Budgeting

1. Budgeting Fomefielding.comoter Text

2. Planning • All companies have some form of planning: • Formal or informal • Short-term, long-term, intermediate • Production planning • Project planning • Planning is determination of what should be done, how it should be done, when it should be done, where it should be done and who should do it. • Planning is done for both financial (usually through a budget) and nonfinancial items (production). Fomefielding.comoter Text

3. External Environment in Planning and Budgeting • Planning does not occur in a vacuum. It must consider external influences that will impact the company´s operations and budgets such as: • Industry: rivals, the company´s competitive position in the industry, nature of the industry, etc. • Country or international environment: domestic and international political risk, impact of globalization within the industry, possibility of war or expropriation, etc. • Macro-environment: the macroeconomic and social factors that will effect the entire industry or overall economy such as: economic growth, levels of interest rates, inflation or deflation, environmental protection laws, national tax policy, etc. Fomefielding.comoter Text

4. Setting Goals and Objectives • The bases of the planning process are the goals and objectives of the company. Without these, there can be no efficient or effective planning. • The plan is established to help the company achieve its goals and objectives. • Objectives are generally made at the organizational level and goals at the divisional level. • The objectives do not need to be agreed to by each employee, but they do need to be accepted by everyone. • This means that even if an employee does not agree with the plan, they still need to act in accordance with the plan. Fomefielding.comoter Text

5. Characteristics of Objectives and Goals • Objectives and goals must be: • Prioritized, • Clearly stated, • Specific, and • Communicated to employees. • Goals and objectives are measured in respect to their efficiency and effectiveness • Effectiveness is whether the goal was reached. • Efficiencyis whether it was reached using the fewest resources. Fomefielding.comoter Text

6. Different Types of Plans • Long-term (strategic) plans – five years or more. Based on long-term objectives and tend not to be specific or detailed. More what is to be done rather than how it is to be done. • Made by company´s top management • Looks at strategies, objectives and goals of the company, and internal/external factors affecting the company • Intermediate (tactical) plans – one to five years. Implement specific parts of the strategic plan. • Made by upper and middle managers Fomefielding.comoter Text

7. Different Types of Plans Cont´d • Short-term (operational) plans – less than 1-year in time. Relate usually to production, materials requirements, staffing, cash flows and the income statement. • Developed by middle or low level managers • Primary basis for budgets • Provide the basis to develop programs, policies and performance expectations required to achieve the company´s long-term strategic goals Fomefielding.comoter Text

8. Other Types of Plans • Single-purpose plans – plans for a specific project. • Standing-purpose plans – these plans are used multiple times for a recurring project or effort. • Contingency planning – this is planning for disruptions to the business. Also called disaster recovery planning. Fomefielding.comoter Text

9. Planning, Budgeting and Performance Evaluation • Planning, budgeting, and performance evaluation are interrelated and inseparable. The process is: • Management develops the plan consisting of goals, objectives and a proposed action plan for the future • The plan developed by management leads to the formulation of the budget. The budget expresses management´s plans in quantitative terms. • Budgets can lead to changes in plans and strategies because they provide feedback to the planning process. Managers may revise their plans based on this feedback. This back and forth exchange may occur for several iterations before the plans and budgets are adopted. Fomefielding.comoter Text

10. Planning, Budgeting and Performance Evaluation • Planning, budgeting, and performance evaluation are interrelated and inseparable. The process is (cont´d): • Once the plans and budgets are finalized, the company implements the plans to achieve its goals. • Actual results are compared to the plan. The budget is a control tool. • Sometimes this control will result in the revision of prior plans and goals or in formulation of new plans, changes in operations and revisions to the budget. • Changed conditions during the year will be used in planning for the next period. Fomefielding.comoter Text

11. Budgeting • A budget is a quantitative (numerical) expression of the company’s plans and objectives. • The Master Budget is the final, complete budget for the upcoming time period. • However, the master budget is composed of many, smaller budgets that are developed for departments, divisions, and individual products. • Operating budgets are used to identify the resources that will be needed by the individual units to carry our planned activities • Financial budgets identify the sources and uses of fund for the budgeted operations Fomefielding.comoter Text

12. Advantages of Budgets • When properly developed and administered, budgets: • Provide coordination and communication among organization units and activities • Provide a framework for measuring performance • Provide motivation for managers and employees to achieve the company´s plans • Promote the efficient allocation of organizational resources • Provide a means for controlling operations • Provide a means to check on progress toward the organization’s objectives Fomefielding.comoter Text

13. Characteristics of Successful Budgeting • The process must start with the company’s plans – both short-term plans and long-term plans. • The budget needs management support at all levels. • The people who are responsible for ‘delivering’ the budget must have input into the development of the budget. This gives them a sense of ownership over the budget. • The budget should be seen as motivational. • The budget should be an accurate representation of what is expected to occur. • The budget should be flexible to allow for changes in the business environment during the year. Fomefielding.comoter Text

14. Characteristics of Successful Budgeting • The budget should be an accurate representation of the expected future events. • Budgeting should not be rigid that it forces actions to be taken without review by appropriate management • The budget should be coordinated among all departments and divisions in the company. • The time period included in the budget should match the purpose of the budget. Fomefielding.comoter Text

15. Time Frames for Budgets • A budget is generally prepared for a set period of time, usually one year, and it matches the company fiscal year. • Budgets can also be prepared on a continuous basis. This is called a rolling budget or continuous budget. Advantages of this approach are: • Budgets are no longer done just once a year. • A budget for the next full period (usually 12 months) is always in place. • The budget is more likely to be up-to-date, since the addition of a new quarter or month will often lead to revisions in the existing budget. • Managers are more likely to pay attention to budgeted operations for the full budget period. Fomefielding.comoter Text

16. Who Should Prepare the Budget • The budget should be prepared by the people who are most knowledgeable about the different parts of the budget. • Top management should not be involved in the detailed production budget for each month. • Those who know how much things actually cost need to be consulted in the development of the budget. • Participative budgeting is when the individuals impacted by the budget are involved in the development of the budget. • This helps them feel that the budget is able to be accomplished. • The budget should also be more realistic. Fomefielding.comoter Text

17. Who Should Prepare the Budget . • Top management still has a role in the budget process at all levels, even if they do not prepare the budget at all levels. • They need to set the goals and objectives that the company is trying to achieve in the upcoming period. • And they need to communicate these objectives to everyone in the organization. • They need to ensure that all of the individual budgets are working towards that common objective and goal. • They need to provide support and information so that people have the needed information to budget. Fomefielding.comoter Text

18. The Budget Development Process • The process for developing the budget is: • An appropriate authority, such as senior management or a budget committee, set and communicate budget guidelines. • Initial budget proposals are prepared by responsibility centers. • Company managers, at all levels from responsibility center managers to the CEO, negotiate, review and approve the budget for submission to the board of directors. • Revisions: after the budget is finally adopted, it should be able to be changed if the assumptions upon which it was built change significantly. Fomefielding.comoter Text

19. The Budget Development Process • The process for developing the budget are (cont´d): • Actual results should be compared to the budget. This variance reporting is done at all levels of the company. • Variance reports should be used at every level of the company to identify problem areas and to make adjustments to operations. Fomefielding.comoter Text

20. Best Practice Guidelines for the Process • Best practice guidelines for the budgeting process include the following: • Link development of the budget to corporate strategy • Communication is vital • Design procedures to allocate resources strategically • Managers should be evaluated on performance measures other than meeting budget targets • Cost management efforts should be linked to budgeting • Strategic use of variance analysis • Reduce budget complexity and budget cycle time • Develop budgets that can be revised if necessary • Review the budget regularly during the year Fomefielding.comoter Text

21. Budgetary Slack and Goal Congruence • Goal congruence is defined as “aligning the goals of two or more groups.” As used in planning and budgeting, it refers to the aligning of goals of the individual managers with the goals of the organization as a whole. • Budgetary slack is the difference between the budgeted performance and the performance that is actually expected. It is the practice of underestimating budgeted revenues and overestimating budgeted costs to make the overall budgeted profit more achievable. Fomefielding.comoter Text

22. Budgetary Slack and Goal Congruence • Managers who develop the budgets they are going to be accountable to meet may build budgetary slack into their budgets in order to make sure their budgets are achievable without any risk of failure. • Budget slack has advantages and disadvantages: • On the positive side, it can provide managers with a cushion against unforeseen circumstances. This can limit their exposure to uncertainty and reduce their risk aversion. • On the negative side, it misrepresents the true profit potential of the company and can lead to inefficient resource allocation and poor coordination of activities within the company. Fomefielding.comoter Text

23. Standard Costs and Setting Standard Costs • Standard costs are the expected cost for labor, materials, or overhead to produce one unit of product (how much it should cost to produce) • To calculate the standard cost, the company needs to know the expected level of production and usage of the different inputs. There are a number of ways to calculate this: • Activity analysis • Historical data • Target costing • Strategic decisions • Benchmarking Fomefielding.comoter Text

24. Standard Setting Process • As with the budget, the standards need to be set by the correct people. • Authoritative standard setting – standards are set from above. • Employees do not feel ownership or a commitment to these standards because they may see them as unrealistic. • Participative standard setting – employees are involved in the standard setting process. • More support from the employees and a greater commitment to meet the standards because they were part of setting them. Fomefielding.comoter Text

25. Denominator Level Concepts • Supply Denominator Level Concepts • Theoretical or ideal capacity – the level of activity if the company produces at its maximum level with no idle time or downtime and no decreases in sales demand. • Practical (currently attainable) capacity – theoretical level reduced by allowances for idle time and downtime but not for a decrease in sales demand. • Demand Denominator Level Concepts • Master budget capacity utilization – the amount of output expected based on expected demand • Normal capacity utilization – the level of activity achieved in the long run, accounting for seasonal and cyclical changes in sales demand. This is the preferable method. Fomefielding.comoter Text

26. Budget Methodologies

27. The Annual/Master Budget • The development of an annual budget for a large corporation may take many months to complete. • Important concepts for the budgeting process are: • One of the most important things in the process of developing the budget is involving all of the correct people (participative budgeting) • bottom-up budgeting: the budget is developed by starting at the lowest levels in the operations systems and building revenues and costs from there. • A budget manual details the budget process. • A planning calendar is the document that sets forth all of the deadlines, policies and procedures of the budgeting process. Fomefielding.comoter Text

28. The Different Budgets • There are a number of budgets that will need to be prepared. Some of them need to be prepared in a specific order. • This is because some of the budgets build on each other. • The sales budget is the first budget prepared. • The cash budget is the last budget prepared. Fomefielding.comoter Text

29. The Sales Budget • This is the budget that must be completed first. • Everything else the company will do during the year is based on how many units they expect to sell. • This is also the hardest budget to do, because it based on the decisions and factors not controlled by the company: • Consumers • Competitors • The economy Fomefielding.comoter Text

30. The Production Budget • After the sales budget is completed, the company can prepare the production budget. This budget is based on: • The expected level of sales, • Whether the company wants to change the level of inventory, • Any decisions about outsourcing production (if the company will buy finished products or parts from an external supplier). • This budget also needs to include when during the year the units will be produced. Fomefielding.comoter Text

31. The Next Budgets • Once the production budget is set, the company can create a number of other budgets that are based on the level of production: • Direct materials budget • Labor budget • Overhead budget • Ending inventory budget • Cost of goods sold budget • These are all interrelated so a change in one of these budgets will likely cause a change in another. Fomefielding.comoter Text

32. Following Budgets • There are also a lot of other budgets that need to be prepared • Selling and marketing budget, • General and administrative budget, • Accounting and finance budget, • Research and development budget, and • Any budget for other type of revenue or expense that the company has during the budgeted period. Fomefielding.comoter Text

33. The Cash Budget • The cash budget is the last budget prepared because all other budgets go into this budget. • This budget will be prepared on a monthly basis. • By preparing it on a monthly basis the company can identify any future cash shortages before they happen. • Better planning for cash shortages will make the cost of borrowing lower. Fomefielding.comoter Text

34. Operating and Financial Budgets • The operating budget is the budgeted income statement and its supporting budget schedules. • It is made up of all the revenue budget and the production, purchasing, marketing, and research & development budgets. • The financial budget is the budgeted balance sheet and statement of cash flows, cash budget and capital budget. • These budgets are what the company’s financial statements will look like next year if reality exactly matched the budgeted amounts. • By looking at them now, the company can see what the ratios will be like, and if they would be in violation of any covenants or loan agreements. Fomefielding.comoter Text

35. The Capital Budget • This is the budget for large, capital expenditures (property, plant and equipment). • Because these are large expenditures, the capital budget is often prepared years in advance. • The company will need to plan for the financing of these purchases. • This budget is often prepared outside of the budgeting process that we have discussed leading to the forecasted financial statements. • Top management is very heavily involved in this budget because it is connected to their long-term plans. Fomefielding.comoter Text

36. The Master Budget • The individual budgets that make up the operating and financial budgets together make up the master budget. • The master budget is a summary of management’s operating and financial plans for the period, expressed as a set of financial statements. Fomefielding.comoter Text

37. Flexible Budgeting • Flexible budgeting is the process of producing budgets for different levels of activity. • This makes the evaluation process better and more useful. • The master budget is a static budget. It is produced for one level of activity, and if actual sales are different, it is not as useful to make actual vs. budget comparisons. • Flexible budgeting allows better comparisons because there is a budget for what income should have been at the level of sales that actually occurred. • A flexible budget requires standard costs to be available. Fomefielding.comoter Text

38. Other Types of Budgets

39. Project Budget • A project budget is a budget for a specific project. As such, the time frame of the budget may be very short or more long-term, depending upon the length of the project. • Project budgets are different from the master budget and the flexible budget. • The master budget or the flexible budget covers a distinct time span. In contrast, a project budget covers an identifiable project that has its own time span. • Projects must be planned over their entire life spans and should be viewed as special commitments. Fomefielding.comoter Text

40. Life-Cycle Budgeting • This is a budget not for a specific time period, but for a specific product. • It traces all of the costs and revenues from the design of the product, through production and includes after sale costs that the company will incur. • This provides a more accurate pricing for the product because the design, pre-production and post-production costs also need to be covered by the selling price. Fomefielding.comoter Text

41. Activity-Based Budgeting • Activity-based budgets are prepared based on the resource consumption and related costs to perform the budgeted activities. • Activities that drive the costs are identified • A budgeted level of activity for each of these drivers is determined based on a budgeted level of production • Budgets are developed based on budgeted activity levels. • In an activity-based budget system, there is a clear relationship between resource consumption and output. Preparing an activity-based budget brings out information about opportunities for cost reductions and elimination of wasteful activities. Fomefielding.comoter Text

42. Zero-Based Budgeting • This system starts each year with a blank page, and all items are created new for the year. • In incremental budgeting, the prior period’s budget is just increased by 10%, or some determined amount. • All revenues need to be planned for each year. • All expenses need to be accounted for and justified. • By looking at every expense each year, management should be able to eliminate non-value adding expenses and try to find cheaper alternatives. Fomefielding.comoter Text

43. Budget Reports and the Control Loop • The budget report is the comparison between the budgeted amount and the actual result. (This is also variance analysis and is covered in more detail in that material). • The steps in the control loop are: • Establish the budget, or standard, • Measure the actual performance, • Analyze and compare actual results with the budget, • Investigate unexpected variances, • Devise and implement needed corrective actions, • Review and revise the standards as needed. Fomefielding.comoter Text