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Chapter 10

Static and Flexible Budgets

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.

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
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


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.


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.


If individuals who are affected by some aspect of the budget participate in that budgets
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.


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.


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.


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.


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


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 managers 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
organizations prices and costs.

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 years 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 organizations vision and
strategies as shown in Exhibit 10.2.

10-4 Cost Management

10.13 Seer Manufacturing
A. Production Budget
Desired ending inventory
Planned sales
Total units needed
Planned beginning inventory
Production requirements







B. Direct Materials Unit Forecast

Desired ending inventorya
Planned usageb
Total units needed
Planned beginning inventoryc
Materials acquisitions

Current production x 3 units direct materials x 0.5 to reflect 3 direct materials

units per product, and half of this months production for ending inventory
Current production x 3
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
Labor hours neededa
Current production x 10




Chapter 10: Static and Flexible Budgets 10-5

(1) Production budget (units)
Sales units (a)
Plus ending inventory (b)
Total Units needed
Less Beginning inventory
Total units to be produced





(a) Current month's sales

(b) 50% of following month's sales
(2) Direct labor budget (hours)









Units to be produced
Direct labor hours per unit
Total labor budget (hours)


(3) Direct materials budget (dollars)

Units to be produced
Cost per unit
Total direct material cost


(4) Sales budget (dollars)

Sales units
Sales price per unit
Total sales revenue budget


10-6 Cost Management

Bullen & Company
Budgeted Contribution Margin
First Quarter, 20X5







Sales revenue
Direct labor cost
Direct materials cost
Contribution margin $ 200,000

$ 240,000

$ 144,000

$ 584,000

Direct labor hours per unit

Direct labor hourly rate
Direct labor cost per unit
Sales units


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

include the following.

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


Cost of Sales
Fixed overhead
Variable selling
Fixed selling
Total costs

$ 2,118

6,245 (a)
483 (b)
$ 2,727





$ 1,629

Chapter 10: Static and Flexible Budgets 10-7

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 = $17,480
Market = $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:
Less variable costs:
Cost of sales
Variable selling
Contribution Margin


Contribution Margin Ratio



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

10-8 Cost Management

B. Beginning inventories are 30% of that months 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)
+ July cost of goods sold (0.8*1,810,000)
- Beginning inventory (part B)
= Purchases

$ 460,800

D. 40% of receivables are collected in the month sold, and 50% are collected the next
month. For July:
Cash sales
Collections from July credit sales (0.4 * $1,600,000)
Collections from June credit sales (0.5 * $1,500,000)
July cash collections

$ 210,000

10.17 New Ventures

First, determine the purchases budget for the 1st quarter:
Production (units)
Raw materials needed per unit
Production requirement
Ending inventory requirement
(25% of next month's production requirement)

Total needed
Less: Beginning inventory
Raw materials purchases (units)
Raw material unit cost
Raw materials purchases

January February
40,000 100,000


65,000 135,000 175,000
(0) (25,000) (35,000)
65,000 110,000 140,000
x $7
x $7
x $7
$455,000 $770,000 $980,000


Chapter 10: Static and Flexible Budgets 10-9

Next compute cash disbursements for purchases of raw materials:
January purchases (a)
February purchases (b)
March purchases (c)
Total cash payments






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

February: ($455,000 x 0.6) = $273,000
(b) February: ($770,000 x 0.4).9 = $277,200
March: ($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 are
From January (25,000 x 18 x .70)
From February (30,000 x 18 x .25 x .97)
Total February cash receipts


Production requirements are

Sales requirement (units)
Plus: Ending inventory (units)
Total needs
Less: Beginning inventory (units)
Production requirement (units)




Materials Purchases Budget

To support production (units)
Plus: Ending inventory (units)
Total needs
Less: Beginning inventory (units)
Total purchases (units)




Raw materials cost per unit

Total purchases





Cash disbursements in February for raw materials are

From January (57,900 x 0.40)
From February (46,425 x 0.60)
Total raw materials disbursements


10-10 Cost Management

Labor costs in February are
30,500 units x .50 hour per unit
Wage rate
Total cash disbursement, labor

15,250 hours

Overhead costs in February are

Total costs = 2(30,500) + 25,000
Less: Depreciation
Total cash overhead costs
The February cash budget is thus:
Beginning balance, February 1
Plus: February receipts
Less: Disbursements
Raw materials
Total disbursements
Ending balance, February 28


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 managers 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.
Direct Materials
Direct Labor
Variable Overhead
Fixed Overhead
Total Costs








$ 100

Chapter 10: Static and Flexible Budgets 10-11

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
Cash Receipts




Cash sales (a)

Credit card sales (b)
One month later (c)
Two months later (d)
Three months later (e)


$ 5,760

$ 7,200

Units sold






Cash sales: Unit sales x $50 x 40% x (1-10%)

Credit card sales: Unit sales x $50 x 30% x (1-5%)
Collected one month later: Unit sales last month x $50 x 15%
Collected two months later: Unit sales two months ago x $50 x 6%
Collected three months later: Unit sales three months ago x $50 x 4%



10-12 Cost Management

Cash Disbursements

Unit sold

Desired ending inventory (a) 154
Units sold this month
Less beginning inventory (b) (50)
Budgeted purchases
Cash Disbursements:
Paid same month (c)
Paid next month (d)








$ 4,362

$ 5,655




Next months unit sales x 70%

Prior months ending inventory
Zero for Sept; other months: units purchased x $32 x 50% x (1-6%)
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

Cash receipts
Cash disbursements
Net cash flow

$3,870 $ 7,995 $12,330 $16,200 $ 4,400 $ 1,840 $
(1,600) (11,530) (10,295)
( 0)
$2,270 $ (3,535) $ 2,035 $ 8,379 $ 2,480 $ 1,840 $

Cumulative cash flow $2,270

$ (1,265) $


$ 9,149





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.

Chapter 10: Static and Flexible Budgets 10-13

10.21 Patricias 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. Patricias 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 newlyhired staff member.
1. If Ron thinks that Patricias 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 expectedsuch as unanticipated reconciliation
1. Assuming that there were no unusual problems causing the reconciliation to be
significantly more complex than expected, Patricia has probably prioritized selfreliance and worry about her performance as more important than meeting the jobs
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 Patricias responsibilities to her supervisor, her
firm, and her client. Her supervisor and firm are both responsible for Patricias
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

10-14 Cost Management

ethically. Her supervisor is probably evaluated at least in part on Patricias
performance, so her poor performance would also reflect poorly on Rons
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 Patricias 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 overallfor 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 Patricias 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 Instructors web
site for the textbook (available at
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

Chapter 10: Static and Flexible Budgets 10-15

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 years 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)
Medical supplies: ($18,197 / 4,312 visits * 5,101 visits)
Cleaning supplies ($6,894 / 4,312 visits * 5,101 visits)
Transportation ($9,068 / 4,312 visits * 5,101 visits)


10-16 Cost Management

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.
One third years salary ($135,378 / 3)
Two thirds years salary (($135,378 * 105%) / 3) x 2

$ 45,126

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:
Medical supplies
Cleaning supplies
Home visits
Average cost per visit











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:

Chapter 10: Static and Flexible Budgets 10-17

Variable costs per visit:
Medical supplies
Cleaning supplies
Total Variable Costs

$ 71,033

Divided by benchmark number of visits

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


Now the additional number of visits that could have been made is calculated for the
$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 Instructors
web site for the textbook (available at
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

10-18 Cost Management

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

E. The direct labor budget can now be prepared.

10.24 Fighting Kites Part 2

A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at Here is an excerpt
from the spreadsheet showing the additional input area for Part 2:

Chapter 10: Static and Flexible Budgets 10-19


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

10-20 Cost Management

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

10.24 Fighting Kites Part 3

A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at Here is an excerpt
from the spreadsheet showing the additional input area for Part 3:

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

Chapter 10: Static and Flexible Budgets 10-21

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.

10.24 Fighting Kites Part 4

A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at Here is an excerpt
from the spreadsheet showing the additional input area for Part 4:

10-22 Cost Management

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%

Chapter 10: Static and Flexible Budgets 10-23

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 companys
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.

10-24 Cost Management

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 companys 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
companys line of credit agreement requires a minimum balance of $100,000 in the cash
accounting, and this account is non-interest-bearing.

Chapter 10: Static and Flexible Budgets 10-25

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
10.25 Fighting Kites (continued)
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at
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

10-26 Cost Management

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

Chapter 10: Static and Flexible Budgets 10-27

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
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 Instructors
web site for the textbook (available at 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 Woks market share. Economic downturns can also affect volumes. If people

10-28 Cost Management

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 share
Cons: Cost might exceed the benefit
Distribute coupons to attract new customers.
Pros: Increase volume, thus increasing revenues; potential increase in market share
Cons: Cost to distribute and price discounts might exceed benefit
Increase prices.
Pros: Increase price per meal
Cons: Decrease in sales volume might exceed benefit
10.26 Wok and Egg Roll Express Part 2
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at 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.

Chapter 10: Static and Flexible Budgets 10-29

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.
10.26 Wok and Egg Roll Express Part 3
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at 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.

10-30 Cost Management

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.
10.26 Wok and Egg Roll Express Part 4
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at 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
managers 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

Chapter 10: Static and Flexible Budgets 10-31

reducing usage. However, customers might complain and it may take more time to get
people through the line during busy times.
10.26 Wok and Egg Roll Express Part 5
A sample spreadsheet showing the calculations for this problem is available on the Instructors
web site for the textbook (available at
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
10.27 The Red Midget Company
Cash receipts
February sales (14,000 x $0.50 x 100) x 18%
March sales (16,000 x $0.50 x 100) x 80%
Total March receipts


10-32 Cost Management

Cash disbursements
February ($60,000 x 90%)
$ 54,000
March ($75,000 x 10%)
Total cash disbursements for advertising
Administrative salaries
Sales commissions
Direct materials purchases
Labor costs
Overhead costs ($115,000 less depreciation of $80,000)
Total cash disbursements for operations
Cash dividends
Total cash disbursements
The cash budget for March is thus:
Beginning balance at March 1
Plus: March receipts
Less: March disbursements
Ending balance at March 31

$ 25,000

Note: Credit loss expense and depreciation are ignored because they do not directly
affect cash flows.
10.28 National Public Radio
A. An organizations 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 organizations
financial capability. It was critical for NPRs 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

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.

Chapter 10: Static and Flexible Budgets 10-33

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.

10-34 Cost Management


10.29 Focus on Professional Competency: Resource Management
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.
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.
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.

Chapter 10: Static and Flexible Budgets 10-35

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 managers control. Thus, variances calculated using a flexible budget provide
better measures of the managers 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
b. Removing allocated costs: When allocated costs cannot be controlled by the
manager, they provide no information about the managers performance.
Therefore, variances related to these costs also provide no information about the
managers 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 citizens budget guide, refer them to guidance
available for this problem on the web site for the textbook (available at
1. Following are possible reasons why a government might publish a citizens guide to
the budget; students may think of others:

Legal requirement; laws may exist to require the government to publish a

citizens 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

10-36 Cost Management

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
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 Delannas 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 CPAs 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
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

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

Chapter 10: Static and Flexible Budgets 10-37

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

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 stores 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.

10-38 Cost Management

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 CPAs 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.