MANAGEMENT CONTROL SYSTEM

SESSION 8 BUDGET PREPARATION OCTOBER 15, 2012 JAKARTA, INDONESIA

By Vienda A. Kuntjoro

Budget
Budget is planning that is stated in quantitative in monetary unit for one year period. Characteristic of budget are as following : 1. Estimate potential level of earnings from one business unit 2. Budged is stated in financial (number of unit sales or produce) 3. Budget is for one year period 4. Proposal of budget agreed by upper level authority 5. Budget that is agreed can be changed only if certain condition happens 6. Periodically, financial performance compared to budget then the variance would be analyzed.

Budget cycle and Master Budget

Well managed companies usually cycle through the following budgeting steps during the course of the fiscal year: 1. Working together, managers and management accountants plan the performance of the company as a whole and the performance of its subunits (such as departments or divisions). Taking into account past performance and anticipated changes in the future, managers at all levels reach a common understanding on what is expected 2. Senior managers give subordinate managers a frame of reference, a set of specific financial or nonfinancial expectations against which actual result will be compared. 3. Management accountants help manager investigate variation from plans, such as an unexpected decline in sales. If necessary, corrective action follows, such as a reduction in price to boost sales or cutting of costs to maintain profitability 4. Managers and management accountants take into account market feedback, changed conditions, and their own experiences as they begin to make plans for the next period. For example, a decline in sales may cause managers to make changes in product features for the next period.

Master Budget
Master budget expresses managements operating and financial plans for a specified and period (usually a fiscal year), and it includes a set of budgeted financial statements. The master budget is the initial plan of what the company intends to accomplish in the budget period. The master budget evolves from both operating and financing decision made by managers. Operating decision deal with how to obtain the funds to acquire those resources.

Advantages of budgets
Budget are an integral part of management control system. When administered thoughtfully by managers, budgets do the following: Promote coordination and communication among subunits within the company Provide a framework for judging performance and facilitating learning Motivate managers and other employees. Support strategic planning

Challenges in Administering Budgets

The budgeting process involves all level management. It has been estimated that senior managers spend about 10% to 20% of their time on budgeting, and finance planning departments spend as much as 50% of their time on it. A manager may commit to a budget, but if a situation arises in which some unplanned repairs or an unplanned advertising program would serve the long run interests of the company, the manager should undertake the additional spending. On the flip side, the dramatic decline in consumer demand during the recent recession led designers such as Gucci to slash their ad budgets and put on hold planned new boutique.

Developing an operating budget

Business are increasingly using rolling budgets. (also called continuous budget), is a budget that is always available for a specified future period. Steps in preparing an operating budget 1. Identify the problem and uncertainties. 2. Obtain information (discover the direct material have increase slightly during 2011). 3. Make about the futures (the purchasing manager anticipates that price of direct material will be about the same in year 2011. The manufacturing manager believes that efficiency improvement would allow costs manufacturing tables to be maintained at 2011 cost despite an increase in the price of other inputs. 4. Make decisions by choosing among alternatives 5. Implement the decision, evaluate performance, and learn

Budgetary slack
At times, subordinates may try to play games and build in budgetary slack. Budgetary slack describes the practice of underestimating budgeted revenues, or over estimating budgeted costs, to make budgeted targets more easily achieved. It frequently occurs when budget variances (the difference actual result and budgeted amounts) are used to evaluate performance. Budgetary slack provide managers with a hedge against unexpected adverse circumstances. But budgetary slack also misleads top management about the true profit potential of the company, which leads to inefficient resource planning and allocation and poor coordination of activities across different parts of the company.

Human aspects in budgeting?

Why are human factors crucial in budgeting? The administration of budget requires education, participation, persuasion , and intelligent interpretation. When wisely administered, budgets create commitment, accountability, and honest communication, and can be used as the basis for continuous improvement efforts. When badly managed, budgeting can lead to game playing and budgetary slack the practice of making budget targets more easily

Prepare Budget
Prepare budget for Stylistic Furniture for 2012. The details are follow: Stylistic sells two models of granite-top coffee tables: casual and deluxe, Revenue unrelated to sales, such as interest income, is zero Work in process inventory is negligible and is ignored Direct materials inventory and finished goods inventory are costed using the first in, first out (FIFO method). Unit costs of direct material purchased and unit costs of finished goods sold remain unchanged throughout each budget year but can change from year to year. There are two types of direct material : red oak (RO) and granite slabs (GS). Direct material costs are variable with respect to units of output coffee tables. Direct manufacturing labor workers are hired on an hourly basis; no overtime is worked. There are two cost drivers for manufacturing overhead costs-direct manufacturing labor hours and setup labor hours Direct manufacturing labor hours is the cost driver for the variable portion of manufacturing operations overhead. The fixed component of manufacturing operations overhead is tied to the manufacturing capacity of 300,000 direct manufacturing labor hours that Stylistic has planned for 2012.

Prepare budget (cont.)

Setup labor hours is the cost driver for the variable portion of machine setup overhead. The fixed component of machine setup overhead is tied to the setup capacity of 15,000 setup labor hours that Stylistic has planned for 2012. For computing inventoriable costs, Stylistic allocates all (variable and fixed) manufacturing operations overhead costs using direct manufacturing labor hours and machine setup overhead costs using setup labor hours. Nonmanufacturing costs consists of product design, marketing, and distribution costs. All product design costs are fixed costs for 2012. The variable component of marketing costs equals the 6.5% sales commission on revenues paid to salespeople. The variable portion of distribution costs varies with cubic feet of tables moved. The following data are available for 2012 budget : Direct material Red Oak $7 per board foot (b.f) (same as 2011) Granite $10 per square foot (sqft) (same as 2011) Direct manufacturing labor $20 per hour

Prepare budget (cont.1)

PRODUCT

Red Oak Granite Direct manufacturing labor

Casual Granit Table 12 board feet 6 square feet 4 hours PRODUCT

Deluxe Granite Table 12 board feet 8 square feet 6 hours Deluxe Granite Table 10,000 $800 500 500 $262,000

Casual Granit Table Expected sales in units 50,000 Selling price $600 Target ending inventory unit 11,000 Beginning inventory in units 1,000 Beginning inventory in USD $384,000 DIRECT MATERIAL Red Oak Beginning inventory 70.000 b.f Target ending inventory 80.000 b.f Note . Maintain Stylistics 12% operating margin.

Granite 60.000 sqft 20.000 sqft

Step 1 Prepare the revenue budget

In stylistics case, the revenue budget for 2012 reflects Stylistics strategy to grow revenues by increasing sales deluxe tables from 8,000 tables in 2011 to 10,000 tables in 2012. Schedule 1 Revenue For the year ending December 31, 2012 units Selling price Total revenues Casual 50,000 $600 $30,000,000 Deluxe 10,000 $800 $8,000,000 Total $38,000,000 The $38,000,000 is the amount of revenues in the budgeted income statement.

Step 2 Prepare the production budget in units

Schedule 2 Production Budget (in units) For the year ending Dec 31, 2012 Product Casual Deluxe Budgeted unit sales (sch. 1) 50,000 10,000 Add target ending finished goods inventory 11,000 500 Total required units 61,000 10,500 Deduct beginning finished goods inventory 1,000 500 Units of finished goods to be produced 60,000 10,000 Note. For step 3 for example, the bill materials would indicate that 12 bf of red oak and 6sqft of granite are needed to produce each casual coffee table and 12 bf of red oak and 8 sqft of granite to produce each deluxe coffee table. To calculate 3A.

Step 3 Prepare the Direct material usage budget and direct material purchases budget
Schedule 3A Direct material usage Budget in Quantity and Dollars For the year ending December 31, 2012 Material Red Oak Physical units budget Direct material required for casual tables (60,000 units*12 b.f and 6 sq.ft) Direct material required for deluxe tables (10,000 units*12 b.f and 8 sqft) Total quantity of direct materials to be used Cost budget Available from beginning direct materils inventory (under a FIFO cost flow assumption) Red Oak 70,000 b.f * $7 per b.f $490,000 840,000 b.f 440,000 sqft 120,000 b.f 80,000 sqft 720,000 b.f 360,000 sqft Granite Total

Granite 60,000 sqft*$10per sqft

To be purchased this period Red Oak (840,000-70,000) bf*$7 per bf Granite (440,000-60,000) sqft *$10 per sqft Direct material to be used this period $5,880,000 $5,390,000

$600,000

$3,800,000 $4,400,000 $10,280,000

Step 3 Prepare the Direct material usage budget and direct material purchases budget (cont.)

Schedule 3B Direct material purchase Budget For the year ending December 31, 2012 Material Red Oak Physical units budget To be used in production (from schedule 3A) Add target ending inventory Total requirements Deduct beginning inventory Purchase to be made Cost budget Red oak : 850,000bf*$7 per bf Granite 400,000 sqft*$10 per sqft $5,950,000 $5,950,000 $4,000,000 $4,000,000 $9,950,000 840,000 bf 80,000 bf 920,000 bf 70,000 bf 850,000 bf 440,000 sqft 20,000 sqft 460,000 sqft 60,000 sqft 400,000 sqft Granite Total

Step 4 Prepare the Direct manufacturing labor costs budget

Schedule 4 : Direct Manufacturing Labor costs budget For the year ending Dec 31, 2012
Output units produced Direct Mft. Total hours Hourly (schedule 2) Labor hr per unit wage rate Total 60,000 4 240,000 $20 $4,800,000 10,000 6 60,000 $20 $1,200,000 300,000 $6,000,000

Casual Deluxe Total

For 300,000 direct manufacturing labor hours, Stylistics manufacturing managers estimate various line items of overhead costs that constitute manufacturing operations overhead (that is, all costs for which direct manufacturing labor hours is the cost drivers).

Step 5 : Prepare the Manufacturing Overhead costs budget

Stylistic s managers determine how setups should be done for the casual and deluxe line of table, taking into account past experience and potential improvements in setup efficiency. For example, managers consider the following: 1. Increasing the length of the production run per batch so that fewer batches (and therefore fewer setups) are needed for the budgeted production of tables 2. Decreasing the setup time per batch 3. Reducing the supervisory time needed, for instance by increasing the skill base of workers.

Step 5 : Prepare the Manufacturing Overhead costs budget (cont.)

Casual Deluxe tables Total
1.Quantity of tables to be produced 60,000 tables 10,000 tables 2.No. of tables to be produced per batch 59 tables/batch 40 tables/batch 3. No. of batches (1)/(2) 1,200 batches 250 batches 4. Setup time per batch 10 hr/batch 12 hr/batch 5.Total setup hours (3)*(4) 12,000 hours 3,000 hours 15,000 hr 6. Setup hours per table (5)/(1) 0.2 hours 0.3 hours Using an approach similar to the one described for manufacturing operations overhead costs, Stylistics managers estimate various line items of costs that comprise machine setup overhead costs that is, all costs that are caused by the 15,000 setup labor hours (the cost driver). Note how using activity based cost drivers provide additional and detailed information that improves decision making compared with budgeting based solely on output based cost drivers. Of course, managers must always evaluate whether the expected benefit of adding more cost drivers exceeds the expected cost.

Step 5 : Prepare the Manufacturing Overhead costs budget (cont.1)

Schedule 5 : Manufacturing Overhead Costs Budget For the year ending Dec 31, 2012

manfuacturing Operations Overhead costs

Variables costs Supplies Indirect manufacturing labor Power (support department costs) Maintenance (support deparment costs) Fixed costs (to support department costs) Depreciation Supervision Power (support department costs) Maintenance (supportdperatment costs) Total manufacturing operationsoverhead costs Manufacturing Setup Overhead costs Variables costs Supplies Indirect manufacturing labor $390,000 840,000 1,020,000 390,000 630,000 480,000 2,520,000 $9,000,000 1,500,000 1,680,000 2,100,000 1,200,000 $6,480,000

Power (support department costs) Fixed costs (to support capacity of 15,000 setup labor hours

90,000

$1,320,000

Depreciation Supervision Power (support department costs) Maintenance (supportdperatment costs) Total manufacturing operationsoverhead costs

603,000 1,050,000 27,000 1,680,000 $3,000,000 $12,000,000

Step 6 : Prepare the ending inventories Budget

Manufacturing operations overhead costs are allocated to finished goods inventory at the budgeted rate $30 per direct manufacturing labor hour (total budgeted manufacturing operations overhead, 90,000,000/300,000 budgeted direct manufacturing labor hours). Machine setup overhead costs are allocated to finished goods inventory at the budgeted rate $200 per setup hours (total budgeted machine setup overhead, $300,000/15,000 budgeted setup labor hours).

Step 6 : Prepare the ending inventories Budget (cont.)

Schedule 6A : unit costs of Ending Finished goods inventory December 31, 2012 PRODUCT Casual Tables Cost per unit Input per unit of output TOTAL Deluxe tables Input per unit of output TOTAL

Red Oak Granite Direct manufacturing Labor Manufacturing overhead Machine setup overhead TOTAL

$7 12 bf 10 6 sqft 20 4 hrs 30 4 hrs 200 0.2 hrs

$84 12 bf 60 8 sqft 80 6 hrs 120 6 hrs 40 0.3 hrs $384

$84 80 120 180 60 $524

Schedule 6B : Endign Inventories budget December 31, 2012 Quantity Direct material Red Oak Granite Finished Goods Casual Deluxe Total ending inventory 80,000 20,000 11,000 500 Cost per unit $7 10 $384 524 $560,000 200,000 $4,224,000 262,000 TOTAL

$760,000

$4,486,000 $5,246,000

Step 7 : Prepare the cost of goods sold budget

Schedule 7 : Cost of goods Sold Budget For the year ending Dec 31, 2012 From the schedule Beginning finished goods invetory, Jan 01, 2012 Direct material used Direct manufacturing labor Manufacturing overhead cost of goods manufactured cost of goods available for sale Deduct ending finished goods inventory, Dec 31, 2012 Cost of goods sold 6B Given 3A 4 5 $10,280,000 6,000,000 12,000,000 28,280,000 28,926,000 4,486,000 $24,440,000 TOTAL $646,000

Step 8 : Prepare the non manufacturing costs budget

Product design costs are fixed costs, determined on the basis of the product design work anticipated for 2012. The variable component of budgeted marketing costs is the commissions paid to sales people equal to 6.5% of revenues. The fixed component of budged marketing costs equal to $1,330,000 is tied to the marketing capacity for 2012. The cost driver of the variable component of budgeted distribution costs is cubic feet of tables moved (Casual : 18 cubic ft * 50,000 tables + deluxe 35 cubic ft*10,000 tables = 1,440,000 cubic ft). Variable distribution costs equal $2 per cubic foot. The fixed component of budged distribution costs equals $1,596,000 and is tied to the distribution capacity for 2012. Schedule 8 shows that the product design, marketing, and distribution costs budget 2012. Schedule 8 : Non manufacturing costs budget For the year ending December 31, 2012 Business function Var costs Fixed costs Total cost Production design $1.024,000 $1,024,000 Marketing (var cost :$38,000,000*0.065) $2,470,000 1,330,000 3,800,000 Distribution (var cost : $2*1,140,000 cuft) 2,280,000 1,596,000 3,876,000 $4,750,000 $3,950,000 $8,700,000

Step 9 : Prepare the budget income statement

Rex Jordan, the CEO of Sytlistic Furniture, is very pleased with the 2012 budget. It call fro a 10% increase in operating income compared with 2011. The keys to achieving a higher operating income are a significant increase in sales of Deluxe tables, and process improvement and efficiency gains throughout the value chain. As Rex studies the budget more carefully, he is struck by two comment appended to the budget. First, to achieve the budged number of tables sold, Stylistic may need to reduce its selling prices by 3% to %582 for Casual tables and to $776 for Deluxe tables. Second, a supply shortage in direct materials may result in a 5% increase in the prices of direct materials (red oak and granite) above the material prices anticipated in the 2012 budget. He asks Tina Larsen, the management accountant, to use Stylistics financial planning model to evaluate how those outcomes will affect budgeted will affect budgeted operating income.

Step 9 : Prepare the budget income statement (cont.)

Budgeted Income Statement for Stylistic Furniture For the year ending December 21, 2012 Revenues Sch. 1 $38,000,000 Costs of goods sold Sch. 7 $24,440,000 Gross margin $13,560,000 Operating costs Product design costs Sch. 8 $1,024,000 Marketing costs Sch.8 $3,800,000 Distribution costs Sch. 8 $3,876,000 $8,700,000 Operating income $4,860000

Sample
Consider the stylistic furniture. Suppose that to maintain its sales quantities, Stylistic needs to decrease selling prices to $582 per Casual table and $776 per Deluxe table, a 3% decrease in the selling price used. All other data is unchanged. Solution: Schedule 1 & 8 will changes because a change in selling price affects revenues. Schedule 8 changes because revenues are a cost driver of marketing costs (sales commissions). The remaining schedules will not change because a change in selling price has no effect on manufacturing costs. The revised schedules and the new budgeted income statement follows:

Sample (cont.)
Casual tables Deluxe tables Total Schedule 1 : Revenue Budget For the year Ending Dec 31, 2012 Selling price Units $582 50,000 $776 10,000

Total Revenues $29,100,000 $7,760,000 $36,860,000

Business function Product design Marketing (Var cost : $36,860,000*0.065) Distribution (Var. cost: $2*1,140,000cuft)

Schedule 8: Nonmanufacturing costs budget For the year Ending December 31, 2012 Var. Costs Fixed cost $1,024,000
$2,395,900 $2,280,000 $4,675,000 $1,330,000 $1,596,000 $3,950,000

Total costs $1,024,000 $3,725,900 $3,876,000 $8,625,900

Sample (cont. 1)
Stylistic Furniture Budget Income Statement For the year Ending Dec 31, 2012 Revenues Schedule 1 Cost of goods sold Schedule 7 Gross margin Operating costs Product design Schedule 8 $1,024,000 Marketing costs Schedule 8 $3,725,000 Distribution Schedule 8 $ 3,876,000 Operating Income

$36,860,000 $24,440,000 $12,420,000

$8,625,000 $3,794,100

Financial Planning models and sensitivity analysis

Sensitivity analysis is a what if technique that examines how a result will change if the original predicted data are not achieved or if an underlying assumption changes. To see how sensitivity analysis works, it considers two scenarios identified as possibly affecting Stylistic Furnitures budget model for 2012: 1. Scenario 1 : a 3% decrease in the selling price of the casual table and a 3% decrease in the selling price of the Deluxe table 2. Scenario 2 : a 5% increase in the price per board foot of red oak and a 5% increase in the price per square foot of granite. Key assumption Units sold Selling price Direct Budgeted material cost Opr. income Casual Deluxe Casual Deluxe Red oak Granite Dollars Change from master budget What if scenario 50,000 10,000 $600 $800 $7 $10 $ 4,860,000 Scenario1 50,000 10,000 582 776 $7 $10 3,794,100 22% decrease Scenario2 50,000 10,000 600 800 $7.35 $10.50 4,483,800 8% decrease

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