Master Budgeting

CHAPTER 8

Managerial
Accounting
Seventeenth edition

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw Hill.
Basic Framework of
5-2

Budgeting
A budget is a detailed quantitative plan for
acquiring and using financial and other resources
over a specified forthcoming time period.

1. A company’s budget ordinarily covers a one-year

period corresponding to its fiscal year.
2. Some companies also use a perpetual budget,
which is a 12-month budget that continuously
rolls forward.
 5-3

Choosing the Budget Period

Operating budgets ordinarily A continuous budget is a 12-

cover a one-year period month budget that rolls forward
corresponding to a company’s one month (or quarter) as the
fiscal year. Many companies current month (or quarter) is
divide their annual budget into completed.
four quarters.
 5-4

Why Do Organizations Create

Budgets? (Planning Perspective)
 5-5

Why Do Organizations Create

Budgets? (Control Perspective)
From a control standpoint, organizations
compare their budgets to actual results to:

Improve the Evaluate and

efficiency and reward employees.
effectiveness of
operations.
 5-6

How Do Organizations Create

Budgets?
Companies usually create budgets by relying on
some combination of top-down budgeting and
self-imposed budgeting. A self-imposed budget
or participative budget is a budget that is
prepared with the full cooperation and
participation of managers at all levels.
 5-7

Self-Imposed Budgets

When managers throughout the organization work collaboratively to prepare a

budget, they often strive to establish challenging targets that are also highly
achievable. These goals are likely to build a lower-level manager’s confidence and
commitment to the budget.
 5-8

Self-Imposed Budgets –
Management Review
Self-imposed budgets should be reviewed by
higher levels of management to prevent
“budgetary slack.”
Most companies issue broad guidelines in
terms of overall profits or sales. Lower-level
managers are directed to prepare budgets
that meet those targets.
 5-9

2 Types of Budgets:
Master Budget

Flexible Budget
 5-10

Master Budget – An Overview

2

A master budget is based on various estimates and

assumptions. For example, the sales budget
requires three estimates/assumptions as follows:
1. What are the budgeted unit sales?
2. What is the budgeted selling price per unit?
3. What percentage of accounts receivable will be
collected in the current and subsequent
periods?
 5-11

Seeing the Big Picture 2

1. How much sales revenue 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 costs will we incur?
5. How much cash will we pay to our suppliers and our direct laborers, and how
much cash will we pay for manufacturing overhead resources?
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?
 5-12

Master Budget – An Overview

1

Access the text alternative for slide images.

 5-13

Budgeting Example
1. Royal Company is preparing budgets for the
quarter ending June 30.
2. 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

3. The selling price is $10 per unit.

 5-14

Sales Budget
The individual months of April, May, and June are
summed to obtain the total budgeted sales in units
and dollars for the quarter ended June 30.
April May June Quarter
Budgeted sales in units 20,000 50,000 30,000 100,000
Selling price per unit $ 10 $ 10 $ 10 $ 10
Total budgeted sales $ 200,000 $ 500,000 $ 300,000 $ 1,000,000
 5-15

Production Budget 6

April May June Quarter

Budgeted sales 20,000 50,000 30,000 100,000
Add: Desired ending inventory 10,000 6,000 5,000 5,000
Total needs 30,000 56,000 35,000 105,000
Less: Beginning inventory 4,000 10,000 6,000 4,000
Required production 26,000 46,000 29,000 101,000

July sales of 25,000 units×20% = 5,000

 5-16

Direct Materials Budget 6

April May June Quarter

Production 26,000 46,000 29,000 101,000
Materials per unit (pounds) 5 5 5 5
Production needs 130,000 230,000 145,000 505,000
Add: Desired ending inventory 23,000 14,500 11,500 11,500
Total needed 153,000 244,500 156,500 516,000
Less: Beginning inventory 13,000 23,000 14,500 13,000
Materials to be purchased 140,000 221,500 142,000 503,500

Beginning inventory from April

 5-17

Direct Labor Budget 4

April May June Quarter

Units of production 26,000 46,000 29,000 101,000
Direct labor time per unit 0.05 0.05 0.05 0.05
Labor-hours required 1,300 2,300 1,450 5,050
Hourly wage rate $ 10 $ 10 $ 10 $ 10
Total direct labor costs $ 13,000 $ 23,000 $ 14,500 $ 50,500
 Flexible Budgets and
Performance Analysis
CHAPTER 9

Managerial
Accounting
Seventeenth edition

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw Hill.
 Variance Analysis Cycle

Access the text alternative for slide images.

© McGraw Hill 9-19

 Learning Objective 1
Prepare a planning budget and a flexible
budget with one cost driver.

© McGraw Hill 9-20

 Characteristics of Flexible
Budgets 1

Planning budgets are prepared for a single, planned

level of activity.

Performance evaluation is difficult when

actual activity differs from the planned
level of activity.

© McGraw Hill 9-21

 Characteristics of Flexible
Budgets 2

1. May be prepared for any activity level in

the relevant range.
2. Show costs that should have been incurred
at the actual level of activity, enabling
“apples to apples” cost comparison.
3. Help managers control costs.
4. Improve performance evaluation.

Let’s look at Larry’s Lawn Service.

© McGraw Hill 9-22
 Deficiencies of the Static
Planning Budget 1

Larry’s Lawn Service provides lawn care in a planned

community where all lawns are approximately the same size.
At the end of May, Larry prepared his June budget based on
mowing 500 lawns. Since all the lawns are similar in size,
Larry felt that the number of lawns mowed in a month would
be the best way to measure overall activity for his business.

© McGraw Hill 9-23

 Deficiencies of the Static
Planning Budget 2

Larry’s Planning Budget

Larry’s Lawn Service
For the Month Ended June 30
Planning
Revenue/Cost Formulas
(Master) Budget
Number of lawns (Q) 500
Revenue ($75Q) $ 37,500
Expenses:
Wages and salaries ($5,000 + $30Q) $ 20,000
Gasoline and supplies ($9Q) 4,500
Equipment maintenance ($3Q) 1,500
Office and shop utilities ($1,000) 1,000
Office and shop rent ($2,000) 2,000
Equipment depreciation ($2,500) 2,500
Insurance ($1,000) 1,000
Total expenses 32,500
Net operating income $ 5,000

© McGraw Hill 9-24

 Deficiencies of the Static
Planning Budget 3

Larry’s Actual Results

Larry’s Lawn Service
For the Month Ended June 30
Actual Results
Number of lawns (Q) 550
Revenue $ 43,000
Expenses:
Wages and salaries $ 23,500
Gasoline and supplies 5,100
Equipment maintenance 1,300
Office and shop utilities 950
Office and shop rent 2,000
Equipment depreciation 2,500
Insurance 1,200
Total expenses 36,550
Net operating income $ 6,450

© McGraw Hill 9-25

 Deficiencies of the Static
Planning Budget 4

Larry’s Actual Results Compared with the Planning Budget

Larry’s Lawn Service
For the Month Ended June 30
Planning (Master)
Revenue/Cost Formulas Actual Results Variances
Budget
Number of lawns (Q) 550 500
Revenue ($75Q) $ 43,000 $ 37,500 $ 5,500 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 23,500 $ 20,000 $ 3,500 U
Gasoline and supplies ($9Q) 5,100 4,500 600 U
Equipment maintenance ($3Q) 1,300 1,500 200 F
Office and shop utilities ($1,000) 950 1,000 50 F
Office and shop rent ($2,000) 2,000 2,000 -
Equipment depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,200 1,000 200 U
Total expenses 36,550 32,500 4,050 U
Net operating income $ 6,450 $ 5,000 $ 1,450 F

© McGraw Hill 9-26

 Deficiencies of the Static
Planning Budget 5

Larry’s Actual Results Compared with the Planning

Budget
• F = Favorable variance that occurs when actual
revenue is greater than budgeted revenue.
• U = Unfavorable variance that occurs when actual
costs are greater than budgeted costs.
• F = Favorable variance that occurs when actual
costs are less than budgeted costs.

© McGraw Hill 9-27

 Deficiencies of the Static
Planning Budget 6

Larry’s Actual Results Compared with the Planning

Budget
• Since these variances are unfavorable, has Larry
done a poor job controlling costs?
• Since these variances are unfavorable, has Larry
done a poor job controlling costs?
• Since these variances are favorable, has Larry
done a good job controlling costs?

© McGraw Hill 9-28

 Deficiencies of the Static
Planning Budget 7

At this point, we cannot answer this question

because the actual level of activity is greater than
the planned level of activity. Therefore, actual
variable costs are likely to be higher than planned
variable costs regardless of Larry’s managerial
efficiency.

© McGraw Hill 9-29

 Deficiencies of the Static
Planning Budget 8

The relevant question is . . .

“How much of the cost variances are due to higher
activity, and how much are due to cost control?”

In other words, total cost variances can be explained by

Activity Variance and Spending Variance. Each of this
variance will help us answer the question.

To find the Activity Variance and the Spending Variance, we

need to create a flexible budget.

© McGraw Hill 9-30

 How a Flexible Budget Works
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.

© McGraw Hill 9-31

 How a Flexible Budget Works
2

Let’s prepare a
flexible budget
for Larry’s Lawn Service.

© McGraw Hill 9-32

 Preparing a Flexible Budget
Larry’s Flexible Budget
Larry’s Lawn Service
For the Month Ended June 30
Revenue/Cost Formulas Flexible Budget
Number of lawns (Q) 550
Revenue ($75Q) $ 41,250
Expenses:
Wages and salaries ($5,000 + $30Q) $ 21,500
Gasoline and supplies ($9Q) 4,950
Equipment maintenance ($3Q) 1,650
Office and shop utilities ($1,000) 1,000
Office and shop rent ($2,000) 2,000
Equipment depreciation ($2,500) 2,500
Insurance ($1,000) 1,000
Total expenses 34,600
Net operating income $ 6,650

$75 × 550 lawns = $41,250

© McGraw Hill 9-33
 Learning Objective 2
Calculate and interpret
activity variances.

© McGraw Hill 9-34

 Activity Variances 1

An activity variance arises solely due to the

difference in the actual level of activity and
the standard level of activity included in the
master budget.

© McGraw Hill 9-35

 Activity Variances 3

Larry’s Flexible Budget Compared with the Planning Budget

Larry’s Lawn Service
For the Month Ended June 30
Revenue/ Flexible Planning (Master) Activity
Cost Formulas Budget Budget Variances

Number of lawns (Q) 550 500

Revenue ($75Q) $ 41,250 $ 37,500 $ 3,750 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 21,500 $ 20,000 $ 1,500 U
Gasoline and supplies ($9Q) 4,950 4,500 450 U
Equipment maintenance ($3Q) 1,650 1,500 150 U
Office and shop utilities ($1,000) 1,000 1,000 -
Office and shop rent ($2,000) 2,000 2,000 -
Equipment depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,000 1,000 -
Total expenses 34,600 32,500 2,100 U
Net operating income $ 6,650 $ 5,000 $ 1,650 F

© McGraw Hill 9-36

 Activity Variances 4

Larry’s Flexible Budget Compared with the Planning Budget

Larry’s Lawn Service
For the Month Ended June 30
Activity and revenue increase by 10%, but net operating income
increases by more than 10% due to the presence of fixed costs.
Revenue/ Flexible Planning Activity
Cost Formulas Budget Budget Variances
Number of lawns (Q) 550 500
Revenue ($75Q) $ 41,250 $ 37,500 $ 3,750 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 21,500 $ 20,000 $ 1,500 U
Gasoline and supplies ($9Q) 4,950 4,500 450 U
Equipment maintenance ($3Q) 1,650 1,500 150 U
Office and shop utilities ($1,000) 1,000 1,000 -

© McGraw Hill 9-37

 Activity Variances 5

Larry’s Flexible Budget Compared with the Planning Budget

Larry’s Lawn Service
For the Month Ended June 30

Revenue/ Flexible Planning Activity

Cost Formulas Budget Budget Variances
Office and shop rent ($2,000) 2,000 2,000 -
Equipment depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,000 1,000 -
Total expenses 34,600 32,500 2,100 U
Net operating income $ 6,650 $ 5,000 $ 1,650 F

© McGraw Hill 9-38

 Learning Objective 3
Calculate and interpret revenue and
spending variances.

© McGraw Hill 9-39

 Key Terminology

© McGraw Hill 9-40

 Revenue and Spending
Variances 1

Now let’s use flexible budgeting concepts to

compute revenue and spending variances
for Larry’s Lawn Service.

© McGraw Hill 9-41

 Revenue and Spending
Variances 2

Larry’s Flexible Budget Compared with the Actual Results

Larry’s Lawn Service
For the Month Ended June 30
Revenue/ Actual Flexible Revenue and
Cost Formulas Results Budget Spending Variances
Number of lawns (Q) 550 500
Revenue ($75Q) $ 43,000 $ 41,250 $ 1,750 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 23,500 $ 21,500 $ 2,000 U
Gasoline and supplies ($9Q) 5,100 4,950 150 U
Equipment maintenance ($3Q) 1,300 1,650 350 F
Office and shop utilities ($1,000) 950 1,000 50 F
Office and shop rent ($2,000) 2,000 2,000 -
Equipment depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,200 1,000 200 U
Total expenses 36,550 34,600 1,950 U
Net operating income $ 6,450 $ 6,650 $ 200 U

$1,750 favorable revenue variance

© McGraw Hill 9-42
 Revenue and Spending
Variances 3

Larry’s Flexible Budget Compared with the Actual Results

Larry’s Lawn Service
For the Month Ended June 30
Revenue/ Actual Flexible Revenue and
Cost Formulas Results Budget Spending Variances
Number of lawns (Q) 550 500
Revenue ($75Q) $ 43,000 $ 41,250 $ 1,750 F
Expenses:
Wages and salaries ($5,000 + $30Q) $ 23,500 $ 21,500 $ 2,000 U
Gasoline and supplies ($9Q) 5,100 4,950 150 U
Equipment maintenance ($3Q) 1,300 1,650 350 F
Office and shop utilities ($1,000) 950 1,000 50 F
Office and shop rent ($2,000) 2,000 2,000 -
Equipment depreciation ($2,500) 2,500 2,500 -
Insurance ($1,000) 1,200 1,000 200 U
Total expenses 36,550 34,600 1,950 U
Net operating income $ 6,450 $ 6,650 $ 200 U

Spending variances
© McGraw Hill 9-43
 Learning Objective 4
Prepare a performance report with one
cost driver that combines activity
variances and revenue and spending
variances.

© McGraw Hill 9-44

 A Performance Report Combining
Activity and Revenue and Spending
Variances 1

Now let’s use flexible budgeting concepts to

combine the revenue and spending
variances reports for Larry’s Lawn Service.

© McGraw Hill 9-45

 A Performance Report Combining Activity
and Revenue and Spending Variances 2

Larry’s Lawn Service

Flexible Budget Performance Report
For the Month Ended June 30
Revenue and Flexible
Revenue/ Actual Spending Activity Planning
Cost Formulas Results Variances Budget Variances Budget

Number of laws (Q) 550 550 500

Revenue ($75Q) $ 43,000 $ 1,750 F $ 41,250 $ 3,750 F $ 37,500
Expenses:

Wages and salaries ($5,000 + $30Q) $ 23,500 $ 2,000 U $ 21,500 $ 1,500 U $ 20,000

Gasoline and ($9Q) 5,100 150 U 4,950 450 U 4,500

supplies
Equipment ($3Q) 1,300 350 F 1,650 150 U 1,500
maintenance
Office and shop ($1,000) 950 50 F 1,000 - 1,000
utilities

© McGraw Hill 9-46

 A Performance Report Combining Activity
and Revenue and Spending Variances 3

Larry’s Lawn Service

Flexible Budget Performance Report
For the Month Ended June 30
Revenue and Flexible
Revenue/ Actual Spending Budget Activity Planning
Cost Formulas Results Variances Variances Budget
Office and shop ($2,000) 2,000 - 2,000 - 2,000
rent
Equipment
depreciation ($2,500) 2,500 - 2,500 - 2,500

Insurance ($1,000) 1,200 200 U 1,000 - 1,000

Total expenses 36,550 1,950 U 34,600 2,100 U 32,500

Net operating
income $ 6,450 $ 200 U $ 6,650 $ 1,650 F $ 5,000

© McGraw Hill 9-47

 A Performance Report Combining Activity
and Revenue and Spending Variances 4

Larry’s Lawn Service

Flexible Budget Performance Report
For the Month Ended June 30

Revenue/ Actual Revenue and Flexible Activity Planning

Cost Formulas Results Spending Budget Variances Budget
Variances
Number of laws (Q) 550 550 500
Revenue ($75Q) $ 43,000 $ 1,750 F $ 41,250 $ 3,750 F $ 37,500
Expenses:
Wages and ($5,000 +
salaries $30Q) $ 23,500 $ 2,000 U $ 21,500 $ 1,500 U $ 20,000

Gasoline and ($9Q) 5,100 150 U 4,950 450 U 4,500

supplies
Equipment
maintenance ($3Q) 1,300 350 F 1,650 150 U 1,500

50 lawns × $30 per lawn 50 lawns × $75 per lawn

© McGraw Hill 9-48

 A Performance Report Combining Activity
and Revenue and Spending Variances 5

Larry’s Lawn Service

Flexible Budget Performance Report
For the Month Ended June 30
Revenue and Flexible
Revenue/ Actual Spending Budget Activity Planning
Cost Formulas Results Variances Variances Budget
Office and shop ($1,000) 950 50 F 1,000 - 1,000
utilities
Office and shop
rent ($2,000) 2,000 - 2,000 - 2,000
Equipment
depreciation ($2,500) 2,500 - 2,500 - 2,500

Insurance ($1,000) 1,200 200 U 1,000 - 1,000

Total expenses 36,550 1,950 U 34,600 2,100 U 32,500

Net operating $ 6,450 $ 200 U $ 6,650 $ 1,650 F $ 5,000
income

© McGraw Hill 9-49

 A Performance Report Combining Activity
and Revenue and Spending Variances 6

Larry’s Lawn Service

Flexible Budget Performance Report
For the Month Ended June 30

Revenue/ Actual Revenue and Flexible Activity Planning

Cost Formulas Results Spending Budget Variances Budget
Variances
Number of laws (Q) 550 550 500
Revenue ($75Q) $ 43,000 $ 1,750 F $ 41,250 $ 3,750 F $ 37,500
Expenses:
Wages and ($5,000 +
salaries $30Q) $ 23,500 $ 2,000 U $ 21,500 $ 1,500 U $ 20,000

Gasoline and ($9Q) 5,100 150 U 4,950 450 U 4,500

supplies
Equipment
maintenance ($3Q) 1,300 350 F 1,650 150 U 1,500

$43,000 actual − $41,250 budget

© McGraw Hill 9-50

 A Performance Report Combining Activity
and Revenue and Spending Variances 7

Larry’s Lawn Service

Flexible Budget Performance Report
For the Month Ended June 30
Revenue and Flexible
Revenue/ Actual Spending Budget Activity Planning
Cost Formulas Results Variances Variances Budget
Office and shop ($1,000) 950 50 F 1,000 - 1,000
utilities
Office and shop
rent ($2,000) 2,000 - 2,000 - 2,000
Equipment
depreciation ($2,500) 2,500 - 2,500 - 2,500

Insurance ($1,000) 1,200 200 U 1,000 - 1,000

Total expenses 36,550 1,950 U 34,600 2,100 U 32,500

Net operating $ 6,450 $ 200 U $ 6,650 $ 1,650 F $ 5,000
income

© McGraw Hill 9-51

 Variance Analysis
Favorable or unfavorable?
Favorable if actual is less than standard
Implies efficiency or cost savings

Unfavorable if actual is greater than standard

Implies waste or excessive cost

Does not mean “good” or “bad”

Any variance is a deviation from normal

Opposite for revenues

© McGraw Hill 9-52

 Variance Analysis
Responsibility
Why did the variance occur?
Usage issue

Efficiency or inefficiency
Quality issue

Different material or labor mix

Quantity issue

Discount or surcharge

© McGraw Hill 9-53

 Variance Analysis
When should we investigate a variance?
Materiality
How large is it in the great scheme of things?

Significance
Is any variance tolerable?

Direction and consistency

If it is recurring, maybe the standard needs to be revised.

© McGraw Hill 9-54

 Variance Analysis
Criticisms
Variances can be too aggregated
Work best in stable, mass production environment
Focus on cost minimization, not qualitative issues
Greater automation reduces variances
Standards are often relevant for only a short time

© McGraw Hill 9-55