Operational Budgeting

1. 11 C hapter Operational Budgeting Prepared by Douglas Cloud Pepperdine University

2. Objectives 1. Discuss why budgets are important. 2. Describe the basic approaches to budgeting. 3. Develop an activity-based budget. 4. Explain the interrelationships between the elements of a master budget and develop a basic budget. 5. Discuss the interrelationship between budget development and human behavior. After studying this chapter, you should be able to:

3. General Approach to Budgeting 1. Budgeting with unit level cost drivers 2. Budgeting with unit and nonunit level cost drivers

4. Reasons for Budgeting • Budgets compel planning • Budgets improve communication and coordination • Budgets provide a guide to action • Budgets provide a basis of performance

5. Some of the Characteristics of a Good Multi-User Budgeting System • Support changes to hierarchy to that different levels of budgets can be examined. • Shared access to common data warehouses. • Automatic mapping of imported data for use in multiple applications. • Lots of what-if commands.

6. In the output/inputapproachphysical inputs and costs are budgeted as a function of planned unit level activities. The incrementalapproachbudgets costs for a coming period as a dollar or percentage change from the amount budgeted for (or spent during) some previous period. Using the minimum levelapproach,an organization establishes a base amount for budget items and requires explanation or justification for any budgeted amount above the minimum (base).

7. Activity-Based Budgeting Atlantic Magnetic, Inc. Activity-Based Budget for Compact Disks For the Year Ending December 31, 2004 Unit level costs: Direct materials $180,000 Assembly 245,000 Packaging 380,000 Distribution 60,000 $ 865,000 Continued

8. Activity-Based Budgeting Batch level costs: Procurement $ 30,000 Setup 80,000 Inspection 70,000 $ 180,000 Product level costs: Development and design $ 50,000 Product advertising 120,000 170,000 Total product costs $1,215,000

9. Activity-Based Budgeting Atlantic Magnetic, Inc. Activity-Based Budget for Purchasing Dept. For the Year Ending December 31, 2004 Budgeted activities: New vendors screened 130 Orders placed 1,200 Shipments received and inspected 1,400 Continued

10. Activity-based budgeting focuses on redesigning products or improving processes rather than simply cutting costs. Activity-Based Budgeting Budgeted costs: Vendor screening and quality certification (unit level per vendor) $ 30,000 Procurement (unit level per pur. order): Placing orders $50,000 Verifying orders 25,000 Receiving orders 16,000 Inspecting orders 8,000 99,000 General administration and maintenance (facility level) 25,000 Total purchasing department costs $154,000

11. The Master Budget The master budget groups all budgets and supporting schedules together and coordinates all financial and operational activities, placing them into an organization-wide set of budgets for a given time period. A major goal of developing a master budget is to ensure the smooth functioning of a business throughout the budget period and the organization’s operation cycle.

12. Purchases or merchandise function Collection Accts. Rec. Inven- tory Sales or Services Operating Cycle of a Manufacturing or Merchandising Operation Cash

13. General and Administrative Expense Budget Purchases Budget Selling Expense Budget Cash Budget Overview of Budget Assembly Process in a Merchandising Firm Sales Budget Continued

14. from Purchases, Selling Expense, and General and Administrative Expense Budgets from Sales Budget Pro Forma Statements: Income Statement and Balance Sheet Overview of Budget Assembly Process in a Merchandising Firm Cash Budget Other Special Budgets: Taxes, Dividends, Capital Improvements, etc.

15. Initial Balance Sheet Backpacks Galore, Inc. Balance Sheet December 31, 2004 Continued on next slide Assets Current assets: Cash $ 15,000 Accounts receivable (net) 21,600 Inventory School backpacks $ 50,000 Hiking backpacks 96,000 146,000 $182,600 Property and equipment: Land 60,000 Buildings and equipment 260,000 Less accum. depreciation 124,800 135,200 195,200 Total assets $377,800

16. Initial Balance Sheet Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 40,000 Stockholders’ equity: Capital stock $150,000 Retained earnings 187,800 337,800 Total liabilities and stockholders’ equity $377,800

17. The sales budget contains a forecast of unit sale volume and sale revenue. Sales Budget Backpacks Galore, Inc. Sales Budget For the Year Ending December 31, 2005 First Second Third Fourth Year QuarterQuarter QuarterQuarterTotal Sales (units); School backpacks 4,000 3,400 3,650 3,950 15,000 Hiking backpacks 1,100 1,600 2,500 1,300 6,500 Sales (dollars): School backpacks $ 80,000 $ 68,000 $ 73,000 $ 79,000 $300,000 Hiking backpacks 110,000 160,000 250,000 130,000 650,000 Total $190,000 $228,000 $323,000 $209,000 $950,000

18. Assumptions for Purchases Budget • Management desires to have all inventory needed to fill the following quarter’s sales in stock at the end of the previous quarter. • To provide for a possible delay in the receipt of inventory, BGI also carries a safety stock of 1,000 stock backpacks and 500 hiking backpacks. Continued

19. Assumptions for Purchases Budget • The total inventory needs are equal to current sales plus desired ending inventory, including the safety stock. • Budgeted purchases are computed as total inventory needs less the beginning inventory.

20. Partial Purchases Budget Backpacks Galore, Inc. Purchases Budget For the Year Ending December 31, 2005 First Second Third Four Year QuarterQuarter QuarterQuarterTotal Purchases (units): School backpacks: Current qtr. sales 4,000 3,400 3,650 3,950 Desired end. inv. 4,4004,6504,9505,100 Total needs 8,400 8,050 8,600 9,050 Less beg. inv. -5,000 -4,400 -4,650 -4,950 Purchases 3,400 3,650 3,950 4,100 15,100

21. Partial Selling Expense Budget Backpacks Galore, Inc. Selling Expense Budget For the Year Ending December 31, 2005 First Second Third Fourth Year QuarterQuarterQuarterQuarterTotal Budgeted sales $190,000 $228,000 $323,000 $209,000 $950,000 Variable costs: Setup/Display $ 1,900 $ 2,280 $ 3,230 $ 2,090 $ 9,500 Commissions 3,800 4,560 6,460 4,180 19,000 Miscellaneous 1,900 2,280 3,230 2,090 9,500 Total 7,600 9,120 12,920 8,360 18,000 Fixed costs (total) 4,500 4,500 4,500 4,500 4,500 Total selling exp. $12,100 $13,620 $17,420 $12,860 $56,000

22. Assumptions for Cash Budget • The cash budget summarizes all cash receipts and disbursements expected to occur during the budget period. • Cash is critical to survival.

23. Partial Cash Budget Backpacks Galore, Inc. Cash Budget For the Year Ending December 31, 2005 First Quarter

24. Partial Cash Budget Cash balance, beginning $ 15,000 Collection on sales: Cash sales $ 95,000 From credit sales: Current quarter 71,250 Prior quarter 21,500 Total $187,850 Total available from operations $202,850 Continued

25. Total available from operations $202,850 Less budgeted disbursements: Purchasing, current quarter $ 65,000 Purchasing, previous quarter 40,000 Total $105,000 Selling 12,100 General and administrative 31,000 Other: Income taxes 22,000 Dividends 20,000 Total disbursements -$190,100 Continued

26. This amount becomes the beginning balance for the second quarter. Total disbursements -$190,100 Excess cash available for disbursements $ 12,750 Short-term financing: New loans $ 3,000 Net cash flow from financing $ 3,000 Cash balance, ending $ 15,750

27. Budgeted Income Statement Backpacks Galore, Inc. Budgeted Income Statement (Functional Format) For the Year Ending December 31, 2005 Sales $950,000 Expenses: Cost of goods sold: Beginning inventory $146,000 Purchases 547,000 Cost of merchandise avail. $693,000 Ending inventory -153,000 $540,000 Selling operations 56,000 General and administrative 132,000 Bad debt expense 4,750-732,750 Income from operations $217,250 continued

28. Income from operations $217,250 Other expenses: Interest expense - 1,590 Net income before taxes $215,660 Allowance for income taxes - 77,200 Net income $138,460

29. Budgeted Balance Sheet Backpacks Galore, Inc. Budgeted Balance Sheet December 31, 2005 Assets Current assets: Cash $ 77,480 Accounts receivable (net) 25,080 Merchandise inventory 153,000 $255,560 Property and equipment: Land $ 60,000 Building and equipment $260,000 Less accumulated depr. - 132,800 127,200 187,200 Total assets $442,760 continued

30. Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 56,500 Stockholders’ equity: Capital stock $150,000 Retained earnings 236,260 386,260 Total liabilities and stockholders’ equity $442,760

31. Finalizing the Budget Is the proposed budget acceptable? Is the proposed budget feasible? Before finalizing the budget, two questions must be addressed.

32. Types of Forecasts Used in Budgeting • The sales forecast is primary to most organizations. • The collection period for sales on account. • Percent of uncollectible sales on account. • Cost of materials, supplies, utilities, etc. • Employee turnover. • Time required to perform activities. • Interest rates. • Development time for new products or services.

33. Developing Budgets that Work 1. Emphasize the importance of budgeting as a planning device. 2. Encourage wide participation in budget preparation at all levels of the organization. 3. Demonstrate that the budget has the complete support of top management. 4. Recognize that the budget is not unalterable. Continued

34. Developing Budgets that Work 5. Use budget performance reports not just to identify poor performers, but also to recognize good performance. 6. Conduct programs in budget education to provide new managers with information about the purposes of budgets and to dispel erroneous misconceptions that may exist.

35. C 11 hapter The End