Operating Budgets: A Tool for Planning and Control Chapter 7 Operating Budgets: A Tool for Planning and Control

Definition A budget is a plan of action that Wide variation in use Taking a set of assumptions Formulates targets For a specific period Wide variation in use We discuss two major aspects Mechanics Process LO1: Understand the role budgets play in organizations

Linking Role for Operational Budgets LO1: Understand the role budgets play in organizations

Roles for Budgets Planning Coordination Strategic, Business, and Tactical (Operating) Coordination Decentralization Performance evaluation & feedback Benchmark Tension between planning and control roles LO1: Understand the role budgets play in organizations 4

A Budget Has Many Steps LO1: Understand the role budgets play in organizations

Revenue Foundational step Triangulate using Customer / region / product forecasts Triangulate using Local knowledge Macro trends Market research LO2: Link individual budgets to form an organization-wide plan

Production Inventory equation Applying inventory equation to sales targets gets production plans LO2: Link individual budgets to form an organization-wide plan 7

40 (the ending inventory from quarter 1) 50 3 70 450 570 2 4 40 50 1 500 x 0.10 = 50 2 40 (the ending inventory from quarter 1) 3 700 x 0.10 = 70 4 50 (the ending inventory from quarter 2)

Input Resources Materials Labor Overhead Bill of materials to determine need Inventory equation to determine purchases MRP III and other systems Labor Routing sheet Overhead Cost of capacity LO2: Link individual budgets to form an organization-wide plan

1,575 BuildIT + 425 BuildIT-PLUS = 2,000 3 1,960 500 500 2 4 1 1,575 BuildIT + 425 BuildIT-PLUS = 2,000 2 2,000 lots X $500 per lot 3 1,550 BuildIT + 410 BuildIT-PLUS = 1,960 4 1,960 lots X $500 per lot

Materials and Labor Budgets LO2: Link individual budgets to form an organization-wide plan

1,425 410 520 650 12 12 12 12 $15 $15 $15 $15 $76,500 $73,800 $93,600 $117,000

Budgeting for Overhead Costs LO2: Link individual budgets to form an organization-wide plan

Flowing Costs to Income Statement Add materials, labor and (applied) overhead to calculate COGM Use inventory equation to calculate COGS and flow these product costs to income statement LO2: Link individual budgets to form an organization-wide plan

Selling and Administrative Costs Sales projections are the basis for estimating required selling and administration costs These period costs flow directly through to income statement LO2: Link individual budgets to form an organization-wide plan

Consolidate for Financial Budgets LO2: Link individual budgets to form an organization-wide plan

Consolidated Income Statement LO2: Link individual budgets to form an organization-wide plan

Recursive Nature Budgets are rarely linear Benefit comes from Each step goes through revisions Entire cycles get iterated Benefit comes from Intense examination of targets Challenging assumptions Examining alternatives & making choices LO2: Link individual budgets to form an organization-wide plan 18

Cash Budget Apply inventory equation to cash Three components Cash flow statement Three components Inflows Outflows Special items LO3: Construct a cash budget and understand cash management 19

A Cash Budget has Many Steps LO3: Construct a cash budget and understand cash management

Operating Inflows Adjust sales receipt for collection schedule LO3: Construct a cash budget and understand cash management 21

Operating Outflows Materials: Adjust for credit purchases Labor Capacity costs Adjust for non-cash item Marketing, distribution and administration LO3: Construct a cash budget and understand cash management 22

$6,270,000 0.05 $6,270,000 0.35 $8,200,000 0.60 $20,740,000 1.00

Materials LO3: Construct a cash budget and understand cash management

Materials LO3: Construct a cash budget and understand cash management

Labor, Overhead & Other LO3: Construct a cash budget and understand cash management

Special Items Capital expenses Financing flows Adjust capacity levels Part of capital budgeting (Chapter 11) Financing flows Receipts from issuing stock, debt Outflows for dividends, debt payments LO3: Construct a cash budget and understand cash management 27

1 196 2 262 3 344 2,196 2,222 2,964 3,565 196 262 344 2,071 2,026 2,702 3,221 1 1,960 x 0.10 = 196 2 2,620 (from quarter 3) x 0.10 = 262 3 3,440 (from quarter 4) x 0.10 = 344

Summary of Cash Flows LO3: Construct a cash budget and understand cash management

Summary of Cash Flows LO3: Construct a cash budget and understand cash management

$429,690 1 $168,000 2 $429,690 $97,690 1 ($50,000 + $118,000) 2 ($175,000 + $118,000)

The Budgeting Process Wide variation across firms and industries Some factors that influence process Organizational structure Management style Past Performance LO3: Construct a cash budget and understand cash management 32

Organizational Structure Strategy leads to structure Structure influences planning & control Co-locate knowledge and decisions Responsibility Centers Cost, profit, and investment centers Center managers responsible for Using knowledge to set best plan Delivering results per plan LO4: Describe factors affecting the budgeting process 33

Management Style Information flow Goal setting Top down budgeting Bottom up or participative budgeting Most firms employ a mix Goal setting “Tight but attainable” LO4: Describe factors affecting the budgeting process 34

Past Performance Many firms use the previous period as the base line Advantages Reflects operations “on the ground” Budgeting becomes easy Disadvantages Encourages game playing (“ratcheting effects”) Across the board changes in place of focused resource allocations Miss the forest for the trees LO4: Describe factors affecting the budgeting process 35

Test Your Knowledge! Merrill Financial is creating its budget for the next year. Which of the following is NOT one of the primary reasons why organizations use budgets? Coordination Control Productivity Planning While productivity may be an operating concern for a company, it is not one of the primary reasons companies use budgets.

Test Your Knowledge! Which of the following is a fixed cost included on the manufacturing overhead cost budget? Supplies used during production Machine oil used by the production machines Production supervisor salaries Plastic wheels for toy trucks being produced This is a fixed cost because it is not dependant on the amount produced.

These slides can be used to generate discussion in an MBA class Additional Slides These slides can be used to generate discussion in an MBA class

Role of Discretion in Budgets Should we revise targets for new information? Better plan but worse control? Should we implement a “rolling budget” Planning without accountability? Should we have a global budget or budget by line item Forced spending on (unneeded) items? What are the costs and benefits of budget lapsing Wasteful spending or cost shifting? LO4: Describe factors affecting the budgeting process 39

Are Budgets Good for You? Reinforce organization’s aims Vertical and horizontal communication Induce long-term thinking Re-examine processes Foster coordination among divisions Provide sound basis for performance evaluation LO4: Describe factors affecting the budgeting process 40

Are Budgets Bad for You? Appearance of certainty in uncertain times Fixed targets based on fuzzy estimates Time sink More time in planning than doing Quashes innovation Making the numbers becomes the goal Fosters game playing Encourages “across the board” cuts LO4: Describe factors affecting the budgeting process 41

Exercise 7.31 Revenue Budget (LO2). Premium Windows makes one type of standard windows for residential buildings. Premium desires to end March with 2,500 windows in stock. Premium’s inventory on March 1 is 1,750 windows, and its budgeted production for the month is 8,000 windows. Each window sells for $60. Required: Prepare Premium’s revenue budget for March.

Exercise 7.31 (Continued) In solving budgeting exercises, we repeatedly use the “inventory equation.” In its simplest form, the inventory equation is:

Exercise 7.31 (Continued) We replace these terms with the appropriate account-specific terms when computing specific revenue and cost budgets. For Premium, we have:

Exercise 7.31 (Concluded) Thus, we find Sales for March = 7,250 windows. Multiplying 7,250 windows by the $60 price per window gives budgeted March revenue of $435,000.