OPERATIONAL BUDGETING

1. OPERATIONAL BUDGETING

2. Profit Rich, Yet Cash Poor Conditions leading to cashshortages when profits are high. Large investmentsin assets to supportrapid revenue growth. Long operating cycles(cash-to-cash cycles). Consider the following cash-to-cash cycle

3. Cash InventoriesMaterialsLaborFinal Goods166 days 247 Days Accounts Receivable81 days Cash Profit Rich, Yet Cash Poor Even if salesare growing rapidly,cash is tied up in inventory andreceivables for so long that a cashshortage will bethe likely result.

4. Control Steps taken by management to ensure that objectives are attained. Planning Developing objectives for acquisitionand use of resources. Budgeting: The Basis forPlanning and Control A budget is a comprehensive financialplan for achieving the financial andoperational goals of an organization.

5. Benefits Derived from Budgeting Enhanced managementresponsibility Coordinationof activities Performanceevaluation Benefits Assignment of decision-making responsibilities

6. The Disadvantages of Budgeting • Time and Cost • Anxiety by managers and employees about achieving targets • The tendency “spending to the budget” • Future is uncertain – affect accuracy

7. Budget Cycle • Establish attainable and reasonable goals or objectives • Create plan to achieve the goals • Compare the result to the budget • Take action to correct variances • Improve the effectiveness of budgeting

8. Participation in Budget Process Flow of Budget Data

9. 2005 2006 2007 2008 The Budget Period The annual operating budget may be divided into quarterly or monthly budgets. A continuous budgetis usually a twelve-month budget that adds one month as the current month is completed.

10. Types of Budgets • Long Term and Short Term • Fixed and Flexible • Capital • Operating • Department • Master

11. EstimatedUnit Sales EstimatedUnit Price Analysis of economic and market conditions+Forecasts of customer needs from marketing personnel The Master Budget SalesBudget

12. The Master Budget • Financial budgets • Budgeted Income Statement • Budgeted Balance sheet • Budgeted Cash Flow Statement • Capital expenditure budgets

13. Budgeted Income Statement An example of a simplified budgeted income statement

15. Budgeting in a Hospitality Operation • Calculating breakfast budgeted sales revenue: Number of Seat Average Operating Breakfast seats x turnover x check per x days = total sales available expected meal period available revenue • For a rooms department, the equation will look like this: Forecasted Average Number Operating Total occupancy x room x of rooms x days = rooms sales percentage rate available available revenue

16. Budgeting in an Operation A motel has 50 rooms available, an occupancy rate of 83.5%, and an average room rate of $80. In the budget period, because of a new hotel in the area, the occupancy is expected to drop down to 80%. This will be compensated by an increase in average room rate by 5%.The owner wants you to estimate sales revenue for the month of April. Forecasted Average Number Operating Total occupancy x room x of rooms x days = rooms sales percentage rate available available revenue 80% x $84 x 50 x 30 = $100,800

17. Cash Budget • Provides the management and other users with information about the liquidity of the business • Allows management to take appropriate action when any potential dangerous cash shortfalls are identified as well as investment opportunities where there is excess cash

18. Cash Budget • A forecast of cash receipts (cash inflows) • Sales forecast • Credit terms offered by company to customers • Borrowing • Issuance of Capital/Common Stock • Cash payments (cash outflows) • Manufacturing costs • Operating expenses • Capital expenditures • Credit terms offered by suppliers to company • Debt repayment

19. Cash Budget – simple example • Let’s assume that 60% of the month’s income is received in the current month and the other 40% is received in the following month. The schedule of cash receipts would look as follows:

20. Cash Budget – simple example Schedule of Cash Receipts (Cash Inflow)

21. Cash Budget – simple example • Lets assume that all expenses are paid in the current month. • Note that not all expenses are cash. There are “non-cash” expenses such as bad debts, depreciation, discount expense which must be disregarded when looking at cash outflows (do not appear as cash payments). • The schedule of cash payments would look as follows:

22. Cash Budget – simple example Schedule of Cash Payments (Cash Outflow) We are now able to do the cash budget. Lets assume that the company starts with $80,000 cash at the bank at the beginning of January. The cash budget would look as follows:

23. Cash Budget – simple example Cash Budget

24. Comprehensive Cash BudgetAdditional Information • Basket Company: • Has a $100,000 line of credit at its bank, with a zero balance on April 1. • Maintains a $30,000 minimum cash balance. • Borrows at the beginning of a month and repays at the end of a month. • Pays interest at 16 percent (annual interest rate) when a principal payment (debt repayment) is made. • Pays a $51,000 cash dividend in April. • Purchases equipment costing $143,700 in May and $48,800 in June. • Has a $40,000 cash balance on April 1.

30. $50,000 × .16 × 3/12 = $2,000

31. Performance Reports • Compare actual and budget • Identify variances • Improve the actual performance

32. Performance Reports (Variance) • Investigation will be made for unfavourable variances to determine the causes and what to do to improve future performance. • Favourable variances will also be examined • Was the budget reasonable? • A better performance was achieved and can be used for company’s advantage. • Variances can be shown as either a $ amount or % or both

33. Performance Reports An example of a budget performance report Budget Performance Report

34. Flexible Budgeting Show expenses that should haveoccurred at the actual level ofactivity. Reveal variances due to good cost control or lack of cost control. Improve performance evaluation.

35. Toa budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costschangein direct proportion to changes in activity. Total fixed costs remainunchanged. Flexible Budgeting Variable Fixed

36. Flexible Budgeting

37. Flexible Budgeting Total variable cost = $7.50 per unit × budget level in units

38. Flexible Budgeting Fixed costs are expressed as a total amount that does not change within the relevant range of activity.

39. Flexible BudgetingPerformance Report

40. Flexible BudgetingPerformance Report Indirect labor and indirect material have unfavorable variances because actual costs are more than the flexible budget costs.

41. Flexible BudgetingPerformance Report Power has a favorable variance because the actual cost is less than the flexible budget cost.

42. Variance Analysis Matrix • Price variance – difference between the budgeted average check or selling price and the actual. • Cost variance – difference between the budgeted cost per unit and the actual. • Sales volume variance (from price point of view) – difference between budgeted number of guests or units sold and the actual. • Sales volume variance (from cost point of view) - difference between budgeted number of rooms (units) and the actual

43. Variance Analysis Matrix If we analyze the budget and actual figures for a banquet operation we get the following information: Budget 5,000 guests x $15.00 average check = $75,000 Actual 4,500 guests x $15.50 average check = $69,750 Variance (unfavourable) $5,250

44. Variance Analysis Matrix • Variance is composed of a price and sales volume variance. • Price variance (actual volume x price variance) 4,500 guests x $0.50 = $2,250 favourable • Sales volume variance (guest variance x budg. price) 500 guests x $15.00 = $7,500 unfavourable Price variance $2,250 favourable Sales volume variance 7,500 unfavourable Total variance ($5,250) unfavourable

45. Variance Analysis Matrix

46. Variance Analysis Matrix We now have information that tells us that the major reason for our difference between budget and actual sales revenue is a reduction in sales revenue of $5,250 due to serving fewer customers. This has been partly compensated for by $2,250 since the average banquet customer paid $0.50 more than the standard selling price. This indicates that our banquet department is probably doing an effective job in selling higher-priced menus to banquet groups but is failing to bring in as many banquets or guests as anticipated.

47. Variance Analysis Matrix If we analyze the budget and actual figures for a laundry operation we get the following information: Budget 3,000 rooms sold x $2.75 per rom = $8,250 Actual 3,100 rooms sold x $3.00 per room = $9,300 Variance (unfavourable) $1,050

48. Variance Analysis Matrix • Variance is composed of a cost and sales volume variance. • Cost variance (actual volume x cost variance) 3,100 rooms x $0.25= $775 unfavourable • Sales volume variance (rooms variance x budg. cost) 100 rooms x $2.75 = $275 unfavourable Cost variance $775.00 unfavourable Sales volume variance 275.00 unfavourable Total variance ($1,050) unfavourable

49. Variance Analysis Matrix

50. Variance Analysis Matrix This tells us that, although our total variance was $1,050 over budget, only $775 is of concern to us. Even though this is considered unfavourable as a cost increase, we would not necessarily be concerned about it. $775 overspending could depend on a supplier increasing costs that we may/may not be able to do something about; or it could be that we actually sold more twin rooms than budgeted for. The cause would therefore determine whether the overspending was serious or necessary to run the operations smoothly.