Master Budget and Responsibility Accounting Chapter Cost Accounting Horngreen Datar

Master Budget and
Responsibility Accounting
Chapter 6
Cost Accounting Horngreen, Datar, Foster

Learning Objectives
Understand what a master budget is and explain its benefits

Describe the advantages of budgets
Prepare the operating budget and its supporting schedules
Explain kaizen budgeting and how it is used for cost
management
Prepare an activity-based budget
Describe responsibility centers and responsibility
accounting.
Explain how controllability relates to responsibility
accounting.

Budgeting Cycle
Performance planning
Providing a frame of reference
Investigating variations
Corrective action
Planning again

The Master Budget
Master
Master Budget
Budget based on one
expected scenario
Operating
Operating Financial
Financial
Decisions
Decisions Decisions
Decisions

Why Budgets?
Conveys strategy to employees and managers
Provides a framework for judging performance
Motivates employees and managers
Promotes coordination and communication

Strategy, Planning, and Budgets
Long-run Long-run
Planning Budgets
Strategy
Analysis
Short-run Short-run
Planning Budgets

Time Coverage of Budgets
Budgets typically have a set time period

(month, quarter, year).
This time period can itself be broken into sub-
periods.
The most frequently used budget period is one
year.
Businesses are increasingly using rolling
budgets.

Operating Budget
Materials
Inventory B.
Procurement B.
Requirements
Sales Budget Production B.
Budget:
- Materials
Finished Goods - Labor
Inventory B. - Capacities
Revenue B. Production Cost B.

-direct
Non-Production - overhead
Cost B.

Operating Budget Example
Hawaii Diving expects 1,100 units to be sold

during the month of August 2004.
Selling price is expected to be $240 per unit.
How much are budgeted revenues for the
month?
1,100 × $240 = $264,000

Operating Budget Example
Two pounds of direct materials are budgeted per unit at a

cost of $2.00 per pound, $4.00 per unit.
Three direct labor-hours are budgeted per unit at $7.00 per
hour, $21.00 per unit.
Variable overhead is budgeted at $8.00 per direct labor-
hour, $24.00 per unit.
Fixed overhead is budgeted at $5,400 per month.
Variable nonmanufacturing costs are expected to be $0.14
per revenue dollar.
Fixed nonmanufacturing costs are $7,800 per month.

Production Budget Example
Budgeted sales (units)

+ Target ending finished goods inventory (units)
– Beginning finished goods inventory (units)
= Budgeted production (units)

Production Budget Example
Assume that target ending finished goods inventory is 80 units.

Beginning finished goods inventory is 100 units.
How many units need to be produced?
Units required for sales 1,100

Add ending inv. of finished units 80
Total finished units required 1,180
Less beg. inv. of finished units 100
Units to be produced 1,080

Direct Materials Usage Budget
Each finished unit requires 2 pounds of direct materials at a

cost of $2.00 per pound.
Desired ending inventory equals 15% of the materials
required to produce next month’s sales.
September sales are forecasted to be 1,600 units.
What is the ending inventory in August?
480 pounds

Direct Materials Usage Budget
September sales: 1,600 × 2 pounds per unit

= 3,200 pounds
3,200 × 15% = 480 pounds (the desired ending inventory)
What is the beginning inventory in August?
1,100 units × 2 × 15% = 330 units
How many pounds are needed to produce 1,080 units in
August?
1,080 × 2 = 2,160 pounds

Material Purchases Budget
Hawaii Diving Direct Material Purchases Budget for the

Month of August 2004
Units needed for production 2,160

Target ending inventory 480
Total material to provide for 2,640
Less beginning inventory 330
Units to be purchased 2,310
Unit purchase price $ 2.00
Total purchase cost $4,620
Direct Manufacturing Labor Budget
Each unit requires 3 direct labor-hours at $7.00 per hour.

Hawaii Diving Direct Labor Budget for the Month of August
2004
Units produced: 1,080

Direct labor-hours/unit 3
Total direct labor-hours: 3,240
Total budget at $7.00/hour: $22,680

Manufacturing Overhead Budget
Variable overhead is budgeted at $8.00 per direct labor-

hour.
Fixed overhead is budgeted at $5,400 per month.
Hawaii Diving Manufacturing Overhead Budget for the
Month of August 2004:
Variable Overhead: (3,240 × $8.00) $25,920

Fixed Overhead 5,400
Total $31,320

Ending Inventory Budget
Cost per finished unit:

• Materials $ 4
• Labor 21
• Variable manufacturing overhead 24
• Fixed manufacturing overhead 5*
• Total $54
» *$5,400 ÷ 1,080 = $5
What is the cost of the target ending inventory for materials?

• 480 × $2 = $960
What is the cost of the target finished goods inventory?
• 80 × $54 = $4,320

Cost of Goods Sold Budget
• Direct materials used 2,160 × $2.00 4,320

• Direct labor 22,680
• Total overhead 31,320
• Cost of goods manufactured $58,320
Assume that the beginning finished goods inventory is

$5,400.
Ending finished goods inventory is $4,320.
What is the cost of goods sold?

Beginning finished goods inventory $ 5,400

+ Cost of goods manufactured $58,320
= Goods available for sale $63,720
– Ending finished goods inventory $ 4,320
= Cost of goods sold $59,400

Nonmanufacturing Costs Budget
Hawaii Diving Other Expenses Budget for the Month of

August 2004
Variable Expenses: ($0.14 × $264,000) $36,960

Fixed expenses 7,800
Total $44,760

Hawaii Diving has budgeted sales of $264,000 for the month
of August.
Cost of goods sold are budgeted at $59,400.
What is the budgeted gross margin?
Hawaii Diving Budgeted Income Statement for the Month
ending August 31, 2004
Sales $264,000 100%
Less cost of sales 59,400 22%
Gross margin $204,600 78%
Other expenses 44,760 17%
Operating income $159,840 61%

Financial Planning Models
Financial planning models are

mathematical representations of the
interrelationships among operating
activities, financial activities, and other
factors that affect the master budget.

Example: Cash Budget
Depends on collection pattern:
In the month of sale: 50%

In the month following sale: 27%
In the second month following sale: 20%
Uncollectible: 3%

Cash Budget
Budgeted charge sales are as follows:
• June $200,000
• July $250,000
• August $264,000
• September $260,000
What are the expected cash collections in August?

Cash Budget
Budgeted Cash Receipts
for the Month Ending August 31, 2004
August sales: $264,000 × 50% $132,000

July sales: $250,000 × 27% $67,500
June sales: $200,000 × 20% $40,000
Total $239,500

Cash Budget
Budgeted Cash Disbursements

August purchases $ 4,620
Direct labor $22,680
Total overhead $31,320
Other expenses $9,760*
Total $68,380
*Other expenses exclude depreciation

Cash Budget
Cash Budget
Budgeted receipts $239,500

Budgeted disbursements 68,380
Net increase in cash $171,120

Exercise: Prepare a purchases budget in pounds for July, August, and
September, and give total purchases in both pounds and dollars for each month.
Lubriderm Corporation has the following budgeted sales for the next six-month
period:
Month Unit Sales
June 90,000
July 120,000
August 210,000
September 150,000
October 180,000
November 120,000
There were 30,000 units of finished goods in inventory at the beginning of June.
Plans are to have an inventory of finished products that equal 20% of the unit
sales for the next month.
Five pounds of materials are required for each unit produced. Each pound of
material costs $8. Inventory levels for materials are equal to 30% of the needs
for the next month. Materials inventory on June 1 was 15,000 pounds

What is Kaizen?
The Japanese use the term “kaizen” for continuous

improvement.
Kaizen budgeting is an approach that explicitly
incorporates continuous improvement during the
budget period into the budget numbers.

Kaizen Budgeting
A kaizen budgeting approach would

incorporate future improvements.
Budgeted Hours/Item
January – March 2004 3.00
April – June 2004 2.95
July – September 2004 2.90
October – December 2004 2.85
Activity-Based Budgeting
Activity-based costing reports and analyzes

past and current costs.
Activity-based budgeting (ABB) focuses

on the budgeted cost of activities necessary
to produce and sell products and services.

Product A Product B
Units produced: 880 200
Labor-hours per unit: 3 3
Budgeted setup-hours: 5 5
Total budgeted machine setup related cost is $25,920 per month.
Total budgeted labor-hours are:

Product A: 880 × 3 2,640
Product B: 200 × 3 600
Total 3,240
What is the allocation rate per labor-hour?
• $25,920 ÷ 3,240 = $8.00

Total cost allocated to each product line:

Product A: $8.00 × 2,640 = $21,120
Product B: $8.00 × 600 = $ 4,800
Under ABB, the number of setups is the cost driver.

$25,920 budgeted machine setup cost
÷ 10 budgeted machine setup-hours
= $2,592 allocation rate per machine setup-hour.
How much machine setup related costs are allocated to
each product line?

Product A Product B
$12,960 $12,960
$2,592 × 5 $2,592 × 5
Setup-related cost per unit:

Product A: $12,960 ÷ 880 $14.73
Product B: $12,960 ÷ 200 $64.80

What is a Responsibility Center?
It is any part, segment, or subunit

of a business that needs control.
– production
– service

Types of Responsibility Centers
Cost Center
Profit Center
Investment Center

What is Controllability?
It is the degree of influence that a specific

manager has over costs, revenues,
or other items in question.
A controllable cost is any cost that is

primarily subject to the influence of a
given responsibility center manager
for a given time period.
Controllability
Responsibility accounting focuses on

information and knowledge, not control.
A responsibility accounting system could

exclude all uncontrollable costs from
a manager’s performance report.
In practice, controllability is difficult to pinpoint.

Human aspects of Budgeting
Budgeting should not be considered as a „mechanical tool“

Quality of the budget depends on the information that is fed
into the process
There are incentives for dishonest reports
• Budgetary slack
• Empire building
Management aims to ensure honest reporting by lower level
management
• Via appropriate performance measures
• Monitoring

True or False ???
A budget that covers the financial aspects is a qualitative expression of

a proposed plan of action by management for a specified period.
The master budget reflects the impact of only operating decisions.
Feedback in the budgeting process may cause a firm to alter its

strategies and plans.
Statistical analysis should be the only input used to forecast sales.
Sensitivity analysis allows managers to see how results will change if

predicted data are not achieved or an underlying assumption changes.

Pick your Choice I:
When a budget is administered wisely, it will

• discourage strategic planning.
• provide a framework for performance evaluation.
• discourage managers and employees.
• eliminate coordination and communication between subunits.
If a firm is using activity-based budgeting, the firm would use this in

place of which of the following budgets?
• Direct materials budget
• Revenue budget
• Direct labor budget
• Manufacturing overhead budget

Pick your Choice II:
BDH Corporation, which makes only one product, Kisty, has the
following information available for the coming year. BDH expects sales
to be 30,000 units at $50 per unit. The current inventory of Kisty is 3,000
units. BDH wants an ending inventory of 3,500 units. Each unit of Kisty
takes two units of component L. Component L is budgeted to cost $12
per unit. Current inventory of L is 4,000 units. BDH wants 6,000 units of
L on hand at the end of the next year. How much will the direct materials
budget show as the cost of materials to be purchased?
• $330,000
• $390,000
• $684,000
• $756,000

Who Gets the Money?
New York Post, April 29, 2001
In the above-cited article, ABC and its parent company, Walt Disney Company,
say that the show "Who Wants to be a Millionaire," is the most profitable
television show ever - generating almost $1 billion in revenue in a little less than
two years on the air.
Each individual show costs about $700,000 to produce, including prize money
and host Regis Philbin's salary. Each show earns $2 million in advertising
revenue. The rights to air Millionaire are also sold to Canada for $250,000 per
episode.
The Millionaire show also sells a CD-ROM game for $20. About 4 million of
these games have been sold.
There is also an on-line version of the game that Millionaire fans can play. Users
of the game don't pay, but each "hit" is noted when advertising space is sold for
the site.
The article also points out that Disney also sells hats and t-shirts of the game,
and markets a special version of "Millionaire" to corporations that can be played
at conventions by employees and clients.

“Who Gets the Money?“ - Questions
1. The Millionaire show itself generates about $1.3 million per episode in
net income ($2 million in revenue, $700,000 in expenses.) Give a
reason why this should be considered a profit center for evaluating a
manager's performance.
2. Do you think that one manager has responsibility for the Millionaire
show, as a profit center, or is it divided as a cost center and as a
revenue center?
3. Should the ancillaries of the show (the t-shirts, CD-ROM, etc.) be

evaluated as a profit center, cost center or revenue center? Why?

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Master Budget and

Cost Accounting Horngreen, Datar, Foster

Understand what a master budget is and explain its benefits

Cost Accounting Horngreen, Datar, Foster

Cost Accounting Horngreen, Datar, Foster

Cost Accounting Horngreen, Datar, Foster

Conveys strategy to employees and managers

Provides a framework for judging performance

Motivates employees and managers

Promotes coordination and communication

Cost Accounting Horngreen, Datar, Foster

Cost Accounting Horngreen, Datar, Foster

Budgets typically have a set time period

Cost Accounting Horngreen, Datar, Foster

Revenue B. Production Cost B.

Cost Accounting Horngreen, Datar, Foster

Hawaii Diving expects 1,100 units to be sold

Cost Accounting Horngreen, Datar, Foster

Two pounds of direct materials are budgeted per unit at a

Cost Accounting Horngreen, Datar, Foster

Budgeted sales (units)

= Budgeted production (units)

Cost Accounting Horngreen, Datar, Foster

Assume that target ending finished goods inventory is 80 units.

Units required for sales 1,100

Cost Accounting Horngreen, Datar, Foster

Each finished unit requires 2 pounds of direct materials at a

Cost Accounting Horngreen, Datar, Foster

September sales: 1,600 × 2 pounds per unit

Cost Accounting Horngreen, Datar, Foster

Hawaii Diving Direct Material Purchases Budget for the

Units needed for production 2,160

Each unit requires 3 direct labor-hours at $7.00 per hour.

Units produced: 1,080

Cost Accounting Horngreen, Datar, Foster

Variable overhead is budgeted at $8.00 per direct labor-

Variable Overhead: (3,240 × $8.00) $25,920

Cost Accounting Horngreen, Datar, Foster

Cost per finished unit:

What is the cost of the target ending inventory for materials?

Cost Accounting Horngreen, Datar, Foster

• Direct materials used 2,160 × $2.00 4,320

Assume that the beginning finished goods inventory is

Cost Accounting Horngreen, Datar, Foster

Beginning finished goods inventory $ 5,400

Cost Accounting Horngreen, Datar, Foster

Hawaii Diving Other Expenses Budget for the Month of

Variable Expenses: ($0.14 × $264,000) $36,960

Cost Accounting Horngreen, Datar, Foster

Cost Accounting Horngreen, Datar, Foster

Financial planning models are

Cost Accounting Horngreen, Datar, Foster

Depends on collection pattern:

In the month of sale: 50%

Cost Accounting Horngreen, Datar, Foster

Budgeted charge sales are as follows:

What are the expected cash collections in August?

Cost Accounting Horngreen, Datar, Foster

Budgeted Cash Receipts

for the Month Ending August 31, 2004

August sales: $264,000 × 50% $132,000

Cost Accounting Horngreen, Datar, Foster

Budgeted Cash Disbursements