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

2. 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

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

4. 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

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

6. 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

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

8. 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)

9. 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

10. 1,575 BuildIT + 425 BuildIT-PLUS = 2,0003
1,960
500
500 2 4 1
1,575 BuildIT BuildIT-PLUS = 2,000 2
2,000 lots X $500 per lot 3
1,550 BuildIT BuildIT-PLUS = 1,960 4
1,960 lots X $500 per lot

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

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

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

14. 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

15. 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

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

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

18. 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

19. 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

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

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

22. 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

23. $6,270,000
0.05
$6,270,000
0.35
$8,200,000
0.60
$20,740,000
1.00

24. Materials
LO3: Construct a cash budget and understand cash management

25. Materials
LO3: Construct a cash budget and understand cash management

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

27. 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

28. 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

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

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

31. $429,690 1
$168,000 2
$429,690
$97,690 1
($50,000 + $118,000) 2
($175,000 + $118,000)

32. 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

33. 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

34. 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

35. 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

36. 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.

37. 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.

38. 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

39. 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

40. 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

41. 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

42. 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.

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

44. 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:

45. 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.