The budgeting process

1
The budgeting process

• The traditional goals of the planning and control
  process are
• - to identify the economic goals and how to
  achieve them
• - to measure if the goals have been achieved
• - to determine the variance causes between the
  actual values and planned valued
• - to introduce the necessary correction measures
  
• Two basic steps are analyzed in the next lessons
• - the budgeting process or operative planning
• - the variance analysis.

2
The budgeting process

• The budgeting is included in the more general
  strategic planning process which is composed of
  the following phases
• - identification of the companys objectives
  in terms of product/market segments, strategy and
  expected development/growing
• - strategic planning, with the definition of
  the long-term plans necessary to achieve the
  objectives (new products introduction, existing
  products modify, efficiency or flexibility
  increasing)
• - budgeting which determines the short-term
  actions to realize the long-term plans the
  activity budgeting receives the input of the
  long-term strategic planning. From an
  organizational point of view the coherence
  between the three phases requires that in the
  definition of goals and in the strategic planning
  are involved all responsibility centers

3
The budgeting goals

• The final goal of the budgeting phase is the
  drawing up of the MASTER BUDGET, document which
  allows to prepare the expected Balance sheet
  (Expected Profit/Loss and Expected Assets and
  Liabilities Statement)
• The Master budget is composed by
• - the operative budgets related to the
  short-term planning of the operative management
• - the annual investment budget related to the
  new investment in tangible/intangible resources
  necessary to achieve the strategic goals
• - the financial budgets to evaluate the impact on
  the net cash flow due to the operative budgets
  and investment budget
• It can be very complex to draw up a budget which
  is consistent with the strategic planning and to
  achieve a coherence between the plans which
  compose the master budget. Very often a
  negotiation process is necessary (e.g. a
  growing of the market share through the prices
  reduction can not be consistent with the expected
  return on investment investments in Research and
  Development can not be consistent with the
  established dividend distribution selling
  choices are not consistent with production
  capacity)

4
The operative budgets

• Sales budget
• Production budget
• Cost of goods sold (purchases, variable and fixed
  conversion costs)
• Period costs budget (commercial costs, general
  and administrative costs, discretional costs)

5
Sales budget

• Its the first budget which is the base for the
  preparation of the other operative budgets and
  the financial budget
• Its drawing up by the Marketing Sales function
  with the support of the Planning and Control
  Staff Unit
• Monthly or yearly the sales budget defines the
  expected revenues in terms of volumes and prices.
  Values can be grouped by customer or geographic
  area
• Sales budgets are based on the market evolution
  forecasting, on the competitive strategy, on the
  historical growing of sales

6
Sales budget graphic

7
Production budget (and ending inventory budget)

• After identifying the sales, the
  opening/beginning inventory and the expected
  closing/ending inventory in quantity, it is
  possible to define the expected production
  quantity for each product in each relevant period
  (e.g. month)
• PiVi (EI - BI)
• Its necessary to verify the feasibility of the
  production budget. In other words for each
  resource must be
• ? Pitij ltTj for i1,N
• tij is the quantity of the resourse j required by
  product i unit
• Tj is the total quantity of the resource j that
  is available (e.g. machine hours, labor hours)
  

8
Production budget non feasibility actions

• Reviewing sales policy, for example increasing
  the price and reducing the quantity
• Reviewing the inventory policy, for example
  decreasing the expected level of ending inventory
• Modifying the production capacity through new
  investment (long-term action)
• Purchasing a share of production by the market
  (outsourcing)

9
Cost of goods sold

• After identifying a feasible production plan, the
  amount of resources necessary to achieve the
  production plan must be defined
• The Process Engineering Function and the Purchase
  Function defines the standard quantity and the
  standard price of the raw materials, direct
  labor, any other resourced to be used to realize
  the expected production level
• Consequently the following budget can be
  determined consumption for the production
• - Direct Material budget or consumption of raw
  material for the production plan that could be
  different with respect to Budget of purchases
  consumption of raw material desired EI BI of
  raw material
• - Direct Labor budget, or consumption of labor
  for the production plan
• - Other Conversion costs (ex. Energy,
  amortization) budget
• External working budget (if any)
• BUT TO DEFINE OPERATING INCOME (P/L) ITS
  RELEVANT THE COST OF GOODS SOLD (COMPETENCE
  PRINCIPLE)

10
Cost of goods sold

• On the full or variable production cost base its
  possible to determine the inventory value - raw
  materials, finished goods - (previously it had
  been determined the quantity) and then the cost
  of goods sold as
• Cost of goods sold (variable or full) raw mat
  consumption conversion costs BI - EI
  (finished goods)
• Cost of goods sold (variable or full) purchases
  conversion costs BI - EI (raw material and
  finished goods)
• What type of costs can be included in the
  inventory evaluation?
• Production costs as
• Variable approach raw material, energy, labor if
  variable according to production level, usually
  NO selling, administrative and financial costs.
  Selling costs are included in the variable costs,
  but as period costs.
• Full approach raw material, energy, labor,
  amortization (overhead)
• All production costs, variable and fixed.
• Anyway, we need to calculate the production cost
  per unit, and then well apply to inventory

11
Cost of goods sold

• TWO profit and loss budgeted statements are
  linked to these different approaches
• Contribution margin Sales- Variable costs
  (production and selling)
• -Fixed costs (production and selling)
• Net Operating margin (income)
• Note variable COGS can include also selling
  costs, but inventory evaluation does not because
  they are period costs. Inventory evaluation
  includes only variable production costs.
• 2. Gross (industrial) margin Sales Full COGS
• Selling administrative costs (period costs)
• Net Operating margin (income)
• Note Full COGS includes only production costs,
  all included in inventory evaluation

12
Cost of goods sold
IF EI gt BI WE POSTPONE/DEFER COSTS AND COGS lt
PRODUCTION SALES lt PRODUCTION IF EI lt BI WE
UPLOAD COSTS TO THE PERIOD AND COGS gt PROD SALES
gt PRODUCTION VITALE CASE TO UNDERSTAND THE COGS
(FULL) IRON (I PART) TO UNDERSTAND THE
IMPLICATIONS ON NET OPERATING INCOME DERIVED BY
USING VARIABLE OR FULL APPROACH

13
Cost of goods sold graphics
Direct Material Budget

Conversion cost Budget
14
Period costs budget two possible approaches

• Costs related to Discretional and support
  activities such as General Administrative costs,
  Selling costs, Research and Development costs
• Two possible approaches
• - Incremental approach
• - Zero based budget approach
• According to the incremental approach the budget
  is determined multiplying the past actual values
  (of the previous year) by a coefficient based on
  the inflation rate and the expansion of activity
  company level. This approach has two limits
• - assumes a linear relation between the activity
  level and the period costs (it can be wrong for
  the period costs incurred una tantum)
• - derives the budget values from the past year
  actual values and consequently causes an
  amplification of inefficiencies

15
Period costs budget two possible approaches

• According to the zero based budget approach each
  year the amount of period costs is re-defined
• The period costs budget is independent from the
  past but this approach is more complex and
  requires the strong commitment of the
  responsibility centers and Planning Control
  Staff
• Usually, an incremental approach is used each
  year and a zero based budget is used each 3/4
  year

16
Variance analysis

• The goal of this analysis is the explanations of
  the difference incurred between the actual
  costs/revenues and the expected costs/revenues
• The analysis is different according to the type
  of the organizational unit
• - cost center (responsible on the use of
  resources to achieve the output)
• - revenue center (responsible on the revenue)
• - expense center (e.g. administrative unit) for
  these centers there is only a total budget
  control without searching in detail the variance
  causes

17
Variance analysis revenue centers

• Sales are the relevant entities for
  responsibility related to these units
• Sales ? PiVQvi i 1,..N
• Pisale price of product i
• V total sales in quantity for all products
• Qvi of the sales in quantity for product i
  (sales MIX)
• to understand the causes of difference between
  actual and expected sales 4 entities must be
  compared.
• - budget (standard conditions)
• - flexible budget with standard mix
• - flexible budget with actual mix
• - actual

18
Variance analysis revenue centers

• Flexible budget standard mix - Budget variance
  of volume
• Flexible budget actual mix - Flexible budget
  standard mix variance of mix
• Actual - Flexible budget actual mix variance of
  price
• EXERCISE

19
Variance analysis cost centers
There are two different levels of analysis 1
level

Actual - Flexible budget variance of efficiency
(internal cause) Flexible budget - Budget
variance of volume (external cause) NOTES
Flexible budget has an actual production level
but a standard consumption of resource (standard
efficiency)
20
Variance analysis cost centers

• 2 level
• for the direct variable costs (Direct material
  and Direct labor) is possible to have a higher
  detail as concerns the variance of efficiency
• - 2a) variance of price (basically external,
  responsible Purchases Unit)
• - 2b) variance of employment (basically internal,
  responsible Production Unit)
• Between the Flexible Budget and the Actual is
  necessary to to introduce also the Flexible
  Budget with ACTUAL consumption
• Actual - Flexible Budget is the total variance
  of efficiency that is composed by
• 2a) Actual -Flexible Budget with actual
  consumption variance of price
• qVp - qVpst (p -pst)qV
• q actual quantity of resource j for unit of
  production
• 2b) Flexible Budget with actual consumption -
  Flexible Budget with standard consumption
  variance of employment
• pstqV - pstqstV (q -qst)pstV
• EXERCISE