1. Budgeting & Profit Planning
November 19, 2015
Budgeting & Profit Planning
Chapter 7: Profit Planning.
This chapter focuses on the steps taken by businesses to achieve their planned levels of profits – a process called profit planning. Profit planning is accomplished by preparing numerous budgets, which, when brought together, form an integrated business plan known as a master budget.

2. November 19, 2015 What is a budget Why and how organizations budget
Budgeting
Sales
Production
Sales & Administration
Balance Sheet Budget Items
Working Capital
Capital Equipment
Financing
Financial Statements

3. Budget
A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period
Its purpose is to plan for the future and control behaviour and costs
Planning to prepare for objectives and setting out a framework to achieve the objectives
Providing incentives to managers to achieve the objectives
Control by holding people to account with respect to their objectives
Cost control
Revenue generation

4. Planning and Control
Planning – involves developing objectives and preparing various budgets to achieve those objectives.
Control – involves the steps taken by management to increase the likelihood that the objectives set down while planning are attained and that all parts of the organization are working together toward that goal.
Planning involves developing objectives and preparing various budgets to achieve those objectives.
Control involves the steps taken by management to increase the likelihood that the objectives set down at the planning stage are attained and that all parts of the organization are working together toward that goal.
To be effective, a good budgeting system must provide for both planning and control. Good planning without effective control is time wasted.

5. Advantages of Budgeting
The budgeting process forces managers to think through a plan from their perspective
It provides a forum for people to interact and determine how to best allocate limited resources
Defines a set of consistent goals and objectives
Communicated throughout the organization for common understanding and cooperation
The budget provides a document against which to measure performance
The advantages of budgeting are:
Budgets communicate management’s plans throughout the organization.
Budgets force managers to think about and plan for the future.
The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively.
The budgeting process can also uncover potential bottlenecks before they occur.
Budgets coordinate the activities of the entire organization by integrating the plans of its various parts.
Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.

6. Factors in Budgeting There are a number of human factors in budgeting:
Requires the full support and commitment from senior management
People who are engaged in the process are more likely to support it
Managers and executives need to be reasonable
Managers may feel they should lower their own targets to reduce expectations
Executives may feel they should pressure managers to unachievable levels
Be reasonable (set budgets for different audiences) – Board, Fall-back, Management Incentive, Stretch
Work to root out personal ambitions
The success of a budget program depends on three important factors:
Top management must be enthusiastic and committed to the budgeting process, otherwise nobody will take it seriously.
Top management must not use the budget to pressure employees or blame them when something goes wrong. This breeds hostility and mistrust rather than cooperative and coordinated efforts.
Highly achievable budget targets are usually preferred (rather than “stretch budget” targets) when managers are rewarded based on meeting budget targets.

7. Responsibility Accounting
Managers should be held responsible for those items - and only those items - that they can actually control to a significant extent.
The premise of responsibility accounting is that managers should be held responsible only for those items that they can control to a significant extent. Responsibility accounting systems enable organizations to react quickly to deviations from their plans and to learn from feedback obtained by comparing budgeted goals to actual results. The point is not to penalize individuals for missing targets.
It is unreasonable and de-motivating to be held accountable for something beyond your control.

8. Self-Imposed Budget
A self-imposed budget or participative budget is a budget that is prepared with the full cooperation and participation of managers at all levels. It is a particularly useful approach if the budget will be used to evaluate managerial performance.
A participative budget is prepared with the full cooperation and participation of managers at all levels. A participative budget is also known as a self-imposed budget.

9. Advantages of Self-Imposed Budgets
Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management.
Budget estimates prepared by front-line managers are often more accurate than estimates prepared by top managers.
Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above.
A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse.
The key to self-imposed budgets is to get operational managers involved in the budgeting process and to clearly state their goals and expectations. Here is a list of four major advantages of self-imposed budgets.
First, individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management.
Second, budget estimates prepared by front-line managers (who have intimate knowledge of day-to-day operations) are often more accurate than estimates prepared by top managers.
Third, motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above.
Fourth, a manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse.

10. Self-Imposed Budgets
Self-imposed budgets should be reviewed by higher levels of management to prevent “budgetary slack.”
Most companies issue broad guidelines in terms of overall profits or sales. Lower-level managers are directed to prepare budgets that meet those targets.
Self-imposed budgets should be reviewed by higher levels of management. Without such a review, self-imposed budgets may have too much “budgetary slack,” or may not be aligned with overall strategic objectives. Most companies do not rely exclusively upon self-imposed budgets in the sense that top managers usually initiate the budget process by issuing broad guidelines in terms of overall target profits or sales. Lower-level managers are directed to prepare budgets that meet those targets.

11. Choosing the Budget Period
Operating Budget
2011
2012
2013
2014
Operating budgets ordinarily
cover a one-year period
corresponding to a company’s fiscal year. Many companies divide their annual budget
into four quarters.
A continuous budget is a 12-month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed.
Operating budgets ordinarily cover a one-year period corresponding to a company’s fiscal year. Many companies divide their annual budget into four quarters. In this chapter, we focus on one-year operating budgets.
A continuous or perpetual budget is a 12-month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. This approach keeps managers focused on the future at least one year ahead.

12. Managing the Budgeting Process
Usually driven by the CFO
Establishes a leadership team
Builds up the data through meetings with all profit and cost centers
Note: The system (ABC, Process Costing, Account mapping) is already assumed to have been done by this time

13. Key Budget Segments
There are a few critical budget segments to get in place
Each organization may have its own twists to the approach
Sales Budget
Production Budget
Direct Labour, Direct Materials, Manufacturing Overhead
Selling, General and Administration
Working Capital Budget
Capital Budget
With the assumptions in these budgets in place, full cash flow, income statement and balance sheet plans can be published

14. The Master Budget: An Overview
Sales
budget
Ending inventory
budget
Selling and
administrative
expense budget
Production
budget
Direct
materials
budget
Direct
labor
budget
Manufacturing
overhead
budget
The master budget consists of a number of separate but interdependent budgets. The sales budget shows the expected sales for the budget period expressed in dollars and units. It is usually based on a company’s sales forecast. All other parts of the master budget are dependent on the sales budget.
The production budget is prepared after the sales budget. It lists the number of units that must be produced during each budget period to meet sales needs and to provide for the desired ending inventory. The production budget in turn directly influences the direct materials, direct labor, and manufacturing overhead budgets, which in turn enable the preparation of the ending finished goods inventory budget.
These budgets are then combined with data from the sales budget and the selling and administrative expense budget to determine the cash budget. The cash budget is a detailed plan showing how cash resources will be acquired and used over a specified time period. All of the operating budgets have an impact on the cash budget.
The last step of the process is to prepare a budgeted income statement and a budgeted balance sheet.
Cash
budget
Budgeted income statement
Budgeted balance sheet

15. Sales Budget Understand your market Size, growth rate, market share
Cyclicality, seasonality
Competitive position for each product/service
New entrant, established player
Put forward and discuss a reasonable matrix of targets for the circumstances
This budget proposes no price increases
10% growth in Motorbike sales
5% growth in car sales
no seasonality
What might this quarterly budget look like?

16. Sales Budget
After discussions with the sales team, we would look to have them sign off on the final version
Commissions would be put in place
To incentivize them to meet the targets
To ensure they emphasize the products with the highest contribution
Consider when accounts will be collected – Days Accounts Receivable will impact cash planning & financing requirements

17. Budget and Expected Cash Collections
The Production Budget
Sales
Budget and Expected Cash Collections
Production
Budget
Completed
After we have budgeted our sales and expected cash collection, we must make sure the production budget is adequate to meet the forecasted sales and to provide for the desired ending inventory. We need inventory on hand at the end of the period to minimize the likelihood of an inventory stock-out.
The production budget must be adequate to
meet budgeted sales and to provide for
the desired ending inventory.

18. Production Budget
The Production Budget must deliver the final product committed to in the Sales Budget, in the time frame it calls for

19. Production Budget Production budgets can be complex
There would of course be build ups behind each of the accounts
Direct Labour – based on units of labour per production unit
Direct Materials “ “ material “
Manufacturing Overhead
Fixed and Variable
Furthermore, there are production lead times to be managed
Long lead time parts can constrain production
Inflation, expected pay hikes, etc. will also impact each cost function
As there were challenges to the sales force, there may be challenges in production to reduce cost, defects, inventory
Finally, timing of cash outlays – Days Accounts Payable – will impact cash planning & financing requirements

20. Sales & Administration Budget
The Sales & Administration budget must support the level of business activity planned in the Sales Budget and Production Budget
Sales are budgeted to increase 5%-10%
Bad economic climate calls for challenges
Do not increase spending from last year unless unavoidable
Carry on with same level of advertising and promotion
Non-discretionary variable costs must increase with sales
Obtain sign off from those in control of these costs
Develop a compensation structure that rewards being within budget

21. Sales & Administration Budget
If the promotional campaign supporting the increase in sales, cost $150 million, was it justified?

22. Sales & Administration Budget
Promotional campaign analysis
Task marketing group to forecast incremental sales
$488m
Break even ($ sales) = fixed cost / contribution margin (%)
Fixed cost ?
Contribution margin
(Sales less Variable Costs) / Sales
Sales: $7,238
Variable Costs: $3,798
Total absorption costs: $3,398
The campaign is justified as it supports incremental sales of much more than $320 million required to cove the cost

23. Sales & Administration Budget
Promotional campaign analysis
Break even ($ sales) = fixed cost / contribution margin (%)
The campaign is justified as it supports incremental sales of much more than $320 million required to cove the cost

24. Sales & Administration Budget
Sales Budget, Production Budget and Sales & Administration Budget in place
We can exhibit the Operating Profit and Cash Flow from Operations
Budget forecasts ~$1.5 billion Operating Profit
21% Operating Margin

25. Review
We are working towards building a Cash Budget and Financial Statements, including a Cash Flow Statement
Cash Flow Statements have different categories of sources and uses of cash
Cash Flow from Operations
Sales Budget
Production Budget
S&A Budget
Cash Flow from Changes in Working Capital
Balance Sheet Budget
Cash Flow from Investing Activities

26. Balance Sheet Budget Working Capital Assumptions
Can be made at very detailed or high level
Try to balance for practicality
Accounts Receivable
Assume # of days sales outstanding
Challenge collections department to get cash in earlier
Inventory
Forecast demand
Assume # of days COGS outstanding
Accounts Payable (including payroll)
Payroll is under corporate control – eg pay every 30 days
Assume # days of Direct Materials and other outstanding
Other (Prepaid assets; Accrued liabilities)
Similar methodologies can be applied

27. Balance Sheet Budget Balance Sheet Model
We have run the assumptions (from sales straight through to these balance sheet assumptions). Assume opening balances as given
We learn there will be a requirement for cash of $57 million in the first quarter
This is required to fund increased A/R and inventory from sales growth

28. Balance Sheet Budget – Working Capital
Accounts Receivable ($ balance)
Sales / 365 * # of days it takes to collect AR
# of Days Sales in AR
AR balance / Sales * 365
Accounts Payable ($ balance)
COGS/365 * # of days before the company pays AP
# of Days COGS in AP
AP balance / COGS * 365
Inventory $ balance
COGS/365 * # of days in inventory held
# of Days COGS in Inventory
Inventory balance / COGS * 365

29. Balance Sheet Budget Investments/Capital assumptions
By investment, we primarily mean Property, Plant & Equipment
As with Working Capital, can be made at very detailed or high level
Organizations will have detailed asset schedules, including depreciation
Decisions to purchase assets are based upon a number of factors
Capacity utilization
Forecast volume
Financing
For our purposes, we will assume the following:
Factory capacity is at 80% - no need to expand
Machinery & Equipment is at full capacity and must be increased in proportion to sales
Depreciation on new M&E flows through Variable Manufacturing Overhead

30. Balance Sheet Budget Balance Sheet Model – Capex
We learn there will be a requirement for cash of $12 million in the first quarter
This is required to fund increased machinery and equipment to produce the incremental volume

31. Financial Statements
Final budgeted Income and Cash Flow Statements

32. Financial Statements
Final budgeted Balance Sheet

33. Review What is a budget Why and how organizations budget Budgeting
Sales
Production
Sales & Administration
Balance Sheet Budget Items
Working Capital
Capital Equipment
Financing
Financial Statements

34. Tutorial Balance Sheet forecasting 3 years
Apply working capital ratios for forecast balances