Balakrishnan MGRL Solutions Ch07

CHAPTER 7
OPERATING BUDGETS: BRIDGING PLANNING AND CONTROL

SOLUTIONS
REVIEW QUESTIONS
7.1 A plan for using limited resources.
7.2 Firms budget for (1) planning, (2) coordination, and (3) control (performance evaluation
and feedback).
7.3 Operating budgets reflect the collective epression of numerous short!term decisions that
conform to the direction set b" long!term plans. Financial budgets #uantif" the outcomes
of operating budgets in summar" financial statements.
7.4 $he revenue budget. Organi%ations begin &ith the revenue budget because it is the first
line on the income statement. Additionall", organi%ations begin &ith the revenue budget
because revenues dictate the volume of operations &hich, in turn, drive man" costs such
as those related to materials and labor.
7.5 $he production budget.
7.6 $he budgets for materials, labor, and overhead.
7.7 'ost of goods sold ( 'ost of beginning finished goods inventor" ) cost of goods
manufactured * cost of ending finished goods inventor".
7.8 $he cash budget is important for managing a firm+s &orking capital. ,t allo&s companies
to determine &hether the" &ill have enough mone" on hand to sustain pro-ected
operations.
7.9 (1) ,nflo&s from operations, (2) outflo&s from operations, and (3) special items.
7.1 .ecause most businesses offer credit terms to their customers * as such, the" receive cash
a fe& da"s, &eeks, or months after the sale occurs. /oreover, a firm+s credit polic"
affects the timing and amount of cash flo&s.
7.11 (1) 0urchases of direct materials, (2) pa"ments for labor, (3) ependitures on
manufacturing overhead, and (1) outflo&s for marketing and administration costs.
7.12 2ome eamples include the purchase or sale of e#uipment, the purchase or sale of stock,
and the pa"ment of dividends.
7.13 A responsibilit" center is an organi%ational subunit. $here are three t"pes of responsibilit"
centers3 (1) cost centers, (2) profit centers, and (3) investment centers.
.alakrishnan, /anagerial Accounting 1e FO4 ,52$46'$O4 627 O589
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7.14 $op!do&n is more of an authoritative approach, &hereas a bottom!up approach is more
participative, encouraging organi%ation!&ide input into the budgeting process.
7.15 An incremental approach to budgeting can be useful as past trends ma" help &ith future
pro-ections. ,t is pragmatic, as it focuses attention on making changes to the previous
"ear+s budget based on actual performance and ne& information. Finall", incremental
changes are easier to -ustif" and communicate * it is human nature to compare
performance across people and periods.
DISCUSSION QUESTIONS
7.16 $he span of the operation often determines the need for a formal budget. ,t is easier to
plan and keep track of &hat is happening if the operation is small enough. As the business
epands to a point &here it is difficult one person can oversee the &hole operation and
multiple people have to make decisions &ith respect to different aspects of the business,
planning and coordination become necessar". /oreover, ho& can the o&ner of this
epanding business ensure that all other emplo"ees making the various decisions are in
fact making them as he &ould make them; 2ome control also becomes necessar"<
.udgets serve these purposes.
7.17 9es, this is in general a true statement. =aving a formal &ritten document that different
decision units commit to is the most efficient of ensuring that there is proper coordination
and there is goal congruence across these units.
7.18 ,t is true that there is al&a"s likel" to some deviation from &hat is epected. .ut,
deviations can occur because of factors outside decision makers+ control, and there is not
much one can do to avoid these chance deviations. >eviations can also occur because the
organi%ational actions and decisions are not in line &ith &hat the" &ere epected to do.
." providing a baseline for comparison, budgets allo& us to measure and anal"%e these
deviations so that corrective actions can be taken &hen necessar".
7.19 ,f budgets can be used to create the right organi%ational incentives, and all decision
makers in the organi%ations are motivated to do the right thing, then close supervision
ma" not be necessar". =o&ever, as discussed in the chapter, budgets cannot be a perfect
substitute for supervision monitoring because the" are susceptible to game!pla"ing? no
budget can be perfect &hen it comes to setting the right incentives. 2ome supervision and
monitoring is al&a"s beneficial.
7.2 .udgets pla" a limited role as a benchmark for performance evaluation in settings &here
forecasting is difficult and there is a high level of inherent uncertaint". =o&ever, it is
better to have rough budgets than no budgets at all, and supplement budgets &ith other
monitoring mechanisms such as close supervision.
7.21 >epending on the si%e of the organi%ation and the number of products it offers,
forecasting sales is a difficult eercise because it re#uires careful eamination of market
conditions and trends. ,naccurate sales forecasts can thro& the entire planning process out
:!2
of gear. 2o, man" organi%ations devote a lot of time to develop dependable sales
forecasts. 7stimating overheads is also difficult especiall" in large organi%ations because
there are multiple drivers of overhead. ,dentif"ing the right drivers and estimating the
precise relations bet&een the overhead and its drivers is a difficult but an important step
in the budgeting process.
7.22 @ust!in!s"stem is often referred to as a ApullB s"stem because an order from a customer
triggers all the production and procurement activities. $he idea is to carr" no inventor" in
the s"stem, but respond to demand #uickl" b" achieving b" coordinating all necessar"
activities smoothl". $o the etent a perfect pull s"stem can be achieved there are minimal
inventor" budgets that reconcile the difference bet&een sales and production. 2imilarl",
there are minimal ra& and &ork!in!process inventories that account for the difference
bet&een material purchase and use.
7.23 $he budgeting process is time consuming in most organi%ations. 2ome large
organi%ations are kno&n to start their budgeting process si months ahead of time. $he
benefit of going through several iterations is that budgets become more accurate, serve as
better benchmarks to evaluate performance, and there is better coordination across the
organi%ation because ever"bod" is a&are of &hat is in it. $he cost is that it takes time and
effort.
7.24 .oth the cash budget and cash flo& statement reconcile the cash position of a compan" at
the beginning of a period to the cash position at the end of the period. .ut there are man"
differences. First, the cash flo& statement is prepared at the end of the period, and reports
past cash inflo&s and outflo&s. 2econd, the cash flo& statement reports cash flo&s
associated &ith investing, financing, and operating decisions of the firm. On the other
hand, a cash flo& budget presents a plan of cash inflo&s and outflo&s at a more detailed
level, such as &hen and ho& much cash is epected from customers, &hen cash is to be
paid to suppliers, and &orking capital re#uirements.
7.25 2ome believe that budgets promote a financial emphasis in organi%ations. ,t is true that
budgets are mostl" financial plans of organi%ational activities. $he reason for this is that
ultimatel" the performance of a compan" is -udged in terms of the financial returns it
generates for its shareholders. .ut budgets need not necessaril" be restricted to financial
measures. /an" firms are no& benchmarking ke" non!financial measures to ensure
organi%ational success.
7.26 .oth lines of reasoning have merit. For gro&th companies, it is often difficult to develop
precise budgets because of the difficult" in forecasting outcomes from research and
development and other gro&th activities. /oreover, rigid budgets are often said to stifle
innovation and gro&th b" not giving enough room to eercise discretion to sei%e
opportunities in a timel" fashion. On the other hand, budgets that allo& discretion are
also sub-ect to misuse because formal control is difficult. Often more informal control
mechanisms and closer supervision are needed to achieve a measure of control in such
organi%ations.
:!3
7.27 $he advantages of participative budgeting include benefiting of the epertise and
kno&ledge of emplo"ees in all levels of the organi%ation b" involving them in the
budgeting process, promoting a sense of o&nership and empo&erment among all
emplo"ees, ensuring that ever"bod" bu"s into the budget so that implementation is
smooth, better communication and coordination. $he disadvantages are that participative
budgeting is time consuming, and can lead to conflicts and disagreements that are hard to
resolve (as the sa"ing goes !! Atoo man" cooks spoil the broth<B).
7.28 $op!do&n budgeting is preferable &hen decisions need to be taken #uickl", and time is of
essence. $op!do&n budgeting is most suitable in smaller organi%ations &ith a narro& and
manageable range of products and services, and centrali%ed decision making. ,n these
settings, top managers are likel" to possess detailed enough information for budgeting
purposes.
7.29 8ine!item budgeting is a term used to refer to budgets that are built line!item b" line!
item. 6suall", budget for line!item cannot be used for another line item even if there is
still some mone" left in it. ,n the government, for eample, each line item in the budget
represents a certain use of public mone" such as road construction, maintenance of public
buildings, parks, medical care, public securit" etc. $he reason for not allo&ing
appropriation of funds set aside for one line!item for another purpose is to ensure the no
public good or service is left underfunded. 2imilar considerations appl" to nonprofit
organi%ations. $hese considerations are not as applicable to commercial companies &here
the &hole purpose is to allocate funds in a &a" that generates most profits.
7.3 A budget is said to lapse if an" unspent amount in the budget is not carried over to the
net period. 9es, the criticism is valid. $here are man" documented instances of such
behavior. =o&ever, budget lapsing is a good &a" to force ependitures on some desirable
activities and causes. 4esearch and development budgets are a good eample in
commercial organi%ations.
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E!ERCISES
7.31
,n solving budgeting eercises, &e repeatedl" use the Ainventor" e#uation.B ,n its
simplest form, the inventor" e#uation is3
Beginning balance ) What we put in * What we take out ( Ending balance.
Ce replace these terms &ith the appropriate account!specific terms &hen computing
specific revenue and cost budgets.
For 0remium, &e have3
.eginning inventor" 1,:DE Cindo&s
) 0roduction F,EEE
! 2ales ;
( 7nding inventor" 2,DEE &indo&s
$hus, &e find S"#$% &'( )"(*+ , 7-25 ./01'.%.
/ultipl"ing :,2DE &indo&s b" the GHE price per &indo& gives 2314$5$1 )"(*+
($6$03$ '& 7435-.
7.32
a. $his eercise illustrates that budgets allo& organi%ations to pro-ect results for various
options, helping them make the profit!maimi%ing choice. .elo&, &e calculate the
annual sales and revenues for each price.
S"#$% R$6$03$%
)'05+ Price = $60 Price = $57 Price = $60 Price = $57
@anuar" 2,DEE 2,HEE G1DE,EEE G11F,2EE
Februar" 2,HEE 2,:2D 1DH,EEE 1DD,32D
/arch 2,:EE 2,FDE 1H2,EEE 1H2,1DE
April 2,FEE 2,I:D 1HF,EEE 1HI,D:D
/a" 2,IEE 3,1EE 1:1,EEE 1:H,:EE
@une 3,EEE 3,22D 1FE,EEE 1F3,F2D
@ul" 3,1EE 3,3DE 1FH,EEE 1IE,IDE
August 3,2EE 3,1:D 1I2,EEE 1IF,E:D
2eptember 3,EDE 3,32D 1F3,EEE 1FI,D2D
October 2,IEE 3,1:D 1:1,EEE 1FE,I:D
5ovember 2,:DE 3,E2D 1HD,EEE 1:2,12D
>ecember 2,HEE 2,F:D 1DH,EEE 1H3,F:D
T'5"#% 34-1 36-7 72-46- 72-91-9
:!D
Ce see that pricing at GD: maimi%es 0remium+s revenues. 7ven though the compan"
receives a smaller amount for each Cindo&, the increased volume compensates for the
lo&er price.
b. 0erhaps the most important factor to consider is cost * after all, 0remium is interested
in maimi%ing profit, not -ust revenues. 0ricing its product at GD:, 0remium &ill be
selling additional 2,HEE &indo&s (3H,:EE * 31,1EE) over the course of the "ear.
=o&ever, reducing the price &ill not increase profit unless the additional costs of
producing and selling the etra &indo&s are less than G1D,IEE (( G2,EI1,IEE !
G2,E1H,EEE) or about G1D,IEEJ2,HEE ( G1:.HD per &indo&. Along these lines,
0remium must consider &hether it has enough capacit" to produce the higher volume,
and if the higher volume might add to congestion in the factor".
0remium also needs to consider the accurac" of its demand forecasts and &hether a price
cut &ould adversel" affect the perceived #ualit" of its product. Finall", 0remium needs to
consider &hat its competitors &ill do in terms of their pricing strateg" * if competitors
also reduce their prices, 0remium ma" not en-o" the increase in forecasted demand.
7.33
Ce can appl" the inventor" e#uation to find the missing data, as follo&s3
Number of Window !pril
"eptembe
r #ecember
>esired ending inventor" 1,FEE 2,EEE 3,2EE
) .udgeted sales 1E,EEE 1D,EEE 2E,EEE
( $otal re#uirements 11,FEE 1:,EEE 23,2EE
! .eginning inventor" 1,2EE 3,EEE 2,2EE
( .udgeted production 1-6 11,EEE 21,EEE
,n each instance, &e perform the suitable arithmetic to rearrange the terms and solve for
the re#uired item.
7.34
$o begin, &e kno& that3
.eginning inventor" (/arch) ( 7nding inventor" (Februar")
and,
>esired ending inventor" (Februar") ( 1DK of /arch sales.
( E.1D L 1D,EEE ( 2,2DE.
:!H
Cith this step, &e can fill in the table partiall"3
Number of Window
$ebruar
% &arch !pril
>esired ending inventor"
M
2-25 3- 3,EEE
( $otal re#uirements 12,2DE 1F,EEE 23,EEE
! .eginning inventor"
MM
1,DEE 2-25 3-
( .udgeted production 8 8 8
M 2,2DE ( E.1D L 1D,EEE? 3,EEE ( E.1D L 2E,EEE
MM .eginning inventor" (/arch) ( 7nding inventor" (Februar").
Ce then use the inventor" e#uation to fill in the missing data, as follo&s3
Number of Window
$ebruar
% &arch !pril
>esired ending inventor" 2-25 3- 3,EEE
( $otal re#uirements 12,2DE 1F,EEE 23,EEE
! .eginning inventor" 1,DEE 2-25 3-
( .udgeted production 1-75 15-75 2-
,n each instance, &e perform the suitable arithmetic to rearrange the terms and solve for
the re#uired item. ,n particular, &e first solve for Februar" ending inventor" and Februar"
production. ,n turn, this gives us the .eginning inventor" for /arch. Ce repeat the
process for /arch to get /arch production, and so on.
7.35
a. $he follo&ing table provides the re#uired revenue budget, and income statement.
August 2eptember October 5ovember
,ndividuals :EE HIE HFE H:D
Famil" memberships 3EE 3EE 2ID 2IE
4evenue ! ,ndividual G :E,EEE
1
G HI,EEE G HF,EEE G H:,DEE
4evenue ! Famil" G 1F,EEE
1
G 1F,EEE G 1:,2EE G 1H,1EE
$otal 4evenue G 11F,EEE G 11:,EEE G 11D,2EE G 113,IEE
Nariable cost *
,ndividual G 21,DEE
1
G 21,1DE G 23,FEE G 23,H2D
Nariable cost ! Famil" G 1F,EEE
1
G 1F,EEE G 1:,:EE G 1:,1EE
'ontribution margin G :D,DEE G :1,FDE G :3,:EE G :2,F:D
Fied cost G 1E,EEE G 1E,EEE G 1E,EEE G 1E,EEE
0rofit before taes G 3D,DEE G 31,FDE G 33,:EE G 32,F:D
1
G:E,EEE ( :EE L 1EE? G1F,EEE ( 3EE L G1HE? G21,DEE ( :EE L G3D? G1F,EEE ( 3EE L GHE.
:!:
b. $he follo&ing table provides the re#uired revenue budget, and income statement.
August

2eptember October

5ovember
,ndividuals :EE :EE HIE HFD
Famil" memberships 3EE 3ED 3EE 2ID
4evenue ! ,ndividual G:E,EEE G:E,EEE GHI,EEE GHF,DEE
4evenue ! Famil" 1F,EEE 1F,FEE 1F,EEE 1:,2EE
$otal 4evenue G11F,EEE G11F,FEE G11:,EEE G11D,:EE
Nariable cost ! ,ndividual G21,DEE G21,DEE G21,1DE G23,I:D
Nariable cost ! Famil" 1F,EEE 1F,3EE 1F,EEE 1:,:EE
'ontribution margin G:D,DEE G:H,EEE G:1,FDE G:1,E2D
Fied cost 1E,EEE 1E,EEE 1E,EEE 1E,EEE
Ad campaign 1E,EEE
0rofit before taes G3D,DEE G2H,EEE G31,FDE G31,E2D
c. .ased on the above, it &ould appear that profits have decreased. .ased on pro-ection
in part OaP, =ercules epected to earn G13H,I2D (( G3D,DEE ) G31,FDE ) G33,:EE )
G32,F:D). $he pro-ection in part ObP sho&s a cumulative profit of G13E,3:D ((
G3D,DEE ) G2H,EEE ) G31,FDE ) G31,E2D) onl", a decrease of about GH,DDE. =o&ever,
&e cannot conclude that the ad campaign is a bad idea. $his is because the ne&
members &ill continue to benefit =ercules in the future as &ell (but not indefinitel").
2uppose that the average ne& membership is for 12 months. $hen, the epected
benefit from the campaign is 12 months L O1E individuals L (G1EE!G3D) ) D familiesL
(G1HE *GHE) P ( G13,FEE, &hich eceeds the cost of the ad campaign.
5ote3 Firms develop Alife!c"cleB models to account for such future effects. 2uch models
are crucial in service firms such as cable operators and &ireless providers &ho epect to
get a continuing stream of revenue from each ne& customer. $hus, these firms are &illing
to take a AlossB in the first fe& months b" spending a lot to get ne& customers.
:!F
7.36
$he follo&ing table provides the re#uired information. 5otice the use of the inventor"
e#uation to back out the amount of purchases.
August 2eptember October
,ndividuals :EE HIE HFE
Famil" memberships 3EE 3EE 2ID
2upplies needed 13,HEE
1
13,DEE 13,2IE
7nding inventor" D,EEE 1,DEE 1,DEE
($otal needed 1F,HEE 1F,EEE 1:,:IE
!.eginning inventor" D,EEE D,EEE 1,DEE
( 0urchases 713-6 713- 713-29
1
13,HEE ( :EE L 1E ) 3EE L 22.
5otice that the beginning inventor" in 2eptember is the ending inventor" in August. Ce
also calculate supplies needed as Q of individual memberships L G1E ) Q of famil"
memberships L G22. Finall", notice that &e cannot compute the purchases in 5ovember
because &e do not kno& the re#uired ending inventor".
7.37
8et us begin b" calculating the operating cash flo&.
Item Detail September
,ndividual fees (HIE!1FE)L G1EE GD1,EEE
Famil" (3EE * HE) L G1HE 3F,1EE
0repaid (individual) (1FEJ12) M (12 L 1EE L IEK) 1H,2EE
0repaid (famil") (HEJ12) L (12 L 1HE L IEK) F,H1E
$otal inflo&s G111,21E
0urchase (current) E.H L G13,EEE G :,FEE
0urchases (prior) E.1 L G13,HEE D,11E
Nariable costs (HIE L G2D) ) (3EE L G1D) 3E,:DE
Fied costs G11,EEE !G12,DEE 2F,DEE
$otal outflo&s G:2,1IE
Operating cash flo& G11,:DE
:!I
Ce can no& prepare the cash budget.
Item September
.eginning balance G H,EEE
Operating cash flo& 11,:DE
2pecial items ! e#uipment (2E,EEE)
Amount taken out (1D,EEE)
7nding balance G12,:DE
7.38
$his eercise is Atrick"B in the sense that &e cannot directl" appl" the inventor" e#uation
to the ne& sales pro-ection for April. $his is because &e do not kno& the original or
revised sales for April. =o&ever, &e kno& the original production for April. 6sing this
data, &e can back out the original sales as 113,EEE units (as sho&n in the table belo&).
$he revised sales therefore ( IEK of 113,EEE ( 1E1,:EE units. Ce could then back out
the ($6/%$1 9('13*5/'0 &'( A9(/# "% 16-5 30/5%. 5otice that there is no change in the
beginning inventor" for April. $his is because /arch is almost over and Rant% &ould
have alread" built up inventor" as per the original budget. =o&ever, because /a"+s
estimates are do&n 1EK, the desired ending inventor" for April &ould be do&n 1EK,
from 22,EEE to 1I,FEE.
A9(/# :'#1; A9(/# :0$.;
>esired ending inventor" 22,EEE E.I L 22,EEE ( 1I,FEE
) .udgeted sales 113,EEE
1
E.I L 113,EEE ( 1E1,:EE
( $otal re#uirements 13D,EEE 121,DEE
! .eginning inventor" 1D,EEE 1D,EEE
( .udgeted production 12E,EEE 16-5
1
113,EEE ( 12E,EEE ) 1D,EEE * 22,EEE.
7.39
$he ke" point in this problem is that &e have to perform the calculations separatel" for
each t"pe of bo (although &e use the same inventor" e#uation for all boes).
Additionall", it+s important to remember that the ending inventor" for an" one month
e#uals the beginning inventor" of the follo&ing month * thus, &e can calculate the
beginning inventor" for /arch as 2EK of /arch+s sales (&hich is the ending inventor" of
Februar").
:!1E
S<"## 2'=$%:
&arch !pril
( (.2E L net month+s sales) 3,EEE 1,EEE
) .udgeted sales 1E,EEE 1D,EEE
( $otal 4e#uirements 13,EEE 1I,EEE
( (.2E L current month+s sales) 2,EEE 3,EEE
( B314$5$1 9('13*5/'0 11- 16-
R$6$03$ 2314$5 (( 2ales L G2.:D) 727-5 741-25
)$1/3< 2'=$%:
&arch !pril
( (.2E L net month+s sales) H,EEE F,EEE
) .udgeted sales 2D,EEE 3E,EEE
( $otal re#uirements 31,EEE 3F,EEE
( (.2E L current month+s sales) D,EEE H,EEE
( B314$5$1 9('13*5/'0 26- 32-
R$6$03$ B314$5 (( 2ales L G3.:D)
793-75
7112-5
L"(4$ 2'=$%:
&arch !pril
( (.2E L net month+s sales) 1,EEE D,EEE
) .udgeted sales 1D,EEE 2E,EEE
( $otal re#uirements 1I,EEE 2D,EEE
( (.2E L current month+s sales) 3,EEE 1,EEE
( B314$5$1 9('13*5/'0 16- 21-
R$6$03$ B314$5 (( 2ales L GD.EE) 775- 71-
:!11
7.4
a. Once again, &e appl" the inventor" e#uation to solve this problem. 6sing the
information provided, &e have (units in linear feet)3
)"(*+ >etail
(in linear feet)
:D,F1E 1EK of April needs (
E.1E L 1D,FEE boes L
12 feetJbo.
) 5eeded for production 111,EEE 12,EEE boes to be
produced L 12 feetJbo.
( $otal re#uirements 21I,F1E
! .eginning inventor" DE,EEE Riven
( B314$5$1 93(*+"%$%
(linear feet)
169-84
P3(*+"%$% 2314$5 (
budgeted purchases L GE.:D
per foot

7127-38
b. .os&orth &ould use 111,EEE linear feet of cardboard strips to produce the boes. T+$
5'5"# <"5$(/"#% *'%5 ( 111,EEE L GE.:D ( 718-. An inventor" cost flo&
assumption is not re#uired in this instance because the entire inventor" (beginning
inventor" plus purchases) is valued at GE.:D per linear foot.

c. .ecause .os&orth has different la"ers of inventor" &ith differing prices, the cost
flo& assumption no& becomes important. Cith F,FO, the firm &ill consume the
oldest la"er first before consuming purchases.
$hus, &e have3
From beginning inventor" DE,EEE linear feet S GE.:EJft
G3D,EEE
From /arch purchases I1,EEEM linear feet SGE.:DJft G:E,DEE
T'5"# <"5$(/"#% *'%5 715-5
M I1,EEE ( 111,EEE * DE,EEE
5otice that the cost of materials usage has decreased. Ch";
6nder the F,FO cost flo& assumption used b" .oso&orth, the materials in beginning
inventor" &ill be used up first. .os&orth+s beginning inventor" is valued at G3D,EEE.
$hat difference of G2,DEE (DE,EEE linear feet L E.EDJft) causes the cost of material usage
to decrease.
:!12
5ote3 $he usage budget for /arch &ould not change if .os&orth uses the 8,FO method.
$he firm &ould not be dipping into the la"er of beginning inventor", meaning that all
111,EEE linear feet used &ould be valued at GE.:D per foot.
7.41
Ce compute budgeted cash inflo&s using the follo&ing table3
N'6$<2$( D$*$<2$(
4evenues G13D,EEE G1DE,EEE
'ash collections from current revenues 1E,DEE 1D,EEE
'ash collected one month later DH,EEE D1,EEE
'ash collected t&o months later 33,:DE 3D,EEE
'ash collected three months later H,EEE H,:DE
T'5"# C"%+ C'##$*5/'0% 7136-25 714-75
5otice that the collections for 5ovember include 3EK of 5ovember sales (E.3E L
G13D,EEE), 1EK of October sales (E.1E L G11E,EEE), 2DK of 2eptember sales (E.2D L
G13D,EEE), and DK of August sales (E.ED L G12E,EEE). Ce need to stagger sales in this
fashion because it takes .ruce 3) months to collect cash from his sales.
7.42
As &ith the prior problem (&hich deals &ith receivables), it is most convenient to
calculate .ruce+s cash outflo&s using a table such as the follo&ing3
O*5'2$( N'6$<2$( D$*$<2$(
0urchases 12E,EEE 11E,EEE 12E,EEE
'ash pa"ment for current purchases G:2,EEE GHH,EEE G:2,EEE
'ash pa"ment for prior month purchase 2F,DEE 3H,EEE 33,EEE
'ash pa"ment for purchases made 2 months ago I,EEE I,DEE 12,EEE
T'5"# C"%+ O35&#'. 719-5 7111-5 7117-
5otice that the total cash outflo& for >ecember includes pa"ments for >ecember
purchases (E.HE L 12E,EEE), for 5ovember purchases (E.3E L 11E,EEE), and for October
purchases (E.1E L 12E,EEE). Ce compute the cash outflo&s for October and 5ovember in
a similar fashion.
7.43
$he follo&ing items pertain to October, and illustrate the logic for the cash budget.
1. $otal cash available ( beginning balance ) receipts ( GI,DEE ) G11,1EE ( G23,HEE.
2. $otal disbursement ( 2um of pa"ments for materials, labor and overhead. .acking
out the numbers, for the pa"ments for overhead &e have G1F,3EE !G1,1EE !GF,1DE (
GD,1DE
3. .alance prior to financing ( total available * total pa"ments (or, disbursements).
$hus, G23,HEE ! G1F,3EE ( GD,3EE.
:!13
1. .orro&ing needed (if an") ( /inimum balance * balance prior to financing.
D. 7nding balance (October) ( .eginning balance (5ovember)
$he follo&ing table provides the completed cash budget.
C"%+ B314$5 > ?'3(5+ Q3"(5$(
'ctobe
r
No(embe
r
#ecembe
r
.eginning cash balance GI,DEE GI,DEE GI,DEE
'ash receipts 11,1EE 17-9 18-4
$otal cash available 723-6 G2:,1EE G2:,IEE
'ash disbursements
0a"ments for materials 1,1EE 3-63 1,1EE
0a"ments for labor F,1DE :,2DE 7-21
0a"ments for overhead 5-45 D,I2E D,:2E
$otal disbursements 1F,3EE 1H,FEE 1:,E3E
.alance prior to financing 5-3 1-6 1-87
/inimum cash balance I,DEE I,DEE I,DEE
Financing
.orro&ingJ(repa"ment) 4-2 :1-1; :1-37;
7nding cash balance 79-5 79-5 79-5
$he firm+s ending loan balance is therefore G1,2EE ! G1,1EE ! G1,3:E ( 71-73.
7.44
$he follo&ing table provides Rilbert+s cash budget for 5ovember and >ecember.
No(ember #ecember
Opening balance of cash G1H,EEE G2:,EEE
) 4eceipts from current sales (:EK of
current revenues)
3D,EEE 12,EEE
) 4eceipts from prior month sales (3EK of
prior month revenues)
12,EEE 1D,EEE
( $otal available GH3,EEE GF1,EEE
! 0urchase cost
(( 'OR2 ( HEK of revenues)
3E,EEE 3H,EEE
! /arketing and admin. epenses H,EEE D,EEE
7nding balance of cash 727- 743-
5otice that Rilbert+s 5ovember collections include :EK of 5ovember sales (G3D,EEE)
and 3EK of October sales (G12,EEE). .ased on our anal"sis, it appears that Rilbert &ill
have plent" of cash on hand and, thus, &ill not need to borro& mone".
:!11
7.45
a. Ce can do this problem in t&o &a"s. $he short method is to recogni%e that Tris
&ould have collected all of her sales for /arch and April b" /a" 31. 2he also &ould
have collected DEK of /a" sales in /a". $hus, her accounts receivable &ould be
DEK of /a" sales or 723- (( G1H,EEE L E.DE).
$he longer method is to &rite do&n her accounts receivable, using a format similar to
that for inventor" accounts. Ce have3
A9(/# )"@
Opening balance for receivables G2D,EEE G2E,EEE
) 'urrent sales 1E,EEE 1H,EEE
( $otal collectible GHD,EEE GHH,EEE
! 'ollections for prior month 2D,EEE 2E,EEE
! 'ollections for current month 2E,EEE 23,EEE
'losing balance for receivables 72- 723-
b. Again, &e can do this problem in t&o &a"s. $he short method is to recogni%e that
Tris &ould have paid for all of her purchases in /arch and April b" /a" 31. 2he also
&ould have paid for FEK of purchases in /a". $hus, her accounts pa"able &ould be
2EK of /a" purchases or E.2E L G1E,EEE ( 78-.
$he longer method is to &rite do&n her accounts pa"able, using a format similar to that
for inventor" accounts. Ce have3
A9(/# )"@
Opening balance for pa"ables GH,EEE GH,1EE
) 'urrent purchases 32,EEE 1E,EEE
( $otal pa"able 3F,EEE 1H,1EE
! 0a"ments for prior month H,EEE H,1EE
! 0a"ments for current month 2D,HEE 32,EEE
'losing balance for pa"ables 76-4 78-
7.46
$his is an open!ended #uestion &ith man" possible vie&s on the Cilma+s best course of
action. Ce summari%e some possible arguments belo&.
2ome might argue that Cilma should follo& 2cott Ford and @ake+s 8e&is lead and pad
her budget as &ell. $he problem appears to be ver" rigid standards and a formulaic
approach to incentive compensation. $he founder+s approach, some ma" argue, leaves the
managers no choice, but to build in some cushion. ,ndeed, &e might -ustif" @ake+s actions
as beneficial in the long term, although &e onl" have his &ord that the cushion is for
long!term improvements. 2ome might #uestion 2cott+s AecessiveB lo&!balling, although
ho& much is AOTB and ho& much is AecessiveB is not resolved easil".
:!1D
At the other etreme, clearl" the firm+s plans contain information kno&n to be false.
7thical standards for accounting professionals preclude Cilma from kno&ingl"
compromising the integrit" of information. $hus, she might have no choice but to tr" and
rectif" the situation as much as possible. >oing so, ho&ever, might pit her against the
other managers, limiting her effectiveness.
Overall, a pragmatic approach might involve attempting to educate the o&ner about the
pitfalls of his methods. ,ndeed, Cilma might find that 4o" is &ell a&are of the padding
b" his managers and that this is the Ugame+ that all in the firm agree to (implicitl"). ,n this
case, Cilma+s conscience is clear and, in our opinion, she &ould compl" &ith accounting
standards as &ell. $hus, our recommendation is for Cilma to speak &ith 4o" and feel
him out on his vie&s about budget padding before taking the net step.
7.47
$his #uestion is likel" to provoke a range of ans&ers. 'learl", the manager eperienced
an unfavorable and uncontrollable event. 9et, should 'arrie revise the budget; Ce see the
issue as t&o separate problems. $he first is a planning problem in terms of scheduling
production, ordering materials, and so on. 5aturall", the firm should take the latest
information into account for such decisions.
$he second problem is &hether the manager+s performance targets should be changed.
One could argue either for or against a change * &e are inclined to not change the
performance targets in this instance. First, as 'arrie notes, a change re#uires that she
define a Ubig+ event, and this is a slipper" slope. ,t &ould not be long before an" adverse
event triggered a re#uest for a target reset. 2econd, good managers are supposed to deal
&ith risk. ,nsulating them against risk defeats the purpose. $hird, managers often are ver"
innovative &hen their back is against the &all. $his event might spur management into
un!chartered territor". And, the final argument is A&ill the manager ask for a target reset
if the fire &ere in a competitor) plant;B
:!1H
PROBLE)S
7.48
a. .lue2teel appears to have enough capacit" to meet its annual sales forecast. Annual
sales are 112,DEE units (21,EEE ) 2F,DEE ) 33,EEE ) 2:,EEE) and the firm has
installed capacit" for 12E,EEE units (12 months L 1E,EEE units per month).
b. 'learl", .lue2teel needs to build up inventor" to meet the demand surge in V3.
.lue2teel could do this b" building up inventor" in V1 and V2. $he compan" &ould
need to begin in V1 because there is limited ecess capacit" is V2 * the ecess
capacit" in V2 is not enough to make the etra units to meet the demand for V3.
$he follo&ing table illustrates one possible production schedule that enables the firm to
meet its sales forecast.
Q3"(5$( 1 Q3"(5$( 2 Q3"(5$( 3 Q3"(5$( 4
2ales for #uarter 21,EEE 2F,DEE 33,EEE 2:,EEE
0roduction for #uarter 2D,DEE 3E,EEE 3E,EEE 2:,EEE
,nventor" at end of #uarter 1,DEE 3,EEE E E
,n realit", the firm might &ish to build up more inventor" in V1 so that the factor" has
some slack in V2 and V3 to deal &ith unanticipated problems.
Another alternative is to produce something like 2F,DEE? 2F,DEE? 2F,DEE, 2:,EEE cabinets
in the four #uarters. $his schedule smoothes out production (from a hiring standpoint),
leaves some additional capacit" in V2 and V3 if needed, and lightens a bit in V1, perhaps
for additional maintenance, and to secure desired "ear!end inventor".
c. $he '7O+s basic approach appears to be sound. /odern management practice is to
limit the amount of inventor" as much as possible. 2uch curtailing of capacit" has
several advantages. First, it reduces the capital tied up. 2econd, it reduces
obsolescence. $hird, a lo& inventor" polic", if done in con-unction &ith suitable
changes to production processes, could help the firm improve #ualit" and increase
responsiveness.
=o&ever, the lo& inventor" polic" comes &ith a cost. For .lue2teel, a %ero inventor"
polic" &ould curtail V3 sales to 3E,EEE units. Other than building inventor", the onl"
&a" to meet demand is b" adding to capacit", &hich &ill increase capacit" for all four
#uarters.
d. ,nventor" gives firms a &a" to AmoveB capacit" across periods, as sho&n in part ObP.
=o&ever, such movement is costl" because of storage costs and the cost of capital
tied up in inventor", as &ell as intangible #ualit" costs. $he best solution is, of course,
situation specific, but the problem highlights that holding inventor" has both costs
and benefits.
:!1:
7.49
,t is convenient to compute /ina+s epected cash inflo&s using a table such as the
follo&ing3
O*5'2$( N'6$<2$( D$*$<2$(
2ales G1H1,EEE G1:D,EEE G1IE,EEE
'ash from current sales
G1I,2EE GD2,DEE GD:,EEE
'redit sales (current month)
3D,EEE 1D,I2E 1I,EEE
'redit (one month later)
33,2DE 13,:DE D:,1EE
'redit (t&o months later)
1,:HE D,32E :,EEE
$otal 7122-21 7 147-49 717-4
$hirt" percent of /ina+s sales are made for cash, so the collections for October include
3EK of October sales (E.3E L G1H1,EEE). $he remainder of :EK credit purchases for
October is calculated as follo&s3 1EK of the credit sales in 2eptember (E.1E L E.:E L
G12D,EEE), DEK of the credit sales in August (E.DE L E.:E L GID,EEE) and FK of the credit
sales in @ul" (E.EF L E.:E L FD,EEE). Ce need to stagger sales in this fashion because
/ina takes several months to collect cash from her sales. Ce compute the collections for
5ovember and >ecember in a similar fashion.
5otice that /ina &riting off 2K of her credit sales has no impact on her epected cash
inflo&. $he &rite off &ould, ho&ever, reduce her balance of accounts receivable b"
increasing the balance of allo&ance for doubtful accounts ($he other side of the entr" is
an epense in the income statement.)
7.5
$he numerical ans&er to this #uestion is relativel" straightfor&ard. Ash&ini &ill commit
G1DE,EEE in April, G1FD,EEE in /a" and G21E,EEE in @une. =o&ever, her bank statement
&ill record a cash outflo& e#ual to received items3 G1DE,EEE in /a", G1FD,EEE in @une,
and G21E,EEE in @ul".
$his discrepanc" bet&een committed outflo&s and actual outflo&s highlights t&o
observations. First, &e might have to pa" for some purchases before &e receive the items.
2uch arrangements are common in international settings, and in settings &here the seller
has a great deal of bargaining po&er. 2econd, Ash&ini+s actual cash outflo& (in the sense
of an outflo& from her bank account) &ould take place the same month she receives the
items. =o&ever, she needs to budget a bit differentl" because the bank &ould place a
AholdB on the mone". $his hold means that the mone" &ould not be available to Ash&ini
for other purposes.
$hus, the problem emphasi%es that cash budgets must include the commitment of cash,
even if the actual outflo& might take place later. Ce often see this in purchase budgets
that go into future months to sho& commitments triggered b" current purchases. ,n cases
like the one Ash&ini faces, firms &ould often have a separate line item for committed
funds that the" &ould remove from available cash balances.
:!1F
5ote3 Ash&ini+s problem is similar, in principle, to depositing a check at a bank but not
having access to the funds until the check clears.
7.51
a. $he follo&ing table provides Rar"+s income statement for October through
>ecember. ,n this statement, notice that the cost of purchases ( FEK of sales. (Rar"
marks up G1 of cost to G1.2D in sales. 2o, G1 in sales ( G1J1.2D ( GE.FE in cost.)
O*5'2$( N'6$<2$( D$*$<2$(
4evenues G1:D,EEE GD2D,EEE GDH2,DEE
0urchases cost 3FE,EEE 12E,EEE 1DE,EEE
'ontribution /argin GID,EEE G1ED,EEE G112,DEE
'ash fied costs FD,EEE FD,EEE FD,EEE
5on cash fied costs 1E,EEE 1E,EEE 1E,EEE
0rofit before taes 7 71- 717-5
Overall, Rar" appears to be running a profitable business, &ith breakeven sales of
G1:D,EEE. ('heck3 G1:D,EEE L '/4 of 2EK ! GID,EEE ( E). $hus, &hile Rar" is at
breakeven in October, he is &ell past the re#uired volume in 5ovember and >ecember.
b. $he follo&ing table provides Rar"+s cash budget for October * >ecember. ,n this
statement, 'ollections * 1 month are the collections from prior month sales (e.g.,
October ( E.3E of 2eptember sales) and 'ollections * 2 months are the collections
from sales 2 months ago (October ( E.:E L August sales). 8ike&ise, purchases *
current month ( DEK of current month purchases and purchases * 1 month are DEK
of the prior months purchases.
O*5'2$( N'6$<2$( D$*$<2$(
'ollections ! 1 month G11E,H2D G112,DEE G1D:,DEE
'ollections ! 2 months 32F,12D 32F,12D 332,DEE
$otal cash available G1HF,:DE G1:E,H2D G1IE,EEE
0urchase ! current month 1IE,EEE 21E,EEE 22D,EEE
0urchase month ago
1F:,DEE
1
1IE,EEE
2
21E,EEE
'ash fied costs FD,EEE FD,EEE FD,EEE
5et cash from operations GH,2DE (G11,3:D) (G3E,EEE)
)opening balance D,EEE 11,2DE (3,12D)
, E01/04 2"#"0*$ 711-25 :73-125; :733-125;
1
G1F:,DEE ( (1HF,:DEJ1.2D) L E.DE.
2
G1IE,EEE ( (1:D,EEEJ1.2D) L E.DE.
:!1I
Overall, Rar" appears to be facing a cash crunch. Available cash dips from G11,2DE in
October to an anticipated shortfall of (G33,12D) in >ecember. $his occurs even though
sales have increased in this time period.
c. Rar"+s problem is common among firms &hich eperience gro&th. ,n essence, Rar"
is pumping mone" into &orking capital because he is financing his customers+
purchases. =e is pa"ing his suppliers faster than his customers are pa"ing him. $hus,
&hen his business gro&s, he has to put more mone" into the business. Ce can see this
b" calculating that the accounts receivable at the start of October is G:IH,F:D (( :EK
of August sales ) 2eptember sales), &hereas it is GI3E,EEE (( :EK of 5ovember sales
) >ecember sales) at the start of @anuar" net "ear.
Rar" needs to find &a"s to manage this imbalance. One avenue is to borro&, but he
has to consider interest costs. $he other avenue is to accelerate collections or defer
pa"ments, but then customers might cut back on orders and suppliers might raise
prices. .oth actions are costl" to Rar". Rar" &ould need to estimate his epected
profit to evaluate each option.
7.52
Ce kno& that the 'OR/ is the outflo& from the C,0 inventor" account. >irect
materials, direct labor, and overhead are the inflo&s into this account. Appl"ing the
inventor" e#uation then helps us fill in the re#uired data.
8ike&ise, &e kno& that the 'OR2 is the cost of the items removed from finished goods
inventor". $hus, &e can compute 'OR2 b" appl"ing the inventor" e#uation to the FR
inventor" account.
5otice that 'OR/ is the linking number bet&een the t&o accounts. $his amount is the
outflo& from the C,0 account and is the inflo& into the FR account.
8et us begin &ith the C,0 account. Ce have3
)"@ A30$
Opening C,0 G1FE,EEE 7275-5
) >irect materials usage 2DE,EEE 2FE,EEE
) >irect labor 2HD,DEE 31D,EEE
) Nariable overhead 12D,EEE 11D,EEE
( $otal inflo& into C,0 F2E,DEE 1,E1D,DEE
! Nariable cost of goods manufactured D1D,EEE D:1,EEE
( 7nding C,0 7275-5 7471-5
.eginning &ith /a", &e appl" the standard inventor" e#uation to obtain ending
inventor" as G2:D,DEE. $he ending inventor" in /a" is the beginning inventor" for @une.
$his allo&s us to calculate the remaining A;+sB for @une.
:!2E
5et, let us appl" the inventor" e#uation to the FR inventor" account.
)"@ A30$
Opening FR G22E,EEE 715-
) 'ost of goods manufactured D1D,EEE D:1,EEE
( 'ost of goods available for sale :HD,EEE :21,EEE
! 'ost of goods sold H1D,EEE 7499-
( 7nding FR inventor" 715- G22D,EEE
Once again, our computation uses the fact that the ending inventor" in /a" ( the
beginning inventor" in @une.
7.53
$his problem highlights the planning role for budgets. 8et us first determine the variable
and fied costs corresponding to 5aomi+s operations.
I5$< D$5"/# C3(($05 *'%5 E=9$*5$1 *'%5
>irect materials G1FE,EEEJ12E,EEE units G1Junit G1.1EJunit
>irect labor G:2E,EEEJ12E,EEE units GHJunit GH.3EJunit
2elling W Adm. G12E,EEEJG2.1 million DK of sales G DK of sales G
Fied costs GFFF,EEE GFFF,EEE
Cith this data in hand, let us prepare a pro-ected income statement if 5aomi raises her
price to G22 per unit.
Price = $22 & Number of units sold = 120,000
4evenues (12E,EEE units L G22) G2,H1E,EEE
Nariable costs
>irect materials GD2F,EEE
>irect labor :DH,EEE
2elling and administration 132,EEE G1,11H,EEE
'ontribution /argin G1,221,EEE
Fied costs
/anufacturing D1E,EEE
/arketing and sales 12E,EEE
Reneral administration 22F,EEE GFFF,EEE
P('&/5 2$&'($ 5"=$% 7336-
4eturn on sales
(G33H,EEEJG2,H1E,EEE) 12.:3K
:!21
8et us repeat the eercise &ith the lo&er!price, high!volume strateg".
Price = $19 & Number of units sold = 17,000
4evenues (1:D,EEE units L G1I) G3,32D,EEE
Nariable costs
>irect materials G::E,EEE
>irect labor 1,1E2,DEE
2elling and administration 1HH,2DE G2,E3F,:DE
'ontribution /argin G1,2FH,2DE
Fied costs
/anufacturing GD1E,EEE
/arketing and sales 12E,EEE
Reneral administration 22F,EEE GFFF,EEE
P('&/5 2$&'($ 5"=$% 7398-25
4eturn on sales
(G3IF,2DEJG3,32D,EEE) 11.IFK
.oth strategies meet 5aomi+s goals of increasing her profit and return on sales. =o&ever,
the t&o income statements conflict in terms of epected profit and epected profitabilit".
$he higher!price, lo&er volume strateg" has lo&er profit but higher profitabilit".
5aomi+s choice therefore depends on her goals and the nature of the product market. ,n
some instances, such as often occurs &ith premium products, it can make most sense to
go for a high margin strateg", sacrificing volume. ,n other instances, such as &ith
consumer goods, it might make more sense to lock up the market b" going for sales
gro&th. 4egardless, pro-ecting future income statements under alternate formats help
firms put a number on the tradeoff and make a more informed choice.
,n 5aomi+s case, she does not appear to have a sustainable competitive advantage for the
t"pes of products she offers (the barriers to entr" are likel" minimal) * thus, &e &ould
argue for setting a lo&er price and getting a larger share of the market.
7.54
$he participative budget described here seems participative in name onl". $he goal for
participative budgets is to take advantage of locali%ed kno&ledge that operating
personnel possess. ,n virtuall" ever" instance, the participative input is sub-ect to
oversight and discussion. 2ome amount of revision is also common. =o&ever, ecessive
and arbitrar" revie& that substitutes a top!do&n target for a bottom!up estimate makes a
mocker" of the process, eliminating its value. 2uch a gutting appears to be the case in
$im+s firm. /elanie+s statement hints at a ver" autocratic st"le that essentiall" sa"s, A/"
&a" or the high&a".B
$he revision process also appears to be arbitrar" and capricious. $here is little incentive
for the salespersons to spend much time and effort in pro-ecting the true epected sales
because the" kno& that the target &ould be revised up&ards and $im+s estimate &ill
:!22
prevail.
$his problem la"s the foundation for an interesting discussion about the costs and
benefits of participative budgeting. Chile these budgets are useful, the" also give rise to
game pla"ing and slack. 4evie&s b" top management cut do&n on slack, but also remove
some of the benefits. =o& best to manage the tradeoff is an open!ended problem &ith no
clear ans&er. 4esearch has identified factors that increase game pla"ing (ecessive
reliance on incentives, uncertain environment, lack of management eperience at the top,
lack of trust) but eecuting the tradeoff &ell remains an art.
7.55
a. $he follo&ing tables provide the re#uired classifications. $he classification into
manufacturing and selling depends is some&hat intuitive. $he classification into fied
versus variable costs is sub-ective to some degree. Ce gain confidence in this estimate
b" computing unit costs (for manufacturing epenses) and the cost per sales dollar
(for selling epenses) * if these costs sta" mostl" the same as volume changes, then
&e classif" the epense as variable. ,f, ho&ever, these costs decrease markedl" as
volume increases, then &e classif" the epense as fied.

)"03&"*53(/04 :);B
S$##/04 :S;
?/=$1 :?;B
V"(/"2#$ :V;
>irect materials ) V
>irect labor hours ) V
0lant maintenance ) ?
0lant depreciation ) ?
,ndirect labor ) V
7ngineering design ) ?
6tilities ) V
0lant administration ) ?
/arketing administration S ?
2ales force commissions S V
0lant supervision ) ?
.ased on the above &e conclude that3

(1) Nariable manufacturing costs >irect materials, direct labor, indirect labor, utilities
(2) Nariable selling costs 2ales commissions
(3) Fied manufacturing costs 0lant maintenance, plant depreciation, engineering
design, plant administration, and plant supervision
(1) Fied selling costs /arketing administration
:!23
b. 6sing the above table, &e obtain the follo&ing estimates (averages of three "ears)3
6nit price GDH.EEJunit
Nariable manufacturing costs G2:.H:Junit (the average for 3 months)
Nariable selling costs GE.E3 per sales G
$otal fied costs G2,1:F,EEE (the average for 3 months)
$hus, &e could &rite the firm+s contribution margin statement as follo&s3
6nits 1DE,EEE
4evenues GF,1EE,EEE
Nariable manufacturing costs 1,1DE,DEE
Nariable selling costs 2D2,EEE
'ontribution /argin G3,II:,DEE
$otal fied costs 2,1:F,EEE
P('&/5 2$&'($ 5"=$% 71-819-5
c. $his problem illustrates a A#uick and dirt"B &a" to budget operations. ,n essence, the
firm is using the 'N0 relation to pro-ect its goals for the coming "ear. $he parameters
for the 'N0 relation are the average of operations for the past three "ears. Chile this
approach has merit, there are potential concerns. First, given the significant change in
operations, it is likel" that the demand pro-ection falls outside the firm+s relevant
range of operations * thus, 7sse ma" need to add additional capacit" to manage the
additional demand. $he simple 'N0 relation ignores these complications. A second
ma-or problem is the omission of an" kind of detailed breakdo&n or basis for the
sales forecast * this is particularl" important given the optimistic nature of the
forecast * 7sse could find itself in an a&k&ard position if sales fall dramaticall"
short of pro-ections.

7.56
a. Cith the given data, &e could &rite the firm+s contribution margin statement as
follo&s3
O(/4/0"# A1C3%5<$05
R$6/%$1
B314$5
6nits 1DE,EEE 1DE,EEE
4evenues GF,1EE,EEE GF,1EE,EEE
Nariable manufacturing costs 1,1DE,DEE 1,1DE,DEE
Nariable selling costs 2D2,EEE 2D2,EEE
'ontribution /argin G3,II:,DEE G3,II:,DEE
$otal fied costs 2,1:F,EEE 7565-
1
G2,:13,EEE
P('&/5 2$&'($ 5"=$% 71-819-5 7565- 71-254-5
1
GDHD,EEE ( (22D,EEE ) 12D,EEE ) 1EE,EEE ) 1E,EEE ) :D,EEE).
:!21
5otice that &e have collapsed all of the increase in fied costs into one line item. $his
increase reflects the additional capacit" costs that stem from increasing the firm+s
production capabilities * as &e &ill learn in 'hapters I and 1E, cost allocations provide
us &ith a &a" to estimate such changes in capacit" costs.
b. Ce could pro-ect the income statement for 12D,EEE units, using the estimates for fied
and variable costs that &e derived for the previous problem. Ce have3
O(/4/0"# R$6$03$BC'%5 9$( 30/5
R$6/%$1
B314$5
6nits 1DE,EEE 125-
4evenues GF,1EE,EEE GDH.EE G:,EEE,EEE
Nariable manufacturing costs 1,1DE,DEE G2:.H: per unit 3,1DF,:DE
Nariable selling costs 2D2,EEE GE.E3 per sales G 21E,EEE
'ontribution /argin G3,II:,DEE G3,331,2DE
$otal fied costs 2,1:F,EEE 2,1:F,EEE
P('&/5 2$&'($ 5"=$% 71-819-5 71-153-25
5otice that 7sse+s profit decreases substantiall", b" 3:K, if the firm produces 12D,EEE
units.
c. .ased on our anal"sis, 7sse &ill more profitable situation if it produces 1DE,EEE
units and invests in additional capacit" resources. =o&ever, if the compan" decides to
go ahead and make the investment to meet the budgeted volume of 1DE,EEE and
demand falls short of epectations, either in the coming "ear or in future "ears, then
7sse &ill have to AeatB the additional fied costs. $his problem helps us see ho&
budgets enable firms to evaluate options in terms of their potential risks and re&ards.
7.57
$he follo&ing table provides the re#uired income statement.
Q3"(5$( 1 Q3"(5$( 2 Q3"(5$( 3 Q3"(5$( 4 T'5"#
2ales G1EH,EEE GD2I,2DE G12E,DEE GDI1,DEE G1,IDE,2DE
>iscounts
1
D2,I2D DI,1DE 112,3:D
5et 2ales G1EH,EEE G1:H,32D G12E,DEE GD3D,EDE G1,F3:,F:D
'ost of merchandise
2
2FE,EEE 3HD,EEE 2IE,EEE 11E,EEE 1,31D,EEE
'redit card fees
3
H,1IH :,H21 H,:2F F,DH1 2I,1EH
Fied costs
1
1ED,EEE 1ED,EEE 1ED,EEE 1ED,EEE 12E,EEE
P('&/5 714-54 :71-296; 718-772 711-489 743-469
5otes3
1. >iscounts ( "ale L .DE L .2E in Vuarters 2 and 1.
2. 'ost of merchandise ( 2alesJ1.1D.
3. 'redit card fees ( .E2 L .FE L Net "ale.
1. Fied costs ( G3D,EEE L 3 months per #uarter.
:!2D
7.58
a. $he follo&ing table provides the re#uired monthl" budget.
I5$< D$5"/# A<'305
2ubscription fees
.asic 'able DE,EEE L E.ED L G2E GDE,EEE
7tended .asic DE,EEE L E.ID L GDE 2,3:D,EEE
0remium 'hannels 1D,EEE L G1E 1DE,EEE
,nternet connection 2H,EEE L G1D 1,1:E,EEE
/odem fees 2E,EEE L G3 HE,EEE
$otal subscriptions G3,FED,EEE
>iscounts
0remium channels 1,EEE L G(2EKM1E) F,EEE
.undling 2D,DEE L GD 12:,DEE
5et 4evenues G3,HHI,DEE
'ontent fees Fied G1,1EE,EEE
'ontent fee (0remium) 1D,EEE L GH IE,EEE
Franchise fee (2pudcit") 1EK L 5et 4evenues 3HH,IDE
,nternet fee 2H,EEE L G3D I1E,EEE
,nternet fee Fied FD,EEE
Operating costs
,nstallation 2DE S GHE 1D,EEE
4epair HEE S G3D 21,EEE
8ine maintenance 3D S G:D 2,H2D
Operating costs Fied 1DE,EEE
$otal costs G3,31E,D:D
P('&/5 2$&'($ T"=$% 7328-925
b. $here are man" similarities in the process. One similarit" includes the focus on output
activit" (number of subscribers) for the firm+s various products ($N, 0remium
channels, ,nternet) as the starting point. $his estimate serves as the basis for both
revenues and costs (e.g., franchise fees). @ust like a manufacturing firm, the service
firm has both variable and fied costs.
$here are a fe& differences, though. For eample, there is not much room for a
production or purchases budget for /edia /ogul. $he primar" service is to act as a pass
through agent bet&een the $N content providers and the retail customer. Other than this
difference in orientation, &e &ould argue that the budgeting process is more alike than
not.
:!2H
7.59
5ot!for!profit organi%ations, &hich often operate multiple programs, face uni#ue
planning, control, and reporting needs.
From the output side, ,!'are needs to track budgets and actual results b" program so that
it could assess the effectiveness of individual activities.
From the input side, ,!'are also might need to track epenses and activities b" specific
grants. For eample, suppose 62A,> gives ,!'are a grant of G1,EEE,EEE. ,!'are &ould
need to submit periodic reports that sho& ho& it used these funds. Often, the mone" ma"
be spent for multiple programs, &hich complicates the reporting process.
From a regulator" vie& point, ,!'are needs to submit reports to the ,42 and other
agencies (e.g., Form IIE). $hese forms have specific epense categories such as fund
raising epenses.
From a control perspective, a significant amount of cost is common across programs.
2uch costs often pertain to personnel because the same set of people might &ork on
several programs simultaneousl". Of course, ,!'are also needs to have appropriate
epense approval and reporting policies in place because of the significant fiduciar"
responsibilit" it bears to&ards donors. Often, charities &ill voluntaril" undergo annual
audits (b" suitabl" #ualified accountants) to increase confidence among donors.
$hus, &e see that not!for!profit institutions such as ,!'are re#uire sophisticated budgeting
and control s"stems to meet their various information needs. 6suall", such organi%ations
prepare a program!centered budget, &herein the" estimate costs for each of the man"
programs the" might eecute during a "ear. ,n addition, the organi%ation needs to budget
for common activities such as a fund!raising campaign or office administration.
Riven the number of eternal constituents, the budgeting process at ,!'are t"picall"
&ould be more detailed and involved than the process for a for!profit organi%ation (&hose
primar" goal is to make mone"). ,ndeed, for each program, ,!'are needs to estimate the
activit" volume and associated costs. /oreover, each program might comprise several
modules (such as the number of senior centers visited, &ith each visit being a module)
that might be scaled up or do&n based on the availabilit" of funds and actual epenses.
6suall", accounting s"stems in such organi%ations allo& the data to be aggregated along
multiple dimensions. For eample, an" specific ependiture &ould be classified as to
program ('orneal transplant), source of funds (Taufman Foundation grant Q11!DH:!
2EED), and functional categor" ($ravel3 Airfare).
Overall, this problem looks at ho& budgeting needs might s"stematicall" differ across
organi%ations.
7.6
:!2:
$o prepare an income statement, &e need to be able to calculate the cost of goods sold
('OR2). $his is the outflo& from the finished goods (FR) inventor" account. =o&ever,
&e do not have the inflo& into the FR account.
For 0eterson, the inflo&s into the FR account comprise materials and labor (because all
overhead epenses are fied). Once again, &hile &e kno& labor costs, &e do not kno&
the materials used in production. =o&ever, &e do have information about the amount of
materials purchased and epected inventories.
$hus, &e can back out the materials issued, as sho&n belo&3
Q3"(5$( 1 Q3"(5$( 2 Q3"(5$( 3 Q3"(5$( 4
Opening balance for materials
G1EE,EEE G12E,EEE G11D,EEE G12D,EEE
) 0urchases
23D,EEE 211,2EE 222,3EE 2E:,DEE
( $otal available
GH3D,EEE GH31,2EE GH3:,3EE GH32,DEE
! 7nding balance
12E,EEE 11D,EEE 12D,EEE 11E,EEE
( /aterials used for production
G21D,EEE G21H,2EE G212,3EE G222,DEE
,n this table, notice that &e link #uarters b" the fact that ending inventor" in V1 (
beginning inventor" in V2. 8et us no& compute 0eterson+s 'OR/.
Q3"(5$( 1 Q3"(5$( 2 Q3"(5$( 3 Q3"(5$( 4
/aterials used for production
G21D,EEE G21H,2EE G212,3EE G222,DEE
) >irect labor
21E,EEE 211,DEE 23F,DEE 21F,HEE
( 'ost of goods manufactured
G1DD,EEE G1HE,:EE G1DE,FEE G1:1,1EE
5et, &e use the inventor" e#uation for the FR inventor" to determine 'OR2.
Q3"(5$( 1 Q3"(5$( 2 Q3"(5$( 3 Q3"(5$( 4
Opening balance
G3FE,EEE G3IE,1EE G3FD,HEE G3I1,2DE
) 'ost of goods manufactured
1DD,EEE 1HE,:EE 1DE,FEE 1:1,1EE
( $otal available
GF3D,EEE GFD1,1EE GF3H,1EE GFH2,3DE
! 7nding balance
3IE,1EE 3FD,HEE 3I1,2DE 3IH,DEE
( 'ost of goods sold
G111,HEE G1HD,DEE G11D,1DE G1HD,FDE
Again, notice that ending balance in V1 ( opening balance in V2.
:!2F
Ce are finall" read" to prepare the 0eterson+s contribution margin income statement.
Q3"(5$( 1 Q3"(5$( 2 Q3"(5$( 3 Q3"(5$( 4
4evenue
G:ID,2EE GF31,2EE GFH1,1DE GFDH,2DE
! Nariable cost of goods sold
111,HEE 1HD,DEE 11D,1DE 1HD,FDE
( 'ontribution margin
G3DE,HEE G3HF,:EE G11I,3EE G3IE,1EE
! Fied manufacturing costs
1DE,EEE 1:2,2DE 1HI,2DE 1:1,3EE
! Fied selling epenses
FE,EEE ID,EEE 1EH,EEE 1EE,EEE
( 0rofit before taes
712-6 711-45 7144-5 7116-1
7.61
8et us begin b" first constructing 0eterson+s budgeted cash collections. Ce have3
Q1 Q2 Q3 Q4
Opening
receivables
balance G12D,EEE G1EH,E2: G111,22: G11D,2HE
) 2ales :ID,2EE F31,2EE FH1,1DE FDH,2DE
( $otal collectible GI2E,2EE GI1E,22: GI:D,H:: GI:1,D1E
D C'##$*5/'0% 814-173 829- 86-417 857-343
( 7nding balance G1EH,E2: G111,22: G11D,2HE G111,1H:
5otice that collections include all of the opening balance. $he" also include all sales for
the first t&o months of the #uarter and HEK for the third month. Alternativel", &e
compute the ending balance as 1EK of the last month+s sales (all else &ould have been
collected) and back out the collections.
5et, &e compute the cash outflo& for purchases.
Q1 Q2 Q3 Q4
Opening pa"ables
balance G12H,DEE G3I,1H: G3D,2EE G3:,EDE
) 0urchases 23D,EEE 211,2EE 222,3EE 2E:,DEE
( $otal 0a"able G3H1,DEE G2DE,3H: G2D:,DEE G211,DDE
D P"@<$05% 322-333 215-167 22-45 29-967
( 7nding balance G3I,1H: G3D,2EE G3:,EDE G31,DF3
As &ith collections, pa"ments include all of the opening balance. $he" also include all
purchases for the first t&o months of the #uarter and DEK for the third month.
Alternativel", &e compute the ending balance as DEK of the last month+s purchases
(0eterson+s &ould have paid all other bills.)
:!2I
Cith these estimates in hand, &e are no& read" to construct the overall cash budget.
Q1 Q2 Q3 Q4
Opening balance G:D,EEE 111,F1E G22F,I23 G3:E,11E
) 'ollections 814-173 829- 86-417 857-343
( $otal available GFFI,1:3 GI1E,F1E G1,EFI,31E G1,22:,1F3
0a"ments for purchases 322,333 21D,1H: 22E,1DE 2EI,IH:
8abor costs 21E,EEE 211,DEE 23F,DEE 21F,HEE
Fied manufacturing costs 13D,EEE 1D:,2DE 1D1,2DE 1DI,3EE
Fied selling costs FE,EEE ID,EEE 1EH,EEE 1EE,EEE
, E01/04 2"#"0*$ 7111-84 7228-923 737-14 759-616
,n our computations, notice that &e have removed G1D,EEE each #uarter for non!cash
manufacturing overhead epenses.
5otice that the cash balance is gro&ing &hile income (see the prior problem) sta"s
relativel" stable over the four #uarters. Ch" is this; $his occurs because &e assumed that
0eterson hoards all of its cash * thus, the cash balance increases each #uarter b" the
amount of income (there also is a G1D,EEE difference due to the non!cash overhead
epense, &hich is accounted for in the income statement but not in the cash budget). ,n
realit", 0eterson &ould not maintain such a large cash balance but &ould reinvest the
proceeds back in its o&n business or else&here.
:!3E
)INI CASES
7.62 $his is a fairl" involved problem, best done on a spreadsheet. Ce follo& the same
template as in the tet. Ce begin &ith 0umpkin 0atch+s revenue budget3
a.(see ehibits beginning net page)
:!31
E=+/2/5 1
P3<9E/0 P"5*+ > R$6$03$ B314$5
*ul% !ugut
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S5"01"(1
2ales in units 1E,EEE 11,1EE 12,EEE 1D,HEE 1F,EEE 22,EEE FI,EEE
0rice per unit G1: G1: G 1: G1: G1: G1: G1:
4evenues G1:E,EEE G1I3,FEE G 2E1,EEE G2HD,2EE G3EH,EEE G3:1,EEE G 1,D13,EEE
D$#3=$
2ales in units 3,DEE 1,EEE 1,DEE D,EEE D,DEE H,EEE 2F,DEE
0rice per unit G2H G2H G 2H G2H G2H G2H G2H
4evenues GI1,EEE G1E1,EEE G 11:,EEE G13E,EEE G113,EEE G1DH,EEE G:11,EEE
$otal 4evenues G2H1,EEE G2I:,FEE G 321,EEE G3ID,2EE G11I,EEE GD3E,EEE G 2,2D1,EEE
:.32
:!32
Ce net prepare 0umpkin 0atch+s production budget3
E=+/2/5 2
P3<9E/0 P"5*+ > P('13*5/'0 B314$5
*ul% !ugut
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S5"01"(1
2ales in units (see 7hibit 1) 1E,EEE 11,1EE 12,EEE 1D,HEE 1F,EEE 22,EEE
) >esired ending inventor" +Note ,- 2,FDE 3,EEE 3,IEE 1,DEE D,DEE 1,DEE
( $otal re#uirements 12,FDE 11,1EE 1D,IEE 2E,1EE 23,DEE 2H,DEE
! .eginning inventor" +Note .- 2,DEE 2,FDE 3,EEE 3,IEE 1,DEE D,DEE
( 6nits to be produced 1E,3DE 11,DDE 12,IEE 1H,2EE 1I,EEE 21,EEE
D$#3=$
2ales in units (see 7hibit 1) 3,DEE 1,EEE 1,DEE D,EEE D,DEE H,EEE
) >esired ending inventor" +Note ,- 1,EEE 1,12D 1,2DE 1,3:D 1,DEE 1,EDE
( $otal re#uirements 1,DEE D,12D D,:DE H,3:D :,EEE :,EDE
! .eginning inventor" +Note .- F:D 1,EEE 1,12D 1,2DE 1,3:D 1,DEE
( 6nits to be produced 3,H2D 1,12D 1,H2D D,12D D,H2D D,DDE
+Note ,-/ >esired ending inventor" e#uals 2DK of the follo&ing month+s forecasted sales volume in
units. >esired ending inventories for @anuar", 2EEI are 1,EEE standard units and 1,EEE delue units, as
stipulated in the problem tet.
+Note .-3 $he beginning inventor" for @ul" is the desired ending inventor" of @une, &hich e#uals 2DK of
the @ul" forecast.
:.33
:!33
5et, &e prepare the materials usage budget3
E=+/2/5 3
P3<9E/0 P"5*+ > D/($*5 )"5$(/"#% U%"4$ B314$5
*ul% !ugut
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S5"01"(1
6nits of production (see 7hibit 2) 1E,3DE 11,DDE 12,IEE 1H,2EE 1I,EEE 21,EEE
0lastic (( units of production L 1
pound per set L G3 per pound) G31,EDE G31,HDE G3F,:EE G1F,HEE GD:,EEE G H3,EEE
Other materials (( units of
production L G1) 1E,3DE 11,DDE 12,IEE 1H,2EE 1I,EEE 21,EEE
2tandard materials cost G11,1EE G1H,2EE GD1,HEE GH1,FEE G:H,EEE G F1,EEE
D$#3=$
6nits of production (see 7hibit 2) 3,H2D 1,12D 1,H2D D,12D D,H2D D,DDE
0lastic (( units of production L 1.DE
pounds per set L G3 per pound) G1H,313
G1F,DH
3 G2E,F13
G23,EH
3 G2D,313 G21,I:D
Other materials (( units of
production L G1.2D) 1,D31 D,1DH D,:F1 H,1EH :,E31 H,I3F
>elue materials cost G2E,F11 G23,:1I G2H,DI1 G2I,1HI G32,311 G31,I13
B'5+ P('13*5%
$otal units of production 13,I:D 1D,H:D 1:,D2D 21,32D 21,H2D 2H,DDE
$otal plastic G1:,3H3 GD3,213 GDI,D13 G:1,HH3 GF2,313 GF:,I:D
$otal other materials G11,FF1 G1H,:EH G1F,HF1 G22,HEH G2H,E31 G2:,I3F
$otal materials cost GH2,211 GHI,I1I G:F,1I1 GI1,2HI G1EF,311 G11D,I13
:.31
:!31
For direct labor costs, &e have3
E=+/2/5 4
P3<9E/0 P"5*+ > D/($*5 L"2'( B314$5
*ul% !ugut
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S5"01"(1
6nits of production (see 7hibit 2) 1E,3DE 11,DDE 12,IEE 1H,2EE 1I,EEE 21,EEE
8abor hours per unit E.DE E.DE E.DE E.DE E.DE E.DE
8abor cost per hour G1H G1H G 1H G1H G1H G1H
>irect labor cost GF2,FEE GI2,1EE G 1E3,2EE G12I,HEE G1D2,EEE G1HF,EEE
D$#3=$
6nits of production (see 7hibit 2) 3,H2D 1,12D 1,H2D D,12D D,H2D D,DDE
8abor hours per unit E.:D E.:D E.:D E.:D E.:D E.:D
8abor cost per hour G1H G1H G 1H G1H G1H G1H
>irect labor cost G13,DEE G1I,DEE GDD,DEE GH1,DEE GH:,DEE GHH,HEE
$otal labor cost G12H,3EE G111,IEE G1DF,:EE G1I1,1EE G21I,DEE G231,HEE
$he third component is manufacturing overhead costs3
E=+/2/5 5
P3<9E/0 P"5*+ > )"03&"*53(/04 O6$(+$"1 B314$5
*ul% !ugut
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V"(/"2#$ )"03&"*53(/04 O6$(+$"1 E E E E E E
?/=$1 )"03&"*53(/04 O6$(+$"1
'ash epenses G2H,EEE G2H,EEE G2H,EEE G2H,EEE G2H,EEE G2H,EEE
>epreciation and other non!cash epenses G22,EEE G22,EEE G22,EEE G22,EEE G22,EEE G22,EEE
$otal fied overhead G1F,EEE G1F,EEE G1F,EEE G1F,EEE G1F,EEE G1F,EEE
:.3D
:!3D
$otal /anufacturing Overhead G1F,EEE G1F,EEE G1F,EEE G1F,EEE G 1F,EEE G 1F,EEE
Ce net compute the variable cost of goods manufactured3
E=+/2/5 6
P3<9E/0 P"5*+ > V"(/"2#$ C'%5 '& G''1% )"03&"*53($1
From
7hibit *ul% !ugut "eptember 'ctober No(ember #ecember
S5"01"(1
0lastic 3 G31,EDE G31,HDE G3F,:EE G1F,HEE GD:,EEE GH3,EEE
Other materials 3 1E,3DE 11,DDE 12,IEE 1H,2EE 1I,EEE 21,EEE
>irect manufacturing labor 1 F2,FEE I2,1EE 1E3,2EE 12I,HEE 1D2,EEE 1HF,EEE
2tandard cost of goods manufactured G121,2EE G13F,HEE G1D1,FEE G1I1,1EE G 22F,EEE G2D2,EEE
D$#3=$
0lastic 3 G1H,313 G1F,DH3 G2E,F13 G23,EH3 G2D,313 G21,I:D
Other /aterials 3 1,D31 D,1DH D,:F1 H,1EH :,E31 H,I3F
>irect /anufacturing 8abor 1 13,DEE 1I,DEE DD,DEE H1,DEE H:,DEE HH,HEE
>elue cost of goods manufactured GH1,311 G:3,21I GF2,EI1 GIE,IHI GII,F11 GIF,D13
$otal variable cost of goods manufactured G1FF,D11 G211,F1I G23H,FI1 G2FD,3HI G32:,F11 G3DE,D13
:.3H
:!3H
As goods manufactured flo& through the FR inventor" account, let us eamine the cost flo& through the FR inventor" account as &ell.
E=+/2/5 7
C'%5 '& ?/0/%+$1 G''1% I06$05'(@ "% '& A30$ 3- 28
"tandard #elu0e
Nariable cost per unit +gi(en- G12.EE G1:.EE
C'%5 '& ?/0/%+$1 G''1% I06$05'(@ "% '& A3#@ 31- 28
"tandard #elu0e
V"(/"2#$ C'%5 9$( U0/5
0lastic G3.EE G1.DE
Other materials 1.EE 1.2D
>irect labor F.EE 12.EE
$otal G12.EE G1:.:D
C'%5 '& B$4/00/04 "01 E01/04 ?/0/%+$1 G''1% I06$05'(@ :2"%$1 '0 ?I?O /06$05'(@ "**'305/04;
*ul% !ugut
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S5"01"(1
.eginning inventor" in units 2,DEE 2,FDE 3,EEE 3,IEE 1,DEE D,DEE
Nariable cost per unit G12.EE G12.EE G12.EE G12.EE G12.EE G12.EE
.eginning inventor" cost G3E,EEE G31,2EE G3H,EEE G1H,FEE GD1,EEE GHH,EEE
7nding inventor" in units 2,FDE 3,EEE 3,IEE 1,DEE D,DEE 1,DEE
Nariable cost per unit G12.EE G12.EE G12.EE G12.EE G12.EE G12.EE
7nding inventor" cost G31,2EE G3H,EEE G1H,FEE GD1,EEE GHH,EEE GD1,EEE
D$#3=$
.eginning inventor" in units F:D 1,EEE 1,12D 1,2DE 1,3:D 1,DEE
Nariable cost per unit G1:.EE G1:.:D G1:.:D G1:.:D G1:.:D G1:.:D
.eginning inventor" cost G11,F:D G1:,:DE G1I,IHI G22,1FF G21,1EH G2H,H2D
7nding inventor" in units 1,EEE 1,12D 1,2DE 1,3:D 1,DEE 1,EDE
Nariable cost per unit G1:.:D G1:.:D G1:.:D G1:.:D G1:.:D G1:.:D
:.3:
:!3:
7nding inventor" cost G1:,:DE G1I,IHI G 22,1FF G21,1EH G 2H,H2D G1F,H3F
:.3F
:!3F
Ce are no& read" to compute the variable cost of goods sold.
E=+/2/5 8
P3<9E/0 P"5*+ > C'%5 '& G''1% S'#1 B314$5
*ul% !ugut
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S5"01"(1
.eginning Finished Roods ,nventor" (see 7hibit :) G3E,EEE G31,2EE G3H,EEE G1H,FEE GD1,EEE GHH,EEE
) 'ost of Roods /anufactured (see 7hibit H) 121,2EE 13F,HEE 1D1,FEE 1I1,1EE 22F,EEE 2D2,EEE
( 'ost of Roods Available for 2ale G1D1,2EE
G1:2,FE
E G1IE,FEE
G211,2E
E G2F2,EEE G31F,EEE
! 7nding Finished Roods ,nventor" (see 7hibit :) 31,2EE 3H,EEE 1H,FEE D1,EEE HH,EEE D1,EEE
( Nariable 'ost of Roods 2old G12E,EEE G13H,FEE G111,EEE
G1F:,2E
E G21H,EEE G2H1,EEE
D$#3=$
.eginning Finished Roods ,nventor" (see 7hibit :) G11,F:D G1:,:DE G1I,IHI G22,1FF G21,1EH G2H,H2D
) 'ost of Roods /anufactured (see 7hibit H) H1,311 :3,21I F2,EI1 IE,IHI II,F11 IF,D13
( 'ost of Roods Available for 2ale G:I,21I GIE,IHI G1E2,EH3 G113,1D: G121,2DE G12D,13F
! 7nding Finished Roods ,nventor" (see 7hibit :)
1:,:
DE
1I,
IHI
22,1F
F
21,1E
H 2H,H2D 1F,H3F
( Nariable 'ost of Roods 2old GH1,1HI G:1,EEE G:I,F:D GFF,:DE GI:,H2D G1EH,DEE
:.3I
:!3I
8et us finish the final piece, marketing and administrative epenses.
E=+/2/5 9
P3<9E/0 P"5*+ > )"(E$5/04 "01 A1</0/%5("5/6$ C'%5% B314$5
*ul% !ugut
"eptembe
r 'ctober No(ember
#ecembe
r
Nariable /arketing and Administrative 'osts
S5"01"(1
4evenues (see 7hibit 1) G1:E,EEE G1I3,FEE G 2E1,EEE G2HD,2EE G3EH,EEE G3:1,EEE
'ommissions (HK of revenues) 1E,2EE 11,H2F 12,21E 1D,I12 1F,3HE 22,11E
Other (1K of revenues) H,FEE :,:D2 F,1HE 1E,HEF 12,21E 11,IHE
Nariable 'osts G1:,EEE G1I,3FE G2E,1EE G2H,D2E G3E,HEE G3:,1EE
D$#3=$
4evenues (see 7hibit 1) GI1,EEE
G1E1,EE
E G 11:,EEE
G13E,EE
E G113,EEE G1DH,EEE
'ommissions (HK of revenues) D,1HE H,21E :,E2E :,FEE F,DFE I,3HE
Other (1K of revenues) 3,H1E 1,1HE 1,HFE D,2EE D,:2E H,21E
Nariable 'osts GI,1EE G1E,1EE G11,:EE G13,EEE G11,3EE G1D,HEE
$otal Nariable /arketing and
Administrative 'osts G2H,1EE G2I,:FE G32,1EE G3I,D2E G11,IEE GD3,EEE
Fied /arketing and Administrative 'osts
2alaries and &ages G3,EEE G3,EEE G3,EEE G3,EEE G3,EEE G3,EEE
4ent :,EEE :,EEE :,EEE :,EEE :,EEE :,EEE
>epreciation (non!cash) 1,DEE 1,DEE 1,DEE 1,DEE 1,DEE 1,DEE
$otal Fied /arketing and G11,DEE G11,DEE G11,DEE G11,DEE G11,DEE G11,DEE
:.1E
:!1E
Administrative 'osts
:.11
:!11
Cith all of the data in hand, &e can construct the income statement, as follo&s.
P3<9E/0 P"5*+ > B314$5$1 I0*'<$ S5"5$<$05
*ul% !ugut
"eptembe
r 'ctober
No(embe
r
#ecembe
r 1otal
4evenues (see 7hibit 1) G2H1,EEE G2I:,FEE G321,EEE G3ID,2EE G11I,EEE GD3E,EEE G2,2D1,EEE
Nariable 'osts
/anufacturing (see 7hibit F) 1F1,1HI 2E:,FEE 223,F:D 2:D,IDE 313,H2D 3:E,DEE 1,D:3,21I
/arketing W Admin (see 7hibit I) 2H,1EE 2I,:FE 32,1EE 3I,D2E 11,IEE D3,EEE 22D,1EE
$otal 'ontribution /argin GD3,131 GHE,22E GHD,E2D G:I,:3E GIE,1:D G1EH,DEE G1DD,3F1
Fied 'osts
/anufacturing (see 7hibit D) G1F,EEE G1F,EEE G1F,EEE G1F,EEE G1F,EEE G1F,EEE G2FF,EEE
/arketing W Admin (see 7hibit I) 11,DEE 11,DEE 11,DEE 11,DEE 11,DEE 11,DEE HI,EEE
$otal Fied 'osts GDI,DEE GDI,DEE GDI,DEE GDI,DEE GDI,DEE GDI,DEE G3D:,EEE
.ad >ebt 7pense ( ( 4evenues
from 2 months ago L E.HE L E.E2) 2,H1E 2,H1E 3,132 3,D:1 3,FD2 1,:12 2E,DFE
P('&/5 B$&'($ T"=$% :78-79; :71-92; 72-393 716-656 727-123 742-258 777-81
:.12
:!12
As &e learned in the tet, the cash budget consists of collections, pa"ments, and special items. 8et us begin &ith collections.
R$*$/6"2#$% 2314$5 *ul% !ugut "eptember 'ctober
No(embe
r
#ecembe
r
'ash collections 1E.EK G1E1,1EE G11I,12E G12F,1EE G1DF,EFE G1:I,HEE G212,EEE
'redit * to be received this
month H.EK 1D,HHE 1:,FHF 1I,2HE 23,:12 2H,I1E 31,FEE
'redit * to be received net
month 12.EK 1EI,H2E 12D,E:H 131,F2E 1HD,IF1 1FF,DFE 222,HEE
'redit * to be received in
t&o months 1E.FK 2F,1FF 32,1H2 31,HHF 12,HF2 1F,1I2 D:,21E
$otal 'ollections 2D:,FHF 2I1,22H 31:,11F 3IE,1DF 113,H12 D23,H1E
7pected .ad >ebt 1.2K 3,132 3,D:1 3,FD2 1,:12 D,3FF H,3HE
C"%+ R$*$/6$1
'ash 2ales G1E1,1EE G11I,12E G12F,1EE G1DF,EFE G1:I,HEE G212,EEE
'redit * this month 1D,HHE 1:,FHF 1I,2HE 23,:12 2H,I1E 31,FEE
'redit * last month I2,1EE 1EI,H2E 12D,E:H 131,F2E 1HD,IF1 1FF,DFE
'redit * 2 months ago 23,:HE 23,:HE 2F,1FF 32,1H2 31,HHF 12,HF2
C"%+ C'##$*5$1 G23H,22E G2:E,3HF G3EE,I21 G31F,::1 G1E:,1I2 G1:D,EH2
B"1 D$25 E=9$0%$ G2,H1E G2,H1E G3,132 G3,D:1 G3,FD2 G1,:12
5otice that HK ( 1EK of the HEK that is credit, 12K ( :EK of the HEK of sales that are on credit and so on.
:.13
:!13
5et, let us turn to pa"ments for purchases. $he other pa"ments are relativel" eas" to compute from earlier ehibits.
E=+/2/5 1
P3<9E/0 P"5*+ > P#"%5/* I06$05'(@ F U%"4$ B314$5
*une *ul% !ugut "eptember 'ctober No(ember #ecember @anuar"
S5"01"(1
6nits of 0roduction (see 7hibit 2) 1E,3DE 11,DDE 12,IEE 1H,2EE 1I,EEE 21,EEE 1F,DEE
0lastic 5eeded (lbs) 1E,3DE.EE 11,DDE.EE 12,IEE.EE 1H,2EE.EE 1I,EEE.EE 21,EEE.EE 1F,DEE.EE
D$#3=$
6nits of 0roduction (see 7hibit 2) 3,H2D 1,12D 1,H2D D,12D D,H2D D,DDE D,1DE
0lastic 5eeded (lbs) D,13:.DE H,1F:.DE H,I3:.DE :,HF:.DE F,13:.DE F,32D.EE :,:2D.EE
P#"%5/* U%"4$ B314$5
0lastic ,nventor" (lbs at month end) 13,EEE 1:,:3:.DE 1I,F3:.DE 23,FF:.DE 2:,13:.DE 2I,32D.EE 2H,22D.EE 1E,EEE.EE
0lastic 5eeded (lbs) 1D,:F:.DE 1:,:3:.DE 1I,F3:.DE 23,FF:.DE 2:,13:.DE 2I,32D.EE 2H,22D.EE
0lastic from ,nventor" (lbs) 13,EEE.EE 1:,:3:.DE 1I,F3:.DE 23,FF:.DE 2:,13:.DE 2I,32D.EE 2H,22D.EE
0lastic purchased (lbs) 13,EEE.EE 2E,D2D.EE 1I,F3:.DE 23,FF:.DE 2:,13:.DE 2I,32D.EE 2H,22D.EE 1E,EEE.EE
0lastic 0urchase ('ash) G1I,DEE.EE
G3E,:F:.D
E
G2I,:DH.2
D
G3D,F31.2
D
G11,1DH.2
D
G13,IF:.D
E
G3D,DF:.D
E G1D,EEE.EE
0lastic 0urchase (AcctsJ0a"able) G1I,DEE.EE G3E,:F:.DE
G2I,:DH.2
D
G3D,F31.2
D
G11,1DH.2
D G13,IF:.DE
G3D,DF:.D
E G1D,EEE.EE
'ash 2ettlement of AcctsJ0a"able
G1I,DEE.E
E
G3E,:F:.D
E
G2I,:DH.2
D
G3D,F31.2
D
G11,1DH.2
D
G13,IF:.D
E G3D,DF:.DE
$otal 'ash 0a"ment
GDE,2F:.D
E
GHE,D13.:
D
GHD,DF:.D
E
G:H,IF:.D
E
GFD,113.:
D
G:I,D:D.E
E GDE,DF:.DE
:.11
:!11
b. Cith both of these pieces in hand, &e can no& compute the cash budget.
*ul% !ugut
"eptembe
r 'ctober No(ember
#ecembe
r
.eginning 'ash G1H,EEE G1D,HD1 G1D,EFI G1D,I1D G1D,DED G1D,122
) 'ollections (2ee 4eceivables .udget) 23H,22E 2:E,3HF 3EE,I21 31F,::1 1E:,1I2 1:D,EH2
( $otal 'ash Available G2D2,22E G2FH,E1I G31H,E13 G3H1,:1I G122,HI: G1IE,1F1
! 0urchases! plastic (see 7hibit 1E) DE,2FF HE,D11 HD,DFF :H,IFF FD,111 :I,D:D
! Other materials (see 7hibit H) 11,FF1 1H,:EH 1F,HF1 22,HEH 2H,E31 2:,I3F
! >irect labor (see 7hibit 1) 12H,3EE 111,IEE 1DF,:EE 1I1,1EE 21I,DEE 231,HEE
! /anufacturing overhead (see 7hibit D) 2H,EEE 2H,EEE 2H,EEE 2H,EEE 2H,EEE 2H,EEE
! Nariable marketing W admin costs (7hibit I) 2H,1EE 2I,:FE 32,1EE 3I,D2E 11,IEE D3,EEE
! 2alaries (see 7hibit I) 3,EEE 3,EEE 3,EEE 3,EEE 3,EEE 3,EEE
! 4ent (see 7hibit I) :,EEE :,EEE :,EEE :,EEE :,EEE :,EEE
( 'ash balance before financing W special items (G1,31I) G1,EFI G1,I1D (G1,1ID) G11,122 GDI,E:1
! >ividend pa"out 2E,EEE
! 5otes pa"able (for e#uipment) 1D,EEE
( 'ash balance before financing (1H,31I) 1,EFI (1D,EDH) (1,1ID) 11,122 DI,E:1
) 8oanJ(8oan 4epa"ment) 32,EEE 11,EEE 31,EEE 1:,EEE 1,EEE (11,EEE)
( 7nding cash balance G1D,HD1 G1D,EFI G1D,I1D G1D,DED G1D,122 G1D,E:1
:.1D
:!1D
c. $his report summari%es the pro forma income statement and cash budget for
the second half of fiscal "ear 2EEF.
I0*'<$ S5"5$<$05
$otal unit sales are epected to be 11:,DEE &ith revenues of G2,2D1,EEE. $otal contribution
margin is epected to be G1DD,3F1. $otal profit before taes (0.$) is epected to be
G::,FE1. 0.$ is epected to be negative in @ul" and August, and then increase to G12,2DF in
>ecember.
2tandard unit sales are epected to be FI,EEE &ith revenues of G1,D13,EEE. 'onsistent &ith the
historical seasonalit" of 2tandard sets, revenue is epected to be G1:E,EEE in @ul" and gro&
consistentl" throughout the period to G3:1,EEE in >ecember. 2tandard+s overall contribution
margin is epected to be G2I3,:EE.
>elue unit sales are epected to be 2F,DEE, &ith revenues of G:11,EEE. Also seasonal,
>elue+s revenue is epected to be GI1,EEE in @ul" and gro& to G1DH,EEE in >ecember.
>elue+s overall contribution margin is epected to be G1H1,HF1.
Nariable /arketing and Administration costs for both 2tandard and >elue are epected to
remain at a constant 1EK of sales. $otal fied costs are epected to remain constant at GDI,DEE
per month during the period.
C"%+ B314$5
0umpkin 0atch+s month!end cash balances before financing are epected to be &eak &ith the
eception of >ecember &hen the balance is epected to be GDI,E:1. /oreover, bank loan
financing &ill be re#uired each month through 5ovember to maintain the 'ompan"+s G1D,EEE
minimum balance re#uirement. $otal re#uired financing is epected to be GIF,EEE for the period
(( G23,EEE ) G11,EEE ) G31,EEE ) G1:,EEE G1,EEE), &ith GD1,EEE (( GII,EEE ! G11EEE) being
outstanding at "ear!end.
Riven the 'ompan"+s poor epected cash performance for the period, it is recommended that
the follo&ing actions be taken to improve &orking capital management.
4econsider the polic" to have each month+s ending plastic inventor" e#ual to the net
month+s manufacturing needs. $his polic" results in the purchase of plastic inventor"
sooner than is needed.
4econsider the practice of stocking 2DK of the net month+s forecasted demand in
finished goods inventor". A reduction from 2DK &ould improve cash flo&.
1
5egotiate HE da" pa"ment terms &ith plastic and other material suppliers to defer more
pa"ments be"ond the month of purchase.
,mplement 3E da" pa"ment terms for credit sales. $his &ould accelerate collection of the
12K of total sales that remain outstanding after 3E da"s. $he 'ompan" should also focus
on its collection activities to ensure sales are collected in 3E da"s.
Focus on reducing direct labor costs. >irect labor is the largest component of 0umpkin
0atch+s cost structure. $he 'ompan" should evaluate capital investments to automate the
manufacturing process. Chile such investments &ould result in large upfront cash
outflo&s re#uiring financing, the" ma" be net present value positive &hen considering
direct labor cost savings.
7.63
/ar"+s problem is common. Firms have to trade off several factors &hen setting budget
targets and designing incentive schemes. First, sales personnel often possess superior
information about sales prospects for the net fe& months, #uarters, or even "ears. $he"
obtain this information via their dail" interactions &ith customers, other sales representatives,
and trade association meetings. Obviousl", such information is of great value from a planning
perspective. $he firm &ould like to have the most detailed and accurate information about
sales estimates because these estimates form the basis for the firm+s entire budget.
=o&ever, sales personnel have incentives not to divulge this information. $his second
factor arises because of the agenc" conflict that &e introduced in 'hapter 1. As &e
learned there, sales personnel are risk ! and effort!averse. ,f the" give out information,
then the" have to &ork hard to meet the resulting target. $here is no built!in slack to
guard against unanticipated adverse events. $hus, sales personnel often build in a little
cushion (padding or slack) in their sales forecasts. 2ales personnel must also be motivated
to &ork hard to meet the target. ,t is easier to get their private information if the data have
no effect on ho& the" are rated.
Firms use incentive contracts to induce the sales personnel to reveal their private
information and to &ork hard at meeting the resulting target. =o&ever, because such
contracts are based on output targets and environmental factors affect the actual output,
such contracts impose risk on the sales person. A &ell performing, hard!&orking sales
person might not meet her target simpl" because of unfavorable economic circumstances
outside her control. $hus, the contract has to limit the risk imposed. =o&ever, imposing
some risk is critical to motivate the sales person to &ork hard. ,nducing information is
also a t&o!edged s&ord. On the one hand, &e can get good information if it &ill not
affect the sales compensation. .ut, &e can set much better targets and incentive s"stems
if &e have good information.
/ar"+s suggested schemes are all compromises that reflect tradeoffs among these factors.
8et us eamine each in turn.
2
A salar" onl" scheme &ill induce the sales person to reveal private information
about sales targets. After all, their pa" is fied and there is no reason to build
cushions into the budget. =o&ever, once the target has been set, the sales
personnel have no incentive to &ork hard to meet the target. Ce have good
information, but &e cannot use it to motivate the sales force<
2ales gro&th is unlikel" &ith this compensation scheme. $he incentive is not to
&ork hard b" doing -ust enough to get b".
/an" firms follo& this kind of a scheme (actual parameters &ill of course var")
to balance the forces. 4aising the budget, either b" some arbitrar" percentage or
via negotiation, helps to remove some of the slack. Ce prefer negotiation (ideall"
based on data about macro conditions and prior eperience) to a mechanical
ad-ustment. (/echanical ad-ustments onl" induce the sales force to build the
ad-ustment into their initial forecast<) ,n a t"pical budget, there are several rounds
of negotiations before firms agree on targets.
A variable commission allo&s the incentive to operate after the target as &ell. ,n
contrast, the eisting contract induces sales personnel to -ust meet the target and
stop? there is no benefit to eceeding the target b" much. =o&ever, a variable
scale also accentuates the incentive to lo& ball the target. Firms often balance the
incentives b" starting the bonus at IEK of the target (much like /ar"+s idea).
Firms also usuall" cap the maimum bonus pa"able to 12EK (sa") of the target.
2ales gro&th is likel" under this s"stem although it is not likel" to vastl" eceed
industr" averages. $he eistence of a target!based pa" s"stem puts natural breaks
on sales personnel+s incentives to set high targets (or provide information that
high targets are even achievable.)
Ad-usting based on an industr" gro&th rate is a good idea and one that relies on
relative performance evaluation. $his s"stem ensures that .artlett gro&s at the
same rate as the industr". $he Abang!bangB nature of the compensation contract,
though, ensures that sales personnel have no incentive to eceed the industr"
gro&th rate.
$he final incentive scheme takes the idea of relative performance evaluation to
the etreme and implements it &ithin the firm. 2uch Arank and "ankB s"stems
(populari%ed b" the legendar" '7O of Reneral 7lectric, @ack Celch) force
managers to ecel b" pitting them against each other. Chile such s"stems have
much to recommend them, &e note that the" also dampen the incentives to
cooperate. $hus, the" &ork &ell &hen &e have multiple persons doing roughl"
the same task (as in .artlett+s case). $he" are ineffective &hen &e re#uire team
&ork and cooperative kno&ledge sharing.
Overall, &e believe that /ar" should give active consideration to the rank and "ank
s"stem. $he described environment seems ideall" suited for relative performance
3
evaluation as man" reps are selling the same drugs to essentiall" similar clientele. Chile
geographical differences surel" eist, benchmarking against peers appears to be a &inner
in this setting.
7.64
$his is an open!ended #uestion, &ith no obvious correct ans&er. /aking a forecast of
future activit" is, b" nature, an imprecise activit". $here could be, and often is, legitimate
disagreement about the feasible level of activit". $hus, this area is one &here individuals
can AmassageB the numbers to attain a desired result. From a control perspective,
managers therefore scrutini%e these numbers carefull".
7she is caught bet&een a rock and a hard place. 2ticking to her guns &ould probabl" get
her fired or at least increase the chance of shutting off funding. $he latter outcome also
adversel" affects the man" recipients of the charit"+s efforts to distribute computing
e#uipment. A lot is riding on her estimate. =o&ever, accepting the '7O+s
recommendation is also problematic. $he '7O+s estimate appears to be too ros" and is
designed to get this "ear+s funding approved. Tno&ingl" submitting false estimates to
grantors compromises information integrit", putting her actions outside the ethical norms
epected of accounting professionals.
Our recommendation is for 7she to collect more data that might support a rosier estimate,
or confirm a pessimistic estimate. 2he might also provide a range of possible outcomes
(best case, &orst case) so that the grantor has complete information about the charit"+s
prospects.
7.65
$here is no one correct ans&er to this #uestion. On the one hand, not a&arding a bonus is
-ustifiable. $he firm has incurred a substantial loss and re&arding performance for this
result seems odd. Furthermore, revising budgets causes them to lose their Abite.B After
all, &ould the manager argue for a target reset if Florida eperienced much nicer &eather
than epected and tourism boomed; .ecause the manager has control over operations,
she should be held accountable for delivering results.
On the other hand, the forecast clearl" did not account for the actual turn of events. ,t also
appears that the manager and staff &orked hard to keep costs under control. 5otice that
fied costs have increased b" G12E,EEE onl" even though hurricane related repair cost
G11E,EEE. Further, the operations have also cut back on fied marketing and selling
epenses. Fuel costs appear to account for the bulk of direct materials (the actual is 2DK
of sales versus the budget of 1:K of sales). $he onl" item that seems out of line is direct
labor * there is an unepected increase from 3IK of sales to 1HK of sales. ,ndeed, &e
&ould epect the ratio to drop as the tourism industr" dried up and more deck hands &ere
laid off.
Ce &ould also consider long!term effects of this decision. $he o&ner, &ho ma" be
&ealth" and have other sources of income, has a much greater abilit" to bear risk than do
the manager and staff. A&arding a bonus (albeit lo&er than last "ear) as a token of
1
appreciation &ould go a long &a" in building lo"alt" and emplo"ee morale. ,n the long
run, the success of the operations relies on staff attitude * interactions &ith staff are a
crucial part of the overall customer eperience, &hich drives repeat business and &ord of
mouth.
$aking all of these arguments into account, one could reasonabl" argue for at least some
bonus. 6suall", &e &ould argue for holding the manager accountable for her choices * in
this instance, ho&ever, some budget revisions seem called for given the nature and
magnitude of the uncontrollable events.
D

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CHAPTER 7

OPERATING BUDGETS: BRIDGING PLANNING AND CONTROL

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