Chapter 7

Profit Planning
 Learning Objective
LO1

To understand why
organizations budget
and the processes
they use to create
budgets.
 The Basic Framework of Budgeting

A budget is a detailed quantitative plan for

acquiring and using financial and other resources
over a specified forthcoming time period.
1. The act of preparing a budget is called
budgeting.
2. The use of budgets to control an
organization’s activity is known as
budgetary control.
 Planning and Control

Planning – Control –
involves developing involves the steps
objectives and taken by
preparing various management that
budgets to achieve attempt to ensure
these objectives. the objectives are
attained.
 Advantages of Budgeting

Define goal
and objectives
Communicate Think about and
plans plan for the future

Advantages
Coordinate Means of allocating
activities resources

Uncover potential
bottlenecks
 Responsibility Accounting

Managers should be held responsible for

those items — and only those items —
that the manager can actually control
to a significant extent.
 Choosing the Budget Period

Operating Budget

2003 2004 2005 2006

The annual operating budget

may be divided into quarterly
or monthly budgets.
 Self-Imposed Budget
Top Management

Middle Middle
Management Management

Supervisor Supervisor Supervisor Supervisor

A 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.
 Self-Imposed Budgets
Most companies do not rely exclusively upon
self-imposed budget in the sense that top
managers usually initiate the budget process
by issuing broad guidelines in terms of overall
profits or sales.
 Human Factors in Budgeting
The success of budgeting depends upon three
important factors:
1. Top management must be enthusiastic 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.
 Zero Based Budgeting
A zero-based budget requires managers to
justify all budgeted expenditures, not just
changes in the budget from the prior year.

Most managers argue that

zero-based budgeting is too
time consuming and costly to
justify on an annual basis.
 The Budget Committee

A standing committee responsible for

 overall policy matters relating to the budget
 coordinating the preparation of the budget
The Master Budget: An Overview
Sales
Budget
Ending
Finished Goods
Budget Selling and
Production
Administrative
Budget
Budget

Direct Direct Manufacturing

Materials Labor Overhead
Budget Budget Budget

Cash
Budget

Budgeted Financial Statements

 Learning Objective
LO2

To prepare a sales budget,

including a schedule of
expected cash collections.
 Budgeting Example
 Royal Company 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
June 30,000 units
July 25,000 units
August 15,000 units.
 The selling price is $10 per unit.
 The Sales Budget
The individual months of April, May, and June are
summed to obtain the total projected sales in units
and dollars for the quarter ended June 30th
 Expected Cash Collections

 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% uncollectible.
 The March 31 accounts receivable balance of
$30,000 will be collected in full.
Expected Cash Collections
Expected Cash Collections

From the Sales Budget for April.

Expected Cash Collections

From the Sales Budget for May.

 Quick Check 

What will be the expected cash collections in

June from the June sales?
a. $125,000
b. $210,000
c. $335,000
d. $905,000
 Quick Check 

What will be the expected cash collections in

June from the June sales?
a. $125,000
b. $210,000
c. $335,000
d. $905,000
Expected Cash Collections
 The Production Budget

Sales Production
Budget Budget
and
Expected
Cash
Collections

Production must be adequate to meet budgeted

sales and provide for sufficient ending inventory.
 Learning Objective
LO3

To prepare a
production budget.
 The Production Budget

 The management at Royal Company wants

ending inventory to be equal to 20% of the
following month’s budgeted sales in units.

 On March 31, 4,000 units were on hand.

Let’s prepare the production budget.

The Production Budget
 The Production Budget

Budgeted May sales 50,000

Desired ending inventory % 20%
March 31
Desired ending inventory 10,000
ending inventory
 Quick Check 

What is the required production for May?

a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
 Quick Check 

What is the required production for May?

a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units
The Production Budget
The Production Budget

Assumed ending inventory.

 Learning Objective
LO4

To prepare a direct
materials budget,
including a schedule
of expected cash
disbursements for
purchases of materials.
 The Direct Materials Budget

 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.
Let’s prepare the direct materials budget.
 The Direct Materials Budget

From production budget

The Direct Materials Budget
 The Direct Materials Budget

March 31 inventory

10% of following month’s Calculate the materials to

production needs. by purchased in May.
 Quick Check 

How much materials should be purchased in May?

a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds
 Quick Check 

How much materials should be purchased in May?

a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds
The Direct Materials Budget
The Direct Materials Budget

Assumed ending inventory

 Expected Cash Disbursement for
Materials
 Royal pays $0.40 per pound for its materials.
 One-half of a month’s purchases is 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.

Let’s calculate expected cash disbursements.
Expected Cash Disbursement for
Materials
 Expected Cash Disbursement for
Materials

Compute the expected cash

disbursements for materials
for the quarter.

140,000 lbs. × $.40/lb. = $56,000

 Quick Check 

What are the total cash disbursements for the

quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
 Quick Check 

What are the total cash disbursements for the

quarter?
a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400
Expected Cash Disbursement for
Materials
 Learning Objective
LO5

To prepare a
direct labor budget.
 The Direct Labor Budget
 At Royal, each unit of product requires 0.05 hours (3
minutes) 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 agree 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.
 Let’s prepare the direct labor budget.
The Direct Labor Budget

From production budget

The Direct Labor Budget
The Direct Labor Budget

Greater of labor hours required

or labor hours guaranteed.
The Direct Labor Budget
 Quick Check 

What would be the total direct labor cost for

the quarter if the company follows its no lay-off
policy, but pays $15 (time-and-a-half) for every
hour worked in excess of 1,500 hours in a
month?
a. $79,500
b. $64,500
c. $61,000
d. $57,000
 Quick Check 

What would be the total direct labor cost for

the quarter if the company follows its no lay-off
policy, but pays $15 (time-and-a-half) for every
April May June Quarter
hour workedLabor
in excess of 1,500
hours required 1,300 hours
2,300 in1,450
a
month? Regular hours paid 1,500 1,500 1,500 4,500
Overtime hours paid - 800 - 800
a. $79,500
b. $64,500 Total regular hours
Total overtime hours
4,500
800
$10 $ 45,000
$15 $ 12,000
c. $61,000 Total pay $ 57,000

d. $57,000
 Learning Objective
LO6

To prepare a manufacturing
overhead budget.
 Manufacturing Overhead Budget
 At Royal manufacturing overhead is applied to
units of product on the basis of direct labor
hours.
 The variable manufacturing overhead rate is
$20 per direct labor hour.
 Fixed manufacturing overhead is $50,000 per
month and includes $20,000 of noncash costs
(primarily depreciation of plant assets).

 Let’s prepare the manufacturing overhead

budget.
Manufacturing Overhead Budget

Direct Labor Budget

Manufacturing Overhead Budget

Total mfg. OH for quarter $251,000

= $49.70 per hour*
Total labor hours required 5,050 *rounded
Manufacturing Overhead Budget

Depreciation is a noncash charge.

Ending Finished Goods Inventory Budget

Production costs per unit Quantity Cost Total

Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor
Manufacturing overhead

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct materials
budget and information
Ending Finished Goods Inventory Budget

Production costs 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

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct labor budget

Ending Finished Goods Inventory Budget

Production costs 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
Unit product cost $ 4.99
Ending finished goods inventory

Total mfg. OH for quarter $251,000

= $49.70 per hour*
Total labor hours required 5,050
Ending Finished Goods Inventory Budget

Production costs 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

Production Budget
 Learning Objective
LO7

To prepare a selling and

administrative expense
budget.
 Selling and Administrative Expense
Budget
 At Royal, the selling and administrative expenses
budget is divided into variable and fixed components.
 The 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.

Let’s prepare the company’s selling and

administrative expense budget.
Selling and Administrative Expense
Budget

Calculate the selling and administrative

cash expenses for the quarter.
 Quick Check 

What are the total cash disbursements for

selling and administrative expenses for the
quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
 Quick Check 

What are the total cash disbursements for

selling and administrative expenses for the
quarter?
a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
Selling and Administrative Expense
Budget
 Learning Objective
LO8

To prepare a
cash budget.
 Format of the Cash Budget

The cash budget is divided into four sections:

1. Cash receipts listing all cash inflows excluding
borrowing;
2. Cash disbursements listing all payments
excluding repayments of principal and interest;
3. Cash excess or deficiency; and
4. The financing section listing all borrowings,
repayments and 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
HR56

The Cash Budget

Schedule of Expected
Cash Collections
Slide 75

HR56 Slide 75 Teaching Notes

$X and/or X

Reconstruct the second sentence to read

"To this amount, we add $170,000 from the expected cash collections for April sales."

Helen Roybark, 6/5/2006

The Cash Budget

Schedule of Expected
Cash Disbursements

Direct Labor
Budget

Manufacturing
Overhead Budget

Selling and Administrative

Expense Budget
The Cash Budget

In the month of April will

expect to have a cash
deficiency of $20,000.
The Cash Budget

Because Royal maintains

a cash balance of $30,000,
the company must borrow
$50,000 on it line-of-credit.

Ending cash balance for April

is the beginning May balance.
The Cash Budget
 Quick Check 

What is the excess (deficiency) of cash

available over disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
 Quick Check 

What is the excess (deficiency) of cash

available over disbursements for June?
a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000
 The Cash Budget

$50,000 × 16% × 3/12 = $2,000

Borrowings on April 1 and
repayment on June 30.
 Learning Objective
LO9

To prepare a budgeted
income statement.
The Budgeted Income Statement

Cash Budgeted
Budget Income
Statement

After we complete the cash budget,

we can prepare the budgeted income
statement for Royal.
 The Budgeted Income Statement
Sales Budget
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30
Ending Finished
Sales (100,000 units @ $10) $ 1,000,000 Goods Inventory
Cost of goods sold (100,000 @ $4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000 Selling and
Operating income 241,000 Administrative
Interest expense 2,000 Expense Budget
Net income $ 239,000

Cash Budget
 Learning Objective
LO10

To prepare a budgeted
balance sheet.
 The Budgeted Balance Sheet

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
 Royal Company
Budgeted Balance Sheet 25% of June
June 30 sales of
Current assets $300,000
Cash $ 43,000
Accounts receivable 75,000 11,500 lbs.
Raw materials inventory 4,600 at $0.40/lb.
Finished goods inventory 24,950
Total current assets 147,550 5,000 units
Property and equipment at $4.99 each
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550
50% of June
Accounts payable $ 28,400 purchases
Common stock 200,000
of $56,800
Retained earnings 336,150
Total liabilities and equities $ 564,550
 Royal Company
Budgeted Balance Sheet
June 30
Current assets
Cash $ 43,000
Accounts receivable Beginning balance
75,000 $146,150
Add: net income 239,000
Raw materials inventory 4,600
Deduct: dividends (49,000)
Finished goods inventory 24,950
Ending balance $336,150
Total current assets 147,550
Property and equipment
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550

Accounts payable $ 28,400

Common stock 200,000
Retained earnings 336,150
Total liabilities and equities $ 564,550
End of Chapter 7