Lecture 7

Paolo Perego

Management Accounting
IBA 2005-2006
 Program

• Chapter 9: Budgeting
– Master Budget
– Activity-Based Budgeting
– Behavioral aspects of budgeting
• Chapter 6:
– Activity-Based Management
– Customer Profitability Analysis
– Advanced Manufacturing Technologies
• Just-In-Time
• Inventory management
 Purposes of Budgeting Systems

Budget
a detailed plan, expressed in quantitative terms,
that specifies how resources will be acquired
and used during a specified period of time
Chapter 9

Decision-making purposes:
• Planning and Allocation of Resources
• Facilitating Communication and Coordination

Decision-control purposes:
• Controlling Profit and Operations
• Evaluating Performance and Providing Incentives
 Budgeting Cycle
• Planning the performance of the organisation
• Providing a set of specific objectives (budget
goals) against which actual results can be
compared
• Investigating variations from plans (variance
analysis)
Chapter 9

• Correcting actionCapital
follows, if with
budgets necessary
acquisitions
• Planning again that normally cover several years
Long Range Budgets

Continuous or
Rolling Budget
2004 2005 2006 2007

This budget is usually a twelve-month

budget that rolls forward one month
as the current month is completed
 Master Budget
• It is a comprehensive expression of
management’s operating and financial plans for
a future time period (usually one year).
• The master budget is summarized in a set of
budgeted financial statements.
– embraces the impact of both operational
Chapter 9

decisions and financing decisions.

• Operational decisions center on the use of

scarce resources.

• Financing decisions center on how to obtain the

funds to acquire those resources.
 Master Budget Components (1)
• Operational budget
– Supporting budget schedules
– Revenue budget
– Production budget in units
– Direct materials purchase budget
– Direct labor budget
Chapter 9

– Cost of goods sold budget

– Non-manufacturing costs budget
– Budgeted income statement

• Financial budget
– Capital budget
– Cash budget
– Budgeted balance sheet
– Budgeted statement of cash flows
 Master Budget Components (2)

Sales of Services or Goods

Exhibit
Ending
9-1
Inventory
Budget Production
Work in Process Budget
and Finished
Goods
Chapter 9

Direct Direct Selling and

Overhead
Materials Labor Administrative
Budget Budget Budget
Budget

Ending Cash Budget

Inventory
Budget
Direct Materials Budgeted Financial Statements
 Sales Budget

• Breakers, Inc. is preparing budgets for the

quarter ending June 30.
• Budgeted sales for the next five months are:
April 20,000 units
May 50,000 units
Chapter 9

June 30,000 units

July 25,000 units
August 15,000 units

• The selling price is $10 per unit.

 Sales Budget
April May June Quarter

Budgeted
sales (units) 20.000 50.000 30.000 100.000
Selling price
per unit $ 10 $ 10 $ 10 $ 10
Total
Chapter 9

Revenue $ 200.000 $ 500.000 $ 300.000 $ 1.000.000

• Production must be adequate to meet budgeted sales and

provide for sufficient ending inventory
Assume that:
• The management of Breakers, Inc. wants ending
inventory to be equal to 20% of the following month’s
budgeted sales in units
• On March 31, 4,000 units were available
 Production Budget

April May June Quarter

Sales in units 20.000 50.000 30.000 100.000
Add: desired
end. inventory 10.000 6.000 5.000 5.000
Total needed 30.000 56.000 35.000 105.000
Less: beg.
Chapter 9

inventory 4.000 10.000 6.000 4.000

Units to be
started 26.000 46.000 29.000 101.000

March 31
ending inventory
 Direct-Material Budget

• At Breakers, 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 month’s production.
Chapter 9

• On March 31, 13,000 pounds of material are

on hand. Material cost $0.40 per pound.

Let’s prepare the direct materials budget.

Chapter 9
Direct-Material Budget

From our
production March 31
budget inventory

10% of the following

month’s production
 Direct-Material Budget

July Production
Sales in units 25.000
Add: desired ending inventory 3.000
Total units needed 28.000
Less: beginning inventory 5.000
Production in units 23.000
Chapter 9

June Ending Inventory

July production in units 23.000
Materials per unit 5
Total units needed 115.000
Inventory percentage 10%
June desired ending inventory 11.500
 Direct-Labor Budget

• At Breakers, each unit of product requires 0.1

hours of direct labor.
• The Company has a “no layoff” policy so all
employees will be paid for 40 hours of work
each week.
Chapter 9

• In exchange for the “no layoff” policy, workers

agreed to a wage rate of $8 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 3,000
hours per month.

Let’s prepare the direct-labor budget

Chapter 9
Direct-Labor Budget

From our This is the greater of

production labor hours required or
budget labor hours guaranteed.
Chapter 9
Overhead Budget
 Selling & Adm. Expenses Budget

• At Breakers, variable selling and

administrative expenses are $0.50 per unit
sold.
• Fixed selling and administrative expenses are
$70,000 per month.
Chapter 9

• The $70,000 fixed expenses include $10,000

in depreciation expense that does not require
a cash outflows for the month
Chapter 9
Selling & Administrative Expenses Budget
 Cash Receipts Budget

• At Breakers all sales are on account.

• The company’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following sale,
5% is uncollected.
Chapter 9

• The March 31 accounts receivable balance of

$30,000 will be collected in full.
Chapter 9
Cash Receipts Budget
 Cash Disbursement Budget

• Breakers pays $0.40 per pound for its

materials.
• One-half of a month’s purchases are paid for
in the month of purchase; the other half is
paid in the following month.
Chapter 9

• No discounts are available.

• The March 31 accounts payable balance is
$12,000.
Chapter 9
Cash Disbursement Budget

140,000 lbs. × $.40/lb. = $56,000

 Cash Disbursement Budget (continued)

Breakers:
– Maintains a 12% open line of credit for
$75,000.
– Maintains a minimum cash balance of
$30,000.
Chapter 9

– Borrows and repays loans on the last day

of the month.
– Pays a cash dividend of $25,000 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.
 Cash Disbursement Budget (continued)

From our Cash

Receipts Budget

e.g. From Cash Disbursements

Budget
Chapter 9

To maintain a cash
balance of $30,000,
Breakers must borrow
$35,000 on its line of credit.
 Cash Disbursement Budget (continued)
(Financing and Repayment)

Ending cash balance for April

is the beginning May balance.
Chapter 9
 Cash Disbursement Budget (continued)

Ending cash balance for Aprilmust

Breakers
is the beginning May balance.
Chapter 9

borrow an
addition $13,800
to maintain a
cash balance
of $30,000.
 Cash Disbursement Budget (continued)
(Financing and Repayment)
Chapter 9
 Cash Disbursement Budget (continued)

At the end of June,

Breakers has enough
cash to repay
the $48,800 loan plus
interest at 12%.
Chapter 9
 Cash Disbursement Budget
(Financing and Repayment)
Chapter 9
Chapter 9
Cash Disbursement Budget (continued)
Chapter 9
Cash Disbursement Budget (continued)

After we complete the cash budget, we can prepare

the budgeted income statement for Breakers.
 Budgeted Ending Inventory

Manufacturing overhead is applied on the basis of direct labor

hours.
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.10 hrs. $ 8.00 0.80
Manufacturing overhead 0.10 hrs. $18.02 1.80
$ 4.60
Chapter 9

Budgeted finished goods inventory

Ending inventory in units 5,000
Unit product cost $ 4.60
Ending finished goods inventory $23,000

Total overhead $191,000

= $18.02 per hr.
Total labor hours 10,600 hrs.
 Budgeted Income Statement
Breakers, Inc.
Budgeted Income Statement
For the Three Months Ended June 30
Revenue (100,000 × $10) $ 1.000.000
Cost of goods sold (100,000 × $4.60) 460.000
Gross margin 540.000
Chapter 9

Operating expenses:
Selling and admin. Expenses $ 260.000
Interest expense 838
Total operating expenses 260.838
Net income $ 279.162
 Budgeted Balance Sheet

Breakers reports the following account

balances on June 30 prior to preparing its
budgeted financial statements:
Land - $50,000
Building (net) - $148,000
Chapter 9

Common stock - $200,000

Retained earnings - $46,400
 25% of June
sales of
$300,000

11,500 lbs. at
$.40 per lb.
Chapter 9

5,000 units at
$4.60 per unit.
 50% of June
purchases
of $56,800
Chapter 9
 Activity-Based Budgeting

Activity-based budgeting (ABB) focuses on the

budgeted cost of activities necessary to produce
and sell products and services.
Resources Resources
Activity-Based
Chapter 9

Costing (ABC)
Activities Activities

Activity-Based
Cost objects: Budgeting (ABB)
Forecast of products
products and services and services to be
produced, and produced and
customers served. customers served.

See example in Hilton!

 Behavioral Aspects of Budgeting

Budgets and motivation:

• Hofstede (1960):
– Budgets and cost standards act as incentives for
motivating the budgetees
• Shillinglaw (1964):
– …the budget can be a motivator. Is this generally
Chapter 9

true? Does motivation vary from tight to loose

budgets? What happens if the agreed budget
becomes patently unachievable?
Motivati Findings of 30 years of
on research in
organizational
psychology about
Goal-setting Theory

Goal
difficulty
 Budgeting research
• Seminal studies:
– Argyris’ (1952) study about budgets and
people found that accountants operate
budgetary control in a punitive rather than
supportive way
– Hofstede (1968) suggested that the following
Chapter 9

features need to be present for performance

improvement in a budgetary process:
• Participation in the setting of the budget
• Frequent communication/group meetings
• Budget-related behaviors object of research:
– Budget preparation (budget participation)
– Use of budget to control/evaluate managerial
performance (budget emphasis or
performance evaluation style)
 Budgetary participation
• Determinants of budgetary participation
(disciplines):
– Vertical information asymmetry (economics)
– Motivation, trust and value of attainment
(psychology)
– Environmental uncertainty (sociology)
Chapter 9

• Dysfunctional effects of budgetary participation:

– Budget slack: the provision of resources
beyond the minimum required (or expected to
be required) to complete a task
– Counterevidence in recent experimental
studies: participative budgeting may indeed
lead to the truthful revelation of private
information, improved information sharing,
and higher performance
 Budgetary emphasis
• Universal hypothesis from past research:
– When budget emphasis increases, the level of
managers’ stress also increases
– Use of accounting performance measures fails
because budgets:
• do not completely reflect managerial
Chapter 9

performance
• do not reflect individual controllable
performance
• do not reflect relevant performance
• do not reflect performance precisely
• measure output, and not managerial inputs
• measure short-term performance
• Overall, negative effect of budget emphasis not
supported by empirical research!
 Budget: paying people to lie?
Bonus pool
(variable pay)

Cap

“Move
profits
“Hold
into next
profits
Chapter 9

period”
back”
Performance
80% of 120% measured as % of
budget of
budget the budget

• Criticism of traditional incentive schemes, as they lead to

a distortion of management behavior
• Jensen (2003) proposes an open linear relationship:
– “removing the kink eliminates the incentive to game
the process”
Chapter 9
Recent debate: Beyond-Budgeting

Source: web-site of Beyond Budgeting Round Table (www.bbrt.org)

 Beyond-Budgeting principles
– Do not base rewards on a fixed performance
contract
– Evaluate performance relative to peers,
benchmarks and prior periods
– Use a few, simple and transparent measures
– Align rewards with strategic goals
Chapter 9

– Reward the performance of teams and

interdependent groups
– Do not use rewards to ‘motivate people’
– Make rewards fair and inclusive

Source: web-site of Beyond Budgeting Round Table (www.bbrt.org)

 Activity-Based Management
• Activity-Based management focuses on the use
of Activity-Based Costing (ABC) to improve
operations and eliminate non-value-added
activities
Cost Assignment View
Chapter 6

Resource costs
Process View
Activity Analysis Activity Evaluation

Root Activity Performance

Causes Triggers Activities Measures

Cost Objects
 Elimination of Non-Value-Added Costs

Activities

Analysis and
Classification
Chapter 6

Non-value- Value-
added added
Activities Activities

Reduce or Continually Evaluate

Eliminate and Improve

Non-value-added activities:
– Unnecessary and dispensable
– Or, necessary, but inefficient and improvable
Using ABM to Eliminate Non-Value-Added Activities

• Identify Activities
• Identify Non-Value-Added Activities
• Understand Activity Linkages, Root Causes,
and Triggers

Inspect Rework
Specify Select Receive Produce
finished defective
parts vendor parts goods
goods products

• Establish Performance Measures

• Report Non-Value-Added Costs
 Customer Profitability Analysis

• Integration of Management Accounting with

Marketing Management
• How companies manage and communicate with
customers and sell products will change due to:
– New technological developments
Chapter 6

– Expansion of global marketplace

– Growing competition among internal
departments and external suppliers
– Shift from manufacturing to a service-based
economy
– Increase of Mergers & Acquisitions
– Critical and demanding customers
 Customer Profitability Analysis

Customer profitability analysis uses ABC to

determine the activities, costs, and profit
associated with serving particular customers
Customers
above the
Types of customers cost-plus
High
Chapter 6

diagonal are
more
Costly to
profitable
Passive service, but
pay well
Net margin
realized Price-sensitive and
few special Aggressive, low
demands price, customized
service & feature

Low High

Cost to serve
 Customer Profitability Analysis

Customer Profitability

125,0%
Cumulative Operating Income as a % of

100,0%
Total Operating Income
Chapter 6

75% of actual operating income

75,0%

50% of actual operating income

50,0%

25% of actual operating income

25,0%

0,0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
 Just-In-Time

Three primary goals:

• eliminate any production process or operation that does
not add value to the product/service
• continuously improve production performance efficiency
• reduce the total cost of production/performance while
increasing quality (Total Quality Management)
Chapter 6

Inventory management:
• Pull system: initiated in response to a customer demand.
Also known as make to order processes.
• Push system: initiated in anticipation of a customer
demand. Also known as make to stock processes.

JIT = pull system!

 Just-In-Time
Benefits of JIT (=“lean production”):
• Smaller inventories: less is better
• Shorter lead times
• Improved quality
• Reduced space requirements
• Lower production costs
Chapter 6

• Greater flexibility
 Inventory Management
Questions to be asked before ordering:
• Is storage space a limited resource?
• How critical is the item to production?
• How critical is cash flow?
• Can units be ordered in the quantity indicated?
Chapter 6

Economic Order Quantity (EOQ) (Appendix pp.

378-381):
Total annual cost of inventory policy =
Holding cost + Ordering costThe optimal order size
2DCo
Q *
=
TC(Q) = (Q/2)Ch (+D/Q)Co Ch
 EOQ Fixed order quantity model

The optimal EOQ policy consists of same-size

orders
Q Q Q

R
Chapter 6

L L Time

R = Reorder point = L*d

Q = Economic order quantity
L = Lead time
d = Demand per Unit of Time

Assumptions:
Inventory holding cost is based on average inventory ....
Ordering or setup costs are constant
All demands for the product will be satisfied (No back orders are
allowed)