 Hello and welcome to the session. This is Professor Farhad and this session we look at the budgeting process. It's a topic that's covered in managerial as well as cost accounting. This is a cost accounting course but remember cost accounting and managerial accounting. They cover close to 80% the information overlap but anyhow to find more lectures you could visit my website for additional lectures about the topic or related topic. Now this session it's going to be more than 30 minutes and I hope not too much more than 30 minutes because there's a worktop game I would like to view within that time period but if it takes longer it's the nature of the beast. So the budgetary process I can break this process into multiple steps but I don't like to I would like to show you the whole process this way you can see through how things are processing from the beginning till the end anyhow you could always stop and come back and view the lecture later so that's not a problem. So what is the budgetary process and what is a budget? Are you going to be completing a whole budget? Most probably not unless you work for a small non-profit organization or a small business or you own the business but most probably in your lifetime you're going to be dealing with maybe you're going to be responsible for part of the budget so it's very important that you familiarize yourself. The first thing I need to tell you about the budget the budget will be wrong. What do I mean by it will be wrong? The budget it's not going to be 100% accurate so why do we prepare a budget if we know it's not going to be 100% accurate because we need some directions we need some direction so therefore we prepare a budget. We don't want to fly blind because anything could happen so we just want to kind of have a starting point some direction so we don't fly blind. The budget that we're going to be preparing it's going to be called the master or the static budget. What does it mean master or a static budget? It means it's affixed for a certain number of units but anyway we're going to be dealing with variances later so that's why we start with a static budget and from static budget we'll prepare a flexible budget then we prepare we prepare some variances but for now we're going to be preparing a static budget so you know what type of budget we are preparing okay and we have to remember there are many steps that goes through the budgeting process so that's another thing you need to be aware of and that's why it's going to take a little bit of time little bit of time and usually we prepare a budget for one year now we break the budget into monthly but it's going to be for one year then we total all the months and it will be for one year. Now how do we start the budget? How does it begin? Well before we punch the numbers the company will need to answer certain questions what are those certain questions? There are many questions they will need to answer for example what product are we selling? What product are we selling? Are we making any changes to our current product? Why? Because that's going to change our production cost if we are making any changes our production cost will change. Are we introducing a new product? If we're introducing a new product then also we have a cost for that. Are we changing our marketing strategy? How are we marketing our product? If that's the case our advertising and selling expenses will change our commission will change our commission expense. Is there any changes in the distribution channel? Are we selling directly? Are we selling to retailers? So are we building new warehouses? Are we closing existing warehouses? Other questions will be pricing strategy. What is our goal in our pricing strategy? Are we trying to capture market share therefore have aggressive discount? Are we targeting any specific company? Are we targeting a competitor? What is our pricing strategy? And is there any changes in the production process? Are we changing how we produce our items? Are we replacing any equipment? Are we making our process a little bit more efficient? And many many other questions the reason I'm going through this list of questions is simple. Just to tell you that the numbers that we're going to go over that's not what matters. What matters is the company's culture, is the company's value, it's the company's strategy behind the numbers. Okay so there are many things that goes behind the numbers because you're wondering how did they come up with this number? Just there are many things that goes into that that figure. Okay so let's go ahead and start the process and the first thing we are going to prepare is something called the sales forecast. And what is the sales forecast? Basically trying to predict what are we how much are we going to be selling? Is this an AC process? Not at all. This is the most difficult and important most important and difficult and difficult aspect of budgeting. How can we forecast? Well we can ask our sales people like how much you think will be our sales. We can ask market researchers. We can see our trend. Are we going up every year five percent five percent five percent? Well we're going to go up this year five percent. We could use econometrics model, complicated models such as if we change the material that goes into our product, reduce our cost, increase our marketing, change our distribution channel, what would happen to the end product? What's the projection for our sales? So we could use many factors. The model is called econometrics model. So worst case situation best guess. This is how we predict sales. But sales is very important. So we're going to be starting always with sales. So sales is basically the first schedule that we're going to be working with. And to make this process make sense specifically we're going to be selling pants, cutting pants, to be more specific. And this is sample of our product. So what happened is this. The first thing we do is as I said we start with the sales schedule. So what do we do in the sales schedule? Sales schedule just kind of repeat myself. It's going to drive everything in the budget. So this is the key driver for the whole budget. So it's going to have everything in the budget. So if this is wrong, so if the sales schedule is wrong, everything else in the budget that's going to follow, it's going to be wrong because it's going to be based on that. Now what do we do? Well we need to determine how many units are we going to selling and obviously for what period. Okay. And basically also what we need to know is the units and what is the price? What is the selling price? I'm going to call this SP. What's the selling price? So here we have to predict two things. How many units and this is most important, what's the selling price and also for what period. Okay. Once again, how do we book this? How do we book this? It's based on the prior year forecast increasing by 10%. We could use many other factors. Now it's as simple as that. We're going to take units times selling price. It's going to give us total sales and it's simplest form. For our purposes, we're going to be working with a company called San Diego Pants. So what's their budgeting? They're going to be budgeting 160,000 units. So they're going to be selling 160,000 pants at a price at $45. Total sales of $7.2 million. After the selling schedule, once we determine how many units we are going to sell, which happens to be 160,000 units, the next thing we are going to determine is our production schedule. What is our production schedule? What is our production schedule? Okay. Basically, once we know how many units, you tell me how many units we need to sell, then I will tell you how much, tell me how many units you need to sell. I will tell you how many how many units I need to produce. So we're going to sell, we said in the planning process for this, for the sake of this example, we said we are going to sell 160,000, we are going to sell 160,000 unit. Then let me use, let me use the, I'm not going to use figures, I'm just going to use formula. So we're going to take the sales plus we're going to add to the sales, whatever the sales is, we're going to add desired ending inventory. Now, what is the desired ending inventory? It's, let's assume this, we are predicting the month of January. So okay, so we are producing for January. We also, we want to make sure we have some units and ending inventory for the month of February. Why? Because when we start February, we need to have some units ready when the, when the production, when the production start, when the production start. So sales plus the desired ending unit, it's going to give us what we need to produce but we're not done yet. Then remember, since we have, since we are predicting for the next month, from the previous month, we're going to have some units available, we're going to deduct any beginning inventory from the prior unit. And this is what we need for our production requirement. Okay, so need to produce here. I'm assuming that we did not have any ending inventory but we have, if we have any ending inventory, we have to subtract. So let's assume just use simple example, use simple numbers. We need, our, our, our estimated sales is 100 unit. We need to have 10% for the 10, 10 units for the following month. So this is 110. Let's assume from the prior month, we had five units. It means, it means we need to produce 105 unit. And this is my production requirement. I need to produce 105 units. So notice, this number here, 105 unit started with the estimated sales of this number is wrong, then everything else is wrong. Okay, and let's use this information for, for our production budget here. We are starting with 160,000 units, sales, budgeted sales. And let's assume for our purposes, we have, we have 5,000 unit and beginning inventory and 15,000 and ending inventory. So what does that mean? It means we started with 160,000 plus we need 15,000 for the next month. But we are starting the month with 5,000 unit. Therefore, we need to produce production, required production. We need to produce for this example, 170,000 unit. Another way to look at it is something like this. Basically expected sales is 160 plus the ending desired ending inventory, which is total needs of 175 minus what we have in beginning inventory, gives us what we need to produce 170,000 unit. Once again, I don't need to repeat this. If this is wrong, then how much we need to produce is wrong as well. Okay. The next thing we're going to look at is the production cost. What is the production cost? Basically we need labor, material and overhead to produce the product. So basically what we need is some material, labor and overhead to mix them all together. And remember overhead will include indirect labor and direct material. And others, we mix them all together to produce the product. Now, what we're going to be doing is we're going to be also preparing a schedule for each one of them, starting with the direct labor cost or direct for, no, we're going to start with direct material. Okay. How much material do I need? Well, what's my production need? Based on my production need, I will figure out my material. Okay. So how do I do this? Basically, I need to know how many units I am producing. Okay. For example, I'm producing for the purpose of my example 100 and what's my units and what's the production needed. For this purpose, 170 units need to be produced. But whatever unit I need to produce, I need to budget for it. Okay. So if I'm producing 170,000 unit and I need two pounds per unit, whatever I'm doing, then I need to budget with that. That's 340,000 pounds of material to produce this. But also there's a formula for the direct material schedule. What I'm going to be starting with, let's assume I need one unit to produce one unit. I need, just for the sake of illustration, I need 10 pounds. Okay. So one unit times 10 pounds, that means I need, you know, basically let's do it this way. So I need to produce 10, one unit and each unit is for each unit, I need 10 pounds. Each unit I need 10 pounds. Well, so let's assume I need only one unit. So that's going to be, I need 10 pounds. Then I am going to add any desired ending inventory. Again, I need the material for this period and I need some material to be ready on hand for the next period. Then let's assume I need four pounds of material for the next period. That's equal to 14. Then guess what? Then when I start the period, I may start with some material from the prior period. Let's assume that I started with two pounds. It means I need 12 pounds of material. Now, now I need 12 pounds of material. This is what I need to purchase. And what I did, I just, this is, I just started my purchasing schedule. Let's assume the pound is $2. Well, I need to budget purchase of $24. Okay. So this is how it basically worked. What I need, what I need, okay, I said I need one unit. Then I add to a desired ending inventory. Then subtract from the beginning ending inventory. Basically the same concept as we did earlier. And basically, most inventory, they follow the same concept. For the purpose of our example, which is the, here's what we need. To produce, to produce those cotton pens that we talked about, we need three yard, we have two types of material. We have cotton, regular cotton and fine cotton. We need three yard of regular cotton. And the cost per yard is $3. The fine cotton is a little bit more higher price, $5, but we only need 0.2 yards. We have a beginning inventory. We have 10,000 yards. And we would like to have an ending inventory, 15,000 yards for the regular cotton. The same thing for fine cotton. We need, we have an beginning inventory, 1,000. And we need to have an ending inventory, 1,000. Now let's go ahead and figure out how many, how much material do we need? How much material? How many yards do we need? Well, let's look at the cotton. The cotton, remember, we need to produce 170,000 unit times three. Three. What is three? Three is the three yard per unit. Three yard per unit. Then we add to it, okay, because this is how much we add to it, the beginning inventory. Then we have beginning inventory of 15,000, then we subtract ending inventory. Simply put, we need 500,000 yards of the regular cotton. For the fine cotton, we need to produce 170,000 unit. The product, the each unit would consume 0.2 yard of a cotton of the fine cotton. We started with 1,000 unit with 1,000 yard. We need to end up with 1,000 yard. Basically those two cancel each other out. So we need to have 34,000 yards of fine cotton for our production based on our production schedule. Remember, I'm going to keep repeating this. If sales is wrong, then all these figures are wrong as well. Now let's take a look at this schedule. Basically, what is the schedule? Basically, the schedule's given us how much do we need to buy, how much do we need to buy. Let's take a look first at the regular cotton. Again, we need to produce 170,000 unit. Total production need 170,000 unit times three is 510,000. Add the desired ending inventory. Subtract the ending inventory. We need to purchase 515,000 yards of regular cotton. Multiply this by $3. We need $1,545,000 for the cotton, the regular cotton. For the fine cotton, we'll do the same thing. 170,000 unit times 0.2. We need 34,000 yards. Add beginning inventory. Subtract ending inventory. We need to purchase 34,000. $5 per yard, $170,000. Add those two together. We need to come up with on our direct material budget, 1,715,000. 1,715,000. Okay. So this is the direct material production. The fourth schedule, which is direct labor. Now I need labor. How does labor work? Basically, for every unit, let's assume for every unit, I need five hours. Okay. Well, simply put, if I'm producing 10,000 unit, that's easy, times five hours. I need 50,000 hours. I'm paying my employees $20 per hour. One, two, three, four, five and 10. So it's a one, two, three, four, five. It's going to be six zeros. So I need six zeros here. If my edition is right, one, two, three, four, five, plus 10, six. Yes. I need a million dollar in my labor budget. I just figured out my labor budget. I need a million dollar. And that's important because you want to know how much you need to produce it. This way you know how many employees to hire. This way you know how much the budget. Once again, it's all driven. It's all driven by sales. It's all driven by sales. So this number of units, how many am I selling or am I producing? How much am I selling? We'll drive my production. Well, production will drive my material and my labor budget. So it all goes back to sales. And I keep repeating myself, but that's fine. For our purposes, units to produce is 170,000 units. And we need half an hour for each unit. So we need 85,000 total labor hours needed to produce what we need to produce. We are paying our employees $22 per hour. So that's 1,870,000. And this is our direct labor cost. Now, what we need to do also, we have to keep in mind that we also have a schedule for the overhead and the overhead. It's going to be by function, for example, insurance supply, so on and so forth. And we do this. And by the way, when we prepare those schedule, we prepare those schedule on a monthly basis. And why do you say on a monthly basis? So we can compare what's happening from month to month. Okay, what happened to the budget, what happened to the actual, which is something we're going to be dealing with later in this, not in the session, but in the next session. So let's take a look at our overhead schedule, just to see what the overhead looks like. So we need variable overhead needed to produce 170,000 unit and direct material and supplies 30 cent per unit. So we need 51,000 material handling. This is the, this is the variable overhead. We need 40 cent per unit. Again, what we're doing is multiplying those by 170,000, which is from our production budget, 170,000. Remember the production budget is based on the sales budget. Other indirect labor is 10 pennies, 10 pennies, which is 17,000. So the total variable overhead is 160,000, 36,000. Fixed manufacturing overhead, we have supervisory labor, 100, 100 and 2000, repair and maintenance, plant administration, utilities, depreciation, insurance, property taxes, so on and so forth. The total of 544,000. So the total manufacturing overhead variable plus fixed equal to $680,000. Now also what we can do, we could compute, now of course if we have any selling general and administrative, we'll have a schedule for that. And most of the time selling general and administrative, most of the time they're fixed in nature. Once again, because they're fixed in nature, whether they're fixed or not, we prepare them month-to-month comparison. Now we could also prepare cost of goods sold schedule. What is cost of goods sold schedule? Basically, we need to prepare eventually an income statement, eventually in the balance sheet. So it's very important to know what is our cost of goods sold. What is our cost of goods sold? It's direct material, sorry, it's direct material, direct labor plus manufacturing overhead. Those are the three. So for the material, we started with the material right here. We started with $35,000. We purchased $1,715,000. Material available for manufacturing $1,750,000. Ending inventory, we have $50,000 remaining. It means total material cost is $1.7 million. So this is our direct material used in the production. Direct labor $1,870,000. And top manufacturing overhead $680,000. Labor material and overhead. Total manufacturing cost $4,250,000. Now if we have anything in ending work and process, we will subtract anything in ending work and process because it's going to stay with us, ending work and process. We happen to have, we happen not to have anything. Then we add any beginning inventory. We do this, the beginning inventory, it's going to be with us this period. Then we subtract any ending finished goods inventory. Okay, finished goods inventory, $375,000. Cost of goods sold is $3,995,000. Why is this number important? This number important because we're going to be preparing an income statement. Basically an income statement to be more specific, a budgeted income statement. A budgeted income statement means it's an income statement that's based on our budgeted numbers. So let's take a look at our budgeted. Actually, we're going to look at marketing and administrative cost, SG&A. So we're going to have some variable component, some fixed component. So let's take a look at it. Here we go. We have sales commission. This is based on total sales. This is assuming 160,000 unit, which is this is what we estimated in sales, multiplied by 150. Our sales commission will be 240,000. Other marketing cost, which is variable 120. Then we have our fixed marketing cost, sales salaries, which are fixed, advertising, which is fixed, and other fixed costs. So total fixed marketing cost 350, variable 350 and 360. Total marketing cost is 710. Now we have SG&A. As I told you, most of it is fixed, such as administrative, legal and accounting, data processing, outside professional services, like consulting services, maybe auditing, so on and so forth. Interest, taxes, total administrative cost, total budget marketing and administrative, 1,506,000. Again, where is this number coming from? Most probably it's coming from prior period. Once we have the schedule, once we have cost of goods sold, once we have the sales scheduled, we are ready to prepare our income, our budgeted income statement. Again, budgeted income statement looks like a regular income statement, except that you are dealing with budgeted figures, starting with sales. So sales is 160,000. Now we're going to sell each pant for $45, quite an expensive pants. Our total sales is 7.8 million, based on a budget of 160. Now remember this budget. This is called this is part of the master budget. Why this is important? This is a static budget. Static means it's based on this figure 160. Eventually we are going to do some comparison later on called variances. So remember that we work with this budget. Cost of goods sold, we computed it to be 3,995,000. Marketing and administrative, total budgeted cost 5,500,000. Budgeted operating profit almost 1.7 million. Federal and other taxes, we're going to have to pay 550,000. And the budgeted profit is 1,149,000. That's all good and dandy, but this is an income statement. And remember an income statement is based on what? An income statement is based on the cruel accounting. A cruel accounting is different than cash. What matters for the controller of the company, for the people that were there is actual cash. What's actual cash? It means how much cash did I bring in? How much cash did I bring out? How much cash do I need? So on and so on and so forth. Let's take a look at our cash. So the first thing we need to know is that our cash, where is cash coming from? The cash budget is a statement of cash on hand at the start of the budget period. Expected cash receipts, expected cash disbursement, and the resulting balance at the end of the period. So how does cash work? Well, we're going to have a beginning balance and we're going to have some receipts. We're going to have some disbursement. And we're going to net them out and we're going to figure out what's the balance. And if we have any desired balance, we might have to borrow some money. It's as simple as that. So let's assume we started with $100 just to use simple figures here. We started with $100 and we expect to receive $230 and we expect to disburse $220. So this is going to be $110. But we would like to have $150. It means we are short $40. So we need to make sure we can borrow $40 from somewhere because next period we need to start with $150, which is our desired balance. But we need to know what our cash receipts. Cash receipts comes from usually collection of receivable, cash sales. If we sold any asset during the period, if we borrowed or if we issue stocks, basically, you know, issuing stocks or issuing bonds, or some other factor, who knows from where, but those are the main factors. We also need to know what is our cash disbursement? Well, what do you think the cash disbursement would involve in a manufacturing environment? Well, material purchases, manufacturing cost, operating activities to pay our employees, pay that if we happen to be buying a new asset, pay our shareholders dividend, pay our taxes, and any other payment we need to come up with. So this is what the cash budget, the cash budget would look like. Just kind of just to show you an example of it. Let's assume the beginning cash is $830,000. We have collection on account, $6,840, collection on employee loans. I guess the employees, we lend them some money. They're going to be paying us back. So the total cash receipts, $6,940,000. Then we, this is our disbursement. Okay, total disbursement. So what we do is beginning plus what we're going to be receiving minus what we're going to be paying. It's going to be our budgeted ending cash, $371,000. If this number is good for us, if this number is, yes, acceptable, then we don't have to do anything. Let's assume we need half a million for the next period, then we need to borrow the difference. Okay? Or if we need to pay back some loans, because we are above the desired balance, then we'll subtract it. Now, the question is, how do we know how much are we going to be collecting on account? How much are we going to be paying on accounts payable? Well, that depends on our pattern. What is our pattern? Depending on our pattern. How often, when we make a sale, when do we expect to receive our payment? When we purchase something, when do we expect to receive our payment? So basically, let's take a look at this example, just to show you how this works. So you know how to work with account receivable and account payable patterns. For example, this company here, Santiago, cash collected from the current month sales is 20%. Whatever we sell in that month, we collect immediately 20%. Cash collected from last month's sales, so from the previous month, we collect 75% of it. Cash discount taken, we're going to be basically, some people buy and they pay within the discount period, they're going to get 2% off. And we're going to write off 3% as bad debt, people that don't pay us, which is basically we lose 5% between bad debt and cash discount. So let's see how this works. January sales is 500,000, February sales is 450, March sales is 600,000. So let's go ahead and start with this. For January, we're going to be collecting 20% collected in January, 75% collected in February, and 5% basically not collected. So for January, we made a sales of half a million. We're going to take half a million, multiply it by 20%, they're going to pay us that month. So we're going to get $100,000, 20% of half a million. From the prior period, the prior period, which is December of the prior year, December of the prior year, we had $540,000 of receivable, basically we received it. Therefore, the cash for January is 640,000. For February, February sales is 450,000, we're going to get 20% of it right there. Then also we're going to be receiving in February, how much of January we're going to be receiving, 75% of January. January sales is half a million, 75% of it is 375, which is we received 375. Then March, we're going to be receiving, March we had 600,000 in sales, $600,000 in sales, we're going to be receiving 20% immediately, which is 120,000. Then February, in February, we had $450,000 in sales, and we're going to be receiving 75% of that, which is $337,500. Together, we'll give us $457,500. So this is going to be the total for the quarter, March, April, May, and whatever we collected from the previous month, $1,562,000. Also for the cash disbursement payment, the company will have basically some sort of a pattern. For example, when we pay for our expenditure, cash disbursement for the current month, 50%, whatever we pay, whatever we buy, we pay 50% in that month, and cash disbursement for prior month, we pay 48% from the prior month, and we pay some of it was paid earlier, so we'll get always 2% off. So let's take a look at an example to see how it works. Expected purchases for three months, we expect to purchase 120, 200, and 250. Those are what we expect to purchase. Once again, for January, we pay immediately, we're going to be buying 120. We pay immediately $60,000 of it in that month. $60,000 of it is paid within that month immediately. Then from the prior period, we had $256,000 of accounts payable, we're going to pay it off, that's fine. Then $57,600, that's for February. What was February purchases? February purchases were, now sorry, let's look at February purchases, $200,000, we're going to pay 50% immediately. Then we're going to pay for 48% of the prior month, which is 120 times 48%, which is $57,600. What we're doing in this example also, we are assuming that we have an additional cash payment of 250, 250 of 250. This could be paying down alone, making payment on a piece of equipment, whatever the reason is. If there is a cash disbursement, we'll have to include it in there, and March, we'll do the same thing. Half of March and 48% of February is paid. Then we add all the cash disbursement out, which happens to be $1,444,600. Now also, we could prepare, not we could, we should prepare a budgeted balance sheet, and basically what is a budgeted balance sheet? We'll take our beginning balances in the balance sheet. If there's any addition to each one of those, like for example, if we're receiving that much cash, deducting that much cash, we'll get to the ending balance for cash, and we'll do the same thing for the others. For example, receivable, that's our beginning balance, that's where we're going to add that much receivable. We're going to be receiving that much receivable, and that's the ending balance. So basically we find the ending balance of each account, also for the liabilities, also for stockholders. If you have any questions, any comments, by all means email me or see me in class. If you're studying for your CPA exam, no one how to create a budget is important, but also what's going to be imported next is how we prepare variances. So stay tuned to prepare variances, the front type of variances.