) Note to the Instructor: We urge stressing that inventory, and hence purchases, must be stated in cost dollars, not selling prices. Despite the attention paid to this point in the chapter, some students will insist on interpreting "one and one-half times the coming month's budgeted sales" as meaning that inventory is 1.5 times sales for the coming month, not cost of sales. 6-10 Cash Budget and Pro Forma Balance Sheet (Continuation of 6 -9) minutes) 1. Cash receipts budget January $ 70,000 $ 42,000 30,000 $ 72,000 January $ 50,000 $ 20,000 18,000 12,000 $ 50,000 February $ 70,000 $ 42,000 28,000 $ 70,000 February $ 60,000 $ 24,000 30,000 12,000 $ 66,000 March $ 90,000 $ 54,000 28,000 $ 82,000 March $ 45,000 $ 18,000 36,000 12,000 $ 66,000 March $ 46,000 82,000 128,000 66,000 $ 62,000 Total $138,000 86,000 $224,000 Total $ 62,000 84,000 36,000 $182,000 Total $ 20,000 224,000 244,000 182,000 $ 62,000 (20-25

Sales budget Collections from: Current month (60%) Prior month (40%) Total 2. Cash disbursements budget

Purchases (6-9) Payments for purchases: Current month (40%) Prior month (60%) Fixed costs Total 3. Cash budget

Beginning balance Receipts Available Disbursements Ending balance

January February $ 20,000 $ 42,000 72,000 70,000 92,000 112,000 50,000 66,000 $ 42,000 $ 46,000

4. Pro Forma Balance Sheet as of March 31, 20X9 Assets Cash (cash budget) Accounts receivable (40% of March sales of $90,000) Inventory (6-9 purchases budget) Total assets Equities Accounts payable (60% x $45,000 March purchases) Stockholders' equity 143,000* Total equities $ 62,000 36,000 72,000 $170,000 $ 27,000 $170,000

6- 5

* $87,000 beginning balance + $56,000 income, from 6-9 6-11 Budgeted Income Statement and Purchases Budget (20 minutes) 1. Budgeted income statements January $100,000 40,000 60,000 30,000 30,000 22,000 $ 8,000 January $ 40,000 104,000 144,000 50,000 $ 94,000 February $130,000 52,000 78,000 39,000 39,000 22,000 $ 17,000 February $ 52,000 128,000 180,000 104,000 $ 76,000 March $160,000 64,000 96,000 48,000 48,000 22,000 $ 26,000 March $ 64,000 120,000 184,000 128,000 $ 56,000 Total $390,000 156,000 234,000 117,000 117,000 66,000 $ 51,000 Total $156,000 120,000 276,000 50,000 $226,000

Sales Cost of sales at 40% Gross profit Other variable costs at 30% Contribution margin Fixed costs Income 2. Purchases budget

Cost of sales Desired ending inventory* Total requirements Beginning inventory Purchases

* Inventories are twice cost of sales for the coming month, $104,000 = $52,000 x 2, etc. The $120,000 is $150,000 (April budgeted sales) x 40% x 2. Note to the Instructor: In their entirety, these assignments are a bit more challenging than 6-9 and 6-10. The latter do not have depreciation, those of this exercise do. The cash balance in 6-12 drops in the face of positive income, giving you the opportunity to pursue the important point that cash and income are not the same. The same point about cost dollars versus sales that is discussed in the Note to the Instructor in 6-9 also applies here. 6& 2 Cash 'udget and "ro (orma 'alance Sheet )Continuation of 6& minutes* + Cash recei,ts budget January $ 00,000 $ 20,000 .0,000 $ 0,000 (ebruary $ !0,000 $ 26,000 -0,000 $ 06,000 March $ 60,000 $ !2,000 0#,000 $ !6,000 $otal $ %-,000 2%#,000 $!52,000 $otal $2!0,000 %,000 5#,000 $#0 ,000 * )20&25

Sales budget Collections from: Current month )20%* "rior month )-0%* $otal 2+ Cash disbursements budget

January "rior month/s ,urchases )6& * 60,000 0ther 1ariable costs )!0% of sales* !0,000 (i2ed costs3 -,000 $otal $ 0-,000 3 $22,000 & $#,000 de,reciation !+ Cash budget January $ 50,000

(ebruary March $ .#,000 $ %6,000 !.,000 #-,000 -,000 -,000 $ 5 ,000 $ #2,000

'eginning balance

(ebruary $ 52,000

March %,000

$otal $ 50,000

6- 6

4ecei,ts 0,000 06,000 51ailable 60,000 5-,000 6isbursements 0-,000 5 ,000 7nding balance $ 52,000 $ %,000 #+ "ro forma balance sheet as of March ! , 208# 5ssets Cash )cash budget* 5ccounts recei1able )-0% of $ 60,000 March sales* 9n1entory ),urchases budget from 6& * (i2ed assets )$ 50,000 & $ 2,000 de,reciation* $otal assets 7:uities 5ccounts ,ayable )March ,urchases, from 6& Stoc;holder/s e:uity $otal e:uities *

!6,000 #!,000 #2,000 $ ,000

!52,000 #02,000 #0 ,000 $ ,000

,000 2-,000 20,000 !-,000 $!-%,000

$ 56,000 !! ,0003 $!-%,000

3 $2-0,000 'eginning balance < $5 ,000 income =ote to the 9nstructor: >ou might as; the class ?hy cash is budgeted to di1e to $ ,000, a decrease of $#.,000, ?hen budgeted income for the :uarter ?as $5 ,000+ 5n analysis a,,ears belo?+ $he reasons are that cash collections ?ere $!-,000 less than sales )$!.0,000 sales & $!52,000 cash recei,ts*, ,ayments to su,,liers ?ere $%#,000 higher than cost of sales )$2!0,000 from cash budget & $ 56,000 cost of sales*, and de,reciation ?as $ 2,000+ $he $%#,000 difference bet?een ,ayments for merchandise and cost of sales ?as a $%0,000 )$ 20,000 & $5,000* increase in in1entory less a $#,000 increase in ,ayables )$56,000 March 5@" from ,ro forma balance sheet, or March ,urchases budget, less $60,000 beginning balance*+ 9ncome 6e,reciation 9ncrease in recei1ables, $ 2-,000 & $.0,000 9ncrease in in1entory, $ 20,000 & $50,000 6ecrease in accounts ,ayable, $60,000 & $56,000 Change in cash 6-13 Budget for Service Company April Sales of merchandise Cost of sales at 90% Gross profit Design fees Total Fixed expenses Income $14,000 12,600 1,400 6,000 7,400 4,100 $ 3,300 May $17,000 15,300 1,700 9,500 11,200 4,100 $ 7,100 June $13,000 11,700 1,300 7,500 8,800 4,100 $ 4,700 Total $44,000 39,600 4,400 23,000 27,400 12,300 $15,100 $ 5 ,000 2,000 )!-,000* )%0,000* ) #,000* $)#.,000*

Other formats for the income statements are possible. Ms Davis might want a two-column income statement showing the two types of sales separately. 6-14 Purchases BudgetUnits and Dollars 1. (a) Purchases budgetunits (20 minutes)

6- 7

Sales Desired ending inventory* Total requirements Beginning inventory Purchases

February 1,900 1,100 3,000 1,000 2,000

March 2,200 1,150 3,350 1,100 2,250

April 2,300 1,050 3,350 1,150 2,200

May 2,100 850 2,950 1,050 1,900

June 1,700

* 50% of budgeted sales for the following month: 1,100 = 2,200 x .50, 1,150 = 2,300 x .50, 1,050 = 2,100 x .50, 850 = 1,700 x .50 (b) Purchases budgetdollars March $ 8,800 4,600 13,400 4,400 $ 9,000 April $ 9,200 4,200 13,400 4,600 $ 8,800 May $ 8,400 3,400 11,800 4,200 $ 7,600 June $ 6,800

February Cost of sales at $4 $ 7,600 Desired ending inventory* 4,400 Total requirements 12,000 Beginning inventory 4,000 Purchases $ 8,000

* budgeted cost of sales for the next month x 50%, or $4 times desired units from requirement (a). 2. We stop with May. Determining June purchases requires knowing July sales. Note to the Instructor: Some students will determine dollar purchases for requirement 1b by multiplying the answers in requirement 1a by the $4 unit cost. The resulting dollar amounts for purchases are correct, of course. 6-15 Budgeted Income Statement for a Manufacturer (5-10 minutes) $2,000 $ 600 700 300 $ 150 70 $ (5-10

Sales (50 units x $40) Variable costs: Manufacturing, materials (50 x $12) other (50 x $14) Commissions, 15% of sales Contribution margin Fixed costs, manufacturing other Profit

1,600 400 220 180

6-16 Production Budget for a Manufacturer (Continuation of 6-15) minutes) Variable manufacturing costs (50 units): Materials (50 units x 4 lbs. per unit x $3 per lb.) Other variable manufacturing cost [50 units x ($26 - $12)] Fixed manufacturing costs Total production cost

600 700 150 $1,450

6-17 Purchases Budget for a Manufacturer (Continuation of 6 -15 and 6-16) (10 minutes) Dollars Pounds Pounds x $3 Material needed for production (50 units x 4 lbs.) 200 $ 600 Material needed for ending inventory 55 units x 4 lbs. x 20% 44 132

6- 8

Total required Material in beginning inventory, given Required purchases 6-18 Expense Budgets and Variances (5 minutes)

244 34 210

732 102 630

Note to the Instructor: We do not wish to introduce the difference between flexible budgets based on output and on those based on input at this stage. We used both input and output, and had no efficiency variance, in the assignment so that students would not be confused by overuse or underuse of the resource. The budget variance is $450 unfavorable Flexible budget allowance, $22,700 + ($1.815 x 14,000 hours) Actual cost Flexible budget variance, unfavorable $48,110 48,550 $ 450

The flexible budget allowance is much more useful than the original budget of $49,925 because it reflects the actual activity and the cot that should have been incurred based on the work done during the period. The responsible manager did not save $1,375 on utilities, given that he worked less than the originally budgeted amount. Note to the Instructor: Because they have seen cost-prediction formulas in Chapter 3, students usually have little trouble with the concept of a flexible-budget allowance in Chapter 6. Nevertheless, we developed this simple exercise to emphasize the budgeted/actual distinction because students often err in determining a flexible-budget allowance in Chapter 11 (on standard costs) and in the chapters on product costing (Chapters 12-14). 6-19 Budgeted Income Statements (25 minutes) April $136.0 156.0 292.0 131.4 160.6 23.4 137.2 140.0 ($ 2.8) May $136.0 247.0 383.0 172.4 210.6 30.6 180.0 140.0 $ 40.0 June $136.0 358.8 494.8 222.7 272.1 39.6 232.5 140.0 $ 92.5 July $136.0 369.2 505.2 227.3 277.9 40.4 237.5 140.0 $ 97.5

Sales, monthly base Variable at $0.052 x value of permits in prior month Total sales Cost of sales at 45% Gross profit Other variable costs at 8% Contribution margin Fixed costs Income (loss)

Note to the Instructor: This exercise can be used to explain a lag relationship. In this case, building permits precede sales, which is reasonable given that permits are issued prior to the start of construction. The one-month lag is not necessarily realistic because it assumes that all materials will be bought in the month after the permit is secured. It is more likely that there would be several months of permits in the equation, with differing weights assigned to the various months. The resulting equation would be a multiple regression equation as illustrated in the appendix to Chapter 3. If we suppose that materials bought by builders are spread over a three-month period, we would have an equation of the form $ Sales = a + b1X1 + b2X2 + bnXn

where the b's are the coefficients for each month and the X's are months following the issuances of permits.

6- 9

Finally, it is convenient to think of the $136,000 intercept as the company's business that does not depend on new construction. Replacements, repairs, do-it-yourself work, and other such sources of demand fit this category. It should be noted that the intercept (zero building permits) is outside the relevant range, so that it is not warranted to assume that sales are likely to be $136,000 if there is no building activity. 6-20 1. Flexible Budget and Variances (15 minutes)

Total production cost = $70,000 + [($4 + $3 + $5) x units produced]

2, 3. Materials ($4 x 18,000) Labor ($3 x 18,000) Variable overhead ($5 x 18,000) Fixed overhead Totals Budget $ 72,000 54,000 90,000 70,000 $286,000 Actual $ 71,800 56,100 89,000 70,000 $286,900 Variance $ 200 F 2,100 U 1,000 F $ 900 U

6-21 Income Statement and Purchases Budget Sales, 4,000 x $20, 4,500 x $20 Variable costs: Cost of goods sold at $8 Commissions at 20% Total variable costs Contribution margin Fixed costs Income 2. 3,000 units

(15 minutes) March $ 80,000 32,000 16,000 48,000 32,000 14,000 $ 18,000 April $ 90,000 36,000 18,000 54,000 36,000 14,000 $ 22,000

Sales Ending inventory, 2 x May sales of 3,750 Total required Beginning inventory, 2 x April sales of 4,500 Purchases 3. 6,250, June sales are 5,000 units, $100,000/$20 Sales Ending inventory, 2 x June sales of 5,000 Total required Beginning inventory, 2 x May sales of 3,750 Purchases 6-22 1. 1 Cash BudgetQuarters (30 minutes)

4,500 7,500 12,000 9,000 3,000

3,750 10,000 13,750 7,500 6,250

Cash budget, in thousands of dollars Quarter . $3,200 $10,100 Total $2,400 $2,800

2 3 4 Cash receipts: From prior quarter $1,700 1/3 of current quarter's

6-10

sales Total Cash disbursements Excess (deficiency) Beginning balance Indicated ending balance Borrowing required Repayments Ending balance 2. 6-23

1,200 2,900 3,350 ( 450) 200 ( 250) 450 $ 200

1,400 3,800 4,240 ( 440) 200 ( 240) 440 $ 200

1,600 4,400 4,520 ( 120) 200 80 120 $ 200 ( $

1,100 4,300 3,470 830 200 1,030 830) 200

5,300 15,400 15,580 ( 180) 200 20 1,010 ( 830) $ 200

The loan outstanding is $180 thousand ($1,010 - $830). Flexible and Static Budgets--Service Department (15 minutes)

The memo should point out that: 1. The $13,940 unfavorable variance is based on a static budget allowance of $155,400 ($169,340 - $155,400 = $13,940). This allowance does not recognize that actual activity might differ from budgeted activity. Such an allowance is appropriate for fixed costs, but not for variable or mixed costs. 2. A better comparison is of actual costs with a flexible budget allowance, which does consider the level of activity actually achieved. The analysis below better shows performance, and indicates that I controlled costs very well. Flexible budget allowance, $12,400 + ($1.43 x 112,500) $173,275 Actual cost 169,340 Favorable budget variance $ 3,935 6-24 Production Budget (10-15 minutes) April 18,000 48,000 66,000 41,000 25,000 May 24,000 50,000 74,000 48,000 26,000 June 25,000

Sales Desired ending inventory* Total requirements Beginning inventory Production * Next month's unit sales x 2 6-25 (a)

Purchases Budget (Extension of 6-24) Purchases budget in pounds

(10-15 minutes)

Used in production Desired ending inventory Total requirements Beginning inventory Purchases (b) Purchases budget in dollars $

April 300,000 468,000 768,000 540,000 228,000

25,000 x 12 26,000 x 150% x 12

Used in production Desired ending inventory Total requirements Beginning inventory Purchases

April 750,000 1,170,000 1,920,000 1,350,000 $ 570,000

300,000 x $2.50 468,000 x $2.50 540,000 x $2.50 228,000 x $2.50

6-11

6-26 1.

JIT Manufacturing (Extension of 6-24 and 6-25) Production budgets

(20 minutes) May 24,000 800 24,800 800 24,000

Sales Desired ending inventory Total requirements Beginning inventory Production

April 18,000 800 18,800 800 18,000

Having constant inventory means that production equals sales every month.

6-12

Purchases budget in pounds Used in production Desired ending inventory Total requirements Beginning inventory Purchases Purchases budget in dollars Used in production Desired ending inventory Total requirements Beginning inventory Purchases 2. April $540,000 48,000 588,000 36,000 $552,000 216,000 x $2.50 19,200 x $2.50 14,400 x $2.50 220,800 x $2.50 April 216,000 19,200 235,200 14,400 220,800 18,000 x 12 24,000/15 x 12 18,000/15 x 12

Cost-saving opportunities that might be included in the memo:

(a) Reduced floor-space requirements. This might permit subletting or expansion without increasing floor space. (b) Reduced investment in inventory. Cash tied up in inventory cannot be used for other purposes. Reducing the investment in inventory permits cash to be used elsewhere. The cash could earn a return if invested elsewhere; or it might be used to reduce interest costs, either by paying off debt or by reducing borrowing requirements. (c) Reduced storage costs. Reducing inventory should reduce handling, insurance, personal property taxes, pilferage, shrinkage, and other costs. (d) Reduced rework and inspection costs. Cost savings in these areas are likely if the company's move to JIT operating conditions includes assigning some inspection responsibilities to manufacturing personnel. Additionally, when inventories are low, defective units cannot hide for lengthy periods. Workers find defectives quicker and can eliminate their causes quicker. Note to the Instructor: Some students will mistakenly assert that costs are lower because the company produces and buys less under these policies. This is not so, though the numbers used here create the impression. Overall costs might go down because of increased efficiency and less waste, but the costs of production and of purchases do not fall nearly as much as indicated here. 6-27 1. Cash Budget--Nursery School Cash disbursements budget $24,150 4,000 28,150 2,414 3,402 2,270 1,650 335 1,226 $39,447 (15-25 minutes)

Payroll: Teacher's salary, $21,000 x 1.15 Teacher's assistant Total payroll Payroll-related cost, $28,150 x [$2,144/($21,000 + $4,000)] Supplies, $3,240 x 105% Food, $2,162 x 105% Equipment-related costs Licenses, $285 + $50 Miscellaneous Total 2. About $110 per child per month

6-13

Revenue divided Monthly divided Monthly 6-28

required by number of months revenue required by enrollment fee (10-15 minutes)

$39,447 9 $ 4,383 40 $109.58

Preparing Flexible Budgets 10,000 $28,000 12,300 27,600 14,700 8,000 $90,600

Cost Supplies Repairs Power Depreciation Supervision Totals

Direct Labor Hours 12,000 $28,800 12,460 30,000 14,700 11,000 $96,960

14,000 $29,600 12,620 32,400 14,700 14,000 $103,320

For the first four costs, the allowances are the fixed costs, plus the variable component multiplied by direct labor hours. Supervision is $8,000 plus $3,000 for each 2,000-hour increase beyond 10,000 hours. Note to the Instructor: This basic assignment permits you to discuss some points of flexible budgeting. For example, determining the total budget allowances for all costs except supervision is simply a matter of multiplying the direct labor hours by the variable rate and adding the fixed amount. Thus, one could group the first four costs into a single formula for a flexible budget allowance. That formula is: $1.68 DLH plus $65,800. Supervision can't be included in this formula because the variable portion is not $1.50 per DLH ($1,500 increase for 1,000 DLH), but $1,500 for each 1,000 DLH above 10,000. Note, however, that budgeting the first four items as a group is not advantageous for two reasons. First, the company is likely to want to compare actual and budgeted costs for each cost element. Second, the cash-payment patterns of the costs might differ. 6-29 Relationships (30 minutes)

1. 900 units, because inventories are to remain constant. 2. $15,300 (material costs of $5,400 + labor costs of $6,300 + $3,600 variable overhead costs of manufacturing) 3. $420 $ 60 18 $ 42 $420

Selling price Variable costs ($6 + $7 + $4 + $1) Contribution margin Contribution margin on extra units (10 x $42) 4. $34,480 (910 x $18)

Variable costs Fixed costs Total costs

$16,380 18,100 $34,480

We could also add current budgeted costs and incremental costs, as follows. Costs, as budgeted for 900 units ($16,200 + $18,100) Variable costs for 10 extra units (10 x $18) Total costs $34,300 180 $34,480

6-14

5. 6.

About 431 units, $18,100/$42 $17,900

New contribution margin (current less additional variable cost) $40 Number of units planned 900 Total contribution margin using new variable costs $36,000 Fixed costs 18,100 Income $17,900 We can also compute the decline in contribution margin, as follows: Current income Reduction in contribution, 900 units x $2 New income 7. 8. About 1,014 units $24,810 $ 5,580 6,510 3,720 15,810 9,000 $24,810 (30 minutes) [($18,100 + $4,800 + $19,700)/$42] $19,700 1,800 $17,900

Materials (930 x $6) Labor (930 x $7) Variable overhead (930 x $4) Total variable costs Fixed manufacturing costs Total manufacturing costs with production of 930 units 6-30 Relationships Among Sales and Production Budgets

Sales budget (units) January 3,000 (20) February 3,400 March 4,200 (7) April 4,600 (12) May 6,200 (14) June 5,800 (21) July 5,400

Production budget (units) EI (19) Sales Total (18) BI (17) Prod 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. January February 5,100 (1) 6,300 3,000 8,100 (2) 4,500 (3) 3,600 March 6,900 (8) April 9,300 (13) May 8,700 June 8,100

3,400 (4) 4,200 (7) 9,700 (5) 11,100 (9) 5,100 4,600 (6) 6,300 (10) 4,800 (11) 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

4,600 (12) 6,200 (14) 5,800 13,900 14,900 (15) 13,900 6,900 7,000 9,300 (13) 5,600 (16) 8,700 5,200

150% of February sales 1 + January sales 2 - January production February sales forecast 4 + February ending inventory 5 - beginning inventory 2/3 of February EI April beginning inventory 7 + 8 February ending inventory

9 - 10 2/3 of 8 April total requirements minus April sales 2/3 of April ending inventory 14 + May ending inventory 15 - 13 May ending inventory 17 + June production 18 - June sales 2/3 of June ending inventory

6-15

21.

2/3 of May ending inventory

Note to the Instructor: Many students find this problem quite difficult. In any case, the order in which the blanks are filled in will differ among individuals. One-Month Cash BudgetDiscounts

6-31

(30 minutes) $ 73,000 $ 93,600 72,000 68,000 54,400 $ 68,600 123,480 81,000

Beginning balance Collections: June sales ($260,000 x 80% x 45%) July sales ($300,000 x 80% x 30%) August cash sales ($340,000 x 20%) August credit sales ($340,000 x 80% x 20%) Cash available Disbursements: July purchases ($210,000 x 98% x 1/3) August purchases* S & A expenses ($102,000 - $21,000) Budgeted balance, end of August * 2/3 x August purchases (below) Cost of sales (gross = $340,000 x 60%) Desired ending inventory (gross = $300,000 x 60% x 2.5) Required Beginning inventory (gross = $455,700/98%) Purchases

288,000 361,000

273,080 $ 87,920 Net $199,920 441,000 640,920 455,700 $185,220

Gross $204,000 450,000 654,000 465,000 $189,000

Note to the Instructor: The 2% purchase discount will give some students difficulty. The subject is usually mentioned in the first financial accounting course, but the coverage of the gross and net methods varies among schools. We believe that the better interpretation of the inventory policy is that the company should have enough goods to cover 2.5 times the coming month's budgeted sales, so we do not solve the problem assuming that the dollar amount of inventory, net of purchase discounts, should be $450,000, which would make the ending inventory at gross $459,184 ($450,000/98%). However, department stores frequently treat purchase discounts as revenue, and you might wish to take the opportunity to discuss this practice. Another point that is illustrated in this problem, and in others in the chapter, is that the beginning inventory is not always equal to the budgeted amount. If the firm did have 2.5 times August sales on hand at July 31, it would have $510,000 (gross, or net of $499,800), which is $340,000 x 60% x 2.5. Students seem to need constant reminding that budgets are based on expectations and that actual results will not always equal budgeted results. Moreover, because of the timing of purchases or temporary shortages of cash or a host of other causes, the firm may not reach a budgeted level of inventory even if its sales expectations are realized. In this problem, the firm could have had higher sales in July than expected and, if it could not respond quickly and change its purchasing, could easily have wound up short of what would have been its budgeted inventory level at July 31. 6-32 Budgeting in a CPA Firm (25 minutes)

6-16

Revenues (1) Expenses ($16,100 monthly) Income

January through April $143,200 64,400 $ 78,800

May through December $190,800 128,800 $ 62,000

Total $334,000 193,200 $140,800

6-17

(1)

Schedule of revenues January through April (4 months) May through December (8 months) $ 84,000 80,000 96,000 7,200 $143,200 10,800 $190,800 (35 minutes)

Ms. Watson 40% x 1,400 hrs. x $100 60% x 1,400 hrs. x $100 Staff accountants: 200 hrs. x 2 people x 4 months x $50 120 hrs. x 2 people x 8 months x $50 Clerical: 40% x 600 hrs. x 2 people x $15 60% x 600 hrs. x 2 people x $15 Total 6-33

$ 56,000

Sales ForecastingScatter Diagram and Regression

1. A scatter diagram is easy to construct, but the formulas for predicting sales will differ among students. Regression analysis yields the formula: Sales = $437,500 + ($1,542 x thousands of housing units built). 2. $3,213,100 [($437,500 + ($1,542 x 1,800)] The results here will differ because slightly different formulas will be developed. The high r2 of the regression (.9986) indicates that considerable confidence can be placed in the forecast provided that underlying conditions do not change. The standard error is also low, indicating a good fit. Lotus 1-2-3 output appears below. We rounded the fixed component. Regression Output: Constant 437.4892 Std Err of Y Est 18.21279 R Squared 0.998565 No. of Observations 6 Degrees of Freedom 4 X Coefficient(s) 1.542274 Std Err of Coef. 0.029226 6-34 Flexible Budget, Multiple Drivers (20 minutes)

Case A Variable Component Inspection $120.00 Maintenance 2.40 Data processing 0.25 Purchasing 180.00 Other 2.20 Case B Variable Component Inspection $120.00 Maintenance 2.40 Data processing 0.25 Purchasing 180.00 Other 2.20 x Level of Total Variable Fixed Total Activity = Amount + Component = Cost 75 $ 9,000 $72,500 $ 81,500 22,000 52,800 61,200 114,000 360,000 90,000 9,700 99,700 40 7,200 63,600 70,800 11,000 24,200 278,800 303,000 $669,000 x Level of Total Variable Fixed Total Activity = Amount + Component = Cost 110 $13,200 $72,500 $ 85,700 15,000 36,000 61,200 97,200 220,000 55,000 9,700 64,700 120 21,600 63,600 85,200 7,000 15,400 278,800 294,200 $627,000

6-18

6-35

Budgeting and Behavior

(15 minutes)

1. A-1303, because of the higher contribution margin (in dollars per unit and percentage) and potential for growth. 2. D-165, because they are easier to sell and the sales quota is based on dollars of sales, not contribution margin produced. 3. The salespeople should be judged by other factors besides dollar sales. Contribution margin should play some part. Possibly, separate quotas could be established for each product. A special commission might be offered on A1303 sales. If salespeople are not well acquainted with the advantages and uses of A-1303, the company should undertake an educational program. In any case, suggestions for promotional plans could be solicited from the salespeople. 6-36 Conflicts in Policy (30 minutes)

It is not possible to keep inventory within the limits. There are two solutions that violate the desired limits in only one month. In one month (February), Plan 1 produces an inventory that is 6,000 units below the desired minimum. Plan 2 produces an inventory that is 11,000 units above the desired maximum in April. Both plans offer relatively stable production, which might be important in maintaining good labor relations. Of some importance is the accuracy of the sales forecasts. For example, if the forecasts are likely to be optimistic, Plan 1 is preferable because it yields an inventory shortage but still offers a cushion to cover problems with suppliers. But the most important quantitative factor in choosing between the two plans is the relative cost of being over and under the desired levels. The manager should know the additional contribution margin per unit and the added cost of carrying a unit in excess of 40,000. Without information about costs, it is impossible to choose among the many plans that would meet the sales, but not the inventory objectives. Month Production January 72,000 February 72,000 March 72,000 April 72,000 May 90,000 June 72,000 Plan 1 Ending Inventory 27,000 9,000* 21,000 33,000 23,000 15,000 Production 72,000 90,000 72,000 72,000 72,000 72,000 Plan 2 Ending Inventory 27,000 27,000 39,000 51,000* 23,000 15,000

* Outside stated limits 6-37 Budgeting Administrative Expenses (35 minutes)

1. Eight order clerks and three data entry clerks are required and the slack times available are 13 hours and 25 hours, respectively. Order Data Entry Clerks Clerks Calculation of persons needed: Orders that can be processed per hour 3 10 Hours per week 35 35 Orders per week, per person 105 350 Required for 800 orders per week 8 3

6-19

Order Clerks Calculation of slack time: Orders per hour Time required for 800 orders Time available (number of persons x 35 hours) Slack time, in hours * Rounded 3 267* 280 13

Data Entry Clerks 10 80 105 25

2. The likely flexible budget formula is: Total costs = $500 + ($2.90 x orders processed). The typical week is likely to produce an unfavorable budget variance of $205. Calculation of components of budget formula: Fixed cost - purchasing agent's salary of $500 Variable costs: Supplies $0.40 Data entry 0.50 ($5.00/10 orders per hour) Order clerks 2.00 ($6.00/3 orders per hour) Variable cost per order $2.90 Calculation of likely budget variance: Flexible budget allowance of $500 + ($2.90 x 800) Total costs incurred: Purchasing agent $ 500 Supplies 320 (800 x $0.40) Data entry 525 (3 x $5.00 x 35 Order clerks 1,680 (8 x $6.00 x 35 Total Budget variance 3. 840 orders Data Entry Clerks Number of persons 3 Hours worked per week 35 Total hours of work 105 Orders that can be completed per hour 10 Total number of orders that can be handled 1,050 Order Clerks 8 35 280 3 840 $2,820

hours) hours) $ 3,025 205U

Although the data entry clerks could handle 1,050 orders, the current capacity of the department is set by the lower capacity of the order clerks. 4. $2,705 + ($0.40 x orders processed) Fixed costs would be all the costs listed in requirement 2, except the cost of supplies. 6-38 1. Budget Cost Material Direct labor Indirect labor At 10,000 $20,000 30,000 5,000 At 8,000 $16,000 24,000 4,000 Change $ 4,000 6,000 1,000 Reporting Budget Variances (50 minutes) Change/ 2,000 = Variable Portion $2.00 3.00 0.50 Total Variable Cost at Cost at 8,000 - 8,000 $16,000 $16,000 24,000 4,000 24,000 4,000

Fixed Amount 0 0 0

6-20

Power 8,000 Maintenance 6,000 Supplies, other 5,000 Totals $74,000

7,000 5,200 4,600 $60,800

1,000 800 400 $13,200

0.50 0.40 0.20 $6.60

7,000 5,200 4,600 $60,800

4,000 3,200 1,600 $52,800

$3,000 2,000 3,000 $8,000

The memo should say that the reports currently provided do not help managers because the reports do not focus on the behavior of costs when activity changes. Unless budgeted production equals actual production, it is hard to tell whether operations went well or poorly. The memo could include a revised report, as shown below. The current confusion is understandable, as witnessed by changes in direction of most of the variances. 2. Budget Unit production 7,000 Costs: Material $14,000 F Direct labor 21,000 F Indirect labor 3,500 U Power 6,500 U Maintenance 4,800 Supplies, etc 4,400 F Total costs $54,200 F April Actual 7,000 $14,600 21,600 3,900 6,700 4,700 4,580 $56,080 Variance -0$ (600) U (600) U (400) U (200) U 100 F (180) U ($1,880) U Budget 10,500 $21,000 31,500 5,250 8,250 6,200 5,100 $77,300 May Actual Variance 10,500 -0$20,800 31,300 5,300 8,400 6,200 5,050 $77,050 $200 200 (50) (150) 0 50 $250

The reporting method might be partly to blame for some of the variances. For example, a manager who knows that production for a month will be lower than budgeted could be tempted to exercise less control over costs because the variances will still probably be favorable. In months when production is higher than budgeted, it is difficult to decide what a manager might do because the variances (based on the original budget of costs) will probably be unfavorable anyway. A manager who has learned to "play the game" could be tempted to move costs, and production, from one period to another to reduce variances. We do not know whether managers in this case can shift costs from period to period, but they can almost certainly do so with production. Note to the Instructor: A point worth mentioning now, although it is taken up in greater depth later, is the interpretation of the variance in units of production. The question here is whether the variances occurred because of factors not controllable by the production manager, or whether they were the result of lack of effectiveness. The possibility of manipulation is also present, as discussed above. 6-39 1. Understanding Budgets $41,000 Receivable at December 31, 20X0 Collected on January sales ($50,000 x 20%) Total 2. $78,000 [($60,000 + $70,000) x 60%] $ 31,000 10,000 $ 41,000 (20 minutes)

6-21

3.

$49,000 January cost of sales, $50,000 x 60% Required ending inventory, requirement 2 Total requirements Beginning inventory, given Purchases $ 30,000 78,000 108,000 59,000 $ 49,000

6-22

4.

$3,000 Sales, given Cost of sales (60%) Gross profit Other variable costs (20%) Contribution margin Fixed costs, given Income before taxes Taxes, at 25% Net income $ 50,000 30,000 20,000 10,000 10,000 6,000 4,000 1,000 $ 3,000

5.

$2,800

Balance, 12/31 (given in balance sheet) $ 33,000 Receipts from sales, requirement 1 41,000 Total 74,000 Disbursements: December purchases (accounts payable at 12/31) $ 9,000 January purchases (80% of requirement 3) 39,200 Variable cost for January (20% of January sales) 10,000 January fixed costs, cash only 5,000 Taxes on December income (liability at 12/31) 8,000 71,200 Balance $ 2,800 6. 7. 8. $48,000 $99,000 ($60,000 x 80%) [$102,000 - (3 x $1,000)] $ 42,000 78,600 120,600 81,600 $ 39,000 $ 28,000 3,000 31,000 1,200 $ 29,800

$7,800 (20% x $39,000) March cost of sales (60% x $70,000) Inventory 3/31 [60% x ($66,000 + $65,000)] Required Inventory 2/28 [60% x ($70,000 + $66,000)] Purchases $29,800 Retained earnings, 12/31 Budgeted net income (requirement 4) Total Dividend Budgeted retained earnings, 1/31

9.

10. $2,000, from March tax accrual. accrual per item g. Sales Cost of sales at 60% Gross profit Other variable costs at 20% Contribution margin Fixed costs Income before taxes Income taxes at 25% 6-40 Cash Budget for a Student

Taxes are paid in the month after $ 70,000 42,000 28,000 14,000 14,000 6,000 $ 8,000 $ 2,000

(15 minutes)

Phelps must work about 81 hours in September and about 62 hours in the other two months to meet his expenses and maintain a minimum balance of $100.

6-23

Beginning balance Scholarship check Cash available Disbursements: Tuition, books, and rent Meals Clothing Dates and miscellaneous Total disbursements Indicated balance (deficit) Funds required from working1
1

September $1,250 2,000 3,250 3,280 300 50 100 3,730 ( 480) ($580)

October $ 100 100 0 300 50 100 450 ( 350) ($450)

November $ 100 100 0 300 50 100 450 ( 350) ($450)

Deficit plus $100 minimum required balance

Hours required: $580 / $7.20* 80.6 $450 / $7.20* * $8 hourly wage - 10% withholding tax 6-41 1. 2. Analysis of Budgets of a Manufacturing Firm

62.5

62.5

(35 minutes)

$0.80 ($8,000 total variable manufacturing costs divided by 10,000 units) $600, as given in the cash disbursements budget.

3. Collections are expected to be 25% in the month of sale and 75% in the month after sale. The cash receipts budget shows that each month's sales are so collected. (January sales collections are $1,500 in January, $4,500 in February, and so on.) 4. $1,000, because collections in January on December sales are to be $750, which is 75% of December sales. 5. $11,250, which is 75% of $15,000 budgeted sales in March ($3,750 cash collections/25%). 6. 40% in the month of sale and 60% in the following month. The "current month" portion of variable S&A expenses in the cash budget is always 40% of the total of the S&A associated with that month. For example, $600 paid in January is 40% of the January total ($600 + $900). 7. $2,250 March sales (5,000 x $3) Variable cost, at 25% of sales Unpaid portion, at 60% of variable cost 8. $900 Beginning balance Budgeted receipts ($2,250 + $6,750 + $10,500) Budgeted disbursements ($5,350 + $8,000 + $7,050) Budgeted ending balance 9. $13,200 Revenue increase Cost increase [($6,000 x 25%) + (2,000 x $0.80)] Increased contribution margin $15,000 $ 3,750 $ 2,250 $ 1,800 19,500 21,300 20,400 $ 900 $ 6,000 3,100 2,900

6-24

Current profit budgeted 10,300 Revised profit $13,200 10. Inventory is equal to one and one-half times the budgeted sales of the coming month. (The desired ending inventory in January is 4,500, one and one-half times February's budgeted sales of 3,000, and so on.) 11. No, because only 2,500 units are on hand at January 1. If the policy were followed, there would be 3,000 units (2,000 units x 1 1/2). 12. 4,000 units, since the desired inventory at March 31 is 6,000 units. Dividing 6,000 by 1.5 gives 4,000.

6-25