Chapter 10 financial management from management science PDF

Preview

Summary

CHAPTER 10FORECASTING SHORT-TERM OPERATING FINANCIAL REQUIREMENTSExpected Learning OutcomesAfter studying Chapter 10, you should be able to: Understand the relationship between financial planning and control. Know the nature, purposes and limitations of the budget. Enumerate the types of budgets. Un...

Description

CHAPTER 10

FORECASTING SHORT-TERM OPERATING FINANCIAL REQUIREMENTS Expected Learning Outcomes After studying Chapter 10, you should be able to:

1. Understand the relationship between financial planning and control.

2. Know the nature, purposes and limitations of the budget.

3. Enumerate the types of budgets.

4. Understand and apply the steps in developing a master budget.

FINANCIAL PLANNING AND CONTROL PROCESS Business is becoming increasingly competitive and corporate profitability is increasingly dependent upon operating efficiency. This situation is desirable from a social standpoint, for consumers are getting higher quality goods at lower prices but intense competition does make life tough on corporate managers. In the previous chapter, focus was given on financial forecasting emphasizing how growth in sales requires additional investments in assets which in turn generally requires the firm to raise new external capital. This chapter will now consider the planning or budgeting and control or evaluation systems used by financial managers covering a period of one year or less. Financial planning involves making projections of sales, income, and assets based on alternative production and marketing strategies and then deciding how to meet the forecasted financial requirements. In the financial planning process, managers should also evaluate plans and identify changes in operations that would improve results. Financial control moves on to the implementation phase dealing with the feedback and adjustment process that is required (a) to ensure that plans are followed and, (b) to modify existing plans in response to changes in the operating environment. The process begins with the specification of the corporate goals, after which management lays out a series of forecasts and budgets for every significant area of the firm's activities, as shown in Figure 10-1.

Financial forecasting analysis begins with projections of sales revenues and production costs. In standard business terminology, a budget is a plan which sets forth the projected expenditures for a certain activity and explains where the required funds will come from. Thus, the production budget presents a detailed analysis of the required investments in materials, labor, and plant necessary to support the forecasted sales level. Each of the major elements of the production budget is likely to have a sub-budget of its own; thus, there will be a materials budget, a personnel budget and a facilities budget. The marketing staff will also develop selling and advertising budgets. Typically, these budgets will be set up on monthly

basis, and as time goes by, actual figures will be compared with a projected figure for the remainder of the year will be adjusted if it appears that the original projections were unrealistic. During the planning process, the projected levels of each of the different operating budgets will be combined, and from this set of data the firm's cash flow will be set forth in its cash budget. If a projected increase in sales leads to a projected cash shortage, management can make arrangements to obtain the required funds in the least-cost manner. After all the cost and revenue elements have been forecasted, the firm's projected statements can be developed. These projected statements are later compared with the actual statements such as; comparisons can help the firm pinpoint reasons for deviations, correct operating problems, and adjust projections for the remainder of the budget period to reflect actual operating conditions. Through its financial planning and control processes, management seeks to avoid cash squeezes and to improve the profitability of the individual divisions and thus the entire company.

BUDGETING DEFINED Budgeting is the act of preparing a budget. A budget is a financial plan of the resources needed to carry out tasks and meet financial goals. It is also a quantitative expression of the goals the organizations wishes to achieve and the cost of attaining these goals. The use of budgets to control a firm's activities is known as budgetary control. THE PURPOSES OF THE BUDGET A budget is a description in quantitative - usually monetary - terms of a desired future result. The process of preparing the budget requires management at all levels to focus on the future of the business entity. The benefits that may be realized from a budgeting program are 1. Defining broad objectives and goals and formulating strategies to achieve such objectives 2. Coordinating the activities of the organization by integrating the plans of the various parts thereby pulling every one in the same direction; 3. Allocating resources to those parts of the organization where they can be used most effectively; 4. Communicating management's approved plans throughout the organization; 5. Uncovering and preparing for potential bottleneck in the operations before they occur; 6. Motivating managers to achieve the desired results, and 7. Setting a standard or benchmark for evaluating actual performance.

ADVANTAGES AND LIMITATIONS OF BUDGETS The advantages of budgeting include:

1. It forces planning and exposes situations in which plans of subcomponents are inadequate to attain the total organization's objectives. 2. It allows a reiterative process to bring the goals of the organization and the subcomponents into agreement. 3. It provides a means of communicating organization goals down through the organization and sub-unit operational limitations up though the organization. 4. It provides a basis for financial planning, sub-unit coordination, resource acquisition, inventory policy, scheduling and output distribution. 5. It provides a basis by which activity can be monitored, with actual results being compared to the planned results. The limitations of budgeting are: 1. Budgets tend to oversimplify the real situation and fail to allow for variations in external factors. They do not reflect qualitative variables. 2. It is difficult to prepare a detailed budget for an organization that has never existed or for a new division, product, or department of an existing firm, 3. There may be lack of higher and lower management commitment because of lack of understanding of the fundamentals of budget preparation and utilization. 4. The budget is only a representation of future plans or a means to the goal of profitable activity and not an end in itself. It may interfere with the supervisor's style of leadership and can therefore stifle initiative. 5. Budget reports usually emphasize results, not reasons.

TYPES OF BUDGETS The types of budgets or the major composition of the master budget are: 1. The Operating Budget 2. The Financial Budget 3. The Capital Investment Budget The following is a simplified subclassification of the above-mentioned types of budget for a manufacturing firm: A. Operating Budget 1. Budgeted Income Statement a. Sales budget b. Production budget

   

Materials cost budget Direct labor cost budget Factory overhead budget Inventory levels

2. Cost of Sales budget 3. Selling and Administrative expenses budget 4. Financial expense budget B. Financial Budget 1. Budgeted Statement of Financial Position 2 Cash budget 3. Budgeted Statement of Sources and Uses of Funds C. Capital Investment Budget

STEPS IN DEVELOPING A MASTER BUDGET The major steps in developing a Master Budget may be outlined as follows: 1. Establish basic goals and long-range plans for the company. These will serve as guidelines in the preparation of budget estimates. 2. Prepare a sales forecast for the budget period 3. Estimate the cost of goods sold and operating expenses. 4. Determine the effect of budgeted operating results on assets, liabilities and ownership equity accounts. The cash budget is the largest part of this step, since changes in many asset and liability accounts will depend upon the cash flow forecast. 5. Summarize the estimated data in the form of a projected income statement for the budget period and the projected statement of financial position as of the end of the budget period. Figure 10-2 depicts the sequence and types of budgets commonly found.

Figure 10-2. The Master Budget Interrelationships

Illustrative Case 10-1. Comprehensive Master Budget Preparation Gilbert Manufacturing Company manufactures a special line of tools. As of December 31, 20X4, the Statement of Financial Position of the firm is as follows:

Gilbert Company Statement of Financial Position December 31, 20X4 Assets Current assets Cash Accounts receivable Inventories Other current assets Total current assets Long-term assets Property, plant and equipment Less: Accumulated

P 150,000 220,000 592,000 23,000 P 985,000

P 2,475,000

Equities Current liabilites Accounts payable P 140,000 Taxes payable 156,000 Current portion of long-term debt 83,000 Total current liabilities P 379,000 Long-term liabilities 576,000 Total liabilities P 955,000 Equity Share capital

P 350,000

Depreciation Net Total assets

850,000 P 1,625,000 P 2,610,000

Retained earnings Total Total Equities

The following information is available for the development of its Master Budget for 20X5: Estimated sales: Units Price per unit Finished goods inventory: Beginning Ending Work in process inventory: NONE

6,400 P800 900 units @ P500 1,000

Raw materials: Material Materials required per unit of finished product Beginning inventory Ending inventory Unit Cost Direct labor Overhead is estimated as follows: Variable: Indirect materials and supplies Materials handling Other indirect labor Fixed: Supervisor labor Maintenance & repair Plant administration Utilities Depreciation Insurance Property taxes Other

R

S

3 units 2,200 1,300 P10 P146 per unit produced

5 units 4,000 4,600 P30

P5.85 per unit produced 9.07 per unit 5.07 per unit P 175,000 85,000 173,000 87,000 280,000 43,000 117,000 41,000

Marketing and Administrative expenses are budgeted as follows: Variable Marketing Costs: Sales commissions P40.625 per unit sold Other marketing costs P16.250 per unit sold Fixed Marketing Costs: Sales salaries P 100,000 Advertising 193,000

1,305,000 P1,655,000 P2,610,000

Other Administrative costs (all fixed): Administrative salaries Data processing services Legal and other professional fees Depreciation - building, furniture and equipment Taxes - other than income Other

78,000 P 254,000 103,000 180,000 94,000 160,000 26,000

Additional information: The treasurer's office also provided the following information and estimates: 1) All sales are on account and collections from customers are expected to amount to P5,185,000. 2) Equipment costing P300,000 with accumulated depreciation of 1275,000 will be sold at its net book value, New equipment costing P320,000 will be purchased during the year. 3) Accounts payable will increase by P15,000 and assumed to be for materials purchases only. 4) Income taxes will be provided at an average rate of 35% of income before taxes while P252,000 will be paid during the year. 5) Dividends amounting to P140,000 will be paid during the year and the current portion of the longterm debt shall also be settled at the end of the year. Interest rate is 8% per annum. REQUIRED: Prepare the Master Budget for Gilbert Company for the year ending December 31, 20XS. Based on the above preliminary data, each of Gilbert Company's budgets will now be discussed and illustrated. Sales Budget The sales budget showing what products will be sold in what quantities at what prices, is the foundation on which all other short-term budgets are built. The sales budget triggers a chain reaction that leads to the development of many other budget figures in an organization. The sales budget provides the revenue predictions from which cash receipts from customers can be estimated and supplies the basic data for constructing budgets for production costs and selling and administrative expenses. In short, the sales forecast is the keystone of the budget structure. The accuracy and reasonableness of the sales data will affect the whole budget. The sales forecast is made after consideration of the following factors. 1. Past sales volume 2. General economic and industry conditions 3. Relationship of sales to economic indicators 4. Relative product profitability 5. Market research studies and competition 6. Pricing, advertising and other promotion policies 7. Production capacity 8. Quality of sales force

9. Seasonal variations 10. Long-term sales trends for various products For Gilbert Company, the Sales Budget is presented follows: Schedule 1 Sales Budget For 20X5

Estimated sales

Price Per Unit 800

Units 6,400

Total Sales Revenue P5,120,000

Production Budget After the sales budget has been set, a decision can be made on the level of production that will be needed for the period to support sales and the production budget can be set as well. The production budget becomes a key factor in the determination of other budgets, including the direct materials budget, the direct labor budget and the manufacturing overhead budget. These budgets in turn are needed to assist in formulating a cash budget. Using the data from the previously prepared sales budget as well as the inventory summary information, the following production budget is developed. Schedule 2 Production Budget For 20X5 Units to be sold Add: Desired ending inventory Total Less: Beginning inventory Units to be produced

6,400 1,000 7,400 900 6,500

Raw Materials Budget After determining the number of units to be produced, the Raw Materials Purchases can now be prepared, as follows: Schedule 3 Raw Materials Purchases For 20x5 Materials R Units required for production

S

R (6,500 X 3) S (6,500 X 3) Add: Desired ending Inventory Total units required Less: beginning inventory Units to be purchased Unit price Total purchases

19,500 32,500 1,300 20,800 2,200 18,600 X P10 P 186,000

4,600 37,100 4,000 33,100 X P30 P 993,000

Direct Labor Budget The preliminary data show that the budgeted direct labor cost per unit produced is P146. This must have been arrived at after considering such factors as skills level of the workers, labor rate per hour, time requirement, conditions of union contracts, etc. The direct labor is therefore budgeted as follows: Schedule 4 Number of units to be produced Multiply by: Direct labor cost per unit Total budgeted direct labor costs

6,500 P 146 P 949,000

Overhead Cost Budget Study of past records will show how the cost reacts to changes in volume or in relation to other factors. Some overhead items may be projected on the basis of direct labor hours or on materials costs or on machine hours. The overhead costs budget for 20X5 is illustrated below using the basic information from the preliminary data previously established. Schedule 5 Budgeted Manufacturing Overhead For 20X5 Variable overhead: units needed to produce Indirect materials and supplies (@P5.85) Materials handling (@ P9.07) Other indirect labor (@P5.07) Total Fixed manufacturing overhead Supervisor labor Maintenance & repairs Plant administration

6,500 units P 38,000 59,000 33,000 130,000 175,000 85,000 173,000

Utilities Depreciation Insurance Property taxes Others Total Total manufacturing overhead

87,000 280,000 43,000 117,000 41,000 1,001,000 P 1,131,000

Budgeted Cost of Sales The Budgeted Cost of Sales Statement can now be developed using the data from the following:

Production Budget Raw Materials Budget Direct Labor Budget Overhead Cost Budget Budgeted Statement of Cost of Sales

Schedule 2 Schedule 3 Schedule 4 Schedule 5 Schedule 6

Schedule 6 Budgeted Statement of Cost of Sales For 20X5 Beginning work in process inventory Manufacturing costs Direct materials Beginning inventory [(2,200 R @ P10) + (4,000 S @P30)] Purchases (Schedule 3) Total Less: Ending inventory [(1,300 R @ P10) + (1,600 S@ P30) Total direct materials cost Direct labor (6,500 @ P146) Manufacturing overhead (Schedule 5) Total manufacturing cost Less: Ending work in process inventory Cost of goods manufactured Add: Beginning finished goods inventory (900 @ P500) Total available for sale Less: Ending finished goods inventory (1,000 @ P500) Cost of sales Marketing and Administrative Expense Budget

P ___________

P

142,000 1,179,000 P 1,321,000

151,000 P 1,170,000 949,000 1,131,000 P 3,250,000 P 3,250,000 450,000 P 3,700,000 500,000 P 3,200,000

As with overhead costs, marketing and administrative expenses are also made up of fixed and marketing variable components. The marketing and administrative expense budget for 20X5 is shown on the next page. Previously provided data are used. Schedule 7 Budgeted Marketing and Administrative Costs For 20X5 Variable marketing costs Sales commission (6,400 @ P40.625) Others (6,400 @ P16.25) Total Fixed marketing costs Sales salaries Advertising Others Total Total marketing costs Administrative costs (all fixed) Administrative salaries Data processing services Legal and other professional fees Depreciation - building, furniture and equipment Taxes - other than income Others Total Total marketing and administrative costs

P 260,000 104,000 P 364,000 P 100,000 193,000 78,000 P 371,000 P 735,000 P 254,000 103,000 180,000 94,000 108,000 26,000 765,000 P1,500,000

Cash Budget Cash Receipts Normally, the bulk of a firm's cash receipts come from customers. The possibility of cash from other sources (such as additional investments, sales of assets, borrowings) should likewise be considered when cash receipts are being budgeted. Cash Disbursements Data converted from individual budgets previously illustrated supply the basic information for the cash disbursements budget. However, various adjustments and additions will have to be made when preparing the budget for prepayments, accruals as well extraneous items (such as the purchase of new equipment, dividend payment) that do not show up in any of the individual budgets already prepared. If the financial policy of the company requires that a minimum cash. Schedule 9 Gilbert Manufacturing Company Budgeted Income Statement

For the Budget Year Ending December 31, 20X5 Sales (Schedule 1) Less: Cost of Sales (Schedule 6) Gross profit Less: Marketing and Administrative costs (Schedule 7) Net operating profit Less: Interest expense Net income before taxes Less: Provision for income taxes (35%) Net income after taxes

P 5,120,000 3,200,000 P 1,920,000 1,500,000 P 420,000 52,000 P 368,000 128,000 P 240,000

Budgeted Statement of Financial Position The budgeted statement of financial position is developed by beginning with the current statement of financial position and adjusting it for the data contained in the other budgets. Gilbert Company's budgeted statement of financial position is presented below: Schedule 10 Gilbert Manufacturing Company Budgeted Statement of Financial Position December 31, 20X5 Assets Current assets Cash (Schedule 8) Accounts receivable Inventories Other current assets Total current assets Long-term assets Property, plant and equipment Less: Accumulated depreciation Net Total assets

P 143,000 155,000 651,000 23,000 P 972,000 P2,495,000 949,000 P1,546,000 P 2,518,000

Equities Current liabilities Accounts payable Taxes payable Current portion of long-term debt Total current liabilities Long-term liabilities Total liabilities

P 155,000 32,000 P 187,000 576,000 P 763,000

Equity Share capital Retained earnings Total Equities

P 350,000 1,405,000 P2518,000

REVIEW QUESTIONS AND PROBLEMS Questions 1. What are the basic benefits and purposes of developing pro forma statements ...