23

OPERATIONAL
BUDGETING

Chapter Summary

The master budget can be a powerful tool for successful planning and control.
Organizations benefit from an effective budgeting process in several ways. First, the
budget assigns responsibility for decision-making to specific managers. Second, it
enhances the degree of planned coordination among organizational units. Third,
performance evaluation is improved since the budget assigns responsibility and allows
comparison between actual and expected outcomes.
The master budget is developed as a set of interrelated plans. These are derived
sequentially beginning with a sales forecast. The sales forecast leads to a production
schedule and an integrated set of manufacturing cost budgets. A plan for ending
inventory then leads to a budget for the cost of goods sold. Budgeting for operating
expenses completes the operating budget. With the operating budget in hand, we next
prepare a budgeted income statement. One of the objectives in so doing is to emphasize
that a firm may be profitable but cash poor due to the length of its operating cycle.
The cash budget is the key to identifying the points in the operating cycle causing
the cash flow problem. Development of the cash budget requires assumptions regarding
the timing of cash receipts and payments. These assumptions combined with the
operating budget yield the cash budget.
The chapter concludes with an illustration of flexible budgeting. This analysis
emphasizes that the flexible budget improves performance evaluation by isolating the
effects of unanticipated volume changes.

Learning Objectives

1. Explain how a company can be "profit rich, yet cash poor."

2. Discuss the benefits that a company may derive from a formal budgeting process.

3. Explain two philosophies that may be used in setting budgeted amounts.

4. Describe the elements of a master budget.

5. Prepare the budgets and supporting schedules included in a master budget.

6. Prepare a flexible budget and explain its uses.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

Financial and Managerial Accounting: The Basis for Business Decisions, 13e 89
Brief topical outline

A Profit rich, yet cash poor

1 Operating cash flows: the lifeblood of survival
B Budgeting: the basis for planning and control – see Case in Point
(page 950)
1 Benefits derived from budgeting
a Enhanced managerial responsibility
b Assignment of decision-making responsibility
c Coordination of activities
d Performance evaluation
2 Establishing budgeted amounts
a The behavioral approach – see Your Turn (page 951)
b The total quality management approach
c Selecting and using a budgeting approach – see Case in Point
(page 952)
3 The budget period – see Management Strategy (page 952)
4 The master budget: a package of related budgets
5 Steps in preparing a master budget
6 Preparing the master budget: an illustration
7 Operating budget estimates
a Manufacturing cost estimates
b The sales forecast
c Production budgets - see Your Turn (page 956)
d Manufacturing cost budgets
e Cost of goods manufactured and sold budget
f Finished goods inventory - see Your Turn (page 959)
g Selling and administrative expense budget
8 Budgeted income statement
9 Cash budget estimates
a Current payables budget
b Prepayments budget
c Debt service budget
d Budgeted income taxes
e Estimated cash receipts from customers
10 The cash budget - see Your Turn (page 965)
11 Budgeted balance sheets
12 Using budgets effectively
a Advance warning of and responsibility for decision-making -
see Case in Point (page 968)
b Coordination of the activities of departments
c A yardstick for evaluating management performance
13 Flexible budgeting

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

90 Instructor’s Resource Manual
 a Computers and flexible budgeting - see Case in Point (page
970)
C Concluding remarks – see A Second Look (page 970)

Topical coverage and suggested assignment

Homework Assignment
(To Be Completed Prior to Class)
Class Topical
Meetings Outline Discussion
on Chapter Coverage Questions Exercises Problems Cases Internet
1 A–B 1, 2, 3
2 B 4, 5, 6, 7 1, 2, 3, 4, 5 1, 2, 3, 4 1 1
3 B–C 8, 9, 10 6, 9, 10, 12 5, 6, 7, 9, 10 2

Comments and observations

Teaching objectives for Chapter 23

The topics presented in Chapter 23 are central to the managerial functions of planning
and control. Our teaching objectives in presenting these topics are to:

1 Discuss the benefits of budgeting to virtually every business organization.

2 Discuss whether budgets should be established at optimal levels or at reasonably

achievable levels.

3 Describe the elements of a master budget, and discuss the logical sequence of their
preparation.

4 Explain the necessity of using a computer in preparing the master budget for a large
organization. Extend this discussion into the preparation of flexible budgets and
budgets reflecting different assumptions.

5 Illustrate several basic computations of budgeted amounts, such as the budgeted

level of production (given a sales forecast and budgeted inventories), and budgeted
cash collections from customers (given a sales forecast and the pattern in which
receivables are collected).

6 Explain the limitations of a static budget for conducting performance evaluation.

7 Using the concepts of cost-volume-profit analysis, develop a flexible budget and

demonstrate how it is used to evaluate performance.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

Financial and Managerial Accounting: The Basis for Business Decisions, 13e 91
New features in Chapter 23

Our treatment of operational budgeting parallels that in our previous edition. We have
added a new introduction to illustrate that a business can be "profit rich, yet cash poor."
The new introduction also emphasizes that the budget assigns decision-making
responsibility to specific managers in the organization. This discussion motivates the
study of the remainder of the chapter. Our integrated illustration of the development of
the master budget is repeated from the previous edition.

General comments
In covering budgeting, it is important not to get "bogged down" in the computations of
budgeted amounts. With this in mind, the chapter is focused from the outset on the
importance of planning and controlling cash flows from operations. There are, of course,
an unlimited number of potential computations; it is not possible to illustrate them all.
Therefore, we usually illustrate only one or two of the "basic" types of budgeting
computations. Exercises 1 thru 9 are intended for this purpose. Case 1 provides an
opportunity for students to confront the interrelationships among budgeted financial
statements free from an excessive computational burden. We highly recommend
reviewing this case in class.
We also emphasize that in a large organization, the number of specific schedules
and budgets comprising the master budget requires the use of a computer in the
budgeting process. The computer is programmed with the "cost formulas" and the
interrelationships among budgeted amounts. Once this task is completed, the computer
can almost instantly develop every element of the budget from forecast sales data. In
addition, the budgeting software can be used to assess the expected impact of changes in
sales, production costs, or any of the other variables upon which the budget is based. The
original development of budgeting software is a formidable task. Once this software has
been developed, however, the time-consuming "number crunching" aspects of budgeting
are eliminated. Also, this software may be used for many years, requiring only minor
adjustments to cost formulas and interrelationships among the budgeted amounts.

An aside There is no more dramatic case of a profit rich - cash poor company than W.T.
Grant, Inc. in the years leading up to its liquidation in 1976. In each of the nine years
prior to declaring bankruptcy, the company reported positive net income. However, it
experienced negative cash flows from operations as it continued to invest in unsalable
inventory and uncollectible receivables. The history of this failed corporation is an
object lesson in the importance of budgeting cash flows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

92 Instructor’s Resource Manual
Supplementary Exercises

Business Week Exercise

In “Detroit: Pedal To The Metal”, Business Week, January 12, 2004, the author
states the big three US auto makers are filling showrooms with new cars to beat back
foreign rivals. Failure to revive car sales would almost certainly force domestic auto
makers to close more factories. So US auto makers have been investing heavily in new
car models. GM has been plunging two-thirds of its annual $7 bill product-development
budget into cars to years ago, about what trucks had been receiving until then. List some
budget-line items that would be included in GM’s product-development budget for cars
and trucks.

Group Exercise

(To complete this exercise, at least one group member must have basic
knowledge of the use of personal computer and spreadsheet software.) Reconsider
Problems 23-9 and 23-10. Using an electronic spreadsheet such as Lotus 1-2-3 of Excel,
develop automated models to solve these problems. Your worksheets should be able to
recompute the flexible budget for any level of volume within a relevant range.
Demonstrate the operation of the computerized flexible budget to the class.

Internet Exercise

Read “Managers to Watch”, Business Week, January 12, 2004. Newly elected
Governor Arnold Achwarzenegger settled for smaller cuts in a balanced-budget
amendment that goes before voters in March 2004 and terminated a car-tax hike. The
Governor still needs to trim $14 billion from spemding. How do you think the budgeting
process for state and local governments and municipalities would differ from the
corporate budget process.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

Financial and Managerial Accounting: The Basis for Business Decisions, 13e 93
CHAPTER 23 NAME #

10-MINUTE QUIZ A SECTION

Indicate the best answer for each question in the space provided.
1 Which of the following is not normally a characteristic of a profit rich, cash poor
company?
a Low inventory turnover.
b High accounts receivable turnover.
c High operating income, but low cash flow from operations.
d A long operating cycle.

2 Which of the following is not considered a benefit from budgeting?

a Limited managerial perspectives.
b Advance warning of problems.
c Better coordination among activities.
d A measure of performance evaluation.

3 Which of the following is a characteristic of the behavioral approach to setting

budget targets?
a Complete elimination of inefficiency.
b Complete elimination of non-value-adding activities.
c Constant need for improvement.
d Achievable performance expectations.

4 Which of the following is not normally considered an element of a master budget?

a The production schedule.
b The employee turnover budget.
c The operating expense budget.
d The cash budget.

5 Which budget typically serves as a starting point in developing a master budget?

a The sales budget.
b The cost of goods sold budget.
c The employee turnover budget.
d The manufacturing cost budget.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

94 Instructor’s Resource Manual
CHAPTER 23 NAME #

10-MINUTE QUIZ B SECTION

Use the following data for questions 1 through 3.

The following budget for the 80,000-unit product level was prepared for the
Production Department for September:

Budgeted
(80,000 Units)
Variable costs:
Direct materials cost......................................................................... $ 32,000
Direct labor....................................................................................... 40,000
Variable overhead............................................................................. 24,000
Fixed costs:
Manufacturing overhead................................................................... 56,000
Total manufacturing costs.................................................................... $152,000
During September, the Production Department actually produced 90,000 units at a
total manufacturing cost of $162,000.

1 Refer to the above data. Which of the following is not an accurate amount to be
included in a flexible budget prepared for the 90,000-unit level of production?
a Total overhead cost, $83,000.
b Total manufacturing costs, $168,000.
c Direct materials, $36,000.
d Direct labor, $45,000.
2 Refer to the above data. A performance report prepared for September operations
under a flexible budget approach would show:
a Actual costs under budget by $2,000.
b Total costs per flexible budget of $171,000.
c Actual costs under budget by $8,000.
d Actual costs over budget by $10,000.
3 Refer to the above data. The cost-volume relationship used to prepare the flexible
budget for this department includes:
a Manufacturing overhead cost of $0.80 per unit.
b Fixed cost of $0.70 per unit.
c Total cost of $1.90 per unit.
d Variable costs of $1.20 per unit.
4 Basset’s actual manufacturing costs for the month of May totaled $72,000, while
the budgeted manufacturing costs were $80,000. Comparison of the budgeted
costs with actual amounts:
a Is not significant unless the budgeted and actual figures are based upon the
same level of production.
b Demonstrates that Basset’s Manufacturing Department operated very
efficiently during May.
c Indicates that production cost per unit was 10% below budgeted cost per unit.
d Indicates that Basset produced only 90% of the number of units budgeted for
production in May.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

Financial and Managerial Accounting: The Basis for Business Decisions, 13e 95
 5 A flexible budget is used to evaluate:
a Costs that should have been incurred for a level of output achieved.
b Costs that should have been incurred for a level of output considered to be normal.
c How variable unit costs change as output changes.
d How flexible management was at adapting to changes in business conditions.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

96 Instructor’s Resource Manual
CHAPTER 23 NAME #

10-MINUTE QUIZ C SECTION

The cost accountant for Nichol’s Co. prepared the following monthly performance report
relating to the Production Department.

Budgeted Actual
Production Production
(10,000 Units) (11,000 Units)

Direct materials used.......................................................... $210,000 $230,000

Direct labor ..................................................................... 70,000 81,000
Variable manufacturing overhead....................................... 30,000 35,000
Fixed manufacturing overhead........................................... 130,000 134,000

1 Refer to the above data. Compute the amounts that should be included for each of the
following in a flexible budget prepared at a 11,000-unit level of production:

a Direct materials: $____________

b Direct labor: $____________

c Fixed manufacturing overhead: $____________

2 Refer to the above data. Assume that a revised performance report is prepared for the
11,000-unit level of production using a flexible budget approach. Compute the cost variances
for each of the following. Indicate whether each variance is favorable (F) or unfavorable (U).

a Direct materials variance from flexible budget: $____________

b Direct labor variance from flexible budget: $____________

c Total manufacturing overhead variance from flexible budget: $____________

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

Financial and Managerial Accounting: The Basis for Business Decisions, 13e 97
CHAPTER 23 NAME #

10-MINUTE QUIZ D SECTION

1 Duane Corporation budgeted its cost of finished goods manufactured at $450,000 for May.
Its May 31 finished goods inventory budgeted to be twice the level of its May 1 finished
goods inventory. The cost of goods sold budget for May has been set at $400,000.

Duane’s finished goods inventory at May 31 is budgeted at: $____________

2 Nassau Corporation expects to incur $350,000 in expenses during June (excluding interest and
taxes). Of this amount, depreciation is budgeted at $60,000, and expired prepayments are
budgeted at $25,000. Nassau’s current payables total $50,000 at June 1 and are budgeted to
increase to $60,000 by June 30.

Payments on current payables budgeted for June total: $____________

3 Brandon Corporation pays its debt service costs in full each month. April debt service costs
are budgeted at $10,000. However, of this amount, only $1,000 represents a reduction
principal. The company expects to issue no new debt during the month.

What cash disbursement amount will be shown on Brandon’s debt service budget?
$____________

4 Jasper Corporation’s accounts receivable remain outstanding approximately 40 days, whereas

its inventory remains in stock approximately 15 days before it is sold. It takes suppliers
approximately 7 days to deliver inventory to Jasper once an order is received.

Jasper’s operating cycle is: __________ days

5 As budgeted output per the flexible budget increases, per-unit fixed costs (increase/decrease):
___________

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

98 Instructor’s Resource Manual
SOLUTIONS TO CHAPTER 23 10-MINUTE QUIZZES

QUIZ A QUIZ B
1 B 1 B
2 A 2 A
3 D 3 D
4 B 4 A
5 A 5 A

QUIZ C
1
a ($210,000/10,000 units) x 11,000 units = $231,000
b ($70,000/10,000 units) x 11,000 units = $77,000
c $130,000 (Fixed costs remain unchanged throughout a relevant range of production)

2
a $231,000 flexible budget - $230,000 actual cost = $1,000 U
b $77,000 flexible budget - $81,000 actual cost = $4,000 F
c $6,000 U
Total overhead per flexible budget:
Fixed.................................................................................... $130,000
Variable ($30,000/10,000) x 11,000..................................... 33,000 $163,000
Actual overhead ($134,000 + $35,000)...................................... (169,000)
Cost variance-total manufacturing overhead............................... $6,000 F

QUIZ D
1
Let X = Finished Goods Inventory, May 1
X + $450,000 - 2X = $400,000
X = $50,000
2X = Finished Goods Inventory, May 31 =$100,000

2
($350,000 - $60,000 -$25,000) + $50,000 -$60,000 = $255,000

3
$10,000

4
40 days + 15 days = 55 days

5
Decrease

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005

Financial and Managerial Accounting: The Basis for Business Decisions, 13e 99