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Chapter 6: Master Budget andResponsibility Accounting

Coordinating Actions and Tuning them according to Strategic Goals

andEvolutions in the External Environment

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Budgeting Cycle

Performance planningProviding a frame of referenceInvestigating variationsCorrective actionPlanning again

Figure: from Anthony, Robert N.(1988)The Management Control Function, Harvard Business School Press, Boston (Mass.), p.80.

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The Master Budget

Master Budget

OperatingDecisions

Financial Decisions

based on one expected scenario

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Why Budgets?

BudgetsConvey understanding of strategy to managers and other employees

Provide a framework for judging performance

Motivate employees and managers by setting targets as a basis of performance measurement

Promote coordination and communication

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Time Coverage of Budgets

Budgets typically concern a definite time period (month, quarter, year).This time period can itself be broken into sub-periods with extended or refined targetsThe most frequently used budget period is one year.

Businesses are increasingly using rolling horizon budgets: a coarse budget for a long period is decomposed in a sequence of finer budgets for consecutive sub-periods

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Example: Operating Budget

Sales Budget Production Budget

Finished GoodsInventory Budget

Production Cost Budget- direct- overhead

Revenue Budget

RequirementsBudget:- Materials- Labor- Capacities

MaterialsInventory Budget Procurement Budget

Non-ProductionCost Budget

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Revenues and Cost of Goods Sold BudgetHawaii Diving expects 1,600 units of surfboards to be sold during the month of August 2004.

Selling price is expected to be $240 per unit.⇒ budgeted revenues for the month: 1,600 × $240 =

$384,000Two pounds of direct materials are budgeted per unit at a cost of $2.00 per pound, $4.00 per unit $ 6,400Three direct labor-hours are budgeted per unit at $7.00 per hour, $21.00 per unit $ 33,600Variable overhead is budgeted at $8.00 per direct labor-hour, $24.00 per unit. $ 38,400Fixed overhead is budgeted at $8,000 per month*) $ 8,000Budgeted Cost of goods sold: 86,400i.e. 54.00 per unit.

*) at normal capacity of 1600

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Production Budget, Example

Budgeted sales (units): 1 600

Target ending finished goods inventory (units): 580

Beginning finished goods inventory (units): 1 100

Budgeted production (units): 1080

+–=

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Direct Materials Usage Budget

Data requirements: materials content of product per unit+ budgeted allowance for waste and scrap= material required per unit× budgeted production (from production budget)= budgeted material usage× budgeted purchase price per unit of materialsummed over all kinds of direct material= budgeted materials cost

For each material:Budgeted material usage+ desired ending inventory= budgeted materials procurement

procurement volume× purchase pricesummed over all kinds of material+ change in accounts payable= budgeted financial requirementsfor direct materials

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Direct Materials Usage Budget

Each finished unit requires 2 pounds of direct materials at a cost of $2.00 per pound. Desired ending inventory equals 15% of the materials required to produce next month’s sales.September sales are forecasted to be 1,600 units.Budgeted Ending inventory in August: 480 pounds

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Direct Materials Usage Budget

Budgeted September sales 1,600× 2 pounds per unit = 3,200 pounds

desired ending inventory: 3,200 × 15% = 480 pounds budgeted beginning inventory in August

1,100 units × 2 × 15% = 330 unitsPounds needed to produce 1,080 units in August:

1,080 × 2 = 2,160 pounds

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Material Purchases Budget

Hawaii Diving Direct Material Purchases Budget for the Month of August 2004

Units needed for production 2,160Target ending inventory 480Total material to provide for 2,640Less beginning inventory 330Units to be purchased 2,310

Unit purchase price $ 2.00Total purchase cost $4,620

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Direct Manufacturing Labor Budget

Each unit requires 3 direct labor-hours at $7.00 per hour.Hawaii Diving Direct Labor Budget for the Month of August 2004

Units produced: 1,080Direct labor-hours/unit 3Total direct labor-hours: 3,240Total budget at $7.00/hour: $22,680

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Manufacturing Overhead Budget

Variable overhead is budgeted at $8.00 per direct labor-hour.Fixed overhead is budgeted at $5,400 per month.Hawaii Diving Manufacturing Overhead Budget for the Month of August 2004:

Variable Overhead: (3,240 × $8.00) $25,920Fixed Overhead 5,400Total $31,320

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Ending Inventory Budget

Cost per finished unit:Materials $ 4Labor 21Variable manufacturing overhead 24Fixed manufacturing overhead 5*Total $54

• * $8,000 ÷ 1,600 = $5• Notice that only the cost of utilized capacity are

inventoriable. (1,600 – 1080)·5 = 2,600 go directly into period costs.

Cost of the target ending inventory for materials:480 × $2 = $960

Cost of the target finished goods inventory:580 × $54 = $31,320

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Cost of Goods Sold Budget

Direct materials used 2,160 × $2.00 4,320Direct labor 22,680Total overhead (= 24 + 5)·1,080 = 31,320Cost of goods manufactured $58,320

Assume:beginning finished goods inventory: 1100@54 = $59,400Ending finished goods inventory is 580@54 = 31,320.

Cost of goods sold

Beginning finished goods inventory $59,400+ Cost of goods manufactured $58,320= Goods available for sale $117,720– Ending finished goods inventory $ 31,320= Cost of goods sold (cf. p.7) $ 86,400

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Nonmanufacturing Costs Budget

Hawaii Diving Other Expenses Budget for the Month of September 2004

Variable Expenses: ($0.14 × $264,000) $36,960Fixed expenses*) 7,800Total $44,760

*) Includes the unabsorbed capacity cost of 5,200, see p.15

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Cost of Goods Sold Budget

Hawaii Diving has budgeted sales of $264,000 for the month of August.Cost of goods sold are budgeted at $59,400.What is the budgeted gross margin?Hawaii Diving Budgeted Income Statement for the Month ending August 31, 2004

Sales $264,000 100%Less cost of sales 59,400 22%Gross margin $204,600 78%Other expenses 44,760 17%Operating income $159,840 61%

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Financial Planning Models

Financial planning models are mathematical representations of the interrelationships among operating activities, financial activities, and other factors that affect the master budget.

see also: Budget.xls at the course web site.

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Example: Cash Budget

Depends on collection pattern:

In the month of sale: 50%In the month following sale: 27%In the second month following sale: 20%Uncollectible: 3%

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Cash Budget

Budgeted sales are as follows:

June $200,000July $250,000August $264,000September $260,000

What are the expected cash collections in August?

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Cash Budget

Budgeted Cash Receipts

for the Month Ending August 31, 2004

August sales: $264,000 × 50% $132,000July sales: $250,000 × 27% $67,500June sales: $200,000 × 20% $40,000

Total $239,500

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Cash Budget

Budgeted Cash Disbursements

for the Month Ending August 31, 2004August purchases $ 4,620Direct labor $22,680Total overhead $31,320Other expenses $ 9,760*Total $68,380

*Other expenses exclude depreciation

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Cash Budget

Cash Budgetfor the Month Ending August 31, 2004

Budgeted receipts $239,500Budgeted disbursements 68,380Net increase in cash $171,120

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Exercise:Prepare a purchases budget in pounds for July, August, and September, and give total purchases in both pounds and dollars for each month.

Lubriderm Corporation has the following budgeted sales for thenext six-month period:

There were 30,000 units of finished goods in inventory at thebeginning of June. Plans are to have an inventory of finishedproducts that equal 20% of the unit sales for the next month.Five pounds of materials are required for each unit produced.Each pound of material costs $8. Inventory levels for materialsare equal to 30% of the needs for the next month. Materialsinventory on June 1 was 15,000 pounds

Month Unit SalesJune 90,000 July 120,000 August 210,000 September 150,000 October 180,000 November 120,000

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What is Kaizen?

The Japanese use the term “kaizen” for continuous improvement.Kaizen budgeting is an approach that explicitly incorporates continuous improvement during the budget period into the budget numbers.

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Kaizen Budgeting

Budgeted Hours/ItemJanuary – March 2004 3.00April – June 2004 2.95July – September 2004 2.90

October – December 2004 2.85

A kaizen budgeting approach wouldincorporate future improvements.

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Controlling achievement

volume

Costs

Budgeted volume

Budgetedfixed cost

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Actual volume

ActualKaizen Costing Effect

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See: Monden, Y.,Japanese management accounting : a world class approach to profit management3rd print. - Cambridge, Mass. [u.a.] : Productivity Press, 1992 Ch. 28

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Activity-Based Budgeting

Activity-based Costing (ABC)reports and analyzes past and current costs.

Activity-based budgeting (ABB) focuses on

the budgeted cost of activities necessaryto produce and sell products and services.

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Activity-Based Budgeting

Product A Product BUnits produced: 880 200Labor-hours per unit: 3 3Budgeted setup-hours: 5 5Total budgeted machine setup related cost is $25,920 per month.

Total budgeted labor-hours are:Product A: 880 × 3 2,640Product B: 200 × 3 600Total 3,240What is the allocation rate per labor-hour?

$25,920 ÷ 3,240 = $8.00

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Activity-Based Budgeting

Total cost allocated to each product line:Product A: $8.00 × 2,640 = $21,120Product B: $8.00 × 600 = $ 4,800

Under ABB, the number of setups is the cost driver.$25,920 budgeted machine setup cost÷ 10 budgeted machine setup-hours= $2,592 allocation rate per machine setup-hour.How much machine setup related costs are allocated to each product line?

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Activity-Based Budgeting

Product A Product B$12,960 $12,960

$2,592 × 5 $2,592 × 5

Setup-related cost per unit:Product A: $12,960 ÷ 880 $14.73Product B: $12,960 ÷ 200 $64.80

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Responsibility Accounting

Responsibility accounting tries to figure out the causal relationship between managers‘ actions and the achievement of organization‘s objectives as clearly as possible

isolating other influencesaccounting for known outside effectsconsiderable noise in the measures will remain

Responsibility center (Definition)any part, segment, or subunit of a business that needs control.

Types of Responsibility CentersCost CenterProfit CenterInvestment Center

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Controllability

Definitionproperty of a performance measure such as• costs• revenues• department profit• return ob investment;

A performance measure is controllable to the degree the responsible manager can exert influence on it.

Controllability is less relevant a property for responsibility accounting than is informativeness on the actions of the manager

any (costlessly available) performance measure that is informative on the manager‘s action should enter his or her performance evaluatione.g. benchmarking information

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Human aspects of Budgeting

Budgeting should not be considered as a „mechanical tool“Quality of the budget depends on the information that is fed into the process There are incentives for dishonest reports

Budgetary slackEmpire building

Management aims to ensure honest reporting by lower level management

Via appropriate performance measuresMonitoring