The Budget Preparation

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CHAPTER 9

• The Budget Preparation

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In this chapter, we will discuss

• The basics of budgeting
• Why budgets are important for control purposes
• Various types of budgets
• When each type of budget is used
• How to prepare some of the important budgets
• What are their limitations
• Behavioral implications

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What is a budget?

• Budgets are summaries of short-term operational
  activities of a firm.
• For example, a firm may prepare cash budget to
  predict cash inflows and outflows or
• A production budget to plan its production
  levels.
• Budgets are quantitative representations.

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How does a budget differ from a forecasting?

• A forecast is a prediction and usually
• There are many ifs and buts before a forecast
  resembles reality.
• Most importantly, a forecaster can only predict
  (sales would increase by 20 by next year).
  However,
• A forecaster cannot shape the selling events to
  make the sales go up by 20

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How does a budget differ from a forecasting?

• In contrast, a budget is a plan (sales must go up
  by 20 by next year).
• The budget plan is based on facts, events in
  progress, actions planned, etc.
• The budget preparer must consult those affected,
  obtain input before preparing the budget, and
• The Manager of a unit must take active steps to
  achieve the budget.
• Both forecasts and budgets are necessary.
  Forecast is useful for planning while budget is
  useful for both planning and for controlling.

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Characteristics of a budget

• Stated in monetary units but,
• Could contain non-monetary items such as units
  produced, sold, no. of items processed etc.
• Usually, short-term (one year) but could be
  extrapolated from or to the longer term.
• Senior management must be involved in the process
  and must approve it.
• Most important budgets must be compared to
  actual and the variances must be investigated.

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Usefulness of the budget

• Fundamentally, it is a planning and control tool
  (coordination, problem signaling, and
  problem-solving activities).
• It is a good tool to communicate short-term goals
  to employees.
• It also helps senior management in assessing
  whether organizational goals are met (e.g.
  improvement in customer service but no allocation
  for employee training).
• Since input is required from multiple units, it
  promotes coordination, planning, and sharing.
• Allows a firm to anticipate problems so that
  corrective action can be taken early.

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How does a budget help with strategic planning?

• Strategic Plan Tells managers what the
  organizational goals for this year are (e.g.
  sales growth, profits, new products, expansion in
  production capacity).
• To accomplish the plan, every unit must
  contribute through its efforts.
• Therefore, each unit is subjected to a budgeting
  plan, process, and proposed results (operational
  plan).
• Collectively, the individual budgets would point
  out whether the strategic plan is likely to be
  achieved or not.
• If not, what corrective actions must be taken.
• Consequently, budget not only demands
  responsibility but also accountability.

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Budget helps strategic planning A real-world
example

• Repertory Theatre of St. Louis (somewhat like
  Music Academy).
• Not-for-profit professional art/music theater
  supported by contributions from donors and
  members and from ticket sales.
• Initial financial assessment indicated that the
  theater is doing well.

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Repertory Theater of St. Louis The problems

• However, a five-year budget showed that expenses
  are likely to exceed revenues within a few years.
• Additional contribution from donors will not
  bridge the gap.
• Cost cutting would not work because it is already
  low.
• Ticket prices cannot be increased because of
  competitive pressures.

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Repertory Theater of St. Louis The Solution

• Build a second main-stage performing space that
  would allow the theater to
• Put on more performances
• Sell more tickets.
• Thus, the long-range budget identified a
  financial crisis and suggested a strategic
  solution to deal with the problem.

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How does a budget help with performance
evaluation or accountability?

• By creating benchmarks.
• A budget is a rationally prepared set of
  benchmarks.
• By comparing actual performance to the budget,
  deviations can be ascertained and evaluated.
• Within reasonable limits, the budget points to
  accomplishments or lack thereof.

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Various types of budgets

• Two major types
• Operating budgets (most middle level managers
  would be involved in this process)
• Capital or Investment budgets (mostly senior
  managers are involved in this process).
• Operating budget could includes several
  sub-budgets (e.g. Revenue budget, production
  budget, marketing budget, etc.)

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The Budgeting Process Where do we begin and
when do we end it?

• An organizations strategic goals is the starting
  point for the budgeting process.
• Projected financial results for the next year is
  compared to the goals to assess acceptability.
• The budgeting process is driven by the demand
  forecast (demand for a product at a given price).
• Demand forecast can be developed in multiple ways
  (market survey, growth trends, or other
  estimates).
• Based on demand forecast, prepare a sales plan
  for each product line and services.

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The budgeting process (continued)

• Based on the sales plan, develop the factors of
  production (or other procurement) raw
  materials, labor, overheads, cash.
• Lots of details would improve the budgeting
  process but is time consuming and expensive.
  Strike a balance.
• We will work on one or two budgets later.

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Preparing the initial budget

• Initial budget preparation is done by each
  responsibility center (revenue centers, cost
  centers, etc.)
• Because, they know more about their individual
  units, requirements, constraints, etc.
• Thee centers must consider both external factors
  and internal factors that could have an impact on
  their budget estimates.

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Top Management
Middle Management
Middle Management
Supervisor
Supervisor
Supervisor
Supervisor
Note Initial flow of budget data in a
participatory system is from lower levels of
responsibility to higher levels of
responsibility. Each responsibility center
manager prepares his/her budget estimates and
submits to the next higher level of management.
These estimates are reviewed and consolidated as
they move upward in the organization.
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Budgeting Process The Role of the
Responsibility Centers

• Prepare the budget compatible with organizational
  goals.
• Communicate with other units and validate units
  numbers.
• Dont be optimistic but do not be pessimistic to
  show achievement of budget targets.
• Remember that eventually, resp. center budgets
  are subject to approval by senior managers and
  analysts, and are subject to revisions.

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What we rarely discuss Human Factors in
Budgeting

• Regardless of what we discussed so far,
• Budget process depends on 1) the degree to which
  top management accepts the budget program and 2)
  the way top management uses the budget data.
• Top management should NOT use the budget as a
  weapon to pressure employees or to blame if
  something goes wrong.
• There should be meaningful dialogue.
• The human aspect is the key.

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Let us now prepare one or two small budgets
use the description and the numbers given in the
next set of slides. The exercises would give you
a basic idea of the budgeting process (although
not the human interactions involved during such a
process)
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Mylar Company

• Manufactures and sells a product that has
  seasonal variations in demand with peak sales
  coming in the 3rd quarter. The following
  information concerns operations for Year 2 the
  coming year and for the first two quarters of
  Year 3.

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Mylar Company data
The companys single product sells for 8 per
unit. Budgeted sales in units for the next six
quarters are as follows
Year 2 Quarter Year 2 Quarter Year 2 Quarter Year 2 Quarter Year 3 Quarter Year 3 Quarter
1 2 3 4 1 2
Budgeted Sales in Units 40,000 60,000 100,000 50,000 70,000 80,000
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Mylar Company Data

• Sales are collected 75 in the qr. Sales are
  made, remaining 25 in the following quarter. On
  Jan. 1, Year 2, the balance sheet showed 65,000
  in accounts receivable, all of which will be
  collected in the first quarter of the year. Bad
  debts are negligible and can be ignored.
• Company desires an ending inventory of finished
  units on hand at the end of each quarter equal to
  30 of the budgeted sales for the next quarter.
  On Dec. 31, year 1, the company 12,000 units on
  hand.
• Five pounds of raw materials are required to
  complete one unit of product. Company requires
  an ending inventory of raw materials on hand at
  the end of each quarter equal to 10 of the
  production needs of the following quarter. On
  Dec. 31, Year 1, the company had 23,000 pounds of
  raw materials on hand.
• The raw material costs 0.80 per pound.
  Purchases of raw material are paid for in the
  following pattern 60 in the quarter purchases
  are made, remaining 40 in the following quarter.
  On Jan. 1, Year 2, the companys balance sheet
  showed 81,500 in accounts payable for raw
  material purchases, all of which will be paid for
  in the first quarter of the year.

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Mylar Company

• We will prepare
• A sales budget and a schedule of expected cash
  collections.
• A production budget
• A direct materials purchases budget and a
  schedule of expected cash payments for material
  purchases.

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Sales Budget for Mylar
Year 2 Quarter Year 2 Quarter Year 2 Quarter Year 2 Quarter
1 2 3 4 Year
Bud. Sales 40,000 60,000 100,000 60,000 250,000
Selling price per unit X 8 X 8 X 8 X 8 X 8
Total Sales 320,000 480,000 800,000 400,000 2,000,000
Based on these numbers, we will prepare a
schedule of cash collections
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Mylar Schedule of Cash Collections
Year 2 Quarter Year 2 Quarter Year 2 Quarter Year 2 Quarter Year 2 Quarter Year 2 Quarter
1 2 3 4 Year
A/Rec. Beg. Bal. A/Rec. Beg. Bal. 65,000 65,000
1st Qr. Sales (320,000x75, 25) 1st Qr. Sales (320,000x75, 25) 240,000 80,000 320,000
2nd Qr. Sales (480,000 x75, 25) 2nd Qr. Sales (480,000 x75, 25) 360,000 120,000 480,000
3rd Qr. Sales (800,000x75, 25) 3rd Qr. Sales (800,000x75, 25) 600,000 200,000 800,000
4th Qr. Sales (400,000x75, 25) 4th Qr. Sales (400,000x75, 25) 300,000 300,000
Total Cash Collections Total Cash Collections 305,000 440,000 720,000 500,000 1,965,000
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Based on Sales Budget, The Production Budget for
Mylar
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Mylar Production Budget Raw Material
Requirement
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One more example for you to take a look at -
Revenue (Sales) budget Davenport Company Data

• Davenport Co. makes cash (20 of total sales),
  credit card (50 total sales) and account sales
  (30 of total sales). Credit card sales are
  collected in the month following the sale, net of
  3 credit card fee. Account sales are collected
  as follows 40 in the first month following the
  sales, 50 in the second month following the
  sale, 8 in the third month following the sales,
  and 2 is never collected.
• Using the data from the table, prepare a
  statement showing the cash expected each month.

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Davenport Co. Projected Sales
Month Sales Month Sales
Jan. 12,369,348 July 21,747,839
Feb. 15,936,293 Aug 14,908,534
Mar. 13,294,309 Sep 11,984,398
Apr. 19,373,689 Oct 18,894,535
May 20,957,566 Nov 21,983,545
June 18,874,717 Dec 20,408,367