Budgeting and Forecasting II By Dr. Dilrukshi Yapa Abeywardhana

The Master Budget: An Overview Production budget Selling and administrative budget Selling and administrative budget Direct materials budget Direct materials budget Manufacturing overhead budget Manufacturing overhead budget Direct labor budget Cash Budget Sales budget Ending inventory budget Ending inventory budget Budgeted balance sheet Budgeted income statement

Sales Budget Sales forecast Ask sales personnel Extrapolate past trends Use market research Employ statistical models and simulation Units to be sold *Selling price per unit =Dollars of sales

Production Budget Production manager combines Sales estimates Beginning inventory targets Ending inventory targets Determines the types, quantities, and timing of products to be manufactured

Ending Inventory Policy Percentage of next period’s projected sales Constant amount Buildup of inventory for high-demand periods Near zero in just-in-time systems Cost of holding inventory includes storage, insurance, obsolescence, shrinkage, damage

Direct Labor Budget Total number of people Specific types of workers Production hours needed Costs Union contracts Minimum wage laws Fringe benefit costs Payroll taxes Units to be produced (or DM components) * Standard time allowed per unit = Standard labor time allowed * Per hour direct labor cost = Total direct labor cost

Overhead Budget Identify activity base Estimate overhead costs Separate costs as fixed or variable Show total costs for operating budgets Show costs without depreciation for cash budgets Predicted activity base * Variable overhead rate per unit of activity =Total variable overhead cost +Fixed overhead cost =Total overhead cost =Total cost without depreciation

Selling and Administrative Budget Predicted sales dollars (or other measure) *Variable S&A rate per dollar =Total variable overhead cost + Fixed S&A cost =Total S&A cost = Total cost without depreciation

Cash Budget Highlights importance of cash for organization’s continued existence Translates accrual-based information into cash flows Indicates effectiveness of credit practices Allows for planned cash borrowing or investing Used to prepare pro forma Cash Flow Statement Beginning cash balance + Cash receipts (collections) =Cash available for disbursements – Cash disbursements =Cash excess or deficiency – Minimum desired cash balance =Cash needed/available for investment or loan repayment +/– Various financing measures =Ending cash balance

11 Example: A cash budget for the six months ended 30 th June 2017 is to be Drafted from the following information. (a)Opening cash balance at 1 st January 2017 Rs.3200 (b)Sales: at Rs.12 per unit: cash received three months after sale units: Oct Nov Dec Jan Feb Mar AprMay Jun Jul Aug Sep (c) Production: in units 2016 Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep (d) Raw materials used in production cost Rs.4 per unit of production. They are paid for two months before being used in production (e)Direct labour: Rs.3 per unit paid for in the same month as the unit is produced.

12 ((f) Other variable expenses Rs.2 per unit, ¾ of the cost being paid for in the same month as production, the other ¼ paid in the month after production (g) Other variable expenses Rs.2 per unit, ¾ of the cost being paid for in the same month as production, the other ¼ paid in the month after production. (h) Fixed expenses of Rs.100 per month is paid monthly (i) A motor van is to be bought and paid for in April for Rs.800 Required: Prepare the cash budget for six months ended 30 June 2017

13 Budgeted income statement and balance sheet These financial statements reflect the predicted results to be achieved. These financial statements are key elements in helping a company plan for the future. Based on this pro forma statements, a company can determine if it is meeting its pre determined target estimate the amount of external funding needed to support its projected sales growth and perform sensitivity analysis to identify the impacts of estimates, operating and policy changes on selected financial ratios.

14 ABC Ltd. Balance sheet as at 31 December 2016 Fixed AssetsCostDepNet Machinery Motor vehicles Current Assets Stock: finished goods (75 units)900 Raw materials500 Debtors (2016 Oct Rs.540 +Nov Rs.360+Dec Rs.450)1350 Cash and bank Less: Current liabilities Creditors for raw materials (Nov Rs.120+ Dec Rs.180)300 Creditors for fixed expenses (Dec)

15 Financed by:Rs.Rs. Share capital, 4000 shares of Rs.1 each4000 Profit and loss account The plans for the six months ended 30 June 2017 are as follows: (i)Production will be 60 units per month for the first months, followed by 70 units per month for May and June (ii)Production costs will be (per unit): Direct materialsRs.5 Direct labour4 Variable overhead 3 12 (iii)Fixed overhead is Rs.100 per month, payable always one month in arrears. (iv)Sales, at price of Rs.18 per unit, are expected to be: JanFebMarAprMayJun no. of units

16 (v)Purchases of direct materials will be: JanFebMarAprMayJun Rs.Rs.Rs.Rs.Rs.Rs (vi) The creditors for raw materials bought are paid two months after purchase (vii) Debtors are expected to pay their accounts three months after they have bought the goods (viii) Direct labour and variable overhead are paid in the same month as the units are produced (ix) A machine costing Rs.2000 will be bought and paid for in March (x)3000 shares of Rs.1 each are to be issued at par in May (xi)Depreciation for the six months: machinery Rs.450, motor vehicles Rs.200 Required: Prepare budget income statement and balance sheet as at 30 June 2017

Human Aspects of Budgeting Budgeting is thought of as a mechanical tool However, the administration of budgeting requires education, persuasion, and intelligent interpretation

Budgetary Slack The practice of underestimating budgeted revenues, or overestimating budgeted expenses, in an effort to make the resulting budgeted goals (profits) more easily attainable

Avoiding Budgetary Slack Companies use budgets primarily for planning and not performance evaluation Obtain good benchmark data when setting the budget Practicing rolling budgets Managers involve themselves regularly in understanding what their subordinates are doing

Stretch Targets Challenging but achievable levels of expected performance Intended to create a little discomfort The more a company tries to push performance, the greater the emphasis it must place on following the ethics of the company

Kaizen Budgeting It explicitly incorporates continuous improvement anticipated during the budget period into the budget numbers A budgeting approach that includes product improvement costs. With the objective of reducing actual costs below standard costs, projected costs of improvement are already incorporated in the budget.

Summary Budgeting plays an extraordinary role in the overall planning and performance evaluation process of the organization and formulating short term objectives and controlling operations to meet those objectives. In monitoring and controlling to meet strategic objectives budget is essential. Forecasting is required before budgeting and there are different forecasting techniques that can be used to predict the future demand based on the past demand information. Company choose different approaches in formulating its master budget.

The master budget consists of a number of separate but interdependent budgets. We have developed this schematic of the budgeting process to illustrate the interdependency of the various individual budgets. Company uses pro forma financial statement in the planning process to assess whether the anticipated performance is in line with its established goals, anticipate amount of funding needed to achieve its forecasted sales growth and estimate the effects of changes in assumptions of key numbers by performing sensitivity analysis. Human factors are crucial in budgeting.