(March sales price and unit sales will not change. Continue using a $2.00 per unit applied overhead rate.) — After preparing the budget for second quarter based parameters Case

After preparing the budget for the second quarter based on the parameters in Case 5-38, Kim Klandon was not satisfied with the projected results and began to investigate the following alternatives. Each of the alternatives is independent of all others.

a. Reducing the price of a bag of rocks to $9.70 and spending an additional $1,000 per month on advertising are expected to increase sales volume by 10 percent each month.

(March sales price and unit sales will not change. Continue using a $2.00 per unit applied overhead rate.)

b. Klandon can switch to a new supplier that has promised to provide raw materials at a price of $0.32 per pound. These rocks are a lesser quality than those provided by the current supplier. As a result, it will take 6 pounds of raw materials for each bag of fi nished rocks. Klandon will also need to maintain ending Raw Materials Inventory equal to 15 percent of the following month's production needs.

c. Klandon's current supplier has offered to provide a higher quality rock for $0.50 per pound. If the higher quality rock is used, only 4 pounds will be needed for each bag of fi nished rocks. As a result, Klandon will only need to maintain ending Raw Materials Inventory of 8 percent of the following month's production needs.

d. Klandon would like to reduce the age of accounts receivable to better manage the cash cycle. Instead of charging a fee for accounts that are paid in the second month after sale, she wants to offer a 2 percent cash discount. Since the company cannot afford for total revenue to decrease, Klandon plans to increase the sales price to

$10.20 per bag. Customers who pay with cash at the time of purchase won't see any increase in their costs, but customers who purchase on account and pay later will.

Klandon anticipates the following collection pattern if such a change is made:

Cash sales………………….. 75%

Credit:

Month of sale……………… 10%

Month after sale…………… 10%

Uncollectible………………... 5%

……………………………… 100%

Required

Use your solution to 5-38 to answer the following questions for each of the alternatives:

• What budgets were impacted by the new information in the alternative?

• By how much did income change from the amount in the original budget of 5-38?

• What balance sheet accounts changed from the amounts in the original budget of 5-38? What caused the changes?

• What is your recommendation about pursuing the alternative? Why?

SOLUTION

a. Changes from base case in 5-38: decrease price, increase advertising, increase units sold

Affected budget components	All budgets affected
Net income impact	Income increases by $5,544 ($81,326 – $75,782)
Balance sheet impact	Accounts receivable increases by $5,025 due to higher sales. By the end of the quarter, short-term debt is $2,000 less, though more cash had to be borrowed in April. Increased initial borrowing caused interest expense to be higher. Taxes payable and retained earnings are higher due to increased net income.
Recommendation	A 7% increase in net income is a good result. Before Klandon implements this strategy, though, she needs to conduct sensitivity analysis, reducing the number of units sold to determine the minimum increase in sales required to break even on the price change.
	Sales Budget

	April	May	June	Quarter
Budgeted units sold	22,000	55,000	33,000	110,000
Budgeted sales price	× $ 9.70	× $ 9.70	× $ 9.70	× $ 9.70
Budgeted sales revenue	$213,400	$533,500	$320,100	$1,067,000
	Selling and Administrative Expense Budget

	April	May	June	Quarter
Depreciation	$10,000	$10,000	$10,800	$30,800
Sales personnel compensation	35,670	51,675	41,005	128,350
Advertising	2,000	2,000	2,000	6,000
Management salaries	10,000	10,000	10,000	30,000
Miscellaneous	500	500	500	1,500
Bad debts	10,670	26,675	16,005	53,350
Total budgeted expenses	$68,840	$100,850	$80,310	$250,000
Less non-cash expenses
Depreciation	$10,000	$10,000	$10,800	$30,800
Bad debts	10,670	26,675	16,005	53,350
Total cash costs	$48,170	$64,175	$53,505	$165,850
	Production Budget

		April	May	June	Quarter
	Budgeted unit sales	22,000	55,000	33,000	110,000
+	Budgeted ending inventory	11,000	6,600	5,500	5,500
=	Total units required	33,000	61,600	38,500	115,500
-	Beginning inventory	4,000	11,000	6,600	4,000
=	Budgeted production	29,000	50,600	31,900	111,500

Materials Purchases Budget

		April	May	June	Quarter
	Budgeted production	29,000	50,600	31,900	111,500
×	Standard pounds per unit	5	5	5	5
=	Production needs	145,000	253,000	159,500	557,500
+	Budgeted ending inventory (pounds)	25,300	15,950	12,650	12,650
=	Total pounds required	170,300	268,950	172,150	570,150
-	Beginning inventory	13,000	25,300	15,950	13,000
=	Budgeted purchases (pounds)	157,300	243,650	156,200	557,150
×	Standard price per pound	$0.40	$0.40	$0.40	$0.40
=	Budgeted purchases cost	$62,920	$97,460	$62,480	$222,860

Direct Labor Budget

		April	May	June	Quarter
	Budgeted production	29,000	50,600	31,900	111,500
×	Standard DLH per unit	0.25	0.25	0.25	0.25
=	Total direct labor hours required	7,250	12,650	7,975	27,875
×	Standard wage rate	$10	$10	$10	$10
=	Budgeted direct labor cost	$72,500	$126,500	$79,750	$278,750

Manufacturing Overhead Budget

		April	May	June	Quarter
	Budgeted production	29,000	50,600	31,900	111,500
×	Variable overhead per unit	0.50	0.50	0.50	0.50
=	Total variable overhead	14,500	25,300	15,950	55,750
+	Fixed overhead	50,000	50,000	50,000	150,000
	Total budgeted manufacturing overhead	64,500	75,300	65,950	205,750
	Less: Non-cash items
	Depreciation	8,000	8,000	8,000	24,000
=	Total cash costs	$56,500	$67,300	$57,950	$181,750

Ending Inventory and Cost of Goods Sold Budget

Raw Materials
Beginning balance	$5,200
Purchases of raw materials	222,860
Less: Ending raw materials inventory (12,650 lbs. $0.40)	5,060
Raw materials used	$223,000
Finished Goods
Unit costs:
Direct materials ($0.40/lb. × 5 lbs.)	$2.00
Direct labor ($10/DLH × .25 DLH)	2.50
Overhead	2.00
Total standard unit cost	6.50
× Ending inventory units	5,500
Ending finished goods inventory	$35,750
Cost of Goods Sold
Beginning work in process inventory	$ 0
Direct materials used	223,000
Direct labor	278,750
Manufacturing overhead	205,750
Total manufacturing costs	707,500
Less: Ending work in process inventory	0
Cost of goods manufactured	707,500
Add: Beginning finished goods inventory	26,000
Less: Ending finished goods inventory	35,750
Cost of goods sold	$697,750

Cash Receipts Budget

	April	May	June	Total Cash Receipts	Bad Debts	Accounts Receivable
March A/R	$30,000			$30,000
April sales	149,380	$53,350		202,730	$10,670
May sales		373,450	$133,375	506,825	26,675
June sales			224,070	224,070	16,005	$80,025
Totals	$179,380	$426,800	$357,445	$963,625	$53,350	$80,025

Cash Payments for Materials Budget

	April	May	June	Total Cash Payments	Accounts Payable
A/P from March	$12,000			$ 12,000
April purchases	31,460	31,460		62,920
May purchases		48,730	$48,730	97,460
June purchases			31,240	31,240	$31,240
Total	$43,460	$80,190	$79,970	$203,620	$31,240

Cash Budget

	April	May	June	Quarter
Beginning cash balance	$40,000	$30,750	$30,765	$40,000
Collections from sales	179,380	426,800	357,445	963,625
Total cash available to spend	219,380	457,550	388,210	1,003,625
Less disbursements
Materials purchases	43,460	80,190	79,970	203,620
Direct labor	72,500	126,500	79,750	278,750
Manufacturing overhead	56,500	67,300	57,950	181,750
Selling & administrative expenses	48,170	64,175	53,505	165,850
Income taxes	50,000			50,000
Equipment purchase			48,000	48,000
Dividends	49,000			49,000
Total cash disbursements	319,630	338,165	319,175	976,970
Cash excess (deficiency)	(100,250)	119,385	69,035	26,655
Minimum cash balance	30,000	30,000	30,000	30,000
Cash excess (needed)	(130,250)	89,385	39,035	(3,345)
Financing:
Borrowings	131,000			131,000
Repayments		(86,000)	(38,000)	(124,000)
Interest		(2,620)a	(450)a	(3,070)
Total financing	131,000	(88,620)	(38,450)	3,930
Ending cash balance	$30,750	$30,765	$30,585	$30,585

a$131,000 × 12% × = $2,620, ($131,000 – $86,000) × 12% × = $2,620 = $450

Income Statement for the quarter ended June 30

Sales	$1,067,000
Cost of goods sold	697,750
Gross profit	369,250
Selling and administrative expense	250,000
Operating income	119,250
Interest expense	3,070
Income before taxes	116,180
Income tax expense (30%)	34,854
Net income	$81,326

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Balance Sheet as of 6/30
Cash	$30,585
Accounts receivable	80,025
Finished goods	35,750
Raw materials inventory	5,060
Property, plant & equipment	248,000
Less: Accumulated depreciation	(104,800)
Total Assets	$294,620
Accounts payable	$31,240
Income taxes payable	34,854
Short-term note payable	7,000
Common stock	52,000
Retained earnings	169,526
Total Liabilities and Equities	$294,620
b.	Changes from base case in 5-38: purchase lower quality rocks for $.32 per pound, requires 6 pounds per unit, maintain 15% ending raw materials inventory

Affected budget components	Materials purchases budget, ending inventory & COGS budget, payments for materials budget, cash budget, pro-forma financial statements
Net income impact	Income increases by $4,613 ($80,395 – $75,782), primarily driven by a decrease in COGS. Interest expense increases a slight bit, as does income tax expense.
Balance sheet impact	Total assets don’t change by much. Finished goods inventory decreases because of reduced materials cost, but raw materials inventory increases since more materials needs to be held. $2,000 in additional short-term borrowing is required in April. But with the lower cash disbursements in May and June, the ending note payable balance is $4,000 lower.
Recommendation	This alternative could be a good idea if Klandon can be convinced that the lower quality rocks won’t result in a lower quality finished product. It also requires a higher investment in inventory.

Materials Purchases Budget

		April	May	June	Quarter
	Budgeted production	26,000	46,000	29,000	101,000
×	Standard pounds per unit	6	6	6	6
=	Production needs	156,000	276,000	174,000	606,000
+	Budgeted ending inventory (pounds)	41,400	26,100	20,700	20,700
=	Total pounds required	197,400	302,100	194,700	626,700
-	Beginning inventory	13,000	41,400	26,100	13,000
=	Budgeted purchases (pounds)	184,400	260,700	168,600	613,700
×	Standard price per pound	$0.32	$0.32	$0.32	$0.32
=	Budgeted purchases cost	$59,008	$83,424	$53,952	$196,384

Raw Materials
Beginning balance	$5,200
Purchases of raw materials	196,384
Less: Ending raw materials inventory (20,700 lbs. $0.32)	6,624
Raw materials used	$194,960
Finished Goods
Unit costs:
Direct materials ($0.32/lb. × 6 lbs.)	$1.92
Direct labor ($10/DLH × .25 DLH)	2.50
Overhead	2.00
Total standard unit cost	6.42
× Ending inventory units	5,000
Ending finished goods inventory	$32,100
Cost of Goods Sold
Beginning work in process inventory	$ 0
Direct materials used	194,960
Direct labor	252,500
Manufacturing overhead	200,500
Total manufacturing costs	647,960
Less: Ending work in process inventory	0
Cost of goods manufactured	647,960
Add: Beginning finished goods inventory	26,000
Less: Ending finished goods inventory	32,100
Cost of goods sold	$641,860

Cash Payments for Materials Budget

	April	May	June	Total Cash Payments	Accounts Payable
A/P from March	$12,000			$ 12,000
April purchases	29,504	$29,504		59,008
May purchases		41,712	$41,712	83,424
June purchases			26,976	26,976	$26,976
Total	$41,504	$71,216	$68,688	$181,408	$26,976

Cash Budget

	April	May	June	Quarter
Beginning cash balance	$40,000	$30,996	$30,720	$40,000
Collections from sales	170,000	400,000	335,000	905,000
Total cash available to spend	210,000	430,996	365,720	945,000
Less disbursements
Materials purchases	41,504	71,216	68,688	181,408
Direct labor	65,000	115,000	72,500	252,500
Manufacturing overhead	55,000	65,000	56,500	176,500
Selling & administrative expenses	46,500	61,500	51,500	159,500
Income taxes	50,000			50,000
Equipment purchase			48,000	48,000
Dividends	49,000			49,000
Total cash disbursements	307,004	312,716	297,188	916,908
Cash excess (deficiency)	(97,004)	118,280	68,532	28,092
Minimum cash balance	30,000	30,000	30,000	30,000
Cash excess (needed)	(127,004)	88,280	38,532	(1,908)
Financing:
Borrowings	128,000			128,000
Repayments		(85,000)	(38,000)	(123,000)
Interest		(2,560)a	(430)a	(2,990)
Total financing	128,000	(87,560)	(38,430)	2,010
Ending cash balance	$30,996	$30,720	$30,102	$30,102

a$128,000 × 12% × = $2,560, ($128,000 – $85,000) × 12% × = $2,620 = $430

Income Statement for the quarter ended June 30

Sales	$1,000,000
Cost of goods sold	641,860
Gross profit	358,140
Selling and administrative expense	240,300
Operating income	117,840
Interest expense	2,990
Income before taxes	114,850
Income tax expense (30%)	34,455
Net income	$80,395

Balance Sheet as of 6/30
Cash	$30,102
A/R	75,000
Finished Goods	32,100
Raw Materials Inventory	6,624
Property, Plant & Equipment	248,000
Less: Accumulated Depreciation	(104,800)
Total Assets	$287,026
A/P	$26,976
Income Taxes Payable	34,455
Note Payable	5,000
Common Stock	52,000
Retained Earnings	168,595
Total Liabilities and Equities	$287,026
c.	Changes from base case in 5-38: purchase higher quality rocks for $.50 per pound; requires 4 pounds per unit; maintain 8% ending raw materials inventory

Affected budget components	Materials purchases budget, ending inventory & COGS budget, payments for materials budget, cash budget, pro-forma financial statements
Net income impact	Income increases by $959 ($76,741 – $75,782); COGS and interest expense both decrease by a small amount
Balance sheet impact	Total assets changes by very little, and only by the decrease in raw materials inventory. $2,000 less short-term debt is borrowed in April and in total, as cash disbursements are lower for the quarter.
Recommendation	A $959 dollar difference in expected income may not be enough to risk trying this strategy. While the cost of the rocks is certain, the amount of rocks needed per unit may not be as low as expected. A slight deviation from budgeted results could leave Klandon worse off than if the change had not been made.
c.	Changes from base case in 5-38: purchase higher quality rocks for $.50 per pound; requires 4 pounds per unit; maintain 8% ending raw materials inventory

Affected budget components	Materials purchases budget, ending inventory & COGS budget, payments for materials budget, cash budget, pro-forma financial statements
Net income impact	Income increases by $959 ($76,741 – $75,782); COGS and interest expense both decrease by a small amount
Balance sheet impact	Total assets changes by very little, and only by the decrease in raw materials inventory. $2,000 less short-term debt is borrowed in April and in total, as cash disbursements are lower for the quarter.
Recommendation	A $959 dollar difference in expected income may not be enough to risk trying this strategy. While the cost of the rocks is certain, the amount of rocks needed per unit may not be as low as expected. A slight deviation from budgeted results could leave Klandon worse off than if the change had not been made.

Materials Purchases Budget

		April	May	June	Quarter
	Budgeted production	26,000	46,000	29,000	101,000
×	Standard pounds per unit	4	4	4	4
=	Production needs	104,000	184,000	116,000	404,000
+	Budgeted ending inventory (pounds)	14,720	9,280	7,360	7,360
=	Total pounds required	118,720	193,280	123,360	411,360
-	Beginning inventory	13,000	14,720	9,280	13,000
=	Budgeted purchases (pounds)	105,720	178,560	114,080	398,360
×	Standard price per pound	$0.50	$0.50	$0.50	$0.50
=	Budgeted purchases cost	$52,860	$89,280	$57,040	$199,180

Ending Inventory and Cost of Goods Sold Budget

Raw Materials
Beginning balance	$5,200
Purchases of raw materials	199,180
Less: Ending raw materials inventory (7,360 lbs. $0.50)	3,680
Raw materials used	$200,700
Finished Goods
Unit costs:
Direct materials ($0.40/lb. × 5 lbs.)	$2.00
Direct labor ($10/DLH × .25 DLH)	2.50
Overhead	2.00
Total standard unit cost	6.50
× Ending inventory units	5,000
Ending finished goods inventory	$32,500
Cost of Goods Sold
Beginning work in process inventory	$ 0
Direct materials used	200,700
Direct labor	252,500
Manufacturing overhead	200,500
Total manufacturing costs	653,700
Less: Ending work in process inventory	0
Cost of goods manufactured	653,700
Add: Beginning finished goods inventory	26,000
Less: Ending finished goods inventory	32,500
Cost of goods sold	$647,200

Cash Payments for Materials Budget

	April	May	June	Total Cash Payments	Accounts Payable
A/P from March	$12,000			$ 12,000
April purchases	26,430	26,430		52,860
May purchases		44,640	44,640	89,280
June purchases			28,520	28,520	$28,520
Total	$38,430	$71,070	$73,160	$182,660	$28,520

Cash Budget

	April	May	June	Quarter
Beginning cash balance	$40,000	$30,070	$30,020	$40,000
Collections from sales	170,000	400,000	335,000	905,000
Total cash available to spend	210,000	430,070	365,020	945,000
Less disbursements
Materials purchases	38,430	71,070	73,160	182,660
Direct labor	65,000	115,000	72,500	252,500
Manufacturing overhead	55,000	65,000	56,500	176,500
Selling & administrative expenses	46,500	61,500	51,500	159,500
Income taxes	50,000			50,000
Equipment purchase			48,000	48,000
Dividends	49,000			49,000
Total cash disbursements	303,930	312,570	301,660	918,160
Cash excess (deficiency)	(93,930)	117,500	63,360	26,840
Minimum cash balance	30,000	30,000	30,000	30,000
Cash excess (needed)	(123,930)	87,500	33,360	(3,160)
Financing:
Borrowings	124,000			124,000
Repayments		(85,000)	(32,000)	(117,000)
Interest		(2,480)a	(390)a	(2,870)
Total financing	124,000	(87,480)	(32,390)	4,130
Ending cash balance	$30,070	$30,020	$30,970	$30,970

a$124,000 × 12% × = $2,480, ($124,000 – $85,000) × 12% × = $2,620 = $390

Income Statement for the quarter ended June 30

Sales	$1,000,000
Cost of goods sold	647,200
Gross profit	352,800
Selling and administrative expense	240,300
Operating income	112,500
Interest expense	2,870
Income before taxes	109,630
Income tax expense (30%)	32,889
Net income	$76,741

Balance Sheet as of 6/30
Cash	$30,970
A/R	75,000
Finished Goods	32,500
Raw Materials Inventory	3,680
Property, Plant & Equipment	248,000
Less: Accumulated Depreciation	(104,800)
Total Assets	$285,350
A/P	$28,520
Income Taxes Payable	32,889
Note Payable	7,000
Common Stock	52,000
Retained Earnings	164,941
Total Liabilities and Equities	$285,350
d.	Changes from base case in 5-38: Sales price increased to $10.20; 2% cash discount; cash collection pattern changed

Affected budget components	sales budget, selling and administrative expense budget, cash receipts budget, cash budget, pro-forma financial statements
Net income impact	Income increases by $2,604 ($78,386 – $75,782) due to increase in net sales and decrease in interest expense.
Balance sheet impact	Cash increased by almost $40,000 due to decrease in accounts receivable. By the end of the quarter, no short-term payable is outstanding.
Recommendation	While this strategy has a good result, Klandon has made no prediction about the change in unit sales. Customers may not respond favorably to the change, and if it is easy to switch to another vendor, Klandon may lose sales. She needs to investigate what her competitors are doing and have her sales reps visit with customers before implementing this strategy.

Sales Budget

	April	May	June	Quarter
Budgeted units sold	20,000	50,000	30,000	100,000
Budgeted sales price	× $ 10.20	× $ 10.20	× $ 10.20	× $ 10.20
Budgeted sales revenue	$204,000	$510,000	$306,000	$1,020,000

Selling and Administrative Expense Budget

	April	May	June	Quarter
Depreciation	$10,000	$10,000	$10,800	$30,800
Sales personnel compensation	35,200	50,500	40,300	126,000
Advertising	1,000	1,000	1,000	3,000
Management salaries	10,000	10,000	10,000	30,000
Miscellaneous	500	500	500	1,500
Bad debts	10,200	25,500	15,300	51,000
Total budgeted expenses	$66,900	$97,500	$77,900	$242,300
Less non-cash expenses
Depreciation	$10,000	$10,000	$10,800	$30,800
Bad debts	10,200	25,500	15,300	51,000
Total cash costs	$46,700	$62,000	$51,800	$160,500

Cash Receipts Budget

	April	May	June	Total Cash Receipts	Bad Debts	Accounts Receivable	Sales Discounts
March A/R	$30,000			$30,000
April sales
Cash	149,940			149,940			$3,060a
Credit	20,400	$20,400		40,800	$10,200
May sales
Cash		374,850		374,850			7,650b
Credit		51,000	$51,000	102,000	25,500
June sales
Cash			224,910	224,910			4,590c
Credit			30,600	30,600	15,300	$30,600
Totals	$200,340	$446,250	$306,510	$953,100	$51,000	$30,600	$15,300

a $204,000 × 0.75 × 0.02

b $510,000 × 0.75 × 0.02

c $306,000 × 0.75 × 0.02

Cash Budget

	April	May	June	Quarter
Beginning cash balance	$40,000	$30,640	$64,670	$40,000
Collections from sales	200,340	446,250	306,510	953,100
Total cash available to spend	240,340	476,890	371,180	993,100
Less disbursements
Materials purchases	40,000	72,300	72,700	185,000
Direct labor	65,000	115,000	72,500	252,500
Manufacturing overhead	55,000	65,000	56,500	176,500
Selling & administrative expenses	46,700	62,000	51,800	160,500
Income taxes	50,000			50,000
Equipment purchase			48,000	48,000
Dividends	49,000			49,000
Total cash disbursements	305,700	314,300	301,500	921,500
Cash excess (deficiency)	(65,360)	162,590	69,680	71,600
Minimum cash balance	30,000	30,000	30,000	30,000
Cash excess (needed)	(95,360)	132,590	39,680	41,600
Financing:
Borrowings	96,000			96,000
Repayments		(96,000)		(96,000)
Interest		(1,920)a		(1,920)
Total financing	96,000	(97,920)		(1,920)
Ending cash balance	$30,640	$64,670	$69,680	$69,680

a$96,000 × 12% × = $1,920

Income Statement for the quarter ended June 30

Sales	$1,020,000
Sales discounts	15,300
Net sales	1,004,700
Cost of goods sold	648,500
Gross profit	356,200
Selling and administrative expense	242,300
Operating income	113,900
Interest expense	1,920
Income before taxes	111,980
Income tax expense (30%)	33,594
Net income	$78,386

Balance Sheet as of 6/30
Cash	$69,680
A/R	30,600
Finished Goods	32,500
Raw Materials Inventory	4,600
Property, Plant & Equipment	248,000
Less: Accumulated Depreciation	(104,800)
Total Assets	$280,580
A/P	$28,400
Income Taxes Payable	33,594
Note Payable	0
Common Stock	52,000
Retained Earnings	166,586
Total Liabilities and Equities	$280,580