CORNERSTONES

of Managerial Accounting, 6e
 CHAPTER 9:
PROFIT PLANNING
Cornerstones of Managerial
Accounting, 6e

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Description of Budgeting
 All businesses should prepare budgets.
 Budgets help business owners and managers to
plan ahead, and later, exercise control by
comparing what actually happened to what was
expected in the budget.
 Budgets formalize managers’ expectations
regarding sales, prices, and costs.
 Small businesses and nonprofit entities can
benefit from the planning and control provided by
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Budgeting and Planning and
Control
 Planning and control are linked.
 Planning is looking ahead to see what actions
should be taken to realize particular goals.
 Control is looking backward, determining what
actually happened and comparing it with the
previously planned outcomes.
 Budgets are financial plans for the future and are
a key component of planning.
 They identify objectives and the actions needed to
achieve them.
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Budgeting and Planning
and Control (cont.)
 Before preparing a budget, an organization
should develop a strategic plan.
 The strategic plan plots a direction for an
organization’s future activities and operations; it
generally covers at least five years.

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Planning, Control, and Budgets

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Advantages of Budgeting
A budgetary system gives an organization
several advantages:
Planning

Information for decision making

Standards for performance evaluation

Improved Communication & Coordination

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The Master Budget
 The master budget is the comprehensive
financial plan for the organization as a whole.
 Typically for a one-year period, corresponding to
the fiscal year of the company.
 Yearly budgets are broken down into quarterly
and monthly budgets.

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The Master Budget (cont.)
 The use of smaller time periods allows managers
to compare actual data with budgeted data more
frequently, so problems may be noticed and
resolved sooner.

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Master Budget:
Directing and Coordinating
 Most organizations prepare the master budget for
the coming year during the last four or five
months of the current year.
 The budget committee:
 reviews the budget
 provides policy guidelines and budgetary goals
 resolves differences that arise as the budget is prepared
 approves the final budget
 monitors the actual performance of the organization as the
year unfolds.
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Master Budget:
Directing and Coordinating (cont.)
 The controller usually serves as the budget
director, the person responsible for directing and
coordinating the organization’s overall budgeting
process.

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Master Budget:
Major Components
 A master budget can be divided into operating
and financial budgets:
 Operating budgets describe the income-generating
activities of a firm: sales, production, and finished goods
inventories. The ultimate outcome of the operating
budgets is a pro forma or budgeted income statement.

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Master Budget:
Major Components (cont.)
 Financial budgets detail the inflows and outflows of
cash and the overall financial position. Planned cash
inflows and outflows appear in the cash budget. The
expected financial position at the end of the budget
period is shown in a budgeted, or pro forma, balance
sheet.
 Since many of the financing activities are not
known until the operating budgets are known, the
operating budget is prepared first.

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The Master Budget and
Its Interrelationships

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Preparing the Operating Budget
 The operating budget consists of a budgeted
income statement accompanied by the following
supporting schedules:
 sales budget
 production budget
 direct materials purchases budget
 direct labor budget
 overhead budget
 selling and administrative expenses budget
 ending finished goods inventory budget
 cost of goods sold budget LO-2
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Sales Budget
 The sales budget is approved by the budget
committee and describes expected sales in units
and dollars.
 The sales budget is the basis for all of the other
operating budgets and most of the financial
budgets.
 It is important that it be as accurate as possible.

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Sales Budget (cont.)
 The first step in creating a sales budget is to
develop the sales forecast.
 The sales forecast is just the initial estimate, and
it is often adjusted by the budget committee.

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Production Budget
 The production budget tells how many units must
be produced to meet sales needs and to satisfy
ending inventory requirements.
 To compute the units to be produced, both unit
sales and units of beginning and ending finished
goods inventory are needed:
Units to be produced = Expected unit sales + Units
in desired ending inventory (EI) – Units in
beginning inventory (BI)
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Direct Materials Purchases Budget
 After the production budget is completed, the
budgets for direct materials, direct labor, and
overhead can be prepared.
 The direct materials purchases budget tells the
amount and cost of raw materials to be
purchased in each time period.

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Direct Materials Purchases
Budget (cont.)
 The formula used for calculating purchases is as
follows:

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Direct Labor Budget
 The direct labor budget shows the total direct
labor hours and the direct labor cost needed for
the number of units in the production budget.
 The budgeted hours of direct labor are
determined by the relationship between labor and
output.

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Overhead Budget
 The overhead budget shows the expected cost of
all production costs other than direct materials
and direct labor.
 Many companies use direct labor hours as the
driver for overhead.
 Then costs that vary with direct labor hours are
pooled and called variable overhead.
 The remaining overhead items are pooled into
fixed overhead.
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Ending Finished Goods
Inventory Budget
 The ending finished goods inventory budget:
 Supplies information needed for the balance sheet
 Serves as an important input for the preparation of the
cost of goods sold budget.
 To prepare this budget, the unit cost of producing
finished goods must be calculated by using
information from the direct materials, direct labor,
and overhead budgets.

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Cost of Goods Sold Budget
 The cost of goods sold budget reveals the
expected cost of the goods to be sold.

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Selling and Administrative
Expenses Budget
 The selling and administrative expenses budget
outlines planned expenditures for
nonmanufacturing activities.
 As with overhead, selling and administrative
expenses can be broken down into fixed and
variable components.
 Such items as sales commissions, freight, and
supplies vary with sales activity.

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Budgeted Income Statement
 With the completion of the budgeted cost of
goods sold schedule and the budgeted selling
and administrative expenses budget, Texas Rex
has all the operating budgets needed to prepare
an estimate of operating income.

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Preparing the Financial Budget
 The remaining budgets found in the master
budget are the financial budgets.
 The usual financial budgets prepared are:
 cash budget
 budgeted balance sheet
 budget for capital expenditures

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Cash Budget
 Understanding cash flows is critical in managing
a business.
 Often, a business successfully produces and sells
products but fails because of timing problems
associated with cash inflows and outflows.

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Cash Budget
 Because cash flow is the lifeblood of an
organization, the cash budget is one of the most
important budgets in the master budget.
 The basic structure of a cash budget includes
cash receipts, disbursements, any excess or
deficiency of cash, and financing as shown here:

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Budgeted Balance Sheet
 The budgeted balance sheet depends on
information contained in the current balance
sheet and in the other budgets in the master
budget.
 Explanations for the budgeted figures are
typically provided in the footnotes.

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Using Budgets for Performance
Evaluation
 Budgets are often used to judge the performance
of managers.
 Bonuses, salary increases, and promotions are
all affected by a manager’s ability to achieve or
beat budgeted goals.
 Positive behavior occurs when the goals of each
manager are aligned with the goals of the
organization and each manager has the drive to
achieve them.
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Using Budgets for Performance
Evaluation (cont.)
 The alignment of managerial and organizational
goals is often referred to as goal congruence.
 If the budget is improperly administered,
subordinate managers may subvert the
organization’s goals.
 Dysfunctional behavior is individual behavior
that is in basic conflict with the goals of the
organization.

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Participative Budgeting
 Rather than imposing budgets on subordinate
managers, participative budgeting allows
subordinate managers considerable say in how
the budgets are established.
 The increased responsibility and challenge
inherent in the process provide nonmonetary
incentives that lead to a higher level of
performance.

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Participative Budgeting (cont.)
 However, participative budgeting has three
potential problems:
 setting standards that are either too high or too low
 building slack into the budget (padding the budget)
 pseudoparticipation

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Controllability of Costs
 Managers are held accountable only for costs
that they can control.
 Controllable costs are costs whose level a
manager can influence.
 If noncontrollable costs are put in the budgets of
subordinate managers to help them understand
that these costs also need to be covered
 Should be separated from controllable costs and
labeled as noncontrollable.

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Multiple Measures of Performance
 Organizations make the mistake of using budgets
as their only measure of managerial
performance.
 While financial measures of performance are
important, overemphasis can lead to a form of
dysfunctional behavior called milking the firm or
myopia.

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Multiple Measures of
Performance (cont.)
 Myopic behavior occurs when a manager takes
actions that improve budgetary performance in
the short run but bring long-run harm to the firm.
 Budgetary measures alone cannot prevent
myopic behavior.

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