PART TWO: PLANNING

1. PART TWO:PLANNING Chapter 6 - Planning and Budgeting

2. Completes the planning phase Budgeting strategies Revenue cycle planning YOU ARE HERE! Expenditure cycle planning Conversion cycle planning Pro-forma financial statements Cash planning Chapter 6 Planning and Budgeting

3. CHAPTER 6 LEARNING OBJECTIVES L.O.1: Explain why companies use budgets. L.O.2: Describe the various budgeting strategies companies use. L.O.3: Explain the planning process in the revenue cycle and the resulting budgets. L.O.4: Describe the planning process in the conversion cycle and the resulting budgets.

4. CHAPTER 6 LEARNING OBJECTIVES L.O.5: Explain the planning process in the expenditure cycle and the resulting budgets. L.O.6: Describe the relationships of the revenue, conversion, and expenditure cycle to pro forma financial statements. L.O.7:(Appendix) Indicate the purpose of the economic order quantity model of inventory planning.

5. WHAT IS A BUDGET? A budget is a plan for the future expressed in financial terms. • Budgeting is a process of expressing a company’s goals and objectives in quantitative terms and is crucial to the planning process.

6. WHAT ARE THE BENEFITS OF BUDGETING? • Planning • Communication and coordination • Resource allocation • Evaluation and control

7. PLANNING Budgeting Benefits Budgeting requires a business to plan by considering the financial ramification of future goals and objectives and how they will be accomplished. “What should our sales goals be this year? How can we reduce our operating costs?”

8. COMMUNICATION AND COORDINATION Budgeting Benefits Budgeting promotes communication and coordination because the company as a whole must work together to achieve future goals and objectives. “Lets discuss our sales goals with the department heads and then ask the production department to prepare a production plan.”

9. RESOURCE ALLOCATION Budgeting Benefits Budgeting requires a business to determine which activities should receive the company’s limited resources to maximize effectiveness and efficiency. “How should we spend our technology budget this year to maximize our technology resources?

10. RESOURCE ALLOCATION: ANALYSIS OF ACTIVITIES Activity-based management Non-value Added Activities Focus on activities that add value to products from customer’s perspective. Value Added Activities Reduce or eliminate activities that do not add value the product from customer’s perspective.

11. EVALUATION AND CONTROL Budgeting Benefits A budget serves as a useful benchmark against which to evaluate and control actual performance. “Why were sales for the month less than expected?”

12. WHAT ARE THE COSTS OF BUDGETING? • Time and resource requirements. • Adaptability of departments and segments in the business. • Motivation and behavior of individuals.

13. TIME AND RESOURCE REQUIREMENTS Sept. 98 Oct 98 Nov 98 Dec 98 Budgeting is time-consuming. A typical yearly budget sequence may takes as long as three or four months. Budget Sequence for 1999

14. ADAPTABILITY OF DEPARTMENTS AND SEGMENTS If a budget is too rigid it inhibits a department or business segments from responding to changes in the environment. “We can’t take the customer’s order because our costs will exceed the budgeted amount!”

15. MOTIVATION AND BEHAVIOR OF INDIVIDUALS The budgeting process can sometimes result in inaccurate department budgets (that ultimate impact the overall budget) if employees are rewarded for meeting or exceeding budgets. “Let’s budget for $40,000 in sales but we can easily hit $45,000 -it will makes the department look better to exceed our goal.”

16. BUDGETING STRATEGIES A budgeting strategy is the manner in which a company approaches the budgeting process. Mandated versus participative budgeting? Incremental versus zero-based budgeting?

17. MANDATED BUDGETING Upper-level management Lower-level management Sets operating budgets in line with goals and objectives of upper-level management Employees Top down budgeting

18. PARTICIPATORY BUDGETING Upper-level management Budgeting process begins at lower levels of the organization; budget director coordinates budget to develop a comprehensive budget plan Lower-level management Employees Bottom-up budgeting

19. A BLENDED APPROACH TO BUDGETING Mandated Top down budgeting Bottom up budgeting Participatory

20. DETERMINING THE BUDGET NUMBERS: INCREMENTAL BUDGETING Starting point for next period’s budget Current period budget

21. DETERMINING THE BUDGET NUMBERS: ZERO-BASED BUDGETING Starting point for next period’s budget Current period budget

22. Probably, the best approach would be a combination of mandated and participatory budgeting, considering each activity in the business cycle. A combination of zero-based and incremental might be appropriate also as well as information on other Sherwin-Williams retails stores. PAUSE AND REFLECT If you were a manager of a new Sherwin-Williams retail store, what budget approach and budget strategy would you adopt? Why?

23. WHAT TYPES OF BUDGETS DO COMPANIES PREPARE? Going concern principle - the business has continuity Strategic Budgets • Long-term plan for the company • 5-10 years • General in nature • Should the company expand its product lines? • Should the company expand into new markets? • Should the company align with a strategic business partner? • How will it improve shareholder value?

24. WHAT TYPES OF BUDGETS DO COMPANIES PREPARE? The periodicity principle - measure profits at regular intervals Operating Budgets • Guides day to day operations - carries out segment of the strategic plan • 1 year or less • Specific in nature • What are the sales targets? • How many units should be produced? • How much will raw materials cost? • How much will labor cost? • What will be the target earnings growth?

25. MASTER BUDGETING • Compiles all of the operational budgets for the period through the revenue, conversion and expenditure cycle. • Converts these budgets to cash budgets and pro forma financial statements for review. • After review and acceptance, the master budget then proceeds to execution stage.

26. Exhibit 6.1 MASTER BUDGETING Selling and administrative expense budget Expenditure Cycle Sales Budget Conversion Cycle Revenue Cycle Direct material Purchases Budget Cash Receipts Schedule Accounts Receivable Schedule Direct Labor/ Manufacturing Overhead Budget Production Budget Cash Disbursement Schedule Accounts Payable Schedule Pro-forma financials

27. BUDGETING IN THE REVENUE CYCLE • Sales Trends, Target Markets • Customer needs & demands • Competitive trends • Demographic Data • Advertising promotion to achieve targets • New products • Analysis of economic, political, legal, social trends Sales Planning and Budgeting Monthly Sales Budget in Dollars, Quantity, Product Line

28. BUDGETING IN THE REVENUE CYCLE • Timing of sales collections • Credit policies and bad debts • Timing of major revenue and expense items • Maximize investment earnings Cash Receipts Budgeting and Planning Monthly Cash Receipts Schedule Monthly Accounts Receivable Schedule

29. BUDGETING IN THE CONVERSION CYCLE • Determine the level of inventory to support operating plan Inventory Planning Monthly Inventory Levels Ordering costs Carrying Costs Just-in-Time Inventory Model

30. JUST-IN-TIME INVENTORY MODEL JIT is a pull system Customer demand

31. Sherwin-Williams’ manufacturing division would be a good candidate for JIT if its customers are fairly consistent in their ordering patterns. The retail stores would not be good candidates because customer demand is more difficult to predict. PAUSE AND REFLECT Do you think Sherwin-Williams would be a good candidate for adopting JIT? Why or why not?

32. BUDGETING IN THE CONVERSION CYCLE • Determine how many units and when to produce to meet sales budgets Exhibit 6.6 Production Planning Sherwin-Williams Monthly Production Budget in Gallons Jan Feb Mar Sales in Gallons 7,500 9,200 9,500 Add: desired ending inventory 92 95 98 Total inventory to have on hand 7,592 9,295 9,598 Less: beginning inventory 0 92 95 Gallons of paint to produce 7,592 9,203 9,503

33. The desired inventory for March is 1% of April’s anticipated sales in gallons, or 9800 x .01 =98 PAUSE AND REFLECT How does Sherwin-Williams compute the desired ending inventory for March?

34. BUDGETING IN THE EXPENDITURE CYCLE • Determine product costs (raw materials direct labor, and manufacturing overhead) Production Expenditures Planning Direct raw materials cost (traceable) Direct labor costs (traceable) Manufacturing/overhead (indirect - not traceable costs)

35. BUDGETING IN THE EXPENDITURE CYCLE • Companies must also plan for other expenditures such as salespersons’ commissions, and other selling and administrative costs. Selling and Administrative Costs Planning Advertising, Marketing Expenses Sales Commissions Product Warranty Costs Office and Administrative Salaries

36. BUDGETING IN THE EXPENDITURE CYCLE • Timing of cash payment for goods and services to meet operating plan. • Are there sufficient cash resources when they are needed? Cash Disbursement Planning Monthly Cash Disbursement Schedule Monthly Accounts Payable Schedule

37. The Pro-Forma Income Statement The Pro-Forma Balance Sheet Assets $100,000 Liabilities $15,000 Owners’ Equity $85,000 Total Liabilities & Owners’ Equity $100,000 Revenues $25,000 Expenses $15,000 Net Income $10,000 Pro-Forma Statement of Cash Flows Operating activities Investing activities Financing activities Net cash flow Beginning cash Ending cash $50,000 PRO-FORMA FINANCIAL STATEMENTS • Pro-forma financial statements provide the business with the expected results of the budget if executed. • Management can evaluate whether operating goals and objectives would be achieved in financial terms. Projected financial position Projected profits Projected cash

38. THE CASH BUDGET • Cash receipts from: • Operating activities (Customers) • Financing activities • Investing activities • Cash payments for: • Operating activities (suppliers, employees • Financing activities • Investing activities Beginning cash Change in cash + - Monthly Cash Budget Ending cash

39. REACTING TO THE BUDGET: CASH PLANNNG • Forecasts cash position in the operating plan. • Identifies cash shortages up-front so that cash inflows through short-term financing can be arranged. • Identifies cash surpluses up-front so that short-term investments can be arranged. Acquiring Short-term Loans Selling Notes and Account Receivables Investing in Treasury Bills Investing in Certificate of Deposits Investing in Money Market Accounts

40. COVERING CASH SHORTAGES Time period • It is possible for a business to obtain short-term loans from banks or other financial institutions and suppliers when immediate cash is needed. Acquiring short-term loans Creditworthiness of the business I promise to pay New York Bank $3,000 plus 12% annual interest on August 13, 1996. Date: May 15, 1996 Signed:_________ Payee of note Maker of note

41. INTEREST BEARING NOTES Interest = Principal x Rate x Time • On a interest bearing note, the maker of the note borrows a fixed sum and agrees to pay a stated rate of interest for the time period borrowed. • Lets assume the business borrows $100,000 for 60 days at 12% annual interest.How much interest and principal would have to be paid at the end of the 60 day period? Interest =$100,000 x .12 x 60/365 Interest = $1,973 Maturity Value of Note = $100,000 + $1,973, or $101,973 Due in 60 days

42. NONINTEREST BEARING NOTES • On a noninterest bearing note, the maker of the note (borrower) receives less that the amount of money borrowed to compensate the lender for interest. Computing the effective rate of interest is more complex: Face value of note - Amount received Amount received X Days in the year Length of loan in days

43. NONINTEREST BEARING NOTES Borrower beware! • Lets assume a business borrows $100,000 for 60 days. A noninteresting bearing note is signed and the borrower receives $98,000 in loan proceeds. • How much is the interest? Interest paid is difference between face value of note and loan proceeds, or $2,000. $100,000 - $98,000 $98,000 X 365 60 Effective interest rate = 12.4%

44. It might be time to reconsider your friends. You will pay unstated interest of $1, or $.20/day for that $4 loan. That works out to an effective annual rate of 1825% ($1/$4 x 365/5 =18.25 or 1825%)!! You can prove this using the I = PRT formula: I = $4 x18.25 x 5/365 = $1. Understanding unstated interest is important! PAUSE AND REFLECT You asked your best friend if you could borrow $4 until payday on Friday (5 days from now). She was a little reluctant because she thought she would need the cash but finally agreed if you gave her back $5 on Friday. Is this a good deal? Why or why not?

45. FACTORING ACCOUNTSRECEIVABLES • Companies in need of immediate cash can sell other short-term assets such as notes or accounts receivable. • When a company sells accounts receivables to a third party such as a bank or financing company, it is called factoring. • A factoring fee is charged that represents the cost of lending money to the borrower until the cash is collected from the open accounts receivable. Factoring fee = Face Amount of Accounts Receivable x Interest x Time (amount of time before accounts receivable are collected)

46. Interest to lender FACTORING ACCOUNTS RECEIVABLE • Lets assume a business has $150,000 of accounts receivable due in 30 days, the buyer charges 15% and withholds a 10% reserve against uncollectible accounts. • How much is the factoring fee paid and the net proceeds to the borrower? Factoring fee: $150,000 x .15 x 30/365 = $1,849.31 Proceeds to borrower: Gross amount of accounts receivable $150,000.00 Reserve for uncollectible accounts (10%) 15,000.00 Factoring fee 1,849.31 Net proceeds to borrower $133,150.69

47. The lender is taking the risk that the notes or accounts receivable will ultimately be collected. Sometimes a lender will only agree to purchase with the right of recourse against the borrower. PAUSE AND REFLECT When a factoring company or a bank buys notes or accounts receivables from a business, what risk is taken?

48. U.S.Treasury Bills U.S.Treasury Bills U.S.Treasury Bills U.S.Treasury Bills INVESTING CASH SURPLUSES • T-bills are short-term federal government securities. When the government issues T-bills, it is borrowing money from willing investors on a short-term basis, usually 30 days to 12 months. • Treasury bill investments are virtually risk-free and very liquid. • Sometimes companies have excess cash that is not immediately needed. • An investment in Treasury bills provides an alternative for idle cash to be invested to earn a return.

49. Certificates of deposit U.S.Treasury Bills U.S.Treasury Bills U.S.Treasury Bills INVESTING CASH SURPLUSES • CDs are guaranteed savings deposits with banks or other financial institutions through the Federal Deposit Insurance Corporation. • While available on demand, a penalty is charged for early withdrawal. • These are low risk investments but do not have the flexibility that exist with T-bill investments. • An investment in certificate of deposits provides another alternative for idle cash to be invested to earn a return.

50. U.S.Treasury Bills U.S.Treasury Bills U.S.Treasury Bills INVESTING CASH SURPLUSES • Money market accounts are similar to interest-bearing checking accounts except the rate of interest is higher, number of withdrawals are limited over a stated period of time, and usually a minimum balance is required. • Money market accounts are very low risk and provide good liquidity because the investor can simply write a check for funds needed. • An investment in money market accounts is another alternative for idle cash be invested to earn a return. Money Market Accounts