CHAPTER 10: STRATEGY AND THE MASTER BUDGET

QUESTIONS

10-1 Compel strategic planning and facilitate implementation of strategic plans. An organization’s strategy, strategic plans, and budgets are interrelated. Preparing budgets compels reviews of an organization’s strategy and its strategic plans and can facilitate implementations of the strategic plan. Feedback from budgets often results in improvements to an organization’s strategy and strategic plan.

Serve as a basis for performance evaluation. Budgets serve as the benchmark against which actual performance can be compared. Budgets are a better basis for judging performance than past performance for two reasons. First, budgeted amounts take into account expected changes and improvements in the environment. Second, past performance is a result of past events and operations and may not be suitable to serve as a benchmark. To the extent past performance was not effective/efficient it does not make sense to use this as the standard against which actual performance is compared.

Motivate managers and employees. Budgets, if internalized, serve as goals for managers and employees and, if properly implemented, can motivate them toward achievements of the goals.

Promote coordination and communication within the organization. Budgets compel managers to think of interdependencies and interrelationships among subunits of the organization. A budget is also a communication device that helps all employees and managers understand and accept the organization’s objectives and expected roles and contributions over the coming period.

Authorization to act. The approved budget, particularly in a not-for-profit setting, gives the manager authorization to act (make decisions, etc.).

Other benefits can include serving as a basis for resource allocation, aiding cash-flow management, and providing authorization documentation.

10-2 An organization’s strategic plan describes how the organization matches its strengths and weaknesses with the opportunities and threats in the marketplace in order to accomplish its long-term goals (e.g., achieve sustainable competitive advantage). It is the guideline for the firm’s short-term and long-term operations. A strategic plan may extend over several budget periods (e.g., years) covered by a master budget.

A master budget is a comprehensive operational plan of action for the coming year. It includes both operating budgets and financial budgets and culminates in a set of forecasted (i.e., pro-forma) financial statements (cash flow, income statement, and balance sheet). The strategic plan of a firm guides, in a general sense, the determination of the master budgets prepared annually by the organization. Specialized consulting companies now provide software that can be used to integrate master budgets with strategic plans as part of a comprehensive performance management system. (See, for example, Geac, at http://www.geac.com/object/GeacMPCBrochure_PM.html.)

10-3 A master budget is a comprehensive plan of action for an organization for a future period while a capital budget is an investment (and financing) plan for a major project or program that has long-range effects on operations. As indicated in text Exhibit 10.3, resources specified in the capital budget of the current period are included in the master budget of the period.

10-4 A master budget is a comprehensive plan of action for a future period; as such, the master budget includes both operating and financial budgets. An operating budget consists of plans regarding revenues and resource acquisition/use across all major operating areas of the organization (e.g., sales, production, purchasing, marketing, research and development, and general administrative activities). The set of operating budgets culminates in a budgeted income statement. Financial budgets relate to sources and uses of funds for an upcoming period. The set of financial budgets culminates in a budgeted cash flow statement and budgeted balance sheet.

10-5 Some would argue that the primary purpose of budgets is for planning and that problems are created when budgets are used for control and incentive-compensation purposes. The latter use of budgets is thought to engender both unethical practices (e.g., ENRON, WorldCom) or, more prevalently, gaming behavior. For example people whose performance will be compared to the budget targets may understate their potential in order to have achievable targets set. Therefore, tying plans to after-the-fact control compromises the integrity of the information-gathering process. Some people have argued that information used for planning should not be used in after-the-fact control. (Standards for after-the-fact control could, instead, be based on independent benchmark information or improvements on previous performance.) Some organizations have designed incentive schemes that reward people jointly on their ability to improve performance and to meet budget projections.

10-6 Many organizations are “run by the numbers.” In these organizations managers are held accountable for financial results and therefore need to be “data literate” as regards the factors that combine to determine financial results. Much of this information needed by managers comes from the annual planning process known as master budgeting. Therefore, their interest tends to focus on projections of financial results and they judge the desirability of a set of operating strategies based on the financial results projected for those strategies.

10-7 The sales budget is often regarded as the cornerstone in the master budget because all operating activities in a business emanate from efforts to attain the level of sales specified in the sales budget. A firm can complete the plan for other activities of a period only after it knows the expected sales levels for the current and the immediate future periods. A manufacturing firm, for example, cannot complete its production schedule for the upcoming period without knowing the number of units it must produce for each of its products. The firm can ascertain the number of units to be produced only after it knows both forecasted sales and the desired ending inventory. The units to be produced, in turn, affect many other activities of the firm including amount and kinds of materials to be purchased, number of employees to be hired, levels of factory overhead, and selling and administrative expenses.

10-8 Additional factors include:

▪ Beginning and desired ending inventories of work-in-process (WIP) and finished goods ▪ The required material inputs (in lbs., liters, etc.) for each product ▪ Beginning and desired ending inventories of direct materials ▪ The cost of materials (per lb., liter, etc.)

10-9 A cash budget that is prepared according to the statement of cash flows required for external reporting purposes generally includes five components:

▪ Beginning-of-period cash balance ▪ Net cash flow from operations ▪ Cash flow from investment activities ▪ Cash flow from financing activities (new financing, repayment of principal, and interest expense) ▪ End-of-period cash balance

10-10 In comparison with manufacturing organizations, unique budget characteristics of service organizations include:

▪ Absence of production and materials purchases budgets ▪ Emphasis on workforce planning

10-11 Both terms refer to methods or techniques for dealing with uncertainty in the budget-preparation process.

The term “what-if” analysis refers to the process of estimating the effect of a change of one or more factors (e.g., selling price per unit) on an output variable of interest (e.g., budgeted cash flow or budgeted operating income). Typical “what-if” type questions would include:

• What if we increase prices by 10%, and demand drops by 8%? • What if we engage in a marketing campaign at a cost of $50,000 and sales volume increases by 20%?

Sensitivity analysis focuses more on validating a given model (e.g., a profit-planning, or CVP, model) used by the organization. Any model, by definition, is based on a set of assumptions (e.g., selling price per unit, variable cost per unit, etc.). Sensitivity analysis attempts to assess which input factors or assumptions are key to the validity of the model. Several end-of-chapter exercises and problems deal with the creation of profit-planning models and the sensitivity of decision alternatives with respect to assumed model inputs.

Spreadsheet software, such as Excel, can be used to perform a variety of “what-if” and sensitivity analyses. The following tutorials, available from the Microsoft website, are useful in this regard:

1. Introduction to What-If Analysis: http://office.microsoft.com/en-us/excel/HA102431641033.aspx 2. Using Excel to Perform Scenario Analysis: http://office.microsoft.com/en-us/excel/HP100726691033.aspx 3. Using Solver to Perform What-If Analysis: http://office.microsoft.com/en-us/excel/HA102190021033.aspx

10-12 Zero-base budgeting (ZBB) is a budgeting process that requires managers to prepare budgets each period from ground zero for all operations.

A typical budgeting process is “incremental” in nature. That is, budgets for the upcoming period start from the approved budgets for the current period, with amounts added to reflect planned changes for the upcoming period. Thus, traditional budgets assume that most, if not all, of the current activities and functions will continue into the coming budget period. In contrast, a zero-base budgeting process allows no activities or functions to be included in the budget unless managers can justify their need. Pure forms of ZBB are expensive and time-consuming. For this reason, some companies have partial ZBB systems.

A number of companies (e.g., Xerox, Texas Instruments) and government organizations (e.g., State of Georgia) have at one time or another used ZBB.

10-13 No. Kaizen budgeting is a budgeting approach that explicitly incorporates continuous improvement standards/expectations in the approved budgets.

In contrast, activity-based budgeting (ABB) is a budgeting process that relies on the costs of activities and activity-cost drivers to prepare budgets. In other words, ABB develops master budget data using the organization’s activity-based cost (ABC) system. Thus, ABB begins by quantifying products and services to be produced for an upcoming period. These forecasts are then used to estimate the amount of activities, across the internal value chain, that are needed to meet forecasted output (products or services). The budgeting process is completed by assigning estimated resource costs to the specified activities. Both American Express and AT&T Paradyne provide examples of actual implementation of ABB systems. See, Player, S. & Keys, D. E. (eds.), Activity-Based Management: Arthur Andersen’s Lessons from the ABM Battlefield. New York: John Wiley & Sons, 1999.

10-14 Budgetary slack, or "padding" the budget, is the practice of knowingly including a higher amount of expenditure in the budget (or lower amount of revenue) than managers actually believe should be the case. One reason that it is common to find slacks in budgets is the desire of managers to use such slack as a cushion for unpredictable/uncontrollable future events (e.g., worker attrition, machine breakdowns/malfunctions). Another reason is the increased recognition or reward that might accrue to those who “beat” their budget target. Finally, managers may believe that the budgets they submit will be “cut” in the budget negotiation process. Therefore, such managers must “pad” their budgets in order to secure the amount of resources they feel they actually need.

10-15 A time-driven activity-based cost (TDABC) system, as explained in Chapter 5, is a refinement and simplification of a traditional ABC system. Rather than identifying activities and associated activity costs, a TDABC system calculates a cost rate for each major activity, process, or department using only pieces of information: (1) the resource cost associated with the process or department, and (2) the resource consumption (measure in time) of each activity (e.g., handling a production run, shipping a product, packaging a product, etc.). More complex situations can be captured by time equations used in a TDABC system.

Advocates of TDABC believe that this system both reduces the cost of implementing an ABC system and improves the accuracy of the resulting activity-cost data. Resulting activity-cost data from a TDABC system can be used, as is the case with ABB, to budget resource requirements once a sales and production plan has been determined for an upcoming period. As with ABB, we work backwards from this plan to determine resource requirements. This planning process is facilitated by simplifications introduced by a TDABC system.

Finally, note that both ABB and time-driven activity-based budgeting facilitate the budgeting process because both systems tend to reduce the amount of “negotiations” that occur. That is, there is less room to negotiate because once the production and sales plan for the upcoming period has been determined, the resources requirements (and therefore resource budgets) are all but automatically determined.

10-16 A “highly achievable” budget has a target that is achievable by most managers “most of the time” (e.g., 80 to 90 percent of the time). In a study by Merchant (1990), the author finds that a budget with a highly achievable target serves well in the vast majority of organizational situations, especially when accompanied by extra rewards for performance exceeding the target.

Among the advantages of using a highly achievable budget target are the following:

1. Increasing managers' commitment to achieving the budget target. 2. Maintaining managers' confidence in the budget. 3. Decreasing organizational control cost. 4. Allowing effective and efficient managers greater operating flexibility. 5. Reducing the risk that managers will engage in harmful earnings-management practices or violate corporate ethical standards. 6. Improving predictability of earnings or operating results. 7. Enhancing the usefulness of a budget as a planning and coordinating tool.

10-17 Participative budgeting is a “bottom-up” approach that involves everyone in the budget-preparation process—from low-level workers all the way to the top managers of the organization. The principal idea is to have employees/managers “internalize” (i.e., take ownership of) the budgets that are prepared.

For participative budgeting to be effective, top management needs to be actively involved. Furthermore, top management should institute incentives to guard against excessive budget padding, and encourage the generation of accurate budgetary projections. Finally, top managers may have to serve as arbiters when irreconcilable differences occur in the budget preparation process.

10-18 A fixed-performance contract refers to the performance associated with the results reflected in the master (static) budget that is prepared at the beginning of the year. This amount is “fixed” in the sense that the amount is negotiated prior to the beginning of the budget period and not adjusted afterwards. For incentive-compensation purposes, actual performance (e.g., operating income generated) can be compared to this fixed budgeted amount, hence the term “fixed-performance contract.”

From a planning perspective, the use of fixed-performance targets lead to a narrow (i.e., artificially short) horizon. From a control standpoint, such fixed-performance contracts have been criticized because they encourage both gaming behavior and ethically questionable behavior. In short, under such contracts managers are motivated to “do whatever it takes, but no more” to achieve the (fixed) budgeted target.

10-19 A fixed-performance contract implies a fixed (static) target, usually negotiated prior to the start of the budget period. Incentive compensation (i.e., managerial reward) is contingent on whether, or the extent to which, this fixed target is achieved during the period. In typical fixed-performance contracts there are minimum and maximum rewards. Thus, the performance-reward contract is discontinuous.

By contrast, an organization can employ a “linear performance contract.” Quite literally, this implies a zero compensation if performance (e.g., operating income) is zero (or negative). It also implies unlimited compensation for extraordinary performance. From a motivational standpoint, such a plan is thought to be superior to a fixed-performance contract. In essence, linear performance contracts encourage exceptional performance. The use of such contracts is thought to counter some of the criticisms of the “control” aspects of traditional budgeting systems. See, for example, Michael C. Jensen, “Corporate Budgeting Is Broken—Let’s Fix It,” Harvard Business Review (November 2001), pp. 95-101.

10-20 The term “relative performance contract” means that the basis against which actual managerial performance is compared is either an internal or an external benchmark, rather than budgeted performance embodied in the annual (fixed or static) master budget. In other words, actual performance is benchmarked against peer performance for purposes of determining incentive compensation and managerial rewards.

The term “rolling financial forecast” refers to a process of continually updating budgets as each budget period (e.g., month) passes. In this way, the organization has a constant (e.g., 12-month) planning horizon.

The use of both “relative performance contracts” and “rolling financial forecasts” are key recommendations set forth by the Beyond Budgeting Roundtable (www.bbrt.org). Also, see Jeremy Hope and Robin Fraser, Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap. Boston, MA: Harvard Business School Press, 2003; and, Jeremy Hope and Robin Fraser, “Who Needs Budgets?” HBR OnPoint Product Number 306X. Boston, MA: Harvard Business School Publishing Corporation, 2003.

BRIEF EXERCISES
10-21 Q2 Q3 Sales—2010 16,000 15,000 Projected % increase for 2011 25% 25% Estimated Sales Volume—2011 20,000 18,750 x Estimated Unit Selling Price—2011 $4.00 $4.00 Estimated Sales Dollars—2011 $80,000 $75,000

10-22 Payment history: % paid in month of purchase: 25% % paid in month following month of purchase: 75%

Expected Cash Disbursements: February: ($5,500 x 0.75) + ($6,500 x 0.25) = $5,750 March: ($6,500 x 0.75) + ($8,000 x 0.25) = $6,875

10-23 Number of units produced in Qtr. 1:

Ending inventory of DM (in lbs.) = 50,000 Target ending inventory % = 25% of following month’s production requirements Therefore, DM used for production in Qtr. 1 = 50,000/0.25 = 200,000 lbs.

Units produced in Qtr. 1 = lbs. of DM used/lbs. of DM per unit of output = 200,000/8 = 25,000 units

DM requirements (in lbs.), Qtr. 2 = Planned production, Qtr. 2 x DM lbs./unit = (25,000 units x 1.10) x 8 lbs./unit = 27,500 units x 8 lbs./unit = 220,000 lbs.

10-24 Scheduled Production, Quarter 2:

Units required to meet estimated sales, Qtr. 2 = 12,000 units Units required to meet targeted ending inventory: 15,000 units x 10% = 1,500 units Total units needed 13,500 units Less: Beginning inventory, Qtr.2 (12,000 units x 10%) = 1,200 units Scheduled production, Quarter 2 = 12,300 units

10-25 Current level of monthly operating costs = $10,000:

Estimated operating costs, January = $10,000 x 0.991 = $9,900 Estimated operating costs, June = $10,000 x 0.996 = $9,415 Estimated operating costs, December = $10,000 x 0.9912 = $8,864

10-26 Collection of Credit Sales—November:

30% of Credit Sales made in October = 0.30 x $30,000 = $9,000 70% of Credit Sales made in November = 0.70 x $24,000 = $16,800 Total Estimated Collections--November = $25,800

Collection of Credit Sales—December:

30% of Credit Sales made in November = 0.30 x $24,000 = $7,200 70% of Credit Sales made in December = 0.70 x $20,000 = $14,000 Total Estimated Collections--December = $21,200

10-27 Collection of Credit Sales—December:

From credit sales made in November = 0.20 x $90,000 = $18,000 From credit sales made in December: = (0.75 x $100,000) x 0.98 = $73,500 Total Estimated Collections—December = $91,500

10-28 Estimated interest expense—April = borrowing in April x (annual rate/12)

= [($30,000 - $18,000) + $1,000] x (0.12/12)

= $13,000 x 0.01 = $130.00

Note that, strictly speaking, to maintain a minimum cash balance of $30,000, the company would have to borrow an extra $1,000 to be able to cover the interest payment (eom) and still have at least $30,000 of cash.

Estimated financing transactions—May: Interest expense (paid eom): $13,000 x 0.01 = $130 Principal repayment: Beginning-of-month cash balance = $18,000 + ($13,000 - $130) = $30,870 Plus: net cash flow in May, prior to financing = $22,000 Cash balance prior to financing transactions = $52,870 Less: interest expense (eom) for May ($130) Less: minimum cash balance requirement = ($30,000) Cash available for principal repayment = $22,740 Rounded down to nearest $1,000 = $22,000 Total financing transactions—May = $22,130

10-29 DM purchases, December = (DM issued to production + ending DM inventory) – beginning DM inventory

= ($150,000 + $39,500) – $37,000 = $152,500

10-30 Total estimated marketing expenses, 4th quarter:

|Sales volume (units) | | | |
| 3rd Quarter (actual) = | | |4,000 |
| Estimated 4th Qtr. Increase = | |10% |
|Variable marketing expenses, per unit sold = |$0.05 |
|Fixed marketing expenses, per MONTH: | | |
| Salaries (cash) = | |$10,000 | |
| Depreciation--delivery trucks = |$5,000 | |
| Insurance (paid monthly) = | |$2,000 | |
| | | | | | |
|Total estimated marketing expenses, 4th quarter: | |
| Variable costs ($0.05 x [4,000 units x 1.10]) = |$220 |
| Fixed costs: | | | | |
| Salaries = (3 x $10,000) = | |$30,000 | |
| Depreciation = (3 x $5,000) = |$15,000 | |
| Insurance = (3 x $2,000) = | |$6,000 |$51,000 |
|Total estimated marketing expenses, 4th quarter = |$51,220 |
|Less: Non-cash charges: | | | |
| Depreciation expense = | | |$15,000 |
|Estimated cash payments for marketing expenses = |$36,220 |

EXERCISES

10-31 “What-If” Analysis (25 Minutes)

1. The term “what if” analysis is one example of the more general term “sensitivity analysis” and is used to explore the effects (e.g., on a decision or a budget for an upcoming period) of different marketing, production, or selling strategies (e.g., the effect on revenues of lowering product selling prices, the profit-effect of using a different sales-promotion plan). That is, a “what-if” analysis examines how a result will change if the original (base-line) data are not achieved or, as in the present case, if an underlying assumption (viz., rate of bad-debts expense) changes.

| 2. What-if Analysis | | | | |
| | | |January |February |March |
| Credit Sales | |$100,000 |$120,000 |$110,000 |
| | | | | | |
| | | | Estimated Bad-Debts Expense |
| | | |January |February |March |
| Assumed rate of B/D percentage: | | | |
|1% | | |$1,000 |$1,200 |$1,100 |
|3% | | |$3,000 |$3,600 |$3,300 |
|5% | | |$5,000 |$6,000 |$5,500 |
|8% | | |$8,000 |$9,600 |$8,800 |

3. Managers today work in a world of uncertainty. One way to cope with uncertainty in the master budgeting process is to model the underlying relationships associated with the various budgets that are prepared and then to perform sensitivity analysis. One form of sensitivity analysis is the “what-if” analysis described above. For Tyson Company, this type of analysis can help the firm decide whether it might need to implement a more restrictive credit-granting policy and, if so, how much it might be willing to spend in this regard.

10-32 Behavioral Considerations (15 Minutes)

There are at least two issues here. One is the failure to take advantage of all the cash discount included in the sales term. (In this regard, see Exercise 10-37.) The other is the constant occurrence of rush orders, last-minute changes, and other operating emergencies that require the purchasing department to do last minute purchases.

Janet needs to ensure that the Accounting Department records all purchases at the net price whenever a purchase is made with cash discounts included in the sales terms. Any additional amount that the firm has to pay because of the failure to make the payment within the payment terms should be charged to the finance department as a loss and not treated as an adjustment to the cost of purchase.

The firm needs to be very clear in its operating procedures about the minimum amount of time required for purchases. Any additional acquisition cost because of rush orders, last-minute changes, or operating emergencies should be borne by the department making the request.

10-33 Budgetary Slack and Zero-Based Budgeting (ZBB) (30 minutes)

1. Budgetary slack is a planned difference between budgeted revenue and expected revenue, and/or budgeted expenditures and expected expenditures. Budgetary slack describes the tendency of managers to under-estimate revenues and over-estimate expenditures during the budgetary process in order to build in allowances (“cushions”) for unexpected declines in revenue and/or unforeseen expenses. Budgetary slack occurs because of conflicts between the personal interests of a manager and the interests of the organization. These conflicts include pressure from top management to achieve budgets and the desire on the part of the manager to look favorable in the eyes of top management.

2. a. From the point of view of the business unit manager, budgetary slack provides:

▪ performance that will “look better” in the eyes of their superiors ▪ a coping mechanism regarding uncertainty ▪ a way to obtain what is needed since initially submitted budgets tend to be cut during the budget-negotiation process

However, the use of budgetary slack limits the objective evaluation of a business unit and, therefore, limits the objective evaluation of the performance of the unit manager. It also becomes more difficult for the business unit manager to evaluate the performance of subordinates and to use the budget as a control mechanism over subordinate performance.

b. From the perspective of corporate management, the use of budgetary slack increases the probability that budgets will be achieved. This increased probability facilitates the overall corporate budgeting process. Corporate management may also allow budgetary slack as a form of reward to managers for previous good performance.

However, from the point of view of corporate management, the use of budgetary slack increases the likelihood of inefficient allocation of scarce resources, and decreases the ability to identify potential weaknesses or trouble spots in operating activities.

3. a. Zero-based budgeting (ZBB) is a budgeting technique that evaluates all proposed operating and administrative expenditures as though they were being initiated for the first time. Each manager must evaluate the proposed expenditure for each activity to be undertaken during the upcoming budget period, investigate alternative means of conducting each activity, and rank expenditures in order of perceived importance.

b. Atlantis Laboratories could benefit from ZBB as each of the business unit managers would be required to identify and justify all proposed expenditures for the upcoming year. This increased evaluation of expenditures would make it difficult to include budgetary slack in the budget for the upcoming year and likely uncover opportunities of cost savings and operational improvements. 10-33 (Continued)

c. The biggest disadvantage of ZBB is the significant amount of time and cost involved in its implementation. In addition, the concept of zero-based budgeting may be difficult for management to learn and accept. Atlantis must be sure that the benefits of ZBB outweigh the associated costs.
10-34 Budgeted Cash Disbursements (30 minutes)

1. Budgeted cash payments for merchandise purchases:

a. February: 25% x $100,000 = $25,000 75% x $120,000 = $90,000 $115,000

b. March: 25% x $120,000 = $30,000 75% x $110,000 = $82,500 $112,500

2. Budgeted cash payments for merchandise purchases:

a. February: 25% x $100,000 x 0.98 = $24,500 75% x $120,000 x 0.98 = $88,200 $112,700

b. March: 25% x $120,000 x 0.98 = $29,400 75% x $110,000 x 0.98 = $80,850 $110,250

3. The financial cost of not taking advantage of the early-payment discount can be approximated by the following formula:

Opportunity cost (%) = [discount %/(1 – discount %)] x [365/no. of extra days allowed if discount is not taken]

= [0.02/(1 - 0.02)] x [365/20] = 0.020408 x 18.25 = 37.25%

Basically, if you choose not to take the early-payment discount, you are giving up a 2% discount (on the net amount) in return for an extra 20 days in which to pay. There are 18.25 (365/20) 20-day periods in a year. Note that in the first term of this formula we divide the 2% discount rate by 98% (1 - 2%) because, in effect, you are paying 2% to delay for 20 days paying 98% of the total bill. So, the percentage rate you are paying in this case is really 2.0408% of the net bill (the bill without financing cost). Regardless of the technicalities here, students should understand that the opportunity cost of not taking advantage of the early-payment (cash) discount can be very significant, as is the case here. For this reason, firms record purchases at net cost and any discounts lost as interest expense.

10-35 Budgeted Cash Receipts and Disbursements (30 minutes)

1. Budgeted Cash Receipts:

November: Cash sales = $120,000 Collection of accounts receivable: ($100,000 x 0.95) x 0.35 x 0.80 x 0.98 = $26,068 ($100,000 x 0.95) x 0.35 x 0.20 = $6,650 ($150,000 x 0.95) x 0.65 x 0.80 x 0.98 = $72,618 ($150,000 x 0.95) x 0.65 x 0.20 = $18,525 $243,861 December: Cash sales = $80,000 Collection of accounts receivable: ($150,000 x 0.95) x 0.35 x 0.80 x 0.98 = $39,102 ($150,000 x 0.95) x 0.35 x 0.20 = $9,975 ($ 90,000 x 0.95) x 0.65 x 0.80 x 0.98 = $43,571 ($ 90,000 x 0.95) x 0.65 x 0.20 = $11,115 $183,763

2. Budgeted Cash Disbursements:

November: ($170,000 x 0.70) x 0.25 = $29,750 ($270,000 x 0.70) x 0.75 = $141,750 $171,500 December: ($200,000 x 0.70) x 0.25 = $35,000 ($170,000 x 0.70) x 0.75 = $89,250 $124,250

10-36 Production and Materials Purchases Budgets (20-25 minutes)

Production Budget: 2nd Quarter 3rd Quarter Budgeted sales 38,000 34,000 Desired ending inventory (10%) + 3,400 + 4,800 Total units needed 41,400 38,800 Beginning inventory – 3,800 – 3,400 Total units to produce 37,600 35,400

Budgeted Purchases of Direct Materials for the Second quarter:

2nd Quarter 3rd Quarter Budgeted production 37,600 35,400 Direct materials per unit x 3 x 3 Direct materials needed in production 112,800 106,200 Desired ending inventory of direct materials (20% of 106,200) + 21,240 Total direct materials needed 134,040 Beginning inventory of DM (20% of 112,800) – 22,560 Budgeted purchases of direct materials (lbs.) 111,480

10-37 Purchase Discounts (25 minutes)

The financial cost of not taking advantage of the early-payment discount for purchases made on credit can be approximated by the following formula (we use the term “approximate” here to denote the fact that the estimate below does not assume compounding of interest and as such provides a conservative estimate):

Opportunity cost (%) = [discount %/(1 - discount %)] x [365/no. of extra days allowed if discount is not taken]

1. In the case of 2/10, n/30, the approximate economic cost of not taking advantage of the early-payment discount is:

= [0.02/(1 - 0.02)] x [365/20] = 0.020408 x 18.25 = 37.25%

Basically, if you choose not to take the early-payment discount, you are giving up a 2% discount (on the net amount) in return for an extra 20 days in which to pay. There are 18.25 (365/20) 20-day periods in a year. Note that in the first term of this formula we divide the 2% discount rate by 98% (1 - 2%) because, in effect, you are paying 2% to delay for 20 days paying 98% of the total bill. So, the percentage rate you are paying in this case is really 2.0408% of the net bill (the bill without financing cost).

2. In the case of 1/10, n/30, the opportunity cost of not taking advantage of the early-payment cash discount is:

= [0.01/(1 - 0.01)] x [365/20] = 0.010101 x 18.25 = 18.43%

3. Given the significant opportunity cost of not taking advantage of early-payment cash discounts, good accounting practice would be to record purchases at their net-of-discount amount and then to record as “interest expense” or “purchase discounts lost” any cash discounts not taken advantage of.

10-38 Production and Materials Budgets—Process Costing (30 minutes)

1. Budgeted Production (XPL30): Units Budgeted sales 480,000 Budgeted finished goods ending inventory (June 30, 2011) + 50,000 Total number of units needed 530,000 Less: Budgeted finished goods beginning inventory – 80,000 Budgeted production (units) 450,000

2. Units of XPL30 to Start into Production:

Budgeted production (from (1) above) 450,000 Budgeted WIP ending inventory (June 30, 2011) + 20,000 Total number of units needed 470,000 Less: Budgeted WIP beginning inventory (July 1, 2010) – 10,000 Total units of XPL30 to start into production 460,000

3. Raw Materials Purchases Budget:

Units of XPL30 to start into production (from (2) above) 460,000 Units of raw materials needed per unit of XPL30 x 2 Total raw materials needed for production 920,000 Budgeted raw materials ending inventory (June 30, 2011) + 50,000 Total number of units of raw materials needed 970,000 Budgeted raw materials beginning inventory (July 1, 2010) – 40,000 Total units of raw materials that must be purchased 930,000

4. While the timing of the addition of materials would affect the calculation for number of equivalent units produced, number of equivalent units in the ending WIP inventory, and the raw materials cost per equivalent unit, it will have no impact on the budgeted purchases of materials for the period.

10-39 Cash Budget--Financing Effects (20-30 minutes)

Hartz & Co. Cash Budget For November and December, 2010

November December

Cash balance, beginning $75,000 $99,000
Plus: Cash receipts $525,000 $450,000
Total cash available (A) $600,000 $549,000

Cash disbursements, prior to financing (B) $450,500 $550,000
Plus: Minimum cash balance (given) $50,000 $50,000
Total cash needed (C) $500,500 $600,000

Excess (deficiency of) cash, before financing (D) = (A) - (B) $99,500 ($51,000)

Financing: Short-term borrowing, beginning of month -0- $52,000 Repayments (loan principal), end of month ($50,000) -0- Cash Interest (@12%), end of month ($500) ($520)
Total Effects of Financing = (E) ($50,500) $51,480

Ending cash balance = (A) - (B) + (E) $99,000 $50,480

10-40 Cash Budget (20 minutes)

|Carla Inc. |
|Cash Budget for Year 2010 |
| | | | | | | |
|Beginning cash balance | | | |$10,000 |
|Net cash flow from operations: | | | |
| Cash inflows: | | | | | |
| Cash collections from customers | |$150,000 | |
| Cash outflows: | | | | |
| Direct materials purchases | |($25,000) | |
| Operating expenses | |$50,000 | | |
| Less: Depreciation |$20,000 |($30,000) | |
| Payroll | | | |($75,000) | |
| Income taxes | | | |($6,000) |$14,000 |
|Investing activities: | | | | | |
| Purchase of machinery | | |$30,000 |
|Financing activities: | | | | |
| Cash excess (shortage) before financing |($6,000) | |
| Minimum cash balance required | |$20,000 | |
| New financing required | | |$26,000 |
|Budgeted end-of-period cash balance | | |$20,000 |
| | | | | | | |

10-41 Cash Budget (20-30 minutes)

Cash Available: Cash balance, beginning (given) $ 6,000 Cash collections from customers (given) + 175,000 Total cash available $181,000

Budgeted Cash Disbursements, 2010: Payroll $160,000 Other operating expenses $18,000 Less: Property taxes (see below) - 3,000 Less: Depreciation expense - 5,000 Cash operating expenses 10,000 Property taxes:

2nd half of 2009 (0.50 x $2,500) $1,250

1st half of 2010 (0.50 x $3,000) 1,500 2,750 Payment for office equipment + 6,000 Total cash disbursements, prior to financing $178,750

Financing: Cash balance before financing $2,250

No, the cash budget shows that Bill will not be able to meet the minimum cash balance requirement of $6,000. As such, borrowing (or some other source of financing) must occur in order to meet the minimum cash requirement.

10-42 Cash Budgeting: Not-for-Profit Context (30-45 minutes)

1. “Endowment fund:” a gift (contribution) whose principal must be maintained but whose income may be expended. (You might use the example of an “endowed professorship” as an example.)

2.
Cash Budget for Tri-County Social Service Agency
2010
(in thousands) Quarters I II III IV Year
Cash Balance, beginning $11 $8 $8 $8 $11
Receipts:
Grants $80 $70 $75 $75 $300 Contracts $20 $20 $20 $20 $80 Mental Health Income $20 $25 $30 $30 $105 Charitable donations $250 $350 $200 $400 $1,200
Total Cash Available $381 $473 $333 $533 $1,696
Less: Disbursements: Salaries and Benefits $335 $342 $342 $346 $1,365 Office expenses $70 $65 $71 $50 $256 Equipment purchases & maintenance $2 $4 $6 $5 $17 Specific assistance $20 $15 $18 $20 $73 Total disbursements $427 $426 $437 $421 $1,711
Excess (deficiency) of cash available over disbursements ($46) $47 ($104) $112 ($15)
Financing:
Borrow from endowment fund $54 $0 $112 $0 $166 Repayments $0 ($39) $0 ($104) ($143) Total financing effects $54 ($39) $112 ($104) $23
Cash Balance, ending $8 $8 $8 $8 $8

3. $23,000.

4. It is probable that both donations and requests for services are unevenly distributed over the year. The agency may want to increase requests for donations and seek additional grants.

5. No. Assuming there is careful fiscal management, borrowing only occurs when necessary.

10-43 Collection of Accounts Receivable (20 minutes)

1. Month Total % to be Collected Budgeted Cash of Sale Credit Sales in October Collection In October October $90,000 70% $ 63,000 September 80,000 15% 12,000 August 70,000 10% 7,000 July 60,000 4% 2,400 Estimated Total Cash Collections in October $84,400

2. Amount Budgeted collection Month of Credit % Collected in in the 4th quarter from of Sale Sales Oct. Nov. Dec. Sales in the 4th Quarter

October $ 90,000 70% $ 63,000

15% 13,500 10% 9,000 November 100,000 70% 70,000 15% 15,000 December 85,000 70% 59,500 Total budgeted cash collections in the 4th quarter from credit sales made in the 4th quarter $230,000

10-44 Accounts Receivable Collections and Sensitivity Analysis (50 minutes)

Original Assumptions/Data:
Actual credit sales for March $120,000
Actual credit sales for April $150,000
Estimated credit sales for May $200,000
Estimated collections in month of sale 25%
Estimated collections in first month following month of sale 60%
Estimated collections in the second month after month of sale 10%
Estimated provision for bad debts in month of sale 5%

1. Estimated cash receipts from collections in May: Collection from sales in March (0.10 x $120,000) $12,000 Collection from sales in April (0.60 x $150,000) $90,000 Collection from sales in May (0.25 x $200,000) $50,000 Total estimated cash collections in May $152,000

2. Gross accounts receivable, May 31st: From credit sales made in April (0.15 x $150,000) $22,500 From credit sales made in May (0.75 x $200,000) $150,000 Estimated gross accounts receivable, May 31st $172,500

3. Net accounts receivable, May 31st: Gross accounts receivable, May 31st $172,500 Less: Allowance for uncollectible accounts: From credit sales made in April $7,500 From credit sales made in May $10,000 Net accounts receivable, May 31st $155,000

4. Revised data/assumptions: Actual credit sales for March $120,000 Actual credit sales for April $150,000 Estimated credit sales for May $200,000 Estimated collections in month of sale 60% Estimated collections in first month following month of sale 25% Estimated collections in the second month after month of sale 10% Estimated provision for bad debts in month of sale 5%

10-44 (Continued)

a. Estimated cash receipts from collections in May: Collection from sales in March (0.10 x $120,000) $12,000 Collection from sales in April (0.25 x $150,000) $37,500 Collection from sales in May (0.60 x $200,000) $120,000 Total cash collections in May $169,500

b. Gross accounts receivable, May 31st: From credit sales made in April (0.15 x $150,000) $22,500 From credit sales made in May (0.40 x $200,000) $80,000 Gross accounts receivable, May 31st $102,500

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “worksheet object” and then select “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode. The screen should then return you to the Word document.

5. The principal benefit is the accelerated receipt of cash, which the company can potentially employ to pay down debt, reduce borrowing, invest, etc. Principal costs would relate to whatever programs are needed to secure the accelerated collection of cash. These costs could include personal, travel, mailings, telephone, incentive programs, and costs related to customer relations.

10-45 Budgeting: Not-for-Profit Sector (20-30 minutes)

1. Stewardship is defined by Merriam-Webster Online Dictionary as “the conducting, supervising, or managing of something; especially: the careful and responsible management of something entrusted to one's care.”

The Socially Responsible Investment Guidelines cited states: “Although it is a moral and legal fiduciary responsibility of the trustees to ensure an adequate return on investment for the support of the work of the church, their stewardship embraces broader moral concerns.” Also, the principles of stewardship lists two fundamental and interdependent principles: “The Conference should exercise responsible financial stewardship over its economic resources.” and “The Conference should exercise ethical and social stewardship in its investment policy.”

The latter states: “Socially responsible investment involves investment strategies based on Catholic moral principles. These strategies are based on the moral demands posed by the virtues of prudence and justice. They recognize the reality that socially beneficial activities and socially undesirable or even immoral activities are often inextricably linked in the products produced and the policies followed by individual corporations. Given the realities of mergers, buyouts and conglomeration, it is increasingly likely that investments will be in companies whose policies or products make the holding of their stock a "mixed investment" from a moral and social point of view. Nevertheless, by prudently applying traditional Catholic moral teaching, and employing traditional principles on cooperation and toleration, as well as the duty to avoid scandal, the Conference can reflect moral and social teaching in investments.”

2. “These two major principles work together to encourage the Conference to identify investment opportunities that meet both our financial needs and our social criteria. These principles are carried out through strategies that seek: 1) to avoid participation in harmful activities, 2) to use the Conference's role as stockholder for social stewardship, and 3) to promote the common good.”

3. No. (Reasons should vary.)

4. Yes.

10-46 Budgeting Cash Receipts: Cash Discounts Allowed on Receivables (40 Minutes)

1. Breakdown of Cash/ Sales Data Amount Bank Credit-Card Sales June $60,000 Cash sales 40% July $80,000 Credit cards 60% August $90,000 September $96,000 Bank charges 3% October $88,000 Credit sales: Collection of Credit Sales Current month 20% Sales Breakdown and Terms 1st month 50% Cash and bank credit card sales 25% 2nd month 15% Credit sales 75% 3rd month 12% Terms 1/eom, n/45 Late charge/month 2%

Sales % % Cash
September Total % Paid Collected Receipts
Cash sales $96,000 25% 40% $ 9,600
Bank credit card sales $96,000 25% 60% 97% $13,968
Collections of A/R: September credit sales $96,000 75% 20% 99% $14,256 August credit sales $90,000 75% 50% $33,750 July credit sales $80,000 75% 15% $ 9,000 June credit sales $60,000 75% 12% 102% $ 5,508
Total Cash Receipts, September $86,082

2. Appropriate accounting treatment for:

a) Bank service (collection) fees: these can be considered an offset to gross sales and thus can be reflected as a deduction in determining “net sales” (see text Exhibit 10.15). Alternatively, these amounts can be considered “selling expenses” and, as such, be treated as an “operating expense,” (i.e., an element of “Selling and Administrative Expenses” on the Income Statement).

b) Cash discounts allowed on collection of receivables: these can be considered a “selling expense” and, as such, would be included within the “Selling and Administrative” expense category on the Income Statement.
10-47 Cash Discounts with Spreadsheet Application (45 Minutes)

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “worksheet object,” then select “Open” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode. The screen should then return you to the Word document below.

10-48 Activity-Based Budgeting (ABB) (20-30 Minutes)

1. Budgeted Cost- Activity Volume Driver Rate Total Cost Storage 400,000 $0.4925 $ 197,000 Requisition Handling 30,000 $12.50 $ 375,000 Pick Packing 800,000 $ 1.50 $1,200,000 Data Entry 800,000 $ 0.80 $ 640,000 30,000 $ 1.20 $ 36,000 Desktop Delivery 12,000 $30.00 $ 360,000 Total Budgeted Cost for the Division $2,808,000

2. Average number of cartons/delivery = 1,170,000 cartons ( 11,700 deliveries = 100 cartons/delivery Total number of cartons budgeted for delivery in January 2010: 12,000 deliveries x 100 cartons/delivery = 1,200,000 cartons Cost per carton delivered = $2,808,000 ( 1,200,000 = $2.34 Therefore, the total budgeted cost for the division remains the same at $2,808,000.

3. Expected saving in costs—January 2010: Requisition Handling $ 375,000 Data Entry: number of lines 640,000 Data Entry: number of requisitions 36,000 Expected Cost Savings, January 2010 = $1,051,000

If the firm uses a single cost-rate system based on the number of cartons delivered, the firm will not be able to estimate the savings without special efforts to gather additional information.

10-49 Activity-Based Budgeting (ABB) with Kaizen (40 Minutes)

1. Unit-Level: Pick packing, Data entry—Lines Batch-Level: Requisition handling, Data entry—Requisitions, Desktop delivery

2. Cost-driver rates:

Cost-Reduction Cost-Driver Rates Activity Rate (per month) January February March Requisition Handling 98% $12.50 $12.250 $12.0050 Pick Packing 99% $ 1.50 $ 1.485 $ 1.4702 Data Entry—Lines 99% $ 0.80 $ 0.792 $ 0.7841 Data Entry—Requisitions 98% $ 1.20 $ 1.176 $ 1.1525 Desktop Delivery 98% $30.00 $29.400 $28.8120

Budgeted Costs: Activity Activity Volume February March Requisition Handling 30,000 $ 367,500 $ 360,150 Pick Packing 800,000 $1,188,000 $1,176,120 Data Entry—Lines 800,000 $ 633,600 $ 627,264 Data Entry—Requisitions 30,000 $ 35,280 $ 34,574 Desktop Delivery 12,000 $ 352,800 $ 345,744 Divisional Totals $2,577,180 $2,543,852

3. Factors that may influence the success of a continuous improvement (Kaizen) program include:

▪ Reasonable or achievable cost reductions. ▪ Awareness of all employees on the expected (scheduled) cost improvements over at least the immediate future periods. ▪ Acceptance by both management and employees. ▪ Commitment of both management and employees on the strategic importance of the success of the continuous improvement program. ▪ Close link between the scheduled improvements and performance evaluations and rewards. ▪ Cost reductions possible from small, incremental improvements, not from large discontinuous changes in factors such as operating processes, capital equipment, supplier networks, or customer interactions.

10-49 (Continued)

4. Primary criticisms of Kaizen (continuous improvement) budgets include the following:

▪ The budgeting process tends to place enormous pressure on employees to reduce all costs, which can lead to employee “burnout.” ▪ The use of Kaizen budgets tends to motivate small, incremental rather than major/significant process improvements. ▪ If the Kaizen targets are confined to the manufacturing function (including product and process design engineering), frictions can arise if manufacturing believes that other parts of the organization (e.g., marketing) are not subjected to the same budgetary pressure.

10-50 Cash Budget (30-40 minutes)

1. Total credit sales in November $240,000 Percentage collectible x _ 95% Total amount collectible from credit sales in November $228,000 Percentage collected in the month following month of sales x 40% Budgeted collections in December from Nov. credit sales $ 91,200

2. Cash sales in January $ 60,000 Collections from credit sales in January: Total collectible from credit sales $180,000 x 95% = $171,000 Percentage to be collected in January x 60% $102,600 Collections from credit sales in December: Total collectible from credit sales $360,000 x 95% = $342,000 Percentage to be collected in January x 40% 136,800 Budgeted total cash receipts in January $299,400

1. Total inventory purchases in November: For November sales: $320,000 x 0.3 X 0.6 = $ 57,600 For December sales: $460,000 x 0.7 X 0.6 = 193,200 $250,800 Percentage of Nov. purchases to be paid in December x 75% Payment in December for purchases in November $188,100 Budgeted purchases in December: For December sales: $460,000 x 0.3 X 0.6 = $ 82,800 For January sales: $240,000 x 0.7 X 0.6 = 100,800 $183,600 Percentage of Dec. purchases to be paid in December x 25% Payment in December for purchases in December $45,900 Budgeted payment in December for inventory purchases $234,000

10-51 Service Firm Budget (60-75 minutes)

Total hours for the budgeted activities: Hourly Budgeted Charge Revenue Rate Required (Given) (Given) Hours
Business returns $1,000,000 $250 4,000
Complex individual returns $1,200,000 $100 12,000
Simple individual returns $1,640,000 $50 32,800 $3,840,000 48,800

Staff requirements for the budgeted activities: Senior Total Hours Partner Manager Consultants Consultants Required Each Total Each Total Each Total Each Total
Business return 4,000 0.30 1,200 0.20 800 0.50 2,000 0.00 0
Complex individual return 12,000 0.05 600 0.15 1,800 0.40 4,800 0.40 4,800
Simple individual return 32,800 0.00 0 0.00 0 0.20 6,560 0.80 26,240 Total Hours 48,800 1,800 2,600 13,360 31,040 Hours per week 50 45 40 40 # of weeks needed 36 58 334 776 # of weeks per employee per year 40 45 45 48 # of employees needed 1 1 8 16 Excess (deficiency) hours 1,040 (320)

Note: Because Consultants can be hired on a part-time basis, we round the calculation DOWN for this class of labor. The other three labor classes are given (i.e., do not have to be planned for based on data in the problem).
10-51 (Continued)

SOLUTION:

1. Since, according to the present staffing plan and anticipated workload needs, there is an excess of senior consultant hours, the budgeted cost for overtime hours worked by senior consultants would be $0.

2. Number of full-time consultants needed for the year:

|No. of consultant-weeks needed for the yr = |776 |
|No. of weeks/full-time consultant/yr = |48 |
|No. of full-time consultants needed = |16 |

3. The manager's total compensation, assuming that the revenues from preparing tax returns remains the same:

| Consultant's pay: | |
| Earning per year = |$60,000 |
| Hrs. worked/year = |1,920 |
| Hourly pay rate = |$31.25 |
| No. of PT hours, consultants = |320 |

Annual Salaries: Per partner = $250,000 Per manager = $90,000 Per senior consultant = $90,000 Per support staff = $40,000

Staffing Plan: Partners = 1 Managers = 1 Senior consultants = 8 Full-time Consultants = 16 Support staff = 5

10-51 (Continued)

AccuTax, Inc.
Budgeted Operating Income
Year ended August 31, 2010

Revenue $3,840,000
Payroll expenses: Partner $250,000 Manager $90,000 Senior consultants—base pay $720,000 Senior consultants—pay for overtime hours $0 Consultants: Full-time $960,000 Part-time $10,000 $970,000 Support staff $200,000 $2,230,000
General and administrative expenses $373,000 Operating income before bonus to manager $1,237,000
Less: manager's bonus $73,700
Operating income before taxes $1,163,300

Total compensation for the manager: Salary (given) $90,000 Bonus (0.10 x [$1,237,000 - $500,000]) $73,700 Total $163,700

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

10-52 Budgetary Pressure and Ethics (20-30 minutes) 1. The use of alternative accounting methods to manipulate reported earnings is professionally unethical because it violates the Standards contained in the IMA’s Statement of Ethical Professional Practice (see: www.imanet.org). The Competence standard is violated because of failure to perform duties in accordance with relevant accounting (technical) standards. It can probably be argued that the competence standard is also violated because the accountant is not providing information that is accurate. The Integrity standard is violated because the underlying activity would discredit the profession. The Credibility standard is violated because of failure to communicate information fairly and objectively.

2. Yes, costs related to revenue should be expensed in the period in which the revenue is recognized (“matching principle”). Perishable supplies are purchased for use in the current period, will not provide benefits in future periods, and should therefore be matched against revenue recognized in the current period. In short, the accounting treatment for supplies was not in accordance with generally accepted accounting principles (GAAP). Note that similar issues, but on an extremely large basis, occurred at WorldCom and at Global Crossing. In the case of the latter, the company was engaging simultaneously in contracts to buy and to sell bandwidth, treating the former as capitalized expenses and the latter as revenue for the current accounting period.

3. The actions of Gary Woods were appropriate. Upon discovering how supplies were being accounted for, Wood brought the matter to the attention of his immediate superior, Gonzales. Upon learning of the arrangement with P&R, Wood told Gonzales that the action was improper; he then requested that the accounts be corrected and the arrangement discontinued. Wood clarified the situation with a qualified and objective peer (advisor) before disclosing Gonzales’s arrangement with P&R to Belco’s division manager, Tom Lin—Gonzales’s immediate superior. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior is not involved. In this case, however, the superior is involved. According to the IMA’s statement regarding Resolution of Ethical Conduct, Wood acted appropriately by approaching Lin without Gonzales’s knowledge and by having a confidential discussion with an impartial advisor.
10-53 Scenario Analysis (45 minutes)

1. “What-If Analysis,” within the context of budgeting, refers to the process of varying one or more budget inputs for the purpose of examining the resulting effect on a variable of interest (e.g., budgeted sales, operating income, or operating cash flows). Scenario analysis can be viewed as the result of simultaneously changing two or more inputs and examining the resulting effect on a variable of interest.

The basic version of Excel can perform three kinds of “what-if” analyses: scenarios, data tables, and Goal Seek. Scenarios and data tables take sets of input values and determine possible results. A data table works only with one or two variables, but it can accept many different values for those variables. A scenario can have multiple variables, but it can accommodate only up to 32 values. Goal Seek works differently from scenarios and data tables in that it takes a result and determines possible input values that produce that result. In addition to these three methods, an Excel add-in, Solver, can be used to perform “what-if” analyses. The Solver add-in is similar to Goal Seek, but it can accommodate more variables.

See the following tutorial for additional information about performing “what-if” analyses using Excel 2007:

1. Introduction to What-If Analysis:

(http://office.microsoft.com/en-us/excel/HA102431641033.aspx)

2. Using Excel to Perform Scenario Analysis:

(http://office.microsoft.com/en-us/excel/HP100726691033.aspx)

3. Using Excel to Perform “What-If” Analysis:

(http://office.microsoft.com/en-us/excel/HA102190021033.aspx)

|2. Budgeted Operating Income--Current Year: | | | | |
| | | | | | | | |
| |Sales Revenue (1,000 units x $750 per unit) = | | |$750,000 |
| |Less: Variable Costs (1,000 units x $500 per unit) = | | |$500,000 |
| |Contribution Margin (1,000 units x $250 per unit) = | | |$250,000 |
| |Less: Fixed Costs = | | | | |$100,000 |
| |Operating Income = | | | | |$150,000 |

10-53 (Continued)

|3. Scenario Analysis: | | | |
| | | |Percentage Change from Baseline |
| | |Sales Volume |Selling Price |Variable Cost |Total Fixed |
| | Scenario |(units) |per Unit |per Unit |Costs |
| |a |0.00% |10.00% |0.00% |10.00% |
| |b |0.00% |0.00% |5.00% |-5.00% |
| |c |-8.00% |10.00% |0.00% |0.00% |
| | | | | | |
| | |Sales Volume |Selling Price |Variable Cost |Total Fixed |
| |Scenario |(units) |per Unit |per Unit |Costs |
| |Baseline |1,000 |$750 |$500 |$100,000 |
| |a |1,000 |$825 |$500 |$110,000 |
| |b |1,000 |$750 |$525 |$95,000 |
| |c |920 |$825 |$500 |$100,000 |
| | | | | | |
| | | | | |% Change |
| | |Baseline |Budgeted |$ Change in Budgeted |from Baseline |
| | |Operating |Operating | | |
| |Scenario |Income |Income |Op. Income |Op. Income |
| |Baseline |$150,000 |$150,000 |$0 |N/A |
| |a |$150,000 |$215,000 |$65,000 |+43.33% |
| |b |$150,000 |$130,000 |($20,000) |-13.33% |
| |c |$150,000 |$199,000 |$65,000 |+32.67% |

10-54 Profit Planning and Sensitivity Analysis (45 minutes)

|1. Sales volume in units: |
| | | | | |
| |Let "X" = required sales volume. Thus, when total cost at each alternative cost structure is the same, we have: |
| | | | | |
| |$85.00X + $40,000 = $80.00X + $45,000 |
| | | X = |1,000 units | |

|2. Sales level needed: |
| |
| Pre-tax profit = (cm/unit * X) - FC = 5% (sp/unit * X) |
| 0 = [(cm/unit * X) - 5% (sp/unit*X)] - FC |
| X = FC/[(cm/unit) - 5% (sp/unit)] |

| | |Alternative 1 |Alternative 2 |
|Selling price/unit = | |$100.00 |$100.00 |
|Variable cost/unit = | |$85.00 |$80.00 |
|Contribution margin /unit = | |$15.00 |$20.00 |
|Operating profit target (%) = |5% |5% |
|Required Sales Volume = |4,000 |3,000 |
| | | | |
|Check: | | | |
|Sales Revenue |$400,000 |$300,000 |
|Variable Costs |$340,000 |$240,000 |
|CM | |$60,000 |$60,000 |
|Fixed Costs | |$40,000 |$45,000 |
|Operating Profit |$20,000 |$15,000 |
| | | | |
|Operating Profit/Sales Revenue |5.00% |5.00% |

10-54 (Continued)

|3. Sales volume needed: |

|Let X = sales dollars, then: |
| Pre-tax profit = [(cm ratio)*X] - FC = 5.00%X |
| FC = (cm ratio * X) - 5.00%X |
| FC = (cm ratio -5.00%)X |
| X = FC/[(cm ratio - 5.00%)*X] |

| Targeted pre-tax profit (% of sales) = |5.00% |5.00% |
| | | | | |
| | | |Alternative 1 |Alternative 2 |
| |Selling price/unit = | |$100.00 |$100.00 |
| |Contribution margin/unit = | |$15.00 |$20.00 |
| |Contribution margin ratio = | |15.00% |20.00% |
| | | | | |
| |Operating profit target (%) = |5% |5% |
| |Required Sales Volume = |$400,000 |$300,000 |
| | | | | |
| |Check: | | | |
| |Sales Revenue |$400,000 |$300,000 |
| |Variable Costs |$340,000 |$240,000 |
| |CM | |$60,000 |$60,000 |
| |Fixed Costs | |$40,000 |$45,000 |
| |Operating Profit |$20,000 |$15,000 |
| | | | | |
| |Operating Profit/Sales Revenue |5.00% |5.00% |

10-55 Time-Driven Activity-Based Budgeting (TDABB) (45 minutes)

|1. Calculation of budgeted resource costs per hour: | | | | |
| | | | | |Practical | |Budgeted |
| | | |Budgeted | |Capacity | |Cost per |
| |Resource | |Cost | |(Hours) | |Hour |
| | | | | | | | |
| | Indirect labor support |$1,000,000 | |20,000 | |$50 |
| | Computer support |$500,000 | |500 | |$1,000 |

2. Determination of the cost-driver rates for each activity (handle production runs, and support product):

Activity #1: Handle Production Runs
| | | | |Unit | |Budgeted | |
| | |Budgeted | |Times | |Cost-Driver | |
|Resource | |Cost/Hour | |(hours) | |Rate | |
|Indirect Labor |$50 | |10.00 | |$500.00 | |
|Computer support |$1,000 | |0.40 | |$400.00 | |
| | | | | | |$900.00 |per run |
| | |Budgeted | |Times | |Cost-Driver | |
|Resource | |Cost/Hour | |(hours) | |Rate | |
|Indirect Labor |$50 | |500.00 | |$25,000 | |
|Computer Support |$1,000 | |50.00 | |$50,000 | |
| | | | | | | $75,000 |
| | |Resource |Units |Units |Resources |Unused |
|Resource | |Supplied |Supplied |Used |Used |Capacity |
|Indirect labor |$1,000,000 |20,000 |18,000 |$900,000 |$100,000 |
|Computer support |$500,000 |500 |450 |$450,000 |$50,000 |

|10-55 (Continued) |
| |
|Generally speaking, the cost of unused capacity should not be assigned to actual units produced or customers served during the period. |
|However, the cost of unused capacity should not be ignored--it is someone's responsibility in the organization. That is, the cost of unused|
|capacity for a period should be assigned to the person or office that authorized the level of capacity when that capacity was acquired. |
|Typically, this assignment would be made on a “lump-sum” basis. This assignment provides feedback to managers regarding their resource |
|supply/demand decisions. |

4. After implementing a TQM program, the company was able to implement process-efficiency changes, the end result of which was a 10% reduction in the indirectly labor time associated with the activity “handling production runs.” Re-estimate the indirect labor cost component of the cost to handle a production run. Also, recalculate the cost of unused capacity for indirect labor assuming the original facts but the 10% efficiency gain. Assume that in the original case facts, 16,000 of the 18,000 hours related to handling production runs.
| |
|Efficiency gain: indirect labor consumed by "handling a production run": 10% |
| Original indirect labor hours: handling production runs = 16,000 |
| Original indirect labor hours: computer support = 2,000 |
| |
|Revised Budgeted Cost-Driver Rate: Indirect labor support for "handling a production run": |
| |
| |
| |
| |
|Unit |
| |
|Budgeted |
| |
| |
| |
| |
|Budgeted |
| |
|Times |
| |
|Cost-Driver |
| |
| |
|Resource |
| |
|Cost/Hour |
| |
|(hours) |
| |
|Rate |
| |
| |
|Indirect Labor |
|$50 |
| |
|9.00 |
| |
|$450.00 |
|per run |
| |
| |
| Revised Cost of Unused Capacity--Indirect Labor Support Cost: |
| |
| |
| |
|Cost of |
|Resource |
|Resource |
|Cost of |
|Cost of |
| |
| |
| |
|Resource |
|Units |
|Units |
|Resources |
|Unused |
| |
|Resource |
| |
|Supplied |
|Supplied |
|Used |
|Used |
|Capacity |
| |
|Indirect labor |
|$1,000,000 |
|20,000 |
|16,400* |
|$820,000 |
|$180,000 |
| |
| |
| |
|*Resource Units Used Calculation: 2,000 + (16,000 *(1 – 10%)) = 16,400 |
| |
|As can be seen, the efficiency gain resulted in "freed-up" indirect labor resources, which are now available for use elsewhere in the |
|company. In the event that alternative uses for this labor cannot be found, then management faces the issue of whether to reduce its |
|workforce. Also, the reduced cost-driver rate ($50 reduction) would be of potential strategic use to management, for pricing and product |
|promotion purposes. |
| |

10-56 Rolling Financial Forecasts (20 minutes)

1. “Rolling forecasts” of sales:
| | | | | | | |
|Month of | | |Forecast for Month of | |
|Forecast |January |February |March |April |May |June |
|December |100 |95 |100 |110 |120 |125 |
|January | |90 |100 |105 |110 |120 |
|February | | |95 |105 |105 |120 |
|March | | | |105 |100 |110 |
|April | | | | |90 |105 |
|May | | | | | |105 |

2. Three-month forecast error rates, March through June. (Note: Error rate = 1 – absolute forecast error.) For example, the forecast error rate for March’s sales is found by dividing the absolute value of the forecast error for this month by the actual sales volume for the month. The forecast error for any month (e.g., March) is defined as the difference between the actual sales volume for the month and the sales volume for that month provided three months earlier (i.e., December).

January February March April May June
|Actual Sales |98 |95 |92 |108 |98 |100 |
|Forecast error rate |- |- |8.70%1 |1.85% |22.45% |25.00% |
|Direction of error |- |- |Below |Below |Below |Below |

1Example: (ABS(100 – 92))/92 = 8.70%

10-57 Profit Planning and Sensitivity Analysis (60 minutes)

1. Break-even volume, in units and dollars, for the coming year:

| Annual fixed costs = | | |$450,000 | |
| Contribution margin, per unit: | | | |
| Selling price per unit = | |$40.00 | | |
| Variable cost, per unit = | |$32.00 | | |
| Contribution margin, per unit = |$8.00 | | |
| Contribution margin ratio: | | | | |
| Selling price, per unit = | |$40.00 | | |
| Contribution margin, per unit = |$8.00 | | |
| Contribution margin ratio = |20.00% | | |
| | | | | | |
| Annual break-even volume (units) = | |56,250 |units |
| Annual break-even volume (dollars) = | |$2,250,000 | |

|2. Units needed to be sold for the company to meet the $180,000 profit goal: |

| Annual fixed costs (FC) = | | |$450,000 | |
| Pre-tax profit target (dollars) = | |$180,000 | |
| Required sales volume (units) = | |78,750 |Units* |

*($450,000 + $180,000)/$8.00 per unit

3.
| | | | | | | |
|Situation |% Change in DL Cost |Revised Variable |Revised Contribution |Break-Even volume |Unit Change in |% Change in B/E |
| |Component |Cost per Unit |Margin per Unit |(units) |B/E Point |Point |
|Baseline |0.00% |$32.00 |$8.00 |56,250 |N/A |N/A |
|1 |4.00% |$32.40 |$7.60 |59,211 |2,961 |5.26% |
|2 |6.00% |$32.60 |$7.40 |60,811 |4,561 |8.11% |
|3 |8.00% |$32.80 |$7.20 |62,500 |6,250 |11.11% |

10-57 (Continued-1)

4. Selling price per unit the company must charge to maintain the budgeted ratio of contribution margin to sales (hint: Use the Goal-Seek function in Excel to answer this question):

|Original selling price per unit = | |$40.00 |
|Original variable cost per unit = | |$32.00 |
|Original contribution margin per unit = |$8.00 |
|Original contribution margin ratio = |20.00% |
| | | | |
|Revised selling price per unit = |$40.62 |
|Increase in labor-cost component of vc per unit = |5.00% |
|Labor-cost component of variable cost per unit = |$10.00 |
|Revised variable cost per unit = | |$32.50 |
|Revised contribution margin per unit = |$8.12 |
| | | | |
|Revised contribution margin ratio = |19.99% |
| |
|Thus, we access from Data, then What-If analysis, Goal-Seek. In the Goal-Seek menu we instruct Excel to adjust the selling price per unit |
|(cell E82) upward until the revised contribution margin ratio (cell E88) is equal to the original case (i.e., 20%). As can be seen, a |
|selling price of approximately $40.62 per unit accomplishes this goal. |

5. As stated in the chapter, inputs to the construction of individual budgets are subject to uncertainty. That is, the inputs represent forecasts (e.g., selling price per unit, sales volume, and sales mix) and therefore are subject to estimation error. "What-if" analysis is a tool that allows us to vary one or more of these inputs in order to examine the resulting effect on one or more budgets (e.g., operating income or cash flows). In essence, we attempt to determine how sensitive our budgets and forecasted financial statements are with respect to assumptions we are making as to the value of input factors. For example, the analysis in 3 above suggests that the budgeted break-even point for the company is sensitive (i.e., it reacts significantly) to changes in the labor-cost component of variable cost per unit. As such, management would want to control this cost as carefully as it could.

|1110-57 (Continued-2) |
| |
|See the following tutorials for additional information about performing "what-if" analyses using Excel 2007: |
| |
|1. Introduction to What-If Analysis: |
|http://office.microsoft.com/en-us/excel/HA102431641033.aspx |
| |
|2. Using Excel to Perform Scenario Analysis: |
|http://office.microsoft.com/en-us/excel/HP100726691033.aspx |
| |
|3. Using Solver to Perform What-If Analysis: |
|http://office.microsoft.com/en-us/excel/HA102190021033.aspx |
| |

10-58 Profit Planning & Strategic Considerations (60 minutes)

1. What is the Break-even volume for each of the two decision alternatives?

| | | | |Existing |New |
| | | | |Machine |Machine |
| Monthly fixed costs = | | |$100,000 |$200,000 |
| Contribution margin, per unit: | | | |
| Selling price per unit = | | |$15.00 |$17.50 |
| Variable cost, per unit = | | |$12.00 |$12.00 |
| Contribution margin, per unit = | |$3.00 |$5.50 |
| | | | | | |
| Monthly break-even volume (units) = | |33,333 |36,364 |
| Monthly break-even volume (dollars) = | |$500,000 |$636,364 |

|2. Required sales level, in units per month, to generate the stated profitability target: |

| Let X = required sales volume (in units) to achieve the stated profit target (operating profit = 12.00% of |
|sales dollars). |
| |
|Then, CM - FC = 0.12*(sp/unit*X) |
| [(cm/unit*X) – FC] = 0.12*(sp/unit*X) |
| [X*((cm/unit - 0.12(sp/unit))] = FC |
| |
| | |Existing | New |
| | |Machine |Machine |
|FC = | |$100,000 |$200,000 |
|cm per unit = | |$3.00 |$5.50 |
|profit target % * sp per unit = |$1.80 |$2.10 |
|required sales volume, X = |83,333 |58,824 |
|% increase over B/E volume = |150.00% |61.76% |

You can get a sense of the trade-off of having a greater proportion of fixed costs in the cost structure (i.e., high degree of operating of operating leverage). Once the break-even point is passed, profits for such a company increase quickly.

10-58 (Continued-1)

3.
| Profit equation, decision alternative #1: |
| |pre-tax profit = CM - FC = (cm/unit * X) - FC = ($3.00X) - $100,000 |
| Profit equation, decision alternative #2: |
| |pre-tax profit = CM - FC = (cm/unit * X) - FC = ($5.50X) - $200,000 |
| | |
|Indifference point = volume of sales, X, such that total pre-tax profit under each alternative is the same: |
| |
|($3.00X) - $100,000 = ($5.50X) - $200,000 |
| |
|$2.50X = $100,000 |
| |
|X = $100,000/$2.50 = 40,000 |
| |
| |
| Check: | | | | | |
| Total Contribution Margin (CM) = |$120,000 |$220,000 | |
| Less: FC = | |$100,000 |$200,000 | |
| Pre-tax profit = | |$20,000 |$20,000 |OK |

| Data Table | | |Existing Machine |New Machine |
| | |Volume (X) |Pre-tax Profit |Pre-tax Profit |
| | |0 |($100,000) |($200,000) |
| | |5,000 |($85,000) |($172,500) |
| | |10,000 |($70,000) |($145,000) |
| | |15,000 |($55,000) |($117,500) |
| | |20,000 |($40,000) |($90,000) |
| | |25,000 |($25,000) |($62,500) |
| | |30,000 |($10,000) |($35,000) |
| | |35,000 |$5,000 |($7,500) |
| | |40,000 |$20,000 |$20,000 |
| | |45,000 |$35,000 |$47,500 |
| | |50,000 |$50,000 |$75,000 |
| | |55,000 |$65,000 |$102,500 |
| | |60,000 |$80,000 |$130,000 |
| | | | | |

10-58 (Continued-2)

[pic]

10-58 (Continued-3)

4. Strategic factors or considerations that might affect the decision as to whether the company should keep or replace the existing equipment:

| a) How is the company competing? If it is pursuing a differentiation strategy then the decision to replace the existing machine might |
|become more attractive. The problem tells us that the new machine provides some additional benefits associated with the new machine |
|(reduction in manufacturing cycle time and increase in product quality). The company plans, in response to these improvements, to increase |
|product selling price. However, these benefits may translate into additional sales volume--an issue that in the problem is left unexplored.|
| |
|b) Does the company have any additional investment opportunities compared to the proposed equipment purchase? |
| |
|c) What is the attitude of the managers/owners as regards risk, in this case, the risk associated with increased level of fixed cost. (A |
|measure of this is the degree of operating leverage.) The instructor here has the opportunity to draw a parallel to financial leverage--its|
|benefits and costs. |
| |
|d) Variable costs per unit are expected to be unaffected by this decision. However, are there any employee training costs for the new |
|machine that we haven't captured? Would there be any additional costs, fixed or variable, associated with the new machine? For example, |
|would power consumption be affected? What about property taxes levied on the value of the assets of the business? |
| |
|e) Is the anticipated life-span of the two machines the same? If not, what is the assumption regarding equipment replacement when the |
|existing machine wears out? |
| |
|f) In reality, this decision is a capital budgeting decision because it has long-term implications. How does the proposed investment |
|compare to the minimum required return on invested capital for this company? That is, does it provide an adequate rate of return? |

10-59 Ethics in Budgeting/Budgetary Slack (30-40 minutes)

1. a. The reasons that Marge Atkins and Pete Granger use budgetary slack include the following:

▪ These employees are hedging against the unexpected (i.e., they use slack to deal with or reduce uncertainty and risk). ▪ Budgetary slack allows employees to “look good,” (i.e., to exceed expectations and/or show consistent performance). This is particularly important when performance is evaluated on the basis of actual versus budgeted results. ▪ Employees who are able to blend personal and organizational goals through budgetary slack and show good performance generally are rewarded with higher salaries, promotions, and bonuses. ▪ By “padding the budget,” the manager is more likely to get what he/she actually needs in terms of resources for the upcoming period.

b. The use of budgetary slack can adversely affect Atkins and Granger by:

▪ limiting the usefulness of the budget to motivate their employees to top performance ▪ affecting their ability to identify trouble spots and take appropriate corrective action ▪ reducing their credibility in the eyes of management ▪ reducing the ability of top management to effectively allocate resources to organizational subunits on the basis of actual economic performance. For example, the use of budgetary slack may affect management decision-making, as the budgets will show lower contribution margins (lower sales, higher expenses). Decisions regarding the profitability of product lines, staffing levels, incentives, etc. could have an adverse effect on Atkins's and Granger's departments.

2. The use of budgetary slack, particularly if it has a detrimental effect on the company, may be unethical. In assessing the situation, the IMA’s Statement of Ethical Professional Practice can be consulted (www.imanet.org). This statement notes that “a commitment to ethical professional practice” includes: overarching principles (expressions of core values) and a set of standards intended to guide actual conduct and practice.

10-59 (Continued)

The IMA’s overarching PRINCIPLES include: Honesty, Fairness, Objectivity, and Responsibility. The list of STANDARDS includes the following: Competence, Confidentiality, Integrity, and Credibility. The following Standards could be referenced in conjunction with the use of budgetary slack, as described above:

▪ Competence: Provide decision support information and recommendations that are accurate, clear, concise, and timely. ▪ Integrity: Refrain from engaging in any conduct that would prejudice carrying out duties ethically. ▪ Credibility: Communicate information fairly and objectively; disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.

Though not asked for in the original CMA exam problem, you might want to discuss with students how, in practice, they would deal with ethical dilemmas. In its Resolution of Ethical Conflict statement the IMA provides the following guidance:

1. Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. If your immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with your superior’s knowledge, assuming he or she is not involved. Communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law.

2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action.

3. Consult your own attorney as to legal obligations and rights concerning the ethical conflict.

10-60 Comprehensive Profit Plan (90 minutes)

1. Sales Budget

Spring Manufacturing Company
Sales Budget
2010

C12 D57 Total Sales (in units) 12,000 9,000 21,000 x Selling Price Per Unit $150 $220 Total Sales Revenue $1,800,000 $1,980,000 $3,780,000

2. Production Budget

Spring Manufacturing Company
Production Budget
2010
C12 D57 Budgeted Sales (in units) 12,000 9,000 + Desired finished goods ending inventory 300 200 Total units needed 12,300 9,200 – Beginning finished goods inventory 400 150 Budgeted Production (in units) 11,900 9,050

10-60 (Continued-1)

3. Direct Materials Purchases Budget

Spring Manufacturing Company
Direct Materials Purchases Budget (units and dollars)
2010

C12 D57 Total Raw Material (RM) 1: Budgeted Production 11,900 9,050 Pounds per Unit x 10 x 8 RM 1 needed for production 119,000 72,400 191,400 Plus: Desired Ending Inventory (lbs.) 4,000 Total RM 1 needed (lbs.) 195,400 Less: Beginning inventory (lbs.) 3,000 Required purchases of RM 1 (lbs.) 192,400 Cost per pound $2.00 Budgeted purchases, RM 1 $384,800

Raw Material (RM) 2: Budgeted Production 11,900 9,050 Pounds per Unit x 0 x 4 RM 2 needed for production 0 36,200 36,200 Plus: Desired Ending Inventory (lbs.) 1,000 Total RM 2 needed (lbs.) 37,200 Less: Beginning inventory (lbs.) 1,500 Required purchases of RM 2 (lbs.) 35,700 Cost per pound $2.50 Budgeted purchases, RM 2 $89,250

Raw Material 3: Budgeted Production 11,900 9,050 Pounds per Unit x 2 x 1 RM 3 needed for production 23,800 9,050 32,850 Plus: Desired Ending Inventory (lbs.) 1,500 Total RM 3 needed (lbs.) 34,350 Less: Beginning inventory (lbs.) 1,000 Required purchases of RM 3 (lbs.) 33,350 Cost per pound $0.50 Budgeted purchases, RM 3 $16,675
10-60 (Continued-2)

4. Direct Manufacturing Labor Budget

Spring Manufacturing Company
Direct Labor Budget
2010

C12 D57 Total Budgeted production 11,900 9,050 Direct labor hours per unit x 2 x 3 Total direct labor hours needed 23,800 27,150 50,950 Hourly wage rate $25.00 Budgeted direct labor costs $1,273,750

5. Factory Overhead Budget

Spring Manufacturing Company
Factory Overhead Budget 2010

Variable Factory Overhead: Indirect materials $10,000 Miscellaneous supplies and tools 5,000 Indirect labor 40,000 Payroll taxes and fringe benefits 250,000 Maintenance costs 10,080 Heat, light, and power 11,000 $326,080

Fixed Factory Overhead: Supervision $120,000 Maintenance costs 20,000 Heat, light, and power 43,420 Total Cash Fixed Factory Overhead $183,420 Depreciation 71,330 $254,750 Total Budgeted Factory Overhead $580,830

10-60 (Continued-3)

6. Budgeted Cost of Goods Sold

Spring Manufacturing Company
Ending Finished Goods Inventory and Budgeted CGS
2010

C12 D57 Total Sales volume 12,000 9,000 21,000 Cost per unit (Schedule 1 and 2) $93.80 $135.70 Cost of goods sold $1,125,600 $1,221,300 $2,346,900

Finished goods ending inventory 300 200 Cost per unit (Schedule 1 and 2) $93.80 $135.70 Budgeted ending inventories $28,140 $27,140 $55,280

Schedule 1: Cost per Unit--Product C12: Inputs Cost Cost Element Unit Input Cost Quantity Per Unit RM-1 $2.00 10 $20.00 RM-3 $0.50 2 $1.00 Direct labor $25.00 2 $50.00 Variable factory OH ($326,080/50,950) $6.40 2 $12.80 Fixed factory OH ($254,750/50,950) $5.00 2 $10.00 Manufacturing cost per unit $93.80

Schedule 2: Cost per Unit--Product D57: Inputs Cost Cost Element Unit Input Cost Quantity Per Unit RM-1 $2.00 8 $16.00 RM-2 $2.50 4 $10.00 RM-3 $0.50 1 $0.50 Direct labor $25.00 3 $75.00 Variable factory OH ($326,080/50,950) $6.40 3 $19.20 Fixed factory OH ($254,750/50,950) $5.00 3 $15.00 Manufacturing cost per unit $135.70

10-60 (Continued-4)

7. Budgeted selling and administrative expenses:

Spring Manufacturing Company
Selling and Administrative Expense Budget
2010

Selling Expenses: Advertising $60,000 Sales salaries 200,000 Travel and entertainment 60,000 Depreciation 5,000 $325,000 Administrative expenses: Offices salaries $60,000 Executive salaries 250,000 Supplies 4,000 Depreciation 6,000 $320,000 Total selling and administrative expenses $645,000

8. Budgeted Income Statement:

Spring Manufacturing Company
Budget Income Statement
For the Year 2010

C12 D57 Total
Sales (part 1) $1,800,000 $1,980,000 $3,780,000
Cost of goods sold (part 6) 1,125,600 1,221,300 2,346,900
Gross profit $674,400 $758,700 $1,433,100
Selling and administrative expenses (part 7) $645,000
Pre-tax operating income $788,100
Income taxes (@40%) $315,240
After-tax operating income $472,860

10-60 (Continued-5)

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

10-61 Spring Manufacturing Company—Comprehensive Profit Plan (90 Minutes, but much less if used in conjunction with 10-60 and completed with an Excel spreadsheet)

1. Sales Budget

Spring Manufacturing Company
Sales Budget
2010

C12 D57 Total Sales (in units) 12,000 18,000 30,000 x Selling Price Per Unit $160 $180 Total revenue $1,920,000 $3,240,000 $5,160,000

2. Production Budget

Spring Manufacturing Company
Production Budget
2010

C12 D57
Budgeted Sales (in units) 12,000 18,000
Plus: Desired finished goods ending inventory 300 200
Total units needed 12,300 18,200
Less: Beginning finished goods inventory 400 150
Budgeted Production (in units) 11,900 18,050

10-61 (Continued-1)

3. Direct Materials Purchases Budget (units and dollars)

Spring Manufacturing Company
Direct Materials Purchases Budget (units and dollars)
2010
C12 D57 Total Raw Material (RM) 1: Budgeted Production 11,900 18,050 Pounds per Unit x 10 x 8 RM 1 needed for production 119,000 144,400 263,400 Plus: Desired Ending Inventory (lbs.) 4,000 Total RM 1 needed (lbs.) 267,400 Less: Beginning inventory (lbs.) 3,000 Required purchases of RM 1 (lbs.) 264,400 Cost per pound $2.00 Budgeted purchases, RM 1 $528,800

Raw Material (RM) 2: Budgeted Production 11,900 18,050 Pounds per Unit x 0 x 4 RM 2 needed for production 0 72,200 72,200 Plus: Desired Ending Inventory (lbs.) 1,000 Total RM 2 needed (lbs.) 73,200 Less: Beginning inventory (lbs.) 1,500 Required purchases of RM 2 (lbs.) 71,700 Cost per pound $2.50 Budgeted purchases, RM 2 $179,250

Raw Material 3: Budgeted Production 11,900 18,050 Pounds per Unit x 2 x 1 RM 3 needed for production 23,800 18,050 41,850 Plus: Desired Ending Inventory (lbs.) 1,500 Total RM 3 needed (lbs.) 43,350 Less: Beginning inventory (lbs.) 1,000 Required purchases of RM 3 (lbs.) 42,350 Cost per pound $0.50 Budgeted purchases, RM 3 $21,175

10-61 (Continued-2)

4. Direct Manufacturing Labor Budget

Spring Manufacturing Company
Direct Labor Budget
2010

C12 D57 Total
Budgeted production 11,900 18,050
Direct labor hours (DLH) per unit x 2 x 3

Total direct labor hours needed 23,800 54,150 77,950
Hourly wage rate $25.00
Budgeted direct labor costs $1,948,750

5. Factory Overhead Budget

Variable OH per DLH (from Prob. 10-60): $6.40

Spring Manufacturing Company
Factory Overhead Budget
2010

Variable Factory Overhead ($6.40/DLH x 77,950) $498,880
Fixed Factory Overhead: Supervision $120,000 Maintenance costs 20,000 Heat, light, and power 43,420 Total Cash Fixed Factory Overhead $183,420 Depreciation 71,330 $254,750
Total Budgeted Factory Overhead $753,630

Variable OH rate per DLH $6.40
Fixed OH rate per DLH ($254,750/77,950 DLHs) $3.26812

10-61 (Continued-3)

6. Budgeted CGS and Ending Finished Goods Inventory Budget

Spring Manufacturing Company
Ending Finished Goods Inventory and Budgeted CGS
2010

C12 D57 Total Sales volume 12,000 18,000 30,000 Cost per unit (Schedule 1 and 2) $90.33624 $130.50436 Cost of goods sold $1,084,035 $2,349,079 $3,433,114

Finished goods ending inventory 300 200 Cost per unit (Schedule 1 and 2) $90.33624 $114.50 Budgeted ending inventories $27,101 $26,101 $53,202

Schedule 1: Cost per Unit—Product C12: Inputs Cost Cost Element Unit Input Cost Quantity Per Unit RM-1 $2.00 10 $20.00 RM-3 $0.50 2 $1.00 Direct labor $25.00 2 $50.00 Variable factory OH ($326,080/50,950) $6.40 2 $12.80 Fixed factory OH ($254,750/77,950) $3.26812 2 $6.53624 Manufacturing cost per unit $90.33624

Schedule 2: Cost per Unit—Product D57: Inputs Cost Cost Element Unit Input Cost Quantity Per Unit RM-1 $2.00 8 $16.00 RM-2 $2.50 4 $10.00 RM-3 $0.50 1 $0.50 Direct labor $25.00 3 $75.00 Variable factory OH ($326,080/50,950) $6.40 3 $19.20 Fixed factory OH ($254,750/77,950) $3.26812 3 $9.80436 Manufacturing cost per unit $130.50436

10-61 (Continued-4)

7. Selling and Administrative Expense Budget

Spring Manufacturing Company
Selling and Administrative Expense Budget
2010

Selling Expenses: Advertising $60,000 Sales salaries 200,000 Travel and entertainment 60,000 Depreciation 5,000 $325,000 Administrative expenses: Offices salaries $60,000 Executive salaries 250,000 Supplies 4,000 Depreciation 6,000 $320,000 Total selling and administrative expenses $645,000

8. Budgeted Income Statement

Spring Manufacturing Company
Budget Income Statement
For the Year 2010

C12 D57 Total
Sales (part 1) $1,920,000 $3,240,000 $5,160,000
Cost of goods sold (part 6) 1,084,035 2,349,079 3,433,114
Gross profit $835,965 $890,921 $1,726,886
Selling and administrative expenses (part 7) $645,000
Pre-tax operating income $1,081,886
Income taxes (@40%) $432,754
After-tax operating income $649,132

10-61 (Continued-5)

Answers:

1. The projected increase in after-tax operating income =

$649,132 – $472,860 = $176,272

2. While the changes are projected to increase after-tax operating income, the company should examine the decision more closely. Although the company increases its after-tax operating income by 37% ($176,272/$472,860), it requires a doubling of units of D57 to achieve this. In fact, a 100% increase in units sold of D57 increases the gross profit of D57 from $758,700 to $890,921, an increase of $132,221, while the total change in gross profit is $293,786 (from $1,433,100 to $1,726,886). The 100% increase in D57 accounts for only 45% ($132,221 ( $293,786) of the increase in gross profit; C12 contributes 55% of the increase.

Further, the price increase in C12 has no effect on the units sold. This may be an indication that C12 may have a higher potential than the firm perceived.

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

10-62 Comprehensive Profit Plan with Kaizen (90 minutes, but much less if assigned in conjunction with 10-60 and completed with an Excel spreadsheet)

1. Sales Budget

Spring Manufacturing Company
Sales Budget
2010

C12 D57 Total Sales (in units) 12,000 9,000 21,000 x Selling Price Per Unit $150 $220 Total revenue $1,800,000 $1,980,000 $3,780,000

2. Production Budget

Spring Manufacturing Company
Production Budget
2010

C12 D57 Budgeted Sales (in units) 12,000 9,000 Plus: Desired finished goods ending inventory 300 200 Total units needed 12,300 9,200 Less: Beginning finished goods inventory 400 150 Budgeted Production (in units) 11,900 9,050

10-62 (Continued-1)

3. Direct Materials Purchases Budget (units and dollars)

Spring Manufacturing Company
Direct Materials Purchases Budget (units and dollars)
2010

C12 D57 Total Raw Material (RM) 1: Budgeted Production 11,900 9,050 Pounds per Unit x 9 x 7 RM 1 needed for production 107,100 63,350 170,450 Plus: Desired Ending Inventory (lbs.) 4,000 Total RM 1 needed (lbs.) 174,450 Less: Beginning inventory (lbs.) 3,000 Required purchases of RM 1 (lbs.) 171,450 Cost per pound $2.00 Budgeted purchases, RM 1 $342,900

Raw Material (RM) 2: Budgeted Production 11,900 9,050 Pounds per Unit x 0 x 3.6 RM 2 needed for production 0 32,580 32,580 Plus: Desired Ending Inventory (lbs.) 1,000 Total RM 2 needed (lbs.) 33,580 Less: Beginning inventory (lbs.) 1,500 Required purchases of RM 2 (lbs.) 32,080 Cost per pound $2.50 Budgeted purchases, RM 2 $80,200

Raw Material 3: Budgeted Production 11,900 9,050 Pounds per Unit x 1.8 x 0.8 RM 3 needed for production 21,420 7,240 28,660 Plus: Desired Ending Inventory (lbs.) 1,500 Total RM 3 needed (lbs.) 30,160 Less: Beginning inventory (lbs.) 1,000 Required purchases of RM 3 (lbs.) 29,160 Cost per pound $0.50 Budgeted purchases, RM 3 $14,580

10-62 (Continued-2)

4. Direct Manufacturing Labor Budget

Spring Manufacturing Company
Direct Labor Budget
2010

C12 D57 Total Budgeted production 11,900 9,050 Direct labor hours per unit x 1.5 x 2 Total direct labor hours needed 17,850 18,100 35,950 Hourly wage rate $30.00 Budgeted direct labor costs $1,078,500

5. Factory Overhead Budget

Spring Manufacturing Company
Factory Overhead Budget
2010

Original Variable OH Budget: Indirect materials $10,000 Miscellaneous supplies and tools 5,000 Indirect labor 40,000 Payroll taxes and fringe benefits 250,000 Maintenance costs 10,080 Heat, light, and power 11,000 Total Variable Factory Overhead $326,080

Reduction Rate for Variable OH Costs 10.00%

Original Fixed OH, Excluding Depreciation: Supervision $120,000 Maintenance costs 20,000 Heat, light, and power 43,420 Total Cash Fixed Factory Overhead $183,420 Depreciation 71,330 Total Original Fixed OH $254,750

Reduction Rate for Cash Fixed OH Costs = 5.00%

10-62 (Continued-3)

Budgeted Variable OH: ($326,080 x (1 - 0.10)) = $293,472 Budgeted Fixed OH: Cash Charges = ($183,420 x (1 - 0.05)) = $174,249 Depreciation (same as last year) = $71,330 Total Budgeted Fixed OH = $245,579

6. Budgeted CGS and Ending Finished Goods Inventory Budget

Spring Manufacturing Company
Ending Finished Goods Inventory and Budgeted CGS
2010

C12 D57 Total Sales volume 12,000 9,000 21,000 Cost per unit (Schedule 1 and 2) $86.39170 $113.38893 Cost of goods sold $1,036,700 $1,020,500 $2,057,200

Finished goods ending inventory 300 200 Cost per unit (Schedule 1 and 2) $86.39170 $113.38893 Budgeted ending inventories $25,918 $22,678 $48,596

Schedule 1: Cost per Unit—Product C12: Inputs Cost Cost Element Unit Input Cost Quantity Per Unit RM-1 $2.00 9 $18.00 RM-3 $0.50 1.8 $0.90 Direct labor $30.00 1.5 $45.00 Variable factory OH ($293,472/35,950) $8.16334 1.5 $12.24501 Fixed factory OH ($245,579/35,950) $6.83113 1.5 $10.24669 Manufacturing cost per unit $86.39170

10-62 (Continued-4)

Schedule 2: Cost per Unit—Product D57: Inputs Cost Cost Element Unit Input Cost Quantity Per Unit RM-1 $2.00 7 $14.00 RM-2 $2.50 3.6 $9.00 RM-3 $0.50 0.8 $0.40 Direct labor $30.00 2 $60.00 Variable factory OH ($293,472/35,950) $8.16334 2 $16.32668 Fixed factory OH ($245,579/35,950) $6.83113 2 $13.66225 Manufacturing cost per unit $113.38893

7. Selling and Administrative Expense Budget

Spring Manufacturing Company
Selling and Administrative Expense Budget
2010
Selling Expenses: Advertising $60,000 Sales salaries 200,000 Travel and entertainment 60,000 Depreciation 5,000 $325,000 Administrative expenses: Offices salaries $60,000 Executive salaries 250,000 Supplies 4,000 Depreciation 6,000 $320,000 Total selling and administrative expenses $645,000

10-62 (Continued-5)

8. Budgeted Income Statement

Spring Manufacturing Company
Budget Income Statement
For the Year 2010

C12 D57 Total
Sales (part 1) $1,800,000 $1,980,000 $3,780,000
Cost of goods sold (part 6) 1,036,700 1,020,500 2,057,200
Gross profit $763,300 $959,500 $1,722,800
Selling and administrative expenses (part 7) $645,000
Pre-tax operating income $1,077,800
Income taxes (@40%) $431,120
After-tax operating income $646,680

Answers:

1. The budgeted after-tax operating income with Kaizen is $646,680.

2. The immediate benefit is an increase of $173,820 in operating income, or 37% from $472,860.

The firm is also likely benefit in the long-run from the reductions in materials, labor hours, and factory overhead required in production. Decreases in consumption of manufacturing elements reduce wear and tear of equipment and other facilities and lessens the need for additional capital investments/replacements.

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open this spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

10-63 Retailer Budget (50-60 minutes)

1. Budgeted merchandise purchases

D. Tomlinson Retail
Budgeted Merchandise Purchases
May and June

May June July
Sales (in units) 11,900 11,400 12,000
Cost per unit x $20 x $20 x $20
Cost of Goods Sold (CGS) $238,000 $228,000 $240,000
Ending inventory (130% of next month’s CGS) + 296,400 + 312,000
Total needed $534,400 $540,000
Beginning inventory (130% of this month’s CGS) – 309,400 – 296,400
Budgeted Merchandise Purchases $225,000 $243,600

2. Budgeted cash disbursements

S, G, & A expenses: May June

Sales revenue $357,000 $342,000 S, G, & A expense ratio x 0.15 x 0.15 Total S, G, & A expense $ 53,550 $ 51,300 Less: Depreciation – 2,000 – 2,000 Out-of-pocket S, G & A expense $ 51,550 $ 49,300

D. Tomlinson Retail Budgeted Cash Disbursements for June

May June
Merchandise purchases $ 225,000 $ 243,600
Out-of-Pocket S, G, & A expenses + 51,550 + 49,300
Total payables $276,550 $292,900
Payment for the current month’s payables (54%) $158,166
Owed from last month (46%) + 127,213
Budgeted cash outflow for payables $285,379

10-63 (Continued)

3. Budgeted cash collections

D. Tomlinson Retail
Cash Collections
May

From last month's (April) credit sales

Within the discount period ($363,000) x 60% x 97% = $211,266
After the discount period $363,000 x 25% = 90,750

From credit sales two months ago (i.e., March)

Collection of credit sales made in March $354,000 x 9% = 31,860

Total cash collections $333,876

4. Gross and Net Balance of Accounts Receivable (AR) as of May 31 March April May Total
Sales $354,000 $363,000 $357,000
Remaining AR % 6% 15% 100%
AR Balance (Gross) $21,240 $54,450 $357,000 $432,690
Bad-debt allowance* $21,240 $21,780 $21,420 64,440
AR Balance (Net) $368,250

* @ 6% of gross sales dollars

10-64 Sales Budget and Pro-Forma Financial Statements (75-90 minutes)

1.
Original Budget Data

Sales (units):

Beginning inventory of finished goods (9/1/2010) 9,300 Estimated production for the 2010-2011 fiscal year 162,000 Units available for sale 171,300 Planned ending finished goods inventory (8/31/2011) 3,300 Projected unit sales, 2010-2011 fiscal year 168,000

Selling price/unit:

a. & b. Revised sales volume--units and dollars: Sales in units in the original budget (see above) 168,000 Increase in units of production (170,000 - 162,000)* + 8,000 Revised total sales—units 176,000 Selling price per unit (see above) x $ 186 Revised projected dollar-volume of net sales $32,736,000

*With no change in the ending finished goods inventory (3,300 units) the increase in production is a result of the expected increase in sales.

10-64 (Continued-1)

2.
Molid Company
Pro-Forma Statement of Cost of Goods Sold (Revised)
For the Year Ending August 31, 2011

Direct materials: Materials inventory, 9/1/2010 $ 1,360,000 Materials purchases1 15,576,000 Materials available for use $16,936,000 Materials inventory, 8/31/20112 1,709,400 Direct Materials used $15,226,600 Direct labor3 1,215,200 Factory overhead: Indirect material4 $ 1,522,660 General factory overhead5 3,320,000 4,842,660 Cost of goods manufactured $21,284,460 Plus: Finished goods inventory, 9/1/2010 (given) 1,169,000 Cost of goods available for sale $22,453,460 Less: Finished goods inventory, 8/31/20116 413,169 Cost of goods sold $ 22,040,291

1Supporting Calculations (units represent “equivalent units of output”): 37,500 units @ $88.00* = $ 3,300,000 45,000 units** @ $88.00 = 3,960,000 90,000 units @ $92.40***= 8,316,000 $15,576,000

10-64 (Continued-2)

*$3,300,000/37,500 units = $88.00

**Desired ending inventory of materials 18,500 Materials needed for production this year + 170,000 Total materials needed 188,500 Beginning inventory – 16,000 Total materials purchases for the year 172,500 Less: Materials purchased in the 1st quarter – 37,500 Materials yet to be purchased during the year 135,000 Number of remaining quarters ÷ 3 Materials to be purchased in each remaining quarter 45,000

***$88.00 x 1.05 = $92.40

2 18,500 units @ $92.40 = $1,709,400

3 Direct labor cost
[pic]

4 Indirect material: $15,226,600 x 0.10 = $1,522,660

5 General factory overhead: Variable: $1,620,000 x (170,000units/162,000units) = $1,700,000 Fixed $3,240,000 x 1/2 = 1,620,000 Total $3,320,000

6 Average manufacturing cost/unit, 2010-2011: $21,284,460 /170,000 units = $125.2027 Ending finished goods inventory (units) x 3,300 Cost of ending finished goods inventory (FIFO basis) $ 413,169

10-64 (Continued-3)

3.
a. Savings in working capital from eliminating ending inventory:

Finished goods $ 413,169 Direct materials $92.40 x (18,500 – 100) = 1,700,160 Total savings $2,113,329

The firm can reduce the need for working capital by $2,113,329. The final net savings depends on the cost of capital of the firm. At 10%, the company saves financing costs of over $200,000 per year. The firm can save more than $211,333 per year if the cost of capital exceeds 10%. Note that this estimate refers to financing (cost-of-capital-related) costs, not operating costs.

b. Yes. Under the assumption that the company’s cost of capital is 10%, the economic savings would represent about 4% of its current pre-tax operating income figure, as shown below. Note that these savings put the company in an improved economic position, although the formal accounting statements might not reflect this. As such, this gives the instructor the opportunity to discuss with students the notion of “Economic Value Added” (EVA®) as alternative financial performance indicator to conventional accounting income statements.

Molid Company
Pro-Forma Statement Income Statement
For the Year Ending August 31, 2011

Net sales (part 1b above) $32,736,000 Cost of goods sold (part 2 above) 22,040,291 Gross profit $10,695,709 Operating expenses (given—see text): Marketing $3,200,000 General and administrative 2,200,000 5,400,000 Income from operations before income taxes $ 5,295,709

$211,333/$5,295,709 = 4%

c. In addition to financial terms, the firm needs to consider carefully, among other items:

▪ adequacy of the firm's equipment to support the new system ▪ proficiency of the firm's accounting information system to handle the new system ▪ support of vendors ▪ acceptance of factory managers and production workers

10-65 Budgeting for a Merchandising Firm (50 minutes)

1. Budgeted cash collections—December: From November’s sales = net A/R, November 30th = $ 76,000 From December’s sales = $220,000 x 60% x 99% = 130,680 Budgeted cash collections--December $206,680

2. Net accounts receivable—December 31st: Budgeted sales in December (given) $220,000 Allowance for doubtful accounts $220,000 x 2% = 4,400 Net A/R from sales in December $215,600 Collections of December sales in December $220,000 x 60% = 132,000 Net Accounts Receivable—December 31st $ 83,600

3. Budgeted pre-tax operating income—December: Total sales $220,000 Gross margin ratio x 25% Gross margin $ 55,000 Operating expenses: Monthly cash operating expenses $22,600 Bad-debts expense $220,000 x 2% = 4,400 Depreciation expense $216,000/12 = 18,000 45,000 Pre-tax operating income $10,000

4. Budgeted Inventory—December 31st:

Inventory, December 31st = ($200,000 x 0.75) x 80% = $120,000

5. Budgeted Purchases—December:

Inventory, December 1st (given) = $132,000 Plus: Purchases during December (plug figure) = 153,000 Cost of goods available for sale $285,000 Less: Cost of goods sold $220,000 x 75% = 165,000 Inventory, December 31st (part 4 above) = $120,000

10-65 (Continued)

6. Budgeted Accounts Payable—December 31st:

Accounts Payable, December 1st (given) $162,000 Plus: Budgeted Purchases, December (part 5 above) $153,000 Total Accounts Payable during December $315,000 Less: Payments in December (entire beginning balance) $162,000 Budgeted Accounts Payable, December 31st $153,000

Alternatively, the end-of-December Accounts Payable Balance = Purchases made in December = answer to Part 5 above.

10-66 Budgets for a Service Firm (50 Minutes)

1. The annual cash budget is presented on the next page.

2. Operating problems that Triple-F Health Club could experience include:

▪ The cash contribution from lessons and classes will decrease because the projected wage increase for lesson and class employees is significantly greater than the projected increases in revenues (i.e., in additional volume). Last year, the cash generated from these operations was $39,000 ($234,000 – $195,000). The 2012 projection is only $12,675 ($304,200 – $291,525).

▪ Operating expenses are increasing faster than revenues from membership fees. Last year (2011), cash generated from regular operations was $91,000 [($355,000 + $2,000) – ($461,000 – $195,000)]. The 2012 projection is only $92,482 [($402,215 + $2,667) – ($603,925 – $291,525)]. The increase in cash from regular operations is projected to be about 4%, whereas these revenues are projected to increase 13%.

▪ Triple-F Health Club seems to have a cash-management problem. The club does not generate enough cash from operations to meet its obligations. It may not be able to meet expenditures for day-to-day operations if the trend continues. To avoid cash crises, the club should prepare monthly cash budgets to help cash management.

▪ Non-operational payments are projected to use up virtually all of the cash generated from operations. Given the recent declines in mortgage interest rates, management should consider refinancing this debt to reduce this cash drain.

3. Jane Crowe's concern with regard to the Board's expansion goals is justified. The 2012 budget projections show only a minimal increase in the cash balance (i.e., an increase of only $2,757). The total cash available is well short of the $60,000 annual additional cash needed for the land purchase. If the Board desires to purchase the adjoining property, it is going to have to consider increases in fees, refinancing existing debt, or other methods of financing the acquisition (such as additional mortgage debt or membership bonds).

10-66 (continued)

TRIPLE-F HEALTH CLUB

Cash Budget

For the Year Ending October 31, 2012

Price 2011 Growth Increase 2012
Operating Cash Inflows:
Annual membership fees $355,000 3.0% 10.0% $402,215
Lesson and class fees 234,000 30.0% 304,200
Miscellaneous 2,000 33.33% 2,667
Total Operating Cash Inflows $591,000 $709,082

Operating Cash Outflows:
Manager’s salary and benefits $36,000 15.0% $41,400
Employee wages and benefits: Regular employees 190,000 15.0% 218,500 Lesson and class employees 195,000 30.0% 15.0% 291,525
Towels and supplies 16,000 25.0% 20,000
Utilities (heat and lights) 22,000 25.0% 27,500
Miscellaneous 2,000 25.0% 2,500
Payoff of outstanding A/P N/A given 2,500
Total Operating Cash Outflows $461,000 $603,925

Net Operating Cash Flow $130,000 $105,157

Non-Operating Cash Outflows:
Payoff of equipment payable given $15,000
Mortgage principal given 30,000
Mortgage interest 32,4001
Planned equipment purchases given 25,000
Total Non-Operating Cash Outflow $102,400

Net Cash Flow $2,757
Beginning Cash Balance (given) 7,300
Budgeted Ending Cash Balance $10,057
_______________
1$360,000 x 0.09 = $32,400 ($360,000 = principal balance at beginning of the year)

10-67 Budgeting for Marketing Expenses; Strategy (45-50 minutes)

1. The following screen shots are from the Excel spreadsheet created for this problem. It shows that the original monthly budgeted marketing expense is $338,000 and that the revised (budgeted) amount is $372,628, an overall increase of 10.24%.

[pic]

10-67 (Continued-1)

[pic]

2. To achieve the monthly targeted cost of $350,000, the rate of “telephone and mailing” costs cannot increase at all (as is the case in the proposed budget); in fact, the results of the “goal seek” analysis indicates that such rates must be decreased by approximately 43%, as shown below:

[pic]

These results are generated by completing the following dialog box that appears after activating the “goal-seek” command from the “Data” tab, then “What-If Analysis” menu in Excel 2007:

10-67 (Continued-2)

[pic]

3. As indicated in the text, budgets can be used both for control and for planning purposes. The relative importance of each can be linked either to the competitive strategy the business is pursuing or to the product life-cycle. In the present case (start-up company, competing on the basis of a product-differentiation strategy), the relative emphasis of the marketing budget is likely more for planning than control. That is, the information contained in this budget can assist the company in determining its financing needs. However, it probably should not be used for “controlling” (i.e., cutting) expenses in situations where the underlying expenditures are determinants of competitive success. Further, many types of so-called “discretionary costs” (such as marketing) are fixed (or at least “sticky”) and therefore difficult to cut in the short run. As such, the primary benefit of the budget in such cases is to better plan for, rather than control, the underlying expenses.

Note to Instructor: The Excel 2007 spreadsheet solution referred to above is embedded below. You can open the spreadsheet “object” by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

[pic]

The following web-accessible tutorials regarding the use of Excel 2007 to perform What-If analysis may be helpful: Introduction to What-If Analysis (http://office.microsoft.com/en-us/excel/HA102431641033.aspx); Using Excel to Perform Scenario Analysis (http://office.microsoft.com/en-us/excel/HP100726691033.aspx); and, Using Solver to Perform What-If Analysis (http://office.microsoft.com/en-us/excel/HA102190021033.aspx).

10-68 Strategy, Product Life-Cycle, and Cash Flow (25-30 minutes)

1. The development stage is generally characterized by large cash outflows and little or no cash inflows. Expenditures for research and development, plant and equipment, retooling, distribution, and promotion are required. During this stage, a project or company normally generates losses and may require an infusion of outside capital. During the growth stage, sales and revenues rise rapidly. Significant cash inflows are generally present; however, these may be offset in part or completely by cash outflows to build production capacity and for growing inventories and receivables. During this stage, manufacturing efficiencies will improve contribution margins as volume increases. During the maturity stage, net cash inflows are generally at an optimum. Production capacity is in place and inventories and receivables should approach a steady state. However, by this stage, competitors generally have entered the market resulting in higher promotional costs to maintain market share. As a consequence, margins may begin to decline.

During the decline stage, both sales volume and profits fall. Increased price competition and the increased availability of alternative products will reduce margins. The declining volume will generally increase the unit cost at the manufacturing level. Sometimes, significant cash inflows can be generated from the liquidation of inventories and other product-related assets.

2. The maturity stage, the period of optimum net cash inflows, is missing from Burke Company's product cycle. The company must be able to generate or raise sufficient cash to support R & D, capital investment, and promotional costs during the development stages and depend on the growth stage for significant cash inflows. This will require rapid improvement in manufacturing efficiencies and careful investment in production facilities and inventories. In addition, inventory control is extremely important in order to minimize cash investment and reduce potential obsolescence.

3. The techniques that Devin Ward should consider to cope with Burke Company's cash-management problems include:

▪ Careful, timely cash-flow projections and monitoring, matching the cash receipts from products in the growth stage with the expenditures for products in the development stage. ▪ Establishing good banking relationships and flexible lines of credit to facilitate short-term borrowing needs. ▪ Aggressive accounts-receivable management. ▪ Tight control of materials purchasing and inventory management. ▪ Improved cost controls. ▪ Timely decisions on inventory liquidation as product life cycles near collapse.

10-69 Budgeting Customer Retention and Insurance-Policy Renewal; Sensitivity Analysis (75-90 Minutes)

1. Budget for Customer-Retention and Premiums Earned

|Budget Item |January |February |March |April |May |June |
|No. of active policyholders, beginning of the month |100,000 |99,500 |99,003 |98,507 |98,015 |97,525 |
|Mid-term cancellation rate (%) |0.50% |0.50% |0.50% |0.50% |0.50% |0.50% |
|No. of active policyholders, end of the month |99,500 |99,003 |98,507 |98,015 |97,525 |97,037 |
|Average no. of active policyholders during the month |99,750 |99,251 |98,755 |98,261 |97,770 |97,281 |
|Average monthly premium per policy |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |
|Total premiums earned from active policyholders |$9,975,000 |$9,925,125 |$9,875,499 |$9,826,122 |$9,776,991 |$9,728,106 |

|Budget Item |July |August |September |October |November |December |
|No. of active policyholders, beginning of the month |97,037 |96,552 |96,069 |95,589 |95,111 |94,635 |
|Mid-term cancellation rate (%) |0.50% |0.50% |0.50% |0.50% |0.50% |0.50% |
|No. of active policyholders, end of the month |96,552 |96,069 |95,589 |95,111 |94,635 |94,162 |
|Average no. of active policyholders during the month |96,795 |96,311 |95,829 |95,350 |94,873 |94,399 |
|Average monthly premium per policy |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |
|Total premiums earned from active policyholders |$9,679,466 |$9,631,068 |$9,582,913 |$9,534,999 |$9,487,324 |$9,439,887 |
10-69 (Continued-1)
| Active policies, end of December |94,162 |
| Policy renewal rate |85.00% |
| No. of estimated policyholders, beginning of new year |80,038 |

2.
|As stated in the chapter, inputs to the construction of individual budgets are subject to uncertainty. That is, the inputs represent forecasts |
|(e.g., selling price per unit, sales volume, and sales mix) and therefore are subject to estimation error. "What-if" analysis is a tool that allows |
|us to vary one or more of these inputs in order to examine the resulting effect on one or more budgets (e.g., operating income or cash flows). In |
|essence, we attempt to determine how sensitive our budgets and forecasted financial statements are with respect to assumptions we are making as to |
|the value of input factors. For example, in the present case we might be interested in knowing how the assumption of mid-term cancellation rate |
|affects monthly premium--is premium revenue sensitive to this assumption? If so, then management may want to carefully monitor and control this |
|rate. |
|See the following tutorials for additional information about performing "what-if" analyses using Excel 2007: |
| |
|1. Introduction to What-If Analysis: |
|http://office.microsoft.com/en-us/excel/HA102431641033.aspx |
|2. Using Excel to Perform Scenario Analysis: |
|http://office.microsoft.com/en-us/excel/HP100726691033.aspx |
|3. Using Solver to Perform What-If Analysis: |
|http://office.microsoft.com/en-us/excel/HA102190021033.aspx |
| |
| |

3. Sensitivity Analysis: Revision of the original 12-month budget created above in (1) to reflect a decrease in the policy-renewal rate to 80.0% and a change in the mid-term cancellation rate to 0.75%.

10-69 (Continued-2)

|Budget Item |January |February |March |April |May |June |
|No. of active policyholders, beginning of the month |100,000 |99,250 |98,506 |97,767 |97,034 |96,306 |
|Mid-term cancellation rate (%) |0.75% |0.75% |0.75% |0.75% |0.75% |0.75% |
|No. of active policyholders, end of the month |99,250 |98,506 |97,767 |97,034 |96,306 |95,584 |
|Average no. of active policyholders during the month |99,625 |98,878 |98,136 |97,400 |96,670 |95,945 |
|Average monthly premium per policy |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |
|Total premiums earned from active policyholders |$9,962,500 |$9,887,781 |$9,813,623 |$9,740,021 |$9,666,971 |$9,594,468 |

|Budget Item |July |August |September |October |November |December |
|No. of active policyholders, beginning of the month |95,584 |94,867 |94,155 |93,449 |92,748 |92,053 |
|Mid-term cancellation rate (%) |0.75% |0.75% |0.75% |0.75% |0.75% |0.75% |
|No. of active policyholders, end of the month |94,867 |94,155 |93,449 |92,748 |92,053 |91,362 |
|Average no. of active policyholders during the month |95,225 |94,511 |93,802 |93,099 |92,400 |91,707 |
|Average monthly premium per policy |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |
|Total premiums earned from active policyholders |$9,522,510 |$9,451,091 |$9,380,208 |$9,309,856 |$9,240,032 |$9,170,732 |

10-69 (Continued-3)

| Active policies, end of December |91,362 |
| Policy renewal rate |80.00% |
| No. of estimated policyholders, beginning of new year |73,090 |
| | |
| Recap: | |
| Premiums Earned, original assumptions |$116,462,500 |
| Premiums Earned, revised assumptions |$114,739,793 |
| % change |-1.48% |
| Estimated policy renewals, end of year: | |
| Original assumption |80,038 |
| Revised assumption |73,090 |
| % change |-8.68% |
| |
| |
|4. What other information or data would be included in a full budget prepared each month for this insurance company? |
| |
|This question is meant to reinforce real-world complexities in the budget-preparation process and the interrelationship (articulation) of |
|various sub-budgets. The following are some additional considerations for the present insurance company example: |
| |
| a) The schedules presented above assumed that the renewal date for all policyholders was the end of December. Naturally, this is a |
|simplification. In reality, policyholders renew their policies throughout the entire year. Thus, one can view the present analysis as |
|1/12th of the budgets that would have to be prepared. |
| |
|b) Policyholder attrition rate is a variable that has to be modeled. Most organizations working in financial services, such as an insurance|
|company where there are large numbers of policyholders paying monthly premiums, would have sophisticated policyholder-retention models that|
|measure the separate elements of mid-term cancellations and policy renewals. With appropriate predictive models, a company could quickly |
|forecast the number of active customers in any given period. In the present case, the two components of customer attrition were assumed |
|given. |

|10-69 (Continued-4) |
| |
|c) In the case of life insurance, where different policyholders pay different monthly premiums, the estimation of insurance premiums |
|earned each month becomes more challenging. |
| |
|d) For simplicity we assumed a constant monthly mid-term cancellation rate. The use of sophisticated business intelligence tools might |
|provide finer forecasts each period. |
| |
|e) This problem provides an excellent opportunity to introduce, within a financial services context, the important role that "rolling |
|financial forecasts" can play, and the associated superficiality of a traditional 12-month fixed budget. |
| |
|f) It is likely that some of the non-financial indicators in this company's budget (e.g., customer attrition rates) would also be included|
|in the "Customer Perspective" of the company's Balanced Scorecard (BSC). This is principally because these nonfinancial performance |
|indicators are leading indicators of future financial performance. |

10-70: Budgeting Insurance Policy Volume and Monthly Revenues (75 Minutes)

|Part 1: Monthly budgets broken down into three parts: market size and volume; volume for National Auto Insurance Company; and, Premium Revenues earned. |

| |January |February |March |April |May |June |
|Part a: Market Size & Volumes | | | | | | |
|Total # of households (market size) |100,000,000 |100,050,000 |100,100,025 |100,150,075 |100,200,150 |100,250,250 |
|% of households--car ownership |80.00% |80.00% |80.00% |80.00% |80.00% |80.00% |
|avg. # of cars owned per household |2.2 |2.2 |2.2 |2.2 |2.2 |2.2 |
| % of car owners with insurance |85.000% |85.085% |85.170% |85.255% |85.341% |85.426% |
|total # of insured autos (market-wide) |149,600,000 |149,824,475 |150,049,286 |150,274,435 |150,499,922 |150,725,747 |
|market share of National Auto Insurance |10.00% |10.001% |10.001% |10.002% |10.002% |10.003% |
|# of autos insured by National, end of mo. |14,960,000 |14,983,197 |15,006,429 |15,029,698 |15,053,002 |15,076,343 |

10-70 (Continued-2)

| |January |February |March |April |May |June |
|Part b: Volume for National Auto Insurance | | | | | | |
|# of autos insured, beginning of month |14,940,000 |14,921,325 |14,902,673 |14,884,045 |14,865,440 |14,846,858 |
|cancellations during the month |18,675 |18,652 |18,628 |18,605 |18,582 |18,559 |
| # of insured autos, end of month |14,921,325 |14,902,673 |14,884,045 |14,865,440 |14,846,858 |14,828,300 |
|avg. # of insured autos during the month |14,930,663 |14,911,999 |14,893,359 |14,874,742 |14,856,149 |14,837,579 |

| |January |February |March |April |May |June |
|Part c: Volume for National Auto Insurance | | | | | | |
|# of autos insured during the month |14,930,663 |14,911,999 |14,893,359 |14,874,742 |14,856,149 |14,837,579 |
|avg. insurance premium per auto per month |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |$100.00 |
|monthly premiums revenue |$1,493,066,250 |$1,491,199,917 |$1,489,335,917 |$1,487,474,247 |$1,485,614,905 |$1,483,757,886 |

| Change in Total Premiums Revenue, January to June: |
| January's Total Premiums = |$1,493,066,250 |
| June's Total Premiums = |$1,483,757,886 |
| Six-month Dollar Change = |-$9,308,364 |
| Six-month % change = |-0.623% |

10-70 (Continued-3)

|2. What additional real-life refinements would you envision for the budgets you prepared above in (1)? What additional budgets would you |
|anticipate preparing for the company were you in charge of the budget-preparation process? |

| a) As the person in charge of the budget-preparation process, one obvious recommended change would be to report separately the number |
|of new policies written (the logical offset in Part b to the number of policy cancellations). Currently the number of new policy-holders is |
|buried somewhere in part a of the budget. Thus, a significant improvement is to disclose prominently each month the net change in (average) |
|policies outstanding, which is defined as the difference between the number of new policies written and the number of policy cancellations. |
| |
|b) In the example problem we assumed, for simplicity, that all policyholders paid the same premium. Alternatively, we used an average |
|premium rate per month per policy, which is acceptable for budgeting purposes as long as the mix of policyholders was not anticipated to |
|change from the mix used to calculate the weighted-average premium amount. |
| |
|c) The budget we created applied to those individuals whose policies covered the calendar year, January through December. A fuller, more |
|realistic analysis would gather similar data for policyholders whose anniversary date is something other than January 1st. Whether the |
|profiles of such policyholders is different from the profile assumed above is an empirical question. |
| |
|d) The cancellation rate, and growth rate in new underwritings, would probably be monitored carefully since these are key drivers of future |
|financial performers. That is, they are "leading indicators" of financial performance and as such would probably be included in the customer|
|perspective of the company's balanced scorecard (BSC). |
| |
|e) The problem includes information regarding a mid-term policy cancellation rate (i.e., policies cancelled before the annual renewal date).|
|It would seem appropriate, however, to include in the model a policy-renewal rate (85%, 90%, etc.). |
| |
|f) The above calculations and budgets deal solely with forecasted volume (# of policies) and premiums revenue ($). The output of the budgets|
|we prepared would then be used to prepare other budgets for the company. In this sense, and similar to the extended example in the chapter, |
|we say that the budgets articulate with one another. For example, once a budget for volume and sales has been prepared, the company can |
|proceed to prepare a "cost of claims" budget. In turn, information from both of these budgets would be used to forecast staffing needs, what|
|we might call "claims handling." Claims processing times, the mix of "simple" versus "complicated" claims, the average time to process a |
|10-70 (Continued-4) |
| |
|claim, the time available per day (month) for each claims handler, the % of submitted claims that are paid, etc. would all be "drivers" that|
|would be incorporated into the claims-processing budget. |
| |
| |
|g) The budget as presented is static in nature and covers a fixed period of time. For reasons discussed more fully in the chapter, the |
|limitations of such budgets can be addressed by generating "rolling forecasts." |
| |
|3. The budgets you prepared above in (1) can be referred to as “driver-based budgets.” List some of the pros and the cons of such budgets, |
|relative to traditional budgeting practices. |
| |
|Pros |
|1. Driver-based budgeting (e.g., traditional activity-based budgeting (ABB) or Time-Driven Activity-Based Budgeting) reduces the time to |
|produce a budget or to re-forecast. |
|2. Driver-based budgeting requires fewer iterations--that is, it reduces the "give and take" and time devoted to the "negotiations" aspect |
|of traditional budgets. |
|3. Driver-based budgeting saves costs--for example, overtime payments (required to support time-consuming traditional budgeting processes) |
|can be eliminated; similarly, part-time (temporary) help to support the traditional budget-preparation process can be reduced or eliminated.|
|Managers are "freed" to attend to more strategic imperatives. |
|4. Driver-based budgets make managers accountable--situations such as decreases in efficiency or unused capacity become more visible under |
|driver-based budgeting. |
|5. Driver-based budgeting provides insight and agility--if drivers are appropriately chosen, then information about # of transactions and |
|cost-driver quantities for the period aid in the end-of-month evaluation of operating performance. As well, this budgeting process provides |
|valuable non-financial information, which can be incorporate into the organization's Balanced Scorecard (BSC). |
|6. Driver-based budgeting reduces risk exposure--if performance drivers are appropriately defined and included in the budget, then |
|management can readily evaluate different risks and scenarios (mix of products/services sold, productivity ratios, unit resource costs, |
|etc.). |
|7. Driver-based budgeting may decrease the amount of "gaming behavior" on the part of managers and employees. With driver-based budgeting |
|causal relationships are transparent, a situation that can limit the opportunity for "gaming." There is simply less opportunity to fool |
|senior managers if all of the assumptions in budgets are laid out for everyone to see. |
| |
|10-70 (Continued-5) |
| |
|Cons |
|1. Driver-based budgeting is perceived to be difficult to implement. |
|2. Driver-based budgets require a sophisticated information processing system--that is, the ability to capture, across the organization, key|
|resource drivers, activity cost drivers, and activities. |
| |
| |
| |
| |
| |

10-71: Comprehensive Budget (90 minutes)

1. Schedule A: Budgeted Monthly Cash Receipts

Item June July August Sept.
Cash sales (80% x sales) $60,000 $64,000 $65,600 $72,000
Credit sales (20% x sales) 15,000 16,000 16,400 18,000
Total sales $75,000 $80,000 $82,000 $90,000
Receipts:
Cash sales $64,000 $65,600 $72,000 Collections on accounts (last month’s credit sales) 15,000 16,000 16,400
Total cash collections $79,000 $81,600 $88,400

Schedule B: Budgeted Monthly Cash Disbursements for Purchases

Item July August September 3rd Qtr.
Purchases (@ gross cost) $49,200 $54,000 $60,000 $163,200
Cash discount (1% of gross cost) 492 540 600 1,632 Net purchases $48,708 $53,460 $59,400 $161,568

Schedule C: Budgeted Monthly Cash Disbursements for Operating Costs

Item July August September 3rd Qtr.
Salaries and wages $12,000 $12,100 $12,500 $36,600
Rent & Property Taxes 1,000 1,000 1,000 3,000
Other cash operating costs 1,600 1,640 1,800 5,040 Total $14,600 $14,740 $15,300 $44,640

Schedule D: Budgeted Cash Disbursements Prior to Financing

Item July August September 3rd Qtr.
Cash operating costs $14,600 $14,740 $15,300 $44,640
Net purchases 48,708 53,460 59,400 161,568
Equipment -0- 63,500 -0- 63,500 Total $63,308 $131,700 $74,700 $269,708

10-71 (Continued-1)

Schedule E: Cash Budget

Item July August September 3rd Qtr.
Cash balance, beginning $25,000 $40,692 $39,967 $25,000
Total cash receipts 79,000 81,600 88,400 249,000
Cash disbursements prior to financing 63,308 131,700 74,700 269,708
Cash balance before financing $40,692 ($9,408) $53,667 $4,292
Financing:
Borrowing required $0 $50,000 $0 $50,000 Interest payment $0 $625 $625 $1,250 Borrowing repaid $0 $0 $20,000 $20,000 Net effect of financing $0 $49,375 ($20,625) $28,750
Cash balance, ending $40,692 $39,967 $33,042 $33,042

Minimum cash balance required $30,000 $30,000 $30,000 $30,000
Check for minimum balance OK OK OK OK

2. Gold Sporting Equipment
Budgeted Income Statement
For the Third Quarter, 2010

Sales $252,000 Cost of Goods Sold (Sales x (1 - 0.40) x (1 - 0.01)) $149,688 Gross Profit $102,312 Operating Expenses: Salaries & wages $36,600 Rent & property taxes $3,000 Depreciation $2,400 Other operating expenses $5,040 $47,040 Operating Income $55,272 Other Income/Expenses: Interest Expense $1,250 Pre-tax Income $54,022 Income Taxes (@25%) $13,506 Net Income $40,516

10-71 (Continued-3)

Gold Sporting Equipment
Budgeted Balance Sheet
June 30th and September 30th, 2010

June 30th September 30th
Assets
Cash $25,000 $33,042
Accounts Receivable (A/R) $15,000 $18,0001
Merchandise Inventory $47,520 $59,4002
Building and equipment (net) $200,000 $324,6003 Total Assets $287,520 $435,042

Liabilities and Stockholders’ Equity
Short-term payable (new equipment purchase) $0 $63,500
Short-term bank loan payable $0 $30,000
Income Tax Payable $0 $13,506 Total Liabilities $0 $107,006
Stockholders' Equity $287,520 $328,037 Total Liabilities & Stockholders’ Equity $287,520 $435,042

Notes: 1Credit sales made in September, to be collected in October 2Net merchandise purchases made in September (to meet expected sales in October) 3Beg. Balance (net) + New Equipment Purchased – Depreciation Expense = $200,000 + $127,000 – $2,400

Note to Instructor: An Excel spreadsheet solution file is embedded in this document. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

10-71 (Continued-4)

3. Gold needs to borrow to finance part of the payment for the new equipment during the third quarter. In addition, fluctuations in business may require the firm to seek short-term loans. Payrolls, materials, and supplies have to be paid before collections from customers. In anticipation of rising sales in the coming season, Gold may experience a peak demand for cash to pay for the increased purchases of materials, payrolls, and supplies while collections from customers may be at the lowest point of the year as the firm comes out of a low-activity season.

A short-term financing arrangement is the best way to meet seasonal cash needs. A short-term loan can be repaid as soon as activities in cash collections increase and payrolls and purchases of materials and supplies decrease as the firm enters into a slow season. Although the firm may have to pay a higher cost for short-term borrowing, the total financing cost likely would be lower than if the firm raised sufficient funds through either issuing long-term bonds or capital stock to meet peak demands for cash. A bond requires interest payments whether or not the firm uses the funds raised from the bond in operations. Additional capital stock is not without cost. Management needs to earn a desired return on equity to satisfy investors.

Furthermore, studies have shown that management is prone to be careless in spending when abundant funds are available.

4. The scenarios described involved many simplified assumptions in order to make the problem managable. Among possible complicating factors are:

▪ No bad debts are considered. ▪ Customers always make payment as prescribed in sales terms. ▪ Within a given month cash inflows are in time to meet cash outflows. It is conceivable that the bulk of cash inflows occur toward the end of the month while payments need to go out at the beginning of the month. ▪ Cash customers do not use bank credit cards for the purchases.

10-72: Cash Budgeting; Sensitivity Analysis (50-60 Minutes)

1. Estimated Cash Receipts, April 2010:

April Cash Receipts:

April cash sales (25.0% x $425,000) = $106,250

April credit-card sales ($425,000 x 55% x 97%) = $226,738

Collection of accounts receivable:

From April Sales (20% x $425,000 x 25%) = $21,250

From March Sales ($400,000 x 20% x 45%) = $36,000

From February Sales ($550,000 x 20% x 27%) = $29,700

Total $419,938
2. Purchase Order for Hardware, executed January 25th (to be paid April 10th):

a) Number of units to be ordered: Estimated Unit Sales, March = 90 Plus: Desired End. Inv., March (30% x 100) = 30 Total Needs (in Units) = 120 Less: Beg. Inv., March (30% x 90) = 27 Required Purchases (in Units) = 93

b) Cost of purchases: Selling price per unit (e.g., $300,000/100 units) = $3,000 Estimated cost per unit (@65% of selling price) = $1,950 Total cost of purchases (93 units x $1,950/unit) = $181,350

Note that the cash outflow associated with these purchases will be 4/10/2010 (75 days after executing the purchase order).

10-72 (Continued-1)

3. Sensitivity Analysis: Three Senarios for March Sales and the CGS% Estimated Sales—March CGS %

Optimistic Estimate = 100 60%

Base-line Estimate = 90 65%

Pessimistic Estimate = 80 70% March Cash Sales Payment Scenario (units) CGS % April 10th

1 100 60% $180,000

2 100 65% $195,000

3 100 70% $210,000

4 90 60% $167,400

5 90 65% $181,350

6 90 70% $195,300

7 80 60% $154,800

8 80 65% $167,700

9 80 70% $180,600

Maximum = $210,000

Minimum = $154,800

Range = $55,200

4. Monthly cash budgets are prepared by companies such as CompCity, Inc., in order to plan for their cash needs This means identifying when both excess cash and cash shortages may occur. A company needs to know when cash shortages will occur so that prior arrangements can be made with lending institutions in order to have cash

10-72 (Continued-2)

available for borrowing when the company needs it. At the same time, a company should be aware of when there is excess cash available for investment or repaying loans so that planned usage of the excess can be made.

Sensitivity analysis, one type of which is illustrated in part (3) above, can be used to help managers deal with uncertainties in the budgeting process. Sensitivity analysis enables managers to examine how a budget would change in response to changes in one or more underlying assumptions (such as sales volume level and CGS %). As such, the process enables managers to monitor key assumptions and to make timely adjustments to plans. In practice, management might view the base-line outcome as the expected value prediction. It might define, subjectively, “optimistic” and “pessimistic” values as those having a small probability, (e.g., 10% or less).

Note to Instructor: An Excel 2007 spreadsheet solution file for this assignment is embedded below. You can open the spreadsheet “object” that follows by doing the following:

1. Right click anywhere in the worksheet area below. 2. Select “Worksheet Object,” then “Open.” 3. To return to the Word document, select “File” and then “Close and return to...” while you are in the spreadsheet mode.

4. Embedded in the above Excel file is a tutorial for using Excel 2007’s “Scenario Manager” for conducting and reporting the results of scenario analysis. This tutorial is also available at the following site:

http://office.microsoft.com/en-us/excel/HP100726691033.aspx

10-73 Criticisms of Traditional Budgeting/Incentive Issues (45 Minutes)

Many critics of conventional budgeting procedures cite dysfunctional consequences of using fixed-performance budgets in managerial compensation contracts. These individuals believe, among other problems, that such contracts motivate managers and employees to “game the performance indicator,” that is, to take actions that improve the performance indicator but are not value-adding to the organization. The following are selected examples of “gaming behavior”:

• managing earnings by pushing expenses into the future (e.g., by delaying purchases, delay making new hires, delaying an important product-development initiative, or delaying needed expenditures)

• managing earnings by moving future revenues to the present (e.g., by booking orders early or by offering excessive discounts to customers)

• managing earnings from the present to the future (e.g., by prepaying expenses, or by taking write-offs, or by delaying the realization of revenues)

• managing earnings by pushing profits to the future (e.g., by accelerating expenses or postponing sales)

• “channel stuffing” (or “trade loading”)—that is, shipping excessive amounts of products to distributors to meet near-term sales goals, recognizing that many such products are likely to be returned; such items are sometimes referred to as “sale-or-return” products

• announcing price hikes for the next fiscal year, in an attempt to motivate increases in end-of-current-year sales

• shifting funds between accounts to avoid budget overruns (costly, non-value-added managerial activity)

Other dysfunctional consequences of traditional fixed-performance reward systems include the following:

• negotiating low targets and high rewards (i.e., pushing for targets that are inwardly comfortable yet appear outwardly difficult to achieve)

• failure to take appropriate risks by deviating from the budget (i.e., “if it’s not in the budget, why take the risk?)

• planning to meet, but not exceed, budgeted performance because such increased performance might be incorporated into future budgets, which works against the manager

• spending whatever is in your budget (“use it or lose it”)

• intentionally asking for more resources than you need, anticipating that reductions to your request will be made during the upcoming budget negotiation process

In addition to gaming behavior, some critics suggest that excessive reliance on budget-based incentive contracts leads to unethical and even fraudulent behavior. This conclusion is based on the view that in an attempt to meet budgeted performance requirements (which are tied to compensation), managers resort to questionable, if not illegal, behaviors. Enron and WorldCom serve as good examples.

10-73 (Continued)

Critics of conventional budgeting practices, including those in the Beyond Budgeting Roundtable (BBRT), believe that the annual fixed-performance contract should be replaced with a new management model, one in which the tie between budgets and annual compensation is severed. As discussed in the chapter, this can be accomplished (for example) by the use of a “linear compensation plan” or the use of relative-performance contracts combined with “rolling financial forecasts.” Because of its focus on budgeting activities and activity costs, one might argue that the use of activity-based budgeting (ABB) decreases some of the negative incentive effects of traditional budgeting systems. Because of the use of time equations, and therefore greater specification of resource requirements, the use of time-driven activity-based budgeting (TDABB) may be particularly useful.

Check Figures: Chapter 10

10-31 Base case (5%) for March: $5,500

10-32 No check figure

10-33 No check figure

10-34 1(a) = $115,000; 2(b) = $110,250; 3 = 37.25%

10-35 1 (Nov.) = $243,861; 2 (Nov.) = $171,500

10-36 Production, Qtr. 2 = 37,600 units; Purchases, Qtr. 2 = 111,480 lbs.

10-37 1 = 37.25%; 2 = 18.43%

10-38 1 = 450,000; 2 = 460,000; 3 = 930,000

10-39 Ending cash balances: $99,000 (Nov.); $50,480 (Dec.)

10-40 $26,000

10-41 Cash balance before financing = $2,250

10-42 2. Qtr. I: Total cash available = $381; Salaries & benefits = $335; Total financing effects = $54.

10-43 1 = $84,400; 2 = $230,000

10-44 1 = $152,000; 2 = $172,500; 3 = $155,000; 4(a) = $169,500, 4(b) = $102,500

10-45 No check figure

10-46 1. $86,082 (total cash receipts, September)

10-47 Total cash receipts: September = $86,082; October = $88,141

10-48 1. $2,808,000; 2. cost per carton delivered = $2.34; 3 = $1,051,000 (expected cost savings, January 2010)

10-49 2. Budgeted cost-driver rates, Data entry—Requisitions: $1.20 (Jan.), $1.176 (Feb.), and $1.1525 (March)

10-50 1 = $91,200; 2 = $299,400; 3 = $234,000

10-51 1 = $0 (no budgeted overhead for senior consultants); 2 = 16; 3 = $163,700 (total compensation)

10-52 No check figure

10-53 2. $150,000; 3a. $215,000; 3b. $130,000; 3c. $199,000

10-54 1. 1,000 units; 2. 4,000 units (alternative #1), 3,000 units (alternative #2); 3. $400,000 (alternative #1), $300,000 (alternative #2)

10-55 1. $50/hour (Indirect Labor Support); 2. $900/run (Handle Production Runs); 3. $100,000 (Indirect Labor Support); 4. $180,000 (Cost of Unused Capacity, Indirect Labor Support)

10-56 1. For February: 95 (from December), 90 (from January); 2. For March: 8.70% (below)

10-57 1. 56,250 units; 2. 78,750 units; 3. For 4% increase, break-even = 59,211 units; 4. $40.62/unit

10-58 1. 33,333 units (Alt. #1), 36,364 units (Alt. #2); 2. 83,333 units (Alt. #1), 58,824 units (Alt. #2); 3. Indifference point = 40,000 units

10-59 No check figure

10-60 1 = $1,800,000 (C12); 2 = 11,900 (C12); 3 = $384,800 (budgeted purchases, RM1); 4 = $1,273,750; 5 = $580,830 (total budgeted overhead); 6 = $2,346,900 (CGS), $55,280 (Ending Inventory); 7 = $645,000; 8 = $472,860 (after-tax income).

10-61 1 = $1,920,000 (C12); 2 = 11,900 (C12); 3 = $528,800 (budgeted purchases, RM1); 4 = $1,948,750; 5 = $753,630 (total budgeted overhead); 6 = $3,433,113 (CGS), $53,202 (Ending Inventory); 7 = $645,000; 8 = $649,132 (after-tax income)

10-62 1 = $1,800,000 (C12); 2 = 11,900 (C12); 3 = $342,900 (budgeted purchases, RM1); 4 = $1,078,500; 5 = $293,472 (budgeted variable overhead), $245,579 (budgeted fixed overhead); 6 = $2,057,200 (CGS), $48,595 (Ending Inventory); 7 = $645,000; 8 = $646,680 (after-tax income)

10-63 1 = $225,000 (May); 2 = $285,379; 3 = $333,876; 4 = $368,250 (net accounts receivable)

10-64 1a = 168,000 units; 1b = $32,736,000; 2 = $22,040,291 (CGS); 3 = reduced investment in working capital = $2,113,329

10-65 1 = $206,680; 2 = $83,600; 3 = $10,000; 4 = $120,000; 5 = 153,000 units; 6 = $153,000

10-66 1. Total operating cash inflows, 2012 = $709,082; Total operating cash outflows: $461,000 (2011), $603,925 (2012); Budgeted ending cash balance, 2012 = $10,057.

10-67 1 = $372,628; 2: cost-reduction rate = 43%

10-68 No check figure

10-69 1. January: Avg. # of active policyholders during the month = 99,750; total premiums earned from active policyholders = $9,975,000; 3. January: Avg. # of active policyholders during the month = 99,625; total premiums earned from active policyholders = $9,962,500

10-70 1. Part a—February: total # of households = 100,050,000; % of car owners with insurance = 85.085%; # of autos insured by National (eom) = 14,983,197; Part b—February: # of cancellations during the month = 18,652; avg. # of autos insured during the month = 14,911,999; Part c—February: premiums revenue = $1,491,199,917

10-71 1. Cash receipts: $79,000 (July); Cash Disbursements for Purchases: $59,400 (Sept.); Cash Disbursements for Operating Costs: $14,600 (July); Ending Cash Balance: $40,692 (July), $39,967 (August), $33,042 (Sept.). 2. Net Income = $40,516; Sept. 30th Balances: Total Assets = $435,042; Total Liabilities = $107,006.

10-72 1 = $419,938; 2a = 93 units; 2b = $181,350; 3: Budgeted cash payment on April 10th when March Sales = 100 units and CGS % = 60%, is $180,000.

10-73 No check figure
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The following web-accessible tutorials regarding the use of Excel 2007 to perform What-If analysis may be helpful: Introduction to What-If Analysis (http://office.microsoft.com/en-us/excel/HA102431641033.aspx ); Using Excel to Perform Scenario Analysis (http://office.microsoft.com/en-us/excel/HP100726691033.aspx ); and, Using Solver to Perform What-If Analysis (http://office.microsoft.com/en-us/excel/HA102190021033.aspx ).

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