Chapter 13 Outline

Chapter Outline LO 13-1 • Understand the role of budgets in overall organization plans. The budget is a financial plan of the resources needed to carry out activities and meet financial goals. o A recent study shows that small businesses rely on budgets to help manage cash flow, among things. (See Business Application box “Using the Budget to Help Manage Cash Flow.”) o The budgeting process is widely used and necessary for success. The usual problems with budgeting are the use of budgets as targets and the dysfunctional effects caused by that use. HOW STRATEGIC PLANNING INCREASES COMPETITIVENESS • Critical success factors are strengths of a company that enable it to outperform competitors. o By identifying critical success factors and ensuring that they are incorporated into the strategic plan, companies are able to maintain an edge over competitors. o Important critical success factors can be exploited to improve the company’s overall competitiveness. OVERALL PLAN • A master budget is made up of three components: o The organization goals o The strategic long-range profit plan o The master budget (i.e., the tactical short-range profit plan) • Organization Goals o Organization goals are a company’s broad objectives established by management that employees work to achieve. • Strategic Long-Range Profit Plan o The strategic long-range profit plan is a statement detailing steps to take to achieve a company’s organization goals. The plan provides a general framework for guiding management’s operating decisions. o Strategic plans discuss the major capital investments required to maintain present facilities, increase capacity, diversify products and/or processes, and develop particular markets. • Master Budget (Tactical Short-Range Profit Plan): Tying the Strategic Plan to the Operating Plan o The master budget (also known as the static budget, the budget plan, or the planning budget) is the financial plan of an organization for the coming year or other planning period.  The profit plan is the income statement portion of the master budget.  The master budget indicates the sales levels, production and cost levels, income, and cash flows anticipated for the coming year. In addition, these budget data are used to construct a budgeted balance sheet. o Budgeting is a dynamic process that ties together goals, plans, decision making, and employee performance evaluation. o Exhibit 13.1 shows the master budget and its relationship to other plans, accounting reports, and management decision-making processes.  The master budget is derived from the long-range plan in consideration of conditions expected during the coming period. Such plans are subject to change as the events of the year unfold. o Benchmarking is the continuous process of measuring products, services, or activities against competitors’ performance.  Competitive intelligence can be part of a benchmarking activity in which some companies gather information by speaking to their competitors, customers, and suppliers. LO 13-2 Understand the importance of people in the budgeting process. HUMAN ELEMENT IN BUDGETING • Although budgets are often viewed in purely quantitative, technical terms, managers’ personal goals and values will affect their beliefs about the coming period. o Budget preparation rests on human estimates of an unknown future. People’s forecasts are likely to be greatly influenced by their experiences with various segments of the company. o One challenge of budgeting is to identify who in the organization is best able to provide the most accurate information about particular topics. • Value of Employee Participation o Participative budgeting (also called grass roots budgeting) is the use of input from lowerand middle-management employees for budget preparation.  Participative budgeting is time consuming, yet it enhances employee motivation and acceptance of goals, and provides information that enables employees to associate rewards and penalties with performance. It also serves a training or development role for managers.  Studies have found that managers often provide inaccurate data when asked to give budget estimates. Managers who believe that the budget will be used as a norm for evaluating their performance could provide an estimate that will not be too hard to achieve.  Ideally, the budget will motivate people and facilitate their activities so that the organization can achieve its goals. DEVELOPING THE MASTER BUDGET: WHERE TO START? • All budgeting processes share some common elements. o After organization goals, strategies, and long-range plans have been developed, work begins on the master budget, a detailed budget for the coming fiscal year with some lessdetailed figures for subsequent years. o The bulk of the work preparing the master budget is usually done in the six months immediately preceding the beginning of the coming fiscal year. o Final budget approvals by the chief executive and board of directors are made one month to six weeks before the beginning of the coming fiscal year. LO 13-3 • Estimate sales. Sales Forecasting o Beginning with a sales forecast, the firm can plan the activities over which it has more control. As better information about sales becomes available, it is reasonably easy to adjust the rest of the budget.  In most firms, forecasting sales is the most difficult aspect of budgeting because it is most uncertain.  If, on the other hand, production is more uncertain than sales because of unpredictable supply of materials, the firm may want to begin with a raw material and production forecast. o Sales Staff  Salespeople are in the unique position of being close to the customers, and they may possess the best information and the best local knowledge in the company about customers’ immediate and near-term needs.  Salespeople realize that they will be evaluated based, in part, on the budget. As a result, they have an incentive to bias their sales forecasts. • Incentive compensation plans can be designed to motivate different behaviors, each with their own strengths and weaknesses. o Market Researchers  Market researchers do not have the same incentives that sales personnel have to bias the budget.  Market researchers have a different perspective on the market. That is, they can predict long-term trends in attitudes and the effects of social and economic changes on the company’s sales, potential markets, and products. o Delphi Technique  The Delphi technique is a forecasting method in which individual forecasts of group members are submitted anonymously and evaluated by the group as a whole. •  Each group member obtains a copy of all forecasts but is unaware of their sources. Differences among individual forecasts can be addressed and reconciled without involving the personality or position of individual forecasters. • After the differences are discussed, the process is repeated until the forecasts converge on a single best estimate of the coming year’s sales level. o Trend Analysis  Trend analysis is a forecasting method that ranges from simple visual extrapolation of points on a graph to highly sophisticated computerized time series analysis. • Time series techniques use only past observations of the data series to be forecasted. • This approach is relatively economical. • Forecasting techniques based on trend analysis often requires long series of past data to derive a suitable solution. When used in accounting applications, monthly data are required to obtain an adequate number of observations. o Econometric Model  Econometric models are statistical methods of forecasting economic data using regression models. • Econometric models can include many relevant predictors. Manipulating the assumed values of the predictors makes it possible to examine a variety of hypothetical conditions and relate them to the sales forecast. • No model removes the uncertainty surrounding sales forecasts. Cost-benefit tests should be used to determine which methods are most appropriate. COMPREHENSIVE ILLUSTRATION • To illustrate the discussion of the budgeting process, the budget for Santiago Pants, a manufacturer, is developed. o A manufacturing example because it includes most aspects of a firm’s operations. o The methods we discuss also apply to nonmanufacturing and not-for-profit organizations. LO 13-4 • Develop production and cost budgets. Forecasting Production o The production budget is the production plan of resources needed to meet current sales demand and ensure that inventory levels are sufficient for future sales. o It is necessary to determine the required inventory level for the beginning and end of the budget period.  The basic cost flow equation (also known as the basic inventory formula) can be adapted for inventories, production, and sales to solve for the required production. Recall from Chapter 6 the inventory equation: Beginning balance (BB) + Transfer in (TI) – Transfer out (TO) = Ending balance (EB) • Rearranging the terms, this revised equation states that production equals the sales demand plus or minus an inventory adjustment. Required production (units) • = Budgeted sales (units) + Units in ending inventory – Units in beginning inventory Another way to solve the required production is to go through the following Taccount: Finished Goods Inventory Units in beginning inventory Budgeted sales Required production (?) (from sales forecast) Units in ending inventory  Production and inventory are stated in equivalent finished units. o Exhibit 13.2 presents a production budget example. o Management of the production facilities reviews the production budget to ascertain whether the budgeted level of production can be reached with the capacity available.  • One benefit of the budgeting process is that it facilitates the coordination of activities. Forecasting Production Costs o Direct Materials  Once the sales and production budgets have been developed and the efforts of the sales and production groups have been coordinated, the next step is to estimate costs of direct materials, direct labor, and manufacturing overhead at budgeted levels of production so the budgeted cost of goods sold can be prepared. • Direct materials purchases needed for the budget period are derived from the equation: Required material purchases • Materials = to be used in production + Estimated ending materials inventory – Estimated beginning materials inventory Another way to solve the required materials purchases is to go through the following T-account: Materials Inventory Estimated beginning inventory Required usage Required purchases (?) (converted from production budget) Estimated ending inventory  • Required usage = Required production × Materials needed per unit of output. • Cost of materials to be purchased = Required purchases × Cost of materials per unit. Exhibit 13.3 shows the direct materials budget. o Direct Labor   Estimates of direct labor costs often are obtained from engineering and production management. • Direct labor usage = Required production × Labor hours needed per unit of output. • Direct labor cost = Direct labor usage × Direct labor cost per hour. Exhibit 13.4 shows a direct labor budget. o Overhead  Overhead is composed of many different types of costs with varying cost behaviors.  Budgeting overhead requires an estimate based on production levels, management discretion, long-range capacity and other corporate policies, and external factors such as increases in property taxes. •  To simplify the budgeting process, overhead costs are usually divided into fixed and variable components, with discretionary and semi-fixed costs treated as fixed costs within the relevant range. Exhibit 13.5 presents a sample schedule of budgeted manufacturing overhead. o The total manufacturing costs can be determined by adding materials, labor, and overhead together. Exhibit 13.6 shows the calculation for the budgeted statement of cost of goods sold.  • In most companies, estimates of work-in-process inventories are omitted from the budget because they have a minimal impact on the budget. Completing the Budgeted Cost of Goods Sold o The calculation of the cost of goods sold follows the equation: Estimated cost of = goods sold Estimated beginning + finished goods inventory Estimated cost of goods manufactured – Estimated ending finished goods inventory o Another way to determine the estimated cost of goods sold is to go through the finished goods Taccount: Finished goods Inventory Beginning inventory Cost of goods manufactured Cost of goods sold (?) Ending inventory o This part of the budgeting effort can be extremely complex for manufacturing companies. It can be very difficult to coordinate production schedules among numerous plants; it is also difficult to coordinate production schedules with sales forecasts. • Revising the Initial Budget o The budget usually undergoes a good deal of coordinating and revising before it is considered final.  Not part of the budget is really formally adopted until the board of directors finally approves the master budget. MARKETING AND ADMINISTRATIVE BUDGET • Budgeting marketing and administrative costs is very difficult because managers have discretion about how much money is spent and the timing of the expenditures. o The budgeting objective is to estimate the amount of marketing and administrative costs required to operate the company at its projected level of sales and production, and to achieve long-term company goals.  An easy and inexpensive way is to start with a previous period’s actual or budgeted amounts and make adjustments for inflation, changes in operations, and similar changes between periods. o Exhibit 13.7 shows a schedule of budgeted marketing and administrative costs.  Variable marketing costs vary with sales.  Fixed marketing costs are usually those that can be changed at management’s discretion. PULLING IT TOGETHER INTO THE INCOME STATEMENT • The budgeting process culminates in the projected operating profits reported in the budgeted income statement, as shown in Exhibit 13.8. o The budgeted income statement also includes estimated federal and other income taxes. • The process will be repeated to see if sales revenue can be increased, or costs cut, until the desired financial results can be reached. KEY RELATIONSHIPS: THE SALES CYCLE • The master budget is rooted in some key relations among sales, accounts receivable, and cash flows in the sales cycle. That is, Sales Accounts receivable BB Budgeted sales Budgeted sales Cash BB Collection EB Collection on account Disbursements Other receipts EB o BB and EB refer to beginning and ending balances, respectively. All sales are assumed to be on account.  LO 13-5 If an amount in the sales cycle is unknown, the basic accounting equation (BB + TI – TO = EB) can be used to find it. Estimate cash flows. USING CASH FLOW BUDGETS TO ESTIMATE CASH NEEDS • The cash budget refers to a statement of cash on hand at the start of the budget period, expected cash receipts, expected cash disbursements, and the resulting cash balance at the end of the budget period. o Cash budgeting is important to ensure company solvency, maximize interest earned on cash balances, and determine whether the company is generating enough cash for present and future operations. o Preparing a cash budget requires that all revenues, costs, and other transactions be examined in terms of their effects on cash.  Cash receipts come from the collection of accounts receivable, cash sales, sale of assets, borrowing, issuing stock, and other cash-generating activities.  Cash disbursements are used to pay for materials purchases, manufacturing and other operations, federal income taxes, and stockholder dividends. o A cash budget is shown in Exhibit 13.9. • Multiperiod Cash Flows o A more detailed analysis looks at multiperiod cash receipts (Exhibit 13.10) and cash disbursements (Exhibit 13.11) to ensure that the company will not run out of cash during the year. (See Business Application box “The Curse of Growth.”) LO 13-6 Develop budgeted financial statements. PLANNING FOR THE ASSETS AND LIABILITIES ON THE BUDGETED BALANCE SHEETS • Budgeted balance sheets are statements of budgeted financial position. o Budgeted balance sheets combine an estimate of financial position at the beginning of the budget period with the estimated results of operations for the period and estimated changes in assets and liabilities.  Decision making in these areas is, for the most part, the treasurer’s function. o Exhibit 13.12 presents budgeted balance sheets at the beginning and end of the budget period. BIG PICTURE: HOW IT ALL FITS TOGETHER • A model of the budgeting process for a manufacturing firm is presented in Exhibit 13.13. o Assembling a master budget is a complex process requiring careful coordination of many different organization segments. LO 13-7 Explain budgeting in merchandising and service organizations. BUDGETING IN SERVICE ORGANIZATIONS • Budgeting is used extensively in different types of organizations. o As in manufacturing, the sales budget in retail and wholesale (often called merchandising) businesses drives the rest of the budgeted income statement.  A merchandiser has no production budget but a merchandise purchases budget, which is much like the direct materials purchases budget in manufacturing. •  Exhibit 13.14 presents a merchandise purchases budget. Because of the critical importance of timing and seasonality in merchandising, special attention is usually given to short-term budgets. The budget helps formalize an ongoing process of coordinating buying and selling. • A key difference in the master budget of a service enterprise is the absence of product or material inventories. Neither a production budget (for manufacturing firms) nor a merchandise purchases budget (for merchandising firms) is needed. • Service businesses need to carefully coordinate sales with the necessary labor. Managers must ensure that personnel with the right skills are available at the right times.  Example: Revenue projections for a consulting firm may be based on estimates of the number and types of clients to be served in the budget year and the amount of services requested. The forecasts stem primarily from services provided in previous years with adjustments for new clients, new services to existing clients, loss of clients, and changes in the rates charged for services. Once the amount of services is forecast, the firm develops its budget for personnel. The firm faces a trade-off between not having the staff to do the work and having costly staff who are underemployed. o In governmental organizations, the budget serves as an expression of the legislature’s desires and is a legally binding authorization. (See Business Application box “Budget Is the Law in Government.”) LO 13-8 Explain why ethical issues arise in budgeting. ETHICAL PROBLEMS IN BUDGETING • Budgeting creates serious ethical issues for many people. • Managers and employees provide much of the information for the budget. Their performance then is compared with the budget they help develop. o Part of the problem is the form of the merit pay schedule that creates strong incentives right around the target. • The company must recognize the trade-off between encouraging unbiased reporting by local managers and the use of this information in performance evaluation and reward. o While the conflict cannot be avoided, managers who are aware of the potential problems are in a position to take steps to mitigate the consequences. LO 13-9 Explain how to use sensitivity analysis to budget under uncertainty. BUDGETING UNDER UNCERTAINTY • Formal planning models allow many alternatives and options to be explored in the planning process. o Any projection of the future is uncertain.  Managers often perform sensitivity analysis on their projections. • By asking and answering hypothetical questions during the planning phase, management can determine the risk of various phases of its operations and can develop contingency plans.  Local managers can be asked to provide three forecasts of prices and quantities: a best estimate, an optimistic estimate (an estimate so high that there is only a 10 percent or less chance that conditions will be better than the optimistic estimate), and a pessimistic estimate (an estimate so low that there is only a 10 percent or less chance that conditions will be worse than the pessimistic estimate). Nine possible scenarios can be defined by selling prices and sales quantity combinations. o The incorporation of uncertainty into budget estimates can be quite useful.  Spreadsheets are extremely useful in preparing budgets, which require considerable what-if thinking. • Exhibit13.15 shows a spreadsheet analysis of alternative budgeting scenarios.