How Strategic Planning Increases Competitiveness

Transcription

1 Last year was a tough one. The economy did not recover as much as we had hoped and there was increased competition from overseas. It is crucial for our budget to be realistic. We will probably have to ask the bank for some additional fi nancing. I need you to answer one question for me How much cash will we need to get us through next year, so we will be ready when the economy recovers? We have a high level of debt already, so while I want you to be realistic in identifying our needs, there is no room for extras that you would like to have. There are two other issues I want you to address. First, although I am concerned about the cash needs for the year, I am particularly concerned about the fi rst three months. Will our cash collections cover the disbursements for the fi rst quarter? Second, I know that sales forecasts are just that forecasts. Is there some way you can summarize the uncertainty in the forecasts and what it means for our fi nancials next year? I just read an article that reported that small companies commonly use budgets as an important cash fl ow management tool [see the In Action item, Using the Budget to Help Manage Cash Flow ]. That certainly describes Santiago Pants! Gary Adams, the chief fi nancial offi cer of Santiago Pants, left the budgeting task force with this assignment. It was late October, and the task force was just starting to develop plans for the coming year. Santiago Pants is a manufacturer of designer pants. The company is small, but it has long-term goals that include diversifi ed clothing products and a move to other markets. Meeting these goals will not be possible with the current economic conditions, and the company will have to weather a year or two of uncertainty. This does not make the budgeting process easy, but it is a situation Santiago Pants is used to. Task force members ordered a take-out lunch and got down to work. Budgeting is a process that is widely used and necessary, at least in some form, for success, yet it is one of the least popular management processes practiced. Budgeting has become the target of criticism in the management press recently as being outdated and fundamentally flawed. These are provocative statements for a process that is widely practiced. However, a closer reading of the commentary reveals that the problem is not the budgeting process itself, though it also comes in for its share of criticism. The problems the authors identify are the use of budgets as targets and the dysfunctional effects caused by that use. In this chapter, we focus on the planning purpose of the budgeting process. For our purposes here, a budget is simply the plan, stated in financial terms, of how the organization expects to carry out its activities and meet the financial goals established in the planning process. We show how a master budget is developed and how it fits into the overall plan for achieving organization goals. Before we investigate the details of developing a master budget, we discuss the way that strategic planning can increase competitiveness and affect global operations. L.O. Understand the role of budgets in overall organization plans. budget Financial plan of the resources needed to carry out activities and meet fi nancial goals. How Strategic Planning Increases Competitiveness During the strategic planning process, companies often outline their critical success factors, which are the strengths that are responsible for making them successful. Critical success factors enable a company to outperform its competitors. By identifying these factors and ensuring that they are incorporated into the strategic plan, companies are able to critical success factors Strengths of a company that enable it to outperform competitors. Michael Jensen, Corporate Budgeting Is Broken Let s Fix It, Harvard Business Review (no. 0): ; and Jeremy Hope and Robin Fraser, Beyond Budgeting (Watertown, MA: Harvard Business School Press, 00).

2 Part IV Management Control Systems In Action Using the Budget to Help Manage Cash Flow Companies use a budget for many things including forecasting, reporting, performance evaluation, and so on. One recent study collected survey data that shows, just as with Santiago Pants, small firms rely on budgets to help manage cash flow. Executives at percent of the companies surveyed view their budgets as extremely or very important cash fl ow management tools and percent rate them somewhat important.... The budget s cash fl ow management aspect is most important at companies with annual revenues less than $0 million. The following graph breaks down the responses. 0% 0% 0% 0% 0% 0% 0% Less than $0 m $0 m $ m $00 m $ m $00 m+ 0% Extremely/very important Somewhat important Not very/not at all important Source: J. Orlando, Turning Budgeting Pain into Budgeting Gain, Strategic Finance, March 00, pp.. maintain an edge over competitors. In addition, important critical success factors can be exploited to improve the company s overall competitiveness. For example, Walmart has relied on several factors to maintain its competitive edge, one of which is to keep its prices consistently low by leveraging its purchasing power. The company knows that this is a critical success factor and has continued to increase its competitiveness by building this factor into its strategic planning process. Overall Plan master budget Financial plan of an organization for the coming year or other planning period. organization goals Company s broad objectives established by management that employees work to achieve. A master budget is part of an overall organization plan for the next year made up of three components: () the organization goals, () the strategic long-range profit plan, and () the tactical short-range profit plan. Organization Goals Top managers establish broad objectives, which serve as organization goals that company employees work to achieve. These goals often include financial goals, such as income growth, as well as more general goals focusing on employee learning, innovation, and community involvement. Such broad goals provide a philosophical statement that the

3 Chapter Planning and Budgeting company is expected to follow in its operations. Many companies include their goal statements in published codes of conduct, annual reports to stockholders, and Web sites. Strategic Long-Range Profit Plan Although a statement of goals is necessary to guide an organization, it is important to detail the specific steps required to achieve them. These steps are expressed in a strategic long-range plan. Because the long-range plans look into the intermediate and distant future, they are usually stated in rather broad terms. Strategic plans discuss the major capital investments required to maintain present facilities, increase capacity, diversify products and/or processes, and develop particular markets. For example, in describing its growth strategy, General Electric identifies a Growth as a Process Initiative. T h e initiative require consistent execution in: Technology Commercial excellence Customer focus Globalization Innovation Developing growth leaders Firms with a growth strategy that depends on selling the lowest cost product, such as Southwest Airlines, will have different steps to achieve that strategy. Each strategy statement is supported by general plans and achievements. The plans provide a general framework for guiding management s operating decisions. Master Budget (Tactical Short-Range Profit Plan): Tying the Strategic Plan to the Operating Plan Long-range plans are achieved in year-by-year steps. The guidance they provide is more specific for the coming year than it is for more distant years. The plan for the coming year, which is more specific than long-range plans, is called the master budget, also known as the static budget, the budget plan, or the planning budget. The income statement portion of the master budget is often called the profit plan. The master budget indicates the level of sales, production, and cost as well as income and cash flows anticipated for the coming year. In addition, these budget data are used to construct a budgeted statement of financial position (balance sheet). Budgeting is a dynamic process that ties together goals, plans, decision making, and employee performance evaluation. The master budget and its relationship to other plans, accounting reports, and management decision-making processes is diagrammed in Exhibit.. On the left side are the organizational goals and strategies that set the company s long-term plan. The master budget is derived from the long-range plan in consideration of conditions expected during the coming period. Such plans are subject to change as the events of the year unfold. Recently airlines such as Delta have postponed the introduction of services to selected international destinations because of global economic conditions. The conditions anticipated for the coming year are based in part on managers nearterm projections. Companies can gather this information from production managers, purchasing agents (materials prices), the accounting department, and employee relations (wage agreements), among others. As part of a benchmarking activity, some companies gather information through competitive intelligence, speaking to their competitors, customers, and suppliers. strategic long-range plan Statement detailing steps to take to achieve a company s organization goals. profit plan Income statement portion of the master budget.

4 Part IV Management Control Systems Exhibit. Organizational and Individual Interaction in Developing the Master Budget Organization Organization goals Long-range strategic plans Individual Individual goals and values Anticipated conditions for the budget period Individual beliefs and expectations Master budget Strategic evaluation Actual reported results for period Periodic performance evaluation Human Element in Budgeting L.O. Understand the importance of people in the budgeting process. A number of factors, including personal goals and values, affect managers expectations about the coming period. Although budgets are often viewed in purely quantitative, technical terms, the importance of this human factor cannot be overemphasized. The individual s relationship to the budget is diagrammed on the right side of Exhibit.. Budget preparation rests on human estimates of an unknown future. People s forecasts are likely to be greatly influenced by their experiences with various segments of the company. For example, district sales managers are in an excellent position to project customer orders over the next several months, but market researchers are usually better able to identify long-run market trends and make macro forecasts of sales. One challenge of budgeting is to identify who in the organization is best able to provide the most accurate information about particular topics. Value of Employee Participation participative budgeting Use of input from lowerand middle-management employees; also called grass roots budgeting. The use of input from lower- and middle-management employees is often called participative budgeting o r grass roots budgeting. The use of lower and middle managers in budgeting has an obvious cost; it is time-consuming. It also has some benefits; it enhances employee motivation and acceptance of goals and provides information that enables employees to associate rewards and penalties with performance. It also serves a training or development role for managers. Participative budgeting can yield information that employees know but managers do not. A number of studies have shown that managers often provide inaccurate data when asked to give budget estimates. They might request more money than they need because they expect their request to be cut. Managers who believe that the budget will be used as

5 Chapter Planning and Budgeting a norm for evaluating their performance could provide an estimate that will not be much of a challenge to achieve. Thus, managers usually view the technical steps required to construct a comprehensive tactical budget plan in the context of the effect that people have on the budget and the effect that the budget will have on them. Ideally, the budget will motivate people and facilitate their activities so that the organization can achieve its goals. Although each organization is unique in the way it puts together its budget, all budgeting processes share some common elements. After organizational goals, strategies, and longrange plans have been developed, work begins on the master budget, a detailed budget for the coming fiscal year with some less-detailed figures for subsequent years. Although budgeting is an ongoing process in most companies, the bulk of the work is usually done in the six months immediately preceding the beginning of the coming fiscal year. Final budget approvals by the chief executive and board of directors are made one month to six weeks before the beginning of the fiscal year. To envision the master budgeting process, picture the financial statements most commonly prepared by companies: the income statement, the balance sheet, and the cash flow statement. Then imagine preparing these statements before the beginning of the fiscal period. Developing the Master Budget Where do you start when preparing a master budget? One way to think about the question is to understand that the organization has more control over some aspects of the business (for example, how much to produce) and less control over other aspects (the demand for its products and services, for example). For most organizations, sales are most uncertain. Therefore, beginning with a sales forecast, the firm can plan the activities over which it has more control. As better information about sales becomes available, it is reasonably easy to adjust the rest of the budget. If, on the other hand, production is more uncertain than sales because the firm relies on a material that is rationed and the supply is uncertain, the firm may want to begin with a raw material and production forecast. Firms that rely on natural resources that are rationed or firms operating in economies in which a government agency controls supply (e.g., centrally planned economies) are examples of companies that start the process by preparing a forecast of production. Where to Start? Sales Forecasting In most firms, forecasting sales is the most difficult aspect of budgeting because it involves considerable subjectivity. To reduce subjectivity and gather as much information as possible, management often uses a number of different methods to obtain forecasts from a number of different sources. We begin with a forecast of revenues for the budget period. L.O. Estimate sales. Sales Staff Salespeople are in the unique position of being close to the customers, and they could be the people in the company who possess the best information and the best local knowledge about customers immediate and near-term needs. As we discussed in Chapter, salespeople also realize that they will be evaluated based, at least in part, on their actual performance compared to the budget. As a result, they have an incentive to bias their sales forecasts.

6 Part IV Management Control Systems One of the first things the budgeting task force at Santiago Pants did was to ask Yulia Makmur, the company sales manager, to join them for an afternoon to begin developing the sales forecast. For the coming budget year, she expects sales to be about $. million, although they could drop as low as $ million or run as high as $ million. Her bonus at the end of next year will be percent of the excess of actual sales over the sales budget. So if the budget is $ million and actual sales are also $ million, she will receive no bonus. The task force is aware that Yulia faces conflicting incentives when it comes to providing a sales forecast. On the one hand, if she forecasts sales that are too high, she risks losing her bonus. On the other hand, if she forecasts sales that are too low, the approved budget might not include production necessary to meet sales. In the pants business, customers will not wait for Santiago Pants to increase production. Instead, they will buy pants from competitors. In addition, Yulia might have her sales force reduced, which will also have a negative effect on sales. Thus, Yulia decides on a conservative but reasonable sales forecast of $ million, which, she believes, will give her a high probability of getting a bonus and a low risk of failing to meet her other objectives. Incentive compensation plans can be designed to motivate different behaviors, each with their own strengths and weaknesses. If, for instance, her bonus were a fixed percentage of sales, she would have an incentive to maximize sales. Then she might be motivated to make an optimistic sales forecast to justify obtaining a larger sales staff. The high sales forecast also would be used to estimate the amount of production capacity needed, thus ensuring that adequate inventory would be available to satisfy any and all customer needs. Of course, the managers and staff who receive forecasts usually recognize the subjectivity of the situation. As Rex Kohler, the head of the budgeting task force, put it, We ve received sales forecasts from her for several years, and they are always a bit conservative. We don t ask her to revise her estimates. We simply take her conservatism into account when we put together the overall sales forecast. Market Researchers To provide a check on forecasts from local sales personnel, management often turns to market researchers. This group probably does not have the same incentives that sales personnel have to bias the budget. Furthermore, researchers have a different perspective on the market. They may know little about customers immediate needs, but they can predict long-term trends in attitudes and the effects of social and economic changes on the company s sales, potential markets, and products. Delphi technique Forecasting method in which individual forecasts of group members are submitted anonymously and evaluated by the group as a whole. trend analysis Forecasting method that ranges from a simple visual extrapolation of points on a graph to a highly sophisticated computerized time series analysis. Delphi Technique The Delphi technique is another method used to enhance forecasting and reduce bias in estimates. With this method, members of the forecasting group prepare individual forecasts and submit them anonymously. Each group member obtains a copy of all forecasts but is unaware of their sources. The group then discusses the results. In this way, differences among individual forecasts can be addressed and reconciled without involving the personality or position of individual forecasters. After the differences are discussed, each group member prepares a new forecast and distributes it anonymously to the others. These forecasts are then discussed in the same manner as before. The process is repeated until the forecasts converge on a single best estimate of the coming year s sales level. Trend Analysis Trend analysis, which can range from a simple visual extrapolation of points on a graph to a highly sophisticated computerized time series analysis, also can be helpful in preparing sales forecasts. Time series techniques use only past observations of the data series to be forecasted. No other data are included. This methodology is justified on the grounds that because all factors that affect the data series are reflected in the actual past observations, the past data are the best reflection of available information. This approach is also relatively economical because only a list of past sales figures is needed. No other data are gathered. Forecasting techniques based on trend analysis often require long series of past data to derive a suitable solution. Generally, when these models are used in accounting applications, monthly data are required to obtain an adequate number of observations.

7 Chapter Planning and Budgeting Econometric Models Another forecasting approach is to enter past sales data into a regression model to obtain a statistical estimate of factors affecting sales. For example, the predicted sales for the coming period can be related to such factors as economic indicators, consumer-confidence indexes, back-order volume, and other internal and external factors that the company deems relevant. Advocates of these econometric models contend that they can include many relevant predictors. Manipulating the assumed values of the predictors makes it possible to examine a variety of hypothetical conditions and relate them to the sales forecast. This is particularly useful for performing sensitivity analysis, which we discuss later in this chapter. Sophisticated analytical models for forecasting are now widely available. Most companies have computer software packages that allow economical use of these models. Nonetheless, it is important to remember that no model removes the uncertainty surrounding sales forecasts. Management often has found that the intuition of local sales personnel is a better predictor than sophisticated analyses and models. As in any management decision, cost-benefit tests should be used to determine which methods are most appropriate. econometric models Statistical methods of forecasting economic data using regression models. To make our discussion of the budgeting process more concrete, we ll develop the budget for Santiago Pants. We use a manufacturing example because it includes most aspects of a firm s operations. The methods we discuss also apply to nonmanufacturing and not-forprofit organizations. At the end of the chapter, we consider some of the unique budgeting issues in these organizations. After evaluating the sales forecasts derived from various sources, the budgeting task force at Santiago Pants arrived at the following sales budget for the next budget year: Comprehensive Illustration Price Total Sales Units per Unit Revenues Estimated sales... 0,000 $ $,00,000 Forecasting Production The production budget plans the resources needed to meet current sales demand and ensure that inventory levels are sufficient for expected activity levels. It is necessary, therefore, to determine the required inventory level for the beginning and end of the budget period. The production level may be computed from the basic cost flow equation (also known as the basic inventory formula ): Beginning balance Transfers in Transfers out Ending balance BB TI TO EB Adapting that equation to inventories, production, and sales, we have Units in beginning Required inventory production (units) Budgeted Units in ending sales (units) inventory Rearranging terms to solve for required production results in Required production (units) Budgeted Units in ending Units in beginning sales (units) inventory inventory This equation states that production equals the sales demand plus or minus an inventory adjustment. Production and inventory are stated in equivalent finished units. L.O. Develop production and cost budgets. production budget Production plan of resources needed to meet current sales demand and ensure that inventory levels are sufficient for future sales.

8 0 Part IV Management Control Systems Exhibit. Production Budget 0 A SANTIAGO PANTS Production Budget For the Budget Year Ended December (in units) Expected sales Add desired ending inventory of finished goods Total needs Less beginning inventory of finished goods Units to be produced B 0,000,000,000,000 0,000 Production Budget Cost Sheet Direct Materials Budget Direct La Santiago Pants s sales budget projects sales of 0,000 units. Management estimates that,000 units will be in the beginning inventory of finished goods with an estimated cost of $0,000. Based on management s analysis, the required ending inventory is estimated to be,000 units. We assume for simplicity that there is no beginning or ending work-in-process inventory. With this information, the budgeted level of production is computed as follows: Required 0,000 units production (units) (sales) 0,000 units,000 units (ending inventory),000 units (beginning inventory) See Exhibit. for the production budget for Santiago Pants. The production manager reviews the production budget to ascertain whether the budgeted level of production can be reached with the capacity available. If not, management can revise the sales forecast or consider ways to increase capacity. If it appears that production capacity will exceed requirements, management might want to consider other opportunities for using the capacity. One benefit of the budgeting process is that it facilitates the coordination of activities. As the sales forecast increases, for example, the budget communicates to the production manager that more pants need to be produced. Conversely, if production capacity falls, the sales manager can avoid accepting orders the company cannot fill, thus reducing the possibility of dissatisfied customers. It is far better to learn about discrepancies between the sales forecast and production capacity in advance so that remedial action can be taken. Forecasting Production Costs After the sales and production budgets have been developed and the efforts of the sales and production groups have been coordinated, the budgeted cost of goods sold (production costs) can be prepared. The primary job of this budget is to estimate the costs of direct materials, direct labor, and manufacturing overhead at budgeted levels of production. Direct Materials Direct materials purchases needed for the budget period are derived from this equation: Required materials purchases Materials to be used in production Estimated ending Estimated beginning materials inventory materials inventory

9 Chapter Planning and Budgeting The beginning and ending levels of materials inventory for the budget period are estimated, often with the help of an inventory control model. The materials to be used in production are based on production requirements. Production at Santiago Pants for the coming period will require two kinds of materials, cotton and fine cotton. Cotton has an estimated beginning inventory of 0,000 yards and estimated ending inventory of,000 yards. Fine cotton has estimated beginning and ending inventories of,000 yards, as shown below. B Beg. Inv. 0,000 End. Inv.,000 Estimated Production Materials Data Cotton.0 yards 0. yards yards C D E F Beg. Inv.,000 End. Inv.,000 $ $ Production Budget Cost Sheet Fine Cotton yards yards yards Direct Mat The cost per yard is expected to remain constant during the coming budget period. Required production (from the production budget) is 0,000 units. Computation of the required materials purchases in units of each material follows: Cotton (0,000.0),000 0,000,000 yards Fine cotton (0,000 0.),000,000,000 yards In dollar terms, this amounts to estimated purchases of $,,000 for cotton (,000 $) and $0,000 for fine cotton (,000 $). The direct materials budget (Exhibit.) shows the materials required for production. Exhibit. Direct Materials Budget 0 Add desired ending inventory Total direct materials needs Less beginning inventory of materials Direct materials to be purchased Cost of materials, per yard Total cost of direct materials to be purchased A B SANTIAGO PANTS Direct Materials Budget For the Budget Year Ended December Units to be produced (from the production budget in Exhibit.) Direct materials needed per unit Total production needs (amount per unit times 0,000 units) Sum of materials (cotton and fine cotton) to be purchased ($,,000 $ 0,000) Production Budget Cost Sheet Direct Materials Budget Direct C D E 0,000 Cotton Fine Cotton.0 yards 0. yards 0,000,000,000,000,000 0,000,000,000,000 yards,000 yards $ $ $,,000 $ 0,000 $,,000

10 Part IV Management Control Systems Exhibit. Direct Labor Budget 0 A SANTIAGO PANTS Direct Labor Budget For the Budget Year Ended December Units to be produced (from the production budget Exhibit.) Direct labor time per unit (in hours) Total direct labor-hours needed Direct labor cost per hour Total direct labor cost B 0, ,000 $ $,0,000 Direct Labor Estimates of direct labor costs often are obtained from engineering and production management. For Santiago Pants, the direct labor costs are estimated at 0.0 hours per unit at $ per hour (or $ per output unit produced). Thus, for the budget year, the budgeted direct labor cost of production of 0,000 units is $,0,000 (see Exhibit.). Overhead Unlike direct materials and direct labor, which often can be determined from an engineer s specifications for a product, overhead is composed of many different types of costs with varying cost behaviors. Some overhead costs vary in direct proportion to production (variable overhead); some costs vary with production but in a step fashion (for example, supervisory labor); and other costs are fixed and remain the same unless capacity or longrange policies are changed. Still other costs (for example, plant depreciation) do not necessarily vary with production but can be changed at management s discretion. Budgeting overhead requires an estimate based on production levels, management discretion, long-range capacity and other corporate policies, and external factors such as increases in property taxes. Due to the complexity and diversity of overhead costs, several cost estimation methods are frequently used. To simplify the budgeting process, costs usually are divided into fixed and variable components, with discretionary and semi-fixed costs treated as fixed costs within the relevant range. See Exhibit. for Santiago Pants s schedule of budgeted manufacturing overhead. For convenience, after consultation with department management, the budgeting task force at Santiago Pants has divided all overhead into fixed and variable costs. The budgeting task force now can determine the budgeted total manufacturing costs by adding the three components: materials, labor, and overhead. This total is $,0,000 (see Exhibit.). Completing the Budgeted Cost of Goods Sold We need only include the estimated beginning and ending work-in-process and finished goods inventories to determine the required number of units produced: 0,000. As previously indicated, no work-in-process inventories exist. Finished goods inventories are as follows, given the management estimate of beginning inventory and the estimated $ cost of producing pants this year: Units Dollars Beginning fi nished goods inventory..,000 $0,000 (management estimate) Ending fi nished goods inventory....,000,000 (,000 units $) If the company has beginning and ending work-in-process inventories, units are usually expressed as equivalent finished units and treated the way we have treated finished goods inventories. In most companies, estimates of work-in-process inventories are omitted from the budget because they have a minimal impact on the budget.

11 Chapter Planning and Budgeting Exhibit. Manufacturing Overhead Budget 0 0 Units to be produced (from the production budget Exhibit.) Variable overhead Indirect materials and supplies Materials handling Other indirect labor Fixed manufacturing overhead Supervisory labor Maintenance and repairs Plant administration Utilities Depreciation Insurance Property taxes Other Total manufacturing overhead A B C D E SANTIAGO PANTS Schedule of Budgeted Manufacturing Overhead For the Budget Year Ended December Variable For Total Overhead Production per Unit (Exhibit.) 0,000 units $ $,000,000 $,000 $ 0,000 0,000,000,000 0,000 0,000 0,000,000 $,000,000 $ 0,000 Exhibit. Budgeted Statement of Cost of Goods Sold 0 0 A B SANTIAGO PANTS Budgeted Statement of Cost of Goods Sold For the Budget Year Ended December Beginning work-in-process inventory Manufacturing costs Direct materials Beginning inventory Purchases (from the direct materials budget in Exhibit.) $,000,,000 Materials available for manufacturing Less ending inventory $,0,000 (0,000) Total direct materials costs Direct labor (from the direct labor budget in Exhibit.) Manufacturing overhead (from the schedule of manufacturing overhead in Exhibit.) Total manufacturing costs Less ending work-in-process inventory Cost of goods manufactured Add beginning finished goods inventory (,000 units) Less ending finished goods inventory (,000 units) Cost of goods sold C D E F $ 0 $,00,000,0,000 0,000 $,0,000 0 $,0,000 0,000 a (,000) b $,,000 a Management estimate. b Finished goods are valued at $ per unit ($,0,000 0,000 units produced) assuming FIFO. Hence, ending fi nished goods inventory is estimated to be $,000 (,000 units $).

12 Part IV Management Control Systems Adding the estimated beginning finished goods inventory to the estimated cost of goods manufactured and then deducting the ending finished goods inventory yields a cost of goods sold of $,,000 (Exhibit.). This completes the second major step in the budgeting process: determining budgeted production requirements and the cost of goods sold. Obviously, this part of the budgeting effort can be extremely complex for manufacturing companies. It can be very difficult to coordinate production schedules among numerous plants, some of which use other plants products as their direct materials. It also is difficult to coordinate production schedules with sales forecasts. New estimates of material availability, labor shortages, strikes, availability of energy, and production capacity often require reworking the entire budget. Revising the Initial Budget At this point in the budget cycle, a first-draft budget has been prepared. It usually undergoes a good deal of coordinating and revising before it is considered final. For example, projected production figures could call for revised estimates of direct materials purchases and direct labor costs. Bottlenecks could be discovered in production that will hamper the company s ability to deliver a particular product and thus affect the sales forecast. The revision process can be repeated several times until a coordinated, feasible master budget evolves. No part of the budget is formally adopted until the board of directors finally approves the master budget. Self-Study Question. The self-study questions in this chapter provide a comprehensive budgeting problem based on data from the Santiago Pants example in the chapter. Refer to the data for Santiago Pants in the chapter example. Assume that the sales forecast was decreased to 0,000 units with no change in price. Managers revised their estimate of property taxes to $,00 (reduced from $0,000) based on a recent property tax law change. The new target ending inventories follow: Finished goods Cotton Fine cotton ,000 units,000 yards 00 yards Prepare a budgeted cost of goods sold statement and budgeted overhead statement with these new data. (Assume fi rst-in, fi rst-out.) The solution to this question is at the end of the chapter on pages 0. Marketing and Administrative Budget Creating budgets for marketing and administrative costs is very difficult because managers have discretion about how much money they spend and the timing of these expenditures. It is also often difficult to establish the link between the costs and the benefits for the company. For example, a company hired a new marketing executive who was famous for his cost-cutting skills. The executive ordered an immediate 0 percent cut in the company s advertising budget, a freeze on hiring, and a 0 percent cut in the travel budget. Costs did fall, but with little immediate impact on sales. A year later, looking for new challenges, the executive moved to another company. Soon afterward, the executive s former employers noticed that sales were down because the company had lost market share to some aggressive competitors. Were the marketing executive s cost-cutting actions really in the company s best interests? To this day, nobody can give a documented answer to that question because it is difficult to prove a causal link between the cost cutting and the subsequent decrease in sales.

13 Chapter Planning and Budgeting In another case, a company s president was the only one who used the corporate jet, and he used it only rarely. So the internal audit staff recommended selling it. The company president rejected the idea, saying, One of the reasons I put up with the pressures and responsibilities of this job is because I enjoy some of its perquisites, including the corporate jet. Some costs that appear unnecessary, especially perquisites, are really part of the total compensation package, which is likely determined by the labor market for unique skills. The budgeting objective here is to estimate the amount of marketing and administrative costs required to operate the company at its projected level of sales and production and to achieve long-term company goals. For example, the budgeted sales figures can be based on a new product promotion campaign. If production and sales are projected to increase, an increase in support services data processing, accounting, personnel, and so forth likely will be needed to operate the company at the higher projected levels. An easy way to deal with the problem is to start with a previous period s actual or budgeted amounts and make adjustments for inflation, changes in operations, and similar changes between periods. This method has been criticized and can be viewed as being very simplistic, but it has one advantage: It is relatively easy and inexpensive. As always, the benefits of improving budgeting methods must justify their increased costs. At Santiago Pants, each management level submits a budget request for marketing and administrative costs to the next higher level, which reviews it and approves it, usually after making some adjustments. The budget is passed up through the ranks until it reaches top management. The schedule of marketing and administrative costs is divided into variable and fixed components (see Exhibit.). In this case, variable marketing costs are those that vary with sales (not production). Fixed marketing costs are usually those that can be changed at management s discretion, for example, advertising. 0 0 A B C SANTIAGO PANTS Schedule of Budgeted Marketing and Administrative Costs For the Budget Year Ended December Variable For Total Marketing per Unit Sold Variable marketing costs Sales commissions $.0 Other marketing 0. Total variable marketing costs Fixed marketing costs Sales salaries Advertising Other Total fixed marketing costs Total marketing costs Administrative costs (all fixed) Administrative salaries Legal and accounting staff Data processing services Outside professional services Depreciation building, furniture, and equipment Other, including interest Taxes other than income Total administrative costs Total budgeted marketing and administrative costs Sales 0,000 (Exhibit.) $ 0,000 0,000 $ 0,000,000,000 $,000,000,000,000,000,000 0,000 D units $ 0,000 0,000 $ 0,000,000 $,0,000 Exhibit. Marketing and Administrative Costs Budget Cost of Goods Sold Budget SG&A Budget Budgeted Income Stateme

14 Part IV Management Control Systems Exhibit. Budgeted Income Statement 0 A B SANTIAGO PANTS Budgeted Income Statement For the Budget Year Ended December Budgeted revenues Budgeted price per unit Budgeted sales volume (Exhibit.) Costs Cost of goods sold (Exhibit.) Marketing and administrative costs (Exhibit.) Total budgeted costs Budgeted operating profit Federal and other income taxes Budgeted profit after taxes SG&A Budget Budgeted Income Statement $ 0,000 C $,,000,0,000 D $,00,000,0,000 $,,000 0,000 $,,000 Pulling It Together into the Income Statement According to Rex Kohler, head of the budgeting task force at Santiago Pants, At this point, we re able to put together the entire budgeted income statement for the period [Exhibit.] so we can determine our projected operating profits. By making whatever adjustments are required to satisfy generally accepted accounting principles for external reporting, we can project net income after income taxes and earnings per share. If we don t like the results, we go back to the budgeted income statement and, starting at the top, go through each step to see if we can increase sales revenues or cut costs. We usually find some plant overhead, marketing, or administrative costs that can be cut or postponed without doing too much damage to the company s operations. The board of directors at Santiago Pants approved the sales, production, and marketing and administrative budgets and the budgeted income statement as submitted. Note that the budgeted income statement also includes estimated federal and other income taxes, which the tax staff provided. We will not detail the tax estimation process because it is a highly technical area separate from cost accounting. Self-Study Question. Refer to Self-Study Question. Recall that Santiago Pants has a sales forecast of 0,000 units and new target ending inventories as follows: Finished goods Cotton Fine cotton ,000 units,000 yards 00 yards In addition, you learn that income tax expense is $00,000. Variable marketing costs change proportionately with volume; that is, the amount now is (0,000 0,000) of the amount in the text example. Prepare a budgeted schedule of marketing and administrative costs and a budgeted income statement. The solution to this question is at the end of the chapter on page.

15 Chapter Planning and Budgeting Key Relationships: The Sales Cycle Assembling the master budget demonstrates some key relations among sales, accounts receivable, and cash flows in the sales cycle. Advantages of understanding these relations include the ability to solve for unknown amounts and to audit the master budget to ensure that the basic accounting equation has been correctly applied. At Santiago Pants, for example, the relations among budgeted sales, accounts receivable, and cash receipts are as follows (sales are assumed to be on account): Sales Cash (Exhibit.) Accounts Receivable (Exhibit.) (BB ) 0,000 (BB ) 0,000,00,000,00,000,0,000,0,000,,000 (EB ) 00,000 00,000 (EB ),000 Note: BB and EB refer to beginning and ending balances. These balances for accounts receivable appear in later exhibits. We present them here to help you see how cash, sales, and accounts receivable are interrelated. If an amount in the sales cycle is unknown, the basic accounting equation can be used to find it. For example, suppose that all of the amounts in the preceding diagram are known except ending cash balance and sales. Using the basic cost flow equation, BB TI TO EB we find sales from the Accounts Receivable account: $0,000 TI (sales) $,0,000 $00,000 TI $00,000 $0,000 $,0,000 TI $,00,000 We can find the ending cash balance from the Cash account: $0,000 ($,0,000 $00,000) $,,000 EB EB $,000 Using Cash Flow Budgets to Estimate Cash Needs Although the budgeted income statement is an important tool for planning operations, a company also requires cash to operate. Cash budgeting is important to ensure company solvency, maximize interest earned on cash balances, and determine whether the company is generating enough cash for present and future operations. Preparing a cash budget requires that all revenues, costs, and other transactions be examined in terms of their effects on cash. The budgeted cash receipts are computed from the collections from accounts receivable, cash sales, sale of assets, borrowing, issuing stock, and other cash-generating activities. Disbursements are computed by counting the cash required to pay for materials purchases, manufacturing and other operations, federal income taxes, and stockholder dividends. In addition, the cash disbursements necessary to repay debt and acquire new assets also must be incorporated into the cash budget. See Exhibit. for the cash budget for Santiago Pants. The source of each item is indicated. L.O. Estimate cash fl ows. cash budget Statement of cash on hand at the start of the budget period, expected cash receipts, expected cash disbursements, and the resulting cash balance at the end of the budget period.

16 Part IV Management Control Systems Exhibit. Cash Budget 0 0 A SANTIAGO PANTS Cash Budget For the Budget Year Ended December Cash balance beginning of period Receipts Collections on accounts Collections on employee loans Total receipts Less disbursements Payments for accounts payable Direct labor (from the direct labor budget in Exhibit.) Manufacturing overhead less noncash depreciation charges (from manufacturing overhead budget in Exhibit.) Marketing and administrative costs less noncash charges (from marketing and administrative budget in Exhibit.) Payments for federal income taxes (per discussion with the tax staff) Dividends Reduction in long-term debts Acquisition of new assets Total disbursements Budgeted ending cash balance (ties to Exhibit.) Budgeted Income Statement Cash Budget a Estimated by the treasurer s offi ce. b Estimated by the treasurer s offi ce per the capital budget. B $,0,000 a 00,000 a,,000 a,0,000 0,000,,000 0,000 0,000 a,000 a,0,000 b C D $ 0,000 a,0,000,,000 $,000 Multiperiod Cash Flows Although the cash budget for Santiago Pants shows a surplus for the end of the year, we cannot be sure that the company will not run out of cash during the year. For that reason, cash flows often are analyzed in more detail than shown in the Santiago Pants example so far. Assume that the following is consistent with the experience of Santiago Pants concerning its monthly collection experience for sales on credit: Cash collected from current month s sales % Cash collected from last month s sales Cash discounts taken (percentage of gross sales) Written off as bad debt Total disposition of credit sales in current month % This means that if January s credit sales are $00,000, expected collections are $00,000 in January and $,000 in February; $0,000 is not expected to be collected because the customers paid early enough to get a discount; and $,000 is not expected to be collected because these accounts will be written off as bad debts. See Exhibit.0 for a multiperiod schedule of cash collections for the three months of the quarter ending March for Santiago Pants. Assume that the beginning accounts receivable balance on January is expected to be $0,000 (net of discounts and bad debts), all of which is anticipated to be collected during January. The expected sales for the three months follow: January sales $00,000 February sales ,000 March sales ,000

17 Chapter Planning and Budgeting Exhibit.0 Multiperiod Schedule of Cash Receipts 0 A B D F G SANTIAGO PANTS Multiperiod Schedule of Cash Collections For the Quarter Ended March Beginning accounts receivable, January, $ 0,000 January sales, $ 00,000 a February sales, $ 0,000 b March sales, $ 00,000 January $ 0,000 00,000 Total cash collections $ 0,000 Collections Disbursements Sheet Month February $,000 0,000 $,000 March $,00 0,000 $,00 Total for Quarter $ 0,000,000,00 0,000 $,,00 Note: Assumptions for the budget: 0 percent of a month s sales is collected in cash during the month: percent is collected in the next month; percent is taken as a cash discount for early payments; and percent will not be collected because it is written off as bad debts. a 0 percent collected in January, percent collected in February, and percent not collected, according to the preceding assumption. b 0 percent collected in February, percent collected in March, and percent not collected, according to the preceding assumption. Exhibit. Multiperiod Schedule of Cash Disbursements 0 Beginning accounts payable, January, $,000 January purchases, $ 0,000 a February purchases, $ 00,000 b March purchases, $ 0,000 Additional cash payments Total cash disbursements Collections A B C D E F SANTIAGO PANTS Disbursements Multiperiod Schedule of Cash Disbursements Sheet For the Quarter Ended March Month January $,000 0,000 0,000 $,000 February $,00 00,000 0,000 $ 0,00 March $,000,000 0,000 $,000 G H Total for Quarter $,000,00,000,000 0,000 $,,00 Note: Assumptions for the budget: 0 percent of a month s purchases is paid in cash during the month: percent is paid in the next month; and percent is taken as a cash discount for early payments. a 0 percent paid in January, percent paid in February, and percent discounts taken, according to the preceding assumption. b 0 percent paid in February, percent paid in March, and percent discounts taken, according to the preceding assumption. The same approach is used for cash disbursements. See the cash disbursements in Exhibit. for Santiago Pants, which pays for 0 percent of its purchases in the month of purchase and percent in the following month, and takes a percent discount for paying on time. Following is a list of purchases for the three months January through March: January $0,000 February ,000 March ,000

18 0 Part IV Management Control Systems In addition, all other cash payments are expected to be $0,000 per month. Santiago Pants had accounts payable of $,000 on January, all of which it paid in January. In Action The Curse of Growth A quick look at the budgeted income statement and cash position of Santiago Pants reveals a seemingly contradictory phenomenon. Based on income, Santiago Pants is projected to do quite well this year: $. million in income on sales of $. million, a percent return on sales. Looking at cash, however, the firm is in danger of not being able to pay its debts. This is a common problem, especially among new fi rms that experience high growth because of the success of their product in the market. The problem is that cash is required to purchase inventory prior to the sale but is not collected until after the sale. In a growing fi rm, the dollar purchases of new inventory (or of the resources to produce new inventory) are higher than the dollar collections of prior sales. Looking only at projected income statements gives a misleading view of the operations. Self-Study Question. This question is based on the previous Self-Study Questions in this chapter and on the Santiago Pants example in the text. Prepare a cash budget given the revised fi gures for Santiago Pants provided in Self-Study Questions and. Assume, however, that cash collections will decrease by the same amount as the decrease in sales except that the ending accounts receivable level will decrease by another $0,000. Lower payments for purchases of materials equal to the reduction in purchases will be required, but ending accounts payable also will decrease by $,000. Payments for income taxes will decrease to $00,000. The solution to this question is at the end of the chapter on page. Planning for the Assets and Liabilities on the Budgeted Balance Sheets L.O. Develop budgeted fi nancial statements. budgeted balance sheets Statements of budgeted financial position. Budgeted balance sheets, or statements of financial position, combine an estimate of financial position at the beginning of the budget period with the estimated results of operations for the period (from the income statements) and estimated changes in assets and liabilities. The latter result from management s decisions about optimal levels of capital investment in long-term assets (the capital budget), investment in working capital, and financing decisions. Decision making in these areas is, for the most part, the treasurer s function. We assume that these decisions have been made and incorporate their results in the budgeted balance sheets. See Exhibit. for Santiago Pants s budgeted balance sheets at the beginning and end of the budget year. Big Picture: How It All Fits Together We have completed the development of a comprehensive budget for Santiago Pants. See Exhibit. for a model of the budgeting process. Although we have simplified the presentation, you can still see that assembling a master budget is a complex process requiring careful coordination of many different organization segments.

19 Chapter Planning and Budgeting Exhibit. Budgeted Balance Sheet Assets Current assets Cash Accounts receivable Inventories Other current assets Total current assets Long-term assets Property, plant, and equipment Less accumulated depreciation Total assets Liabilities and shareholders equity Current liabilities Accounts payable Taxes payable Current portion of long-term debt Total current liabilities Long-term liabilities Total liabilities Shareholders equity Common stock Retained earnings Total shareholders equity Total liabilities and shareholders equity A B C D E F G H I SANTIAGO PANTS Budgeted Balance Sheets For the Budget Year Ended December ($ 000) Balance (January ) $ 0 a 0 b d b $,, b (,) b $,0 $ b $, j b 0 b b b $ $, b 0 b $ $, $ b, b $, $,0 Budget Year Balance Additions Subtractions (December ) $,0 a,00 c, e 0 b $,0,0 a () i $, $ 0 b, k $, $, $, a,0 a, f 00 h $, 0 b 0 b $, $, a 0 a a $,0 b $,00 $ 0 b 0 a $ 0 $,0 $ a 00 b g b $,, b (,0) b $, $ b b b $ b $ $ b, b $,0 $, a From cash budget (Exhibit.). b Estimated by personnel in the company s accounting department. c From budgeted income statement (Exhibit.). Assumes that all sales are on account. d From budgeted statement of cost of goods sold (Exhibit.), sum of beginning direct materials, work-in-process, and fi nished goods inventories ($ 0 $0 $). e From budgeted statement of costs of goods sold (Exhibit.), sum of materials purchases, direct labor, and manufacturing overhead ($, $,0 $0 $,). f From budgeted statement of cost of goods sold (Exhibit.). g From budgeted statement of cost of goods sold (Exhibit.), sum of ending direct materials, work-in-process, and fi nished goods inventories ($0 0 $ $). h From employee loans. i Depreciation of $0 from schedule of budgeted manufacturing overhead (Exhibit.), plus depreciation of $ from the schedule of budgeted marketing and administrative costs (Exhibit.) equals $ increase in accumulated depreciation. j From budgeted statement of cost of goods sold (Exhibit.). Accounts payable increases are assumed to be for materials purchases only. k From budgeted income statement (Exhibit.), operating profi t after taxes.

20 Part IV Management Control Systems Exhibit. Assembling the Master Budget for a Manufacturing Firm Sales forecast Production budget (Exhibit.) Marketing and administrative costs budget (Exhibit.) Required direct materials, direct labor, and manufacturing overhead budgets (Exhibits..) Budgeted cost of goods sold (Exhibit.) Budgeted income statement (Exhibit.) Cash budget (Exhibit.) Budgeted balance sheets (Exhibit.) Budgeting in Retail and Wholesale Organizations L.O. Explain budgeting in merchandising and service organizations. We used a manufacturing example, Santiago Pants, to illustrate the construction of the master budget because it allowed us to include the effects of inventories and inventory balances on the budgeting process. Although a manufacturing operation provides a good comprehensive example, budgeting is used extensively in other environments as well, and we now consider some of the unique features of budgeting in these settings. As in manufacturing, the sales budget in retail and wholesale (often called merchandising ) organizations drives the rest of the budgeted income statement. A merchandiser does not have a production budget but instead has a merchandise purchases budget, which is much like the direct materials purchases budget in manufacturing. For example, managers at Castro Audio & Video, Inc., prepared the following purchases budget for a particular home entertainment system: Estimated sales units Estimated ending inventory Estimated beginning inventory Estimated cost per unit $, See Exhibit. for the merchandise purchases budget for Castro. As you can see, this budget requires extensive coordination between the managers responsible for sales and those in charge of buying. Because of the critical importance of timing and seasonality in merchandising, special attention is usually given to short-term

21 Chapter Planning and Budgeting A B CASTRO AUDIO & VIDEO, INC. 0 Merchandise Purchases Budget For the Year Ended December Estimated sales (units) Add estimated ending inventory Total merchandise needs Less beginning inventory Merchandise to be purchased Estimated cost per unit Total estimated cost of merchandise C 00 units 0 0 units $, $, Exhibit. Purchases Budget budgets (for example, spring, summer, and holiday season budgets). The budget helps formalize an ongoing process of coordinating buying and selling. This coordination is critical to the success of merchandising enterprises. Budgeting in Service Organizations A key difference in the master budget of a service enterprise is the absence of product or materials inventories. Consequently, neither a production budget (prepared in manufacturing firm budgets) nor a merchandise purchases budget (prepared in merchandising firm budgets) is needed. Instead, service businesses need to carefully coordinate sales (that is, services rendered) with the necessary labor. Managers must ensure that personnel with the right skills are available at the right times. The budget for Delta Consulting Services, a consulting firm hoping to land the Santiago Pants account, is developed around the three major services offered: strategy, operations, and information systems. Revenue projections are based on estimates of the number and types of clients the firm plans to service in the budget year and the amount of services requested. The forecasts stem primarily from services provided in previous years with adjustments for new clients, new services to existing clients, loss of clients, and changes in the rates charged for services. Budget Is the Law in Government In Action We have emphasized the planning purpose of budgeting in this chapter. However, in governmental organizations, the budget serves as an expression of the legislature s (voters ) desires and as such it is a legally binding spending authorization. This can often lead to unintended confl icts between making good decisions and complying with the budget. For example, a department s budget is typically made up of funds for different purposes (e.g., capital procurement buying machines and operating and maintenance activities). Suppose a department needs to buy a computer. If the department is short of O&M funds and has excess capital procurement funds, it has an incentive to buy the computer rather than lease it, regardless of what a lease-versus-buy analysis suggests. Source: Based on the authors research. The budgeting process for a government unit such as a city is important because it communicates citizens goals by identifying the programs to be funded and sets limits on the spending for any particular activity.