BUDGETING CHAPTER 6

PURPOSES Budgets are proposed as having two uses PLANNING CONTROL

PLANNING I agree that budgets are useful for planning. Everyone budgets, it is simply a question of how formally. By formalizing the budget process, one is more likely to plan and have a direction in which to go.

CONTROL I don’t agree. If one uses the budget for control purposes, I think they damage the use of budgets for planning. If someone is held to the budget, then they will “play games with their estimates.” For example, assume that you are the sales manager and for year X you estimate that sales will be $10 million. Sales for year X are only $9.7 million. The CEO asks, “what went wrong?” Two weeks later, you are asked for your estimate of sales for year Y. You think sales will probably be $10.5 million. What estimate would you give? I believe that planning is so important, one should not do anything that might interfere with it.

ADVANTAGES OF BUDGETS Compels strategic planning Provides a basis for measuring performance Motivates managers and employees Promotes coordination and communication among subunits

MY SOLUTION TO PERFORMANCE MEASURES Compare actual results with what you think they should have been, given the information you now have. That is, in year Y, decide what you think performance should have been. You have more information in year Y than you had in year W (the year before year X). E.g., a new competitor may have entered the market or an old competitor may have left the market. You also know more about year X’s economic situation in year Y than in year W.

BUDGET PROCESS Prepare the sales budget Estimate beginning inventory and determine the desired levels of ending inventory Prepare the production/purchases budget Prepare the labor budget Prepare the overhead budget Prepare the operating budget Prepare the cash budget

OTHER OPERATING BUDGETS BUDGETING PROCESS SALES BUDGET PRODUCTION BUDGET OTHER OPERATING BUDGETS CASH BUDGET

OTHER OPERATING BUDGETS PROCESS SALES BUDGET OTHER OPERATING BUDGETS BUDGETED INCOME STATEMENT BUDGETED BALANCE SHEET

CASH BUDGET An extremely important budget Consider how a lender (banker) would view a loan request if you provided a cash budget long before you requested the loan. It is important to have enough cash, to pay bills, but not have excess cash, it should be invested.

CASH BUDGET JAN FEB MAR BEG. BALANCE 10 RECEIPTS 230 240 225 25 30 DISBURSEMENTS -215 -235 235 END. BALANCE 25 30 30 25 20

EXAMPLE OF CASH RECEIPTS BUDGET Cash is expected to be $10,000 on Oct. 31. Collection on sales has been: 10% in month of sale 50% in next month 35% in next month 5% is never collected Expected sales are: Sept. $50,000 Oct. $60,000 Nov. $70,000

SOLUTION for NOVEMBER CASH BUDGET Cash collected from sales in: Cash Balance: Nov. 1 $10,000 November Receipts 54,500 Cash Available $64,500 Nov. Oct. Sept Total 0.1 X 70,000 7,000 0.5 X 60,000 30,000 0.35 X 50,000 17,500 54,500

KAISAN BUDGETING Incorporates continuous improvement into the process. The budget estimates improved sales or reduced costs over time. An alternative is to set goals of reduced costs or improved revenues.

ACTIVITY BASED BUDGETING Prepare the budget on the basis of activities, e.g., costs that are based on labor hours, rather than functions, e.g., material purchases.

BUDGET BY TYPE OF CENTER Cost Centers Compares actual costs with budgeted costs Revenue Centers Compares actual revenues with budgeted revenues Profit Centers Compares actual profits with budgeted profits Investment Centers Measures profits in relation to investments

BUDGETING FOR RETAIL PURCHASES Estimate retail value of beginning inventory Determine targeted ending inventory, at retail Forecast (budget) sales for period, at retail Ending inventory + Sales - Beginning inventory = Amount of goods needed Divide amount of goods needed by estimated percentage of orders delivered =OPEN TO BUY (at retail) Times Cost Ratio = OPEN TO BUY (at cost)

EXAMPLE OF RETAIL PURCHASES BUDGET Estimated beginning inventory ($10,000) Estimated sales 50,000 Targeted ending inventory 5,000 Goods needed $45,000 Estimated delivery is 80% of goods ordered OPEN TO BUY = $56,250 at retail Cost to retail ratio is 45% OPEN TO BUY = $25,312 at cost

PRODUCTION BUDGET Same process as the retail budget process except that we would use units instead of dollars.

EXAMPLE OF PRODUCTION BUDGET Estimated beginning inventory (4,000) Forecasted (budgeted) sales 9,000 Targeted ending inventory 5,000 Production budget 10,000

OTHER BUDGETS All budgets use the same basic process.