Strategy and the Master Budget

2 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

3 Describe the role of budgets in the overall management process Discuss the importance of strategy and its role in the master budgeting process Provide an overview of the budgeting process Prepare a master budget and explain the interrelationships among its supporting schedules Learning Objectives

4 Identify unique budgeting characteristics of service firms, international firms, and not-for-profit organizations Understand zero-base, activity-based, and kaizen approaches to budgeting Discuss the application of integrated budgeting and planning tools Discuss the role of ethics and behavioral considerations in budgeting Learning Objectives (continued)

5 A budget: –is a financial or nonfinancial expression of a plan of action for a specified period –identifies the resources and commitments required to achieve the organization’s goals for an upcoming period Budgeting: –The process of preparing a budget is called budgeting Basic Terminology

6 The starting point in the budget-preparation process is specification of the organization’s strategy An organization expresses its strategic goals and long- term objectives in its capital and master budgets Long-range planning often entails capital budgeting, which is a process for evaluating, selecting, and financing major projects, such as purchases of new factory equipment and construction of a new factory Strategic Goals and Long-term Objectives

7 The master budget: –Represents the “grand plan of action” for an upcoming period –Translates the organization’s short-term objectives into action steps –Culminates in the preparation of a set of pro-forma financial statements –Communicates to employees and managers alike the expectations of top management –Helps coordinate subunit activities The Master Budget

8 The master budget is made up of operating and financial budgets: –Operating budgets are plans that identify resources needed to carry out the budgeted activities, such as sales and services or production Operating budgets include production, purchase, personnel, and marketing budgets –Financial budgets identify sources and uses of funds for the budgeted operations Financial budgets include the cash budget, budgeted statement of cash flows, the budgeted balance sheet, and the capital expenditures budget The Master Budget (continued)

9 The Budgeting Process The budget committee is the highest authority in an organization for all matters related to the budget Determination of the budget period: –Generally, a fiscal year with sub-period budgets prepared for each quarter or month –A continuous (rolling) budget is a budget system that has a budget for a set number of months, quarters, or years at all times–as one period ends another is added

10 Three-step process: (1)Define the “bottom-line” information contained in the budget (e.g., sales for the upcoming period) (2)Determine what this information is a function of (e.g., budgeted unit sales, budgeted selling price/unit) (3)Put together information in a user-friendly way Preparing Individual Budgets

11 The sales budget is often referred to as the cornerstone of the entire master budget The sales budget has two components: – Forecasted sales volume – Budgeted selling prices Sales Budget

12 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

13 Sales Budget (continued) April May June Quarter Sales in units20,00025,00035,00080,000 Selling price per unitx $30x $30x $30x $30 Total sales$600,000$750,000$1,050,000 $2,400,000 Kerry Industrial Company Sales Budget For the Quarter Ended June 30, 2007

14 After the sales budget, we prepare a production budget, which shows planned production for a given period Budgeted production can be calculated through use of the following formula: Production Budget Budgeted Budgeted DesiredBeginning Production Sales EndingInventory (in units)(in units)Inventory(in units) (in units) Budgeted Budgeted DesiredBeginning Production Sales EndingInventory (in units)(in units)Inventory(in units) (in units) = + –

15 Production Budget (continued) Kerry example: (1) Beginning inventory (April 1) = 5,000 units (2) Desired ending inventory (April 30 th ) = 30% of the following month’s projected unit sales (3) The sales budget has total sales for May at 25,000 units. Kerry example: (1) Beginning inventory (April 1) = 5,000 units (2) Desired ending inventory (April 30 th ) = 30% of the following month’s projected unit sales (3) The sales budget has total sales for May at 25,000 units.

16 Production Budget (continued) 22,500 20,000 7,500 5,000 22,500 20,000 7,500 5,000 = + – Desired ending level at April 30: 30% x 25,000 units (May sales) = 7,500 units Desired ending level at April 30: 30% x 25,000 units (May sales) = 7,500 units Inventory from April 1: 5,000 units From the Sales Budget Budgeted production for April

17 Production Budget (continued) 30% of June’s budgeted sales July sales are budgeted at 40,000 units: 30% × 40,000 = 12,000 units.

18 Direct Materials Budgets The direct materials usage budget: –Shows the amount (and cost) of direct materials required for budgeted production –The last line of the production budget = first line of the direct materials usage budget

19 Direct Materials Budgets (continued) The direct materials purchases budget: –Contains budgeted purchases, in units and dollars, of direct materials for the upcoming period –Is needed to complete the direct materials usage budget (i.e., provides unit cost data) –Is a function of: materials required for production (from materials usage budget), target ending inventory of materials, beginning-of-period materials inventory, budgeted purchase price per unit of raw material

20 Materials Purchases Budget: Kerry Company

21 Direct Labor Budget Enables the personnel department to plan for hiring & repositioning of employees, based on production needs Is prepared for each class (type) of labor, e.g., skilled and semi-skilled Is a function of: – Budgeted output (from production budget) – Standard labor hours per unit of output – Standard wage rate per hour

22 Direct Labor Budget (continued) Kerry uses 0.5 hours of semiskilled labor and 0.2 hours of skilled labor per standard wage rates of $8 and $12 per hour, respectively

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24 Direct Labor Budget: Kerry Company Each unit of output requires 0.5 hours of semi-skilled $8.00/hour, and 0.2 hours of skilled $12.00/hour 22,500 × 0.5 × $8.00 = $90,00022,500 × 0.2 × $12.00 = $54,000

25 Cost of Goods Manufactured & CGS Budgets The cost of goods manufactured and CGS budgets are prepared after the factory overhead budget is prepared The income statement budget and the balance sheet use information from this budget

26 Kerry Company: Cost of Goods Manufactured & CGS Budgets, April 2007

27 The selling and general administrative expenses budget is now prepared: –This budget includes all the planned expenditures for selling and general administrative activities –Many of the expenses included in this budget are considered discretionary and are a likely place for spending cuts –Managers must be careful not to focus solely on short- term affects when making cuts in these areas (e.g., customer-service expenditures) Selling & Administrative Expense Budget

28 Kerry Company--Cash Receipts Budget: April 2007

29 The cash budget brings together the cash effects of all budgeted activities--to ensure that the firm has adequate cash on hand: –This budget generally has three sections: –Cash available –Cash disbursements, and –Financing –Preparation of this budget involves careful review of all other budgets to identify cash inflows and outflows Cash Budget

30 Kerry Company—Cash Budget: April 2007

31 The budgeted income statement (I/S) and budgeted balance sheet (B/S) can then be prepared using all the aforementioned budgets: –The budgeted I/S describes the expected operating income for the upcoming period –The budgeted B/S, the last budget in the budget- preparation process, incorporates the effects of all operations and cash flows during the budget period and shows projected ending balances in asset, liability, and equity accounts Budgeted I/S and B/S

32 These firms have different operating characteristics, operating environments, and considerations than those of manufacturing and merchandising firms Service firms are different due to the absence of production or merchandise purchase budgets and their ancillary budgets–the focus of the budgeting process must be personnel planning: –Does the firm have sufficient staff and resources to provide the expected level of service output in the upcoming period? –Do staff members have the appropriate skills? Budgeting in Service Companies

33 International firms face additional challenges due to cultural and language differences, dissimilar political and legal environments, fluctuating monetary and exchange rates, and discrepancies in inflation rates of different countries NFPs have no single bottom-line that serves as a verifiable goal in budgeting; there is no clear standard by which to measure performance –The budget shows estimated revenues and planned activities–the budget must show the organization can at least break-even Budgeting in International Firms and Not-for-Profit (NFP) Organizations

34 Zero-base budgeting (ZZB) is a budgeting process that requires managers to prepare budgets from a zero base –This type of budgeting allows no activities or functions to be included in the budget unless managers can justify their needs –In-depth reviews and analyses of all budget items make managers aware of activities and functions that have outlived their usefulness –Can be a difficult and time-consuming process Alternative Budgeting Approaches

35 Activity-based budgeting (ABB) is a budgeting process based on activities and cost drivers of operations: –Starts with the budgeted output and segregates costs required for the budgeted output into homogeneous cost pools –Can be a simple extension of a firm’s ABC system Kaizen (Continuous improvement) budgeting: –Incorporates continuous improvement expectations into the budgets –Promotes active engagement in reforming and altering business practices and processes Alternative Budgeting Approaches (continued)

36 Budgetary slack, or padding the budget, is the practice of managers knowingly including a higher amount of expenditures or a lower amount of revenue in a budget Spending the budget is another issue; managers often feel if they do not use all the resources they receive, next year’s budget may be cut Goal congruence is a term that refers to the degree of consistency between goals of the firm, its subunits, and its employees –Involving employees in the budgeting process fosters goal congruence Behavioral Issues in Budgeting

37 Difficulty level of the budget target? –An easy budget may fail to encourage employees to give their best efforts, while a very difficult target can be discourage managers from even trying –A “highly achievable target” is suggested with incentives for exceeding the budgeted figures Authoritative or participative budgeting? –Top-down budgeting is referred to as authoritative budgeting –Bottom-up budgeting is referred to as participative budgeting –Effective budgeting processes often combine the two types Behavioral Issues in Budgeting (continued)

38 A budget is a financial or nonfinancial expression of an organization’s plan of action for a specified period; it identifies the resources and commitments required to achieve the organization’s goals for the period identified Strategy is the starting point in preparing its plans and budgets The “grand plan of action” for an upcoming period is the organization’s Master Budget Summary

39 Components of a master budget for a manufacturing firm include: –Sales budget –Production budget –Direct materials usage budget –Direct materials purchases budget –Direct labor budget –Factory overhead budget –Budgeted cost of goods manufactured/cost of goods sold budgets –Selling and general administrative expenses budget –Cash receipts budget –Cash budget –Budgeted income statement (I/S), and –Budgeted balance sheet (B/S) Chapter Summary (continued)

40 Summary (continued) Service companies, international firms, and not-for- profit (NFP) firms have different operating characteristics, operating environments, and considerations than those of manufacturing and merchandising firms ZBB, ABB, and kaizen are three alternative approaches to budgeting that can improve budgeting effectiveness

41 Summary (continued) Budgets are only as effective as those responsible for their preparation and implementation –Managers must be aware of the potential for budgetary slack and “budget spending” –Participative budgeting often increases motivation in employees

42 JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.