MBA 610 Forecasting

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MBA 610- Forecasting

• Welcome!!
• Don Pagach

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Todays Scedule

• Short review of financial statements
• Discussion of budgeting
• Analysis of budgets
• External forecasting
• Building a model
• Next Time
• Two case studies
• Shirts and Pants MGM Mirage

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My background

• Research
• Forecasting research time series properties of
  earnings
• Analyst forecasts vs. time series forecasts
• Work
• Accounting/finance for a number of startups
• Preparation of pro forma financial statements for
  VCs and other investors

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Your background

• Are you involved in forecasting at work?
• In what manner?
• What do you want to get out of this course?
• Information for work
• Information for personal investing

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Forecasting

• Financial forecasting is a key activities for
  CFOs and financial analysts.
• representing an extension of a firms strategic
  planning efforts.
• Critical to the sustainability of the
  organization. Generally, closely aligned with the
  firms strategic planning activity.
• A methodology for assessing potentially critical
  resource gaps.
• Given uncertainty, a range of possible outcomes
  and the key risks associated with each should be
  considered. Precision is an unlikely outcome
• The planning process cannot be static, it must be
  responsive to and reflect changing internal and
  external realities.

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Forecasting

• Financial Forecasting is driven by financial and
  non-financial information
• Market structure, growth potential, pricing,
  competitive position
• Critical skills (technology, marketing,
  manufacturing)
• Scarce resources (people, distribution channels,
  capital)
• Product and market mix
• Cost structure
• Target rate of return and risk tolerance
• International (foreign exchange, product fit,
  culture)

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Forecasting

• Financial Forecasting supports the non-financial
  strategy by identifying and quantifying
• Sources and cost of capital
• Key relationships
• Investment levels (hard assets, working capital,
  training)
• Potential product/market profitability
• Simulating a range of possible outcomes based
  upon the interaction of key planning assumptions
  (internal and external)

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Forecasting

• Goal of forecasting is to provide a set of pro
  forma financial statements
• representing the range of potential outcomes
• the investment levels and financing necessary to
  support the forecasted mix and level of business
• a measurement benchmark for actual business
  performance that can be continuously reviewed and
  adjusted
• See pro forma Financials for VC

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Best Practices

• Budgeting must be linked to strategic planning
  since strategic decisions usually have financial
  implications.
• Make budgeting procedures part of strategic
  planning. For example, strategic assessments
  should include historical trends, competitive
  analysis, and other procedures that might
  otherwise take place within the budgeting
  process.
• The Budgeting Process should minimize the time
  spent collecting and gathering data and spend
  more time generating information for strategic
  decision making.
• Get agreement on summary budgets before you spend
  time preparing detail budgets.

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Best Practices

• Automate the collection and consolidation of
  budgets within the entire organization. Users
  should have access to budgeting systems for easy
  updating.
• Budgets need to accept changes quickly and
  easily. Budgeting should be a continuous process
  that encourages alternative thinking.
• Budgets should give lower level managers some
  form of fiscal control over what is going on.
• Leverage your financial systems by establishing a
  data warehouse that can be used for both
  financial reporting and budgeting.

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Outside Forces

• Life cycle of the business
• Financial conditions of the business
• General economic conditions
• Competitive situation
• Technology trends
• Availability of resources

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Short Accounting Review

• Lets examine Coldwater Creeks Financial
  Statements

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Forecasting

• Where to start?
• Sales is the one account from which most others
  can be tied. Expenses are incurred to generate
  sales, assets are put in place to generate sales,
  and liabilities are assumed (indirectly) to
  generate sales.

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Pro Forma Financial Statement Development
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Pro Forma Income Statement Simple Corporation
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Pro Forma Balance Sheet Simple Corporation
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Pro Forma Cash Flow - Simple Corporation
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Pro Forma Financial Ratios - Simple Corporation
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Pro Forma Du Pont Analysis - Simple Corporation
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Budgeting, Standard Costs and Variance Analysis

• Our initial discussion will focus on budgeting
  and more detailed internal forecasts
• Budgets are simply plans of actions expressed in
  monetary terms.
• Most companies prepare a strategic plan to
  identify strategies for future activities and
  operations, a key component of the strategic plan
  is the budget
• The strategic plan should set the overall goals
  and strategic objectives

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Budgeting, Standard Costs and Variance Analysis

• The strategic plan should provide the foundation
  for long range planning, which is a five or ten
  year plan
• The long range plan needs to be supported by
  capital budget (long-term investments and sources
  of funds)

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Budgeting, Standard Costs and Variance Analysis

• The Master Budget is short-term and has two
  components
• Operating Budget Focused on the firms operating
  activities
• Financial Budget - Focused on the firms
  investing and financing activities

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Types of Forecasts Used in Budgeting

• The sales forecast is primary to most
  organizations.
• The collection period for sales on account.
• Percent of uncollectible sales on account.
• Cost of materials, supplies, utilities, etc.
• Employee turnover.
• Time required to perform activities.
• Interest rates
• Development time for new products or services.

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Why Budget?

• Forces management to plan
• Provides resource information that can be used to
  improve decision making
• Provides a standard for performance evaluation
• achieved by comparing actual results with
  budgeted results - feedback component of useful
  information
• Improves communication and coordination

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Budgeting Best Practices

• Link budget development to corporate strategy.
• Design procedures that allocate resources
  strategically.
• Tie incentives to performance measures other than
  meeting budget targets.
• Link cost management efforts to budgeting.
• Reduce budget complexity and cycle time.
• Develop budgets that accommodate change.

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Problems with Budgeting

• Main criticisms (from Beyond Budgeting or Better
  Budgeting)
• Too time consuming
• Slow to detect problems
• Not reliable for performance evaluation
• Quickly out of date
• Process lacks rigor
• Disrupts cooperation

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How to Budget

• In the output/input approach physical inputs and
  costs are budgeted as a function of planned unit
  level activities.
• The incremental approach budgets costs for a
  coming period as a dollar or percentage change
  from the amount budgeted for (or spent during)
  some previous period.

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How to Budget

• The minimum level approach - an organization
  establishes a base amount for budget items and
  requires explanation or justification for any
  budgeted amount above the minimum (base).
• Zero-Based Budgets require managers to build
  budgets from the ground up each year rather than
  just add a percentage increase to last years
  numbers. All dollars must be justified.

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Developing a Master Budget

• The master budget consists of all the
  interrelated budgets of the organization. Usually
  one component is the operating budget.
• The Master Budget always starts with a Sales
  forecast.

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Developing Sales Budget

• Begin by forecasting sales volume in units
• Convert unit volume into sales volume
• Begin to consider Cash Flow differences
• Some sales are cash sales
• Some are credit sales
• Sales may be paid in current month (2/10, n30)
• Others paid in later months

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Forecasting sales

• Where to start?
• Past patterns of sales
• Sales force estimates
• General economic conditions
• Competitors what are they doing?
• Pricing increasing/decreasing, is the product
  elastic/inelastic
• What product is selling? What is happening to the
  product mix?
• Advertising plans/sales promotions

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Coldwater Creek Model

• How are Sales forecast in this model?

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Example of a Sales Budget- Exercise 7-30

• Current Accounts Receivable 120,000
• Forecasted Sales
• June 400,000
• July 440,000
• August 500,000
• September 530,000
• Sales are 70 cash and 30 credit (collected
  within one month)
• Prepare a sales and cash collection budget

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Developing a Master Budget

• After the sales budget we focus on production and
  purchases
• For a manufacturing company the production
  budgets contain
• Direct materials budget
• Direct labor budget
• Overhead budget
• Separately, the company would also develop a
  budget for SGA
• All of these would then tie into the CASH Budget

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Developing a Master Budget

• For a Merchandising company the Sales Budget
  drives the Purchases and SGA budgets
• These budgets would then tie into the CASH Budget

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Developing the Purchases Budget

• Reminder of how to Think About Inventory Needs
• Beginning Inventory
• Purchases
• Goods Available for Sale
• - Ending Inventory
• Cost of Goods Sold
• Develop Purchases Budget based on what is needed
  to ensure that there is enough inventory for
  budgeted sales and for estimated ending inventory

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Developing a Purchases Budget exercise 7-33

• Quantrill Furniture plans inventory levels and
  sales as follows
• Month Inventory Sales
• May 250,000
• June 220,000 440,000
• July 270,000 350,000
• August 240,000 400,000

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Example of a Purchases Budget

• ADDITIONAL INFORMATION
• COGS .6Sales
• Payment 10 down, 80 30 days,10 60 days

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Cash Budgets

• Many managers consider managing cash flow to be
  the single most important consideration in
  running a successful business.
• The cash budget summarizes all cash receipts and
  disbursements
• Needs to take into account when the firm will pay
  bills, customer terms, purchases sales

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Cash Budget, Ex. 7-37

• Sales forecast
• October - 30,000
• November - 22,000
• Sales terms 1/30,net/30
• All sales on credit 60in first month, 30 next,
  6 in two months 4 uncollected
• COGS 60 of sales, paid within 10 days
• Expect inventory to be 50 of next month sales
• SGA 61,500 year (24,000 fixed (13,200
  depreciation expense)), balance varies with sales
• Oct. 1 cash balance 4,800

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Spreadsheet analysis

• Exercise 7-41

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Flexible Budgeting

• Flexible budgets vary with activity levels
• The main benefit of flexible budgets is that they
  are based on cost-volume relationships so that
  evaluations are based on comparisons at the
  actual level of activity
• The main drawback is assuming that the same
  cost-volume relationship exists at all levels of
  activity

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Flexible Budgeting

• Benefits of Standard Costs
• Standard costs are carefully predetermined costs.
  
• They help managers plan by providing the unit
  amounts, which are the building blocks of
  budgeting.
• They help simplify record keeping.
• Standard quantity often is referred to as the
  quantity that should have been used.

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Evaluation of Performance

• Variance analysis is used to examine how actual
  results differ from budgeted expectations
• Focus should be on Flexible-budget variances
• However, variances from the Master Budget (which
  are a result of variances in sales activity) are
  important since these are the foundation of the
  budgeting process
• Sales activity variances (actual sales units
  master budget sales units) budgeted
  contribution margin

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What causes variances from budgeted results?

• Easy explanations
• Price differences
• Quantity differences
• Difficult explanations
• errors/mistakes
• poor execution

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Flexible Budget Variances

• Flex Budget Variance
• Total actual results Total Flex budget results

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Variance Analysis

• Standard price indicates how much should be paid
  for each input unit of direct materials or Direct
  labor.
• Price variance is the difference between actual
  and standard cost of materials or labor inputs.
• Standard quantity indicates the amount of direct
  materials/labor allowed to produce one unit of
  output.
• Quantity variance is the difference between
  standard cost of actual materials/labor inputs
  and flexible budget cost for materials/labor.

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Variance formulas

• For Direct Materials Costs
• Price Variance
• (Actual Price - Standard Price) Actual Quantity
• Materials Variance
• (Actual Quantity - Standard Quantity) Std.
  Price
• Total Variance
• (Standard PriceStandard Quant.)-(Actual Price
  Actual Quant.)

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Variance formulas

• For Direct Labor Costs
• Rate Variance
• (Actual Rate - Standard Rate) Actual hours
• Efficiency Variance
• (Actual hours - Standard hours) Std. Rate
• Total Variance
• (Standard RateStandard hours) - (Actual Rate
  Actual hours)

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Understanding Variances

• Favorable price variance indicates that
  management paid less per unit than the price
  allowed by the standard
• Favorable quantity variance means that the actual
  quantity of materials used was less than the
  quantity allowed for the units produced.
• Unfavorable just the opposite

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Fixed OH Budgeting

• Fixed OH Budgeting is based on determining the
  amount of OH that SHOULD be incurred at the
  normal production levels. This is called the
  overhead absorption rate.
• OH Absorption Rate Total Budgeted Indirect
  Costs
• Expected Production

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Fixed OH Budgeting

• OH Variances result from two circumstances
• Actual production differs from budgeted
  production - a VOLUME variance
• Actual OH costs differ from budgeted costs - a
  SPENDING variance.

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What makes budgeting successful

• Emphasize the importance of budgeting as a
  planning device.
• Encourage wide participation in budget
  preparation at all levels of the organization.
  This requires that all employees understand
  budgeting and why it is being done.
• Demonstrate that the budget has the complete
  support of top management.
• Recognize that the budget can be changed
• Use budget performance reports not just to
  identify poor performers, but also to recognize
  good performance.