© The McGraw-Hill Companies, Inc., 2000 6-1 PART TWO: PLANNING Chapter 6 - Planning and Budgeting.

© The McGraw-Hill Companies, Inc., 2000

6-1

PART TWO:PLANNING

Chapter 6 - Planning and Budgeting


6-2

Completes the planning phase

YOU ARE HERE!

Revenue cycle planning

Expenditure cycle planning

Conversion cycle planning

Chapter 6

Planning and

Budgeting

Pro-forma financial statements

Budgeting strategies

Cash planning


6-3

CHAPTER 6 LEARNING OBJECTIVES

L.O.1: Explain why companies use budgets.

L.O.2: Describe the various budgeting strategies companies use.

L.O.3: Explain the planning process in the revenue cycle and the resulting budgets.

L.O.4: Describe the planning process in the conversion cycle and the resulting budgets.


6-4

CHAPTER 6 LEARNING OBJECTIVES

L.O.5: Explain the planning process in the expenditure cycle and the resulting budgets.

L.O.6: Describe the relationships of the revenue, conversion, and expenditure cycle to pro forma financial statements.

L.O.7: (Appendix) Indicate the purpose of the economic order quantity model of inventory planning.


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A budget is a plan for the future expressed in financial terms.

Budgeting is a process of expressing a company’s goals and objectives in quantitative terms and is crucial to the planning process.

WHAT IS A BUDGET?


6-6

Planning

Communication and coordination

Resource allocation

Evaluation and control

WHAT ARE THE BENEFITS OF BUDGETING?


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PLANNING

BudgetingBenefits

Budgeting requires a business to plan by considering the financial ramification of future goals and objectives and how they will be accomplished.

“What should our sales goals be this year? How can we reduce our operating costs?”


6-8

COMMUNICATION AND COORDINATION

BudgetingBenefits

Budgeting promotes communication and coordination because the company as a whole must work together to achieve future goals and objectives.

“Lets discuss our sales goals with the department heads and then ask the production department to prepare a production plan.”


6-9

RESOURCE ALLOCATION

BudgetingBenefits

Budgeting requires a business to determine which activities should receive the company’s limited resources to maximizeeffectiveness and efficiency.

“How should we spend our technology budget this year to maximize our technology resources?


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RESOURCE ALLOCATION: ANALYSIS OF ACTIVITIES

Activity-based management

Non-value Added

Activities

Reduce or eliminate activities that do not add value the product from customer’s perspective.

Value Added

Activities

Focus on activities that add value to products from customer’s perspective.


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BudgetingBenefits

A budget serves as a useful benchmark against which to evaluate and control actual performance.

EVALUATION AND CONTROL

“Why were sales for the month less than expected?”


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Time and resource requirements.

Adaptability of departments and segments in the business.

Motivation and behavior of individuals.

WHAT ARE THE COSTS OF BUDGETING?


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TIME AND RESOURCE REQUIREMENTS

Budgeting is time-consuming. A typical yearly budget sequence may takes as long as three or four months.

Sept. 98

Oct 98

Nov 98

Dec 98

Budget Sequence for 1999


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ADAPTABILITY OF DEPARTMENTS AND SEGMENTS

If a budget is too rigid it inhibits a department or business segments from responding to changes in the environment.

“We can’t take the customer’s order because our costs will exceed the budgeted amount!”


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MOTIVATION AND BEHAVIOR OF INDIVIDUALS

The budgeting process can sometimes result in inaccurate department budgets (that ultimate impact the overall budget) if employees are rewarded for meeting or exceeding budgets.

“Let’s budget for $40,000 in sales but we can easily hit $45,000 -it will makes the department look better to exceed our goal.”


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BUDGETING STRATEGIES

A budgeting strategy is the manner in which a company approaches the budgeting process.

Mandated versusparticipative budgeting?

Incremental versuszero-based budgeting?


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MANDATED BUDGETING

Top down

budgeting

Employees

Upper-level management

Lower-level management

Sets operating budgets in line with goals and objectives of upper-level management


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PARTICIPATORY BUDGETING

Bottom-up

budgeting

Employees

Upper-level management

Lower-level management

Budgeting process begins at lower levels of the organization; budget director coordinates budget to develop a comprehensive budget plan


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MandatedMandated

ParticipatoryParticipatory

Top down budgeting

Bottom up budgeting

A BLENDED APPROACH TO BUDGETING


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Currentperiodbudget

Starting point

for next period’s budget

DETERMINING THE BUDGET NUMBERS: INCREMENTAL

BUDGETING


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Currentperiodbudget

Starting point

for next period’s budget

DETERMINING THE BUDGET NUMBERS: ZERO-BASED

BUDGETING


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PAUSE AND REFLECT

If you were a manager of a new Sherwin-Williams retail store, what budget approach and budget strategy would you adopt? Why?

Probably,the best approach would

be a combination of mandated and participatory budgeting, considering

each activity in the business cycle. A combination of zero-based and incremental might be appropriate

also as well as information on other Sherwin-Williams

retails stores.

Probably,the best approach would

be a combination of mandated and participatory budgeting, considering

each activity in the business cycle. A combination of zero-based and incremental might be appropriate

also as well as information on other Sherwin-Williams

retails stores.


6-23

Long-term plan for the company

5-10 years

General in nature

Going concern principle - the

business has continuity

WHAT TYPES OF BUDGETS DO COMPANIES PREPARE?

Strategic Budgets

Should the company expand its product lines? Should the company expand into new markets? Should the company align with a strategic

business partner? How will it improve shareholder value?


6-24

Guides day to day operations - carries out segment of the strategic plan

1 year or less

Specific in nature

The periodicity principle - measure profits at regular intervals

WHAT TYPES OF BUDGETS DO COMPANIES PREPARE?

Operating Budgets

What are the sales targets? How many units should be produced? How much will raw materials cost? How much will labor cost? What will be the target earnings growth?


6-25

Compiles all of the operational budgets for the period through the revenue, conversion and expenditure cycle.

Converts these budgets to cash budgets and pro forma financial statements for review.

After review and acceptance, the master budget then proceeds to execution stage.

MASTER BUDGETING


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Pro-forma financials

Production Budget

MASTER BUDGETINGExhibit

6.1

Sales Budget

Cash ReceiptsSchedule

AccountsReceivableSchedule

Selling and administrative expense budget

Direct materialPurchases Budget

Direct Labor/ Manufacturing

Overhead Budget

CashDisbursement

Schedule

AccountsPayable

Schedule

Conversion Cycle

Revenue Cycle Expenditure Cycle


6-27

Monthly Sales Budget in Dollars, Quantity, Product Line

Sales Trends, Target Markets Customer needs & demands Competitive trends Demographic Data Advertising promotion to achieve targets New products Analysis of economic, political, legal, social trends

BUDGETING IN THE REVENUE CYCLE

Sales Planning

and Budgeting


6-28

Monthly Cash Receipts Schedule

Monthly Accounts Receivable Schedule

Timing of sales collections Credit policies and bad debts Timing of major revenue and expense

items Maximize investment earnings

BUDGETING IN THE REVENUE CYCLE

Cash Receipts

Budgeting and

Planning


6-29

Monthly Inventory

Levels

BUDGETING IN THE CONVERSION CYCLE

InventoryPlanning

Determine the level of inventory to support operating plan

Ordering costs

Carrying Costs

Just-in-Time Inventory Model


6-30

Customer

demand

JIT isa pull

system

JUST-IN-TIME INVENTORY MODEL


6-31

PAUSE AND REFLECT

Do you think Sherwin-Williams would be a good candidate for adopting JIT? Why or why not?

Sherwin-Williams’ manufacturing division would

be a good candidate for JIT if its customers are fairly consistentin their ordering patterns. The

retail stores would not begood candidates becausecustomer demand is more

difficult to predict.

Sherwin-Williams’ manufacturing division would

be a good candidate for JIT if its customers are fairly consistentin their ordering patterns. The

retail stores would not begood candidates becausecustomer demand is more

difficult to predict.


6-32

Jan Feb Mar

Sales in Gallons 7,500 9,200 9,500

Add: desired ending inventory 92 95 98

Total inventory to have on hand 7,592 9,295 9,598

Less: beginning inventory 0 92 95

Gallons of paint to produce 7,592 9,203 9,503

BUDGETING IN THE CONVERSION CYCLE

Production Planning

Determine how many units and when to produce to meet sales budgets

Sherwin-WilliamsMonthly Production Budget in Gallons

Exhibit 6.6


6-33

PAUSE AND REFLECT

How does Sherwin-Williams compute the desired ending inventory for March?

The desired inventory for March is 1%

of April’s anticipatedsales in gallons, or

9800 x .01 =98

The desired inventory for March is 1%

of April’s anticipatedsales in gallons, or

9800 x .01 =98


6-34

Direct raw materials cost (traceable)

Direct labor costs (traceable)

Manufacturing/overhead (indirect - not traceable costs)

BUDGETING IN THE EXPENDITURE CYCLE

Production Expenditures

Planning

Determine product costs (raw materials direct labor, and manufacturing overhead)


6-35

Advertising,Marketing ExpensesSales Commissions


Selling and Administrative

Costs Planning

Companies must also plan for other expenditures such as salespersons’ commissions, and other selling and administrative costs.

Product Warranty CostsOffice and Administrative

Salaries


6-36

Monthly Cash Disbursement

Schedule


Timing of cash payment for goods and services to meet operating plan.

Are there sufficient cash resources when they are needed?

Monthly Accounts Payable Schedule

CashDisbursement

Planning


6-37

PRO-FORMA FINANCIAL STATEMENTS

The Pro-Forma

Income

Statement

Revenues $25,000

Expenses $15,000

Net Income $10,000

Pro-Forma

Statement of

Cash Flows

Operating activities

Investing activities

Financing activities

Net cash flow

Beginning cash

Ending cash $50,000

The Pro-Forma

Balance Sheet

Assets $100,000

Liabilities $15,000

Owners’ Equity $85,000

Total Liabilities &

Owners’ Equity $100,000

Pro-forma financial statements provide the business with the expected results of the budget if executed.

Management can evaluate whether operating goals and objectives would be achieved in financial terms.

Projectedprofits

Projectedcash

Projected financial position


6-38

THE CASH BUDGET

Changein

cash

Cash receipts from: Operating activities (Customers) Financing activities Investing activities

Cash payments for: Operating activities (suppliers, employees Financing activities Investing activities

Monthly Cash Budget

+ -

Beginning cash

Ending cash


6-39

Forecasts cash position in the operating plan.

Identifies cash shortages up-front so that cash inflows through short-term financing can be arranged.

Identifies cash surpluses up-front so that short-term investments can be arranged.

REACTING TO THE BUDGET: CASH PLANNNG

Acquiring Short-term

Loans Selling Notes and Account Receivables

Investing in Treasury Bills

Investing in Money Market

Accounts

Investing in Certificate of

Deposits


6-40

It is possible for a business to obtain short-term loans from banks or other financial institutions and suppliers when immediate cash is needed.

COVERING CASH SHORTAGES

Time period

Creditworthinessof the business

Acquiring short-term

loans

I promise to pay New York Bank $3,000 plus 12% annual interest on August 13, 1996.

Date: May 15, 1996

Signed:_________

Payee of note

Maker of note


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INTEREST BEARING NOTES

On a interest bearing note, the maker of the note borrows a fixed sum and agrees to pay a stated rate of interest for the time period borrowed.

Lets assume the business borrows $100,000 for 60 days at 12% annual interest. How much interest and principal would have to be paid at the end of the 60 day period?

Interest = Principal x Rate x Time

Interest =$100,000 x .12 x 60/365

Interest = $1,973

Maturity Value of Note = $100,000 + $1,973, or $101,973

Due in 60 days


6-42

NONINTEREST BEARING NOTES

On a noninterest bearing note, the maker of the note (borrower) receives less that the amount of money borrowed to compensate the lender for interest. Computing the effective rate of interest is more complex:

Face value of note - Amount received

Amount received

X

Days in the year

Length of loan in days


6-43

NONINTEREST BEARING NOTES

Lets assume a business borrows $100,000 for 60 days. A noninteresting bearing note is signed and the borrower receives $98,000 in loan proceeds.

How much is the interest?

$100,000 - $98,000

$98,000

X

365

60

Effective interest rate =

12.4%

Interest paid is difference between face value of note and loan proceeds, or $2,000.

Borrower beware!


6-44

PAUSE AND REFLECT

You asked your best friend if you could borrow $4 until payday on Friday (5 days from now). She was a little reluctant because she thought she would need the cash but finally agreed if you gave her back $5 on Friday. Is this a good deal? Why or why not?

It might betime to reconsider your

friends. You will pay unstated interestof $1, or $.20/day for that $4 loan. Thatworks out to an effective annual rate of

1825% ($1/$4 x 365/5 =18.25 or 1825%)!! You can prove this using the I = PRT formula:

I = $4 x18.25 x 5/365 = $1. Understanding unstated interest is

important!

It might betime to reconsider your

friends. You will pay unstated interestof $1, or $.20/day for that $4 loan. Thatworks out to an effective annual rate of

1825% ($1/$4 x 365/5 =18.25 or 1825%)!! You can prove this using the I = PRT formula:

I = $4 x18.25 x 5/365 = $1. Understanding unstated interest is

important!


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FACTORING ACCOUNTSRECEIVABLES

Companies in need of immediate cash can sell other short-term assets such as notes or accounts receivable.

When a company sells accounts receivables to a third party such as a bank or financing company, it is called factoring.

A factoring fee is charged that represents the cost of lending money to the borrower until the cash is collected from the open accounts receivable.

Factoring fee = Face Amount of Accounts Receivable x Interest x Time (amount of time

before accounts receivable are collected)


6-46

FACTORING ACCOUNTS RECEIVABLE

Lets assume a business has $150,000 of accounts receivable due in 30 days, the buyer charges 15% and withholds a 10% reserve against uncollectible accounts.

How much is the factoring fee paid and the net proceeds to the borrower?

Factoring fee:$150,000 x .15 x 30/365 = $1,849.31Proceeds to borrower:Gross amount of accounts receivable $150,000.00Reserve for uncollectible accounts (10%) 15,000.00Factoring fee 1,849.31Net proceeds to borrower $133,150.69

Interest tolender


6-47

PAUSE AND REFLECT

When a factoring company or a bank buys notes or accounts receivables from a business, what risk is taken?

The lender is taking the risk that the notes

or accounts receivable will ultimately be collected. Sometimes a

lender will only agree to purchase with the right of recourse

against the borrower.

The lender is taking the risk that the notes

or accounts receivable will ultimately be collected. Sometimes a

lender will only agree to purchase with the right of recourse

against the borrower.


6-48

Sometimes companies have excess cash that is not immediately needed.

An investment in Treasury bills provides an alternative for idle cash to be invested to earn a return.

INVESTING CASH SURPLUSES

T-bills are short-term federal government securities. When the government issues T-bills, it is borrowing money from willing investors on a short-term basis, usually 30 days to 12 months.

Treasury bill investments are virtually risk-free and very liquid.

U.S.Treasur

y BillsU.S.Treasur

y BillsU.S.Treasur

y BillsU.S.Treasury

Bills


6-49

An investment in certificate of deposits provides another alternative for idle cash to be invested to earn a return.


CDs are guaranteed savings deposits with banks or other financial institutions through the Federal Deposit Insurance Corporation.

While available on demand, a penalty is charged for early withdrawal.

These are low risk investments but do not have the flexibility that exist with T-bill investments.

U.S.Treasury

BillsU.S.Treasury

BillsU.S.Treasury

BillsCertificates

of deposit


6-50

An investment in money market accounts is another alternative for idle cash be invested to earn a return.


Money market accounts are similar to interest-bearing checking accounts except the rate of interest is higher, number of withdrawals are limited over a stated period of time, and usually a minimum balance is required.

Money market accounts are very low risk and provide good liquidity because the investor can simply write a check for funds needed.

U.S.Treasury

BillsU.S.Treasury

BillsU.S.Treasury

BillsMoney Market

Accounts


6-51

PAUSE AND REFLECT

All of the investments discussed are relatively low risk and low return investments that can be made on a short-term basis? Why would a company choose this over a return that is higher?

Companies investing surplus cash on a

short-term basis are doing so to earn a return until the cash is needed in

the business. A higher return investment also means a higher risk. The loss of the money is a business risk most

companies would be unwillingto take with short-term

surplus cash.

Companies investing surplus cash on a

short-term basis are doing so to earn a return until the cash is needed in

the business. A higher return investment also means a higher risk. The loss of the money is a business risk most

companies would be unwillingto take with short-term

surplus cash.

© The McGraw-Hill Companies, Inc., 2000 6-1 PART TWO: PLANNING Chapter 6 - Planning and Budgeting.

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Transcript of © The McGraw-Hill Companies, Inc., 2000 6-1 PART TWO: PLANNING Chapter 6 - Planning and Budgeting.