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Sales Budget
A sales budget shows expected sales in units at their expected selling prices. Preparation of the sales budget for a period usually starts with the firm's forecasted sales level, production capacity, and long-term and shortterm objectives. A sales budget is the cornerstone of budget preparation because a firm can complete the plan for other activities only after it identifies the expected sales level. A manufacturing firm cannot complete its production schedule without knowing the number of units it must produce, and the number of units to be produced can be ascertained only after the firm knows the number of units budgeted to be sold for the period. Once the number of units to be sold and produced has been determined, the units of materials to be purchased, the number of employees needed for the operation, and the required factory overheads can be determined. Expected selling and administrative expenses also are determined by the desired sales level.
Now we have the inputs necessary to the formulation of the production budget
Production Budget
Production Budget The production budget follows the sales budget. Once a firm knows its expected sales, production can be estimated. The production budget is based on assumptions appearing in the sales budget. A production budget is a plan for acquiring and combining the resources needed to carry out the manufacturing operations that allow the firm to satisfy its sales goals and have the desired amount of inventory at the end of the budget period. The total number of units to be produced depends on the budgeted sales, the desired amount of finished goods ending inventory, and the units of finished goods beginning inventory as described in the following:
The above production budget provides the data for the completion of the direct material, direct labor budget and overhead budget
1. Variable overhead contains those elements that vary with the level of production. Indirect materials Some indirect labor Variable factory operating costs (e.g., electricity) 2. Fixed overhead contains those elements that remain the same regardless of the level of production. Real estate taxes Insurance
factory depreciation expenses and Salaries of production supervisors.
3. Other costs of facilities and costs that vary with the batch size and number of setups in
production. Classification in practice Many firms separate the factory overhead budget into variable and fixed overhead items. All factory overhead costs other than those that vary in direct proportion to the units manufactured are treated as fixed costs. Such practices are justified because nonvariable factory overhead costs usually remain the same within a given range of production activities.
Data needed to prepare Overhead budget Budgeting for factory overhead costs requires : forecasting the number of units to be produced, determining the way in which production is to be performed, and Incorporating factors that affect factory overhead.
Financial Budgets
Cash Budget
Cash Budget a table showing cash flows (receipts, disbursements, and cash balances) for a firm over a specified period. The budget preparation process normally begins with the sales budget and continues through the preparation of pro forma financial statements. The last schedule prepared before the financial statements is the cash budget. The cash budget is the most important part of a companys budget program. The cash budget is a schedule of estimated cash collections and payments. The various operating budgets and the capital budget are inputs to the cash budgeting process. A cash budget may be prepared monthly or even weekly to facilitate cash planning and control. A cash budget is an example of a feedforward control because it anticipates cash needs and allows for the provision of resources to meet those needs. Major sections in the cash budget A cash budget generally includes three major sections: 1. Cash available 2. Cash disbursements 3. Financing
The cash budget is a primary tool of short-run financial planning. It allows the financial manager to identify short-term financial needs (and opportunities). It will tell the manager the required borrowing for the short term. It is the way of identifying the cash-flow gap on the cashflow time line. The idea of the cash budget is simple: It records estimates of cash receipts and disbursements. We illustrate cash budgeting with the following example of Fun Toys.
All of Fun Toys cash inflows come from the sale of toys. Cash budgeting for Fun Toys starts with a sales forecast for the next year, by quarter:
Fun Toysfiscal year starts on July 1. Fun Toys sales are seasonal and are usually very high in the second quarter, due to Christmastime sales.
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But Fun Toys sells to department stores on credit, and sales do not generate cash immediately Instead, cash comes later from collections on accounts receivable. Fun Toys has a 90-day collection period ,and 100 percent of sales are collected the following quarter. In other words, Collections = Last quarters sales This relationship implies that Accounts receivable at end of last quarter=Last quarter's sales equation (27.5)
We assume that sales in the fourth quarter of the previous fiscal year were $100 million. From equation (27.5), we know that accounts receivable at the end of the fourth quarter of the previous fiscal year were $100 million and collections in the first quarter of the current fiscal year are $100 million. The first quarter sales of the current fiscal year of $100 million are added to the accounts receivable, but $100 million of collections are subtracted. Therefore, Fun Toys ended the first quarter with accounts receivable of $100 million. The basic relation is End A/R= Starting A/R + Sales - Collection
Table 27.3 shows cash collections for Fun Toys for the next four quarters. Though collections are the only source of cash here, this need not always be the case. Other sources of cash could include sales of assets, investment income, and long-term financing.
Next, we consider the cash disbursements. They can be put into four basic categories, as shown in Table 27.4. Payments of Accounts Payable. These are payments for goods or services, such as raw materials. These payments will generally be made after purchases. Purchases will depend on the sales forecast. In the case of Fun Toys, assume that Payments = Last quarters purchases Purchases = 1/2 next quarters sales forecast
Wages, Taxes, and Other Expenses. This category includes all other normal costs of doing business that require actual expenditures. Depreciation, for example, is often thought of as a normal cost of business, but it requires no cash outflow. Capital Expenditures. These are payments of cash for long-lived assets. Fun Toys plans a major capital expenditure in the fourth quarter. Long-Term Financing. This category includes interest and principal payments on longterm outstanding debt and dividend payments to shareholders.
Cash Outflow
The total forecasted outflow appears in the last line of Table 27.4. The Cash Balance The net cash balance appears in Table 27.5, and a large net cash outflow is forecast in the second quarter. This large outflow is not caused by an inability to earn a profit. Rather, it results from delayed collections on sales. This results in a cumulative cash shortfall of $30 million in the second quarter.
Short-Term Financing Problem Fun Toys had established a minimum operating cash balance equal to $5 million to facilitate transactions, protect against unexpected contingencies, and maintain compensating balances at its commercial banks. This means that it has a cash shortfall in the second quarter equal to $35 million. Fun Toys has a short-term financing problem. It cannot meet the forecasted cash outflows in the second quarter from internal sources. Its financing options include: (1) unsecured bank borrowing, (2) secured borrowing, and (3) other sources.
Prepared by: Sameh.Y.El-lithy. CMA,CIA. 10
To use its budget as an effective planning and management tool, a company must choose a budget methodology that supports and reinforces its management approach.
Factors affecting the selection of budget methodology: a company can choose different
approaches in formulating its master budget.
The company can even adopt different approaches for different pieces of its master budget, six common different budgeting systems that a company can use to create its budgets are: Flexible budgeting serves as a control mechanism that evaluates the performance of managers by comparing actual revenue and expenses to the budgeted amount for the actual activities (and not the budgeted activities) Project budgeting used for creating a budget for specific projects or programs rather than for an entire company, such as the design of a new airliner or the building of a single ship. Continuous (or rolling) budgeting allows the budget to be continually updated(revised) by removing information for the period just ended (e.g., March of this year) and adding estimated data for the same period next year (e.g., March of next year). Kaizen budgeting -The Japanese term kaizen means continuous improvement, and kaizen budgeting assumes the continuous improvement of products and processes. Accordingly, kaizen budgeting is based not on the existing system but on changes yet to be made. Activity-based budgeting (ABB) focuses on classifying costs based on activities rather than based on departments or products; ABB applies activity-based costing principles to budgeting. It focuses on the numerous activities necessary to produce and market goods and services and requires analysis of cost drivers. Zero-based budgeting (ZBB) starts each new budgeting cycle from scratch as though the budgets are prepared for the first time; ZBB is a budget and planning process in which each manager must justify his/her departments entire budget every budget cycle. Other types of budgets.
The master budget expresses management's operating and financial plans for a specified period (usually a year) and it reflects the impact of both operating and financing decisions. Operating decisions deal with the use of scarce resources. Financing decisions deal with how to obtain the funds to acquire those resources. The previous two types of decisions covered by the budgetary components of the master budget as follows: a. Operating budget b. Financial budget a. Operating budget Operating budgets are plans that identify needed resources and the way that these resources will be acquired for all day-to-day activities such as sales and services, production, purchasing, marketing, and research and development. In the operating budget, the emphasis is on obtaining and using current resources. Components of operating budget: Sales budget Production budget:(Direct materials budget, Direct labor budget, Manufacturing overhead budget, Ending finished goods inventory budget, Cost of goods sold budget) Nonmanufacturing(Selling, General & Administration) budget (The value chain activities) o Research and development budget o Design budget o Marketing budget o Distribution budget o Customer service budget o Administrative budget Pro forma income statement b. Financial budgets Financial budgets are plans that identify sources of funds for the budgeted operation and the uses for these funds during a period to carry out the budget activities. In the financial budget, the emphasis is on obtaining the funds needed to purchase operating assets. It contains the 1. Capital budget (completed before operating budget is begun) 2. Cash budget 3. Pro forma balance sheet 4. Pro forma statement of cash flows Interrelationships in the Master Budget
Exhibit 1-5 shows a diagram of the various parts of the master budget for a manufacturer firm. Most of what you see in Exhibit 1-5 comprises a set of budgets the budgeted income statement and its supporting budget schedules - together called the operating budget. These schedules are budgets for various business functions of the value chain, from research and development to customer service. The financial budget is that part of the master budget made up of the capital expenditures budget, the cash budget, the budgeted balance sheet, and the budgeted statement of cash flows. A financial budget focuses on how operations and planned capital outlays affect cash. The master budget is finalized only after several rounds of discussions between top management and managers responsible for various business functions of the value chain.
Prepared by: Sameh.Y.El-lithy. CMA,CIA.
and revenues is consistent. An annual static budget divided by 12 (to establish a monthly budget) may exaggerate variances due to seasonal or volume fluctuations. The product of the process is a set of pro forma financial statements. Although familiar, pro forma financial statements may not provide the type of management information most useful to decisionmaking.
E.CONCEPT EXAMPLE
The below example illustrates how the master (static) budget fail to be a control tool when the actual activity level deviate from the planned one in the master budget EXAMPLE: A company has the following information for the period: Static Static Actual Budget Variance Production in units 1,000 1,200 200 U Direct materials (units $6) $ 6,000 $ 7,200 $1,200 F Direct labor (units $10) 10,000 12,000 2,000 F Variable overhead (units $5) 5,000 6,000 1,000 F Total variable costs $21,000 $25,200 $4,200 F From these results, it appears that, although the production manager failed to achieve his/her production quota, (s) he did a good job of cost control. Contrast this with a flexible budget, which is a series of budgets prepared for many levels of activity. At the end of the period, management can compare actual performance with the appropriate budgeted level in the flexible budget, so we have to prepare another budget but based on the actual activity 1000 units.
When a company develops its budget for a future period, it doesn't know what its actual sales and production volumes will be during that period. All revenues and costs in the master budget are based on forecasted volumes. The master budget is a static budget, because it is developed for one specific sales level. When variance reports comparing actual results to budgeted results in the master budget are prepared and causes for the variances are reported, one of the causes will always be that actual sales volume was different from planned sales volume. Since variances due to volume variations are expected, it does not make much sense to continue reporting them on the variance report as causes of variances. It is more important to focus on variances caused by other factors. For example, a variance caused by an Increase In the cost of direct labor above what is expected for the actual sales could signal a problem in production and should be investigated. But an Increase In the cost of direct labor above what is expected for the budgeted sales and that is caused by Increased production is not a production problem, if the cost of the direct labor per unit is equal to the budgeted amount per unit for the number of units actually sold.
FLEXIBLE BUDGET
II.
FLEXIBLE BUDGETING
A.GENERAL
1. Purpose Flexible budgets represent adjustable economic models that are designed to predict outcomes and accommodate changes in actual activity. Revenues and expenses are adjusted to display anticipated levels for achieved outputs. 2. Appropriate Use Flexible budgets are most effective when a per Unit revenue (e.g., unit sold) can be associated with a per unit cost (e.g., unit manufactured) and is highly effective when a significant level of uncertainty exists regarding sales volume. Flexible budgets are most appropriate for a firm facing a significant level of uncertainty in unit sales volumes for next periods. 3. Timeframe Flexible budgets are normally designed around periods that are one year or less to accommodate the potential changing relationship between per unit revenues and costs. The flexible budget can be prepared only after the end of a period, when the actual sales volume for the period is known.
Flexible budgets offer managers a more realistic comparison of budget and actual revenue and cost items under their control, i.e., control of direct labor and direct materials but not fixed factory overhead. FB is the most appropriate for a firm facing a significant level of uncertainty in unit sales volumes for next year. 2. Limitations Flexible budgets are highly dependent on the accurate identification of fixed and variable costs and the determination of the relevant range. Errors in determination of the relevant range or misestimates in the anticipated output expected from variable costs could inappropriately distort performance evaluations and result in poor decisions.
E.CONCEPT EXAMPLE
The Flex-o-matic Corporation produces the Flex -o-matic, a piece of exercise equipment. Corporate controller Felix Flexmeister is developing a flexible budget. Felix has already developed a master budget but estimates that the relevant range extends 20 percent above and below the master budget. What is the relevant range in dollars assuming a selling price of $60 per unit variable costs of $40 per unit, fixed costs of $1 00,000 and anticipated output according to the master budget of 500 units?
As per the previous example we note that a flexible budget provides cost allowances for different levels of activity, whereas a static budget provides costs for one level of activity.
CMA Q
Barnes Corporation expected to sell 150,000 board games during the month of November, and the companys master budget contained the following data related to the sale and production of these games:
Revenue Cost of goods sold: Direct materials Direct labor Variable overhead Contribution margin Fixed overhead Fixed selling Operating income $2,400,000 675,000 300,000 450,000 $ 975,000 250,000 500,000 $ 225,000
Actual sales during November were 180,000 games. Using a flexible budget, the company expects the operating income for the month of November to be A. $225,000 B. $270,000 C. $420,000 D. $510,000 Answer (C) is correct.
Flexible budgets will be discussed in more depth in ch.7 (Performance Management (Variances)).
III.
A.GENERAL
1. Purpose Project budgets are used when a project is completely separate from other elements of a company or is the only element of the company. 2. Appropriate use Project budgets are appropriate for specific tasks (e.g., construction of building, infrequent events such as discontinuation of a division or a product line, or groups of projects such as new product development, marketing, and refinement, the design of a new airliner or the building of a single ship). 3. Timeframe The time frame for a project budget is simply the duration of the project, but a multi-year project could be broken down by year. Timelines that display project budgets in coordination with annual budgets vertically while displaying project budgets horizontally.
Project budgeting can easily consider resource demands in isolation. Actually supplying the resources must be viewed in the context of their availability.
E. CONCEPT EXAMPLE
A project will typically use resources from many parts of the organization, e.g., design, engineering, production, marketing, accounting, and human resources.
Function Design Engineering Production Marketing Accounting HumanResources Totals Q1 $800,000 500,000 Q2 $200,000 1,200,000 2,100,000 100,000 100,000 20,000 $3,720,000 Q3 $ 400,000 1,500,000 200,000 100,000 20,000 $2,220,000 Q4 $ 1,500,000 200,000 100,000 20,000 $1,820,000 Total $1,000,000 2,100,000 5,100,000 500,000 400,000 80,000 $9,180,000
V.
A.GENERAL
1. Purpose Continuous (rolling or perpetual) budgets add a new budget month - rolls forward- (or quarter) as each current month (or quarter) expires. Managers are involved in the budget process on a continues, rather than an annual, basis. Continuous budgeting techniques are intended to force a long-range and dynamic focus for financial planning. This approach keeps managers focused at least one year ahead so that they do not become too narrowly focused on short-term results. 2. Appropriate Use Continuous (rolling) budgets are most effective in dynamic environments where constant reevaluation of products and activities are required by the market place or where results of activities are critical to operations 3. Timeframe
Prepared by: Sameh.Y.El-lithy. CMA,CIA.
Although a continuous (rolling) budget contemplates a year of activity, it usually does not coincide with the organization's fiscal period because it adds either a month or a quarter to the budget as each month or quarter is completed.
2. Limitations Continuous budgets have the potential of foe using managers exclusively on financial rather than operational issues. Continuous budgets can be weakened by incomplete analysis.
VII.
A.GENERAL
1. Purpose Continuous improvement (kaizen) has become a common practice for firms operating in today's globally competitive environment. Kaizen budgeting is a budgeting approach that explicitly demands continuous improvement and incorporates all expected improvements in the resulting budget. Kaizen budgeting process bases budgets on the desired future operating processes rather than the continuation of the current practices as is often the case in traditional budgeting. Kaizen budgeting assumes innovation and high performance not only from the organization but also from its suppliers. 2. Appropriate Use
Kaizen is often used in highly competitive manufacturing environments where continuous improvement of products and manufacturing processes are necessary to ensure strategic position and survival. 3. Timeframe Kaizen budgeting expectations can be adapted to any timeframe, including a year, or shorter periods that do not coincide with the fiscal period.
E.CONCEPT EXAMPLE
Pavilion Inc. has implemented a Kaizen budget process that begins with the analysis of current practices to find improvements and determine changes needed to attain improvements. Then budgets are based on the improved practices or procedures resulting in budget figures that are lower than the previous period. The firm expects to be able to manufacture its product or render its service at a lower cost. The decrease in the budget amounts are the consequence of doing the same activity more efficiently and with higher quality and is not the result of arbitrary cuts.
CMA Q
Lexcore Manufacturing is currently in the process of preparing its quarterly budgets for the upcoming year. Laborers historically take 3.2 hours to complete an intricate assembly task. Which one of the following most correctly shows how the assembly time should be progressively estimated throughout the year if Lexcore employs Kaizen budgets? a. Hold constant at 3.2. b. Decrease to less than 3.2.
VIII.
A.GENERAL
1. Purpose Activity-based budgeting (ABB) is a budgeting process that focuses on costs of activities or cost drivers necessary for operations, in other words Activity based budgeting focuses the budgeting process on the activities of the organization rather than its outputs. The organization that successfully uses activity based budgeting coordinates and synchronizes organizational activities to the benefit of the customer. 2. Appropriate use ABB is most appropriate in businesses that have complexity in their number of products, number of departments, or other factors such as setups. This is because the more complex a situation becomes, the less useful is the broad brush of traditional costing. Activity based budgeting can be used for any number of applications, including both service industries and manufacturing industries. 3. Timeframe Activity based budgeting is generally applied to annual time periods or less.
Cost pools and related cost drivers are used to apply costs to outputs. Systems must carefully identify the cost pool to the cost driver to the activity and the activity driver to ultimately assign costs to the output or cost object. ABB use Nonoutput-based cost drivers, such as the number of part numbers, number of batches, and number of new products can be used with ABB.
E.CONCEPT EXAMPLE
Figure IA-17 displays an overhead budget created for Bluejay Manufacturing Company using an activity-based approach. It shows overhead cost by activities, such as production setup, fabrication, assembly, quality control inspections, and engineering changes.
IX.
ZERO-BASED BUDGETING
A.GENERAL
1. Purpose Zero- based budgets in their purest form represent a budgeting process that requires justification of all expenditures every year, i.e., requires managers to prepare budgets from ground zero. Many budget systems are referred to as incremental budgets because they assume that previous budgets represent required levels of effort and need only be adjusted for additional or incremental expenses. Zero-based budgets are designed to challenge that assumption and require that manager begin the budget process from zero. Thus, managers must conduct in-depth reviews and analyses of all budget items and of each area under their control to provide such justification. Such a budgeting process encourages managers to be aware of activities or functions that have outlived their usefulness or have been a waste of resources. A tight, efficient budget often results from zero-base budgeting. 2. Appropriate use Zero-base budgeting has drawn considerable attention since the 1970s. Although its popularity has faded since its heyday, many organizations, especially government and not-for-profit organizations still use it. The availability of a finite resource (taxes, contributions, or other public funds) to be allocated over a range of services or activities makes the rigorous process of justifying the need for the service and the cost of the service a valuable financial planning activity. 3. Time frame Zero-based budgets are frequently operating budgets with duration of a single year that coincide with the organizations fiscal year. Zero-based budget concepts are sometimes cycled through the organization whereby individual departments apply zero-based budgeting on a rotating basis.
level of service lower than the current one. Upper management reviews these lists (decision packages), and cuts items that lack justification or are less critical. In other words ZBB divides the activities of individual responsibility centers into a series of packages that are prioritized.
2. Limitations The disadvantage to zero-base budgeting is that it can require a nearly impossible amount of work to review all of a company's activities every year. Thus ZBB is timeconsuming and expensive annual review process as a result. Zero-based budgets have a major drawback in that they encourage managers to exhaust all of their resources during a budget period for fear that they will be allocated less during the next budget cycle. o If a manager has incorporated budget slack into the budget, a zero-based budget can encourage a significant amount of waste and unnecessary purchasing. In addition, by not using prior budgets, the firm may be ignoring lessons learned from prior years.
Alternatives As an alternative, many organizations schedule zero-base budgeting periodically or perform zero-base budgeting for different divisions each year. The time and expense of a zero-based budget is often mitigated by performing zero- based budgets only on a periodic basis, such as once every five years, and applying a different budget method in the other years. Or, the firm might rotate the use of zero- based budgeting for a different division each year.
E.CONCEPT EXAMPLE
Community Volunteers, Inc. is a not-tor-profit voluntary health and welfare organization operating in a major urban area. The organization offers a wide variety of services funded by a combination of general county, city and contributed revenues. Revenues are limited but are not specifically tied to any particular service. Community Volunteers, Inc. has elected to use zero-based budgeting to allocate these limited funds. Managers for Community Volunteers will: 1. Establish the cost of existing services in the upcoming year. 2. Determine the impact of not performing a service and evaluate the budgetary and programmatic impact of eliminating the service. 3. Prioritize the services necessary. 4. Select the services to be funded and the level at which the service is to be provided.
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X.
A. INCREMENTAL BUDGET An incremental budget is a general type of budget that starts with the prior years budget and uses projected changes in sales and the operating environment to adjust individual items in the budget upward or downward. It is the opposite of a zero-based budget. The main drawback to using this type of budget (and the reason that some companies use zero-based budgets) is that the budgets tend to only increase in size over the years. An advantage of incremental budgeting when compared with zero-based budgeting is that incremental budgeting accepts the existing base as being satisfactory. i.e., offers to managers the advantage of requiring less managerial effort to justify changes in the budget. B. LIFE CYCLE BUDGET A life-cycle budget estimates a product's revenues and expenses over its entire life cycle beginning with initial research and development and ending with the withdrawal of customer support (i.e., cradle to-grave budgeting). Life-cycle budgeting is intended to account for the costs at all stages of the value chain The components of life cycle budgets include upstream, manufacturing, and downstream costs as follows: 1. Upstream Costs: Research & Development, and the design. 2. Manufacturing: production costs 3. Downstream Costs: marketing, distribution, and customer service This information is important for pricing decisions because revenues must cover costs incurred in each stage of the value chain, not just production. Life-cycle budgeting also highlights the distinction between incurring costs (actually using resources) and locking in (designing in) future costs. Life-cycle concepts are also helpful in target costing and target pricing. C.PROBABILISTIC BUDGETS Probabilistic budget plan financial activity based on expected values and their probabilities.
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