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Chapter 10Static and Flexible Budgets

LEARNING OBJECTIVES

Chapter 10 addresses the following questions:

Q1 What are the relationships among budgets, long-term strategies, and short-term operating plans?

Q2 What is a master budget, and how is it prepared?Q3 What are budget variances, and how are they calculated?Q4 What are the differences between static and flexible budgets?Q5 How are budgets used to monitor and motivate performance?Q6 What are other approaches to budgeting?Q7 How is the cash budget developed? (Appendix 10A)

These learning questions (Q1 through Q7) are cross-referenced in the textbook to individual exercises and problems.

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems.

Questions Having a Single Correct Answer:No Symbol This question requires students to recall or apply knowledge as shown in the

textbook.e This question requires students to extend knowledge beyond the applications

shown in the textbook.

Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10):

Step 1 skills (Identifying) Step 2 skills (Exploring) Step 3 skills (Prioritizing) Step 4 skills (Envisioning)

10-2 Cost Management

QUESTIONS

10.1 The revenue budget determines the volume of units sold. This amount, less beginning inventories plus desired ending inventories determines the amount of units for the production budget. The production budget determines the amount of direct materials needed. If there are any constraints in the production process or for direct materials, these relationships could change.

10.2 An organization would like the right people to be available at the right place and at the right time. This includes having the necessary talent in marketing to produce sales, and in production to provide the product. The various staff functions should be able to perform their assigned tasks in an effective and efficient manner. The budget provides advance guidance about personnel requirements during specific time periods.

10.3 If individuals who are affected by some aspect of the budget participate in that budget’s construction, there should be greater acceptance of the stated goals and the means to their attainment. If a manager has not had input to setting goals or to the resources required to attain them, there is a possibility that the budget may not be taken seriously as the formal financial expression of that individual's responsibility and authority.

10.4 Zero based budgeting does not take a prior period's performance and budget as given. It requires that each budget be justified by first demonstrating that the projected level of output (of goods or services) justifies the budget submitted. The projected level of output needs to be consistent with the goals of the organization. This means that under zero based budgeting, managers ignore prior period results and proceed as if they were developing budgets for the first time.

10.5 The master budget is a particular application of the flexible budget for the specific level of operations that management expects during the next period. The flexible budget can be readily adapted to any level of activity within the relevant range; the master budget is one particular level of activity.

10.6 To minimize budgetary slack, organizations ask outside consultants or market specialists to make forecasts for the next period and compare their forecasts to those generated internally. In addition, bonuses are paid for accuracy in budgeting as well as for meeting or beating budgets.

10.7 Static budgets need the following adjustments for performance evaluation:* Use flexible budget to adjust for actual volumes* Remove allocated costs* Update costs for anticipated price changes

10.8 Here are some of the challenges that organizations face when they allocate budget authority and responsibility; students might have thought of others. Sometimes managers feel that they are held responsible for costs over which they have little or no control, and they begin to feel resentful. When there is interdependency among divisions and departments, it is difficult to separate the effects of individual manager’s efforts. Sometimes a new manager replaces someone who leaves, and the new manager is held

Chapter 10: Static and Flexible Budgets 10-3

responsible for whatever budget decisions were made previously. Sometimes uncontrollable external or internal factors alter budgets unexpectedly. For example, a few key employees could leave for better jobs. Unanticipated changes could occur in the organization’s prices and costs.

10.9 Cash budgets help managers plan their short term borrowing needs to meet payroll, accounts payable, and other cash obligations. In a seasonal business, there are times when cash levels are quite high, but also times when very little cash is flowing into the company. Managers need to plan ahead for times of reduced cash flow so that employees and vendors are unaffected by these cycles.

10.10 Managers use many different types of information to develop budgets. Often they use last year’s results to determine a base level of costs and revenues. They also estimate future sales volumes, prices, and costs. Information for these estimates can be obtained from very specific sources, such as trade journals that provide total market share information, to very general sources such as economic trends described in business publications such as The Wall Street Journal. Information is also obtained from individuals throughout the organization. For example, engineers might provide estimates of cost changes resulting from expected changes to production processes. Individual department managers submit plans and budget requests. In addition, information is obtained from suppliers, companies from whom they rent, and others who might know whether cost changes are expected during the period for which the budget is developed.

10.11 Both types of budgets forecast revenues and costs using information about past, present, and future operations. Annual budgets forecast for next year while rolling budgets forecast for shorter or longer periods. Annual budgets are developed once a year while rolling budgets are updated more frequently, often on a monthly basis.

10.12 Budgets are prepared in light of organizational strategies and are a method to communicate strategies and objectives throughout the organization. Operating plans are developed from organizational strategies, and these are communicated from top levels throughout the organization. Sub-units then develop budgets considering organizational objectives and communicate their budget goals to top management. After the budgeting process is complete, actual operations are compared to budgets and any differences are investigated. This process leads to re-evaluation of the organization’s vision and strategies as shown in Exhibit 10.2.


EXERCISES

10.13 Seer Manufacturing

A. Production Budget

February March AprilDesired ending inventory 180 110 100Planned sales 90 100 80

Total units needed 270 210 180Planned beginning inventory 190 180 110

Production requirements 80 30 70

B. Direct Materials Unit Forecast

February March AprilDesired ending inventorya 120 45 105Planned usageb 240 90 210

Total units needed 360 135 315Planned beginning inventoryc 150 120 45

Materials acquisitions 210 15 270

a Current production x 3 units direct materials x 0.5 to reflect 3 direct materials units per product, and half of this month’s production for ending inventory balance.

b Current production x 3c Prior month's production x 3 x .5;

January production was change in finished goods inventory plus January sales, or (100 + 90) - (40 + 90) + 40 = 100 units.

C. Labor Requirements Budget

February March AprilLabor hours neededa 800 300 700

a Current production x 10


10.14 Bullen & Company

Notice that the first quarter is the first three months. April’s information is needed for some of March’s budget calculations.

A.(1) Production budget (units)

January February March QuarterSales units (a) 20,000 24,000 16,000 60,000Plus ending inventory (b) 12,000 8,000 9,000 9,000Total Units needed 32,000 32,000 25,000 69,000Less Beginning inventory 10,000 12,000 8,000 10,000

Total units to be produced 22,000 20,000 17,000 59,000

(a) Current month's sales (b) 50% of following month's sales

(2) Direct labor budget (hours)

January February March TotalUnits to be produced 22,000 20,000 17,000 59,000Direct labor hours per unit 4.0 4.0 3.5Total labor budget (hours) 88,000 80,000 59,500 227,500

(3) Direct materials budget (dollars)

January February March TotalUnits to be produced 22,000 20,000 17,000 59,000Cost per unit $10 $10 $10Total direct material cost $220,000 $200,000 $170,000 $590,000

(4) Sales budget (dollars)

January February March TotalSales units 20,000 24,000 16,000 60,000Sales price per unit $80 $80 $75Total sales revenue budget $1,600,000 $1,920,000 $1,200,000 $4,720,000


B.Bullen & Company

Budgeted Contribution MarginFirst Quarter, 20X5

January February March QuarterDirect labor hours per unit 4.0 4.0 3.5Direct labor hourly rate $15 $15 $16Direct labor cost per unit $60 $60 $56

Sales units 20,000 24,000 16,000 60,000

Sales revenue $1,600,000 $1,920,000 $1,200,000 $4,720,000Direct labor cost 1,200,000 1,440,000 896,000 3,536,000Direct materials cost 200,000 240,000 160,000 600,000

Contribution margin $ 200,000 $ 240,000 $ 144,000 $ 584,000

C. At least three behavioral considerations in the profit-planning and budgeting process include the following.

Goal alignment is critical. The individual manager’s goals may conflict with the firm’s goals. Setting targets in a budget process helps focus and motivate managers to achieve the firm’s objectives.

Participation from lower-level managers and other employees has two benefits. It uses information from those closest to the process, and the mangers have a stronger commitment to the budget itself.

The entire budget process is a form of communication. Feedback and other forms of improving communication are essential throughout the process.

10.15 Appliances Now

A.Flexible

Static Flexible BudgetBudget Budget Actual Variance

Revenues $16,491 $17,480 $17,480 $ 0

Cost of Sales 5,892 6,245 (a) 6,451 (206)Fixed overhead 1,977 1,977 2,032 (55)Variable selling 456 483 (b) 550 (67)Fixed selling 1,275 1,275 1,268 7Administration 4,773 4,773 5,550 (777)Total costs 14,373 14,753 15,851 $(1,098)

Income $ 2,118 $ 2,727 $ 1,629


The following computations are short-cuts that can be used to calculate variable costs under a flexible budget, with revenues as the cost driver.

Flexible budget for variable costs = Static budget variable cost/Revenues in static budget * Actual Revenues:

(a) $5,892/$16,491 * $17,480(b) $456/$16,491 * $17,480

B. If market share is 20% and revenues are $17,480, then the following equation estimates the total market:

20% * Market = $17,480Market = $17,480/0.20 = $87,400

If market share of 22% had been obtained, revenues would have been:

$87,400 * 22% = $19,228

Thus, foregone revenue is:

Revenue at 22% Market Share – Actual Revenues= $19,228 - $17,480 = $1,748

The foregone profit is equal to the marginal profit that would have been earned on foregone revenues. Thus, the marginal profit is equal to the contribution margin on foregone revenues. (Remember: Fixed costs would not be affected by higher revenues.) The contribution margin per dollar of revenue from the original (static) budget follows:

Revenue $16,491Less variable costs:

Cost of sales (5,892)Variable selling (456)

Contribution Margin $10,143

Contribution Margin Ratio 61 .51%

Foregone profit is equal to the contribution margin on foregone revenues:

Foregone Revenues * Contribution Margin Ratio= $1,748 * 61.51% = $1,075

10.16 The Zel Company

A. Cost of goods sold = (0.8*sales)= (0.8*$1,700,000)= $1,360,000


B. Beginning inventories are 30% of that month’s cost of goods sold. Therefore, July Beginning Inventory = (0.3*cost of goods sold)

= (0.3*0.8*$1,810,000)= $434,400

C. Ending inventory for July is the beginning inventory for August.

Ending inventory (0.3*0.8*1,920,000) $ 460,800+ July cost of goods sold (0.8*1,810,000) 1,448,000- Beginning inventory (part B) (434,400 ) = Purchases $1,474,400

D. 40% of receivables are collected in the month sold, and 50% are collected the next month. For July:

Cash sales $ 210,000Collections from July credit sales (0.4 * $1,600,000) 640,000Collections from June credit sales (0.5 * $1,500,000) 750,000

July cash collections $1,600,000

10.17 New Ventures

First, determine the purchases budget for the 1st quarter:

January February March AprilProduction (units) 20,000 50,000 70,000 70,000Raw materials needed per unit x 2 x 2 x 2 x 2

Production requirement 40,000 100,000 140,000 140,000Ending inventory requirement

(25% of next month's production requirement) 25,000 35,000 35,000Total needed 65,000 135,000 175,000

Less: Beginning inventory (0) (25,000) (35,000)Raw materials purchases (units) 65,000 110,000 140,000

Raw material unit cost x $7 x $7 x $7Raw materials purchases $455,000 $770,000 $980,000


Next compute cash disbursements for purchases of raw materials:

January February MarchJanuary purchases (a) $163,800 $273,000February purchases (b) 277,200 $462,000March purchases (c) 352,800

Total cash payments $163,800 $550,200 $814,800

(a) January: ($455,000 x 0.4).9 = $163,800February: ($455,000 x 0.6) = $273,000

(b) February: ($770,000 x 0.4).9 = $277,200March: ($770,000 x 0.6) = $462,000

(c) March: ($980,000 x 0.4).9 = $352,800

10.18 Myrna Manufacturing

Cash receipts for February areFrom January (25,000 x €18 x .70) €315,000From February (30,000 x €18 x .25 x .97) 130,950

Total February cash receipts €445,950

Production requirements areJanuary February March

Sales requirement (units) 25,000 30,000 32,000Plus: Ending inventory (units) 7,500 8,000 8,750

Total needs 32,500 38,000 40,750Less: Beginning inventory (units) 0 (7,500 ) (8,000 )

Production requirement (units) 32,500 30,500 32,750

Materials Purchases BudgetTo support production (units) 65,000 61,000 65,500Plus: Ending inventory (units) 12,200 13,100

Total needs 77,200 74,100Less: Beginning inventory (units) 0 (12,200 )

Total purchases (units) 77,200 61,900

Raw materials cost per unit €0.75 €0.75

Total purchases €57,900 €45,425

Cash disbursements in February for raw materials areFrom January (€57,900 x 0.40) €23,160From February (€46,425 x 0.60) 27,855

Total raw materials disbursements €51,015


Labor costs in February are30,500 units x .50 hour per unit 15,250 hoursWage rate €15

Total cash disbursement, labor €228,750

Overhead costs in February areTotal costs = €2(30,500) + 25,000 €86,000Less: Depreciation 12,000

Total cash overhead costs €74,000

The February cash budget is thus:Beginning balance, February 1 € 80,000Plus: February receipts 445,950

Subtotal 525,950Less: Disbursements

Raw materials 51,015Labor 228,750Overhead 74,000

Total disbursements 353,765Ending balance, February 28 €172,185

10.19 Play Time Toys

[Note about problem complexity: Items A and B are coded as “Extend” instead of “Step 2” because a similar example was provided in the chapter.]

A. Play Time Toys is using a static budget. It does not reflect the activity levels, so it is not a good measure of performance. The variable costs need to be related to actual production volumes. It also includes division, marketing and headquarters overhead costs and managers are not responsible for those. They should be eliminated. Managers and their departments should be evaluated relative to costs they can control. Any costs they cannot control should be removed.

B and C. The following schedule eliminates costs that are not under the dolls production department manager’s control. These include production division costs, headquarters costs, and marketing costs. Revenues and volume are included only because provide information about activity levels. Variable costs are adjusted for actual volume.

Budget Benchmark Actual VarianceVolume 1,000 1,100 1,100Revenue $12,000 $13,200 $12,400

Direct Materials $2,000 $2,200 $2,100 $ 100Direct Labor 1,000 1,100 1,225 (125)Variable Overhead 1,000 1,100 1,100 0Fixed Overhead 800 800 1,020 (220 )

Total Costs $4,800 $5,200 $5,445 $(245)


D. The direct material variance is favorable and about 5% of the benchmark. Perhaps materials of lower quality than usual were purchased, or perhaps there was a price decrease that should be reflected through a new standard. If lower quality materials were purchased, more labor time might have been needed to produce the dolls, resulting in a negative labor variance. If there was no change in the quality of materials, then other reasons need to be investigated for the negative labor variance (11% of the benchmark). Perhaps there was unusually high turnover or other factors, resulting in lower productivity. It is also possible that the standard labor cost is too low, particularly if there was an unanticipated labor rate increase. The unfavorable fixed overhead variance is very large (28% of benchmark). Perhaps there were large discretionary expenditures, such as painting the production facility. Or, perhaps there was an unexpected increase in one or more fixed overhead cost categories. It is also possible that the budgeted cost is too low.

10.20 Brad Worth

A.Cash Receipts

Sept Oct Nov Dec Jan Feb MarUnits sold 120 220 320 400 0 0 0

Cash sales (a) $2,160 $3,960 $ 5,760 $ 7,200 $ 0 $ 0 $ 0Credit card sales (b) 1,710 3,135 4,560 5,700 0 0 0One month later (c) 0 900 1,650 2,400 3,000 0 0Two months later (d) 0 0 360 660 960 1,200 0Three months later (e) 0 0 0 240 440 640 800

Total $3,870 $7,995 $12,330 $16,200 $4,400 $1,840 $800

(a) Cash sales: Unit sales x $50 x 40% x (1-10%)(b) Credit card sales: Unit sales x $50 x 30% x (1-5%)(c) Collected one month later: Unit sales last month x $50 x 15%(d) Collected two months later: Unit sales two months ago x $50 x 6%(e) Collected three months later: Unit sales three months ago x $50 x 4%


Cash Disbursements

Sept Oct Nov Dec JanUnit sold 120 220 320 400 0

Purchases:Desired ending inventory (a) 154 224 280 0Units sold this month 120 220 320 400Less beginning inventory (b) (50) (154) (224) (280)

Budgeted purchases 224 290 376 120

Cash Disbursements:Paid same month (c) $ 0 $ 4,362 $ 5,655 $1,805 $ 0Paid next month (d) 1,600 7,168 4,640 6,016 1,920

Total $1,600 $11,530 $10,295 $7,821 $1,920

(a) Next month’s unit sales x 70%(b) Prior month’s ending inventory(c) Zero for Sept; other months: units purchased x $32 x 50% x (1-6%)(d) September: 50 units purchased during August x $32; October: units

purchased during Sept x $32; other months: prior month units purchased x $32 x 50%

Summary of Budgeted Cash Receipts and Disbursements

Sept Oct Nov Dec Jan Feb MarCash receipts $3,870 $ 7,995 $12,330 $16,200 $ 4,400 $ 1,840 $ 800Cash disbursements (1,600 ) (11,530 ) (10,295 ) (7,821 ) (1,920 ) ( 0 ) (0 )

Net cash flow $2,270 $ (3,535) $ 2,035 $ 8,379 $ 2,480 $ 1,840 $ 800

Cumulative cash flow $2,270 $ (1,265) $ 770 $ 9,149 $11,629 $13,460 $14,269

B. Although the problem does not require this calculation, the total amount of uncollectible accounts can be estimated as follows:

(120+220+320+400) x $50 x 5% = $2,650

Because the only option under consideration is to write off the accounts, Brad could allow the collection agency to keep 100% of collections and still be no worse off.


PROBLEMS

10.21 Patricia’s Reconciliation

A. Many accounting tasks are nonroutine and involve unpredictable activities. For example, a reconciliation could require investigation of unusual items or uncover problems with the mathematical accuracy of other accounting records. Unforeseen problems make it difficult to establish an accurate time budget.

B. Patricia’s time might exceed the budget because of unforeseen items, as discussed in Part A. Alternatively, her time could exceed the budget because she is inexperienced or is distracted by other matters (such as worrying about her performance).

C. Patricia is probably concerned that asking for more help will lead Ron to believe that she is incompetent or lacks confidence, which could in turn lead to a poor performance evaluation. She also might want to avoid interrupting Ron from performing his work.

D. It is uncertain how Ron would respond to either situation. Although he has told Patricia that “All new-hires are slow to begin with,” he probably has some unspoken expectation for how long it should take her to complete the task. He probably also has some expectation about the number and types of questions that are appropriate for a newly-hired staff member.

1. If Ron thinks that Patricia’s questions are reasonable and she completes the assignment in 4 hours, he will probably consider her performance to be acceptable for a new-hire. However, he will probably expect her to perform more quickly on future tasks. On the other hand, he might view her performance as poor if he believes that her questions involved issues about which she should already know.

2. Ron will probably give Patricia a poor performance review if she does not seek his help and completes the assignment in 8 hours. He will probably assume that she wasted time by failing to ask him questions. However, he might consider this amount of time reasonable if Patricia adequately explains to him legitimate reasons for the reconciliation taking twice as long as expected—such as unanticipated reconciliation problems.

E.1. Assuming that there were no unusual problems causing the reconciliation to be

significantly more complex than expected, Patricia has probably prioritized self-reliance and worry about her performance as more important than meeting the job’s time budget. In addition, she has placed a low priority on communicating her work status with her supervisor.

2. The ethics in this problem involve Patricia’s responsibilities to her supervisor, her firm, and her client. Her supervisor and firm are both responsible for Patricia’s professional development and the quality of her job performance. If failing to ask questions hindered her development or job performance, then Patricia has not acted


ethically. Her supervisor is probably evaluated at least in part on Patricia’s performance, so her poor performance would also reflect poorly on Ron’s performance. In addition, the firm and client have a financial stake in this situation. Time is money to a CPA firm; either the firm absorbs the cost of the additional time, or the time will be billed to the client. A failure to ask questions might have increased the length of time to complete Patricia’s tasks, and a failure to provide timely communication about problems with the reconciliation might prevent the firm from billing the client for legitimate cost overruns. Ethical behavior in this situation would require Patricia to focus on what is best overall—for herself, her supervisor, her firm, and her client. In this case, her personal concerns appeared to override the interests of other stakeholders. Thus, Patricia did not appear to act ethically.

F. Because of Patricia’s lack of experience, it was difficult for her to gauge the quality of her work and the appropriateness of questions she might ask her supervisor. Nevertheless, once the job is completed she has an opportunity to reflect upon what occurred and to consider things she might have done differently. For example, she might identify a different way to sequence the work she performed to reduce the overall time. Or, she might think about how the work was similar to what she had learned in school, how it was different, and why. She might also ask Ron for suggestions about ways to improve her work. By reflecting on her work and asking for suggestions, Patricia can more readily recognize problems and solutions in future assignments.

G. and H. There is no one answer to these parts. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg).

10.22 Helping a Friend

A. A friend would need to prepare budgets for revenues and for costs that vary per month such as rent, food, and entertainment. An additional budget should be prepared for things that vary per semester, like books and tuition. Because personal costs tend to vary by month, these budgets are prepared for monthly costs by category instead of direct cost budgets that are used in manufacturing. Finally, she needs to prepare a cash budget to estimate her cash needs throughout the semester so that she does not run short.

B. Monthly information that is known for certain includes rent, insurance (if monthly), and car payments. Tuition and fees are known for certain. Other costs that must be estimated include food, books, and entertainment.

C. Assumptions may need to be made about tuition and fees. Do they vary with credit hours? If so, how many credit hours are expected? Assumptions also need to be made about the frequency and cost of events such as eating in restaurants and entertainment. If a lease has not been signed, an assumption needs to be made about the cost of rent. She will make assumptions about the amount and cost of food she will eat, entertainment costs, car and travel related costs. She will not have to make assumptions about costs that she knows ahead, for example tuition (if fixed) and rent. However she will have to make assumptions about other costs that are not known ahead. These assumptions include the


amount that will be spent, the frequency and timing of the expenditures. She will need to make similar assumptions about cash inflows that she does not know ahead. If she works a variable schedule at a restaurant, she cannot know the amount of tips she will receive and will have to make assumptions about the amounts and timing of these cash inflows. Similarly, there may be uncertainties with regard to the money that she receives from her parents. She may know for certain the amounts and timing of scholarship funds.

D. Here is a plan for monitoring your budget.

Each month, compare actual costs to the budgeted costs by budget category. The differences between actual and budgeted costs are called variances. If you have spent more than budgeted, a variance is considered unfavorable. If you have spent less than budgeted, the variance is favorable. At the end of each month, calculate a variance for each budget category and then add all of the variances together to see if you are over or under budget that month.

To calculate these variances, you need to track your costs using the same categories included in the budget. I recommend you use one category to track monthly fixed costs like rent, utilities, car payment, and utilities. Keep two separate categories for discretionary costs, one for food and one for entertainment. You can cut back on discretionary costs more easily than the fixed costs. For example, if utilities are high one month, you could cut back on entertainment the next month to avoid having an overall variance from the budget at the end of the semester.

If you have unfavorable variances for several months, you will need to find additional sources of revenue or cut back on discretionary expenditures. If you have favorable variances for several months you may want to wait until the end of the semester to adjust the budget, to make certain you have not overlooked anything.

10.23 Central County Public Clinic

A. The prior year’s actual results can be used as a static budget for the next period. The 2004 results can be used as the basis for a benchmark for 2005, adjusting for activity levels and any price changes.

B. To convert the 2004 results to a benchmark for 2005, adjust 2004 variable costs to reflect activity levels in 2005. In addition, adjust 2004 amounts for any known price changes.

The following costs are most likely variable. To create an estimate for 2005, divide each cost by the level of activity in 2004 and then multiply by the level of activity in 2005. Home visits can be used to measure activity levels. Adjust for known cost increases, using information given in the problem.

Homemakers: ($60,046 / 4,312 visits * 5,101 visits) $71,033Medical supplies: ($18,197 / 4,312 visits * 5,101 visits) 21,527Cleaning supplies ($6,894 / 4,312 visits * 5,101 visits) 8,155Transportation ($9,068 / 4,312 visits * 5,101 visits) 10,727


The following costs are most likely fixed. To create an estimate for 2005, these costs are adjusted for known cost increases, using information given in the problem.

Nurses:One third year’s salary ($135,378 / 3) $ 45,126Two thirds year’s salary (($135,378 * 105%) / 3) x 2 94,765

Total $139,891

Clinic general overhead is not included in the flexible budget because it is an allocated cost and the clinic manager has no control over it.

Given the preceding calculations, the 2005 benchmark and variances are as follows:

2004 2005 2005Costs Actual Benchmark Actual VarianceNurses $135,378 $139,891 $145,019 $(5,128)Homemakers 60,046 71,033 71,500 (467)Medical supplies 18,197 21,527 21,402 125Cleaning supplies 6,894 8,155 9,216 (1,061)Transportation 9,068 10,727 11,144 (417 ) Total $229,583 $251,333 $258,281 $(6,948 )

Home visits 4,312 5,101 5,101

Average cost per visit $53.24 $49.27 $50.63

C. It seems there is a large variance in cleaning supplies. Are employees taking supplies home? The homemakers did not get a raise but the nurses did, are homemakers taking home cleaning supplies because they feel they are underpaid? Why are nurses’ salaries so high? Did you add hours, or are some nurses getting larger raises? Do patients live further away or are errands being run using clinic car expense?

D. If costs had been in control, there would have been no variances. Thus, this question calls for the number of home visits that could have been made for the extra $6,948 in unfavorable variances. The benchmark average cost of $49.27 cannot be used in the calculations because average cost includes fixed costs that do not change with changes in volume. Therefore, a benchmark variable cost per unit is calculated:


Variable costs per visit:Homemakers $ 71,033Medical supplies 21,527Cleaning supplies 8,155Transportation 10,727

Total Variable Costs $111,442

Divided by benchmark number of visits 5,101

Benchmark Variable Cost Per Visit ($111,442/5,101) $21.85

Now the additional number of visits that could have been made is calculated for the variance:

$6,948 / $21.85 variable cost per visit = 318 visits

Total visits that could have been made if costs had been in control:

5,101 actual visits + 318 additional visits = 5,419 visits

10.24 Fighting Kites Part 1

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg).

A. Below is the input section of the sample spreadsheet for this problem. The data input box shown here includes only the input for Part 1. The solution for later parts will show additional input items.

B. The Revenues Budget reflects the value of estimated sales volume and expected price as follows.


C. Estimated sales volumes and anticipated inventory levels are used to predict the number of units to produce as follows.

D. The above schedules are used to prepare the direct materials usage and purchases budgets.

E. The direct labor budget can now be prepared.


A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg). Here is an excerpt from the spreadsheet showing the additional input area for Part 2:


F.

G. Using information above, determine the cost of ending inventories.


H. Using information above, the cost of goods sold budget is prepared.



I. The support department costs budget is a simple summary of the information provided in the problem:


J. The income statement uses information from the individual budgets prepared in Parts 1 and Parts 2 of this problem. Because the pretax income is negative, it is not clear how to compute the income tax expense. Under U.S. tax law, companies are allowed to carry losses back to offset income reported in prior years. Thus, the company might have a negative income tax expense. However, the problem does not provide information about whether Fighting Kites had income in prior years. Thus, the solution below assumes that no loss carryback is available, and the income tax expense is set to $0.




K. The cash budget requires a series of steps.

Preparation of the cash receipts budget requires calculating the sales for each month within each quarter because only 50% of customer sales are received during the month of sale. Another 47% is collected the following month, and 3% is uncollectible. Cash receipts also include the anticipated sale of equipment during January.

Here are details for some of the calculations: Sales from prior quarter = (Sales during prior quarter/3 months) x (50%-3%).

For Jan-Mar, however, this is calculated as beginning A/R x (100%-2*3%). The uncollectible percent must be doubled because beginning A/R is only one-half the prior month's sales.

Sales 1st and 2nd months of quarter = (Sales during quarter/3 months) x (100%-3%)

Sales 3rd month of quarter = (Sales during quarter/3 months) x 50%

Although the problem does not require it, the sample spreadsheet shows a reconciliation of total sales to total cash receipts from customers. This type of reconciliation is useful because it provides a check on the mathematical accuracy of the cash receipts schedule.

Ending accounts receivable = (Sales during fourth quarter/3 months) x 50%


Because the company carries accounts payable for raw material purchases, it is helpful to begin the cash disbursement calculations by summarizing the cash payments for raw material purchases. First, calculate the raw material purchases by month. The company’s policy is to pay approximately 2/3 of its purchases during the month of purchase and the remainder the following month.

Here are details for some of the calculations: Unit production by month = Quarterly unit sales ÷3 months, where quarterly

unit sales are calculated by multiplying total annual unit sales by the percent of sales expected to occur each quarter. The third month of first quarter, however, includes production of an additional 200 units to increase inventory from the prior year level to the new target level.

Purchases prior quarter = Units produced 3rd month prior quarter * ($10+$5+$2) * 33.3333%. For the 1st quarter, purchases prior quarter = beginning A/P. For the 2nd quarter, the payments also include 1/3 of the targeted increase in raw material inventories (from $9,000 to $11,400) that takes place during the 3rd month of the 1st quarter.

Purchases 1st, 2nd, and 3rd month of qtr = Units produced during month * ($10+$5+$2). For the 1st quarter, the payments also include 2/3 of the targeted increase in raw material inventories (from $9,000 to $11,400) that takes place during the 3rd month.

Although the problem does not require it, the sample spreadsheet shows a reconciliation of total raw material purchases to total cash disbursements for purchases. This type of reconciliation is useful because it provides a check on the mathematical accuracy of the cash disbursements schedule.


The cash disbursements for raw material purchases are then combined with other disbursements in the cash disbursements budget shown below. Notice that the input section of the spreadsheet (shown at the beginning of the solution for Part 4) is designed to facilitate preparation of the cash disbursements budget; the percent of fixed costs paid during each quarter is included in the input section.

Here are details for some of the calculations: Direct labor paid = Units produced during quarter * ($15+$1.50) Variable overhead costs paid = Units produced during quarter * $6 Payments for property taxes, insurance, support costs, and income taxes are

calculated by multiplying the total cost by the percent paid in each quarter shown in the input section.

Other fixed overhead costs = (Plant management + Fringe benefits + Miscellaneous) * 25%. Notice that depreciation is excluded because it is a noncash expense.

The short-term financing budget includes a summary of cash receipts and disbursements, which includes interest on the bank loan. It then calculates the estimated amounts repaid or borrowed on the company’s line of credit. The spreadsheet allows any extra cash to be deposited in the cash account (but there is no extra cash in this problem). Recall that the company’s line of credit agreement requires a minimum balance of $100,000 in the cash accounting, and this account is non-interest-bearing.


Here are details for some of the calculations: Interest on loan = Beginning loan balance * 5.5% * 1/4 year Although the problem does not explicitly provide the beginning cash balance,

it is assumed to be $100,000 because of the minimum balance requirement and because the company had an outstanding bank loan. It is reasonable to assume that the company would have reduced its bank loan with any excess cash.

10.25 Fighting Kites (continued)


A. Assumptions that can be changed: Revenue assumptions: price per kite and number of kites sold Direct materials assumptions: price and quantity used for each direct material Direct labor assumptions: labor hourly rate and number of labor hours per unit in

each department (assembly and packing) Overhead and support department costs: estimated costs in each category can be

modified


B. This question is an extension of Part A; it involves identifying the types of changes that the company might could make to eliminate its forecasted loss. Here are some ideas; students may think of others:

Increase the selling price. This change might also require a reduction in the volume of kites sold, because the quantity demanded is likely to be smaller if the price is increased.

Reduce the selling price and increase sales volume.

Increase the marketing support cost budget for advertising or other product promotions, and increase the volume sold.

Reduce raw material costs by locating new raw material vendors or renegotiating prices with existing vendors.

Establish a change in operating process to reduce assembly and packing time. This change would allow a reduction in direct labor cost, assuming that the company is able to maintain a smaller work force.

Identify ways to reduce variable and fixed overhead costs by reducing the need for indirect labor, becoming more efficient in using supplies, obtaining competitive insurance bids, reevaluating the employee benefits package, etc.

Identify ways to reduce support costs by outsourcing some activities, seeking a new office supplies vendor, eliminating unnecessary job positions, reducing discretionary spending, etc.

C. There is no one solution to this part. Try different combinations of the changes identified in Part B to achieve the breakeven point. The sample spreadsheet for this problem shows the following combination of changes and achieves income close to zero (loss of $210):

Increase marketing costs by $65,000 Increase sales volume by 5,000 kites Reduce the cost of nylon from $10 per kite to $9,75 per kite Decrease administrative costs by $20,000


D. For selling price changes: Wok managers do not know the effects of price on demand or what competitors will do if price changes are made. If Wok increases its price but competitors do not increase theirs, the company may lose sales.

For sales volume changes: Managers do not know whether their efforts such as advertising or sales representative visits to customers will cause sales volumes to increase.

For cost changes: Managers do not know how easy it would be to reduce fixed or variable costs. They also do not know whether improvements can be made in productivity of labor and efficiency in the use of materials.

10.26 Wok and Egg Roll Express Part 1

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg). Below is the input section of the sample spreadsheet for this problem. The data input box shown here includes only the input for Part 1. The solution for later parts will show additional input items.

A. The revenue budget is calculated assuming 30 days per month:

B. There can be unanticipated changes in demand. An eating establishment can be very popular and then become less popular. A new restaurant could open nearby and take some of Wok’s market share. Economic downturns can also affect volumes. If people are not using expensive restaurants, they may increase their use of Wok. However, if people do not eat out as often, demand could drop. If a new office building opens nearby, lunch traffic could increase.

C. Launch an advertising campaign.Pros: Increase volume, thus increasing revenues; potential increase in market shareCons: Cost might exceed the benefit

Distribute coupons to attract new customers.Pros: Increase volume, thus increasing revenues; potential increase in market shareCons: Cost to distribute and price discounts might exceed benefit


Increase prices.Pros: Increase price per mealCons: Decrease in sales volume might exceed benefit


A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg). As shown below, the product cost information is added as a new column in the input area of the spreadsheet.

D. Beginning and ending inventories are minimal or nonexistent in a restaurant. Thus, an appropriate assumption is that production approximately equals sales, and there is no need to calculate production.

E. Given the answer to Part D and assuming no changes in direct material inventories, direct materials usage is equal to direct material purchases:

F. Food prices, such as rice, vegetables, and meat, change regularly. Weather conditions and government regulation can affect the amount of crops harvested. Import and export law changes might affect the price of vegetables and meat. Food preferences also might affect prices. For example, when people stopped eating as much beef, prices dropped.

G. If food costs increase, portion size could be reduced. Or, less expensive ingredients could be used. However, it is likely that customers would notice these changes and may go elsewhere if they feel quality or value has diminished. The owner could also seek ways to reduce food waste. However, there might be little waste that can be eliminated if operations are already efficient.



A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg). Below is the additional input section for this part of the problem.

H. The direct labor budget is calculated assuming 30 days per month (same as Part 1):

I. Sometimes employees are sent home when business is slow, reducing labor hours. If volumes increase, workers may be asked to stay overtime, and costs would increase. There could be a change in minimum wage laws so that the cashiers would need to be paid more. If turnover is high, the owner may need to increase the hourly wage for cooks or cashiers to reduce turnover.

J. Labor costs can be reduced by monitoring the shifts carefully to determine whether there are days of the week when fewer people could be used. If weekends or certain nights are slow, Wok may not need the same number of workers scheduled for each day of the week. A problem arises if volumes are unexpectedly large and people have to wait. Long lines annoy customers and cause them to leave or prevent them from coming back.

Not all of the kitchen employees need to be cooks. Some employees could be hired at a cheaper wage just to prepare the foods but not cook them. However, if these people are poorly trained, quality could suffer and customers could be lost.



A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg). Below is the additional input section for this part of the problem.

K. Below is the overhead budget:

L. Before answering this question, it is necessary to visualize the types of costs included in overhead. Fixed overhead is likely to include costs such as utilities, manager salary, and fixed rent. Utilities vary according to weather (for heating and cooling), so uncertainties exist about the monthly cost. If the manager quits, a replacement might cost more or less than the previous manager. The lease costs might remain stable, but could be renegotiated at the end of the lease term. Variable overhead might include supplies (such as napkins, condiments, and disposable dishes) as well as labor-related costs such as employment taxes and benefits. The costs of these items can vary. Also, there are likely to be fluctuations in the quantities of supplies used.

M. It could be difficult to reduce utilities, the lease cost, or employment taxes. If the manager’s salary is cut, the manager may not do as good a job, or may quit. If the salary is not competitive, a new manager may not be as effective as the old one. The company could put supplies behind the counter and require customers to ask for the, potentially reducing usage. However, customers might complain and it may take more time to get people through the line during busy times.




N. Below is the budgeted income statement, which incorporates the answers to Parts 1-4 of this problem:

O. Volume of sales and cost of food are the two most important uncertain estimates. If sales are off, profit will be less, or a loss could be incurred. If food prices increase, some of the profit will be lost. Labor is probably fairly stable, although turnover could be costly and should be monitored.

P. The manager should keep track of advertising costs and volumes to see if advertising is beneficial. Also, the company could sponsor sporting events as a way of advertising, or walk-a-thons for good causes. All fixed and variable costs could be analyzed for possible reduction, keeping in mind that quality needs to be held constant, or improved if possible. A cost benefit analysis needs to be done. There are a wide variety of good answers to this question.

10.27 The Red Midget Company

Cash receiptsFebruary sales (14,000 x $0.50 x 100) x 18% $126,000March sales (16,000 x $0.50 x 100) x 80% 640,000

Total March receipts $766,000


Cash disbursementsAdvertising:

February ($60,000 x 90%) $ 54,000March ($75,000 x 10%) 7,500

Total cash disbursements for advertising 61,500Administrative salaries 80,000Sales commissions 69,000Direct materials purchases 330,000Labor costs 90,000Overhead costs ($115,000 less depreciation of $80,000) 35,000

Total cash disbursements for operations 665,500Cash dividends 15,000

Total cash disbursements $680,500

The cash budget for March is thus:Beginning balance at March 1 $ 25,000Plus: March receipts 766,000

Subtotal 791,000Less: March disbursements (680,500 ) Ending balance at March 31 $110,500

Note: Credit loss expense and depreciation are ignored because they do not directly affect cash flows.

10.28 National Public Radio

A. An organization’s budget should reflect its strategies, which in turn should reflect its mission and core competencies. Therefore, the budgeting process for any organization should begin with clarification of the mission, core competencies, and strategies. However, this process might be more important than usual for NPR in light of the significant donation. The size of the donation might permit NPR to develop core competencies and pursue strategies that were previously beyond the organization’s financial capability. It was critical for NPR’s management to consider possible long-term changes before making specific plans for how money would be spent in the short term.

B. Following are pros for involving affiliate stations and freelance workers in the budgeting process.

Affiliate stations are likely to better understand consumer preferences. Freelance workers who understand factors that affect the budget may

have more realistic expectations about their compensation. Both affiliate stations and freelance workers are likely to be more

motivated to help NPR succeed if they are involved in the budgeting process because they assume greater ownership of the results.

Following are cons. Affiliate stations may not agree with NPR management, resulting in

conflicting goals and suboptimal decision-making at the station level.


Freelance workers may feel that they are not compensated generously enough considering other expenditures.

Negotiations may take too much time away from top managers at both the NPR administrative level and affiliate station level.

C. If managers use funds to improve programming quality, they would want to invest more funds in hiring quality writers and reporters. They may also want to increase funds for surveying their customers to find the types of programming that is preferred by the most listeners. Further, money could be invested in research to determine listeners’ perceptions about the quality of current programming.


BUILD YOUR PROFESSIONAL COMPETENCIES

10.29 Focus on Professional Competency: Resource Management

A.1. The budget includes anticipated spending on various activities within an organization.

Through the process of creating budgets, managers are forced to make decisions about the amount of resources to allocate to different activities. The budget communicates the results of those decisions.

2. Budgets are typically prepared at the department level and proceed through a process of negotiations between the department managers and head office. Thus, the budget communicates the resources that can be used for individual departments.

B.1. Prices for most resources are uncertain because they may change and decisions about

how to spend resources may change. Prices for resources are subject to economic supply and demand as well as firm-specific arrangements. For example, companies that pay lower than market wages are likely to lose employees. To become more competitive in hiring employees, a company may need to increase pay levels or benefits, modify work hours, or make other concessions that increase resource costs. Raw material prices also fluctuate with market prices and with alternative contractual arrangements that are available to suppliers.

2. Large increases in the cost of an individual resource are likely to cause managers to seek ways to reduce use of that resource. For example, as labor costs increase managers may reduce labor time by increasing the quality of raw materials or by modifying production processes to use greater automation. Managers may also outsource work to countries having lower labor costs. Decreases in resource costs have the opposite effect; managers are likely to seek ways to increase the use of the resource. For example, managers have increased their use of automated production equipment as the cost automation has declined.

3. Fluctuations in the costs and use of resources are likely to lead to budget variances because specific fluctuations cannot be foreseen when the budget is created. Although managers know that prices will fluctuate, they cannot perfectly estimate future prices. They also cannot perfectly anticipate modifications in their use of resources until future market conditions occur.

C.1. One way to measure organizational performance is to compare actual results to

budgeted results. This comparison provides information about how well the organization met its goals.


2.a. Using flexible budgets to adjust for actual volumes: When an individual manager

is not responsible for differences between budgeted and actual volumes, a flexible budget does a better job of measuring the level of expected costs that are under the manager’s control. Thus, variances calculated using a flexible budget provide better measures of the manager’s performance. When a flexible budget is not used, the manager may be inappropriately rewarded when actual volume is less than budgeted, and inappropriately penalized when actual volume exceeds the budget.

b. Removing allocated costs: When allocated costs cannot be controlled by the manager, they provide no information about the manager’s performance. Therefore, variances related to these costs also provide no information about the manager’s performance. To avoid inappropriately rewarding or penalizing managers for variances in allocated costs, these costs should be removed from the performance evaluation.

c. Updating costs for anticipated price changes: managers should be held responsible for their use of resources at the expected price. As discussed in Part B above, managers are likely to change their use of resources based on changes in price. To encourage managers to make the best use of resources, they should be held accountable for their decisions based on the expected prices.

3. Continuous improvement is the process of constantly making small changes to enhance organizational performance. The analysis of budget variances helps managers identify areas where organizational performance is different than expected, leading to recommendations for ways to improve future planning and operations. For example, a favorable variance can focus manager attention on ways to achieve similar favorable results in the future. An unfavorable cost variance can help managers identify and eliminate waste or inefficiencies.

D. If students have difficulty locating a citizen’s budget guide, refer them to guidance available for this problem on the web site for the textbook (available at www.wiley.com/college/eldenburg).

1. Following are possible reasons why a government might publish a citizen’s guide to the budget; students may think of others:

Legal requirement; laws may exist to require the government to publish a citizen’s guide

Provide an overview of the budget and budgeting process for citizens, government managers and staff, legislative bodies, and other interest parties

Improve communication with the general public Demonstrate fiduciary responsibility

2. This answer depends on the governmental entity chosen by the student. The purpose of this question is to help students recognize that different organizations use different terminology and slightly different processes, but that the general underlying


budgeting cycle is the same for all types of organizations. The purpose is also to encourage student interest in governmental budgeting and accounting.

3. Citizens could analyze the budget to study the relative amount of resources assigned to different types of activities. They could also analyze the budgeting process for the degree and type of citizen input. When financial statements are released after the end of the budget period, citizens could determine whether the original budget was met or whether it was necessary to modify the budget to avoid exceeding the legally-adopted budget.

10.30 Integrating Across the Curriculum: Financial Accounting and Attestation

The U.S. professional standards that are primarily relevant for this problem are Statement of Standards for Attestation Engagements (SSAE) No. 10, Attestation Standards: Revision and Recodification; and Prospective Financial Information, AICPA Audit and Accounting Guide, May 1, 2003.1

A. Based on the definitions given in the problem, an estimated income statement for the existing store would be considered a financial forecast; it would be based on expected results given current operations and Delanna’s plans for the store. However, an estimated income statement for the new store would be considered a financial projection; it would be based on the hypothetical assumption that the store would be opened. Taken together, the set of prospective income statements would be considered a financial projection.

B. Assuming that the use of the financial projection would be limited to the client and the bank, the CPA could perform any of the following types of attestation services:

Compilation: The CPA would be responsible for reading the prospective financial statements, including the summary of significant assumptions and accounting policies, to determine whether they appear to be presented in accordance with the AICPA Audit and Accounting Guide, Prospective Financial Information.

Examination: The CPA would be responsible for evaluating evidence and issuing a report stating whether or not, in the CPA’s opinion, the financial statements are presented in conformity with the AICPA Audit and Accounting Guide, Prospective Financial Information and whether the hypothetical assumptions provide a reasonable basis for the projection.

Agreed-Upon Procedures: The CPA would be responsible for performing procedures agreed-upon with the client and for reporting the findings of the procedures. The CPA would not issue an opinion or provide any other type of assurance on the financial statements.

1 The information about SSAE 10 discussed in this answer was obtained from Section 2301 in M. Guy, D. R. Carmichael, and L. A. Lach, Practitioner’s Guide to GAAS: Covering all SASs, SSAEs, SSARSs, and Interpretations, 2004, John Wiley & Sons.


C. There are many possible answers to this question. Below is a list of questions; students may think of others.

Have you investigated potential store locations? Do you have an estimate for the rental cost?

Will your other occupancy costs (e.g., electricity and janitorial service) remain about the same over the next 3 years for the existing store? Do you expect about the same level of cost for the new store?

What volume of sales do you expect for each store over the next 3 years? Is your estimate for the new store comparable to your sales volumes during the first 3 years for the existing store?

Do you anticipate any changes in gross margin percentage over the next 3 years? Do you expect the gross margin percentage for the new store be the same as for the existing store?

How much time will you spend at the new store? Will you need to hire a store manager for either store? If so, how much will that cost?

What portion of employee wages and commissions is a fixed cost, and how much varies with sales? Will the structure of fixed and variable costs be similar for the new store?

Will your office and miscellaneous costs for the existing store remain about the same over the next 3 years? How much office and miscellaneous expense do you expect for the new store? How much do you plan to spend on advertising and promotion for the new store?

Will supplies at the existing store remain about the same over the next 3 years? How much will this cost be for the new store?

Assuming your loan is approved, what interest rate do you think you will pay? What repayment terms have you discussed with your banker?

Do you expect any other changes in your revenues or costs over the next 3 years?

D. For the existing store, estimated future income could be estimated by beginning with the existing income statement and then modifying it for changes expected by the owner. The existing store’s financial statements could also be used to help develop cost functions for the new store. For example, the owner might expect the gross margin in the new store to be similar to that of the old store. The owner also might expect about the same level of fixed costs such as wages, supplies, etc. for the new store as in the old store.

E. The assumptions would basically be the answers to the list of questions in Part C. For example, one assumption might be that the sales in the existing store will increase by 5%


over each of the next 3 years and that sales in the new store will amount to $X during the first year, increase by 20% during the second year and by 10% during the third year. Another assumption might be that cost of goods sold is 55% of sales for both stores.

F. Delanna is likely to be biased because she believes that opening the new store is a good idea and that the store will be successful. Specific biases will be difficult to detect when compiling the financial statements, because the CPA’s responsibility is merely to assemble the statements and then read them for obvious deviations from the accounting standards. The CPA is not responsible for evaluating evidence to verify the reasonableness of the assumptions.

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