Unit VI

Managerial Accounting Techniques for Planning, Controlling, and Decision

Making
1. Cost-Volume-Profit Relationship
2. Responsibility Accounting
3. Transfer Pricing
4. Master Budgeting (Slides 2)
 Budgets are important tool used by management to communicate financial
objectives for the future, allocate resources and coordinate activities across the
different functional areas within the organization. Budgets can also be an
important tool used by managers to periodically compare actual performance of
revenues, expenses, and profits to the plan. When actual results are significantly
better or worse than those in the budget, management will seek explanations as
to the causes and take corrective action when necessary. My report focuses on
the major steps involved in preparing budgets.
 A budget is a detailed plan for the future that is typically expressed in
quantitative terms. The use of budgets to control a firm’s activities is known as
budgetary control.
 Budgets serve as both a planning tool and control tool in organizations. Planning
involves developing objectives and preparing various budgets to achieve these
objectives. Control involves gathering feedback to assess the extent to which the
objectives developed at the planning stage are being attained. An effective
budgeting system provides for both planning and control. Good planning without
effective control is time wasted.
 Advantages of Budgeting: (Slides 3)
1. Budgets communicate management’s plans throughout the organization,
leading to a better understanding by all employees of the organizations’s
goals and objectives.
2. Budgets force managers to think about and plan for the future. Without a
budget, many managers would spend considerable time dealing with day-
to-day emergencies.
3. The budgeting process provides a means of allocating resources to those
parts of the organization where they can be used most effectively and are
most needed.
4. The budgeting process can uncover potential bottlenecks before they
occur, by identifying the demands that will be placed on key activities and
processes. If necessary, changes can be made to any activity or process
that does not currently have the capability or capacity to meet the
budgeted level of activity on a timely basis.
 5. Budgets coordinate the activities of the entire organization by integrating
the plans of the various areas. Budgeting helps to ensure that everyone in
the organization is pulling in the same direction.
6. Budgets define goals and objectives that can serve as benchmarks for
evaluating subsequent actual performance. Periodic comparison of actual
results to budgeted amounts allows management to determine whether
the organization’s goals are being met and to take corrective action as
necessary.
 Definition of Master Budget (Slides 5)
1. The master budget summarizes a company’s plans, settings specific
targets for sales, production, distribution, administrative, and financing
activities. It represents a comprehensive financial expression of
management’s plans for the future and how these plans are to be
accomplished.
2. It consists of a number of separate but interdependent budgets.
Preparing a master budget for a manufacturing company is somewhat
more complex than for other types of organizations. (Insert photo here
of master budget interdependency)

 Master Budget Preparation Overview (Slides 6)

1. A sales budget is a detailed schedule showing the expected sales for the
budget period; typically, it is expressed in both dollars and units of
product. An accurate sales budget is the key to the entire budgeting
process. All of the other parts of the master budget depend on the sales
budget in some way, as illustrated. So, if the sales budget is inaccurate,
the rest of the budget will be inaccurate. The sales budget helps
determine how many units must be produced by manufacturing
companies. For this reason, the production budget is prepared after the
sales budget for manufacturing companies. The production budget in
turn is used to determine the budgets for manufacturing costs, including
the direct materials purchases budget, the direct labor budget, and the
manufacturing overhead budget. These budgets are then combined with
data from the sales budget and the selling and administrative expense
budget to determine the cash budget. As shown in the illustration, the
selling and administrative expense budget is both dependent on and a
determinant of the sales budget. This reciprocal relationship arises
because sales will in part be determined by the funds committed for
advertising and sales promotion.
2. Once the operating budgets (sales, production, etc.) have been
established, the cash budget and other financial budgets can be
prepared. A cash budget is a detailed plan that shows how cash resources
will be acquired and used over some specified period. Observe from the
illustration, that all of the operating budgets have an impact on the cash
 budget. In the case of the sales budget, the impact comes from the
planned cash receipts to be received from sales. In the case of the other
budgets, the impact comes from the planned cash expenditures within
the budgets themselves.

 Preparing the Master Budget

1. Sales Forecasting – A Critical Step - The sales budget is usually based on
the company’s sales forecast. Sales from prior years are often used as a
starting point in preparing the sales forecast. In addition, the managers
will examine the company’s unfilled orders, the company’s pricing policy
and marketing plans, trends in the industry, and general economic
conditions. Some companies utilize complex statistical tools to analyze
the data and build models that predict the company’s sales in the coming
year.
 Schedules in Preparing Master Budget (Slides 7)
1. Sales budget including a schedule of expected collections
2. Production budget
3. Direct materials purchases budget, including a schedule of
expected cash disbursements for raw materials
4. Direct labor budget
5. Manufacturing overhead budget
6. Ending finished goods inventory budget
7. Selling and Administrative Expense budget
8. Cash budget
9. Budgeted Income Statement
10. Budgeted Balance Sheet

(Slides 8): Let’s do an overview on how to prepare the master budget.

 Sales budget (Slides 9)

o The sales budget is the starting point in preparing the master budget.
As shown earlier as to the illustration of master budget
interrelationship, all other items in the master budget including
production, purchases, inventories, and expenses, depend on it in
some way. The sales budget is constructed by multiplying the
budgeted sales in units by the selling price.
o A schedule of expected cash collections is prepared after the sales
budget. This schedule will be needed to prepare the cash budget.
Cash collections consist of collections on sales made to customers in
prior periods plus the collections on sales made in the current budget
period. For the illustrative sample, the assumption is 60% of sales in
collected in the quarter in which the sale is made and the remaining
40% is collected on the following quarter.
  Production Budget (Slides 10)
o The production budget is prepared after the sales budget. The
production budget lists the number of units that must be produced
during each budget period to meet expected sales and to provide for
the desired ending inventory. Production needs can be determined as
follows:

But for the purpose of our illustrative example, GMG Power Corporation
does not maintain a finished goods inventory since power cannot be stored.
So the budgeted production quantity is equivalent to sales quantity.

 Direct Materials Purchases Budget (Slides 11)

o After the production requirements have been computed, a direct
materials purchases budget can be prepared. The direct materials
purchases budget details the raw materials that must be purchased to
meet the production budget and to provide for adequate inventories. The
required purchases of raw materials are computed as follows:

Slides 12
 The Schedule 3 contains the direct materials purchases budget for GMG
Power Corporation. The only raw material included in that budget is a
coal mineral, which is the major material used to generate power. The
remaining raw materials, such as silica sand and limestone, are relatively
insignificant and are included in variable manufacturing overhead. Notice
that materials requirements are first determined in units (MT kilograms)
and then translated into peso by multiplying by the appropriate unit cost.
Also note that the management of GMG Power Corporation wants to
maintain ending inventories of raw materials equal to 20% of the
following quarter’s production needs.

As with the production budget, the amounts listed under the Year
column are not always the sum of the quarterly amounts. The desired
 ending inventory of raw materials for the year is the same as the desired
ending inventory of raw materials for the fourth quarter. Likewise, the
beginning inventory of raw materials for the year is the same as the
beginning inventory of raw materials for the first quarter. The direct
materials purchases budget is usually accompanied by a schedule of
expected cash disbursements for raw materials. This schedule is needed
to prepare the overall cash budget. Disbursements for raw materials
consist of payments for purchases on account in prior periods plus any
payments for purchases in the current budget period. Schedule 3
contains such a schedule of cash disbursements. Ordinarily, companies
do not immediately pay their suppliers. At GMG, the policy is to pay for
70% of purchase in the quarter in which the purchase is made and 30% in
the following quarter.

 Direct Labor Budget

o The direct labor budget is also developed from the production
budget. By knowing in advance what will be needed in terms of
labor time throughout the budget year, the company can plan to
adjust the labor force as required. Firms that neglect to budget
face the risk of labor shortages or having to hire and lay off
employees at awkward times. Erratic labor policies can lead to
insecurity and inefficiency on the part of employees.

For GMG, the direct labor cost is at fixed amount since the GMG is
machine intensive.

 Manufacturing Overhead Budget

o The manufacturing overhead budget provides a schedule of all
costs of production other than direct materials and direct labor.
Schedule 5 shows the manufacturing overhead budget for GMG
Power Corporation. Note how the production costs are separated
into variable and fixed components. The variable component is
P250 per quantity produced. The fixed component is P400,000 per
quarter. Because the variable component of the manufacturing
overhead depends on quantity produced, the first line in the
manufacturing overhead budget consists of the production
budget quantity from the production budget. The budgeted
production quantity in each quarter are multiplied by the variable
overhead rate to determine the variable component of
manufacturing overhead.

 Ending Finished Goods Inventory Budget

o After Schedules 1 through 5 are completed, all of the data needed
to compute unit product costs will be available. This computation
 is needed for two reasons: first, to determine cost of goods sold
on the budgeted income statement and, second, to identify the
amount to put on the balance sheet inventory account for unsold
units. The carrying cost of the unsold units is computed on the
ending finished goods inventory budget.

But for our illustrative example, ending finished goods inventory

budget is not applicable since GMG Power Corporation does not
maintain finished goods inventory.

 Selling and Administrative Expense Budget

o The selling and administrative expense budget lists the
budgeted expenses for areas other than manufacturing. In
large organizations, this budget is a compilation of many
smaller, individual budgets submitted by department heads
and other people responsible for selling and administrative
expenses. For example, the marketing manager in a large
organization would submit a budget detailing the advertising
expenses for each budget period.

Schedule 6 contains the selling and administrative expense

budget for GMG Power Corporation. The fixed selling and
administrative expenses (all given data) are then added to the
variable selling and administrative expenses to arrive at the
total budgeted selling and administrative expenses. Finally, to
determine the cash disbursements for selling and
administrative expenses, the total budgeted expenses are
adjusted by subtracting any non-cash items included in the
budget and adding any cash expenditures not reflected in the
budgeted amounts. As shown in Schedule 6, two items must
be subtracted: insurance of P20,000 per quarter because
although this is an expense under accrual accounting, it does
not represent an actual outflow of cash each quarter; and
property taxes of P10,000 because this too is an expense
under accrual accounting, but not a cash outflow each
quarter. Two cash disbursements are added: the insurance
premium payment of P80,000 in the first quarter, and the
property tax payment of P40,000 in the fourth quarter. Each
of these additions is necessary to reflect the actual timing of
the cash outflows for insurance premiums and property taxes.

 Cash Budget
o Once the operating budgets (sales, production, etc.) have
been established, the cash budget and other financial budgets
 can be prepared. A cash budget is a detailed plan that shows
how cash resources will be acquired and used over some
specified time period. Observe from Exhibit 9–2 that all of the
operating budgets have an impact on the cash budget. In the
case of the sales budget, the impact comes from the planned
cash receipts to be received from sales. In the case of the
other budgets, the impact comes from the planned cash
expenditures within the budgets themselves.

The cash budget is composed of four major sections:

1. Receipts section.
2. Disbursements section.
3. Cash excess or deficiency section.
4. Financing section (borrowings, loan repayments, and
interest expense)

The receipts section is a list of all of the cash inflows (except

for financing) expected during the budget period. Generally,
the major source of receipts is sales. The disbursements
section consists of all cash payments that are planned for the
budget period. These payments include raw materials
purchases, direct labor payments, manufacturing overhead
costs, and so on, as contained in their respective budgets. In
addition, other cash disbursements, such as equipment
purchases, dividends, and other cash withdrawals by owners,
are included.
The cash excess or deficiency section is computed as follows:

If there is a cash deficiency during any budget period, the

company will need to borrow funds. If there is a cash excess
during any budget period, after ensuring any targeted minimum
cash balance is met, funds borrowed in previous periods may be
repaid or the excess funds (i.e., above the targeted cash balance)
can be invested. The financing section provides a detailed account
of the borrowings and loan repayments projected to take place
during the budget period. It also includes the details of interest
payments that will be due on money borrowed. A well-
coordinated budgeting program eliminates uncertainty as to what
the cash situation will be in two months, six months, or a year
 from now. The cash budget should be broken down into time
periods that are short enough
to capture major fluctuations in cash balances. While a monthly
cash budget is most common, many firms budget cash on a
weekly or even daily basis, particularly start-up companies where
cash needs are particularly high in the early months (or years) of
operation.

As with the production and raw materials budgets, the amounts

under the Year column in the cash budget are not always the sum
of the amounts for the four quarters. In particular, the beginning
cash balance for the year is the same as the beginning cash
balance for the first quarter, and the ending cash balance is the
same as the ending cash balance for the fourth quarter. Also, note
that the beginning cash balance for any quarter is the same as the
ending cash balance for the previous quarter.

 Budgeted Income Statement

o A budgeted income statement can be prepared from the data
developed in Schedules 1 to 6. The budgeted income
statement is one of the key schedules in the budget process. It
shows the company’s planned profit for the upcoming budget
period, and it stands as a benchmark against which actual
company performance can be measured. Schedule 8 contains
the budgeted income statement for GMG Power Corporation.

 Budgeted Balance Sheet

o The budgeted balance sheet is developed using the actual
balance sheet at the end of the most recent fiscal period as
the starting point (e.g., December 31, 2021, for GMG Power
Corporation) and adjusting it for the data contained in the
other budgets. GMG Power Corporation budgeted balance
sheet is presented in Schedule 9. It is important to point out
that not all companies that prepare a master budget will
necessarily prepare a budgeted balance sheet since
responsibility accounting, discussed earlier, largely focuses on
comparing actual results for revenues and costs to budgeted
amounts. As such, a budgeted income statement and a cash
budget are commonly prepared, but practice varies with
respect to budgeted balance sheets. However, external
stakeholders, such as lenders, may require budgeted balance
sheets as part of their assessment of the company’s financial
position for making decisions about credit terms such as
interest rates, loan amounts, and maturity dates.
5. Opportunity Costing/Differential Analysis
 Costs are an important feature of many business decisions. In making decisions, it is
essential to have a clear understanding of the concepts of differential cost, and
opportunity cost.

 Opportunity Costing
Opportunity cost is the potential benefit that is given up when one alternative is
selected over another. To illustrate this important concept, consider the following
examples:

Example 1
Vicki, a university student, has a part-time job that pays her $200 per week. She
would like to spend a week at the beach during the study break, and her employer
has agreed to give her the time off, but without pay. The $200 in lost wages would
be an opportunity cost of taking the week off to be at the beach.

Example 2
Steve is employed with a company that pays him a salary of $40,000 per year. He is
thinking about leaving the company and returning to school. Since returning to
school would require that he give up his $40,000 salary, the forgone salary is an
opportunity cost of getting further education.

Opportunity costs are not usually entered in the accounting records of an

organization, but they must be explicitly considered in every decision a manager
makes. Virtually every alternative has an associated opportunity cost. In Example 2,
for instance, if Steve decides to stay at his job, an opportunity cost is still involved—
the higher income that could be realized in future years as a result of returning to
school.

 Differential Analysis
o Decisions involve choosing among alternatives. In business decisions, each
alternative has certain costs and benefits that must be compared to the costs
and benefits of the other available alternatives. A difference in costs
between any two alternatives is known as a differential cost. A difference in
revenues between any two alternatives is known as differential revenue.

A differential cost is also known as an incremental cost, although technically

an incremental cost should refer only to an increase in cost from one
alternative to another; decreases in cost should be referred to as
decremental costs. Differential cost is a broader term, encompassing both
 cost increases (incremental costs) and cost decreases (decremental costs)
between alternatives.

o Keep or Drop a Product Segment

o Make or Buy
 Many steps may be involved in getting a finished product into the
hands of a consumer. First, raw materials may have to be
obtained through mining, drilling, growing crops, raising animals,
and so forth. Second, these raw materials may have to be
processed to remove impurities and to extract the desirable and
usable materials. Third, the usable materials may have to undergo
some preliminary conversion so as to be usable in final products.
For example, cotton must be made into thread and textiles before
being made into clothing. Fourth, the actual manufacturing of the
finished product must take place. And, finally, the finished
product must be distributed to the ultimate consumer. Each of
these steps is part of the value chain.

A decision to produce internally, rather than to buy externally

from a supplier, is called a make or buy decision . Indeed, any
decision relating to vertical integration is a make or buy decision,
since the company is deciding whether to meet its own needs
internally or to buy externally.

An Example of Make or Buy

To illustrate a make or buy decision, let’s consider OSN Cycles.
The company is now producing the heavy-duty gear shifters used
in its most popular line of mountain bikes. The company’s
Accounting Department reports the following costs of producing
the shifter internally:

An outside supplier has offered to sell OSN Cycles 8,000 shifter per year at a price of
only $19 each. Should the company stop producing the shifters internally and start
purchasing them from the outside supplier? To approach the decision from a
financial point of view, the manager should again focus on the differential costs. As
we have seen, the differential costs can be obtained by eliminating those costs that
are not avoidable—that is, by eliminating (1) the sunk costs and (2) the future costs
that will continue regardless of whether the shifters are produced internally or
purchased outside. The costs that remain after making these eliminations are the
costs that are avoidable to the company by purchasing outside. If these avoidable
costs are less than the outside purchase price, then the company should continue to
manufacture its own shifters and reject the outside supplier’s offer. That is, the
company should purchase outside only if the outside purchase price is less than the
costs that can be avoided internally as a result of stopping production of the shifters.

Looking at the data above, note first that depreciation of special equipment is listed
as one of the costs of producing the shifters internally. Since the equipment has
already been purchased, this depreciation is a sunk cost and is therefore irrelevant.
If the equipment could be sold, its salvage value would be relevant. Or if the
machine could be used to make other products, this could be relevant as well.
However, we will assume that the equipment has no salvage value and that it has no
other use except in making the heavy-duty gear shifters. Also note that the company
is allocating a portion of its general overhead costs to the shifters. Any portion of
this general overhead cost that would actually be eliminated if the gear shifters were
purchased rather than made is relevant in the analysis. However, it is likely that the
general overhead costs allocated to the gear shifters are in fact common to all items
produced in the factory and would continue unchanged even if the shifters were
purchased from outside. Such allocated common costs are not differential costs
(because they do not differ between the make and buy alternatives) and should be
eliminated from the analysis along with the sunk costs. The variable costs of
producing the shifters (materials, labor, and variable overhead) are differential costs,
because they can be avoided by buying the shifters from the outside supplier. If the
supervisor can be laid off and her salary avoided by buying the shifters, then her
salary will be a differential cost and relevant to the decision. Assuming that both the
variable costs and the supervisor’s salary can be avoided by buying from the outside
supplier, the analysis takes the form shown in Exhibit 12–5. Since it costs $5 less per
unit to continue to make the shifters, OSN Cycles should reject the outside supplier’s
offer. However, there is one additional factor that the company may wish to
consider before coming to a final decision. This factor is the opportunity cost of the
space now being used to produce the shifters. If the space now being used to
produce the shifters would otherwise be idle , then OSN Cycles should continue to
produce its own shifters and the supplier’s offer should be rejected, as stated above.
Idle space that has no alternative use has an opportunity cost of zero. But what if the
space now being used to produce shifters could be used for some other purpose? In
that case, the space has an opportunity cost that must be considered in assessing
the desirability of the supplier’s offer. What is this opportunity cost? It is the
segment margin that could be derived from the best alternative use of the space. To
 illustrate, assume that the space now being used to produce shifters could be used
to produce disc brakes that would generate a segment margin of $60,000 per year.
Under these conditions, OSN Cycles would be better off to accept the supplier’s offer
and to use the available space to produce the new product line:

Opportunity costs are not recorded in the accounts of an organization because they do not
represent actual dollar outlays. Rather, they represent economic benefits that are forgone as a
result of pursuing a particular course of action. Because of this opportunity costs are often
erroneously ignored by managers when making decisions. The opportunity costs of OSN Cycles
are sufficiently large in this case to make continued production of the shifters very costly from
an economic point of view.

 Accept or Reject Special Order

o Managers must often evaluate whether a special order
should be accepted, and if the order is accepted, what
price should be charged. A special order is a one-time
order that is not considered part of the company’s normal
ongoing business. The objective in setting a price for
special orders is to achieve positive incremental operating
income.

To illustrate, OSN Cycles has just received a request from the police department of a large
Canadian city to produce 100 specially modified mountain bikes at a price of $560 each. The
bikes would be used to patrol some of the more densely populated residential sections of the
city. OSN Cycles can easily modify its City Cruiser model to fit the specifications of the police
department. The normal selling price of the City Cruiser bike is $700, and its unit product cost is
$564, as shown below:
The variable portion of the above manufacturing overhead is $12 per unit. The order would
have no effect on the company’s total fixed manufacturing overhead costs. The modifications to
the bikes consist of welded brackets to hold radios, nightsticks, and other gear. These
modifications would require $34 in incremental variable costs per unit. In addition, the
company would have to pay a graphic design studio $1,200 to design and cut stencils that
would be used for spray painting the police department’s logo and other identifying marks on
the bikes.

This order should have no effect on the company’s other sales. The production manager says
that he can handle the special order without disrupting any of the regular scheduled
production. What effect would accepting this order have on the company’s operating income?
Only the incremental costs and benefits are relevant. Since the existing fixed manufacturing
overhead costs would not be affected by the order, they are not incremental costs and
therefore are not relevant. The incremental operating income can be computed as follows:

Therefore, even though the price on the special order ($560) is below the normal unit product
cost ($564) and the order would require incurring additional costs, it would result in an increase
in operating income. In general, a special order is profitable as long as the incremental revenue
from the special order exceeds the incremental costs of the order. However, in performing the
analysis it is important to make sure that there is indeed idle capacity and that the special order
does not affect the company’s ability to meet normal demand. For example, what if OSN Cycles
is already operating at 100% of capacity and normally sells all the bikes it can produce for $700
each? What is the opportunity cost of accepting the order? Should the company accept the
$560 price? If not, what is the minimum price it should accept? To answer these questions, the
analysis can be conducted as follows:

Since the total relevant costs of $746 exceed the offer price of $560, OSN Cycles should decline
the offer. Indeed, to be no worse off from a financial perspective, the minimum price that
should be charged on the special order is $746 per bike. At this price, management should be
indifferent between filling the special order and continuing to sell all it can produce to regular
customers.