CHAPTER 9:

Budgeting
Excess cash (Deficiency) +
Borrowing − Interest on borrowing
= Target cash balance
total financing= Borrowing-interest
rate
borrowing=total financing(1-rate)
interest= borrowing*-rate
 Learning Objectives
1 Explain why organizations budget, and
describe the processes they use to create
budgets.
2 Prepare the supporting components of a
master budget and the budgeted financial
statements.
3 Prepare a flexible budget, and explain the
need for the flexible budget approach.
4 Prepare a performance report using the
flexible budget approach.
5 (Online Appendix 9A) Compute the optimal
inventory level and order size.
© 2021 McGraw-Hill Limited 9-2
 The Basic Framework of
Budgeting
• A budget is a detailed quantitative plan for
acquiring and using financial and other
resources over a specified forthcoming time
period.
• The act of preparing a budget is called
budgeting.
• The use of budgets to control an
organization’s activity is known as budgetary
control.
• The master budget summarizes a company’s plans,
setting specific targets for sales, production, distribution,
administrative, and financing activities.
9-3
Why Organizations Create
Budgets
• Budgets serve as both a planning tool and
a control tool in organizations.
• Planning involves developing objectives
and preparing various budgets to achieve
these objectives.
• Control involves gathering feedback to
assess the extent to which the objectives
developed at the planning stage are being
attained.
• An effective budgeting system provides
for both planning and control.
© 2021 McGraw-Hill Limited 9-4
 Planning Process
• As part of the planning process, budgets
are used to:
1. Encourage managers to think about
and plan for the future.
2. Communicate management’s financial
goals throughout the organization.
3. Allocate resources to those parts of the
organization where they can be used
most effectively.
4. Coordinate the plans and activities of
managers in different departments.

© 2021 McGraw-Hill Limited 9-5

 Control System
• As part of a control system, budgets are
compared to actual results during the
year to:

1. Improve the efficiency and

effectiveness of operations.
2. Evaluate and reward employees.

© 2021 McGraw-Hill Limited 9-6

Choosing a Budget Period
The annual operating
budget
may be divided into
Operating Budget quarterly
or monthly budgets.

2012 2013 2014 2015

A continuous budget is a 12-month budget

that rolls forward one month (or quarter)
as the current month (or quarter) is
completed.
© 2021 McGraw-Hill Limited 9-7
How Organizations Create
Budgets Part 1
• Companies usually create budgets by
relying on some combination of top-down
budgeting and participative budgeting.
• A participative budget involves managers
from across the organization in developing
budget estimates for their areas of
responsibility.
• With a top-down approach, top-level
managers initiate the budgeting process by
issuing overall profit targets.
© 2021 McGraw-Hill Limited 9-8
 How Organizations Create Budgets Part 2
• Many companies choose to use a
participative budgeting approach, involving
lower-level managers in developing the
budget because it:
• Shows respect for their experience and
opinions.
• Leverages their knowledge and
experience to provide more accurate
estimates.
• Increases their motivation to achieve goals
they had input in setting.
• Empowers them to take ownership of the
© 2021 McGraw-Hill Limited
budget and to be accountable for
deviations from it.
9-9
 Budgetary Slack
• Budget estimates prepared by lower-level
managers cannot simply be accepted
without review by higher levels of
management.
• If no review system is present,
participative budgets may contain
excessive budgetary slack.
• Slack is the difference between the
revenues and expenses a manager
expects can be achieved and the amounts
included in the budget.
© 2021 McGraw-Hill Limited 9-10
 Benchmarking
• An input to creating budgets that some
companies use is the performance of
competitors, “best-in-class” companies, or
other business units in the same company.
• A best-in-class company is one known for
achieving exceptional levels of performance
on some aspect of their operations such as
customer service, distribution, marketing,
and so on.
• The approach of comparing revenue, cost, or
process performance to other high-
performing companies, or to other successful
business units in the same company, is
known as benchmarking.
© 2021 McGraw-Hill Limited

9-11
 Behavioural Factors in
Budgeting Part 1
• Two important purposes of the budget are
to motivate people and coordinate their
efforts.
• These purposes can be undermined if the
budget is used in an inflexible manner to
control people.
• This relates to the idea of responsibility
accounting, whereby managers are held
responsible for those items—and only
those items—that they can actually
influence to a significant extent.
© 2021 McGraw-Hill Limited 9-12
 Behavioural Factors in
Budgeting Part 2
• Another key issue related to the
motivational aspect of budgets is the
difficulty level of the budget targets for
revenues and expenses.
• If budgets are too difficult, employees will
eventually recognize that they are
unattainable, and motivation and morale
will likely suffer.
• If the budgets are too easy, inefficiencies
or less effort will result.
© 2021 McGraw-Hill Limited 9-13
The Master Budget: An Overview

Exhibit 9-
2

© 2021 McGraw-Hill Limited 9-14

The Sales Budget Defined
• A sales budget is detailed schedule
showing the expected sales for the
budget period; typically it is expressed
in both dollars and units of product.
• An accurate sales budget is the key to
the entire budgeting process.
• All of the other parts of the master
budget depend on the sales budget in
some way.

© 2021 McGraw-Hill Limited 9-15

 The Big Picture 1
• A master budget for a manufacturing
company is designed to answer 10 key
questions:
1. How much sales will we earn?
2. How much cash will we collect from
customers?
3. How much raw material will we need to
purchase?
4. How much manufacturing cost (including
direct materials, direct labour, and
manufacturing overhead) will we incur?
5. How much cash will we pay to our suppliers and our direct labourers, and how
much will we pay for manufacturing overhead resources?

9-16
 The Big Picture 2
6. What is the total cost that will be
transferred from finished goods inventory
to cost of goods sold?
7. How much selling and administrative
expense will we incur and how much cash
will we pay related to those expenses?
8. How much money will we borrow from or
repay to lenders, including interest?
9. How much operating income will we
earn?
10. What will our balance sheet look like at
the end of the budget period?
© 2021 McGraw-Hill Limited 9-17
 Budgeting Example
• Royal Company is preparing budgets for
the quarter ending June 30.
• Budgeted sales for the next five months
are:
April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units.
• The selling price is $10 per unit.

© 2021 McGraw-Hill Limited 9-18

 The Sales Budget

The individual months of April, May, and June

are summed to obtain the total projected sales
in units and dollars for the quarter ended June
30th.

© 2021 McGraw-Hill Limited 9-19

Expected Cash Collections 1
• All sales are on account.
• Royal’s collection pattern is:
• 70% collected in the month of sale,
• 25% collected in the month following sale,
• 5% uncollectible.

• The March 31 accounts receivable

balance of $30,000 will be collected
in full.

© 2021 McGraw-Hill Limited 9-20

Expected Cash Collections 2

© 2021 McGraw-Hill Limited 9-21

Expected Cash Collections 3

From the Sales Budget for

April.

© 2021 McGraw-Hill Limited 9-22

Expected Cash Collections 4

From the Sales Budget for

May.

© 2021 McGraw-Hill Limited 9-23

 Quick Check 

What will be the total cash

collections for the quarter?

a. $700,000
b. $220,000
c. $190,000
d. $905,000

© 2021 McGraw-Hill Limited 9-24

 Quick Check 

What will be the total cash

collections for the quarter?

Answer:
d. $905,000

© 2021 McGraw-Hill Limited 9-25

Expected Cash Collections 5

© 2021 McGraw-Hill Limited 9-26

 The Production Budget 1

Sales
Budget
ed Production
andle t
p Budget
Expected
om
C
Cash
Collections

Production must be adequate to meet budgeted

sales and provide for sufficient ending inventory.

© 2021 McGraw-Hill Limited 9-27

 The Production Budget 2

• The management at Royal

Company wants ending inventory
to be equal to 20% of the following
month’s budgeted sales in units.
• On March 31, 4,000 units were on
hand.
• Let’s prepare the production
budget.
© 2021 McGraw-Hill Limited 9-28
The Production Budget 3

© 2021 McGraw-Hill Limited 9-29

The Production Budget 4

Budgeted May sales 50,000

Desired ending inventory % 20%
March 31
Desired ending inventory 10,000
ending inventory
© 2021 McGraw-Hill Limited 9-30
 Quick Check 

What is the required production for

May?

a. 56,000 units
b. 46,000 units
c. 62,000 units
d. 52,000 units

© 2021 McGraw-Hill Limited 9-31

 Quick Check 

What is the required production for

May?

Answer:
b. 46,000 units

© 2021 McGraw-Hill Limited 9-32

The Production Budget 5

© 2021 McGraw-Hill Limited 9-33

The Production Budget 6

Assumed ending
inventory.
© 2021 McGraw-Hill Limited 9-34
The Direct Materials Budget
1

ed
Direct
Production
e t
pl Materials
Budget
m
Co Budget

The direct materials budget details the raw

materials that must be purchased to fulfill the
production budget and to provide for adequate
inventories.
© 2021 McGraw-Hill Limited 9-35
The Direct Materials Budget
2
• At Royal Company, five pounds of
material are required per unit of
product.
• Management wants materials on hand
at the end of each month equal to 10%
of the following month’s production.
• On March 31, 13,000 pounds of
material are on hand. Material cost is
$0.40 per pound.
Let’s prepare the direct materials
© 2021 McGraw-Hill Limited 9-36
The Direct Materials Budget
3

From production
budget
© 2021 McGraw-Hill Limited 9-37
The Direct Materials Budget
4

© 2021 McGraw-Hill Limited 9-38

The Direct Materials Budget
5

March 31
inventory

10% of following Calculate the materials to

month’s be purchased in May.
production needs. © 2021 McGraw-Hill Limited 9-39
 Quick Check 

How much materials should be

purchased in May?

a. 221,500 pounds
b. 240,000 pounds
c. 230,000 pounds
d. 211,500 pounds

© 2021 McGraw-Hill Limited 9-40

 Quick Check 

How much materials should be

purchased in May?

Answer:
a. 221,500 pounds

© 2021 McGraw-Hill Limited 9-41

The Direct Materials Budget
6

© 2021 McGraw-Hill Limited 9-42

The Direct Materials Budget
7

Assumed ending
inventory
© 2021 McGraw-Hill Limited 9-43
 Expected Cash
Disbursement for Materials
1 pound for its
• Royal pays $0.40 per
materials.
• One-half of a month’s purchases is paid
for in the month of purchase; the other
half is paid in the following month.
• The March 31 accounts payable
balance is $12,000.
Let’s calculate expected cash
disbursements.
© 2021 McGraw-Hill Limited 9-44
 Expected Cash
Disbursement for Materials
2

© 2021 McGraw-Hill Limited 9-45

 Expected Cash
Disbursement for Materials
3

Compute the expected cash

disbursements for materials
for the quarter.

140,000 lbs. × $.40/lb. = $56,000

© 2021 McGraw-Hill Limited 9-46
 Quick Check 

What are the total cash

disbursements for the quarter?

a. $185,000
b. $ 68,000
c. $ 56,000
d. $201,400

© 2021 McGraw-Hill Limited 9-47

 Quick Check 

What are the total cash

disbursements for the quarter?

Answer:
a. $185,000

© 2021 McGraw-Hill Limited 9-48

 Expected Cash
Disbursement for Materials
4

© 2021 McGraw-Hill Limited 9-49

The Direct Labour Budget 1

Directed Direct
e t
l
Materials
p Labour
om
Budget
C Budget

The direct labour budget is a detailed plan

showing labour requirements over some
specific time period.
© 2021 McGraw-Hill Limited 9-50
The Direct Labour Budget 2
• At Royal, each unit of product requires 0.05
hours (3 minutes) of direct labour.
• The Company has a “no layoff” policy so all
employees will be paid for 40 hours of work
each week.
• In exchange for the “no layoff” policy,
workers agree to a wage rate of $10 per hour
regardless of the hours worked (no overtime
pay).
• For the next three months, the direct labour
workforce will be paid for a minimum of 1,500
hours per month.
• Let’s prepare the© 2021
direct
McGraw-Hilllabour
Limited budget. 9-51
The Direct Labour Budget 3

From production budget.

© 2021 McGraw-Hill Limited 9-52

The Direct Labour Budget 4

© 2021 McGraw-Hill Limited 9-53

The Direct Labour Budget 5

Greater of labour hours required

or labour hours guaranteed.
© 2021 McGraw-Hill Limited 9-54
The Direct Labour Budget 6

© 2021 McGraw-Hill Limited 9-55

 Quick Check 
What would be the total direct labour
cost for the quarter if the company
follows its no lay-off policy, but pays
$15 (time-and-a-half) for every hour
worked in excess of 1,500 hours in a
month?
a. $79,500
b. $64,500
c. $61,000
d. $57,000
© 2021 McGraw-Hill Limited 9-56
 Quick Check 
What would be the total direct labour
cost for the quarter if the company
follows its no lay-off policy, but pays
$15 (time-and-a-half) for every hour
worked in excess of 1,500 hours in a
month?

Answer:
d. $57,000
© 2021 McGraw-Hill Limited 9-57
 The Manufacturing
Overhead Budget

Direct ed Manufacturing
l
Labour et Overhead
p
m
Budget
o Budget
C

The manufacturing overhead budget

provides a schedule of all costs of
production other
than direct materials and direct labour.
© 2021 McGraw-Hill Limited 9-58
 Manufacturing Overhead
Budget 1
• At Royal, manufacturing overhead is
applied to units of product on the basis of
direct labour hours.
• The variable manufacturing overhead rate
is $20 per direct labour hour.
• Fixed manufacturing overhead is $50,000
per month and includes $20,000 of
noncash costs (primarily depreciation of
plant assets).
• Let’s prepare the manufacturing OH
budget. © 2021 McGraw-Hill Limited 9-59
Manufacturing Overhead
Budget 2

Direct Labour Budget.

© 2021 McGraw-Hill Limited 9-60
Manufacturing Overhead
Budget 3

Total mfg. OH for quarter $251,000

= $49.70 per hour *
Total labour hours required 5,050

* rounded

© 2021 McGraw-Hill Limited 9-61

Manufacturing Overhead
Budget 4

Depreciation is a noncash charge.

© 2021 McGraw-Hill Limited 9-62
The Ending Finished Goods
Inventory Budget

d Ending
e
l et
Manufacturing Finished
p
Overhead Goods
om
CBudget Inventory
Budget

After computing unit product costs, the carrying

cost of the unsold units is computed on the
ending finished goods inventory budget.
© 2021 McGraw-Hill Limited 9-63
 Ending Finished Goods
Inventory Budget 1
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labour
Manufacturing overhead

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory
Direct materials
budget and information.

© 2021 McGraw-Hill Limited 9-64

 Ending Finished Goods
Inventory Budget 2
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labour 0.05 hrs. $ 10.00 0.50
Manufacturing overhead

Budgeted finished goods inventory

Ending inventory in units
Unit product cost
Ending finished goods inventory

Direct labour
budget.

© 2021 McGraw-Hill Limited 9-65

 Ending Finished Goods
Inventory Budget 3
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labour 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units
Unit product cost $ 4.99
Ending finished goods inventory ?

Total mfg. OH for quarter $251,000

= $49.70 per hour *
Total labour hours required 5,050

© 2021 McGraw-Hill Limited 9-66

 Ending Finished Goods
Inventory Budget 4
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labour 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $ 24,950

Production Budget.

© 2021 McGraw-Hill Limited 9-67

 The Selling and
Administrative Expense
Budget
Ending Selling
Finished t ed and
l e Administrative
p
Goods
om Expense
Inventory
C
Budget Budget

The selling and administrative expense budget

lists the budgeted expenses for areas other
than manufacturing.
© 2021 McGraw-Hill Limited 9-68
 Selling and Administrative
Expense Budget 1
• At Royal, the selling and administrative
expenses budget is divided into variable and
fixed components.
• The variable selling and administrative
expenses are $0.50 per unit sold.
• Fixed selling and administrative expenses are
$70,000 per month.
• The fixed selling and administrative expenses
include $10,000 in costs – primarily
depreciation – that are not cash outflows of
the current month.
• Let’s prepare the company’s selling and
administrative expense budget.
© 2021 McGraw-Hill Limited 9-69
Selling and Administrative
Expense Budget 2

Calculate the selling and administrative

cash expenses for the quarter.
© 2021 McGraw-Hill Limited 9-70
 Quick Check 

What are the total cash

disbursements for selling and
administrative expenses for the
quarter?

a. $180,000
b. $230,000
c. $110,000
d. $ 70,000
© 2021 McGraw-Hill Limited 9-71
 Quick Check 

What are the total cash

disbursements for selling and
administrative expenses for the
quarter?

Answer:
b. $230,000

© 2021 McGraw-Hill Limited 9-72

Selling and Administrative
Expense Budget 3

© 2021 McGraw-Hill Limited 9-73

 The Cash Budget

Selling
and d Cash
t e
e
Administrative
pl Budget
m
Expense
o
CBudget

The cash budget pulls together much of the

data developed in the preceding steps and
displays it in four major sections: receipts,
disbursements, cash excess or deficiency, and
financing.
© 2021 McGraw-Hill Limited 9-74
Format of the Cash Budget
The cash budget is divided into four sections:
1. Cash receipts listing all cash inflows
excluding borrowing;
2. Cash disbursements listing all payments
excluding repayments of principal and
interest;
3. Cash excess or deficiency; and
4. The financing section listing all borrowings,
repayments and interest.

© 2021 McGraw-Hill Limited 9-75

 The Cash Budget 1
Royal:
• Maintains a 16% open line of credit for
$75,000
• Maintains a minimum cash balance of
$30,000
• Borrows on the first day of the month and
repays loans on the last day of the month
• Pays a cash dividend of $49,000 in April
• Purchases $143,700 of equipment in May
and $48,300 in June (both purchases paid in
cash).
• has a begining cash of 40,000
© 2021 McGraw-Hill Limited 9-76
The Cash Budget 2

Schedule of Expected
Cash Collections.

© 2021 McGraw-Hill Limited 9-77

The Cash Budget 3

Schedule of Expected
Cash Disbursements.

Direct Labour
Budget.

Manufacturing
Overhead Budget.

Selling and Administrative

Expense Budget.
© 2021 McGraw-Hill Limited 9-78
The Cash Budget 4

© 2021 McGraw-Hill Limited 9-79

The Cash Budget 5

Ending cash
balance for April
is the beginning
May balance.

© 2021 McGraw-Hill Limited 9-80

The Cash Budget 6

© 2021 McGraw-Hill Limited 9-81

 Quick Check 

What is the excess (deficiency) of

cash available over disbursements
for June?

a. $ 85,000
b. $(10,000)
c. $ 75,000
d. $ 95,000

© 2021 McGraw-Hill Limited 9-82

 Quick Check 

What is the excess (deficiency) of

cash available over disbursements
for June?

Answer:
d. $ 95,000

© 2021 McGraw-Hill Limited 9-83

 The Cash Budget 7

$50,000 × 16% × 3/12 =

$2,000
Borrowings on April 1 and
repayment on June 30.

© 2021 McGraw-Hill Limited 9-84

 The Budgeted Financial
Statements

d Budgeted
Cash et
e
pl Financial
Budget
m
Co Statements

After we complete the cash budget, we can

prepare the budgeted income statement and
budgeted balance sheet for Royal.
© 2021 McGraw-Hill Limited 9-85
The Budgeted Income
Statement

© 2021 McGraw-Hill Limited 9-86

 The Budgeted Balance
Sheet
• Royal reported the following account
balances prior to preparing its
budgeted financial statements:

• Land – $50,000
• Common shares – $200,000
• Retained earnings – $146,150
• Equipment – $175,000

© 2021 McGraw-Hill Limited 9-87

 Royal Company 25% of June
Budgeted Balance Sheet
June 30
sales of
$300,000.
Current assets
Cash $ 43,000
Accounts receivable 75,000 11,500 lbs.
Raw materials inventory 4,600
Finished goods inventory 24,950
at $0.40/lb.
Total current assets 147,550
Property and equipment
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550

Accounts payable $ 28,400

Common shares 200,000
Retained earnings 336,150
Total liabilities and equities $ 564,550
© 2021 McGraw-Hill Limited 9-88
 ‫در اﻣﺗﺣﺎن ﮐل‬
‫ﺑودﺟﮫ رو ﻧﻣﯾﺧواد‬
Royal Company ‫ﺗﻌﯾﯾن ﮐﻧﯾد ﻓﻘط‬
Budgeted Balance Sheet ‫ﺑﺧﺷﯽ از اون رو‬
June 30 ‫ﻣﯾده ﮐﮫ ﺣل ﮐﻧﯾم ﻣل‬
Current assets ‫ﺟﺎی ﺧﺎﻟﯽ‬
Cash $ 43,000
Accounts receivable Beginning
75,000balance $146,150
Add: net income 239,000
Raw materials inventory 4,600
Deduct: dividends (49,000)
Finished goods inventory 24,950
Ending balance $336,150
Total current assets 147,550
Property and equipment
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550

Accounts payable $ 28,400

Common shares 200,000
Retained earnings 336,150
Total liabilities and equities $ 564,550
© 2021 McGraw-Hill Limited 9-89
 Static Budgets
• The budgets we just went over are static
budgets.
• A static budget is prepared only for the
planned or budgeted level of activity.
• These budgets are suitable for planning,
however they can be inadequate for control
if the actual level of activity during the
period differs significantly from the budgeted
level.
• Therefore an alternative approach is needed
to restore the usefulness of budgets as a
© 2021 McGraw-Hill Limited 9-90
 Flexible Budgets
‫ﻧﻣﯾﺎد از اﯾﻧﺟﺎ اﻣﺗﺣﺎن ﻧﻣﯾﺎد‬
Flexible budgets:
• Take into account changes in
revenues and costs expected to occur
as a consequence of changes in
actual activity.
• Provides estimates of what revenues
and costs should be for any level of
activity within a specified range.
• Improves performance evaluation

© 2021 McGraw-Hill Limited 9-91

 Forecasts Part 1
• A planning tool often used by companies
is the forecast.
• Like a budget, a forecast represents
management’s estimates of revenues and
expenses likely to occur in a future period.
• Forecasts are typically prepared after a
fiscal period has started and can cover
periods as short as a week or a month or
as long as several years.

© 2021 McGraw-Hill Limited 9-92

 Forecasts Part 2
• An advantage of using a forecast as a
planning tool after the fiscal period has
started is that it will be based on current
information that may differ from the
information used to prepare the static
budget.

© 2021 McGraw-Hill Limited 9-93

 Static Budgets and
Performance Reports 1
Static Actual
Budget Results Variances
Machine hours 10,000
Variable costs
Indirect labour $ 40,000
Indirect materials 30,000
Power 5,000
Fixed costs
Depreciation 12,000
Insurance 2,000
Total overhead costs $ 89,000

© 2021 McGraw-Hill Limited 9-94

 Static Budgets and
Performance Reports 2
Static Actual
Budget Results Variances
Machine hours 10,000 8,000
Variable costs
Indirect labour $ 40,000 $ 34,000
Indirect materials 30,000 25,500
Power 5,000 3,800
Fixed costs
Depreciation 12,000 12,000
Insurance 2,000 2,050
Total overhead costs $ 89,000 $ 77,350

© 2021 McGraw-Hill Limited 9-95

 Static Budgets and
Performance Reports 3
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
U = Unfavourable variance
Indirect labour $ 40,000 $ 34,000 $6,000 F
Unable to
Indirect materials
achieve the
30,000 25,500 4,500 F
Power budgeted level 5,000of activity.
3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

© 2021 McGraw-Hill Limited 9-96

 Static Budgets and
Performance Reports 4
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Indirect labour $ 40,000 $ 34,000 $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
F = Favourable
Fixed costs variance that occurs when
actual costs are less than
Depreciation budgeted12,000
12,000 costs. 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

© 2021 McGraw-Hill Limited 9-97

 Static Budgets and
Performance Reports 5
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Variable costs
Indirect labour $ 40,000 $ 34,000 $6,000 F
Indirect materials 30,000 25,500 4,500 F
Power 5,000 3,800 1,200 F
Since cost variances are favourable, have
Fixed costs
we done a good job controlling
Depreciation 12,000
costs?
12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

© 2021 McGraw-Hill Limited 9-98

 Static Budgets and
Performance Reports 6
Question from last slide: Since cost variances
are favourable, have we done a good job
controlling costs?
This question can’t be answered using a
static budget. The relevant question should
be…
“How much of the favourable cost variance is
due to lower activity, and how much is due to
good cost control?

To answer the question, we must flex the

budget to the actual level of activity.
© 2021 McGraw-Hill Limited 9-99
Preparing a Flexible Budget
1
To flex a budget we need to know that:
• Total variable costs change in direct
proportion to changes in activity.
• Total fixed costs remain unchanged
within the relevant range.
• Let’s prepare a flexible budget…

© 2021 McGraw-Hill Limited 9-100

Preparing a Flexible Budget
2

Variable costs are expressed as

a constant amount per hour.
$40,000 ÷ 10,000 hours is
$4.00 per hour.
Fixed costs
are
expressed as
a
© 2021 McGraw-Hill Limited
total amount.9-101
Preparing a Flexible Budget
3

$4.00 per hour × 8,000 hours =

$32,000

© 2021 McGraw-Hill Limited 9-102

Preparing a Flexible Budget
4

© 2021 McGraw-Hill Limited 9-103

Preparing a Flexible Budget
5

© 2021 McGraw-Hill Limited 9-104

 Quick Check 

What should be the total overhead

costs for the Flexible Budget at
12,000 hours?

a. $92,500.
b. $89,000.
c. $106,800.
d. $104,000.

© 2021 McGraw-Hill Limited 9-105

 Quick Check 

What should be the total overhead

costs for the Flexible Budget at
12,000 hours?

Answer:
d. $104,000.
Total overhead cost
= $14,000 + $7.50 per hour 
12,000 hours
= $14,000 + $90,000 = $104,000
© 2021 McGraw-Hill Limited 9-106
Preparing a Flexible Budget
6

© 2021 McGraw-Hill Limited 9-107

 Flexible Budget
Performance Report 1

© 2021 McGraw-Hill Limited 9-108

 Quick Check 

What is the variance for indirect

labour when the flexible budget for
8,000 hours is compared to the
actual results?

a. $2,000 U
b. $2,000 F
c. $6,000 U
d. $6,000 F
© 2021 McGraw-Hill Limited 9-109
 Quick Check 

What is the variance for indirect

labour when the flexible budget for
8,000 hours is compared to the
actual results?

Answer:
a. $2,000 U

© 2021 McGraw-Hill Limited 9-110

 Flexible Budget
Performance Report 2

© 2021 McGraw-Hill Limited 9-111

 Quick Check 

What is the variance for indirect

material when the flexible budget for
8,000 hours is compared to the actual
results?

a. $1,500 U
b. $1,500 F
c. $4,500 U
d. $4,500 F
© 2021 McGraw-Hill Limited 9-112
 Quick Check 

What is the variance for indirect

material when the flexible budget for
8,000 hours is compared to the
actual results?

Answer:
a. $1,500 U

© 2021 McGraw-Hill Limited 9-113

 Flexible Budget
Performance Report 3

© 2021 McGraw-Hill Limited 9-114

 Static Budgets and
Performance Reports
Static Actual
Budget Results Variances
Machine hours 10,000 8,000 2,000 U
Remember the question from earlier: How
Variable costs
muchIndirect
of thelabour
$11,650 favourable
$ 40,000 variance
$ 34,000is $6,000 F
due to lower materials
Indirect activity and how much is25,500
30,000 due to 4,500 F
Power 5,000
cost control? 3,800 1,200 F
Fixed costs
Depreciation 12,000 12,000 0
Insurance 2,000 2,050 50 U
Total overhead costs $ 89,000 $ 77,350 $11,650 F

© 2021 McGraw-Hill Limited 9-115

 Flexible Budget
Performance Report 4
Overhead Variance Analysis
Static Let’s Actual
Overhead place the Overhead
Budget at at
flexible
10,000 Hours 8,000 Hours
budget
$ 89,000 for 8,000 $ 77,350
hours
here.
Difference between original static
budget
and actual overhead = $11,650 F.
© 2021 McGraw-Hill Limited 9-116
 Flexible Budget
Performance Report 5
Overhead Variance Analysis
Static Flexible Actual
Overhead Overhead Overhead
Budget at Budget at at
10,000 Hours 8,000 Hours 8,000 Hours
$ 89,000 $ 74,000 $ 77,350

Activity Cost control

This $15,000F This $3,350U

variance is due to variance is due
lower activity. to poor cost control.
© 2021 McGraw-Hill Limited 9-117
End of Chapter Summary 1
• Budgets play a dual role in organizations
(planning and control) and offer several
benefits; including, communication of
management’s plans, allocation of
resources, coordination of activities, and
establishment of goals and objectives that
can be used to evaluate subsequent
performance.
• Budgets represent a key element of
responsibility accounting systems, whereby
managers are held responsible for revenue
and cost items over which they have
significant influence.
© 2021 McGraw-Hill Limited 9-118
End of Chapter Summary 2
• A master budget involves numerous
interrelated schedules and starts with the
sales budget, which is based on the sales
forecast.
• For a manufacturing company, once the
sales budget has been set, the production
budget can be prepared since it depends
on how many units are to be sold.
• The production budget determines how
many units are to be produced.
• After the production budget is prepared,
the various manufacturing cost budgets
and selling and ©administrative
2021 McGraw-Hill Limited
budgets can 9-119
End of Chapter Summary 3
• After the detailed budget schedules have
been completed, the cash budget, budgeted
income statement, and budgeted balance
sheet can be prepared.
• Flexible budgets can be used to address the
limitations that arise with static budgets
when actual activity levels differ
significantly from budgeted levels.
• Flexible budgets also allow companies to
prepare performance reports that show the
difference between actual and static budget
into flexible budget variances and sales
volume variances.© 2021 McGraw-Hill Limited 9-120
 Appendix 9A
Inventory Decisions

© 2021 McGraw-Hill Limited 9-121

 Inventory Decisions
• Inventory planning and control decisions
are an important aspect of the
management of many organizations.
• Inventory planning and control play an
integral role in preparing the master
budget.
• The major issues that need to be
addressed are:
• How does the manger know what
inventory level is appropriate?
• Will the appropriate level vary from
organization ©to organization?
2021 McGraw-Hill Limited 9-122
 Costs Associated with
Inventory 1
• Inventory Ordering Costs: Costs
associated with the acquisition of
inventory, such as clerical costs and
transportation costs.
• Inventory Carrying Costs: Costs
associated with having inventory on
hand, such as storage space, handling
costs, property taxes, insurance,
obsolescence losses and interest on
capital invested in inventory.
© 2021 McGraw-Hill Limited 9-123
 Costs Associated with
Inventory 2
• Costs of not carrying sufficient
inventory:
• Costs that result from not having
enough inventory on hand to meet
customers’ needs, including;
customer dissatisfaction and lost
sales, forgone quantity discounts,
uneven production, inefficient
production runs, and additional
transportation charges.
© 2021 McGraw-Hill Limited 9-124
Computing the Economic
Order Quantity
• The economic order quantity is the
order size for materials that
minimizes the costs of ordering and
carrying inventory.
• There are two approaches:
1. The Tabular Approach
2. The Formula Approach

© 2021 McGraw-Hill Limited 9-125

Tabular Approach

© 2021 McGraw-Hill Limited

Formula Approach

© 2021 McGraw-Hill Limited

 Just-in-Time and the
Economic Order Quantity

• The EOQ will decrease under either

of these circumstances:
1. The cost of placing an order
decreases.
2. The cost of carrying inventory
increases.

© 2021 McGraw-Hill Limited 9-128

Just-in-Time and the Economic Order
Quantity

© 2021 McGraw-Hill Limited 9-129

 Production Lot Size,
Reorder
• Point
Economicand Safety
production Stock
Lot Size: The 1
number of units produced in a production lot
that minimizes setup costs and the costs of
carrying inventory.
• Setup costs: Labour and other costs
involved in getting facilities ready to
produce a batch of a particular production
item.
• Reorder point: The point in time when an
order must be laced to replenish deplete
inventory; it is determined by multiplying
© 2021 McGraw-Hill Limited 9-130
 Production Lot Size,
Reorder
Point and Safety Stock 2
• Lead time: The interval between the time
that an order is placed and the time that the
order is actually received from the supplier
or production is completed.
• Safety stock: The difference between
average usage of materials and maximum
usage of materials that can reasonably be
expected during the lead time.

© 2021 McGraw-Hill Limited 9-131

 Production Lot Size,
Reorder
Point and Safety Stock 2

© 2021 McGraw-Hill Limited 9-132

Lead Time

© 2021 McGraw-Hill Limited

 Perishable Products

• Inventory for perishable products or

services pose an interesting problem:
• If too much or too many are
ordered, the cost of the inventory is
similar to a carrying cost, while
ordering too few has the cost of
contribution forgone from the lost
sale.

© 2021 McGraw-Hill Limited 9-134