Assignment 1 MGMT

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1CHAPTER ONE The What and Why of Budgeting

An Introduction

A BUDGET IS DEFINED as the formal expression of plans, goals, andobjectives of management that covers all aspects of operations for adesignated time period. The budget is a tool providing targets and direction. Budgets provide control over the immediate environment, help to master the financial aspects of the job and department, and solve problems before they occur. Budgets focus on the importance of evaluating alternative actions before decisions actually are implemented.

A budget is a financial plan to control future operations and results. It is expressed in numbers, such as dollars, units, pounds, and hours. It is needed to operate effectively and efficiently. Budgeting, when used effectively, is a technique resulting in systematic, productive management. Budgeting facilitates control and communication and also provides motivation to employees.

Budgeting allocates funds to achieve desired outcomes. A budget may span any period of time. It may be short-term (one year or less, which is usually the case), intermediate (two to three years), or long-term (three years or more). Short-term budgets provide greater detail and specifics. Intermediate budgets examine the projects the company currently is undertaking and start the programs necessary to achieve long-term objectives. Long-term plans are very

Shim, J. K., Siegel, J. G., & Shim, A. I. (2011). Budgeting basics and beyond. ProQuest Ebook Central <a onclick=window.open('http://ebookcentral.proquest.com','_blank') href='http://ebookcentral.proquest.com' target='_blank' style='cursor: pointer;'>http://ebookcentral.proquest.com</a> Created from apus on 2021-08-12 12:54:05.

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broad and may be translated into short-term plans. The budget period varies according to its objectives, use, and the dependability of the data used to prepare it. The budget period is contingent on business risk, sales and operating stability, production methods, and length of the processing cycle.

There is a definite relationship between long-range planning and short- term business plans. The ability to meet near-term budget goals will move the business in the direction of accomplishing long-term objectives. Budgeting is done for the company as a whole, as well as for its component segments, including divisions, departments, products, projects, services, and geographic areas. Budgets aid decision making, measurement, and coordination of the efforts of the various groups within the entity. Budgets highlight the interaction of each business segment with the whole organization. For example, budgets are prepared for units within a department, such as product lines; for the department itself; for the division, which consists of a number of departments; and for the company.

Master (comprehensive) budgeting is a complete expression of the plan- ning operations of the company for a specific period. It is involved with both manufacturing and nonmanufacturing activities. Budgets should set priorities within the organization. They may be in the form of a plan, project, or strategy. Budgets consider external factors, such as market trends and economic conditions. The budget should list assumptions, targeted objectives, and agenda before number crunching begins.

The first step in creating a budget is to determine the overall goals and strategies of the business, which are then translated into specific long-term goals, annual budgets, and operating plans. Corporate goals include earnings growth, cost minimization, sales, production volume, return on investment, and product or service quality. The budget requires the analysis and study of historical information, current trends, and industry norms. Budgets may be prepared of expected revenue, costs, profits, cash flow, production purchases, net worth, and so on. Budgets should be prepared for all major areas of the business.

The techniques and details of preparing, reviewing, and approving budgets vary among companies. The process should be tailored to each entity’s individual needs. Five important areas in budgeting are planning, coordinating, directing, analyzing, and controlling. The longer the budgeting period, the less reliable the estimates.

Budgets link the nonfinancial plans and controls that constitute daily managerial operations with the corresponding plans and controls designed to obtain satisfactory earnings and financial position.

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Effective budgeting requires the existence of:

& Predictive ability & Clear channels of communication, authority, and responsibility & Accounting-generated accurate, reliable, and timely information & Compatibility and understandability of information & Support at all levels of the organization: upper, middle, and lower

The budget should be reviewed by a group so that there is a broad knowledge base. Budget figures should be honest to ensure trust between the parties. At the corporate level, the budget examines sales and production to estimate corporate earnings and cash flow. At the department level, the budget examines the effect of work output on costs. A departmental budget shows resources available, when and how they will be used, and expected accomplishments.

Budgets are useful tools in allocating resources (e.g., machinery, employ- ees), making staff changes, scheduling production, and operating the business. Budgets help keep expenditures within defined limits. Consideration should be given to alternative methods of operations.

Budgets are by departments and responsibility centers. They should reflect the goals and objectives of each department through all levels of the organiza- tion. Budgeting aids all departmental areas, including management, marke- ting, human resources, engineering, production, distribution, and facilities.

In budgeting, consideration should be given to the company’s labor and production scheduling, labor relations, pricing, resources, new product introduction and development, raw material cycles, technological trends, in- ventory levels, turnover rate, product or service obsolescence, reliability of input data, stability of market or industry, seasonality, financing needs, and marketing and advertising. Consideration should also be given to the economy, politics, competition, changing consumer base and taste, and market share.

Budgets should be understandable and attainable. Flexibility and innova- tion are needed to allow for unexpected contingencies. Flexibility is aided by variable budgets, supplemental budgets, authorized variances, and review and revision. Budgets should be computerized to aid what-if analysis. Budgeting enhances flexibility through the planning process because alternative courses of action are considered in advance rather than forcing less-informed decisions to be made on the spot. As one factor changes, other factors within the budget also change. Internal factors are controllable by the company, whereas external factors usually cannot be controlled. Internal factors include risk and product innovation.

The What and Why of Budgeting & 3

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Forecasting is predicting the outcome of events. It is an essential starting point for budgeting. Budgeting is planning for a result and controlling to accomplish that result. Budgeting is a tool, and its success depends on the effectiveness with which staff use it. In a recessionary environment, proper budgeting can in- crease the survival rate. A company may fail from sloppy or incomplete budgeting. Exhibit 1.1 shows a graphic depiction of budget segments.

We now consider planning, types of budgets, the budgetary process, budget coordination, departmental budgeting, comparing actual to budgeted figures, budget revision and weaknesses, control and audit, participative budgeting, and the pros and the cons of budgets.

PLANNING

Budgeting is a planning and control system. It communicates to all members of the organization what is expected of them. Planning is determining the activities to be accomplished to achieve objectives and goals. Planning is needed so that a company can operate its departments and segments successfully. It looks at what should be done, how it should be done, when it should be done, and by whom.

President

Director of Sales

Investment Centers

Profit Centers

Revenue Centers

Cost Centers

Controller

Vice President of Manufacturing

Vice President of Marketing

Vice President of Finance

Director of Manufacturing

EXHIBIT 1.1 Budget Segments

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Planning involves the determination of objectives, evaluation of alternative courses of action, and authorization to select programs. There should be a good interface of segments within the organization.

Budgets are blueprints for projected action and a formalization of the planning process. Plans are expressed in quantitative and monetary terms. Planning is taking an action based on investigation, analysis, and research. Potential problems are searched out. Budgeting induces planning in each phase of the company’s operation.

A profit plan is what a company expects to follow to attain a profit goal. Managers should be discouraged from spending their entire budget, and should be given credit for cost savings.

Budget planning meetings should be held routinely to discuss such topics as the number of staff needed, objectives, resources, and time schedules. There should be clear communication of how the numbers are established and why, what assumptions were made, and what the objectives are.

TYPES OF BUDGETS

It is necessary to be familiar with the various types of budgets to understand the whole picture and how these budgets interrelate. The types of budgets include:

& Master budget & Operating and financial budgets & Cash budget & Static (fixed) budget & Flexible (expense) budget & Capital expenditure budget & Program budget & Incremental budget & Add-on budget & Supplemental budget & Bracket budget & Stretch budget & Strategic budget & Activity-based budget & Target budget & Rolling (continuous) budget & Probabilistic budget

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These budgets are briefly explained next.

Master Budget

A master budget is an overall financial and operating plan for a forthcoming calendar or fiscal year. It is usually prepared annually or quarterly. The master budget is really a number of subbudgets tied together to summarize the planned activities of the business. The format of the master budget depends on the size and nature of the business.

Operating and Financial Budgets

The operating budget deals with the costs for merchandise or services pro- duced. It covers income statement items comprised of revenues and expenses. In contrast, the financial budget examines the expected assets, liabilities, and stockholders’ equity of the business. It encompasses balance sheet items. Both budgets are needed to see the company’s financial health.

Cash Budget

The cash budget is for cash planning and control. It presents expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs and aids in avoiding idle cash and possible cash shortages. The cash budget typically consists of four major sections:

1. Receipts section, which is the beginning cash balance, cash collections from customers, and other receipts

2. Disbursement section, comprised of all cash payments made by purpose 3. Cash surplus or deficit section, showing the difference between cash

receipts and cash payments 4. Financing section, providing a detailed account of the borrowings and

repayments expected during the period

Static (Fixed) Budget

The static (fixed) budget is budgeted figures at the expected capacity level. Allowances are set forth for specific purposes with monetary limitations. It is used when a company is relatively stable. Stability usually refers to sales. The problem with a static budget is that it lacks the flexibility to adjust to unpredictable changes.

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In industry, fixed budgets are appropriate for those departments whose workload does not have a direct current relationship to sales, production, or some other volume determinant related to the department’s operations. The work of the departments is determined by management decision rather than by sales volume. Most administrative, general marketing, and even manufactur- ing management departments are in this category. Fixed appropriations for specific projects or programs not necessarily completed in the fiscal period also become fixed budgets to the extent that they will be expended during the year. Examples include appropriations for capital expenditures, major repair projects, and specific advertising or promotional programs. The static budget will be illustrated in Chapter 6, “Master Budget.”

Flexible (Expense) Budget

The flexible (expense) budget is most commonly used by companies. It allows for variability in the business and for unexpected changes. It is dynamic in nature rather than static. Flexible budgets adjust budget allowances to the actual activity. Flexible budgets are effective when volumes vary within a relatively narrow range. They are easy to prepare with computerized spreadsheets such as Excel.

The four basic steps in preparing a flexible (expense) budget are:

1. Determine the relevant range over which activity is expected to fluctuate during the coming period.

2. Analyze costs that will be incurred over the relevant range in terms of determining cost behavior patterns (variable, fixed, or mixed).

3. Separate costs by behavior, determining the formula for variable and mixed costs.

4. Using the formula for the variable portion of the costs, prepare a budget showing what costs will be incurred at various points throughout the relevant range.

Due to uncertainties inherent in planning, three forecasts may be pro- jected: one at an optimistic level, one at a pessimistic or extremely conservative level, and one at a balanced, in-between level. Flexible budgets are illustrated in Chapter 7, “Cost Behavior.”

Capital Expenditure Budget

The capital expenditure budget is a listing of important long-term projects to be undertaken and capital (fixed assets such as plant and equipment) to be

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acquired. The estimated cost of the project and the timing of the capital expenditures are enumerated, along with how the capital assets are to be financed. The budgeting period is typically 3 to 10 years. A capital projects committee, which is typically separate from the budget committee, may be created solely for capital budgeting purposes.

The capital expenditures budget often classifies individual projects by objective, as for:

& Expansion and enhancement of existing product lines & Cost reduction and replacement & Development of new products & Health and safety expenditures

The lack of funds may prevent attractive potential projects from being approved.

An approval of a capital project typically means approval of the project in principle. However, final approval is not automatic. To obtain final approval, a special authorization request is prepared for the project, spelling out the proposal in more detail. The authorization requests may be approved at various managerial levels, depending on their nature and dollar magnitude.

BUDGETING IN ACTION Need for Flexible Budgets

The difficulty of accurately predicting future financial performance can bereadily understood by reading the annual report of any publicly traded company. For example, Nucor Corporation, a steel manufacturer headquartered in Charlotte, North Carolina, cites numerous reasons why its actual results may differ from expectations, including: (1) the supply and cost of raw materials, electricity, and natural gas may change unexpectedly; (2) the market demand for steel products may change; (3) competitive pressures from imports and substitute materials may intensify; (4) uncertainties regarding the global economy may affect customer demand; (5) changes to U.S. and foreign trade policy may alter current importing and exporting practices; and (6) new government regulations could significantly increase environmental compliance costs. Each of these factors could cause static budget revenues and/or costs to differ from actual results.

Source: Nucor Corporation 2010 annual report.

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Program Budget

Programmingis deciding which programs shouldbe funded andbyhowmuch. A common application of program budgets is to product lines. Resources are allocated to accomplish a specific objective with a review of existing and new programs. Some suitable program activities include research and development, marketing, training, preventive maintenance, engineering, and public relations. Funds usually are allocated based on cost-effectiveness. In budget negotiations, proposed budgetary figures should be explained and justified. The program budget typically cannot be used for control purposes because the costs shown cannot ordinarily be related to the responsibilities of specific individuals.

Incremental Budget

Incremental budgeting looks at the increase in the budget in terms of dollars or percentages without considering the whole accumulated body of the budget.

There are also self-contained, self-justified increments of projects. Each one specifies resource utilization and expected benefits. A project may be segregated into one or more increments. Additional increments are required to complete the project. Labor and resources are assigned to each increment.

Add-On Budget

An add-on budget is one in which previous years’ budgets are examined and adjusted for current information, such as inflation and employee raises. Money is added to the budget to satisfy the new requirements. With add-on, there is no incentive for efficiency, but competition forces one to look for new, better ways of doing things. For example, Konica Imaging U.S.A. has combined add-on with zero-based review.

Supplemental Budget

Supplemental budgets provide additional funding for an area not included in the regular budget.

Bracket Budget

A bracket budget is a contingency plan with costs projected at higher and lower levels than the base amount. Sales are then forecasted for these levels. The purpose of this method is to provide management with a sense of earnings impact and a contingency expense plan if the base budget and the resulting sales forecast are not achieved. A contingency budget may be appropriate

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when there are downside risks that should be planned for, such as a sharp drop in revenue.

Stretch Budget

A stretch budget may be considered a contingency budget on the optimistic side. Typically, it is confined to sales and marketing projections that are higher than estimates. It is rarely applied to expenses. Stretch targets may be held informally without making operating units accountable for them. Alterna- tively, stretch targets may be official estimates for sales and marketing personnel. Expenses may be estimated at the standard budget sales target. Many of the best-performing companies, such as GE and Microsoft, set stretch targets. Stretch targets are challenging but achievable levels of expected performance, intended to create a little discomfort and to motivate employees to exert extra effort and attain better performance. Firms such as Goldman Sachs also use “horizontal” stretch goal initiatives. The aim is to enhance professional development of employees by asking them to take on significantly different responsibilities or roles outside their comfort zone.

Strategic Budget

Strategic budgeting integrates strategic planning and budgeting control. It is effective under conditions of uncertainty and instability.

Activity-Based Budget

Activity-based budgeting (ABB) estimates costs for individual activities. Tradi- tional budgeting is functional budgeting because the focus is on preparing budgets by function, such as production, selling, and administrative support. Organizations that have implemented activity-based cost (ABC) systems often use these systems as a vehicle to prepare activity-based budgets that focus on the budgeted cost of activities required to produce and sell products and services. Activity-based budgeting is discussed at great length in Chapter 21, “Budgeting for Cost Management.”

Target Budget

A target budget is a plan in which categories of major expenditures are matched to company goals. The emphasis is on formulating methods of project funding to move the company forward. There must be strict justification for large dollars and special project requests.

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Rolling (Continuous) Budget

A rolling budget, also called a continuous or perpetual budget, is revised on a regular (continuous) basis. Typically, a company extends such a budget for another month or quarter in accordance with new data as the current month or quarter ends. For example, if the budget is for 12 months, a budget for the next 12 months will be available continuously as each month ends. In other words, one month (or quarter) is added to the end of the budget as each month (or quarter) comes to a close. This approach keeps managers focused at least one year ahead so that they do not become too narrowly focused on short-term results. Static (fixed) budgets are criticized as being ineffective in a rapidly changing world. Companies report performance on a calendar basis, but events such as floods, earthquakes, tsunamis, stock market crashes, strikes, and competitors’ new product announce- ments happen continuously. In consequence, some leading companies have abandoned fixed budgets and changed to rolling forecasts to inspire and lead their companies to better performance. Rolling forecasts direct management’s atten- tion toward the future and ensure that planning is ongoing, as opposed to an annual exercise. The rolling budget largely eliminates the budget revision problem. Frequent restudy of plans is required by this approach. The rolling budget is illustrated in Chapter 19, “Using Software Packages and E-Budgeting.”

Probabilistic Budget

One way in which uncertainty can be explicitly introduced into the profit planning and control program is by the use of probabilistic profit budgets. Under this approach, several estimates are made for each of several key components in the budget, and probabilities are assigned to these estimates. One reasonable approach is to select an optimistic, a pessimistic, and a most likely estimate for each key number in the budget. This approach is illustrated in Chapter 19, “Using Software Packages and E-Budgeting.”

BUDGETARY PROCESS

A sound budget process communicates organizational goals, allocates resources, provides feedback, and motivates employees. The budgetary process should be standardized by using budget manuals, budget forms, and formal procedures. Software, the Program Evaluation and Review Technique (PERT), and Gantt charts facilitate the budgeting process and preparation. The timetable for the budget must be kept. If the budget is a rush job, unrealistic targets may be set.

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The budget process used by a company should suit its needs, be consistent with its organizational structure, and take into account human resources. The budgetary process establishes goals and policies, formulates limits, enumerates resource needs, examines specific requirements, provides flexibility, incorpo- rates assumptions, and considers constraints. It should take into account a careful analysis of the current status of the company. The process takes longer as the complexity of the operations increase. A budget is based on past experience plus changes in light of the current environment.

The six steps in the budgeting process are:

1. Setting objectives 2. Analyzing available resources 3. Negotiating to estimate budget components 4. Coordinating and reviewing components 5. Obtaining final approval 6. Distributing the approved budget

A budget committee should review budget estimates from each segment, make recommendations, revise budgeted figures as needed, and approve or disapprove of the budget. The committee should be available for advice if a problem arises in gathering financial data. The committee can also reconcile diverse interests of budget preparers and users.

The success of the budgeting process requires the cooperation of all levels within the organization. For example, without top management or operating management support, the budget will fail. Those involved in budgeting must be properly trained and guided in the objectives, benefits, steps, and procedures. There should be adequate supervision.

The preparation of a comprehensive budget usually begins with the anticipated volume of sales or services, which is a crucial factor that determines the level of activity for a period. In other cases, factory capacity, the supply of labor, or the availability of raw materials could be the limiting factor for sales. After sales are forecasted, production costs and operating expenses can be estimated. The budgeting period varies with the type of business, but it should be long enough to include complete cycles of season, production, inventory turnover, and financial activities. Other considerations are product or service to be rendered and regulatory requirements.

The budget guidelines prepared by top management are passed down through successive levels in the company. Managers at each level may make additions and provide greater detail for subordinates. The managers at each

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level prepare the plans for items under their control. For example, Philip Morris formulates departmental budgets for each functional area.

The budgeting process will forewarn management of possible problems that may arise. By knowing the problems, solutions may be formulated. For example, at the valleys in cash flow, a shortage of cash may occur. By knowing this in advance, management may arrange for a short-term loan for the financing need rather than face a sudden financing crisis. In a similar vein, planning allows for a smooth manufacturing schedule to result in both lower production costs and lower inventory levels. It avoids a crisis situation requiring overtime or high transportation charges to receive supplies ordered on a rush basis. Without proper planning, cyclical product demand needs may arise, straining resources and capacity. Resources include material, labor, and storage.

Bottom-Up versus Top-Down

A budget plans for future business actions. Managers prefer a participative bottom-up approach to an authoritative top-down approach. The bottom-up method begins at the bottom or operating (departmental) level based on the objectives of the segment. However, operating levels must satisfy the overall company goals. Each department prepares its own budget (such as estimates of component activities and product lines by department) before it is integrated into the master budget.

Managers are more motivated to achieve budgeted goals when they are involved in budget preparation. A broad level of participation usually leads to greater support for the budget and the entity as a whole, as well as greater understanding of what is to be accomplished. Such participation can give employees the feeling that “this is our budget,” rather than the all-too-common feeling that “this is the budget you imposed on us.” Advantages of participative budgeting (or self-imposed budgeting) include greater accuracy of budget esti- mates. Managers with immediate operational responsibility for activities have a better understanding of what results can be achieved and at what costs. Also, managers cannot claim unrealistic goals as an excuse for not achieving budget expectations when they have helped to establish those goals. Despite the involvement of lower-level managers, top management still must participate in the budget process to ensure that the combined goals of the various departments are consistent with the profitability objectives of the company. The goals may include growth rates, labor needs, minimum return on invest- ment, and pricing. In effect, departmental budgets are used to determine the organizational budget. The budget is reviewed, adjusted if necessary, and

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approved at each higher level. The bottom-up approach forecasts sales by product or other category, then by company sales, and then by market share. The bottom-up method may be used to increase the feeling of unit-level owner- ship in the budget. Disadvantages are the time-consuming process from partici- pative input and the fact that operating units may neglect some company objectives. Bottom-up planning does not allow for control of the process, and the resulting budget is likely to be unbalanced with regard to the relationship of expenses to revenue. Typical questions to answer when preparing a bottom-up budget are: What are the expected promotional and travel expenses for the coming period? What staff requirements will be needed? What are the expected raises for the coming year? What quantity of supplies will be needed?

This approach is particularly necessary when responsibility center managers are expected to be very innovative. Responsibility center manag- ers know what must be achieved, where the opportunities are, what problem areas must be resolved, and where resources must be allocated. One important limitation of participative budgeting is that lower-level managers may allow too much budgetary slack. Since the manager who creates the budget will be held accountable for actual results that deviate from the budget, the manager will have a natural tendency to submit a budget that is easy to attain (i.e., the manager will build slack into the budget). For this reason, budgets prepared by lower-level managers should be scrutinized by higher levels of management. Questionable items should be discussed and modified as appropriate. Without such a review, self-imposed budgets may be too slack, resulting in suboptimal performance.

In the top-down approach, a central corporate staff under the chief executive officer or president determines overall company objectives and strategies, enumerates resource constraints, considers competition, prepares the budget, and makes allocations. Management considers the competitive and economic environment. Top management knows the company’s objectives, strategies, resources, strengths, and weaknesses. Departmental objectives follow from the action plans.

The top-down method is commonly used in long-range planning. A top- down approach is needed for a company having significant interdependence among operating units to enhance coordination. This approach first would forecast sales based on an examination of the economy, then the company’s share of the market and the company’s sales, and then sales by products or other category. A top-down approach may be needed when business unit managers must be given specific performance objectives due to a crisis situation and when close coordination is required between business units. It is possible

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that the sum of the unit budgets would not meet corporate expectations. If unit managers develop budgets independently of other units, there are inconsisten- cies in the assumptions used by different units.

A disadvantage with this approach is that central staff may not have all the knowledge needed to prepare the budget within every segment of the organization. Managers at the operating levels are more knowledgeable and familiar with the segment’s operations. Managers will not support or commit to a budget they were not involved in preparing, which will cause a motivational problem. Further, the top-down approach stifles creativity. A budget needs input from affected managers, but upper management knows the overall picture.

A combination of the bottom-up and top-down approaches may be appropriate in certain cases. Some large companies may integrate the methods. For example, Konica Imaging uses a blend. Direction is supplied from the top, and senior management develops action plans. Each department must then determine how it will actually implement the plan, specifically looking at the resources and expenditures required. This is the quantification of the action plans into dollars. It is then reviewed to see if it achieves the desired results. If it does not, it will be kicked back until it is brought in line with the desired outcomes. The what, why, and when are specified from the top, and the how and who are specified from the bottom.

BUDGET COORDINATION

There should be one person responsible for centralized control over the budget who must work closely with general management and department heads. A budget is a quantitative plan of action that aids in coordination and imple- mentation. The budget communicates objectives to all the departments within the company. It presents upper management with coordinated and summa- rized data as to the financial ramifications of plans and actions of various departments and units within the company.

Budgets usually are established for all departments and major segments in the company. They must be comprehensive, including all interrelated depart- ments. The budget process should receive input from all departments so there is coordination within the firm. For example, operations will improve when marketing, purchasing, personnel, and finance departments cooperate.

Coordination involves obtaining and organizing the needed personnel, equipment, and materials to carry out the business. A budget aids in

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coordination between separate activity units to ensure that all parts of the company are in balance with each other and know how they fit in. It discloses weaknesses in the organizational structure and communicates to staff what is expected of them. It allows for a consensus of ideas, strategies, and direction.

The interdependencies between departments and activities must be con- sidered in a budget. For example, the sales manager depends on sufficient units produced in the production department. Production depends on how many units can be sold. Most budget components are affected by other components. For example, most components are impacted by expected sales volume and inventory levels, while purchases are based on expected production and raw material inventories.

A budget allows for directing and control. Directing means supervising the activities to ensure they are carried out in an effective and efficient manner within time and cost constraints. Controlling involves measuring the progress of resources and personnel to accomplish a desired objective. A comparison is made between actual results and budgeting estimates to identify problems needing attention.

In summation, the budget must consider the requirements of each depart- ment or functionand the relationshipsthat each has with other departments and functions. Activities and resources have to be coordinated.

DEPARTMENTAL BUDGETING

All department managers within a company must accurately determine their future costs and must plan activities to accomplish corporate objectives. Departmental supervisors must have significant input into budgeting costs and revenues because these people are directly involved with the activity and have the best knowledge of it. Managers must examine whether their budget- ary assumptions and estimates are reasonable. Budget targets should match manager responsibilities. At the departmental level, the budget considers the expected work output and translates it into estimated future costs.

Budgets are needed for each department. The sales department must forecast future sales volume of each product or service, as well as the selling price. It probably will budget revenue by sales territory and customer. It will also budget costs such as wages, promotion and entertainment, and travel. The production department must estimate future costs to produce the product or service and the cost per unit. The production manager may have to budget work during the manufacturing activity so the work flow continues smoothly.

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The purchasing department will budget units and dollar purchases. There may be a breakdown by supplier. There will be a cost budget for salaries, supplies, rent, and so on. The stores department will budget its costs for holding inventory. There may be a breakdown of products into categories. The finance department must estimate how much money will be received and where it will be spent to determine cash adequacy. An illustrative budget showing revenue and expense by product line appears in Exhibit 1.2.

ACTUAL COSTS VERSUS BUDGET COSTS

A budget provides an early warning of impending problems. The effectiveness of a budget depends on how sound and accurate the estimates are. The planning must take all factors into account in a realistic way. The budget figures may be inaccurate because of such factors as economic problems, political unrest, competitive shifts in the industry, introduction of new prod- ucts, and regulatory changes.

At the beginning of the period, the budget is a plan. At the end of the period, the budget is a control instrument to assist management in measuring its performance against the plan so as to improve future performance. Budgeted revenue and costs are compared with actual revenue and costs to determine variances. A determination has to be made whether the variances are con- trollable or uncontrollable. If controllable, the parties responsible must be identified. Action must be taken to correct any problems.

A comparison should be made between actual costs at actual activity to budgeted costs at actual activity. In this way, there is a common base of comparison. The percentage and dollar difference between the budget and actual figures should be shown. A typical performance report for a division appears in Exhibit 1.3.

Authorized variances in cost budgets allow for an increase in the initial budget for unfavorable variances. This increase may result from unexpected wage increases, prices of raw materials, and so on. Allowance is given for cost excesses that a manager can justify.

BUDGET REVISION

A budget should be monitored regularly. It should be revised to make it accurate during the period in response to error, feedback, new data, changing conditions (e.g., economic, political, corporate), or modification of the

The What and Why of Budgeting & 17

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E X H IB IT

1 .2

S ta te m e n t o f R e ve

n u e an

d E xp

e n se

b y P ro d u ct

fo r th e Y e ar

E n d e d 2 X 1 2

A ll P ro d u ct s

P ro d u ct

Li n e

D e sc ri p ti o n

A m o u n t

P e rc e n ta g e

o f N e t S al e s

X A m o u n t

P e rc e n ta g e

o f N e t S al e s

Y A m o u n t

P e rc e n ta g e

o f N e t S al e s

Z A m o u n t

P e rc e n ta g e

o f N e t S al e s

G ro ss

re ve

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al e s re tu rn s an

d al lo w an

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N e t re ve

n u e

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ar ia b le

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ax e s

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company’s plan. Human error is more likely when the budget is large and complex. A change in conditions typically will affect the sales forecast and resulting cost estimates. Revisions are more common in volatile industries. The budget revision applies to the remainder of the accounting period.

A company may roll a budget, which means continuously budgeting for an additional incremental period at the end of the reporting period. The new period is added to the remaining periods to form the new budget. Continuous budgets reinforce constant planning, consider past information, and take into account emerging conditions.

BUDGET WEAKNESSES

The signs of budget weaknesses must be spotted so that corrective action may be taken. Such signs include:

& Managerial goals are off target or unrealistic. & Management is indecisive. & The budget takes too long to prepare. & Budget preparers are unfamiliar with the operations being budgeted and

do not seek such information. Budget preparers should visit the actual operations firsthand.

& Budget preparers do not keep current. & The budget is prepared using different methods each year. & There is a lack of raw information going into the budgeting process.

EXHIBIT 1.3 XYZ Company Divisional Performance Evaluation December 31, 2X12

Net Income Net Sales

Division Actual Expected Over

(Under) Plan Actual Expected Over

(Under) Plan

A $ 2,000 $ 4,000 ($2,000) $1,000 $ 800 $200

B 3,000 5,000 (2,000) 700 600 100

C 5,000 6,000 (1,000) 600 1,000 (400)

Total $10,000 $15,000 ($5,000) $2,300 $2,400 ($100)

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& There is a lack of communication between those involved in budgeting and operating personnel.

& The budget is formulated without input from those affected by it. This will probably result in budgeting errors. Further, budget preparers do not go into the operations field.

& Managers do not know how their budget allowances have been assigned or what the components of their charges are. If managers do not under- stand the information, they will not perform their functions properly.

& The budget document is excessively long, confusing, or filled with un- necessary information. There may be inadequate narrative data to explain the numbers.

& Managers are ignoring their budgets because they appear unusable and unrealistic.

& Managers feel they are not getting anything out of the budget process. Changes are made to the budget too frequently.

& Significant unfavorable variances are not investigated and corrected. These variances also may not be considered in deriving budgeted figures for the next period. Further, a large variance between actual and budgeted figures, either positive or negative, that repeatedly occurs is an indicator of poor budgeting. Perhaps the budgeted figures were unrealistic. Another problem is that after variances are identified, it is too late to correct their causes.

& There is a mismatching of products or services.

BUDGETARY CONTROL AND AUDIT

As discussed previously, the budget is a major control device for revenue, costs, and operations. The purpose is to increase profitability and reduce costs or to meet other corporate objectives as quickly as possible. Budgetary control may also be related to nonfinancial activities, such as the life cycle of the product or seasonality. An illustrative budget control report is shown in Exhibit 1.4.

A budget audit should be undertaken to determine the correctness of the budgeted figures. Was there a proper evaluation of costs? Were all costs included that should have been? What are the cost trends? Are budgeted figures too tight or too loose? Are budgeted figures properly supported by documentation? A budget audit appraises budgeting techniques, procedures,

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manager attitudes, and effectiveness. The major aspects of the budgeting process have to be examined.

Exhibit 1.5 depicts the control process in budgeting.

COMPUTER APPLICATIONS

A computer should be used to make quick and accurate calculations, keep track of projects instantly, and make proper comparisons.

With the use of a spreadsheet program, budgeting can be an effective tool to perform sensitivity analysis that is designed to evaluate what-if scenarios. This way the manager should be able to move toward finding the best course of action among various alternatives through simulation. If the manager does not like the result, he or she may alter the contemplated decision and planning set. Specialized software that is solely devoted to budget preparation

EXHIBIT 1.4 Budget Control Report

I. Budget Savings

One-Year Savings Amount:

Two- to Five-Year Savings Amount:

More Than Five-Year Savings Amount:

Savings Description:

II. Budget Impact

Reduction in Current Year Budget Budget Account Budget Amount

Budget Adjustment Not Needed

III. Budget Participants

Management: Names: Job Description:

Employees: Names: Job Description:

IV. Management Incentives:

V. Employee Awards

Prepared by:

Reviewed by:

Approved by:

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and analysis also exists. Currently, an increasing number of companies are using a Web-based (or Web-enabled) budgeting approach in a cloud computing environment. The new system enables firms and their management and support staff to directly input their business plan and budget requests, eliminating the need for central business planning and budgeting staff to upload the numerous budget requests and subsequent changes. This system is discussed in more detail in Chapter 19, “Using Software Packages and E- Budgeting.”

MOTIVATION

Budgets can be used to affect employee attitudes and performance. Budgets should be participative, including participation by those to be affected by them. Further, lower-level employees are on the operating line every day so they are quite knowledgeable. Their input is needed. Budgets can be used to motivate because participants will internalize the budget goals as their own since they

Feedback

Good Performance?

Yes

Retain As Is

Remedial Steps

Selection

Analysis of Information, Assumptions, and Different Scenarios

Plan Budget Reports

Budget Reports

Operational Functions

Study and Evaluation

EXHIBIT 1.5 Budgeting Control Process

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participated in their development. Information should be interchanged among budget participants. An imposed budget will have a negative effect on motiva- tion. Further, there is a correlation between task difficulty and loss of control to negative attitudes.

A budget is a motivational and challenging tool if it is tight but attainable. It has to be realistic. If the budget is too tight, it results in frustration because managers will give up and not try to achieve the unrealistic targets. If it is too loose, complacency will arise and workers may goof off.

The best way to set budget targets is with a probability of achievement by most managers 80 to 90 percent of the time. Performance above the target level should be supplemented with incentives, including bonuses, promotion, and additional responsibility.

ADVANTAGES AND DISADVANTAGES OF BUDGETS

Preparing a budget takes time and resources. The benefits of budgeting must outweigh the drawbacks. A budget can be advantageous because it:

& Links objectives and resources. & Communicates to managers what is expected of them. Any problems in

communication and working relationships are identified. Resources and requirements are identified.

& Establishes guidelines in the form of a road map to proceed in the right direction.

& Improves managerial decision making because emphasis is on future events and associated opportunities.

& Encourages delegation of responsibility and enables managers to focus more on the specifics of their plans, how realistic the plans are, and how such plans may be effectively achieved.

& Provides an accurate analytical technique. & Provides better management of subordinates. For example, a manager can

use the budget to encourage salespeople to consider their clientele in a long-term strategic perspective.

& Fosters careful study before making decisions. & Helps management become aware of the problems faced by lower levels

within the organization, which promotes labor relations.

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& Encourages employees to think about how to make operations and resources more productive, efficient, competitive, and profitable. It leads to cost reduction.

& Allows management to monitor, control, and direct activities within the company. Performance standards act as incentives to perform more effectively.

& Points out deviations between budget and actual, resulting in warning signals for changes or alterations.

& Helps identify, on a timely basis, weaknesses in the organizational struc- ture. There is early notice of dangers or departures from forecasts. The formulation and administration of budgets pinpoints communication weaknesses, assigns responsibility, and improves working relationships.

& Provides management with foresight into potential crisis situations so alternative plans may be instituted.

& Provides early signals of upcoming threats and opportunities. & Aids coordination between departments to attain efficiency and productiv-

ity. There is an interlocking within the business organization. For example, the production department will manufacture based on the sales depart- ment’s anticipated sales volume. The purchasing department will buy raw materials based on the production department’s expected production vol- ume. The human resources department will hire or lay off workers based on anticipated production levels. Executives are forced to consider relationships among individual operations and the company as a whole.

& Provides a motivational device setting a standard for employees to achieve. & Provides measures of self-evaluation. & Allows management to make distasteful decisions and blame them on the

budget.

A budget can be disadvantageous because:

& It promotes gamesmanship in that those managers who significantly inflate requests, knowing they will be reduced, are in effect rewarded by getting what they probably really wanted.

& It may reward managers who set modest goals and penalize those who set ambitious goals that are missed.

& There is judgment and subjectivity in the budgeting process. & Managers may think that budgets restrict their flexibility to adjust to

changing conditions. & It does not consider quality and customer service. & There is a risk it will be padded, thereby creating budgetary slack.

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BUDGETARY SLACK: PADDING THE BUDGET

Budget padding means underestimating revenue or overestimating costs. The difference between the revenue or cost projection that a manager provides and a realistic estimate of the revenue or cost is called budgetary slack. For example, if a manager believes the annual utilities cost will be $18,000 but gives a budgetary projection of $20,000, the manager has built $2,000 of slack into the budget. One reason for padding the budget is that people often perceive that their performance will look better in their superiors’ eyes if they can beat the budget.

BUDGETING IN ACTION Budgeting Tied to Compensation

1. A manager’s compensation is often tied to the budget. Typically, no bonus is paid unless a minimum performance hurdle, such as 80 percent of the budget target, is attained. Once that hurdle is passed, the manager’s bonus increases until a cap is reached. That cap is often set at 120 percent of the budget target. This common method of tying a manager’s compensation to the budget has some serious negative side effects.

Example 1: A marketing manager for a big beverage company intentionally grossly understated demand for the company’s products for an upcoming major holiday so that the budget target for revenues would be low and easy to beat. Unfortunately, the company tied its production to this biased forecast and ran out of products to sell during the height of the holiday selling season.

Example 2: Near the end of the year, another group of managers announced a price increase of 10 percent effective January 2 of the following year. Why would they do this? By announcing this price increase, managers hoped that customers would order before the end of the year, helping managers meet their sales targets for the current year. Sales in the following year would, of course, drop. What trick would managers pull to meet their sales targets next year in the face of this drop in demand?

Source: Michael C. Jensen, “Corporate Budgeting Is Broken—Let’s Fix It,” Harvard Business Review (November 2010).

(continued )

The What and Why of Budgeting & 25

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SUMMARY

A budget should be based on norms and standards. The budget should be coordinated, integrated, organized, systematic, clear, and comprehensive to accomplish optimal results. The budget preparation, review, and evaluation process must be facilitated. An orderly budgeting process will result in less cost, fewer man-hours, and minimization of conflict and turmoil. It will re- quire less revision at a later date. The budget process must consider input- output relationships. The budget aids in anticipating problems before they become critical. Short-term budgets should be used for businesses subject to rapid change. A budget is a tool for planning and for what-if analysis. It aids in identifying the best course of action.

As it is in the computer world—garbage in, garbage out—so it is with budgeting. If forecasts are inaccurate, so will be the projections, resulting in bad management decisions to the detriment of the firm. A manager must be cautious when analyzing past experience. Unforeseen circumstances, such as economic downturns and future innovations, have direct inputs on current operations. A manager deviating from a budget target must explain why and, of course, is on the defensive. Without proper justification for missing targets, the manager may be dismissed.

The failure to budget may result in conflicting and contradictory plans, as well as in wasting corporate resources. Budget slack, the underestimation of revenues and the overestimation of expenses, should be avoided or mini- mized. Budgets should be revised as circumstances materially change. A manager who has responsibility to meet a budget should also have the au- thorization to use corporate resources to accomplish that budget. Priorities

(continued )

2. Towers Perrin, a consulting firm, reports that the bonuses of more than two out of three corporate managers are based on meeting targets set in annual budgets. “Under this arrangement, managers at the beginning of a year all too often argue that their targets should be lowered because of tough business conditions, when in fact conditions are better than projected. If their arguments are successful, they can easily surpass the targets.”

Source: Ronald Fink and Towers Perrin, “Riding the Bull: The 2000 Compensation Survey,” CFO (June 2000): 45–60.

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should be established for the allocation of scarce resources. Budgets may include supplementary information such as break-even analysis by depart- ment, by product, and for overall operations.

It is important to avoid a situation in which a manager feels he or she must spend the entire budget or else lose funding in the next period. Managers should not be motivated to spend the entire budget. Rather, cost savings should be realized, and those responsible should be recognized, such as through cash bonuses or nonmonetary awards (e.g., trophies, medals). Budget savers should be protected in the funding for future budgets.

Budgets should not be arbitrarily cut across the board. Doing so may result in disastrous consequences in certain programs. If budget reductions are necessary, determine exactly where and by how much.

The What and Why of Budgeting & 27

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2CHAPTER TWO Strategic Planning and Budgeting

Process, Preparation, and Control

ALTHOUGH IT DIFFERS AMONG companies, planning charts thedirection of the company over a period of time to accomplish a desiredresult, such as improving profitability. Budgeting is simply one portion of the plan, and the annual budget should be consistent with the long-term goals of the business. Planning should link short-term, intermediate-term, and long-term goals. Plans are interrelated, and the annual plan may be based on the long-term plan. The objective is to make the best use of the company’s available resources over the long term.

In planning, management selects long-term and short-term goals and draws up plans to accomplish those goals. Planning is more important in long- run management. The objectives of a plan must be continually appraised in terms of degree of accomplishment and how long implementation will take. There should be feedback as to the plan’s progress. It is best to concentrate on accomplishing fewer targets so proper attention will be given to them. Objectives must be specific and measurable. For example, a target to increase sales by 20 percent is definite and specific. The manager can quantitatively measure progress toward meeting this target.

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The plan is the set of details implementing a strategy. The plan of execution typically is explained in sequential steps, including costs and timing for each step. Deadlines are set.

The planning function includes all managerial activities that ultimately enable an organization to achieve its goals. Because every organization needs to set and achieve goals, planning often is called the first function of manage- ment. At the highest levels of business, planning involves establishing company strategies—that is, determining how the resources of the business will be used to reach its objective. Planning also involves the establishment of policies—the day-to-day guidelines used by managers to accomplish their objectives. The elements of a plan include objectives, performance standards, appraisal of performance, action plan, and financial figures.

All management levels should be involved in preparing budgets. There should be a budget for each responsibility center. Responsibility in particular areas should be assigned for planning to specific personnel. At MillerCoors Company, planning is ongoing, encouraging managers to assume active roles in the organization.

A plan is a predetermined action course. Planning has to consider the organizational structure, taking into account authority and responsibility. Planning is determining what should be done, how it should be done, and when it should be done. The plan should specify the nature of the problems, reasons for them, constraints, contents, characteristics, category, alterna- tive ways of accomplishing objectives, and information required. Planning objectives include quantity and quality of products and services, as well as growth opportunities.

A plan is a detailed outline of activities to meet desired strategies to accomplish goals. Such goals must be realistic. The assumptions of a plan must be specified and appraised as to whether they are reasonable. The financial effects of alternative strategies should be noted, and planning should allow for creativity. Planning involves analyzing the strengths and weaknesses of the company and each segment therein. It requires analysis of the situation and is needed to allocate various resources to organizational units and programs. The plan should specify the evaluative criteria and measurement methods.

Long-term plans should consider new opportunities, competition, re- sources (equipment, machinery, staff), diversification, expansion, financial strength, and flexibility. In planning, consideration has to be given to non- cyclical occurrences, such as a new product or service introduction, modifica- tion of manufacturing processes, or discontinuance of a product or service.

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Strategic budgeting is a form of long-range planning based on identifying and specifying organizational goals and objectives. The strengths and weaknesses of the organization are evaluated, and risk levels are assessed. The influences of environmental factors are forecasted to derive the best strategy for reaching the organization’s objectives.

Several planning assumptions should be made at the beginning of the budget process. Some of these assumptions are internal factors; others are external to the company. External factors include general economic conditions and their expected trend, governmental regulatory measures, the labor market in the locale of the company’s facilities, and the activities of competitors, including the effects of mergers.

Planning is facilitated when the business is stable. For example, a company with a few products or services operating in stable markets can plan better than one with many diverse products operating in volatile markets. Planning should take into account industry and competing company conditions.

A description of products, facilities, resources, and markets should be noted in the plan. The emphasis should be on better use of resources, including physical facilities and personnel. In summation, a plan is a detailed outline of activities and strategies to satisfy a long-term objective. An objective is a quantifiable target. The objective is derived from an evaluation of the situation. A diagram of the strategic planning process appears in Exhibit 2.1.

BUDGETING

Budgeting is a form of planning and policy development considering resource constraints. It is a profit-planning mechanism that may look at what-if scenarios. Budgets are detailed and communicate to subunits what is expected of them. Those responsible for expenditures and revenue should provide budget information. Planning should be by the smallest practical segment. Budgeting is worthwhile if its use makes the company more profitable than without it.

Budgets are quantitative expressions of the yearly profit plan and measure progress during the period. The shorter the budgeting period, the more reliable the budget will be. A cumulative budget may drop the prior month and add the next month.

Probabilities may be used in budgeting. Of course, the total probabilities must add up to 100 percent.

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Example 1

The sales manager assigns these probabilities to expected sales for the year: Probability Expected Sales Probable Sales

50% $3,000,000 $1,500,000 30% 2,000,000 600,000 20% 4,000,000 800,000

100% $2,900,000

The probabilities are based on the manager’s best judgment. The proba- bilities may be expressed in either quantitative terms (percentages) or relative terms (high or low probability of something happening).

A typical department budget appears in Exhibit 2.2. A typical checklist for the budgeting system appears in Exhibit 2.3.

Reject

Strategic Planning

Long-Term Planning

Evaluate Industry and Company Conditions

Ascertain Mission of Company

Select Long-Term Corporate Objectives

Formulate Strategies to Meet Objectives

Prepare Long-Term Plan

Compare Performance against Plan

Appraise Feedback

EXHIBIT 2.1 Strategic Planning Process

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E X H IB IT

2 .2

X Y Z C o m p an

y D e p ar tm

e n t B u d g e t R e p o rt

D e p ar tm

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__ __

D e p ar tm

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__ __

__ __ __

__ __

D o lla

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O ve

r o r U n d e r

P e rc e n t R e al iz e d

C u rr e n t M o n th

M o vi n g A ve

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C u rr e n t

P ri o r

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1 2 3 4 5

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In d ir e ct

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In d ir e ct

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S u p e rv is o r S al ar ie s

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Id le

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O th e r S al ar ie s

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e n t C o st s

O p e ra ti n g S u p p lie

T o o ls

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T ra ve

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M e m b e rs h ip s

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STRATEGIC PLANNING

Strategic plans are long-term, broad plans ranging from 2 to 30 years, with 5 to 10 years being most typical. Strategic planning is continuous and looks where the company is going. It is done by upper management and

EXHIBIT 2.3 A Budgetary Checklist

Schedule Who Is

Accountable? Date

Required Date Received

1. Establish overall goals

2. Set division and department objectives

3. Estimate

a. Capital resource needs

b. Personnel requirements

c. Sales to customers

d. Financial status

4. Preparation of budgets for:

a. Profitability

b. Revenue

c. Production

Direct material

Direct labor

Factory overhead

d. Marketing budget

Advertising and promotion

Sales personnel and administration

Distribution

Service and parts

e. Cash budget

f. Budgeted balance sheet

g. Capital facilities budget

h. Research and development budget

5. Prepare individual budgets and the master budget

6. Review budgets and prepare required changes

7. Prepare monthly performance reports

8. Determine difference between budget and actual costs (revenue)

9. Prepare recommendations to improve future performance

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divisional managers. Most of the information used is external to the company.

The strategic plan is the mission of the company and looks to existing and prospective products and markets. Strategic plans are designed to direct the company’s activities, priorities, and goals in order to position the company to accomplish objectives. Strategic goals are for the long term, considering the internal and external environment, strengths, and weaknesses.

Strategy is the means by which the company uses its capital, financial, and human resources to achieve its objectives. It shows the company’s future direction and rationale and looks at expected costs and return. Strategic planning provides detailed plans to implement policies and strategies. Risk- taking decisions are made. Strategies may be implemented at different times. Strategic planning should take into account the company’s financial position, the economy, the political environment, social trends, technology, risks, markets, competition, product line, customer base, research support, manu- facturing capabilities, labor, product life cycle, and major problems.

Strategic planning is a prerequisite to short-term planning. There should be a linkage between the two. There is considerably more subjectivity in a strategic plan than in a short-term plan.

The strategic plan is formulated by the chief executive officer (CEO) and his or her staff. It considers acquisitions and divestitures. Financial policies, including debt position, are determined. The plan must consider economic, competitive, and industry factors. It establishes direction, priorities, alterna- tives, and tasks to be performed. The strategic plan is the guideline for each business segment and the needed activities to accomplish the common goals.

Strategic planning is irregular. Further, strategic planning problems are unstructured. If a strategy becomes unworkable, abandon it.

The elements of a strategic plan are:

& The company’s overall objectives, such as market position, product leader- ship, and employee development

& The strategies necessary to achieve the objectives, such as engaging in a new promotion plan; enhancing research, product, and geographical diversification; and eliminating a division

& The goals to be met under the strategy & The progress to date of accomplishing goals such as sales, profitability,

return on investment, and market price of stock

In summation, strategic planning is planning for the company as a whole, not just combining the separate plans of the respective parts; there must be a

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common thread. The strategic plans look to the long term and are concerned with the few key decisions that determine the company’s success or failure. They provide overalldirection andindicatehowthe long-term goalswillbeachieved.A strategic plan is a mission policy statement and must deal with critical issues.

SHORT-TERM PLANS

Short-term plans are typically for one year (although some are for two years). The plans examine expected earnings, cash flow, and capital expenditures. Short-term plans may be for a period within one year, such as a month or a week. Short-term planning relies primarily on internal information and details tactical objectives. It is structured, fixed, foreseeable, and continually deter- minable. The short-term profit plan is based on the strategic plan. It is concerned with existing products and markets.

There should be a short-term profit plan by area of responsibility (product, service, territory, division, department, project, function, and activity). Short- term plans usually are expressed on a departmental basis, such as sales, manufacturing, marketing, management (administration), research, and con- solidation (integration) plans. Short-term planning has more lower-level managers involved in providing input. The line manager typically is involved with short-term rather than long-term plans. In making the short-term plan, the line manager should consider the company’s objectives and targets as outlined in its long-term plan. The manager’s short-term plan must satisfy the long-term objectives of the company.

LONG-TERM PLANS

Long-termplanningisusuallyofabroad,strategic(tactical)naturetoaccomplish objectives. A long-term plan is typically 5 to 10 years (or more) and looks at the future direction of the company. It also considers economic, political, and industry conditions. Long-term plans are formulated by upper management. They deal with products, markets, services, and operations, and aim to enhance sales, profitability, return on investment, and growth. Long-range plans should be constantly revised as new information becomes available.

Long-range planning covers all major areas of the business, including manufacturing, marketing, research, finance, engineering, law, accounting, and human resources. Planning for these areas should be coordinated into a comprehensive plan to attain corporate objectives.

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A long-term plan is a combination of the operating and developmental plans. It should specify what is needed, by whom, and when. Responsibility should be assigned to segments. Long-term goals include increased market share, new markets, expansion, new distribution channels, cost reduction, capital maintenance, and reduction of risk. The characteristics of sound long- term objectives include flexibility, motivation, measurability, consistency and compatibility, adequateness, and flexibility. Long-range plans may be used for growth, market share, product development, plant expansion, and financing.

Long-term plans are details of accomplishing the strategic plans. Compared with strategic planning, long-range planning is closer to planning current operations of all units of the business. It includes evaluating alternatives, developing financial information, analyzing activities, allocating resources, product planning, market analysis, human resources planning, analyzing finances, research and development planning, and production planning.

The time period for a long-term plan depends on the time required for product development, product life cycle, market development, and construc- tion of capital facilities. More alternatives are available in long-term plans than in short-term plans. When there is greater uncertainty in the economic and business environment, long-range plans become more important. However, it is more difficult to plan long term than short term because of the greater uncertainties that exist. An illustrative long-term plan appears in Exhibit 2.4.

EXHIBIT 2.4 Long-Term Plan

Amount

Contract acquisitions —Customer

—Division

—Company

Sales backlog —Customer

—Division

—Company

Total sales

Profit margin

Return on investment

Capital expenditures —Assets

—Leases

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CHOOSING A BUDGET PERIOD

The budget period depends on the objective of the budget and the reliability of the data. Most companies budget yearly, month by month. For example, a seasonal business should use the natural business year, beginning when accounts receivable and inventory are at their lowest level.

The time period for a plan should be as far as is useful. The period chosen depends on many factors: the time to develop a market, production period, the time to develop raw material sources and to construct capital facilities, product development, and product life cycle. The time period also should take into account the type of industry, reliability of financial data and the use to which the data will be put, seasonality, and inventory turnover. Shorter budgeting cycles may be called for when unpredictable and unstable events occur during the year. Short-term budgets have considerably more detail than long-term budgets.

Operating budgets ordinarily cover a one-year period corresponding to the company’s fiscal year. Many companies divide their budget year into four quarters. The first quarter is then subdivided into months, and monthly budgets are developed. The last three quarters may be carried in the budget as quarterly totals only. As the year progresses, the figures for the second quarter are broken down into monthly amounts, then the third-quarter figures are broken down, and then the fourth. This approach has the advantage of requiring periodic review and reappraisal of budget data throughout the year.

ADMINISTERING THE PLAN

A committee of senior operating and financial executives should be involved in administering a budget. The administration plan involves human resource planning for the various functions to be carried out, technological resource planning, and organizational planning.

PROFIT PLAN

A profit plan is the premise on which management charts an action course for the upcoming year. It is good for planning and control. Alternatives must be evaluated, and the profit plan should be flexible to adjust for contingencies. Profit planning includes a study of appraising profits relative to investment.

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A profit budget may be used to supplement a cost budget. Profit budgets may be by customer, territory, or product.

The profit plan must set forth selling price, sales volume, sales mix, per-unit cost, competition, advertising, research, market potential, and economic conditions. Profit may be improved through a closer correlation of manufac- turing, selling, and administrative expense budgeting to sales and earnings objectives. Cost-reduction programs will lower expenses.

Continuous profit planning is used when planning should be for short time periods and where frequent planning is needed. The yearly or quarterly plan may be revised each month.

OPERATIONAL PLAN

The preliminary operational plan is an important part of the strategic plan. It examines alternative strategies to select the best one. The final operational plan is much more detailed and is the basis to prepare the annual budgets and evaluate performance. It also acts as the basis to integrate and communicate business functions. It is concerned with short-term activity or functions of the business. The operational plan typically includes production, marketing (selling), admin- istration, and finance. It examines properly serving product or service markets.

The operational plan summarizes the major action programs and contains this information: objective, program description, responsibility assignments, resource needs (e.g., assets, employees), expected costs, time deadlines for each stage, input needed from other business segments, and anticipated results.

DEVELOPMENT PLAN

The development plan typically includes research and development, diversifi- cation, and divestment. It relates to developing future products, services, or markets. The development plan mostly applies to new markets and products. Bonuses should be given for new ideas.

The corporate development plan is concerned with:

& Discovering or creating new products & Identifying financially lucrative areas and those having growth potential & Ascertaining what resources are required in terms of assets, staffing,

and so on & Determining the feasibility of expanding operations into new areas

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CONTINGENCY PLANNING

Contingency planning is anticipating in advance unexpected circumstances, occurrences, and situations so that there can be a fast response to a crisis. All possible eventualities should be considered. Contingency planning involves identifying the possible occurrence, ascertaining warning signs and indicators of a problem, and formulating a response.

Contingency planning can be in the form of flexible (bracket) budgets. The plan should be modified if needed to generate the best results. There should be flexibility in the plan to adjust to new information and circumstances and to allow for the resolution of uncertainties.

BUDGET PROCESS

In one company we are familiar with, the financial planning department issues guidelines to department managers. The manager then submits his or her plan to financial planning. The plan is returned to the manager if guidelines have not been adhered to. Financial planning coordinates the plan from the bottom up. The budget goes down to the supervisory level. The company also uses program budgeting, which involves the allocation of resources. The budgeting process requires good, timely communication. Upper management must make its budget goals clear to departmental managers. In turn, the managers must explain departmental operating conditions and limitations.

DEPARTMENTAL BUDGETS

The decision units in the plan must be identified, and the labor and dollar support at each decision unit must be noted. Department managers should plan for specific activities. They should put their budgets and trends in perspective relative to other departments in the company, to competing departments in other companies, and to industry norms. The manager should list problems needing solutions and opportunities to be further capitalized on.

BUDGET ACCURACY

The accuracy of budget preparation may be determined by comparing actual numbers to budget numbers in terms of dollars and units. Budget accuracy is

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higher when the two figures are closer to each other. Ratios showing budget accuracy include:

Sales accuracy D Actual sales=Budgeted sales Cost accuracy D Actual cost=Budgeted cost

Profit accuracy D Actual profit=Budgeted profit

Example 2

A manager budgeted sales for 2 million but the actual sales were 2.5 million. This favorable development might be attributed to one or more of these reasons:

& Deficient planning because past and current information were not prop- erly considered when the budget was prepared

& The intentional understatement of expected sales so the manager would look like a hero when actual sales substantially exceeded the anticipated sales

& Higher revenue arising from better economic conditions, new product lines, improved sales promotion, excellent salesperson performance, or other reasons

A significant deviation between budget and actual amounts may indicate poor planning. Is the planning unrealistic, optimistic, or due to incompetent performance? However, the problem may be with wasteful spending or inefficient operations.

REPORTS

A typical report for manufacturing cost analysis is presented in Exhibit 2.5. Performance reports typically are issued monthly.

BUDGET REVISION

A budget should be revised when it no longer acts as a useful planning and control device. Budgets should be revised when a major change in processes or operations occurs or when there are significant changes in salary rates.

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E X H IB IT

2 .5

M an

u fa ct u ri n g C o st A n al ys is

O ve

rh e ad

A ve

ra g e

P ro d u ct

Li n e

U n it s P ro d u ce

d M at e ri al

La b o r

V ar ia b le

F ix e d

T o ta lC

o st

U n it C o st

S e lli n g P ri ce

G ro ss

M ar g in

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For example, additional competitors may enter the market with a product that sells at a lower price and is a good substitute for the company’s product. This competition may make meeting the budgeted market share and sales unlikely. If management recognizes that even with increased promotional expenditures, budgeted sales are not realistic, all budgets affected should be revised. These revisions are preferable to using unattainable budgets. Budgets that are repeatedly revised are more informative as a control measure. For a one- year budget, budget estimates may be revised quarterly. Budget revisions should be more frequent in unstable businesses.

PERFORMANCE MEASURES

Performance measures also should be directed at the lower levels. Specific task performance for each employee should be measured. Employee performance may be measured by computing revenue per employee, man-hours per employee, and production volume to man-hours.

CONTROL AND ANALYSIS

Control is important in budgeting. Budget figures may be checked for reason- ableness by looking at relationships. The budgeted costs must be directly tied to planned production output. The manager must be able to strongly defend the initial budget figure and to obtain needed facts. Budget comparisons may be made by current-year month to last-year month, current-year quarter to last- year quarter, and cumulative year to date. A comparison is therefore made to similar time periods.

Costs should be examined by responsibility. Cost reduction is different from cost control. Cost reduction attempts to lower costs by improving manufacturing methods and procedures, work assignments, and product or service quality. Cost control includes cost reduction. Cost control attempts to obtain cost objectives within the operational setting. Value analysis is an evaluation of cost components in an operation so as to minimize them to achieve higher profits.

Compare the company’s segments with similar segments in competing companies. Variations from the plan should be studied and controlled. The integrated (consolidated) plan usually is prepared yearly. A change in one department’s plan is likely to affect another department’s plan.

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SUMMARY

An objective of planning is to improve profitability. Plans are interrelated. Planning should link short-term, intermediate-term, and long-term goals. Budgeting is simply one portion of the plan. The annual plan may be based on the long-term plan. The annual budget should be consistent with the long- term goals of the business. There should be a climate conducive to planning and friendly relationships.

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3CHAPTER THREE Administering the Budget

Reports, Analyses, and Evaluations

A BUDGET SHOULD BE prepared for each department. Divisionalbudgets should be consolidated in a binder, and each departmentshould have a separate file folder. The chief executive officer should distribute to each department manager an executive budget memorandum detailing the schedule, policies, and benchmarks for next year’s budget. Responsibility should be assigned for collection and consolidation of budget information. Budget instructions, forms, and timetables should be provided. Budget forms should be simple and easy to follow. The budget committee should consider these items before approving a budget: accuracy of budgetary numbers, reliability of information on which estimates are based, budget integration, reliability of source data, budgetary assumptions, and achievability of budgetary goals.

TYPES OF REPORTS

Long-term reports may be for the company as a whole or for specific areas. The benefit derived from reports should justify their cost. Budget reports are used for planning, control, and information.

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Planning reports may be short-term, looking at the company as a whole and at each division, each department, and each responsibility center within a department. Short-term planning reports may be of income, cash flow, net assets, and capital expenditures. The reports should be prepared regularly. Special studies may be performed of problem segments not performing well. The special studies may pertain to product or service lines, activities or functions, geographic areas, salesperson performance, and warehousing.

Control reports concentrate on performance effectiveness and areas in need of improvement. Budget to actual figures are compared by product, service, territory, and headcount.

Information reports assist in planning and policy formulation. The reports show areas of growth or contraction, with trends shown over time. They may be in dollars, units, percentages, or ratios. An example of an informative ratio is selling expense to revenue. Informational reports study the trends in earnings, profit by product or service, profit by territory, and profit by customer.

Reports for upper management are comprehensive summaries of overall corporate operations. Top management generally prefers narrative reports. Reports are also prepared for special events of concern to top management. Adequate detail should be provided as needed. Middle-management reports include summarized information and detailed information on daily operations. A brief report should be presented at budget meetings.

Lower-level management reports typically deal with daily coordination and control operations. The reports usually emphasize production. Exception reports should be prepared indicating problems. Budget reports inform man- agers of progress made in meeting budgets and what went wrong, if anything.

A critical area should be reported on more frequently. The frequency of reporting is less as the level of responsibility becomes higher.

Budget reports depend on the requirements of the situation and user. Budget reports should contain these data:

& Trends over the years. & Comparison to industry norms. & Comparison of actual to budget with explanation and responsible party for

variances. Follow-up procedures are needed for control.

Reports should get to the main points. Each report should begin with a summary, followed by detailed information, and should be comprehensible to those using it. The emphasis should be on clarity rather than complexity.

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Reports should be logically organized, relevant, and concise, and they should be updated on a periodic basis.

Reports may contain schedules, explanations, graphs, and tables. Reports should contain recommendations and highlight problem areas. All reports should be computerized. An illustrative budget worksheet appears in Exhibit 3.1.

Reports may be periodic, advance, or special.

Periodic Reports

Periodic reports are prepared at regular intervals. A continual comparison- between budget and actual figures is the usual source of information to maintain control. Reports may be issued semiannually, quarterly, monthly, or at other regular intervals; monthly reports are most common. Some information may be reported daily (e.g., shipments), while other information may be reported weekly (e.g., sales and production). The timeliness depends on cost-benefit analysis.

Advance Reports

Important partial information may be reported before all information is available for a periodic report when delay in reporting this information will cause a managerial problem. Flash reports should be issued for unusual occurrences that must be reported on immediately.

Special Reports

Special reports are issued for a specific, nonroutine purpose. Special studies may be required for problem situations or if a negative trend exists, such as costs that keep rising even though a cost-reduction program has been implemented.

EXHIBIT 3.1 Budget Worksheet

Account:

For the period:

Date:

Month Components

Explanation:

Assumptions:

Analysis:

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Budget reports may contain this supplementary information, depending on need:

& Percent of capacity utilization & Changes in marketing and distribution & Change in selling price & Average selling price & Sales volume and units produced & Distribution cost relative to sales & Effect on sales of new product introduction, dropping products, and

entering new product lines & Change in the number of employees and man-hours

A performance report should be prepared for each responsibility center, from the lowest level to the highest level. The report indicates whether goals have been accomplished. Performance reports evaluate efficiency and should be repetitive, covering a short time period.

The performance-to-budget report should contain this information by department for the year to date and for the current period:

& Cost accounts & Budget & Actual & Variances and reasons

An illustrative report summarizing departmental performance is shown in Exhibit 3.2.

EXHIBIT 3.2 Summary of Department Performance

Item and Explanation Actual Budget Percent of Budget

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A performance-to-budget report (cost and variance statement) should be kept for feedback. It is used by management to evaluate the degree to which operating managers meet their budget.

Monthly performance reports should contain variances for the month and cumulative variances to date for the year. Variances can be expressed in dollars and as a percentage of budget.

The statistics and graphics in the report should vary depending on user preference. For example, marketing managers are less inclined to receive statistical data than engineers. However, marketing managers usually prefer graphs, including diagrams and charts. Graphs may be more informative in presenting relationships and summary comparisons.

Reports should be timely. If reports are issued periodically, they should be on schedule. If reports must be delayed, a short update should be presented.

BUDGET MANUAL

A budget manual describes how a budget is to be prepared. Items usually included in a budget manual are a planning calendar and distribution instruc- tions for all budget schedules. Distribution instructions are important because once a schedule is prepared, other departments within the organization will use the schedule to prepare their own budgets. Without distribution instructions, someone who needs a particular schedule may be overlooked.

The budget manual communicates throughout the company the policies and procedures for budget preparation. It lists the activities and rules to be followed in preparing a budget. It tells how the budget should be used by managers and who is responsible for the different aspects of the budgeting process, including preparation, presentation, reporting, evaluation, and ap- proval. It should list positions rather than names to avoid unnecessary updating. A flow chart for budget preparation provides the budgeting steps and aids in cooperation and coordination. The procedures to be followed to revise the budget based on changing conditions and goals should be specified. For example, revisions may be needed because of changing objectives, new methods, a changing economic environment, or errors. The budget manual should receive participation from all affected managerial levels.

The budget manual stipulates authority, responsibility, and duties; fosters standardization; documents procedures; simplifies the process; provides commu- nication; answers users’ questions; enhances supervision; and fosters training.

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The manual includes:

& Standardized forms, lists, and reports & Instructions & Format and coverage of performance reports & Administrative details & Follow-up procedures

Each department should be included in a separate section of the manual with an index tab. Operating department managers and employees should provide input in the preparation of the budget manual. Managers and workers may have different information to impart. There may be operating problems, constraints, and limitations that must receive attention. A standard cost table for different types of expenses used by managers of different departments throughout the organization allows for consistency and uniformity.

The manual should be in loose-leaf form so pages may be substituted for updates. The budget manual should contain:

& Budget objectives, purposes, procedures, guidelines, and policy & Desired accomplishments & Data description & Personnel duties (who is to prepare, review, approve, and revise the budget) & Who has authority and responsibility for budget items (with a designation

of manager or subordinate who will perform the activity) & Approval requirements & Who is to evaluate the difference between budget and actual figures, as

well as who is to take corrective action and when & Budget timetable & Illustrative forms, lists, and reports & Glossary of terminology & Instructions to complete budget activities & Uses of budget information & Policies for budget modification and update calendar & Communication between upper management and subordinates & Coordination between departments of the budget & Explanatory footnotes

The layout of the manual should enhance its clarity and conciseness. It should be easy to understand for nonaccountants, so it should not contain

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complex or technical language. Its arrangement should be logical and orderly, with a user-friendly index, and it should be updated as conditions warrant. It should look professional in design, color, print size, and so on, so it is taken seriously by users.

Having a budget manual offers many advantages, including simplification and standardization of budget procedures. The manual acts as a reference and provides an organized approach to the budget process. It establishes consistency between departments, provides job description guidance to new employees, and assists current employees in adjusting to new positions when transferred or promoted. The manual enhances employee continuity in doing the job.

BUDGET SHEET

A budget sheet should be designed to record the information used by the operating manager and budget preparer. The budgeting sheet should include this information:

& Historical cost records used & Cost formulas & Changes in operating conditions & Foreseeable conditions

A budget data sheet should be prepared for each cost account in each department or cost center. Attached to the data sheet may be graphs, work- paper analysis, mathematical and statistical calculations, and so on. Budget revisions may also be incorporated.

Fixed, variable, and mixed costs are shown on the data sheet. Material, labor, and overhead should be listed. The sheets should be initialed by those preparing and approving them. The allowances specified in the data sheet should be mutually agreed on by the preparer and the operating manager.

A typical budget data sheet is shown in Exhibit 3.3. A budget summary sheet also should be prepared, summarizing the

department’s budget data sheets by listing each budgeted cost and the budget allowance based on average activity. The operating departmental manager always should be provided with a copy of the budget summary sheet and budget data sheets.

A budget data book should be maintained to keep the budgeting informa- tion in an orderly manner. The book contains the budget data sheets,

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supporting worksheets and analysis, and budget summary sheets by department.

PERFORMANCE REPORTS

The manager should prepare performance reports. Are objectives and targets being met by subordinates? Are operations being performed efficiently and effectively?

The performance-to-budget report should include this information by department for month and year to date: budget, actual, and variance. Vari- ances may be stated in dollars and percentage terms.

An illustrative performance-to-budget report is presented in Exhibit 3.4.

BUDGET AUDIT

A budget audit examines whether the budgeting process is operating effec- tively. It is an evaluation of the budgeting effort. The budget audit examines techniques, procedures, motivation, and budget effectiveness. Effective budget- ing should be dynamic.

A budget audit detects problems in the budgeting process. It should be conducted every two to three years by an independent party who is not a part of

EXHIBIT 3.3 Budget Data Sheet

Date prepared: Time period:

Date accepted:

Date approved:

Date revised:

Cost center identifier:

Account identifier:

Activity unit:

Amount and reason for revision:

Items Total Fixed Variable Mixed (Semivariable)

Total Budget:

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the budget staff. The budget auditor should report to upper management, who can take appropriate action. An outside consultant should be independent and objective, and should provide fresh ideas.

An audit plan assists in arriving at corrective action. The budget audit considers:

& Cost trends and controls & Budget revisions & How adequately costs were analyzed & How costs were identified and classified & Looseness or tightness of budget allowances & Completeness of budget documentation, records, and schedules & Degree of participation by managers and workers & Quality of supportive data & Degree of subjectivity involved

EXHIBIT 3.4 Performance-to-Budget Report

Department Identifier____________ Activity

Nonfinancial Manager____________ Budget

Actual

Percent of Budget

Year to Date This Period

Budget Actual Variance Budget Actual Variance Cause of Variance

Extra Budgetary Allowance for Variance

Totals

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THE BUDGET COMMITTEE

A standing budget committee is usually responsible for overall policy relating to the budget program and for coordinating the preparation of the budget itself. This committee may consist of the president; vice presidents in charge of various functions such as sales, production, and purchasing; the chief financial officer (CFO); and the controller. Difficulties and disputes relating to the budget are resolved by the budget committee. In addition, the budget committee approves the final budget, although more precisely, the authority to give final approval to the master budget usually belongs to the board of directors or, in many nonprofit organizations, a board of trustees. Usually the board has a subcommittee whose task is to examine the proposed budget carefully and recommend approval or any changes deemed necessary. By exercising its authority to make changes in the budget and grant final approval, the board of directors or trustees can wield considerable influence on the overall direction the organization takes.

BUDGET CALENDAR

The budget planning calendar is the schedule of activities for the development and adoption of the budget. It should include a list of dates indicating when specific information is to be provided by each information source to others. A budget calendar should be prepared for the timing of each aspect or operation of the budget. A timetable must be given to operating managers to submit their proposed budgets so the overall company budget may be prepared on time. The schedule of due dates for documents and reports must be adhered to. Review and approval dates should also be specified. The schedule dates should be realistic and attainable.

A company can begin the process by issuing a budget preparation calendar, which is an overall review of each sequential step in the budgeting process. Accompanying this is a rough time schedule in which the budgeting process will be implemented, identifying deadlines, the personnel responsi- ble, and those to receive this information. The plan furnishes the structure of the budgeting process and the overall objectives. These items are crucial for the budgeting process and must be completed before the process can proceed. An illustrative budget calendar for a company is presented in Exhibit 3.5.

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EXHIBIT 3.5 ABC Company Budget Preparation Calendar Fiscal 2X13

1. General Guidelines issued to senior management staff by president give the broad objectives of the company for the ensuing year. These objectives must be specific enough to provide divisions with adequate direction, yet they should be broad enough to allow creativity. General indications of gross margins, operating profit, net profit, and productivity are some of the areas to be addressed.

2. New Products Forecast provides an indication of new or improved products to be available next year, including estimated availability dates and likely segment as applicable.

3. Discussion of Action Plans with particular emphasis on how to achieve objectives (on an individual basis) with senior management by president. Each senior vice president produces in writing and justifies in detail how the objectives for the next year will be achieved. For example, sales and marketing should give expected sales by regions, supported by level of sales force and related promotional expenses (e.g., advertising, conventions, and product giveaways).

a. Headcount by department and division to support objectives must be justified by each senior vice president.

b. Capital Expenditure Projections outline the major projects to be executed in the budget year as determined by the department managers and facilities engineering. Projects should be ranked in order of priority, with pros and cons of doing and not doing the projects.

c. Inventory Projections as furnished by vice president of respective user department (film, chemistry, or equipment) should indicate the levels of the inventory by major product lines. Where applicable, minimum, desired, and maximum levels to support production and sales should be given.

4. Fringe Benefits Package, including payroll increases, prepared by the human resources department should outline the basis of the company’s contribution of the major programs and fringes. Both quantitative and qualitative factors should be presented. Major areas to be covered are incentives, medical and dental insurance, retirement, life insurance, and workers’ compensation. Other expenditures such as FICA and unemployment tax are computed by corporate planning.

5. Budget Package issued to departmental managers by corporate planning contains the necessary forms and instructions to prepare the budget.

6. Preliminary Profit & Loss (P&L) Fiscal 2X13 based on sales forecast and assumptions in guidelines 2 through 4 is prepared by corporate planning to give an indication of the likely outcome of the actions contemplated. Major directions and proactive measures are then taken to manage the budget process in line with the president’s guidelines.

7. Final Sales Forecast as issued to senior management staff by sales and marketing gives sales volume and dollars by major product lines. For example, film and paper (square feet and $), chemistry (quantity S), and equipment (units and $). Film and paper should be analyzed by region, international, dealers, national accounts, and other

(continued)

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EXHIBIT 3.5 (Continued)

characteristics. New products should be clearly identified. Adequate explanation should be given for any significant changes (over the current year) in volume or price.

8. Departmental Expense Budgets are prepared (monthly basis) by department managers and approved by their respective senior management. These include all the operating expenses (excluding payroll, fringes, depreciation, and facilities cost) as prepared in the basic budget worksheet.

9. Preliminary Budget incorporates data and payroll, fringes, depreciation, and facilities cost as computed by corporate planning. The preliminary data are returned to managers for review and any necessary changes.

10. Revisions made by managers to preliminary budget are sent to corporate planning on a timely basis.

11–13. Budgets are sent to senior vice president, and meetings are held to review budgets. Senior vice presidents present their budgets and negotiate the necessary changes to bring budgets in line with corporate objectives.

14. Preparation of Budgeted P&L, Cash Flow, and Balance Sheet by corporate planning and finance division to provide management with the financial picture of the budget year.

15–16. Budget Package sent to senior management for review and approval prior to presentation to ABC Company.

17. Presentation of Budget Package by corporate planning and president to ABC Company (its budget committee or board of directors) for approval.

18. Approved Budgets issued to respective departments. These form the guide for the upper limit of expenditures for the coming year.

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4CHAPTER FOUR Break-Even and Contribution

Margin Analysis

Profit, Cost, and Volume Changes

BREAK-EVEN AND CONTRIBUTION MARGIN analysis, also knownas cost-volume-profit (CVP) analysis, helps managers perform manyuseful analyses. It deals with how profits and costs change with a change in volume. More specifically, it looks at the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and mix of products sold. By studying the relationships of costs, sales, and net income, management is better able to cope with many planning decisions.

Break-even analysis determines the break-even sales. The break-even point—the financial crossover point where revenues exactly match costs— does not show up in corporate earnings reports, but managers find it an extremely useful measurement in a variety of ways.

QUESTIONS ANSWERED BY BREAK-EVEN AND CONTRIBUTION MARGIN ANALYSIS

Break-even and contribution margin analysis tries to answer these five questions:

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1. What sales volume is required to break even? 2. What sales volume is necessary to earn a desired profit? 3. What profit can be expected on a given sales volume? 4. How would changes in selling price, variable costs, fixed costs, and output

affect profits? 5. How would a change in the mix of products sold affect the break-even and

target income volume and profit potential?

APPLICATIONS OF THE CVP MODEL

There are many actual and potential applications of the CVP approach. Some of these include:

& Economic analysis of new product. Based on demand forecasts and estimates of production costs (variable and fixed), the economic impact of a new product can be estimated.

& Labor contract negotiations. The effect of increased variable costs resul- ting from higher wages on the break-even level of output can be analyzed.

& Choice of production process. The choice of reducing variable costs at the expense of incurring higher fixed costs can be evaluated. Management might decide to become more capital-intensive by performing tasks in the production process through use of equipment rather than labor. Applica- tion of the CVP model can indicate what the effects of this trade-off will be on the break-even output for the given product.

& Pricing policy. The sales price of a new product can be set to achieve a target income level. Furthermore, should market penetration be a prime objective, the price could be set that would cover slightly more than the variable costs of production and provide only a partial contribution to the recovery of fixed costs. The negative income at several possible sales prices can then be studied.

& Location selection. Some of the costs of having a facility in a location are fixed, and some vary with the volume of business. The cost structure and the volume of sales are probably different for each location being considered. It is important to realize that the lowest-cost location will always be the maximum-profit location.

& Financing decisions. Analysis of the firm’s cost structure will reveal the proportion that fixed operating costs bear to sales. If this proportion is high, the firm might reasonably decide not to add any fixed financing costs on top of the high fixed operating costs.

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& Make or buy decision. Break-even analysis can often be used to deter- mine volume requirements in deciding whether to purchase from suppliers or manufacture in-house a certain component part.

& Capital budgeting analysis. As a complementary technique to dis- counted cash flow (DCF) techniques, the CVP model locates in a rough way the sales volume needed to make a project economically beneficial to the firm. It should not be used to replace the DCF methodology.

CONTRIBUTION MARGIN INCOME STATEMENT

The traditional income statement for external reporting shows the functional classification of costs, that is, manufacturing costs versus nonmanufacturing expenses (or operating expenses). An alternative format of income statement, known as the contribution margin income statement, organizes the costs by behavior rather than by function. It shows the relationship of variable costs and fixed costs a given cost item is associated with, regardless of the functions.

The contribution approach to income determination provides data that are useful for managerial planning and decision making. The statement highlights the concept of contribution margin, which is the difference between sales and variable costs. The traditional format emphasizes the concept of gross margin, which is the difference between sales and cost of goods sold.

These two concepts are independent and have nothing to do with each other. Gross margin is available to cover nonmanufacturing expenses, whereas contribution margin is available to cover fixed costs. Next, a comparison is made between the traditional format and the contribution format.

Traditional Format Contribution Format

Sales $15,000 Sales $15,000

Less: Cost of Goods Sold 7,000 Less: Variable Expenses

Gross Margin $ 8,000 Manufacturing $4,000

Less: Operating Expenses Selling 1,600

Selling $2,100 Administrative 500 6,100

Administrative 1,500 3,600 Contribution Margin $ 8,900

Net Income $ 4,400 Less: Fixed Expenses

Manufacturing $3,000

Selling 500

Administrative 1,000 4,500

Net Income $ 4,400

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Contribution Margin

For accurate break-even and contribution margin analysis, a distinction must be made between costs as being either variable or fixed. Mixed costs must be separated into their variable and fixed components (covered in Chapter 7).

To compute the break-even point and perform various break-even and contribution margin analyses, note the following important concepts.

Contribution Margin (CM)

The contribution margin is the excess of sales (S) over the variable costs (VC) of the product or service. It is the amount of money available to cover fixed costs (FC) and to generate profit. Symbolically, CM D S ¡ VC. Unit CM

The unit CM is the excess of the unit selling price (p) over the unit variable cost (v). Symbolically, unit CM D p ¡ v. CM Ratio

The CM ratio is the contribution margin as a percentage of sales, that is,

CM ratio D CM S

D S ¡ VC S

D 1 ¡ VC S

The CM ratio can also be computed using per-unit data:

CM ratio D Unit CM p

D p ¡ v p

D 1 ¡ v p

Note that the CM ratio is 1 minus the variable cost ratio. For example, if variable costs account for 70 percent of the price, the CM ratio is 30 percent.

Example 1

To illustrate the various concepts of CM, consider these data for Flip Toy Store:

Total Per Unit Percentage

Sales (1,500 units) $37,500 $25 100%

Less: Variable costs 15,000 10 40

Contribution margin $22,500 $15 60%

Less: Fixed costs 15,000

Net income $ 7,500

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From the data listed, CM, unit CM, and the CM ratio are computed as:

CM D S ¡ VC D $37;500 ¡ $15;000 D $22;500 Unit CM D p ¡ v D $25 ¡ $10 D $15

CM ratio D CM S

D $22;500 $37;500

D 60% or Unit CM p

D $15 $25

D 0:6 D 60%

Break-Even Analysis

The break-even point represents the level of sales revenue that equals the total of the variable and fixed costs for a given volume of output at a particular capacity use rate. For example, one might want to ask the break-even occupancy rate (or vacancy rate) for a hotel or the break-even load rate for an airliner.

Generally, the lower the break-even point, the higher the profit and the less the operating risk, other things being equal. The break-even point also provides nonfinancial managers with insights into profit planning. It can be computed using these formulas:

Break-even point in units D Fixed costs Unit CM

Break-even point in dollars D Fixed costs CM ratio

Example 2

Using the same data given in Example 1, where unit CM D $25 ¡ $10 D $15 and CM ratio D 60 percent, we get:

Break-even point in units D $15;000=$15 D 1;000 units Break-even point in dollars D $15;000=0:6 D $25;000

Or, alternatively,

1;000 units � $25 D $25;000

Graphical Approach in a Spreadsheet Format

The graphical approach to obtaining the break-even point is based on the so- called break-even (B-E) chart, as shown in Exhibit 4.1. Sales revenue, variable costs, and fixed costs are plotted on the vertical axis, and volume, x, is plotted on the horizontal axis. The break-even point is the point where the total sales revenue line intersects the total cost line. The chart can also effectively report

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profit potentials over a wide range of activity and therefore be used as a tool for discussion and presentation.

The profit-volume (P-V) chart, as shown in Exhibit 4.2, focuses directly on how profits vary with changes in volume. Profits are plotted on the vertical axis, and units of output are shown on the horizontal axis. The P-V chart provides a quick condensed comparison of how alternatives on pricing, variable costs, or fixed costs may affect net income as volume changes. The P-V chart can be easily constructed from the B-E chart. Note that the slope of the chart is the unit CM.

60,000

50,000

40,000

30,000

20,000

10,000

50 0

1, 00

1, 50

2, 00

2, 50

Profit

Loss

S al

es a

nd C

os ts

( $)

Units of Output

Break-Even Point

Fixed Costs

Variable Costs

EXHIBIT 4.1 Break-Even Chart

20,000

10,000

–10,000

–20,000

50 0

1, 00

1, 50

2, 00

2, 50

Profit

LossP ro

fi t

($ )

Units of Output

EXHIBIT 4.2 Profit-Volume (P-V) Chart

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Determination of Target Income Volume

Besides determining the break-even point, break-even and contribution margin analysis determines the sales required to attain a particular income level or target net income. The formula is:

Target income volume D Fixed costs C Target income Unit CM

Example 3

Using the same data given in Example 1, assume that Flip Toy Store wishes to attain a target income of $15,000 before tax.

Then the target income volume would be:

$15;000 C $15;000 $25 ¡ $10 D

$30;000 $15

D 2;000 units

IMPACT OF INCOME TAXES

If target income is given on an after-tax basis, the target income volume formula becomes:

Target income volume D Fixed costs C ½Target after-tax income=ð1 ¡ tax rateÞ� Unit CM

Example 4

Assume in Example 1 that Flip Toy Store wants to achieve an after-tax income of $6,000. The tax rate is 40 percent. Then

Target income volume D $15;000 C ½$6;000 ð12 ¡ 0:4Þ� $15

D ð$15;000 C $10;000Þ $15

D 1;667 units

Margin of Safety

The margin of safety is a measure of difference between the actual sales and the break-even sales. It is the amount by which sales revenue may drop before losses begin and is expressed as a percentage of expected sales:

Margin of safety D Break-even sales Expected sales

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The margin of safety is used as a measure of operating risk. The larger the ratio, the safer the situation since there is less risk of reaching the break-even point.

Example 5

Assume Flip Toy Store projects sales of $35,000 with a break-even sales level of $25,000. The projected margin of safety is

ð$35;000 ¡ $25;000Þ $35;000

D 28:57%

SOME APPLICATIONS OF CONTRIBUTION MARGIN ANALYSIS AND WHAT-IF ANALYSIS

The concepts of contribution margin and the contribution income statement have many applications in profit planning and short-term decision making. Many what-if scenarios can be evaluated using them as planning tools, especially utilizing a spreadsheet program. Some applications are illustrated in Examples 6 to 10, using the same data as in Example 1.

Example 6

Recall from Example 1 that Flip Toy Store has a CM of 60 percent and fixed costs of $15,000 per period. Assume that the company expects sales to go up by $10,000 for the next period. How much will income increase?

Using the CM concepts, we can quickly compute the impact of a change in sales on profits. The formula for computing the impact is:

Change in net income D Dollar change in sales£CM ratio Thus:

Increase in net income D $10;000 � 60% D $6;000 Therefore, the income will go up by $6,000, assuming there is no change

in fixed costs. If we are given a change in unit sales instead of dollars, then the formula

becomes:

Change in net income D Change in unit sales � Unit CM

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Example 7

Assume that the store expects sales to go up by 400 units. How much will income increase? From Example 1, the company’s unit CM is $15. Again, assuming there is no change in fixed costs, the income will increase by $6,000.

400 units � $15 D $6;000

Example 8

What net income is expected on sales of $47,500? The answer is the difference between the CM and the fixed costs:

CM: $47,500 £ 60% $28,500 Less: Fixed costs 15,000

Net income $13,500

Example 9

Flip Toy Store is considering increasing the advertising budget by $5,000, which would increase sales revenue by $8,000. Should the advertising budget be increased?

The answer is no, since the increase in the CM is less than the increased cost:

Increase in CM: $8,000 £ 60% $4,800 Increase in advertising 5,000

Decrease in net income $ (200)

Example 10

Consider the original data. Assume again that Flip Toy Store is currently selling 1,500 units per period. In an effort to increase sales, management is consider- ing cutting its unit price by $5 and increasing the advertising budget by $1,000.

Management believes that if these two steps are taken, unit sales will go up by 60 percent. Should the two steps be taken?

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The answer can be obtained by developing comparative income statements in a contribution format:

(A) Present (1,500 Units)

(B) Proposed (2,400 Units)

(B ¡ A) Difference

Sales $37,500 (@$25) $48,000 (@$20) $10,500 Less: Variable cost 15,000 24,000 9,000

CM $22,500 $24,000 $ 1,500

Less: Fixed costs 15,000 16,000 1,000

Net income $ 7,500 $ 8,000 $ 500

The answer, therefore, is yes.

SALES MIX ANALYSIS

Break-even and cost-volume-profit analyses require some additional computa- tions and assumptions when a company produces and sells more than one product. In multiproduct firms, sales mix is an important factor in calculating an overall company break-even point.

Different selling prices and different variable costs result in different unit CM and CM ratios. As a result, the break-even points and CVP relationships vary with the relative proportions of the products sold, called the sales mix.

In break-even and CVP analysis, it is necessary to predetermine the sales mix and then compute a weighted average unit CM. It is also necessary to assume that the sales mix does not change for a specified period. The break- even formula for the company as a whole is:

Break-even sales in units ðor in dollarsÞ D Fixed Costs Weighted Average Unit CM ðor CM RatioÞ

Example 11

Assume that Knibex, Inc., produces cutlery sets out of high-quality wood and steel. The company makes a deluxe cutlery set and a standard set that have these unit CM data:

Deluxe Standard

Selling price $ 15 $10

Variable cost per unit 12 5

Unit CM $ 3 $ 5 Sales mix 60% 40%

(based on sales volume)

Fixed costs $76,000

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The weighted average unit CM D ($3)(0.6) C ($5)(0.4) D $3.80. There- fore, the company’s break-even point in units is:

$76;000 $3:80

D 20;000 units

which is divided in this way:

Deluxe: 20,000 units £ 60% D12,000 units Standard: 20,000 units £ 40% D 8,000

20,000 units

Note: An alternative is to build a package containing three deluxe models and two standard models (3:2 ratio). By defining the product as a package, the multiple-product problem is converted into a single-product one. Then follow the next three steps.

Step 1. Compute the package CM.

Deluxe Standard

Selling price $15 $10

Variable cost per unit 12 5

Unit CM $ 3 $ 5

Sales mix 3 2

Package CM $ 9 $10

$19 package total

$76;000=$19 per package D 4;000 packages

Step 2. Multiply this number by their respective mix units.

Deluxe: 4,000 packages £ 3 units D12,000 units Standard: 4,000 packages £ 2 units D 8,000

20,000 units

Example 12

Assume that Dante, Inc., is a producer of recreational equipment. It expects to produce and sell three types of sleeping bags: the economy, the regular, and the backpacker. Information on the bags follows.

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Budgeted

Economy Regular Backpacker Total

Sales $30,000 $60,000 $10,000 $100,000

Sales mix 30% 60% 10% 100%

Less VC 24,000 40,000 5,000 69,000

(80%)� (66.67%) (50%) (69%)

CM $ 6,000 $20,000 $ 5,000 $ 31,000y

CM ratio 20% 33.33% 50% 31%

Fixed costs $ 18,600

Net income $ 12,400

*$24,000/$30,000 D 80% y$31,000/$100,000 D 31%

The CM ratio for Dante, Inc., is $31,000/$100,000 D 31 percent. Therefore, the break-even point in dollars is

$18;600 0:31

D $60;000

which will be split in the mix ratio of 3:6:1 to give us these break-even points for the individual products:

Economy: $60,000 £ 30% D $18,000 Regular: $60,000 £ 60% D 36,000 Backpacker: $60,000 £ 10% D 6,000

$60,000

One of the most important assumptions underlying CVP analysis in a multiproduct firm is that the sales mix will not change during the plan- ning period. But if the sales mix changes, the break-even point will also change.

Example 13

Assume that total sales from Example 12 was achieved at $100,000 but that an actual mix came out differently from the budgeted mix (i.e., for economy, 30% to 55%; for regular, 60% to 40%; and for backpacker, 10% to 5%).

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Actual

Economy Regular Backpacker Total

Sales $55,000 $40,000 $5,000 $100,000

Sales mix 55% 40% 5% 100%

Less: VC 44,000� 26,667� 2,500� 69,000

(80%) (66.67%) (50%) (69%)

CM $11,000 $13,333 $2,500 $ 26,833

CM ratio 20% 33.33% 50% 26.83%y

Fixed Costs $ 18,600

Net income $ 8,233

�$55,000 £ 80% D $44,000; $40,000 £ 66.67% D $26,667; $5,000 £ 50% D $2,500 y$26,833/$100,000 D 26.83%

Note: The shift in sales mix toward the less profitable economy line has caused the CM ratio for the company as a whole to drop from 31 percent to 26.83 percent.

The new break-even point will be $18,600/0.2683 D $69,325. The break-even dollar volume has increased from $60,000 to $69,325. The deterioration (improvement) in the mix caused net income to go down

(up). It is important to note that, generally, the shift of emphasis from low- margin products to high-margin ones will increase the overall profits of the company.

Example 14 (Sales Mix Analysis for Service Organizations)

The City Ballet Company features five different ballets per year. For the upcoming season, the five ballets to be performed are The Dream, Petroushka, The Nutcracker, Sleeping Beauty, and Bugaku. The general manager has tenta- tively scheduled the following number of performances for each ballet for the coming season:

Dream: 5

Petroushka: 5

Nutcracker: 20

Sleeping Beauty: 10

Bugaku: 5

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To produce each ballet, costs must be incurred for costumes, props, rehearsals, royalties, guest artist fees, choreography, salaries of production staff, music, and wardrobe. These costs are fixed for a particular ballet regardless of the number of performances. The direct fixed costs for each ballet are:

Dream: $275,500

Petroushka: $145,500

Nutcracker: $ 70,500

Sleeping Beauty: $345,000

Bugaku: $155,500

Other fixed costs are incurred:

Advertising: $ 80,000

Insurance: 15,000

Administrative salaries: 222,000

Office rental, phone, and so on: 84,000

Total: $401,000

For each performance of each ballet, these costs also are incurred:

City Symphony: $3,800

Auditorium rental: 700

Dancers’ payroll: 4,000

Total: $8,500

The auditorium in which the ballet is presented has 1,854 seats, which are classified as A, B, and C. The best viewing ranges from A seats to C seats. Information concerning the different types of seats follows.

A Seats B Seats C Seats

Quantity 114 756 984

Price $35 $25 $15

Percentage sold for each performance�

Nutcracker 100 100 100

All others 100 80 75

�Based on past experience; the same percentages are expected for the coming season.

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The expected revenues from the performances that have been tentatively scheduled can be calculated in this way:

Number of seats sold ðexpectedÞ: Seats sold D Number of performances � Capacity � Percent sold

Type of Seat

A B C

Dream 570 3,024 3,690

Petroushka 570 3,024 3,690

Nutcracker 2,280 15,120 19,680

Sleeping Beauty 1,140 6,048 7,380

Bugaku 570 3,024 3,690

5,130 30,240 38,130

Total revenues D ð$35 � 5;130Þ C ð$25 � 30;240Þ C ð$15 � 38;130Þ D $179;550 C $756;000 C $571;950 D $1;507;500

Segmented revenues (Seat price £ Total seats): A B C Total

Dream $19,950 $75,600 $ 55,350 $150,900

Petroushka 19,950 75,600 55,350 150,900

Nutcracker 79,800 378,000 295,200 753,000

Sleeping Beauty 39,900 151,200 110,700 301,800

Bugaku 19,950 75,600 55,350 150,900

Segmented income statement:

Dream Petroushka Nutcracker

Sales $150,900 $150,900 $753,000

Variable expenses 42,500 42,500 170,000

Contribution margin $108,400 $108,400 $583,000

Direct fixed expenses 275,500 145,500 70,500

Segment margin $(167,100) $(37,100) $512,500

(continued)

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Sleeping Beauty Bugaku Total

Sales $ 301,800 $150,900 $1,507,500

Variable expenses 85,000 42,500 382,500

Contribution margin $ 216,800 $108,400 $1,125,000

Direct fixed expenses 345,000 155,500 992,000

Segment margin $(128,200) $(47,100) $ 133,000

Common fixed expenses 401,000

Operating income $ (268,000)

The computation of the number of performances of each ballet required for the company as a whole to break even requires two steps:

Step 1. Computer-weighted contribution margin (package). Note that the current mix is 1:1:4:2:1.

$21;680 C $21;680 C 4ð$29;150Þ C 2ð$21;680Þ C $21;680 D $225;000 Packages D ð$992;000 C $401;000Þ=$225;000 D 6:19 or 7 packages ðrounded upÞ

Step 2. Multiply this number by the respective mix units. This yields the following number of performances:

7 Dream (1 £ 7) 7 Petroushka (1 £ 7) 28 Nutcracker (4 £ 7) 17 Sleeping Beauty (2 £ 7) 7 Bugaku (1 £ 7)

Contribution Margin Analysis and Nonprofit Organizations

Break-even and contribution margin analysis is not limited to for-profit firms. For nonprofit organizations, it not only calculates the break-even service level but also helps answer a variety of what-if decision questions.

Example 15

OCM, Inc., a Los Angeles county agency, has a $1.2 million lump-sum annual budget appropriation for an agency to help rehabilitate mentally ill patients.

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On top of this, the agency charges each patient $600 a month for board and care. All of the appropriation and revenue must be spent. The variable costs for rehabilitation activity average $700 per patient per month. The agency’s annual fixed costs are $800,000. The agency manager wishes to know how many patients can be served. Let x D number of patients to be served.

Revenue D Total expenses Lump-sum appropriation C $600 � 12x D Variable expenses C Fixed costs

$1;200;000 C $7;200x D $8;400x C $800;000 ð$7;200 ¡ $8;400Þx D $800;000 ¡ $1;200;000

¡ $1;200x D ¡ $400;000 x D $400;000=$1;200 x D 333 patients

We will investigate two what-if scenarios: (1) Suppose the manager of the agency is concerned that the total budget

for the coming year will be cut by 10 percent to a new amount of $1.08 million. All other things remain unchanged. The manager wants to know how this budget cut affects the next year’s service level.

$1;080;000 C $7;200x D $8;400x C $800;000 ð$7;200 ¡ $8;400Þx D $800;000 ¡ $1;080;000

¡ $1;200x D ¡ $280;000 x D $280;000=$1;200 x D 233 patients

(2) The manager does not reduce the number of patients served despite a budget cut of 10 percent. All other things remain unchanged. How much more does the manager have to charge patients for board and care? In this case, x D board and care charge per year.

$1;080;000 C 333x D $8;400 � 333x C $800;000 333x D $2;797;200 C $800;000 ¡ $1;080;000 333x D $2;517;200

x D $2;517;200=333 patients x D $7;559

Thus, the monthly board and care charge must be increased to $630 ($7,559/12 months).

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CVP ANALYSIS WITH STEP-FUNCTION COSTS

The introduction of step-function costs is somewhat more difficult than it might first appear. Ideally, we would like to be able to assume that, for any given relevant range, we could simply add together the step-function costs and the fixed costs to give us the total applicable fixed costs. We then could utilize the formula as described earlier. Unfortunately, the process is not quite that simple, as the next example illustrates.

Example 16

Amco Magazine Company publishes a monthly magazine. The company has fixed costs of $100,000 a month and variable costs per magazine of $0.80, and it charges $1.80 per magazine. In addition, the company also has supervisory costs. These costs behave in this way:

Volume Costs

0–50,000 $10,000

50,001–100,000 $20,000

100,001–150,000 $30,000

Amco’s monthly break-even volume (number of magazines) can be calculated step by step.

If we attempt to solve the break-even formula at the first level of fixed costs, we have this equation:

x D FC=ðp ¡ vÞ D ð$100;000 C 10;000Þ=ð$1:80 ¡ $0:80Þ D $110;000=$1 D 110;000 units

The problem with this solution is that, while the break-even volume is 110,000 magazines, the relevant range for the step-function costs was only 0–50,000 magazines. Thus, a break-even of greater than 50,000 magazines is invalid, and we must move to the next step on the step function, which gives us the next equation:

x D FC=ðp ¡ vÞ D ð$100;000 C 20;000Þ=ð$1:80 ¡ $0:80Þ D $120;000=$1 D 120;000 units

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This solution is also invalid. Only when we get to the third level do we encounter a valid solution:

x D FC=ðp ¡ vÞ D ð$100;000 C 30;000Þ=ð$1:80 ¡ $0:80Þ D $130;000=$1 D 130;000 units

The conclusion we must draw is that the incorporation of step-function costs in the CVP formula requires a trial-and-error process to reach the break- even volume.

From a profit-seeking perspective, a 150,000 unit level is most profitable.

50,000 100,000 150,000

CM (@ 1) $ 50,000 $100,000 $150,000

FC 100,000 120,000 130,000

NI ($ 50,000) ($ 20,000) $ 20,000

IMPORTANCE OF IDENTIFYING VARIABLE AND FIXED COSTS—CVP-BASED STRATEGIES

Why is it important to segregate costs into variable and fixed elements? The answer may become apparent if we look at the following four business decisions.

1. If American Airlines is to make a profit when it reduces all domestic fares by 30 percent, what reduction in costs or increase in passengers will be required? Answer: To make a profit when it cuts domestic fares by 30 percent,

American Airlines will have to increase the number of passengers or cut its variable costs for those flights. Its fixed costs will not change.

2. If Ford Motor Company meets the United Auto Workers’ demands for higher wages, what increase in sales revenue will be needed to maintain current profit levels? Answer: Higher wages to UAW members at Ford Motor Company will

increase the variable costs of manufacturing automobiles. To maintain present profit levels, Ford will have to cut other variable costs or increase the price of its automobiles.

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3. If USX Corp.’s program to modernize plant facilities through significant equipment purchases reduces the workforce by 50 percent, what will be the effect on the cost of producing one ton of steel? Answer: The modernizing of plant facilities at USX Corp. changes the

proportion of fixed and variable costs of producing one ton of steel. Fixed costs increase because of higher depreciation charges, whereas variable costs decrease due to the reduction in the number of steelworkers.

4. What happens if Kellogg Company increases its advertising expenses but cannot increase prices because of competitive pressure? Answer: Sales volume must be increased to cover the increase in fixed

advertising costs.

CVP Analysis under Uncertainty

CVP analysis can be conducted with probabilistic estimates of the sales price, variable cost, fixed cost, and so forth. Under this approach, instead of a single break-even point, one calculates a probability of breaking even. Probabilities can also be used in such areas as cost variance investigation, budgeting, and capital budgeting—to name a few.

Assumptions Underlying Break-Even Contribution Margin Analysis

The basic break-even and contribution margin models are subject to six limiting assumptions. They are:

1. The selling price per unit is constant throughout the entire relevant range of activity.

2. All costs are classified as fixed or variable. 3. The variable cost per unit is constant. 4. There is only one product or a constant sales mix. 5. Inventories do not change significantly from period to period. 6. Volume is the only factor affecting variable costs.

SUMMARY

Break-even and contribution margin analysis is useful as a frame of reference, as a vehicle for expressing overall managerial performance, and as a planning device via break-even techniques and what-if scenarios.

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The next points highlight the analytical usefulness of contribution margin analysis as a tool for profit planning:

& A change in either the selling price or the variable cost per unit alters CM or the CM ratio and thus the break-even point.

& As sales exceed the break-even point, a higher unit CM or CM ratio will result in greater profits than a small unit CM or CM ratio.

& The lower the break-even sales, the less risky the business and the safer the investment, other things being equal.

& A large margin of safety means lower operating risk since a large decrease in sales can occur before losses are experienced.

& Using the contribution income statement model and a spreadsheet pro- gram, such as Excel, a variety of what-if planning and decision scenarios can be evaluated.

& In a multiproduct firm, sales mix is often more important than overall market share. The emphasis on high-margin products tends to maximize overall profits of the firm.

We discussed how the traditional contribution analysis can be applied to profit and nonprofit setting and provided illustrations. Managers can prepare the income statement in a contribution format, which organizes costs by behavior rather than by the functions of manufacturing, sales, and adminis- tration. The contribution income statement is widely used as an internal planning and decision-making tool.

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5CHAPTER FIVE Profit Planning

Targeting and Reaching Achievable Goals

IN PROFIT PLANNING, WE must determine the strategy, which is one ofseveral ways to reach a goal. But we must also determine the objective,which is the target that can be quantified and that is developed from analysis of the situation at present and in the future. And finally, we must see what is needed to implement the plan.

Profit planning involves setting realistic profit objectives and targets and accomplishing them. The plan must consider the organization structure, product line (e.g., whether it is up-to-date or obsolete), services rendered, selling prices, sales volume, costs (manufacturing and operating expenses), market share, territories, skillof the laborforce, sources ofsupply, economicconditions,political environment, risk, sales force effectiveness, financial health (e.g., cash flow to fund programs), physical resources and condition, production schedules, human resources (e.g., number and quality of employees, training programs, relation- ship with union), distribution facilities, growth rate, technological ability, motivational aspects, and publicity.

Each part of the plan must be evaluated for reasonableness, as well as for its effect on other parts of the plan. Trouble spots must be identified and corrected.

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Information should be in the simplest and clearest form. Profits may be increased by increasing revenue (selling price and/or sales volume), reducing costs, eliminating duplication of work, and inconsistencies.

Managers can improve profitability of their responsibility unit by:

& Operating the department with the minimum number of employees. This may include downsizing through layoffs.

& Reducing operating costs, such as using automation and robotics to replace the cost of manual labor.

& Buying rather than leasing when cost beneficial. & Emphasizing previous success. For example, if growth has come from

product development, then allocate more funds to research and develop- ment (R&D).

& Keeping up-to-date. & Using high-technology equipment. & Self-constructing assets when feasible. & Eliminating useless operations and paperwork (e.g., reports). & Being productive and progressive in obtaining efficiencies realizable with

existing resources and capabilities. & Improving the reliability of the product and service. & Expanding into new operations and areas so every opportunity is pursued. & Improving supplier relationships, including negotiating better prices and

terms. Alternative sources of supply may be bought when cost-effective. & Screening new hires for honesty and competence. & Having adequate insurance, including business interruption and product

liability.

The profit plan should be in writing, consistently applied, and contain these key elements:

& Statement of objectives & Parameters of achieving those objectives (e.g., prohibition of reducing

discretionary costs, such as R&D, in the current year just to bolster near- term profits when this will have long-term negative effects)

& Plans (operating and financial) & Schedules & Ways to measure and track performance & Review procedures & Mechanism for making needed changes

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An operating plan tells how the objective is to be achieved. For example, an operating plan for a sales manager may provide for a reduction in selling expenses of 10 percent by improving salesperson productivity through better training, reducing the number of salespeople, and increasing the number of calls per salesperson.

The financial plan is a budget expressed in dollars that quantifies the operating plan. Lower-level managers are more involved with operational specifics (details) and carrying out plans than upper-level managers.

Planning should occur within a reasonable time frame, not rushed, considering alternatives that accomplish the long-term objectives of the manager. For example, a new product should undergo test marketing before it is introduced on a massive scale. Profit planning for the next year should begin as early as possible. It must be in place by January 1 of that year.

The profit plan may be for one year or multiple years. For example, in a five-year plan, there should be profit objectives set for each of the years included in that plan. A five-year plan should be the maximum time period because the longer the time horizon, the more difficult it is to predict; a five- year period would be more practical and attainable than longer periods. The time period chosen should take into account the nature and stability of the business.

Reports should provide managers with the right information needed to make a good decision. Once that decision has been made, control reports should show whether it has worked out. Managers should not procrastinate once they have made a decision or keep changing their minds because of employee reactions.

Managers must address what is crucial. For example, material costs are important to a manufacturing company but not to a financial service business. In airlines, passenger revenue per mile is crucial.

Information has to be given to the right managers and must directly relate to their operations. The type of profit plan and its components will differ among companies, depending on their unique characteristics, features, problems, condi- tions, and requirements. Unfortunately, profit planning has become more difficult because of competition, the high cost associated with introducing new products (e.g., R&D), more educated consumers, and government regulation.

This chapter discusses establishing and evaluating profit targets, planning objectives, the role of nonfinancial managers, plan assumptions and alternatives, manager responsibilities, participation in the planning process, employee rela- tions, coordination and communication, scheduling, handling problems, and analysis and control of the profit plan.

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GOAL CONGRUENCE

We must keep in mind goal congruence, which is agreement between top management’s viewpoint and the lower-level managers’ viewpoint. Some of this activity could be misdirected if each manager assumes, as is human, that what is best for his or her responsibility center is best for the company. Therefore, the manager must consider general company goals and assumptions as a background for all planning activity.

The standard philosophy is that more is better; that is, more sales, products, fields of activity, profit, and return. Most businesses feel that ceasing to grow is beginning to die.

PROFIT TARGETS

Profit planning sets a target profit that takes into account expected sales and costs for next year and for longer periods. The manager should track, on a regular basis, the progress in meeting the profit plan so any needed adjustments may be made in selling effort or cost containment. For example, if the yearly target is an increase in sales of 20 percent and in the first quarter sales have actually decreased by 2 percent, a problem is indicated. Yet if the plan calls for a reduction in yearly costs of 10 percent and at the end of the second quarter costs have been trimmed by 12 percent, the situation is quite favorable.

A profit target can apply to the individual components of that profit. For example, a company that now derives 80 percent of its earnings from one product may have as its profit goal in three years to derive 40 percent of its profit from this product and 60 percent of its profit from other products. This goal may be achieved through developing new products, enhancing existing products, changing advertising and sales promotion, and R&D efforts.

OBJECTIVES IN THE PROFIT PLAN

An objective states what is going to be done. The objective must be clear, quantifiable, compatible, practical, strong, realistic, and attainable. The objec- tive should be in writing. Objectives changed too often become meaningless. Further, objectives must not conflict with each other.

The objective must be specific. For example, an objective of increasing sales should state by how much, where, and when. It may take this form: “The

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divisional objective is to increase sales by 50,000 units of product X in territory A for20XX.” The manager should clearly communicate objectives to subordinates.

Objectives should be established in priority order. An example is a market- ing department that should give primary emphasis to the existing, successful product line and secondary emphasis to unproven, high-risk new products. Another example is the R&D manager who should give first priority to basic research to improve the existing products and a lower level of priority to research on new products.

Objectives should be ranked in terms of those having the highest return. The progress toward meeting the objective should be measured at regular intervals (e.g., quarterly).

ROLE OF NONFINANCIAL MANAGERS

The nonfinancial manager must abandon sacred cows to increase profits. For example, a less expensive raw material may be used to result in cost savings without sacrificing product quality. Another example is to lower the quality of a product to save on costs and reduce the selling price to attract more business from price-oriented customers. A company that sells only to a few prestigious accounts that are willing to pay a higher price may produce greater overall profits by lowering the quality and price to get a huge number of price-sensitive accounts. Conversely, the company may keep its high-priced product as is and develop a second product line of lower prices with a different label to attract the price-conscious consumer.

The marketing manager may increase profits by increasing the selling price, increasing volume, improving quality and service, reducing the time to respond to customer complaints, concentrating on high-demand products, modifying geographic locations, having clean facilities, altering distribution outlets, introducing new products, redesigning packaging, using more attract- ive styling, discontinuing unprofitable products, increasing personal selling, changing the sales force, and modifying advertising and sales promotion policy.

The marketing manager should determine how much of each sales dollar goes to meeting marketing expenses. He or she should determine the ratio of the change in marketing expenses over the year to expenses last year to indicate the degree of cost control. The manager must also keep abreast of marketing trends for products and services.

The manager should rate salespeople in terms of the net profitability brought in. A comparison should be made between the salesperson’s actual

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sales relative to the costs to obtain those sales. Other performance measures are dollar sales quotas and the number of orders from existing and new customers.

A sales analysis should examine orders booked, orders backlogged, orders lost by out-of-stock or delayed shipments, ratio of orders billed to orders booked, and aging of orders. A sales effort analysis involves the number of sales calls, number of advertisements and mailings, number of new customers, market share, and sales mix.

The production manager can maximize profits by spreading manufactur- ing as regularly as possible over the entire year. This may add stability to manufacturing and lower costs (e.g., eliminate overtime, layoffs versus rehiring and training). The manager may also increase profits through private labeling for other companies. This would achieve better plant and machinery utilization and spread fixed costs over more units. The manager should also maintain plant facilities, obtain givebacks from employees or not give raises, derive optimum inventory balances and reduce inventory costs, lower raw material costs, and properly schedule production.

The production manager should use these factory performance measures: capacity in use and units produced, percentage of rejects and rework, yield percentages for direct materials and purchased parts, and trends in costs of service, especially during new product learning curve periods.

The purchasing manager can increase profits by properly timing the purchase of raw materials, obtaining volume and cash discounts, changing suppliers to obtain lower prices (assuming reliability in delivery), and inspect- ing items to ensure quality.

The transportation manager can boost profits by scheduling delivery routes to economize on time and by lowering mileage costs, including fuel and depreciation.

The human resources manager can improve profits by instituting an incentive plan to improve dollar revenue per employee and sales volume per worker. The ratio of annual terminations to the average number of employees can also be examined.

The research director can contribute by substituting low-cost components for high-cost ones without sacrificing quality or customer acceptance.

The engineering manager can reduce the number of diverse elements in use (e.g., 100) to standardized ones (e.g., 20) and find fewer cost combinations of inputs (e.g., materials and labor mix).

The service manager is concerned with the percentage of billable time, standard and average billing rate, average cost per hour of employee time, and

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overhead (or markup) rate to labor time. The manager should maintain a system that can differentiate quickly and accurately between customers based on the degree of service they require and the revenues their patronage is likely to generate.

The credit manager can reduce bad debts and the collection period without losing sales.

Because a nonfinancial manager’s responsibility is to plan and control, he or she must be able to communicate effectively to accomplish goals. Commu- nication may be written (formal financial reports, ratio, statistics, narrative), graphical (charts, diagrams, pictures), and oral (conferences, group meetings).

ASSUMPTIONS

Profit plans rely on assumptions and projections. Nonfinancial managers will have to make assumptions to predict the future. The assumptions must be continually updated. Any revisions require special approval.

If the assumptions are not realistic—for example, for an increase in selling price if there is a high degree of competition and/or a recession—the basis of the profit plan is in doubt. Further, an increase in selling price may result in a decline in sales volume, hurting overall profits because consumers will switch to cheaper brands (e.g., away from Philip Morris cigarettes).

ALTERNATIVES

The financial impact of alternatives in the profit plan has to be considered. Alternative plans can allow for such possibilities as a strike. The alternative selected should be practical and result in the highest profit in conformity with the nonfinancial manager’s goals. The bottom line, and not the personal tastes of the manager, is all that counts. For example, the sales manager may prefer to sell through direct mail but should use the manufacturer’s representatives if that is more profitable.

The sales manager should try to obtain the most profitable sales at the minimum cost. Some of the sales manager’s options are:

& Modify advertising and sales promotion. & Change the method of distribution. & Eliminate unprofitable products.

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& Develop new markets and products. & Combine small orders to reduce transportation charges. & Redesign truck routes to economize on fuel. & Change the sales territory. & Alter the selling price. & Change credit and collection policies. & Alter packaging and labeling.

The production manager is responsible for manufacturing sufficient quan- tities to meet sales needs at the lowest practical cost while maintaining quality within a desired time period. The production manager can:

& Improve the production process and supervision of workers. & Change the repair and maintenance policy. & Move production elements (e.g., machinery) or entire facilities. & Use higher-technology equipment. & Determine the best production run. & Properly schedule work flow and employee time. & Synchronize production and inventory levels. & Reduce fixed costs.

The purchasing manager is responsible for buying materials and supplies at the least cost while maintaining quality. The purchasing manager should:

& Carefully inspect the quality of purchased items. & Decrease the days that elapse between purchase and delivery. & Decide on less expensive product substitutes. & Obtain volume discounts from larger orders. & Reduce inventory cost with more frequent deliveries. & Emphasize standardized (uniform) items. & Change unreliable suppliers.

The human resources manager can:

& Expand job training. & Improve recruitment. & Establish merit increases based on performance. & Select the right person for the right job.

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RESPONSIBILITY

Profit planning requires that managers be held accountable for their results if they have authority over the items in question. Responsibility without author- ity causes the profit-planning system to fail and results in manager frustration.

Planning should avoid conflicts that have a net negative profit impact on the business. An example is a sales manager who accepts short-term, low- volume sales orders even though they result in unusually high manufacturing costs for the production manager.

A solution is to make nonfinancial managers jointly responsible for an objective that affects both. Interrelated departments must work as a group to maximize company profit by considering the net advantage or disadvantage to the business. The managers should share credit or blame for these interrelated performances. In this way, managers will work toward meeting overall company objectives.

Each manager must determine whether responsibility unit managers are contributing to the profit plan in the expected proportion.

PARTICIPATION

Profit planning involves effort and input by managers in sales, production, distribution, research and development, service, engineering, finance, traffic, and general business.

Line managers are concerned with operating and executing plans. Staff managers assist others in an advisory capacity. In either case, the manager must be able to change and try new things.

Financial people should spend time with operating personnel to familiarize themselves with operations, problems, and requirements. Managers should encourage financial personnel to discuss with them the nature and character- istics of their department’s or responsibility unit’s operations. In this way, the accountant or financial executive can prepare meaningful budget information and performance reports that can be used by nonfinancial managers.

Managers should insist on getting reports, schedules, and forms that are useful. Otherwise, the information may not be suitable or relevant and will be discarded.

Nonfinancial managers should communicate clearly to financial managers the type and nature of information they need. Otherwise, time and money will

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be wasted on useless information for managers. As a result, the managers may waste time accumulating accounting numbers themselves.

SUBORDINATES

Managers should monitor the performance of subordinates but should also give them latitude in making decisions.

Subordinates should be rewarded (e.g., with salary increases, merit bo- nuses) on the basis of results that improve divisional profitability. The optimum pay raise is the minimum pay increase that will yield the maximum produc- tivity increase. Employees whose decisions have hurt profitability should be called to account. They should learn from their errors. If too many errors have been made, a replacement might be appropriate.

Compensation of subordinates should be competitive with other companies in the industry. No limit should be placed on salaries, or the successful employee may quit.

COORDINATION

Profit planning is a team effort involving all managers, line and staff, to accomplish the profit goal. For example, there should be coordination among the sales manager, production supervisor, purchasing manager, receiving manager, director of engineering, and quality control supervisor, because interrelationships exist between them.

SCHEDULING

A product introduced should be planned and scheduled in the most economical way. Workers should be available when needed. Each step should proceed logically. Profit planning involves delivering products on time by such means as reducing workers’ absentee rates.

PROBLEMS

Problems must be identified and addressed with solutions, and profit impacts must be considered. If the problems cannot be rectified (e.g., they are not

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controllable by the company), the adverse effects must also be taken into account. An example is a manufacturer losing some retail accounts because of competitors’ price cuts, or an existing poor relationship between the manu- facturer and the retailers because of delivery delays due to a strike.

CONTROL, EVALUATION, AND ANALYSIS

A management information system (MIS) includes financial information that allows the manager to compare actual results with target figures. It is better to analyze variances regularly, preferably monthly. For example, quarterly variance analysis may be too late to give managers the opportunity to correct problems.

A comparison should be made over time between actual profit and budgeted profit. Related useful ratios are actual revenue to budgeted revenue and actual costs to budgeted costs.

The profit expectation of the plan should be compared with prior years’ experience as an indicator of reasonableness. For example, it may not be reasonable to project a sales increase of 40 percent for next year when in previous years the sales increase has never exceeded 20 percent. There must be hard evidence (e.g., something in the current year and expected for a future year to justify it) for this dramatic increase.

The projections in the profit plan should be compared with competing companies’ experiences. For example, company X will start a new program or project if it earns a rate of return of 30 percent. However, six competing companies have already tried this program or project and either have lost money or earned a return rate below 5 percent. This makes the company’s projected 30 percent rate of return questionable unless special or unique reasons to justify it can be shown.

Ratios may be prepared comparing projected performance to historical performance. Some useful ratios include return on investment (ROI) (net income/total assets), profit margin (net income/sales), cost of sales to sales, direct material to sales, direct labor to sales, factory overhead to sales, selling expenses to sales, and general and administrative expenses to sales. However, in making ratio calculations, the data must be comparable over the years.

The manager should not overstate current year profit at the expense of sacrificing future profitability.

The manager must track the status of a project or program and make immediate decisions if an operation is not productive or profitable. Further, part of a department that no longer serves a useful purpose may be disbanded.

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A comparison may be made between the unit costs of the old and the new manufacturing operation to see if the latter is successful.

After a product has been marketed, the company must continually evaluate and improve it, based on customer reaction. Feedback should occur on a timely basis so that necessary corrective steps may be taken.

To make valid comparisons between the company and a competitor, there must be a comparable base. For example, if one company has old and inefficient plant facilities, it is not comparable to one with modern, efficient facilities.

An illustrative profit plan is presented in Exhibit 5.1.

INTERNAL CONTROLS

Internal controls are fundamental in profit planning. Assets should be safe- guarded and controlled. Each individual’s work should be checked by another employee. One person should not have control over a transaction from beginning to end. Requests and requisitions should be reviewed and approved. Before an item is paid, make certain it is appropriate.

REAL-LIFE ILLUSTRATIONS IN PROFIT PLANNING

Staples, the office supply company, achieves the lowest net-landed cost in the entire office stationery business. But it also targets small businesses employing fewer than 50 people. To further the relationship with this market segment, Staples has created a club. Customers join at no extra cost and get at least a 5 percent discount on fast-moving items. To get the discount, customers must show their cards, allowing Staples to track sales by customer and gain useful data for satisfying its market. Some store managers now have incentives based on customer satisfaction.

Some companies look at a customer’s lifetime value to the company, not the value of a single transaction. Home Depot is an example of such a company. Clerks do not spend time with customers to be nice. They do so because the company’s business strategy is built around not only selling home repair and improvement items inexpensively but also customers’ needs for information and service.

Although new products win new markets, it may be better in some cases to stick with existing customer segments. It is easier to build sales volume with customers who already know the company. When Entenmann’s of New York,

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E X H IB IT

5 .1

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O p e ra ti n g P ro fi t

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a loyalty leader in specialty bakery products, saw its sales leveling off, it monitored customer purchase patterns in each local market. Through tele- phone surveys and focus groups, the company found that customers were looking for fat-free and cholesterol-free items. Entenmann’s determined that it was much more economical to develop new health products than to go with another group of customers. Its new product line has been highly successful by addressing the changing needs of the core clientele and also attracting new customers.

The Olive Garden restaurant chain is another company that believes that customer loyalty plays a major role in profit planning. The chain goes against the norm of promoting successful managers to other restaurants every few years and letting assistants take over. It hires local managers whose major asset is that they are known and trusted in the community. Managers stay where they are. They get to know the customers, and their longtime hires add value to the company. It is with employees that the customer builds a bond of trust and expectations. When those people leave, the bond is broken.

Another company that uses this same philosophy is State Farm, the insurance company. Its focus on customer service has resulted in faster growth than most other multiple-line insurers. But rather than being consumed by growth, its capital has mushroomed (all through internally generated surplus) to more than $25 billion, representing the largest capital base of any financial services company in North America.

State Farm began by choosing the right customers. Because of this, it was still able to build the capital necessary to protect its policyholders in years such as 2005, when the company incurred some $6 billion in catastrophe losses.

State Farm agents work from neighborhood offices, which allows them to build long-lasting relationships with their customers and provide personal service. For example, agents scan the local newspaper for the high school honor roll and make sure that their young customers’ good grades are recognized with discounts. Commissions are structured to encourage long-term thinking. Rather than bringing in lots of new customers, the company’s marketing efforts encourage existing customers to buy additional products, such as home and life insurance.

State Farm’s success in building customer loyalty is reflected in retention rates that exceed 90 percent, consistently the best performance of all the national insurers that sell through agents.

Global competition, changing markets, and new technologies are opening new roads to reinvent value. IKEA (http://franchisor.ikea.com/showContent .asp?swfIdDfacts1) is one company that accomplished this. It changed from a

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http://franchisor.ikea.com/showContent.asp?swfIdDfacts1

small Swedish mail-order furniture operation into the world’s largest retailer of home furnishings, with a global network of 316 enormous stores. In 2010, these stores were visited by more than 699 million people, generated revenues of $30.2 billion, and had an average annual growth rate of 15 percent with profit margins estimated between 8 and 10 percent. The IKEA catalogue is mass distributed to 191 million households, free of charge.

IKEA’s huge suburban stores sell simple, high-quality knock-down furni- ture kits that customers transport and assemble themselves. IKEA passes down a portion of what it saves on low-cost components, efficient warehousing, and customer self-service to its customers in the form of lower prices—from 25 to 50 percent below those of competitors.

IKEA’s strategy is to allow customers to take on key tasks that were traditionally done by manufacturers and retailers, such as the assembly of products and delivery to customers’ homes. And for doing this, it promises substantially lower prices. Part of IKEA’s goal is to make itself not just a furniture store but a family outing destination. It provides free strollers, child care, and playgrounds, as well as wheelchairs for the disabled and elderly. IKEA stores also have dining facilities.

IKEA’s strategic intent is to have its customers understand that their role is not to consume value but to create it. It provides customers with catalogues, tape measures, pens, and notepaper to help them make choices without the need of salespeople. IKEA’s goal is not to relieve customers of doing certain tasks but to mobilize them to easily do certain things they have never done before. IKEA has set out to reinvent value and the business system that delivers value for customers and suppliers alike.

The question is “Does IKEA offer a product or a service?” The answer is neither—and both.

This change of values can be compared to cash withdrawals from automatic teller machines (ATMs). Not long ago, it was inconceivable that a customer would replace a personal relationship with a bank teller for a computer system. But today most cash withdrawals come from ATMs.

There are many implications for profit planning:

& Value for customers can be restated to mobilize customers to take advantage and create value for themselves.

& Companies do not compete with each other anymore. Rather, it is the offerings that compete for the customers’ money.

& A result of a company’s strategic task is the reconfiguration of its relation- ships and business systems.

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& To win at this strategy, the key is to keep offerings competitive. This is why IKEA has become the world’s largest furniture retailer, using a strategy that could be applied to many industries.

SUMMARY

A profit plan may be stated as target return on investment (e.g., 20 percent ROI), growth in earnings (e.g., 5 percent), or in earnings per share and percentage of sales.

Performance reporting compares actual results with expectations. All efforts must be expended to accomplish profit goals. Problems have to

be identified and addressed immediately. The manager should rank items in terms of profit potential and growth.

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6CHAPTER SIX Master Budget

Genesis of Financial Forecasting and Profit Planning

A COMPREHENSIVE—MASTER—BUDGET is a formal statement ofmanagement’s expectations regarding sales, expenses, volume, andother financial transactions for the coming period. It consists basically of a pro forma income statement, pro forma balance sheet, and cash budget.

At the beginning of the period, the budget is a plan or standard. At the end, it serves as a control device to help management measure its performance against the plan so that future performance may be improved.

With the aid of computer technology, budgeting can be used as an effective device for evaluation of what-if scenarios. Management can find the best course of action among various alternatives through simulation. If management does not like what it sees on the budgeted financial statements in terms of financial ratios such as liquidity, activity (turnover), leverage, profit margin, and market value ratios, it can always alter its contemplated decision and planning set.

The budget is classified broadly into two categories:

1. Operating budget 2. Financial budget

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The operating budget consists of:

& Sales budget & Production budget & Direct materials budget & Direct labor budget & Factory overhead budget & Selling and administrative expense budget & Pro forma income statement

The financial budget consists of:

& Cash budget & Pro forma balance sheet

The five major steps in preparing the budget are:

1. Prepare a sales forecast. 2. Determine expected production volume. 3. Estimate manufacturing costs and operating expenses. 4. Determine cash flow and other financial effects. 5. Formulate projected financial statements.

Exhibit 6.1 presents a master budget.

COMPREHENSIVE SALES PLANNING

Chapter 5 gave an overview of a comprehensive profit plan. The initiating management decisions in developing the plan were the statements of broad objectives, specific goals, basic strategies, and planning premises. The sales planning process is a necessary part of profit planning and control because (1) it provides for the basic management decisions about marketing and (2), based on those decisions, it is an organized approach for developing a comprehensive sales plan. If the sales plan is not realistic, most if not all of the other parts of the overall profit plan also are not realistic. Therefore, if management believes that a realistic sales plan cannot be developed, there is little justification for profit planning and control. Despite the views of a particular management, such a conclusion may be an implicit admission of incompetence. Simply put, if it were really impossible to assess the future revenue potential of a business, there would be little incentive for investment in the business initially or for its continuation, except for purely speculative ventures that most managers and investors prefer to avoid.

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The primary purposes of a sales plan are (1) to reduce uncertainty about the future revenues, (2) to incorporate management judgments and decisions into the planning process (e.g., in the marketing plans), (3) to provide necessary information for developing other elements of a comprehensive profit plan, and (4) to facilitate management’s control of sales activities.

Sales Planning Compared with Forecasting

Sales planning and forecasting often are confused. Although related, they have distinctly different purposes. A forecast is not a plan; rather it is a statement and/ or a quantified assessment of future conditions about a particular subject (e.g.,

Budgeted Income Statement

Budgeted Balance Sheet

Selling Expense Budget

Administrative Expense Budget

Direct Labor

Direct Material

Factory Overhead

Capital Budget

Cash Budget

Cost of Goods Sold Budget

Sales Budget

Production BudgetDesired Ending Inventory Budget

EXHIBIT 6.1 Master Budget

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sales revenue) based on one or more explicit assumptions. A forecast should always state the assumptions on which it is based. A forecast should be viewed as only one input into the development of a sales plan. The management of a company may accept, modify, or reject the forecast. In contrast, a sales plan incorporates management decisions that are based on the forecast, other inputs, and management judgments about such related items as sales volume, prices, sales effects, production, and financing.

Testing the Top Line

Most companies do not really manage top-line growth. They allocate resources to businesses they think will be most productive and hope the economy coope- rates. But a growing number of companies are taking a less passive approach and studying revenue growth more carefully. They argue that quantifying the sources of revenue can yield a wealth of information, which results in more targeted and more effective decision making. With the right discipline and analysis, they say, growing revenues can be as straightforward as cutting costs. Some companies go so far as to link the two efforts. The idea is to bring the same systematic analysis to growing revenue that we have brought to cost cutting.

A sources-of-revenue statement (SRS) is useful in this effort. The informa- tion on revenue captured by traditional financial statements is woefully inadequate. Sorting revenues by geographic market, business unit, or product line tells the source of sales. But it does not explain the underlying reason for those sales.

The SRS model breaks revenue into five categories:

1. Continuing sales to established customers (known as base retention) 2. Sales won from the competition (share gain) 3. New sales from expanding markets 4. Moves into adjacent markets where core capabilities can be leveraged 5. Entirely new lines of business unrelated to the core

To produce an SRS statement, five steps are required in addition to establishing total revenues for comparable periods, as is commonly done for purposes of completing an income statement:

1. Determine revenue from the core business by establishing the revenue gain or loss from entry to or exit from adjacent markets and the revenue gain from new lines of business, and subtracting this from total revenue.

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2. Determine growth attributable to market positioning by estimating the market growth rate for the current period and multiplying this by the prior period’s core revenue.

3. Determine the revenue not attributable to market growth by subtracting the amount determined in Step 2 from that determined in Step 1.

4. To calculate base retention revenue, estimate the customer churn rate, multiply it by the prior period’s core revenue, and deduct this from the prior period’s core revenue.

5. To determine revenue from market-share gain, subtract retention revenue, growth attributable to market positioning, and growth from new lines of business and from adjacent markets from core revenue.

Example 1

To illustrate how all these budgets are put together, we will focus on a manu- facturing company called the Putnam Company, which produces and markets a single product. The budget process to be used in this chapter is often called functional budgeting because the focus is on preparing budgets by function, such as manufacturing, selling, and general and administrative support.

We will make these assumptions:

& The company uses a single material and one type of labor in the manufacture of the product.

& It prepares a master budget on a quarterly basis. & Work-in-process inventories at the beginning and end of the year are

negligible and are ignored. & The company uses a single cost driver—direct labor hours (DLH)—as the

allocation base for assigning all factory overhead costs to the product.

SALES BUDGET

The sales budget is the starting point in preparing the master budget, since estimated sales volume influences nearly all other items appearing throughout the master budget. The sales budget should show total sales in quantity and value. The expected total sales can be break-even or target income sales or projected sales. It may be analyzed further by product, by territory, by customer, and, of course, by seasonal pattern of expected sales.

Generally, the sales budget includes a computation of expected cash collections from credit sales, which will be used later for cash budgeting.

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Schedule 1

THE PUTNAM COMPANY Sales Budget

For the Year Ended December 31, 2X12

Quarter

1 2 3 4 Year as

a Whole

Expected sales in units� 1,000 1,800 2,000 1,200 6,000

Unit sales price� £ $150 £ $150 £ $150 £ $150 £ $150 Total sales $150,000 $270,000 $300,000 $180,000 $900,000

�Given.

Schedule of Expected Cash Collections

Accounts receivable, 12/31/2X11 $100,000 �

$100,000 1st-quarter sales ($150,000) 60,000y $90,000z 150,000 2nd-quarter sales ($270,000) 108,000 $162,000 270,000 3rd-quarter sales ($300,000) 120,000 $180,000 300,000 4th-quarter sales ($180,000) 72,000 72,000 Total cash collections $160,000 $198,000 $282,000 $252,000 $892,000

�All of the $100,000 accounts receivable balance is assumed to be collectible in the first quarter. y40 percent of a quarter’s sales are collected in the quarter of sale. z60 percent of a quarter’s sales are collected in the quarter following.

MONTHLY CASH COLLECTIONS FROM CUSTOMERS

Frequently, there are time lags between monthly sales made on account and their related monthly cash collections. For example, in any month, credit sales are collected in this manner: 15 percent in month of sale, 60 percent in the following month, 24 percent in the month after, and the remaining 1 percent are uncollectible.

April—Actual May—Actual June—Budgeted July—Budgeted

Credit sales $320 200 300 280

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The budgeted cash receipts for June and July are computed:

For June:

From April sales $320 £ 0.24 $ 76.80 From May sales 200 £ 0.6 120.00 From June sales 300 £ 0.15 45.00 Total budgeted collections in June $241.80

For July:

From May sales $200 £ 0.24 $ 48 From June sales 300 £ 0.6 180 From July sales 280 £ 0.15 42 Total budgeted collections in July $270

PRODUCTION BUDGET

After sales are budgeted, the production budget can be determined. The production budget is a statement of the output by product and is generally expressed in units. It should take into account the sales budget, plant capacity, whether stocks are to be increased or decreased, and outside purchases. The number of units expected to be manufactured to meet budgeted sales and inventory requirements is set forth in the production budget. In the just-in-time (JIT) firm, there are no inventory requirements, since a customer triggers production. Note that the production budget is expressed in terms of units. At this juncture, we do not know how much they will cost.

Expected production volume D Planning sales C Desired ending inventory ¡ Beginning inventory

The production budget is illustrated in Schedule 2.

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Schedule 2

THE PUTNAM COMPANY Production Budget

For the Year Ended December 31, 2X12

Quarter

1 2 3 4 Year as a Whole

Planned Sales (Schedule 1) 1,000 1,800 2,000 1,200 6,000

Desired ending inventory� 180 200 120 300 300

Total needs 1,180 2,000 2,120 1,500 6,300

Less: Beginning inventory 200 y 180z 200 120 200

Units to be produced 980 1,820 1,920 1,380 6,100

�10 percent of the next quarter’s sales (for example, 180 D 10% £ 1,800). yGiven. zThe same as the previous quarter’s ending inventory. Notes: 1. The beginning inventory for one quarter is always equal to the ending inventory in the previous quarter. 2. The column for the year is not simply the addition of the amounts for the four quarters. Notice that the desired ending inventory for the year is 300, which is, of course, equal to the desired ending inventory for the 4th quarter.

INVENTORY PURCHASES, MERCHANDISING FIRM

Putnam Company is a manufacturing firm, so it prepares a production budget, as shown in Schedule 2. If the company were a merchandising (retailing or wholesaling) firm, then instead of a production budget, it would develop a merchandise purchase budget showing the amount of goods to be purchased from its suppliers during the period. The merchandise purchases budget is in the same basic format as the production budget, except that it shows goods to be purchased rather than goods to be produced:

Budgeted cost of goods sold (in units or dollars) $560,000y

Add: Desired ending merchandise inventory 120,000

Total needs $680,000

Less: Beginning merchandise inventory (80,000)

Required purchases (in units or in dollars)� $600,000

�Cost of goods sold D beginning inventory C purchases ¡ ending inventory. Hence, purchases D cost of goods sold C ending inventory ¡ beginning inventory yGross profit (margin) D sales ¡ cost of goods sold (or cost of sales). For example, percentagewise, 30% D 100% ¡ 70%. For example, sales is $800,000, then the cost of goods sold is $800,000 £ 70% D $560,000. The merchandise purchase budget can be prepared in units as well as in dollars.

II I

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DIRECT MATERIAL BUDGET

When the level of production has been computed, a direct material budget should be constructed to show how much material will be required for production and how much material must be purchased to meet this production requirement. It also tells the cost of direct materials to be purchased, which is needed later for a cash budgeting purpose.

The purchase will depend on both expected use of materials in production and the materials inventory needs of the firm. The formula for computation of the purchase is:

Purchase in units D Direct materials needed for production C Desired ending material inventory units ¡ Beginning inventory units

The desired ending inventory is determined by the firm’s inventory policy. The direct material budget is usually accompanied by a computation of expected cash payments for materials.

Schedule 3

THE PUTNAM COMPANY Direct Material Budget

For the Year Ended December 31, 2X12

Quarter

1 2 3 4 Year as a Whole

Units to be produced (Sch. 2) 980 1,820 1,920 1,380 6,100

Material needs per unit (lb)� £ 2 £ 2 £ 2 £ 2 £ 2 Production needs (usage) 1,960 3,640 3,840 2,760 12,200

Desired ending inventory of materialsy 910 960 690 520z 520

Total needs 2,870 4,600 4,530 3,280 12,720^

Less: Beginning inventory of materials 490y 910x 960 690 490

Materials to be purchased 2,380 3,690 3,570 2,590 12,230

Unit price� £ $5 £ $5 £ $5 £ $5 £ $5 Purchase cost $11,900 $18,450 $17,850 $12,950 $61,150

�Given. y25 percent of the next quarter’s units needed for production. For example, the 2nd-quarter production needs are 3,640 lb. Therefore, the desired ending inventory for the 1st quarter would be 25% £ 3,640 lb. D 910 lb. Also note: 490 lb. D 25% £ 1,960 D 490 lb. zAssume that the budgeted production needs in lb. for the 1st quarter of 20C D 2,080 lb. So, 25% £ 2,080 lb. D 520 lb. xThe same as the prior quarter’s ending inventory. ^The cost of direct materials used is therefore $61,000 (12,200 units £ $5 per unit).

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Schedule of Expected Cash Collections

Accounts payable, 12/31/2X11 $ 6,275� $ 6,275

1st-quarter purchases ($11,900) 5,950 5,950z 11,900

2nd-quarter purchases ($18,450) 5,950�y 9,225 9,225 18,450

3rd-quarter purchases ($17,850) 8,925 8,925 17,850

4th-quarter sales ($180,000) 6,475 6,475

Total disbursements $12,225 $15,175 $18,150 $15,400 $60,950

�All of the $6,275 accounts payable balance (from the balance sheet, 2X11) is assumed to be paid in the first quarter. y50 percent of a quarter’s purchases are paid for in the quarter of purchase; the remaining 50 percent are paid for in the following quarter.

DIRECT LABOR BUDGET

The production requirements as set forth in the production budget also provide the starting point for the preparation of the direct labor budget. To compute direct labor requirements, expected production volume for each period is multiplied by the number of direct labor hours required to produce a single unit. The number of direct labor hours to meet production requirements is then multiplied by the (standard) direct labor cost per hour to obtain budgeted total direct labor costs.

Schedule 4

THE PUTNAM COMPANY Direct Labor Budget

For the Year Ended December 31, 2X12

Quarter

1 2 3 4 Year as a Whole

Units to be produced (Sch. 2) 980 1,820 1,920 1,380 6,100

Direct labor hours per unit� £ 5 £ 5 £ 5 £ 5 £ 5 Total hours 4,900 9,100 9,600 6,900 30,500

Direct labor cost per hour� £ $10 £ $10 £ $10 £ $10 £ $10 Total direct labor cost $49,000 $91,000 $96,000 $69,000 $305,000

�Both are given.

FACTORY OVERHEAD BUDGET

The factory overheadbudgetshouldprovide a scheduleofall manufacturing costs other than direct materials and direct labor, namely, indirect manufacturing

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costs. Unlike direct materials and direct labor, there is no readily identifiable input-output relationship for overhead items. Recall, however, factory overhead consists of two types of costs: variable and fixed. Past experience can be used as a guide. To illustrate the factory overhead budget, we will assume that:

& Total factory overhead budgeted D $18,300 fixed (per quarter), plus $2 per hour of direct labor. This is one example of a cost-volume (or flexible budget) formula (Y D a C bX), developed via the least-squares method with a high R2.

& Depreciation expenses are $4,000 each quarter. Note that depreciation does not entail a cash outlay and therefore must be deducted from the total factory overhead in computing cash disbursement for factory overhead.

& Overhead costs involving cash outlays are paid for in the quarter incurred.

Schedule 5

To illustrate the factory overhead budget, we will assume that:

& Depreciation expenses are $4,000 each quarter. & Overhead costs involving cash outlays are paid for in the quarter incurred.

THE PUTNAM COMPANY Factory Overhead Budget

For the Year Ended December 31, 2X12

Quarter

1 2 3 4 Year as a Whole

Budgeted direct labor 4,900 9,100 9,600 6,900 30,500

Variable overhead rate £ 2 £ 2 £ 2 £ 2 £ 2 Variable overhead budgeted 9,800 18,200 19,200 13,800 61,000

Fixed overhead budgeted 18,300 18,300 18,300 18,300 73,200

Total budgeted overhead 28,100 36,500 37,500 32,100 134,200

Less: depreciation� 4,000 4,000 4,000 4,000 16,000

Cash disbursements for factory overhead

$24,100 $32,500 $33,500 $28,100 $118,200

�Depreciation does not require a cash outlay.

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ENDING FINISHED GOODS INVENTORY BUDGET

The ending finished goods inventory budget provides us with the information required for the construction of budgeted financial statements. After com- pleting Schedules 1 through 5, sufficient data will have been generated to compute the per-unit manufacturing cost of finished product. This compu- tation is required for two reasons: (1) to help compute the cost of goods sold on the budgeted income statement and (2) to give the dollar value of the ending finished goods inventory to appear on the budgeted balance sheet. The unit manufacturing cost and the dollar value of the desired ending inventory are shown in Schedule 6.

Schedule 6

THE PUTNAM COMPANY Ending Inventory Budget

For the Year Ended December 31, 2X12 Ending Inventory

Units Unit Product Cost Total

300 units (Sch. 2) $82� $24,600

�The unit product cost of $82 is computed as follows:

Unit Cost Units Total

Direct materials $5 per lb. 2 lb $10 Direct labor $10 per hr. 5 hours 50 Factory overhead $4.40 per hr. 5 hours 22 Unit product cost $82

where the predetermined factory overhead applied rate D budgeted annual factory overhead/budgeted annual activity units D $134,200/30,500 DLH D $4.40.

THE COST OF GOODS SOLD BUDGET

Assuming that the beginning finished goods inventory is valued at $26,400 (Schedule 11), the budgeted cost of goods sold schedule can be prepared using Schedules 3, 4, 5, and 6. The cost of goods sold schedule (Schedule 7) will be used as an input for the budgeted income statement.

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Schedule 7

THE PUTNAM COMPANY Cost of Goods Sold Budget

For the Year Ended December 31, 2X12

From Schedule

Direct materials used 3 $ 61,000

Direct labor 4 305,000

Factory overhead 5 134,200

Total manufacturing costs 500,200�

Beginning finished goods inventory 11 16,400

Cost of goods available for sale 516,600

Less: Ending finished goods inventory 6 24,600

Budgeted cost of goods sold $492,000

�From Chapter 4, cost of goods manufactured D total manufacturing cost C beginning work in process inventory ¡ ending work in process inventory. Since there are no work-in-process inventories in this illustration, cost of goods manufactured D total manufacturing cost. Thus cost of goods manu- factured D direct materials used C direct labor C factory overhead D $61,000 (12,200 lb. @ $5 per lb. from Schedule 3) C $305,000 (Schedule 4) C $134,200 (Schedule 5) D $500,200.

SELLING AND ADMINISTRATIVE EXPENSE BUDGET

The selling and administrative expense budget lists the operating expenses involved in selling the products and in managing the business. Just as in the case of the factory overhead budget, selling and administrative expenses can be broken down into variable and fixed components. Such items as sales com- missions, freight, and supplies vary with sales activity. Just as in the case of the factory overhead budget, this budget can be developed using the cost-volume (flexible budget) formula in the form of Y D a C bX.

If the number of expense items is very large, separate budgets may be needed for the selling and administrative functions. The selling and adminis- trative expense budget is illustrated in Schedule 8.

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Schedule 8

THE PUTNAM COMPANY Selling and Administrative Expense Budget

For the Year Ended December 31, 2X12

Quarter

1 2 3 4 Year as a Whole

Expected sales in units 1,000 1,800 2,000 12,000 6,000

Variable selling and administrative expense per unit�

£ 3 £ 3 £ 3 £ 3 £ 3

Budgeted variable expense $ 3,000 $ 5,400 $ 6,000 $ 3,200 $ 18,000

Fixed selling and administrative expense:y

Advertising 20,000 20,000 20,000 20,000 80,000

Insurance 12,600 12,600

Office salaries 40,000 40,000 40,000 40,000 160,000

Taxes 7,400 7,400

Total budgeted selling and administrative expensesz

$63,000 $78,000 $66,000 $71,000 $278,000

�Assumed. It includes sales agents’ commissions, shipping, and supplies. yScheduled to be paid. zPaid for in the quarter incurred.

CASH BUDGET

The cash budget is prepared for the purpose of cash planning and control. It presents the expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs. It aids in avoiding unnecessary idle cash and possible cash shortages. The cash budget consists typically of five major sections:

1. The cash receipts section, which is cash collections from customers and other cash receipts, such as royalty income and investment income.

2. The cash disbursements section, which comprises all cash payments made by purpose.

3. The cash surplus or deficit section, which simply shows the difference between the total cash available and the total cash needed, including a minimum cash balance if required. If there is surplus cash, loans may be repaid or temporary investments made.

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4. The financing section, which provides a detailed account of the borrowings, repayments, and interest payments expected during the budgeting period.

5. The investments section, which encompasses investment of excess cash and liquidation of investment of surplus cash.

Schedule 9

To illustrate the cash budget, we make these assumptions:

& Putnam Company has an open line of credit with its bank, which can be used as needed to bolster the cash position.

& The company desires to maintain a $10,000 minimum cash balance at the end of each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall and to provide for the minimum cash balance of $10,000.

& All borrowings and repayments must be in multiples of $1,000 amounts, and interest is 10 percent per annum.

& Interest is computed and paid on the principal as the principal is repaid. & All borrowings take place at the beginning of a quarter, and all repayments

are made at the end of a quarter. & No investment option is allowed in this example. The loan is self-liquidating

in the sense that the borrowed money is used to obtain resources that are combined for sale, and the proceeds from sales are used to pay back the loan.

Note: To be useful for cash planning and control, the cash budget must be prepared on a monthly basis.

Note also:

Cash balance, beginning Add receipts:

Total cash available before financing (a) Deduct disbursements:

Total cash disbursements (b) C Minimum cash balance desired

Total cash needed (c) Cash surplus or deficit (a) – (c) Financing:

Borrowing (at beginning) Repayment (at end) Interest Total effects of financing (d)

Cash balance, ending [(a) ¡ (b) C (d)]

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THE PUTNAM COMPANY Cash Budget

For the Year Ended December 31, 2X12

From Quarter

Year as Schedule 1 2 3 4 a Whole

Expected sales in units $19,000� 10,675 10,000 10,350 19,000

Add: Receipts:

Collections from customers 1 160,000 198,000 282,000 252,000 892,000

Total cash available (a) 179,000 208,675 292,000 262,350 911,000

Less:

Disbursements:

Direct materials 3 12,225 15,175 18,150 15,400 60,950

Direct labor 4 49,000 91,000 96,000 69,000 305,000

Factory overhead 5 24,100 32,500 33,500 28,100 118,200

Selling and admin. 8 63,000 78,000 66,000 71,000 278,000

Equipment purchase Given 30,000 12,000 0 0 42,000

Dividends Given 5,000 5,000 5,000 5,000 20,000

Income tax 11 15,000 15,000 15,000 15,000 60,000

Total disbursements (b) 198,325 248,675 233,650 203,500 884,150

Minimum cash balance 10,000 10,000 10,000 10,000 10,000

Total cash needed (c) 208,325 258,675 243,650 213,500 894,150

Cash surplus (deficit) (a) – (c) (29,325) (50,000) 48,350 48,850 16,850

Finance:

Borrowing 30,000y 50,000 0 0 80,000

Repayment 0 0 (45,000) (35,000) (80,000)

Interest 0 0 (3,000)z (2,625)x (5,625)

Total effect of financing (d) 30,000 50,000 (48,000) (37,625) (5,625)

Cash balance, ending [(a) – (b) C (d)]

$10,675 $10,000 $10,350 $21,225 $21,225

�$19,000 (from balance sheet 2X11—Schedule 11). yThe company desires to maintain a $10,000 minimum cash balance at the end of each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall of $19,325 and to provide for the minimum cash balance of $10,000, for a total of $29,325. zThe interest payments relate only to the principal being repaid at the time it is repaid. For example, the interest in quarter 3 relates only to the interest due on the $30,000 principal being repaid from quarter 1 borrowing and on the $15,000 principal being repaid from quarter 2 borrowing. Total interest being paid is $3,000, shown as:

$30,000 £ 10% £ 3/4 D $2,250 $15,000 £ 10% £ 2/4 D $750

x $35,000 £ 10% £ 3/4 D $2,625

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