Budget preparation- Puneet

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1 Budget Preparation

description

By Puneet Mathur

Transcript of Budget preparation- Puneet

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Budget Preparation

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Key Topics

• The basics of budgeting

• Why budgets are important for control purposes

• Various types of budgets

• When each type of budget is used

• How to prepare some of the important budgets

• What are their limitations

• Behavioral implications

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What is a budget?

• Budgets are summaries of short-term

operational activities of a firm.

• For example, a firm may prepare cash budget

to predict cash inflows and outflows or

• A production budget to plan its production

levels.

• Budgets are quantitative representations.

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How does a budget differ from a forecasting?

• A forecast is a prediction and usually

• There are many ifs and buts before a forecast

resembles reality.

• Most importantly, a forecaster can only predict

(sales would increase by 20% by next year).

However,

• A forecaster cannot shape the selling events to

make the sales go up by 20%

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How does a budget differ from a forecasting?

• In contrast, a budget is a plan (sales must go up by 20%

by next year).

• The budget plan is based on facts, events in progress,

actions planned, etc.

• The budget preparer must consult those affected, obtain

input before preparing the budget, and

• The Manager of a unit must take active steps to achieve

the budget.

• Both forecasts and budgets are necessary. Forecast is

useful for planning while budget is useful for both

planning and for controlling.

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Characteristics of a budget

• Stated in monetary units but,

• Could contain non-monetary items such as units

produced, sold, no. of items processed etc.

• Usually, short-term (one year) but could be extrapolated

from or to the longer term.

• Senior management must be involved in the process and

must approve it.

• Most important – budgets must be compared to actual

and the variances must be investigated.

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Usefulness of the budget

• Fundamentally, it is a planning and control tool (coordination,

problem signaling, and problem-solving activities).

• It is a good tool to communicate short-term goals to employees.

• It also helps senior management in assessing whether

organizational goals are met (e.g. improvement in customer

service but no allocation for employee training).

• Since input is required from multiple units, it promotes

coordination, planning, and sharing.

• Allows a firm to anticipate problems so that corrective action

can be taken early.

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How does a budget help with strategic planning?

• Strategic Plan: Tells managers what the organizational goals for this

year are (e.g. sales growth, profits, new products, expansion in

production capacity).

• To accomplish the plan, every unit must contribute through its efforts.

• Therefore, each unit is subjected to a budgeting plan, process, and

proposed results (operational plan).

• Collectively, the individual budgets would point out whether the

strategic plan is likely to be achieved or not.

• If not, what corrective actions must be taken.

• Consequently, budget not only demands responsibility but also

accountability.

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How does a budget help with performance evaluation or accountability?

• By creating benchmarks.

• A budget is a rationally prepared set of

benchmarks.

• By comparing actual performance to the budget,

deviations can be ascertained and evaluated.

• Within reasonable limits, the budget points to

accomplishments or lack thereof.

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Static (Fixed) vs. Flexible Budgets

Static Budget Flexible Budget

• Prepared for only one level

of sales volume

• Prepared for several different

volume levels within a

relevant range

• Separates fixed and variable

costs

Variance = difference between actual and budgetVariance = difference between actual and budget

Favorable – actual amount increases income

Favorable – actual amount increases income

Unfavorable – actual amount decreases income

Unfavorable – actual amount decreases income

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Static Budget Variances

Sales Volume VarianceFlexible Budget Variance

Actual Results

Flexible Budgetbased on actual

number of outputs

Static Budgetbased on expectednumber of outputs

Static Budget Variance

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Budget Variances

Sales Volume VarianceSales Volume Variance

Flexible Budget (for the number of units actually sold)

Flexible Budget (for the number of units actually sold)

Master Budget (for the expected

number of units to be sold)

Master Budget (for the expected

number of units to be sold)

Flexible Budget Variance

Flexible Budget Variance

Actual results(for the actual number

of units to be sold)

Actual results(for the actual number

of units to be sold)

Flexible Budget (for the number of units actually sold)

Flexible Budget (for the number of units actually sold)

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Example

Actual Results at

Actual Prices

Flexible Budget

Variance

Flexible Budget for Actual # of Output Units

Sales Volume Variance

Static Budget

Output units 41,000 - 41,000 7,000 F 34,000

Sales revenue 215,000$ -$ 215,000$ 19,000$ F 196,000$ Variable costs 85,000 6,000 U 79,000 9,000 U 70,000 Fixed costs 107,000 6,000 U 101,000 - 101,000

Total costs 192,000 12,000 U 180,000 9,000 U 171,000 Operating income 23,000$ 12,000$ U 35,000$ 10,000$ F 25,000$

White Pro CompanyIncome Statement Performance

Year Ended J uly 31, 2011

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MASTER BUDGETMASTER BUDGET

A comprehensive—master—budget is a formal

statement of management’s expectation regarding

sales, expenses, volume, and other financial

transactions for the coming period. It consists

basically of a pro forma income statement, pro

forma balance sheet, and cash budget.

The budget is classified broadly into two categories:

1. Operating budget

2. Financial budget

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Various types of budgets

• Two major types:

• Operating budgets (most middle level managers would be involved

in this process)

• Capital or Investment budgets (mostly senior managers are

involved in this process)

• Operating budget could includes several sub-budgets (e.g.

Revenue budget, production budget, marketing budget, etc.)

• Budgeted Balance Sheet & cash flow statement also worked out as

part of the budgeting process

• MBOs & role of MBO in the budgeting process

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CAPITAL BUDGETINGCAPITAL BUDGETING

Capital budgeting relates to planning for the best selection and

financing of long-term investment proposals.

Capital budgeting decisions are not equally essential to all

companies. The relative importance of this function varies with

company size, the nature of the industry, and the growth rate

of the firm.

As a business expands, problems regarding long-range

investment proposals become more important.

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CAPITAL BUDGETINGCAPITAL BUDGETING

The two broad categories of capital budgeting decisions are

screening decisions and preference decisions.

Screening decisions relate to whether a proposed project

satisfies some current acceptance standard. For instance, a

company may have a policy of accepting cost reduction

projects only if they provide a return of, say, 15 percent.

Preference decisions apply to selecting from competing

courses of action. For example, a company may be looking at

four different manufacturing machines to replace an existing

one. The selection of the best machine is referred to as a

preference decision.

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The Budgeting Process –Where do we begin and when do we end it?

• An organization’s strategic goals is the starting point for

the budgeting process.

• Projected financial results for the next year is compared to

the goals to assess acceptability.

• The budgeting process is driven by the demand forecast

(demand for a product at a given price).

• Demand forecast can be developed in multiple ways

(market survey, growth trends, or other estimates).

• Based on demand forecast, prepare a sales plan for each

product line and services.

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The budgeting process (continued)

• Based on the sales plan, develop the factors of

production (or other procurement) – raw

materials, labor, overheads, cash.

• Lots of details would improve the budgeting

process but is time consuming and expensive.

Strike a balance.

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Budget Preparation Process – Role of Budget Dept

• Publishes procedures & forms for budget

• Coordinates & publishes corporatewide assumptions that are the

basis for the budget

• Provides assistance to the budgetees in budget preparation

• Analyzes proposed budgets & makes recommendations initially

to budgetee & then to Sr. mgmt

• Administers process of making budget revisions during the year

• Coordinates work of budget depts within the units

• Analyzes reported performance against budget, interprets the

results & prepares summary reports for Sr mgmt

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Key Steps in Budget Formulation

• Budget Committee Formulation

• Issuance of Guidelines

• Initial Budget Proposal

• Negotiation

• Review & Approval

• Budget Revisions

• Contingency Budgets

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Preparing the initial budget

• Initial budget preparation is done by each

responsibility center (revenue centers, cost

centers, etc.)

• Because, they know more about their individual

units, requirements, constraints, etc.

• Thee centers must consider both external factors

and internal factors that could have an impact on

their budget estimates.

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TopManagement

Middle Management

Middle Management

Supervisor Supervisor Supervisor Supervisor

Note: Initial flow of budget data in a participatory system is from lower levels of responsibility to higher levels of responsibility. Each responsibility center manager prepares his/her budget estimates and submits to the next higher level of management. These estimates are reviewed and consolidated as they move upward in the organization.

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Budgeting Process – The Role of the Responsibility Centers

• Prepare the budget compatible with organizational

goals.

• Communicate with other units and validate unit’s

numbers.

• Don’t be optimistic but do not be pessimistic to show

achievement of budget targets.

• Remember that eventually, resp. center budgets are

subject to approval by senior managers and analysts,

and are subject to revisions.

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What we rarely discuss – Human Factors in Budgeting

• Regardless of what we discussed so far,

• Budget process depends on 1) the degree to which top

management accepts the budget program and 2) the way

top management uses the budget data.

• Top management should NOT use the budget as a weapon

to pressure employees or to blame if something goes wrong.

• There should be meaningful dialogue

• The human aspect is the key

• Budget Dept plays key role in maintaining balance

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Let us now prepare one or two small budgets – use the description and the numbers given in the next set of slides.

The exercises would give you a basic idea of the budgeting process (although not the human interactions involved during such a process)

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Mylar Company

• Manufactures and sells a product that has

seasonal variations in demand with peak sales

coming in the 3rd quarter. The following

information concerns operations for Year 2 –

the coming year – and for the first two quarters

of Year 3.

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Mylar Company data

The company’s single product sells for $8 per unit. Budgeted sales in units for the next six quarters are as follows:

Year 2 Quarter Year 3

Quarter

1 2 3 4 1 2

Budgeted Sales in Units

40,000 60,000 100,000 50,000 70,000 80,000

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Mylar Company Data• Sales are collected: 75% in the qr. Sales are made, remaining 25% in the following quarter. On

Jan. 1, Year 2, the balance sheet showed $65,000 in accounts receivable, all of which will be

collected in the first quarter of the year. Bad debts are negligible and can be ignored.

• Company desires an ending inventory of finished units on hand at the end of each quarter

equal to 30% of the budgeted sales for the next quarter. On Dec. 31, year 1, the company

12,000 units on hand.

• Five pounds of raw materials are required to complete one unit of product. Company requires

an ending inventory of raw materials on hand at the end of each quarter equal to 10% of the

production needs of the following quarter. On Dec. 31, Year 1, the company had 23,000

pounds of raw materials on hand.

• The raw material costs $0.80 per pound. Purchases of raw material are paid for in the

following pattern: 60% in the quarter purchases are made, remaining 40% in the following

quarter. On Jan. 1, Year 2, the company’s balance sheet showed $81,500 in accounts payable

for raw material purchases, all of which will be paid for in the first quarter of the year.

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Mylar Company

• We will prepare:

• A sales budget and a schedule of expected

cash collections.

• A production budget

• A direct materials purchases budget and a

schedule of expected cash payments for

material purchases.

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Sales Budget for Mylar

Year 2 Quarter

1 2 3 4 Year

Bud. Sales 40,000 60,000 100,000 60,000 250,000

Selling price per unit

X $8 X $8 X $8 X $8 X $8

Total Sales

$320,000 $480,000 $800,000 $400,000 $2,000,000

Based on these numbers, we will prepare a schedule of cash collections

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Mylar – Schedule of Cash Collections

Year 2 Quarter

1 2 3 4 Year

A/Rec. Beg. Bal. 65,000 65,000

1st Qr. Sales

(320,000x75%, 25%)

240,000 80,000 320,000

2nd Qr. Sales

(480,000 x75%, 25%)

360,000 120,000 480,000

3rd Qr. Sales

(800,000x75%, 25%)

600,000 200,000 800,000

4th Qr. Sales

(400,000x75%, 25%)

300,000 300,000

Total Cash Collections 305,000 440,000 720,000 500,000 1,965,000

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Year1 2 3 4 1 2

40,000 60,000 1,00,000 50,000 2,50,000 70,000 80000Desired End. Inv.* 18,000 30,000 15,000 21,000 21,000 24,000Total needs 58,000 90,000 1,15,000 71,000 2,71,000 94,000

-12,000 -18,000 -30,000 -15,000 -12,000 -21,00046,000 72,000 85,000 56,000 2,59,000 73,000

*30% of following qr. Budgeted sales in units

Req. Production

Year 2 Quarter Year 3 Quarter

Bud. Sales (units)

Less. Beg. Inv.

Based on Sales Budget, The Production Budget for Mylar

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Year 2 Yr. 3 Qr. 11 2 3 4

46,000 72,000 85,000 56,000 2,59,000 73,000x 5 x 5 x 5 x 5 x 5 x 5

2,30,000 3,60,000 4,25,000 2,80,000 12,95,000 3,65,00036,000 42,500 28,000 36,500 36,500

2,66,000 4,02,500 4,53,000 3,16,500 13,31,500 23000 36000 42500 28000 23000

2,43,000 3,66,500 4,10,500 2,88,500 13,08,500

Less Beg. RM (lbs.)Raw materials to purchase (lbs.)

Year 2 Quarter

Req. Production

Raw Materials (lbs.)

Production needs (in lbs.)

Add. Desired End. Inv.

Total Needs (lbs.)

Mylar – Production Budget – Raw Material Requirement