The Budget Preparation CHAPTER 9 The Budget Preparation

In this chapter, we will discuss: The basics of budgeting Why budgets are important for control purposes Various types of budgets When each type of budget is used How to prepare some of the important budgets What are their limitations Behavioral implications

What is a budget? Budgets are summaries of short-term operational activities of a firm. For example, a firm may prepare cash budget to predict cash inflows and outflows or A production budget to plan its production levels. Budgets are quantitative representations.

How does a budget differ from a forecasting? A forecast is a prediction and usually There are many ifs and buts before a forecast resembles reality. Most importantly, a forecaster can only predict (sales would increase by 20% by next year). However, A forecaster cannot shape the selling events to make the sales go up by 20%

How does a budget differ from a forecasting? In contrast, a budget is a plan (sales must go up by 20% by next year). The budget plan is based on facts, events in progress, actions planned, etc. The budget preparer must consult those affected, obtain input before preparing the budget, and The Manager of a unit must take active steps to achieve the budget. Both forecasts and budgets are necessary. Forecast is useful for planning while budget is useful for both planning and for controlling. The budget plan is based on facts, events in progress, actions planned, etc. (past sales trend and growth, marketing and advertising promotions, new product introductions, concerted sales efforts)

Characteristics of a budget Stated in monetary units but, Could contain non-monetary items such as units produced, sold, no. of items processed etc. Usually, short-term (one year) but could be extrapolated from or to the longer term. Senior management must be involved in the process and must approve it. Most important – budgets must be compared to actual and the variances must be investigated.

Usefulness of the budget Fundamentally, it is a planning and control tool (coordination, problem signaling, and problem-solving activities). It is a good tool to communicate short-term goals to employees. It also helps senior management in assessing whether organizational goals are met (e.g. improvement in customer service but no allocation for employee training). Since input is required from multiple units, it promotes coordination, planning, and sharing. Allows a firm to anticipate problems so that corrective action can be taken early.

How does a budget help with strategic planning? Strategic Plan: Tells managers what the organizational goals for this year are (e.g. sales growth, profits, new products, expansion in production capacity). To accomplish the plan, every unit must contribute through its efforts. Therefore, each unit is subjected to a budgeting plan, process, and proposed results (operational plan). Collectively, the individual budgets would point out whether the strategic plan is likely to be achieved or not. If not, what corrective actions must be taken. Consequently, budget not only demands responsibility but also accountability.

Budget helps strategic planning – A real-world example Repertory Theatre of St. Louis (somewhat like Music Academy). Not-for-profit professional art/music theater supported by contributions from donors and members and from ticket sales. Initial financial assessment indicated that the theater is doing well.

Repertory Theater of St. Louis – The problems However, a five-year budget showed that expenses are likely to exceed revenues within a few years. Additional contribution from donors will not bridge the gap. Cost cutting would not work because it is already low. Ticket prices cannot be increased because of competitive pressures.

Repertory Theater of St. Louis – The Solution Build a second main-stage performing space that would allow the theater to Put on more performances Sell more tickets. Thus, the long-range budget identified a financial crisis and suggested a strategic solution to deal with the problem.

How does a budget help with performance evaluation or accountability? By creating benchmarks. A budget is a rationally prepared set of benchmarks. By comparing actual performance to the budget, deviations can be ascertained and evaluated. Within reasonable limits, the budget points to accomplishments or lack thereof.

Various types of budgets Two major types: Operating budgets (most middle level managers would be involved in this process) Capital or Investment budgets (mostly senior managers are involved in this process). Operating budget could includes several sub-budgets (e.g. Revenue budget, production budget, marketing budget, etc.)

The Budgeting Process – Where do we begin and when do we end it? An organization’s strategic goals is the starting point for the budgeting process. Projected financial results for the next year is compared to the goals to assess acceptability. The budgeting process is driven by the demand forecast (demand for a product at a given price). Demand forecast can be developed in multiple ways (market survey, growth trends, or other estimates). Based on demand forecast, prepare a sales plan for each product line and services.

The budgeting process (continued) Based on the sales plan, develop the factors of production (or other procurement) – raw materials, labor, overheads, cash. Lots of details would improve the budgeting process but is time consuming and expensive. Strike a balance. We will work on one or two budgets later.

Preparing the initial budget Initial budget preparation is done by each responsibility center (revenue centers, cost centers, etc.) Because, they know more about their individual units, requirements, constraints, etc. Thee centers must consider both external factors and internal factors that could have an impact on their budget estimates.

Top Management Middle Management Middle Management Supervisor Note: Initial flow of budget data in a participatory system is from lower levels of responsibility to higher levels of responsibility. Each responsibility center manager prepares his/her budget estimates and submits to the next higher level of management. These estimates are reviewed and consolidated as they move upward in the organization.

Budgeting Process – The Role of the Responsibility Centers Prepare the budget compatible with organizational goals. Communicate with other units and validate unit’s numbers. Don’t be optimistic but do not be pessimistic to show achievement of budget targets. Remember that eventually, resp. center budgets are subject to approval by senior managers and analysts, and are subject to revisions.

What we rarely discuss – Human Factors in Budgeting Regardless of what we discussed so far, Budget process depends on 1) the degree to which top management accepts the budget program and 2) the way top management uses the budget data. Top management should NOT use the budget as a weapon to pressure employees or to blame if something goes wrong. There should be meaningful dialogue. The human aspect is the key. If a budget program is to be successful, it must have the complete acceptance and support of the persons who occupy key management positions. If lower or middle management personnel sense that top management is lukewarm about budgeting or if they sense that top management simply tolerates budget as a necessary evil, then their own attitudes will reflect a similar lack of enthusiasm.

Let us now prepare one or two small budgets – use the description and the numbers given in the next set of slides. The exercises would give you a basic idea of the budgeting process (although not the human interactions involved during such a process)

Mylar Company Manufactures and sells a product that has seasonal variations in demand with peak sales coming in the 3rd quarter. The following information concerns operations for Year 2 – the coming year – and for the first two quarters of Year 3.

Mylar Company data The company’s single product sells for $8 per unit. Budgeted sales in units for the next six quarters are as follows: Year 2 Quarter Year 3 Quarter 1 2 3 4 Budgeted Sales in Units 40,000 60,000 100,000 50,000 70,000 80,000

Mylar Company Data Sales are collected: 75% in the qr. Sales are made, remaining 25% in the following quarter. On Jan. 1, Year 2, the balance sheet showed $65,000 in accounts receivable, all of which will be collected in the first quarter of the year. Bad debts are negligible and can be ignored. Company desires an ending inventory of finished units on hand at the end of each quarter equal to 30% of the budgeted sales for the next quarter. On Dec. 31, year 1, the company 12,000 units on hand. Five pounds of raw materials are required to complete one unit of product. Company requires an ending inventory of raw materials on hand at the end of each quarter equal to 10% of the production needs of the following quarter. On Dec. 31, Year 1, the company had 23,000 pounds of raw materials on hand. The raw material costs $0.80 per pound. Purchases of raw material are paid for in the following pattern: 60% in the quarter purchases are made, remaining 40% in the following quarter. On Jan. 1, Year 2, the company’s balance sheet showed $81,500 in accounts payable for raw material purchases, all of which will be paid for in the first quarter of the year.

Mylar Company We will prepare: A sales budget and a schedule of expected cash collections. A production budget A direct materials purchases budget and a schedule of expected cash payments for material purchases.

Based on these numbers, we will prepare a schedule of cash collections Sales Budget for Mylar Year 2 Quarter 1 2 3 4 Year Bud. Sales 40,000 60,000 100,000 250,000 Selling price per unit X $8 Total Sales $320,000 $480,000 $800,000 $400,000 $2,000,000 Based on these numbers, we will prepare a schedule of cash collections

Mylar – Schedule of Cash Collections Year 2 Quarter 1 2 3 4 Year A/Rec. Beg. Bal. 65,000 1st Qr. Sales (320,000x75%, 25%) 240,000 80,000 320,000 2nd Qr. Sales (480,000 x75%, 25%) 360,000 120,000 480,000 3rd Qr. Sales (800,000x75%, 25%) 600,000 200,000 800,000 4th Qr. Sales (400,000x75%, 25%) 300,000 Total Cash Collections 305,000 440,000 720,000 500,000 1,965,000

Based on Sales Budget, The Production Budget for Mylar

Mylar – Production Budget – Raw Material Requirement

One more example for you to take a look at - Revenue (Sales) budget – Davenport Company Data Davenport Co. makes cash (20% of total sales), credit card (50% total sales) and account sales (30% of total sales). Credit card sales are collected in the month following the sale, net of 3% credit card fee. Account sales are collected as follows: 40% in the first month following the sales, 50% in the second month following the sale, 8% in the third month following the sales, and 2% is never collected. Using the data from the table, prepare a statement showing the cash expected each month.

Davenport Co. Projected Sales Month Sales Jan. 12,369,348 July 21,747,839 Feb. 15,936,293 Aug 14,908,534 Mar. 13,294,309 Sep 11,984,398 Apr. 19,373,689 Oct 18,894,535 May 20,957,566 Nov 21,983,545 June 18,874,717 Dec 20,408,367