CMA Part 1: Budget Methodologies and Annual Profit Planning

The Annual and Master Budget

  • The master budget represents the culmination and goal of the budgeting process, expressing management’s operating and financial plans for a full year, typically the company’s fiscal year.
  • It is also referred to as the comprehensive budget. This set of budgeted financial statements includes:
    • Budgeted balance sheet.
    • Budgeted income statement.
    • Budgeted statement of cash flows.
  • The master budget consists of both monthly and quarterly interim budgeted financial statements. These are first prepared by individual responsibility centers and then consolidated into company-wide statements. The individual responsibility center budgets plus the consolidated budget constitute the master budget.
  • Distinction from Pro Forma Statements:
    • Projected financial statements are known as pro forma financial statements; however, the master budget is not a pro forma statement.
    • The term "pro forma" refers to a forecasted financial statement prepared for a specific purpose, such as "what if" analysis during planning.
    • Pro forma statements are not part of the formal budgeting process and are not used for formal variance reporting, though actual results may eventually be compared to them. They serve as planning and decision-making tools whose amounts may differ significantly from the master budget.
  • Static Budget Nature:
    • The master budget is a static budget, meaning it is prepared for a single planned activity level projected before the period starts.
    • Activity level refers to planned production units, direct labor hours, machine hours, sales volume, or any other planned volume.
  • Inputs and Decisions:
    • The master budget is created using financial and non-financial assumptions (e.g., units to manufacture, number of employees needed).
    • It results from operating decisions (best use of limited resources) and financing decisions (obtaining funds to acquire resources).
  • Role of Responsibility Centers:
    • Budgets organized by responsibility centers provide superior feedback and control because managers are responsible for meeting and, ideally, developing their own center’s budget.

Operating and Financial Budgets

  • The master budget comprises two primary classifications: the operating budget and the financial budget.
  • Operating Budgets:
    • These identify resources needed for planned activities like sales, services, production, purchasing, marketing, and Research and Development (R&D).
    • Individual unit operating budgets are compiled into the budgeted income statement.
  • Financial Budgets:
    • These identify the sources and uses of funds for budgeted operations.
    • Components include:
      • Cash budget.
      • Budgeted statement of cash flows.
      • Budgeted balance sheet.
      • Capital expenditures budget.

Static vs. Flexible Budgets

  • Static Budgets:
    • A disadvantage of the master budget is its static nature; every item is developed for one specific activity level. Variances between actual results and the master budget are often caused simply by differences between planned and actual volume, which provides limited insight into performance efficiency.
  • Flexible Budgets:
    • A flexible budget is prepared by taking the variable revenues and costs planned in the master budget and adjusting them to what they would have been based on the actual sales volume.
    • It answers the question: "If we had known what the actual level of activity was going to be when we prepared the budget, what would the budget have looked like?"
    • Flexible budgets cannot be finalized until the reporting period is over and the actual activity level is known.
    • Relationship to Fixed Costs: In a flexible budget, only variable revenues and costs are adjusted. Fixed costs remain exactly the same as in the static budget, provided activity stays within the relevant range.
  • Alternate View of Flexible Budgets:
    • A budgeting team may create several budgets for different sales levels (e.g., if the master budget is for 100,000100,000 units, they might also create versions for 85,00085,000, 90,00090,000, 105,000105,000, etc.). At year-end, the actual results are compared to the flexible budget matching the actual sales.
  • Benefits and Limitations:
    • Focuses management on variances caused by factors other than volume (e.g., production or administrative problems).
    • Flexible budgeting must be used with a standard costing system.
    • It cannot replace the static budget because the static budget is necessary for identifying declines in sales volume.

Factors for Investigating Variances

  • Magnitude: Materiality depends on the size of the line item. A variance of $1,000\$1,000 is significant for a $1,250\$1,250 budget (80%80 \%) but immaterial for a $1,000,000\$1,000,000 budget (0.10%0.10 \%).
  • Trend: Unfavorable variances that persist over several months and grow larger must be investigated regardless of magnitude.
  • Benefit-Cost Determination: Investigation is warranted only if it is likely to lead to changes that eliminate or mitigate future occurrences of the variance.

Project and Life-Cycle Budgeting

  • Project Budgeting:
    • A project budget focuses on a specific, identifiable project with its own time span (ranging from one week to several years).
    • Examples include capital investments (buying a new machine, constructing a plant), software installation, or R&D for a new product.
    • Indirect costs and overheads allocated to the project must be identified and included.
  • Life-Cycle Budgeting:
    • A long-term project budget for a new product covering its entire life cycle from development to decline.
    • This allows management to set prices that cover all lifetime development and production costs plus the required return on investment.
  • Benefits:
    • Determines project viability in advance.
    • Assists in planning resource levels (personnel, effort, finances).
    • Fosters cooperation among affected responsibility centers.

Activity-Based Budgeting (ABB)

  • ABB is an extension of activity-based costing (ABC). While traditional costing allocates overhead based on direct labor or machine hours, ABB and ABC focus on activities and their specific cost drivers.
  • Process:
    1. Identify activities that drive costs.
    2. Determine the budgeted activity level for each driver based on production.
    3. Develop a budgeted cost pool for each activity.
    4. Determine budgeted overhead costs per unit of activity: Total Budgeted Overhead for ActivityTotal Budgeted Units of Activity\frac{\text{Total Budgeted Overhead for Activity}}{\text{Total Budgeted Units of Activity}}.
    5. Allocate overhead to products based on their use of each activity.
  • Benefits:
    • Identifies opportunities for cost reduction and elimination of wasteful, low value-added activities.
    • Clarifies the relationship between resource consumption, costs, and output.
    • Helps identify budgetary slack.
  • Limitations:
    • Must be used with ABC.
    • Costlier and more complex to implement due to the research and management education required.

Zero-Based and Incremental Budgeting

  • Incremental Budgeting:
    • Starts with current period figures and adjusts them for anticipated changes. It assumes current actual results are a baseline for the future.
  • Zero-Based Budgeting (ZBB):
    • Prepared without reference to the current budget. Every planned activity must be justified via cost-benefit analysis.
    • Managerial accountability: Each manager must justify all expenses from zero.
    • Prioritizing: Activities are ranked to determine resource allocation.
    • Limitation: Requires a nearly impossible amount of work every year. Some companies rotate high-level reviews among departments each year as a compromise.

Continuous (Rolling) Budgets

  • A rolling budget is prepared for a set period ahead (e.g., 1212 months). As one month or quarter concludes, it is dropped, and a new one is added to the end.
  • The budget is constantly updated with new information, ensuring it always covers the same duration in the future.
  • Benefits:
    • Greater flexibility and responsiveness to rapid environmental changes.
    • Continuous planning and more realistic near-term figures.
  • Limitations:
    • High time and resource requirements from staff and managers.
    • Potential volatility in figures and resistance from staff due to the workload.

The Budgeting Cycle and Profit Plan Development

  • The budgeting cycle is an ongoing process:
    1. Planning: Managers and accountants use past data and future expectations to develop the master budget.
    2. Reporting: Actual results are compared with budgeted results monthly or quarterly.
    3. Investigation: Management accountants help investigate variances and recommend operational changes or budget revisions.
    4. Monitoring: Market feedback and external conditions are monitored to prepare for the next cycle.
  • Participative Budgeting:
    • Involves lower-level managers in the process because they possess ground-level knowledge of resources and possibilities.
    • Leads to higher motivation and budget acceptance.
  • Bottom-Up Budgeting:
    • Starts at the lowest operational levels and builds revenue and costs upward.
  • Upper Management Role: Despite bottom-up input, senior management must set goals, priorities, and provide structural support.

Preparing the Operating Budget Components

1. Sales Budget
  • The primary budget from which all others are derived.
  • Based on forecasted sales level, objectives, and capacity. It includes expected units and selling prices.
  • External factors: Economic environment, consumer attitudes (psychographics), competitors, and projected industry market share.
  • Internal factors: Past trends, pricing, credit policies, advertising, and plant capacity.
  • Timing of collections on credit sales is critical for the later development of the cash budget.
2. Production Budget
  • Determines units to produce based on sales forecasts and inventory objectives.
  • Formula: Budgeted unit sales+Desired ending finished goods inventory−Beginning finished goods inventory=Units to be produced\text{Budgeted unit sales} + \text{Desired ending finished goods inventory} - \text{Beginning finished goods inventory} = \text{Units to be produced}
  • Considers labor availability, seasonal sales variations, and inventory storage costs.
3. Direct Materials Usage and Purchases
  • Direct Materials Usage Budget: Calculated using the production budget, bills of materials (specifying material quantity and sequence), and expected costs per unit.
  • Direct Materials Purchases Budget: Adjusts usage needs by the change in raw materials inventory levels.
4. Direct Labor Usage Budget
  • Calculated using labor standards (time allowed per unit) and standard costs per hour.
  • Standard labor costs include wages plus employee benefits (FICA, Medicare, workers' compensation, insurance, pension contributions).
5. Manufacturing Overhead Costs Budget
  • Includes variable (e.g., equipment maintenance, supplies) and fixed (e.g., supervisory salaries, depreciation) costs.
  • Overhead is applied using a predetermined rate based on an allocation base like direct labor hours (DLH\text{DLH}) or machine hours.
  • Formula for predetermined rate: Total Budgeted Overhead CostsBudgeted Allocation Base Hours=Predetermined Overhead Rate\frac{\text{Total Budgeted Overhead Costs}}{\text{Budgeted Allocation Base Hours}} = \text{Predetermined Overhead Rate}
6. Ending Inventories Budgets
  • Calculates the cost of ending finished goods (FGFG) and direct materials (DMDM) inventories.
  • Necessary for calculating the Budgeted Cost of Goods Sold.
7. Nonmanufacturing Budgets
  • Includes R&D, Selling, Marketing, Distribution, and Administrative/General expenses.
  • Expenses should be classified as fixed or variable to support flexible budgeting and contribution margin calculations.

Formulas for Cost of Goods Manufactured and Sold

  • Budgeted Cost of Goods Manufactured (COGM): Direct Materials Used+Direct Labor Used+Manufacturing Overhead Applied=Total Manufacturing Costs\text{Direct Materials Used} + \text{Direct Labor Used} + \text{Manufacturing Overhead Applied} = \text{Total Manufacturing Costs}Total Manufacturing Costs+Beginning WIP Inventory−Ending WIP Inventory=Cost of Goods Manufactured\text{Total Manufacturing Costs} + \text{Beginning WIP Inventory} - \text{Ending WIP Inventory} = \text{Cost of Goods Manufactured}
  • Budgeted Cost of Goods Sold (COGS): Beginning FG Inventory+Cost of Goods Manufactured−Ending FG Inventory=Cost of Goods Sold\text{Beginning FG Inventory} + \text{Cost of Goods Manufactured} - \text{Ending FG Inventory} = \text{Cost of Goods Sold}

Financial Budget and the Cash Budget

  • Capital Expenditures Budget:
    • Planned years in advance for long-term assets like Property, Plant, and Equipment (PP&E).
    • Affects the balance sheet (fixed assets) and income statement (depreciation).
  • Cash Budget:
    • The last budget prepared before financial statements. It tracks cash inflows (receipts) and outflows (disbursements) on a month-by-month basis.
    • Receipts: Based on sales budget and collection policies.
    • Disbursements: Based on purchases, labor, nonmanufacturing budgets, and capital equipment plans.
    • Objective: Identify cash shortfalls to arrange financing in advance and invest excess cash.
  • Structure:
    • Beginning Cash Balance+Receipts=Total Cash Available\text{Beginning Cash Balance} + \text{Receipts} = \text{Total Cash Available}
    • Total Cash Available−Disbursements−Minimum Cash Desired=Cash Excess or Deficit\text{Total Cash Available} - \text{Disbursements} - \text{Minimum Cash Desired} = \text{Cash Excess or Deficit}

Estimating Fixed and Variable Costs

High-Low Points Method
  • Uses the highest and lowest activity levels within the relevant range.
  1. Calculate variable cost per unit: Difference in Associated Costs at High and Low ActivityDifference in High and Low Activity Levels=Variable Cost per Unit\frac{\text{Difference in Associated Costs at High and Low Activity}}{\text{Difference in High and Low Activity Levels}} = \text{Variable Cost per Unit}
  2. Determine fixed cost: Total Cost at High Activity−(Variable Cost per Unit×High Activity Level)=Fixed Cost\text{Total Cost at High Activity} - (\text{Variable Cost per Unit} \times \text{High Activity Level}) = \text{Fixed Cost}
Regression Analysis
  • Simple linear regression models the relationship between an independent variable (activity level xx) and a dependent variable (total cost yy).
  • Assumptions:
    • Variations in yy are explained by one independent variable (xx).
    • The relationship is linear.
  • Cost Function: y^=a+bx\hat{y} = a + bx
    • y^\hat{y} is the predicted total cost.
    • aa is the fixed cost (constant coefficient/y-intercept).
    • bb is the variable cost per unit (variable coefficient).
    • xx is the activity level.
  • Evaluating Strength:
    • Coefficient of Correlation (Multiple R): Ranges from −1-1 to +1+1. A value near +1+1 indicates a strong positive relationship.
    • Coefficient of Determination (R2R^2): The square of Multiple R. It represents the percentage of variation in costs explained by the activity volume.

Top-Level Planning and Pro Forma Analysis

  • Pro forma financial statements are internal projections used for "what if" scenarios, such as evaluating mergers, disinvestments, or new product lines.
  • Forecasting Financing Needs:
    • Spontaneous Liabilities: Increases in accounts payable or accrued wages that occur naturally with increased activity. Bank loans are NOT spontaneous.
    • Additional Funds Needed (AFNAFN): The external financing required after accounting for spontaneous liabilities and retained earnings.
  • Determinants of External Financing Need:
    • Sales Growth Rate: Higher growth requires more external funding.
    • Capital Intensity Ratio: Assets that increase with salesSales revenue\frac{\text{Assets that increase with sales}}{\text{Sales revenue}}. Higher ratios increase financing needs.
    • Spontaneous Liabilities-to-Sales Ratio: Higher ratios decrease external financing needs.
    • Net Profit Margin: Higher margins provide more internal funds.
    • Retention Ratio: The portion of net income not paid out as dividends. Higher retention reduces the need for external financing.
  • Forecasted Financial Statement (FFS) Method: A comprehensive approach that forecasts the entire balance sheet and income statement to determine the "plugged" amount of additional funds needed.