Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Operational BudgetingOperational Budgeting

Chapter 23

Profit Rich, Yet Cash PoorProfit Rich, Yet Cash Poor

Conditions leading to cashshortages when profits are high.

Consider the following cash-to-cash cycle.Consider the following cash-to-cash cycle.

Large investmentsin assets to support

rapid revenue growth.

Long operating cycles(cash-to-cash cycles).

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CashCash

247 Days

Even if sales are growing rapidly, cash is tied up in inventory and receivables for so long that

a cash shortage will be the likely result.

Profit Rich, Yet Cash PoorProfit Rich, Yet Cash PoorCashCash

InventoriesDMWIPFG

166 days

InventoriesDMWIPFG

166 days

Accounts Receivable81 days

Accounts Receivable81 days

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Budgeting: The Basis forBudgeting: The Basis forPlanning and ControlPlanning and Control

Control Steps taken by management to

ensure that objectives are

attained.

Planning Developing objectives for

acquisitionand use of resources.

A budget is a comprehensive financialplan for achieving the financial and

operational goals of an organization.

A budget is a comprehensive financialplan for achieving the financial and

operational goals of an organization.

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Coordinationof activities

Coordinationof activities

Performanceevaluation

Performanceevaluation

Enhanced managementresponsibility

Enhanced managementresponsibility

Assignment of decision-making responsibilities

Assignment of decision-making responsibilities

Benefits Derived from Benefits Derived from BudgetingBudgeting

Benefits

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Budget Problems Perceived unfair

or unrealistic goals.

Poor management-employee communications.

Budget Problems Perceived unfair

or unrealistic goals.

Poor management-employee communications.

Solution Reasonable and

achievable budgets.

Employee participation in budgeting process.

Solution Reasonable and

achievable budgets.

Employee participation in budgeting process.

Establishing Budgeted Establishing Budgeted Amounts: Amounts: Behavioral ApproachBehavioral Approach

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Establishing Budgeted Establishing Budgeted Amounts: Amounts: Total Quality Management Total Quality Management ApproachApproachA commitment to the

goal of completelyeliminating inefficiency.

Budgeted amounts setat levels representingabsolute efficiency.

Small failures toachieve budgeted

amounts directmanagement to

areas where improvement is

possible.

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Flow of Budget Data

S u p erv iso r S u p erv iso r

M id d leM a na ge m e nt

S u p erv iso r S u p erv iso r

M id d leM a na ge m e nt

T o p M an a ge m e nt

Participation in Budget Participation in Budget ProcessProcess

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2005 2006 2007 2008

C a p i t a l B u d g e t s

A continuous budget is usually a twelve-month budget that adds one month as the current month

is completed.

A continuous budget is usually a twelve-month budget that adds one month as the current month

is completed.

The annual operating budget may be divided into quarterly or monthly budgets.

The annual operating budget may be divided into quarterly or monthly budgets.

The Budget PeriodThe Budget Period

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Productionbudgets

Financial Financial budgets:budgets: cash flowcash flow incomeincome balance sheetbalance sheet

Cashbudget

Selling andadministrative

budget

Cost of goodsmanufactured

and soldbudget

The Master BudgetThe Master Budget

Salesbudget

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SalesBudget

EstimatedUnit Sales

EstimatedUnit Price

Analysis of economic and market conditions

+Forecasts of customer needs from

marketing personnel

Steps in Preparing a Master Steps in Preparing a Master BudgetBudget

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Performance evaluation is difficult when actual activity

differs from the activity originally

budgeted.

Flexible BudgetingFlexible Budgeting

Hmm! Comparingcosts at differentlevels of activity is like comparing

apples with oranges.

Consider the followingcondensed examplefrom Barton, Inc. . . .

Consider the followingcondensed examplefrom Barton, Inc. . . .

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Flexible BudgetingFlexible Budgeting

Original ActualBudget Results Variances

Units of Activity 10,000 8,000 2,000 U

Variable costs Indirect labor 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,000 0

Total overhead costs 89,000$ 77,300$ $11,700 F

U = Unfavorable variance – Barton, Inc. was unable to achieve the

budgeted level of activity.

F = Favorable variance: actual costs are less than budgeted costs.

Since cost variances are favorable, havewe done a good job controlling costs?

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I don’t think I can answer the question

using the originalbudget.

How much ofthe favorable cost

variance is due to loweractivity, and how much is due to good cost control?

Flexible BudgetingFlexible Budgeting

To answer the question, we mustthe budget to the actual level of activity.

Central Concept: If you can tell me what your activity was for the period, I will tell you what your

costs and revenue should have been.23-14

Improve performance evaluation.

May be prepared for any activity level in the relevant range.

Show expenses that should have occurred at the actual level of activity.

Reveal variances due to cost control or lack of cost control.

Flexible BudgetingFlexible Budgeting

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To a budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costs change

in direct proportion to changes in activity.

Total fixed costs remainunchanged within therelevant range.

FixedVaria

ble

Flexible BudgetingFlexible Budgeting

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End of Chapter 23End of Chapter 23

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