• Unit 7: Budgets

    In this unit we explore the components for preparing a master budget and its underlying performance schedules. Business managers create budgets to plan for future operations, create benchmarks to measure progress, and maintain necessary accounting controls. The budget process involves coordination among every department within a company. Once the master budget is complete, the company can measure how well their actual performance compares with their budget.

    Completing this unit should take you approximately 7 hours.

    • Upon successful completion of this unit, you will be able to:

      • apply the time value of money to capital budgeting decisions;
      • evaluate investments using the net present value (NPV), internal rate of return (IRR), and the payback method;
      • explain the effects of cash flows, qualitative factors, and ethical issues on long-term investment decisions;
      • demonstrate the effects of income taxes, working capital, and investment cash outflows on capital budgeting decisions; and
      • explain the components of a master budget and the process for creating a master budget that includes multiple schedules.

    • 7.1: Capital Budgeting and Decision Making

      • Capital Budgeting and Decision Making URL

        Read the Chapter 8 introduction, then click "Next Section" to read Section 8.1. You'll read about the example of Jackson's Quality Copies, a store that makes photocopies for its customers. The store wants to evaluate the purchase of an expensive new copier that costs $50,000, but with the potential to reduce expenses, increase productivity, and increase profits. The company president has to make the decision if the new copier is actually a good or bad addition. Managerial accounting methods can give her several tools to evaluate this investment. You use two methods to evaluate long-term investments, both of which consider the time value of money. The first is called the net present value (NPV) method, and the second is called the internal rate of return method. Before you start to consider the two methods, let's discuss the time value of money (present value) concept first.

    • 7.2: Choosing an Evaluation Approach to Investments

      • Net Present Value URL

        NPV combines the present value of all cash flows associated with an investment, both positive (for example, from sales) and negative (from expenses), into one suitable figure for management decision-making. The term discounted cash flows is also used to describe the NPV method. One critical factor in determining the NPV is the discount rate: what time value (forgone interest rate) is associated with future receipts of money.

      • The Internal Rate of Return URL

        Using the internal rate of return (IRR) to evaluate investments is similar to using the net present value (NPV) in that both methods consider the time value of money. The IRR represents the time-adjusted rate of return for the investment being considered. The IRR decision rule states that if the IRR is greater than or equal to the company's required rate of return (recall that this is often called the hurdle rate), the investment is accepted; otherwise, the investment is rejected. This method ensures that any capital investments the company makes are at least equal to the existing rate of return on capital or exceed it. The hurdle rate will vary from company to company.

      • Other Factors Affecting NPV and IRR Analysis URL

        Julie Jackson's life would be easier if all she had to do was find a number and use it to make a decision. It would be easy to agree to buy a new copier if the NPV and IRR say yes. Unfortunately, life is seldom as easy as following a formula. Other factors affect what Julie should do. In this section, we will consider some of those factors.

      • The Payback Method URL

        You hear people talk about the payback period, as in:

        "I live in Nevada, where there are 280 bright and sunny days each year. Yes, I am going solar! My payback period is seven years on a domestic hot water system powered by the sun."

        The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflows from the investment. The method uses a simple sum of future earnings/savings over an arbitrary time period to evaluate capital improvements. It is a quick way to look at an investment and sort potential investments, but the payback method is somewhat lacking in rigor.

    • 7.3: Additional Considerations of Capital Budgetting

    • 7.4: The Operating Budget

      • Planning and Controlling Operations URL

        Companies, much like people, should plan for expenses both big and small. An operating budget assists with planning for the daily activities of running a company with the goal to increase sales and reduce expenses. What does that look like on paper? Read the Chapter 9 introduction, then click "Next Section" to read section 9.1.

      • The Budgeting Process URL

        Jerry's Ice Cream knows that a good budget is the result of consulting with all levels of the company and having a well-rounded budget committee to prepare the master budget. As a planning document, it is essential that all levels of the company share in the creation of the master budget and are prepared to fully implement it. Budgeting is vital to the planning and controlling phases of the management cycle. For a company that ends its fiscal year on December 31, the budgeting process may start as early as August. Read section 9.2 to learn more.

    • 7.5: The Master Budget

      • The Master Budget URL

        Read section 9.3. The master budget for Jerry's Ice Cream includes separate budget schedules for sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative, the income statement, capital expenditures, cash, and the balance sheet. The sales budget is most important because sales projections drive the other budgets. To get the most out of this unit, you should attempt to recreate your own master budget for Jerry's Ice Cream using Microsoft Excel or other spreadsheet software.

    • 7.6: Budgeting in Nonmanufacturing Organizations

      • Budgeting in Nonmanufacturing Organizations URL

        The examples we have used so far to describe a master budget have been limited to manufacturing companies. Manufacturing companies tend to have comprehensive operating budgets and therefore serve as a good starting point in learning how to develop a master budget. However, all types of organizations use operating budgets. This section describes operating budgets for merchandising, service, and not-for-profit organizations.

    • 7.7: Ethical Issues in Creating Operating Budgets

      • Ethical Issues in Creating Operating Budgets URL

        This section considers the inherent conflict that can exist between the planning and control phases of budgeting. During the planning phase, organizations are most concerned about getting accurate estimates that lead to positive results. The control phase requires evaluating the performance of CEOs, managers, and employees by comparing actual results to the operating budget. CEOs, managers, and employees often must decide between doing what is best for them and what is best for the organization.