This is “Ethical Issues in Creating Operating Budgets”, section 9.5 from the book Accounting for Managers (v. 1.0). For details on it (including licensing), click here.
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Question: Although bottom-up budgeting, in which management elicits input from employees throughout the company, is effective in actively engaging those who have to achieve the budgeted goals, this type of budgeting is not free from problems. Ethical issues often arise in the budgeting process, particularly when employees and managers are evaluated by comparing their actual results to the budget. How might ethical issues arise in the budgeting process?
Answer: To demonstrate how ethical dilemmas might arise, assume you are a manager and you help upper management establish the master budget (this is the planning phase). Furthermore, you are evaluated based on achieving budgeted profit on a quarterly basis (this is the control phase). In fact, you will receive a $10,000 quarterly bonus, in addition to your base salary, if you meet or exceed budgeted profit. There is an inherent conflict between the planning and control phases of this process. You are helping the company plan, but you also want to be sure budgeted profit is as low as possible so you can get the $10,000 bonus.
Establishing a sales and profit budget that is considerably lower than what will likely happen causes problems for the entire organization. Production may be short of materials and labor, causing inefficiencies in the production process. Selling and administrative support may be lacking due to underestimating sales. Customers will not be satisfied if they must wait for the product. The dilemma you face as a manager in this situation is whether to do what is best for you (set a low profit estimate to earn the bonus) or do what is best for the company (estimate accurately so the budget reflects true sales and production needs).
Organizations must recognize this conflict and have processes in place to ensure both the interests of individual employees and the interests of the organization as a whole are served. For example, employees can be rewarded not just for meeting goals but also for providing accurate estimates. Perhaps a long-term stock option incentive system would provide motivation to do what is best for the organization, thereby increasing shareholder value. Whatever incentive system is implemented, organizations must promote honest employee input and beware of fraudulent reporting to achieve financial targets.
Assume you are the manager of the computer division of High Tech Retail, Inc. You are asked to help the company prepare a budgeted income statement for the computer division before the start of each fiscal year. At the completion of each fiscal year, division managers receive a bonus equal to 10 percent of actual net income in excess of budgeted net income.
Describe the ethical conflict facing you as division manager when asked to help create the budgeted income statement for your division.
Solution to Review Problem 9.9
Employees who are evaluated in the control phase by comparing actual results to budgeted information have an incentive to create a budget that is easy to achieve, and perhaps unrealistic. This can create problems for the organization as a whole since inventory purchases are made based on budgeted sales. If each of the division managers submits a sales budget that significantly underestimates sales, the company will likely have a shortage of inventory and lose out on sales as customers go elsewhere to find the product. Although the managers will have an easier time achieving sales and profit goals, the company as a whole will suffer. The ethical dilemma of choosing between doing what is best for the division manager and what is best for the organization can ultimately lead to lower sales and dissatisfied customers.
Questions
Brief Exercises
Budgeting at Jerry’s Ice Cream. Refer to the dialogue for Jerry’s Ice Cream presented at the beginning of the chapter and the follow-up dialogue after Note 9.31 "Review Problem 9.7".
Required:
Budget Sequence. Indicate the order in which the following budget schedules are prepared.
Sales Budget for Service Organization; Ethical Issues. Rami and Associates is an accounting firm that estimates revenues based on billable hours. The company expects to charge 8,000 hours to clients in the first quarter, 9,000 hours in the second quarter, 7,000 hours in the third quarter and 8,500 hours in the fourth quarter. The average hourly billing rate is expected to be $100.
Required:
Exercises: Set A
Sales and Production Budgets. Templeton Corporation produces windows used in residential construction. Unit sales last year, ending December 31, are as follow:
First quarter | 40,000 |
Second quarter | 50,000 |
Third quarter | 52,000 |
Fourth quarter | 48,000 |
Unit sales are expected to increase 10 percent this coming year over the same quarter last year. Average sales price per window will remain at $200.
Assume finished goods inventory is maintained at a level equal to 5 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 2,300 units.
Required:
Direct Materials Purchases and Direct Labor Budgets. Templeton Corporation produces windows used in residential construction. The company expects to produce 44,550 units in the first quarter, 55,110 units in the second quarter, 56,980 units in the third quarter, and 52,460 units in the fourth quarter. (This information is derived from the previous exercise for Templeton Corporation.)
With regards to direct materials, each unit of product requires 12 square feet of glass at a cost of $1.50 per square foot. Management prefers to maintain ending raw materials inventory equal to 10 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 65,000 square feet.
With regards to direct labor, each unit of product requires 2 labor hours at a cost of $15 per hour.
Required:
Manufacturing Overhead Budget. Templeton Corporation produces windows used in residential construction. The company expects to produce 44,550 units in the first quarter, 55,110 units in the second quarter, 56,980 units in the third quarter, and 52,460 units in the fourth quarter. (This information is the same as in the previous exercise for Templeton Corporation.) The following information relates to the manufacturing overhead budget.
Variable Overhead Costs | |
Indirect materials | $2.50 per unit |
Indirect labor | $3.20 per unit |
Other | $1.70 per unit |
Fixed Overhead Costs per Quarter | |
Salaries | $50,000 |
Rent | $60,000 |
Depreciation | $36,370 |
Required:
Prepare a manufacturing overhead budget for Templeton Corporation using a format similar to Figure 9.7 "Manufacturing Overhead Budget for Jerry’s Ice Cream".
Budgets for Cash Collections from Sales and Cash Payments for Purchases. Templeton Corporation produces windows used in residential construction. The dollar amount of the company’s quarterly sales and direct materials purchases are projected to be as follows (this information is derived from the previous exercises for Templeton Corporation):
1st | 2nd | 3rd | 4th | |
Sales | $8,800,000 | $11,000,000 | $11,440,000 | $10,560,000 |
Direct materials purchases | $ 820,908 | $ 995,346 | $ 1,017,504 | $ 947,352 |
Assume all sales are made on credit. The company expects to collect 60 percent of sales in the quarter of sale and 40 percent the quarter following the sale. Accounts receivable at the end of last year totaled $3,000,000, all of which will be collected in the first quarter of the coming year.
Assume all direct materials purchases are on credit. The company expects to pay 70 percent of purchases in the quarter of purchase and 30 percent the following quarter. Accounts payable at the end of last year totaled $325,000, all of which will be paid in the first quarter of this coming year.
Required:
Service Company Budgeted Income Statement and Ethical Issues. Lawn Care, Inc., has two owners who maintain lawns for residential customers. The company had the following net income for the most current year.
The following information was gathered from the owners to help prepare this coming year’s budgeted income statement:
Required:
Exercises: Set B
Sales and Production Budgets. Catalina, Inc., produces tents used for camping. Unit sales last year, ending December 31, follow.
First quarter | 6,000 |
Second quarter | 10,000 |
Third quarter | 12,000 |
Fourth quarter | 8,000 |
Unit sales are expected to increase 30 percent this coming year over the same quarter last year. Average sales price per tent will remain at $300.
Assume finished goods inventory is maintained at a level equal to 10 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 1,900 units.
Required:
Direct Materials Purchases and Direct Labor Budgets. Catalina, Inc., produces tents used for camping. The company expects to produce 8,320 units in the first quarter, 13,260 units in the second quarter, 15,080 units in the third quarter, and 11,260 units in the fourth quarter (this information is derived from the previous exercise for Catalina, Inc.).
With regards to direct materials, each unit of product requires 8 yards of material, at a cost of $4 per yard. Management prefers to maintain ending raw materials inventory equal to 15 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 14,000 yards.
With regards to direct labor, each unit of product requires 3 labor hours at a cost of $16 per hour.
Required:
Manufacturing Overhead Budget. Catalina, Inc., produces tents used for camping. The company expects to produce 8,320 units in the first quarter, 13,260 units in the second quarter, 15,080 units in the third quarter, and 11,260 units in the fourth quarter. (This information is the same as in the previous exercise for Catalina, Inc.) The following information relates to the manufacturing overhead budget.
Variable Overhead Costs | |
Indirect materials | $0.20 per unit |
Indirect labor | $4.20 per unit |
Other | $2.70 per unit |
Fixed Overhead Costs per Quarter | |
Salaries | $100,000 |
Rent | $ 30,000 |
Depreciation | $ 44,908 |
Required:
Prepare a manufacturing overhead budget for Catalina, Inc., using a format similar to Figure 9.7 "Manufacturing Overhead Budget for Jerry’s Ice Cream".
Budgets for Cash Collections from Sales and Cash Payments for Purchases. Catalina, Inc., produces tents used for camping. The dollar amount of the company’s quarterly sales and direct materials purchases are projected to be as follows (this information is derived from the previous exercises for Catalina, Inc.):
1st | 2nd | 3rd | 4th | |
Sales | $2,340,000 | $3,900,000 | $4,680,000 | $3,120,000 |
Direct materials purchases | $ 289,952 | $ 433,056 | $ 464,224 | $ 362,272 |
Assume all sales are made on credit. The company expects to collect 80 percent of sales in the quarter of sale and 20 percent the quarter following the sale. Accounts receivable at the end of last year totaled $400,000, all of which will be collected in the first quarter of the coming year.
Assume all direct materials purchases are on credit. The company expects to pay 90 percent of purchases in the quarter of purchase and 10 percent the following quarter. Accounts payable at the end of last year totaled $30,000, all of which will be paid in the first quarter of this coming year.
Required:
Service Company Budgeted Income Statement. Civil Engineers, LLC, has five engineers who design and maintain wetlands. The company had the following net income for the most current year.
The following information was gathered from management to help prepare this coming year’s budgeted income statement:
Required:
Prepare a quarterly budgeted income statement for Civil Engineers, LLC, and include a column summarizing the year.
Problems
Budgeting for Sales, Production, Direct Materials, Direct Labor, and Manufacturing Overhead; Ethical Issues. Sanders Swimwear, Inc., produces swimsuits. The following information is to be used for the operating budget this coming year.
Average sales price for each swimsuit is estimated to be $50. Unit sales for this coming year ending December 31 are expected to be as follows:
First quarter | 3,000 |
Second quarter | 5,000 |
Third quarter | 20,000 |
Fourth quarter | 6,000 |
Variable manufacturing overhead costs are
Indirect materials | $0.60 per unit |
Indirect labor | $3.50 per unit |
Other | $2.80 per unit |
Fixed manufacturing overhead costs per quarter are
Salaries | $30,000 |
Other | $ 5,000 |
Depreciation | $ 9,330 |
Required:
Budgeting for Sales, Production, Direct Materials, Direct Labor, and Manufacturing Overhead. Hershel’s Chocolate produces chocolate bars and sells them by the case (1 unit = 1 case). Information to be used for the operating budget this coming year follows:
Average sales price for each case is estimated to be $25. Unit sales for this coming year, ending December 31, are expected to be as follows:
First quarter | 80,000 |
Second quarter | 84,000 |
Third quarter | 88,000 |
Fourth quarter | 97,000 |
Variable manufacturing overhead costs are
Indirect materials | $0.20 per unit |
Indirect labor | $0.15 per unit |
Other | $0.10 per unit |
Fixed manufacturing overhead costs per quarter are
Salaries | $80,000 |
Other | $70,000 |
Depreciation | $55,625 |
Required:
Selling and Administrative Budget and Budgeted Income Statement. (The previous problem must be completed before working this problem.) Hershel’s Chocolate produces chocolate bars. Management estimates all selling and administrative costs are fixed. Quarterly selling and administrative cost estimates for the coming year follow.
Salaries | $170,000 |
Rent | $ 65,000 |
Advertising | $120,000 |
Depreciation | $ 75,000 |
Other | $ 36,000 |
Required:
Budgeting for Cash Collections and Cash Payments. Hershel’s Chocolate produces chocolate bars. The treasurer at Hershel’s Chocolate is preparing the cash budget and would like to know when cash collections from sales and cash payments for materials will occur. The dollar amount of the company’s quarterly sales and direct materials purchases are projected to be as follows (this information is the result of working the previous problems for Hershel’s Chocolate):
1st | 2nd | 3rd | 4th | |
Sales | $2,000,000 | $2,100,000 | $2,200,000 | $2,425,000 |
Direct materials purchases | $1,215,000 | $1,276,125 | $1,349,400 | $1,417,575 |
Required:
Services Revenue and Direct Labor Budgets for Service Organization; Ethical Issues. Engineering, Inc., provides structural engineering services for its clients. Billable hours for each month of the first quarter of this coming budget period are expected to be as follows:
January | 2,000 |
February | 2,200 |
March | 3,000 |
The average hourly billing rate is estimated to be $150.
Required:
Merchandising Company Master Budget. Big Apple Sporting Goods is a retail store that sells a variety of sports equipment. The company’s fiscal year ends on December 31. Information to be used for the operating budget this coming year follows.
Sales and Merchandise Purchases Budget Information
Sales for this coming year ending December 31 are expected to be as follows:
First quarter | $600,000 |
Second quarter | $650,000 |
Third quarter | $660,000 |
Fourth quarter | $800,000 |
Selling and Administrative Budget Information
Quarterly selling and administrative cost estimates for the coming year are
Salaries | $150,000 |
Rent | $ 25,000 |
Advertising | $ 40,000 |
Depreciation | $ 18,000 |
Other | $ 12,000 |
Capital Expenditure and Cash Budget Information
Budgeted Balance Sheet Information
Expected account balances at the end of the fourth quarter are
Property, plant, and equipment (net) | $120,000 |
Common stock | $175,000 |
Required:
Prepare a quarterly merchandise purchases budget using the following format. All amounts are in dollars.
One Step Further: Skill-Building Cases
Ethics in Budgeting. SportsMax sells sporting goods equipment at 100 stores throughout North America. Robert Manning is the manager of one SportsMax retail store in Chicago. The company is in the planning phase of establishing its operating budget for this coming year and has asked that all store managers submit their estimates of sales revenue, costs, and resulting profit. During the control phase, each store manager is evaluated by comparing budgeted profit with actual profit. Store managers who exceed budgeted profit are given a bonus equal to 10 percent of actual profit in excess of budgeted profit.
Required:
Group Activity: Creating a Budget. Form groups of two to four students. Each group is to complete the following requirements.
Required:
Comprehensive Cases
Comprehensive Master Budget. Creative Shirts, Inc., produces T-shirts. The company’s fiscal year ends on December 31. Information to be used for the operating budget this coming year follows.
Sales and Production-Related Budget Information
Average sales price for each T-shirt is estimated to be $15. Unit sales for this coming year, ending December 31, are expected to be as follows:
First quarter | 20,000 |
Second quarter | 24,000 |
Third quarter | 28,000 |
Fourth quarter | 18,000 |
Variable manufacturing overhead costs are
Indirect materials | $0.70 per unit |
Indirect labor | $0.90 per unit |
Other | $0.50 per unit |
Fixed manufacturing overhead costs per quarter are
Salaries | $18,000 |
Other | $20,000 |
Depreciation | $11,950 |
Selling and Administrative Budget Information
Quarterly selling and administrative cost estimates for the coming year are
Salaries | $15,000 |
Rent | $ 5,000 |
Advertising | $ 4,000 |
Depreciation | $ 9,000 |
Other | $10,000 |
Capital Expenditures and Cash Budget Information
Budgeted Balance Sheet Information
Expected account balances at the end of the fourth quarter are
Property, plant, and equipment (net) | $100,000 |
Common stock | $250,000 |
Required:
Prepare the quarterly sales and production-related budgets using the figure formats referenced here:
Comprehensive Master Budget with Cash Flow Issues. Air Boats, Inc., produces small inflatable boats. The company’s fiscal year ends on December 31. Information to be used for the operating budget this coming year follows.
Sales and Production-Related Budget Information
Average sales price for each boat is estimated to be $150. Unit sales for this coming year, ending December 31, are expected to be as follows:
First quarter | 100,000 |
Second quarter | 110,000 |
Third quarter | 125,000 |
Fourth quarter | 90,000 |
Variable manufacturing overhead costs are
Indirect materials | $2.10 per unit |
Indirect labor | $1.10 per unit |
Other | $1.70 per unit |
Fixed manufacturing overhead costs per quarter are
Salaries | $250,000 |
Other | $300,000 |
Depreciation | $613,250 |
Selling and Administrative Budget Information
Quarterly selling and administrative cost estimates for the coming year are
Salaries | $3,000,000 |
Rent | $1,000,000 |
Advertising | $ 900,000 |
Depreciation | $1,200,000 |
Other | $1,600,000 |
Capital Expenditures and Cash Budget Information
Budgeted Balance Sheet Information
Expected account balances at the end of the fourth quarter are
Property, plant, and equipment (net) | $32,000,000 |
Common stock | $13,500,000 |
Required:
Prepare the quarterly sales and production-related budgets using the figure formats referenced here:
Ethics in Budgeting. Carol Chadwick is the manager of the toys division at Matteler, Inc. Carol is in the process of establishing the budgeted income statement for this coming year, which will be submitted to the company president for approval. The division’s current year actual results were slightly higher than the 5 percent growth Carol had anticipated. These results are shown as follows.
Division managers receive a 20 percent bonus for actual net income in excess of budgeted net income. Carol believes growth in sales this year will be approximately 12 percent. She is considering submitting a budget showing an increase of 5 percent, which will increase her chances of receiving a significant bonus at the end of this coming year. Assume cost of goods sold are variable costs and will increase in proportion with sales revenue. That is, cost of goods sold will always be 60 percent of sales revenue. Assume selling and administrative expenses are fixed costs.
Required: