1. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 15 Budgeting and Financial Planning

2. 15-2 Learning Objective 1

3. 15-3 Strategic Planning Critical success factors Critical success factors - Strengths of the company that enable it to outperform competitors. StrategicPlan Critical Success Factors Incorporated Into

4. 15-4 Strategic Long-Range Plan The master budget is part of an overall organizational plan made up of three components...  Organizational goals – management’s broad objectives that employees work to achieve.  The strategic long-range profit plan – steps to be taken to achieve organizational goals.  The master budget – tactical short-range profit plan.

5. 15-5 Learning Objective 2

6. 15-6 Key Purposes of the Budgeting System The five primary purposes are: 1. Planning. 2. Facilitating Communication and Coordination. 3. Allocating Resources. 4. Managing Financial and Operational Performance. 5. Evaluating Performance and Providing Incentives.

7. 15-7 Organizations Use Many Types of Budgets Organization goals Individual goals and values Long-range strategic plan Anticipated conditions Masterbudget Actual period results Individual beliefs Performance evaluation Strategic evaluation OrganizationIndividual

8. 15-8 Learning Objective 3

9. 15-9 The Master Budget as a Planning Tool After organization goals, strategies and long- range plans have been developed, work begins on the master budget. The master budget is a detailed budget for the coming fiscal year. 2008

10. 15-10 Sales Budget: The Starting Point Sales Staff Sales Staff – close to customer needs. Market Research Market Research – can predict long-term trends in attitudes and the effects of social and economic changes on the company’s sales, potential markets and products. Sales Forecasting Sales Forecasting – the process of predicting sales of services or goods. Let’s look at some forecasting tools.

11. 15-11 Forecasting Tools Delphi technique Delphi technique – the elicitation of forecasts from individual group members, for anonymous evaluation by the group as a whole, in a search for convergence. Econometric modeling Econometric modeling – the use of various economic indicators and market factors to predict future sales, by means of regression analysis.

12. 15-12 Operational Budgets Manufacturing firms Manufacturing firms – A production budget is developed from budgets for direct materials, direct labor and overhead. A budget for selling, general and administrative (SG&A) expenses is also prepared. Merchandising firms Merchandising firms – Instead of a production budget, a budget of merchandise purchased is developed. The SG&A budget is also prepared. Service-industry firms Service-industry firms – Based on the sales budget for its services, a set of budgets is developed for the resources to be used in providing the services.

13. 15-13 Operational Budgets Every business prepares a... 1. Cash budget 2. Capital expenditures budget, and a 3. Summary of operational budgets

14. 15-14 International Aspects of Budgeting Firms with international operations face a variety of additional challenges in preparing their budgets... 1.Translation of foreign currencies into local currency. 2.Budget preparation is difficult when inflation (or deflation) is high or unpredictable. 3.The economies of all countries fluctuate in terms of consumer demand, availability of skilled labor, and laws affecting commerce. 1.Translation of foreign currencies into local currency. 2.Budget preparation is difficult when inflation (or deflation) is high or unpredictable. 3.The economies of all countries fluctuate in terms of consumer demand, availability of skilled labor, and laws affecting commerce.

15. 15-15 Activity-Based Budgeting Activity-based budgeting (ABB) is the process of developing a master budget using information obtained from an activity-based costing (ABC) analysis ResourcesResources ActivitiesActivities Forecast of products and services to be produced, and customers served.

16. 15-16 Illustrating the Master Budget

17. 15-17 The Sales Budget Detailed schedule showing expected sales for the coming periods expressed in units and dollars.

18. 15-18 Sales Budget of Collegiate Apparel  Collegiate Apparel Company is preparing budgets for the year ending December 31, 20x1.  Budgeted sales are: First quarter – 15,000 units Second quarter – 5,000 units Third quarter– 10,000 units Fourth quarter – 20,000 units  The selling price is $12 per unit.  Collegiate Apparel Company is preparing budgets for the year ending December 31, 20x1.  Budgeted sales are: First quarter – 15,000 units Second quarter – 5,000 units Third quarter– 10,000 units Fourth quarter – 20,000 units  The selling price is $12 per unit.

19. 15-19 Sales Budget of Collegiate Apparel

20. 15-20 Production Budget SalesBudget ProductionBudget Completed Plan of resources needed to meet current sales demand and ensure inventory levels are sufficient for future sales.

21. 15-21 Forecasting Production Rearrange the basic inventory formula as follows... Units in beginning inventory Units in beginning inventory Required production in units Required production in units Sales in Units Units in ending inventory Units in ending inventory+–= Now, solve for required production... Units to be Produced = Sales in Units + Units in ending inventory Units in ending inventory – Expected beginning inventory Expected beginning inventory

22. 15-22 The Production Budget  Collegiate Apparel wants units in ending finished goods inventory to be 10% of the next quarter’s expected sales in units.  At the beginning of the year, 1,500 completed units were on hand.  During the first quarter of 20x2, 15,000 units are expected to be sold. Let’s prepare the production budget.  Collegiate Apparel wants units in ending finished goods inventory to be 10% of the next quarter’s expected sales in units.  At the beginning of the year, 1,500 completed units were on hand.  During the first quarter of 20x2, 15,000 units are expected to be sold. Let’s prepare the production budget.

23. 15-23 The Production Budget 5,000 × 10% = 500 units

24. 15-24 Direct-Materials Budget Direct materials needed for the budget period can be determined as follows... RequiredmaterialspurchasesRequiredmaterialspurchases = Materials used in productionMaterials production + EndingmaterialsinventoryEndingmaterialsinventory – BeginningmaterialsinventoryBeginningmaterialsinventory

25. 15-25 Direct-Materials Budget  At Collegiate Apparel 1.5 yards of fabric are required per unit of product.  Management wants fabric on hand at the end of each quarter to be 10% of next quarter’s raw materials required. On January 1 st, 2,100 yards of fabric are on- hand. During the first quarter of 20x2, Collegiate expects 21,000 yards of fabric to be required.  Each yard of fabric cost the company $2.  Let’s prepare the direct materials budget.  At Collegiate Apparel 1.5 yards of fabric are required per unit of product.  Management wants fabric on hand at the end of each quarter to be 10% of next quarter’s raw materials required. On January 1 st, 2,100 yards of fabric are on- hand. During the first quarter of 20x2, Collegiate expects 21,000 yards of fabric to be required.  Each yard of fabric cost the company $2.  Let’s prepare the direct materials budget.

26. 15-26 Direct-Materials Budget 8,250 × 10% = 825 units

27. 15-27 Direct-Labor Budget  At Collegiate Apparel, each unit produced requires 0.20 hour (12 minutes) of direct labor.  Workers earn a wage rate of $10 per hour regardless of the hours worked. Collegiate Apparel can hire workers as needed to meet production. Let’s prepare the direct labor budget.

28. 15-28 Direct-Labor Budget

29. 15-29 Manufacturing-Overhead Budget Collegiate Apparel uses activity-based budgeting.  At the unit-level, each unit produced requires $0.25 of indirect materials and $0.15 of electricity.  At the batch-level, the company expects the following production runs:  1 st quarter – 28  2 nd quarter – 11  3 rd quarter – 22  4 th quarter – 39  At the product-level, the company expects two new style designs each quarter with each new T-shirt design costing $500.  Details of the facilities-level overhead costs are shown on the manufacturing-overhead budget.

30. 15-30 Manufacturing-Overhead Budget Unit-, Batch-, and Product-level Portions of the Budget

31. 15-31 Manufacturing-Overhead Budget Product-, Facilities-level and Total Overhead Budget $5,600 + $8,400 + $1,000 + $36,500 = $51,500

32. 15-32 SG&A Expense Budget  At Collegiate Apparel, sales commissions and freight-out are unit-level SG&A.  Customer-level SG&A expenses include licensing fees for use of names and logos.  Facilities-level SG&A expense include sales salaries, advertising and clerical wages. Let’s prepare the SG&A expense budget.

33. 15-33 SG&A Expense Budget $ $ $$

34. 15-34 Cash Receipts Budget  At Collegiate Apparel all sales are made on account.  The company collects 80% of its billings in the quarter of the sale and 18% in the following quarter. The remaining two percent of each quarter’s sales are expected to be uncollectible.  Sales in the last quarter of 20x0 were $240,000. Let’s prepare the Cash Receipts Budget.

35. 15-35 Cash Receipts Budget $240,000 × 18% = $43,200 $180,000 × 2% = $3,600 $180,000 × 18% = $32,400

36. 15-36 Cash Payments for Direct-Materials  At Collegiate Apparel all purchases of raw materials are made on account.  The company pays for 60% of its purchases in the quarter of the purchase and the remaining 40% in the following quarter.  Purchases in the last quarter of 20x0 were $56,850. Let’s prepare the Cash Disbursements Budget.

37. 15-37 Cash Payments for Direct-Materials $18,150 × 60% = $10,890 $39,450 × 40% = $15,780

38. 15-38 Other Cash Disbursements

39. 15-39 Cash Budget  Collegiate Apparel started the year with a cash balance of $10,000, and borrows $100,000 at the beginning of 20x1 to finance plant expansion.  The loan is repaid in the amount of $25,000 at the end of each quarter with interest on the unpaid balance at 10%.  Payments for the plant additions were:  1 st quarter = $45,000  2 nd quarter = $15,000  3 rd quarter = $5,000  4 th quarter = $35,000 Let’s prepare the Cash Budget.

40. 15-40 Cash Budget $100,000 × 10% × ¼ = $2,500

41. 15-41 Calculation of Absorption Unit Cost

42. 15-42 Cost of Goods Manufactured and Sold Budget  At Collegiate Apparel the production cycle is short enough that it has no work-in-process inventory at any time.  From Schedule 3 in the text, we know there are 2,100 yards of fabric at $2.00 per yard in beginning raw material inventory.  And from Schedule 2 we know there are 1,500 units in ending finished goods inventory. We just computed the absorption cost per unit at $9.00.  Let’s prepare the Cost of Goods Manufactured and Sold Budget.

43. 15-43 Cost of Goods Manufactured and Sold Budget 1,500 × $9 $13,500 2,100 × $2 $4,200

44. 15-44 Budgeted Income Statement

45. 15-45 Budgeted Balance Sheet  The balance in the building account on December 31, 20x0 was $400,000, and the balance in the equipment account was $320,000. Total accumulated depreciation was $240,000. Depreciation expense is recorded at the rate of $60,000 per year.  At December 31, 20x1, the company had a long-term, noninterest-bearing note payable of $200,000. The note is due on December 31, 20x3.  The balance in the owners’ equity account at December 31, 20x0, was $330,160.  Supplies on hand at December 31, 20x1 were $2,000.  Let’s prepare the Budgeted Balance Sheet.

46. 15-46 $330,160 56,750 $386,910 $240,000 × 18% $43,200 $56,850 × 40% $22,740

47. 15-47 How It All Fits Together Sales forecast Production budget SG&A budget

48. 15-48 How It All Fits Together Sales forecast Production budget SG&A budget Required direct materials, labor and mfg. overhead budgets Budgeted income statement

49. 15-49 How It All Fits Together Sales forecast Production budget SG&A budget Required direct materials, labor and mfg. overhead budgets Budgeted cost of goods mfg. and sold Budgeted income statement

50. 15-50 How It All Fits Together Sales forecast Production budget SG&A budget Required direct materials, labor and mfg. overhead budgets Budgeted cost of goods mfg. and sold Budgeted income statement Cash budget Budgeted balance sheet

51. 15-51 Learning Objective 4

52. 15-52 Responsibility for Budget Administration Budget Committee Budget Committee – Consists of key senior executives who may advise the budget director during the preparation of the budget. The authority to give final approval to the budget usually rests with the board of directors.

53. 15-53 Learning Objective 5

54. 15-54 Budgetary Slack: Padding the Budget Padding the budget means intentionally underestimating revenues or overestimating costs. The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack. A solution: reward managers for making accurate estimates. Padding the budget means intentionally underestimating revenues or overestimating costs. The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack. A solution: reward managers for making accurate estimates.

55. 15-55 Participative Budgeting Participative Budgeting Participative Budgeting – the use of input from lower- and middle-management employees. The process is time consuming but enhances employee motivation and acceptance of goals.

56. 15-56 Ethical Problems in Budgeting Much of the information for the budget is provided by persons whose performance is then compared with the budget they help develop. I think sales will increase by 10% next year. Let’s prepare the sales forecast with a 4% increase, so we will really look good!

57. 15-57 Zero-Based Budgeting for Discretionary Costs A system of establishing financial plans beginning with an assumption of no activity and justifying each program or activity level. After some initial success, zero-based budgeting was found to be impractical. Massive amounts of time Massive amounts of time were required to implement and update the budget.

58. 15-58 Learning Objective 6

59. 15-59 Contemporary Trends in Budgeting and Financial Planning The emerging concept of financial planning is gradually replacing a budgeting process in which remote sales projections drive decisions and push costs onto inventory. The process is more customer-driven, not by large- scale sales statistics but by specific orders. The budgeting process is adapting to this sales model. In cost management, costs “don’t just happen” but are actively managed with techniques such as activity-based management. Activities are reviewed for the value they add to products and services.

60. 15-60 Beyond Budgeting A break from the budgeting process already shown, based on the growing need to satisfy customers and relying on a company’s intellectual assets. This approach emphasizes: rolling forecasts and optimization of resources no evaluation on meeting specific targets decentralized decision making and teams a climate based on sustained competitive success transparent and open information systems

61. 15-61 Learning Objective 7

62. 15-62 Inventory Management – Economic Order Quantity “How much inventory to keep on hand?” Inventory decisions involve a delicate balance between these classes of cost: ordering costs holding costs shortage costs EOQ is a mathematical tool to determine the order quantity that minimizes the ordering and holding costs: √

63. 15-63 Inventory Management under JIT Under JIT, there would be no inventories at all! Inventory cost would be wasteful. In fact, as inventory holding costs are reduced, so is EOQ. So, order as needed. There is no ideal order quantity.

64. 15-64 End of Chapter 15