Budgeting

Learning Objectives Explain the use of a budget as a tool for planning and performance evaluation. Explain how a budget can affect employee motivation. Compare the four types of responsibility centers. Describe the master budget.

Organizational Plan Consists of three parts Organization Goals - Broad objectives established by mgmt. that company employees work to achieve Strategic long-range plan - Intermediate and distant future plans stated in broad terms Master Budget - Specific plan for the coming year

Master Budget Also known as the static budget Indicates sales, production and cost levels, income and cash flows anticipated for the following year Also includes an income statement and balance sheet based on budget data

Performance Evaluation Budgets provide estimates of expected performance Comparing budgeted with actual results provides a basis for evaluating performance Budgets must be prepared for individual responsibility centers in order to use them to evaluate performance

Responsibility Centers (Slide 1 of 2) A responsibility center is a division or department responsible for managing a group of activities in the organization Responsibility centers can be classified as follows: Cost centers - mgmt is responsible for managing costs Revenue centers - mgmt is responsible for managing revenues

Responsibility Centers (Slide 2 of 2) Responsibility centers can be classified as follows (continued): Profit centers - mgmt is responsible for both revenues and costs Investment centers - mgmt is responsible for revenues, costs, and assets

Flexible Budgets Shows the expected relation between costs and volumes Has two components: Fixed cost - expected to be incurred regardless of the activity level Variable cost - costs change in total as the activity level changes

Cost Hierarchies When preparing a master budget, it is important to understand how costs are affected by changes in activity levels The following cost hierarchy is helpful in understanding cost behavior: Unit-level activities Batch-level activities Product-level activities Customer-level activities Facility-level activities

Forecasting Sales Developing the master budget starts with forecasting sales Various methods and sources used to obtain sales forecasts include: Sales staff Market research Delphi technique Trend analysis Econometric Models

Production Budget (Slide 1 of 2) The production budget is based on the sales budget and estimates of beginning and desired ending inventories Production is calculated as follows: Number of Units to Be Sold +Units in Ending Inventory -Units in Beginning Inventory Units to Be Produced

Production Budget (Slide 2 of 2) After determining the number of units to be produced, we can budget for the following: Direct materials - traceable to units produced and almost always a variable cost Direct labor - traceable to units produced; usually a variable cost but could be a fixed cost We assume direct labor is a variable cost in this chapter Manufacturing overhead - typically has both variable and fixed components; variable overhead varies with units produced, fixed overhead gives a firm production capacity

Marketing and Administrative Budgets Budgeted marketing costs might include the following: Facility-level activities - salaries, advertising, sales office costs Unit-level activities - sales commissions, shipping Administrative costs include both fixed and variable costs

Discretionary Fixed Costs Many “fixed” costs are really discretionary costs They are budgeted as fixed costs but if, for example, the economic conditions look bad, these costs can be reduced Examples: maintenance, advertising Discretionary fixed costs should be distinguished from committed fixed costs, like rent on a factory building, which are required to run the firm

Budgeted Income Statement Also called the profit plan Prepared using a contribution margin format If management is satisfied with the budget, it is approved If not, management can look for ways to improve budget profits through, for example, sales increases or cost reductions

Accurate Forecasts An accurate sales forecast is critical to the entire budget process If forecast is too low, sales may be lost because purchasing and production have been planned at too low a level If forecast is too high, excess inventory may result

Using the Master Budget Master budget includes budgeted financial statements as well as other relevant budgets Once adopted, the master budget becomes a major planning tool Essentially, becomes authorization to produce and sell goods, purchase materials, hire employees

Comparison of Flexible and Master Budgets The flexible budget is based on actual sales and production volumes Indicates expected revenue and costs at the actual level of activity Comparison of master budget to the flexible budget forms the basis for analyzing differences in planned and actual results

Building the Balanced Scorecard

Introduction Balanced Scorecards provide a framework for communicating strategy in operating terms (metrics, targets, etc.) You must communicate strategy in operating terms if you expect people to execute on your strategy.

Balanced Scorecard Robert Kaplan Harvard Business School David Norton Balanced Scorecards Collaborative "The Balanced Scorecard: Measures that Drive Performance." Harvard Business Review 70, no. 1 (January-February 1992)

Overview Balanced Scorecards are constructed from strategic maps (sometimes referred to as straw models). Throughout the process, we will refer back to these maps, making sure everything is linked. This is very important since we want to capture a “cause and effect” relationship in building the scorecard.

Strategic Goals Establishing strategic goals is the first step in building the Balanced Scorecard. Strategic goals establish direction in concrete terms. For example: “By the year 2003, we will grow revenues by 45%.” Strategic goals anchor the rest of the process. Strategic goals should fit with the vision and mission of the organization.

Strategic Objectives Once we establish our first anchor (goals), we can develop a set of strategic objectives. Strategic objectives define what actions must be taken to reach the strategic goals. Objectives are critical to future success. For example, in order to grow revenues, we must introduce new products and expand our market share.

Strategic Themes Based on strategic goals, three to five strategic themes should emerge. From these themes, we will develop a strategic map. Four common strategic themes are: Operating Efficiencies, Customer Relations, Product Innovation, and Growing the Business.

Strategic Model Strategic Models can emerge from four principles: 1. Translate strategies into operating terms. 2. Link strategies throughout the entire organization. 3. Commit everyone to implementing strategy. 4. Make strategizing a continuous process of learning and adjusting to change.

Four Perspectives Before we build strategic maps, we need to define four perspectives: Financial: Top layer in the map, represents financial outcomes (profits, revenues, etc.) Customer: Next layer down, enables financial results (service, image, price, quality, etc.) Internal Processes: The values added to customers, such as delivery, production, distribution, etc. Learning & Growth: The people, systems, and organization that enable processes.

Strategic Mapping Strategic Maps are the foundation of the Balanced Scorecard. You will need one strategic map for each strategic theme. Maps are constructed over four perspectives. Strategic objectives are mapped over the four perspectives, linked together.

Linking Strategic objectives need to be placed in the Strategic Map according to which perspective fits with the objective. Objectives may cross over more than one perspective. We usually start at the top with outcomes and work our way down, looking at what enables (drives) the outcome.

Approval Once you have completed the strategic maps, you will need to get approval from executive management. Does this map accurately tell the “story” of our strategy? If management disagrees with the map, go back and redo the maps. We need to get this step right since it represents the foundation for the entire scorecard.

Measurements For each strategic objective, you need one measurement. Measurement provides us with feedback on meeting the strategic objective. Most organizations will use many of their existing measurements. Organizations requiring major change should include driver type measurements.

Measurement Criteria Measurements should drive change, providing teeth to our strategy. Measurements define objectives in specific terms. A good measurement should tell you what your objective is – this is an indicator of good linkage. Measurements should be repeatable, quantifiable, and verifiable.

Targets Once you establish measurements, you need to set a target for each measurement. Targets push the organization to a required level of performance. Targets put focus on the strategy, expressing the specifics of the strategy. When an organization hits its targets, then it has successfully implemented its strategy.

Programs In order for things to happen in an organization, you must initiate major programs. For example, improving customer service may require a new customer management system. Once you put programs in place, you should be able to meet your strategic objectives.

Implementation The minimum time for developing a balanced scorecard is three months. Full deployment of scorecards throughout the entire organization can take more than one year. The best place to start building a scorecard is where all components of the value chain are in place: Customer, Innovation, Production, Delivery, Services, etc.