Cash Budgeting

Personal Computers, Inc.*

Personal Computers, Incorporated, (PCI) was founded in 1986 by Steve Wilson, an industrial engineer and former procurement agent for a large, international chemical producer. From humble beginnings in a two-car garage, by the end of 1993 PCI had grown into a dominant regional competitor with hundreds of business and professional customers.

Wilson originally got the idea for PCI after building home computers for several friends and business associates. Using standard components, Wilson would assemble and test the computers in his garage after work and on weekends. Gradually developing a network of personal references and reliable suppliers, he left his full-time job to start Personal Computers, Inc., in late 1986.

Microcomputers, it turned out, were easy to build-to-order. Each consisted of several large components: a case unit (with an integrated power supply), a motherboard (containing the computer’s microprocessor and memory circuitry), floppy and fixed drives with separate controller circuits, a video card and monitor, and a keyboard. Customer decisions were centered around the speed and memory capacity of the motherboard circuits, the speed and storage capacity of the fixed disk drive, and the display resolution or clarity of the monitor and the video card subsystem.

In 1986, the microcomputer industry was still in its infancy. The user (retail) market was dominated by four or five large, national manufacturers, each with its own established and exclusive distribution channel. Though off-brand components were available from mail-order parts distributors, the average user (or potential user) lacked the knowledge and skill necessary to acquire and assemble reliable computers from quality parts. Wilson created PCI to capitalize on his ability to spot good prices and well-made components.

The first few years of success for PCI was derived mostly from its ability to obtain quality microcomputer parts from the West Coast. Wilson’s experience as a purchasing agent was a definite asset, and this was evident several months after the start of the business. After attending a local business trade show for two days in early 1987, PCI had hard orders equal to four months of steady production. Wilson had set prices fully a third lower than his other local competitors, and he promised a quality products as well. This price advantage carried PCI through the end of 1989.

In mid-1988, one of PCI’s largest customers decided to install a local area network (LAN) which would allow all of the individual computers in the company to share the same information, software, and laser printers. Though PCI had not been involved in network software or hardware up to that point. Wilson thought that computer networking would be a likely area for growth as the market for business computers matured. PCI accepted the challenge, at the urgent request of the client, and gained a great deal of practical experience by designing, installing, servicing, and expanding the network. Within two years, PCI had hired another network specialist. The firm

* This case was prepared by Timothy B. Michael, The University of North Carolina at Charlotte, whose cooperation is acknowledged with appreciation.

began to shift its focus away from individual computers and toward integrated networks for small-to medium-sized businesses.

By late 1993, PCI was acknowledged to be one of the best specialty network shops in the region. Wilson, as technical manager, had hired a total of three network engineers and a fulltime computer technician. Assembly was done by up to ten part-time technicians, mostly local college students. The office staff included a business manager, an accounts payable/receivable clerk, and a receptionist. PCI also had two salespeople, though approximately half of the firm’s dollar sales was still generated through referrals and repeat customers.

While Wilson was a competent manager of PCI’s technical matters, he shared the planning function with his business manager, Mike Thompson. Thompson had received a bachelor’s degree in business finance and management information systems from a local university a few years earlier, and had shown that his knowledge of the computer systems and software industry was quite extensive. After his arrival in 1992, Thompson automated the office at PCI and eventually increased productivity in the face of greater sales and order volumes. In late 1993, having completed the most important of his operational streamlining projects, Thompson turned his attention toward forecasting operations for the next full year, 1994.

In late November 1993, Mike worked with the sales staff to develop a reasonable estimate of 1994 sales. PCI’s total sales had been growing at about 25 percent per year, but the firm had begun to concentrate more on selling networking software and expertise rather than just quality computers. It was expected that total sales in 1994 would grow by 15 percent over 1993 sales. After allowing for seasonal variations, Thompson produced an estimate of 1994 sales in dollars, by month. These figures are shown in Table 1, along with 1993 monthly sales for comparison.

By combining these figures with other information, Thompson intended to draft a cash budget for 1994, by month. To forecast monthly collections, the office clerk generated a list of customer invoices which had been paid during the month of November 1993. Mike thought that a pattern of monthly collections could be seen by examining the dollar amounts and the original dates of the sales invoices. A summary of this information is given in Table 2.

Though PCI had stated credit terms of 1/5, net 30, it granted credit to slightly less than half of its customers. Credit customers rarely took the discount, and though some paid late, defaults were extremely rare. Having service agreements with clients also helped remind them to pay PCI’s invoices. Mike felt that the pattern of collections in November would be close to what he could expect for each month in 1994.

To estimate future cash payments, Thompson would need to analyze the relationship between PCI’s cost of goods sold and total sales. In the past, the cost of goods sold had amounted to approximately 60 percent of monthly sales in dollars. Computer component purchases averaged 59 percent of the cost of goods sold, with direct labor and overhead each amounting to another 25 and 16 percent, respectively. Direct labor, overhead, and roughly half of the component purchases were paid for in the month incurred, but half of the component purchases were paid for in the following month. PCI had found several suppliers that would grant the firm credit terms, usually with payment due in less than twenty days. As was common in the computer industry, some suppliers still demanded a company check for payment upon delivery.

Salaries for 1994 were expected to total $221,000, and payroll taxes were expected to be $18,000. Office expenses, which included utilities, telephone service, office supplies, and lease payments on a photocopier, were estimated at $32,500 for the year. PCI leased five vehicles, two cars for the salespeople and three delivery vans, and the cost of insurance and lease payments for these totaled approximately $30,000 per year. Cash payments for all of these expenses would be spreads evenly throughout the year. Rent was a different matter.

PCI had negotiated a five-year lease for a 2,950 square foot space in a new business park. The location was classified as “mixed use,” with approximately half of the floor space outfitted for retail use (or computer assembly, in this case) and the other half divided into offices. PCI’s rental agreement stipulated that the firm was to pay a fixed amount per square foot per year and an additional amount based on the firm’s quarterly sales, known as percentage rent or overage. PCI paid $10 per square foot per year fixed rent, but this amount was divided into twelve equal monthly payments. The percentage rent agreement required PCI to pay 1 percent of quarterly sales, and these payments were usually made in the months following the close of each calendar quarter: January, April, July and October. The next scheduled overage payment was to be made in January 1994.

PCI’s sales staff received a 3 percent commission on any sales which directly resulted from their effort. In the recent past, approximately half of all sales had been from past clients or contacts generated by the technical staff, and half had been primarily due to the work of the sales staff. Commissions were usually paid during the month following the original sale.

In addition to sales commissions, all salaried employees expected to receive a 5 percent cash bonus for “exceptional performance,” based on their annual salary, in June and December.

Thompson had already calculated the firm’s expected tax liability for the coming year, and determined that PCI would need to make estimated tax payments totaling $42,000. One-fourth of this amount would have to be paid in April, July, and October, with the final payment to be made in January 1995. The firm had an estimated tax payment of $9,000 due in January 1994.

Finally, PCI was planning to make several large cash investments over the next twelve months. In February, the firm would update and extend its existing computer network by purchasing $42,500 worth of new computer equipment and laser printers. A site license for an emerging network software program would have to be purchased in June at a cost of $26,000. In September, Wilson planned to acquire exclusive regional distribution rights to another network operating system, and this would cost approximately $35,000.

At present, it was estimated that PCI would have approximately $15,000 in its transactions account on December 31, 1993. Mike generally liked to maintain an account balance of at least $10,000 at all times. This was the smallest amount that would allow him to sleep comfortably at night.

As Thompson pondered the data he had collected, he reflected on his relationship with the firm’s bankers. Though PCI had not needed to use short-term borrowing in the recent past, Mike was certain that he could obtain funds on short notice, provided that he could show the bank a comprehensive and realistic cash budget. First, he would have to determine exactly how much cash would be needed and when, and then he could use the cash budget to illustrate how excess cash in later months

could be used to repay any necessary previous borrowing. In addition, a budget would show the timing and amount of any cash available for investment in short-term, liquid securities which could be sold when cash was later needed to fund operations or special projects.

TABLE 1

Personal Computers, Inc.Dollar Sales per Month

Month 1993Forecasted

for 1994JanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember

$ 101,200102,400

94,700115,900126,800111,300

71,00070,800

101,200116,300126,500

75,900

$ 116,400116,400110,200133,800145,500128,000

81,40081,400

116,400133,800145,500

87,300

Total Sales $ 1,284,000 $ 1,396,100

TABLE 3

Personal Computers, Inc.Collections Summary for November 1993

Month of Invoice AmountSeptemberOctoberNovember

$5,06058,15056,925

Total collected $120,135

QUESTIONS

1. Develop a worksheet which shows expected monthly cash collections for January through December 1994.

2. Develop a worksheet which shows expected monthly cash payments for January through December 1994.

3. Using the worksheets calculated in Questions 1 and 2, create a cash budget which clearly shows the following items:

a. The cash on hand at the beginning of each month.

b. The total cash on hand after net cash from (used by) operations has been calculated for each month.

c. The new borrowing required in any month.

d. Any cumulative amount borrowed, less repayment, in each month.

e. The ending balance for each month.

f. The amount of cash available for short-term investment (if any) in each month.

Assume that PCI will use excess cash (as it becomes available) to repay any outstanding (cumulative) borrowing from prior months.

4. After developing his cash budget, Mike discussed PCI’s borrowing needs with his local branch calling officer. The banker outlined three types of short-term borrowing arrangements:

a. A revolving credit agreement:

The bank would guarantee the availability of a certain amount of funds over a one-year period in exchange for a commitment fee (to be paid on the unused amount of the line of credit). The interest paid on any money borrowed would be variable and based on the prime rate, and rates could change monthly.

b. A line of credit:

The bank would authorize (but not guarantee) loans up to a certain amount during the year. Again, the interest paid would be based on the prime rate, and could change monthly. In addition, an average compensating balance of approximately $5,000 would have to be held in PCI’s transaction (checking) account during the course of the year.

c. A one-year term loan:

PCI could obtain a loan large enough to cover the amount needed during the year. This loan would pay interest at a fixed rate, but the interest on the loan would be determined at creation, and PCI would be responsible for the entire interest amount, regardless of when it repaid the principal.

From Mike Thompson’s perspective, what should be the most important characteristics of any short-term borrowing arrangement? Which of these alternatives would best meet PCI’s needs?

5. PCI will have some excess cash to invest during 1994. Discuss the nature of short-term, liquid investments (marketable securities) which may be available to PCI. What investments, if any, would be most appropriate for Thompson to use in anticipation of a need for these funds later in the year?

6. Use a computer spreadsheet program to create the collections worksheet, payments worksheet, and cash budget from Questions 1, 2, and 3, above.

7. Suppose a monthly cash budget proves to be inadequate for forecasting PCI’s borrowing needs. What information would be needed to calculate a cash budget on a weekly or biweekly basis?

8. A cash budget is just one tool for monitoring the financial position of a firm. What other information or accounting reports could Mike use to track the day-to-day status of PCI?

9. Suppose PCI continue to change its product mix from the building and selling of computers to the selling of network expertise. In general, for each dollar of sales revenue, the relative cost of raw materials (disks and manuals) for network software is lower than the relative cost of computer components, but the cost of the specialized labor and overhead is much higher. How will this change in focus influence PCI’s cash needs over the next several years?

10. Mike Thompson made many assumptions when forecasting PCI’s 1994 operations. How could sensitivity analysis be used to better model the cash situation of the firm for the new year?