Chapter Four: Profit Planning

Learning Objectives
After studying Chapter 4, you should be able to:
LO1 Understand why organizations budget and the processes they use to
create budgets.
LO2 Prepare a sales budget, including a schedule of expected cash collections.
LO3 Prepare a production budget.
LO4 Prepare a direct materials budget, including a schedule of expected cash
disbursements for purchases of materials.
LO5 Prepare a direct labor budget.
LO6 Prepare a manufacturing overhead budget.
LO7 Prepare a selling and administrative expense budget.
LO8 Prepare a cash budget.
LO9 Prepare a budgeted income statement.
LO10 Prepare a budgeted balance sheet.
. Basic Framework of Budgeting
The
A budget is a quantitative plan for acquiring and using resources over a
specified time period.
The use of budgets to control an organization’s activity or actual
spending is compared to the budget to make sure the plan is being
followed is known as budgetary control.
The act of preparing a budget is called budgeting.
Master budget refers to a summary of a company’s plans including
specific targets for sales, production, and financing activities.
Planning involves developing goals and preparing various budgets to
achieve those goals.
Control involves the steps taken by management to increase the
likelihood that all parts of the organization are working together to
achieve the goals set down at the planning stage .

To be effective, a good budgeting system must provide for both planning

and control. Good planning without effective control is a waste of time
and effort.
Advantages of Budgeting
Organizations realize many benefits from budgeting including:
Responsibility Accounting
The point is not to penalize individuals for missing targets.
However, the manager should take the initiative to:
 Correct any unfavorable discrepancies
 Understand the source of significant favorable or unfavorable
discrepancies,
 Should be prepared to explain the reasons for discrepancies to higher
management.
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.
A continuous or perpetual budget is a 12-month budget that rolls
forward one month (or quarter) as the current month (or quarter) is
completed.
The Self-Imposed Budget
A participative budget is prepared with the full cooperation and
participation of managers at all levels. A participative budget is also
known as a self-imposed budget.
Advantages of Self-Imposed Budgets
1. Individuals at all levels of the organization are viewed as
members of the team whose judgments are valued by top
management.
2. Budget estimates prepared by front-line managers are often
more accurate than estimates prepared by top managers.
3. Motivation is generally higher when individuals participate in
setting their own goals than when the goals are imposed from
above.
4. A manager who is not able to meet a budget imposed from
above can claim that it was unrealistic. Self-imposed budgets
eliminate this explanation.
Human Factors in Budgeting
The success of budgeting depends upon three important factors:

1. Top management must be eager and committed to the budget

process.

2. Top management must not use the budget to pressure

employees or blame them when something goes wrong.

3. Highly achievable budget targets are usually preferred when

managers are rewarded based on meeting budget targets.
The Budget Committee
A budget committee is usually responsible for overall policy
relating to the budget program and for coordinating the
preparation of the budget itself.
The Master Budget: An Overview
.
Preparing the Master Budget
1. The Sales Budget
The sales budget is the starting point in preparing the master budget.
All other items in the master budget, including production, purchases,
inventories, and expenses, depend on it.
Required:
Prepare a sales budget, including a schedule of expected cash collections.
2. The Production Budget
The production budget lists the number of units that must be produced
to satisfy sales needs and to provide for the desired ending inventory.
Production needs can be determined as follows:
Required:
Prepare the production budget
3. 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
raw material inventories. The required purchases of raw materials are
computed as follows:
Required:
Prepare a direct
materials budget,
including a schedule
of expected cash
disbursements for
purchases of
materials.
4. 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.
Facing labor shortages
Having to hire workers
Lay off workers at awkward times
Required:
Prepare the direct labor budget.
5. The Manufacturing Overhead Budget
The manufacturing overhead budget lists all costs of production other
than direct materials and direct labor.
Manufacturing overhead is separated into variable and fixed
components.
The total budgeted manufacturing overhead costs must be adjusted to
determine the cash disbursements for manufacturing overhead.
Noncash manufacturing overhead cost is depreciation. Noncash
depreciation charges are deducted from the total budgeted manufacturing
overhead to determine the expected cash disbursements.
Required
Prepare the manufacturing overhead budget
6. The Ending Finished Goods Inventory Budget
After completing all Schedules of Sales, Production, Direct material,
Direct labor and Manufacturing overhead budgets, needing to
compute unit product costs. This computation was needed for two
reasons:
First, to determine cost of goods sold on the budgeted income statement.
Second, to know what amount to put on the balance sheet inventory
account for unsold units. The carrying cost of the unsold units is
computed on the ending finished goods inventory budget.

Required
Prepare the ending finished goods inventory budget
7. The Selling and Administrative Expense Budget
The selling and administrative expense budget lists the budgeted
expenses for areas other than manufacturing.

Required
8. 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.
The cash excess or deficiency section is computed as follows:
Required:
Prepare the cash budget
9. The Budgeted Income Statement
A budgeted income statement can be prepared from the data developed
in Schedules. The budgeted income statement is one of the key schedules
in the budget process. It shows the company’s planned profit.
Following Schedule contains the budgeted income statement for Royal
Company.
10. The 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.
Royal Company’s budgeted balance sheet is presented in incoming
Schedule.
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