BUDGETING BASICS AND BEYOND (4 th Edition) Jae K. Shim Joel G. Siegel Allison I. Shim

1. BUDGETING BASICS AND BEYOND (4th Edition) Jae K. Shim Joel G. Siegel Allison I. Shim

2. CHAPTER 1 The What and Why of Budgeting: An Introduction

3. Budget? A budget is defined as the formal expression of plans, goals, and objectives of management that covers all aspects of operations for a designated time period A budget is a financial plan to control future operations and results

4. Effective Budgeting Effective budgeting requires the existence of the following: Predictive ability Clear channels of communication, authority, and responsibility Accounting-generated accurate, reliable, and timely information Compatibility and understandability of information Support at all levels of the organization from upper, middle, and lower

5. Types of Budgets • Master Budget • Static (Fixed) Budget • Flexible (Expense) Budget • Operating and Financial Budgets • Cash Budget • Capital Expenditure Budget • Program Budget • Incremental Budget • Rolling Budget • Add-On Budget • Supplemental Budget • Bracket Budget • Stretch Budget • Strategic Budget • Activity-Based Budget (ABB) • Target Budget • Probabilistic Budget • Life-cycle budget

6. The Budgetary Process Setting objectives. Analyzing available resources. Negotiating to estimate budget components. Coordinating and reviewing components. Obtaining final approval. Distributing the approved budget.

7. Actual Costs vs. Budget Costs At the beginning of the period, the budget is a plan. At the end of the period, the budget is a control instrument to assist management in measuring its performance against plan so as to improve future performance. Budgeted revenue and costs are compared to actual revenue and costs to determine variances

8. Budget Issues Bottom-up (Participative) versus Top-down Advantages and Disadvantages of Budgets Budgetary Slack: Padding the Budget

9. CHAPTER 2 STRATEGIC PLANNING AND BUDGETING: process, preparation, and control

10. Planning and Budgeting? Planning should link short-term, intermediate-term, and long-term goals. The objective is to make the best use of the companies’ available resources over the long term. Budgeting is simply one portion of the plan. The plan is the set of details implementing the strategy. The plan of ex­ecution is typically explained in sequential steps including costs and timing for each step. Deadlines are set.

11. Strategic Planning Strategic plans are long-term, broad plans ranging from 2 to 30 years, with 5 to 10 years being most typical The strategic plan is the mission of the company and looks to existing and prospective products and markets. Strategic plans are designed to direct the company’s activities, priorities, and goals.

12. Short-term and Long-term Plans Short-range plans are typically for one year (although some plans are for two years). The plans examine expected earnings, cash flow, and capital expenditures Long-term planning is usually of a broad, strategic (tactical) nature to accomplish objectives. A long-term plan is typically 5-10 years (or more) and looks at the future direction of the company. It also considers economic, po­litical, and industry conditions

13. Budget Accuracy The accuracy of budget preparation may be determined by comparing actual numbers to budget numbers in terms of dollars and units. Budget accuracy is higher when the two figures are closer to each other. Ratios showing budget accuracy include: Sales Accuracy = Actual Sales/Budgeted Sales Cost Accuracy = Actual Cost/Budgeted Cost Profit Accuracy = Actual Profit/Budgeted Profit

14. CHAPTER 3 ADMINISTERING THE BUDGET: REPORTS, ANALYSES, AND EVALUATIONS

15. Types of Reports Planning reports may be short term, looking at the company as a whole, each division, each department, and each responsibility center within the department Control reports concentrate on performance effectiveness and areas needing improvement. Information reports assist in planning and policy formulation. The re­ports show areas of growth or contraction

16. More on Reports Budget reports should contain the following data: Trends over the years Comparison to industry norms Comparison of actual to budget with explanation and responsible party for variances. Follow-up procedures are needed for control.

17. More Report Types Periodic Reports. These are reports prepared at regular intervals Advance Reports. Important partial information may be reported before all information is available for a periodic report Special Studies. Special reports are issued for a specific, nonroutine purpose

18. The Budget Manual A budget manual describes how a budget is to be prepared. The manual includes: Standardized forms, lists, and reports Instructions Format and coverage of performance reports Administrative details Follow-up procedures

19. The Budget Sheet A budget sheet should be designed to record the information used by the op­erating manager and budget preparer. The budgeting sheet should include the following information: Historical cost records used Cost formulas Changes in operating conditions Foreseeable conditions

20. The Budget Committee A standing budget committee is usually responsible for overall policy relating to the budget program and for coordinating the preparation of the budget itself. This committee may consist of the president; vice presidents in charge of various functions such as sales, production, purchasing, CFO, and the controller.

21. Budget Calendar The budget planning calendar is the schedule of activities for the development and adoption of the budget. It should include a list of dates indicating when specific information is to be provided by each information source to others.

22. CHAPTER 4 Break-even and Contribution Margin Analysis: Profit, Cost, and Volume Changes

23. Questions Answered by Break-even and Contribution Margin Analysis What sales volume is required to break even? What sales volume is necessary to earn a desired profit? What profit can be expected on a given sales volume? How would changes in selling price, variable costs, fixed costs, and output affect profits? How would a change in the mix of products sold affect the break-even and target income volume and profit potential?

24. Applications of the CVP Model Economic analysis of new product. Labor contract negotiations. Choice of production process. Pricing policy. Location selection. Financing decisions. Make or buy decision Capital budgeting analysis.

25. Some Applications of Contribution Margin Analysis and “What-If” Analysis Sales Mix Analysis Contribution Margin Analysis and Nonprofit Organizations CVP Analysis with Step-function Costs CVP-based Strategies CVP Analysis under Uncertainty

26. Assumptions Underlying Break-even and Contribution Margin Analysis The selling price per unit is constant throughout the entire relevant range of activity. All costs are classified as fixed or variable. The variable cost per unit is constant. There is only one product or a constant sales mix. Inventories do not change significantly from period to period. Volume is the only factor affecting variable costs.

27. CHAPTER 5 PROFIT PLANNING: TARGETING AND REACHING ACHIEVABLE GOALS

28. Profit Planning Profits are planned, they just do not happen. Profit planning involves setting realistic and attainable profit objectives and targets, and then accomplishing them

29. Objectives in the Profit Plan The objective must be definite and specific An objective states what is going to be done. The objective must be clear, quantifiable, compatible, practical, strong, realistic, and attainable (not too easy or too difficult). A general and vague objective is of little value. The objective should be in writing

30. CHAPTER 6 MASTER BUDGET: GENESIS OF FORECASTING AND PROFIT PLANNING

31. Master Budget Flowchart Structure

32. Master (Comprehensive) Budgeting Obviously these budgets cannot be prepared independently. Production is scheduled to meet the sales demand. Materials, labor, and factory overhead costs are related to production. Selling and administrative ex­penses are based on sales. Cash receipts and disbursements can be esti­mated only after sales revenue and costs are known. It is obvious that all of these separate budgets must be closely coordinated.

33. Sales Planning Compared with Forecasting Sales planning and forecasting often are confused. Although related, they have distinctly different purposes. A forecast is not a plan; rather it is a statement and/or a quantified assessment of future conditions about a particular subject (e.g., sales revenue) based on one or more explicit assumptions. A sales plan incorporates management decisions that are based on the forecast, other inputs, and management judgments about such related items as sales volume, prices, sales effects, production, and financing.

34. Types of Budgets • Sales budget • Production budget • Materials requirement budget • Materials purchases budget • Direct labor budget • Factory overhead costs budget • Selling and administrative expenses budget • Cash budget • Budgeted income statement • Budgeted balance sheet

35. The Production Budget

36. CHAPTER 7 COST BEHAVIOR: EMPHASIS ON FLEXIBLE BUDGETS

37. An understanding of cost -behavior is helpful to managers for four reasons: An understanding of cost -behavior is helpful to managers for four reasons: Flexible budgeting Break-even and contribution margin analysis Appraisal of divisional performance Short-term choice decisions

38. Costs by Behavior VARIABLE COSTS. Variable costs, also known as engineered costs, vary in total with changes in volume or level of activity FIXED COSTS. Fixed costs do not change in total regardless of the volume or level of activity MIXED (SEMI-VARIABLE) COSTS. As previously discussed, mixed costs contain both a fixed element and a variable one.

39. Analysis of Mixed (Semi-variable) Costs Since the mixed costs contain both fixed and variable elements, the analysis takes the following mathematical form, which is called a flexible budget formula: Y = a + bX where Y = the mixed cost to be broken up (dependent variable). X = any given measure of activity (cost driver) such as direct labor hours, machine hours, or production volume (independent variable). a = the fixed cost component (constant). b = the variable rate per unit of X (slope).

40. The Contribution Income Statement An alternative format of income statement, known as the contribution incomestatement, organizes the costs by behavior rather than by function. It shows the relationship of variable costs and fixed costs a given cost item is associated with, regardless of the functions.

41. More on Contribution Income Contribution margin is available to cover fixed costs. The statement highlights the concept of contribution margin, which is the difference between sales and variable costs. The traditional format, on the other hand, emphasizes the concept of gross margin, which is the difference between sales and cost of goods sold.

42. CHAPTER 8 Evaluating performances: the use of VARIANCE ANALYSIS

43. Variances Variance analysis compares standard to actual costs or performances There are two types of variances: material and immaterial

44. Defining a Standard Cost Standard cost, which is the predetermined cost of manufacturing, servicing, or marketing an item during a given future period. It is based on current and projected conditions. This norm is also dependent upon quantita­tive and qualitative measurements (e.g., working conditions).

45. Setting Standards There are four types of standards Basic. These are not changed from period to period Maximum efficiency. These are perfect standards, which assume ideal, optimal conditions Currently attainable. These are based on efficient activity Expected. These are expected figures, which should come very close to actual figures

46. Cost Variances Three cost measures: Quantity per unit of work times actual units of work produced Standard cost equals standard price times standard quantity, where standard quantity equals standard quantity per unit of work times actual units of work produced. Total cost variance equals actual cost less standard cost

47. Flexible Budgets The flexible budget is geared toward a range of activities rather than a single level of activity. A flexible budget employs budgeted figures at different capacity levels. It allows you to choose the best expected (normal) capacity level (100%) and to assign pessimistic (80%), optimistic (110%), and full (150%) capacity levels

48. CHAPTER 9 MANUFACTURING COSTS: SALES FORECASTS AND REALISTIC BUDGETS

49. Manufacturing Cost Budgets • In order to budget for manufacturing costs, a production budget needs to be established, which in turn requires a sales budget. • Manufacturing costs are subdivided into direct materials, direct labor, and factory overhead.

50. Planning and Control of Material Purchases and Usage After determining the number of units to be produced, the company prepares the materials requirement budget and the materials purchase budget. Purchase of materials depends on production requirements and inventories. The direct materials budget involves a balancing of raw material needed for production, the raw material inventory balances, and the purchase of raw materials. The budget may provide for allowances for waste and spoilage.