Financial Management
Budgets
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
Business processes are highly complex and require considerable effort to coordinate. Managers frequently cite coordination as one of the greatest leadership challenges. The comprehensive or master budget is an essential part of the coordinating effort.
The base or foundation for the master budget is an assessment of anticipated sales volume via the sales budget. In a merchandising environment (wholesalers and retailers), expected sales are the starting point of budget development, and directly links to the inventory purchasing budget. Warehousing capacity will be impacted by projected inventory activities. Selling and administrative expenses for retail units will be impacted by anticipated sales. All companies have general selling and administrative costs, some of which will not be driven by sales. In a service business, anticipated services (service revenue) will directly impact skilled/professional staff requirements since these businesses are labor intensive (Weygandt, Kimmel, Kieso. Managerial Accounting Tools for Business Decision Making, 5th edition. Wiley Publishing, p. 408.) In a manufacturing environment, expected sales level drives both the production plans and the selling, general, and administrative budget. Production drives the need for materials and labor. Factory overhead is ultimately driven by overall production. The graphics below are simplified illustrations of steps in budget preparation for merchandising and manufacturing companies.
Planned business activities must be considered in terms of their cash flow and financial statement impacts. It is quite easy to plan sales or production that can outstrip the resources of a company. In addition, a business should develop plans that have a successful outcome; the budgeted financial statements are key measures of that objective.
Comprehensive budgeting entails coordination and interconnection of various components. Electronic spreadsheets are useful in compiling a budget. If care is used in constructing the embedded formulas, it becomes very easy to amend the budget to examine the impact of different assumptions about sales, sales price, expenses, and so forth.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
Using the flowchart for merchandising companies illustrated above, let's follow the steps in the budgeting process. Budgeting for merchandising is less complex than that for manufacturing companies, which will be illustrated later in the module.
The budgeting process usually begins with a sales budget, which is a highly challenging activity. The sales budget reflects forecasted sales volume based on previous sales patterns, planned promotions, activities of competitors, current and expected economic conditions, etc. Overly optimistic sales budgets can result in excessive inventory which ties up cash and often leads to markdowns. In a service environment, a company will be overstaffed and labor costs will be high, negatively impacting net income. Highly conservative sales estimates can lead to inventory stockouts which negatively impacts customers and results in a loss of revenue; in a service environment it could result in overwhelming workloads for staff personnel. Both over and under estimating sales impacts the income statement. Developing anticipated sales projections requires "drilling down" to product categories or departments within retail units or specific types of service jobs. It can be further classified by cash or credit sales, store level, geographical regions, or salespersons.
Merchandising companies (wholesalers and retailers) purchase finished products from wholesalers and manufacturers. They do not typically produce products. Inventory relationships can be expressed mathematically as follows:
Beg. Inventory + Net Purchases = Cost of Goods Sold + End. Inventory
Translated: All inventory available to the company for sale to customers to generate sales revenue (BI + P) was either sold to customers (COGS) or remains in stock (EI). Inventory is reported on financial statements as an expense (COGS) on the income statement and a current asset on the balance sheet.
This basic relationship can be algebraically flipped to determine required purchases.
Budgeted Sales + Desired End. Inventory - Beg. Inventory = Required Purchases.
Translated: All inventory needed to meet sales forecasts and maintain a desired level of inventory in stock represents the total inventory needs of the company. Not all of it must be purchased or produced because there is inventory on the shelves/in the warehouse at the beginning of the period, thus subtracting the beginning inventory to determine the amount that needs to be purchased or produced during the current period.
Note the importance of estimated ending inventory and beginning inventory in the determination of purchasing needs. (Remember: ending inventory of one period = beginning inventory of the next period.)
Companies must also plan a selling, general and administrative expenses (SGA) budget. SG&A consists of variable and fixed components. Total variable expenses change based on volume of sales, while fixed expenses are a set amount for the budget period. Labor costs are normally tracked as a % of sales in a retail environment, reflecting that less employees are needed when sales levels are low, with increasing labor scheduling during heavy sales periods. Most fixed items will be the same each quarter (management salaries and depreciation), although some fixed costs, such as an advertising campaign, can fluctuate periodically.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
Please complete the following activity.
Below is an illustration of a merchandising budget preparation sequence (simplified). Each of the individual budgets is used to create the Budgeted Income Statement.
It is now time to look at budgeting in a manufacturing environment. The primary difference in budgeting is that rather than sales driving purchases, in a manufacturing environment budgeted sales drive production. Production budgets require additional budgeting for direct materials (raw materials, parts, and ingredients), direct production labor, and manufacturing overhead. Refer to the illustration of the manufacturing process within this module.
The sales budget for manufacturing reflects the same influences as that of retailers or service companies: forecasted sales volume based on previous sales patterns, planned promotions, activities of competitors, current and expected economic conditions, etc. (Jerry Weygandt and Paul Kimmel, and Donald E. Keiso, Managerial Accounting: Tools for Business Decision Making, 5th ed., (New Jersey: Wiley, 2009), 394,408).
Overly optimistic sales budgets can result in excessive inventory which ties up cash, increases warehousing costs and results in "liquidation" sales to discount/outlet businesses with heavy markdowns. Highly conservative sales estimates can lead to increased production costs, thus lowering net income, due to adding extra production shifts or running overtime to try to meet the unanticipated demand for the product. Both over and under estimating sales impacts the income statement. (Jerry Weygandt and Paul Kimmel, and Donald E. Keiso, Managerial Accounting: Tools for Business Decision Making, 5th ed., (New Jersey: Wiley, 2009), 407-8).
Please watch the following video The Various Components of a Master Budget
"21 - The Various Components of a Master Budget," YouTube Video, 9:27, Posted by "Larry Walther," Published on March 23, 2013, https://www.youtube.com/watch?v=yjtbss4zTvs
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Manufacturing companies prepare production budgets, unlike merchandising firms (wholesalers and retailers), which only prepare a purchasing budget as illustrated previously. Some grocery retailers, such as Kroger, have both retail stores and manufacturing plants for specialized products (dairy, ice cream, cheese, bakery, bottling, etc.), thus requiring both types of budget preparation, production and purchases budgets. (Garrison, Noreen, Brewer. Managerial Accounting, 15th edition. McGraw Hill, p. 354)
Sales drive the level of production. Production is also a function of the beginning finished goods inventory and the desired ending finished goods inventory. In planning production, one must give careful consideration to the productive capacity, availability of raw materials, and similar considerations.
In a manufacturing environment, the inventory relationship is translated as:
Beg. Finished Goods + Goods Manufactured = Units Sold + End. Finished Goods
This basic relationship can be algebraically flipped to determine required production.
Budgeted Sales + Desired End. Finished Goods - Beg. Finished goods = Required Production.
Translated: All inventory needed to meet sales forecasts and maintain a desired level of inventory in stock represents the total inventory needs of the company. Not all of it must be produced because there is inventory in the warehouse at the beginning of the period, thus subtracting the beginning inventory to determine the amount that needs to be produced during the current period.
Following is a multiple period illustration of the process of determining budgeted requirements for a frozen confectionary manufacturer. Carefully examine this information, paying very close attention to how each period's desired ending finished goods can be tied to the following period's planned sales taken from the sales budget.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
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Manufacturing companies must purchase required materials, ingredients and parts to support the planned production; while, merchandising firms (wholesalers and retailers) will purchase finished goods from manufacturers.
Budgeted Sales + Desired End. Inv. - Beg. Inv. = Required Purchases
Budgeted purchases can be calculated as direct materials needed in planned production, plus the desired ending direct material inventory, minus the beginning direct materials inventory. This fundamental calculation is repeated for each quarter in the manufacturing budget below which references direct materials as "ingredients." The frozen confectionary products require the use of milk, eggs, flavorings, and specialized ingredients for different product types within the category. The direct materials budget starts with required production (shown in previous illustration) levels, then factors in the quantity and type of materials needed to support the budgeted production levels. The second stage of calculation then determines the quantity of direct materials (ingredients) needed for production and calculates the expected cost of the purchases. Note that the desired ending inventory level of 5% is much lower than that used in the production budget calculation, reflecting the need for fresh ingredients which have a limited storage life, unlike finished goods which are frozen.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
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In a manufacturing environment the direct labor budget provides the framework for planning staffing needs and costs for the production process. As revealed by the labor budget, the scheduled budgeted production in units is multiplied by the number of hours necessary to produce each unit. The resulting total direct labor hours are multiplied by the expected hourly cost of labor to determine total expected production direct labor costs.
The third component involved in production budgeting, after direct materials and direct labor, involves manufacturing overhead which includes production-specific items such as maintenance and repair on equipment, factory equipment depreciation, miscellaneous factory supplies (indirect), supervisory salaries in the factory, factory utilities and factory property taxes. The total of expected overhead is calculated then must be allocated (or assigned) to each unit of product produced during the period. The allocation of the total overhead can be based on numerous items, with the factory overhead budget illustrated below using direct labor hours.
Manufacturing costs are subdivided into variable and fixed categories. Variable overhead expenses change based on volume of production such as indirect supplies increase as production increases; while fixed overhead expenses are a set amount for the budget period. Examples are the salaries for production supervision and plant executives and depreciation of plant assets which do not change with changes in production level within a period.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
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Companies must also plan a selling, general and administrative expenses (SGA) budget which include corporate functions. SG&A consists of variable and fixed components. Total variable expenses change based on volume of production or sales, while fixed expenses are a set amount for the budget period. Most fixed items will be the same each quarter, although some fixed costs, such as an advertising campaign, can fluctuate periodically.
Cash is an essential resource. Without an adequate supply of cash to meet obligations as they come due, a business will become bankrupt. Even the most successful businesses can get caught by cash crunches due to delays in collecting receivables, overspending on inventory, capital expenditures, and so on. These types of cash crises can usually be avoided. The cash budget provides the necessary tool to anticipate cash receipts and disbursements, along with planned borrowings and repayments.
Cash Receipts Section
The sales budget is complemented by an analysis of the resulting expected cash collections. Sales often occur on account, so there can be a delay between the time of a sale and the actual conversion of the transaction to cash. For the budget to be useful, careful consideration must also be given to the timing and pattern of cash collections. This is simpler in a retail environment in which a large majority of customer collections result in immediate cash (including debit and bank credit cards).
Review illustrations below closely, noting the expected pattern of cash collections of sales for a retailer and manufacturer as follows:
Sales on credit create more detailed collections calculations as illustrated below for a manufacturing firm (or retail/service company that bills customers at end of period).
Note that the lower portion of the sales budget converts the expected sales to expected collections. Manufacturing and wholesale dealers normally give retail customers credit terms of 30 to 45 days, resulting in collections over a series of periods. This example assumes that the company has very few problems with late payments or uncollectible accounts.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
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The direct material purchases budget (manufacturing) and purchases budget (retailing) provides the necessary framework to plan cash payments to vendors. Only a portion of the total cost of materials/ingredients/products purchased during a period will actually be paid during that same period. The company will have a normal payment schedule that takes full advantage of the credit period offered by vendors (30-45 days).
Other cash payments would be for direct labor and selling general and administrative. For labor costs, determine how much is normally owed to employees at the end of a period and subtract that from the total labor costs to calculate cash paid to employees. Manufacturing overhead and selling general and administrative expenses will subtract depreciation (non-cash expense reported on income statement as expense) to determine the amount of cash paid for overhead and SGA.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
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The illustration below reflects a manufacturing budgeting process reflected earlier in the module:
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
Each of the budgets presented thus far are important in their own right. They will guide numerous operating decisions about raw materials acquisition, staffing, and so forth. It is essential that all of these individual budgets be drawn together into a set of reports that provides for outcome assessments. This part of the budgeting process will result in the development of pro forma financial statements. The budgeted Income Statements for ACT-On Retail and ACT-On Frozen Delights were illustrated previously. General templates for the creation of the major financial statements is reflected below:
Companies normally have a minimum desired cash ending balance. If the cash for a given quarter. Is less than the desired minimum balance, the company will borrow the amount necessary to meet the minimum. This borrowing will be shown in the financing section. In following periods where the Cash surplus for a quarter. exceeds the minimum balance requirement, the excess funds can be repaid on the loan along with any accrued interest.
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
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Projected financial statements are often requested by external financial statement users. Lenders, potential investors, and others have a keen interest in such information. While these documents are very common and heavily used for internal planning purposes, great care must be taken in allowing them to be viewed by persons outside of the entity.
The accountant who is involved with external use reports has a duty to utilize appropriate care in preparing them; there must be a reasonable basis for the underlying assumptions. In addition, professional standards dictate the reporting that must accompany such reports if they are to be released for external use. Those reporting standards become fairly complex, and the specifics will depend on the nature of external use. But, those reports will necessarily include language that makes it very clear that the participating accountant is not vouching for their achievability.
Managers must also be careful in external communications of forward-looking information. USA securities laws can hold managers accountable if they fail to include appropriate cautionary language to accompany forward-looking comments, and the comments are later shown to be faulty. In addition, other regulations (Reg FD) may require "full disclosure" to everyone when such information is made available to anyone. As a result, many managers are reticent to make any forward-looking statements. It is no wonder that many budgetary documents are emblazoned "internal use only."
Source: principlesofaccounting.com, Larry M. Walther, Copyright 2016.
Please complete the following activity. There is only one set to be answered.
Out of all the budget components, which two would you select as most important and why?
This module demonstrated how to prepare operational budgets and produce pro-forma financial statements.
Woods, Lisa, "Business Plan vs. Forecast vs. Budget," Managing Americans.Com, https://www.managingamericans.com/Executive-Leadership-General-Management/Success/Business-Plan-vs-Forecast-vs-Budget-392.htm.
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