Profit Planning, Activity-Based Budgeting, and E-Budgeting

CHAPTER 9

Profit Planning, Activity-Based Budgeting, and e-Budgeting

ANSWERS to Review Questions

9-1A master budget, or profit plan, is a comprehensive set of budgets covering all phases of an organization's operations for a specified period of time. The master budget includes the following parts: sales budget, operational budgets (including a production budget, inventory budgets, a labor budget, an overhead budget, a selling and administrative expense budget, and a cash budget), and budgeted financial statements (including a budgeted income statement, budgeted balance sheet, and budgeted statement of cash flows).

9-2A budget facilitates communication and coordination by making each manager throughout the organization aware of the plans made by other managers. The budgeting process pulls together the plans of each manager in the organization.

9-3An example of using the budget to allocate resources in a university is found in the area of research funds and grants. Universities typically have a limited amount of research-support resources that must be allocated among the various colleges and divisions within the university. This allocation process often takes place within the context of the budgeting process.

9-4The flowchart on the following page depicts the components of the master budget for a service station.

9-5General economic trends are important in forecasting sales in the airline industry. The overall health of the economy is an important factor affecting the extent of business travel. In addition, the health of the economy, inflation, and income levels affect the extent to which the general public travels by air.

9-6Operational budgets specify how an organization's operations will be carried out to meet the demand for its goods and services. The operational budgets prepared in a hospital would include a labor budget showing the number of professional personnel of various types required to carry out the hospital's mission, an overhead budget listing planned expenditures for such costs as utilities and maintenance, and a cash budget showing planned cash receipts and disbursements.

Flowchart for Review Question 9-4

9-7Application of activity-based costing to the budgeting process yields activity-based budgeting (ABB). Under ABB, the first step is to specify the products or services to be produced and the customers to be served. Then the activities necessary to produce these products and services are determined. Finally the resources needed to perform the specified activities are determined. ABB differs from traditional budgeting in the emphasis that it places on activities and its use of activity-based costing data in the budgeting process.

9-8E-budgeting stands for an electronic and enterprise-wide budgeting process. Under this approach the information needed to construct a budget is gathered via the Internet from individuals and subunits located throughout the enterprise. The Internet also is used to disseminate the resulting budget schedules and information to authorized users throughout the enterprise.

9-9The city of New York could use budgeting for planning purposes in many ways. For example, the city's personnel budget would be important in planning for required employees in the police and fire departments. The city's capital budget would be used in planning for the replacement of the city's vehicles, computers, administrative buildings, and traffic control equipment. The city's cash budget would be important in planning for cash receipts and disbursements. It is important for any organization, including a municipal government, to make sure that it has enough cash on hand to meet its cash needs at all times.

9-10The budget director, or chief budget officer, specifies the process by which budget data will be gathered, collects the information, and prepares the master budget. To communicate budget procedures and deadlines to employees throughout the organization, the budget director often develops and disseminates a budget manual.

9-11The budget manual says who is responsible for providing various types of information, when the information is required, and what form the information is to take. The budget manual also states who should receive each schedule when the master budget is complete.

9-12A company's board of directors generally has final approval over the master budget. By exercising its authority to make changes in the budget and grant final approval, the board of directors can wield considerable influence on the overall direction the organization takes. Since the budget is used as a resource-allocation mechanism, the board of directors can emphasize some programs and curtail or eliminate others by allocating funds through the budgeting process.

9-13Under zero-base budgeting, the budget for virtually every activity in the organization is initially set to zero. To receive funding during the budgeting process, each activity must be justified in terms of its continued usefulness. The zero-base budgeting approach forces management to rethink each phase of an organization's operations before allocating resources.

9-14A master budget is based on many assumptions and predictions of unknown parameters. For example, the sales budget is built on an assumption about the nature of demand for goods or services. The direct-material budget requires an estimate of the direct-material price and the quantity of material required per unit of production. Many other assumptions are used throughout the rest of the budgeting process.

9-15The difference between the revenue or cost projection that a person provides in the budgeting process and a realistic estimate of the revenue or cost is called budgetary slack. Building budgetary slack into the budget is called padding the budget. A significant problem caused by budgetary slack is that the budget ceases to be an accurate portrayal of likely future events. Cost estimates are often inflated, and revenue estimates are often understated. In this situation, the budget loses its effectiveness as a planning tool.

9-16An organization can reduce the problem of budgetary slack in several ways. First, it can avoid relying on the budget as a negative, evaluative tool. Second, managers can be given incentives not only to achieve budgetary projections but also to provide accurate projections.

9-17The idea of participative budgeting is to involve employees throughout an organization in the budgetary process. Such participation can give employees the feeling that "this is our budget," rather than the feeling that "this is the budget you imposed on us." When employees feel that they were part of the budgeting process, they are more likely to strive to achieve the budget.

9-18This comment is occasionally heard from people who have started and run their own small business for a long period of time. These individuals have great knowledge in their minds about running their business. They feel that they do not need to spend a great deal of time on the budgeting process, because they can essentially run the business by feel. This approach can result in several problems. First, if the person who is running the business is sick or traveling, he or she is not available to make decisions and implement plans that could have been clarified by a budget. Second, the purposes of budgeting are important to the effective running of an organization. Budgets facilitate communication and coordination, are useful in resource allocation, and help in evaluating performance and providing incentives to employees. It is difficult to achieve these benefits without a budgeting process.

9-19In developing a budget to meet your college expenses, the primary steps would be to project your cash receipts and your cash disbursements. Your cash receipts could come from such sources as summer jobs, jobs held during the academic year, college funds saved by relatives or friends for your benefit, scholarships, and financial aid from your college or university. You would also need to carefully project your college expenses. Your expenses would include tuition, room and board, books and other academic supplies, transportation, clothing and other personal needs, and money for entertainment and miscellaneous expenses.

9-20Firms with international operations face a variety of additional challenges in preparing their budgets.

• A multinational firm's budget must reflect the translation of foreign currencies into U.S. dollars. Almost all the world's currencies fluctuate in their values relative to the dollar, and this fluctuation makes budgeting for those translations difficult.
• It is difficult to prepare budgets when inflation is high or unpredictable. Some foreign countries have experienced hyperinflation, sometimes with annual inflation rates well over 100 percent. Predicting such high inflation rates is difficult and complicates a multinational's budgeting process.
• The economies of all countries fluctuate in terms of consumer demand, availability of skilled labor, laws affecting commerce, and so forth. Companies with foreign operations face the task of anticipating such changing conditions in their budgeting processes.

9-21The five phases in a product's life cycle are as follows:

(a)Product planning and concept design

(b)Preliminary design

(c)Detailed design and testing

(d)Production

(e)Distribution and customer service

It is important to budget these costs as early as possible in order to ensure that the revenue a product generates over its life cycle will cover all of the costs to be incurred. A large portion of a product's life-cycle costs will be committed well before they are actually incurred.

9-22(a)Ordering costs: The cost of preparing, placing, and receiving a purchase order. (Examples include the clerical costs of preparing purchase orders, time spent finding suppliers and expediting orders, transportation, and receiving costs, such as unloading and inspection.)

(b)Holding costs: The cost incurred in keeping inventory on hand for some period of time. (Examples include the costs of storage space such as a warehouse, depreciation, security, insurance, forgone interest on working capital tied up in inventory, and the costs of deterioration and theft.)

(c)Shortage costs: The cost incurred by the organization when it does not have materials or finished goods on hand when needed. (Examples include the costs caused by disrupted production when raw materials are unavailable, lost sales, dissatisfied customers, and the loss of quantity discounts on purchases.)

9-23The EOQ approach assumes that some inventory must be held. The objective of the model is to balance the cost of ordering against the cost of holding inventory. In contrast, the JIT philosophy is to reduce all inventories to the absolute minimum, eliminating them completely if possible. The JIT viewpoint asserts that inventory holding costs tend to be higher than may be apparent because of the inefficiency and waste involved in storing inventory. This view, coupled with the JIT goal of reducing ordering costs to very low amounts, results in the desirability of more frequent and smaller order quantities.

In addition, under JIT inventory management, order quantities typically will vary depending on requirements. In contrast, under the EOQ model, the order quantity remains constant.

Solutions to exercises

Exercise 9-24 (20 minutes)

1.

April / May / June
Sales...... / $80,000 / $60,000 / $90,000a
Cash receipts:
From cash sales...... / $ 40,000b / $ 30,000c / $ 45,000
From sales on account...... / 36,000d / 34,000 / 39,000e
Total cash receipts...... / $ 76,000 / $ 64,000 / $ 84,000
a$90,000 / = / $45,000  2
b$40,000 / = / $80,000  .5
c$30,000 / = / $60,000  .5
d$36,000 / = / ($40,000  .6) + ($30,000  .4)
e$39,000 / = / ($45,000  .6) + ($30,000  .4)
2. / Accounts payable, 12/31/x0...... / 300,000DM
Purchases of goods and services on account during 20x1 / 1,200,000DM
Payments of accounts payable during 20x1...... / (1,100,000DM)*
Accounts payable, 12/31/x1...... / 400,000DM
*1,100,000DM = 300,000DM + 1,200,000DM – 400,000DM
3. / Accounts receivable, 12/31/x0...... / 340,000y
Sales on account during 20x1...... / 900,000y
Collections of accounts receivable during 20x1...... / (780,000y)
Accounts receivable, 12/31/x1...... / 460,000y
4. / Accumulated depreciation, 12/31/x0...... / $ 810,000
Depreciation expense during 20x1...... / 150,000
Accumulated depreciation, 12/31/x1...... / $960,000
5. / Retained earnings, 12/31/x0...... / $2,050,000
Net income for 20x1...... / 400,000
Dividends paid in 20x1...... / -0-_
Retained earnings, 12/31/x1...... / $2,450,000

Exercise 9-25 (30 minutes)

Answers will vary widely, depending on the governmental unit selected and the budgetary items on which the student focuses. In the past, students have expressed surprise at the proportion of the U.S. federal budget that goes to entitlement programs (e.g., Social Security and Medicare), interest expense, and the military.

Exercise 9-26 (15 minutes)

1. / Production (in units) required for the year:
Sales for the year...... / 480,000
Add: Desired ending finished-goods inventory on December 31 / 50,000
Deduct: Beginning finished-goods inventory on January 1 / 80,000
Required production during the year...... / 450,000
2. / Purchases of raw material (in units), assuming production of 500,000 finished units:
Raw material required for production (500,000  2)...... / 1,000,000
Add: Desired ending inventory on December 31...... / 45,000
Deduct: Beginning inventory on January 1...... / 35,000
Required raw-material purchases during the year...... / 1,010,000

Exercise 9-27 (25 minutes)

1. / Cash collections in October:
Month of Sale / Amount Collected in October
July...... / $ 60,000  4% / $ 2,400
August...... / 70,000  10% / 7,000
September...... / 80,000  15% / 12,000
October...... / 90,000  70% / 63,000
Total...... / $84,400
Notice that the amount of sales on account in June, $49,000 was not needed to solve the exercise.

Exercise 9-27 (continued)

2. / Cash collections in fourth quarter from credit sales in fourth quarter.
Amount Collected
Month of Sale / Credit Sales / October / November / December
October...... / $90,000 / $ 63,000 / $13,500 / $9,000
November...... / 100,000 / – / 70,000 / 15,000
December...... / 85,0000 / – / – / 59,500
Total...... / $ 63,000 / $83,500 / $ 83,500
Total collections in fourth quarter from credit sales in fourth quarter /
$230,000

Exercise 9-28 (20 minutes)

1. / The total required production is 655,720 units, computed as follows:
Budgeted Sales
(in units) / Planned Ending Inventory
(in units)
June / 160,000 (200,000  80%)
July / 200,000 (given)
August / 210,000 (200,000  1.05)
September / 220,500 (210,000  1.05) / 185,220 (231,525  80%)
October / 231,525 (220,500  1.05)
Sales in units:
July...... / 200,000
August...... / 210,000
September...... / 220,500
Total for third quarter...... / 630,500
Add: Desired ending inventory, September 30...... / 185,220
Subtotal...... / 815,720
Deduct: Desired ending inventory, June 30...... / 160,000
Total required production...... / 655,720
2. / Assumed production during third quarter (in units)..... / 600,000
Raw-material requirements per unit of product (in pounds) /  4
Raw material required for production in third quarter (in pounds) / 2,400,000
Add: Desired ending raw-material inventory, September 30
(2,400,000  25%)...... /
600,000
Subtotal...... / 3,000,000
Deduct: Ending raw-material inventory, June 30...... / 700,000
Raw material to be purchased during third quarter (in pounds) / 2,300,000
Cost per pound of raw material...... / $1.15
Total raw-material purchases during third quarter...... / $2,645,000

Exercise 9-29 (20 minutes)

1. / Binghamton Film Corporation
Expected Cash Collections
August
Month /
Sales /
Percent / Expected Collections
June...... / $60,000 / 9% / $ 5,400
July...... / 78,000 / 20% / 15,600
August...... / 66,000 / 70% / 46,200
Total...... / $67,200
2. / Binghamton Film Corporation
Expected Cash Disbursements
August
July purchases to be paid in August...... / $ 54,000
Less: 2% cash discount...... / 1,080
Net...... / $ 52,920
Cash disbursements for expenses...... / 14,400
Total...... / $67,320
3. / Binghamton Corporation
Expected Cash Balance
August 31
Balance, August 1...... / $22,000
Add: Expected collections...... / 67,200
Less: Expected disbursements...... / 67,320
Expected balance...... / $21,880

Exercise 9-30 (20 minutes)

Memorandum
Date: / Today
To: / President, East Bank of Mississippi
From: / I.M. Student and Associates
Subject: / Budgetary slack
Budgetary slack is the difference between a budget estimate that a person provides and a realistic estimate. The practice of creating budgetary slack is called padding the budget. The primary negative consequence of slack is that it undermines the credibility and usefulness of the budget as a planning and control tool. When a budget includes slack, the amounts in the budget no longer portray a realistic view of future operations.
The bank's bonus system for the new accounts manager tends to encourage budgetary slack. Since the manager's bonus is determined by the number of new accounts generated over the budgeted number, the manager has an incentive to understate her projection of the number of new accounts. The description of the new accounts manager's behavior shows evidence of such understatement. A 10 percent increase over the bank's current 10,000 accounts would mean 1,000 new accounts in 20x2. Yet the new accounts manager's projection is only 700 new accounts. This projection will make it more likely that the actual number of new accounts will exceed the budgeted number.

Exercise 9-31 (20 minutes)

1.

Total Sales in January 20x2
$100,000 / $130,000 / $160,000
Cash receipts in January, 20x2
From December sales on account / $ 7,125* / $7,125 / $7,125
From January cash sales...... / 75,000† / 97,500 / 120,000
From January sales on account. / 20,000** / 26,000 / 32,000
Total cash receipts...... / $ 102,125 / $130,625 / $159,125
*$7,125 = $190,000  .25  .15
†$75,000 = $100,000 .75
**$20,000 = $100,000  .25  .80
2. / Operational plans depend on various assumptions. Usually there is uncertainty about these assumptions, such as sales demand or inflation rates. Financial planning helps management answer "what if" questions about how the budget will look under various sets of assumptions.

Exercise 9-32 (30 minutes)

1. / Budgeted cash collections for December:
Month of Sale / Collections in December
November...... / $200,000  38% / $76,000
December...... / 220,000  60% / 132,000
Total cash collections...... / $208,000
2. / Budgeted income (loss) for December:
Sales revenue...... / $220,000
Less: Cost of goods sold (75% of sales)..... / 165,000
Gross margin (25% of sales)...... / $55,000
Less:...... Operating expenses:
Bad debts expense (2% of sales)...... / $4,400
Depreciation ($216,000/12)...... / 18,000
Other expenses...... / 22,600
Total operating expenses...... / 45,000
Income before taxes...... / $10,000

Exercise 9-32 (continued)

3. / Projected balance in accounts payable on December 31:
The December 31 balance in accounts payable will be equal to December's purchases of merchandise. Since the store's gross margin is 25 percent of sales, its cost of goods sold must be 75 percent of sales.
Month /
Sales / Cost of Goods Sold / Amount Purchased in December
December...... / $220,000 / $165,000 / $165,000  20% / $ 33,000
January...... / 200,000 / 150,000 / 150,000  80% / 120,000
Total December purchases / $153,000
Therefore, the December 31 balance in accounts payable will be $153,000.

Exercise 9-33 (25 minutes)

1. / Direct professional labor budget for the month of June:
Office visits per month = 48,000/12 = 4,000
Professional services in June:
One-hour visits (20%  4,000  1 hr.)...... / 800 / hours
Half-hour visits (80%  4,000  1/2 hr.)...... / 1,600 / hours
Total direct professional labor...... / 2,400 / hours
Hourly rate for dental associates...... /  $ 60
Total direct professional labor cost...... / $144,000

exercise 9-33 (continued)

2. / Cash collections during June:
May / June
Half-hour visits (4,000 80%)...... / 3,200 / 3,200
Billing rate...... /  $40 /  $40
Total billings for half-hour visits...... / $128,000 / $128,000
One-hour visits (4,000  20%)...... / 800 / 800
Billing rate...... /  $70 /  $70
Total billings for one-hour visits...... / $ 56,000 / $ 56,000
Total billings during month...... / $184,000 / $184,000
Percentage of month's billings collected
during June...... /
 10% /
 90%
Collections during June...... / $ 18,400 / $165,600
Total collections in June ($18,400 + $165,600). / $184,000

1. Overhead and administrative expense budget for June:

Patient registration and records (4,000 visits  $2.00 per visit) $ 8,000

Other overhead and administrative expenses

(2,400 hours  $5.00 per hour)...... 12,000

Total overhead and administrative expenses..... $20,000

Exercise 9-34 (15 minutes)

Exercise 9-35 (10 minutes)

1. / Safety stock:
The lead time is one month, so the safety stock is equal to the difference between average monthly usage and the maximum usage in a month. Average monthly usage is 65 tons (780/12), and the maximum usage is 80 tons. Therefore, the safety stock is 15 tons (80 – 65).
2. / Reorder point:
The reorder point is 80 tons. This is the maximum amount of the bonding agent that would be used in a month, which is the time required to receive an order after it is placed.

solutions to Problems

Problem 9-36 (40 minutes)