Developing Operating & Capital Budgeting

Developing Operating & Developing Operating & Capital BudgetingCapital Budgeting

Instructor : Ali KabiriInstructor : Ali Kabiri

BudgetingBudgetingThe process of planning future business actins and expressing The process of planning future business actins and expressing

those plans in a formal quantitative and monetary terms or those plans in a formal quantitative and monetary terms or statement is called Budgeting . statement is called Budgeting .

BudgetBudgetA budget is a quantitative expression of plans. It is used A budget is a quantitative expression of plans. It is used

commonly by: commonly by: Business FirmsBusiness Firms Government AgenciesGovernment Agencies Non-Profit organizationsNon-Profit organizations HouseholdsHouseholds

How Budgets are useful?How Budgets are useful? Induce management to think systematicallyInduce management to think systematically Swerve as a device for coordinating the complex operations Swerve as a device for coordinating the complex operations

of business.of business. Provide a medium for communicating the plans of the firmProvide a medium for communicating the plans of the firm Motivate managers at all levels to perform well.Motivate managers at all levels to perform well. Serve as a standard against which the actual performance Serve as a standard against which the actual performance

may be judged. may be judged.

Framework for BudgetingFramework for Budgeting Strategy, Planning and Budgeting:Strategy, Planning and Budgeting: The exercise of The exercise of

periodic budgeting is based on the framework of corporate periodic budgeting is based on the framework of corporate strategy and long–range plan. The corporate strategy of the strategy and long–range plan. The corporate strategy of the firm reflects its basic objectives and the fundamental policies firm reflects its basic objectives and the fundamental policies for realizing these objectives. The long-range plan of the firm-for realizing these objectives. The long-range plan of the firm-founded on its corporate strategy-delineates its major founded on its corporate strategy-delineates its major programs in various areas (production, marketing, finance, programs in various areas (production, marketing, finance, research and development, human resources, and etc.) , research and development, human resources, and etc.) , expected revenue and expenses, and projected financial expected revenue and expenses, and projected financial conditions over the next few years.conditions over the next few years.

When the corporate strategy and long-range plan are not When the corporate strategy and long-range plan are not explicitly articulated, the top management may specify certain explicitly articulated, the top management may specify certain broad guidelines at the time of budget preparation. Such guide broad guidelines at the time of budget preparation. Such guide lines would reflect the corporate strategy and long-range plan lines would reflect the corporate strategy and long-range plan followed implicitly by the top management. A simple guideline followed implicitly by the top management. A simple guideline may be: may be: “Assume that volume would increase by 5% and “Assume that volume would increase by 5% and prices and cost would increase by 10% next year.”prices and cost would increase by 10% next year.”

The Budget period: The Budget period: In order to be operationally In order to be operationally meaningful, the budget must be drawn up for a specific meaningful, the budget must be drawn up for a specific time period. Usually, the budgets drawn up for a year. The time period. Usually, the budgets drawn up for a year. The yearly budget may be divided into quarterly or even yearly budget may be divided into quarterly or even monthly budgets. Generally, the budget may be divided monthly budgets. Generally, the budget may be divided into two parts with differing levels of detail applying to into two parts with differing levels of detail applying to them. For example, the budget for the first quarter or first them. For example, the budget for the first quarter or first six months may be drawn up on a monthly basis and for the six months may be drawn up on a monthly basis and for the remaining period on a quarterly basis where further it may remaining period on a quarterly basis where further it may then be cast in terms of monthly budgets.then be cast in terms of monthly budgets.

Some firms employ a rolling budget, under this system, at Some firms employ a rolling budget, under this system, at the end of each quarter or each half year, the budget is the end of each quarter or each half year, the budget is extended by adding another quarter or another half year. extended by adding another quarter or another half year. Hence the firm always has the budget for a year ahead of Hence the firm always has the budget for a year ahead of it.it.

Program Budget and Responsibility Budget: Program Budget and Responsibility Budget: The The operating budget for the firm may be constructed in terms operating budget for the firm may be constructed in terms of program (program budget) or responsibility areas of program (program budget) or responsibility areas (responsibility budget).(responsibility budget).

The Program budget is developed in terms of products that The Program budget is developed in terms of products that are regarded as the principal program of the business. Such are regarded as the principal program of the business. Such a budget shows the expected revenues and costs of various a budget shows the expected revenues and costs of various products (direct and indirect costs).products (direct and indirect costs).

The Responsibility budget shows the plan in terms of person The Responsibility budget shows the plan in terms of person responsible for the achieving them. To illustrate, an responsible for the achieving them. To illustrate, an organization may be divided into several departments organization may be divided into several departments (responsible center) and a budget is drawn up for each (responsible center) and a budget is drawn up for each department showing what costs are amenable to control by department showing what costs are amenable to control by the departmental head (head of responsible center).the departmental head (head of responsible center).

Organization for BudgetingOrganization for Budgeting Though there seems to be no standardized organization for Though there seems to be no standardized organization for

budget preparation, in most of the large firms which budget preparation, in most of the large firms which develop formal budgets, a basic pattern exists. There is a develop formal budgets, a basic pattern exists. There is a budget committee and a budget director which guide and budget committee and a budget director which guide and monitor the process of budgeting. In this, understandably, monitor the process of budgeting. In this, understandably, the line executive have a significant involvement. the line executive have a significant involvement. Consisting of several top management executive, the Consisting of several top management executive, the budget committee: budget committee:

* * Sets broad guidelines for budgetingSets broad guidelines for budgeting

* * Coordinates the separate budgets prepared by different departmentsCoordinates the separate budgets prepared by different departments

* * Reconciles inconsistencies among various departmental budgetReconciles inconsistencies among various departmental budget

* * Compiles the budget in its final formCompiles the budget in its final form

* * Sends the budget for the approval of the chief executive and the board of Sends the budget for the approval of the chief executive and the board of directordirector

Limiting FactorLimiting Factor

In every firm, there isIn every firm, there is a critical factor which sets a limit to a critical factor which sets a limit to its level of activity. Often, the expected demand is limiting its level of activity. Often, the expected demand is limiting factor which defines the scope and level of operations. factor which defines the scope and level of operations. When the demand is fairly strong, the limiting factor may When the demand is fairly strong, the limiting factor may be the production capacity of the firm which can not be be the production capacity of the firm which can not be augmented in the short run, or it may be availability of man augmented in the short run, or it may be availability of man power or raw material if the firm is located in a man power power or raw material if the firm is located in a man power or raw material deficit region and finally, for the firms which or raw material deficit region and finally, for the firms which do not have easy access to the capital market, finance may do not have easy access to the capital market, finance may be a limiting factor.be a limiting factor.

Since it determines the scope and level of operations, the Since it determines the scope and level of operations, the limiting factor is the most appropriate starting point for the limiting factor is the most appropriate starting point for the budgeting exercise. For example, it make no sense to begin budgeting exercise. For example, it make no sense to begin planning with production capacity when the limiting factor planning with production capacity when the limiting factor is the expected demand. is the expected demand.

ParticipationParticipation

The budget guidelines prepared by the budget committee The budget guidelines prepared by the budget committee are transmitted down the organizational hierarchy. At each are transmitted down the organizational hierarchy. At each level, the management may provide more detailed level, the management may provide more detailed information for guiding its subordinates till the guidelines information for guiding its subordinates till the guidelines reach the level of supervisors who head the lowest level of reach the level of supervisors who head the lowest level of responsibility centers.responsibility centers. Each supervisor prepares budget Each supervisor prepares budget estimates of items of expense controllable at his level. estimates of items of expense controllable at his level. Expense items not controllable at his level are usually Expense items not controllable at his level are usually added later by the budget staff. The budget prepared by added later by the budget staff. The budget prepared by the supervisor serve as the starting point for the the supervisor serve as the starting point for the negotiation between the supervisor and his superior. negotiation between the supervisor and his superior.

Master BudgetMaster BudgetWhen the plan to be formalized is comprehensive or When the plan to be formalized is comprehensive or

overall plan for the business, the resulting budget is overall plan for the business, the resulting budget is called Master Budget. Comprehensive in scope, the called Master Budget. Comprehensive in scope, the Master BudgetMaster Budget covers all facets of the operation and covers all facets of the operation and finances of the firm.finances of the firm.

A Master Budget has four major components:A Master Budget has four major components:

1.1. Operating BudgetOperating Budget

2.2. Capital Expenditure BudgetCapital Expenditure Budget

3.3. Cash BudgetCash Budget

4.4. Projected Financial Position.Projected Financial Position.

The inter- relationship among these budgets and their The inter- relationship among these budgets and their principal parts is shown in the below Figure.principal parts is shown in the below Figure.

Operating Budget Cash Budget Projected Balance SheetSources and Uses of Funds

Statement

Sales BudgetInvestment and Financing

BudgetCapital Budgeting

Expenditure

Non-Manufacturing Cost Budget

Manufacturing Overhead Budget

Labor Cost Budget

Material & Purchase Budget

Production Budget

Components of a Master Budgeting System

Typical Master BudgetTypical Master Budget1. Operating Budget1. Operating Budget a) For Merchandizing Companies: Merchandize Purchase a) For Merchandizing Companies: Merchandize Purchase

BudgetBudget b) For Manufacturing Companies:b) For Manufacturing Companies: * Production Budget* Production Budget * Manufacturing Budget* Manufacturing Budget c) Selling Expenses Budget – Non Manufacturing cost Budgetc) Selling Expenses Budget – Non Manufacturing cost Budget d) General and Administrative Expense Budgetd) General and Administrative Expense Budget 2. Capital Expenditure Budget2. Capital Expenditure Budget

3. Financial Budgets3. Financial Budgets * Cash Budget: Budgeted statement of cash and * Cash Budget: Budgeted statement of cash and

disbursementsdisbursements * Budgeted Balance sheet – Projected Balance Sheet* Budgeted Balance sheet – Projected Balance Sheet * Budgeted Income Statement* Budgeted Income Statement

Master Budget Preparation Master Budget Preparation SequencesSequences

Preparation of Budgets within the Master Budget Preparation of Budgets within the Master Budget must follow a definite sequence, as follow:must follow a definite sequence, as follow:

1.1. The sales budget must be prepared first because The sales budget must be prepared first because the other sub units of operating budget such as; the other sub units of operating budget such as; production budget, materials and purchase production budget, materials and purchase budget and etc. is depend upon information budget and etc. is depend upon information provided by the sales budget.provided by the sales budget.

2.2. In the next step, the remaining operating In the next step, the remaining operating budgets are prepared.budgets are prepared.

3.3. In this stage Capital expenditure budget is In this stage Capital expenditure budget is prepared. This budget usually depends upon prepared. This budget usually depends upon long-term sales forecasts more than it does upon long-term sales forecasts more than it does upon the sales budget for the next year (Short-term).the sales budget for the next year (Short-term).

4.4. Based upon the information provided in the above Based upon the information provided in the above budgets, the budgeted statement of cash receipts budgets, the budgeted statement of cash receipts and disbursements is prepared. If this budget and disbursements is prepared. If this budget discloses an imbalance between disbursements and discloses an imbalance between disbursements and planned receipts, the previous plans may have to be planned receipts, the previous plans may have to be revised.revised.

5.5. The budgeted income statement is prepared next. If The budgeted income statement is prepared next. If the plans contained in the master budget results in the plans contained in the master budget results in unsatisfactory profits, the entire Master Budget may unsatisfactory profits, the entire Master Budget may be revised to incorporate any corrective measures be revised to incorporate any corrective measures available to the firm.available to the firm.

6.6. The budgeted balance sheet statement for the end The budgeted balance sheet statement for the end of the budgeted period is prepared last. An analysis of the budgeted period is prepared last. An analysis of this statement may also lead to revisions in the of this statement may also lead to revisions in the previous budgets. For examples, the budgeted previous budgets. For examples, the budgeted balance sheet statement may disclose too much balance sheet statement may disclose too much debt resulting from an overly ambitious expenditures debt resulting from an overly ambitious expenditures budget, and revised plans may be necessary.budget, and revised plans may be necessary.

Operating BudgetOperating Budget

Sales BudgetSales Budget Production BudgetProduction Budget Material and Purchases BudgetMaterial and Purchases Budget Labor cost BudgetLabor cost Budget Manufacturing Overhead BudgetManufacturing Overhead Budget Non-Manufacturing cost BudgetNon-Manufacturing cost Budget

Sales BudgetSales BudgetThe sales budget provides an estimate of goods to be sold and The sales budget provides an estimate of goods to be sold and

revenue to be derived from sales. revenue to be derived from sales.

The Sales forecast or budget for the forthcoming (budget) year is The Sales forecast or budget for the forthcoming (budget) year is usually the starting point of the budgetary exercise. usually the starting point of the budgetary exercise. Production, materials, labor, etc., are related to the level of Production, materials, labor, etc., are related to the level of sales. sales.

The sales budget commonly grows from a reconciliation of The sales budget commonly grows from a reconciliation of forecasted business conditions, plant capacity proposed forecasted business conditions, plant capacity proposed selling expenses such as advertising and estimates of sales. selling expenses such as advertising and estimates of sales.

In preparing the sales forecast, the following factors should be In preparing the sales forecast, the following factors should be considered:considered:

The outlook of the industry and economyThe outlook of the industry and economy Past behavior and emerging trends in salesPast behavior and emerging trends in sales Governmental regulations and controls affecting the industryGovernmental regulations and controls affecting the industry Consumer attitudes, dispositions, tastes, and preferencesConsumer attitudes, dispositions, tastes, and preferences The nature and the extent of competitionThe nature and the extent of competition Sales promotion effort of the firmSales promotion effort of the firm

Northern CompanyNorthern CompanyMonthly Sales BudgetMonthly Sales Budget

September 2006 –January 2007September 2006 –January 2007

MonthsMonths BudgeteBudgeted unit d unit SalesSales

BudgeteBudgeted unit d unit PricePrice

Budgeted Total Budgeted Total SalesSales

SeptemberSeptember 7,0007,000 $10$10 70,00070,000

OctoberOctober 10,00010,000 $10$10 100,000100,000

NovemberNovember 8,0008,000 $10$10 80,00080,000

DecemberDecember 14,00014,000 $10$10 140,000140,000

JanuaryJanuary 9,0009,000 $10$10 90,00090,000

Production BudgetProduction BudgetIn manufacturing organization, the budget of production is In manufacturing organization, the budget of production is

one of the operating budget. A well balanced production one of the operating budget. A well balanced production plan is required to ensure economical manufacturing. plan is required to ensure economical manufacturing. The factors that influence t6he plan of production are:The factors that influence t6he plan of production are:

i.i. The volume and timing of salesThe volume and timing of salesii.ii. Inventory of sales andInventory of sales andiii.iii. Productive capacityProductive capacity

The production plan geared to meet the requirement of The production plan geared to meet the requirement of sales. Goods flow from production line largely is in sales. Goods flow from production line largely is in conformity with the needs of sales. There may , conformity with the needs of sales. There may , however be significant divergence between the pattern however be significant divergence between the pattern of sales and pattern of production. This happens under of sales and pattern of production. This happens under two conditions:two conditions:

i.i. There is a pronounced seasonal variation in sales There is a pronounced seasonal variation in sales whereas production is planned in a stable manner.whereas production is planned in a stable manner.

ii.ii. Production necessarily has to be carried out during a Production necessarily has to be carried out during a certain period of the year, whereas sales occur round certain period of the year, whereas sales occur round the year though there may be some seasonal variation.the year though there may be some seasonal variation.

The steps involved in preparing the production budget The steps involved in preparing the production budget are broadly as follows:are broadly as follows:

Assess the productive capacity of the firmAssess the productive capacity of the firm Specify the finished goods inventory policy of the Specify the finished goods inventory policy of the

firmfirm Estimate the total quantity of each product to be Estimate the total quantity of each product to be

manufactured during the budget period on the basis manufactured during the budget period on the basis of sales forecast and finished goods inventory policyof sales forecast and finished goods inventory policy

Schedule the production during the budget period, Schedule the production during the budget period, taking into account the pattern of sales, the finished taking into account the pattern of sales, the finished goods inventory policy, and the productive capacitygoods inventory policy, and the productive capacity

Material and Purchases BudgetMaterial and Purchases BudgetOnce the production budget defines the quantity to be Once the production budget defines the quantity to be

produced, the next logical step is to estimate the material produced, the next logical step is to estimate the material requirements and determine the purchase program. In this requirements and determine the purchase program. In this context, the following principal budgets are developed.context, the following principal budgets are developed.

Material Budget:Material Budget: Materials used in a manufacturing unit are Materials used in a manufacturing unit are traditionally classified as Direct and Indirect.traditionally classified as Direct and Indirect. Direct Direct materials are materials which arte directly identified with materials are materials which arte directly identified with the product and are visibly incorporated init. Indirect the product and are visibly incorporated init. Indirect materials cannot be traced directly to the product. The materials cannot be traced directly to the product. The material budget generally is concerned only with Direct material budget generally is concerned only with Direct materials. Indirect materials and supplies are covered by materials. Indirect materials and supplies are covered by the manufacturing Overhead budget. The material budget the manufacturing Overhead budget. The material budget shows the quantities, and often the prices, of materials shows the quantities, and often the prices, of materials planned to be purchased.planned to be purchased.

Purchase Budget:Purchase Budget: This budget shows: This budget shows: a)a) The quantities of each type of raw material to be The quantities of each type of raw material to be

purchased,purchased,b)b) The schedule of purchases, and The schedule of purchases, and c)c) The estimated cost of purchases.The estimated cost of purchases.

In developing the purchase budget, one has to take into In developing the purchase budget, one has to take into account the following:account the following:

i.i. The quantities specified in the materials budgetThe quantities specified in the materials budget

ii.ii. The planned changes in material inventoriesThe planned changes in material inventories

iii.iii. Re-order levels of various inventory items, andRe-order levels of various inventory items, and

iv.iv. Economic order quantities of various inventory items.Economic order quantities of various inventory items.

Budgeted sales for the monthBudgeted sales for the month XXXX XXXX

Add the budgeted end of the month inventory Add the budgeted end of the month inventory XXXXXXXX

Required amount of available merchandiseRequired amount of available merchandise XXXX XXXX

Deduct the beginning of month inventory (Deduct the beginning of month inventory (XXXXXXXX))

Inventory to be purchased XXXXInventory to be purchased XXXX

Northern CompanyNorthern CompanyMerchandise Purchase BudgetMerchandise Purchase Budget

September, October, November 2006September, October, November 2006

SepSep OctOct Nov Nov

Next month’s budgeted sales (In units) 8,000 14,000 Next month’s budgeted sales (In units) 8,000 14,000 9,000 9,000

Ratio of inventory to future sales Ratio of inventory to future sales x90%x90% x90%x90% x90%x90%

Desired end of month inventory 7,200 12,600 8,100Desired end of month inventory 7,200 12,600 8,100

Budgeted sales for the month (In units) Budgeted sales for the month (In units) 10,00010,000 8,000 8,000 14,00014,000

Required units of available merchandise 17,200 20,600 Required units of available merchandise 17,200 20,600 22,10022,100

Deduct beginning of month inventory Deduct beginning of month inventory (9,000)(9,000) (7,200)(7,200) (12,600)(12,600)

Number of units to be purchased 8,200 13,400 9,500Number of units to be purchased 8,200 13,400 9,500

Budgeted cost per unit Budgeted cost per unit x$6 x$6 x$7 x$7 x$8 x$8

Budgeted cost of merchandise purchases Budgeted cost of merchandise purchases $49,200$49,200 $80,400$80,400 $57,000$57,000

Labor cost BudgetLabor cost BudgetLabor Cost Budget:Labor Cost Budget: Labor is generally classified as Direct and Labor is generally classified as Direct and

Indirect. Direct labor cost represents the Wages paid to workers Indirect. Direct labor cost represents the Wages paid to workers employed directly in the manufacturing activity. Indirect labor employed directly in the manufacturing activity. Indirect labor cost represents all other labor costs , such as supervisory cost represents all other labor costs , such as supervisory salaries, wages paid to storekeepers, maintenance personnel, salaries, wages paid to storekeepers, maintenance personnel, janitors, etc.janitors, etc. The budget for labor cost normally includes the cost The budget for labor cost normally includes the cost of direct labor only. The following approaches may be used for of direct labor only. The following approaches may be used for developing the labor cost budget:developing the labor cost budget:

1.1. Labor cost per unit of production = (Standard direct labor hours required Labor cost per unit of production = (Standard direct labor hours required for each unit of production) x (Average Wage rate per hour)for each unit of production) x (Average Wage rate per hour)

2.2. Labor cost Budget = labor cost per unit x Number of units of finished Labor cost Budget = labor cost per unit x Number of units of finished goods plannedgoods planned

When the above approaches cannot be used, the labor cost budget When the above approaches cannot be used, the labor cost budget may be developed on the basis of information about:may be developed on the basis of information about:

i.i. Permanent manpower employed in direct manufacturing activity Permanent manpower employed in direct manufacturing activity and their remuneration ratesand their remuneration rates

ii.ii. Payments likely to arise on account of overtime workPayments likely to arise on account of overtime work

iii.iii. Temporary manpower that may be needed and their Temporary manpower that may be needed and their remuneration rates.remuneration rates.

Manufacturing Overhead Manufacturing Overhead BudgetBudget

Manufacturing overhead is that part of factory cost which Manufacturing overhead is that part of factory cost which is not included in direct material and direct labor is not included in direct material and direct labor cost. Not directly identifiable with specific products cost. Not directly identifiable with specific products or jobs, manufacturing overhead consists of:or jobs, manufacturing overhead consists of:

i.i. Indirect materialIndirect materialii.ii. Indirect laborIndirect laboriii.iii. Miscellaneous factory expense items, such as Miscellaneous factory expense items, such as

depreciation, utilities, supplies, repairs, depreciation, utilities, supplies, repairs, maintenance, insurance, tax, and etc.maintenance, insurance, tax, and etc.

To construct the manufacturing overhead budget, To construct the manufacturing overhead budget, expense budgets for all the departments in the expense budgets for all the departments in the factory – production as well as service departments factory – production as well as service departments – have to be drawn up and aggregated.– have to be drawn up and aggregated. For this For this purpose, the expected volume of the work to be purpose, the expected volume of the work to be done in each department has to be determined in done in each department has to be determined in terms of an indicator appropriate to its activity. terms of an indicator appropriate to its activity. Some measures of activity are given below:Some measures of activity are given below:

1.1. For producing departmentsFor producing departments * units of output* units of output * Direct labor hours* Direct labor hours * Direct machine hours* Direct machine hours

2.2. For service departmentsFor service departments * Repair and maintenance: direct repair hours or the * Repair and maintenance: direct repair hours or the

number of machines to be maintained.number of machines to be maintained. * Purchase department: total purchases in monetary term * Purchase department: total purchases in monetary term

or the purchases order to be placed.or the purchases order to be placed. * General factory administration: number of employees in * General factory administration: number of employees in

the plant or total direct labor hours. the plant or total direct labor hours.

Given the activity level of each department in terms of a Given the activity level of each department in terms of a suitable measure, departmental budgets are drawn up in suitable measure, departmental budgets are drawn up in terms of two basic components: the variable cost (the terms of two basic components: the variable cost (the cost that changes as the level of output changes) and cost that changes as the level of output changes) and fixed cost (the cost that remains constant as the level of fixed cost (the cost that remains constant as the level of output changes).output changes).

Non-Manufacturing Cost Non-Manufacturing Cost BudgetBudget

Non manufacturing costs consists of expenses for selling and Non manufacturing costs consists of expenses for selling and distribution, general administration, research and distribution, general administration, research and development, and financing. development, and financing.

The budgets for non manufacturing cost are normally The budgets for non manufacturing cost are normally prepared along departmental lines. For each non prepared along departmental lines. For each non manufacturing department the budget may be developed manufacturing department the budget may be developed as the budget for manufacturing overhead is constructed.as the budget for manufacturing overhead is constructed.

For example the responsibility for preparing a budget of For example the responsibility for preparing a budget of selling and distribution expenses typically falls on the vice selling and distribution expenses typically falls on the vice president of Marketing or equivalent Sales manager. In this president of Marketing or equivalent Sales manager. In this case, although budgeted selling expenses should affect the case, although budgeted selling expenses should affect the expected amount of sales, the typical procedure is to expected amount of sales, the typical procedure is to prepare a sales budget first and then to budget selling and prepare a sales budget first and then to budget selling and distribution expenses budget.distribution expenses budget.

Capital Expenditure BudgetCapital Expenditure BudgetThe capital expenditure budget shows the list of capital The capital expenditure budget shows the list of capital

projects selected for investment along with their projects selected for investment along with their estimated cost. The capital expenditure budget or plant estimated cost. The capital expenditure budget or plant and equipment budget lists equipment/s to be scrapped and equipment budget lists equipment/s to be scrapped and additional equipment/s to be purchased if the and additional equipment/s to be purchased if the proposed production program is to be carried out.proposed production program is to be carried out.

The proposals in the capital expenditure budget have to The proposals in the capital expenditure budget have to suitably justified. Usually the justification is in terms of suitably justified. Usually the justification is in terms of quantitative criteria, such as the Payback Period (PBP), quantitative criteria, such as the Payback Period (PBP), Accounting Rate of Return (ARR), Internal Rate of Return Accounting Rate of Return (ARR), Internal Rate of Return (IRR), Cost reduction per unit, productivity and etc.(IRR), Cost reduction per unit, productivity and etc.

There are qualitative criteria that needs to be taken to There are qualitative criteria that needs to be taken to consideration such as; growth opportunity, market consideration such as; growth opportunity, market image, technological competence, morale, employee image, technological competence, morale, employee safety, and etc.safety, and etc.

Cash BudgetCash BudgetThe cash budget shows the cash inflows and outflows The cash budget shows the cash inflows and outflows

expected in the budget period.expected in the budget period.

The major sources of cash inflow are:The major sources of cash inflow are: cash sales, cash sales, collection of accounts receivable, dividend and interest collection of accounts receivable, dividend and interest income, disposal of fixed assets, long term and short term income, disposal of fixed assets, long term and short term borrowing, and raising of equity capital.borrowing, and raising of equity capital.

The major sources of cash outflow are:The major sources of cash outflow are: cash purchase, cash purchase, payments of accounts payable, payments toward wages, payments of accounts payable, payments toward wages, salaries, rent, utilities, and other operating expenses, tax salaries, rent, utilities, and other operating expenses, tax payment, purchase of capital assets, and repayment of payment, purchase of capital assets, and repayment of borrowings.borrowings.

The preparation of the cash budget has its starting point in the The preparation of the cash budget has its starting point in the operating budget of the firm. The revenue and expenses operating budget of the firm. The revenue and expenses shown in the operating budget have to be translated into shown in the operating budget have to be translated into cash inflows and cash outflows. In this context, the cash inflows and cash outflows. In this context, the following points may be mentioned: following points may be mentioned:

i.i. The pattern of collection of accounts receivable (arise The pattern of collection of accounts receivable (arise from credit sales) is estimated by applying a suitable from credit sales) is estimated by applying a suitable “Lag” scheme. For example, it may be assumed that “Lag” scheme. For example, it may be assumed that 40% of a month’s sales will be collected after one 40% of a month’s sales will be collected after one month, 50% after two months and 10% after three month, 50% after two months and 10% after three months.months.

ii.ii. The cash disbursement or credit purchase may also be The cash disbursement or credit purchase may also be estimated on the basis of a “Lag” factor.estimated on the basis of a “Lag” factor.

iii.iii. Operating expenses in terms of wages, salaries, rents, Operating expenses in terms of wages, salaries, rents, etc. are assumed to have been paid in the month in etc. are assumed to have been paid in the month in which they are incurred.which they are incurred.

iv.iv. Depreciation and other Non cash charges are not Depreciation and other Non cash charges are not included in the cash budget.included in the cash budget.

Apart from the operating budget, other influences on the Apart from the operating budget, other influences on the cash budget are: proposed acquisition and disposal of cash budget are: proposed acquisition and disposal of capital assets, anticipated borrowing and their capital assets, anticipated borrowing and their repayments, proposed tax and dividend payments, repayments, proposed tax and dividend payments, planned issues of equity and debt capital.planned issues of equity and debt capital.

SeptemberSeptember November November DecemberDecember

Beginning cash balance $20,000Beginning cash balance $20,000 $20,000 $22,272$20,000 $22,272

Cash receipt from customers Cash receipt from customers 82,000 82,000 92,000 92,000 104,000104,000

Totals 102,000 112,000 Totals 102,000 112,000 126,000126,000

Cash disbursements:Cash disbursements:

Payments for merchandise Payments for merchandise 58,200 49,200 80,40058,200 49,200 80,400

Sales commission Sales commission 10,000 7,900 14,00010,000 7,900 14,000

Salaries Salaries 2,000 2,100 2,0002,000 2,100 2,000

Administration Administration 4,500 4,600 4,5004,500 4,600 4,500

Accrued income taxes payable 20,000 - -Accrued income taxes payable 20,000 - -

Dividend payable - 2,900 -Dividend payable - 2,900 -

Interest on loans from bank 100 228 -Interest on loans from bank 100 228 -

Purchase of equipments Purchase of equipments - - - - 25,000 25,000

Total cash disbursements 94,800 66,928 Total cash disbursements 94,800 66,928 125,900125,900

Balance 7,200 45,072 372Balance 7,200 45,072 372

Additional loan from bank 12,800 - 19,628Additional loan from bank 12,800 - 19,628

Repayment of loan from bank Repayment of loan from bank - - (22,800)(22,800) - -

Ending cash balance 20,000 22,272 20,000Ending cash balance 20,000 22,272 20,000

Loan balance, end of monthLoan balance, end of month 22,800 22,800 0 0 19,62819,628

Northern CompanyNorthern CompanyCash BudgetCash Budget

September ,October, November 2006September ,October, November 2006

Projected Balance Sheet Projected Balance Sheet

The projected Balance Sheet shows The projected Balance Sheet shows projected assets, liabilities, and owner’s projected assets, liabilities, and owner’s equity at the end of the budgeted period.equity at the end of the budgeted period.

The inputs required for its preparation are The inputs required for its preparation are the initial balance sheet, the profit plan, the initial balance sheet, the profit plan, the capital expenditure budget, the cash the capital expenditure budget, the cash budget, and the investment and financing budget, and the investment and financing budget.budget.

Northern CompanyNorthern CompanyBudgeted Balance Sheet, 31Budgeted Balance Sheet, 31stst December 2006 December 2006

AssetsAssetsCash $ 20,000Cash $ 20,000

Accounts receivable 84,000Accounts receivable 84,000

Inventory 48,600Inventory 48,600

Equipments 225,000Equipments 225,000

Less accumulated depreciation Less accumulated depreciation 40,500 40,500 184,500 184,500

Total Assets Total Assets 337,100337,100

Liabilities and stock holders EquityLiabilities and stock holders EquityLiabilities:Liabilities:

Accounts payable 57,000 Accounts payable 57,000

Accrued income tax payable 28,669Accrued income tax payable 28,669

Bank loan payable Bank loan payable 19,62819,628 105,297 105,297

Stock holders’ Equity:Stock holders’ Equity:

Common stock 150,000Common stock 150,000

Retained earnings Retained earnings 81,803 81,803 231,803231,803

Total Liabilities and stock holders equityTotal Liabilities and stock holders equity 337,100337,100

Planning plant asset investments is called Planning plant asset investments is called Capital BudgetingCapital Budgeting. The plans may involve . The plans may involve new building, new machinery, or whole new new building, new machinery, or whole new projects. In all such cases, a fundamental projects. In all such cases, a fundamental objective of business firm is to earn a objective of business firm is to earn a satisfactory return on the invested funds.satisfactory return on the invested funds.

Capital budgeting involves the preparation of Capital budgeting involves the preparation of cost and revenue estimates for all proposed cost and revenue estimates for all proposed projects, an examination ofr the merits of projects, an examination ofr the merits of each, and a choice of those worthy of each, and a choice of those worthy of investment.investment.

Capital BudgetingCapital Budgeting

Capital investments, representing the growing edge of a business, Capital investments, representing the growing edge of a business, are deemed to be very important for three inter-related are deemed to be very important for three inter-related reasons:reasons:

1.1. They have long-term consequences. Capital investment They have long-term consequences. Capital investment decisions have considerable impact on what the firm can do in decisions have considerable impact on what the firm can do in future.future.

2.2. It is difficult to reverse capital investment decisions because It is difficult to reverse capital investment decisions because the market for used a firm are tailored to meet its specific the market for used a firm are tailored to meet its specific requirements.requirements.

3.3. Capital investment decisions involve substantial outlays.Capital investment decisions involve substantial outlays.

This section discusses the basics ofThis section discusses the basics of capital budgeting. It is divided capital budgeting. It is divided into ten sub-sections as follows:into ten sub-sections as follows:

• Capital budgeting processCapital budgeting process• Cost and Benefits Analysis: Basic principlesCost and Benefits Analysis: Basic principles• Cost and Benefits Analysis: IllustrationsCost and Benefits Analysis: Illustrations• Appraisal criteriaAppraisal criteria• Payback period (PBP)Payback period (PBP)• Average Rate of Return (ARR)Average Rate of Return (ARR)• Net Present Value (NPV)Net Present Value (NPV)• Benefit Cost Ratio (BCR)Benefit Cost Ratio (BCR)• Internal Rate of Return (IRR)Internal Rate of Return (IRR)• Investment Appraisal in practiceInvestment Appraisal in practice

Capital budgeting processCapital budgeting processCapital budgeting is a complex process which may Capital budgeting is a complex process which may

be divided into the following phases:be divided into the following phases:1.1. Identification of potential investment Identification of potential investment

opportunitiesopportunities2.2. Assembling of proposed investmentAssembling of proposed investment *Replacement investments*Replacement investments * Expansion investments* Expansion investments * New product investments* New product investments * Obligatory and welfare investments* Obligatory and welfare investments3.3. Decision MakingDecision Making4.4. Preparation of Capital Budget and AppropriationPreparation of Capital Budget and Appropriation5.5. ImplementationImplementation * Adequate and detailed formulation of projects* Adequate and detailed formulation of projects * Use of the principle of responsibility accounting* Use of the principle of responsibility accounting * Use of Network techniques for monitoring the * Use of Network techniques for monitoring the

project.project.6.6. Performance Review ( Post completion audit)Performance Review ( Post completion audit)

Costs and benefits: Basic PrinciplesCosts and benefits: Basic PrinciplesOnce an investment project is proposed, its costs and benefits Once an investment project is proposed, its costs and benefits

must be estimated.must be estimated. In evaluating a capital expenditure In evaluating a capital expenditure proposal, two broad phases are involved:proposal, two broad phases are involved:

1.1. DefiningDefining the stream of Costs and Benefits associated with the stream of Costs and Benefits associated with the investment.the investment.

* Cash Flow Principle* Cash Flow Principle * Incremental Principle* Incremental Principle * Long-Term Funds Principle* Long-Term Funds Principle * Interest Exclusion Principle* Interest Exclusion Principle * Post-Tax Principle* Post-Tax Principle

2.2. AppraisingAppraising the stream of Costs and Benefits associated the stream of Costs and Benefits associated with the investment.with the investment.

* Payback Period* Payback Period * Average Rate of Return* Average Rate of Return * Net Present Value* Net Present Value * Benefit Cost Ratio* Benefit Cost Ratio * Internal Rate of Return* Internal Rate of Return

Cash Flow Principle:Cash Flow Principle: Cost and benefits Cost and benefits must be measured in terms of cash flows- must be measured in terms of cash flows- costs are cash outflows and benefits are costs are cash outflows and benefits are cash inflows.cash inflows.

Incremental Principle:Incremental Principle: Cash flows must be Cash flows must be measured in incremental terms.measured in incremental terms. This This means that the changes in the cash flows means that the changes in the cash flows of the firm which can be attributed to the of the firm which can be attributed to the proposed project alone are relevant. In proposed project alone are relevant. In estimating the incremental cash flows of a estimating the incremental cash flows of a project, the following points must be borne project, the following points must be borne in mind:in mind:

* Consider all incidental effects* Consider all incidental effects * Ignore sunk cost* Ignore sunk cost * Include opportunity cost* Include opportunity cost * Allocation of overhead cost* Allocation of overhead cost

Appraisal Criteria:Appraisal Criteria:Once the stream of costs and benefits of an investment project is Once the stream of costs and benefits of an investment project is defined, the next logical question to ask is: Is the investment project defined, the next logical question to ask is: Is the investment project worthwhile?worthwhile? A wide range of criteria has been suggested to judge A wide range of criteria has been suggested to judge worthwhileness of an investment project. The important investment worthwhileness of an investment project. The important investment appraisal criteria, classified as follow: appraisal criteria, classified as follow:

Appraisal Criteria

Non – Discounting Factor Criteria (NDCF)

Discounting Factor Criteria (DCF)

Pay Back Period (PBP)

Accounting Rate of Return (ARR)

Net Present Value (NPV)

Internal Rate of Return (IRR)

Cost Benefit Ratio (CBR)

APPRAISAL TECHNIQUES

A.A. Non - Discounted Cash Flow (NDCF) Non - Discounted Cash Flow (NDCF)This method of investment appraisal does not take into This method of investment appraisal does not take into

consideration interest rate and Time that is time value of consideration interest rate and Time that is time value of money.money.

1. Payback Period (PBP)1. Payback Period (PBP)The payback period is the length of time required to recover The payback period is the length of time required to recover

the initial cash outlay on the project.the initial cash outlay on the project.0 year0 year 11stst year year 22ndnd year year 33rdrd

yearyear44thth year year

IncomeIncome (500)(500) 150150 200200 350350 400400

Operating CostsOperating Costs 00 5050 5050 5050 5050

Net income FlowNet income Flow (500)(500) 100100 150150 300300 350350

Accumulated Accumulated incomeincome

(500)(500) (400)(400) (250)(250) 5050 400400

2. Average Rate of Return (ARR)2. Average Rate of Return (ARR)The average rate of return, also called the The average rate of return, also called the

accounting rate of return is defined as a method accounting rate of return is defined as a method that measures the net return each year as a that measures the net return each year as a percentage of the initial cost of the investment.percentage of the initial cost of the investment.

ARR =Net Return (profit) per annum / Capital outlay X 100ARR =Net Return (profit) per annum / Capital outlay X 100

Project Project “X”“X”

Project Project “Y”“Y”

Project Project “Z”“Z”

Cost Cost (Capital outlay)(Capital outlay) (50,000)(50,000) (40,000(40,000(( (90,000)(90,000)

Return year 1Return year 1 10,00010,000 10,00010,000 20,00020,000





Total ReturnTotal Return 70,00070,000 60,00060,000 130,000130,000

Total Net ReturnTotal Net Return 20,00020,000 20,00020,000 40,00040,000

Net profit / annumNet profit / annum ) ) 5 5 years)years)

40004000 40004000 80008000

Average Rate of Average Rate of ReturnReturn

8%8% 10%10% 8.98.9%%

B. B. Discounted Cash Flow (DCF)Discounted Cash Flow (DCF)This method of investment appraisal has certain advantages, it deals This method of investment appraisal has certain advantages, it deals

with the problems of interest rate and time, that is time value of with the problems of interest rate and time, that is time value of money which is ignored under Non- discounted factor appraisal money which is ignored under Non- discounted factor appraisal technique. technique.

Discounted cash flow takes into account that interest rates affect the Discounted cash flow takes into account that interest rates affect the present value of future income. It shows that the future cash flow present value of future income. It shows that the future cash flow is discounted by the rate of interest.is discounted by the rate of interest.

The return on an investment project is always in the future, usually The return on an investment project is always in the future, usually over a period of several years. Money earned or paid in the future over a period of several years. Money earned or paid in the future is worth less today. is worth less today.

Present Value = A / (1+r Present Value = A / (1+r ((ⁿn

Where:Where:A = Amount of MoneyA = Amount of MoneyR = Rate of interestR = Rate of interestn = Number of yearsn = Number of years

Net Present Value (NPV):Net Present Value (NPV):The Net Present Value (NPV) of a project is equal to the sum of The Net Present Value (NPV) of a project is equal to the sum of

the present value of all the cash flows associated with the the present value of all the cash flows associated with the project. Symbolically:project. Symbolically:

NPV = CF0 / (1+k)ⁿ + CF1 / (1+k)ⁿ + CF2 / (1+k)ⁿ + CFn / (1+k)ⁿ NPV = CF0 / (1+k)ⁿ + CF1 / (1+k)ⁿ + CF2 / (1+k)ⁿ + CFn / (1+k)ⁿ +……+……

Where:Where:

NPV = Net Present ValueNPV = Net Present Value

CF = Cash flow occurring at the end of year “ n ” (0, 1, 2, 3, CF = Cash flow occurring at the end of year “ n ” (0, 1, 2, 3, ….n)….n)

n = Life of the projectn = Life of the project

K = Discounted rate K = Discounted rate

NPV = Total present value – Initial outlayNPV = Total present value – Initial outlay

A project with the higher NPV value will be A project with the higher NPV value will be chosen as a selected project.chosen as a selected project.

YearYear 00 11 22 33 44 55

Cash flowCash flow (10,000,00(10,000,000)0)

2,000,0002,000,000 2,000,0002,000,000 5,000,0005,000,000 6,000,006,000,0000

6,500,0006,500,000

Discount RateDiscount Rate (10%)(10%)

0%0% 10%10% 10%10% 10%10% 10%10% 10%10%

Discounted FactorDiscounted Factor 11 0.90.9 0.810.81 0.7290.729 0.6560.656 0.5910.591

Discounted Cash Discounted Cash FlowFlow

(10,000,00(10,000,000)0)

1,800,0001,800,000 1,620,0001,620,000 3,645,0003,645,000 3,936,003,936,0000

3,841,5003,841,500

Accumulated Accumulated Discounted Cash Discounted Cash FlowFlow

(10,000,000(10,000,000))

(8,200,000(8,200,000))

(6,580,000(6,580,000))

(2,935,000)(2,935,000) 100,1000100,1000 4,842,5004,842,500

Internal Rate of Return:Internal Rate of Return:The internal Rate of Return of a project is the discount rate at The internal Rate of Return of a project is the discount rate at

whichwhich makes its net present value equal to zero. makes its net present value equal to zero.

0=CF0=CF00 / / (1+r)(1+r)00 + + CFCF1 1 / / (1+r)(1+r)11 + + CFCF2 2 / / (1+r)(1+r)2 2 +………+ +………+ CF CF nn / / (1+r)n(1+r)n

CF = Cash Flow at the end of yearCF = Cash Flow at the end of yearr =r = Discount RateDiscount Raten = Life of the Projectn = Life of the Project

In the Net Present Value (NPV) calculation we assume that In the Net Present Value (NPV) calculation we assume that the discount rate (Cost of Capital) is known and we the discount rate (Cost of Capital) is known and we determine the Net Present Valuedetermine the Net Present Value of the project. of the project.

In the Internal Rate of Return (IRR) calculation, we set the In the Internal Rate of Return (IRR) calculation, we set the net present value equal to “ZERO” and determine the net present value equal to “ZERO” and determine the discount rate (Internal Rate of Return) which satisfies this discount rate (Internal Rate of Return) which satisfies this condition.condition.

To illustrate the calculation of internal rate of return, consider To illustrate the calculation of internal rate of return, consider the cash flows of a project:the cash flows of a project:

The internal rate of return is the value of “ r ” which satisfiesThe internal rate of return is the value of “ r ” which satisfies the the following equation:following equation:

100,000 = 30,000/ (1+r)100,000 = 30,000/ (1+r)11 + 30,000/ (1+r) + 30,000/ (1+r)22 + 40,000/ (1+r) + 40,000/ (1+r)33 + 45,000/ (1+r) + 45,000/ (1+r) 44

The calculation of “ r ” involves a process of trial and error. We try The calculation of “ r ” involves a process of trial and error. We try different values of “ r ” till we find that right –hand side of the above different values of “ r ” till we find that right –hand side of the above equation is equal to 100,000. equation is equal to 100,000.

Let us, to begin with, r=15%. This makes the right-hand side equal to:Let us, to begin with, r=15%. This makes the right-hand side equal to:

YearYear 00 11 22 33 44

Cash Cash FlowFlow

(100,000(100,000))

30,00030,000 30,00030,000 40,00040,000 45,00045,000

30,000 / (1.15)30,000 / (1.15) + + 30,000 / (1.15)30,000 / (1.15)1 + 1 + 30,000 / (1.15)30,000 / (1.15)2 + 2 + 30,000 / (1.15)30,000 / (1.15)3 + 3 + 30,000 / 30,000 /

(1.15)(1.15)44==100,802100,802

30,000 / (1.16)30,000 / (1.16) + + 30,000 / (1.16)30,000 / (1.16)1 + 1 + 30,000 / (1.16)30,000 / (1.16)2 + 2 + 30,000 / (1.16)30,000 / (1.16)3 + 3 + 30,000 / 30,000 /

(1.16)(1.16)44==98,64198,641

Since 98,641 is now less than 100,000, we conclude that Since 98,641 is now less than 100,000, we conclude that the value of “ r ” lies between 15% and 16% and for the value of “ r ” lies between 15% and 16% and for most of the purposes this approximation suffices.most of the purposes this approximation suffices.

Benefit – Cost Ratio (BCR):Benefit – Cost Ratio (BCR):There are two ways of defining the relationship between There are two ways of defining the relationship between

benefits and costs:benefits and costs:

Benefit - Cost Ratio : BCR = PVB / IBenefit - Cost Ratio : BCR = PVB / I

Net Benefit – Cost Ratio: NBCR = PVB – 1 / INet Benefit – Cost Ratio: NBCR = PVB – 1 / I

Where:Where:

PVB = Present Value of BenefitsPVB = Present Value of Benefits

I = Initial InvestmentI = Initial Investment

Rule is:Rule is:

When BCRWhen BCR Or NBCROr NBCR Rule isRule is

>1>1 > 0 Accept > 0 Accept

= 1 = 0 Indifferent= 1 = 0 Indifferent

< 1 < 0< 1 < 0 Reject Reject

To illustrate the calculation of these measure, let us consider a To illustrate the calculation of these measure, let us consider a project which is being evaluated by a firm that has a cost of project which is being evaluated by a firm that has a cost of capital of 12%.capital of 12%.

The benefitThe benefit cost ratio measures for this project are: cost ratio measures for this project are:

25,000/ (1.12) + 40,000 / (1.12)1 + 40,000 / (1.12)2 + 40,000 / (1.12)3 + 40,000 / 25,000/ (1.12) + 40,000 / (1.12)1 + 40,000 / (1.12)2 + 40,000 / (1.12)3 + 40,000 / (1.12)4(1.12)4

BCR =BCR = 100,000100,000

BCR = 1.145 AcceptBCR = 1.145 Accept

NBCR = BCR – 1 =1.145 – 1 = 0.45 AcceptNBCR = BCR – 1 =1.145 – 1 = 0.45 Accept

YearYear 11 22 33 44

Initial Initial investmeinvestmentnt

(100,000)(100,000) 00 00 00

BenefitsBenefits 25,00025,000 40,00040,000 40,00040,000 50,00050,000

Developing Operating & Capital Budgeting

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