Strategic Planning and Control

a.y. 2022/2023

BUILDING A PROFIT PLAN

Simons, Performance Measurement and Control

Systems for Implementing Strategy, 2014, Ch. 5

Dr Sonia Quarchioni
Department of Economics, Business and Statistics, University of Palermo
 The role of PM&MCSs
2

PMSs help set Business Strategy

which is specified
PM&MCSs
into
planned through
formal, information-
based routines and PMSs track the Profit
procedures managers use achievement of Strategic goals
planning
to maintain or alter systems
patterns in whose successful
organizational activities Performance
scorecards implementation leads to

Profit
 Some basic ‘terms’... (1/4)
3
STRATEGIC PLAN

 The most forward-looking plan which sets the overall

objectives of the organization
 It should contain forecast income statement, assets and
liabilities statement and financial statement for three or five-
to-ten year periods (also called long-range plan)
 Usually it is coordinated with the CAPITAL BUDGET planned
expenditures for facilities, equipment, and other long-term
investments
 Some basic ‘terms’... (2/4)
4
MASTER BUDGET

 detailed and comprehensive analysis of the first year of the

strategic plan (e.g. 1/01/2022 - 31/12/2022)
 it links strategic (long-range) plans and short-term budgets
 it summarizes the planned activities of all subunits of an
organization (e.g. Sales Production Distribution Finance)
 Some basic ‘terms’... (3/4)
5

 You can also find Master Rolling budgets... are

a common form of master budgets that add a month
(or three months) in the future as the month (or the
quarter) just ended is dropped

Traditional budget:

Rolling budget:
 Some basic ‘terms’... (4/4)
6

 Master budget has two major sections

OPERATIONAL BUDGET FINANCIAL BUDGET (or

OR PROFIT PLAN Cash Flow statement)

Focuses on the projected Focuses on the effects that the profit

Income Statement plan and other plans (such as the
capital budget) will have on cash
balances
 The profit plan: main objectives (1/3)
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1. To translate the strategy of the business into a detailed plan to

create value

Strategies need to be translated into accounting numbers to

evaluate how they actually create value

In so doing, a profit plan can help answer these questions:

Does the organization’s strategy create economic value?
Does it pay to invest in a new strategic opportunity?
How attractive are different strategic alternatives?
 The profit plan: main objectives (2/3)
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2. To evaluate whether sufficient resources are available to

implement the intended strategy

Companies need operating cash to finance their current

operations and investment cash to invest in new assets for
future growth

In so doing, a profit plan (together with financial and capital budgets) can help
answer these questions:
Does the organization have enough cash to fund the strategy and remain solvent
throughout the year?
Is the cash flow carefully planned to estimate cash reserves and potential
borrowing requirements?
 The profit plan: main objectives (3/3)
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3. To create a link between the performance of the internal

processes and financial goals (level of profit)

This shows to investors if they are likely to receive an adequate return (only in
the case of good levels of performance they will commit their money to a
company)

In so doing, a profit plan can help answer these questions:

Does the organization create enough value to attract the financial resources that it needs to
fund long-term investment in new assets?
Is the organization able to show an attractive return on investment?
 The profit planning process
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 Any profit plan starts with a set of shared

assumptions for the future
 These assumptions are discussed and verified within
an iterative process characterized by 5 main steps

 The first step to build a profit plan is always the

estimation of the level of sales...
 Step 1: estimate the level of sales
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Estimating sales volume requires predictions about the impact of

external factors and estimations of the effect of internal decisions

• Macroeconomic factors • Mix and pricing of product categories

• Government regulation
• Competitor moves
• Customer demand
• Marketing programs made by sales force
(based on past patterns of sales)
• Advertising and sales promotion plans
• Changes in product quality and features
• Manufacturing and distribution capacity
• Market research studies (e.g. Customer service
levels)

All these decisions flow into the Sales Budget

 Step 2: forecast operating expenses (1/3)
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 When the sales budget has been completed,

managers have to forecast operating expenses
which are needed to realize the products to sell

P.S. Difference between “cost” and “expense”!

A company buys goods for €500  500 is the COST of goods
purchased

€400 goods consumed in the year  400 is the annual EXPENSE (in
the Income Statement)

€100 goods not consumed in the year  100 is ‘postponed’ to the

future (in the Assets&Liabilities statement as an asset – inventory)
 Step 2: forecast operating expenses (2/3)
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 In relation to the output, operating expenses can be classified into:

1. Direct costs/expenses:
Can be traced directly to a single product E.g. raw materials, direct
labor costs
typically estimated as a percentage of sales. That is, an increase in
sales volume is assumed to lead to a proportional increase of
production volume and thus in the usage of inputs

2. Overheads (indirect costs):

 cannot be traced directly to a single product (e.g. the rent of a

building; the administrative staff’s salaries)

 Step 2: forecast operating expenses (3/3)
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Several classification of overheads. For instance,

 Manufacturing overheads
 controllable  change with the level of specific underlying support activities
(e.g. indirect materials, indirect labor, indirect-variable portion of power and
maintenance).
 committed  not subject to discretion during the period because depending on
past investment decisions and accounting policies (e.g. depreciation,
amortisation...)
 Non-manufacturing overheads  usually in sales and
administration areas; typically discretionary costs (estimated by
increasing or decreasing past levels of expenses and opened to
subsequent adjustment during the operating period)
 Step 3: Calculate expected operating profit
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 The difference between expected sales and expected

operating expenses determines the amount of
economic value (net operating profit or net operating
income) that the company is expected to generate in
the profit planning period

The overall view of this value is provided by the

planned profit and loss account or income
statement
 An example: The Enterprise Company - 1

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The Enterprise Company manufactures two products, known as

alpha and sigma. Alpha is produced in department 1 and sigma in
department 2. The following information is available.

Alpha Sigma
Actual sales in 2022 (units) 7.727 1.455
Selling price per unit £ 400,00 £ 560,00

-Based on their analysis of several external and internal factors,

managers at the Enterprise Company estimate that sales volume
will grow by 10% for both products in the next year (2023)

Which is the planned level of sales for 2023?

 The sales budget

17

Alpha Sigma
Sales in 2022 (units) 7.727 1.455
Selling price per unit £ 400,00 £ 560,00

Sales volume will grow by 10% for both products in the next year (2023)

7.727 + 10% = 8.500

1.455 + 10% = 1.600
Sales budget for year ending 2023
 An example: The Enterprise Company - 2

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 How many finished products does the company need to produce according
to the forecast sales?

Consider also the planned inventory levels:

 The production budget

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Production budget for year ending 2023

-
 Now, the company can forecast direct costs - 3

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1. Raw materials : How many raw materials are needed to produce

my expected level of finished products? Consider that:

Alpha Sigma
Material X- standard units for each product 10 (at 7.20 £) 8(at 7.20 £)
Material Y- standard units for each product 5 (at 16 £) 9 (at 16 £)

How many raw materials should be purchased taking into account the
planned level of inventory of raw materials? Consider that for 2023:
 Alpha Sigma
Material X- standard units for each product 10 (at 7.20 £) 8(at 7.20 £)
Material Y- standard units for each product 5 (at 16 £) 9 (at 16 £)
Direct materials
purchase budget
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TOT.
1.785.408
 Now, the company can forecast direct costs - 3

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2. Labour costs: Which is the level of labour costs needed to

produce my expected level of finished products? Consider
that:

Alpha Sigma
Direct labour – hours for each product 10 15
Direct labour - standard cost per hour £ 12,00 £ 12,00
 Direct labour budget
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Alpha Sigma
Direct labour - hours of usage for each product 10 15
Direct labour - standard cost per hour £ 12,00 £ 12,00

Direct labour budget

Alpha Sigma
 The next step is to estimate Manufacturing overheads:

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1. Indirect and controllable manufacturing overheads are estimated

considering the direct labour hours:

Overheads Alpha Rate per Tot labour hours Estimated

direct needed for all overheads
labour hour products(from direct
labour budget)
Indirect materials 1,20 £ (x) 102.000 £ 122.400
Indirect labour 1,20 £ (x) 102.000 £ 122.400
Power (indirect variable 0,60 £ (x) 102.000 £ 61.200
portion)
Maintenance (indirect 0,20 £ (x) 102.000 £ 20.400
variable portion)
Tot. £ 326.400

Estimation: e.g. I will spend 1,20£ of indirect

material, for each hour of direct labour
 The next step is to estimate Manufacturing overheads:

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1. Indirect and controllable manufacturing overheads are estimated

considering the direct labour hours:
Overheads Sigma Rate per direct Tot labour hours Estimated
labour hour needed for all overheads
products(from direct
labour budget)
Indirect materials 0,80 £ (x) 24.075 £ 19.260
Indirect labour 1,20 £ (x) 24.075 £ 28.890
Power (indirect variable 0,40 £ (x) 24.075 £ 9.630
portion)
Maintenance (indirect 0,40 £ (x) 24.075 £ 9.630
variable portion)
Tot. £ 67.410
Estimation: e.g. I will spend
0,80£ of indirect material, for
each hour of direct labour
 The next step is to estimate Manufacturing overheads:
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2. Indirect committed (non-controllable) manufacturing

overheads are not subject to discretion (given
values):

Tot. Budget of Manufacturing overheads= 326.400+67.410+410.796=804.606

 The next step is to estimate Non-Manufacturing overheads:
estimation from the previous years
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Selling and
Administration budget Total
The Income Statement... (all in £, total)
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(Opening inventory of RM – Closing inventory of RM)

(Opening inventory of FP – Closing inventory of FP)
 Step 3: Calculate expected profit
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Net operating income (or net operating profit)

- interest expenses
managers can forecast the expected
= Net profit before taxes interest cost by maintaining the same of
- taxes the previous year if change not
significant
= Net profit (or earnings or income)

Non-discretionary
 Step 4: Price the investment in new assets
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 After the identification of the expected profit,

managers must look at the required level of
investment in new assets (which are needed to
support desired sales). In particular,
 Long-term assets  resources held for an extended
period of time, such as land, buildings, and equipment

Capital investment plan (or capital budget)

(assessment of the financial attractiveness of any
single capital investment proposal)
 Step 5: Test key assumptions
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 Managers must go back and forth among the variables

in the profit plan to ensure that it reflects the strategy
and is attractive from an economic point of view
 Expected profit is subjected to a sensitivity analysis
 to estimate how profit might change when underlying
assumptions about the competitive environment or other
predictions embedded in the base profit plan prove to be
under- or overstated.
 Usually, sales, operating expenditures, and capital
acquisition plans are estimated for three different
scenarios: worst-case scenario, most likely scenario, and
best-case scenario
 E.g.
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 The Profit Wheel
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 The final profit plan summarizes the expected sales and

expenses for the next accounting period. These expectations
form the so-called Profit Wheel

1. Helps managers choose

between different
alternatives
2. Provides direction
facilitating coordination
among various departments
3. Used to set performance
goals (but attention if used
as performance evaluation
tool!)
 The Cash Wheel
34

 Before a profit plan can be accepted as feasible, managers must forecast if the
company will have enough cash to operate  the Cash Wheel

Accounts receivable are Cash used to produce

turned into cash inventory

Taking cash from Payment cash to

customers purchase inventory
Sales generate accounts Inventory used to
receivable generate more sales
Time laps: need to borrow
from lenders to cover
operating expenses
 Estimating cash: the direct method
35

E.g.
 Estimating cash: the indirect method (1/3)
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 To estimate cash needs over longer periods of time,

companies generally use the indirect method. Three
steps:

1. Estimate the operating cash flow, i.e. cash that derives

from operating activities:
1. we do not consider non-operating expenses (e.g. financial
expenses) and non-monetary costs (e.g. amortization);
 Estimating cash: the indirect method (2/3)
37
(From the profit plan)

Non-operating expenses

(Not require outlays of cash)

Earnings before interest, taxes, depreciation and amortization

+ accounts receivable  cash

outflow
- Accounts receivable  cash
inflow

+ inventory  cash outflow

-inventory  cash inflow

+accounts payable  cash inflow

- accounts payable  cash outflow
 Estimating cash: the indirect method (3/3)
38

2. Estimate the cash from investment activities (acquisition and

divestiture of long-term assets)

3. Estimate cash from financing activities: needed for (or

generated by) financing and income tax
39

Managers must work to

accelerate the flows
around the cash wheel,
freeing up cash for
investment, financing or
operations growth!
 The ROE wheel
40

 Before a profit plan can be accepted as feasible, managers must also

forecast if the return of the business is sufficiently attractive

From the perspective of

From the perspective of
managers:
investors:
ROE (return on equity)
ROI (return on investment)

Net operating profit Net profit

Total assets Shareholders’ equity
Profit (output) seen as a percentage of
Profit (output) seen as a percentage of
shareholders’ equity (inputs).
total assets invested (inputs).
 ROE
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ROE= Net operating profit X Assets X Net profit

Assets Shareholders’ equity Net operating profit

ROI X Financial leverage X Incidence of non-

ratio operating profit
 The Roe wheel
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 Step 2: compare projected ROE with industry

benchmarks and investor expectations in order to
choose the best alternative
 High returns on investment lead to the willingness of
investors to commit additional financial resources to
support the growth of the firm
 If the expected ROE is not sufficiently high to meet
expectations, managers go back to find ways to
increase profit or make better use of existing assets 
they go back into the three wheels....
 To sum up
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 The three wheels are interlocking  Adjusting or

changing any assumption or number of any of the
wheels causes a change in all the other variables

Wheels impose constraints on every profit plan and

are used to evaluate the economics and internal
consistency of each potential strategy:

1. With the profit wheel a profit plan is prepared for

each alternative which generates different levels of
profit
2. With the cash wheel, managers can be sure that
cash will be adequate to fund different strategies
3. With the ROE wheel, ROE is compared for each
alternative