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must be done for the month of may…

Week Four Assignment

  1. Listen to the following videos and then complete the assignments using the changed numbers on the guidance report.  Place your answers on the guidance report.
  2. Open the Guidance Report and rework the problem with the changed numbers and place your answers on the guidance report. Do not alter the guidance report.
  3. Submit the guidance report using the Assignment Submission tab below.

Complete the following problems and exercises:

  • Chapter Six Exercise 2
  • Chapter Six Exercise 5
  • Chapter Six Problem 3
  • Chapter Seven Exercise 5
  • Chapter Seven Problem 5

chapter 7 Standard Costs and Variances Learning Objectives • Understand the concepts of standards and standard costs. • Know how to calculate direct materials price and quantity variances, and understand their implications in assessing material cost and waste. • Know how to calculate direct labor rate and time variances, and understand their implications in assessing labor cost and utilization. • Know how to calculate factory overhead volume and controllable variances, and understand their implications in assessing overhead spending and efficiency. istockphoto waL80281_07_c07_169-188.indd 1 9/25/12 1:03 PM 170 Section 7.1 What Are Standards? Chapter Outline 7.1 What Are Standards?Controlling Via Standards Establishing Standards Comparing Actual to Standard 7.2 General Variance Model Variances Relating to Direct Material Impact on the Ledger Variances Relating to Direct Labor Impact on the Ledger Variances Related to Factory Overhead Impact on the Ledger 7.3 Concluding Discussion on Variances I n the previous chapter, you studied budgets and general variances. Recall that a variance is just a departure from the expected outcome. You learned many important concepts, including the idea that budget variances are sometimes explainable by volume fluctua – tions. To the extent that a budget variance is only due to a volume fluctuation, it may not be an indication of a lack of cost control or inefficiency. Thus, some variances do not require a response. On the other hand, some unfavorable variances may suggest the n eed for swift corrective actions. How is a manager to discern the nature of a budget variance? One method for sorting out the nature of budget variances is the flexible budget. This concept was also introduced in the previous chapter, and it provides an excellent point of beginning. However, it is only a point of beginning. For example, if a company spent more on direct material than expected, it could be explained by higher than anticipated levels of production, but it could also be due to waste and/or paying more per unit for raw material inputs. Only through a detailed analysis can a manager fully understand the nature of expenditures, and through those understandings begin to look for opportunities for improvement. This is where standards and variance analysis come into play. 7.1 What Are Standards? S tandards are the predetermined expectations about the inputs that will be required to achieve anticipated output. For a manufacturer, inputs generally relate to the factors of production, namely materials, labor, and overhead. Output is usually (but not always) the product or service that is to be delivered to a customer. Standard costs express a measure of what the factors of production should cost. Standards serve multiple purposes. They are essential to business planning. Standards were implicit in the budget process in the prior chapter. You might recall how Wheat Treat anticipated 10 pounds of direct material for each unit. That scenario represented a straightforward example of a standard that was used in the planning process. Standards were also implicit to cost–volume–profit (CVP) analysis. Recall how CVP techniques were waL80281_07_c07_169-188.indd 2 9/25/12 1:03 PM CHAPTER 7 171 Section 7.1 What Are Standards? used to study many facets of business operations, such as the determinat ion of the sales level necessary to achieve profitability. Standards are also very useful in pricing and bill- ing. Have you ever had your car repaired? Look closely at the bill and you will probably see that labor was charged not on actual time or wages but, rather, on a standard amount of time for the designated task. It may have taken the mechanic more or less time to per – form the task, but the work was billed for standard hours and at a standard wage rate. Standards are also used in control applications, which is the primary focus for this chapter. Controlling Via Standards Controlling a business requires constant comparison of achieved results to planned or predetermined standards. In this context, standards are the established benchmarks of efficiency and cost incurrence. You have likely been involved with standards in some job you have performed. For example, many people have been employed in fast- food restau – rants. You are probably aware that these businesses have very specific expectations about customer wait times, food temperatures, cleanliness guidelines, and so forth. These stan – dards are clearly intended to keep the business operating at peak performance. M ost busi – nesses will create their own unique standards. As noted previously, manufacturers tend to focus on the key factors of production in setting standards. Thus, a finished unit can be analyzed from the perspective of its raw material, direct labor, and factory overhead. By the time you complete this chapter, you will be quite familiar with standards and variance calculations related to each. In addition, keep in mind that other nonfinancial standards could relate to product quality, delivery schedule, and so forth; thus, standards apply to both manufacturing and nonmanufacturing environments. Without standards, tasks tend to expand in a costly manner. Establishing Standards Establishing standards is far more complex than you might think. If you were going to tile a floor, you know that you would likely use more square feet of tile than is the size of the room. The nooks and crannies of the room might require some complex cuts with atten – dant scrap, and the overall dimensions of the room will probably require some wasted end cuts. Then, mistakes are also made. Tiles might be broken, set crooked and have to be chipped up and redone, and so forth. In calculating the quantity of tile to buy, you will probably estimate liberally and then buy a few more for unplanned problems. The last thing you would want to happen is to run out of tiles with the room 95% complete. What if you could not then procure enough additional matching tiles to finish? On the other hand, you certainly would not want to have an enormous quantity of unused tiles, especially if you could not return the unused quantity to the supplier. Calculating the quantity of tiles is very similar to the challenge faced in a manufacturing environment. The managerial accountant would need to study the production environment, taking into consideration waste and spoilage. The problems faced in estimating material also relate to labor. How long should it take to tile the room? No doubt you probably find that your own projects take longer than you expect, especially when unanticipated problems arise. There is also a learning curve. If you were to tile two equally shaped rooms, the second one would prob – ably go much quicker than the first. Again, business standard setters face the same issues. Managerial accountants may be helpful in performing studies and building models that are foundational to establishing standards. For instance, a managerial accountant may be one of the few persons with access to overall information. Overall infor mation is needed waL80281_07_c07_169-188.indd 3 9/25/12 1:03 PM CHAPTER 7 172 Section 7.2 General V ariance Model in setting standards because standards are often based on averages; total estimated costs must be divided by total estimated output or activity. This is especially true for overhead where the standard variable overhead is sometimes determined by dividing estimated variable overhead by the estimated activity level. In similar fashion, fixed standard per- unit overhead reflects the total estimated fixed overhead divided by the estimated activity. Notwithstanding the need to engage the managerial accountants in setting standards, it is also imperative to involve personnel who best understand the operational processes. These frontline persons will have the best understanding of the specific amounts of time and materials that are necessary to achieve desired outcomes. Their realistic assessments are invaluable in providing insight needed to understand what is truly necessary to get a job done and thereby set standards. Comparing Actual to Standard In the previous chapter, you saw how a budget could be compared to actual results. The mathematical differences were simply referred to as variances. When actual cost is more than planned, an unfavorable variance is produced, and vice versa. This is quite logical. It is the hallmark of variance analysis. The foundation for variance analysis is the setting of standards; without standards, you would have no basis for comparison. Variance analysis is the examination of the deviations between actual and standard costs. More important, its objective is to identify areas for improvement. This is an important role for management. Although comparing total actual costs to total standard costs is interesting, it provides little useful information for identifying specific problems that can be corrected. A more penetrating analysis into the detailed variances relating to each fac- tor of production is needed. Developing these analytical tools is the goal for th e remainder of this chapter. 7.2 General Variance Model T he point of beginning is to set a general frame of reference and some attendant nomen – clature. Let’s establish the following generalities: When Actual Cost (AC) . Standard Cost (SC), the result is an Unfavorable Variance (UV) and When SC . AC, the result is a Favorable Variance (FV) Furthermore, AC 5 Actual Quantity (AQ) 3 Actual Price (AP) per unit and SC 5 Standard Quantity (SQ) 3 Standard Price (SP) per unit These general formulations are foundational to the variance analysis techniques that follow. waL80281_07_c07_169-188.indd 4 9/25/12 1:03 PM CHAPTER 7 173 Section 7.2 General V ariance Model Variances Relating to Direct Material There are two primary variances that relate to direct materials. Simply, when a company pays more or less than the standard price per unit, the result is an unfavorable or favor – able price variance. The other type of variance relates to usage. When a company uses more or less than the standard quantity, the result is an unfavorable or favorable usage variance. The combination of both variances results in the total materials variance, reflect – ing a combination of effects related to both pricing and usage. The total variance for direct materials is the overall difference between actual direct material cost and standard direct material cost. Although the total variance is important, the individual variances provide the greatest insight and opportunity for control. Thus, your focus should be on the individual variances. The materials price variance reveals the difference between the standard price for mate – rials purchased and the amount actually paid for those materials. Thus, the follo wing formula applies: Materials Price Variance 5 (SP 2 AP) 3 AQ In applying the preceding formula, we shall assume that the quantity purchased and the quantity used are identical; additional fine-tuning of the formulas would be necessary i f such were not the case. The materials quantity variance reveals the difference between the standard cost of the standard quantity of materials that should have been used and the standard cost of the actual quantity of materials used. Thus, consider the following form ula: Materials Quantity Variance 5 (SQ 2 AQ) 3 SP In applying either of the preceding formulas, a negative result suggests an unfavorable variance, and vice versa. In other words, negative values produced by these formulations suggest that actual prices/quantities exceed standard prices/quantities. It is important for you to grasp more than just the formulas. It is good for you to also think in terms of favorable and unfavorable conditions by asking the following question: D oes this vari- ance create a favorable or unfavorable situation for the company? If there is an unfa – vorable price variance (actual . standard) and an unfavorable labor efficiency variance (actual . standard / budgeted), the total variance would also be unfavorable. In other words, a company does not want to pay more than standard cost for materials (price vari – ance) or use more than the standard requirement for materials. The preceding formulas are reinforced with an example. Assume that Bamboo Mat Com – pany produces a flat wooden panel that can be used as a serving tray or laptop desk. The only raw material that is needed for production—other than glues, sand paper, and stains that are treated as indirect materials—is strips of bamboo that are acquired from a dealer. In ideal circumstances, each panel requires 20 strips of bamboo that are aligned and glued together. There is normally some spoilage and wasted materials due to imperfections, c ut – ting errors, and so forth. Based on a careful analysis of the entire production process, the company believes that the standard amount of material per panel should be 23 strips of bamboo. Bamboo normally costs $0.25 per strip. During the month of February, Bamboo waL80281_07_c07_169-188.indd 5 9/25/12 1:03 PM CHAPTER 7 174 Section 7.2 General Variance Model Mat Company produced 5,000 mats. The company purchased and used 112,000 strips of bamboo, paying an average of $0.26 per strip. Table 7.1 reveals calculations of total actual and total standard costs for materials. Table 7.1: Total actual and total standard costs for materials Actual costStandard cost Strips purchased/used 112,000Strips that should have been used (5,000 3 23) 115,000 Per-unit price 3 0.26Per-unit price 3 0.25 Total actual cost $29,120 $28,750 The difference between actual cost of $29,120 and standard cost of $28,750 suggests an unfavorable overall variance of $370 ($28,750 2 $29,120). A casual inspection of the infor-mation suggests that the price per strip was higher than planned ($.026 actual vs. $0.25 standard), whereas less was used (112,000 strips actual vs. 115,000 strips standard) than anticipated. Thus, logic suggests an unfavorable material price variance and a positive materials quantity variance. Let’s look closely at the actual calculations of each variance: Materials Price Variance 5 (SP 2 AP) 3 AQ 5 ($0.25 2 $0.26) 3 112,000 5 ,$1,120. unfavorable Materials Quantity Variance 5 (SQ 2 AQ) 3 SP 5 (115,000 2 112,000) 3 $0.25 5 $750 favorable Notice that these two specific variances net ( ,$1,120. 1 $750) to the overall $370 unfa – vorable outcome. Although management might be concerned about having overspent by $370, that number provides little information for control. This explains the necessity of splitting the overall variance into its specific subcomponents. The indi vidual variances clearly identify that material usage rates are not a problem. The problem was with pric- ing; Bamboo Mat Company paid more than standard cost for each strip of material. This type of analysis allows management to focus on areas for improvement, which should be directed at attempting to improve the purchase price of raw material. One aspect that should always be considered is the possible interplay between price and quantity variances. It is possible that the higher priced material was o f better quality, contributing to less spoilage and waste. This would contribute to offsetting variances. Whatever the specific cause, management needs to explore variances and take corrective action as necessary. Impact on the Ledger Your understanding of variances should not stop with the basic calculations. It is also important to grasp their impact on the accounting system. Never lose sig ht of the fact that waL80281_07_c07_169-188.indd 6 9/25/12 1:03 PM CHAPTER 7 175 Section 7.2 General V ariance Model Bamboo Mat Company spent exactly $29,120 on materials. This is the amoun t that must be accounted for. However, under a standard cost system, inventory is recorded at its standard cost, as follows: 2-28-XXRaw Materials Inventory 28,000 Materials Price Variance 1,120 Accounts Payable 29,120 To record purchase of raw materials at standard price This entry records the raw materials at $28,000 (112,000 actual units purchased 3 $0.25 each), with the difference between that amount and the actual price being shown as a debit (unfavorable) to the Materials Price Variance account. If the company had purchased at less than standard price, a credit (favorable variance) would be needed to balance the entry. The clear intention is to record the raw materials inventory at the standard price, regardless of the actual price. Continuing, as the raw materials are put into process, the Work in Process account is deb – ited for the standard cost of the standard quantity that should be used, regardless of actual use. Differences between standard and actual usage are debited (unfavorable) or credited (favorable) to the Materials Quantity Variance account: 2-28-XX Work in Process Inventory 28,750 Raw Materials Inventory 28,000 Materials Quantity Variance 750 To transfer raw materials to production at standard In the preceding entry, it is important to note that Work in Process is debited for the stan – dard amount of material that was used, calculated at the standard price. Thus, the inven – tory accounts reflect measurements based on standards. The difference between actual and standard is reflected in variance accounts. The Materials Price Variances and Materi- als Quantity Variances are typically disposed of by reporting them as decreases in income (if unfavorable) or increases in income (if favorable). Other methods for closing out vari – ance accounts are possible, and these are usually covered in advanced accounting courses. Variances Relating to Direct Labor Direct labor variances are strikingly similar to direct materials variances. The overall dif – ference between actual direct labor cost and standard direct labor cost can reflect combi – nations of paying laborers more or less than standard wage rates and/or using more or less direct labor hours than anticipated. Thus, we can separate labor variances into rate and time components. waL80281_07_c07_169-188.indd 7 9/25/12 1:03 PM CHAPTER 7 176 Section 7.2 General V ariance Model The labor rate variance reveals the difference between the standard rate and actual rate for the actual labor hours worked. The following formula applies: Labor Rate Variance 5 (SR 2 AR) 3 AH In this formula, SR is the standard labor rate per hour, AR is the actual labor rate per hour, and AH is the actual hours worked. The labor time variance compares the standard hours of direct labor that should have been used to the actual hours worked: Labor Time Variance 5 (SH 2 AH) 3 SR As with the materials variances, negative results for labor variances suggest unfavorable variances, and vice versa. In other words, negative values mean that actual wage rates and/or hours exceeded standard rates/hours. Let’s continue with our illustration for Bamboo Mat Company. The bamboo strips must be glued together, sanded, and stained. Each mat is anticipated to require 45 minutes of labor by employees who are paid $12 per hour. Recall that 5,000 mats were produced dur – ing February. The standard number of hours of labor required for this level of production is 3,750 hours (5,000 mats 3 3/4 of an hour per mat). At $12 per hour, the standard cost of labor for the month was $45,000 (3,750 hours 3 $12 per hour). Bamboo Mat’s direct labor actually cost $42,350, resulting in an overall favorable variance of $2,650 ($45,000 standard vs. $42,350 actual). What the overall variance does not reveal is the cause of the favorable outcome. Was the result due to lower hourly wage rates, better employee efficiency, or a combination of factors? The rate and time variances will reveal the answers: Labor Rate Variance 5 (SR 2 AR) 3 AH 5 ($12 2 $11) 3 3,850 5 $3,850 Labor Time Variance 5 (SH 2 AH) 3 SR 5 (3,750 2 3,850) 3 $12 5 ,$1,200. The rate variance is favorable by $3,850. This reflects that Bamboo Mat Company hired less skilled employees at only $11 per hour rather than $12. This benefit was slightly off- set by an unfavorable time variance. The less skilled laborers took longer to complete the necessary tasks, as revealed by the actual hours of 3,850. Generalizing, labor variances should be examined as to their root causes. For example, suppose a unionized company hired inexperienced workers during a strike. Although the direct labor rate variance might be favorable (by hiring employees below t he union pay scale), it is also highly likely that the labor time variance will reflect poorly (assuming inexperienced employees cannot work as fast). Unfavorable labor time variances may also be due to poorly motivated or trained workers, poor materials or faulty equipment, poor supervision, and scheduling problems. Management should be held accountable for this outcome because many of the root causes are traced to the degree of supervision, plan – ning, and training that go into production management. An issue that these variances will not reveal is the quality of workmanship. If a favorable labor variance is the product of working faster and cheaper, quality can suffer. A company waL80281_07_c07_169-188.indd 8 9/25/12 1:03 PM CHAPTER 7 177 Section 7.2 General V ariance Model must clearly assess all aspects of business performance. Nonetheless, th e labor variances are vitally important in measuring and monitoring costs associated with di rect labor. Impact on the Ledger Bamboo Mat Company can also record its labor variances in the accounting system. The entry for labor variances is actually simpler than that for inventory. Labor costs flow directly to Work in Process Inventory at standard cost (there is no account equivalent to the Raw Materials Inventory as was needed to track materials). The f ollowing entry reflects the standard labor cost, the actual labor obligation, and the differences being charged (when unfavorable) or credited (when favorable) to the labor variance accounts: 2-28-XXWork in Process Inventory 45,000 Labor Time Variance 1,200 Labor Rate Variance 3,850 Wages Payable 42,350 To charge Work in Process for the standard direct labor cost, and record both labor variances As with materials variances, the labor variances typically cause an incr ease (favorable) or decrease (unfavorable) in a company’s income during the period in which they occur. Variances Related to Factory Overhead In addition to direct material and direct labor, production processes also require indirect material, indirect labor, and all of the other costs associated with the production facilities. As you know, this last category is described as factory overhead. Control of factory over – head cost is also important and the subject of additional standards and variance analy – sis. Advanced managerial accounting courses may introduce you to alternative theories about how to calculate and interpret overhead variances. There are two-, three-, and four- variance approaches. The reason for this topic’s complexity relates to the comingling of the application base (e.g., applying overhead based on labor hours) with the overhead cost pool. The following discussion introduces a frame of reference for considering fac – tory overhead variances, but detailed coverage is best deferred to advanced accounting courses, which are likely to devote considerable coverage to this complex topic. Variable overhead consists of items such as indirect material, indirect labor, and factory supplies. Fixed factory overhead typically relates to expenditures such as rent, deprecia – tion, insurance, and maintenance. Like any other expense category, a company may spend more or less on these items than planned. This is especially true if a business finds that it is producing more or less than budgeted. The goal of the overhead variances is to sort out and explain the reasons for deviations from standard costs. Let’s continue with our example for Bamboo Mat Company. Prior to the beginning of the month of February, the company prepared a static budget for its overhead expenditures (Table 7.2). waL80281_07_c07_169-188.indd 9 9/25/12 1:03 PM CHAPTER 7 178 Section 7.2 General Variance Model Table 7.2: Static budget for overhead expenditures Budgeted overhead Variable factory overhead$22,500 Fixed factory overhead 9,000 Total factory overhead $31,500 This budget was based on an assumed production level of 4,500 units. These units should require 3,375 hours of direct labor hours, using the previously discussed rate of 3/4 hours per unit. Bamboo Mat Company applies overhead to production based on direct labor hours. This means that the variable overhead application rate is $6.67 per direct labor hour ($22,500 / 3,375), and the fixed overhead application rate is $2.67 per direct labor hour. The primary purpose of the overhead budget is deriving these overhead application rates. Because 5,000 units were actually produced, the company would apply the amounts of overhead in Table 7.3 to production. Table 7.3: Amounts of overhead applied to production Applied overhead for 5,000 units Variable factory overhead (5,000 units 3 3/4 hours per unit 3 $6.67 per hour) $25,012.50 Fixed factory overhead (5,000 units 3 3/4 hours 3 2.67) 10,0 12.50 Total applied factory overhead $35,0 25 The applied overhead is debited to Work in Process. The difference between the amount applied and the amount actually spent constitutes the overall overhead variance. Assume that actual overhead expenses for the month of February were as stated in Table 7.4. Table 7.4: Actual overhead: February Actual factory overhead Variable factory overhead $24,500 Fixed factory overhead 9,800 Total factory overhead $34,300 The difference between actual factory overhead ($34,300) and applied overhead ($35,025) reflects an overall favorable variance of $725. Of course, a significant factor here is related to the increase in volume. The standard amount of applied fixed overhead is $10,012.50 (3,750 standard hours 3 $2.67 per hour fixed overhead application rate), but the budgeted amount is only $9,000. In other words, added volume results in an overapplication of fixed overhead of $1,012.50 . This is a favorable factory overhead volume variance and is not waL80281_07_c07_169-188.indd 10 9/25/12 1:03 PM CHAPTER 7 179 Section 7.3 Concluding Discussion on Variancesreally controllable; it is the by-product of using a predetermined application rate. In other words, more production is being squeezed from the anticipated fixed overhead expendi-ture. The difference between the $1,012.50 favorable volume variance and the $7 25 overall favorable variance means the remaining factory overhead controllable variance is $287.50 unfavorable. This $287.50 negative result can also be observed in that the company (1) spent $5 12.50 less on variable overhead (i.e., $24,500 actual vs. $25,0 12.50 that should have been spent for 5,000 units) and (2) spent $800 more on fixed overhead (i.e., $9,800 actual vs. $9,000 that should have been spent for any level of production). Impact on the Ledger As you suspect, the application of overhead to work in process must be journalized. The following entry reflects an increase in Work in Process for the applied overhead. The vari – ances are debited (unfavorable) and credited (favorable). The actual amount spent on overhead can be captured in several alternative ways. You have not yet been fully exposed to the accumulation and distribution of costs via a unique Factory Overhead account; for now, let’s simply reflect the actual expenditures via a credit to Cash. In Chapter 4, you were exposed to utilization of a Factory Overhead account for the accumulation and dis – tribution of these costs. 2-28-XX Work in Process Inventory 35,0 25 Controllable Overhead Variance 287.50 Overhead Volume Variance 1,012.50 Cash 34,300 To increase Work in Process for the amount of applied overhead, and allocate the difference between that and actual overhead to related variance accounts 7.3 Concluding Discussion on Variances M anagers must constantly monitor operations to ensure business success. This can entail comparing actual performance to budgets and standards. It is not sufficient to just determine that more or less is being spent than was planned. All deviations must be considered in the context in which they occur. Variance analysis is very helpful in pin – pointing the nature of positive and negative outcomes for all costs of production. Only by drilling down on specific variances can management determine what corrective actions are needed. waL80281_07_c07_169-188.indd 11 9/25/12 1:03 PM CHAPTER 7 180 Concept Check Concept Check The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.) 1. The term used for the differ ence between actual costs and the budgeted costs incurred for actual number of outputs is a. static budget variance. b. flexible budget variance. c.price variance. d. sales volume variance. 2. Flexible budgets assist management in measuring a. the sales volume variance. b. the efficiency of operations at actual levels of activity. c.the differ ence between standard quantities and expected quantities. d. the differ ence between standard prices and expected prices. 3. Assume that both an unfavorable direct material efficiency variance and a favor – able direct material price variance occur during the same production period. Choose the best explanation. a. Higher quality direct materials wer e purchased. b. Lower quality direct materials wer e purchased. c.A machine is out of alignment. d. Inexperienced, nonunion direct labor ers were used. 4. Which of the following actions would not help avoid an unfavorable sales volume variance? a. Incentives are pr ovided to the sales force in order to increase quantity of units sold. b. Improved packaging of pr oducts intended to appeal to broader market is imple – mented. c.Unit selling price is increased in or der to increase revenue. d. Advertising on the internet and television is expanded to broader market. 5. Recording direct materials usage in the production process requires a debit to work in process inventory for a. standard quantity for actual pr oduction times standard cost per bushel. b. actual quantity times actual cost per bushel. c.actual quantity times standard cost per bushel. d. standard quantity for actual pr oduction times actual cost per bushel. waL80281_07_c07_169-188.indd 12 9/25/12 1:03 PM CHAPTER 7 181 Critical Thinking Questions Critical Thinking Questions 1. Give one reason why dir ect material costs may be higher than expected. 2. Define “standards.” 3. Why is it important to sometimes use liberal estimates when establishing standards? 4. The foundation for variance analysis is the setting of standards. Explain. 5. Describe a favorable direct material variance. 6. Describe two primary variances that relate to dir ect materials. 7. Explain the potential connection between direct materials price variance and quantity variance. 8. Explain the potential connection between direct labor rate variance and labor time variance. 9. What is the goal of overhead variances? 10. How does management determine proper methods to corr ect negative variances? factory overhead controllable variance A calculation that explains additional deviations in factory overhead expendi- tures and helps to monitor and control operations. factory overhead volume variance A calculation that focuses on deviations from standards that are based on producing at levels that are above or below planned levels. labor rate variance A measurement that reveals the difference between the stan- dard rate and actual rate for the actual labor hours worked. labor time variance A measurement that compares the standard hours of direct labor that should have been used to the actual hours worked. materials price variance A measurement that reveals the difference between the standard price for materials purchased and the amount actually paid for those materials. materials quantity variance A measure- ment that reveals the difference between the standard cost of the standard quantity of materials that should have been used and the standard cost of the actual quan- tity of materials used. standards Predetermined expectations about the inputs that will be required to achieve anticipated output. Achievable standards represent realistic goals that are within reach. Ideal standards are meant to represent an ideal goal and hence give no room for mistake. Key Terms waL80281_07_c07_169-188.indd 13 9/25/12 1:03 PM CHAPTER 7 182 Exercises Exercises 1. Cost centers and profit centers Crest Manufacturing produces a single product at its Albany plant. Units are processed through departments A and B and then sent to finished goods. The firm has a maintenance department that performs repair jobs for the manufactur – ing departments. The maintenance operation has always been evaluated as a cost center. Now with a change in management, a switch to a profit center setup is being considered. Prices charged for repair jobs would be based on the maintenance department’s cost of operations. a. Discuss the differ ence between a cost center and a profit center. b. Mike Mizer, the head of maintenance, has always operated with a cost minimi – zation philosophy. Will the change to a profit center likely alter the quality of service provided by the maintenance department? Explain your answer. c. What will be the reaction of the manufacturing department changing to a profit center? Consider the probable effect on the number of service req uests when structuring your answer. 2. Flexible budgets and performance reports Home Products Inc. uses flexible budgeting for cost control and performance evaluations. A review of the company’s master budget found that management expects to produce 8,000 units each month, resulting in annual expenditures for direct labor and supervisory salaries of $307,200 and $806,400, respectively. Super – visory salaries, a fixed cost, are spread evenly throughout the year. If October ’s production amounted to 7,800 units, and a $2,900 unfavorable direct labor variance was reported, determine a. the actual direct labor cost that appear ed in the October performance report. b. the budgeted amount for supervisory salaries that appeared in the October per – formance report. 3. Variances for direct materials and direct labor Banner Company manufactures flags of various countries. Each flag has a standard of 8 square feet of fabric and 3 hours of direct labor time. Information about recent production activity follows: Actual cost of fabric: $4.50 per square foot Fabric consumed: 32,080 square feet Standard price per square foot of fabric: $4.25 Standard direct labor rate: $10.00 per hour Actual direct labor rate: $10.20 per hour Actual labor hours worked: 11,940 Actual production completed: 4,000 flags waL80281_07_c07_169-188.indd 14 9/25/12 1:03 PM CHAPTER 7 183 Problems a. Compute the materials price variance and the materials quantity variance . b. Compute the labor rate variance and the labor efficiency variance. 4. V ariance analysis: Working backward Auto Lube performs oil changes and other minor maintenance services (e. g., tire pressure checks and fluid checks). The company advertises that all services are completed in 15 minutes. Eighty cars were serviced on a recent Saturday, resulting in the following labor variances: rate, $18U; efficiency, $64U. If the labor rate stan – dard is $4 per hour, determine the a. standar d hours allowed for Saturday’s work. b. actual hours worked. c. actual wage rate. 5. Over head variances Nova Manufacturing applies factory overhead to products on the basis of direct labor hours. At the beginning of the current year, the company’s accountant made the following estimates for the forthcoming period: • Estimated variable overhead: $500,000 • Estimated fixed overhead: $400,000 • Estimated direct labor hours: 40,000 It is now 12 months later. Actual total overhead incurred in the manufacture of 7,900 units amounted to $895,100. Actual labor hours totaled 39,800. Assuming a direct labor standard of 5 hours per finished unit, calculate the following: a. V ariable overhead efficiency variance b. Fixed over head volume variance c. Over head spending variance Problems 1. Basic flexible budgeting Centron Inc. has the following budgeted production costs: Direct materials $0.40 per unit Direct labor 1.80 per unit Variable factory overhead 2.20 per unit Fixed factory overhead Supervision $24,000 Maintenance 18,000 Other 12,000 waL80281_07_c07_169-188.indd 15 9/25/12 1:03 PM CHAPTER 7 184 Problems The company normally manufactures between 20,000 and 25,000 units each quar- ter. Should output exceed 25,000 units, maintenance and other fixed costs are expected to increase by $6,000 and $4,500, respectively. During the recent quarter ended March 31, Centron produced 25,500 units and incurred the following costs: Direct materials $ 10,710 Direct labor 47,175 Variable factory overhead 51,940 Fixed factory overhead Supervision 24,500 Maintenance 23,700 Other 16,800 Total production costs $174,825 Instructions a. Pr epare a flexible budget for 20,000, 22,500, and 25,000 units of activity. b. W as Centron’s experience in the quarter cited better or worse than anticipated ? Prepare an appropriate performance report, and explain your answer. c. Explain the benefit of using flexible budgets (as opposed to static budgets) in the measurement of performance. 2. Setting standar ds Starr Manufacturing Corporation is considering the implementation of a s tandard costing system. The following information pertains to one of the company ’s prod – ucts, HD-24: Direct materials used* $1,020,000 Direct labor – 348,000 Other traceable variable costs Blending costs $ 148,000 Packaging materials 40,700 Miscellaneous 74,000 262,700 Total variable costs $1,630,700 *240,000 gallons at $4.25 per gallon. -58,000 hours at $6.00 per hour. waL80281_07_c07_169-188.indd 16 9/25/12 1:03 PM CHAPTER 7 185 Problems These costs were incurred in the production of 185,000 gallons of HD-24, which were packaged 4 gallons to a case. Starr has been experiencing problems with the quality of materials used and plans to change suppliers in the forthcomi ng period. The price per gallon of direct materials is expected to rise to $4.40. The company anticipates that HD-24 output will total 80% of the direct materials used in produc- tion; the remainder is lost through evaporation. Management estimates that abnormal production problems in the prior period led to the incurrence of an additional 2,500 labor hours. These problems have been cor – rected and are not expected to recur. Other variable costs are anticipated to remain stable, with the exception of packaging materials. Packaging cost is exp ected to increase by $0.04 per gallon. Instructions a. By analyzing the data pr esented, compute an attainable standard variable cost for a case of HD-24. b. Compar e and contrast ideal and attainable standards. What benefits normally result from the use of attainable standards? c. Discuss several pr oblems that may be encountered in the standard-setting pro – cess by relying too heavily on past experience. 3. V ariance analysis and interpretation Imtex Manufacturing uses a standard costing system. The variable cost standards for product No. 628 follow: Direct materials: 3.2 pounds , $5 $16.00 Direct labor: 8.5 hours , $8 68.00 Variable overhead: 8.5 hours , $3 25.50 The company has been experiencing rough times of late, with constant complaints from customers about poor product quality. In addition, the production supervisor is very unhappy with the performance reports that he receives to monitor factory operations. A typical report appears as follows: waL80281_07_c07_169-188.indd 17 9/25/12 1:03 PM CHAPTER 7 186 Problems Imtex Manufacturing Performance Report for the Month Ended June 30, 20X3 ActualStandard Variance Direct costs* $XX,XXX$ XX,XXX $ XX,XXX Factory overhead XX,XXX XX,XXX XX,XXX Total $ XX,XXX $ XX,XXX $ XX,XXX *Direct materials + direct labor. In an effort to improve product quality, the supervisor has campaigned for a change to a better supplier and the hiring of more competent employees. He has recently been given permission to pursue both of these alternatives. Actual data follow: 1) Dir ect materials purchased and consumed amounted to 6,000 pounds at $5.80 per pound. 2) Dir ect labor incurred in the manufacture of 2,000 completed units totaled 15,400 hours at $10.50 per hour. 3) V ariable overhead incurred totaled $47,200. Instructions a. Suggest several ways that Imtex’s performance r eport could be improved to pro – vide better information for the supervisor. b. Pr epare a complete variance analysis for direct materials, direct labor, and vari – able overhead. Note: Compute the overhead spending variance with regard to variable overhead only. c. Does the pr oduction supervisor ’s plan seem to be working? Discuss. 4. Basic flexible budgeting Paragon Inc. normally manufactures between 36,000 and 42,000 units each month. A static budget based on 36,000 units and actual results for April follows: Budget Actual Direct materials $172,800$175,900 Direct labor 270,000 258,000 Variable factory overhead 115,200 109,000 Supervision 105,000 82,600 Insurance & taxes 60,000 61,500 Depreciation 84,000 88,000 $807,000 $775,000 waL80281_07_c07_169-188.indd 18 9/25/12 1:03 PM CHAPTER 7 187 Problems Conversations with Paragon’s accountant revealed the following information: 1) April’s pr oduction totaled 35,000 units. 2) Supervision, insurance and taxes, and depr eciation are fixed costs. 3) Should pr oduction fall below 36,000 units, supervision costs are expected to be reduced by $20,000 because of temporary layoffs. Instructions a. Pr epare a flexible budget for 36,000, 39,000, and 42,000 units of activity. b. Pr epare a performance report for April that can be used to judge Paragon’s suc – cess or failure in meeting budgeted targets. Comment on your findings. c. Explain the flexibility that is associated with a flexible budget. 5. Straightforwar d variance analysis Arrow Enterprises uses a standard costing system. The standard cost sheet for product No. 549 follows: Direct materials: 4 units , $6.50 $ 26.00 Direct labor: 8 hours , $8.50 68.00 Variable factory overhead: 8 hours , $7.00 56.00 Fixed factory overhead: 8 hours , $2.50 20.00 Total standard cost per unit $170.00 The following information pertains to activity for December: 1) Dir ect materials acquired during the month amounted to 26,350 units at $6.40 per unit. All materials were consumed in operations. 2) Arr ow incurred an average wage rate of $8.75 for 51,400 hours of activity. 3) T otal overhead incurred amounted to $508,400. Budgeted fixed overhead totals $1.8 million and is spread evenly throughout the year. 4) Actual pr oduction amounted to 6,500 completed units. Instructions a. Compute Arrow’s direct material variances. b. Compute Arrow’s direct labor variances. c. Compute Arrow’s variances for factory overhead. waL80281_07_c07_169-188.indd 19 9/25/12 1:03 PM CHAPTER 7 waL80281_07_c07_169-188.indd 20 9/25/12 1:03 PM
chapter 6 Budgeting Learning Objectives • Understand the need for, nature of, and benefits associated with budgeting. • Know about organizational behavior dimensions of the budgeting process. • Know the components of a master budget. • Be familiar with alternative types of budget cycles. • Understand the concepts and methods associated with flexible budgeting and how technology can enhance budgeting and planning. istockphoto waL80281_06_c06_141-168.indd 1 9/25/12 1:03 PM 142 Section 6.1 Purpose of Budgeting Chapter Outline 6.1 Purpose of Budgeting 6.2 Benefits of BudgetingResponsibility Accounting Budgets Drive Efficiency Human Behavior 6.3 Budgeting Drawbacks Quality Estimates The Comprehensive Budget Sales and Cash Collections Budgets 6.4 Production Budget Purchases and Payments for Materials Direct Labor Budget Factory Overhead Budget SG&A Budget Budgeted Income Statement Cash Budget Distribution of Budgets Budget Cycles 6.5 Flexible Budgets Using Flexible Budgets in Business Management Considering Per-Unit Costs and Profit Impacts Extending Flexible Budgeting 6.6 Benefits of Technology in Budgeting 6.1 Purpose of Budg eting I f you have worked in a medium to large-sized organization, you have probably had some level of involvement with a budget and the budget process. Although many may not see the need for a budget, and often question the value of the entir e exercise, by the end of this chapter it is hoped that you will appreciate the importance of budgeting. The substantial positive benefits of budgeting usually offset and justify the time and effort. Budgets are detailed financial plans that quantify future expectations and actions. These expectations and actions relate to numerous facets of business, including planned sales, staffing needs, acquisition of materials to support production, financing, and expendi – tures for plant assets. Budgets are important in proper control of all facets of business operation. They provide benchmarks against which to compare actual results, establish guidelines for expenditures, and may be used to establish forward-looking guidance to persuade investors and creditors to invest or lend to a business. waL80281_06_c06_141-168.indd 2 9/25/12 1:03 PM CHAPTER 6 143 Section 6.2 Benefits of Budgeting 6.2 Benefits of Budgeting A large organization is complex. There are many people and parts that must be coordi- nated to work together in a cohesive manner. As such, the budget becomes a vital tool for both communicating expected outcomes and coordinating the actions of all factors of production. Only through a budget can abstract and general plans be converted into spe – cific goals and objectives. Satisfaction of the budgetary guidelines is expected to result in fulfillment of the identified goals and objectives. When things do not g o as planned, the budget is the tool that provides a mechanism for identifying and focusing on departures from the plan. The budget provides the benchmarks against which to judge success or failure, and it facilitates timely corrective measures. Responsibility Accounting Responsibility accounting is a term meaning that units and their managers are held accountable for transactions and events under their direct influence and control. Budgets should be aligned with units of responsibility. This results in a push down of budgeted revenues and expenses to lower levels within the organization. It becomes difficult to avoid accountability for outcomes when budgeted results are not met. Each unit must assume responsibility for meeting its plan. This forces managers to pay attention to sales results, cost controls, and organization efficiency. Deviations are not always suggestive of the need for corrective actions, but they do require unit managers to explain outcomes. Very few businesses have unlimited resources. Indeed, most businesses face constraints. There are more opportunities than available capital permits pursuing. Thus, it is com mon for unit managers to compete for budgetary allocations from within the available resource pool. For example, each business unit may have employees desiring a pay raise, equip – ment in need of updating, new projects that require startup funding, and so forth. The sum of the resource demands can easily exceed the anticipated level of access to funds. A successful manager is one who can make a strong case for his or her resource needs, understand the needs of other units, and ultimately adopt a strategy tha t meshes his or her unit’s plan with the greater needs of the overall organization. Once the business plan is agreed upon, a successful manager will support the plan and work for the or ganization’s ultimate success. Many managers have difficulty with these concepts, and they respond by working divisively by constantly fighting against the adopted busines s plan. The bud – get reflects the adopted business plan quantitatively. Only by having all team members support the plan can organizational effectiveness be maximized. Budgets Drive Efficiency An organization is made more efficient by improved rates of throughput in the procure – ment, production, and customer delivery process. You have probably witnessed a pro – duction bottleneck. Maybe you have been frustrated at a fast-food restaurant when a particular food item was not ready to meet customer demand. The entire operation can bog down over one missing ingredient. You probably concluded that the business was rapidly losing current and future business because of the situation. Most business opera – tions are subject to these types of constraints. Interestingly, the budget process plays a major role in avoiding these problems. As you will soon see, the comprehensive budget attempts to include planning considerations to ensure that all factors of production are waL80281_06_c06_141-168.indd 3 9/25/12 1:03 PM CHAPTER 6 144 Section 6.2 Benefits of Budgeting available when needed. Budgets allow managers to learn in advance of potential bottle – necks; advance knowledge is a key to solving and avoiding business const raints. Without a well-thought-out budget, an organization will suffer from inefficiencies. The budget serves a vital role in planning for success. This is true in personal affairs as well as in running a business. It is also true for other types of entities, such as municipalities, state governments, churches, not-for-profit hospitals, and countless other organizations. Accordingly, the budget process should be taken quite seriously. Unfortunately, such is not always the case. As you will see in the ensuing discussion, human behavior traits can at times interfere with an optimal budget process. One needs to be aware of these attributes and contemplate their effects. You see, managerial accounting is more than just number crunching. Human Behavior A large business may form a budget committee with senior representatives from each business unit. These individuals should possess knowledge about all phas es of business operations. They should be able to provide insight into sales and production. Their role also includes being an advocate to make the case for resources needed by their business unit. Their initial charge may be to formulate budget guidelines and gather data necessary to formulate the preparation of a comprehensive budget. However, many organizations extend the committee’s work to include a monitoring role. In this context, the committee will meet regularly throughout the period to monitor progress against the budget, and it will make suggestions for budgetary and operational revisions. Be aware that the budget committee’s recommendations are strikingly influential to the fate of an organization. The work of the budget committee includes a significant communication co mponent. In some organizations, the budget information will flow from senior management down through the organization. Other organizations attempt to pull information up from within. These different approaches have earned the alternative monikers of top–down or bottom–up budgeting. The top–down approach to budgeting begins with upper level management establish – ing guidelines that the budget committee is intended to instill in the o rganization. These guidelines cover topics such as anticipated sales, acceptable expenditur e levels and rates, and policies for compensation adjustments. Mid- and lower level personne l have almost no input in goal setting. Their role in constructing the budget consists mainly of compil – ing numerical data in support of the given corporate goals. The top–d own approach can foster resentment because the budget is viewed as dictatorial. Such budgets can also intro – duce ethical challenges when lower level managers feel forced to meet unrealistic targets given to their units. However, an advantage is that the top–down approach serves to give the organization a clear picture of expectations at the top, which then translates its way down into the entire organization. Top–down budgets can set the tone for the organiza – tion and signal expected sales and production activity that the organization is supposed to reach. All parties should be in a position to know top managements’ overall goals and, it is hoped, understand the parameters that are put in place for achievement of those goals. The bottom–up approach is highly participative. Top management initiates the budget process by providing general guidelines, but it is the lower level employees who are pri – marily responsible for developing the budget. Individual budgets from lower levels are waL80281_06_c06_141-168.indd 4 9/25/12 1:03 PM CHAPTER 6 145 Section 6.3 Budgeting Drawbacks compiled to form divisional budgets, which are in turn regrouped at successfully higher levels within the organization. Top management’s budget committee eventually receives the overall plan. The committee reviews this document and identifies areas in need of coordination and revision. As you would suspect, it often becomes necessary to engage in several iterations of asking specific units within the organization to fine-tune their indi- vidual budgets. Because this type of budget is prepared by those with the best knowledge of their units, it can provide for a more realistic and accurate plan. Performance evalua- tion is enhanced because it removes the excuse that the original budget was unrealisti – cally imposed from higher up. Proponents of the bottom–up approach claim a number of benefits leading to positive effects on employee performance. A primary benefit is that the budget is at least partially self-imposed, generating improved morale and results. Cer – tainly, the approach is more in keeping with contemporary team-based theories about optimization of an organization. 6.3 Budgeting Drawbacks Y ou should be aware of certain drawbacks with budgeting. A bottom–up approach to the budget preparation process can be very time-consuming. This entails added cost. Employees can become frustrated with planning tasks, especially when they are addition – ally under pressure to continue to produce products and meet customer needs. Managers may use a bottom–up approach to try to pad their budgets. Human behavior suggests that participants in the budget process will attempt to create a cushion in their budget by underestimating expected sales and overestimating anticipated costs. In other words, they try to leave room in the budget to ensure that they will meet their goals. This phenomenon can be particularly acute when bonuses are tied to actual versus budgeted results. Padding does little to advance organizational efficiency. In addition, padding of planned expenses may induce wasteful overspending. Managers may fear a future loss of funding if they do not spend all budget amounts. This problem seems to be amplified in governmental entities that lack a revenue/profit motive. The managerial accountant’s engagement with budgeting entails considerable skill and judgment to maximize benefits t o the entity. At the opposite end of the spectrum, a top–down approach can introduce unattainable guidelines for revenues and expenses. When employees believe that they have no chance of achieving a budget, they may feel frustrated and capitulate to an attitude of certain failure. They may cease to try and may even engage in wasteful activities. Thi s is akin to fielding a team for the second half of a game when the first half went s o badly that there is no chance to win. Performance typically suffers. You probably never thought of budgeting as an exercise in organizational psychology, but that is certainly the case. Quality Estimates Budgets require significant speculation about future conditions. Thus, a certain amount of error is unavoidable. That the future is unknowable can result in the budget team becoming cavalier about its prognostications. This trap is to be avoided. Although many things about the future cannot be known with certainty, there is ample past information on which to build forward-looking models. Such models should be based on reason and logic, not haphazard guesswork. Careful study, statistical analysis, macroeconomic data and forecasts, and similar tools all provide a strong foundation on which to formulate and evaluate budgets. waL80281_06_c06_141-168.indd 5 9/25/12 1:03 PM CHAPTER 6 146 Section 6.3 Budgeting Drawbacks Often, the starting point for constructing a budget is the prior year ’s budget. One assumes previous budgets have been constructed with great diligence. Adjustments to prior bud- gets are made based on observed prior variances and new information about futur e expec – tations. This results in a new budget that is equivalent to an old budget, plus or minus indicated changes. This overall budgeting framework is termed incremental budgeting. An entirely different approach is known as zero-based budgeting. With the zero-based approach, no planned expenditure is protected by the status quo. Each budget item must be justified during each budget cycle. This is a time-consuming and expe nsive way to develop a budget, and many will question whether cost savings that can b e identified via the process are justified by the effort. Thus, business managers should view such a method as useful but perhaps one that should be used on a selective basis. Consider that this approach can be deployed on a rolling basis that only periodically causes the complete reexamination of budgets within specific business units or related to specific product lines. The Comprehensive Budget A comprehensive budget (or master budget) is the cornerstone documentation revealing a business’s anticipated sales, expenses, financial needs, and so for th. The comprehen – sive budget is actually a compilation of a number of individual budgets. The lynchpin is the sales budget. Once anticipated sales are factored in, you have a benchmark for logi – cally planning production and selling, general, and administrative components. In turn, production data are central to determining the need for materials and labor, as well as establishing the benchmark for the application of factory overhead. You can think of the comprehensive budget as a compilation of numerous individual interlocking blocks, as shown in Exhibit 6.1: Exhibit 6.1 SALES BUDGET PRODUCTION BUDGET SG&A BUDGET FA CTORY OVERHEAD BUDGET MATERIALS BUDGET LABOR BUDGET Budget Building Blocks waL80281_06_c06_141-168.indd 6 9/25/12 1:03 PM CHAPTER 6 147 Section 6.3 Budgeting Drawbacks The budget blocks shown in Exhibit 6.1 can also be linked to their incom e statement and cash (financial) impacts, as will be shown in the following illustrations. Budgeted financial statements are often seen as the culmination of the budgeting process. Quite obviously, a business must have a pathway to successful future performance as reflected in a thought- ful budget. In addition to the operating budget components, businesses m ay extend their budgets to plan for major capital expenditures. Decisions related to capital budgeting are discussed in a later chapter. Considerable effort is needed to coordinate the construction of a comprehensive bud – get. It guides actions over the entire budget period and all phases of activity, including purchasing, staffing, and most other resource procurement and deployment actions. For most organizations, the comprehensive budget begins with an assessment of anticipated sales. The expected level of sales defines production activities as well as the expected selling, general, and administrative expenditures. Production activities are broad. They encompass purchasing of materials, deployment of labor, and allocation of overhead. In addition, consideration must be given to the beginning and ending invent ory levels of materials and finished goods. All plans must be dovetailed to match the cash flow of the organization as well as expected financial statement outcomes. As you will soon see, the comprehensive budget is composed of a series of individual budgets, all of which dovet ail together in a cohesive manner. Sales and Cash Collections Budgets As noted previously, the comprehensive budget begins with a projection of sales. Antici – pated activity is incorporated into a sales budget. The determination of anticipated vol – ume should be based on prior sales patterns, economic conditions, compet itive actions, and so forth. Where a company has multiple products, consideration must be given to each. You will soon see how projected sales drive the budgets for all other factors of pro – duction; in this regard, it can become quite important to know the exact product mix that is contemplated within the sales budget. By now, you clearly understand that sales do not necessarily equal cash collec tions. There are often delays between the date of sale (on account) and conversion of the transaction to cash (i.e., collection). A company needs knowledge of both. Whereas sales drive pro – duction levels, cash flow is necessary to support production. Thus, the comprehensive budget process requires mapping of both sales and collections. How this occurs is best demonstrated with an example. Exhibit 6.2 is the sales and cash collections budget for Wheat Treat. Wheat Treat produces a very large specialized bread roll for use at banquets and weddings. The company is experiencing significant growth. waL80281_06_c06_141-168.indd 7 9/25/12 1:03 PM CHAPTER 6 148 Section 6.4 Production Budget Exhibit 6.2 Notice that the upper portion of Exhibit 6.2 begins with expected sales, in units. Each unit is anticipated to sell for $7.50. Thus, the determination of quarterly s ales is not particularly difficult. The anticipated cash collections require a bit more explanation. Assume that cus- tomers are given credit terms, and the normal result is that 60% of sales in each quarter are collected within the quarter. The remaining 40% are presumed to be collected in the following quarter. Looking closely at the second quarter, note that total sales are forecast at $450,000. Sixty percent of $450,000 is $270,000, which is shown as cash collections from the second quarter ’s sales. The other 40% of $450,000, or $180,000, is shown as collect ed in the third quarter. This allocation of sales to cash collections is repeated for each quarter (collec – tions in the first quarter would relate to sales from the last quarter of the prior year, which are not shown here). Wheat Treat’s sales and cash collections are fairly straightforward. You can well imagine that the complexity could increase if collection activities spanned longer periods of time, including the possibility of uncollectibles. Also, note that the quarterly effects are compiled into an annual total within the final column. Although this exhibit is informative, it is only the point of beginning in the budget construction process. 6.4 Production Budget T he sales, in units, are carried forward from the sales budget into the production bud – get. It should be obvious why sales are a key driver in the decision about how many units to produce. However, beginning and ending inventory are also important to con – sider. Budgeted unit production level is reflective of units sold, plus desired ending fin – ished goods inventory, minus beginning finished goods inventory. Very simply, in units, the following formula applies: Planned Production 5 Sales 1 Desired Ending Inventory 2 Beginning Inventory 50,000 $ 7.50 $ 375,000 $ 225,000 140,000 $ 365,000 SALES: Units X Sales price per unit Estimated sales COLLECTIONS: Fr om current quarter sales Fr om prior quarter sales Cash collections 1st Quarter WHEAT TREAT Sales and Cash Collections Budget For the Year Ending December 31, 20X4 60,000 $ 7.50 $ 450,000 $ 270,000 150,000 $ 420,000 2nd Quarter 65,000 $ 7.50 $ 487,500 $ 292,500 180,000 $ 472,500 3rd Quarter 80,000 $ 7.50 $ 600,000 $ 360,000 195,000 $ 555,000 4th Quarter 255,000 $ 7.50 $ 1,912,500 $ 1,812,500 Annual Recap waL80281_06_c06_141-168.indd 8 9/25/12 1:03 PM CHAPTER 6 149 Section 6.4 Production Budget Exhibit 6.3 shows the production budget for Wheat Treat. The planned ending finished goods inventory for each quarter may appear as a random amount. However, careful inspection for Wheat Treat reveals that it plans to end each quarter with an inventory of 20% of the next quarter ’s anticipated sales (e.g., third quarter sales of 65,000 units 3 20% 5 13,000 ending inventory for the second quarter). Thus, a systematic pr ocess can be fol – lowed to arrive at the various inventory levels. Test your understanding of this concept by looking at the fourth quarter. What can you infer about the company’s planned sales for the first quarter of 20X5? The answer is 100,000 units (20,000/20%). Exhibit 6.3 Purchases and Payments for Materials Purchases of materials are driven by the level of production. Continuing the Wheat Treat example, the next budget component appears to be a bit more intimidating, but only because it involves more computations. The concepts are straightforward. To begin, each quarter ’s scheduled production is carried forward from the preceding budget. An addi – tional fact is that each finished unit requires 10 pounds of raw materials. Thus, you can understand how the total raw material needs are to be calculated. Of course, raw material that is needed for production is not synonymous with purchases of raw materials. One must take into account beginning and ending raw materials. Here, it is assumed that each quarter begins with raw materials sufficient to produce 10% of the quarter ’s needs. Look at Exhibit 6.4, and carefully note how materials needed, plus the desired ending stock, minus the beginning stock, results in an amount equal to anticipated purchases for the period. 50,000 12,000 62,000 (10,000) 52,000 Quarterly sales in units Planned ending finished goods Units needed Less: Beginning finished goods Production le vel 1st Quarter WHEAT TREAT Pr oduction Budge t For the Year Ending December 31, 20X4 60,000 13,000 73,000 (12,000) 61,000 2nd Quarter 65,000 16,000 81,000 (13,000) 68,000 3rd Quarter 80,000 20,000 100,000 (16,000) 84,000 4th Quarter 255,00020,000 (10,000) 265,000 Annual Recap waL80281_06_c06_141-168.indd 9 9/25/12 1:03 PM CHAPTER 6 150 Section 6.4 Production Budget Exhibit 6.4 The raw materials purchases must be multiplied by the price per unit to arrive at the expected cost of raw material purchases. Last, it is again important to consider the cash flows necessary for the direct material purchases. This illustration presumes that cash payments required will be 75% of those purchases made within the quarter of purchase (e.g., second quarter purchases of $92,550 3 75% 5 $69,413) and 25% in the next follow – ing quarter (e.g., second quarter purchases of $92,550 3 25% 5 $23,138). The cash pay – ments in the first quarter, related to the prior quarters purchases, are simply assumed in this illustration. Direct Labor Budget The direct labor budget calculations are relatively simple. Potential complications might relate to developing staffing plans to meet the needs identified within the direct labor budget. This could expand to include the human resources department as it relates to plans for additional hiring or reductions in force. Exhibit 6.5 reveals that each unit of production requires one-quarter hour of direct labor, and direct labor costs $11 per hour. There are no “beginning” and “ending” direct labor hours that can be stored up. And, as is typically the case, labor is generally paid as incurred (weekly, biweekly, or monthly). Thus, it is assumed that cash paid for direct labor is equivalent to the direct labor cost for each quarter, and thus the cash flow needs are equal to the cost of direct labor. 52,000 10 520,000 61,000 581,000 (52,000) 529,000 $ 0.15 $ 79,350 PURCHASES: Scheduled production X Raw materials per unit (lbs.) T otal ra w material needs (lbs.) Plus: Target ending ra w material Total units needed (lbs.) Less: Target beg. raw material Raw material purchases (lbs.) X Estimated cost per pound Cost of ra w material purchases 1st Quarter WHEAT TREAT Direct Materials Budget For the Year Ending December 31, 20X4 61,00010 610,000 68,000 678,000 (61,000) 617,000 $ 0.15 $ 92,550 2nd Quarter 68,000 10 680,000 84,000 764,000 (68,000) 696,000 $ 0.15 $ 104,400 3rd Quarter 84,000 10 840,000 89,000 929,000 (84,000) 845,000 $ 0.15 $ 126,750 4th Quarter 265,000 10 2,650,000 89,000 2,739,000 (52,000) 2,687,000 n/a $ 403,050 Annual Recap 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Annual Recap For current quarter purchases For prior quarter purchases Cash payments for materials PA YMENTS: $ 59,513 15,000 $ 74,513 $ 69,413 19,838 $ 89,251 $ 78,300 23,138 $ 101,438 $ 95,063 26,100 $ 121,163 $ 386,36 5 waL80281_06_c06_141-168.indd 10 9/25/12 1:03 PM CHAPTER 6 151 Section 6.4 Production Budget Exhibit 6.5 Factory Overhead Budget Wheat Treat’s factory overhead budget is presented in Exhibit 6.6. The company’s over – head consists of both variable and fixed components. The variable overhead is expected to be $0.80 per direct labor hour. The fixed factory overhead is expected to be $19,875 per quarter. All of this would be determined based on a careful analysis of the company’s cost structure. Exhibit 6.6 In Exhibit 6.6, notice that the variable overhead driver was considered to be direct labor hours. The direct labor hours were derived by reference to the direct labor budget. Also, notice that $2,500 of the amount incurred for overhead was related to depreciation. Because depreciation does not consume cash, it is subtracted from each quarter ’s total overhead to arrive at the amount of cash that is needed to support overhead costs each period. 52,000 0.25 13,000 $ 11.00 $ 143,000 Scheduled production X Direct labor hours per unit Total direct labor hours X Cost per direct labor hour Cost of direct labor 1st Quarter WHEAT TREAT Direct Labor Budget For the Year Ending December 31, 20X4 61,0000.25 15,250 $ 11.00 $ 167,750 2nd Quarter 68,000 0.25 17,000 $ 11.00 $ 187,000 3rd Quarter 84,000 0.25 21,000 $ 11.00 $ 231,000 4th Quarter 265,000 0.25 66,250 $ 11.00 $ 728,750 Annual Recap 13,000 $ 0.80 $ 10,400 19,875 $ 30,275 (2,500) $ 27,775 Direct labor hours X Va riable factory ov erhead rate Total va riable factory ov erhead Fixed factory ov erhead Total factory ov erhead Less: Depreciation Cash paid for factory ov erhead1st Quarter WHEAT TREAT Factory Overhead Budget For the Year Ending December 31, 20X4 15,250 $ 0.80 $ 12,200 19,875 $ 32,075 (2,500) $ 29,575 2nd Quarter 17,000 $ 0.80 $ 13,600 19,875 $ 33,475 (2,500) $ 30,975 3rd Quarter 21,000 $ 0.80 $ 16,800 19,875 $ 36,675 (2,500) $ 34,175 4th Quarter 66,250 $ 0.80 $ 53,000 79,500 $ 132,500 (10,000) $ 122,500 Annual Recap waL80281_06_c06_141-168.indd 11 9/25/12 1:03 PM CHAPTER 6 152 Section 6.4 Production Budget In a later chapter, you will learn about applying factory overhead in determining a prod- uct’s full cost, so this is an excellent point to begin to introduce this concept. Notice that Wheat Treat is anticipating $132,500 of total overhead. If, as is often the case, overhead is applied based on direct labor hours, then the total overhead application rate would be $2 per hour ($132,500 divided by 66,250 hours). This $2 is included in th e schedule shown in Exhibit 6.7, which shows the calculation of per-unit cost at $4.75. The per-unit amounts for direct materials and direct labor were derived in prior schedules. Likewise, we previously noted that the company plans to end the year with 20,000 units in invent ory. Thus, one is able to project the dollar cost of ending inventory. Exhibit 6.7 SG&A Budget Wheat Treat will also need to develop a selling, general, and administrative exp enses (SG&A) budget. SG&A usually contains both variable and fixed components. Variable components can include shipping costs, sales commissions, and other cost s that tend to vary based on sales volume or other potential measures of activity. Wheat Treat’s bud – get is based on the assumption that each unit sold triggers an additiona l $1.25 in cost (Exhibit 6.8). The fixed SG&A components tend to include management and clerical sala – ries, planned advertising campaigns, the costs associated with office space, insurance, and similar unavoidable costs that are not a function of business volume (over the relevant planned range of operations). Wheat Treat is planning for $30,000 per quarter, divided between salaries, office, and other costs. The budget is based on an assumption that all SG&A costs are all funded in cash as incurred. 10 lbs. 0.25 hours 0.25 hours Cost Component Direct material Direct labor Applied factory ov erhead X Units in ending finished goods inventory Ending finished goods inventory Units WHEAT TREAT Ending Finished Goods Inventory For the Year Ending December 31, 20X4 $ 0.15 $ 11.00 $ 2.00Per Unit Cost $ 1.502.75 0.50 $ 4.75 20,000 $ 95,000 Per Unit Total waL80281_06_c06_141-168.indd 12 9/25/12 1:03 PM CHAPTER 6 153 Section 6.4 Production Budget Exhibit 6.8 Budgeted Income Statement At this juncture, there are numerous individual budgets. Although they are interesting and perhaps useful at lower levels of operation and management, we are lacking an over – all picture of company-wide expectations. For instance, is the company expected to be profitable? To answer important “macrolevel” questions requires drawing together the individual budgeting building blocks into a comprehensive picture. Exhibit 6.9 is the bud – geted income statement for Wheat Treat for 20X4. Exhibit 6.9 50,000 $ 1.25 $ 62,500 $ 20,000 8,000 2,000 $ 30,000 $ 92,500 Estimated units sold X Per unit va riable SG&A Total va riable SG&A Fixed SG&A Salaries Office Other Total fixed SG&A Total budgeted SG&A 1st Quarter WHEAT TREAT Selling, General, and Administrative Budget For the Year Ending December 31, 20X4 60,000 $ 1.25 $ 75,000 $ 20,000 8,000 2,000 $ 30,000 $ 105,000 2nd Quarter 65,000 $ 1.25 $ 81,250 $ 20,000 8,000 2,000 $ 30,000 $ 111,250 3rd Quarter 80,000 $ 1.25 $ 100,000 $ 20,000 8,000 2,000 $ 30,000 $ 130,000 4th Quarter 255,000 $ 1.25 $ 318,750 $ 80,000 32,0008,000 $ 120,000 $ 438,750 Annual Recap Sales Cost of goods sold Beginning finished goods Cost of goods manufactured Goods av ailable for sale Less: Ending finished goods inventory Cost of goods sold Gross profit SG&A Income before interest and taxes Interest Income before taxes Income taxe s Net income $ 47,500 1,258,750 $1,306,250 $ 95,000 $1,912,500 1,211,250 $ 701,250 438,750 $ 262,500 2,000 $ 260,500 60,500 $ 200,000 WHEAT TREAT Budgeted Income Statement For the Year Ending December 31, 20X4 waL80281_06_c06_141-168.indd 13 9/25/12 1:03 PM CHAPTER 6 154 Section 6.4 Production Budget The information in the income statement was derived from various portions of the previ – ous budgets, along with a few added assumptions. To help you understand the income statement amounts, please refer to the notes in Table 6.1. Table 6.1: Additional assumptions Sales Annual recap within sales budget Beginning finished goods Last year’s ending finished goods (assumed) Cost of goods manufactured Production budget quantity times per-unit cost from inventory schedule (265,000 3 $4.75) Goods available for saleSubtotal Ending inventory Inventory schedule Cost of goods sold Subtotal Gross profit Subtotal SG&A Annual recap within SG&A budget Income before interest and taxes Subtotal Interest Assumed amount Income before taxes Subtotal Income taxes Assumed provided by tax department Net income Subtotal The budgeted income statement is essential for allowing management to kn ow the expected outcome for the period. With this information, management knows whether operational adjustments are necessary to ensure satisfactory performance for the year. Furthermore, as deviations from budget take place, management is keenly positioned to know what the effect will be on the overall performance of the enterprise. Imagine tryin g to anticipate future outcomes without a comprehensive budget. Perhaps you can begin to appreciate why the budget process is indeed so important to business success. Cash Budget Another macrolevel view of the enterprise’s expectations can be derived by reference to the cash budget. Although we now know that Wheat Treat is looking forward to a $200,000 profit, we do not yet know much about its cash flows. You might be surprised to find that Wheat Treat will actually run out of cash unless the company makes plans for additional borrowings! How can this be? Begin by looking at the cash budget shown in Ex hibit 6.10. waL80281_06_c06_141-168.indd 14 9/25/12 1:03 PM CHAPTER 6 155 Section 6.4 Production Budget Exhibit 6.10 Without an adequate supply of cash, a business’s plans cannot be realized. Even success- ful businesses can occasionally find themselves squeezed. Causes include delays in col- lecting receivables and capital expenditure decisions. Wheat Treat is expecting both. You have already seen the reconciliation of sales to cash receipts in a prior schedule. Also notice that the second quarter of the year involves a land purchase for $150,000. Given these fac – tors, the company expects a second quarter cash shortage of $66,363. By knowing this in advance, and being able to explain why it is not a systemic problem, the company should be able to arrange for borrowings to bridge over the anticipated shortfall. This planned bor – rowing is reflected in the lower portion of the schedule. By the fourth quarter, operations have generated sufficient cash to repay half of the loan and all of the accrued interest. It is perhaps obvious at this point, but each value (e.g., cash receipts) is taken from one of the prior budgets. The only exceptions relate to the assumed values for beginning cash, the land purchase, and the schedule borrowings/repayments. Take time to relate the val – ues to previous schedules. Distribution of Budgets Budgets are normally prepared for internal use only. Nevertheless, external financial statement users may have a keen interest in knowing what they reveal. Investors and lenders surely would prefer to know what management is thinking about the future, as reflected in budgets. Businesses would not normally choose to make such information broadly available. However, in special circumstances, such as a condition of a loan, a business may conclude that its best interests are served by revealing its internal projec – tions. When this occurs, professional standards include fairly complex disclosure rules, including language noting that the company is not vouching for the achie vability of $ 50,000 365,000 $ 415,000 $ 74,513 143,00027,775 92,500 10,000 – $ 347,788 $ 67,213 – – – $ 67,213 Beginning cash balance Plus: Customer receipts Av ailable cash Less: Disbursements Direct materials Direct labor Factory ov erhead SG&A Ta xes Land purchase Total Disbursements Cash surplus/(deficit) Financing: Planned borrowing Planned repayment Interest on repayment Ending cash balance 1st Quarter WHEAT TREAT Cash Budget For the Year Ending December 31, 20X4 $ 67,213420,000 $ 487,213 $ 89,251 167,750 29,575 105,000 12,000 150,000 $ 553,576 $ (66,363) 100,000– – $ 33,638 2nd Quarter $ 33,638472,500 $ 506,138 $ 101,438 187,00030,975 111,250 18,000 – $ 448,663 $ 57,475 – – – $ 57,475 3rd Quarter $ 57,475555,000 $ 612,475 $ 121,163 231,00034,175 130,000 20,500 – $ 536,838 $ 75,638 – (50,000) (2,000) $ 23,638 4th Quarter $ 50,0001,812,500 $ 1,862,500 $ 386,365 728,750 122,500 438,750 60,500 150,000 $ 1,886,865 $ (24,365) 100,000 (50,000) (2,000) $ 23,635 Annual Recap waL80281_06_c06_141-168.indd 15 9/25/12 1:03 PM CHAPTER 6 156 Section 6.5 Flexible Budgets the results. Notwithstanding that assertion, the involved accountant neverthe less has a duty to prepare the reports carefully and to possess a reasonable basis for the assump- tions utilized in preparing the information. Public companies will sometimes provide forward-looking guidance to their shareholders, but it is invariably accompanied by additional cautionary language. Budget Cycles You will normally see budgets that are prepared for specific time intervals. These budgets may relate to a month, quarter, year, or other clearly identifiable time period. Sometimes, the budget may relate to a natural business cycle. For example, a wheat farmer ’s crop does not follow a calendar year. What use could one make of a calendar year budget in this case? The budget would clearly need to relate to the time period extending from at least planting through harvest. In other business environments, a budget may be continuous in nature. Such budgets are constantly being updated to reflect the addition of future months or quarters. With the completion of one period, another period is pulled into the budget. This rolling approach allows management better insight into business adaptations that are needed for changing economic conditions. 6.5 Flexible Budgets T he comprehensive budget illustration you just studied presumed a static budget. In other words, the budget was developed for a single level of activity. A shortcoming of this approach is that it is insensitive to volume fluctuations. This presents special chal – lenges for managing a business and for performance evaluation. As actual output varies from the anticipated level, significant deviations in revenues and expenses will naturally occur. These variances can produce quite misleading signals. For example, if a company produces and sells more products than anticipated, you would also expect an increase in selected variable expenses. This will appear as a cost overrun when actual results are com – pared to the static budget. Although the natural response to a cost overrun is to assume that this is a bad thing, it may well be that the growth signifies great success. The opposite effects can also be true. Adjusting budgets and budget models for the effects of volume fluctuations is the goal of flexible budgeting. A flexible budget can best be explained with a simple example. Assume that Old Time Dominoes manufactures simulated ivory dominoes. Direct materials are budgeted to cost $1 per set, direct labor is budgeted at $0.50 per set, and variable factory overhead is antici – pated to run $0.70 per set. The company plans for fixed factory overhead of $12,000 per month. The middle column of Exhibit 6.11 reveals the details of the $34,000 monthly bud – get, based on the usual anticipated production run of 10,000 sets. waL80281_06_c06_141-168.indd 16 9/25/12 1:03 PM CHAPTER 6 157 Section 6.5 Flexible Budgets Exhibit 6.11 During May, Old Time Dominoes received a large order from a company that wanted to award sets of dominoes to employees as a thank-you gift. The company was ple ased with the added business but disturbed by the unfavorable budget variances. Fo r most expense categories, the company seems to have spent more than was budgeted, producing several unfavorable indicators. Because of the added volume, the company actually produced 11,000 sets of dominoes. This is not apparent in the preceding report. The company actually needs to prepare a flexible budget to understand better the effectiveness of its cost control. A flexible budget will reveal the amount of expenses that are anticipated for the given level of production. The following example shows that variable costs are “budgeted” at a higher overall level. Because production was 10% greater than normal, so are the budgeted variable expense components within the middle column in Exhibit 6.12. Exhibit 6.12 The flexible budget outcomes paint an entirely different conclusion. There were only slight deviations from budget, as revealed by the variances related to selected expense catego – ries. This information is probably far more useful for performance evaluation purposes. $ 11,000 5,100 7,900 $ 24,000 11,500 $ 35,500 Va riable expenses: Direct materials Direct labor Va riable factory ov erhead Total va riable expenses Total factory ov erhead Total manufacturing costs Actual OLD TIME DOMINOES Expense Budget For the Month Ending May 31, 20XX $ 10,0005,000 7,000 $ 22,000 12,000 $ 34,000 Budget $ (1,000)(100) (900) $ (2,000) 500 $ (1,500) Variance $ 11,000 5,100 7,900 $ 24,000 11,500 $ 35,500 Va riable expenses: Direct materials Direct labor Va riable factory ov erhead Total va riable expenses Total factory ov erhead Total manufacturing costs Actual (11,000 sets) OLD TIME DOMINOES Flexible Expense Budget For the Month Ending May 31, 20XX $ 11,0005,500 7,700 $ 24,200 12,000 $ 36,200 Budget (11,000 sets) $ –400 (200) $ 200 500 $ 700 Va riance waL80281_06_c06_141-168.indd 17 9/25/12 1:03 PM CHAPTER 6 158 Section 6.5 Flexible Budgets Using Flexible Budgets in Business Management A flexible budget can be prepared either before or after actual production is known. Pre- paring a flexible budget “after the fact” may help explain variances and aid in performance evaluation, but it does little to facilitate corporate planning. For planning purposes, it is better to prepare the flexible budget (or a financial model of the anticipated outcomes ) in advance. By anticipating fluctuations in volume, a business is empowered to anticipate needed adjustments to materials and labor. Exhibit 6.13 is an example of a flexible budget that contemplates outcomes based on four different possible outcomes. Exhibit 6.13 Considering Per-Unit Costs and Profit Impacts The preceding perspective on flexible budgeting focused on total costs. These data can be modified for analysis purposes. One modification is to calculate per-unit costs, as shown in Exhibit 6.14. Exhibit 6.14 In Exhibit 6.14, the total manufacturing costs were divided by the total units, yielding a calculation of per-unit cost. It is immediately apparent that per-unit cost declines as vol – ume increases. This occurs because the fixed cost pool is spread across more units. This $ 9,000 4,500 6,300 $ 19,800 12,000 $ 31,800 Va riable expenses: Direct materials Direct labor Va riable factory ov erhead Total va riable expenses Total factory ov erhead Total manufacturing costs Budget (9,000 sets) OLD TIME DOMINOES Flexible Expense Budget/Alternative Scenarios For the Month Ending May 31, 20XX $ 10,0005,000 7,000 $ 22,000 12,000 $ 34,000 Budget (10,000 sets) $ 11,0005,500 7,700 $ 24,200 12,000 $ 36,200 Budget (11,000 sets) $ 12,0006,000 8,400 $ 26,400 12,000 $ 38,400 Budget (12,000 sets) $ 9,000 4,500 6,300 $ 19,800 12,000 $ 31,800 $ 3.53 Va riable expenses: Direct materials Direct labor Va riable factory ov erhead Total va riable expenses Total factory ov erhead Total manufacturing costs Total manufacturing costs per unit (total cost divided by units)OLD TIME DOMINOES Flexible Expense Budget/Per Unit Cost Assessment For the Month Ending May 31, 20XX $ 10,0005,000 7,000 $ 22,000 12,000 $ 34,000 $ 3.40 $ 11,000 5,500 7,700 $ 24,200 12,000 $ 36,200 $ 3.29 $ 12,000 6,000 8,400 $ 26,400 12,000 $ 38,400 $ 3.20 Budge t (9,000 sets) Budget (10,000 sets) Budget (11,000 sets) Budget (12,000 sets) waL80281_06_c06_141-168.indd 18 9/25/12 1:03 PM CHAPTER 6 159 Section 6.5 Flexible Budgets extended analysis enables a better understanding of the need to fully ut ilize fixed capacity to generate maximum efficiency. Furthermore, the tool can facilitate logical pricing deci- sions. You have probably heard how giant retailers such as Wal-Mart drive tough business deals to get low prices from their suppliers. One reason suppliers are willing to respond is because the orders tend to be quite large, enabling them to squeeze maximum efficiency out of their existing cost structure. Another advantage of flexible budgeting is that it aids overall profitability analysis. Con – sider Exhibit 6.15, which is based on an assumed selling price of $10 pe r set. Exhibit 6.15 This report adds information to the flexible budget about sales in dollars. Th e net of the total sales and total manufacturing costs reflects the amount of income that will be avail – able to cover anticipated SG&A costs and provide for a profit margin. The managers of the manufacturing operation may not be provided with information about SG&A, and their flexible budget may stop at the point shown in the preceding budget. However, at higher levels with the organization, more may be known about (including responsibility for) SG&A costs, and the flexible budget could be expanded to include information about these costs. Extending Flexible Budgeting For simplicity, the flexible budget illustration in this chapter reveals aggregated amounts. In actuality, a flexible budget would usually resemble the comprehensive budget. The comprehensive flexible budget would permit a drill down to the smallest level s of oper – ational detail. This information would allow management to pinpoint exac tly where operational efficiencies and inefficiencies are occurring, thereby providing an excellent tool for performance evaluation. When performance evaluation is only based on a static bud – get, there is a reduction in incentive to drive sales increases. This occurs because increases in volume tend to produce greater costs that may appear as unfavorable variances. $ 90,000 $ 9,000 4,500 6,300 $ 19,800 12,000 $ 31,800 $ 58,200 Total Sales Va riable expenses: Direct materials Direct labor Va riable factory ov erhead Total va riable expenses Total factory ov erhead Total manufacturing costs Income av ailable to cover SG&A OLD TIME DOMINOES Income to Cover SG&A For the Month Ending May 31, 20XX $ 100,000 $ 10,0005,000 7,000 $ 22,000 12,000 $ 34,000 $ 66,000 $ 110,000 $ 11,000 5,500 7,700 $ 24,200 12,000 $ 36,200 $ 73,800 $ 120,000 $ 12,000 6,000 8,400 $ 26,400 12,000 $ 38,400 $ 81,600 Budget (9,000 sets) Budget (10,000 sets) Budget (11,000 sets) Budget (12,000 sets) waL80281_06_c06_141-168.indd 19 9/25/12 1:03 PM CHAPTER 6 160 Section 6.6 Benefits of T echnology in Budgeting 6.6 Benefits of Technology in Budgeting B y now, it has surely occurred to you that computers are most helpful in preparing budget information, especially as it relates to flexing the budget for constant changes in volume and cost. The budget preparation is not nearly as tedious and costly as it once was. In the past, building a budget required a number of iterative rounds of information sharing such that each level within an organization found it necessary to do and redo its financial plans based on new information and directives. Today’s electronic tools and budgeting models provide embedded links such that the slightest tweak by one unit is transferred into the budget models deployed by other units. Modern business information systems are often highly sophisticated. Budget data, although not central to a traditional general ledger system, are nonetheless incorporated into a sophisticated modern database of accounting information. These sy stems include real-time feedback on budget versus actual performance, often in graphical form. Further – more, budgeted expenditures can be reflected as authorization “tags,” thereby expediting execution of approved business purchases (i.e., approved expenditures have a shortened purchasing cycle requiring less management action for final approval). Indeed, electronic data interchange between companies and their suppliers and custom – ers facilitates an interlocking of selected budgeting data. As product demand increases or decreases, computerized flexible budgets can be adjusted on a real-time basis to send signals throughout the modern organization (including electronic data interchange with suppliers). The net result is that the supply chain is immediately adjusted to match raw material orders to anticipated production levels, thereby eliminating significant waste. The presence of a sophisticated supply chain management system is a hallmark f eature of today’s successful business. For example, inventory investment is minimized in an optimal manner. Furthermore, obsolescence is greatly reduced. Computer systems are designed to adjust purchases automatically based on real-time flow of goods all the way through to an end customer. Surely you have noticed the proliferation of chain stores such as Best Buy, Lowes, Bed Bath and Beyond, and Kohl’s. One feature they all have in com – mon is a robust information system in support of their supply chain management. De spite their gigantic size, they probably have a better pulse on their business volume and prod – uct flow than any “mom-and-pop” one-location retailer. It is fair to say that the growth of these retail giants would not have occurred without modern technology in support of their business processes. You can easily think of their information technology as the “ulti – mate” in perfecting business performance via a real-time flexible budget. waL80281_06_c06_141-168.indd 20 9/25/12 1:03 PM CHAPTER 6 161 Concept Check Concept Check The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.) 1. Pr eparing the comprehensive budget begins with consideration of a. dir ect labor budget. b. ending inventory levels. c. cash disbursements. d. anticipated sales. 2. Calculating fixed unit manufacturing costs r esults in a. constant unit costs as pr oduction increases. b. constant unit costs as pr oduction decreases. c. incr easing unit costs as production increases. d. incr easing unit costs as production decreases. 3. Which of the following will r esult in a direct materials efficiency variance that is not favorable? a. The actual unit cost of dir ect materials exceeds the standard cost of direct materials. b. The actual cost per unit of dir ect materials was less than the standard cost of direct materials. c. The actual quantity of dir ect materials used per unit exceeds the standard quan – tity of direct materials allowed per unit. d. The actual quantity of dir ect materials used per unit is less than the standard quantity of direct materials allowed per unit. 4. Parno Fitters has beginning inventory of 15,000 units. Sales ar e expected to be 41,000 units. The anticipated ending inventory is 12,500 units. How many units must be produced? a. 41,500 b. 46,000 c. 38,500 d. 43,500 5. Pr eparation of the cash budget takes all but which of the following items into con – sideration? a. Depreciation expense b. Cash r eceived from customers c. Inventory payments d. Payments to suppliers waL80281_06_c06_141-168.indd 21 9/25/12 1:03 PM CHAPTER 6 162 budget committee An entity within a company that can be made up of senior representatives from each business unit. Their role includes being an advocate to make the case for resources needed by their business unit. budgets Detailed financial plans that quantify future expectations and actions. comprehensive budget The cornerstone documentation revealing a business’s anticipated sales, expenses, financial needs, and so forth. It is sometimes referred to as the master budget. flexible budgeting Adjusting budgets and budget models for the effects of volume fluctuations. incremental budgeting Overall budgeting framework in which the previous year ’s budget is used as a starting point. responsibility accounting A term mean- ing that units and their managers are held accountable for transactions and events under their direct influence and control. zero-based budgeting An approach in which no planned expenditure is protected by the status quo. Each budget item must be justified during each budget cycle. Critical Thinking Questions Key Terms Critical Thinking Questions 1. Briefly discuss the advantages of budgeting. 2. Is a budget a planning tool, a contr ol tool, or both? Explain. 3. When evaluating performance, many or ganizations compare current results with the actual results of previous accounting periods. Is an organization that follows this approach likely to encounter any problems? Explain. 4. Explain how a budget assists in coor dinating the plans of an organization’s various subunits (divisions, departments, and so forth). 5. Define and fully explain the top–down appr oach to budgeting. 6. Briefly discuss the concept of slack as it pertains to budgeting. 7. Calabr o Corporation, a manufacturer with annual sales approaching $75 million, is beginning the budget process for the upcoming year. Should Calabro use long-term budgets, yearly budgets, or monthly budgets? Explain your answer. 8. Why is an accurate sales for ecast so important in the preparation of a master budget? 9. Why is it necessary to car efully budget direct labor requirements for an upcoming period? 10. Explain how a cash budget leads to ef fective management of an organization’s cash balances. waL80281_06_c06_141-168.indd 22 9/25/12 1:03 PM CHAPTER 6 163 Exercises Exercises 1. Overview of the budgeting pr ocess Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why. a. When assessing curr ent performance, a comparison of actual results against a predetermined budget is generally preferred over a comparison of the current period’s actual results with those of the preceding period. b. Lower level managers ar e inclined to work harder to achieve budgeted targets if the top–down (rather than the bottom–up) budget approach is used. c. V irtually all budgets are 1 year in duration. d. Land & Sea plans to sell 36,700 units of its single pr oduct during the coming year. If the beginning and ending finished goods inventories are 15,900 and 17,700 units, respectively, the company’s production budget will reveal that 38,500 units should be manufactured. e. The last step in the constr uction of a master budget is the preparation of a cash budget. 2. Schedule of cash collections Sugarland Company sells a single product and anticipates opening a new facility in Charlotte on May 1 of the current year. Expected sales during the first 3 months of activity are as follows: May, $60,000; June, $80,000; and July, $85,000. Thirty percent of all sales are for cash; the remaining 70% are on account. Credit sales have the following collection pattern: Collected in the month of sale 60% Collected in the month following sale 35 Uncollectible 5 a. Pr epare a schedule of cash collections for May through July. b. Compute the expected balance in Accounts Receivable as of July 31. 3. Dir ect material purchases budget Bass Corporation manufactures a home video recorder that requires four No. S1326 circuit boards. Anticipated production of recorders for the upcoming year follows: Quarter Production (units) First 8,000 Second 10,000 Third 12,000 Fourth 16,000 waL80281_06_c06_141-168.indd 23 9/25/12 1:03 PM CHAPTER 6 164 Exercises Bass wants to stock enough circuit boards to meet 30% of the following quarter ’s production needs. Circuit boards cost $2.50 each; the cost has been fairly stable dur- ing the past 6 months. Assuming a beginning circuit board inventory of $23,750, prepare a direct material purchases budget for the first three quarters of the year. 4. Pr oduction and cash-outlay computations RPR Inc. anticipates that 120,000 units of product K will be sold during May. Each unit of product K requires four units of raw material A. Actual inventories as of May 1 and budgeted inventories as of May 31 follow: May 1 May 31 Product K (units) 55,00060,000 Raw material A (units) 40,00037,000 Each unit of raw material A costs $8; RPR pays for all purchases in the month of acquisition. Invoices that account for 80% of the cost of materials acqu ired will be paid within 10 days of receipt, entitling the company to a 2% cash discount. a. Determine the number of units of pr oduct K to be manufactured in May. b. Compute the May cash outlay for pur chases of raw material A. 5. Abbr eviated cash budget; financing emphasis An abbreviated cash budget for Big Chuck Enterprises follows: July AugustSeptember Beginning cash balance $ 10,000 $ ? $ ? Add: Cash receipts 50,00063,000 71,000 Deduct: Cash payments (64,000) (58,000) (64,000) Cash excess (deficiency) before financing $ (4,000) $ ? $ ? Financing Borrowing to maintain minimum balance ? ?? Principal repayment ??? Interest payment ? ? ? Ending cash balance $ ? $ ? $ ? waL80281_06_c06_141-168.indd 24 9/25/12 1:03 PM CHAPTER 6 165 Problems Big Chuck wants to maintain a $10,000 minimum cash balance at all times. Additional financing is available (and retired) in $1,000 multiples at a 12% interest rate. Assume that borrowings take place at the beginning of the month; retirements, in contrast, occur at the end of the month. Interest is paid at the time of repaying principal and computed on the portion of principal repaid. a. Find the unknowns in Big Chuck’s abbr eviated cash budget. b. Determine the outstanding loan balance as of September 30, after any r epay – ments have been made. Problems 1. Pr oduction and purchases budgets; purchasing policy Mason Inc. manufactures and distributes various parts for lawn mowers. The com – pany’s main product, a bilateral assembly, requires five units of direct material at a cost of $0.60 per unit. To keep production moving smoothly, the firm must main – tain a direct materials inventory equal to 70% of the following month’s production needs. Sales projections in units for the past 6 months of 20X6 follow: Month Estimated sales July 9,000 August 12,000 September 16,000 October 22,000 November 29,000 December 26,000 Management wants to carry a finished goods inventory equal to 40% of t he follow- ing month’s sales. On June 30, 20X6, the finished goods inventory t otaled 3,200 assemblies. On the same date, 30,000 units of direct material were in the warehouse. Instructions a. Pr epare a production budget for July through September. b. Pr epare a direct material purchases budget for July through September. c. List several factors that could cause a change in the company’s pr esent direct material inventory policy. 2. Cash budget for service enterprise; analysis of operations The Eastside Tennis Club frequently experiences cash flow difficulties, with its checking account often below a desired minimum balance of $12,000. The follow – ing information pertains to club operations for the upcoming year (20X2): waL80281_06_c06_141-168.indd 25 9/25/12 1:03 PM CHAPTER 6 166 Problems 1) The dir ectors anticipate that 400 memberships will be sold. Family memberships ($150) will comprise 60% of this total; the remainder are individual memberships ($50). 2) Members ar e assessed hourly fees for court time; the rate depends on whether usage occurs during “prime” time or “regular” time. The following hours and rates are expected: 3) Prime timeRegular time Rate per hour $ 10$ 7 Hours of use 4,300 6,500 4) W ith the exception of accounts that total $2,500, all billings for member ships and court fees are expected to be collected during the year. 5) John Connors, club pr o, is paid a salary of $20,000 plus 20% of all court fee revenues. Connors gives private lessons and expects to earn an additional $3,500. Lesson fees are paid directly to Connors by the participating members. 6) Expenses incurr ed during 20X1 were as follows: maintenance, $34,000; utilities, $13,500; and taxes, $6,200. Maintenance and utilities are expected to increase by 10% during 20X2; taxes should amount to $6,800. All expenses will be paid when incurred. 7) An examination of the club’s r ecords revealed outstanding accounts payable of $1,000 on January 1, 20X2. These amounts will be paid by the end of February. 8) The addition of one new court and impr oved lighting will cost $45,000. The club will pay $20,000 down, with the remaining balance financed by a short- term note. Interest and principal payments during 20X2 will amount to $3,600. 9) The cash balance on January 1, 20X2, amounts to $5,000. Instructions a. Pr epare a cash budget for 20X2 for the Eastside Tennis Club. Disregard financing (except for that noted in item 7) to meet minimum balance requirements. b. Assume that the budget r evealed an ending cash balance of $4,400. In light of the club’s target minimum of $12,000, what actions could the directors take to improve the ending cash position? waL80281_06_c06_141-168.indd 26 9/25/12 1:03 PM CHAPTER 6 167 Problems 3. Compr ehensive budgeting The balance sheet of Watson Company as of December 31, 20X1, follows: WATSON COMPANY Balance Sheet December 31, 20X1 Assets Cash $ 4,595 Accounts receivable 10,000 Finished goods (575 units 3 $7.00) 4,025 Direct materials (2,760 units 3 $0.50) 1,380 Plant & equipment $50,000 Less: Accumulated depreciation 10,000 40,000 Total assets $ 60,000 Liabilities & Stockholders’ Equity Accounts payable to suppliers $ 14,000 Common stock $25,000 Retained earnings 21,000 46,000 Total liabilities & Stockholders’ equity $ 60,000 The following information has been extracted from the firm’s accounting records: 1) All sales ar e made on account at $20 per unit. Sixty percent of the sales are collected in the month of sale; the remaining 40% are collected in the following month. Forecasted sales for the first 5 months of 20X2 are as follows: January, 1,500 units; February, 1,600 units; March, 1,800 units; April, 2,000 units; and May, 2,100 units. 2) Management wants to maintain the finished goods inventory at 30% of th e following month’s sales. 3) W atson uses four units of direct material in each finished unit. The direct material price has been stable and is expected to remain so over the next 6 months. Management wants to maintain the ending direct materials inventory at 60% of the following month’s production needs. 4) Seventy per cent of all purchases are paid in the month of purchase; the remaining 30% are paid in the subsequent month. 5) W atson’s product requires 30 minutes of direct labor time. Each hour of direct labor costs $7. waL80281_06_c06_141-168.indd 27 9/25/12 1:03 PM CHAPTER 6 168 Problems Instructions a. Rounding computations to the near est dollar, prepare the following for January through March: 1) Sales budget 2) Schedule of cash collections 3) Pr oduction budget 4) Dir ect material purchases budget 5) Schedule of cash disbursements for material pur chases 6) Dir ect labor budget b. Determine the balances in the following accounts as of Mar ch 31: 1) Accounts Receivable 2) Dir ect Materials 3) Accounts Payable waL80281_06_c06_141-168.indd 28 9/25/12 1:03 PM CHAPTER 6

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