The Budgeting Process

Visualizing the Future The annual budget is the financial plan to implement the organization's strategy for the next year. When that organization's environment is relatively stable, budgeting factors are fairly predictable and the budgeting process is less challenging than when environmental factors are highly uncertain For many organizations some of the underlying budget assumptions are extremely unpredictable. In these situations, factors that can significantly affect the budget require an ongoing monitoring process as the year progresses. Although budgeting is important for all organizations, entities that have significant amounts of cash and other resources should prepare and use detailed budgets for both planning and control purposes. Regardless of the type of endeavor in which you engage, it is necessary at some point to visualize the future, imagine what results you want to achieve, and determine the activities and resources required to achieve those results. © 2007 by Nelson, a division of Thomson Canada Limited.

Learning Objectives What is the importance of the budgeting process? What is the difference between strategic and tactical planning and how do these relate to the budgeting process? What are the benefits and disadvantages of imposed budgets and participatory budgets? What is a flexible budget and how are budget variances computed and used to analyze differences between budgeted and actual revenues? What complicates the budgeting process in a multinational environment? © 2007 by Nelson, a division of Thomson Canada Limited.

Learning Objectives What is the starting point of a master budget and how do the components relate to one another? How does traditional budgeting differ from zero-based budgeting? What are future perspectives for budgeting? © 2007 by Nelson, a division of Thomson Canada Limited.

Purposes of Budgeting Budget – the quantitative expression of an organization's commitment to planned activities and resource acquisition and use Budgeting – the process of determining a financial plan for future operations Detailed plans that are monetarily enumerated are called budgets. They are the detailed quantification of targets for near term choices of actions. Budgeting is not planning – it is the quantification of planning! Commitments defined in the budget are vital management tools to guide and evaluate short-term performance. The budget was, and should always be seen as, the commitment. © 2007 by Nelson, a division of Thomson Canada Limited.

What are Budgets? Formal organizational plans expressed in quantitative terms A standard against which to measure performance Defines in concrete terms the objectives and resource commitments of an organization © 2007 by Nelson, a division of Thomson Canada Limited.

Planning is the cornerstone of effective management and strategic development and implementation. Planning includes qualitative narratives of goals, objectives, and means of accomplishment. Management translates the qualitative narratives into a quantitative format – the budget. The budget expresses an organization's commitment to planned activities and resource acquisition and use. The budget is a commitment. © 2007 by Nelson, a division of Thomson Canada Limited.

The Budgeting Process A Set goals and objectives Analyze key variables B Qualitative internal Gather relevant historical data C Qualitative environmental PLANNING STAGE Determine underlying assumptions about projected changes in key variables; quantitative internal and quantitative environmental Employee participation Input data into budget model IMPLEMENTATION STAGE THE BUDGET Desired results projected? Monitor actual results CONTROL STAGE yes no © 2007 by Nelson, a division of Thomson Canada Limited. flowchart is continued on next slide

The Budgeting Process (continued) Desired results projected? Monitor actual results (carried forward from previous slide) CONTROL STAGE no yes Desired results achieved? Provide feedback Red flow arrows indicate the next period effects through an iterative process. Note: A, B, and C are known as on-page connectors. Their purpose is to indicate the need to return to other locations on the flowchart at the specified points. yes Possibly adjust budget A no Determine causes Internal causes? Provide feedback Provide feedback no yes Adjust budget Correct problem C B © 2007 by Nelson, a division of Thomson Canada Limited.

The Importance of the Budgeting Process A well prepared budget as a means of implementing strategy can be an effective device to communicate objectives, constraints, and expectations to people throughout the organization. Such communication helps everyone understand exactly what is to be accomplished, how those accomplishments are to be achieved, and how resources are to be allocated. © 2007 by Nelson, a division of Thomson Canada Limited.

Strategic and Tactical Planning Strategic planning – the process of developing a statement of long-range (five to ten years) goals for the organization and defining the strategies and policies that will help the organization achieve those goals Key variable – a critical factor believed to be a direct cause of the achievement or nonachievement of organizational goals and objectives; can be internal or external © 2007 by Nelson, a division of Thomson Canada Limited.

Strategic Planning Strategic planning is not concerned with day-to-day operations, although the strategic plan will be the foundation on which short-term planning is based. Managers involved in planning should identify key variables. Internal key variables are under the control of management, while external key variables are normally noncontrollable. One study concluded that a firm's long-term success is dependent on the integration of the forces in its environment into its own planning process so that the firm influences its own destiny instead of constantly reacting to environmental forces. © 2007 by Nelson, a division of Thomson Canada Limited.

External Factors to Include in Strategic Plans • Market share • Quality of products • Discretionary cash flow/gross • capital investment Organizational Characteristics • Market segmentation • Market size • New market development • Buyer loyalty Market and Consumer Behaviour • Rate of technological change • in products or processes • Degrees of product differentiation • Industry price/cost structure • Economies of scale Industry Structure • Major changes in availability of • raw materials Supplier • GNP trend • Interest rates • Energy availability • Government established and • legally enforceable regulations Social, Economic, and Political © 2007 by Nelson, a division of Thomson Canada Limited.

Tactical Planning Tactical Planning – the process of determining the specific objectives and means by which strategic plans will be achieved; are short-term (one to eighteen months), single use plans that have been developed to address a given set of circumstances or for a specific time frame The annual budget is an example of a single use tactical plan. © 2007 by Nelson, a division of Thomson Canada Limited.

Participating in the Budgeting Process Imposed budget – a budget that is prepared by top management with little or no input from operating personnel, who are simply informed of the budget goals and constraints Imposed budgets Top Management Middle Management Participatory budgets Operational Management Participatory budget – a budget that has been developed through a process of joint decision making by top management and operating personnel © 2007 by Nelson, a division of Thomson Canada Limited.

Best Times to Use Imposed Budgets • In start-up organizations • In extremely small businesses • In times of economic crisis • When operating managers lack budgetary skills or perspective • When organizational units require precise coordination of efforts © 2007 by Nelson, a division of Thomson Canada Limited.

Advantages of Imposed Budgets • Increase probability that organization’s strategic plans will be incorporated in planned activities • Enhance coordination among divisional plans and objectives • Use top management’s knowledge of overall resource availability • Reduce the possibility of input from inexperienced or uninformed lower-level employees • Reduce the time frame for the budgeting process © 2007 by Nelson, a division of Thomson Canada Limited.

Disadvantages of Imposed Budgets • May result in dissatisfaction, defensiveness, and low morale among individuals who must work under the budget • Reduce the feeling of teamwork • May limit the acceptance of the stated goals and objectives • Limit the communication process among employees and management • May create a view of the budget as a punitive device • May result in unachievable budgets for international divisions if local operating and political environments are not adequately considered • May stifle the initiative of lower-level managers © 2007 by Nelson, a division of Thomson Canada Limited.

Best Times to Use Participatory Budgets • In well-established organizations • In extremely large businesses • In times of economic affluence • When operating managers have strong budgetary skills and perspectives • When organizational units are quite autonomous © 2007 by Nelson, a division of Thomson Canada Limited.

Advantages of Participatory Budgets • Provide information from persons most familiar with the needs and constraints of organizational units • Integrate knowledge that is diffused among various levels of management • Lead to better morale and higher motivation • Provide a means to develop fiscal responsibility and budgetary skills of employees • Develop a high degree of acceptance of and commitment to organizational goals and objectives by operating management © 2007 by Nelson, a division of Thomson Canada Limited.

Advantages of Participatory Budgets (continued) • Are generally more realistic • Allow organizational units to coordinate with one another • Allow subordinate managers to develop operational plans that conform to organizational goals and objectives • Include specific resource requirements • Blend overview of top management with operating details • Provide a social contract that expresses expectations of top management and subordinates © 2007 by Nelson, a division of Thomson Canada Limited.

Disadvantages of Participatory Budgets • Require significantly more time • Create a level of dissatisfaction with the process approximately equal to that occurring under imposed budgets in cases in which the effects of managerial participation are negated by top-management changes • Create an unachievable budget in cases in which managers may be ambivalent or unqualified to participate • May cause managers to introduce slack into the budget • May support “empire building” by subordinates © 2007 by Nelson, a division of Thomson Canada Limited.

Improving the Budgeting Process The corporate budget is the most effective tool for financial analysis, planning, and control. Improvements to the process can make a dramatic impact. A recent poll reveals that companies that believe their budgets are "very" accurate attribute this to better collaboration more than any other factor, and that 61% of companies use a combination of top-down and bottom-up approaches. About 20% use the top-down approach; and about 20% use the bottom-up approach. A key trend is the move toward a more participatory approach. Whether this is to avoid accounting scandals, to increase employee accountability, or to make the budget process less opaque, companies are involving more people in the budgeting process. © 2007 by Nelson, a division of Thomson Canada Limited.

Activity-Based Budgeting Budget slack – the intentional underestimation of revenues and/or overestimation of expenses To reduce the possibility of slack, management may wish to consider basing the budget on activities rather than costs. Activity-based budgets require an analysis of cost drivers and the relating of budget line items to activities performed. Activity budgeting is a new budget format whereby budget costs are arrayed according to the expected costs of activities rather than products, services or resources. These budgets can be motivational to those who use them because they are easy to understand and department managers can see the changes flow through them. They're user oriented. © 2007 by Nelson, a division of Thomson Canada Limited.

Ten Top Weaknesses of Traditional Budgeting 1. Does not provide a common language that supports common sense 2. Focuses on costs, not quality or time 3. Focuses on input (costs), not output 4. Does not link to the strategic plan 5. Does not identify levels of service 6. Does not identify root causes of costs 7. Focuses on function, not processes 8. Focuses on cuts, not continuous improvement 9. Does not identify work or workload 10. Does not identify or quantify waste © 2007 by Nelson, a division of Thomson Canada Limited.

Ten Top Advantages of Activity-Based Budgeting 1. Uses a common (verb + noun) activity language 2. Focuses on activity cost, time, and quality 3. Focuses on activity input and output 4. Strategic goals are linked to the activity's cost, time, and quality 5. Focuses on required versus discretionary activity output 6. Aids in identifying the cost drivers of activities and processes 7. Focuses on functional activities and business processes 8. Focuses on the unending improvement of activity output 9. Focuses on activity output 10. Quantifies nonvalue-added activity costs © 2007 by Nelson, a division of Thomson Canada Limited.

Continuous Budgets A continuous (or rolling) budget is an ongoing twelve- month budget that adds a new budget month (twelve months into the future) as each current month expires. Continuous budgets make the planning process less sporadic and disruptive. Rather than going into the budget period at a specific point in time, managers are continuously involved in planning and budgeting. Continuous budgets also provide a longer-range focus so that no surprises occur at year-end. © 2007 by Nelson, a division of Thomson Canada Limited.

Implementation and Control Budget implementation means that the budget is now considered a standard against which performance can be measured. Once the budget is implemented, the control phase begins. Control includes making actual-to-budget comparisons, determining variances, providing feedback to operating managers, investigating the causes of the variances, and taking any necessary corrective action. This control process indicates the cyclical nature of budgeting. Feedback (both positive and negative) is essential to the control process and must be provided in a timely manner to be useful. © 2007 by Nelson, a division of Thomson Canada Limited.

Nature of the Budgeting Process Actual Performance Compared to Feedback and discussion of causes Changes, if necessary, implemented Determination of variances © 2007 by Nelson, a division of Thomson Canada Limited.

The Budget Manual • Statements of the budgeting purpose and its desired results • A listing of specific budgetary activities to be performed • A calendar of scheduled budgetary activities • Sample budget forms • Original, revised, and approved budgets Budget Manual – a detailed set of documents that provides information and guidelines about the budgetary process © 2007 by Nelson, a division of Thomson Canada Limited.

Preparing Flexible Budgets A flexible budget is a series of financial plans detailing the individual cost factors that comprise total cost and presents those costs at different levels of activity. A flexible budget is simply a formula (y = a + bx)* that permits the budgeted costs to be determined for any activity level within the relevant range. This formula is the equation for calculating the slope of the line. Using a flexible budget allows the performance at one activity level to be compared to a budget at the same activity level. © 2007 by Nelson, a division of Thomson Canada Limited. * y = total cost; a = fixed costs; b = variable cost rate; x = volume

Preparing Flexible Budgets Activity levels shown on a flexible budget usually cover management's contemplated range of activity for the upcoming period. If all activity levels are within the relevant range, costs at each successive level should equal the amount of the previous level plus a uniform dollar increment for each variable cost factor. The increment is the variable cost per unit of activity multiplied by the quantity of additional activity. © 2007 by Nelson, a division of Thomson Canada Limited.

Preparing Flexible Budgets At Basic Black Ltd., the budget (static budget) has been developed for the cutting department for the month of November. Expected production is 4,000 units. Direct material $8,000 Direct labour 9,200 Manufacturing Overhead Indirect material 1,000 Indirect labour 800 Utilities 400 Depreciation 6,400 $600 of the indirect labour is fixed, as is $200 of the utilities and 6,400 of the depreciation. These items occur on a monthly basis. Using this information, we can prepare a flexible budget for 3,500 units, 4,000 units, and 4,500 units. © 2007 by Nelson, a division of Thomson Canada Limited.

Basic Black Ltd. Flexible Budget Units3,500 4,000 4,500 Direct material $ 7,000 $ 8,000 $ 9,000 Direct labour 8,050 9,200 10,350 Manufacturing overhead Indirect material 875 1,000 1,125 Indirect labour 775 800 825 Utilities 375 400 425 Depreciation 6,4006,4006,400 Total $23,475 $25,800 $28,125 Indirect labour costs = $600 + $0.05X* Utilities cost = $200 + $0.05X *($775 - $600) ÷ 3,500 = $0.05 Flexible budgets permit comparisons to actual events; managers can make valid budget-to-actual cost comparisons to determine if total variable costs were properly controlled. © 2007 by Nelson, a division of Thomson Canada Limited.

Preparing Flexible Budgets An Example Faber Ltd. planned to sell 12,000 units of Product C. However, management wanted to see what would happen to profits if they sold only 11,000 units. What would happen if they could sell 13,000 units? © 2007 by Nelson, a division of Thomson Canada Limited.

Static Budget Variances - Product C The product manager for Product C was dismayed at the unfavourable revenue variance. However, she was pleased that cost variances were favourable. The Marketing Manager was less impressed with costs. He asked you to prepare flexible budget variances. © 2007 by Nelson, a division of Thomson Canada Limited.

What Factors Might Cause Costs to Differ? • Inflation • Technological Advances • Supply and Demand • Tax or regulatory adjustments • Number of competitors • Seasonality or other timing factors • Quantity purchased © 2007 by Nelson, a division of Thomson Canada Limited.

Total Revenue Variance Budgeted Sales (BSP x BV) Actual sales (ASP x AV) Total Revenue Variance* ASP = actual selling price AV = actual volume BSP = budgeted selling price BV = budgeted volume © 2007 by Nelson, a division of Thomson Canada Limited. *favourable or unfavourable

Sales Price Variance BSPx AV ASP x AV BSP x BV Sales Price Variance AV (ASP - BSP) * Sales price variance – the difference between actual and budgeted selling prices multiplied by the actual number of units sold © 2007 by Nelson, a division of Thomson Canada Limited. *favourable or unfavourable

Sales Volume Variance BSP x AV ASP x AV BSP x BV Sales Volume Variance BSP (AV - BV) * Sales volume variance – the difference between actual and budgeted volumes multiplied by the budgeted selling price © 2007 by Nelson, a division of Thomson Canada Limited. *favorable or unfavourable

Example The Maritime Lobsters budget 2008 ticket sales at $70,000 per home game, which represents the sale of an estimated 10,000 tickets at a selling price of $7. At July’s first home game, actual gate ticket revenue was $66,000, creating a total unfavourable revenue variance of $4,000. The actual sales consisted of 12,000 tickets at $5.50. © 2007 by Nelson, a division of Thomson Canada Limited.

Variance Calculations Total Revenue Variance equals: $70,000 - ($5.50 x 12,000) = $4,000 U Sales Price Variance equals: 12,000 x ($5.50 - $7.00) = $18,000 U Sales Volume Variance equals: $7.00 x (12,000 - 10,000) = $14,000 F © 2007 by Nelson, a division of Thomson Canada Limited.

Analyzing Cost Variances Costs should be analyzed in relation to the actual volume of sales rather than the budgeted volume of sales. This requires the use of flexible budgets and flexible budget formulas (looking at costs and revenues at different sales and production levels). Assume that the Maritime Lobsters have a budget formula for selling expenses of $200 per game plus 5% of sales dollars. The original selling expense budget estimate for this game would have been $3,700 [$200 + (10,000 x $7.00 x 0.05)]. However, at a sales level of $66,000, they should expect selling expenses to be only $3,500 [$200 + (12,000 x $5.50 x 0.05)]. If actual selling expenses were $3,700, the team did not perform up to expectations; it should recognize a $200 unfavourable variance for selling expenses. © 2007 by Nelson, a division of Thomson Canada Limited.

Analyzing Cost Variances Managers also need to analyze the ways in which money was spent. Spending analysis should focus on individual line items, not just the totals, and on spending within categories. In some cases, money is spent simply because it is available for spending – not because there was a need for spending. To determine the underlying reasons for variances requires that comparisons be made as early as possible. Delaying variance computations until the end of a period may impede a manager's ability to detect and control variance causes. © 2007 by Nelson, a division of Thomson Canada Limited.

The Budgeting Process