Using Budgets for Planning and Coordination

Resource Flexibility • For decisions affecting the short-term, the firm’s capacity-related costs are considered as given and fixed • The supply of capacity resources is based on the amount needed to produce the projected volume of product • The budgeting process makes clear that some resources, once acquired, cannot be disposed of easily if demand is less than expected © 2012 Pearson Prentice Hall. All rights reserved.

The Budgeting Process • The process that determines the planned level of the most flexible costs • Budgeting also includes discretionary spending such as for R&D, advertising, and employee training • These do not supply the firm with capacity but they do provide support for the organization’s strategy by enhancing its performance potential • Once authorized, discretionary spending budgets are committed or fixed; they do not vary with level of production or service © 2012 Pearson Prentice Hall. All rights reserved.

The Budgeting Process • Budgets serve as a control for managers within the business units of an organization • Budgets play a central role in the relationship between planning and control • Budgets reflect in quantitative terms how to allocate financial resources to each part of an organization, based on the planned activities and short-run objectives of that part of the organization © 2012 Pearson Prentice Hall. All rights reserved.

The Budgeting Process • A budget is a quantitative expression of the money inflows and outflows that reveal whether a financial plan will meet organizational objectives • Budgeting is the process of preparing budgets • Budgets provide a way to communicate the organization’s short-term goals to its members © 2012 Pearson Prentice Hall. All rights reserved.

The Budgeting Process • Budgeting the activities of each unit can • Reflect how well unit managers understand the organization’s goals • Provide an opportunity for the organization’s senior planners to correct misperceptions about the organization’s goals • Budgeting also serves to coordinate the many activities of an organization © 2012 Pearson Prentice Hall. All rights reserved.

The Budgeting Process • Budgets help to anticipate potential problems • Budgeting reflects the cash cycle and provides information anticipate borrowing needed to finance the inventory buildup early in the cash cycle • If budget planning indicates that the organization’s sales potential exceeds its manufacturing potential, then the organization can develop a plan to put more capacity in place or to reduce planned sales © 2012 Pearson Prentice Hall. All rights reserved.

Forecasting Demandfor Resources • Budgeting involves forecasting the demand for four types of resources over different time periods: • Flexible resources that create variable costs • Intermediate-term capacity resources that create capacity-related costs • Resources that, in the intermediate and long run enhance the potential of the organization’s strategy • Long-term capacity resources that create capacity-related costs © 2012 Pearson Prentice Hall. All rights reserved.

Master Budget • Two major types of budgets comprise the master budget: • Operating budgets—summarize the level of activities such as sales, purchasing, and production • Financial budgets—identify the expected financial consequences of the activities summarized in the operating budgets © 2012 Pearson Prentice Hall. All rights reserved.

Operating Budgets • Sales plan—identifies the planned level of sales for each product • Capital spending plan—specifies the long-term capital investments that must be paid in the current budget period to meet activity objectives • Production plan—schedules all required production • Materials purchasing plan—schedules all required purchasing activities © 2012 Pearson Prentice Hall. All rights reserved.

Operating Budgets • Labor hiring and training plan—specifies the number of people the organization must hire or release to achieve its activity objectives • Administrative and discretionary spending plan—includes administration, staffing, research and development, and advertising © 2012 Pearson Prentice Hall. All rights reserved.

Operating Budgets • Operations personnel use the operating budget to guide and coordinate the level of various activities during the budget period • Operations personnel also record data from current operations that can be used to develop future budgets © 2012 Pearson Prentice Hall. All rights reserved.

Financial Budgets • Planners prepare the financial budgets to evaluate the financial consequences of investment, production, and sales plans • Planners use the projected statement of cash flows in two ways: • To plan when excess cash will be generated • To plan how to meet any cash shortages © 2012 Pearson Prentice Hall. All rights reserved.

Demand Forecast • An organization’s goals provide the starting point and the framework for evaluating the budgeting process • Comparison of the tentative operating plan’s projected financial results with the organization’s financial goals • Influence of the demand forecast © 2012 Pearson Prentice Hall. All rights reserved.

Developing the Demand Forecast • Organizations develop demand forecasts in many ways: • Market surveys • Statistical models • Assume that demand will either grow or decline by some estimated rate over previous demand levels • Require a sales plan for each key line of goods and services © 2012 Pearson Prentice Hall. All rights reserved.

Importance of Sales Plans • The sales plans provide the basis for other plans to acquire the necessary factors of production: • Labor • Materials • Production capacity • Cash © 2012 Pearson Prentice Hall. All rights reserved.

Level of Detail in Budget • Choosing the amount of detail to present in the budget involves making trade-offs: • More detail in the forecast improves the ability of the budgeting process to identify potential bottlenecks and problems by specifying the exact timing of production flows • Forecasting and planning in great detail for each item can be extremely expensive and overwhelming to compute © 2012 Pearson Prentice Hall. All rights reserved.

Level of Detail in Budget • Production planners use their judgment to strike a balance between • The need for detail • The cost and practicality of detailed scheduling • Planners do this by grouping products into pools © 2012 Pearson Prentice Hall. All rights reserved.

The Production Plan • Planners determine a production plan by matching the completed sales plan with the organization’s inventory policy and capacity level • The plan identifies the intended production during each of the interim periods comprising the annual budget period © 2012 Pearson Prentice Hall. All rights reserved.

Inventory Policy • The inventory policy is critical and has a unique role in shaping the production plan • One policy is to produce goods for inventory and attempt to keep a target number of units in inventory at all times • Characteristic of an organization with highly skilled employees or equipment dedicated to producing a single product • Reflects a lack of flexibility © 2012 Pearson Prentice Hall. All rights reserved.

Inventory Policy • An alternative policy is to produce for planned sales in the next interim period within the budget period • Organizations moving toward a just-in-time inventory policy produce goods to meet the next interim period’s demand as an intermediate step in moving to a full just-in-time inventory system • Each interim period becomes shorter and shorter until the organization achieves just-in-time production • The scheduled production is the amount required to meet the inventory target of the level of the next interim period’s planned sales © 2012 Pearson Prentice Hall. All rights reserved.

Inventory Policy • Just-in-time (JIT) inventory policy: • Demand directly drives the production plan • Production in each interim period equals the next interim period’s planned sales • JIT requires: • Flexibility among employees, equipment, and suppliers • A production process with little potential for failure © 2012 Pearson Prentice Hall. All rights reserved.

Aggregate Planning • Aggregate planning compares: • The production plan • The amount of available productive capacity • Assesses the feasibility of the proposed production plan © 2012 Pearson Prentice Hall. All rights reserved.

The Spending Plan • Once planners identify a feasible production plan, they may make tentative resource commitments • The purchasing group prepares a plan to acquire the required raw materials and supplies • Because sales and production plans change, the organization and its suppliers must be able to adjust their plans quickly based on new information © 2012 Pearson Prentice Hall. All rights reserved.

The Spending Plan • The personnel and production groups prepare the labor hiring and training plans • When an organization is contracting, it will: • Use retraining plans to redeploy employees to other parts of the organization, or • Develop plans to discharge employees © 2012 Pearson Prentice Hall. All rights reserved.

The Spending Plan • Discretionary expenditures provide the required infrastructure for the proposed production and sales plan • “Discretionary” means the actual sales and production levels do not drive the amount spent • The senior managers in the organization determine the amount of discretionary expenditures • Once determined, the amount to be spent on discretionary activities becomes fixed for the budget period and is unaffected by product volume and mix © 2012 Pearson Prentice Hall. All rights reserved.

The Spending Plan • A long-term planning process rather than the one-year cycle of the operating budget drives the capital spending plan • Capital spending projects usually involve time horizons longer than the period of the operating budget © 2012 Pearson Prentice Hall. All rights reserved.

Choosing Capacity Levels • Three types of resources determine capacity: • Flexible resources that the organization can acquire in the short term • Capacity resources that the organization must acquire for the intermediate term • Capacity resources that the organization must acquire for the long term © 2012 Pearson Prentice Hall. All rights reserved.

Choosing Capacity Levels • Organizations develop sophisticated approaches to balance the use of short-, intermediate-, and long-term capacity to minimize the waste of resources • Three types of resource-consuming activities: • Activities that create the need for resources (and resource expenditures) in the short-term • Activities undertaken to acquire capacity for the intermediate-term • Activities undertaken to acquire capacity needed for the long-term © 2012 Pearson Prentice Hall. All rights reserved.

Choosing Capacity Levels • Analysts evaluate short-term activities by considering efficiency and asking: • Is this expenditure necessary to add to the product value perceived by customers? • Can the organization improve how it does this activity? • Would changing the way this activity is done provide more satisfaction to the customer? • The production plan fixes the short-term expenditures that the master budget summarizes © 2012 Pearson Prentice Hall. All rights reserved.

Choosing Capacity Levels • Analysts evaluate intermediate- and long-term activities by using efficiency and effectiveness considerations and asking: • Are there alternative forms of capacity available that are less expensive? • Is this the best approach to achieve our goals? • How can we improve the capacity selection decision to make capacity less expensive or more flexible? • The capacity plan commits the firm to its intermediate- and long-term expenditures © 2012 Pearson Prentice Hall. All rights reserved.

Handling Infeasible Production Plans • Planners use forecasted demand to plan activity levels and provide required capacity • If planners find the tentative production plan infeasible, then they have to make provisions to: • Acquire more capacity, or • Reduce the planned level of production © 2012 Pearson Prentice Hall. All rights reserved.

Interpreting the Production Plan • Production is the lesser of: • Total demand • Production capacity • Demand is the quantity customers are willing to buy at the stated price • Production capacity is the minimum of: • The long-term capacity • The intermediate-term capacity • The short-term capacity © 2012 Pearson Prentice Hall. All rights reserved.

The Financial Plans • Financial summary of the tentative operating plans • The projected balance sheet serves as an overall evaluation of the net effect of operating and financing decisions during the budget period • The projected income statement serves as an overall test of the profitability of the proposed activities • The projected cash flow forecast helps an organization identify if and when it will require external financing © 2012 Pearson Prentice Hall. All rights reserved.

The Cash Flow Statement • The cash flow statement has three sections: • Cash inflows from cash sales and collections of receivables • Cash outflows • For flexible resources that are acquired and consumed in the short term • For capacity resources that are acquired and consumed in the intermediate and long term • Results of financing operations © 2012 Pearson Prentice Hall. All rights reserved.

Financing Operations • Summarizes the effects on cash of transactions that are not a part of the normal operating activities • Includes the effects of: • Issuing or retiring stock or debt • Buying or selling capital assets • Short-term financing © 2012 Pearson Prentice Hall. All rights reserved.

Using the Financial Plans • Organizations can raise money from outsiders by borrowing from banks, issuing debt, or selling shares of equity • Organizations can plan the appropriate mix of external financing to minimize the long-run cost of capital © 2012 Pearson Prentice Hall. All rights reserved.

Using the Financial Plans • A cash flow forecast helps an organization • Identify if and when it will require external financing • Determine whether any projected cash shortage will be: • Temporary or cyclical • Permanent © 2012 Pearson Prentice Hall. All rights reserved.

What If Analysis • Explore the effects of alternative marketing, production, and selling strategies • Alternative proposals like these can be evaluated in a what-if analysis • The structure and information required to prepare the master budget can be used easily to provide the basis for what-if analyses © 2012 Pearson Prentice Hall. All rights reserved.

Sensitivity Analysis • What-if analysis is only as good as the model used to represent what is being evaluated • Planners test planning models by varying the model estimates • If small changes in an estimate used in the production plan have a dramatic effect on the plan, the model is said to be sensitive to that estimate © 2012 Pearson Prentice Hall. All rights reserved.

Sensitivity Analysis • Sensitivity analysis is the process of selectively varying a plan’s or a budget’s key estimates for the purpose of identifying over what range a decision option is preferred • Sensitivity analysis enables planners to identify the estimates that are critical for the decision under consideration © 2012 Pearson Prentice Hall. All rights reserved.

Variance Analysis • Variance analysis—comparison of planned (or budgeted) results with actual results • Variance analysis has many forms and can result in complex measures, but its basis is very simple: actual cost (or revenue) amount is compared with a target cost (or revenue) amount to identify the difference © 2012 Pearson Prentice Hall. All rights reserved.

Variance Analysis • Variance—difference between planned and actual results • Should be investigated to determine: • What caused the variance • What should be done to correct that variance © 2012 Pearson Prentice Hall. All rights reserved.

Sources of Budgeted Costs • Budgeted or planned costs can come from three sources: • Standards established by industrial engineers • Previous period’s performance • A benchmark—the best in class results achieved by a competitor © 2012 Pearson Prentice Hall. All rights reserved.

Variances • The financial numbers are the product of a price and a quantity component: • Budgeted amount = expected price * expected quantity • Actual amount = actual price * actual quantity • Variance analysis explains the difference between planned and actual costs by evaluating: • Differences between planned and actual prices • Differences between planned and actual quantities © 2012 Pearson Prentice Hall. All rights reserved.

Variances • Accountants focus separately on prices and quantities because in most organizations: • One department or division is responsible for the acquisition of a resource and determining the actual price • A different department uses the resource and determining the quantity • A variance is a signal that is part of a control system for monitoring results © 2012 Pearson Prentice Hall. All rights reserved.

Variances • Supervisory personnel use variances as an overall check on how well employees managing day-to-day operations are performing • When compared to the performance of other organizations engaged in comparable tasks, variances show the effectiveness of the control systems that operations © 2012 Pearson Prentice Hall. All rights reserved.

Variances • If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future • If the factors causing actual costs to be higher than expected can be identified, then actions may be taken to prevent those factors from recurring in the future • If cost changes are likely to be permanent, cost information can be updated for future jobs © 2012 Pearson Prentice Hall. All rights reserved.

First-Level Variances • The first-level variance for a cost item is the difference between the actual costs and the master budget costs for that cost item • Variances are favorable (F) if the actual costs are less than estimated master budget costs • Unfavorable (U) variances arise when actual costs exceed estimated master budget costs © 2012 Pearson Prentice Hall. All rights reserved.

Using Budgets for Planning and Coordination