Chapter 7

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

2. Definition • A budget is a plan of action that • 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 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

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

6. Revenue • Foundational step • 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

8. 1 3 70 50 570 450 2 4 40 50 500 x 0.10 = 50 1 40 (the ending inventory from quarter 1) 2 700 x 0.10 = 70 3 50 (the ending inventory from quarter 2) 4

9. Input Resources • Materials • 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. 2,000 1,960 1 3 500 500 2 4 1,575 BuildIT + 425 BuildIT-PLUS = 2,000 1 2,000 lots X $500 per lot 2 1,550 BuildIT + 410 BuildIT-PLUS = 1,960 3 1,960 lots X $500 per lot 4

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

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

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 productcosts 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 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

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

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

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

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 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

28. 196 344 262 1 2 3 2,964 2,196 2,222 3,565 262 344 196 2,071 3,221 2,702 2,026 1,960 x 0.10 = 196 1 2,620 (from quarter 3) x 0.10 = 262 2 3,440 (from quarter 4) x 0.10 = 344 3

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

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

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

34. Management Style Information flow 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

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

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. 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

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

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

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.