Chapter 10

Question 1

In business, what are budgets?

Answer 1

> In business, budgets are the formal documents that quantify a company’s plans for achieving its goals.

Question 2

The entire planning and control process of many companies is built around what?

Answer 2

> budgets

Question 3

Why are budgets useful in the planning process?

Answer 3

> Budgets are useful in the planning process because they enhance communication and coordination.

Question 4

The process of developing a formal plan—that is, a budget—forces managers to do what?

Answer 4

> The process of developing a formal plan—that is, a budget—forces managers to consider carefully their goals and objectives and to specify means of achieving them.

Question 5

Why are budgets useful in the control process?

Answer 5

Budgets are useful in the control process because they provide a basis for evaluating performance.

Question 6

Significant deviations from planned performance are associated with three potential causes - what are they?

Answer 6

1) It is possible that the plan or budget was poorly conceived. If a budget is not carefully developed, it should not be surprising that actual results are different from planned results.

2) It is possible that although the budget was carefully developed, conditions have changed. For example, if the economy were to take a sudden downturn, actual sales might be less than budgeted sales.

3) It is possible that managers have done a particularly good or poor job managing operations. If this is the case, the managers will be rewarded for good performance (e.g., given a bonus or a promotion) or punished for poor performance (e.g., given reduced responsibility or even fired).

Question 7

If managers know that their performance will be evaluated with respect to the budget, they are likely to do what?

Answer 7

> If managers know that their performance will be evaluated with respect to the budget, they are likely to work especially hard to achieve budgeted goals.

> Thus, it is critical that the budgeted goals be well thought out and clearly communicated to managers

Question 8

What are budgets prepared for?

Answer 8

> Budgets are prepared for departments, for divisions of a company, and for the company as a whole.

Question 9

What group within the organization is responsible for budgeting?

Answer 9

> Often the group within a company that is responsible for approval of the various budgets is the budget committee

> This committee consists of senior managers, including the president, the chief financial officer, the vice president for operations, and the controller.

> Typically, the budget committee works with departments to develop realistic plans that are consistent with overall company goals.

> In some cases, however, the budget committee may impose a budget without soliciting input from department managers.

Question 10

The extent to which departments are consulted relates to the distinction between what two factors? describe each.

Answer 10

> relates to the distinction between top-down and bottom-up approaches to the development of a budget.

> In a top-down approach, budgets are developed at higher organizational levels without substantial input from lower-level managers.

> In a bottom-up approach, lower-level managers are the primary source of information used in setting the budget.

Question 11

Most managers believe a successful budgeting process requires what approach?

Answer 11

> Most managers believe a successful budgeting process requires a bottom-up approach.

> After all, lower-level managers often have the best information regarding business conditions affecting their departments.

Question 12

Before a budget can be prepared, managers must decide on what?

Answer 12

> Before a budget can be prepared, managers must decide on an appropriate budget period.

> Generally, the longer the time period, the less detailed the budget.

Question 13

A common starting point in developing a budget is a consideration of what?

Answer 13

> A common starting point in developing a budget is a consideration of the costs and revenues of the previous period.

> These amounts are adjusted up or down based on current information and assumptions or estimates of what will happen in the future.

Question 14

What is a zero-based budgeting?

Answer 14

> zero-based budgeting is a method of budget preparation that requires budgeted amounts to be justified by each department at the start of each budget period, even if the amounts were supported in prior budget periods.

> That is, managers must start from zero in developing their budgets

Question 15

What are the downsides to zero-based budgets?

Answer 15

> the technique is time-consuming and expensive.

> Although zero-based budgeting has gained some support in governmental budgeting, it is not widely practiced by business enterprises.

Question 16

What is the master budget?

Answer 16

> The master budget is a comprehensive planning document that incorporates a number of individual budgets.

> Typically, it includes budgets for sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative expenses, capital acquisitions, and cash receipts and disbursements, as well as a budgeted income statement and a budgeted balance sheet.

Question 17

Various budgets are interrelated, but what two are most interrelated?

Answer 17

> the sales budget influences the production budget

Question 18

The first step in the budget process involves what?

Answer 18

> involves preparation of sales forecasts and development of a sales budget.

> involves preparation of sales forecasts and development of a sales budget.

Question 19

Companies use numerous methods to estimate sales. What do large organizations do?

Answer 19

> Very large companies may hire economists to prepare sales forecasts using sophisticated mathematical models that take into consideration the rate of inflation, national capital expenditures, and other economic data.

Question 20

Companies use numerous methods to estimate sales. What do small organization do?

Answer 20

> Smaller companies may develop forecasts based on an analysis of the trend in their own sales data.

Question 21

What are good sources of sale data?

Answer 21

> Trade journals or magazines exist for almost every industry, and they may provide useful information for developing sales forecasts.

> Typically, these journals contain information on past industry sales. They may also make predictions about the growth of the industry.

> Sales personnel may be another good source of information for forecasting sales. Some companies periodically ask all of their salespersons to estimate sales in their territories for the coming year.

Question 22

In general, forecasts of sales are part science and part art. what statement solidifies that?

Answer 22

> In general, forecasts of sales are part science and part art.

Question 23

Once the sales budget has been prepared, the production budget can be developed. In deciding how much to produce, managers must take into account what factors?

Answer 23

> how much they expect to sell, how much is in beginning inventory, and how much they want in ending inventory

Question 24

How do we calculate production budget quantities?

Answer 24

finished units to be produced = expected sales in units + desired ending inventory of finished units - beginning inventory of units

Question 25

The amount of direct materials that must be purchased depends on what?

Answer 25

> The amount of direct materials that must be purchased depends on the amount needed for production and the amount needed for ending inventory.

Question 26

The amount that must be purchased can be calculated using the following formula:

Answer 26

required purchase of direct materials = amount required for production + desired ending inventory of direct materials - beginning inventory of direct materials

Question 27

Direct labor cost is calculated by why?

Answer 27

> Direct labor cost is calculated by multiplying the number of units produced each quarter by the labor hours per unit and the rate per hour.

Question 28

However, budget information is also needed for what two expenses?

Answer 28

> for selling and administrative expenses

Question 29

Much of the information contained in the budgets is already contained in what statement?

Answer 29

> already described is utilized in the preparation of a budgeted income statement.

Question 30

Management should carefully consider the budgeted income statement to make sure of what?

Answer 30

> to make sure that anticipated profit is consistent with company goals. > If budgeted profit is less than the amount management considers satisfactory, steps may be taken to increase sales and reduce costs. > If management decides to take steps to increase profit, then the previous budgets will need to be adjusted to reflect the anticipated changes.

Question 31

In respect to long-lived assets, what can be said about them and budgets?

Answer 31

> decisions involving long-lived assets often are called capital expenditure decisions, and the final list of approved projects is documented in the capital acquisitions budget.

Question 32

Acquisitions of capital assets must be carefully planned, in part because they may do what?

Answer 32

> Acquisitions of capital assets must be carefully planned, in part because they may

Question 33

In the cash budget, managers plan what? What statement is considered?

Answer 33

> In the cash budget, managers plan the amount and timing of cash flows. The information in this budget is a necessary supplement to the information presented in the budgeted income statement.

Question 34

In budgets how are cash incomes reduced?

Answer 34

> Although cash reserves may be reduced immediately by the total cost of the equipment, current period income will be reduced by only a fraction of the cost of the equipment (i.e., by the amount of depreciation).

Question 35

To prepare an estimate of cash collections, management must determine what?

Answer 35

> To prepare an estimate of cash collections, management must determine the percent of credit sales revenue that is collected in the period of sale and the percent collected in the subsequent period. > The percentages usually can be estimated based on past collection experience.

Question 36

To prepare an estimate of cash disbursements, management must determine what?

Answer 36

> management must determine the percent of material purchases that is paid in the period of purchase and the percent that is paid in the subsequent period

Question 37

In preparing a cash budget, it is important to remember that some expenses do not require cash outlays - which don't?

Answer 37

> depreciation is part of manufacturing overhead, but it does not require a current outlay of cash. > Cash is disbursed when an asset is purchased, not when depreciation is recorded. > Another example of a noncash expense is the amortization of prepaid insurance. > Cash is disbursed when the insurance is purchased, not when the expense is recognized through the amortization of prepaid insurance.

Question 38

Excessively large cash balances generally should be avoided because:

Answer 38

> because they earn little if any interest.

Question 39

How do companies invest when building up or not building up financial reserves?

Answer 39

> If a company is building up financial reserves for expansion (purchasing a major piece of equipment or even another company), excess cash generally will be invested in low-risk, highly marketable securities. > If the company is not building up reserves to expand, the excess cash may be distributed to shareholders as dividends.

Question 40

What is the budgeted balance sheet?

Answer 40

> This budget is simply a planned balance sheet (sometimes called a pro forma balance sheet). > Managers can use this budget to assess the effect of their planned decisions on the future financial position of the firm.

Question 41

Most companies that use budgets define the budget relationships in what way?

Answer 41

> Most companies that use budgets define the budget relationships in a computer model using a spreadsheet program such as Excel or a custom program specifically designed for them.

Question 42

Budgets facilitate control by providing a standard for evaluation. The standard is what?

Answer 42

> The standard is the budgeted amount, against which actual results are compared.

Question 43

What is budget variance? What reports indicate budget variance?

Answer 43

> Differences between budgeted and actual amounts are referred to as budget variances, and reports that indicate budget variances are referred to as performance reports.

Question 44

What happens when there is no budget variance and then when there is some?

Answer 44

> Differences between budgeted and actual amounts are referred to as budget variances, and reports that indicate budget variances are referred to as performance reports.

Question 45

How would performance be evaluated if budgets were not prepared?

Answer 45

> Most likely, actual performance in the current period would be compared with actual performance in the prior period. > This is obviously an inferior approach because conditions may change significantly from one period to the next, making a comparison of the two periods meaningless.

Question 46

In evaluating performance by using budgets, care must be taken to make sure that the level of activity used in the budget is equal to what?

Answer 46

> is equal to the actual level of activity.

Question 47

What is a static budget?

Answer 47

> a budget that is not equal to the actual level of activity / production.

Question 48

What is a flexible budget?

Answer 48

> which is a set of budget relationships that can be adjusted to various activity levels. > Thus, flexible budgets take into account the fact that when production increases or decreases, variable costs change. > Fixed costs, however, stay the same.

Question 49

If the budget is not carefully developed with reasonable estimates of cost, it should not be surprising if actual costs are not equal to the budgeted amounts. In this case, should budget be attributed to the manager?

Answer 49

> In this case, budget variances should not be blamed on the manager responsible for meeting the budget.

Question 50

Are budgeted variances investigated? What is most practical?

Answer 50

> The cause of a variance cannot be determined without an investigation. However, because of the cost of investigation, it is not practical to investigate all budget variances. > A management by exception approach is more economical. Under this approach, only exceptional variances are investigated. * A management by exception approach is more economical. Under this approach, only exceptional variances are investigated.

Question 51

Unfortunately, there is an inherent conflict when budgets are used for both planning and control. The result of the conflict is that managers may do 2 things:

Answer 51

(1) pad their budgets and (2) shift income between periods to increase their compensation.

Question 52

How do managers pad their budgets?

Answer 52

> Recall that managers who are evaluated with respect to a budget are likely to provide information used in setting it. > This follows because they are likely to have better information about costs and revenues than their superiors. > This leads to the first problem, which is that managers have an incentive to pad a budget and create budget slack—that is, a budget with targets that are easy to achieve. > That’s because the lower the budget target, the more likely it is that the managers will receive the hurdle bonus and the maximum variable bonus. > Managers can create slack by lowering their forecasts of sales and increasing their forecasts of costs.

Question 53

How do shifts between shift income between periods increase manager compensation?

Answer 53

> The second problem relates to the fact that managers who are evaluated with respect to the budget may have an incentive to shift income from one period to another. > Consider a manager who estimates that it is unlikely he or she will meet the hurdle target. This manager has an incentive to shift income from a future period into the current period so that the hurdle target (80 percent of the budget) is reached and the hurdle bonus is received. > This might be done by cutting back research and development expenditures in the current year and delaying them until a future year. > Or a manager could recognize revenue in the current year on goods that are not going to be shipped until the start of the next year. This latter option violates generally accepted accounting principles (GAAP) and is, most likely, illegal. But the action has been used over the years by a number of ethically challenged managers.

Question 54

Perhaps the best that can be done to mitigate the conflict between the planning and control uses of budgets is to assure managers of what?

Answer 54

> is to assure managers that their performance in comparison to the budget will be fairly evaluated and compensated. > Managers should be confident that they will be allowed to comment on the real causes of budget variances and tell their side of the story.

Question 55

Managers pay close attention to those aspects of their jobs that are measured and evaluated. Thus, it is important to quantify in budgets key “success factors” for the company. Historically, budgets have done?

Answer 55

> Historically, budgets primarily have included dollar amounts. However, including some nonmonetary measures of performance in the budget is likely to be advantageous.

Question 56

What is ratcheting?

Answer 56

> Some managers worry that beating their budgeted earnings targets may lead superiors to make their budgets harder to achieve in the next budget period. > That practice, know as ratcheting, is thought to create an incentive problem in that it motivates managers to avoid striving to beat budgeted earnings by a significant margin.