Nature of a Budget. Budgets are an important tool for effective short-term planning and control in organizations.

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1 Budget Preparation

2 Nature of a Budget Budgets are an important tool for effective short-term planning and control in organizations. An operating budget usually covers one year and states the revenues and expenses planned for that year.

3 The budget has these characteristics: A budget estimates the profit potential of the business unit. It is stated in monetary terms, may be backed up by nonmonetary amounts (e.g., units sold or produced). It generally covers a period of one year. In businesses that are strongly influenced by seasonal factors, there may be two budgets per year for example, apparel companies typically have a fall budget and a spring budget. It is a management commitment; managers agree to accept responsibility for attaining the budgeted objectives. The budget proposal is reviewed and approved by an authority higher than the budgetee. Once approved, the budget can be changed only under specified conditions. actual financial performance is compared to budget, and variances are analyzed and explained

4 Relation to Strategic Planning Strategic planning, is the process of deciding on the nature and size of the several programs that are to be undertaken in implementing an organization s strategies. Both strategic planning and budget preparation involve planning, but the types of planning activities are different in the two processes A budget is, a one-year slice of the organization s strategic plan, although the budgeting process involves more than simply carving out a slice.

5 Contrast with Forecasting A budget is a management plan a forecast is merely a prediction of what will most likely happen From management s point of view, a financial forecast is exclusively a planning tool, whereas a budget is both a planning tool and a control tool. All budgets include elements of forecasting

6 Use of a Budget Preparation of an operating budget has four principal purposes: (1) to fine-tune the strategic plan; (2) to help coordinate the activities of the several parts of the organization; (3) to assign responsibility to managers, to authorize the amounts they are permitted to spend, and to inform them of the performance that is expected of them; (4) to obtain a commitment that is a basis for evaluating a manager s actual performance.

7 Fine-Tuning the Strategic Plan The strategic plan has the following characteristics: it is prepared early in the year, it is developed on the basis of the best information available at that time, its preparation involves relatively few managers, The budget provides an opportunity to use the latest available information and is based on the judgment of managers at all levels throughout the organization.

8 Coordination Every responsibility center manager in the organization participates in the preparation of the budget. Then, when the staff assembles the pieces into an overall plan, inconsistencies may show up. The most common is the possibility that the plans of the production organization are not consistent with the planned sales volume, in total or in certain product lines During the budget preparation process, these inconsistencies are identified and resolved.

9 Assigning Responsibility The approved budget should make clear what each manager is responsible for. The budget also authorizes responsibility center managers to spend specified amounts of money for certain designated purposes without seeking the approval of higher authority

10 Basis for Performance Evaluation The budget represents a commitment by the budgetee to his or her superior. It is therefore a benchmark against which actual performance can be judged. The commitment is subject to change if the assumptions on which it is based change,

11 Content of an Operating Budget Exhibit 9.1 shows the content of a typical operating budget: the strategic plan and the capital budget, the cash budget, and the budgeted balance sheet The amounts are the planned dollar amounts for the year, together with quantitative amounts, such as head counts (i.e., number of employees) and sales in units.

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13 Operating Budget Categories In a relatively small organization, especially one that has no business units, the whole budget may fit on one page. In larger organizations, there is a summary page, and other pages contain the details for individual business units, plus research and development, and general and administrative expenses. The revenue item is listed first, because the amount of budgeted revenues influences the amount of many of the other items

14 Revenue Budgets A revenue budget consists of unit sales projection multiplied by expected selling prices. Of all the elements of a profit budget, the revenue budget is the most critical, but it is also the element that is subject to the greatest uncertainty. The degree of uncertainty differs among companies, and within the same company the degree of uncertainty is different at different times

15 Revenue Budgets The revenue budget usually is based on forecasts of some conditions for which the sales manager cannot be held responsible. For example, the state of the economy must be anticipated in preparing a revenue budget, but the marketing manager obviously has no control over it effective advertising, good service, good quality, and well-trained salespeople influence the sales volume, and the marketing manager does control these factors

16 Budgeted Production Cost and Cost of Sales Production managers make plans for obtaining quantities of material and labor, and they may prepare procurement budgets for long-lead-time items. They also develop production schedules to ensure that resources needed to produce the budgeted quantities will be available the cost of sales reported in the summary budget is the standard cost of the products budgeted to be sold.

17 Marketing Expenses Marketing expenses are expenses incurred to obtain sales. A considerable fraction of the amounts included in the budget may have been committed before the year begins. plans for opening or closing offices and for hiring and training new personnel (or for laying off personnel) must be well under way before the year begins. Advertising must be prepared months in advance of its release, and contracts with media also are placed months in advance.

18 Logistics expenses These expenses usually are reported separately from order getting expenses. They include: order entry, warehousing and order picking, transportation to the customer, and collection of accounts receivable. Conceptually, these expenses behave more like production costs than marketing costs; that is, many of them are engineered costs. Nevertheless, many companies include them in the marketing budget, because they tend to be the responsibility of the marketing organization.

19 General and Administrative Expenses These are G&A expenses of staff units, both at headquarters and at business units. Overall, they are discretionary expenses, although some components such as bookkeeping costs in the accounting department are engineered expenses. In budget preparation, much attention is given to these categories; because they are discretionary, the appropriate amount to authorize is subject to much debate

20 Research and Development Expenses The R&D budget uses either of two approaches, or a combination of them. In one approach, total amount is the focus. This may be the current level of spending, adjusted for inflation, or it may be a larger amount, in the belief that more can be spent in good times, if the company expects an increase in sales revenue or if there is a good chance of developing a significantly new product or process.

21 Research and Development Expenses Many companies decide to spend a specified percentage of sales revenue on R&D, but this percentage is based on a long-run average that is, R&D spending is not geared to short-run changes in sales volume.

22 Income Taxes Although the bottom line is income after income taxes, some companies do not take income taxes into account in preparing the budgets for business units. This is because income tax policies are determined at corporate headquarters

23 Other Budgets

24 Capital Budget The capital budget states the approved capital projects, plus a lump-sum amount for small projects that do not require high-level approval. It is usually prepared separately from the operating budget and by different people. During the year, proposals for capital expenditures are considered at various levels within the organization, and some are finally approved. This is part of the strategic planning process.

25 Budgeted Balance Sheet The budgeted balance sheet shows the balance sheet implications of decisions included in the operating budget and the capital budget. Overall, it is not a management control device, but some parts of it are useful for control. Operating managers who can influence the level of inventories, accounts receivable, or accounts payable are often held responsible for the level of those items

26 Budgeted Cash Flow Statement The budgeted cash flow statement shows how much of the cash needs during the year will be supplied by retained earnings and how much, if any, must be obtained by borrowing or from other outside sources. The cash flow statement shows the inflows and outflows of cash during the year, usually by quarters

27 Budget Preparation Process

28 Organization Budget Department The budget department, which normally reports to the corporate controller, administers the information flow of the budgetary control system. The Budget Committee The budget committee consists of members of senior management, such as the chief executive officer, chief operating officer, and the chief financial officer. In some companies, the chief executive officer decides without a committee. The budget committee performs a vital role. It reviews and either approves or adjusts each of the budgets

29 The budget department performs the following functions: Publishes procedures Coordinates Provides assistance to budgetees Analyzes proposed budgets and makes recommendations Analyzes reported performance against budget, interprets the result, and prepares summary reports for senior management.

30 Issuance of Guidelines If a company has a strategic planning process, the first year of the strategic plan which is usually approved in the summer is the beginning of the budget preparation process. The budget staff develops the guidelines and senior management approves them. In some cases lower-level managers may discuss the guidelines before approval

31 Initial Budget Proposal Using the guidelines, responsibility center managers, assisted by their staffs, develop a budget request. Because most responsibility centers will start the budget year with the same facilities, personnel, and other resources that they have currently, this budget is based on the existing levels, which are then modified in accordance with the guidelines.

32 Initial Budget Proposal Changes from the current level of performance can be classified as (a) changes in external forces and (b) changes in internal policies and practices.

33 Changes in External Forces Changes in the general level of economic activity as it affects the volume of sales Expected changes in the price of purchased materials and services. Expected changes in labor rates. Expected changes in the cost of discretionary activities e.g., marketing, R&D, and administration Changes in selling prices.

34 Changes in Internal Policies and Practices Changes in production costs, reflecting new equipment and methods. Changes in discretionary costs, based on anticipated changes in workload. Changes in market share and product mix.

35 Negotiation The budgetee discusses the proposed budget with his or her superior. This is the heart of the process. The superior attempts to judge the validity of each of the adjustments Slack Many budgetees tend to budget revenues somewhat lower, and expenses somewhat higher, than their best estimates of these amounts.

36 Slack The resulting budget, therefore, is an easier target for them to achieve. The difference between the budget amount and the best estimate is called slack. Superiors attempt to discover and eliminate slack, but this is a difficult task

37 Review and Approval The proposed budgets go up through successive levels in the organization. When they reach the top of a business unit, analysts put the pieces together and examine the total. In part, the analyst studies consistency for example, is the production budget consistent with planned sales volume? In part, the examination asks whether the budget will produce a satisfactory profit. If not, it is often sent back for reworking. Final approval is recommended by the budget committee to the chief executive officer. The CEO also submits the approved budget to the board of directors for ratification. This happens in December, just prior to the beginning of the budget year

38 Contingency Budgets Some companies routinely prepare contingency budgets that identify management actions to be taken if there is a significant decrease in the sales volume from what was anticipated at the time of developing the budget e.g., actions to be taken based on a decrease of 20 percent from the best estimate of sales volume The contingency budget provides a way of quickly adjusting to changed conditions if the situation arises