Developing Operating & Capital Budgeting

Developing Operating & Capital Budgeting

Instructor : Ali Kabiri

Budgeting The process of planning future business actins and expressing those plans in a formal quantitative and monetary terms or statement is called Budgeting . Budget A budget is a quantitative expression of plans. It is used commonly by:  Business Firms  Government Agencies  Non-Profit organizations  Households How Budgets are useful?  Induce management to think systematically  Swerve as a device for coordinating the complex operations of business.  Provide a medium for communicating the plans of the firm  Motivate managers at all levels to perform well.  Serve as a standard against which the actual performance may be judged.

Framework for Budgeting 

Strategy, Planning and Budgeting: The exercise of

periodic budgeting is based on the framework of corporate strategy and long–range plan. The corporate strategy of the firm reflects its basic objectives and the fundamental policies for realizing these objectives. The long-range plan of the firmfounded on its corporate strategy-delineates its major programs in various areas (production, marketing, finance, research and development, human resources, and etc.) , expected revenue and expenses, and projected financial conditions over the next few years. When the corporate strategy and long-range plan are not explicitly articulated, the top management may specify certain broad guidelines at the time of budget preparation. Such guide lines would reflect the corporate strategy and long-range plan followed implicitly by the top management. A simple guideline may be: “Assume that volume would increase by 5% and prices and cost would increase by 10% next year.”



The Budget period: In order to be operationally

meaningful, the budget must be drawn up for a specific time period. Usually, the budgets drawn up for a year. The yearly budget may be divided into quarterly or even monthly budgets. Generally, the budget may be divided into two parts with differing levels of detail applying to them. For example, the budget for the first quarter or first six months may be drawn up on a monthly basis and for the remaining period on a quarterly basis where further it may then be cast in terms of monthly budgets. Some firms employ a rolling budget, under this system, at the end of each quarter or each half year, the budget is extended by adding another quarter or another half year. Hence the firm always has the budget for a year ahead of it.

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Program Budget and Responsibility Budget: The

operating budget for the firm may be constructed in terms of program (program budget) or responsibility areas (responsibility budget). The Program budget is developed in terms of products that are regarded as the principal program of the business. Such a budget shows the expected revenues and costs of various products (direct and indirect costs). The Responsibility budget shows the plan in terms of person responsible for the achieving them. To illustrate, an organization may be divided into several departments (responsible center) and a budget is drawn up for each department showing what costs are amenable to control by the departmental head (head of responsible center).

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Organization for Budgeting Though there seems to be no standardized organization for budget preparation, in most of the large firms which develop formal budgets, a basic pattern exists. There is a budget committee and a budget director which guide and monitor the process of budgeting. In this, understandably, the line executive have a significant involvement. Consisting of several top management executive, the budget committee: * Sets broad guidelines for budgeting * Coordinates the separate budgets prepared by different

departments

* Reconciles inconsistencies among various departmental budget * Compiles the budget in its final form * Sends the budget for the approval of the chief executive and the board of director

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Limiting Factor In every firm, there is a critical factor which sets a limit to its level of activity. Often, the expected demand is limiting factor which defines the scope and level of operations. When the demand is fairly strong, the limiting factor may be the production capacity of the firm which can not be augmented in the short run, or it may be availability of man power or raw material if the firm is located in a man power or raw material deficit region and finally, for the firms which do not have easy access to the capital market, finance may be a limiting factor. Since it determines the scope and level of operations, the limiting factor is the most appropriate starting point for the budgeting exercise. For example, it make no sense to begin planning with production capacity when the limiting factor is the expected demand.

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Participation The budget guidelines prepared by the budget committee are transmitted down the organizational hierarchy. At each level, the management may provide more detailed information for guiding its subordinates till the guidelines reach the level of supervisors who head the lowest level of responsibility centers. Each supervisor prepares budget estimates of items of expense controllable at his level. Expense items not controllable at his level are usually added later by the budget staff. The budget prepared by the supervisor serve as the starting point for the negotiation between the supervisor and his superior.

Master Budget When the plan to be formalized is comprehensive or overall plan for the business, the resulting budget is called Master Budget. Comprehensive in scope, the Master Budget covers all facets of the operation and finances of the firm. A Master Budget has four major components: 4. Operating Budget 5. Capital Expenditure Budget 6. Cash Budget 7. Projected Financial Position. The inter- relationship among these budgets and their principal parts is shown in the below Figure.

Components of a Master Budgeting System

Operating Budget

Sales Budget

Production Budget Material & Purchase Budget Labor Cost Budget Manufacturing Overhead Budget Non-Manufacturing Cost Budget

Cash Budget

Projected Balance Sheet

Capital Budgeting Expenditure

Sources and Uses of Funds Statement

Investment and Financing Budget

Typical Master Budget 1. Operating Budget a) For Merchandizing Companies: Merchandize Purchase Budget b) For Manufacturing Companies: * Production Budget * Manufacturing Budget c) Selling Expenses Budget – Non Manufacturing cost Budget d) General and Administrative Expense Budget 2. Capital Expenditure Budget 3. Financial Budgets * Cash Budget: Budgeted statement of cash and disbursements * Budgeted Balance sheet – Projected Balance Sheet * Budgeted Income Statement

Master Budget Preparation Sequences Preparation of Budgets within the Master Budget must follow a definite sequence, as follow: 2. The sales budget must be prepared first because the other sub units of operating budget such as; production budget, materials and purchase budget and etc. is depend upon information provided by the sales budget. 3. In the next step, the remaining operating budgets are prepared. 4. In this stage Capital expenditure budget is prepared. This budget usually depends upon long-term sales forecasts more than it does upon the sales budget for the next year (Shortterm).

1.

2.

3.

Based upon the information provided in the above budgets, the budgeted statement of cash receipts and disbursements is prepared. If this budget discloses an imbalance between disbursements and planned receipts, the previous plans may have to be revised. The budgeted income statement is prepared next. If the plans contained in the master budget results in unsatisfactory profits, the entire Master Budget may be revised to incorporate any corrective measures available to the firm. The budgeted balance sheet statement for the end of the budgeted period is prepared last. An analysis of this statement may also lead to revisions in the previous budgets. For examples, the budgeted balance sheet statement may disclose too much debt resulting from an overly ambitious expenditures budget, and revised plans may be necessary.

Operating Budget Sales Budget  Production Budget  Material and Purchases Budget  Labor cost Budget  Manufacturing Overhead Budget  Non-Manufacturing cost Budget 

Sales Budget The sales budget provides an estimate of goods to be sold and revenue to be derived from sales. The Sales forecast or budget for the forthcoming (budget) year is usually the starting point of the budgetary exercise. Production, materials, labor, etc., are related to the level of sales. The sales budget commonly grows from a reconciliation of forecasted business conditions, plant capacity proposed selling expenses such as advertising and estimates of sales. In preparing the sales forecast, the following factors should be considered:  The outlook of the industry and economy  Past behavior and emerging trends in sales  Governmental regulations and controls affecting the industry  Consumer attitudes, dispositions, tastes, and preferences  The nature and the extent of competition

Northern Company

Monthly Sales Budget September 2006 –January 2007

Months September October

Budgete Budgete Budgeted Total d unit d unit Sales Sales Price 7,000 $10 70,000 10,000

$10

100,000

November

8,000

$10

80,000

December

14,000

$10

140,000

9,000

$10

90,000

January

Production Budget In manufacturing organization, the budget of production is one of the operating budget. A well balanced production plan is required to ensure economical manufacturing. The factors that influence t6he plan of production are: ii. The volume and timing of sales iii. Inventory of sales and iv. Productive capacity The production plan geared to meet the requirement of sales. Goods flow from production line largely is in conformity with the needs of sales. There may , however be significant divergence between the pattern of sales and pattern of production. This happens under two conditions: vii. There is a pronounced seasonal variation in sales whereas production is planned in a stable manner. viii. Production necessarily has to be carried out during a certain period of the year, whereas sales occur

The steps involved in preparing the production budget are broadly as follows:  Assess the productive capacity of the firm  Specify the finished goods inventory policy of the firm  Estimate the total quantity of each product to be manufactured during the budget period on the basis of sales forecast and finished goods inventory policy  Schedule the production during the budget period, taking into account the pattern of sales, the finished goods inventory policy, and the productive capacity

Material and Purchases Budget Once the production budget defines the quantity to be produced, the next logical step is to estimate the material requirements and determine the purchase program. In this context, the following principal budgets are developed. Material Budget: Materials used in a manufacturing unit are traditionally classified as Direct and Indirect. Direct materials are materials which arte directly identified with the product and are visibly incorporated init. Indirect materials cannot be traced directly to the product. The material budget generally is concerned only with Direct materials. Indirect materials and supplies are covered by the manufacturing Overhead budget. The material budget shows the quantities, and often the prices, of materials planned to be purchased. Purchase Budget: This budget shows: f) The quantities of each type of raw material to be purchased, g) The schedule of purchases, and h) The estimated cost of purchases.

In developing the purchase budget, one has to take into account the following: ii. The quantities specified in the materials budget iii. The planned changes in material inventories iv. Re-order levels of various inventory items, and v. Economic order quantities of various inventory items.

Budgeted sales for the month Add the budgeted end of the month inventory Required amount of available merchandise Deduct the beginning of month inventory Inventory to be purchased

XXXX XXXX XXXX (XXXX) XXXX

Northern Company

Merchandise Purchase Budget September, October, November 2006

Next month’s budgeted sales (In units) 9,000 Ratio of inventory to future sales x90% Desired end of month inventory 8,100 Budgeted sales for the month (In units) 14,000 Required units of available merchandise 22,100 Deduct beginning of month inventory (12,600) Number of units to be purchased 9,500 Budgeted cost per unit x$8 Budgeted cost of merchandise purchases $57,000

Sep 8,000

Oct 14,000

x90%

x90%

7,200

12,600

10,000

8,000

17,200

20,600

(9,000)

(7,200)

8,200

13,400

x$6

x$7

$49,200

$80,400

Nov

Labor cost Budget Labor Cost Budget: Labor is generally classified as Direct and Indirect. Direct labor cost represents the Wages paid to workers employed directly in the manufacturing activity. Indirect labor cost represents all other labor costs , such as supervisory salaries, wages paid to storekeepers, maintenance personnel, janitors, etc. The budget for labor cost normally includes the cost of direct labor only. The following approaches may be used for developing the labor cost budget: 3. 4.

Labor cost per unit of production = (Standard direct labor hours required for each unit of production) x (Average Wage rate per hour) Labor cost Budget = labor cost per unit x Number of units of finished goods planned

When the above approaches cannot be used, the labor cost budget may be developed on the basis of information about: vii. Permanent manpower employed in direct manufacturing activity and their remuneration rates viii. Payments likely to arise on account of overtime work ix. Temporary manpower that may be needed and their

Manufacturing Overhead Budget Manufacturing overhead is that part of factory cost which ii. iii. iv.

is not included in direct material and direct labor cost. Not directly identifiable with specific products or jobs, manufacturing overhead consists of: Indirect material Indirect labor Miscellaneous factory expense items, such as depreciation, utilities, supplies, repairs, maintenance, insurance, tax, and etc.

To construct the manufacturing overhead budget, expense budgets for all the departments in the factory – production as well as service departments – have to be drawn up and aggregated. For this purpose, the expected volume of the work to be done in each department has to be determined in terms of an indicator appropriate to its activity. Some measures of activity are given below:

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6.

For producing departments * units of output * Direct labor hours * Direct machine hours For service departments * Repair and maintenance: direct repair hours or the number of machines to be maintained. * Purchase department: total purchases in monetary term or the purchases order to be placed. * General factory administration: number of employees in the plant or total direct labor hours.

Given the activity level of each department in terms of a suitable measure, departmental budgets are drawn up in terms of two basic components: the variable cost (the cost that changes as the level of output changes) and fixed cost (the cost that remains constant as the level of output changes).

Non-Manufacturing Cost Budget

Non manufacturing costs consists of expenses for selling and distribution, general administration, research and development, and financing. The budgets for non manufacturing cost are normally prepared along departmental lines. For each non manufacturing department the budget may be developed as the budget for manufacturing overhead is constructed. For example the responsibility for preparing a budget of selling and distribution expenses typically falls on the vice president of Marketing or equivalent Sales manager. In this case, although budgeted selling expenses should affect the expected amount of sales, the typical procedure is to prepare a sales budget first and then to budget selling and distribution expenses budget.

Capital Expenditure Budget The capital expenditure budget shows the list of capital projects selected for investment along with their estimated cost. The capital expenditure budget or plant and equipment budget lists equipment/s to be scrapped and additional equipment/s to be purchased if the proposed production program is to be carried out. The proposals in the capital expenditure budget have to suitably justified. Usually the justification is in terms of quantitative criteria, such as the Payback Period (PBP), Accounting Rate of Return (ARR), Internal Rate of Return (IRR), Cost reduction per unit, productivity and etc. There are qualitative criteria that needs to be taken to consideration such as; growth opportunity, market image, technological competence, morale, employee safety, and etc.

Cash Budget The cash budget shows the cash inflows and outflows expected in the budget period. The major sources of cash inflow are: cash sales, collection of accounts receivable, dividend and interest income, disposal of fixed assets, long term and short term borrowing, and raising of equity capital. The major sources of cash outflow are: cash purchase, payments of accounts payable, payments toward wages, salaries, rent, utilities, and other operating expenses, tax payment, purchase of capital assets, and repayment of borrowings. The preparation of the cash budget has its starting point in the operating budget of the firm. The revenue and expenses shown in the operating budget have to be translated into cash inflows and cash outflows. In this context, the following points may be mentioned:

i.

ii. iii.

iv.

The pattern of collection of accounts receivable (arise from credit sales) is estimated by applying a suitable “Lag” scheme. For example, it may be assumed that 40% of a month’s sales will be collected after one month, 50% after two months and 10% after three months. The cash disbursement or credit purchase may also be estimated on the basis of a “Lag” factor. Operating expenses in terms of wages, salaries, rents, etc. are assumed to have been paid in the month in which they are incurred. Depreciation and other Non cash charges are not included in the cash budget.

Apart from the operating budget, other influences on the cash budget are: proposed acquisition and disposal of capital assets, anticipated borrowing and their repayments, proposed tax and dividend payments, planned issues of equity and debt capital.

Northern Company

Cash Budget September ,October, November 2006 Beginning cash balance Cash receipt from customers Totals 126,000

September November $20,000 $20,000 82,000 92,000 102,000 112,000

December $22,272 104,000

Cash disbursements: Payments for merchandise Sales commission Salaries Administration

Accrued income taxes payable Dividend payable Interest on loans from bank Purchase of equipments Total cash disbursements 125,900 Balance Additional loan from bank Repayment of loan from bank Ending cash balance

58,200 10,000 2,000 4,500 20,000 100 94,800

7,200 12,800 20,000

49,200 7,900 2,100 4,600 2,900 228 66,928

45,072 (22,800) 22,272

80,400 14,000 2,000 4,500 25,000

372 19,628 20,000

Projected Balance Sheet The projected Balance Sheet shows projected assets, liabilities, and owner’s equity at the end of the budgeted period. The inputs required for its preparation are the initial balance sheet, the profit plan, the capital expenditure budget, the cash budget, and the investment and financing budget.

Northern Company

Budgeted Balance Sheet, 31st December 2006 Assets Cash Accounts receivable Inventory Equipments Less accumulated depreciation

$ 20,000 84,000 48,600 225,000 40,500

184,500

Total Assets 337,100

Liabilities and stock holders Equity Liabilities: Accounts payable Accrued income tax payable Bank loan payable Stock holders’ Equity: Common stock Retained earnings

57,000 28,669 19,628

150,000 81,803

Total Liabilities and stock holders equity 337,100

105,297

231,803

Capital Budgeting Planning plant asset investments is called Capital Budgeting. The plans may involve new building, new machinery, or whole new projects. In all such cases, a fundamental objective of business firm is to earn a satisfactory return on the invested funds. Capital budgeting involves the preparation of cost and revenue estimates for all proposed projects, an examination ofr the merits of each, and a choice of those worthy of investment.

Capital investments, representing the growing edge of a business, are deemed to be very important for three inter-related reasons: 2. They have long-term consequences. Capital investment decisions have considerable impact on what the firm can do in future. 3. It is difficult to reverse capital investment decisions because the market for used a firm are tailored to meet its specific requirements. 4. Capital investment decisions involve substantial outlays. This section discusses the basics of capital budgeting. It is divided into ten sub-sections as follows: • Capital budgeting process • Cost and Benefits Analysis: Basic principles • Cost and Benefits Analysis: Illustrations • Appraisal criteria • Payback period (PBP) • Average Rate of Return (ARR) • Net Present Value (NPV) • Benefit Cost Ratio (BCR) • Internal Rate of Return (IRR)

Capital budgeting process

Capital budgeting is a complex process which may be divided into the following phases: 3. Identification of potential investment opportunities 4. Assembling of proposed investment *Replacement investments * Expansion investments * New product investments * Obligatory and welfare investments

Decision Making Preparation of Capital Budget and Appropriation 11. Implementation 9. 10.

* Adequate and detailed formulation of projects * Use of the principle of responsibility accounting * Use of Network techniques for monitoring the

Costs and benefits: Basic Principles

Once an investment project is proposed, its costs and benefits must be estimated. In evaluating a capital expenditure proposal, two broad phases are involved:  Defining the stream of Costs and Benefits associated with the investment. * Cash Flow Principle * Incremental Principle * Long-Term Funds Principle * Interest Exclusion Principle * Post-Tax Principle 

Appraising the stream of Costs and Benefits associated with the investment. * Payback Period * Average Rate of Return * Net Present Value * Benefit Cost Ratio * Internal Rate of Return

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Cash Flow Principle: Cost and benefits must be measured in terms of cash flowscosts are cash outflows and benefits are cash inflows. Incremental Principle: Cash flows must be measured in incremental terms. This means that the changes in the cash flows of the firm which can be attributed to the proposed project alone are relevant. In estimating the incremental cash flows of a project, the following points must be borne in mind: * Consider all incidental effects * Ignore sunk cost * Include opportunity cost * Allocation of overhead cost

Appraisal Criteria:

Once the stream of costs and benefits of an investment project is defined, the next logical question to ask is: Is the investment project worthwhile? A wide range of criteria has been suggested to judge worthwhileness of an investment project. The important investment appraisal criteria, classified as follow: APPRAISAL TECHNIQUES Appraisal Criteria

Non – Discounting Factor Criteria (NDCF)

Pay Back Period (PBP)

Accounting Rate of Return (ARR)

Discounting Factor Criteria (DCF)

Net Present Value (NPV)

Internal Rate of Return (IRR)

Cost Benefit Ratio (CBR)

A. Non - Discounted Cash Flow (NDCF) This method of investment appraisal does not take into consideration interest rate and Time that is time value of money.

1. Payback Period (PBP) The payback period is the length of time required to recover the initial cash outlay on the project. 0 year 1st year 2nd year 3rd 4th year year Income (500) 150 200 350 400 Operating Costs

0

50

50

50

50

Net income Flow

(500)

100

150

300

350

Accumulated income

(500)

(400)

(250)

50

400

2. Average Rate of Return (ARR) The average rate of return, also called the accounting rate of return is defined as a method that measures the net return each year as a percentage of the initial cost of the investment. ARR =Net Return (profit) per annum / Capital outlay X 100

Project “X”

Project “Y”

Project “Z”

Return year 1

10,000

10,000

20,000

Return year 2

10,000

10,000

20,000

Return year 3

15,000

10,000

30,000

Return year 4

15,000

15,000

30,000

Return year 5

20,000

15,000

30,000

Total Return

70,000

60,000

130,000

Total Net Return

20,000

20,000

40,000

4000

4000

8000

8%

10%

8.9%

Cost

(Capital outlay)

Net profit / annum ) 5

(50,000)

(40,000(

(90,000)

years)

Average Rate of Return

B. Discounted Cash Flow (DCF) This method of investment appraisal has certain advantages, it deals with the problems of interest rate and time, that is time value of money which is ignored under Non- discounted factor appraisal technique. Discounted cash flow takes into account that interest rates affect the present value of future income. It shows that the future cash flow is discounted by the rate of interest. The return on an investment project is always in the future, usually over a period of several years. Money earned or paid in the future is worth less today. Present Value = A / (1+r (ⁿ Where: A = Amount of Money R = Rate of interest n = Number of years

Net Present Value (NPV): The Net Present Value (NPV) of a project is equal to the sum of the present value of all the cash flows associated with the project. Symbolically:

NPV = CF0 / (1+k)ⁿ + CF1 / (1+k)ⁿ + CF2 / (1+k)ⁿ + CFn / (1+k)ⁿ +……

Where: NPV = Net Present Value CF = Cash flow occurring at the end of year “ n ” (0, 1, 2, 3, …. n) n = Life of the project K = Discounted rate

0

1

2

3

4

5

(10,000,00 0)

2,000,000

2,000,000

5,000,000

6,000,00 0

6,500,000

0%

10%

10%

10%

10%

10%

1

0.9

0.81

0.729

0.656

0.591

Discounted Cash Flow

(10,000,00 0)

1,800,000

1,620,000

3,645,000

3,936,00 0

3,841,500

Accumulated Discounted Cash Flow

(10,000,000 )

(8,200,000 )

(6,580,000 )

(2,935,000)

100,1000

4,842,500

Year Cash flow Discount Rate (10%) Discounted Factor

NPV = Total present value – Initial outlay A project with the higher NPV value will be chosen as a selected project.

Internal Rate of Return: The internal Rate of Return of a project is the discount rate at which makes its net present value equal to zero. 0=CF0

/ (1+r)0 +

CF1

/ (1+r)1 +

CF2

/ (1+r)2 +………+

CF n

/ (1+r)n

CF = Cash Flow at the end of year r = Discount Rate n = Life of the Project

In the Net Present Value (NPV) calculation we assume that the discount rate (Cost of Capital) is known and we determine the Net Present Value of the project. In the Internal Rate of Return (IRR) calculation, we set the net present value equal to “ZERO” and determine the discount rate (Internal Rate of Return) which satisfies this condition.

To illustrate the calculation of internal rate of return, consider the cash flows of a project: Year

0

1

2

3

4

Cash Flow

(100,000 )

30,000

30,000

40,000

45,000

The internal rate of return is the value of “ r ” which satisfies the following equation: 100,000 = 30,000/ (1+r)1 + 30,000/ (1+r)2 + 40,000/ (1+r)3 + 45,000/ (1+r)

4

The calculation of “ r ” involves a process of trial and error. We try different values of “ r ” till we find that right –hand side of the above equation is equal to 100,000. Let us, to begin with, r=15%. This makes the right-hand side equal to:

30,000 / (1.15) (1.15)4

+ 30,000 / (1.15)1 + 30,000 / (1.15)2 + 30,000 / (1.15)3 + 30,000 /

=100,802

30,000 / (1.16) (1.16)4

+ 30,000 / (1.16)1 + 30,000 / (1.16)2 + 30,000 / (1.16)3 + 30,000 /

=98,641

Since 98,641 is now less than 100,000, we conclude that the value of “ r ” lies between 15% and 16% and for most of the purposes this approximation suffices.

Benefit – Cost Ratio (BCR): There are two ways of defining the relationship between benefits and costs: Benefit - Cost Ratio : BCR = PVB / I Net Benefit – Cost Ratio: NBCR = PVB – 1 / I Where: PVB = Present Value of Benefits I = Initial Investment Rule is: When BCR >1 =1 <1

Or NBCR >0 =0 <0

Rule is Accept Indifferent Reject

To illustrate the calculation of these measure, let us consider a project which is being evaluated by a firm that has a cost of capital of 12%.

Year

Initial investme nt Benefits

1

2

3

4

(100,000)

0

0

0

25,000

40,000

40,000

50,000

The benefit cost ratio measures for this project are: 25,000/ (1.12) + 40,000 / (1.12)1 + 40,000 / (1.12)2 + 40,000 / (1.12)3 + 40,000 / (1.12)4

BCR = 100,000

BCR = 1.145 NBCR = BCR – 1 =1.145 – 1 = 0.45

Accept Accept