Profit Planning Chapter 7: Profit Planning. This chapter focuses on the steps taken by businesses to achieve their planned levels of profits – a process called profit planning. Profit planning is accomplished by preparing numerous budgets, which, when brought together, form an integrated business plan known as a master budget.

May 20, 2009 What is a budget Why and how organizations budget Budgeting Sales Production Sales & Administration Balance Sheet Budget Items Working Capital Capital Equipment Financing Financial Statements

Budget A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period Its purpose is to plan for the future and control behaviour and costs Planning to prepare for objectives and setting out a framework to achieve the objectives Providing incentives to managers to achieve the objectives Control by holding people to account with respect to their objectives Cost control Revenue generation

Advantages of Budgeting The budgeting process forces managers to think through a plan from their perspective It provides a forum for people to interact and determine how to best allocate limited resources Defines a set of consistent goals and objectives Communicated throughout the organization for common understanding and cooperation The budget provides a document against which to measure performance The advantages of budgeting are: Budgets communicate management’s plans throughout the organization. Budgets force managers to think about and plan for the future. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively. The budgeting process can also uncover potential bottlenecks before they occur. Budgets coordinate the activities of the entire organization by integrating the plans of its various parts. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.

Self-Imposed Budget A self-imposed budget or participative budget is a budget that is prepared with the full cooperation and participation of managers at all levels. It is a particularly useful approach if the budget will be used to evaluate managerial performance. A participative budget is prepared with the full cooperation and participation of managers at all levels. A participative budget is also known as a self-imposed budget.

Factors in Budgeting There are a number of human factors in budgeting: Requires the full support and commitment from senior management People who are engaged in the process are more likely to support it Managers and executives need to be reasonable Managers may feel they should lower their own targets to reduce expectations Executives may feel they should pressure managers to unachievable levels Be reasonable (set budgets for different audiences) – Board, Fall-back, Management Incentive, Stretch Work to root out personal ambitions The success of a budget program depends on three important factors: Top management must be enthusiastic and committed to the budgeting process, otherwise nobody will take it seriously. Top management must not use the budget to pressure employees or blame them when something goes wrong. This breeds hostility and mistrust rather than cooperative and coordinated efforts. Highly achievable budget targets are usually preferred (rather than “stretch budget” targets) when managers are rewarded based on meeting budget targets.

Managing the Budgeting Process Usually driven by the CFO Establishes a leadership team Builds up the data through meetings with all profit and cost centers Note: The system (ABC, Process Costing, Account mapping) is already assumed to have been done by this time

The Master Budget: An Overview Sales budget Ending inventory budget Selling and administrative expense budget Production budget Direct materials budget Direct labor budget Manufacturing overhead budget The master budget consists of a number of separate but interdependent budgets. The sales budget shows the expected sales for the budget period expressed in dollars and units. It is usually based on a company’s sales forecast. All other parts of the master budget are dependent on the sales budget. The production budget is prepared after the sales budget. It lists the number of units that must be produced during each budget period to meet sales needs and to provide for the desired ending inventory. The production budget in turn directly influences the direct materials, direct labor, and manufacturing overhead budgets, which in turn enable the preparation of the ending finished goods inventory budget. These budgets are then combined with data from the sales budget and the selling and administrative expense budget to determine the cash budget. The cash budget is a detailed plan showing how cash resources will be acquired and used over a specified time period. All of the operating budgets have an impact on the cash budget. The last step of the process is to prepare a budgeted income statement and a budgeted balance sheet. Cash budget Budgeted income statement Budgeted balance sheet

Key Budget Segments There are a few critical budget segments to get in place Each organization may have its own twists to the approach Sales Budget Production Budget Direct Labour, Direct Materials, Manufacturing Overhead Selling, General and Administration Working Capital Budget Capital Budget With the assumptions in these budgets in place, full cash flow, income statement and balance sheet plans can be published

Sales Budget Understand your market Size, growth rate, market share Cyclicality, seasonality Competitive position for each product/service New entrant, established player Put forward and discuss a reasonable matrix of targets for the circumstances This budget proposes no price increases 10% growth in Motorbike sales 5% growth in car sales no seasonality What might this quarterly budget look like?

Sales Budget After discussions with the sales team, we would look to have them sign off on the final version Commissions would be put in place To incentivize them to meet the targets To ensure they emphasize the products with the highest contribution

Production Budget The Production Budget must deliver the final product committed to in the Sales Budget, in the time frame it calls for

Production Budget Production budgets can complex There would of course be build ups behind each of the accounts Direct Labour – based on units of labour per production unit Direct Materials - “ “ “ “ Manufacturing Overhead Fixed and Variable Furthermore, there are production lead times to be managed Long lead time parts can constrain production Inflation, expected pay hikes, etc. will also impact each cost function As there were challenges to the sales force, there may be challenges in production to reduce cost, defects, inventory

Sales & Administration Budget The Sales & Administration budget must support the level of business activity planned in the Sales Budget and Production Budget Sales are budgeted to increase 5%-10% Bad economic climate calls for challenges Do not increase spending from last year unless unavoidable Carry on with same level of advertising and promotion Non-discretionary variable costs must increase with sales Obtain sign off from those in control of these costs Develop a compensation structure that rewards being within budget

Sales & Administration Budget If the promotional campaign supporting the increase in sales cost $150 million, was it justified?

Sales & Administration Budget Promotional campaign analysis Break even ($ sales) = fixed cost / contribution margin (%) The campaign is justified as it supports incremental sales of much more than $320 million required to cove the cost

Sales & Administration Budget Sales Budget, Production Budget and Sales & Administration Budget in place We can exhibit the Operating Profit and Cash Flow from Operations Budget forecasts $1.5 billion Operating Profit 21% Operating Margin

Interlude We are working towards building a Cash Budget and Financial Statements, including a Cash Flow Statement Cash Flow Statements have different categories of sources and uses of cash Cash Flow from Operations Sales Budget Production Budget S&A Budget Cash Flow from Changes in Working Capital Balance Sheet Budget Cash Flow from Investing Activities

Balance Sheet Budget Working Capital Assumptions Can be made at very detailed or high level Try to balance for practicality Accounts Receivable Assume # of days sales outstanding Challenge collections department to get cash in earlier Inventory Forecast demand Assume # of days COGS outstanding Accounts Payable (including payroll) Payroll is under corporate control – eg pay every 30 days Assume # days of Direct Materials and other outstanding Other (Prepaid assets; Accrued liabilities) Similar methodologies can be applied

Balance Sheet Budget Balance Sheet Model We have run the assumptions (from sales straight through to these balance sheet assumptions) We learn there will be a requirement for cash of $57 million in the first quarter This is required to fund increased A/R and inventory from sales growth

Balance Sheet Budget Investments/Capital assumptions By investment, we primarily mean Property, Plant & Equipment As with Working Capital, can be made at very detailed or high level Organizations will have detailed asset schedules, including depreciation Decisions to purchase assets are based upon a number of factors Capacity utilization Forecast volume Financing For our purposes, we will assume the following: Factory capacity is at 80% - no need to expand Machinery & Equipment is at full capacity and must be increased in proportion to sales Depreciation on new M&E flows through Variable Manufacturing Overhead

Balance Sheet Budget Balance Sheet Model – Capex We learn there will be a requirement for cash of $12 million in the first quarter This is required to fund increased machinery and equipment to produce the incremental volume

Financial Statements Final budgeted Income and Cash Flow Statements

Financial Statements Final budgeted Balance Sheet

Review What is a budget Why and how organizations budget Budgeting Sales Production Sales & Administration Balance Sheet Budget Items Working Capital Capital Equipment Financing Financial Statements

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