Budgetary Planning and Control

BudgetsBudgets  The formal documents that quantify a company’s plans for achieving its goals.  For many companies, the planning and control process is built around budgets.

Use of Budgets in Planning  Enhances communication and coordination  Forces managers to consider:  Goals  Objectives  Specify means of achieving them

Use of Budgets in Control  Provide a basis for evaluating performance by comparing the actual with the planned performance  Deviations from planned performance have three potential causes:  Plan or budget was poorly conceived  Conditions have changed  Managers have done a particularly good or poor job managing operations

Developing the Budget Budgets are prepared for:  Departments  Divisions of a company  For the entire company

Developing the Budget  Budget Committee  Responsible for approval of various budgets  Made up of senior managers (Presidents, CFO, controller, etc.)  Typically works with departments to develop realistic plans

Role of Budgets in Planning and Control

Budget Time Period  Management must first decide on a budget time period  Long-run budgets (3-year, 5-year)  Short-run budgets (month, quarter)  Length of time period determines the amount of detail in a budget

Five-Year Budgets

Better Budgets

Zero Base Budgeting  Managers must start at zero in developing their budgets and justify budgeted amounts  Provides validation for budgeted amounts  Time consuming and expensive process  Not widely used by business enterprises

Master Budget

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

Production Budget Quantity to be produced based on following formula:

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.

Example Exercise #1 Solution  Production Budget for January Expected Sales12,600 +Desired Ending Inventory 1,450 -Beginning Inventory(1,260) Total Production12,790  Production Budget for February Expected Sales 14,500 + Desired Ending Inventory 1,900 -Beginning Inventory (1,450) Total Production14,950

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

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

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

Selling and Administrative Expense Budget Includes the following:  Salaries  Advertising  Office Expenses  Other General Expenses

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

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

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

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.

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

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

Study Break #1 Which of the following statements regarding budgets is false? a.They are formal documents that quantify a company’s plans. b.They enhance communication and coordination. c.They are useful in planning but not in control. d.They provide a basis for evaluating performance. Answer: c. They are useful in planning but not in control

Study Break #2 Which of the following items do not require a cash outflow? a.Salaries b.Purchase of raw materials c.Advertising d.Depreciation Answer: d. Depreciation

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

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

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

SpreadsheetsSpreadsheets

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

Investigating Budget Variances Management by Exception  Economical approach  Only exceptional variances are investigated  Must investigate both unfavorable and favorable exceptional variances

“Unfavorable” Budget Variance

Conflict in Planning and Control Uses of Budgets  Budgets used for planning and control  Focus of management on meeting or beating budgeted targets  Compensation could be dependent upon this  Creates an inherent conflict

Common Budget-based Compensation Scheme

Issues With Budget-based Compensation  Managers have incentive to pad a budget  Lower sales forecasts and increasing cost forecasts  Makes budget targets easier to achieve creating budget slack  Managers may have incentive to shift income from one period to another

Study Break #3 Differences between budget and actual amounts are referred to as: a.An error b.A variance c.A flexible budget d.A static budget Answer: b. A variance

Study Break #4 A ____ budget is not adjusted for the actual level of production. a.Static b.Flexible c.Pro forma d.None of the above Answer: a. Static

Budget Padding