BUDGETING

Budgets and the Organization

Budgets

Goals and objectives

A budget provides a comprehensive financial overview of planned company operations.

Benefits of Budgets
Compel managers to think ahead

Provide an opportunity to reevaluate existing activities and evaluate new ones.

Provide Benchmark for Performance Evaluation

Aid managers in communicating objectives and coordinating actions across the organization.

Potential Problems in Implementing Budgets

1. Low levels of participation in the budget process and Lack of acceptance of responsibility for the final budget. 2. Incentives to lie and cheat in the budget process. 3. Difficulties in obtaining accurate sales forecasts.

Management should seek to create an environment where there is a true two-way flow of information.

Sales Forecasting

A sales forecast is a prediction of sales under a given set of conditions.

Sales forecasts are usually prepared under the direction of the top sales executive.

The sales budget is the result of decisions to create Conditions that will generate a desired level of sales.

Factors to Consider When Forecasting Sales

Master Budget
The master budget is a detailed and comprehensive analysis of the first year of the long-range plan. It summarizes the planned activities of all subunits of an organization.

Sales Production Distribution Finance

Master Budget

Operating budget (Profit plan). . .

Financial budget. . .

Focuses on the Income Statement and supporting schedules or budgeted expenses.

Focuses on the effects that the operating budget and other plans will have on cash balances.

Steps in Preparing the Master Budget

1. Basic data

2. Operating budget

3. Financial budget

Steps in Preparing the Master Budget

The principal steps in preparing the master budget:

1. Basic data a. Sales budget b. Cash collections from customers c. Purchases and cost-of-goods sold budget d. Cash disbursements for purchases e. Operating expense budget f. Cash disbursements for operating expenses

Steps in Preparing the Master Budget

Operating Budget 2. Prepare budgeted income statement using basic data in step 1.

Financial Budget 3. Prepare forecasted financial statements: b. Capital budget c. Cash budget d. Budgeted Balance sheet

Operating Budget

Sales budget

Cash collections from customers

Purchases budget

Disbursements for purchases

Operating expenses budget

Disbursements for operating expenses

Cash Collections
It is easiest to prepare budgeted cash collections at the same time as the sales budget.

Cash collections include the current periods cash sales plus the previous periods credit sales.

Purchases Budget and Cash Disbursements

Budgeted purchases = Desired ending inventory + Cost of goods sold Beginning inventory

Disbursements could include a % of the current months purchases and a % of the Previous months purchases.

Operating Expense Budget

The budgeting of operating expenses depends on several factors.

Month-to-month changes in sales volume and other cost-driver activities directly influence many operating expenses. Expenses driven by sales volume include sales commissions and many delivery expenses.

Operating Expense Budget

Other expenses are not influenced by sales or other cost-driver activity and are regarded as fixed, within appropriate relevant ranges.

Rent

Depreciation

Insurance

Salaries

Operating Expense Disbursements

Disbursements for operating expenses are based on the operating expense budget.

Disbursements may include a % of last months and this months wages and commissions plus miscellaneous and rent expenses.

The total of these disbursements is then used in preparing the cash budget.

Budgeted Income Statement

The income statement will be complete after addition of the interest expense, which is computed after the cash budget has been prepared.

Budgeted income from operations is often a benchmark for judging management performance.

Financial Budget
The cash budget is a statement of planned cash receipts and disbursements.

The Cash budget contains these major sections: available cash balance net cash receipts and disbursements financing

Cash Budget
Available cash balance = Beginning cash balance Minimum cash balance desired.

Cash receipts depend on collections from customers accounts receivable, cash sales, and on other operating income sources.

Cash Budget

Cash disbursements for purchases depend on the credit terms extended by suppliers and the bill-paying habits of the buyer.

Payroll depends on wage, salary, and commission terms and on payroll dates.

Cash Budget
Disbursements for some costs and expenses depend on contractual terms for installment payments, mortgage payments, rents, leases, and miscellaneous items.

Other disbursements include outlays for fixed assets, long-term investments, dividends, and the like.

Cash Budget

Management determines the minimum cash balance desired depending on the nature of the business and credit arrangements.

Cash Budget

Financing requirements depend on how the total cash available compares with the total cash needed.

Needs include the disbursements plus the desired ending cash balance.

Cash Budget

Ending cash balance = Beginning cash balance + Receipts Disbursements + Cash from financing

The cash from financing can be either positive (borrowing) or negative (repayment).

Budgeted Balance Sheet

The final step in preparing the master budget is to construct the budgeted balance sheet that projects each balance sheet item in accordance with the business plan. Management then considers all the major financial statements as a basis for changing the course of events.

SALT LAKE LIGHT OPERA CASE

SLLO is a growing organization. It is not uncommon for such organization to have a shortfall in cash in initial years. SLLO has a profit of $575K but a shortfall of cash to the tune of $1,720K. (1,331 + 389). However, SLLO is borrowing through short term sources of funds, whereas the requirement is rather long term. The investment of $640K is clearly long term. Another $449K required for operations also seem to be long term unless SLLO can collect the receivables quickly. Thus SLLO must consider a long term financing option. SLLO has not been able to meet the condition that loan must be paid off atleast for one month during the year. It has a danger of defaulting in the bank loan. It requires a loan without such a stipulation.

Favorable and Unfavorable Variances

Favorable variances arise when actual results exceed budgeted.

Unfavorable variances arise when actual results fall below budgeted.

Favorable (F) versus Unfavorable (U) Variances Profit Revenue Costs F F U U U F

Actual > Expected Actual < Expected

Static and Flexible Budgets

A static budget is prepared for only one level of a given type of activity. Differences between actual results and the static budget for level of output achieved are static-budget variances.

A flexible budget (variable budget) adjusts for different levels of activities. Differences between actual results and the flexible budget are flexible-budget variances.

Flexible Budget Formulas

To develop a flexible budget, managers determine revenue and cost behavior (within the relevant range) with respect to cost drivers.

Note that the static budget is just the flexible budget for a single assumed level of activity.

Group Assignments Group#3 Case 7.62