BU247 Lecture 15-17 Thurs. July 4-11, 2013.
Chapter 10 – Using Budgets for Planning & Coordination
The budgeting process determines the planned level of most variable costs (VC)
Budgeting includes discretionary spending, for machine maintenance, research and development,
advertising, and employee training These discretionary costs do not supply the firm with capacity
to produce, but they provide support for strategy by enhancing performance potential
Once authorized, discretionary spending budgets are committed or fixed – they do not vary with
levels of production or service
limits what can be spent in each budget category budgets reflect (quantitative) how to allocate
financial resources to each part of an organization based on planned activities and SR objectives
Budget: quantitative that reveals whether the current business plan will meet financial objectives.
Budgets communicate ST goals to employees. Asking unit managers to undertake budgeting
activities can accomplish:
1. reflect how well unit managers understand organization’s goals, so that they can align their
activities and spending priorities with those goals
2. Provide an opportunity for the organization’s senior planners to correct misperceptions about the
organization’s goals and ensure that the goals are communicated.
By considering the interrelationships among operating activities, a budget anticipates potential
problems and can provide solutions to these problems.
If budget planning suggests that sales potential >
manufacturing potential, the organization can develop a plan
to put more capacity in place or to reduce planned sales
Faster adoption of budgeting systems is associated with faster
Start-up companies with more experienced CEOs, and those
with venture capital funds, are more like to adopt budgeting
*ELEMENTS OF BUDGETING
1) Flexible resources that create VC: resources that can be acquired or disposed of in the short term
2) Intermediate term capacity resources that create FC: storage space is an example
3) Resources that, in the intermediate/long run, enhance potential of strategy: these are
discretionary expenditures which include R&D, training, maintenance of capacity resources, ads, and
promotion. These do not provide capacity, nor do they vary with level of activity.
4) LT capacity resources that create FC: example is a new facility that may take several years to plan
and build, and might be used for 10 years
Types of budgets
1) Strategic plan: sets overall goals and objectives
2) Capital budget: long range plan for investing in and financing LT capacity resources
3) Master budget: yearly projection of revenues, costs, and volumes.
1 | N A T A S H A P A R K K BU247 Lecture 15-17 Thurs. July 4-11, 2013.
2 major types of budgets make up the master budget
1) Operating budgets summarize the level of activities, like sales, purchasing, and production
2) Financial budgets (balance sheets, income statements, cash flow) identify the expected
financial consequences of the activities summarized in the operating budgets
*BEHAVIORAL CONSIDERATIONS IN BUDGETING
Budget planners solicit info from mgrs. or workers who are in the best position to know
performance potential (sales, production potential, costs). This info is incorporated into the budget
which is used to evaluate actual performance (later). This creates incentive for mgrs. to
misrepresent info gaming the budgeting process
Ex: sales manager may understate sales potential in a region to have lower target set for sales
Maybe don’t use manager’s information to evaluate their performance
*Participative budgeting: prepared with the full cooperation of managers at all levels
Estimated financial consequences from tentative budgets can influence plans/objectives
Dashed lines show a recursive process in which planners compare projections with goals. If initial
budgets prove infeasible (due to lack of capacity to produce/sell planned level of output) or
financially unacceptable (because the proposal doesn’t yield desired target profit), planners repeat
the budgeting cycle with a new set of decisions until results are feasible & financially acceptable.
Budgeting describes the acquisition, production, selling, and logistical activities performed during
the period. Planners usually choose 1 year to conform to the company’s external reporting cycle.
Compare financial goals with tentative operating plan’s projected financial results
The diagram above includes two broad sets of outputs
1) Plans or operating budgets that operating personnel use to guide operations (box 2, 3, 5, 6, 7, 8, 9)
o Operating budgets specify the expected resource requirements during the budget period.
o Operations personnel use those plans to guide and coordinate the level of activities
o operations personnel record data from current operations to develop future budgets
o use demand forecasts to prepare a sales plan for each major line of goods/services
o Greater detail in forecast improves chances that the budgeting process will identify potential
problems by specifying the exact timing of production flows in the organizations. But forecasting
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in great detail for each item among many can be expensive and overwhelming. so group
products into pools to give each product in a given pool has roughly equivalent demands
o Operating budgets typically consist of 6 operating plans:
1. Sales plan: identifies the planned level of sales for each product basis for acquiring the
necessary factors of production, such as labor, materials, production capacity, cash…
2. Capital spending plan: specifies the LT capital investments needed to meet objectives
Must be approved by the appropriate authority after all 6 steps
Usually goes on longer than the period of an operating budget, so this is a long term
planning process rather than the one-year cycle of the operating budget
3. Production plan: schedules required production; sensitive to the sales plan
Planners match the completed sales plan with the company’s inventory policy and capacity
level to determine a production plan
Identify required production in each interim period that forms the annual budget period
Inventory policy shapes the production plan some companies produce goods FOR
inventory, and have a targeted # of units in inventory at all times. This reflects a level
production strategy of companies with skilled workers/equipment dedicated to producing a
single product lack of flexibility since workers/machines only specialize in one job
Another inventory policy is to produce for planned sales in the next interim period within
the budget period. Each interim period becomes shorter until the organization achieves just-
in-time production, in which only an order can trigger production (demand driven)
requires flexibility in workers, machines, and suppliers Inventory target is the level of
next interim period’s planned sales, and schedule production = inventory target.
4. Materials purchasing plan: schedules required purchasing activities for raw materials and
supplies that the production plan requires driven by cycle of the organization’s production
plans, and therefore the suppliers’ production plans (we depend on suppliers)
Sales and production plans change, so the company & suppliers must be able to adjust
quickly based on info received during the operating period. However, at some point, the
plans must be locked in place so that there’s time for preparation.
5. Labour hiring and training plan: works backwards by first specifying # people needed to
achieve activity level objectives, & then the hiring/training/counseling out requirements
develop hiring and training schedules that will ensure worker availability
When company is contracting, use retraining plans to redeploy workers to other parts of the
company, or discharge workers discharge may include retraining to help find new jobs.
6. Admin and discretionary spending plan: admin, staffing, R&D, ads expenditures
Provides infrastructure required by proposed production & sales plans
Discretionary plan, so sales doesn’t drive the amount spent. Senior managers determine the
amount spent, and then this amount becomes fixed, unaffected by product volume and mix.
2) The expected/projected financial results PRO FORMA (box 11 & 12), which are presented in 3 forms
a) Statement of expected cash flows: used in 2 ways
1) To plan when excess cash will be generated so that it can be used to make ST
investments (vs. holding cash during ST)
2) To plan how to meet any cash shortages
b) Projected balance sheet
c) Projected income statement
o Estimate financial consequences of investment, production, and sales plans
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BUDGETING PROCESS ILLUSTRATED
Oxford sells high-quality wood and metal objects, new and antique, painted by the owner, G. until
recently, each object was unique and G did all the work herself. 2 years ago, G developed a new
product line that she intended to sell in larger volumes (to expand her business).
The new products are 2 models of painting fishing buoys: Santa, and Danny Buoy. G set up a new
operation for this new product in the Buoy Division. G did the planning, and hired a manager named
April to handle the daily operations of the new business.
Production process begins when G purchases used fishing buoys from local fishers for $2.25 each.
An artist sands the used buoys, applies a base coat of primer paint, paints the image of Santa or
Danny onto the buoy, applies a finishing coat of varnish, wraps the buoy in packing material, and
inserts it into a specially designed mailing contained that Oxford ships directly to the customer.
Oxford has 2 types of customers: retail and dealer. Retail orders arrive by mail and are prepaid for
$80 (all inclusive). If capacity > retail demand, G sells to dealers at lower unit price of $55. Because
dealers buy from other suppliers, G loses dealer orders that she isn’t able to fill immediately.
Sales to dealers are on account; dealers must pay the full amount within 30 days of billing. Receipts
from dealers, however, are often delinquent. Typically only 30% of dealers pay in the month
following the sale, 45% pay in the second month following the sale, 20% pay in the third month
following the sale, and 5% of sales to dealers are never collected.
Because of local employment conditions, Oxford must hire artists for periods of 3 months. The
artists receive a fixed monthly salary of $2k and work a maximum of 160h per month.
April, the Oxford manager, makes staffing decisions at the start of each quarter, beginning January 1.
The total time to sand, apply the base coat, paint, and pack each buoy is 0.8 labor hour.
Paint costs $3.15 per buoy. Other manufacturing costs, including supplies, are $2.75 per buoy.
Packing materials cost $1.95 per buoy, and shipping by courier costs $7.50 per buoy.
Oxford purchases for cash all flexible resources in the month they are needed.
Oxford rents space in a local park where the artists work on the buoys. The one-year lease stipulates
that rent is to be paid quarterly and in advance. Oxford can rent production space of several sizes
that would provide enough space to produce the following monthly capacities in buoys:
Insurance, heating, lighting, and taxes are $20,000 per year. Ad expenses = $40,000 per year.
April receives $30,000 per year to supervise, manage raw materials, accounting, etc.
All operating expenses are incurred and paid in equal monthly installments.
Realized sales for October, November, and December 2010 and forecasted demand for 2011:
4 | N A T A S H A P A R K K BU247 Lecture 15-17 Thurs. July 4-11, 2013.
Based on this forecasted demand, G and April have decided to rent an 800-capacity unit for 2011
and hire two painters in the first quarter, two painters in the second quarter, one painter in the
third quarter, and three painters in the fourth quarter.
G plans to withdraw $20,000 from the company at the start of each six-month period for a total of
$40,000/year as her compensation as owner and planner. She also wants to maintain the entire
firm’s cash in a separate bank account for her business with a minimum cash balance of $5,000
She has arranged a $50,000 line of credit with her bank to provide her with short-term funds for the
company. At the start of each month, the bank charges interest at the rate of 1% on the outstanding
balance of the line of credit as of the end of the previous month. The bank pays interest at the rate
of 0.6% on any cash in excess of $5,000 held in the account. The bank pays interest on the first day
of each month based on the balance in the account at the end of the previous month.
Choosing the Capacity Levels
3 types of resources determine the monthly production capacity
1) Flexible resources that the org. can acquire in ST, such as paint and packing supplies: if
suppliers do not deliver these, or deliver unacceptable resources, production = disrupted
2) Capacity resources (ex: painters) that the org. must acquire for the intermediate term: Between
July 1 and September 30, Oxford plans to employ one painter. Because each painter works 160
hours per month and because each buoy requires 0.8 hour to complete, the monthly capacity
provided by intermediate-term activity decisions in the period is 200 units (160/0.8=200)
3) Capacity resources that the organization must acquire for the long term—G plans to rent a
shop that provides a monthly capacity of 800 units. G needs a simple setting with a relatively
short commitment period. Capacity resources are expensive and are called committed because
they are the same regardless of how much of the facility is used and because the level of
capacities and FC are difficult to change in ST. Therefore, capacity resources impose financial risk.
Many organizations choose production plan that balances the use of ST, intermediate term, and LT
capacity to minimize committed resource idle time
Level of LT capacity: reflects the organization’s assessment of its LT growth trend. For Oxford,
which is renting capacity, LT capacity is defined by the lease stipulations and equals 1 year. If Oxford
were building this capacity, its LT capacity would be defined by the time needed to plan and build.
The intermediate-term capacity decision: longer of either the duration needed to put intermediate-
term capacity in place, OR the duration of the contracting period for intermediate-term capacity. #
of full-time staff employed by a bank determines the LT capacity available for the intermediate term.
For Oxford, this is the contracting period for artists, which is 3 months.
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The ST capacity decision: time needed to put ST capacity in place for Oxford, this is the time that
suppliers require for delivery, which is assumed to be almost instant.
The resource-consuming activities of Oxford can be classified into 3 common groups
1) Activities that create the need for resources and, thus, resource expenditures in ST—For
Oxford, these include the purchasing, preparation, painting, packing, and shipping of buoys.
Acquiring needed resources requires expenditures that vary directly with the production levels
because the inventory policy is to produce only to order.
2) Activities undertaken to acquire capacity for the intermediate term—For Oxford, this is the
quarterly acquisition of painting capacity; that is, hiring the painters to paint the buoys.
3) Activities undertaken to acquire or support capacity needed for the LT—For Oxford, this
includes annually choosing the level of shop capacity, the level of advertising, the manager and
manager’s salary, and expenditures for such items as insurance and heat.
Planners classify activities by type because they plan, budget, and control expenditures differently.
Analysts evaluate ST activities by considering efficiency.
o Is this expenditure necessary to add to the product value perceived by customers?
o Can the organization improve how it performs this activity?
o Would changing the way this activity is done provide more satisfaction to customers?
Analysts evaluate intermediate- and long-term activities by using efficiency and effectiveness
considerations and asking questions such as these:
o Are alternative forms of capacity available that are less expensive?
o Is this the best approach to achieve our goals?
o How can we improve the capacity selection decision to make capacity cheaper or more flexible?
Choosing capacity plan: acquire intermediate and LT capacity; commits firm to these expenditures.
Choosing production plan: level of ST activities; fixes ST expenditures that the budget summarizes.
Handling Infeasible Production Plans
Planning reflects how planners use forecasted demand to plan activity levels & get required capacity
If the tentative production plan is infeasible because projected demand > available capacity,
provisions must be made to get more capacity or reduce the planned level of production
Interpreting the Production Plan
3 factors drive planning
1) Demand: quantity customers are willing to buy at the stated price
2) Capacity levels chosen
3) Production output quantity
Oxford starts no production until it receives an order. So, for Oxford,
o production is the minimum of total demand and production capacity
o production capacity is the minimum of shop capacity(LT), painting capacity, supplies capacity(ST)
o total demand = retail demand + dealer demand
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The Financial Plans
Once the planners have developed the production, staffing, and capacity plans, they can prepare a
financial summary of the tentative operating plans.
The financial results for Oxford implied by the production plan appear in the following exhibits:
7 | N A T A S H A P A R K K BU247 Lecture 15-17 Thurs. July 4-11, 2013.
Planners use the projected balance sheet as evaluation of the net effect of operating and financing
decisions during the budget period
Income statement = overall test of the profitability of the planners’ proposed activities.
To keep it simple, this example ignores taxes.
Taxes are part of the budgeting and cash flow estimation process of all organizations.
*Understanding the Cash Flow Statement CASH BUDGET
The cash flow statement in Exhibit 10-8 is organized into three sections:
1) Cash inflows from retail cash sales and collections of dealer receivables (exclude borrowing)
o For Oxford, retail orders are paid for with the order at a retail price per unit of $80
o Sales to dealers for $55 per unit are on account with a typical collection pattern being 30% in
the month after the sale, 45% the month after that, and then 20% (5% not collected)
2) Cash outflows for flexible resources that are acquired and consumed in ST (buoys, paint, other
supplies, packing, shipping) and cash outflows for capacity resources acquired and consumed in the
IT & LT (painters, shop rent, mgr.’s salary, other shop costs, interest paid, and ad costs)
o Cash outflow = Units of flexible resource purchased x Price per unit of flexible resource
o for resources in the IT or LT (not flexible), cash outflow = this month’s expenditure for that
3) Results of financing operations. Net cash flows from operations = cash inflows – cash outflows
o The financing section of the cash flow statement summarizes the effects on cash of transactions
that are not part of normal operating activities
o Net operating cash flow + Opening cash + Cash from financing activities= Ending cash
8 | N A T A S H A P A R K K BU247 Lecture 15-17 Thurs. July 4-11, 2013.
The major sources and uses of cash in most organizations are the following 4:
(2) investments or withdrawals by the owner in an unincorporated organization,
(3) long-term financing activities related to issuing or retiring stock or debt
(4) Short-term financing activities: often involves obtaining a line of credit, secured or unsecured,
with a financial institution. The line of credit allows an organization to borrow up to a specified
amount at any time. The line of credit is secured if the organization has pledged an asset that the
financial institution can seize if the borrower defaults on any of the bank’s requirements. The
financial institution sets a limit on the line of credit, and the borrower pays the specified interest at
specified periods on the outstanding balance borrowed.
The format of the financing section of the cash flow statement in Exhibit 10-8 for Oxford does not
follow the format used in Exhibit 10-13. The financing section provides information about the line-of
credit balance. Many organizations include the line-of-credit info in the cash flow statement
because readers should be aware of the limits that can potentially constrain operations.
Using the Financial Plans
Oxford’s cash flow statement, Exhibit 10-8, contains a short-term financing plan that suggests that, if
events unfold as expected, their cash balance increases only modestly during the year because of
the $40,000 withdrawal that Gael will make from the business. Therefore, the company will use its
line-of credit agreement heavily. It will be borrowing from the bank for 11 of the 12 months.
A cash flow forecast helps an organization identify if and when it will require external financing. It
shows whether any projected cash shortage will be temporary or cyclical, (which can be met by a
line-of-credit arrangement), or whether it will be permanent, which would require a LT loan from a
bank, further investment by the current owners, or investment by new owners.
Based on the info provided by the cash flow forecast, organizations can plan the appropriate mix of
external financing to minimize the long-run cost of capital.
The projected income statement and balance sheet provide a general assessment of the operating
efficiencies at Oxford. If these projected results are unacceptable, change the organizational
processes that create the unacceptable results.
Suppose April studied the projected financial results in the initial budget plans and decided that the
14.6% profit margin on sales ($0,666/279,134; Exhibit 10-10) is too low. Manager may develop a
marketing program or cost reduction program to improve the cost/revenue performance at Oxford.
Using the Projected Results
The operating budgets provide a framework for developing expectations about activity levels in the
upcoming period. Planners use the operating budgets to test the feasibility of production plans.
As the budget period unfolds, production and operations schedulers will make more accurate
forecasts and base their production commitments on them.
Thus, planners use the budget information to accomplish:
1. Identify broad resource requirements— helps develop plans to put needed resources in place.
2. Identify potential problems—This helps to avoid problems or to deal with them systematically.
3. Compare projected operating and financial results—serve as a measure for comparison with the
operating and financial results of competitors. Such a comparison to plan can be used as a test of
the efficiency of the organization’s operating processes. The differences between planned and
actual costs at Oxford will focus April’s attention on understanding whether the plans were
unrealistic or whether the execution of a sound business plan was flawed.
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Cost-volume-profit analysis assumed a constant product mix. Now, software make it possible to
consider product mixes so that mgrs. can evaluate alternative strategies
Structure and info required to prepare the master budget can be used to provide what-if analysis
What-if analysis: alternative proposals for marketing, production, and selling strategies
Evaluating decision-making alternatives: April is considering renting a machine to automatically
sand the buoys and apply the primer coat. The machine’s capacity is 1300 buoys/month, and
reduces the painting time from 0.8 to 0.5 hours/buoy. The machine increases other costs from $20k
to $35k. The reduction in painting time per buoy allows Oxford to reduce # painters needed for any
level of scheduled production. Renting this machine raises projected net income from $40666 to
$57490. The revised estimated income statement reflecting the rental of the machine is shown here:
What-if analysis is only as good as the model used to represent what is being evaluated. The model
must be complete, it must reflect relationships accurately, and it must use accurate estimates.
Sensitivity analysis is the process of selectively varying a plan’s or a budget’s key estimates for the
purpose of identifying over what range a decision option is preferred.
If small forecasting errors of an estimate used in the production plan change the plan, we say that
the model is sensitive to that estimate. If the performance consequences (ex: profits) from a bad
estimate are severe, planners should improve the accuracy of their estimates.
Ex. of sensitivity analysis: suppose an organization has capacity to accept only one of two possible
orders. Order 1 gives revenues of $1,000,000 and expected costs of $750,000. Order 2 promises
revenues of $800,000 and has costs of $600,000. Based on this info, order 1—with an expected
profit of $250,000—looks better than order 2, which has profit of $200,000. However, the profit
associated with order 1 is uncertain, whereas the profit associated with order 2 is certain. Suppose
planners decide that the costs associated with order 1 could be between $720,000 and $780,000.
This would not affect the decision because even if the worst costs are realized for order 1, profits
will still be $220,000, which is more than the $200,000 for order 2. However, certain circumstances
(when costs of order1 > $800,000) will have planners wishing they had accepted order 2.
Sensitivity analysis enables planners to identify the estimates that are critical for the decision under
consideration. For example, for Oxford, small changes in the estimate of labour, which is the key
resource, produce large changes in the projected profit. If Oxford can reduce labor time needed to
make a buoy by 10%, from 0.8 to 0.72 hour per buoy, projected profit would increase 31%. This is a
signal to April that efficient artists = critical to the success of her business.
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*VARIANCE ANALYSIS: Comparing Actual And Planned Results
Variance analysis has many forms and can result in complex measures, but its basis is very simple—
an actual cost/revenue amount is compared with a target cost/revenue amount to identify the
difference, which is called a variance: departure from what was budgeted or planned