Chapter 9

Profit Planning
4/14/04

Planning and Control

Planning -involves developing objectives and preparing various budgets to achieve these objectives.
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Control involves the steps taken by mgmt that attempt to ensure the org. is working together & objectives are attained.
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Budget
A plan to acquire and use financial and other resources to achieve the firms goals and objectives Usually a painful process, but absolutely necessary for the efficient running of a firm This chapter provides a very useful model for creating a budget
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Advantages of Budgeting
Define goal and objectives, benchmark Getting mgrs to think about and plan for the future

Communicating Plans thru Org.

Coordinate activities, integrate plans

Advantage s
Uncover potential bottlenecks

Means of allocating resources efficiently

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Choosing the Budget Period

(Generally fiscal years)

Operating Budget

1999

2000

2001

2002

The annual operating budget may be divided into quarterly and monthly budgets.

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Participative Budget System

Managers prepare their own budget estimates
Top Management

Middle Management

Middle Management

Supervisor

Supervisor

Supervisor

Supervisor

Flow of Self-Imposed Budget Data, Self(Versus a top down approach)

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Advantages of Self-Imposed Budget

Prepared by lower management levels who are closer to the action and provide more accurate and reliable estimates Recognizes them as part of the team Motivates them to perform, walk their talk Generates buy-in because its not topdown approach
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Human Factors in Budgeting

Motivate employees Establish goals Measure progress Identify problems and solutions CoCo-ordinate efforts Create flexibility Never used as a club
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Zero-based Budgeting
Managers are required to justify all budgeted expenditures Baseline is zero, not last years Requires more work, more time and more documentation Usually done when deep cuts in spending are required
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The Master Budget Model

Sales Budget

Production Budget Direct Materials Budget Direct Labor Budget

Selling and Administrative Budget Manufacturing Overhead Budget

Cash Budget

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Budgeted Financial StatementsThe McGraw-Hill Companies, Inc., 2003

The Sales Budget

Key to the entire budgeting process All other schedules derive from it A mistake here makes the entire budget less effective Where would you go to get accurate sales forecasting information?

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Source of Sales Data

Forecasting includes the following sources: past history, backlog of unfulfilled orders, marketing plans, competition, new products, availability of resources, economic conditions, customer, sales force, industry trends

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Budgeting Example
Royal Company is preparing budgets for the quarter ending June 30. Budgeted sales for the next five months are:
April May June July August 20,000 units 50,000 units 30,000 units 25,000 units 15,000 units.

The selling price is $10 per unit.

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The Sales Budget

April Budgeted sales (units) Selling price per unit Total sales 20,000 $ 10 $200,000 May 50,000 $ 10 $500,000 June 30,000 $ 10 $300,000 Quarter 100,000 $ 10 $ 1,000,000

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Expected Cash Collections

All sales are on account. Royals collection pattern is:
70% collected in the month of sale, 25% collected in the month following sale, 5% is uncollectible.

The March 31 accounts receivable balance of $30,000 will be collected in full.

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Expected Cash Collections

Accounts rec. - 3/31 April sales 70% x $200,000 25% x $200,000 April $ 30,000 140,000 $ 50,000 May June Quarter $ 30,000 140,000 50,000

Total cash collections $ 170,000

$ 50,000

From the Sales Budget for April.

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Expected Cash Collections

Accounts rec. - 3/31 April sales 70% x $200,000 25% x $200,000 May sales 70% x $500,000 25% x $500,000 April $ 30,000 140,000 $ 50,000 350,000 $ 125,000 May June Quarter $ 30,000 140,000 50,000 350,000 125,000

Total cash collections $ 170,000

$ 400,000

From the Sales Budget for May.

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Expected Cash Collections

Accounts rec. - 3/31 April sales 70% x $200,000 25% x $200,000 May sales 70% x $500,000 25% x $500,000 June sales 70% x $300,000 Total cash collections April $ 30,000 140,000 $ 50,000 350,000 $ 125,000 210,000 $ 335,000 May June Quarter $ 30,000 140,000 50,000 350,000 125,000 210,000 $ 905,000

$ 170,000

$ 400,000

Note: The 25% of June sales ($75,000) to be collected in July becomes the Accounts Receivable balance at the end of June
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The Production Budget

Sales Budget and Expected Cash Collections Production Budget

Production must be adequate to meet budgeted sales and provide for sufficient ending inventory.
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The Production Budget

The management at Royal Company wants ending inventory to be equal to 20% of the following months budgeted sales in units. This is how much inventory that is required to meet production needs in the next period. On March 31, 4,000 units were on hand.

Lets prepare the production budget.

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The Production Budget

Budgeted sales Add desired ending inventory Total needed Less beginning inventory Required production April 20,000 10,000 30,000 4,000 26,000
Budgeted sales Desired percent Desired inventory
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May 50,000

June 30,000

Quarter 100,000

50,000 20% 10,000

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The Production Budget

Budgeted sales Add desired ending inventory Total needed Less beginning inventory Required production April 20,000 10,000 30,000 4,000 26,000 ? May 50,000 June 30,000 Quarter 100,000

March 31 ending inventory

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Quick Check 
What is the required production for May? a. 56,000 units b. 46,000 units c. 62,000 units d. 52,000 units

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Quick Check 
What is the required production for May? a. 56,000 units b. 46,000 units c. 62,000 units d. 52,000 units

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The Production Budget

Budgeted sales Add desired ending inventory Total needed Less beginning inventory Required production April 20,000 10,000 30,000 4,000 26,000 May 50,000 6,000 56,000 10,000 46,000 June 30,000 Quarter 100,000

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The Production Budget

Budgeted sales Add desired ending inventory Total needed Less beginning inventory Required production April 20,000 10,000 30,000 4,000 26,000 May 50,000 6,000 56,000 10,000 46,000 June 30,000 5,000 35,000 6,000 29,000 Quarter 100,000 5,000 105,000 4,000 101,000

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Ending inventory based on 20% of July sales (25,000). The McGraw-Hill Companies, Inc., 2003

Manufacturing Cost Budgets

Now that we know production needs, we need to determine how much material, labor and overhead will be required to meet those needs. To determine cost of goods manufactured, we also need to know endiing WIP inventory.

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The Direct Materials Budget

At Royal Company, five pounds of material are required per unit of product. Management wants materials on hand at the end of each month equal to 10% of the following months production. On March 31, 13,000 pounds of material are on hand. Material cost is $0.40 per pound. Lets prepare the direct materials budget.
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The Direct Materials Budget

Production Materials per unit Production needs Add desired ending inventory Total needed Less beginning inventory Materials to be purchased April 26,000 May 46,000 June 29,000 Quarter 101,000

From production budget

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The Direct Materials Budget

Production Materials per unit Production needs Add desired ending inventory Total needed Less beginning inventory Materials to be purchased April 26,000 5 130,000 May 46,000 5 230,000 June 29,000 5 145,000 Quarter 101,000 5 505,000

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The Direct Materials Budget

Production Materials per unit Production needs Add desired ending inventory Total needed Less beginning inventory Materials to be purchased April 26,000 5 130,000 23,000 153,000 May 46,000 5 230,000 June 29,000 5 145,000 Quarter 101,000 5 505,000

10% of the following months production

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The Direct Materials Budget

Production Materials per unit Production needs Add desired ending inventory Total needed Less beginning inventory Materials to be purchased April 26,000 5 130,000 23,000 153,000 13,000 140,000 ? May 46,000 5 230,000 June 29,000 5 145,000 Quarter 101,000 5 505,000

March 31 inventory
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Quick Check 
How much materials should be purchased in May? a. 221,500 pounds b. 240,000 pounds c. 230,000 pounds d. 211,500 pounds

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Quick Check 
How much materials should be purchased in May? a. 221,500 pounds b. 240,000 pounds c. 230,000 pounds d. 211,500 pounds

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The Direct Materials Budget

Production Materials per unit Production needs Add desired ending inventory Total needed Less beginning inventory Materials to be purc ased April 26 000 5 130 000 23 000 153 000 13 000 140 000 Ma 46 000 5 230 000 14 500 244 500 23 000 221 500 J e 29 000 5 145 000 11 500 156 500 14 500 142 000 arter 101 000 5 505 000 11 500 516 500 13 000 503 500

Ending inventory will be 10% of July production needs

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Direct Materials Budget

Production needs Add desired ending inventory Total needed Less beginning inventory Materials to be purchased Cost per pound Material Cost
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130,000 23,000 153,000 13,000 140,000 $0.40 $56,000

230,000 14,500 244,500 23,000 221,500 $0.40 $88,600

145,000 11,500 156,500 14,500 142,000 $0.40 $56,800

505,000 11,500 516,500 13,000 503,500 $0.40 $201,400

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Expected Cash Disbursement for Materials

Royal pays $0.40 per pound for its materials. OneOne-half of a months purchases are paid for in the month of purchase; the other half is paid in the following month. The March 31 accounts payable balance is $12,000.

Lets calculate expected cash disbursements.

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Expected Cash Disbursement for Materials

Accounts pay. 3/31 April purchases 50% x $56,000 50% x $56,000 May purchases April $ 12,000 28,000 $ 28,000 May June Quarter $ 12,000 28,000 28,000

June purchases Total cash disbursements

$ 40,000

140,000 lbs. $.40/lb. = $56,000

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Expected Cash Disbursement for Materials

Accounts pay. 3/31 April purchases 50% x $56,000 50% x $56,000 May purchases 50% x $88,600 50% x $88,600 June purchases 50% x $56,800 Total cash disbursements April $ 12,000 28,000 $ 28,000 44,300 $ 44,300 28,400 $ 40,000 $ 72,300 $ 72,700 May June Quarter $ 12,000 28,000 28,000 44,300 44,300 28,400 $185,000

Note: The 50% of June purchases payable in July ($28,400) is the Accounts Payable balance at the end of June.
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The Direct Labor Budget

At Royal, each unit of product requires 0.05 hours of direct labor. The Company has a no layoff policy so all employees will be paid for 40 hours of work each week. In exchange for the no layoff policy, workers agreed to a wage rate of $10 per hour regardless of the hours worked (No overtime pay). For the next three months, the direct labor workforce will be paid for a minimum of 1,500 hours per month.

Lets prepare the direct labor budget.

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The Direct Labor Budget

Production Direct labor hours Labor hours required Guaranteed labor hours Labor hours paid Wage rate Total direct labor cost April 26,000 May 46,000 June 29,000 Quarter 101,000

From production budget

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The Direct Labor Budget

Production Direct labor hours Labor hours required Guaranteed labor hours Labor hours paid Wage rate Total direct labor cost April 26,000 0.05 1,300 May 46,000 0.05 2,300 June 29,000 0.05 1,450 Quarter 101,000 0.05 5,050

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The Direct Labor Budget

Production Direct labor hours Labor hours required Guaranteed labor hours Labor hours paid Wage rate Total direct labor cost April 26,000 0.05 1,300 1,500 1,500 May 46,000 0.05 2,300 1,500 2,300 June 29,000 0.05 1,450 1,500 1,500 Quarter 101,000 0.05 5,050 5,300

Higher of labor hours required or labor hours guaranteed.

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The Direct Labor Budget

Production Direct labor hours Labor hours required Guaranteed labor hours Labor hours paid Wage rate Total direct labor cost April 26,000 0.05 1,300 1,500 1,500 $ 10 $ 15,000 May 46,000 0.05 2,300 1,500 2,300 $ 10 $ 23,000 June 29,000 0.05 1,450 1,500 1,500 $ 10 $ 15,000 Quarter 101,000 0.05 5,050 5,300 $ 10 $ 53,000

Note: Cash disbursement equals total direct labor cost since it is paid in period earned
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Manufacturing Overhead Budget

Royal Company uses a variable manufacturing overhead rate of $1 per unit produced. produced Fixed manufacturing overhead is $50,000 per month and includes $20,000 of noncash costs (primarily depreciation of plant assets).

Lets prepare the manufacturing overhead budget.

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Manufacturing Overhead Budget

April Production in units 26,000 Variable mfg. OH rate $ 1 Variable mfg. OH costs $ 26,000 Fixed mfg. OH costs Total mfg. OH costs Less noncash costs Cash disbursements for manufacturing OH May 46,000 $ 1 $ 46,000 June 29,000 $ 1 $ 29,000 Quarter 101,000 $ 1 $ 101,000

From production budget

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Manufacturing Overhead Budget

April Production in units 26,000 Variable mfg. OH rate $ 1 Variable mfg. OH costs $ 26,000 Fixed mfg. OH costs 50,000 Total mfg. OH costs 76,000 Less noncash costs Cash disbursements for manufacturing OH May 46,000 $ 1 $ 46,000 50,000 96,000 June 29,000 $ 1 $ 29,000 50,000 79,000 Quarter 101,000 $ 1 $ 101,000 150,000 251,000

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Manufacturing Overhead Budget

April Production in units 26,000 Variable mfg. OH rate $ 1 Variable mfg. OH costs $ 26,000 Fixed mfg. OH costs 50,000 Total mfg. OH costs 76,000 Less noncash costs 20,000 May 46,000 $ 1 $ 46,000 50,000 96,000 20,000 June 29,000 $ 1 $ 29,000 50,000 79,000 20,000 Quarter 101,000 $ 1 $ 101,000 150,000 251,000 60,000

Cash disbursements for manufacturing OH $ 56,000

$ 76,000

$ 59,000

$ 191,000

Depreciation is a noncash charge.

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Ending Finished Goods Inventory Budget

Now, Royal can complete the ending finished goods inventory budget. At Royal, manufacturing overhead is applied to units of product on the basis of direct labor hours. Lets calculate ending finished goods inventory.
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Ending Finished Goods Inventory Budget

Production costs r unit Quantity Direct aterials 5. l s. Direct labor anufacturing overhead Budgeted finished goods inventory Ending inventory in units Unit roduct cost Ending finished goods inventory Cost . Total .

Direct materials budget and information

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Ending Finished Goods Inventory Budget

Production costs er unit Quantity Cost Direct aterials 5. lbs. . Direct labor 0.05 hrs. $ 0.00 anufacturing overhead Budgeted finished goods inventory Ending inventory in units Unit roduct cost Ending finished goods inventory Total . 0.50

Direct labor budget

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Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Direct materials 5.00 lbs. $ 0.40 Direct labor 0.05 hrs. $ 10.00 Manufacturing overhead 0.05 hrs. $ 49.70 Budgeted finished goods inventory Ending inventory in units Unit product cost Ending finished goods inventory $ Total 2.00 0.50 2.49 4.99

4.99 ?

Total mfg. OH for quarter $251,000 = $49.70 per hr.* Total labor hours required 5,050 hrs (from DL budget & MOH budget) *rounded
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Ending Finished Goods Inventory Budget

Production costs er unit Quantity Cost Direct aterials 5.00 lbs. $ 0. 0 Direct labor 0.05 hrs. $ 0.00 anufacturing overhead 0.05 hrs. $ . 0 Budgeted finished goods inventory Ending inventory in units Unit roduct cost Ending finished goods inventory $ Total .00 0.50 . .

5,000 $ 4. $24, 50

Production Budget

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Selling and Administrative Expense Budget

At Royal, variable selling and administrative expenses are $0.50 per unit sold. Fixed selling and administrative expenses are $70,000 per month. The fixed selling and administrative expenses include $10,000 in costs primarily depreciation that are not cash outflows of the current month. Lets prepare the companys selling and administrative expense budget.
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Selling and Administrative Expense Budget

Budgeted sales Variable selling and admin. rate $ 0.50 Variable expense $ 10,000 Fixed selling and 70,000 admin. expense Total expense 80,000 Less noncash 10,000 expenses Cash disbursements for selling & admin. $ 70,000 April 20,000 May June Quarter

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Selling and Administrative Expense Budget

Budgeted sales Variable selling and admin. rate $ 0.50 Variable expense $ 10,000 Fixed selling and admin. expense 70,000 Total expense 80,000 Less noncash 10,000 expenses Cash disbursements for McGraw-Hill/Irwin selling & admin. $ 70,000 April 20,000 May 50,000 $ 0.50 $ 25,000 70,000 95,000 10,000 June 30,000 $ 0.50 $ 15,000 70,000 85,000 10,000 Quarter 100,000 $ 0.50 $ 50,000 210,000 260,000 30,000

$ 85,000

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$ 75,000

$ 230,000

The Cash Budget

Royal:
  

Maintains a 16% open line of credit for $75,000. Maintains a minimum cash balance of $30,000. Borrows on the first day of the month and repays loans on the last day of the month. Pays a cash dividend of $49,000 in April. Purchases $143,700 of equipment in May and $48,300 in June paid in cash. Has an April 1 cash balance of $40,000.
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The Cash Budget

Beginning cash balance Add cash collections Total cash available Less disbursements Materials 40,000 Direct labor Mfg. overhead Selling and admin. Schedule of Expected Equipment purchase Dividends Cash Disbursements Total disbursements Excess (deficiency) of cash available over Schedule of Expected Cash Collections disbursements April $ 40,000 170,000 210,000 May June Quarter

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The Cash Budget

Beginning cash balance Add cash collections Total cash available Less disbursements Materials Direct labor Mfg. overhead Selling and admin. Equipment purchase Dividends Total disbursements Excess (deficiency) of cash available over disbursements April $ 40,000 170,000 210,000 40,000 15,000 56,000 70,000 May June Quarter

Direct Labor Budget Manufacturing Overhead Budget

Selling and Administrative Expense Budget

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The Cash Budget

Beginning cash balance Add cash collections Total cash available Less disbursements Materials Direct labor Mfg. overhead Selling and admin. Equipment purchase Dividends Total disbursements Excess (deficiency) of cash available over disbursements April $ 40,000 170,000 210,000 40,000 15,000 56,000 70,000 49,000 230,000 May June Quarter

Because Royal maintains a cash balance of $30,000, the company must borrow on its line-ofline-of-credit

$ (20,000)

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Financing and Repayment

Apr E fC v r F ( f v r ) m t ( ) r r

g: B rr w g R paym t I t r t tal f ancing Ending cash balance

$ 30,000

$ 30,000

Ending cash balance for April is the beginning May balance.

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The Cash Budget

Beginning cash balance Add cash collections Total cash available Less disbursements Materials Direct labor Mfg. overhead Selling and admin. Equipment purchase Dividends Total disbursements Excess (deficiency) of cash available over disbursements April $ 40,000 170,000 210,000 40,000 15,000 56,000 70,000 49,000 230,000 May $ 30,000 400,000 430,000 72,300 23,000 76,000 85,000 143,700 400,000 June Quarter

$ (20,000)

$ 30,000

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Financing and Repayment

April E cess (deficiency) of Cash available over disbursements Financing: Borrowing Repayments Interest Total financing Ending cash balance May June Quarter

$ ( 0,000) 0,000 0,000 $ 30,000

$30,000 $ 30,000

Because the ending cash balance is exactly $30,000, Royal will not repay the loan this month.

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The Cash Budget

Beginning cash balance Add cash collections Total cash available Less disbursements Materials Direct labor Mfg. overhead Selling and admin. Equipment purchase Dividends Total disbursements Excess (deficiency) of cash available over disbursements April $ 40,000 170,000 210,000 40,000 15,000 56,000 70,000 49,000 230,000 May $ 30,000 400,000 430,000 72,300 23,000 76,000 85,000 143,700 400,000 June $ 30,000 335,000 365,000 72,700 15,000 59,000 75,000 48,300 270,000 Quarter $ 40,000 905,000 945,000 185,000 53,000 191,000 230,000 192,000 49,000 900,000

$ (20,000)

$ 30,000

$ 95,000

$ 45,000

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Financing and Repayment

April E cess (deficiency) of Cash available over disbursements Financing: Borrowing Repayments Interest Total financing Ending cash balance May June Quarter

$ ( 0,000) 50,000 50,000 $ 30,000

$30,000 $ 30,000

$ 95,000 (50,000) ( ,000) (52,000) $ 43,000

$ 45,000 50,000 (50,000) ( ,000) (2,000) $ 43,000

$50,000 16% 3/12 = $2,000 Borrowings on April 1 and repayment of June 30.
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The Budgeted Income Statement

Cash Budget Budgeted Income Statement

After we complete the cash budget, we can prepare the budgeted income statement for Royal.
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The Budgeted Income Statement

Roy Company B t Income Statement For t e Three Months Ended June 30 Sales (100,000 units @ $10) Cost of goods sold (100,000 @ $4.99) Gross margin Selling and administrative expenses Operating income Interest expense Net income $ 1,000,000 499,000 501,000 260,000 241,000 2,000 $ 239,000

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The Budgeted Balance Sheet

Royal reported the following account balances prior to preparing its budgeted financial statements:
   

Land - $50,000 Common stock - $200,000 Retained earnings - $146,150 Equipment - $175,000


Add 143,700 in May and 48,300 in June for ending balance of $367,000

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R B d

lC p dB l

C rr C A r iv l R ri l i v d d i v Fi i T l rr r p r d ip d E ip T l pr p r d l T A C R T p i d r i l li ili i l

25% of June sales of $300,000

, , ,6 , , , 6 , , 6 , 8, , 6, 6 ,

r r

11,500 lbs. at $0.40/lb. 5,000 units at $4.99 each

ip

50% of June purchases of $56,800

The McGraw-Hill Companies, Inc., 2003

ii

McGraw-Hill/Irwin

R B d

lC p dB l

C rr C A r iv l R ri l i v d d i v Fi i T l rr r p r d ip d E ip T l pr p r d l T A C R T p i d r i l li ili i l

r r

, B, i i l Add: i ,6 : divid d d l E, di , , 6 , , 6 , 8, , 6, 6 ,

6, , , 6,

ip

ii

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc., 2003

End of Chapter 9

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The McGraw-Hill Companies, Inc., 2003