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E'ce ence in Financia Manage"ent

Course 2: Financial Planning and Forecasting


Prepared by: Matt H. Evans, CPA, CMA, CFM

This course provides a basic understanding of how to prepare a financia p an !budgeted financia state"ents#. This course wi a so discuss so"e of the prob e"s associated with budgeting a ong with $best practices$ in budgeting. This course is reco""ended for % hours of Continuing Professiona Education. &n order to receive credit, you wi need to pass a "u tip e choice e'a" which is ad"inistered over the internet at www.e'inf".co"(training
)evised March %***

The First Steps


Chapter
Introduction

Financia p anning is a continuous process of directing and a ocating financia resources to "eet strategic goa s and ob+ectives. The output fro" financia p anning ta,es the for" of budgets. The "ost wide y used for" of budgets is Pro For"a or -udgeted Financia .tate"ents. The foundation for -udgeted Financia .tate"ents is /etai -udgets. /etai -udgets inc ude sa es forecasts, production forecasts, and other esti"ates in support of the Financia P an. Co ective y, a of these budgets are referred to as the Master -udget. 0e can a so brea, financia p anning down into p anning for operations and p anning for financing. 1perating peop e focus on sa es and production whi e financia p anners are interested in how to finance the operations. Therefore, we can have an 1perating P an and a Financia P an. However, to ,eep things si"p e and to "a,e sure we integrate the process fu y, we wi consider financia p anning as one sing e process that enco"passes both operations and financing.

Start with Strategic Planning


Financia P anning starts at the top of the organi2ation with strategic p anning. .ince strategic decisions have financia i"p ications, you "ust start your budgeting process within the strategic p anning process. Fai ure to in, and connect budgeting with strategic p anning can resu t in budgets that are $dead on arriva .$ .trategic p anning is a for"a process for estab ishing goa s and ob+ectives over the ong run. .trategic p anning invo ves deve oping a "ission state"ent that captures why the organi2ation e'ists and p ans for how the organi2ation wi thrive in the future. .trategic ob+ectives and corresponding goa s are deve oped based on a very thorough assess"ent of the organi2ation and the e'terna environ"ent. Fina y, strategic p ans are i"p e"ented by deve oping an 1perating or Action P an. 0ithin this 1perating P an, we wi inc ude a co"p ete set of financia p ans or budgets. Financial Plans (Budgets) Operating Plan Strategic Plan NOTE: Short Course 10 describes ho to prepare a Strategic Plan!

The Sales Forecast


&n order to deve op budgets, we wi start with a forecast of what drives "uch of our financia activity3 na"e y sa es. Therefore, the first forecast we wi prepare is the .a es Forecast. &n order to esti"ate sa es, we wi oo, at past sa es histories and various factors that inf uence sa es. For e'a"p e, "ar,eting research "ay revea that future sa es are e'pected to stabi i2e. Maybe we cannot "eet growing sa es because of i"ited production capacities or "aybe there wi be a genera econo"ic s ow down resu ting in fa ing sa es. Therefore, we need to oo, at severa factors in arriving at our sa es forecast. After we have co ected and ana y2ed a of the re evant infor"ation, we can esti"ate sa es vo u"es for the p anning period. &t is very i"portant that we arrive at a good esti"ate since this esti"ate wi be used for severa other esti"ates in our budgets. The .a es Forecast has to ta,e into account what we e'pect to se at what sa es price. E4H&-&T 5 6 .A7E. F1)ECA.T Product 7ace .hoes 8o u"e 59,*** : ;<.** Price Tota .a es : =%*,***

Percent of Sales
0e now need to esti"ate account changes because of esti"ated sa es. 1ne way to esti"ate and forecast certain account ba ances is with the Percent of .a es Method. -y oo,ing at past account ba ances and past changes in sa es, we can estab ish a percentage re ationship. For e'a"p e, a variab e costs and "ost current assets and current iabi ities wi vary as sa es change.

E4AMP7E 5 6 E.T&MATE/ ACC1>?T. )ECE&8A-7E Past history shows that accounts receivab e runs around @*A of sa es. 0e have esti"ated that ne't yearBs sa es wi be : 59*,***. Therefore, our esti"ated accounts receivab e is : ;C,*** !: 59*,*** ' .@*#.

Detail Budgets

Chapter

0e a so need to prepare severa detai budgets for deve oping a -udgeted &nco"e .tate"ent. For e'a"p e, production "ust be p anned for our esti"ated sa es of 59,*** units fro" E'hibit 5. The Production /epart"ent wi need to budget for "ateria s, abor, and overhead based on what we e'pect to se and what we e'pect in inventory. E4H&-&T % 6 P)1/>CT&1? ->/DET P anned .a es !E'hibit 5# /esired Ending &nventory Tota >nits 7ess -eginning &nventory Planned Production 59,*** 5,<** 5=,<** ! @,***# 5;,<**

1nce we have estab ished our eve of production !E'hibit %#, we can prepare a Materia s -udget. The Materia s -udget atte"pts to forecast the eve of purchases reEuired, ta,ing into account "ateria s reEuired for production and inventory eve s. 0e can su""ari2e "ateria s to be purchased as: Materia s Purchased F Materia s )eEuired G Ending &nventory H -eginning &nventory E4H&-&T @ 6 MATE)&A7. ->/DET 7ace .hoes reEuire .%< sEuare yards of eather and eather is esti"ated to costs : <.** per yard ne't year. Materia s )eEuired F 5;,<** !E'hibit %# ' . %< F @,9%< yards. Materia s )eEuired for Production /esired Ending &nventory Tota Materia s 7ess -eginning &nventory Tota Materia s )eEuired >nit Cost for Materia s Total Materials Purchased @,9%< @=< ;,*** ! <**# @,<** ' : <.** : 5=,<**

The second co"ponent of production is abor. 0e need to forecast our abor needs based on e'pected production. The 7abor -udget arrives at e'pected abor cost by app ying an e'pected abor rate to reEuired abor hours. E4H&-&T ; 6 7A-1) ->/DET 7ace .hoes reEuire .<* hours to produce one unit. 5;,<** units ' .<* F =,%<* hours. The e'pected hour y abor rate ne't year is : 5%.**. Esti"ated Production Hours Hour y 7abor )ate Total Labor Costs =,%<* ' 5%.** : C=,***

As production "oves up or down, support services and other costs re ated to production wi a so change. These overhead costs represent the third "a+or costs of production. Each ite" that co"prises overhead "ay warrant independent ana ysis so that we can deter"ine what drives the specific cost. For e'a"p e, production renta eEuip"ent "ay be driven by production orders whi e depreciation is driven by eve s of capita invest"ent spending.

E4H&-&T < 6 18E)HEA/ ->/DET !-ased on >niEue /rivers# Esti"ated for each ine ite" as fo ows: &ndirect 7abor Costs I >ti ities /epreciation Maintenance &nsurance and Ta'es Total Overhead Costs IProduction .upervision and &nspection 1nce production costs !direct "ateria s, direct abor, and overhead# have been budgeted, we can wor, these nu"bers into our beginning inventory eve s for /irect Materia s, 0or, &n Progress, and Finished &nventory. -eginning inventory eve s are actua a"ounts fro" the ast reporting period. 0e need to app y our costs based on what we want ending inventory to be. The endHresu t is a -udget for Cost of Doods .o d, which we wi use for our Forecasted &nco"e .tate"ent. : 5%,*** <,*** @,*** 5,*** ;,*** : %<,***

E4H&-&T 9 6 C1.T 1F D11/. .17/ ->/DET /irect 0or, &n Materia s Progress -eginning &nventory : %,<** : 59,*** Purchases !E'hibit @# 5=,<** 7ess Ending &nventory ! 5,C=<# Materia s )eEuired 5C,5%< /irect 7abor !E'hibit ;# C=,*** 1verhead !E'hibit <# %<,*** Tota Manufacturing Costs : 5@*,5%< 5@*,5%< Tota 0or, &n Progress 5;9,5%< 7ess Ending &nventory ! 5%,***# Cost of Doods Manufactured : 5@;,5%< Cost of Doods Avai ab e for .a e 7ess Ending &nventory Cost of Goods Sold

Finished &nventory : ;9,***

5@;,5%< 5C*,5%< ! @9,***# : 5;;,5%<

0e can now finish our esti"ate of e'penses by oo,ing at a re"aining operating e'penses. The first "a+or type of operating e'pense is "ar,eting. Mar,eting and .a es ManagerBs wi prepare and sub"it a Mar,eting -udget to upper eve "anage"ent for approva . E4H&-&T = 6 MA)JET&?D ->/DET Esti"ated for each ine ite" per the Mar,eting /epart"ent: Mar,eting Personne Advertising K Pro"otion Mar,eting )esearch Trave K Persona E'penses Total Marketing Expenses : =<,*** ;%,*** 5%,*** 9,<** : 5@<,<**

The fina area of operating e'penses is the ad"inistrative costs of running the overa business. These types of e'penses wi be esti"ated based on past trends and what we e'pect to happen in the future. For e'a"p e, if the co"pany has p ans for a new co"puter syste", then we shou d budget for additiona techno ogy re ated e'penses. .evera depart"ent "anagers wi be invo ved in preparing the Denera and Ad"inistrative E'pense -udget.

E4H&-&T C 6 DE?E)A7 K A/M&?&.T)AT&8E ->/DET Esti"ated for each ine ite" per /epart"ent Managers: Manage"ent Personne Accounting Personne 7ega Personne Techno ogy Personne )ent K >ti ities .upp ies Misce aneous Total G & Expenses :55*,*** <<,*** ;*,*** ;<,*** %<,*** 5<,*** =,<** : %L=,<**

3 Budgeted Financial State!ents


-ased on the detai budgets we have prepared !E'hibits 5 thru C#, we can fina i2e our budgets in the for" of a -udgeted &nco"e .tate"ent. A few new ine ite"s are added to account for nonHoperating ite"s, such as inco"e received on invest"ents and financing costs. The Finance and Ta' /epart"ents wi assist in esti"ating ite"s i,e financing e'penses and inco"e ta' e'penses. The -udgeted &nco"e .tate"ent wi pu together a revenue and e'pense esti"ates fro" our previous y prepared detai budgets. E4H&-&T L 6 ->/DETE/ &?C1ME .TATEME?T )evenues !E'hibit 5# 7ess Cost of Doods .o d !E'h 9# Dross Profit 7ess Mar,eting !E'hibit =# 7ess D K A !E'hibit C# 1perating &nco"e 7ess &nterest on /ebt &nco"e -efore Ta'es Ta'es M @=.<A !et "nco#e :=%*,*** !5;;,5%<# <=<,C=< !5@<,<**# !%L=,<**# 5;%,C=< ! C,***# 5@;,C=< ! <*,<=C# : C;,%L=

Chapter

"

E4AMP7E % 6 ->/DETE/ &?C1ME .TATEME?T Ha ton Co"pany has co"pi ed the fo owing infor"ation: P anned sa es are <*,*** units at a price of : 55*.** per unit. -eginning &nventory consists of <,*** units at a cost of : 9*.** per unit. P anned production is <<,*** units with the fo owing production cost: /irect Materia s are : 5C.<* per unit /irect 7abor reEuired is ; hours per unit M : 5%.** per hour 1verhead is esti"ated at %*A of /irect 7abor Cost /esired Ending &nventory is 9,*** units under the 7&F1 Method. Mar,eting E'penses are budgeted at : @<*,*** Denera K Ad"inistrative E'penses are budgeted at : ;**,*** N H H H H H H H H H H H H H H H -udgeted &nco"e .tate"ent H H H H H H H H H H H H H H O .a es !<*,*** ' : 55*# 7ess Cost of Doods .o d: -eginning &nventory !<,*** ' : 9*.**# /irect Materia s !<<,*** ' : 5C.<*# /irect 7abor !<<,*** ' ; hours ' : 5%.**# 1verhead !: %,9;*,*** ' .%*# Cost of Avai ab e .a es 7ess Ending &nventory !5# Cost of Doods .o d Dross Profits 7ess 1perating E'penses: Mar,eting E'penses Denera K Ad"inistrative ?et &nco"e : <,<**,*** : @**,*** 5,*5=,<** %,9;*,*** <%C,*** ;,;C<,<** ! @C*,<**# !;,5*<,***# 5,@L<,*** ! @<*,***# ! ;**,***# : 9;<,***

!5# >nder 7&F1, ast costs in are: : 5,*5=,<** G : %,9;*,*** G : <%C,*** F : ;,5C<,<** ( <<,*** F : =9.5* ' <,*** F : @C*,<**.

?ow that we have a -udgeted &nco"e .tate"ent, we can prepare a -udgeted -a ance .heet. The -udgeted -a ance .heet wi provide us with an esti"ate of how "uch e'terna financing is reEuired to support our esti"ated sa es. The "ain in, between the &nco"e .tate"ent and the -a ance .heet is )etained Earnings. Therefore, preparation of the -udgeted -a ance .heet starts with an esti"ate of the ending ba ance for )etained Earnings. &n order to esti"ate ending )etained Earnings, we need to pro+ect future dividends based on current dividend po icies and what "anage"ent e'pects to pay in the ne't p anning period.

E4H&-&T 5* 6 E.T&MATE/ )ETA&?E/ EA)?&?D. -eginning -a ance -udgeted ?et &nco"e !E'hibit L# 7ess Esti"ated /ividends Ending $etained Earnings : %=*,*** C;,%L= !<<,***# : %LL,%L=

?e't, we need to account for the acEuisition of fi'ed assets. As a business dep etes its asset base, it "ust reHinvest to sustain assets which are the basis for generating revenues. For e'a"p e, do we need to purchase new "achinery or co"puter eEuip"entP /o we p an to e'pand our production faci itiesP 1perating personne and upperH eve "anage"ent wi decide on future capita spending. Future capita e'penditures are su""ari2ed on the Capita E'penditures -udget. E4H&-&T 55 6 CAP&TA7 E4PE?/&T>)E. ->/DET Purchase ?ew 1ffice EEuip"ent )ep ace 7eather Cutting Machine Total Capital Expenditures : 59,*** C,<** : %;,<**

-ased on the beginning ba ance in assets and the budget for capita assets !E'hibit 55#, we can esti"ate an ending asset ba ance for the -udgeted -a ance .heet. E4H&-&T 5% 6 CHA?DE &? F&4E/ A..ET. -eginning -a ance ?ew AcEuisitions !E'hibit 55# 7ess /epreciation for the Qear Ending %ixed ssets : CC9,*** %;,<** !@@,<**# : C==,***

0e wi assu"e that iabi ities and interest e'pense wi re"ain the sa"e. However, after we have deter"ined our eve of e'terna financing, we wi need to revise these a"ounts. Additiona y, we need to ana y2e trends and ratios in order to ascertain accounts that do not f uctuate with sa es. For e'a"p e, prepaid e'pense is a current asset that has itt e to do with sa es. .ince the -a ance .heet is a yearHend esti"ate, it assu"es that a other esti"ates have been "et. &n a wor d of rapid change, annua forecasts are rare y c ose. Therefore, we wi si"p ify our preparation of the -udgeted -a ance .heet by re ying on re ationships. .tab e re ationships over the ast five years are particu ar y he pfu . The -udgeted -a ance .heet wi show either a surp us !e'cess financing over assets# or a deficit !additiona

financing needed to cover assets#. This difference is derived fro" the Accounting EEuation: Assets F 7iabi ities G EEuity.

E4H&-&T 5@ 6 ->/DETE/ -A7A?CE .HEET Cash Accounts )eceivab e &nventory Prepaid E'penses Fi'ed Assets Tota Assets Accounts Payab e Current Portion of 7T /ebt 7ong Ter" /ebt Tota 7iabi ities Co""on .toc, )etained Earnings Tota EEuity Tota 7iab K EEuity External %inancing $e&uired : @9,*** C9,;** <*,;** 55,*** C==,*** :5,*9*,C** <A of .a es 5%A of .a es =A of .a es < year trend ana ysis E'hibit 5%

=L,%** 55A of .a es 9,*** Principa Paid 9*,*** .ub+ect to )evision 5;<,%** ;<*,*** unchanged %LL,%L= E'hibit 5* =;L,%L= CL;,;L= : 599,@*@

0e a so can ca cu ate E'terna Financing )eEuired !EF)# based on the re ationships between assets, iabi ities, and sa es. The fo owing for"u a can be used: EF) F !A ( . ' .a es# H !7 ( . ' .a es# H !PM ' F. ' !5 H d## A ( .: Assets that change given a change in sa es, e'pressed as a percentage of sa es. .a es: Change in sa es between the ast reporting period and the forecasted sa es. 7 ( .: 7iabi ities that change given a change in sa es, e'pressed as a percentage of sa es. PM: Profit Margin on .a es3 i.e. net inco"e ( sa es. F.: Forecasted .a es !5 H d#: Percent of earnings retained after paying out dividends3 d is the dividend payout ratio. E4AMP7E @ 6 CA7C>7ATE E4TE)?A7 F&?A?C&?D ?EE/E/ Fa con Co"pany has co"pi ed the fo owing infor"ation:

Assets of : L** !"ost y current assets# fro" the ast period change with sa es. 7iabi ities of : @** fro" the ast period change with sa es. .a es were : @,*** for the ast period. Forecasted sa es are : @,L**. Profit "argins on sa es are 9A and ;*A of earnings are paidHout as dividends. A ( . F : L** ( : @,*** F .@* 7 ( . F : @** ( : @,*** F .5* Change in .a es F : @,L** H : @,*** F : L** EF) F .@*!: L**# H .5*!: L**# H .*9!:@,L**#!5H.;*# F : %=* H : L* H : 5;*.; F ' ()*+

E4AMP7E ; 6 P)EPA)E ->/DETE/ -A7A?CE .HEET Di "er Co"pany has co"pi ed the fo owing infor"ation: .a es for the ast reporting period were : 9**,*** Pro+ected sa es are : C**,*** Profit )atio is <A of sa es /ividend Payout )atio is ;*A Current -a ance in )etained Earnings is : %**,*** Cash as a A of sa es is ;A Accounts )eceivab e as a A of sa es 5*A &nventory as a A of sa es is @*A ?et Fi'ed Assets are budgeted at : @**,*** Accounts Payab e as a A of sa es is =A Accrued 7iabi ities as a A of sa es is 5<A Co""on .toc, wi re"ain at : %%*,*** -udgeted -a ance .heet Cash !: C**,*** ' .*;# Accounts )eceivab e !: C**,*** ' .5*# &nventory !: C**,*** ' .@*# ?et Fi'ed Assets Tota Assets Accounts Payab e !: C**,*** ' .*=# Accrued 7iabi ities !: C**,*** ' .5<# Co""on .toc, )etained Earnings !5# Tota 7iabi ities K EEuity Tota Additiona Financing )eEuired Tota 7iabi ities K EEuity after financing !5#: -eginning -a ance &ncrease for ?ew &nco"e: : @%,*** C*,*** %;*,*** @**,*** : 9<%,*** : <9,*** 5%*,*** %%*,***

9%*,*** @%,*** : 9<%,***

: %**,***

1&

: C**,*** ' .*< !profit "argin# 7ess /ividends: .;* ' : ;*,*** ?et &nco"e Ending -a ance

;*,*** !59,***# : %%;,***

After we have prepared budgeted financia state"ents, it is very i"portant to carefu y review these state"ents with "anage"ent. For e'a"p e, can we tru y e'pect to raise : 599,@*@ in capita as indicated in E'hibit 5@P 0i the budgeted financia state"ents "eet the e'pectations of shareho dersP .evera critica Euestions "ust be as,ed before we fina i2e our budgeted financia state"ents. Additiona y, our budgets were prepared on an annua basis. Many unp anned events can ta,e p ace during the year, "a,ing our annua budgets e'tre"e y inaccurate. Therefore, financia p anning is often i"proved by si"p y forecasting on a "onth y or Euarter y basis as opposed to an annua basis.

The Cash Budget


A good e'a"p e of shortHter" financia p anning is the Cash -udget. The Cash -udget is an esti"ate of future cash inf ows and outf ows. Cash -udgets are often inc uded with the -udgeted -a ance .heet. However, it shou d be noted that Cash -udgets are not wide y used as a genera forecasting too since they are specific to one account, na"e y cash. &nstead, Cash -udgets are often used by Cash Managers and Treasury personne for "anaging cash. 0e can use our previous forecasts to he p us prepare a Cash -udget. For e'a"p e, we can get an idea of payab e disburse"ents for "anufacturing by oo,ing at the Materia s -udget !E'hibit @#, 7abor -udget !E'hibit ;#, and the 1verhead -udget !E'hibit <#. 0e can start preparing a Cash -udget by si"p y oo,ing at our stab e cash f ow patterns, such as accounts receivab e, accounts payab e, payro , etc. 0e a so have severa predictab e transactions, such as insurance pay"ents, oan pay"ents, etc. E4H&-&T 5; 6 CA.H ->/DET F1) RA?>A)Q -eginning Cash -a ance Cash Co ections on .a es !9* day ag# .o d o d "achine in Ranuary &nvest"ent )evenues Tota Cash &nf ows : %C,*** : ;=,*** @,*** %,*** <%,***

/isburse"ents for Manufacturing !@* day ag# 5%,;** Mar,eting E'penses 5*,*** Denera K Ad"inistrative E'penses %9,*** Capita E'penditures H*H
11

)epay"ents on /ebt /ebt &nterest Pay"ents /ividend Pay"ents Ta'es Paid Tota Cash 1utf ows ?et Cash &nf ow !1utf ow# Ending Cash -a ance Mini"u" /esired Cash -a ance Cash Surplus or ,-eficit.

=<* ;<* H*H H*H ;L,9** %,;**

%,;** @*,;** 5*,*** : %*,;**

Su!!ar' of the Budgeting Process


0e started our budgeting process by oo,ing at strategic p anning. .trategic

Chapter

P anning shou d a ways be the starting point for financia p anning. Fro" the .trategic P an, we deve op a P an of Action so we can i"p e"ent the .trategic P an. This is often ca ed an 1perating P an. 0ithin the 1perating P an, we wi inc ude a set of budgets for successfu i"p e"entation of the .trategic P an. The entire set of budgets can be categori2ed as fo ows: N H H H H H H H H H H H H H H H H H H H H H H H H H H Master -udget H H H H H H H H H H H H H H H H H H H HHHHHHO N H H H H H H H H H H H 1perating P an H H H H H H H HO N H H H H H H H H H Financia P an H H H H H H H H HO .a es Forecast !E'hibit 5# -udgeted )etained Earnings !E'hibit5*# -udgeted Production !E'hibit %# -udgeted Capita E'penditures !E'hibit 55# -udgeted Production Costs !E'hibits @H<# Change in Fi'ed Assets !E'hibit 5%# -udgeted Cost of Doods .o d !E'hibit 9# -udgeted -a ance .heet !E'hibit 5@# -udgeted 1perating E'penses !E'hibits =HC# Cash -udget !E'hibit 5;# -udgeted &nco"e .tate"ent !E'hibit L#

(dditional Concepts in Budgeting


.o far, we have e"phasi2ed si"p e approaches to preparing budgets, such as oo,ing at re ationships between account ba ances and sa es. 0e a so
12

shou d have a c ear understanding of past financia perfor"ance to he p us predict future financia perfor"ance. E'tending past trends and ad+usting for what is e'pected is a co""on approach to preparing a forecast. However, we can i"prove forecasting by using severa techniEues. The first step is recogni2e certain funda"enta s about forecasting: 5. Forecasting re ies on past re ationships and e'isting historica infor"ation. &f these re ationships change, forecasting beco"es increasing y inaccurate. %. .ince forecasting can be inaccurate due to uncertainty, we shou d consider deve oping severa forecast under different scenarios. 0e can assign probabi ities to each scenario and arrive at our e'pected forecast. @. The onger the p anning period, the "ore inaccurate the forecast. &f we need to increase re iabi ity in forecasting, we shou d consider a shorter p anning period. The p anning period depends upon how often e'isting p ans need to be eva uated. This wi depend upon stabi ity in sa es, business ris,, financia conditions, etc. ;. Forecasting of arge interHre ated ite"s is "ore accurate than forecasting a specific ite"i2ed a"ount. 0hen a arge group of ite"s are forecast together, errors within the group tend to cance out. For e'a"p e, an overa econo"ic forecast wi be "ore accurate than an industry specific forecast.

)uantitati*e and )ualitati*e Techni+ues


Qou shou d forecast for a specific reason H to he p "a,e better decisions. Forecasting is e'tre"e y difficu t and you "ust pu fro" a re evant sources. 0e previous y discussed the Percent of .a es Method and Trend Ana ysis as a way of forecasting. These forecasting techniEues are "uantitati#e. Suantitative techniEues of forecasting are best used when changes are infreEuent. &n todayBs wor d of rapid change, Euantitative techniEues tend to be of itt e use. 0e need to add "ore Eua itative techniEues into the budgeting process. Sua itative techniEues inc ude surveys, interviews with peop e who are $in the ,now$, "ar,et reports, artic es, and other infor"ation sources that a ow us to "a,e a better +udge"ent. Sua itative or Rudg"enta Forecasting can he p i"prove the budgeting process, especia y if we are operating in a rapid y changing environ"ent. The /e phi Method is an e'a"p e of a Eua itative techniEue where a group of e'perts gets together and reaches a consensus on what wi happen in the future. A Euestionnaire is so"eti"es used to faci itate the process. Two disadvantages of the /e phi Method are ow re iabi ity with the consensus and inabi ity to reach a c ear consensus.

S!oothing out the ,u!-ers


1ne si"p e approach to forecasting is to setup a "ode that re ies on averages fro" past historica data. For e'a"p e, we can ta,e an average of the ast five years. As we "ove forward to the ne't p anning period, a new
13

"oving average is ca cu ated and used as the forecast for the ne't p anning period. E'ponentia s"oothing can be used whereby we p ace "ore weight on the "ost recent set of actua nu"bers. This can be i"portant where changes have occurred, "a,ing o der data ess re iab e.

.egression (nal'sis
A statistica approach can be used for forecasting. 0e can re y on the average re ationships between a dependent variab e and an independent variab e. .i"p e regressions oo, at one independent variab e !such as sa es pricing or advertising e'penses# whereas "u tip e regressions consider two or "ore variab es !such as sa es pricing and advertising e'penses together#. )egression ana ysis is very popu ar for forecasting sa es since it he ps us find the right fit over a range of observations. For e'a"p e, if we p ot out the fo owing observations, we can prepare a scatter graph and find the right fit: Advertising E'pense : 5** 5<* 5C* %%* %=* 5,<9* 5,95* 5,9<< 5,9C< .a es /o ars : 5,<**

Scatter Graph for %ive Observations


:5,=** Sales -ollars :5,9<* :5,9** :5,<<* :5,<** :5,;<* :* :<* :5** :5<* :%** :%<* :@** dvertising -ollars

Sensiti*it' (nal'sis
0e can "easure how sensitive our forecast is to changes in certain variab es. 0e can deve op a range of possibi ities under different assu"ptions and prepare a ternative p ans. &f P an A fai s, we can Euic, y "ove to P an -. .ensitivity ana ysis a so te s us which assu"ptions have the biggest i"pact on the forecast. Managers can concentrate "ost of their resources on the biggest i"pact areas for i"proving the forecast. The "ain

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benefit of sensitivity ana ysis is to "easure the possibi ity of errors in the forecast.

Financial /odels
-udgets can be prepared with the use of for"a "ode s which ta,e advantage of techniEues i,e regressions and sensitivity ana ysis. Mode s are bui t around the co ection of eEuations, ogic, and data that f ows according to the re ationships between operating variab es and financia outputs. Financia variab es !costs, sa es, invest"ents, ta'es, etc.# can be "anipu ated by the user so that the user can see the outco"e of a decision before it is "ade. This can he p faci itate strategic thin,ing within the budgeting process. Two types of financia "ode s are si"u ation and opti"i2ation. .i"u ation atte"pts to dup icate the effects of a decision and show its i"pact. 1pti"i2ation see,s to opti"i2e !"a'i"i2e or "ini"i2e# a forecast ob+ective !revenues, production costs, etc.#. Financia "ode s provide decision support services for i"prove"ents within budgeting. .o"e of the benefits of financia "ode s inc ude: .hows the resu ts of p anning under a variety of assu"ptions, a owing the user to assess the i"pacts of esti"ates that have been used. Denerates the -udgeted &nco"e .tate"ent and -udgeted -a ance .heet as we as forecasted financia s by business unit or depart"ent. &n order to bui d a financia "ode , we need to estab ish variab es, para"eters, and re ationships. Additiona y, we can divide variab es into three types: 5. Contro 8ariab es: The inputs that the co"pany can contro , such as the eve of debt financing or the eve of capita spending. %. E'terna 8ariab es: &nputs that the co"pany cannot contro , such as econo"ic conditions, consu"er spending, interest rates, etc. @. Po icy 8ariab es: Doa s and ob+ectives of the co"pany can i"pact the e'pected outco"es. For e'a"p e, "anage"ent "ay set targets for sa es, profitabi ity, and costs. Para"eters are the base ines or boundaries for the financia "ode . For e'a"p e, the eve of debt "ay have a "ini"u" and "a'i"u" va ue. 0e a so wi set our beginning account ba ances within the financia "ode . )e ationships are the ogic and specifications reEuired for "a,ing things wor,. For e'a"p e, the -udgeted -a ance .heet wi reEuire that Assets F 7iabi ities G EEuity. .evera eEuations wi be used within the financia "ode . Many of these eEuations wi be re ationa 3 i.e. if we change sa es prices, tota revenues wi change. EEuations are tested and added to the financia "ode to "a,e it co"p ete. EEuations can be e'panded into business and decision ru es so that users do not have to worry about ca cu ating things i,e return on eEuity. The financia "ode ta,es care of critica ru es for running the business or "a,ing decisions.
1

E4H&-&T 5< 6 F&?A?C&A7 M1/E7 F1) CA.H

Chapter

)e ationships !EEuations#: Cash!t# F Cash!tH5# G Cash )eceipts!t# G Cash /isburse"ents!t# Cash )eceipts!t# F !a# ' .a es!t# G !b# ' .a es!tH5# G !c# ' .a es!tH%# G 7oan!t# Cash /isburse"ents!t# F Accounts Payab e!tG5# G &nterest!t# G 7oan Pay"ent!t# &nput 8ariab es in /o ars: .a es!tH5#, .a es!tH%#, .a es!tH@# 7oan!t#, 7oan Pay"ent!t# !a#: Accounts )eceivab e Co ection Pattern in current period !b#: Accounts )eceivab e Co ection Pattern one period ago !c#: Accounts )eceivab e Co ection Pattern two periods ago !a# G !b# G !c# N 5.* Para"eters !&nitia 8a ues in /o ars#: Cash!tH5#, .a es!tH5#, .a es!tH%#, -an, 7oan!tH5#, Accounts Payab e!tH5#

/a0ing the Budgeting Process 1or0


?ow that we understand what goes into financia p anning, it is ti"e to focus on how to "a,e the process into a va ueHadded activity. Many organi2ations are atte"pting to reHengineer budgeting practices since budgeting is usua y a nonHva ue added activity3 i.e. it does not add va ue to the decision "a,ing process. The goa is to "a,e the entire financia p anning process into a decision support service within the organi2ation whereby the benefits of the process e'ceed the costs. &n order to fu y co"prehend the prob e"s associated with budgeting, etBs Euic, y ist the top ten prob e"s with budgeting according to Contro er Maga2ine:
1"

5. Ta,es too ong to prepare. %. /oesnBt he p us run our business. @. -udgets are outHofHdate by the ti"e we get the". ;. Too "uch p aying with the nu"bers. <. Too "any iterations ( repetitive tas,s within the process. 9. -udgets are cast in stone in a constant y changing business environ"ent. =. Too "any peop e are invo ved in the budgeting process. C. >nab e to contro budget a ocations. L. -y the ti"e budgets are co"p ete, & donBt recogni2e the nu"bers. 5*. -udgets do not "atch the strategic goa s and ob+ectives of the organi2ation. 0e wi now discuss severa ways of "a,ing budgeting into a va ueHadded activity within the organi2ation.

(uto!ate the Process


&n order for budgeting to be va ueHadded, it "ust accept revisions Euic, y and easi y. A high y auto"ated budgeting process can he p strea" ine the process for Euic, and easy updating. As a "ini"u", budgets shou d be "aintained on spreadsheets. A spreadsheet !such as E'ce , 7otus 5H%H@, etc.# can have an input pane for entering variab es and auto"atic generation of budgets within a fu y integrated set of spreadsheets. For e'a"p e, we can use a for"u a to ca cu ate interest e'pense as: $nterest %ate & (Beginning 'ong Ter( )ebt * Current Portion o+ 'ong Ter( )ebt * E&ternal Financing ,sing 'ong Ter( )ebt) .preadsheets a so a ow us to perfor" sensitivity ana ysis. 0e can si"p y enter new variab es into the input pane and review the i"pact on our budgets. 0e can a so use "ore for"a software progra"s for budgeting. The best software progra"s wi give us the option of contro ing the eve of detai . For e'a"p e, do we want a cash budget by custo"er or do we want cash budgets by account or can we si"p y enter the cash f ow data ourse vesP &t is very i"portant that we have contro over the detai since co""ercia progra"s so"eti"es overHana y2e transactions and provide way too "uch detai . This is why "any financia p anners prefer spreadsheets over co""ercia progra"s.

1#

Ten Best Practices in Budgeting


Fina y, here are so"e best practices that can transfor" budgeting into a va ueHadded activity: 5. -udgeting "ust be in,ed to strategic p anning since strategic decisions usua y have financia i"p ications. %. Ma,e budgeting procedures part of strategic p anning. For e'a"p e, strategic assess"ents shou d inc ude historica trends, co"petitive ana ysis, and other procedures that "ight otherwise ta,e p ace within the budgeting process. @. The -udgeting Process shou d "ini"i2e the ti"e spent co ecting and gathering data and spend "ore ti"e generating infor"ation for strategic decision "a,ing. ;. Det agree"ent on su""ary budgets before you spend ti"e preparing detai budgets. <. Auto"ate the co ection and conso idation of budgets within the entire organi2ation. >sers shou d have access to budgeting syste"s for easy updating. 9. -udgets need to accept changes Euic, y and easi y. -udgeting shou d be a continuous process that encourages a ternative thin,ing. =. 7ine ite" detai in budgets shou d be based on "ateria thresho ds and not re y on a syste" of genera edger accounts. C. -udgets shou d give ower eve "anagers so"e for" of fisca contro over what is going on. L. 7everage your financia syste"s by estab ishing a data warehouse that can be used for both financia reporting and budgeting. 5*. Mu tiH?ationa Co"panies shou d have a budgeting syste" that can hand e interH co"pany e i"inationBs and foreign currency conversions.

Su!!ar'
Financia P anning is a continuous process that f ows with strategic decision "a,ing. The 1perating P an and the Financia P an wi both support the .trategic P an. The best p ace to start in preparing a budget is with sa es since this is a driving force behind "uch of our financia activity. However, we have to ta,e into account nu"erous factors before we can fina i2e our budgets. -udgeting shou d be f e'ib e, a owing "odification when so"ething changes. For e'a"p e, the fo owing wi i"pact budgeting:

1$

7ife cyc e of the business Financia conditions of the business Denera econo"ic conditions Co"petitive situation Techno ogy trends Avai abi ity of resources -udgeting shou d be both top down and botto" up3 i.e. upper eve "anage"ent and "idd e eve "anage"ent wi both wor, to fina i2e a budget. 0e can strea" ine the budgeting process by deve oping a financia "ode . Financia "ode s can faci itate $what if$ ana ysis so we can assess decisions before they are "ade. This can dra"atica y i"prove the budgeting process. 1ne of the biggest cha enges within financia p anning and budgeting is how do we "a,e it va ueHadded. -udgeting reEuires c ear channe s of co""unication, support fro" upperH eve "anage"ent, participation fro" various personne , and predictive characteristics. -udgeting shou d not strive for accuracy, but shou d strive to support the decision "a,ing process. &f we focus too "uch on accuracy, we wi endHup with a budgeting process that incurs ti"e and costs in e'cess of the benefits derived. The cha enge is to "a,e financia p anning a va ueHadded activity that he ps the organi2ation achieve its strategic goa s and ob+ectives.

Final 23a!
.e ect the best answer for each Euestion. E'a"s are graded and ad"inistered by insta ing the e'e fi e version of this course. The e'e fi e version of this course can be down oaded over the internet at www.e'inf".co"(training.

5. &n order for budgeting to rea y wor,, we "ust in, the budgeting process with: a. Financia .tate"ents

1%

b. Accounting Transactions c. .trategic P anning d. 1perating )eports %. The first forecast we wi prepare for budgeting wi be the: a. -udgeted &nco"e .tate"ent b. .a es Forecast c. Cash -udget d. -udgeted -a ance .heet @. Tay or Manufacturing has co"pi ed "anufacturing +ugs of beverages: the fo owing production infor"ation for

P anned production is 9,*** +ugs Materia s reEuired per +ug: 5* pounds of powder /esired Ending &nventory for Materia s: ;,*** pounds -eginning &nventory for Materia s: @,*** pounds Purchase Cost for Materia s: : %.** per pound -ased on the above infor"ation, what is the tota cost for p anned "ateria s purchasedP a. : 55*,*** b. : 5%*,*** c. : 5%%,*** d. :5%C,***

;. 0hich of the fo owing detai budgets wi .tate"entP a. /irect 7abor -udget b. Cash -udget c. -udgeted -a ance .heet d. Qear End -a ance .heet

he p us prepare the -udgeted &nco"e

<. &f accounts payab e have historica y been %*A of sa es and we have esti"ated sa es of : %**,***, than esti"ated accounts payab e "ust be:

2&

a. : 5*,*** b. : %*,*** c. : @*,*** d. : ;*,*** 9. 0hich budget is prepared for deter"ining how "uch e'terna financing we wi need to support esti"ated sa esP a. Cash -udget b. -udgeted &nco"e .tate"ent c. -udgeted -a ance .heet d. .a es Forecast =. A good p ace to start in preparing the -udgeted -a ance .heet is with the "ain in, between the &nco"e .tate"ent and the -a ance .heet. This in, is: a. Cash b. )etained Earnings c. Current Assets d. 7ong Ter" 7iabi ities C. 1ne way to i"prove the budgeting process is to inc ude Eua itative techniEues into forecasting. 0hich of the fo owing is an e'a"p e of a Eua itative techniEueP a. < Qear Trend Ana ysis b. )atio Ana ysis c. Percent of .a es Method d. &nterviewing the President of the Co"pany L. .tatistica "ethods can be used to i"prove the accuracy of forecasting. This approach is particu ar y usefu for forecasting sa es since we are searching for the right fit based on severa observations. 1ne popu ar approach to finding the right statistica fit is to use: a. E'ponentia ."oothing b. )egression Ana ysis c. E'ecutive Po ing d. Moving Average
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5*. 0hich of the fo owing wi contribute to "a,ing budgeting a nonHva ue added activity3 i.e. the cost of budgeting e'ceeds the benefitP a. The budgeting process is inc uded within the strategic p anning process. b. /etai and .u""ary -udgets are prepared at the sa"e ti"e and are distributed to "anage"ent for approva . c. -udgets throughout the organi2ation are auto"ated for enterpriseHwide conso idation. d. 7ine ite" detai in budgets is based on "ateria thresho ds.

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