Planning and BudgetingChapter 13Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Budgeting is necessary for success. In Chapter 13 we discuss the planning purpose of the budgeting process. We show how a master budget is developed and how it fits into the overall plan for achieving the organizational goals.*

Budgets A budget is a financial plan of the resources needed

to carry out activities and meet financial goals. Budgets play an important role in managing cash flows.

Critical success factors are the strengths of a

company that enable it to outperform competitors.LO1L.O. 1Understand the role of budgets in overall organization plans.13 - *

A budget is a financial plan of the resources needed to carry out activities and meet financial goals. The budget ties togetherthe goals of the organization, the plans for achieving those goals, the decisions that are made, and finally, the performanceevaluation. By identifying a companys critical success factors, those strengths that enable the company to outperform competitors,and incorporating those factors into the strategic plan, companies are able to improve their overall competitiveness. *

Human Element in BudgetingL.O. 2Understand the importance of people in the budgeting process. Participative budgeting:

Use of input from lower- and middle-managementemployees; also called grass roots budgeting13 - *

Using input from lower- and middle management, a participative budget facilitates goal congruence between the organization and individual goals.*

Sales ForecastingL.O. 3Estimate sales. Forecasting sales is the most difficult aspect of budgeting.

13 - *

Forecasting sales is the most difficult aspect of budgeting, and the rest of the budget depends upon sales. A participative sales budget, including input from staff, along with the use of other techniques and analyses is often used to reduce subjectivity.*

Forecasting ProductionL.O. 4Develop production and cost budgets. A production budget is a plan of resources needed

to meet current sales demand and ensure thatinventory levels are sufficient for future sales.13 - *

After completing the sales budget, the production budget can be developed. The production budget plans resources needed to meet current sales demand and ensure that inventory levels are sufficient for future sales. Required production can be computed using the basic cost flow model. The units in beginning inventory (the units already available) plus budgeted units produced minus budgeted units sold equals budgeted units in ending inventory. *

Cash BudgetL.O. 5Estimate cash flows. The cash budget is a statement of cash on hand at

the start of the budget period, expected cash receipts,expected cash disbursements, and the resulting cashbalance at the end of the budget period. Cash receipts:

Collection of accounts receivable Cash sales Sales of assets Borrowing Issuing stock Other13 - *

Regardless of budgeted profits, a company requires cash to operate. Cash budgeting is important to ensure company solvency, maximize interest earned on cash balances, and determine whether the company is generating enough cash for operations. Preparing a cash budget requires that all revenues, costs, and other transactions be examined in terms of their effects on cash. Budgeted cash receipts are computed from collections of accounts receivable, cash sales, sales of assets, borrowing, issuing stock, and other cash-generating activities.*

Cash BudgetLO5 Cash disbursements:

Materials purchases Manufacturing costs Operating activities Debt repayment Acquisition of new assets Income taxes Dividends Other activities13 - *

Cash disbursements are computed by determining cash required for materials purchases, manufacturing costs,operating activities, debt repayment, acquisition of new assets, income taxes, dividends, and other activities.*

Cash Collections ExampleLO513 - *

Assume that Santiago Pants collects 20% of the cash on credit sales in the month of the sale and 75% in the following month.2% of sales are taken as a discount by customers and 3% is written off as bad debt. Notice, a total of 5% is never collected(2% taken in discounts and 3% written off as bad debt). Lets look at cash receipts from sales for the first quarter if expectedsales for January, February, and March are $500,000, $450,000, and $600,000 respectively.*

Cash Collections ExampleLO5Santiago PantsMultiperiod Schedule of Cash CollectionsFor the Quarter Ended March 31a 20% collected in January, 75% collected in February, and 5% not collectedb 20% collected in February, 75% collected in March, and 5% not collectedc 20% collected in March, 75% collected in April, and 5% not collected13 - *

Accounts receivable on January 1 total $540,000 (net of discounts and bad debt) all of which is anticipated to be collected during January. Santiago Pants also expects to collect 20% of the $500,000 January sales during January, so cash collections budgeted for January total $640,000. In February, 75% of January sales (75% of $500,000 equals $375,000), and 20% of February sales (20% of $450,000 or $90,000) are expected to be collected for total cash collections of $465,000 in February. Finally, in March, total collections are $457,500, 20% of March sales and 75% of February sales. Total budgeted cash collections for the first quarter are $1,562,500.*

Cash Disbursements ExampleLO513 - *

We also need to analyze cash disbursements for the quarter. Santiago pays suppliers 50% in the month of purchase, 48% in the following month, and takes advantage of a 2% discount. Expected purchases for the quarter are $120,000 in January, $200,000 in February, and $250,000 in March.*

Cash Disbursements ExampleLO5Santiago PantsMultiperiod Schedule of Cash DisbursementsFor the Quarter Ended March 31Beginning accounts payable,January 1, $256,000January purchases, $120,000aFebruary purchases, $200,000bMarch purchases, $250,000cAdditional cash paymentsTotal cash disbursements

$256,000 60,000

250,000$566,000

$ 57,600 100,000

250,000$407,600

$ 96,000 125,000 250,000$471,000January

$ 256,000 117,600 196,000 125,000 750,000$1,444,600MonthFebruaryMarchTotal forQuartera 50% paid in January, 48% paid in February, and 2% discounts takenb 50% paid in February, 48% paid in March, and 2% discounts takenc 50% paid in March, 48% paid in April, and 2% discounts taken13 - *

Total cash disbursements for purchases in January include the beginning accounts payable balance of $256,000 and 50% of theJanuary purchases of $120,000, or $60,000, and $250,000 cash disbursements for items other than inventory purchases. Total cash disbursements for January are $566,000. Total cash disbursements for February are $407,600 and total cash disbursements for March are $471,000. Total cash disbursements for the first quarter are $1,444,600. Now, reviewing the schedule of cash receipts and the schedule of cash disbursements, Santiago Pants can determine if cash is available each month for operations.*

Budgeted Balance Sheet ExampleL.O. 6Develop budgeted financial statements.13 - *

The next step in the budgeting process is the budgeted balance sheet. The budgeted balance sheet combines an estimate of financial position at the beginning of the budget period with the budgeted results of operations for the period and estimated changes in assets and liabilities. Santiago Pants budgeted balance sheet shows total assets at the beginning of the year of $2,306,000 and at the end of the year of $3,623,000.*

Budgeted Balance Sheet ExampleLO6Santiago PantsBudget Balance SheetFor the Budget Year Ended December 31 ($000)13 - *

The budgeted liabilities and shareholders equity are also $2,306,000 at the beginning and $3,623,000 and end of the year.*

Budgeting in Service OrganizationsL.O. 7Explain budgeting in merchandising and service organizations. 13 - *

Budgeting in a service organization follows the same process except that a service organization does not produce products and, therefore, has no production budget. A significant part of the cost budget is the cost of labor. Again, start with the sales forecast and end with the budgeted balance sheets.*

Ethical Problems in BudgetingL.O. 8Explain why ethical issues arise in budgeting. Budgets can create serious ethical issues

for many people. The company must recognize the trade-off

between encouraging unbiased reporting bymanagers and the use of budget informationin performance evaluation and rewards.13 - *

Budgeting creates serious ethical issues for many people. Managers and employees provide much of the information for the budget and their performance is then compared to the budget. For example, as a manager, suppose that you believe that although it is possible to achieve a 10% increase in sales in your department, a 2% increase is virtually certain. If you budget a 10% increase and fall short of your budget you may lose the opportunity for merit pay or for a promotion. If you budget a 2% increase, however, the company will not provide enough capacity to fill orders if sales actually increase 10%. As the manager, how do you budget sales? Do you do what is in your interest, budget a 2% increase knowing you can meet budget (and perhaps get that merit pay or promotion) or do what is in the interest of the company and budget a 10% increase?*

Budgeting Under UncertaintyL.O. 9Explain how to use sensitivity analysisto budget under uncertainty. Budgets allow management to explore many

alternatives. Spreadsheets are helpful in preparing budgets

and quantifying what-if conditions.13 - *

All types of uncertainties exist. Management may use sensitivity analysis to determine what will happen under changing market conditions.*

End of Chapter 13Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Budgeting is necessary for success. In Chapter 13 we discuss the planning purpose of the budgeting process. We show how a master budget is developed and how it fits into the overall plan for achieving the organizational goals.*A budget is a financial plan of the resources needed to carry out activities and meet financial goals. The budget ties togetherthe goals of the organization, the plans for achieving those goals, the decisions that are made, and finally, the performanceevaluation. By identifying a companys critical success factors, those strengths that enable the company to outperform competitors,and incorporating those factors into the strategic plan, companies are able to improve their overall competitiveness. *Using input from lower- and middle management, a participative budget facilitates goal congruence between the organization and individual goals.*Forecasting sales is the most difficult aspect of budgeting, and the rest of the budget depends upon sales. A participative sales budget, including input from staff, along with the use of other techniques and analyses is often used to reduce subjectivity.*After completing the sales budget, the production budget can be developed. The production budget plans resources needed to meet current sales demand and ensure that inventory levels are sufficient for future sales. Required production can be computed using the basic cost flow model. The units in beginning inventory (the units already available) plus budgeted units produced minus budgeted units sold equals budgeted units in ending inventory. *Regardless of budgeted profits, a company requires cash to operate. Cash budgeting is important to ensure company solvency, maximize interest earned on cash balances, and determine whether the company is generating enough cash for operations. Preparing a cash budget requires that all revenues, costs, and other transactions be examined in terms of their effects on cash. Budgeted cash receipts are computed from collections of accounts receivable, cash sales, sales of assets, borrowing, issuing stock, and other cash-generating activities.*Cash disbursements are computed by determining cash required for materials purchases, manufacturing costs,operating activities, debt repayment, acquisition of new assets, income taxes, dividends, and other activities.*Assume that Santiago Pants collects 20% of the cash on credit sales in the month of the sale and 75% in the following month.2% of sales are taken as a discount by customers and 3% is written off as bad debt. Notice, a total of 5% is never collected(2% taken in discounts and 3% written off as bad debt). Lets look at cash receipts from sales for the first quarter if expectedsales for January, February, and March are $500,000, $450,000, and $600,000 respectively.*Accounts receivable on January 1 total $540,000 (net of discounts and bad debt) all of which is anticipated to be collected during January. Santiago Pants also expects to collect 20% of the $500,000 January sales during January, so cash collections budgeted for January total $640,000. In February, 75% of January sales (75% of $500,000 equals $375,000), and 20% of February sales (20% of $450,000 or $90,000) are expected to be collected for total cash collections of $465,000 in February. Finally, in March, total collections are $457,500, 20% of March sales and 75% of February sales. Total budgeted cash collections for the first quarter are $1,562,500.*We also need to analyze cash disbursements for the quarter. Santiago pays suppliers 50% in the month of purchase, 48% in the following month, and takes advantage of a 2% discount. Expected purchases for the quarter are $120,000 in January, $200,000 in February, and $250,000 in March.*Total cash disbursements for purchases in January include the beginning accounts payable balance of $256,000 and 50% of theJanuary purchases of $120,000, or $60,000, and $250,000 cash disbursements for items other than inventory purchases. Total cash disbursements for January are $566,000. Total cash disbursements for February are $407,600 and total cash disbursements for March are $471,000. Total cash disbursements for the first quarter are $1,444,600. Now, reviewing the schedule of cash receipts and the schedule of cash disbursements, Santiago Pants can determine if cash is available each month for operations.*The next step in the budgeting process is the budgeted balance sheet. The budgeted balance sheet combines an estimate of financial position at the beginning of the budget period with the budgeted results of operations for the period and estimated changes in assets and liabilities. Santiago Pants budgeted balance sheet shows total assets at the beginning of the year of $2,306,000 and at the end of the year of $3,623,000.*The budgeted liabilities and shareholders equity are also $2,306,000 at the beginning and $3,623,000 and end of the year.*Budgeting in a service organization follows the same process except that a service organization does not produce products and, therefore, has no production budget. A significant part of the cost budget is the cost of labor. Again, start with the sales forecast and end with the budgeted balance sheets.*Budgeting creates serious ethical issues for many people. Managers and employees provide much of the information for the budget and their performance is then compared to the budget. For example, as a manager, suppose that you believe that although it is possible to achieve a 10% increase in sales in your department, a 2% increase is virtually certain. If you budget a 10% increase and fall short of your budget you may lose the opportunity for merit pay or for a promotion. If you budget a 2% increase, however, the company will not provide enough capacity to fill orders if sales actually increase 10%. As the manager, how do you budget sales? Do you do what is in your interest, budget a 2% increase knowing you can meet budget (and perhaps get that merit pay or promotion) or do what is in the interest of the company and budget a 10% increase?*All types of uncertainties exist. Management may use sensitivity analysis to determine what will happen under changing market conditions.*

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