PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 6 potx

Planning en-compasses the entire process of preparing the budget, from initial strategic rection through preparation of expected financial results.. The compari-son of actual results wi

Robert Halsey

THE CONCEPT OF BUDGETING

Budgets serve a critical role in managing any business, from the smallest soleproprietor to the largest multinational corporation Businesses cannot operateeffectively without estimating the financial implications of their strategic plansand monitoring their progress throughout the year During preparation, bud-gets require managers to make resource allocation decisions and, as a result, toreaffirm their core operating strategy by requiring each business unit to justifyits part of the overall business plan During the subsequent year, variances ofactual results from expectations serve to direct management to the areas thatmay deserve a greater allocation of capital and those that may need adjust-ments to retain their viability

A budget is a comprehensive formal plan, expressed in quantitative terms,

describing the expected operations of an organization over some future time

period Thus, the characteristics of a budget are that it deals with a specific tity, covers a specific future time period, and is expressed in quantitative terms.

en-This chapter describes the essential features of a budget and includes acomprehensive example of the preparation of a monthly budget for a smallbusiness Although the focus of this chapter is on budgeting from a businessperspective, many of the principles are also applicable to individuals in theplanning of their personal finances

FUNCTIONS OF BUDGETING

The two basic functions of budgeting are planning and control Planning

en-compasses the entire process of preparing the budget, from initial strategic rection through preparation of expected financial results Planning is the

di-process that most people think of when the term budgeting is mentioned Most

of the time and effort devoted to budgeting is expended in the planning stage.Careful planning provides the framework for the second function of budgeting,control

Control involves comparing actual results with budgeted data, evaluating

the differences, and taking corrective actions when necessary The comparison

of budget and actual data can occur only after the period is over and actual counting data are available For example, April manufacturing cost data arenecessary to compare with the April production budget to measure the differ-ence between planned and actual results for the month of April The compari-son of actual results with budget expectations is called performance reporting.The budget acts as a gauge against which managers compare actual financialresults

ac-R EASONS FOac-R BUDGETING

Budgeting is a time-consuming and costly process Managers and employees areasked to contribute information and time in preparing the budget and in re-sponding to performance reports and other control-phase budgeting activities

Is it all worth it? Do firms get their money’s worth from their budgetingsystems?

The answer to those questions cannot be generalized for all firms Somefirms receive far more value than other firms for the dollars they spend onbudgeting Budgets do, however, provide a wealth of value for many firms whoeffectively operate their budgeting systems I now discuss some of the reasonsfor investing in formal budgeting systems In the next section of this chapter Idiscuss issues that contribute to effective budgeting

Budgets offer a variety of benefits to organizations Some common fits of budgeting include the following:

bene-1 Requires periodic planning

2 Fosters coordination, cooperation, and communication

3 Forces quantification of proposals

4 Provides a framework for performance evaluation

5 Creates an awareness of business costs

6 Satisfies legal and contractual requirements

7 Orients a firm’s activities toward organizational goals

Periodic Planning

Virtually all organizations require some planning to ensure efficient and tive use of scarce resources Some managers are compulsive planners who con-tinuously update plans that have already been made and plan for new activitiesand functions At the other extreme are people who do not like to plan at alland, therefore, find little or no time to get involved in the planning process.The budgeting process closes the gap between these two extremes by creating

effec-a formeffec-al pleffec-anning freffec-amework theffec-at provides specific, uniform periodic deeffec-ad-lines for each phase of the planning process People who are not attuned to thisprocess must still meet budget deadlines Of course, planning does not guaran-tee success People must still execute the plans, but budgeting is an importantprerequisite to the accomplishment of many activities

dead-Coordination, Cooperation, and Communication

Planning by individual managers does not ensure an optimum plan for the tire organization The budgeting process, however, provides a vehicle for theexchange of ideas and objectives among people in an organization’s various seg-ments The budget review process and other budget communication networksshould minimize redundant and counterproductive programs by the time thefinal budget is approved

en-Quantif ication

Because we live in a world of limited resources, virtually all individuals and ganizations must ration their resources The rationing process is easier for somethan for others Each person and each organization must compare the costs andbenefits of each potential project or activity and choose those that result in themost efficient resource allocation

or-Measuring costs and benefits requires some degree of quantification.Profit-oriented firms make dollar measurements for both costs and benefits.This is not always an easy task For example, the benefits of an advertising cam-paign are increased sales and a better company image, but it is difficult to esti-mate precisely the additional sales revenue caused by a particular advertisingcampaign, and it is even more difficult to quantify the improvements in the com-pany image In nonprofit organizations such as government agencies, quantifica-tion of benefits can be even more difficult For example, how does one quantifythe benefits of better police protection, more music programs at the city park,

or better fire protection, and how should the benefits be evaluated in allocatingresources to each activity? Despite the difficulties, resource-allocation decisionsnecessitate some reasonable quantification of the costs and benefits of the vari-ous projects under consideration

Performance Evaluation

Budgets serve as estimates of acceptable performance Managerial ness in each budgeting entity is appraised by comparing actual performancewith budgeted projections Most managers want to know what is expected ofthem so that they can monitor their own performance Budgets help to providethat information Of course, managers can also be evaluated on other criteria,but it is valuable to have some quantifiable measure of performance

effective-Cost Awareness

Accountants and financial managers are concerned daily about the cost cations of decisions and activities, but many other managers are not Produc-tion supervisors focus on output, marketing managers on sales, and so forth It

impli-is easy for people to overlook costs and cost-benefit relationships At budgetingtime, however, all managers with budget responsibility must convert theirplans for projects and activities to costs and benefits This cost awareness pro-vides a common ground for communication among the various functional areas

of the organization

Legal and Contractual Requirements

Some organizations are required to budget Local police departments, for ample, cannot ignore budgeting even if it seems too much trouble, and the Na-tional Park Service would soon be out of funds if its management decided not

ex-to submit a budget this year Some firms commit themselves ex-to budgeting quirements when signing loan agreements or other operating agreements Forexample, a bank may require a firm to submit an annual operating budget andmonthly cash budgets throughout the life of a bank loan

re-Goal Orientation

Resources should be allocated to projects and activities according to tional goals and objectives Logical as this may sound, relating general organi-zational goals to specific projects or activities is sometimes difficult Manygeneral goals are not operational, meaning that determining the impact of spe-cific projects on the organization’s general goals is difficult For example, orga-nizational goals may be stated as follows:

organiza-1 Earn a satisfactory profit

2 Maintain sufficient funds for liquidity

3 Provide high-quality products for customers

These goals, which use terms such as satisfactory, sufficient, and quality, are not operational: the terms may be interpreted differently by each

high-manager To be effective, goals must be more specific and provide clear tion for managers The previous goals can be made operational as follows:

direc-1 Provide a minimum return on gross assets invested of 18%.

2 Maintain a minimum current ratio of 2 to 1 and a minimum quick ratio of1.2 to 1

3 Products must receive at least an 80% approval rating on customer faction surveys

2 Budgets must be realistic plans of action rather than wishful thinking

3 The control phase of budgeting must be used effectively to provide aframework for evaluating performance and improving budget planning

4 Participative budgeting should be utilized to instill a sense of cooperationand team play

5 Budgets should not be used as an excuse for denying appropriate ployee resource requests

em-6 Management should use the budgeting process as a vehicle for modifyingthe behavior of employees to achieve company goals

Goal Orientation

Some firms have more resources than others, but it seems no firm has all theresources it needs to accomplish all its goals Consequently, budgets shouldprovide a means by which resources are allocated among projects, activities,and business units in accordance with the goals and objectives of the organi-zation As logical as this may sound, it is sometimes difficult to relate general,organization-wide goals to specific projects or activities Many general goalsare not operational, meaning the impact of specific projects on the achieve-ment of the general goals of the organization is not readily measurable

A prerequisite to goal-oriented budgeting is the development of a formalset of operational goals Some organizations have no formally defined goals,and even those that do often have only general goals for the entire organiza-tion Major operating units may function without written or clearly definedgoals or objectives A logical first step toward effective budgeting is to formal-ize the goals of the organization Starting at the top, general organizationalgoals should be as specific as possible, and written Next, each major unit ofthe organization should develop more specific operational goals The processshould continue down the organizational structure to the lowest level of budgetresponsibility This goal development process requires management at all levels

to resolve difficult issues, but it results in a budgeting framework that is muchmore likely to be effective since all business units proceed in a coordinatedmanner toward the achievement of a common objective Even individuals need

to understand their goals and objectives as they prepare budgets for their ownactivities

Realistic Plan

Budgeting is not wishful thinking; it is a process designed to optimize the use ofscarce resources in accordance with the goals of the company Many firms havebudgets that call for sales growth, higher profits, and improved market share,but to be effective such plans must be based on specific executable plans and

on available resources and management talent that the company can bring tobear in meeting the budget If the management of a firm wants to improve itslevel of operations, there must be a clearly defined path between the presentand the future that the firm can travel

The process begins with an analysis of the market and preparation of aSWOT (strengths, weaknesses, opportunities, and threats) analysis Utilizingthis background information, the company develops an overall strategy to-gether with the operational tactics required to achieve it (the development of abusiness plan is discussed further in Chapter 9) The financial impact of thisstrategy is then assessed in the preparation of the budget If the financial re-sults are unfavorable, strategies and tactics must be revised until an acceptableoutcome is achieved Once the budget is finalized, strategies are implementedand the company’s operations are subsequently monitored throughout the year

in the control phase, as discussed next Exhibit 6.1 presents an iterative modelthat embodies these concepts

Participative Budgeting

Most behavioral experts believe that individuals work harder to achieve tives that they have had a part in creating Applied to budgeting, this conceptstates that employees will strive harder to achieve performance levels defined

objec-by budgets if the employees have had a part in creating the budget Budgetsimposed by top-level management, in contrast, may get little support fromemployees The concept of building budgets from the bottom up with input

from all employees and managers affected by the budget is called participative budgeting.

The Control Phase of Budgeting

The first and most time-consuming phase of budgeting is the planning process.The control phase of budgeting, however, may be the time when firms get themost value from their budgeting activities Exhibit 6.2 is a budget-performancereport for the first quarter of 2001 The difference between budgeted and

actual amount is called a budget variance Budget variances are reported forboth revenues and costs separately In this case, revenues were $20,000 underbudget and are, therefore, considered as an unfavorable budget variance (U).Expenses, though, were $30,000 less than expected, a favorable budget vari-ance (F) The net result is a favorable, profit budget variance of $10,000.Each category is then separately analyzed to uncover the source of thevariance Although total revenues are lower than expected, management is in-terested in the actual product lines causing this variance Further analysismight reveal, for example, that all of the product lines are performing satisfacto-rily except for one that is performing more poorly than expected On theexpense side, a favorable budget variance may be due to positive effects of man-agement actions to operate the company more efficiently Or, positive variancesmay have occurred because costs necessary for long-term performance—such asmaintenance of machinery, research and development, or advertising—were deferred to achieve short-term gains.

Management must thoroughly investigate the causes for budget cies so that corrective action can be taken Are markets as a whole performing

discrepan-EXHIBIT 6.1 Comprehensive budgeting process.

Strategic planning Market/SWOT analysis

Strategic development

Budgeting

Implementation

Control

EXHIBIT 6.2 Budget variance repor t.

Budgeted Actual Variance

Revenues $800,000 $780,000 $(20,000)U Expenses (500,000) (470,00) 30,000 F

better or worse than expected? Is the company’s marketing support adequate?Has the competitive landscape changed? Are cost variances the result of man-agement actions in response to competitive pressures or due to inadequatecontrol? The answers to these questions may suggest changes in the company’sstrategic and tactical plans to compensate for the variances.

When actual prices and quantities are compared with expected pricesand quantities, an additional level of analysis can be conducted Exhibit 6.3 il-lustrates a more in-depth analysis of price and quantity variance During themonth, the firm realizes a positive variance of $6,000 relating to the cost ofaluminum, one of its production inputs

This $6,000 variance can then be further decomposed into a price ance and a quantity variance The price variance is $21,000 favorable because

vari-of the lower than expected purchase price for aluminum It is computed bymultiplying the price variance per unit ($3 to $2.80) by the actual pounds uti-lized (105,000) The quantity variance is $15,000 unfavorable as a result oflower efficiency in the production process that led to more material usage thanhad been expected This is computed by multiplying the quantity variance(105,000 to 100,000) by the expected price ($3) This analysis reveals that themanufacturing process was less efficient than planned in that it utilized morematerial to produce its products This inefficiency was more than offset, how-ever, by lower prices for direct materials than had been forecasted The pricevariance, therefore, masks the production inefficiency, which would not be re-vealed without the additional level of analysis

Comparing actual results with the budget, adjusting plans when sary, and evaluating the performance of managers are essential elements ofbudget control Many people, however, find the control phase difficult Whenbusiness results are less than expected it may be painful to evaluate the results.For some it is much easier to look ahead to future periods when things hope-fully will be better But frequently, realistic plans for future success can bemade only when management learns from its past mistakes The control phase

neces-of budgeting provides much neces-of that learning process Firms must be willing toevaluate performance carefully, adjusting plans and performance to stay ontrack toward achieving goals and objectives

EXHIBIT 6.3 Price and quantity variance analysis.

Budgeted Actual Variance

Many companies have intricate budget performance reporting systems inplace, but the firms achieve little control from their use In order to provideeffective control, a business must use the budget as an integral part of the com-pany’s reward system That is, employees must understand that budget perfor-mance reports are a component of their performance evaluation Rewards such

as pay raises, bonuses, and promotions should be tied to budget performance.Generally it is easy to determine if a company’s budget performance re-porting system is working effectively If, on one hand, discussions with man-agers yield comments such as, “If we fail to achieve the budget, we just addmore to it next period,” the budget-control process is likely ineffective If, onthe other hand, employees say, “If we are over our budget by more than 2%, wewill be called on the carpet and forced to explain the problem,” then oneknows the control process is having an effect

Improper Use of Budgets

Sometimes managers use budgets as scapegoats for unpopular decisions Forexample, rather than telling a department head that his or her budget requestfor three additional employees is not convincing when compared with all of theother budget requests, the vice president says, “The budget just would notallow any new employees this year.” In another case, the director of the mar-keting department requests travel funds to send all of his staff to an overseaseducation program The vice president believes the program is a waste ofmoney Instead of giving the marketing director his opinion, the vice presidentsays, “We would really like to send your staff to the program, but the budget isjust too tight this year.” Of course, the truth in this situation is that the trip isnot a good use of business resources, regardless of the condition of the budget.The marketing director is left with the impression that the real problem is thestate of the budget, when in fact the benefits of his travel proposal did not out-weigh the cost Management should be careful not to undermine the budgetingprocess by assigning to it adverse characteristics

Behavioral Issues in Budgeting

Many of the internal accounting reports firms prepare are intended to inf ence managers and employees to behave in a particular way For example, manymanufacturing cost reports are intended to enable and motivate employees toreduce costs or keep them at an acceptable level Similarly, reports that com-pare the performance of one division with those of other divisions are used toevaluate the performance of division managers and encourage better resultsfor each division

lu-Budgets and budget performance reports are among the more useful ternal accounting reports businesses use to inf luence employee performance in

in-a positive min-anner Budget control is bin-ased on the principle thin-at min-anin-agers beheld responsible for activities they manage Performance reports ref lect the

degree of achievement of plans embodied in the budget To minimize adversebehavioral problems, managers should take care to develop and administer bud-gets appropriately Budgets should not be used as a hammer to demand unat-tainable performance from employees The best safeguard against unrealisticbudgets is participative budgeting.

DEVELOPING A BUDGET

Budgets are useful, and in most cases essential, to the success of virtually allorganizations whether they are for-profit or not-for-profit organizations Thelarger and more complex the organization, the more time, energy, and re-sources are needed to prepare and implement the budget

The Structure of Budgets

Regardless of the size or type of organization, most budgets can be dividedinto two categories: the operating budget and the financial budget The operat-ing budget consists of plans for all those activities that make up the normal op-erations of the firm For a manufacturing business, the operating budgetincludes plans for sales, production, marketing, distribution, administration,and any other activities that the firm carries on in its normal course of busi-ness For a merchandising firm, the operating budget includes plans for sales,merchandise purchases, marketing, distribution, advertising, personnel, ad-ministration, and any other normal activities of the merchandising firm Thefinancial budget includes all of the plans for financing the activities described

in the operating budget plus any plans for major new projects, such as a newproduction plant or plant expansion Both the operating and financial budgetsare described later in more detail

The Master Budget

The master budget is the total budget package for an organization; it is the endproduct of the budget preparation process The master budget consists of all theindividual budgets for each part of the organization combined into one overallbudget for the entire organization The exact composition of the master budgetdepends on the type and size of the business However, all master budgets rep-resent the organization’s overall plan for a specific budget period Exhibit 6.4lists the common components of a master budget for a manufacturing business.The components of the master budget form the firm’s detailed operatingplan for the coming year As noted earlier, the master budget is divided into theoperating budget and the financial budget The operating budget includes rev-enues, product costs, operating expenses, and other components of the incomestatement The financial budget includes the budgeted balance sheet, capitalexpenditure budget, and other budgets used in financial management A largepart of the financial budget is determined by the operating budget and the be-ginning balance sheet

Exhibit 6.5 is a simplified budget for C&G’s Gift Shop It is prepared on amonthly basis The number preceding each heading refers to the applicableline in the budget.

Sales Budget (1–3)

The sales budget, or revenue budget, is the first to be prepared It is usually themost important budget because so many other budgets are directly related tosales and therefore largely derived from the sales budget Inventory budgets,production budgets, personnel budgets, marketing budgets, administrativebudgets, and other budget areas are all affected significantly by the overallsales volume expected

For C&G’s Gift Shop, expected sales in units are reported on line 1 Notethat the business is highly seasonal, with most of the sales and profits realizedduring the months of November and December To keep the budget simple, weassume an average sales price of $100 per unit In practice, the business wouldforecast unit sales by individual product lines

Budgeted Cost of Goods Sold (4)

C&G assumes a cost of goods sold of 65% of sales revenues This results in agross profit of 35% For a retailing company, cost of goods sold represents thepurchase cost of inventories sold during the period It is computed as

where all inventories and purchases are computed at the purchase price to thecompany

Cost of Goods Sold Beginning Inventory Purchases during the Period

Materials budget Direct labor budget Manufacturing overhead budget Administrative expense budget Budgeted non-operating items Budgeted net income

Financial Budget

Capital expenditure budget Budgeted statement of financial position (balance sheet) Budgeted statement of cash f lows

EXHIBIT 6.5 C&G’s Gif t Shop: 2000 cash budget.

4 TOTAL COST OF SALES 65% 325000 417950 239200 229450 179400

10 Depreciation expense 15yr sl amort 3472 3472 3472 3472 3472

11 TOTAL OPERATING EXPENSE 151472 187222 118472 114722 95472 12

22 Accounts and interest receivable 65%,30/35%,60 637000 412050 300800 218904

23 Inventory Next month sales 239200 229450 179400 170950

25

26 Property, plant, & equipment (gross) 625000 625000 625000 625000

27 Accumulated depreciation 15yr sl amort −41667 −45139 −48611 −52083

28 Property, plant, & equipment (net) 583333 579861 576389 572917 29

41 TOTAL LIAB + S/H EQUITY 1484533 1246361 1152425 1122831

42 STATEMENT OF CASH FLOWS (INDIRECT METHOD)

45 Change in current assets (other than cash) 234700 161300 90346

46 Change in current liabilities (other than notes payable) −88699 −55332 −30557

Apr May Jun Jul Aug Sep Oct Nov Dec Jan