Budgeting

1. Budgeting Fall 2011

2. Introduction • tool for planning and controlling organizations. • A budget is the quantitative expression of a proposed plan of action by management for a future time period and an aid to the coordination and implementation of the plan. Mugan

3. Budgeting Cycle • Planning the performance of the organization • Providing a frame of reference, a set of specific expectations against which actual results can be compared • Investigating variations from plans • Correcting action follows, if necessary • Planning again Mugan

4. Budget • Quantitative plans • Static –Master Budget • For a certain level • Flexible • Adjusted for different levels and actual level • Short term or long term • Capital budgets • Operational budgets • Financial and nonfinancial data Mugan

5. Uses of Budgets • Goal congruence • Enhance communication and coordination • Among different units of the business • Among managers, and subunits • Performance evaluation • Determining possible bottlenecks Mugan

6. Budgets and Feedback • Feedback through variance analysis • Variance= deviations from the budget; both negative and positive; the amount of deviation is important • Variances provide managers with • Early warning of problems • A basis for performance evaluation-who’s responsible • A basis for strategy evaluation Mugan

7. Budgeting and Human Behavior • Top-down and bottom-up approach • Participative budgeting • Superiors may dominate the budget process or hold subordinates accountable for events they have no control over • Subordinates may build “budgetary slack” into their budgets • By underestimating budgeted revenues, or overestimating budgeted expenses, in an effort to make the resulting budgeted goals (profits) more easily attainable Mugan

8. Comparison Top-down budgets: • Top management makes the aggregate forecasts • then disaggregates down to lower levels • Decision control more important than decision management Bottom-up budgets (participative budgeting): • Lower levels know better what they are doing • They make initial forecasts therefore can be held responsible • Decision management more important than decision control • Top executive officers of firms have final decision rights over the entire budget process and resolve disputes • After adoption, the budget acts as a set of contracts among the various units of the firm Mugan

9. Responsibility Centers • a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities • Responsibility Accounting – a system that measures the plans, budgets, actions, and actual results of each Responsibility Center Mugan

10. Types of Responsibility Centers • Cost – accountable for costs only- evaluated based on actual and budgeted costs • Revenue – accountable for revenues only-evaluated based on actual and budgeted revenues • Profit – accountable for revenues and costs-evaluated on the profit • Investment – accountable for investments, revenues, and costs – return on investment; residual income; EVA Mugan

11. Controllability • What items are under the control of the manager? • Allocated? • Avoidable? • Unavoidable? Mugan

12. Budget Process • Based on historical data and changing conditions develop estimates • Goals and budgets are made known to key personnel • Deviations from budgets are investigated and corrective action taken – managers and accountants Mugan

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14. Components of Master Budgets • Operating Budget – leads to budgeted income statement • Sales budget • Production budget • Direct Materials budget • Direct Labor budget • Manufacturing overhead budget • Financial Budget – leads to balance sheet and cash flow statement • Cash collections • Cash payments • Purchase of assets • Payment of dividends • Borrowing and lending Mugan

15. Time Coverage of Budgets • Strategic planning requires long-term budgets (2, 5, or 10 years) • Many firms require managers to prepare both short-term and long-term budgets as part of the periodic budget review • Operating budgets-usually prepared on monthly, quarterly, annually basis • Usually the master budget or the static budget is prepared on yearly basis • Flexible budgets – rolling budgets Mugan

16. Master Budget Mugan

17. Basic Operating Budget Steps • Prepare the Sales Budget • Prepare the Production Budget (in Units) • Prepare the Direct Materials Usage Budget and Direct Materials Purchases Budget • Prepare the Direct Labor Budget Mugan

18. Basic Operating Budget Steps • Prepare the Manufacturing Overhead Budget • Prepare the Cost of Goods Sold Budget • Prepare the Selling and Administrative Expense Budget • Prepare the Budgeted Income Statement Mugan

19. Basic Financial Budget Steps Based on the Operating Budgets: • Prepare the Cash Budget • Prepare the Budgeted Balance Sheet • Prepare the Budgeted Statement of Cash Flows Mugan

20. Cash Budget • A cash budget shows expected cash receipts and disbursements; it indicates the months having cash shortages and excesses. Mugan

21. Sales Budget • First budget prepared since most budgets cannot be prepared without an estimate of sales • A variety of methods are used to estimate sales: • Economic models • Sales trends • Trade journals • Sales force estimates Mugan

22. Production Budget Quantity to be produced based on following formula: Mugan

23. Example Exercise #1 • VitaPup produces a vitamin-enhanced dog food that is sold in Kansas. The company expects sales to be 12,600 bags in January, 14,500 bags in February, and 19,000 bags in March. There are 1,260 bags on hand at the start of January. VitaPup desires to maintain monthly ending inventory equal to 10% of next month’s expected sales. • Prepare the production budget for VitaPup for the months of January and February. Mugan

24. Example Exercise #1 Solution • Production Budget for January Expected Sales 12,600 +Desired Ending Inventory 1,450 - Beginning Inventory (1,260) Total Production 12,790 • Production Budget for February Expected Sales 14,500 + Desired Ending Inventory 1,900 - Beginning Inventory (1,450) Total Production 14,950 Mugan

25. Direct Material Purchase Budget • Depends upon the amount needed for production and the amount needed for ending inventory • The following formula can be used: Mugan

26. Direct Labor Budget • Direct labor can be calculated using the following formula: • Number of units produced x Labor hours per unit x Rate per hour • Once calculated, can be used to determine the approximate number of employees needed Mugan

27. Manufacturing Overhead Budget • Variable Costs • Multiply variable cost per unit by quantity produced • Fixed Costs • Remain relatively constant • Depreciation could fluctuate based on planned acquisitions Mugan

28. Selling and Administrative Expense Budget Includes the following: • Salaries • Advertising • Office Expenses • Other General Expenses Mugan

29. Budgeted Income Statement Compilation of information provided by previously prepared budgets • Sales Budget • Direct Materials Budget • Direct Labor Budget • Manufacturing Overhead Budget • Selling and Administrative Expense Budget Mugan

30. Capital Acquisitions Budget • Acquisitions include: • Property • Plant • Equipment • Must be carefully planned due to the large amounts of cash that could be used Mugan

31. Cash Receipts and Disbursements Budget • Managers must plan for two items: • Amount of Cash Flows • Timing of Cash Flows • Importance • Differences between cash flows and income • Anticipate cash shortages or surpluses Mugan

32. Example Exercise #2 • The Warrenburg Antique Mall budgeted credit sales in the first quarter of 2009 to be as follows: January $150,000 February $160,000 March $172,000 Credit sales in December of 2008 are expected to be $200,000. The company expects to collect 75% of a month’s sales in the month of sale and 25% in the following month. • Estimate the cash receipts for January and February. Mugan

33. Example Exercise #2 Solution • January Estimated Cash Receipts December (200,000 x 25%) $50,000 January (150,000 x 75%) $112,500 Total $162,500 • February Estimated Cash Receipts January (150,000 x 25%) $37,500 February (160,000 x 75%) $120,000 Total $157,500 Mugan

34. Budgeted Balance Sheet • Last budget prepared • Sometimes referred to as the pro forma balance sheet • Used to assess the effect of planned decisions on the future financial position of the firm Mugan

35. Budgeting Overview Flowchart Mugan

36. MASTER BUDGET EXAMPLE Mugan

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45. Use of Computers in the Budget Planning Process • Extremely useful in budgeting process • Excel Spreadsheet • Other specialized program • Allows for company to determine effects of a decision on entire budget • “What if” Analysis Mugan

46. Budgetary Control • Budgets as a Standard for Evaluation • Actual amounts are compared with budgeted amounts • Differences between actual and budgeted amounts are referred to as budget variances • Budget variances should be investigated when they are material Mugan

47. Budgetary Control • Management must make sure the level of activity in the budget is equal to the actual level of activity • Static Budget • Not adjusted for the actual level of production • Flexible Budget • A set of budget relationships that can be adjusted for various production activity levels Mugan

48. Investigating Budget Variances Causes of Budget Variances • Budget may not have been well conceived • Conditions may have changed • Managers may have performed particularly well or poorly Mugan

49. Investigating Budget Variances Management by Exception • Economical approach • Only exceptional variances are investigated • Must investigate both unfavorable and favorable exceptional variances Mugan

50. Variances • If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future • If the factors causing actual costs to be higher than expected can be identified, then actions may be taken to prevent those factors from recurring in the future • If cost changes are likely to be permanent, cost information can be updated for future jobs Mugan