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Confirming Pages www.downloadslide.com Chapter BU SIN E S S F O CU S 8 Profit Planning Learning Objectives Lilo & Stitch on Budget After studying Chapter 8, you should be able to: The full-length feature cartoon Tarzan grossed about $450 million worldwide for the Walt Disney Company. However, production costs got out of control. The company traditionally manages film production by focusing on meeting the planned release date—paying little attention to costs. In the case of Tarzan, production fell behind schedule due to the tendency of animation teams to add more eye-dazzling complexity to each production. At one point, it was estimated that 190,000 individual drawings would be needed to complete the film in contrast to the 130,000 drawings needed to complete The Lion King. To meet Tarzan’s release date, workers were pulled off other productions and were often paid at overtime rates. The size of the film crew eventually reached 573, which was nearly twice the size of the crew that had made The Lion King. With animators earning salaries in the hundreds of thousands of dollars, the cost implications were staggering. Thomas S. Schumacher, Disney’s feature-animation chief, was charged with dramatically reducing the cost of future films while making sure that the audience wouldn’t notice any decline in quality. Lilo & Stitch was the first film to be produced with this goal in mind. The process began by prioritizing where the money was to be spent. The budget for music was kept generous; animation costs were cut by controlling the small details that add big costs with little effect on the quality of the film. For example, animators wanted to draw cute designs on the shirts worn by Nani, Lilo’s big sister. However, adding this level of detail on every frame in which Nani appears in the film would have added about $250,000 in cost. By controlling such details, Lilo & Stitch was finished on time and at a cost of about $80 million. This contrasted with a cost of more than $150 million for Tarzan. ■ Source: Bruce Orwall, “Comics Stripped: At Disney, String of Weak Cartoons Leads to Cost Cuts,” The Wall Street Journal, June 18, 2002, pp. A1 and A8. nor27130_ch08_287-333.indd 287 LO1 Understand why organizations budget and the processes they use to create budgets. LO2 Prepare a sales budget, including a schedule of expected cash collections. LO3 Prepare a production budget. LO4 Prepare a direct materials budget, including a schedule of expected cash disbursements for purchases of materials. LO5 Prepare a direct labor budget. LO6 Prepare a manufacturing overhead budget. LO7 Prepare a selling and administrative expense budget. LO8 Prepare a cash budget. LO9 Prepare a budgeted income statement. LO10 Prepare a budgeted balance sheet. 287 9/14/09 7:23:03 AM Confirming Pages www.downloadslide.com 288 Chapter 8 I n this chapter, we focus on the steps taken by businesses to achieve their planned levels of profits—a process called profit planning. Profit planning is accomplished by preparing a number of budgets that together form an integrated business plan known as the master budget. The master budget is an essential management tool that communicates management’s plans throughout the organization, allocates resources, and coordinates activities. The Basic Framework of Budgeting LEARNING OBJECTIVE 1 Understand why organizations budget and the processes they use to create budgets. A budget is a quantitative plan for acquiring and using resources over a specified time period. Individuals sometimes create household budgets that balance their income and expenditures for food, clothing, housing, and so on while providing for some savings. Once the budget is established, actual spending is compared to the budget to make sure the plan is being followed. Companies use budgets in a similar way, although the amount of work and underlying details far exceed a personal budget. Budgets are used for two distinct purposes—planning and control. Planning involves developing goals and preparing various budgets to achieve those goals. Control involves the steps taken by management to increase the likelihood that all parts of the organization are working together to achieve the goals set down at the planning stage. To be effective, a good budgeting system must provide for both planning and control. Good planning without effective control is a waste of time and effort. Advantages of Budgeting Organizations realize many benefits from budgeting including: 1. Budgets communicate management’s plans throughout the organization. 2. Budgets force managers to think about and plan for the future. In the absence of the necessity to prepare a budget, many managers would spend all of their time dealing with day-to-day emergencies. 3. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively. 4. The budgeting process can uncover potential bottlenecks before they occur. 5. Budgets coordinate the activities of the entire organization by integrating the plans of its various parts. Budgeting helps to ensure that everyone in the organization is pulling in the same direction. 6. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance. Responsibility Accounting Most of what we say in this chapter and in the next three chapters is concerned with responsibility accounting. The basic idea underlying responsibility accounting is that a manager should be held responsible for those items—and only those items—that the manager can actually control to a significant extent. Each line item (i.e., revenue or cost) in the budget is the responsibility of a manager who is held responsible for subsequent deviations between budgeted goals and actual results. In effect, responsibility accounting personalizes accounting information by holding individuals responsible for revenues and costs. This concept is central to any effective profit planning and control system. Someone must be held responsible for each cost or else no one will be responsible and the cost will inevitably grow out of control. What happens if actual results do not measure up to the budgeted goals? The manager is not necessarily penalized. However, the manager should take the initiative to correct any unfavorable discrepancies, should understand the source of significant favorable or nor27130_ch08_287-333.indd 288 9/14/09 7:23:06 AM Confirming Pages www.downloadslide.com Profit Planning 289 IN BUSINESS NEW YORK CITY MAYOR BENEFITS FROM BUDGETS Michael Bloomberg, the mayor of New York City, makes annual budget presentations to his fellow elected officials, the city council, and the media. Historically, the city’s mayors had delegated these types of presentations to one of their budget directors; however, Bloomberg believes that by investing his time in explaining the factors influencing the city’s economy, his constituents will gain a better understanding of his fiscal priorities. This, in turn, helps improve his negotiations with the city council and his relationships with various advocacy groups. The mayor also makes his entire budget available online so that New Yorkers can scrutinize budgeting details, such as the cost of running specific government agencies. Source: Tom Lowry, “The CEO Mayor,” BusinessWeek, June 25, 2007, pp. 58–64. unfavorable discrepancies, and should be prepared to explain the reasons for discrepancies to higher management. The point of an effective responsibility accounting system is to make sure that nothing “falls through the cracks,” that the organization reacts quickly and appropriately to deviations from its plans, and that the organization learns from the feedback it gets by comparing budgeted goals to actual results. The point is not to penalize individuals for missing targets. Choosing a Budget Period Operating budgets ordinarily cover a one-year period corresponding to the company’s fiscal year. Many companies divide their budget year into four quarters. The first quarter is then subdivided into months, and monthly budgets are developed. The last three quarters may be carried in the budget as quarterly totals only. As the year progresses, the figures for the second quarter are broken down into monthly amounts, then the thirdquarter figures are broken down, and so forth. This approach has the advantage of requiring periodic review and reappraisal of budget data throughout the year. Continuous or perpetual budgets are sometimes used. A continuous or perpetual budget is a 12-month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. In other words, one month (or quarter) is added to the end of the budget as each month (or quarter) comes to a close. This approach keeps managers focused at least one year ahead so that they do not become too narrowly focused on short-term results. In this chapter, we will look at one-year operating budgets. However, using basically the same techniques, operating budgets can be prepared for periods that extend over many years. It may be difficult to accurately forecast sales and other data much beyond a year, but even rough estimates can be invaluable in uncovering potential problems and opportunities that would otherwise be overlooked. IN BUSINESS KEEPING CURRENT Jim Bell, Hunstman Corp.’s director of corporate finance, says that his company must frequently update its budgets and its forecasts to meet the demands of investors, creditors, and others. The company updates its annual budget each month, using the most recent data, to provide greater accuracy as the year unfolds. The budget is also used together with sophisticated modeling software to evaluate what effects decisions and various changes in input prices and other parameters might have on future results. Source: Tim Reason, “Partial Clearing,” CFO, December 2002, pp. 73–76. nor27130_ch08_287-333.indd 289 9/14/09 7:23:06 AM Confirming Pages www.downloadslide.com 290 Chapter 8 EXHIBIT 8–1 The Initial Flow of Budget Data in a Participative Budgeting System Top management Middle management Supervisor Supervisor Middle management Supervisor Supervisor The initial flow of budget data in a participative budgeting system is from lower levels of responsibility to higher levels of responsibility. Each person with responsibility for cost control will prepare his or her own budget estimates and submit them to the next higher level of management. These estimates are reviewed and consolidated as they move upward in the organization. The Self-Imposed Budget The success of a budget program is largely determined by the way a budget is developed. Oftentimes, the budget is imposed from above, with little participation by lower-level managers. However, in the most successful budget programs, managers actively participate in preparing their own budgets. Imposing expectations from above and then penalizing employees who do not meet those expectations will generate resentment rather than cooperation and commitment. In fact, many managers believe that being empowered to create their own self-imposed budgets is the most effective method of budget preparation. A self-imposed budget or participative budget, as illustrated in Exhibit 8–1, is a budget that is prepared with the full cooperation and participation of managers at all levels. Self-imposed budgets have a number of advantages: 1. Individuals at all levels of the organization are recognized as members of the team whose views and judgments are valued by top management. 2. Budget estimates prepared by front-line managers are often more accurate and reliable than estimates prepared by top managers who have less intimate knowledge of markets and day-to-day operations. 3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. Self-imposed budgets create commitment. 4. A manager who is not able to meet a budget that has been imposed from above can always say that the budget was unrealistic and impossible to meet. With a selfimposed budget, this excuse is not available. nor27130_ch08_287-333.indd 290 9/14/09 7:23:09 AM Confirming Pages www.downloadslide.com Profit Planning 291 One important limitation of self-imposed budgeting is that lower-level managers may allow too much budgetary slack. Because the manager who creates the budget will be held accountable for actual results that deviate from the budget, the manager will have a natural tendency to submit a budget that is easy to attain (i.e., the manager will build slack into the budget). For this reason, budgets prepared by lower-level managers should be scrutinized by higher levels of management. Questionable items should be discussed and modified as appropriate. Without such a review, self-imposed budgets may be too slack, resulting in suboptimal performance. As these comments suggest, all levels in the organization should work together to produce the budget. Lower-level managers are more familiar with day-to-day operations than top managers. Top managers should have a more strategic perspective than lowerlevel managers. Each level of responsibility in an organization should contribute its unique knowledge and perspective in a cooperative effort to develop an integrated budget. Nevertheless, a self-imposed approach to setting budgets works best when all managers understand the organization’s strategy. Otherwise, the budgets proposed by the lowerlevel managers will lack coherent direction. In later chapters, we discuss in greater detail how a company can go about formulating its strategy and communicating it throughout the organization. Unfortunately, most companies do not follow the budgeting process we have described. Typically, top managers initiate the budgeting process by issuing profit targets. Lower-level managers are directed to prepare budgets that meet those targets. The difficulty is that the targets set by top managers may be unrealistically high or may allow too much slack. If the targets are too high and employees know they are unrealistic, motivation will suffer. If the targets allow too much slack, waste will occur. Unfortunately, top managers are often not in a position to know whether the targets are appropriate. Admittedly, a self-imposed budgeting system may lack sufficient strategic direction and lower-level managers may be tempted to build slack into their budgets. Nevertheless, because of the motivational advantages of self-imposed budgets, top managers should be cautious about imposing inflexible targets from above. Human Factors in Budgeting The success of a budget program also depends on the degree to which top management accepts the budget program as a vital part of the company’s activities and the way in which top management uses budgeted data. If a budget program is to be successful, it must have the complete acceptance and support of the persons who occupy key management positions. If lower or middle managers sense that top management is lukewarm about budgeting, or if they sense that top management simply tolerates budgeting as a necessary evil, then their own attitudes will reflect a similar lack of enthusiasm. Budgeting is hard work, and if top management is not enthusiastic about and committed to the budget program, then it is unlikely that anyone else in the organization will be either. In administering the budget program, it is particularly important that top management not use the budget to pressure or blame employees. Using budgets in such negative ways will breed hostility, tension, and mistrust rather than cooperation and productivity. Unfortunately, the budget is too often used as a pressure device and excessive emphasis is placed on “meeting the budget” under all circumstances. Rather than being used as a weapon, the budget should be used as a positive instrument to assist in establishing goals, measuring operating results, and isolating areas that need attention. The human aspects of budgeting are extremely important. The remainder of the chapter deals with technical aspects of budgeting, but do not lose sight of the human aspects. The purpose of the budget is to motivate people and to coordinate their efforts. This purpose is undermined if managers become preoccupied with the technical aspects or if the budget is used in a rigid and inflexible manner to control people. nor27130_ch08_287-333.indd 291 9/14/09 7:23:09 AM Confirming Pages www.downloadslide.com 292 Chapter 8 IN BUSINESS WHO CARES ABOUT BUDGETS? Towers Perrin, a consulting firm, reports that the bonuses of more than two out of three corporate managers are based on meeting targets set in annual budgets. “Under this arrangement, managers at the beginning of a year all too often argue that their targets should be lowered because of tough business conditions, when in fact conditions are better than projected. If their arguments are successful, they can easily surpass the targets.” Source: Ronald Fink and Towers Perrin, “Riding the Bull: The 2000 Compensation Survey,” CFO, June 2000, pp. 45–60. How challenging should budget targets be? Some experts argue that budget targets should be very challenging and should require managers to stretch to meet goals. Even the most capable managers may have to scramble to meet such a “stretch budget” and they may not always succeed. In practice, most companies set their budget targets at a “highly achievable” level. A highly achievable budget may be challenging, but it can almost always be met by competent managers exerting reasonable effort. Bonuses based on meeting and exceeding budgets are often a key element of management compensation. Typically, no bonus is paid unless the budget is met. The bonus often increases when the budget target is exceeded, but the bonus is usually capped out at some level. For obvious reasons, managers who have such a bonus plan or whose performance is evaluated based on meeting budget targets usually prefer to be evaluated based on highly achievable budgets rather than on stretch budgets. Moreover, highly achievable budgets may help build a manager’s confidence and generate greater commitment to the budget. And finally, highly achievable budgets may result in less undesirable behavior at the end of budgetary periods by managers who are intent on earning their bonuses. Examples of such undesirable behaviors are presented in several of the In Business boxes in this chapter. IN BUSINESS BIASING FORECASTS A manager’s compensation is often tied to the budget. Typically, no bonus is paid unless a minimum performance hurdle such as 80% of the budget target is attained. Once that hurdle is passed, the manager’s bonus increases until a cap is reached. That cap is often set at 120% of the budget target. This common method of tying a manager’s compensation to the budget has some serious negative side effects. For example, a marketing manager for a big beverage company intentionally grossly understated demand for the company’s products for an upcoming major holiday so that the budget target for revenues would be low and easy to beat. Unfortunately, the company tied its production to this biased forecast and ran out of products to sell during the height of the holiday selling season. As another example, near the end of the year another group of managers announced a price increase of 10% effective January 2 of the following year. Why would they do this? By announcing this price increase, managers hoped that customers would order before the end of the year, helping managers meet their sales targets for the current year. Sales in the following year would, of course, drop. What trick would managers pull to meet their sales targets next year in the face of this drop in demand? Sources: Michael C. Jensen, “Corporate Budgeting Is Broken—Let’s Fix It,” Harvard Business Review, November 2001; and Michael C. Jensen, “Why Pay People to Lie?” The Wall Street Journal, January 8, 2001, p. A32. The Budget Committee A standing budget committee is usually responsible for overall policy relating to the budget program and for coordinating the preparation of the budget itself. This committee may consist of the president; vice presidents in charge of various functions such as sales, nor27130_ch08_287-333.indd 292 9/14/09 7:23:09 AM Confirming Pages www.downloadslide.com Profit Planning 293 production, and purchasing; and the controller. Difficulties and disputes relating to the budget are resolved by the budget committee. In addition, the budget committee approves the final budget. Disputes can (and do) erupt over budget matters. Because budgets allocate resources, the budgeting process determines to a large extent which departments get more resources and which get less. Also, the budget sets the benchmarks used to evaluate managers and their departments. Therefore, it should not be surprising that managers take the budgeting process very seriously and invest considerable energy and emotion in ensuring that their interests, and those of their departments, are protected. Because of this, the budgeting process can easily degenerate into an interoffice brawl in which the ultimate goal of working together toward common goals is forgotten. Running a successful budgeting program that avoids interoffice battles requires considerable interpersonal skills in addition to purely technical skills. But even the best interpersonal skills will fail if, as discussed earlier, top management uses the budget process to inappropriately pressure employees or to assign blame. The Master Budget: An Overview The master budget consists of a number of separate but interdependent budgets that formally lay out the company’s sales, production, and financial goals. The master budget culminates in a cash budget, a budgeted income statement, and a budgeted balance sheet. Exhibit 8–2 provides an overview of the various parts of the master budget and how they are related. EXHIBIT 8–2 The Master Budget Interrelationships Sales budget Ending inventory budget Production budget Direct materials budget Direct labor budget Selling and administrative expense budget Manufacturing overhead budget Cash budget Budgeted income statement nor27130_ch08_287-333.indd 293 Budgeted balance sheet 9/14/09 7:23:10 AM Confirming Pages www.downloadslide.com 294 Chapter 8 The first step in the budgeting process is the preparation of the sales budget, which is a detailed schedule showing the expected sales for the budget period. An accurate sales budget is the key to the entire budgeting process. As illustrated in Exhibit 8–2, all other parts of the master budget depend on the sales budget. If the sales budget is inaccurate, the rest of the budget will be inaccurate. The sales budget is based on the company’s sales forecast, which may require the use of sophisticated mathematical models and statistical tools. We will not go into the details of how sales forecasts are made. This is a subject that is most appropriately covered in marketing courses. The sales budget helps determine how many units need to be produced. Thus, the production budget is prepared after the sales budget. The production budget in turn is used to determine the budgets for manufacturing costs including the direct materials budget, the direct labor budget, and the manufacturing overhead budget. These budgets are then combined with data from the sales budget and the selling and administrative expense budget to determine the cash budget. A cash budget is a detailed plan showing how cash resources will be acquired and used. Observe from Exhibit 8–2 that all of the operating budgets have an impact on the cash budget. After the cash budget is prepared, the budgeted income statement and then the budgeted balance sheet can be prepared. IN BUSINESS BE REALISTIC Gillette, the company that makes razors and other consumer products, got into trouble trying to meet increasingly unrealistic sales targets. The buyer at one of the company’s big retail customers told Gillette’s new CEO, Jim Kilts, that “he always waited until the last week of the quarter to order anything from Gillette ‘because I know that you will always cut a deal.’ To hit their numbers each quarter, [the Gillette salepersons] were willing to do anything—offer cut-rate deals, rearrange product packaging—whatever it took to make the sale.” This resulted in artificially large sales at the end of the quarter—-disrupting production schedules and loading the retail stores with excess inventory at discounted prices that would have to be sold off before more inventory would be ordered from Gillette. Source: Katrina Brooker, “Jim Kilts Is an Old-School Curmudgeon,” Fortune, December 30, 2002, pp. 95–102. Preparing the Master Budget MANAGERIAL ACCOUNTING IN ACTION The Issue Tom Wills is the majority stockholder and chief executive officer of Hampton Freeze, Inc., a company he started in 2006. The company makes premium popsicles using only natural ingredients and featuring exotic flavors such as tangy tangerine and minty mango. The company’s business is highly seasonal, with most of the sales occurring in spring and summer. In 2007, the company’s second year of operations, a major cash crunch in the first and second quarters almost forced the company into bankruptcy. In spite of this cash crunch, 2007 turned out to be a very successful year in terms of both cash flow and net income. Partly as a result of that harrowing experience, Tom decided toward the end of 2007 to hire a professional financial manager. Tom interviewed several promising candidates for the job and settled on Larry Giano, who had considerable experience in the packaged foods industry. In the job interview, Tom questioned Larry about the steps he would take to prevent a recurrence of the 2007 cash crunch: Tom: As I mentioned earlier, we are going to end 2007 with a very nice profit. What you may not know is that we had some very big financial problems this year. Larry: Let me guess. You ran out of cash sometime in the first or second quarter. nor27130_ch08_287-333.indd 294 9/14/09 7:23:10 AM Confirming Pages www.downloadslide.com Profit Planning 295 Tom: How did you know? Larry: Most of your sales are in the second and third quarter, right? Tom: Sure, everyone wants to buy popsicles in the spring and summer, but nobody wants them when the weather turns cold. Larry: So you don’t have many sales in the first quarter? Tom: Right. Larry: And in the second quarter, which is the spring, you are producing like crazy to fill orders? Tom: Sure. Larry: Do your customers, the grocery stores, pay you the day you make your deliveries? Tom: Are you kidding? Of course not. Larry: So in the first quarter, you don’t have many sales. In the second quarter, you are producing like crazy, which eats up cash, but you aren’t paid by your customers until long after you have paid your employees and suppliers. No wonder you had a cash problem. I see this pattern all the time in food processing because of the seasonality of the business. Tom: So what can we do about it? Larry: The first step is to predict the magnitude of the problem before it occurs. If we can predict early in the year what the cash shortfall is going to be, we can go to the bank and arrange for credit before we really need it. Bankers tend to be leery of panicky people who show up begging for emergency loans. They are much more likely to make the loan if you look like you are in control of the situation. Tom: How can we predict the cash shortfall? Larry: You can put together a cash budget. While you’re at it, you might as well do a master budget. You’ll find it is well worth the effort. Tom: I don’t like budgets. They are too confining. My wife budgets everything at home, and I can’t spend what I want. Larry: Can I ask a personal question? Tom: What? Larry: Where did you get the money to start this business? Tom: Mainly from our family’s savings. I get your point. We wouldn’t have had the money to start the business if my wife hadn’t been forcing us to save every month. Larry: Exactly. I suggest you use the same discipline in your business. It is even more important here because you can’t expect your employees to spend your money as carefully as you would. With the full backing of Tom Wills, Larry Giano set out to create a master budget for the company for the year 2008. In his planning for the budgeting process, Larry drew up the following list of documents that would be a part of the master budget: 1. A sales budget, including a schedule of expected cash collections. 2. A production budget (a merchandise purchases budget would be used in a merchandising company). 3. A direct materials budget, including a schedule of expected cash disbursements for purchases of materials. 4. A direct labor budget. 5. A manufacturing overhead budget. 6. An ending finished goods inventory budget. 7. A selling and administrative expense budget. 8. A cash budget. 9. A budgeted income statement. 10. A budgeted balance sheet. Larry felt it was important to have everyone’s cooperation in the budgeting process, so he asked Tom to call a companywide meeting to explain the budgeting process. At the meeting there was initially some grumbling, but Tom was able to convince nearly everyone of the necessity for planning and getting better control over spending. It helped that the cash nor27130_ch08_287-333.indd 295 9/14/09 7:23:11 AM Confirming Pages www.downloadslide.com 296 Chapter 8 crisis earlier in the year was still fresh in everyone’s minds. As much as some people disliked the idea of budgets, they liked their jobs more. In the months that followed, Larry worked closely with all of the managers involved in the master budget, gathering data from them and making sure that they understood and fully supported the parts of the master budget that would affect them. In subsequent years, Larry hoped to turn the whole budgeting process over to the managers and to take a more advisory role. The interdependent documents that Larry Giano prepared for Hampton Freeze are Schedules 1 through 10 of the company’s master budget. In this section, we will study these schedules. SCHEDULE 1 1 Cash collections from last year’s fourth-quarter sales. See the beginning-of-year balance sheet on page 309. $200,000  70%; $200,000  30%. 3 $600,000  70%; $600,000  30%. 4 $800,000  70%; $800,000  30%. 5 $400,000  70%. 6 Uncollected fourth-quarter sales appear as accounts receivable on the company’s end-of-year budgeted balance sheet (see Schedule 10 on page 310). 2 nor27130_ch08_287-333.indd 296 9/14/09 7:23:11 AM