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9.3: The Master Budget (Part 2)

Selling and Administrative Budget

Question: Now that the sales and production-related budgets are complete, it is time to estimate selling and administrative costs. What is a selling and administrative budget, and how is it prepared?

Answer:

The selling and administrative budget10 is an estimate of all operating costs other than production. This budget is presented in Figure 9.8.

Although many organizations may have variable and fixed costs in this budget, Jerry’s Ice Cream treats all selling and administrative costs as fixed costs. Once again, depreciation is deducted at the bottom of this budget to determine cash payments for selling and administrative costs, which we use later in the chapter for the cash budget.

Figure 9.8.png

Figure 9.8 - Selling and Administrative Budget for Jerry’s Ice Cream

*Deduct depreciation to get the actual cash payment for selling and administrative costs.

**This information is needed for the cash budget presented in Figure 9.11 "Cash Budget for Jerry’s Ice Cream".

Budgeted Income Statement

Question: Budgets completed to this point include sales (Figure 9.3), production (Figure 9.4), direct materials (Figure 9.5), direct labor (Figure 9.6), manufacturing overhead (Figure 9.7), and selling and administrative (Figure 9.8). Jerry’s Ice Cream now has enough information to prepare the budgeted income statement. What is a budgeted income statement, and how is it prepared?

Answer:

The budgeted income statement11 is an estimate of the organization’s profit for a given budget period. Most organizations, including Jerry’s Ice Cream, prepare the budgeted income statement using the accrual basis of accounting: revenues are recorded when earned and expenses are recorded when incurred. The budgeted income statement for Jerry’s Ice Cream is presented in Figure 9.9. The cash budget we prepare later in the chapter will show when cash is received and paid.

Figure 9.9.png

Figure 9.9 - Budgeted Income Statement for Jerry’s Ice Cream

*Cost of goods sold = Per unit cost of $4.50 (see above) × Units sold (from Figure 9.3); for the first quarter, $180,000 cost of goods sold = $4.50 unit cost × 40,000 units.

The first line in the budgeted income statement, sales, comes from the sales budget in Figure 9.3. The next line, cost of goods sold, is calculated by multiplying unit sales from Figure 9.3 by the cost per unit. The cost per unit calculation is shown at the bottom of Figure 9.9. Carefully review this calculation. Since Jerry’s Ice Cream uses full-absorption costing, all manufacturing costs related to goods sold are included (or fully absorbed) in cost of goods sold. Figure 9.5, Figure 9.6, and Figure 9.7 provide this information on a per unit basis for direct materials, direct labor, and manufacturing overhead, respectively.

The third line, gross margin, is simply sales minus cost of goods sold. The fourth line, selling and administrative costs, comes from the selling and administrative budget in Figure 9.8. The bottom line of the budgeted income statement, net income, is gross margin minus selling and administrative costs. Income tax expense is not included in this example for the sake of simplicity. However, income taxes can significantly reduce projected net income and cash flows.

Question: How do companies use the budgeted income statement to improve operations?

Answer:

The budgeted income statement is perhaps the most carefully scrutinized component of the master budget. The management and employees throughout the organization use this information for planning purposes and to evaluate company performance. The board of directors and budget committee are responsible for approving the budget and often review periodic reports comparing actual net income to budgeted net income to determine if profit goals are being achieved. Lenders and owners often review the budget to ensure the organization is on track to meet its goals. The budgeted income statement answers the question: what profits does the organization expect to achieve?

After completing the budgeted income statement, only three budgets remain: the capital expenditures budget, the cash budget, and the budgeted balance sheet. We discuss the capital expenditures budget next.

REVIEW PROBLEM 9.5

Carol’s Cookies estimates that all selling and administrative costs are fixed. Quarterly selling and administrative cost estimates for the coming year are

Salaries $60,000
Rent $ 7,000
Advertising $10,000
Depreciation $ 8,000
Other $ 1,000
  1. Prepare a selling and administrative budget for Carol’s Cookies using the format shown in Figure 9.8.
  2. Prepare a budgeted income statement for Carol’s Cookies using the format shown in Figure 9.9.
Answer:
  1. Figure 9.3.7-1.png
    *Deduct depreciation to get the actual cash payment for selling and administrative costs.

    **This information is needed for the cash budget prepared later.
  2. Figure 9.3.8.png
    *Cost of goods sold = Per unit cost of $6.76 (see above) × Units sold (from sales budget); for first quarter, $540,800 cost of goods sold = $6.76 unit cost × 80,000 units.

    **From selling and administrative budget.

Capital Expenditures Budget

Question: What is a capital expenditures budget, and how is it prepared?

Answer:

The capital expenditures budget12 is an estimate of the long-term assets to be purchased during the budget period. This includes purchases of tangible longterm assets such as property, plant, and equipment, and intangible assets, such as patents, copyrights, and trademarks. This budget can have a significant impact on cash flow and requires careful planning and analysis (Chapter 8 presents a detailed discussion of capital budgeting). As shown in Figure 9.10, Jerry’s Ice Cream plans to purchase computers and production equipment at the end of the fourth quarter.

Figure 9.10.png

Figure 9.10 - Capital Expenditures Budget for Jerry’s Ice Cream

Note: These acquisitions will have no effect on depreciation expense in the fourth quarter. Items will be purchased at the end of the year. Thus depreciation begins the following year.

Because long-term asset purchases occur at the end of the year, depreciation will begin the following year. Thus depreciation shown in the manufacturing overhead and selling and administrative budgets will not be affected until the following year. The cash outlay required to make these purchases is reflected in the cash budget presented next.

Cash Budget

Question: What is a cash budget, and how is it prepared?

Answer:

The cash budget13 is an estimate of the amount and timing of cash inflows and outflows for the budget period. Although the budgeted income statement provides an estimate of profitability, it stops short of providing cash flow information. For example, some of the $240,000 in first quarter sales revenue will be collected during the first quarter and some will be collected the following quarter. A section of the cash budget will show when cash from sales will be received.

The cash budget has the following sections, each of which is described after Figure 9.11:

  • Cash collections from sales
  • Cash payments for purchases of materials
  • Other cash collections and payments

Figure 9.11 shows the cash budget for Jerry’s Ice Cream. Amounts shown in parentheses represent cash outflows; amounts without parentheses represent cash inflows.

Figure 9.11.png

Figure 9.11 - Cash Budget for Jerry’s Ice Cream

*Based on sales budget shown in Figure 9.3. All sales are on credit: 60 percent collected in the quarter of sale and 40 percent collected the following quarter.

**Based on purchases budget shown in Figure 9.5. All purchases are on credit: 70 percent paid in the quarter of purchase and 30 percent paid the following quarter.

***Does not include depreciation since depreciation expense does not involve a cash payment. See related figures for calculations.

^Excess of collections over payments = Cash collections from sales – Cash payments for materials purchases – Other cash payments.

^^ Beginning cash balance = Cash balance at end of previous period. Balance for first quarter is given.

^^^ Ending cash balance = Excess of collections over payments for the quarter + Beginning cash balance.

Cash Collections from Sales

Question: Assume all sales at Jerry’s Ice Cream are on credit. How long does it take, on average, for Jerry’s to collect on credit sales?

Answer:

On average, 60 percent of credit sales are collected in the quarter sold and the remaining 40 percent is collected the following quarter. These percentage estimates are based on previous experience and take into consideration credit terms offered to customers. Since Jerry’s Ice Cream only sells to customers with an excellent credit record, it anticipates no bad debts.

As you examine the cash collections from sales section of Jerry’s cash budget, notice that $180,000 in cash will be collected in the first quarter related to credit sales made in the previous quarter (this amount is given). Next, you will see $144,000 in cash collected in the first quarter related to first quarter sales (= 60 percent collected in quarter of sale × $240,000 first quarter sales). The remaining $96,000 will be collected in the second quarter, as shown in Figure 9.11 (= 40 percent × $240,000 first quarter sales).

Cash Payments for Purchases of Materials

Question: Assume all purchases at Jerry’s Ice Cream are on credit. How long does it take, on average, for Jerry’s to pay for these credit purchases?

Answer:

On average, 70 percent of purchases are paid in the quarter purchased and the remaining 30 percent is paid the following quarter. These percentage estimates are based on previous experience and take into account credit terms offered by suppliers.

As you look at the cash payments for purchases of materials section of Jerry’s cash budget, notice that $30,000 in cash will be paid in the first quarter related to purchases made in the previous quarter (this amount is given). Next, you will see $59,472 in cash paid in the first quarter related to first quarter purchases (= 70 percent paid in quarter purchased × $84,960 first quarter purchases). The remaining $25,488 will be paid in the second quarter, as shown in Figure 9.11 (= 30 percent × $84,960 first quarter purchases). Figure 9.5 shows how cash flows into the company for customer sales and out of the company for purchases of materials.

Other Cash Collections and Payments

Question: What other cash collections and cash payments must be considered at Jerry’s Ice Cream?

Answer:

Assume Jerry’s Ice Cream has other cash payments but no other cash collections. Direct labor cash payments are from Figure 9.6. Manufacturing overhead cash payments are from Figure 9.7. Recall that depreciation was subtracted from total overhead costs in Figure 9.7 to calculate the cash payments for overhead. Selling and administrative cash payments are from Figure 9.8, where a similar depreciation adjustment was made. Capital expenditure cash payments are from Figure 9.10.

The other cash collections and payments section is also where organizations include financing activities such as cash collections from the sale of bonds or cash payments for the repayment of bank loans. Jerry’s Ice Cream does not have any of these financing activities.

The bottom section of the cash budget is where the ending cash balance is calculated for each budget period. The manager responsible for cash planning, typically the treasurer, scrutinizes this section carefully. Some organizations must borrow cash to fund the timing difference between when cash is used for production and when cash is received from sales. The cash budget will signal when short-term borrowing is necessary and allows time for the treasurer to arrange for financing. The cash budget presented in Figure 9.11 shows that Jerry’s will not need to borrow cash in any of the four quarters. In fact, Jerry’s Ice Cream will have a hefty reserve of cash totaling $155,576 at the end of the fourth quarter.

REVIEW PROBLEM 9.6

Carol’s Cookies has the following information pertaining to the capital expenditures and cash budgets.

Capital Expenditures

The company plans to purchase selling and administrative equipment totaling $20,000 and production equipment totaling $28,000. Both will be purchased at the end of the fourth quarter and will not affect depreciation expense for the coming year.

Cash Budget

All sales are on credit. The company expects to collect 70 percent of sales in the quarter of sale, 25 percent of sales in the quarter following the sale, and 5 percent will not be collected (bad debt). Accounts receivable at the end of last year totaled $200,000, all of which will be collected in the first quarter of this coming year.

All direct materials purchases are on credit. The company expects to pay 80 percent of purchases in the quarter of purchase and 20 percent the following quarter. Accounts payable at the end of last year totaled $50,000, all of which will be paid in the first quarter of this coming year.

The cash balance at the end of last year totaled $20,000.

  1. Prepare a capital expenditures budget for Carol’s Cookies using the format shown in Figure 9.10.
  2. Prepare a cash budget for Carol’s Cookies using the format shown in Figure 9.11.
Answer:
  1. Figure 9..3.9.png
    Note: These acquisitions will have no effect on depreciation expense in the fourth quarter. Items will be purchased at the end of the year. Thus depreciation begins the following year.
  2. Figure 9..3.10.png
    *Based on sales budget. All sales are on credit: 70 percent collected in the quarter of sale, 25 percent collected the following quarter, and 5 percent bad debt.
    **Based on purchases budget. All purchases are on credit: 80 percent paid in the quarter of purchase and 20 percent paid the following quarter.
    ***From manufacturing overhead budget. Amount does not include depreciation.
    ****From selling and administrative budget. Amount does not include depreciation.
    *****From capital expenditures budget.
    ^Excess of collections over payments = Cash collections from sales – Cash payments for materials purchases – other cash payments.
    ^^ Beginning cash balance = Cash balance at end of previous period. Balance for first quarter is given.
    ^^^ Ending cash balance = Excess of collections over payments for the quarter + Beginning cash balance.

Budgeted Balance Sheet

Question: The budgeted balance sheet is the last piece of the budget process. What is the budgeted balance sheet, and how is it prepared?

Answer:

The budgeted balance sheet14 is an estimate of the ending balances for all balance sheet accounts. Managers use this to assess the impact that budgeted sales and costs will have on the financial condition of the organization. We present the budgeted balance sheet for Jerry’s Ice Cream in Figure 9.12.

Information needed to prepare the budgeted balance sheet for Jerry’s Ice Cream is shown throughout the chapter and is referenced in Figure 9.12. Additional information is provided here:

  • Plant and equipment (net) expected at the end of the budget period (December 31) is $530,000.
  • Common stock issued and outstanding at the end of the budget period (December 31) is expected to be $650,000.
  • Actual retained earnings at the end of last year totaled $101,600, and no cash dividends will be paid during the current budget period ending December 31.

Figure 9.12.png

Figure 9.12 - Budgeted Balance Sheet for Jerry’s Ice Cream

*$124,800 = $312,000 in fourth quarter sales (Figure 9.3) × 40 percent to be collected next quarter (Figure 9.11).

**$20,000 = 20,000 pounds (Figure 9.5) × $1 per pound (Figure 9.5).

***$19,800 = 4,400 units (Figure 9.4) × $4.50 (Figure 9.9).

^Given. ^^ $30,576 = $101,920 in fourth quarter purchases (Figure 9.5) × 30 percent to be paid next quarter (Figure 9.11).

^^^$169,600 = $101,600 in retained earnings at end of last year (given) + $68,000 budgeted net income for the year (Figure 9.9).

Computer Application

Using Excel to Develop an Operating Budget

Managers often use spreadsheets to develop operating budgets. Spreadsheets help managers perform what-if analysis by linking the components of the master budget and automatically making changes to budget schedules when certain estimates are revised. For example, if managers at Jerry’s Ice Cream wanted to see what would happen if sales in units were decreased by 10 percent from the initial projection shown in Figure 9.3, they would simply reduce sales by 10 percent, and all budget schedules affected by this change would automatically be updated in the spreadsheet. An example of how to use Excel to develop an operating budget for Jerry’s Ice Cream follows. Notice the tabs at the bottom of the spreadsheet.

The first tab is for the sales budget worksheet, the second tab is for the production budget worksheet, the next tab is for the direct materials purchases budget worksheet, and so on. All these worksheets are linked so changes to certain estimates are reflected in the appropriate budget schedules.

Figure 9..3.11.png

Spreadsheet programs are not the only way managers use technology to facilitate the budgeting process. As indicated in Note 9.30 "Business in Action 9.2" the Web is also a useful tool when it comes to efficient budgeting.

Business in Action 9.2

Moving from Spreadsheets to Intranet Budgeting

The Pacific Northwest National Laboratory (PNNL) is one of nine multiprogram national laboratories of the U.S. Department of Energy. PNNL is operated by Battelle Science and Technology International, a global science and technology enterprise that conducts $3,000,000,000 worth of research and development annually.

The Facilities & Operations (F&O) Business Office at PNNL has over 130 budget activities, each of which requires an annual budget. The total annual budget is $70,000,000. Prior to 2000, activity managers were required to use Excel to process budget information. The F&O Business Office then uploaded this information to formulate the division’s budget.

As the F&O Business Office began the budget process for 2001, management decided to build a Web-based, or intranet, budget and planning system. The new system allowed managers to use the Web to input budget information directly, thus eliminating the need to upload initial budgets and subsequent budget changes.

Moving to intranet budgeting benefited PNNL’s F&O Business Office in several ways. Activity managers no longer had to use Excel to enter budget information, which saved 450 hours. The F&O Business Office saved 60 hours by no longer having to upload Excel budget information. Budget reports are easy to create, and the system provides real-time reports for analysis and project management.

Many organizations are adopting intranet budgeting as the primary source of planning and control. As the financial specialist at PNNL stated, intranet budgeting provides “a tool that is easy to use, accurate, and simple and will continue to save us time and money.”

Sources: Mary F. Astley, “Intranet Budgeting,” Strategic Finance, May 2003; Pacific Northwest National Laboratory, “Home Page,” http://www.pnl.gov.

REVIEW PROBLEM 9.7

Assume Carol’s Cookies will collect 25 percent of fourth quarter budgeted sales in full next year (this represents accounts receivable at the end of the fourth quarter). The following account balances are expected at the end of the fourth quarter:

  • Property, plant, and equipment (net): $320,000
  • Common stock: $450,000

Retained earnings at the end of last year totaled $56,180, and no cash dividends are anticipated for the budget period ending December 31.

Prepare a budgeted balance sheet for Carol’s Cookies using the format shown in Figure 9.12.

Answer:

Figure 9..3.12.png

*$208,000 = $832,000 in fourth quarter sales (from sales budget) × 25 percent to be collected next quarter (given).

**$82,000 = 41,000 pounds × $2 per pound (from direct materials budget).

***$60,840 = 9,000 units (from production budget) × $6.76 cost per unit (from budgeted income statement).

^Given.

^^ $59,492 = $297,460 in fourth quarter purchases (from direct materials budget) × 20 percent to be paid next quarter (given).

^^^ $208,180 = $56,180 in retained earnings end of last year (given) + $152,000 budgeted net income (from budgeted income statement).

Wrap-Up of Chapter Example

The management group at Jerry’s Ice Cream is reconvening to discuss sales growth anticipated for the next budget period.

Jerry: Tom, I recall you saying we should expect growth between 10 percent and 25 percent next year. Have you been able to narrow this down a bit?
Tom: Yes, I’ve talked with our salespeople and industry contacts. We also obtained trend data from a market research firm. Based on this information, sales should increase about 15 percent this coming year. Most agree this growth is a result of our high-quality product and our ability to quickly adjust flavors to accommodate consumer tastes
Jerry: This is great news. It looks like our ice cream is really catching on
Michelle: I received Tom’s projection a few days ago and already have a preliminary budget for next year. Lynn, you will have to do some serious planning to guarantee we have enough materials and employees for the third quarter spike in sales.
Lynn: Yes, I realize we have some work to do to ensure we have enough resources to meet budgeted production levels.
Jerry: Can’t we just hire a few more employees and let our suppliers know we will need more materials?
Lynn: The problem is that we have a spike in production during the third quarter. Production goes from 49,200 units in the second quarter to 59,200 units in the third quarter and back down to 51,200 units in the fourth quarter. I don’t think materials will be an issue—our supplier has already assured me this will not be a problem. But I can’t just hire new employees in the third quarter and fire them in the fourth quarter.
Jerry: Perhaps our existing employees can work overtime, or we can hire temporary employees.
Lynn: Hiring temporary employees would be my preference, particularly since college students are looking for part-time work during the summer months. Working overtime would really cause problems with our budgeted hourly rate of $13.
Jerry: Michelle, do we have any cash flow problems with the anticipated growth?
Michelle: Fortunately not. If all goes as planned, we should have more than $90,000 in the bank at the end of each quarter.
Jerry: Excellent! Let’s do our best to stay on track. Michelle, I’d like an update at the end of the first quarter to see if actual profit meets or exceeds budgeted profit.
Michelle: No problem. I’ll have it for you as soon as the books are closed for the first quarter.
Jerry Now that we all have some idea of what to expect this coming year, we can make sure the resources are in place to make it happen. This should be an exciting and challenging year for us. Let’s meet again next month to discuss our progress in preparing for next year.

This narrative provides an example of how the master budget is used for planning purposes. It is much more efficient to plan in advance for significant increases in sales and production than to wait and deal with production issues as they occur. The master budget can also be used for control purposes by evaluating company performance. We discuss the control phase of budgeting further in Chapter 10.

KEY TAKEAWAY

The master budget for a manufacturing company includes budget schedules for sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative, the income statement, capital expenditures, cash, and the balance sheet. The sales budget is most important because sales projections drive the other budgets.

Definitions 

  1. An estimate of all operating costs other than production.
  2. An estimate of the organization’s profit for a given budget period.
  3. An estimate of the long-term assets to be purchased during the budget period.
  4. An estimate of the amount and timing of cash inflows and outflows for the budget period.
  5. An estimate of the ending balances for all balance sheet accounts.