MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES

By Dennis Caplan, University at Albany (State University of New York)

CHAPTER 20: Operating Budgets

Chapter Contents:

- Overview

- The sales budget

- Pro forma income statement

- The production budget

- Accounts receivable and accounts payable budgets

- The cash budget

- Pro forma balance sheet

- Exercises and problems

Overview:

A budget is a quantitative plan for the future that assists the organization in coordinating activities. All large organizations budget. Many organizations prepare detailed budgets that look one year ahead, and budgets that look further into the future that contain relatively less detail and more general strategic direction.

The budget assists in the following activities:

- Planning. A budget helps identify the resources that are needed, and when they will be needed.

- Control. A budget helps control costs by setting spending guidelines.

- Motivating Employees. A budget can motivate employees and managers. Budgets are more effective motivational tools if employees and managers “buy into” the budget, which is more likely to occur if they participate in the preparation of the budget in a meaningful way.

- Communication. A budget can provide either one-way (top-down) or two-way communication within the organization.

A company’s overall budget, which is sometimes called a master budget, consists of many supporting budgets. These supporting budgets include:

- Sales budget

- Pro forma income statement

- The production budget and supporting schedules

- Budgets for capital assets and for financing activities

- Budgets for individual balance sheet accounts and departmental expenses

- Cash budget, including cash disbursements and cash receipts budgets

- Pro forma balance sheet

There is a logical sequence for the preparation of these budgets. The first step in a corporate setting is almost always to forecast sales and to assemble a sales budget.

The Sales Budget:

The individuals who are best able to forecast sales are usually the sales force and product managers. Their ability to accurately forecast sales depends on the nature of the industry and on characteristics of the product. Demand is seasonal for many products, in which case each month’s forecast usually incorporates information about sales for the same month last year. Accurately forecasting sales of new products and fashion products can be difficult. Demand for some products is sensitive to macroeconomic forces such as interest rates and foreign exchange rates. On the other hand, given the seemingly arbitrary way in which most of us decide where to eat lunch, restaurants can usually predict each day’s lunch revenue with astounding accuracy.

Most companies face a downward-sloping demand curve for their products, which implies that forecasting sales revenue requires predicting sales volume at the planned sales price.

Pro Forma Income Statement:

With planned sales prices, forecasted sales volumes, and an understanding of the cost structure of the business, the company can assemble a pro forma income statement (an anticipated income statement for the upcoming period). This process is illustrated below, in a simple one-product setting, for the Guess Who Jeans Company. The planned sales price is $40 per unit. Assume that the sales manager’s best guess of sales volume at this price is 20,000 units for October. Then anticipated revenue for October is $800,000. The company’s cost structure is characterized by $30 of variable manufacturing costs per unit, and $150,000 in fixed manufacturing and S.G.&A. (selling, general and administrative) costs. This information is sufficient to complete the pro forma income statement that is shown below.

GUESS WHO JEANS

PRO FORMA CONTRIBUTION MARGIN

INCOME STATEMENT FOR OCTOBER

Income Statement Account	Budgeted amount Per unit	Sale of 20,000 units
Revenue Variable manufacturing costs: Materials Labor Overhead Total Contribution margin Fixed costs: Manufacturing overhead Selling, general & admin. Total fixed costs Operating income	$40 15 10 5 30 $10	$800,000 300,000 200,000 100,000 600,000 200,000 100,000 50,000 150,000 $50,000

The Production Budget:

The next step in the budgeting process is more complicated for manufacturing firms than for merchandising firms, because manufacturing companies have three types of inventory accounts: raw materials, work-in-process and finished goods. However, regardless of the number of asset accounts involved, the goal is to determine the required additions to each account (purchases or transfers-in from an upstream account). The calculation to determine required additions is derived by expanding the Sources = Uses equality as follows:

Beginning balance + additions = transfers out + ending balance

This calculation sometimes uses physical quantities, and sometimes uses dollar values, depending on which makes the most sense under the circumstances.

The beginning balance equals the ending balance for the prior period, which is available either from actual results (the ending balance sheet), or from another budget if the start of the period being budgeted is in the future.

The ending balance is a target established by the company, and is usually based on anticipated activity for the following period (that is, the period following the one for which the current budget is being prepared).

Transfers-out equals the demand for the asset derived from a previous step in the budgeting process:

- If the asset account is finished goods inventory, the demand is based on cost of goods sold, as derived from the pro forma income statement.

- If the asset account is work-in-process inventory, the demand is based on the additions to the finished goods account, as calculated by applying the sources = uses equation shown above to the finished goods account.

- If the asset account is raw materials inventory, the demand is based on the additions to the work-in-process account for materials, as calculated by applying the sources = uses equation shown above to the work-in-process account.

The unknown in the sources = uses equation is additions, which can be solved for, thus completing the production budget. The following table provides balance sheet information for Guess Who Jeans for September 30, which is the period just ended. (This is also the beginning balance for October 1, the period for which the budget is being prepared, because balance sheet amounts at the end of the day on September 30 are the same as the opening balances on the morning of October 1). We will use the information in this table to budget for October’s production. Because Guess Who Jeans makes only one product, it is more convenient to use physical quantities in the sources = uses equations than dollars. We assume that the budget for October is being prepared on October 1^st.

GUESS WHO JEANS

BALANCE SHEET

SEPTEMBER 30 (THE MONTH JUST ENDED)

Assets	Amount	Liabilities	Amount
Cash Accounts Receivable Inventory: Raw Materials (1,800 yards) Work in Process (1,500 units) Finished Goods (5,000 units) Total inventory Property, Plant & Equipment, net of accumulated depreciation Total	$ 67,000 676,000 13,500 35,000 150,000 198,500 880,000 $1,821,500	Accounts Payable Line of Credit Stockholders’ Equity: Common stock Additional paid-in capital Retained earnings Total S/H equity Total	$ 295,000 345,000 100,000 72,500 1,009,000 1,181,500 $1,821,500

Required additions to finished goods inventory: Guess Who Jeans expects to sell 20,000 units each month for the next two months (October and November). The company would like to have on hand, at the beginning of each month, 20% of next month’s sales. The company did not achieve this operational goal for October, because 5,000 units are on hand on October 1, and expected sales are 20,000 units, but the company came close to its goal (25% versus 20%). At the end of October, the company would like to have 4,000 units on hand (20% of 20,000 units expected to be sold in November).

Beginning balance + additions = transfers out + ending balance

5,000 units + additions = 20,000 units in expected sales + 4,000 units for desired ending inventory

additions = 19,000

Hence, Guess Who Jeans should plan to transfer out 19,000 units from work-in-process to finished goods inventory during the month of October.

Required additions to work-in-process: Guess Who Jeans would like to have on hand, at any point in time, 1,200 units in work-in-process. The company has determined that this level of work-in-process provides optimal efficiency on the production line. (As shown above, the level of work-in-process is slightly higher than desired at the end of September.)

Beginning balance + additions = transfers out + ending balance

1,500 units + additions = 19,000 units transferred to finished goods + 1,200 units for desired ending WIP

additions = 18,700

Hence, Guess Who Jeans should plan to start production of 18,700 units during the upcoming month of October.

Required additions to raw materials: On average, 2 yards of fabric are required for each unit of product. Guess Who Jeans would like to maintain 2,000 yards of fabric on hand at any point in time. (The company had less fabric on hand than desired at the end of September.)

Beginning balance + additions = transfers out + ending inventory

1,800 yards + additions = (2 yards per unit x 18,700 units) + 2,000 yards desired in ending inventory on October 31

1,800 yards + additions = 37,400 yards + 2,000 yards

Additions = 37,600 yards of fabric

Hence, Guess Who Jeans should plan to purchase 37,600 yards of fabric during the month of October. Using the budgeted cost of $7.50 per yard, the expected expenditure for these fabric purchases is $282,000.

Accounts Receivable and Accounts Payable Budgets:

Accounts receivable: To budget for the ending balance of accounts receivable, the company incorporates information about the rate at which receivables are collected. Guess Who Jeans makes all sales on credit, and past experience indicates that the following collection schedule can be anticipated:

50% of sales are collected in the month of sale

30% of sales are collected in the month following the sale

20% of sales are collected two months following the sale

This collection schedule implies that on October 31, accounts receivable will consist of:

50% of October sales

20% of September sales

Nothing from sales that occurred prior to September

(E.g., August sales would be collected in August, September, and October)

Actual sales for September were 25,000 units.

Anticipated sales for October are 20,000 units.

Therefore, the budget for accounts receivable at the end of October can be calculated as follows:

50% of October sales 20% of September sales

20,000 units x $40 per unit x 50% = $400,000 25,000 units x $40 per unit x 20% = 200,000 $600,000

However, this calculation does not incorporate information available about September collections of September sales and September collections of prior month sales. Possibly, September collections of September sales differed from the 50% that is budgeted, or perhaps not all of August’s sales were collected by the end of September. This additional information would normally be used to refine the budget of Accounts Receivable at the end of October.

Accounts payable: To budget for the ending balance of accounts payable, the company incorporates information about the extent to which the company makes purchases on credit. Guess Who Jeans pays cash for all types of purchases except for fabric purchases. The company pays for fabric 30 days after the fabric is purchased, on average.

This payment policy implies that at the end of October, accounts payable will consist of all October purchases of fabric, and nothing else. In the raw materials budget (see above), we determined that $282,000 would be incurred for fabric purchases in October. Hence, this amount is the anticipated the balance in Accounts Payable on October 31.

The cash budget:

One of the most important components of the budgeting process for most organizations is the cash budget. The cash budget indicates how much cash the company will have on hand at the end of each period, and also indicates when the company will need to borrow funds to cover temporary cash shortfalls, and when the company will have excess funds to invest in short-term financial instruments. Cash flow is so important that in some organizations, cash balances are projected for the end of each week, or even on a daily basis.

Often, the cash budget is assembled from supporting schedules. These schedules show, for the period being budgeted, anticipated cash disbursements and cash receipts that arise from (1) operating activities, (2) additions and disposals of fixed assets, and (3) financing activities.

Cash receipts: the company anticipates that the only cash receipts that will occur in October will come from collections of receivables. Cash receipts in October are based on anticipated collections of sales that were made in August and September, and anticipated sales for October, and are projected as follows:

Sales made in the month of:	Sales volume during the month	Unit sales price	percentage collected during October	Collections in October
August September October	22,000 25,000 20,000	$40 $40 $40	20% 30% 50%	$176,000 300,000 400,000 $876,000

Cash disbursements are anticipated as follows:

Fabric purchases (for fabric acquired in September) Manufacturing labor Manufacturing variable overhead Fixed manufacturing overhead (excluding non-cash items) Fixed selling, general and admin. overhead (excluding non-cash items) Cash payments for capital acquisitions (from the capital budget) Payments of short-term borrowings Total disbursements for October

$295,000 189,000 94,500 50,000 35,000 110,000 60,000 $833,500

This information about receipts and disbursements is used to project the ending cash balance for the month, as follows:

Beginning balance + cash receipts - cash disbursements = ending balance

$67,000 + $876,000 - $833,500 = $109,500

Pro Forma Balance Sheet:

The foregoing analysis can be used to assemble a pro forma balance sheet, projecting the balance sheet at the end of the October. The amounts in the pro forma balance sheet are derived as follows:

Cash: from the cash budget, shown above.

Accounts receivable: from the accounts receivable budget, shown above.

Raw materials inventory: from the projected ending inventory of 2,000 yards multiplied by the budgeted price of $7.50 per yard.

Work-in-process inventory:

Beginning balance + Fabric additions (37,400 yards x $7.50 per yard) + Manufacturing labor (from the cash disbursements budget) + Manufacturing variable overhead (from the cash disbursements budget) - Transfers out to finished goods inventory (19,000 units x $30 per unit) Ending balance

$ 35,000 280,500 189,000 94,500 570,000 $ 29,000

Finished goods inventory: from the projected ending inventory of 4,000 units, multiplied by the budgeted cost of $30 per unit. (Note: the company uses Variable Costing for internal reporting.)

Property, plant & equipment, net of accumulated depreciation:

Beginning balance + Capital acquisitions (from the cash disbursements budget) - Depreciation expense Ending balance

$880,000 110,000 65,000 $925,000

The $65,000 in depreciation expense reconciles to the non-cash portion of the $150,000 in fixed manufacturing and fixed selling, general and administrative costs shown on the pro forma income statement. The difference of $85,000 (i.e., the cash portion of these fixed costs) is shown on the cash disbursements budget as $50,000 for fixed manufacturing overhead and $35,000 for fixed selling, general and administrative overhead.

Accounts payable: from the accounts payable budget, shown above.

Short-term borrowings: beginning balance of $345,000 less the anticipated payment of $60,000 as per the cash disbursements budget.

Common stock and Additional paid-in capital: no change.

Retained earnings: beginning balance of $1,009,000 + October income of $50,000, as per the pro forma income statement.

GUESS WHO JEANS

PRO FORMA BALANCE SHEET

OCTOBER 31

Assets	Amount	Liabilities	Amount
Cash Accounts Receivable Inventory: Raw Materials (2,000 yards) Work in Process (1,200 units) Finished Goods (4,000 units) Total inventory Property, Plant & Equipment, net of accumulated depreciation Total	$109,500 600,000 15,000 29,000 120,000 164,000 925,000 $1,798,500	Accounts Payable Line of Credit Stockholders’ Equity: Common stock Additional paid-in capital Retained earnings Total S/H equity Total	$282,000 285,000 100,000 72,500 1,059,000 1,231,500 $1,798,500

It is interesting to note that whereas the pro forma income statement can be prepared early in the budgeting process (at least for the results of operating activities), the pro forma balance sheet is one of the last schedules to be prepared, because it depends on information obtained from numerous supporting budgets and schedules.

Go to the End-of-Chapter Exercises and Problems

Go to the Next Chapter

Return to the Table of Contents

Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010

For a printer-friendly version, contact Dennis Caplan at dcaplan@uamail.albany.edu