Chapter 4

Profit Planning
 Budget

Budget: A detailed plan for acquiring and

using financial and other resources over
specified time period.
The act of preparing budget is called
‘budgeting’.
Master budget is a summary of a
company’s plans that sets specific targets
for sales, production, distribution, and
financing activities.
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 Planning and Control

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

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 Advantages of Budgeting

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

Advantages
Coordinate Means of allocating
activities resources

Uncover potential
bottlenecks

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 Choosing the Budget Period
Operating Budget

1999 2000 2001 2002

•Operating budget ordinarily cover a one-year period

corresponding to the company’s fiscal year.

•The annual operating budget may be divided into

quarterly or monthly budgets.

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 Choosing the Budget Period
Continuous Budget

1999 2000 2001 2002

Continuous or perpetual budget is a 12-

month budget that rolls forward one
month as the current month is completed.
Advocates of this budget argue that there
is less danger that managers will become
narrowly focused on short-term basis.
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 Participative Budget System

Top M an ag em en t

M id d le M id d le
M an ag em en t M an ag em en t

S u p ervis or S u p ervisor S u p ervisor S u p ervisor

Flow of Budget Data

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 The Master Budget
Sales
Budget

Selling and
Production
Administrative
Budget
Budget

Direct Direct Manufacturing

Materials Labor Overhead
Budget Budget Budget

Cash
Budget

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Budgeted Financial Statements
© The McGraw-Hill Companies, Inc., 2003
 The Sales Budget

Detailed schedule showing expected

sales for the coming periods
expressed in units and dollars.

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 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.

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 The Sales Budget

April May June Quarter

Budgeted
  sales (units) 20,000 50,000 30,000 100,000
Selling price
  per unit
Total sales

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 The Sales Budget

April May June Quarter

Budgeted
  sales (units) 20,000 50,000 30,000 100,000
Selling price
  per unit $ 10 $ 10 $ 10 $ 10
Total sales $200,000 $500,000 $300,000 $1,000,000

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 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% is uncollectible.
The March 31 accounts receivable
balance of $30,000 will be collected in full.

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 Expected Cash Collections

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 Expected Cash Collections

From the Sales Budget for April.

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 Expected Cash Collections

From the Sales Budget for May.

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 Quick Check 

What will be the total cash collections for the

quarter?
a. $700,000
b. $220,000
c. $190,000
d. $905,000

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 Quick Check 

What will be the total cash collections for the

quarter?
a. $700,000
b. $220,000
c. $190,000
d. $905,000

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 Expected Cash Collections

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 The Production Budget

Sales Production
Budget Budget
ed
and l et
p
Expected
o m
C
Cash
Collections

Production must be adequate to meet budgeted

sales and provide for sufficient ending inventory.

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 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.

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 The Production Budget
April May June Quarter
Budgeted sales 20,000 50,000 30,000 100,000
Add desired ending
  inventory 10,000
Total needed 30,000
Less beginning
  inventory 4,000

Required production 26,000

Budgeted sales 50,000
Desired percent 20%
Desired inventory 10,000

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 The Production Budget

April May June Quarter

Budgeted sales 20,000 50,000 30,000 100,000
Add desired ending
  inventory 10,000
Total needed 30,000
Less beginning
  inventory 4,000

Required production 26,000 ?

March 31
ending inventory
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 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

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 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

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 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
Total needed 30,000 56,000
Less beginning
  inventory 4,000 10,000

Required production 26,000 46,000

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 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

Assumed ending inventory.

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 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.
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 The Direct Materials Budget
April May June Quarter
Production 26,000 46,000 29,000 101,000
Materials per unit
Production needs
Add desired
  ending inventory
Total needed
Less beginning
  inventory
Materials to be
  purchased

From production
budget

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 The Direct Materials Budget
April May June Quarter
Production 26,000 46,000 29,000 101,000
Materials per unit 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add desired
  ending inventory
Total needed
Less beginning
  inventory
Materials to be
  purchased

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 The Direct Materials Budget
April May June Quarter
Production 26,000 46,000 29,000 101,000
Materials per unit 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add desired
  ending inventory 23,000
Total needed 153,000
Less beginning
  inventory
Materials to be
  purchased

10% of the following

month’s production

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 The Direct Materials Budget
April May June Quarter
Production 26,000 46,000 29,000 101,000
Materials per unit 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add desired
  ending inventory 23,000
Total needed 153,000
Less beginning
  inventory 13,000
Materials to be
  purchased 140,000 ?

March 31
inventory

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 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

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 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

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 The Direct Materials Budget
April May June Quarter
Production 26,000 46,000 29,000 101,000
Materials per unit 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add desired
  ending inventory 23,000 14,500 11,500 11,500
Total needed 153,000 244,500 156,500 516,500
Less beginning
  inventory 13,000 23,000 14,500 13,000
Materials to be
  purchased 140,000 221,500 142,000 503,500

Assumed ending inventory

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 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.
 Let’s calculate expected cash
disbursements.
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 Expected Cash Disbursement for
Materials
April May June Quarter
Accounts pay. 3/31 $ 12,000 $ 12,000
April purchases

May purchases

June purchases

Total cash
disbursements

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 Expected Cash Disbursement for
Materials
April May June Quarter
Accounts 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 purchases

June purchases

Total cash
disbursements $ 40,000 ?

140,000 lbs. × $.40/lb. = $56,000

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 Quick Check 

What are the total cash disbursements for the

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

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 Quick Check 

What are the total cash disbursements for the

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

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 Expected Cash Disbursement for
Materials
April May June Quarter
Accounts 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 purchases
50% x $88,600 44,300 44,300
50% x $88,600 $ 44,300 44,300
June purchases
50% x $56,800 28,400 28,400
Total cash
disbursements $ 40,000 $ 72,300 $ 72,700 $185,000

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 The Direct Labor Budget
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.
 Let’s prepare the direct labor budget.

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 The Direct Labor Budget

From production budget

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 The Direct Labor Budget

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 The Direct Labor Budget

Higher of labor hours required

or labor hours guaranteed.

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 The Direct Labor Budget

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 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 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

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 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 for every hour worked in
excess of 1,500 hours in a month?
a. $79,500 April May June Quarter
b. $64,500 Labor hours required 1,300 2,300 1,450
Regular hours paid 1,500 1,500 1,500 4,500
c. $61,000 Overtime hours paid - 800 - 800
d. $57,000 Total regular hours 4,500 $10 $ 45,000
Total overtime hours 800 $15 $ 12,000
Total pay $ 57,000
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 Manufacturing Overhead
Budget
Royal Company uses a variable
manufacturing overhead rate of $1 per unit
produced.
produced
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.

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 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
Total mfg. OH costs
Less noncash costs
Cash disbursements
  for manufacturing OH
From production budget

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 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
Cash disbursements
  for manufacturing OH

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 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 disbursements
  for manufacturing OH $ 56,000 $ 76,000 $ 59,000 $ 191,000

Depreciation is a noncash charge.

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 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.

 Let’s calculate ending finished goods

inventory.

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 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

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 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

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 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 hr.*
Total labor hours required 5,050 hrs.

*rounded
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 Quick Check 

What is the value of the ending finished goods

inventory?
a. $ 9,980
b. $24,950
c. $57,385
d. $49,900

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 Quick Check 

What is the value of the ending finished goods

inventory?
a. $ 9,980
b. $24,950
c. $57,385
d. $49,900

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 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

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 Selling and Administrative Expense
Budget
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.

Let’s prepare the company’s selling and

administrative expense budget.

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 Selling and Administrative Expense
Budget
April May June Quarter
Budgeted sales 20,000
Variable selling
  and admin. rate $ 0.50
Variable expense $ 10,000
Fixed selling and
  admin. expense 70,000
Total expense 80,000
Less noncash
  expenses 10,000
Cash disburse-
  ments for
  selling & admin. $ 70,000 ?

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 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 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

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 Selling and Administrative Expense
Budget
April May June Quarter
Budgeted 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 disburse-
  ments for
  selling & admin. $70,000 $85,000 $75,000 $230,000

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 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.

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 The Cash Budget
April May June Quarter
Beginning cash balance $ 40,000
Add cash collections 170,000
Total cash available 210,000
Less disbursements
Materials 40,000
Direct labor
Mfg. overhead
Selling and admin.
Equipment purchase Schedule of Expected
Dividends Cash Disbursements
Total disbursements
Excess (deficiency) of
  cash available over Schedule of Expected
  disbursements Cash Collections

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 The Cash Budget
April May June Quarter
Beginning cash balance $ 40,000
Add cash collections 170,000 Direct Labor
Total cash available 210,000 Budget
Less disbursements
Materials 40,000
Direct labor 15,000
Manufacturing
Mfg. overhead 56,000
Selling and admin. 70,000 Overhead Budget
Equipment purchase
Dividends
Total disbursements
Excess (deficiency) of Selling and Administrative
  cash available over
  disbursements
Expense Budget

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 The Cash Budget
April May June Quarter
Beginning cash balance $ 40,000
Add cash collections 170,000
Total cash available 210,000
Less disbursements
Materials 40,000 Because Royal maintains
Direct labor 15,000 a cash balance of $30,000,
Mfg. overhead 56,000 the company must
Selling and admin. 70,000
Equipment purchase -
borrow on its
Dividends 49,000 line-of-credit
Total disbursements 230,000
Excess (deficiency) of
  cash available over
  disbursements $ (20,000)

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 Financing and Repayment
April May June Quarter
Excess (deficiency)
  of Cash available
  over disbursements $ (20,000)
Financing:
Borrowing 50,000
Repayments -
Interest -
Total financing 50,000
Ending cash balance $ 30,000 $ 30,000 $ - $ -

Ending cash balance for April

is the beginning May balance.

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 The Cash Budget
April May June Quarter
Beginning cash balance $ 40,000 $ 30,000
Add cash collections 170,000 400,000
Total cash available 210,000 430,000
Less disbursements
Materials 40,000 72,300
Direct labor 15,000 23,000
Mfg. overhead 56,000 76,000
Selling and admin. 70,000 85,000
Equipment purchase - 143,700
Dividends 49,000 -
Total disbursements 230,000 400,000
Excess (deficiency) of
  cash available over
  disbursements $ (20,000) $ 30,000

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 Financing and Repayment
April May June Quarter
Excess (deficiency)
  of Cash available
  over disbursements $ (20,000) $ 30,000
Financing:
Borrowing 50,000 -
Repayments - -
Interest - -
Total financing 50,000 -
Ending cash balance $ 30,000 $ 30,000

Because the ending cash balance is

exactly $30,000, Royal will not repay
the loan this month.

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 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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 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

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 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
Materials 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

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 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
Materials 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.
At the end70,000 85,000
of June, Royal has 75,000 230,000
enough cash
Equipment purchase - 143,700 48,300 192,000
Dividends to repay the $50,000
49,000 loan
- plus interest
- at 16%.
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

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 Financing and Repayment
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
Repayments - - (50,000) (50,000)
Interest - - (2,000) (2,000)
Total financing 50,000 - (52,000) (2,000)
Ending cash balance $ 30,000 $ 30,000 $ 43,000 $ 43,000

$50,000 × 16% × 3/12 = $2,000

Borrowings on April 1 and
repayment of June 30.

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 The Budgeted Income
Statement
Cash Budgeted
Budget Income
Statement
t ed
e
pl
om
C

After we complete the cash budget,

we can prepare the budgeted income
statement for Royal.

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 The Budgeted Income
Statement
Royal Company
Budgeted Income Statement
For the Three Months Ended June 30

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

Cost of goods sold (100,000 @ $4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000
Operating income 241,000
Interest expense 2,000
Net income $ 239,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

 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

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 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
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 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
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003