Question

Problem 7-16B Behavioral impact of budgeting

Melissa Putnam, the director of Kelso Corporation’s Mail-Order Division, is preparing the division’s budget proposal for next year. The company’s president will review the proposal for approval. Ms. Putnam estimates the current year final operating results will be as follows:

	Current Year
Sales revenue	$3,000,000
Cost of goods sold	1,800,000
Gross profit	1,200,000
Selling & admin. expenses	480,000
Net income	$ 720,000

Ms. Putnam believes that the cost of goods sold as well as selling and administrative expenses will continue to be stable in proportion to sales revenue.

Kelso has an incentive policy to reward division managers whose performance exceeds their budget. Division directors receive a 10 percent bonus based on the excess of actual net income over the division’s budget. For the last two years, Ms. Putnam has proposed a 4 percent rate of increase, which proved accurate. However, her honesty and accuracy in forecasting caused her to receive no year-end bonus at all. She is pondering whether she should do something differently this time. If she continues to be honest, she should propose an 8 percent growth rate because of robust market demand. Alternatively, she can propose a 4 percent growth rate as usual and thereby expect to receive some bonus at year-end.

Required

Round all computations to the nearest whole dollar.

Prepare a pro forma income statement, assuming a 4 percent estimated increase.

Prepare a pro forma income statement, assuming an 8 percent increase.

Assume the president eventually approves the division’s proposal with the 4 percent growth rate. If growth actually is 8 percent, how much bonus would Ms. Putnam receive?

Propose a better budgeting procedure for Kelso Corporation.

Answer 1

Proforma income statement assuming 4% and 8% growth rate

			Estimated increase
	Original	% of cost to revenue	4%	8%
Sales	3,000,000		3,120,000	3,240,000
Cost of goods sold	(1,800,000)	-60%	(1,872,000)	(1,944,000)
Gross profit	1,200,000	40%	1,248,000	1,296,000
Selling and admin cost	(480,000)	-16%	(499,200)	(518,400)
Net income	720,000	24%	748,800	777,600

Bonus: (776000-748800)*10%= 2880

Better budgeting procedure:

1. Cost should be breakdown between fixed and variable cost for assessing the profitability better

2. Bonus payout should not be based on incremental net income as the Managers might prepare inaccurate budget to extract more bonus

3. Growth rate should factor the industry growth rate and inflation rate

4. The cost should be broken down in other heads like employee cost, general admin, etc