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The Budgeting Process. Chapter 9. Visualizing the Future.

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slide1
The Budgeting Process

Chapter 9

© 2007 by Nelson, a division of Thomson Canada Limited.

slide2
Visualizing the Future

The annual budget is the financial plan to implement the organization's strategy for the next year. When that organization's environment is relatively stable, budgeting factors are fairly predictable and the budgeting process is less challenging than when environmental factors are highly uncertain For many organizations some of the underlying budget assumptions are extremely unpredictable. In these situations, factors that can significantly affect the budget require an ongoing monitoring process as the year progresses. Although budgeting is important for all organizations, entities that have significant amounts of cash and other resources should prepare and use detailed budgets for both planning and control purposes.

Regardless of the type of endeavor in which you engage, it is necessary at some point to visualize the future, imagine what results you want to achieve, and determine the activities and resources required to achieve those results.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide3
Learning Objectives

What is the importance of the budgeting process?

What is the difference between strategic and tactical planning and how do these relate to the budgeting process?

What are the benefits and disadvantages of imposed budgets and participatory budgets?

What is a flexible budget and how are budget variances computed and used to analyze differences between budgeted and actual revenues?

What complicates the budgeting process in a multinational environment?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide4
Learning Objectives

What is the starting point of a master budget and how do the components relate to one another?

How does traditional budgeting differ from zero-based budgeting?

What are future perspectives for budgeting?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide5
Purposes of Budgeting

Budget – the quantitative expression of an organization's

commitment to planned activities and resource acquisition

and use

Budgeting – the process of determining a financial plan for

future operations

Detailed plans that are monetarily enumerated are called

budgets. They are the detailed quantification of targets for

near term choices of actions. Budgeting is not planning –

it is the quantification of planning! Commitments defined

in the budget are vital management tools to guide and

evaluate short-term performance. The budget was, and

should always be seen as, the commitment.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide6
What are Budgets?

Formal organizational plans expressed in

quantitative terms

A standard against which to measure

performance

Defines in concrete terms the objectives

and resource commitments of an

organization

© 2007 by Nelson, a division of Thomson Canada Limited.

slide7
Planning is the cornerstone of effective management and strategic development and implementation. Planning includes qualitative narratives

of goals, objectives, and

means of accomplishment.

Management translates the qualitative narratives into a quantitative format – the budget. The budget expresses an organization's commitment to planned activities and resource acquisition and use. The budget is a commitment.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide8
The Importance of the Budgeting Process

Planning

Motivation

Evaluation

Coordination

Communication

Education

Ritual

© 2007 by Nelson, a division of Thomson Canada Limited.

slide9
The Budgeting Process

A

Set goals and objectives

Analyze key variables

B

Qualitative

internal

Gather relevant

historical data

C

Qualitative

environmental

PLANNING STAGE

Determine underlying

assumptions about

projected changes in

key variables;

quantitative internal and

quantitative environmental

Employee

participation

Input data into budget model

IMPLEMENTATION STAGE

THE BUDGET

Desired

results

projected?

Monitor

actual

results

CONTROL STAGE

yes

no

© 2007 by Nelson, a division of Thomson Canada Limited.

flowchart is continued on next slide

slide10
The Budgeting Process (continued)

Desired

results

projected?

Monitor

actual

results

(carried forward

from previous slide)

CONTROL STAGE

no

yes

Desired

results

achieved?

Provide

feedback

Red flow arrows indicate the

next period effects through an

iterative process.

Note: A, B, and C are known

as on-page connectors. Their

purpose is to indicate the need

to return to other locations on

the flowchart at the specified

points.

yes

Possibly

adjust budget

A

no

Determine

causes

Internal

causes?

Provide

feedback

Provide

feedback

no

yes

Adjust

budget

Correct

problem

C

B

© 2007 by Nelson, a division of Thomson Canada Limited.

slide11
The Importance of the Budgeting Process

A well prepared budget as

a means of implementing

strategy can be an effective

device to communicate

objectives, constraints,

and expectations to people

throughout the organization.

Such communication helps

everyone understand exactly

what is to be accomplished,

how those accomplishments

are to be achieved, and how

resources are to be allocated.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide12
Strategic and Tactical Planning

Strategic planning – the process of developing a

statement of long-range (five to ten years) goals

for the organization and defining the strategies

and policies that will help the organization

achieve those goals

Key variable – a critical factor believed to be a

direct cause of the achievement or

nonachievement of organizational goals and

objectives; can be internal or external

© 2007 by Nelson, a division of Thomson Canada Limited.

slide13
Strategic Planning

Strategic planning is not concerned with day-to-day operations,

although the strategic plan will be the foundation on which short-term planning is based. Managers involved in planning should identify key variables. Internal key variables are under the control of management, while external key variables are normally noncontrollable. One study concluded that a firm's long-term success is dependent on the integration of the forces in its environment into its own planning process so that the firm influences its own destiny instead of constantly reacting to environmental forces.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide14
External Factors to Include in Strategic Plans
  • Market share
  • Quality of products
  • Discretionary cash flow/gross
  • capital investment

Organizational Characteristics

  • Market segmentation
  • Market size
  • New market development
  • Buyer loyalty

Market and Consumer Behaviour

  • Rate of technological change
  • in products or processes
  • Degrees of product differentiation
  • Industry price/cost structure
  • Economies of scale

Industry Structure

  • Major changes in availability of
  • raw materials

Supplier

  • GNP trend
  • Interest rates
  • Energy availability
  • Government established and
  • legally enforceable regulations

Social, Economic, and Political

© 2007 by Nelson, a division of Thomson Canada Limited.

slide15
Tactical Planning

Tactical Planning – the process of determining the specific objectives and means by which strategic plans will be achieved; are short-term (one to eighteen months), single use plans that have been developed to address a given set of circumstances or for a specific time frame

The annual budget is an example of a single use tactical plan.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide16
Relationships Among Planning Processes

© 2007 by Nelson, a division of Thomson Canada Limited.

slide17
Participating in the Budgeting Process

Imposed budget – a budget that is prepared by top management with

little or no input from operating personnel, who are simply informed

of the budget goals and constraints

Imposed budgets

Top

Management

Middle Management

Participatory

budgets

Operational Management

Participatory budget – a budget that has been developed through a

process of joint decision making by top management and operating

personnel

© 2007 by Nelson, a division of Thomson Canada Limited.

slide18
Best Times to Use Imposed Budgets
  • In start-up organizations
  • In extremely small businesses
  • In times of economic crisis
  • When operating managers lack budgetary skills or perspective
  • When organizational units require precise coordination of efforts

© 2007 by Nelson, a division of Thomson Canada Limited.

slide19
Advantages of Imposed Budgets
  • Increase probability that organization’s strategic plans will be incorporated in planned activities
  • Enhance coordination among divisional plans and objectives
  • Use top management’s knowledge of overall resource availability
  • Reduce the possibility of input from inexperienced or uninformed lower-level employees
  • Reduce the time frame for the budgeting process

© 2007 by Nelson, a division of Thomson Canada Limited.

slide20
Disadvantages of Imposed Budgets
  • May result in dissatisfaction, defensiveness, and low morale among individuals who must work under the budget
  • Reduce the feeling of teamwork
  • May limit the acceptance of the stated goals and objectives
  • Limit the communication process among employees and management
  • May create a view of the budget as a punitive device
  • May result in unachievable budgets for international divisions if local operating and political environments are not adequately considered
  • May stifle the initiative of lower-level managers

© 2007 by Nelson, a division of Thomson Canada Limited.

slide21
Best Times to Use Participatory Budgets
  • In well-established organizations
  • In extremely large businesses
  • In times of economic affluence
  • When operating managers have strong budgetary skills and perspectives
  • When organizational units are quite autonomous

© 2007 by Nelson, a division of Thomson Canada Limited.

slide22
Advantages of Participatory Budgets
  • Provide information from persons most familiar with the needs and constraints of organizational units
  • Integrate knowledge that is diffused among various levels of management
  • Lead to better morale and higher motivation
  • Provide a means to develop fiscal responsibility and budgetary skills of employees
  • Develop a high degree of acceptance of and commitment to organizational goals and objectives by operating management

© 2007 by Nelson, a division of Thomson Canada Limited.

slide23
Advantages of Participatory Budgets

(continued)

  • Are generally more realistic
  • Allow organizational units to coordinate with one another
  • Allow subordinate managers to develop operational plans that conform to organizational goals and objectives
  • Include specific resource requirements
  • Blend overview of top management with operating details
  • Provide a social contract that expresses expectations of top management and subordinates

© 2007 by Nelson, a division of Thomson Canada Limited.

slide24
Disadvantages of Participatory Budgets
  • Require significantly more time
  • Create a level of dissatisfaction with the process approximately equal to that occurring under imposed budgets in cases in which the effects of managerial participation are negated by top-management changes
  • Create an unachievable budget in cases in which managers may be ambivalent or unqualified to participate
  • May cause managers to introduce slack into the budget
  • May support “empire building” by subordinates

© 2007 by Nelson, a division of Thomson Canada Limited.

slide25
Improving the Budgeting Process

The corporate budget is the most effective tool for financial

analysis, planning, and control. Improvements to the process

can make a dramatic impact.

A recent poll reveals that companies that believe their budgets

are "very" accurate attribute this to better collaboration more

than any other factor, and that 61% of companies use a

combination of top-down and bottom-up approaches. About

20% use the top-down approach; and about 20% use the

bottom-up approach. A key trend is the move toward a more

participatory approach. Whether this is to avoid accounting

scandals, to increase employee accountability, or to make the

budget process less opaque, companies are involving more

people in the budgeting process.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide26
Activity-Based Budgeting

Budget slack – the intentional underestimation of revenues and/or

overestimation of expenses

To reduce the possibility of slack, management may wish to consider

basing the budget on activities rather than costs. Activity-based

budgets require an analysis of cost drivers and the relating of budget

line items to activities performed.

Activity budgeting is a new budget format whereby budget costs are

arrayed according to the expected costs of activities rather than

products, services or resources. These budgets can be motivational to

those who use them because they are easy to understand and

department managers can see the changes flow through them. They're

user oriented.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide27
Ten Top Weaknesses of Traditional Budgeting

1. Does not provide a common language that supports common sense

2. Focuses on costs, not quality or time

3. Focuses on input (costs), not output

4. Does not link to the strategic plan

5. Does not identify levels of service

6. Does not identify root causes of costs

7. Focuses on function, not processes

8. Focuses on cuts, not continuous improvement

9. Does not identify work or workload

10. Does not identify or quantify waste

© 2007 by Nelson, a division of Thomson Canada Limited.

slide28
Ten Top Advantages of Activity-Based Budgeting

1. Uses a common (verb + noun) activity language

2. Focuses on activity cost, time, and quality

3. Focuses on activity input and output

4. Strategic goals are linked to the activity's cost,

time, and quality

5. Focuses on required versus discretionary

activity output

6. Aids in identifying the cost drivers of activities

and processes

7. Focuses on functional activities and business

processes

8. Focuses on the unending improvement of

activity output

9. Focuses on activity output

10. Quantifies nonvalue-added activity costs

© 2007 by Nelson, a division of Thomson Canada Limited.

slide29
Continuous Budgets

A continuous (or rolling) budget is an ongoing twelve-

month budget that adds a new budget month (twelve

months into the future) as each current month expires.

Continuous budgets make the planning process less

sporadic and disruptive. Rather than going into the

budget period at a specific point in time, managers

are continuously involved in planning and budgeting.

Continuous budgets also provide a longer-range focus

so that no surprises occur at year-end.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide30
Implementation and Control

Budget implementation means that the budget is now

considered a standard against which performance can be

measured.

Once the budget is implemented, the control phase begins.

Control includes making actual-to-budget comparisons,

determining variances, providing feedback to operating

managers, investigating the causes of the variances,

and taking any necessary corrective action. This control

process indicates the cyclical nature of budgeting.

Feedback (both positive and negative) is essential to the

control process and must be provided in a timely manner to

be useful.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide31
Nature of the Budgeting Process

Actual Performance

Compared to

Feedback and discussion of causes

Changes, if

necessary,

implemented

Determination

of variances

© 2007 by Nelson, a division of Thomson Canada Limited.

slide32
The Budget Manual
  • Statements of the budgeting purpose and its desired results
  • A listing of specific budgetary activities to be performed
  • A calendar of scheduled budgetary activities
  • Sample budget forms
  • Original, revised, and approved budgets

Budget Manual – a detailed set of documents that provides information and guidelines about the budgetary process

© 2007 by Nelson, a division of Thomson Canada Limited.

slide33
Preparing Flexible Budgets

A flexible budget is a series of financial plans detailing the

individual cost factors that comprise total cost and presents

those costs at different levels of activity.

A flexible budget is simply a formula (y = a + bx)* that permits the budgeted costs to be determined for any activity level within the relevant range. This formula is the equation

for calculating the slope of the line.

Using a flexible budget allows the performance at one activity level to be compared to a budget at the same activity level.

© 2007 by Nelson, a division of Thomson Canada Limited.

* y = total cost; a = fixed costs; b = variable cost rate; x = volume

slide34
Preparing Flexible Budgets

Activity levels shown on a flexible budget usually cover

management's contemplated range of activity for the

upcoming period. If all activity levels are within the

relevant range, costs at each successive level should

equal the amount of the previous level plus a uniform

dollar increment for each variable cost factor. The

increment is the variable cost per unit of activity

multiplied by the quantity of additional activity.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide35
Preparing Flexible Budgets

At Basic Black Ltd., the budget (static budget) has been developed

for the cutting department for the month of November. Expected

production is 4,000 units.

Direct material $8,000

Direct labour 9,200

Manufacturing Overhead

Indirect material 1,000

Indirect labour 800

Utilities 400

Depreciation 6,400

$600 of the indirect labour is fixed, as is $200 of the utilities and

6,400 of the depreciation. These items occur on a monthly basis.

Using this information, we can prepare a flexible budget for 3,500

units, 4,000 units, and 4,500 units.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide36
Basic Black Ltd.

Flexible Budget

Units3,500 4,000 4,500

Direct material $ 7,000 $ 8,000 $ 9,000

Direct labour 8,050 9,200 10,350

Manufacturing overhead

Indirect material 875 1,000 1,125

Indirect labour 775 800 825

Utilities 375 400 425

Depreciation 6,4006,4006,400

Total $23,475 $25,800 $28,125

Indirect labour costs = $600 + $0.05X*

Utilities cost = $200 + $0.05X

*($775 - $600) ÷ 3,500 = $0.05

Flexible budgets permit comparisons to actual events; managers can

make valid budget-to-actual cost comparisons to determine if total

variable costs were properly controlled.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide37
Preparing Flexible Budgets

An Example

Faber Ltd. planned to sell 12,000 units of Product C.

However, management wanted to see what would happen

to profits if they sold only 11,000 units. What would

happen if they could sell 13,000 units?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide38
Flexible Budgets

© 2007 by Nelson, a division of Thomson Canada Limited.

slide39
Faber Ltd.

The following two slides show the differences between a static budget variance report and a flexible budget variance report.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide40
Static Budget Variances - Product C

The product manager for Product C was dismayed at the unfavourable revenue variance. However, she was pleased that cost variances were favourable. The Marketing Manager was less impressed with costs. He asked you to prepare flexible budget variances.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide41
Flexible Budget Variances

Product C

© 2007 by Nelson, a division of Thomson Canada Limited.

slide42
What Factors Might

Cause Costs to Differ?

  • Inflation
  • Technological Advances
  • Supply and Demand
  • Tax or regulatory adjustments
  • Number of competitors
  • Seasonality or other timing factors
  • Quantity purchased

© 2007 by Nelson, a division of Thomson Canada Limited.

slide43
Total Revenue Variance

Budgeted Sales

(BSP x BV)

Actual sales

(ASP x AV)

Total Revenue Variance*

ASP = actual selling price

AV = actual volume

BSP = budgeted selling price

BV = budgeted volume

© 2007 by Nelson, a division of Thomson Canada Limited.

*favourable or unfavourable

slide44
Sales Price Variance

BSPx AV

ASP x AV

BSP x BV

Sales Price Variance

AV (ASP - BSP) *

Sales price variance – the difference between actual and

budgeted selling prices multiplied by the actual number

of units sold

© 2007 by Nelson, a division of Thomson Canada Limited.

*favourable or unfavourable

slide45
Sales Volume Variance

BSP x AV

ASP x AV

BSP x BV

Sales Volume Variance

BSP (AV - BV) *

Sales volume variance – the difference between actual and

budgeted volumes multiplied by the budgeted selling price

© 2007 by Nelson, a division of Thomson Canada Limited.

*favorable or unfavourable

slide46
Example

The Maritime Lobsters budget 2008 ticket sales at $70,000 per home game, which represents the sale of an estimated 10,000 tickets at a selling price of $7. At July’s first home game, actual gate ticket revenue was $66,000, creating a total unfavourable revenue variance of $4,000. The actual sales consisted of 12,000 tickets at $5.50.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide47
Variance Calculations

Total Revenue Variance equals:

$70,000 - ($5.50 x 12,000) = $4,000 U

Sales Price Variance equals:

12,000 x ($5.50 - $7.00) = $18,000 U

Sales Volume Variance equals:

$7.00 x (12,000 - 10,000) = $14,000 F

© 2007 by Nelson, a division of Thomson Canada Limited.

slide48
Analyzing Cost Variances

Costs should be analyzed in relation to the actual volume of

sales rather than the budgeted volume of sales. This requires

the use of flexible budgets and flexible budget formulas (looking

at costs and revenues at different sales and production levels).

Assume that the Maritime Lobsters have a budget formula for

selling expenses of $200 per game plus 5% of sales dollars.

The original selling expense budget estimate for this game

would have been $3,700 [$200 + (10,000 x $7.00 x 0.05)].

However, at a sales level of $66,000, they should expect selling

expenses to be only $3,500 [$200 + (12,000 x $5.50 x 0.05)]. If

actual selling expenses were $3,700, the team did not perform

up to expectations; it should recognize a $200 unfavourable

variance for selling expenses.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide49
Analyzing Cost Variances

Managers also need to analyze the ways in which money

was spent. Spending analysis should focus on individual

line items, not just the totals, and on spending within

categories. In some cases, money is spent simply because

it is available for spending – not because there was a need

for spending.

To determine the underlying reasons for variances requires

that comparisons be made as early as possible. Delaying

variance computations until the end of a period may impede

a manager's ability to detect and control variance causes.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide50
Problems and Causes of Poor Performance

© 2007 by Nelson, a division of Thomson Canada Limited.

slide51
Budget Revisions

Management may decide to revise the budget. If actual

performance is substantially less than what was expected,

the budget may or may not be adjusted depending on the

causes of the variances. If the causes are beyond the

organization's control, management may decide to revise

budget estimates to more realistically reflect costs, i.e.,

SARS impact on travel. If the causes are internal, manage-

ment may leave the budget in its original form so that the

lack of operational control is visible in the comparisons.

If actual performance is substantially better than expected,

budget alterations may or may not be made. In any case,

managers should commend those responsible and

communicate the effects of such performance to related

departments. For example, if sales is higher than expected

both purchasing and production need to be informed.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide52
1. The Dictator Game – imposed budgeting

2. The Father-Knows-Best Game – input is sought,

but ignored or changed with no reasons provided

3. The Do-What-You-Want (and Fail) Game – managers are not informed of the big

picture and then fail to measure up because they either budgeted too high (unachievable), or too low (which had never been accepted)

4. The It's-Not-in-the-Budget Game – a manager submits a worthwhile project which is

turned down because money is unavailable. Then he or she may be criticized for not justifying the project convincingly.

5. The Cut-Everything-10 Percent Game – a favourite – the problem, if played too often,

lower-level managers increase their budget requests by 10% and are not disturbed by the reduction.

6. The End-of-Year (or Spend-it-or-Lose-it) Game – lower-level managers evaluate

remaining budget dollars and spend everything that is left before year end. Then, they can justify budget increases for next year.

7. The It-Wasn't-My-Fault Game – the manager tries to shift the blame for failure to meet

their budget on someone or something else. The economy is a good target.

8. The Accounting Change Game – unfortunately you are only allowed one play for any

given accounting change.

9. The Sell-It-No-Matter-What Game – for managers who are leaving or transferring and want to make a final name for themselves – a big increase in sales by using high-

pressure tactics, or by reducing quality. Watch out for next year!

10.The Build-a-Kingdom Game – use the budget to create a kingdom. The larger the

budget, the more possessions the kingdom has. Win friends by helping others build

their kingdoms; in exchange they help you. System fails when all the kingdoms are

competing for the same budget dollars.

Budget Games

© 2007 by Nelson, a division of Thomson Canada Limited.

slide53
Budgeting in an International Business

Similar to many other business practices, the budgeting process and

budget uses are unique to individual businesses. As the organization

becomes more complex, so does the budgeting process. When an

organization reaches multinational status, participatory budgeting is

not simply desired, it becomes necessary for the effort to be effective.

In a multinational environment, an organization faces an almost

unlimited number of external variables that can affect the planning

process: foreign currency exchange rates, interest rates, inflation,

inventory transfer price implications, etc. The risk may necessitate

the preparation of separate budgets for each international market

served in addition to a coordinated corporate-wide budget. Budget

preparation must incorporate a thorough understanding of local

market conditions. Each foreign operation's budget should be

supported by a comprehensive list of assumptions explaining how the

budget figures were derived.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide54
The Master Budget

A comprehensive set of an organization’s

budgetary schedules and

pro forma (projected) financial statements

© 2007 by Nelson, a division of Thomson Canada Limited.

slide55
The Master Budget

Master budget – the comprehensive set of all budgetary schedules

and the pro forma financial statements of an organization

Operating budget – a budget that is expressed in both units and

dollars

Financial budget – a budget that reflects the funds to be generated

or used during the budget period; includes the cash and capital

budgets and the projected or pro forma financial statements

Budget committee – a group, usually composed of top management

and the chief financial officer, that reviews and approves or makes

adjustments to the master budget and/or the budgets submitted

from operational managers

© 2007 by Nelson, a division of Thomson Canada Limited.

slide56
The Budgetary Process in a Manufacturing Organization

Purchasing

Department

(Raw Material)

Human

Resources

Department

(Labour)

Operations

Management

(Overhead)

Capacity

(Capital

Facilities)

Sales

Department

Production Department

(Work in Process)

Finished

Goods

Accounts

Receivable

Non-

Manufacturing

Operations

(Selling and

Administrative

Expenses)

Debt

Service

Payroll

Accounts

Payable

Other

Payables

Cash

Receipts

Cash Disbursements

TREASURER

(Funds Management)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide57
The Master Budget: An Overview

SALES BUDGET

(prepared by Sales/Marketing Department; demand driven)

Direct Labour Budget (prepared

by Human Resources Department)

Finished Goods

Inventory level

A

PRODUCTION BUDGET

Manufacturing Overhead Budget

(prepared by Operations Dept.)

Raw Material

Inventory level

Capital Budget

(prepared by Capital Facilities Dept.)

B

PURCHASING BUDGET

for Direct and Indirect Materials

(prepared by the Purchasing Department)

Note: The circled letters

reflect a flow of information

as an output of one area

and an input of another.

A

B

NONMANUFACTURING EXPENSE

BUDGETS (prepared by Sales and

Administrative Department)

A

B

Cash balance

Receivables balances

Payables balances

Investment balances

Shareholders' equity balances

PRO FORMA

FINANCIAL STATEMENTS

(prepared by Accounting Dept.)

CASH BUDGET

(prepared by Treasurer)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide58
The Master Budget

The sales budget is the starting point. The sales budget is prepared

in terms of both units and sales dollars.

The production budget follows naturally from the sales budget and

uses information regarding the type, quantity and timing of units to

be sold. Sales information is combined with information on beginning

and ending inventories so that managers can schedule the necessary

production.

The direct material purchases budget is first stated in whole units of

finished products. It is then converted to individual direct material

component requirements.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide59
The Master Budget

Given expected production, the Engineering and Human Resources

Departments can work together to determine the necessary labour

requirements for the factory, sales force, and office staff. Labour costs are

computed based on items such as union labour contracts, minimum wage

laws, fringe benefit costs, payroll taxes, and bonus arrangements. The

various personnel amounts are incorporated into the appropriate budgets:

direct labour budget, manufacturing overhead budget, or selling and

administrative costs budget.

In estimating overhead, all costs must be specified and mixed costs

must be separated into their fixed and variable elements. Both the

total cost and the cost net of depreciation will be shown in the budget.

Selling, general, and administrative expenses for each month can be

predicted in the same manner as overhead costs.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide60
The Capital Budget

Capital budgeting – a process for evaluating proposed long-range

projects or courses of future activity for the purpose of allocating

limited resources to desirable projects

The capital budget is prepared separately from the master

budget, but since expenditures are involved, capital budgeting

does affect the master budgeting process.

Capital asset decisions are the most irrevocable long-range

activities. They involve significant corporate funding; are the

least flexible in terms of changing the strategic direction, or for

conversion into more liquid assets. Capital decisions must

support the company's strategic plans.

© 2007 by Nelson, a division of Thomson Canada Limited.

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The Cash Budget

Once the master budget and the capital budget have been developed,

a cash budget can be prepared. The cash budget is the most

important schedule prepared during the budgeting process. A

company cannot survive without cash.

Cash budgets can be used to predict

seasonal variances in any potential cash

flow. Such predictions can indicate a

need for short-term borrowing and a

potential schedule of repayments. The

cash budget will also show how much

and when surplus cash will be available

for investment (and for how long).

They can be used to measure performance

of the accounts receivable and accounts

payable departments.

© 2007 by Nelson, a division of Thomson Canada Limited.

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Cash Budget Model

Beginning cash balance

+ Cash receipts from collections

= Cash available for disbursements exclusive of financing

- Cash needed for disbursements

= Cash excess or deficiency (a)

- Minimum desired cash balance

= Cash (needed) or available for investment or repayment

Financing methods:

+/- Borrow money (repay loans)

+/- Issue (reacquire) capital stock

+/- Sell (acquire) investments or plant assets

+/- Receive (pay) interest or dividends

Total impact (+ or -) of planned financing (b)

= Ending cash balance (c) = cash excess (or deficiency) (a) +/- total

impact of planned financing (b)

© 2007 by Nelson, a division of Thomson Canada Limited.

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Budget Example

Sales budgets by month:

January $200

February 300

March 400

April 500

May 600

Direct materials cost will be 60 percent of sales dollars. There is no

direct labour or variable overhead. The plant is completely automated. Selling and administrative variable costs will be 15 percent of sales dollars, which are paid in the following month.

Total fixed costs for the year will be $240, of which $10 per month is depreciation expense.

Desired ending inventory of direct materials is equal to the next two month's variable cost of goods sold (which is only direct materials).

Purchases are paid for in the month following the purchase.

© 2007 by Nelson, a division of Thomson Canada Limited.

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Budget Example

© 2007 by Nelson, a division of Thomson Canada Limited.

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Purchases Budget

Desired Ending Inventory:

January = $180 + $240 = $420

February = $240 + $300 = $540

March = $300 + $360 = $660

Beginning Inventory:

January is from December 31, 2007 Balance Sheet

© 2007 by Nelson, a division of Thomson Canada Limited.

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Budget Example

Collections are estimated to be 20 percent in the month of sale, 48 percent in the month following, and 32 percent in the second month following. There are no uncollectible accounts.

November sales were $275.

December sales were $250.

Purchases are paid for in

the month following the

purchase.

100.00

© 2007 by Nelson, a division of Thomson Canada Limited.

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Cash Receipts

© 2007 by Nelson, a division of Thomson Canada Limited.

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Cash Disbursements

December:

Variable cost of goods sold $150 ($250 x 0.60)

Desired ending inventory 300 ($120 + $180)

Required $450

Less: beginning inventory 270 ($150 + $120)3

Purchases for the month $180

1 Based on December 31 ending inventory figure

2 Based on Purchases Budget

3 (December sales $250 + January sales $200) x 0.60

1December disbursements are

based on December 31 ending

inventory figure.

2January, February, and March

disbursements are taken from

the Purchases Budget.

December 1 inventory:

[(December sales $250 +

January sales $200) x .60]

© 2007 by Nelson, a division of Thomson Canada Limited.

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Total Cash Disbursements

Fixed costs = $20 - $10 (depreciation – a non-cash item)

1January – Other Variable Costs ($250 x 0.15)

© 2007 by Nelson, a division of Thomson Canada Limited.

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Cash Budget

© 2007 by Nelson, a division of Thomson Canada Limited.

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Pro Forma Balance Sheet

Accounts Receivable: $300 x 0.32 + $400 x 0.80 = $416

Inventory = Desired ending inventory for March = $660 (from Purchases Budget)

Plant and Equipment (net) = $300 – (10 x 3 months depreciation) = $270

Accounts Payable = March purchases $360 + Accrued Payables $25 + 0.15 x March

sales $400 ($60) = $445

Dispute exists for opening Accrued Liability which remains unpaid.

Accrued Taxes Payable = $26.

Retained Earnings = $213 + 101 (net income) = $314

© 2007 by Nelson, a division of Thomson Canada Limited.

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Traditional Budgeting
  • Starts with last year's funding appropriation
  • Focuses on money
  • Does not systematically consider alternatives to current operations
  • Produces a single level of appropriation for an activity
  • Appropriation – a maximum allowable expenditure for a budget item

© 2007 by Nelson, a division of Thomson Canada Limited.

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Zero-Based Budgeting
  • Starts with a minimal (or zero) figure for funding
  • Focuses on goals and objectives
  • Directly examines alternative approaches to achieving similar results
  • Produces alternative levels of funding based on availability of funds and desired results

Zero-based budgeting – a comprehensive budgeting process that systematically considers the priorities and alternatives for current and proposed activities in relation to organizational objectives

© 2007 by Nelson, a division of Thomson Canada Limited.

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The Impact of ERP Systems on Budgeting
  • A group called the Beyond Budgeting Round Table (BBRT) was formed in
  • 1998 to discuss best practices to replace traditional budgeting.
  • The BBRT has gathered information to make the case that budgeting, as we
  • know it, is failing users.
  • Few firms are satisfied with their budgeting processes.
  • Too much time is devoted to budgeting, and too little time is spent on
  • strategy.
  • Fixed assets are a small part of the market values of many firms.
  • Intangible assets such as brands and systems for dealing with customers
  • and suppliers are often more valuable.
  • Budgeting is very expensive and often adds little value.

© 2007 by Nelson, a division of Thomson Canada Limited.

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The Impact of ERP Systems on Budgeting

To stay financially viable, corporations must bridge the gap between the

quickening pace of business operations and the much slower rate of

the traditional financial planning and budgeting process. They should

tightly integrate their business planning and budgeting applications into a

single solution. They should consider integrating this single solution with

other ERP systems, including customer relationship management (CRM),

supplier relationship management (SRM), and human capital management

(HCM). This can radically enhance a company's ability to respond

intelligently and quickly to dynamic market conditions.

© 2007 by Nelson, a division of Thomson Canada Limited.

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The Impact of ERP Systems on Budgeting

They say the IT system should be derived from, and thus support, business strategy, and not the IT specialists. The operations should be managed in terms of activities rather than financial terms. With the activity and information orientation, the organization should be measured against its strategy not in financial terms but in operational terms from multiple perspectives with a balanced scorecard (discussed in chapter 11). Using the balanced scorecard, performance should be benchmarked (discussed in chapters 8 and 11) against peers internally and externally.

If the balanced scorecard and benchmarking are used to measure operational or physical performance, budgeting is not needed as the ERP systems can be used frequently to forecast the expected financial results to the end of the next period. These rolling forecasts can be interpreted within the framework of a shareholder value model such as economic value added (EVA), which is discussed in chapter 11.

© 2007 by Nelson, a division of Thomson Canada Limited.

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The Impact of ERP Systems on Budgeting

Pressures on costs and pricing make lean, efficient operations necessary

for survival. Ironically research has found that the traditional budgeting

practice is the root cause of many organizations' current problems. These

businesses need to replace their budgeting process with management

tools that offer continuous planning and adaptive control. Jack Welch, past

CEO General Electric believes that the budgeting process is simply a

negotiating game.

Some argue that traditional budgets are necessary to keep costs in check

because they are a company's primary tool for authorizing spending.

However, practice shows the budgeting process has the opposite effect.

Although it may set a ceiling on expenses, it also sets a floor.

© 2007 by Nelson, a division of Thomson Canada Limited.

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The End

© 2007 by Nelson, a division of Thomson Canada Limited.

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