Chapter Four:

Profit Planning
Accounting for Managerial Decisions

Facilitator: Nisha Adhikari

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Introduction
 A budget is a detailed plan for the future that is usually
expressed in formal quantitative terms.

 Individuals sometimes create household budgets that

balance their income and expenditures for food, clothing,
housing, and so on while providing for some savings.

 Once the budget is established, actual spending is compared

to the budget to make sure the plan is being followed.
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Advantages of Budgeting
1. Budgets communicate management’s plans throughout the
organization.

2. Budgets force managers to think about and plan for the

future. In the absence of the necessity to prepare a budget,
many managers would spend all of their time dealing with
day-to-day emergencies.

3. The budgeting process provides a means of allocating

resources to those parts of the organization where they can
be used most effectively.
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Advantages of Budgeting
4. The budgeting process can uncover potential bottlenecks
before they occur.

5. Budgets coordinate the activities of the entire

organization by integrating the plans of its various parts.
Budgeting helps to ensure that everyone in the
organization is pulling in the same direction.

6. Budgets define goals and objectives that can serve as

benchmarks for evaluating subsequent performance.
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Responsibility Accounting
 A manager should be held responsible for those items—and only those
items—that the manager can actually control to a significant extent.

 Each line item (i.e., revenue or cost) in the budget is the responsibility
of a manager who is held responsible for subsequent deviations
between budgeted goals and actual results.

 In effect, responsibility accounting personalizes accounting

information by holding individuals responsible for revenues and costs.

 This concept is central to any effective planning and control system.

Someone must be held responsible for each cost or else no one will be
responsible and the cost will inevitably grow out of control.
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Responsibility Accounting
 If actual results do not measure up to the
budgeted goals? The manager is not necessarily penalized.

 However, the manager should take the initiative to

understand the sources of significant favorable or
unfavorable discrepancies, should take steps to correct
unfavorable discrepancies and to exploit and replicate
favorable discrepancies, and should be prepared to explain
discrepancies and the steps taken to correct or exploit them
to higher management.
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Choosing a Budget Period

 Operating budgets ordinarily cover a one-year period
corresponding to the company’s fiscal year.

 Many companies divide their budget year into four quarters.

The first quarter is then subdivided into months, and monthly
budgets are developed.

 As the year progresses, the figures for the second quarter are
broken down into monthly amounts, then the third-quarter
figures are broken down, and so forth. This approach has the
advantage of requiring periodic review and reappraisal of
budget data throughout the year.
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The Self-Imposed Budget

 A self-imposed budget or participative budget is a budget that is
prepared with the full cooperation and participation of managers at all
levels.

 The success of a budget program is largely determined by the way a

budget is developed.

 In most successful budget programs, managers actively participate in

preparing their own budgets.

 Many managers believe that being empowered to create their own self-
imposed budgets is the most effective method of budget preparation.
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Advantages of Self imposed budget

1. Individuals at all levels of the organization are recognized as members of
the team whose views and judgments are valued by top management.

2. Budget estimates prepared by front-line managers are often more accurate

and reliable than estimates prepared by top managers who have less
intimate knowledge of markets and day-to-day operations.

3. Motivation is generally higher when individuals participate in setting their

own goals than when the goals are imposed from above. Self-imposed
budgets create commitment.

4. A manager who is not able to meet a budget that has been imposed from
above can always say that the budget was unrealistic and impossible to
meet. With a self-imposed budget, this claim cannot be made.
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Limitation of Self imposed budget

 Because the manager who creates the budget
will be held accountable for actual results that deviate from the
budget, the manager will have a natural tendency to submit a budget
that is easy to attain (i.e., the manager will build slack into the
budget).

 For this reason, budgets prepared by lower-level managers should be

scrutinized by higher levels of management.

 Questionable items should be discussed and modified as appropriate.

Without such a review, self-imposed budgets may fail to support the
organization’s strategy or may be too slack, resulting in suboptimal
performance.
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Master Budget Overview

 The master budget consists of a number of separate but
interdependent budgets that formally lay out the
company’s sales, production, and financial goals.

 Themaster budget culminates in a cash budget, a

budgeted income statement, and a budgeted balance
sheet.
Master Budget
Interrelationship:

An overview of the
various parts of
the master budget
and how they are
related.

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 The Sales Budget

$90,000 is the 30% portion of the sales revenue of last quarter of last
year i.e. 2013 which is expected to be collected in the first quarter of
year 2014
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EXERCISE 8–1 Schedule of Expected Cash Collections
Silver Company makes a product that is very popular as a Mother’s Day gift. Thus, peak
sales occur in May of each year, as shown in the company’s sales budget for the second
quarter given below:

From past experience, the company has learned that 20% of a month’s sales are collected
in the month of sale, another 70% are collected in the month following sale, and the
remaining 10% are collected in the second month following sale. Bad debts are negligible
and can be ignored. February sales totaled $230,000, and March sales totaled $260,000.
Required:
1. Prepare a schedule of expected cash collections from sales, by month and in total, for
the second quarter.
2. Assume that the company will prepare a budgeted balance sheet as of June 30.
Compute the accounts receivable as of that date.

Answer: 1) $265,000 ;$336,000; $420,000; $1,021,0002) $210,000

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 The Production Budget
• The production budget is prepared after the sales budget.

• The production budget lists the number of units that must be produced to
satisfy sales needs and to provide for the desired ending finished goods
inventory.

• Production needs can be determined as follows:

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 The Production Budget

This $2000 is the ending finished goods inventory of last quarter of last year and
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company will not have to produce this much units as they already have on stock.
 EXERCISE 8–2 Production Budget
Down Under Products, Ltd., of Australia has budgeted sales of its popular
boomerang for the next four months as follows:

The company is now in the process of preparing a production budget for

the second quarter. Past experience has shown that end-of-month
inventory levels must equal 10% of the following month’s sales. The
inventory at the end of March was 5,000 units.
Required:
Prepare a production budget for the second quarter; in your budget,
show the number of units to be produced each month and for the
quarter in total.
Answer: 52,500 76,500 89,000 218,000
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 Inventory Purchases—Merchandising
Company
• If the company is merchandising company (not a manufacturing
company) it would prepare a merchandise purchases budget showing
the amount of goods to be purchased from suppliers during the
period.
• The top line of a merchandise purchases budget based on units would
say Budgeted unit sales instead of Budgeted cost of goods sold.
• A merchandise purchases budget is usually accompanied by a schedule
of expected cash disbursements for merchandise purchases.
• The format of the merchandise purchases budget is shown below:

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 The Direct Materials Budget
• A direct materials budget is prepared after the production requirements
have been computed.

• The direct materials budget details the raw materials that must be
purchased to fulfill the production budget and to provide for adequate
inventories. The required purchases of raw materials are computed as
follows:

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Rest of 50% of this amount is Account
payable which will be paid in next year
 EXERCISE 8–3 Direct Materials Budget
Three grams of musk oil are required for each bottle of Mink Caress, a very popular perfume
made by a small company in western Siberia. The cost of the musk oil is $1.50 per gram.
Budgeted production of Mink Caress is given below by quarters for Year 2 and for the first
quarter of Year 3:

Musk oil has become so popular as a perfume ingredient that it has become necessary to
carry large inventories as a precaution against stock-outs. For this reason, the inventory of
musk oil at the end of a quarter must be equal to 20% of the following quarter’s production
needs. Some 36,000 grams of musk oil will be on hand to start the first quarter of Year 2.
Required:
Prepare a direct materials budget for musk oil, by quarter and in total, for Year 2. At the
bottom of your budget, show the amount of purchases for each quarter and for the year in
total.
Answer: in units 198,000 306,000 420,000 282,000 1,206,000
in amount $297,000 $459,000 $630,000 $423,000 $1,809,000
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 The Direct Labor Budget

• The direct labor budget shows the direct labor-hours required to

satisfy the production budget. By knowing in advance how much
labor time will be needed throughout the budget year, the company
can develop plans to adjust the labor force as the situation requires.

• Companies that neglect the budgeting process run the risk of facing
labor shortages or having to hire and lay off workers at awkward
times. Erratic labor policies lead to insecurity, low morale, and
inefficiency.

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 The Direct Labor Budget

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 EXERCISE 8–4 Direct Labor Budget
The production manager of Rordan Corporation has submitted the following forecast of
units to be produced by quarter for the upcoming fiscal year:

Each unit requires 0.35 direct labor-hours, and direct laborers are paid $12.00 per hour.
Required:
1.Construct the company’s direct labor budget for the upcoming fiscal year, assuming that
the direct labor workforce is adjusted each quarter to match the number of hours
required to produce the forecasted number of units produced.
2.Construct the company’s direct labor budget for the upcoming fiscal year, assuming that
the direct labor workforce is not adjusted each quarter. Instead, assume that the
company’s direct labor workforce consists of permanent employees who are guaranteed
to be paid for at least 2,600 hours of work each quarter. If the number of required direct
labor-hours is less than this number, the workers are paid for 2,600 hours anyway. Any
hours worked in excess of 2,600 hours in a quarter are paid at the rate of 1.5 times the
normal hourly rate for direct labor.
Answer: 1) $ 33,600 $ 27,300 $ 29,400 $ 31,500 $121,800
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$34,800 $31,200 $31,200 $31,650 $128,850 25
 The Manufacturing Overhead Budget

• The manufacturing overhead budget lists all

costs of production other than direct materials
and direct labor.

• Schedule 5 shows the manufacturing overhead

budget for Hampton Freeze. At Hampton Freeze,
manufacturing overhead is separated into
variable and fixed components.

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 EXERCISE 8–5 Manufacturing Overhead Budget [LO8–6]
The direct labor budget of Yuvwell Corporation for the upcoming
fiscal year contains the following details concerning budgeted
direct labor-hours:
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Budgeted direct labor- 8000 8200 8500 7800

hours

The company’s variable manufacturing overhead rate is $3.25 per direct labor-hour and the
company’s fixed manufacturing overhead is $48,000 per quarter. The only noncash item
included in fixed manufacturing overhead is depreciation, which is $16,000 per quarter.
Required:
1. Construct the company’s manufacturing overhead budget for the upcoming fiscal year.
2. Compute the company’s manufacturing overhead rate (including both variable and fixed
manufacturing overhead) for the upcoming fiscal year. Round off to the nearest whole
cent.

Answer: 1) $58,000 $58,650 $59,625 $57,350 $233,625;

2) $9.16
 The Ending Finished Goods Inventory Budget

• After completing all above budgets now manager

had all of the data s/he needed to compute the unit
product cost for the units produced during the
budget year.

• This computation was needed for two reasons: first,

to help determine cost of goods sold on the
budgeted income statement; and second, to value
ending inventories on the budgeted balance sheet.

• The cost of unsold units is computed on the ending

finished goods inventory budget .
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???

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 The Selling and Administrative Expense
Budget
• The selling and administrative expense budget lists the budgeted expenses
for areas other than manufacturing.

• In large organizations, this budget would be a compilation of many smaller,

individual budgets submitted by department heads and other persons
responsible for selling and administrative expenses.

• For example, the marketing manager would submit a budget detailing the
advertising expenses for each budget period.

• Like the manufacturing overhead budget, the selling and administrative

expense budget is divided into variable and fixed cost components.
Consequently, budgeted sales in cases for each quarter are entered at the
top of the schedule.
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 Fixed expenses are constant for each
quarter as you can see here
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 EXERCISE 8–6 Selling and Administrative Expense Budget [LO8–
7] The budgeted unit sales of Weller Company for the upcoming
fiscal year are provided below:

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Budgeted unit sales 15000 16000 14000 13000

The company’s variable selling and administrative expense per unit is $2.50.
Fixed selling and administrative expenses include advertising expenses of $8,000 per
quarter, executive salaries of $35,000 per quarter, and depreciation of $20,000 per
quarter.
In addition, the company will make insurance payments of $5,000 in the first quarter
and $5,000 in the third quarter. Finally, property taxes of $8,000 will be paid in the
second quarter.
Required:
Prepare the company’s selling and administrative expense budget for the upcoming
fiscal year.
Answer: 105,500 111,000 103,000 95,500 415,000
$ 85,500 $ 91,000 $ 83,000 $ 75,500 $335,000 34
 The Cash Budget
• The cash budget is composed of four major
sections:
1. The receipts section.
2. The disbursements section.
3. The cash excess or deficiency section.
4. The financing section.

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Minimum cash balance is $30,000.
The bank requires that loans be made in increments of $10,000.

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 The Cash Budget
• The cash excess or deficiency section is computed as follows:

• If a cash deficiency exists during any budget period or if there is a cash

excess during any budget period that is less than the minimum required
cash balance, the company will need to borrow money.

• In Contrast, if there is a cash excess during any budget period that is

greater than the minimum required cash balance, the company can invest
the excess funds or repay principal and interest to lenders.
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 The Cash Budget: The cash budget is
composed of four major sections:
1. The receipts section: The receipts section lists all of the
cash inflows, except from financing, expected during the budget
period. Generally, the major source of receipts is from sales.

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 The Cash Budget
• The cash excess or deficiency section is computed as follows:

• If a cash deficiency exists during any budget period or if there is a cash

excess during any budget period that is less than the minimum required
cash balance, the company will need to borrow money.

• In Contrast, if there is a cash excess during any budget period that is

greater than the minimum required cash balance, the company can invest
the excess funds or repay principal and interest to lenders.
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 The Cash Budget: The cash budget is
composed of four major sections
2. The disbursements section:
• The disbursements section summarizes all cash
payments that are planned for the budget period.
• These payments include raw materials purchases,
direct labor payments, manufacturing overhead
costs, and so on, as contained in their respective
budgets.
• In addition, other cash disbursements such as
equipment purchases and dividends are listed.
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Minimum cash balance is $30,000.
The bank requires that loans be made in increments of $10,000.

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Minimum cash balance is $30,000.
The bank requires that loans be made in increments of $10,000.

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Minimum cash balance is $30,000.
The bank requires that loans be made in increments of $10,000.

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Minimum cash balance is $30,000.
The bank requires that loans be made in increments of $10,000.

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Minimum cash balance is $30,000.
The bank requires that loans be made in increments of $10,000.

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 Add them and you
get the value
94,000 +30,000 =
$124,000

Minimum cash balance is $30,000.

Company need to look for the fund for 94000 + 30000 = $ 124,000
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bank requires that loans be made in increments of $10,000. 48
 36,100+30,000
= 66,100

Minimum cash balance is $30,000.

The bank requires that loans be made in increments of $10,000.

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 Total loan
amount is
130,000+70,00
0 = $200,000

Company have to pay its loan and its interest usually at the end of period. In this
example interest rate is 3% per quarter.
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 Similarly $70,000
Loan amount is taken
is always at the beginning
considered of second
to be taken at the
quarter.
beginningTherefore, interest
of the period. amount
It means for $ is70,000
$130,000 is
taken at
calculated as ?????
the beginning of first quarter. Therefore, interest
$70,000
amount for x 3% peris calculated
$130,000 quarter as x 3 = $ 6,300 15,600 + 6,300
= $21,900
$130,000 x 3% per quarter x 4 = $ 15,600
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 EXERCISE 8–7 Cash Budget [LO8–8]
Garden Depot is a retailer that is preparing its budget for the
upcoming fiscal year. Management has prepared the following
summary of its budgeted cash flows:
  1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Total cash receipts $1,80,000 $3,30,000 $2,10,000 $2,30,000
Total cash disbursements $2,60,000 $2,30,000 $2,20,000 $2,40,000

The company’s beginning cash balance for the upcoming fiscal year will be
$20,000. The company requires a minimum cash balance of $10,000 and may
borrow any amount needed from a local bank at a quarterly interest rate of 3%.

The company may borrow any amount at the beginning of any quarter and may
repay its loans, or any part of its loans, at the end of any quarter. Interest
payments are due on any principal at the time it is repaid. For simplicity,
assume that interest is not compounded.
Required:
Prepare the company’s cash budget for the upcoming fiscal year.

Answer: $ 10,000 $ 35,800 $ 25,800 $ 15,800 $ 15,800 53

 Budgeted Income Statement
• The budgeted income statement is one of the
key schedules in the budget process.
• It shows the company’s planned profit and
serves as a benchmark against which subsequent
company performance can be measured.
• All of the revenues and expenses shown on the
budgeted income statement come from the data
in the beginning balance sheet and the data
developed in all previous budgets.
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 COGS = Sales units X
Unit product cost
= 100,000 units
x $13
= $1,300,000

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EXERCISE 8–8 Budgeted Income Statement [LO8–9]
Gig Harbor Boating is the wholesale distributor of a small recreational
catamaran sailboat. Management has prepared the following
summary data to use in its annual budgeting process:

Required:
Prepare the company’s budgeted income statement. Use the absorption costing
income statement format shown in Schedule 9 .

Answer: Net income $19,000

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 Budgeted Balance Sheet
• The budgeted balance sheet is developed
using data from the balance sheet from the
beginning of the budget period and data
contained in the various schedules.

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 Raw material inventory
= units of material x cost per unit
of material
= 22,500 x $ 0.20
= $ 4,500

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 Add them to get
total amount of
building and
equipment after
having equipment
purchase
$700,000 + $130,000
= $830,000

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 How is there an increment of $
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 $ 40,000

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 $ 60,000
Thus the increment of $100,000 is
came after adding both the
depreciations for the whole year i.e. $ 40,000
$ 60,000 + $ 40,000 = $ 100,000
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 $ 60,000 + $ 40,000 = $ 100,000 Then,
Accumulated depreciation = $292,000 + $100,000 = $392,000

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 Add Net income in opening balance of retained earnings
$ 449,900 + $ 102,100 = $ 552,000 but……

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 You have to deduct dividend expense to get
Closing balance of retained earning = $552,000 - $32,000 = $520,000

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 You have to deduct dividend expense to get
Closing balance of retained earning = $552,000 - $32,000 = $520,000

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EXERCISE 8–9 Budgeted Balance Sheet [LO8–10]
The management of Mecca Copy, a photocopying center located
on University Avenue, has compiled the following data to use in
preparing its budgeted balance sheet for next year:

The beginning balance of retained earnings was $28,000, net income is budgeted to be
$11,500, and dividends are budgeted to be $4,800.
Required:
Prepare the company’s budgeted balance sheet.

Answer: cash $12,200 and retained earnings $34,700

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 End of Chapter 4

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