Cost and Management

Accounting II
Chapter one
MASTER BUDGET
 BUDGETING CONCEPTS
The importance of budgeting is emphasized by an old saying,
"Failing to plan, is like planning to fail." Budgeting is
essentially financial planning, or planning for financial
performance.
In addition to producing revenue, all companies generate
three types of costs including discretionary, engineered and
committed costs.
Although there are a variety of ways to define costs,
categorizing costs in terms of the cause and effect
relationships is a prerequisite for understanding the different
types of budgets
 The Ongoing Budget Process
1. Managers and accountants plan the performance of the
company, taking into account past performance and
anticipated future changes
2. Senior managers distribute a set of goals against which
actual results will be compared
3. Accountants help managers investigate deviations from
budget. Corrective action occurs at this point
4. Managers and accountants assess market feedback, changed
conditions, and their own experiences as plans are laid for
the next budget period
TYPE OF COST EXAMPLES
CAUSE & EFFECT OR COST BEHAVIOR
COST
BENEFIT RELATIONSHIP
Discretionary Fixed,
Cost Variable, Cost administrative and support services
Relationships are and mixed
such as employee training, advertising, sales
in the short
difficult or impossible term promotion, legal advice, and research and
to define maintenance
Engineered Variable in Direct resources used in production
Cost the short
Relationships are run activities such as material and direct
relatively easy to labor and many indirect resources
define such as electric power
Committed Relationships can be
Fixed in the
Cost short run Cost of establishing and maintaining the
estimated but not readiness to conduct business, such as the cost
defined precisely associated with plant and equipment
 TYPES OF BUDGETS AND CHARACTER
TYPE OF CHARACTERISTICS OF THE TYPE OF COST OR EXAMPLES
BUDGET TECHNIQUE EXPENDITURE
APPROPRIATIO
A maximum amount is established Discretionary costs Employee training,
N BUDGET advertising, sales promotion
for certain expenditures based on and research and development.
management judgment
FLEXIBLE A static amount (a) is established The static amount (a) The static part: salaries,
BUDGET for fixed costs and a variable rate includes both depreciation, property taxes and
(b) is determined per activity discretionary and planned maintenance. The flexible
measure for variable costs, i.e., Y = committed costs while the part: direct material, direct labor
and variable overhead. Also, some
a + bX flexible part (b) includes costs related to sales reps such as
engineered costs per X sales commissions and travel.
value.

CAPITAL Decisions concerning potential Committed costs

BUDGET investments are made using discounted
cash flow techniques.
New plant and equipment
MASTER A comprehensive plan is developed Discretionary, engineered All revenue and expenditures
BUDGET for all revenue and expenditures. and committed costs. for any company.
 MASTER BUDGET
The master budget expresses the managements’
operating and financial plan for a specified period and it
includes a set of budgeted financial statements.
Components of Master Budgets
Operating Budget – building blocks leading to the
creation of the Budgeted Income Statement
Financial Budget – building blocks based on the
Operating Budget that lead to the creation of the
Budgeted Balance Sheet and the Budgeted Statement of
Cash Flows
Basic Operating Budget Steps include; prepare the
1. Revenues Budget
2. Production Budget (in Units)
3. Direct Materials Usage Budget and Direct Materials Purchases
Budget
4. Direct Manufacturing Labor Budget
5. Manufacturing Overhead Costs Budget
6. Ending Inventories Budget
7. Cost of Goods Sold Budget
8. Operating Expense (Period Cost) Budget
9. Budgeted Income Statement
Basic Financial Budget Steps Based on the Operating
Budgets: prepare the;

1.Capital Expenditures Budget

2.Cash Budget
3.Budgeted Balance Sheet
4.Budgeted Statement of Cash Flows
THE PURPOSES AND BENEFITS OF THE MASTER BUDGET

a. Periodic Planning (Formalization of Planning). - to quantify a plan of

action
b. Integrates and Coordinates- the various functional areas within the
organization.
c. Communicates and Motivates- each functional area can see how their efforts
contribute to the overall goals of the organization
d. Promotes Continuous Improvement- to consider alternatives that might
improve customer value and reduce costs.
e. Guides Performance- a guide for accomplishing the objectives included in
the plan.
f. Facilitates Evaluation and Control- for evaluating and subsequently
controlling performance.
g. Cost Awareness. - concerned daily about the cost implications of decisions
and activities
 LIMITATIONS AND PROBLEMS
a. Uncertainty- considerable amount of forecasting and this activity
involves a considerable amount of uncertainty because future is full of
uncertain.
b. Costs - budgeting requires a considerable amount of time and
effort.
c. Budgeting And Human Behavior - effect is positive or negative
depends to large extent on how budgets are used.

The behavioral problems include the following: conflicting views,

imposed budgets, budgets as checkup devices, and unwise
adherence to budgets.
THE ASSUMPTIONS OF THE MASTER BUDGET

•Typically, the following simplifying assumptions are made when preparing a

master budget:

1) Sales prices are constant during the budget period,

2) Variable costs per unit of output are constant during the budget period,

3) Fixed costs are constant in total and

4) Sales mix is constant when the company sells more than one product.
 PREPARING A MASTER BUDGET
I. The Operating Budget

A. Sales Budget

Major factors to be considered when forecasting sales are:

1. Past sales levels and trends

2. General economic trends.
3. Economic trends in the company’s industry.
4. Other factors expected to affect sales in the industry.
5. Political and legal events.
6. The intended pricing policy of the company.
7. Planned advertising and product promotion.
8. Expected actions of competitors.
Cont’d
Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)

Current Period Cash Collections = Current Period Cash Sales + Current

Period Credit Sales Collected in Current Period + Prior Period Credit Sales
Collected in Current Period
 Sales budget Illustration
Royal Company is manufacturing business which produces and sold product X to
its existing and new customers. The company is preparing budgets for the
quarter ending June 30, 2019. Budgeted sales for the next five months will be:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units.
The selling price is $10 per unit. So based on the given information prepare the
sales (revenue) budget for the quarter end June 30,2019.
 Sales Budget
April May June Quarter

Budgeted 20,000 50,000 30,000 100,000

sales (units)

Selling price $ 10 $10 $10 $10

per unit

Total sales $200,000 $500,000 $300,000 $1.000,000

Cont’d
All sales are on account. Royal’s 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.
 Expected Cash Collections
April May June Quarter
Accounts rec. 3/31 $30,000 $30,000
April Sales
70% X $200,000 140,000 140,000
25% X $200,000 $50,000 50,000
May sales
70% X $500,000 350,000 350,000
25% X %500,000 125,000 125,000
June Sales
70% X $300,000 210,000 210,000
$170,000 $400,000 $335,000 $905,000

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

Preparing a production budget includes consideration of the

desired inventory change as follows:

Units To Be Produced = Budgeted Unit Sales + Desired

Ending Finished Goods - Beginning Finished Goods
The Production Budget information
Production must be adequate to meet budgeted
sales and provide for sufficient ending inventory.
 The management at Royal Company wants
ending inventory to be equal to 20% of the
following month’s 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.
The Production Budget
April May June Quarter
Budgeted sales 20,000 50.000 30,000 100,000
Add: desired ending
inventory 10,000 6,000 5,000 5,000
Total needed 30,000 56,000 35,000 105,000
Less beginning
inventory 4,000 10,000 6,000 4,000
Required production 26,000 46,000 29,000 101,000

Ending Inventory based on 20% of July sales (25,000)

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 ending WIP
inventory.
 Direct Material Budget
The direct materials budget includes five separate calculations.

a. Quantity of Material Needed for Production

   = (Units to be Produced)(Quantity of Material Budgeted per Unit)

b. Quantity of Material to be purchased

= Quantity of Material Needed for Production + Desired Ending Material - Beginning Material
c. Budgeted Cost of Material Purchases
   = (Quantity of Material to be Purchased)(Budgeted Material Prices)

d. Cost of Material Used

   = (Quantity needed for Production)(Budgeted Material Prices)
e. Cash Payments for Direct Material Purchases
= Current Period Purchases Paid in Current Period + Prior Period Purchases Paid in Current
Period
The Direct Materials Budget information
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 month’s production.
 On March 31, 13,000 pounds of material are on hand.
Material cost is $0.40 per pound
 The Direct Materials Budget
  April May June Quarter
Production 26,000 46,000 29,000 101,000
Material per Unit 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add: Desired
inventory 233,000 14,500 11,500 11,500
Total needs 153,000 244,000 156,000 516,000
Less: Beginning
Inventory 13,000 23,000 14,500 13,000
Material to be
Purchased 140,000 221,500 142,000 503,000

Material cost per unit $0.4 $0.4 $0.4 $0.4

Material cost $56,000 $88,600 $56,800 $201,400
Ending inventory will be 10% of July production needs
Expected Cash Disbursement for Materials
 Royal 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. The March 31 accounts payable balance
is $12,000.
 Expected Cash Disbursements for Materials
  April May June Quarter
Account Pay.3/31 $12,000     $12,000
April Purchases        
50% X$56,000 28,000     28,000
50% X $56,000   $28,000   28,000
May Purchase      
50% X $88,600   44,300   44,300
50% X $88,600     $44,300 44,300
June Purchase        
50% X $56,800     28,400 28,400
Total Cash        
Disbursments $40,000 $72,000 $72,700 $185,000

Note: The 50% of June purchases payable in July ($28,400) is the Accounts Payable balance at the end of June.
 The Direct Labor Budget
Fewer calculations are needed for direct labor than for direct materials because
labor hours cannot be stored in the inventory for future use. Time can be wasted,
but not postponed.

a. Direct Labor Hours Needed For Production

   = (Units to be Produced)(D.L. Hours Budgeted per Unit)

b. Budgeted Direct Labor Cost

= (D.L. Hours needed for Production)(Budgeted Rates Per Hour)

 Cont’d

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.
 The Direct Labor Budget
  April May June Quarter
Production 26,000 46,000 29,000 101,000
Direct labor required 0.05 0.05 0.05 0.05
Labor hours required 1,300 2,300 1,450 5,050
Guaranteed labor hours 1,500 1,500 1,500  
Labor hours paid 1,500 2,300 1,500 5.300
Wage rate $10 $10 $10 $10
Total direct labor cost $15,000 $23,000 $15,000 $53,000
Note: Cash disbursement equals total direct labor cost since it is paid in period earned
Factory Overhead Budget
The factory overhead budget is based on a flexible budget calculation. More specifically, the calculation is as
follows:
Budgeted Factory Overhead Costs
= Budgeted Fixed Overhead  + (Budgeted Variable Overhead Rate)(D.L. Hours needed for Production
from 4a)

Cash Payments for Overhead

= Budgeted Factory Overhead Cost  - Depreciation and other costs that do not require cash payments
 Manufacturing Overhead Budget

• Royal Company uses a variable manufacturing

overhead rate of $1 per unit produced.
• Fixed manufacturing overhead is $50,000 per month
and includes $20,000 of noncash costs (primarily
depreciation of plant assets).
 Manufacturing Overhead Budget
  April May June Quarter
Production in units 26,000 46,000 29,000 101,000
Variable mfg. OH rate $1 $1 $1 $1
Variable mfg. OH costs $26,000 $46,000 $29,000 $101,000
Fixed mfg. OH costs 50,000 50,000 50,000 150,000
Total mfg. OH costs 76,000 96,000 79,000 251,000
Less: noncash costs 20,000 20,000 20,000 60,000
Cash disbursement for        
manufacturing OH costs $56,000 $76,000 $59,000 $191,000

Note: - depreciation is non-cash expense

 Ending Inventory Budget

a.Ending Direct Materials

= (Desired Ending Materials from b)(Budgeted Prices)

b.Ending Finished Goods

= (Desired Ending Finished Goods)(Budgeted Unit Cost)
 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.
 Ending Finished Goods Inventory Budget
Production cost per unit Quantity Cost Total
Direct materials 5.00 lbs. $0.40 $ 2.00
Direct labor 0.05 hrs. $10.00 0.50
Manufacturing overhead 0.05 hrs. $49.70 2.49
      $ 4.99
Budgeted finished goods inventory      
Ending Inventory in Units      5,000
Unit product cost     $4.99
Ending finished goods inventory     ?
 Total mfg. OH for quarter $251,000 = 49.70 mfg OH cost per unit
Total labor hours required 5,050 hrs.
(from DL budge & MOH budget)

Production cost per unit Quantity cost Total

Direct materials 5.00 lbs. $0.40 $2.00
Direct labor 0.05 hrs. $10.00 0.50
Manufacturing overhead 0.05 hrs. $$49.70 2.49
      $4.99
Budgeted finished goods      
inventory
Ending inventory in units 5,000
Unit product cost $4.99
Ending finished goods inventory 24,950
Cost Of Goods Sold Budget
Cost of goods sold is needed for the income statement. One method of determining budgeted
COGS involves accumulating the amounts from the previous sub-budgets as follows.

a. Budgeted Total Manufacturing Cost

   = Cost of Direct Material Used (from 3d.)  + Cost of Direct Labor Used (from 4b.)
   + Total Factory Overhead Costs (from 5a.)

b. Budgeted Cost of Goods Sold

   = Budgeted Total Manufacturing Cost (from 7a.)
   + Beginning Finished Goods (from previous ending or calculate from 2 and 6b)
   - Ending Finished Goods (from 6c or calculate from 2 and 6b)
Selling and Administrative Expense Budget
The preparation of the selling and administrative expense budgets is very similar to the approach
used for factory overhead.

a. Budgeted Selling and Administrative Expenses

   = Budgeted Fixed Selling & Administrative Expenses  + (Budgeted Variable Rate as a
Proportion of Sales $)(Budgeted Sales $)

b. Cash Payments for Selling & Administrative Expenses

= Budgeted Selling & Administrative Expenses  - Depreciation and other cost which do not
require cash payments
 Cont’d

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.
 Selling and Administrative Expense Budget
  April May June Quarter
Budget sales 20,000 50,000 30,000 100,000
Variable selling and admin. rate        
$0.50 $0.50 $0.50 $0.50
Variable expense $10,000 $25,000 $15,000 $50,000
Fixed selling and admin. Expense        
70,000 70,000 70,000 210,000
Total expense 80,000 95,000 85,000 260,000
Less noncash expenses 10,000 10,000 10,000 30,000
Cash disbursements for selling and        
admin. $70,000 $85,000 $75,000 $230,00
0
 Cash Budget

a. Budgeted Cash Available

   = Beginning Cash Balance + Budgeted Cash Collections from 1

b. Budgeted Cash Excess or Deficiency

   = Budgeted Cash Available - Budgeted Cash Payments

c. Ending Cash Balance

   = Cash Excess or Deficiency + Borrowings - Repayments including Interest
 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.
• Borrowing is in multiple of $1,000
 The Cash Budget
April May June Quarter
Beginning cash balance $40,000 $30,000 $30,000 $40,000
Add: cash collections 170,000 400,000 335,000 905,000
Total cash available 210,000 430,000 365,000 945,000
Less: disbursements
Material 40,000 72,300 72,700 185,000
Direct labor 15,000 23,000 15,000 53,000
Mfg. overhead 56,000 76,000 59,000 191,000
Selling and admin. 70,000 85,000 75,000 230,000
Equipment Purchase - 143,700 48,300 192,000
Dividends 49,000 - - 49,000
Total disbursements 230,000 400,000 270,000 900,000
Excess (deficiency) of cash available
over disbursements $(20,000) $30,000 $95,000 $45,000
 April May June Quarter
Excess (deficiency) of Cash
available over disbursements $(20,000) $30,000 $95,000 $$45,000
Financing
Borrowing 50,000 - - 50,000
Repayment - - (50,000) 50,000
Interest - - (2,000) (50,000)
Total Financing 50,000 - (52,000) (2,000)
End cash Balance $30,000 $30,000 $43,000 $43,000
Budgeted Income Statement
Bad debt expense is based on the expected proportion of uncollectible stated in the
information related to cash collections.
a. Budgeted Sales $ - Budgeted Cost of Goods Sold
   = Budgeted Gross Profit

b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses

   = Operating Income

c. Operating Income - Interest Expense - Bad Debts Expense

   = Net Income Before Taxes
• d. Net Income Before Taxes - Income Taxes
   = Net Income After Taxes
Note: - $50,000 × 16% × 3/12 = $2,000
Borrowings on April 1 and repayment of June 30.

The Budgeted Income Statement

After we complete the cash budget, we can
prepare the budgeted income statement for
Royal based on the information available from
the above budgets.
 Royal Company
Budgeted Income
Statement For the Three Months Ended June 30

Sales (100,000 units @$10) $1,000,000

Less: Cost of goods sold (100,000 @$4.99) 499,000
Gross Margin 501,000
Less: Selling and Administrative expense 260,000
Operating Income 241,000
Less: Interest expense 2,000
Net Income $ 239,000
The Financial Budget
The financial budget includes the cash budget, the capital budget and the
budgeted balance sheet.
Cash Budget – is already covered
Budgeted Balance Sheet
Preparing the budgeted balance sheet involves
accumulating information from the previous period’s
balance sheet, the various operating sub-budgets, the
cash budget and other accounting records.
Or the budgeted balance sheet is prepared based on
the information available from both operational and
financial budgets.
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
Royal Company
Budgeted Statement of Financial Position (Balance Sheet)
As of June 30,2019
  Assets  
Current assets:    
Cash $43,000  
Account Receivable 75,000  
Raw Material Inventory 4,600  
Finished Goods Inventory 24,950  
Total Current Assets   147,550
Non-current Assets  
Property, Plant and Equipment  
Land 50,000  
Equipment $367,000  
Accumulated Depreciation    
Plant and Equipment, net 417,000
Total Assets   564,550
 Liabilities and Stockholders’ Equity
Current Liabilities    
Account Payable (raw materials)   28,400
Stockholders’ equity    
Common stock 200,000  
Retained Earning 336,150  
Total Stockholders   536,150
equity
    364,550
 The end

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