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FINANCING AND BUDGETING

CHAPTER 5
KINDS OF CAPITAL
In common usage the word "capital" is the single
term used to cover the land, buildings, machinery,
tools, and materials of a productive enterprise.
Technically, whereas land is capital, it is
distinguished from the other means of production
because they are reproducible and land is not.
Rarely does the businessman make this distinction.
In the word capital, he lumps together all the
elements he will need to start an enterprise,
including the land required.
He also takes another step in his thinking which
results in a different use of the word capital.
He thinks of capital most often in money terms.
Promoting a new enterprise is very largely a financial
operation.
Since money and credit are the chief means for
acquiring the instruments of production, the word
capital has this financial aspect.
And this is the way we shall use it here.
Applied to industrial financing, capital means the
cash money and credit needed to start and to
operate an enterprise
Financial specialization recognizes different
classifications of capital, depending on such features
as the use that is to be made of it, the time element
involved, and the sources and methods of raising it.
These forms of capital are best understood
when we examine the capital requirements of
an ordinary industrial enterprise.
In this way, too, the connection will be clear
between money, capital and productive
capital, the tangible instruments of
production.
If an industrial enterprise is to be started from
the ground up. so to speak, it will need land
and buildings, machinery, tools, and
equipment.
Assets of this kind, intended to be used over and
over again in production for a long period of time,
are commonly called fixed capital and the money
and credit required to pay for such assets take the
same name.
An enterprise also requires funds to cover its
operations-to maintain the plant, to purchase
materials and supplies, to pay salaries and wages,
to cover storage, transportation, and shipping
services, for advertising, and to tide over the
enterprise during the time lag between the sale of
its products and payment for them.
These are current operations, and the funds to
cover them are commonly called working capital
SOURCES OF CAPITAL FUNDS
To finance modern industry, large-scale savings are necessary.
By large scale savings we commonly mean money savings arising in a
variety of ways throughout the economy. Individuals, rich and poor, save.
The rich save directly, largely because their income exceeds even the large
spending they do for themselves and their families.
They also save indirectly as when they pay life insurance premiums,
purchase annuities, establish funds, etc.
From the wealthy to the lower income group, there are gradations in the
amount of direct savings like savings bank accounts, building and loan
shares, savings bonds; and much of the steady savings is done through
such indirect means as life insurance.
The very poor cannot save for themselves at all their income is all used up
in living expenses, But the spending of an individuals from the very poor
to the wealthiest contribute indirectly to the stream of savings through
the prices paid for goods that work back through the entire economic
process, providing business profits and reserves that are invested.
It is through this element that a second large group of savings -business
savings-take place.
Governments make up the third large group of savers.
There are about 100,000 government units in the United States -Federal,
state, and local. When anyone of these units collects more in taxes than is
used for operating expenses and uses the balance for public works, the
part so used represents government savings.
The savings take the form of public works such as highways, river and
harbor construction,
sewage-disposal and water systems, transportation facilities, public
buildings, and the assets in a growing list of government enterprises.
In addition, government purchases many billions of dollars' worth of
goods and services a portion of which finds its way into business capital
savings for future investment.
So far as the stream of savings and investments is concerned, government
savings perform very much the same function as do business savings.
Each takes money from the people's incomes-the one in the form of
prices for goods and the other in taxes-and spends part of it for capital
goods.
All these savings-of individuals, business enterprises; institutions,
governments, and others constitute the capital pool of the national
economy.
THE MONEY MARKET
The financial requirements of modern industrial enterprise are
so great that a large network is needed to mobilize the money
and credit resources needed.
The money market does this- and is therefore one of the chief
reservoirs of capital.
What do we mean by the commercial money market?
If a definition were attempted, it might read something like this:
In its broadest sense, the money market is the total of
individuals, firms, institutions, and the process by which money
and credit are collected, accumulated, and administered for the
financing of economic activities.
The market is not a single place, or channel, or institution, but a
network of many markets; they are distinguished by the areas
they cover, by the different types of loans they make, and by the
variety of borrowers they serve.
Long-Term Capital
For long-term capital, industrial borrowers may tap several channels.
Large investment banking houses serve large industrial enterprises by
undertaking to underwrite and to market stock and bond issues.
Insurance companies have lately become an important source for long-
term capital funds by taking the security issues of industrial enterprises
(particularly utilities) by direct, private placement.
Institutional and endowment trust funds may also supply capital by direct
placement, but usually they do their investing by purchasing securities
distributed by other agencies.
In the past, commercial banks dealt mainly in short-term loans, but
financial changes in the last 20 years-have induced them to seek outlets
for their funds in fixed-term investments for as long as 10 to 15 years'
maturity.
Rarely do wealthy individuals make independent capital loans in
competition with these agencies. The sums wanted by the borrowers are
too large for any but institutions of grant resources and wide connections.
But the wealthy do participate in the process indirectly by purchasing
stocks and bonds distributed by large corporations and financing agencies
Intermediate and Short-Term Loans
Whereas intermediate and short-term loans represent
different types of financing, both are virtually serviced by
the same types of lending agencies.
Short-term loans may range from 30 days up to 2 years,
and intermediate term loans to 5 years, depending upon
the character and circumstances of the loan.
This is the field occupied by the regular commercial banks
which in local communities throughout the nation have
traditionally served the current credit needs of business
enterprises.
Some changes have been taking place in this field in
'recent years
For one thing, the very large industrial companies increasingly tend
to finance themselves in matters of intermediate- and short-term
credit.
On the other hand. the need for bank liquidity, the high lending
standards. and the riskiness of small business tend to make
commercial banks reluctant to serve the credit needs of small
enterprises. unless Federal lending agencies participate with the
banks.
To a considerable extent also the banks have enlarged their role as a
financial service agency in the community in handling the flow of
funds.
Thus they have increased their activities in making personal,
automobile, appliance, and home-improvement loans to individuals
and business.
Where gaps in financing operations have been left open by the
commercial banks, various other lending agencies have become
active.
These include chattel-mortgage companies, miscellaneous finance
and investment companies. and commercial factors.
The chattel-mortgage, finance, and investment
companies operate in a variety of forms.
The rates they charge are likely to be higher, the
conditions put upon the borrower more
burdensome, and the resultant cost of the loan much
higher than regular bank credit.
Commercial factors, frequently referred to as the
"middlemen of credit," have come to occupy an
important place in industrial and business finance.
Originally the commercial factor performed
merchandising functions for the manufacturer, and in
the process realized financial credits which were
made available to producers.
In time the factor came to deal extensively in financing
operations through the purchase of accounts receivable,
installment contracts, promissory notes, and other commercial
paper based on transactions, inventories, and warehouse stocks.
Many of them specialize in aiding struggling entrepreneurs as
well as established firms hard pressed for working capital.
In most cases they operate in areas where banks are reluctant to
enter, and they charge higher rates for accepting the unusual
risks.
With the aid of a factor a manufacturer can turn orders into cash
without waiting weeks and months for a return to be realized.
This is an important but costly and sometimes unreliable service
to small and medium-sized enterprises whose liquid working
capital is often low in proportion to the need to liquidate debts,
carry on operations, acquire equipment, or expand.
Trade Credits
Not mentioned as yet, because it is not exactly a
lending agency, is the trade credit.
This is the mainstay of intermediate and short-
term financing, particularly for the small
enterprise.
It covers not only commodities and supplies, but
also machinery, fixtures, equipment, and other
items of longer term financing.
The small manufacturer simply finds himself
partly financed, at least for materials and small
equipment, through his regular purchases on
credit
A new twist on the trade credit may emerge from the
practice by which a large corporation sometimes gives
financial aid to some among its cluster of smaller satellite
suppliers.
In a somewhat similar manner, large buyers such as mail-
order houses and department stores sometimes aid those
whose production they buy entirely or in substantial part.
A new form of financing relationship may grow out of these
practices, just as factor financing grew out of merchandising
functions originally performed by factors for manufacturers.
In boom times and even in times of normal economic
activity, trade credits play an important part in short-term
financing, but in times of recession, the method tends to fail.
At all times, other disadvantages operate to limit its
effectiveness as a desirable source of financing.
Credit Instruments
Credit instruments are the legal forms through
which loans are made.
They differ with the type of loan, the length of
time it is to run, the use to which the funds are
to be put, and the type of borrower.
They differ also by the way in which they affect
third parties.
Only the more general types of credit
instruments can be touched upon here because
each case is more or less individual and must be
studied specifically
Long-term credit, if required for equity or fixed capital,
usually takes the form of securities-stocks or bonds of the
borrowing company which ultimately come to be held by
individuals, banks, investment trusts, and other investors.
Commercial credit for other than fixed capital of
permanent nature is usually represented by promissory
notes, backed by collateral of various‘ kinds, and almost
always negotiable. In some cases the collateral takes the
form of mortgages against the firm‘s real estate,
machinery, equipment, and other chattels.
In other cases the collateral maybe securities owned by
the firm.
Loans may be made, of course, on straight promissory
notes, without collateral, but in that case the lender often
requires two or more co-makers or guarantors.
Short-term credits or commercial loans intended to finance
single transactions or a group of transactions that are to be
completed in short time are ordinarily evidenced by
promissory notes, drafts, bills of exchange or trade
acceptances.
These may or may not be supported by bills of lading,
warehouse receipts, or chattel mortgage contracts as against
materials involved in transactions, and other claims upon
property.
When accounts receivable are accepted as collateral to a loan,
or taken over outright by a lending agency, the usual form is
to as sign such accounts to the lender.
If the firm markets its products direct to the consumer and
takes installment notes or conditional sales contracts these
may be grouped in series and assigned either outright or as
collateral for a circulating capital loan from many lending
agencies.
PLANNING THE FINANCIAL STRUCTURE.
Few people will deny that enterprises may still be started
on a shoestring and may be developed into large-scale
companies.
This is less possible in the old-line industries where
established firms offer strong competition than it is in the
newer industrial fields where demand and supply forces are
not fully established.
The automotive, airplane, and home-appliance industries
are examples of established fields, while plastics, light
metals, and electronics are examples of the new fields.
The problem of starting a new enterprise is always much
more difficult than that of expansion for existing firms.
But whether the problem is one of financing a new venture
or the expansion of an existing enterprise, modern
conditions make financial planning a necessity.
Financing the Non-corporate Enterprise
In the case of the single proprietorship and the partnership the
initial capital comes from the individuals directly interested
and possibly through the loans and investments that their
friends are willing to make in the business.
In addition to cash, these individuals may contribute the actual
land, buildings, machinery, and materials needed to make up
the productive capital of the business.
We shall see later how these enterprises can augment their
initial capital with working capital from various sources, but at
the start they are largely dependent upon their own resources.
Launching a new enterprise through cash and property
contributions of individuals personally interested in the
venture is one of the oldest forms of business promotion, and
it continues to be an important method of financing even
today.
Corporate Capitalization
It is the corporate enterprise that is most concerned
with the problems of formal capitalization.
At the time of incorporation the promoters or
prospective managers must make the policy decision as
to the total amount at which the enterprise is to be
capitalized and what forms the capital structure should
take.
The chief factors in this decision are the nature and size
of the business.
From careful analysis of the elements in these factors,
analysis of the product, market studies, and a general
business forecast of the prospects of the enterprise, it
should be possible to make a rough estimate of the
fixed capital required.
If real estate, buildings, equipment, and other
tangible property are contributed by the organizers,
the cost or value of such assets will be part of the
total.
To this sum there will have to be added an amount
sufficient to cover necessary promotion, engineering,
and developmental expenses.
It is essential to have a fund of working capital
sufficient in the beginning to carry the firm through
the production cycle to the point when substantial
and sustained returns from sales may be expected.
An estimate of probable earnings may be taken into
account in arriving at the total capital figure.
In some few cases the capitalization may take account of
patents, secret processes, trademarks, and other
intangible items, but in the untried enterprise there is
little basis for anything other than nominal values on
these items.
Current legal requirements, state and Federal, will have
to be considered because they affect franchise fees,
taxation, security sales.
And other affairs of the company. Initial capitalization
might also be planned with an eye toward future
expansion and toward the problem of future
marketing of corporate securities, but the danger of over
and undercapitalization should be carefully weighed.
The grand total will be the amount of authorized capital
stock of the enterprise to be used in applying for the
corporate charter.
CLASSIFICATION OF STOCK To complete
the basic financial structure, the
authorized stock will have to be
classified to define the relations of
stockholders to the enterprise, to fix
the status of the corporation with
creditors and the public, and to provide
the proper securities and financial base
if the company intends to seek funds
from the money market.
COMMON STOCK All the authorized capital
stock of a company may be issued in a single
classification, common stock.
No special rights or privileges are attached to
common stock.
It bears the full risk of the enterprise, its
successes and failures.
Common-stock holders are in law the real
owners of the enterprise, and they are entitled
to the net assets of the business.
They usually exercise control over the business
through the voting power of their
stock.
PREFERRED STOCK Preferred stock is the second of the
main classes into which authorized capital stock may be
divided.
The chief reason for it is to offer inducements to attract
investors.
The stock may be preferred as to dividends and assets it
may be convertible into common stock on attractive
terms; a sinking fund may be set up to guarantee safety of
the investment; it may have other rights.
On the other hand, it may have limited or no voting
power since its other privileges protect it from the risks
which common shareholders assume.
In each case of preference or limitation, some object is
sought which will be of value in the financial
administration of the company'.
No arbitrary rules can be set for division between, common and
preferred stock.
This is a matter of judgment in each case, in answer to such questions as:
How and by whom is the enterprise to be controlled?
How much capital will have to be sought from outsiders?
To what extent is it wise to burden the company with obligations to pay
fixed dividends?
What legal and tax considerations are involved?
How will the sale of securities be affected by different classes of stock?
What financial structure is most assuring to creditors?
What is the most desirable basis for the division of earnings and of
assets of the company on dissolution?
These are a few of the questions entering into the decision when stock is
to be set up in classes.
After the basic decision is made for classifying stock into common and
preferred, similar calculations are made if either stock is further
classified as A and B common or first preferred, second preferred, and
other subclasses
Bond Issues (Company Indebtedness)
When the earnings record is good, assets are
substantial, and prospects of expansion favorable, a
good method of raising needed capital is to borrow it
on bond issues.
In essence, bond issues are company promises to repay
the loan at stated periods and are backed by a
mortgage on part or all of the company's property.
They take the form of bonds debentures certificates, or
notes of issue based upon a trust agreement or
indenture which contains all the rights and obligations
between the company-borrower, the bankers who are
to market the issue, the prospective bondholders
(represented by the trustee), and the general public
(represented by-governmental agencies).
The essential relationship between the company and the
bondholders is that of debtor-creditor.
While this means that bondholders have no ownership
interest in the company, it also implies that their rights
are superior to those of the stockholders until the bonds
are retired.
A company contemplating a bond issue should make
careful studies not only of the varieties of bonds which
may be issued, but of the wisdom of floating a bond issue
at all.
Whereas borrowing for industrial expansion has many
advantages, it also carries with it the great risk of loss.
Even a temporary failure to pay interest charges or
amortization may throw the company into receivership.
Money raised through the sale of capital stock is free
from this risk.
Working Capital
In the new enterprise, working capital must come
largely through the initial financing.
After the firm is in operation, other sources will
be open to it.
Chief of these sources, of course, is the current
operations of the enterprise.
These operations should be sufficient to produce
all the financing required to meet the routine
current needs of the enterprise.
They may, in addition, yield sufficiently in excess
earnings to provide for special reserves and for
expansion of the business.
In common usage, working capital is the total of
current assets consisting of merchandise and
materials, cash, accounts receivable, and other liquid
assets, less current liabilities.
Proper ratios should be sought between current
assets and current liabilities and between current
assets and capital assets.
What these ratios should be depends upon the type
of enterprise and other factors; no fixed rule can be
applied to all concerns.
In general, working capital should be sufficient to
meet current liabilities and to enable the company to
take immediate advantage of opportunities that
present themselves from time to time.
A budget plan is the best device to develop and
control the flow of working capital.
It sizes up the prospects of the business in
advance, proportions the various parts of the
enterprise in proper relation, sets the timing
of income-in relation to expenditures, prepares
for contingencies, and keeps a reserve in
readiness for unexpected opportunities.
A soundly operated enterprise with a realistic
budgeting plan will also have far less difficulty
when seeking to augment working capital
through trade credits and other, short-term
financing.
Reserves and Expansion
Sound financial administration requires the
setting up of reserves for working
capital, to liquidate debts, to cover credit
losses, against contingencies such as fire, theft,
and unexpected liabilities, for depreciation
and obsolescence, to offset price fluctuations
on inventories, for taxes, to provide for
improvements and expansion, and for related
purposes. Reserve items maybe earmarked
cash or property or unidentified as an overall
item reflected in the company's balance sheet.
Ordinarily a going concern will accumulate some capital
for expansion through operations.
Where the competitive price structure allows and in
state-regulate. enterprises like utilities, the unit price of
the product or service may contain a fractional Sum to
be set aside in the form of reserves for expansion of the
business.
Closely analogous to financing expansion through a
specific part of the price are the common methods of
"plowing back the earnings" and depreciation reserves.
Taxes, however, have become so burdensome that there
is a real problem today in finding the money for growth.
In any event, the firm which operates under a complete
budget system is in the best position to use these
methods to the best advantage.
When greater amounts of capital are needed
for expansion, the firm may seek equity capital
through sales of stock to employees,
customers, sometimes to creditors, and the
general public.
Stock rights issued to existing shareholders
often result in increased equity capital for the
company.
In recent years sources of expansion funds
may be found, in community industrial
foundations and investment-development
companies, but ordinarily these involve special
situations and inducements.
One of the chief methods of expansion, used extensively in the last
half century, is to combine two or more enterprises.
So far as financing is concerned, combination is a method of raising
equity capital and often of strengthening the working capital of the
surviving enterprise.
It should not be attempted lightly or without a thorough study of the
many problems involved.
Is the 'physical property of the concern to be merged in good
condition?
How long has the company been in business?
What advantages or disadvantages will be inherited from its position
in the industry and trade?
What are its financial history and record of earnings?
Are the earnings of the combination likely to exceed those of the
separate concerns?
Will they justify the full costs of acquisition?
Will the combination gain the services of the key persons in charge of
the separate concerns and be able to eliminate the incompetents?
These and many other questions must be answered with
great care to be certain that the weight of advantage lies
with the new company over the former separate concerns.
Although a caution sign should always be raised when a
successful, going concern considers a merger with another
concern in difficulties, business history abounds with just
such combinations.
Where the company in difficulties has particular
weaknesses, such as insufficient working capital, poor
management, inadequate sales personnel, or poor
distribution network, but possesses a distinctive product,
established place in the trade, good physical location and
properties, favorable tax features, or other special
advantages, merger may be desirable with a successful
company able to supply the missing links or to profit by the
special advantages.
In particular, tax-loss carry forward has come to
play a prominent part in many recent mergers.
On the other hand, expansion generated by
promoters who saw profits in the manipulation
of companies rather, than in running a sound
industrial enterprise has led to great abuses in
the past and should be avoided.
At all events, the lure of great profits and the
dazzle of empire building through expansion
should not be permitted to obscure the cold
realities of risks which often result when a new
concern is fashioned with the patchwork of
older companies.
The Special Problem of Small Business
Small enterprise is an important element in the entire
economy.
Numerically it is the largest sector of the economy, but if
measured by employment provided and value of products
in the manufacturing field, it is overshadowed
by medium- and large-scale enterprises.
But these are not the only considerations.
Small enterprise provides a source of specialized products
and services, a source of supplies and parts for large
enterprise, a market for goods and services, a healthy
element of competition in the economy, a source of
employment for many persons, and a field for individual
opportunities and experimentation in business ventures
("seed enterprises") which we associate with dynamic free
enterprise.
Because of small size, limited capital and earnings,
lack of personnel for specialized management, and
intense competition, the small enterprise has
difficulty in getting equity capital at the start and in
financing itself later through operations.
For his initial capital the small enterpriser often
has to rely upon his own resources and upon the
willingness of friends, relatives, and potential
business associates to invest in the business.
Until he becomes securely established, the long-
term capital market is usually closed to him
because his needs are too small and the risk is too
great.
Some community banks make short-term loans to small
enterprise, but the aid is limited and rarely covers capital
expansion.
The trade credit is an important mainstay of small-business
financing, but it is costly, limited in amount, and not sufficiently
reliable.
In many cases funds have to be sought from commercial factors,
mortgage and finance companies, and personal loan agencies.
For each satisfactory relationship with these sources, there are
many other small business concerns which have had painful
experiences with this type of financing.
Many such loans carry hidden "service" charges, authorize
lenders to hold back funds, tie up all available collateral, and
allow lenders to interfere in the management of the enterprise.
The net effect of all these financing difficulties is to keep the
small enterpriser under constant strain and to raise his cost of
production so that he is at a competitive disadvantage.
But in many cases the small enterpriser himself is
partly at fault for his plight.
Small enterprises frequently suffer from bad
management, loose accounting practices, too liberal
granting of credit to their customers, excessive
withdrawals of cash by owners, and premature
unwise expansion.
These conditions make small enterprises high risks,
and lenders who share in those risks seek
compensation through high rates and protective
devices.
In the case of reliable lenders, however, the
management aid and supervision they render is a
real service to the small business enterprise.
CAPITAL ALLOCATION
Assuming investment capital is available, there is almost
always a choice of ways to invest it.
The two most important criteria of worthiness are the
risks involved and the pattern of cash flow.
An evaluation of risk results from questioning the
likelihood of expected returns. Many appropriate
questions were posed in the previous chapter.
When it is possible to measure probabilities of success
for alternative investments, the preferred solution
can be obtained quantitatively.
In the more common case, where alternatives are risk-
rated intuitively, a subjective choice is made between
high return-high-risk and lower-return-lower-risk
alternatives
The time-scaled pattern of receipts and
disbursements should always be
Quantitatively evaluated.
The time value of money is synonymous
with interest.
Interest, or the cost of borrowing
capital, has been an accepted aspect of
capital management for centuries.
In the last 30 years much attention has
been given to interest rates as yardsticks
of investment quality.
Receiving a dollar today is preferable to receiving
it a year from now.
Part of the reason is that inflation may detract
from the buying power of the delayed dollar, but
the more germane consideration is that the dollar
received today can be put to work in the interim
period.
It can earn interest during the year it works before
the delay dollar is received.
The amount it earns divided by the amount
invested for the year is the interest rate received.
This interest rate then becomes a standard by
which to measure the attractiveness of the
investment.
There are several ways to utilize interest rates
in the evaluation of proposed investments-
payout period, present worth, equivalent
annual cost, capitalized cost, rate of return-but
only rate of return will be described here.
The rate of return is a percentage figure,
equivalent to an interest rate, which indicates
the return earned over the life of an
investment.
It is calculated from the cash-flow stream
associated with the investment.
The major influence of time is illustrated by
Figure 5-2.
Three possible cash-flow patterns are
shown.
All three represent returns over a period
of 10 years received from an initial
investment of $1,000 made at time O.
Disregarding taxes, the three patterns all
have the same rate of return.
The obvious conclusion to be drawn from
studying the cash-flow streams is that
more rapid recovery of investment capital
raises the rate of return.
After the rate of return has been computed by discounting
the cash flow of each alternative, the final step is to decide
which, if any, of the alternative investments should be
made.
An investment promising a rate of return less than could be
earned from investing in conservative bonds would hardly
be attractive.
Each enterprise has its own minimum acceptable rate of
return, larger for high-risk endeavors and lower for
conservative operations such as public utilities.
Proposals failing to meet the minimum are discarded unless
there are very significant intangible benefits involved.
The calculated rates of return from several alternatives
competing for the some investment funds constitute a
preference rating when the alternatives are otherwise
equivalent.
THE BUDGET
It is the long-term responsibility of
management to so use investment that
it will yield the largest possible profit or
return, and it is the function of budgeting to
plan that profit picture.
Perhaps this planning can be understood
better if we first examine the components of
profit.
Figure 5-3 shows in chart form the basic
elements involved in the return on
investment.
Starting with the upper right-hand comer of the chart we
find that working capital is made up of inventories,
accounts receivable, and cash.
These the permanent investment in assets such as land,
building, and equipment comprise the total investment of
the company.
We determine how hard this investment is being worked
by comparing it with total sales for the designated period
of, let us say, one year.
If sales were $400,000 and investment $100,000 the
turnover of investment for the year would be four or, in
other words, it would have been used four times in the
year.
The more times we are able to use a dollar of investment,
the more profit we should receive from it.
The next question, then, is how much did each
turnover yield?
The lower part of the chart in Figure 5-3 shows
the method for calculating earnings in terms of
the percentage of the sales dollar.
Note that the costs of sales are listed in the lower
right-hand comer.
These comprise the cost of making the product
and getting it to the customers and must be
deducted from total income from sales to
determine earnings on sales.
If we find that earnings on sales is 2112per cent,
then with a turnover of four the return on
investment would be 10 per cent.
PLANNINGTHROUGHTHEBUDGET The task in budgeting is to plan –
production in accordance with sales estimates land a minimum cost.
Recent trends toward decentralization of authority and responsibility,
discussed in preceding chapters, are especially applicable in budget
planning.
Under this system only a relatively small finance staff is maintained
at headquarters under the supervision of a controller.
He may personally exercise the leadership in budget planning or he
may delegate this to a budget director.
Each operating division or plant is provided with its own staffs in
accounting, industrial engineering, industrial relations, and in some
instances product development, where the company is organized on
a product basis.
The plant or division manager, with the aid of his staffs and material
supplied by headquarters, is held responsible for reasonable return
on investment, for budgeting, and for the efficient operation of his
plant.
This is in contrast with some centralized situations,
although certainly not all, where the profit budget is
prepared in headquarters and the division manager is
handed a pattern of operation with predetermined
standards against which his operations will be evaluated.
In such a situation he feels little concern for profit.
Under the decentralized system he is considered an
executive in charge of a unit of the investment which is
expected to produce its share of the return.
Furthermore, it is his responsibility to spread this concern
for profit throughout his unit to department heads,
supervisors, stenographers, and the people at the bench.
The whole philosophy of decentralization tends to make
planning for sales, for production, and for the control of
costs a cooperative undertaking in the setting of profit
goals.
Sales may or may not be decentralized by plants or divisions.
If decentralized, sales will operate as a separate staff unit
working with the budget director and the plant manager in
the establishment of sales goals and production requirements
to serve those goals.
In small and medium-sized companies the job of budget
planning operates in much the same way that it operates in a
division of a larger company except that it may not have the
benefit of extensive data gathering and research provided by
headquarters of the large company.
On the other hand, managers of small companies should have
an advantage in promoting an overall operating awareness on
the part of the total personnel because of their improved
proximity to all operations of the company.
This is one of the advantages that large companies are
attempting to regain through decentralization.
CONTROL THROUGH THE BUDGET It should be
understood that a budget is a means toward an end and is
not an end within itself.
Budgets are made to be used.
They establish goals to which each department and each
worker within a department must contribute his
designated share in terms of the unified plan.
This leads toward precision and confidence.
A department head knows what is laid out for his
department to accomplish.
He knows what is expected of him.
He knows when he has done a good job or when and
where he is falling behind.
Thus, much of the worry of uncertainty is eliminated.
Through recording of actual results
against the estimates of the budget,
reports are constructed that reveal the
points of difficulty and danger-the
points which must be analyzed and
improved upon.
Management operating on the
"exception principle" may pick up these
points of variation and devote attention
to them.
COORDINATION THROUGH THE BUDGET Budgets should be
constructive aids to all departments, within an organization in
achieving their common goals.
Unfortunately, however, this purpose is frequently
misunderstood.
The early emphasis given to budgets as controls of expenditures
established in the minds of subordinates the attitude that
budgets were negative controls only-devices to limit
expenditures.
This led to the "padding" of departmental budgets, the idea
being for each department to get as large an allotment of
expenditures as possible.
When all budgets were assembled and reductions were deemed
essential, each department felt that it was the subject of
discrimination.
Thus the budget became a "sore spot" and a factor of
disintegration among the personnel.
Budgets, properly constructed and
operated, may have a constructive
influence on the personnel of an
organization.
Budgets may serve as a means for
bringing about an understanding of
the common goals of all who belong to
the organization and all who serve it.
In this capacity the budget serves as a
coordinating and unifying influence.
TYPES OF BUDGETS
There are two principal types of budgets: the static,
or fixed, budget and the variable, or flexible, budget.
The static budget depends upon ability to predict
income, sales, or shipments with at least a
reasonable degree of accuracy.
Using this prediction as a base. fixed sums are
allocated for expenditures with a fixed budget of
production operations for the period in question.
The variable budget recognizes the unreliability of
income or sales predictions and makes provisions in
advance for variations in production and
expenditures in accordance with variations in sales.
1. The static budge/ Industry inherited the static budget
from governmental and institutional organizations.
This type of budget served a valuable purpose in the
planning and control of certain fixed types of
expenditures.
The in adequacies of such a budget however, were soon
felt when industry moved into the period of mass
production where margins of profit per unit of
production were small and planning and control over all
operations became more essential.
Through study it was found that costs per unit change at
different levels of production.
The degree of change varies on different products and on
different operations involved in-the manufacture of the
same product.
2. The variable budget The variable
budget is constructed in anticipation of
variations in sales.
It provides in advance for orderly change
in the volume of production
and in expenditures.
This tabulation is based on the recording
of costs of previous periods or on the
standard costs that have been
established through study and
experience.
Figure 5-4 is a simplified version of a typical
cost curve intended to show the variation in
costs as volume increases.
Note that three types of cost are illustrated:
fixed or stand by costs representing those
items of overhead which must be met even
though the plant is closed down; semi-fixed
costs; and variable costs.
Actually, however, the semi fixed costs do
not usually follow a straight line but form
more of a curve upward as volume increases.
For purposes of simplicity and clarity the rise in semi-
fixed costs is indicated at points where the rise is more
pronounced, i.e., at points where it becomes necessary
to establish additional shifts with the addition of
foremen, sweepers, extra maintenance crews, etc.
The same effect would be obtained at points where
additional buildings have to be opened for increased
volume of production.
The greatest variation in costs, however, is in those
items which are classified as variable costs, such as
material and labor.
These are the items of greatest concern in budgeting
because they are flexible and must be controlled and
adjusted as volume increases or decreases.
There are two interpretations of the terms "fixed" and
“variable" costs.
One interpretation considers a fixed cost as one that is
constant in total amount for a given period, while a
variable cost increases or decreases in proportion to the
volume of production.
The second interpretation defines a fixed cost as one that
is constant in amount per unit of production but varies in
total, while a variable cost changes in amount per unit
but remains constant in its total amount for a given
period.
It will be noted that these two interpretations are
directly opposite in their meanings.
The classification as described herein assumes the
acceptance of the first interpretation.
Salaries of major executives, capital taxes,
depreciation, etc., remain fixed regardless of the
volume of production.
These are known as fixed costs.
Other items, such as direct labor and direct material,
vary almost in proportion to the amount of production
and are termed variable costs.
Most costs are subject to some variation.
Cost of electricity may be considered relatively
constant, but even that will vary with extreme changes
in volume of production which may require changes in
the length of the working day or in the number of
working shifts.
Therefore, in some enterprises, a third classification of
semi-fixed costs is added.
Holding to the principle of variable budgets, variations in the
form of budgeting procedure may be established to meet the
peculiar needs of a specific enterprise.
In general, we may say that simplicity in budgeting should be
held as a primary virtue.
Detailed clerical work involved in the preparation and operation
of a budget should be held to a minimum.
This principle not only leads to the elimination of unnecessary
costs in budgeting but in general promotes ease in the
interpretation and control of the budget.
In a small company where; costs are easily identified and
controlled or in companies where there is little variation in
production volume, a very simple type of budget becomes more
practical and appropriate.
As an enterprise increases in size and variability, the budget
procedure must change to provide the necessary information
and control.
Variable budgets are of two principal types.
One is the step budget which is really a series of
budgets set up at different levels of volume of
production or sales.
These steps are usually established at points in the
variation in volume where pronounced changes in
costs will occur, such as additional shifts, buildings,
and supervisory personnel.
The budget for each step recognizes a point of
maximum and minimum production.
Demands in excess of the maximum or below the
minimum require a change in the basic budget or,
in other words, the adoption of the budget which
has been established for the next step.
The second type of variable budget provides an estimate
of the variable rate of cost per unit of production or per
dollar shipments of sales.
Any estimate of the variable rate of cost must recognize
maximum and minimum volumes.
As previously stated, the rate of cost of material maybe
expected to decrease as volume increases, owing to
advantages that maybe attained through purchasing in
larger lots.
Greater labor efficiency however, may be obtained from
the regular force of 1,000 workers than would be realized
per unit of production after an additional 500
inexperienced employees had been added to the payroll.
Therefore, the variable rate of cost is calculated as an
average rate between two points of minimum and
maximum production.
PREPARING THE BUDGET
Mention was made earlier regarding the ,function of the
budget director, most frequently the controller or
assistant controller serving in this capacity
He serves. as a coordinator between divisions or
departments in budget preparation.
Usually the heads of these divisions, together with
selected staff representatives, will serve as the budget
committee of the company.
This committee receives and approves all forecasts,
departmental or division budgets, and periodic reports
showing comparison of actual and budget.
The budget committee may also request special studies
of deviations from the budget and consider revisions of
budget to meet changed business conditions.
The budget officer must see that all department
estimates are prepared with sufficient supporting
data to provide an adequate basis for effective
consideration by the committee.
He has the responsibility for the presentation of
these budgets to the committee and for transmitting
back to the departments the recommendations of
acceptance or revision.
The budget officer is also responsible for the
organization of a system of regular periodic reports
regarding the operations of each department.
He may also prepare special reports regarding points
of special difficulty and recommended revisions to
correct these difficulties.
The preparation of budget estimates within each
department should also be a committee
proposition.
This is in adherence to the same principle of
participation as a means toward cooperation
participation in the preparation of a budget serves
to familiarize the personnel with the problems
involved.
With this knowledge of the problems and the
feeling of having a part in setting the goals and
limitations of the department, the personnel will
give more effective cooperation in the operation of
the budget.
The head of the department may act as chairman
of the department committee but, in the case of a
large department, he should delegate
responsibility for the gathering of details for use by
his committee.
In other words, he should have an organization
within his own department for the preparation of
the budget that follows the same general pattern
as the budget organization for the enterprise as a
whole.
He will find that this organization not only will lead
to better budget preparation but will prove
especially useful in budget control.
Adequate Cost Information
Adequate cost information is a prime essential of
budgeting.
It constitutes the foundation for the conversion of
forecast and business policy into production.
Our forecast tells us how much we can sell at a given
price level.
Our cost information tells us how much it will cost to
produce it in the, volumes specified.
Full realization of cost in advance of budget preparation
may cause management to question the advisability of
the continuance of certain lines of products or it may
lead to the expansion of a particular line that is able to
carry a favorable margin of profit.
Perhaps the most important advantage to be gained through
the availability of accurate cost information is that budgeting
can be based on facts instead of personal guesswork.
The individual who is called upon to provide estimates without
facts on which to base these estimates is in the long run facing
trouble.
Through superior personal judgment he may receive the
praise of management when times are good and when
production is progressing t a relatively even tempo.
If he is wise he will probably allow reasonably safe margins to
protect himself from the possible errors of his
judgment.
This he may be able to do under "normal" conditions.
But invariably there will come a time when the "abnormal"
occurs-when the "pressure" is put on to decrease the budget of
costs in order that the business may continue to operate at a
profit.
Those are the times when the individual may be forced to eliminate
those margins of safety.
He promises to operate at less cost yet he does not have a detailed
plan approved by management as to just how those costs are to be
reduced.
The chances are that they will not be reduced and he will be
criticized, if not discharged, for poor management of his
department.
How much better it would be if he could supply facts regarding
costs-facts that could be interpreted by any member of the
management group.
The individual could then relieve himself of reliance on personal
judgment alone and present his estimates accompanied by
systematically prepared data.
Once the estimates are accepted by the budget committee with full
realization of the facts on which they are based, the committee
shares the responsibility for the accuracy of those estimates.
The Sales Budget
As previously mentioned, the estimates of future
sales set the bounds of limitations for other
budgets of the enterprise.
There are two principal sources of data for use in
the preparation of sales estimates:
(I) past performance (sales of previous periods)
and (2) market analysis.
Both Sources are generally used in gaining a
composite picture of the relative demand for the
different products, manufactured and the general
changes in business conditions which are pertinent
to the future sales of the products of the enterprise.
Salespersons can playa significant role in the preparation of the
sales budgets.
They are in personal contact with the customer.
They are able to obtain firsthand information regarding his wants.
his attitude toward future business conditions, his attitude toward
the services provided by the enterprise, his attitude toward the
program of advertising, etc.
If salespersons are trained in the importance of this information
and the methods by which it should be produced, the enterprise
can develop within its own organization a valuable source of
market information.
Many companies make the preparation of sales estimates and the
introduction of new products to the market a cooperative
undertaking which includes participation by vote on the part of
each salesperson.
A by-product of this procedure is the development of a feeling of
responsibility on the part of the salesperson for meeting sales
estimates once they are cooperatively established.
Manufacturing Budgets
The number and division of budgets for the manufacturing
division of an enterprise will, of course, vary with the size and
type of enterprise and the products it manufactures.
In general, it may be said that six basic budgets are needed:
(I) the production budget which outlines the schedule of
product
units to be manufactured;
(2) the materials budget which specifies the direct material
needed to produce the number of units scheduled;
(3) The plant and equipment budget that sets forth the
requirements of space and machinery;
(4) the maintenance budget;
(5) the manufacturing expense budget which includes the
overhead or burden charges for the period; and
(6) the labor budget specifying the productive personnel
needed to meet the production schedule.
The production budget is taken directly from the
sales estimates, except that it attempts in so far as
possible to spread the work evenly over the period.
This budget forms the basis for other
manufacturing budgets as listed above.
With the aid of the materials specifications sheets
for each product, the materials budget can be
prepared by months for the guidance of the
purchasing department. Similarly, the plant and
equipment, maintenance, and manufacturing
expense budgets must conform to the production
budget for the various departments, not only as to
what will be needed but also when
The Financial Budget
The financial budget presents a summary of anticipated
receipts and disbursements for the budget period.
Its purpose is to plan for the allocation of working capital
as represented by the current assets of the enterprise.
Data for the financial budget are derived from the
budgets as prepared by the various divisions.
The financial budget must anticipate the cash receipts
by months or at other designated points of the period
and make allowance for the raising of additional funds, if
needed, to meet current expenses.
This means that income from accounts receivable, notes
receivable, cash transactions, etc., must be budgeted as
accurately as possible.
Expenditures maybe planned in consideration
of two primary factors:
(I) the absolute necessities of the budgets of
the various divisions, i.e., monthly
requirements of materials for production,
payroll, etc.; and
(II)the-limitations of available cash.
It is not considered good business to have large
amounts of cash lying idle during 10 months of
the year in order that funds will be available to
meet unusually large expenditures during the
other 2 months.
Good business policy would suggest that attempts
should be made either to spread the added
expenses of these two months over a longer
period or to borrow additional funds through
short-term notes.
There are many problems arising out of attempted
control of working capital, and there are likewise
many possible solutions that may be derived to fit
the needs of an individual enterprise.
The significant point here is that these problems
must be anticipated and avenues selected to meet
them.
The financial budget is a device intended to serve
those objectives.
There are times, of course, when the limitations
of capital may make the plans as set forth in the
budgets of various divisions prohibitive.
This is especially true during periods of rapid
expansion when additional plant and equipment
must be provided in order to meet the budgeted
schedule of production.
In such case the financial budget acts as a
negative control over other divisions.
In most instances, however, the financial budget
provides a systematic and positive approach
toward the attainment of the coordinated plans of
all divisions.

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