Hamilton Bakery: Master Budgeting Background Hamilton Bakery is a medium-sized regional bakery that specializes in providing orders to grocery and convenience stores. Because of the popularity of its brand, it has also opened a small caf for walk-in business. In order to maintain its high quality standard, Hamilton produces only three products: breakfast muffins, fresh bread, and chocolate chip cookies. Although business has been good in the past few years, a lucky contact with a large chain has recently allowed it to expand its brand out of the local region. Growth has been high since the new contract went into effect. Tom Spear, the chief executive officer (CEO) and founder, has arranged a meeting with a venture capital firm next week. Hopefully the meeting will result in the sale of some of Hamilton stock and an opportunity to establish a significant line of credit with the venture capital firm. These extra funds, if Tom can secure them, should provide sufficient money to meet Hamilton growth targets for the next few years. The venture capital firms assessment team has asked Tom to provide a quarterly master budget for the coming year, complete with pro forma financial statements, at the meeting. They have expressed special interest in Hamilton earnings per share (EPS), cash flow from operations, and profit margins, indicating that good numbers in these areas will be essential for final approval. In typical managerial style, Tom immediately assigned the task of creating the budget to Elaine Olsen, who has just been hired as Hamilton controller. Since this project is her first assignment, Elaine started by making appointments with each of the divisional managers to gather information for the budget and also to learn more about the company. Creating the Budget: Meetings with Divisional Managers Meeting with the Sales Department Walking down the hallway towards the office of Frank Byron, the sales manager, Elaine read the results for last quarter. Hamilton Bakery sold 45,000 one-dozen packages of muffins for $5.50 each, 65,000 onedozen packages of cookies for $4.75 each, and 85,000 loaves of bread for $5.25 each. When Elaine got to Franks office, he motioned her in to have a seat. Is it time for our meeting already? he asked. Where does the day go? Who knows? It seems like one minute Im having my morning muffin and the next Im saying good-bye to everyone, Elaine said with a sigh. Theres never time to get everything done. And now I get to do the budget. Frank started to laugh. Thanks, she muttered. I knew I could count on your support. 2 Im sorry. I just have to laugh at the amount of time you are going to put into something that isnt really used anyway, except for setting bonuses, of course. Not really used? I dont know how its been around here in the past, but this year, at least, the budget will prove to be a valuable tool. Elaine waved away Franks retort. Anyway, one way or another I have to create one and, as you know, the process always starts with projected sales. Do you have a copy of last quarters results? Yes, right here somewhere, Frank said, shuffling papers around on his desk. Got it! he exclaimed, waving it gently as he pulled it from under a stack of other papers. Now, what do you want to know exactly? Well, Tom thinks that since we have established a strong following both locally and in our new markets, we can raise our prices slightly next year without a sharp drop in sales. He was thinking $6.00 for muffins, $5.25 for cookies, and $5.75 for bread. What do you think? I agree, Frank said eagerly. Ive been pushing that for years. Of course, I think that sales will drop some in the first quarter of next year. They always drop off a bit after the holidays anyway, but with the increase in sales price . . . Id say a 20 percent drop from the fourth quarter results we have here. He looked up questioningly and raised an eyebrow. Elaine frowned. That sounds kind of high. Based on what I saw in the dairy industry, I was thinking the drop would only be about 10 percent. Frank looked a little uncomfortable and shuffled around in his chair. Well, its a little different for a bakery. Our price is a little more elastic than dairy products. Besides, 20 percent is a more conservative estimate and in the past we wanted no surprises. He looked at her and challenged, Are you going to change that? Yeah, but well be using this master budget to create a cash flow budget and pro forma financial statements to show our new investor. We need to look good, not bad. Elaine frowned. She didnt want to start making changes and enemies in her first few months. I guess so. But, lookmy bonus is tied to how well I meet my estimates. If we estimate low results and then go up . . . Seeing the look on her face, he quickly changed direction. Besides, Elaine, we are raising the prices. A 10 percent drop is normal after Christmas, but couple that with the increased prices, and 20 percent is reasonable. Elaine frowned, and then sighed. She didnt quite accept his reasoning, but it would be better to have him on her side until she understood the company politics a bit better. Okay, Frank. Ill take your word for it. Well use 20 percent. After all, youre the expert. Youve got that right! Frank said, trying to hide his relief. He was obviously really counting on that bonus. He looked at a couple of sales reports and market projections on the desk in front of him. After that, I think sales will grow steadily at about 5 percent a quarter with these new prices. Fourth-quarter sales 3 will be high because of the holidayslets say 20 percent, instead of 5 percent, from the third to the fourth quarter. The first quarter of the following year will continue the 5 percent growth as though the holiday jump didnt occur. And Im not messing with those estimates. Thats really my best guess, given what Ive seen in the past. He looked up. Does that give you all you need? Just a few more questions. Have you made any changes to the credit policy? The information I have from last year says that we make about 10 percent of our sales through our caf and that we dont sell to those customers on credit. Frank smiled. Yep. But we do sell on credit to the business customers. If we didnt, theyd definitely go somewhere else. So, we give our business customers a lot of leeway in paying us. It makes it a little hard on us, but it keeps them loyal. Anyway, we collect 30 percent of the credit sales within the current quarter, 45 percent in the following quarter, and 25 percent in the quarter after that. The good news is that we dont have any bad debt. Our customers are mostly large chains with strong sales and even better reputations. Since they are large companies, they take their time paying small companies like us, but we get the money from all of them in the end. Then I have only two more questions. What were total sales during the third and fourth quarters of last year, and are we still collecting any of that money? Frank pulled up a file. Total sales were $802,000 and $1,002,500, respectively, and we are still collecting quite a bit of that money based on our collection breakdown. I think that does it, then. If Ive forgotten something, Ill come back and bug you later. Its more fun to interrupt you several times anyway. And you owe me one now. Meeting with the Production Department Elaine sighed as she headed to her meeting with Bill Holmes, Hamilton head chef. She wasnt sure about that large drop Frank wanted her to use, but as the new member of the staff she wasnt sure what she should do. Of course, she didnt have much time to think about it now anyway. She had met Bill before, so she knew that it was going to be an interesting meeting. As she had suspected, she found Bill in the bakery instead of his office. Bill, she called as she hurried towards him, did you forget our meeting? Me, forget? Bill asked in a surprised voice. I never forget anything! Elaine had to chuckle at the large streak of flour across his face. You said you wanted to see our production facility, and Im ready to show it to you. Elaine shook her head. No, Bill. I didnt say I wanted to see the production facility; I said I wanted to talk to you about the budget for next year. 4 Oh, of course you did. Bills round face had turned a deeper shade of pink. Then why dont we go to my office and talk? Elaine sighed. Thats a great idea, Bill. As they sat down, Elaine asked her first question. Okay, Bill, I need to know how much inventory we keep on hand. Well, we cant keep much in the way of finished goods on hand. My cookies and bread would dry out if we kept them too long. Id say that we normally keep only about two days worth of inventory on hand to avoid shipping issues or problems with the caf. Okay, and you make your estimates based on a 90-day quarter? Bill nodded impatiently. Please, Elaine, dont ask obvious questions. Im sorry. Lets talk about your pantry. You take care of purchasing too, dont you? Yessirree. We decided it would be easier for me to run purchasing than to have a separate manager do it. After all, I do everything else around here. Well, we want it done right. Bill chuckled. Ill have to remember that one. Martha will love it. Okay, lets talk raw materials. Some days we have to produce a lot to meet our orders, so I normally try to keep 15 percent of the next quarters raw materials on hand at all times. Is that what weve got on hand now for the coming year? Of course. Frank and I had already talked about the possibility of raising prices and his estimate of a 20 percent drop in demand, so Im ready to go. Elaine considered telling Bill that she was unsure the 20 percent drop would really materialize, but changed her mind. There would be time to get the extra ingredients ordered if sales only dropped 10 percent, and she didnt want anyone to think she had caved in to peer pressure. Good. Can you give me some estimates of how long it takes to make each package of cookies, bread, and muffins? Are you kidding? We dont really move each item from start to finish. We do them in large batches, so I have no idea how long each final package takes. Seeing Elaines frown, he quickly went on. But, I can tell you that one of my mixers can mix together either 12 dozen cookies, 8 dozen muffins, or 4 loaves of bread in 15 minutes. The bakers then take another half an hour to get the dough ready and bake it. The batch sizes are the same for each product? Yep. I try to keep things as standard as possible. The packaging department is the slowest. They have to double wrap the cookies and muffinsonce to keep them fresh and once in the fancy packages marketing came up withso it takes 15 minutes to package either two one-dozen packages of cookies or two onedozen packages of muffins. The bread is a little faster. In 15 minutes we can package about eight loaves of bread. 5 Do you happen to know what we are paying each group of employees? Bill grabbed a piece of paper. We pay the mixers $7.50 an hour, the bakers $8.00 an hour, and the packers $6.50 an hour. Perfect. Then I just have one more question. Let me guess. You want a breakdown of ingredients for each item we bake. You must be psychic, Bill. No, I just remember being bugged about this by the last controller. He handed Elaine a piece of paper with a table on it. Here they all are. Just make sure you dont let it out of the building! I dont want my secret recipes to get out. Dont worry. Ill be careful. Elaine glanced down at the price sheet. Wow. I wish I could buy my groceries at these prices. Bill chuckled. So do I. You have to remember, though, that we buy in bulk, lots and lots of bulk. That lets us get some great deals from our local vendors. I guess that makes sense. Thanks for taking time to see me. Just make sure you dont leave without taking a cookie or two. Bill held out a plate loaded with perfect, if two-day old, cookies. If we dont eat them, they go into the trash! My pleasure! Meeting with the Accounting Department Elaine hurried back to her own office. She had a staff meeting in 15 minutes. She should be able to get most of the information she still needed from Sarah, since she wrote the checks. Even though Sarah only worked part-time, shed been with the bakery from the beginning and seemed to know just about everything about the accounting system. Anything Sarah didnt know, Bob, their new summer intern, would have found out for her by now. He was very good at digging up information once he was pointed in the right direction. We thought you were going to stand us up, Sarah said as Elaine hurried into the office. Actually, we hoped you were, Bob quipped. We dont want to get stuck doing the budget, so we hoped that you would forget to come. Dont worry, Elaine said with a sigh. Tom wants me to take care of it personally. He seems to think it would be good for me to get to know the company or something. So, have you gathered all the information that I asked for? Of course, Sarah said. Where do you want us to start? Lets start with our accounts payable. Thats me, Bob said. Most of our vendors require that we pay for everything within 30 days of making our purchase. That means that 85 percent of our purchases are paid for within the quarter they are made. 6 And, before you ask, we ordered $210,984 worth of inventory during the last quarter last year, so we still owe 15 percent of that, or $31,648. Thanks, Bob, but I actually knew that last part. After all, its right there in the balance sheet. Oh, yeah, Bob said turning pink. I forgot about that. Sarah laughed. So, you calculated it by hand? Well, yeah. I wanted to be prepared for the meeting today. All right, you two, said Elaine, jumping in before Sarah could pick on the young man any more. Lets move on to our overhead assumptions. Sure, Sarah said. Last year we allocated variable overhead at $1.50 for each direct labor hour. This year, I think that were going to need to increase that to $2.00 to cover increases in security fees, utility rates, and energy prices. We also spend about $160,000 a quarter in fixed overhead. Also, dont forget that we usually use total direct labor hours to calculate a predetermined overhead rate when calculating the unit cost. Unit cost? asked Bob. Oh, wait, he said nodding, I remember. We have to include direct materials, direct labor, and manufacturing overhead to get the cost of producing each unit. Direct materials are calculated from the recipe and direct labor cost from the employee information that Bill gave you. But we need to multiply the number of hours it takes to make each product by the predetermined overhead rate so that we can figure a per-unit applied overhead amount. Sorry to interrupt. No problem. Elaine nodded approvingly at the young intern while finishing up her notes. Just one last question, Sarah. How much of that overhead is from depreciation? Eight percent of the fixed amount. Good. Bob, tell me about our sales costs. Well, we dont really have that much in variable sales costs. We give a one percent commission to our sales staff. Is that based on profit or sales price? Sarah asked. Total sales price. Sorry, I forgot to mention that. The commission is paid both for business sales and sales in the caf. Also, heres the table of fixed selling and administrative expenses. Elaine took the paper. Thanks. Okay, Sarah, tell me about our debt. Well, at the end of last year, we secured a $1,109,969 mortgage at 6 percent interest. Our payment each quarter is $20,000. Since its a mortgage, the calculations are kind of fun. Each payment requires us to pay a bunch of interest and a little bit of principal. To break up the $20,000 into the two parts, we have to multiply the current mortgage value by 6 percent and divide by 4. . . 7 Divide by 4? asked Bob. Well, yeah, 6 percent is the annual rate. Since we make quarterly payments, we divide the annual rate by 4. Oh, Bob said sheepishly. I should have remembered that. Yes, you should have, Elaine said with a smile. She was very pleased with how well Bob was progressing during his summer with the firm. Hiring an intern had been one of her first changes, and it seemed to be working out well. If the company continued to grow, maybe he could be hired full-time once he graduated in a couple of years. Go ahead, Sarah. Right. So, our first payment will be made at the end of the upcoming quarter. Well end up paying $16,650 as interest and $3,350 in principal. This means that the value of the mortgage in the second quarter will be $1,106,619. Thats the original $1,109,969 minus the $3,350, Bob. Thanks, Sarah. I appreciate the help, Bob retorted, rolling his eyes. I appreciate it, too, Elaine said. If I remember right, we have to pay the $20,000 each quarter. Our contract prohibits us from paying any additional principal for the first three years. Sarah nodded. Yep. Kind of a bummer, but that was the only way we could get that 6 percent interest rate. Okay, Elaine said. The last thing is a recap of how we handle income taxes. I think that has pretty much stayed the same? It sure has, Bob responded, rifling through a tax folder. Our corporate tax rate is 30 percent and a portion of our estimated taxes must be paid each quarter to avoid late fees. Our policy is to pay 110 percent of the taxes that we owed last year over the course of the current year. Since we paid $15,000 last year, we will need to pay $16,500 this year. And well pay that equally over the four quarters? Right. At the end of the year, we calculate our actual taxes owed as 30 percent of net income. Any difference between the cash we paid for taxes over the year and actual income tax expense on the income statement is put into income taxes payable if we havent paid enough and into deferred tax assets if we paid too much. Right, Elaine said. I think thats about it. Dont forget the balance sheet from last year, Bob said, handing her a sheet of paper. Thanks. Im starting to lose track of everything. I must be getting old. Oh, I wouldnt say that, Bob quipped, then added with a grin, at least, not as long as youre my boss. Meeting with the CEO So, how goes the battle, Elaine? Tom asked as she came into his office. 8 Oh, its going. Actually, I think were just about there. I just need to check some numbers with you, and Ill be all set. Then its just a matter of actually creating the budget. Thats the fun part, you know. Tom laughed. Right. Thats why youre the accountant and Im not. So, what do you need? First, I just want to confirm a couple of things from some earlier meetings. You told me a couple of weeks ago that the board of directors now wants us to have $40,000 worth of cash on hand at all times and to pay $25,000 in dividends each quarter. Is that still the plan? Yes it is. I think its a little restrictive myself, but sometimes we have to do as were told. Because of the expansion, though, we are going to have to issue another 50,000 shares of common stock to the venture capital firm in the first week of the third quarter. We wont plan on changing our dividend payment schedule this year, but we will probably have to increase the amount we pay in future years. For now, though, the big factor is the capital infusion of $400,000 well get from selling our stock. In the third quarter? Why are they waiting that long? Tom shrugged. Because thats when they will have the money to make the investment. Theyre waiting for another deal to go through. Okay, so increase common stock issued by 50,000 shares and paid-in-capital by $400,000 in the third quarter, got it. My next question is about the expansion to our PPE that you just mentioned. I estimate that we will need to buy $75,000 worth of new equipment in the first quarter, $100,000 in the second, $50,000 in the third, and $35,000 in the fourth. Since many of our long-term assets have already been fully depreciated, this new expansion shouldnt significantly change my depreciation estimates. Does that sound about right to you? Assuming we get this arrangement settled, it sounds perfect. Can you give me a few more details about what else were hoping to get from these new investors? Ill need to include those estimates. Sure. What we are really hoping for, other than the purchase of 50,000 shares of stock of course, is a $1 million revolving line of credit. Basically, if we need additional funding we can pull on the line of credit. The interest rate on the new credit line will be 8 percent and they will require that we pay off any accumulated interest before we repay any principal. Well, I think that gives me everything I need. Just so you know, I am going to use simple interest calculations for the interest estimates. Its not 100 percent accurate, but it is typical for creating a master budget. It also simplifies things considerably and ensures that information flows through the budget easily. Ill also assume that any additional debt from the line of credit is taken out on the first day of the quarter and any payments are made at the end of the quarter. That ensures that the interest estimates should be fairly accurate, even with the simple interest calculation. I think you lost me somewhere in there. 9 Sorry about that. Sometimes I go too fast. To get our interest payments when we repay our line of credit (assuming that we have any to repay and the funds to make a payment), I will multiply the amount Im repaying times the quarterly interest rate times the number of quarters the money has been outstanding. So, if we draw $1,000 on the line of credit in the second quarter and repay it in the third quarter, I will multiply $1,000 by 2 percent and again by 2 percent for the two quarters that I assume its been outstanding. Does that help? Not really, but I think I understand enough that I can explain your assumptions if I have to. Well, let me try again . . . No, dont worry about it, Tom said quickly. As long as I know about what youre doing, and I dont have to do it myself, Im good with just about anything. Elaine grimaced. Thanks. I think Ill estimate my salary up a couple hundred thousand, she said jokingly. Required: Please read the case carefully and create a spreadsheet page for data input as you go. This is where you will find all the numbers necessary to create your budgets as you move through the case. It is important that you think through what numbers you will need and lay those out logically with clear labels. This serves two purposes: first, it will make it easier to create the budgets, and second, when you turn this budget over to management, they may wish to change some of the assumptions and see what results flow through the budget. To this end, you must show all assumptions on the first worksheet. You will need to create the following items: Cash Flows Budget Data Input Sheet Production Budget Projected Balance Sheet Projected Income Statement Sales Budget You may also need to create supporting schedules and tables. Please group these logically on worksheets within your document and label the tabs so that the owners and managers can find whatever budget or schedule they need. Be sure to protect the entire workbook, but to unprotect the cells that contain specific assumptions on your data input sheet. This way the owners and managers can change assumptions and see how the changes flow through the budget. Think about the logical order of budgets. Your data input sheet should be the first worksheet. What should be the second worksheet