Budgeting & Profit Planning

1. November 19, 2015 Budgeting & Profit Planning

2. November 19, 2015 • What is a budget • Why and how organizations budget • Budgeting • Sales • Production • Sales & Administration • Balance Sheet Budget Items • Working Capital • Capital Equipment • Financing • Financial Statements

3. Budget • A budget is a detailed quantitative plan for acquiring and using financial and other resources over a specified forthcoming time period • Its purpose is to plan for the future and control behaviour and costs • Planning to prepare for objectives and setting out a framework to achieve the objectives • Providing incentives to managers to achieve the objectives • Control by holding people to account with respect to their objectives • Cost control • Revenue generation

4. Planning – involves developing objectives and preparing various budgets to achieve those objectives. Control– involves the steps taken by management to increase the likelihood that the objectives set down while planning are attained and that all parts of the organization are working together toward that goal. Planning and Control

5. Advantages of Budgeting • The budgeting process forces managers to think through a plan from their perspective • It provides a forum for people to interact and determine how to best allocate limited resources • Defines a set of consistent goals and objectives • Communicated throughout the organization for common understanding and cooperation • The budget provides a document against which to measure performance

6. Factors in Budgeting • There are a number of human factors in budgeting: • Requires the full support and commitment from senior management • People who are engaged in the process are more likely to support it • Managers and executives need to be reasonable • Managers may feel they should lower their own targets to reduce expectations • Executives may feel they should pressure managers to unachievable levels • Be reasonable (set budgets for different audiences) – Board, Fall-back, Management Incentive, Stretch • Work to root out personal ambitions

7. Managers should be held responsible for those items - and only those items - that they can actually control to a significant extent. Responsibility Accounting • It is unreasonable and de-motivating to be held accountable for something beyond your control.

8. Self-Imposed Budget A participative budget is prepared with the full cooperation and participation of managers at all levels. A participative budget is also known as a self-imposed budget.

9. Advantages of Self-Imposed Budgets • Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top management. • Budget estimates prepared by front-line managers are often more accurate than estimates prepared by top managers. • Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. • A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Self-imposed budgets eliminate this excuse.

10. Self-Imposed Budgets Self-imposed budgets should be reviewed by higher levels of management to prevent “budgetary slack.” Most companies issue broad guidelines in terms of overall profits or sales. Lower-level managers are directed to prepare budgets that meet those targets.

11. Choosing the Budget Period Operating Budget 2011 2012 2013 2014 Operating budgets ordinarily cover a one-year period corresponding to a company’s fiscal year. Many companies divide their annual budget into four quarters. A continuous budget is a12-month budget that rollsforward one month (or quarter)as the current month (or quarter)is completed.

12. Managing the Budgeting Process • Usually driven by the CFO • Establishes a leadership team • Builds up the data through meetings with all profit and cost centers • Note: The system (ABC, Process Costing, Account mapping) is already assumed to have been done by this time

13. Key Budget Segments • There are a few critical budget segments to get in place • Each organization may have its own twists to the approach • Sales Budget • Production Budget • Direct Labour, Direct Materials, Manufacturing Overhead • Selling, General and Administration • Working Capital Budget • Capital Budget • With the assumptions in these budgets in place, full cash flow, income statement and balance sheet plans can be published

14. The Master Budget: An Overview Sales budget Selling and administrative expense budget Endinginventory budget Production budget Direct labor budget Direct materials budget Manufacturing overhead budget Cash budget Budgetedincomestatement Budgetedbalancesheet

15. Sales Budget • Understand your market • Size, growth rate, market share • Cyclicality, seasonality • Competitive position for each product/service • New entrant, established player • Put forward and discuss a reasonable matrix of targets for the circumstances • This budget proposes no price increases • 10% growth in Motorbike sales • 5% growth in car sales • no seasonality • What might this quarterly budget look like?

16. Sales Budget • After discussions with the sales team, we would look to have them sign off on the final version • Commissions would be put in place • To incentivize them to meet the targets • To ensure they emphasize the products with the highest contribution • Consider when accounts will be collected – Days Accounts Receivable will impact cash planning & financing requirements

17. The Production Budget Sales BudgetandExpectedCashCollections Production Budget Completed The production budget must be adequate to meet budgeted sales and to provide for the desired ending inventory.

18. Production Budget • The Production Budget must deliver the final product committed to in the Sales Budget, in the time frame it calls for

19. Production Budget • Production budgets can be complex • There would of course be build ups behind each of the accounts • Direct Labour – based on units of labour per production unit • Direct Materials - ““ material “ • Manufacturing Overhead • Fixed and Variable • Furthermore, there are production lead times to be managed • Long lead time parts can constrain production • Inflation, expected pay hikes, etc. will also impact each cost function • As there were challenges to the sales force, there may be challenges in production to reduce cost, defects, inventory • Finally, timing of cash outlays – Days Accounts Payable – will impact cash planning & financing requirements

20. Sales & Administration Budget • The Sales & Administration budget must support the level of business activity planned in the Sales Budget and Production Budget • Sales are budgeted to increase 5%-10% • Bad economic climate calls for challenges • Do not increase spending from last year unless unavoidable • Carry on with same level of advertising and promotion • Non-discretionary variable costs must increase with sales • Obtain sign off from those in control of these costs • Develop a compensation structure that rewards being within budget

21. Sales & Administration Budget • Sales & Administration Budget • If the promotional campaign supporting the increase in sales, cost $150 million, was it justified?

22. Sales & Administration Budget • Promotional campaign analysis • Task marketing group to forecast incremental sales • $488m • Break even ($ sales) = fixed cost / contribution margin (%) • Fixed cost ? • Contribution margin • (Sales less Variable Costs) / Sales • Sales: $7,238 • Variable Costs: $3,798 • Total absorption costs: $3,398 • The campaign is justified as it supports incremental sales of much more than $320 million required to cove the cost

23. Sales & Administration Budget • Promotional campaign analysis • Break even ($ sales) = fixed cost / contribution margin (%) • The campaign is justified as it supports incremental sales of much more than $320 million required to cove the cost

24. Sales & Administration Budget • Sales Budget, Production Budget and Sales & Administration Budget in place • We can exhibit the Operating Profit and Cash Flow from Operations • Budget forecasts ~$1.5 billion Operating Profit • 21% Operating Margin

25. Review • We are working towards building a Cash Budget and Financial Statements, including a Cash Flow Statement • Cash Flow Statements have different categories of sources and uses of cash • Cash Flow from Operations • Sales Budget • Production Budget • S&A Budget • Cash Flow from Changes in Working Capital • Balance Sheet Budget • Cash Flow from Investing Activities • Balance Sheet Budget

26. Balance Sheet Budget • Working Capital Assumptions • Can be made at very detailed or high level • Try to balance for practicality • Accounts Receivable • Assume # of days sales outstanding • Challenge collections department to get cash in earlier • Inventory • Forecast demand • Assume # of days COGS outstanding • Accounts Payable (including payroll) • Payroll is under corporate control – eg pay every 30 days • Assume # days of Direct Materials and other outstanding • Other (Prepaid assets; Accrued liabilities) • Similar methodologies can be applied

27. Balance Sheet Budget • Balance Sheet Model • We have run the assumptions (from sales straight through to these balance sheet assumptions). Assume opening balances as given • We learn there will be a requirement for cash of $57 million in the first quarter • This is required to fund increased A/R and inventory from sales growth

28. Balance Sheet Budget – Working Capital • Accounts Receivable ($ balance) • Sales / 365 * # of days it takes to collect AR • # of Days Sales in AR • AR balance / Sales * 365 • Accounts Payable ($ balance) • COGS/365 * # of days before the company pays AP • # of Days COGS in AP • AP balance / COGS * 365 • Inventory $ balance • COGS/365 * # of days in inventory held • # of Days COGS in Inventory • Inventory balance / COGS * 365

29. Balance Sheet Budget • Investments/Capital assumptions • By investment, we primarily mean Property, Plant & Equipment • As with Working Capital, can be made at very detailed or high level • Organizations will have detailed asset schedules, including depreciation • Decisions to purchase assets are based upon a number of factors • Capacity utilization • Forecast volume • Financing • For our purposes, we will assume the following: • Factory capacity is at 80% - no need to expand • Machinery & Equipment is at full capacity and must be increased in proportion to sales • Depreciation on new M&E flows through Variable Manufacturing Overhead

30. Balance Sheet Budget • Balance Sheet Model – Capex • We learn there will be a requirement for cash of $12 million in the first quarter • This is required to fund increased machinery and equipment to produce the incremental volume

31. Financial Statements • Final budgeted Income and Cash Flow Statements

32. Financial Statements • Final budgeted Balance Sheet

33. Review • What is a budget • Why and how organizations budget • Budgeting • Sales • Production • Sales & Administration • Balance Sheet Budget Items • Working Capital • Capital Equipment • Financing • Financial Statements

34. Tutorial • Balance Sheet forecasting • 3 years • Apply working capital ratios for forecast balances