IMA The Association of EDUCATIONAL Case Accountants and Case Journal Study ima Financial Professionals in Business ISSN 1940-204X Duralock: Budgeting for Decision-Making Harskini P. Siriwardane, CMA, PAD* Karen De Meyst, PAD Farmer School of Business Farmer School of Business Miami University, Ohio Miami University, Ohio BACKGROUND Lockitt, Inc., a small manufacturing company, produces a specialized sealant lock for hazardous chemical containers. It was founded by an innovative entrepreneur, Brett Lockden. Prior to starting Lockitt, Inc., Lockden had a long career in the petroleum industry. He had firsthand knowledge and experience working with hazardous chemicals and understood the need for safe handling, storage, and transportation of these materials. After retiring from his position with one of the largest petroleum processing companies in the country, Lockden spent a few years experimenting to create a spill- and leak-proof lock that is safe, efficient, and cost effective and fits commercial chemical containers. In 2015, his efforts paid off when he was granted a patent for his invention, Duralock. Duralock is a specialized, single-use sealant lock for commercial chemical containers that prevents liquid chemicals from spilling and fumes from escaping. After receiving the patent, Lockden started his company, Lockitt, Inc. Ted Contador, a trusted former colleague, joined Lockden as his business partner. Being a former chemical industry insider, Lockden had enough connections to spread word-of-mouth about his product. Additionally, his patented product met an unfilled demand that existed across many chemical industries, including petroleum processing, chemical manufacturing, and metal production and fabrication. Therefore, from its inception, Lockitt, Inc., was on a steady growth trajectory. As do most small, privately held manufacturing companies, Lockitt, Inc., focused on its core operations and outsourced some of its other value-chain functions like human resources, IT, and sales and marketing. Lockden managed the manufacturing aspects of the business as well as the continuous improvement efforts. Contador handled the financial aspects and customer service. They jointly handled strategic planning and governance. PLANNING FOR 2020 Today is November 1, 2019. A month ago, soon after he started working on the 2020 operating budgets, Contador had a medical emergency and has since been on long-term disability leave. He is expected to return to work in February 2020. Before Contador fell ill, he had prepared the sales forecast for the first six months of 2020. During the past summer, Contador attended an Excel for Business workshop. IMA EDUCATIONAL CASE JOURNAL VOL. 14, NO. 1, ART. 3, MARCH 2021 #2021 IMABased on what he learned, Contador intended to create a dynamic operating budget, which can be used for sensitivity analysis and decision-making purposes. He had just started the Excel template for the operating budget when he fell ill. CURRENT SITUATION You have been working as a business co-op student at Lockitt, Inc. since September, and you have done projects for both Lockden and Contador. Today, Lockden called you to his office and asked about your understanding of operating budgets and Excel. Based on your answers, he was convinced that you are competent to create an operating budget for the first quarter of 2020. Lockden gave you the Excel template that Contador created and the following information: Expected sales in units for December 2019 and the first six months of 2020 are as follows: December January February March April May June 15,200 15,800 16,500 16,600 17,800 17,700 17,800 The company expects to sell each Duralock for US$88.' Duralock requires two types of direct materials-LD-paste and Chem-glue. Two pounds of LD- paste and 350 ml of Chem-glue are required to produce one Duralock. At the end of each month, ending inventory of Duralock must be equal to 10% of the following month's budgeted sales, or 1,600 (whichever is greater). Lockden is strict on this safety-stock policy; if any of his regular customers has an unexpected need for Duralock, Lockden wants to fulfill that need. The inventory policy for raw materials is to maintain the monthly ending inventory at 5% of the production needs for the next month. Chem-glue tends to dry up over time. Therefore, the monthly ending inventory of Chem-glue should not exceed 300 liters. Lockitt, Inc. expects all inventories at the end of December to be within these guidelines. The cost of LD-paste and Chem-glue are $10.25 per pound and $50 per liter, respectively. The production process requires two types of direct labor-LB075 and LH075. LB075 represents machinists who operate the molding machines. Molding is done in batches; each batch contains 50 Duralocks. One hour of LB075 labor is required to process one batch of Duralock. LH075 represents manual finishing labor. Each Duralock requires one-tenth of an hour of LH075 labor. Hourly wage rates for LB075 and LH075 are $30 and $15 per hour, respectively. Both groups of employees are paid on an hourly basis. Variable manufacturing overhead is caused by batch-level and unit-level activities. The predetermined variable overhead rate at the batch level is $1,000 per batch; at the unit level, it is $50 per direct labor hour (based on total labor hours). Fixed factory overhead is $40,000 per month. Contador had been applying fixed factory overhead based on the budgeted production volume, and Lockden instructed you to do the same. All monetary values are in U.S. dollars. IMA EDUCATIONAL CASE JOURNAL VOL. 14, NO. 1, ART. 3, MARCH 2021 #2021 IMA. The budgeted fixed selling and administrative expenses for the year are $600,000; this amount is to be uniformly divided across 12 months. Variable selling expenses for 2020 are expected to be 3% of the revenue. . Lockitt, Inc. uses the first-in-first-out (FIFO) cost-flow assumption. EXPECTATION Lockden explained that the company's product differentiation strategy had worked well in the past, and further growth can be expected if the macroeconomic conditions stay stable. But he is concerned about a predicted slowdown in the U.S. economy and potential turmoil in the oil markets. These uncertainties were not factored in the sales forecast that Contador prepared but could negatively impact the company's sales volume. There are also reports of a viral epidemic in other parts of the world. Some health experts say it might spread in this country soon. Given these uncertainties, Lockden is interested in actively pursuing cost-reduction strategies to protect the company's profit margin. He expressed the need to critically evaluate the current manufacturing process against possible alternatives. Specifically, he raised concerns about the efficiency of the current production schedule, labor utilization, inventory policy, and supply chain. While he has many ideas, he needs assistance in evaluating their financial viability. Lockden believes that a dynamic budget will be an effective tool to make informed decisions. It may especially be helpful in the upcoming year, as it can be used to evaluate the financial impact of various cost-reduction options. Given the uncertainties the company is facing, Lockden also wants to use it to carry out sensitivity analyses. Further, Lockden expressed his intention to hire you as a full-time financial analyst after graduation. He ended the meeting with this remark: "You may have considered the operating budget merely as a planning tool. However, in addition to planning, I intend to use it heavily for decision-making and risk analysis, especially given the uncertainties we have regarding 2020. You are the owner of this tool, and after you create the tool, please be prepared to answer any "what-if" questions that I throw at you." ABOUT IMA" (INSTITUTE OF MANAGEMENT ACCOUNTANTS] IMA", the association of accountants and financial professionals in business, is a global professional association focused exclusively on advancing the management accounting profession. IMA supports the profession through research, teaching cases, the CMA" (Certified Management Accountant) program, continuing education, networking and advocacy of the highest ethical business practices. IMA has a global network of more than 140,000 members in 140 countries and 300 professional and student chapters. For more information, please visit www.imanat.org. IMA EDUCATIONAL CASE JOURNAL VOL. 14, NO. 1, ART. 3, MARCH 2021 #2021 IMA