Chapter 4

Budget: A condensed business plan for the forthcoming year (or less).

Budget used

-used to attracting funds from investors and creditors

-used by managers to guide them in

Allocating resources

Maintaining control

Measuring progress

Rewarding progress

Functions of budget are

1.planning
2.performance evaluation
3.communication
Budgets provide a comprehensive financial overview of planned company operation.
Budget highlights potential problems and opportunities early,That allowing managers to take
steps to avoid the problems or use the opportunities wisely.
Managers use budgets as a benchmark- a measure of expected or desired performance and
comparing it against actual performance .
Finally, budgets provide an important two-way communication channel.

Advantages of Budgets
1. Evaluation of planning : It provides managers opportunities to reevaluate existing activities
and evaluate possible new activities. Budgeting use current activities as the starting point for
planning.

Managers may thing that the activities of new budget are the same activities of the previous actities ,
others may believe that previous activities may not automatically be continue (zero-budget)

2. Formulate planning It compels managers to think ahead by formalizing their responsibilities

for planning to anticipate and prepare for changing. And set objectives and goals and creat
policies that aid to achieve these goals.
3. Communication and coordination: It aids managers in communicating objectives to units and
coordinate actions across the organization.
A good budget process communicates both from the top down and from the bottom up.

- Top management makes clear the goals and objectives of the organization in its budgetary
directives.

- Employees and lower-level managers then inform higher-level managers how they plan to
achieve the goals and objectives.
 4. Performance evaluation :It provides a benchmarks to evaluate performance.

- Budgeted goals and performance are generally a better basis for judging actual results than is past
performance.

- The major drawback of using historical results for judging current performance is that

1. inefficiencies may be concealed in the past performance.

2. Changes in economic conditions, technology, personnel, competition, etc., also limit the usefulness
of comparisons with the past.

Potential Problems in Implementing Budgets:

1- Budget Participation and Acceptance of the Budget

Budget need the support of all managers and employees,

Subordinates may regard objectives in the budget as straightjackets that are unduly restrictive.

Participative budging The effectiveness of budget depend on the affected managers understand and
acceptance

Problems may arise when managers and employees rewarded on dimensions other than meeting
budgets.

Higher level of management must show to their managers and employees how budget can help them
to achieve better result.

2- Incentives to Lie and Cheat

Lying may arise if the budget process creats incentives to managers to bias the information that goes
in to the budget

Managers may want to increase resources allocation to their department in order to achieve output
targets and receive higher reward.

If the organization use budget as tool to evaluate performance managers may create budgeted slack
or padding Managers may , overstate their costs and understate the revenue , to creat budget profit
level that is easier to achieve

Lying and cheating may create cynicism about a budget process and cultural of unethical behavior in
the organization.

3- Difficulties of Obtaining Accurate Sales Forecasts

- The sales budget is the foundation of the entire master budget. The accuracy of the estimated
purchases budgets, production schedules, and costs depends on the detail and accuracy (in dollars,
units, and mix) of the budgeted sales.
- Sales Forecast (i.e., a prediction of sales under a given set of conditions) is used to prepare the Sales
Budget (i.e., the result of decisions to create the conditions that will generate a desired level of sales).

- A firm may have sales forecasted for various levels of advertising.

- Once a decision has been made regarding the level of advertising expenditures, the sales budget is
determined.

- Sales forecasts are usually prepared under the direction of the top sales executive. Important factors
considered by a forecaster include:

1. Past patterns of sales

2. Estimates made by the sales force

3. General economic conditions

4. Competitors' actions

5. Changes in the firm's prices

6. Changes in product mix

7. Market research studies

8. Advertising and sales promotion plans

Sales forecasting usually combines various techniques. In addition to the opinions of sales staff,
statistical analysis of correlations between sales and economic indicators (prepared by economists and
members of the market research staff) and opinions of line management provide valuable help.
Ultimately, the sales budget is the responsibility of line management.

Types of Budgets:
The planning horizon for budgeting may vary from one day to many years.

1- Strategic Plan:

The most forward-looking budget, which sets the overall goals and objectives of the organization.

2- Long-Range Planning: Forecasted financial statements for 5- or 10-year periods. Long-range

planning includes decisions about the addition or deletion of product lines, design and location of new
plants, acquisition of buildings and equipment, and other long-term commitments.

3- Capital Budgets:

Detail the planned expenditures for facilities, equipment, new products, and other long-term
investments in coordination with long-range plans.

4- Master Budget (Pro Forma Statements):

Summarizes the planned activities of all subunits of an organization (e.g., sales, production,
distribution, and finance).
It quantifies targets for sales, cost-driver activity, purchases, production, net income, and cash
position, and any other objective that management specifies.

It is a periodic business plan that includes a coordinated set of detailed operating schedules and
financial statements. It includes forecasts of sales, expenses, cash receipts and disbursements, and
balance sheets. Managers may also prepare daily or weekly task-oriented budgets that help them
carry out their particular functions and meet operating and financial goals.

5- Continuous Budgets (Rolling Budgets):

Common form of master budgets that add a month in the future as the month just ended is
dropped. This type of budget forces managers to think specifically about the forthcoming 12 months
and thus maintain a stable-planning horizon. While a new month is added to a continuous budget, the
other eleven months can also be updated.

Components of a Master Budget:

The usual master budget for a non-manufacturing company has the following components:

Operating Budget (profit plan):

- Sales budget (and other cost-driver budgets as necessary).

- Purchases budget.

- Cost of goods sold budget.

- Operating expenses budget.

- Budgeted income statement.

Financial budget:

- Capital budget

- Cash budget

- Budgeted balance sheet

Manufacturing companies must prepare ending inventory budgets and budgets for labor, materials,
and factory overhead in addition to the budgets indicated for non-manufacturing organizations.

Preparing the Master Budget:

Steps in Preparing the Master Budget:

The principal steps in preparing the master budget are:

Step 1: Preparing Basic Data

The following schedules are prepared:

a. Sales Budget Schedule (a)

This schedule shows, by month, the expected credit, cash, and total sales. Total sales for the budget
period are shown on the budgeted income statement. -9-

b. Cash Collections from Customers Schedule (b)

This schedule indicates the sources for the cash collections as the current month's cash sales and the
collection of the prior month's credit sales. Total cash collections for each month are the sum of
these two amounts. The total of these collections is used in helping to construct the cash budget.

c. Purchases and Cost-of-Goods Sold Budget Schedule(c).

The budgeted purchases are found using the following equation:

Budgeted purchases=

Desired ending inventory + cost of goods sold beginning inventory

The cost of goods sold is derived from the sales budget by multiplying an appropriate percentage by
the budgeted sales. The total amount of this expense appears in the budgeted income statement.

d. Disbursements for Purchases Schedule (d).

The monthly payment for purchases is based on the dollar purchases derived in Schedule c and the
company's payment pattern for its merchandise purchases. The total of these disbursements is used
in helping to construct the cash budget.

e. Operating Expense Budget Schedule (e).

This schedule details the amounts of wages, commissions, miscellaneous, rent, insurance and
depreciation expenses for each month. Some of these vary with activity, while others are usually
fixed each period. Totals for the budget period for these items are included on the budgeted income
statement.

Chapter 2

A cost driver:
Is an independent variable, such as the level of activity or volume, that causes costs to increase or
decrease over a given time period.

A cause-and-effect relationship exists between a change in the level of activity or volume and a
change in the level of total costs.

The cost driver of variable costs is the level of activity or volume whose change causes these costs to
change proportionately.

For example, the number of trucks assembled is a cost driver of the cost of steering wheels for the
trucks.
Fixed costs have no cost driver in the short run but may have a cost driver in the long run. For
example, the equipment and staff costs of product testing typically are fixed in the short run with
respect to changes in the volume of production.

In the long run, however, the company increases or decreases these costs to the levels needed to
support future production levels.

Two basic types of cost-behavior patterns Variable and Fixed costs.

The variable cost

Changes in total in proportion to changes in the related level of total activity or volume .

A variable cost does not change on a per unit basis when the related level of total activity or volume
changes. (Variable cost per unit is fixed.)

The fixed cost :

Remains unchanged in total for a given time period, despite wide changes in the related level of total
activity or volume. A fixed cost increases (decreases) on a per unit basis when the related level of total
activity or volume decreases (increases). (Fixed cost per unit is variable )

Relevant range:

Is the span of normal activity or volume level in which there is a specific relationship between the
activity or volume level and the cost in question.

Note:

Costs are variable or fixed with respect to a specific cost object (volume level of activity) and for a
given time period .

Note:

Outside the relevant range the fixed cost and the variable cost per unit may change.

Cost-Volume-Profit Analysis
Cost-Volume-Profit (CVP) Analysis is the study of the effects of output volume on revenue (sales),
expenses (costs), and net income (net profit). The major simplifying assumption is to classify costs as
either variable or fixed with respect to the volume of output activity .

Break-Even Point (BEP): is the level of sales at which revenues equals expenses and net income is
zero. One direct use of the BEP is to assess possible risk. By comparing planned sales with the BEP,
managers can determine a Margin of Safety - how far sales can fall below the planned level before
losses occur.

If the planned sales decreased by of which the company is safety in occurring losses.

Margin of Safety = planned unit sales - break-even unit sales

The use of the CM percentage is necessary when a firm produces more than one product .
 The Assumptions Used in Constructing the Typical Break-Even Analysis Include the
Following:

1. Expenses may be classified into variable and fixed categories.

2. The behavior of revenues and expenses is accurately portrayed and is linear over the
relevant range.

3. Efficiency and productivity will be unchanged.

4. Sales Mix (i.e., the relative proportions or combinations of quantities of products that
constitute total sales) is constant.

5. The difference in inventory level at the beginning and end of a period is insignificant.

Sales-Mix Analysis
- Sales Mix means the relative proportions or combinations of quantities of products that
comprise total sales. If the proportions of the mix change, the CVP relationships may also
change.

- Generally, selling a higher (lower) proportion of high CM products than anticipated results in
higher (lower) net income.

Companies try to find their most desirable combination of fixed- and variable-cost factors.
- Some choose to increase their CM ratios and fixed costs by automating,
- while others may choose to lower their fixed costs and lower their CM ratios by putting
their sales force on commissions rather than paying salaries.

When the CM percentage of sales is low, great increases in volume are necessary before significant
improvements in net profits are possible. As sales exceed the BEP, a high CM percentage increases
profits faster than a low CM percentage.

Operating Leverage
Operating Leverage means the firms ratio of fixed and variable costs.

- In highly leveraged firms, (i.e., those with high fixed costs and low variable costs) small
changes in sales volume will result in large changes in net income.

- Less leveraged firms show smaller changes in net income with changes in sales volume.
Above the BEP, net income increases faster for highly leveraged firms. However, below the
BEP, losses mount more rapidly.