Section A - Planning, Budgeting and Forecasting Planning, Budgeting and Forecasting represents 30% of the CMA Part 1 exam. Part 1 is a four hour exam that will contain 100 multiple-choice questions and 2 essay questions. Topics within an examination part and the subject areas within topics may be combined in individual questions. Therefore, we cannot predict how many multiple choice questions you may get from this section, nor can we predict whether you will get any essay questions from this section. The best approach to preparing for this exam is to know and understand the concepts well and be ready for anything. This section focuses on the budgeting process in a business and its inseparable connection with the planning process. Exam questions may address the theories and process of planning and budgeting as well as the different types of planning and budgeting. Top-level planning and the use of pro forma financial statements in the planning process are important topics. Numerical questions may relate to how much should be budgeted or expected during a period. Questions may also involve a more detailed calculation of the expected cash balance at some period in time, or the cash inflows or outflows during a period. The scope of the numerical questions in planning and budgeting is large, requiring the ability to apply principles and ideas to different situations. The topics of strategic and other types of planning are not specifically included in the Learning Outcome Statements for this exam. However, we have included a brief discussion of planning here because of its foundational importance in budgeting. You need to understand the benefits of planning, the goals of planning and the general steps in the planning process. Additionally, you should be familiar with the different types of planning that a business does. In the area of budgeting, you must understand the budget process and the order in which the different budgets are prepared. You also must be able to make different budgeting calculations. These calculations are not necessarily intuitive when you begin your study process, but after doing some questions and memorizing the required formulas, this should become an area where you will feel very comfortable. Forecasting techniques, learning curves and other quantitative analysis tools are included because of their usefulness in planning and budgeting. Another topic in this section, top-level planning and analysis, deals with pro forma financial statements and their use in strategic planning. 3 Planning and Budgeting Concepts CMA Part 1 Planning and Budgeting Concepts We are all familiar with budgets in at least an informal manner. We often see them at work or are impacted by them when something cant be done because it is not in the budget. The budget is developed in advance of the period that it covers, and it is based on forecasts and assumptions. But the budget is not something that is primarily for the purpose of restricting what can be done. It is intended as a planning tool and a guideline to follow in order to achieve the companys planned goals and objectives. The budgeting process is inseparably linked to the planning process in an organization. Major planning decisions by management are required before the budget can be developed for the coming period. Furthermore, the development of the budget may cause previously developed short-term plans by management to require adjustment. As the projected quantitative results of the plans become clear in the developing budget, management may need to revise its plans. And after the plans and the budget have been adopted, as the period unfolds, the budget provides control and feedback. In this section we will look at the different types of planning and budgets and how the planning and budgeting process within a company works. We will also examine the reports that come about as a result of the budget along with the different types of budgets that may be prepared. Planning in Order to Achieve Superior Performance All business endeavors must have objectives and goals. For most companies, if not all, the ultimate objective is to achieve superior performance in comparison with the performance of their competitors. When superior performance is achieved, company profitability will increase. When profits are growing, shareholder value will grow. A publicly-owned for-profit company must have maximizing shareholder value as its ultimate goal. The shareholders are the owners. They have provided risk capital with the expectation that the managers will pursue strategies that will give them a good return on their investment. Thus, managers have an obligation to invest company profits in such a way that shareholder value will be maximized. Shareholders want to see profitable growth: high profitability and also sustainable profit growth. A company with profits but whose profits are not growing will be not be valued as highly by shareholders as a company with profitability and profit growth. Attaining and maintaining both profitability and profit growth is one of the greatest challenges facing managers. The Role of Management in Attaining Profitable Growth There are two opposing philosophies with respect to the role of management. • The market theory gives management a passive role and views its function basically as making reactive decisions to respond to environmental events as they occur. • The planning and control theory views the role of management as an active one that emphasizes the planning function of management and its ability to control the activities of the business. Most companies managements operate somewhere between these two extremes. At times, events will occur that are outside the control of management and may even be important enough to determine the firms destiny. But in almost all of these situations, when noncontrollable variables become dominant, a competent management can manipulate the situation to move the company to environments where the variables are controllable again. When management operates more closely to the planning and control theory, it has more ability to reduce the randomness of events and to deal productively with those that do occur. 4 Section A Planning and Budgeting Concepts The External Environment in Planning and Budgeting Planning does not occur in a vacuum. A business must interact with its external environment, and this environment includes influences that will impact the plans that management makes. These external events will impact not only the companys plans but also its budget. Although past financial results and information may be used in developing the budget for the next period, the budget is still a documented expression of what the company would like to accomplish financially in future periods. For instance, sales in the current year-to-date may have been impacted by the economy or an internal situation that has changed. The past is not a predictor of the future, and the plan and the resulting budget should reflect the conditions anticipated for the coming period, not the conditions that existed in the past period or periods. Three interrelated environments affect managements planning and budgeting : • The industry in which the company operates, • The country or the national environment in which the company operates, • And the wider macroenvironment in which the company operates. An industry analysis involves assessing the companys industry as a whole, the companys competitive position in the industry, and the competitive positions of its major rivals. The nature of the industry, the stage the industry is in, the dynamics and the history are all part of this analysis. For example, the industry the company operates in may be highly competitive, or it may be less competitive. The amount of competition the company faces will impact the prices it can charge, the marketing effort needed, research and development needs, and so forth. Likewise, if the industry is growing, the company can expect and plan to benefit from that growth; or, if the industry is in a decline, the company should plan how it needs to respond to that. Analyzing the national and international environment includes assessing domestic as well as international political risk and the impact of globalization on competition within the industry. International political risks include the obvious risks of government expropriation (government seizure of private property with some minimal compensation offered which is generally not an adequate amount); and war (which can affect employee safety and create additional costs to ensure employees safety)_ The macroenvironment includes macroeconomic factors that will effect the entire industry or economy as a whole. The most important macroeconomic factors in planning and budgeting are (1) the growth rate of the economy, (2) interest rates, (3) currency exchange rates, and (4) inflation or deflation rates. • Economic growth leads to more consumer spending and gives companies the opportunity to ex pand their operations and increase their profits. Economic recession leads to a reduction in consumer spending and, in a mature industry, may cause price wars. Both will affect demand and thus sales revenue and net income in the future. • The level of interest rates can affect a companys sales and net income if the company is in an industry where demand is affected by interest rates, such as the housing market or the manufacture of capital goods. Rising interest rates will cause demand to decrease, while falling interest rates will cause demand to increase. Interest rates also affect any companys cost of capital and thus its ability to raise capital and invest. • Changes in currency exchange rates affect the competitiveness of companies in international trade. A declining U.S. dollar creates opportunities for increased international sales while at the same time, it decreases foreign competition. An increasing U.S. dollar causes the oppOSite condition. • Both Inflation and deflation cause businesses to be less willing to make investments in new projects. When inflation increases, it is difficult to plan on what the real return will be from an in vestment. Deflation also causes a lack of stability in the economy, because when prices are deflating, companies with a high level of debt and the obligation to make regular fixed payments on the debt can find themselves unable to service that debt. So those companies will be reluctant to commit to new investment projects. 5 Planning and Budgeting Concepts CMA Part 1 The macroenvironment also includes social factors such as environmental issues and government, legal, international and technological factors that affect the industry and the company. A couple of the many possible examples are: • The extent to which environmental protection laws are enforced by the Environmental Protection Agency or new ones passed by Congress depends to a great degree upon the position of the adminis tration in charge at any given time, since the President of the United States appoints the head of the EPA. • Current or future anticipated tax credits can affect an entire industry by creating demand. A present example is tax credits for installation of solar electricity-generating panels. Companies affected will include firms that manufacture the materials used by solar panel manufacturers, the manufacturers of the solar panels, and the companies that install them. Setting Objectives and Goals One of the most basic and important outcomes of the planning process is the development of the companys objectives and goals. The identification of the companys objectives is the first step in the planning process. Even if the plan relates to a small business project, all of the project participants must be aware of and understand what is supposed to be accomplished by this project - the goal of the project - before it can be developed. Unfortunately, a company may have a number of different objectives, and in a worst-case scenario, some of these may be contradictory to each other. It is up to management to prioritize the companys objectives and then communicate these priorities to the people within the organization. Without the communication of the plan and its objectives, planning is a useless process for the company. The objectives that are developed must be clearly stated in specific terms. This prevents interpretation of the objectives by employees. Additionally, objectives must be communicated to all individuals that they will impact. A formal way of communicating the organizations objectives is through its mission statement. In many companies the mission statement is very prominently displayed and constitutes a large part of the corporate culture. In any case, the goals and objectives of the company, department or project need to be communicated to the people impacted by them. Finally, for any objective to be effective, individuals within the organization must accept the objectives. Though it is not possible for everyone In the organization to agree with every objective, it is essential that the objectives are clearly understood and communicated, allowing people to address whatever concerns they have about the goals. However, after this is done, all of the employees need to work toward the goals of the company. A goal is similar to an objective, but different in that goals are developed and implemented at the unit or department level while objectives are at the organizational, or enterprise, level. In a sense it is through the accomplishment of the goals of the division that the objectives of the organization are met. Planning is the process that enables a company to achieve its goals and objectives. As stated before, a company may have many objectives throughout the organization. It is the responsibility of management to make sure that all of the smaller goals and objectives work toward the ultimate achievement of the companys main objectives. Management must make certain that this harmonization of goals is done as efficiently and effectively as possible. Note: Because people in each department are most closely connected with the goals of their own department, there is the risk that the employees will develop tunnel vision. Tunnel vision occurs when employees become so concerned with their own goals, they fail to notice or care about the larger objectives of the company. If in doing your job you prevent others from doing their jobs, the company not only does not benefit, but it can actually be hurt. 6 Section A Planning and Budgeting Concepts Two terms that are related to the accomplishments of goals and objectives are efficiency and effectiveness. Efficiency is the attempt to fulfill the objectives of the company while using the least amount of inputs. On the other hand, effectiveness has to do with the actual accomplishment of goals. Though both of these are important, in reality it is obvious that effectiveness is of ultimate importance. If a company is efficient but does not accomplish what is needed, then the efforts and resources used were wasted. When the objectives of one level of the company dovetail (are in agreement with each other) with the objectives of the next highest level, the company has achieved a means-end relationship. This results when the achievement of the objectives of one level enables the next highest level to achieve its objectives as well. Note: No matter how important planning is to an organization or how developed its methodology, the planning process will never replace the control process. Both are necessary. Question 1: Which of the following is not a significant reason for planning in an organization? a) Promoting coordination among operating units. b) Forcing managers to consider expected future trends and conditions. c) Developing a basis for controlling operations. d) Monitoring of profitable operations. (CMA Adapted) Types of Plans and General Principles In order for plans to be as effective as possible, they must be coordinated among the different units and departments in the company so that they are in alignment with the larger goals of the company. If this is not the case, different parts of the company may be working at cross-purposes and the company will not move in a positive direction. Strategic Plans (Long-Term Plans) Planning is done initially on a long-term basis, called strategiC planning. StrategiC plans are broad, general, long-term plans (usually five years or longer) and are based on the objectives of the organization. StrategiC planning is done by the companys top management. This type of planning is neither detailed nor focused on speCific financial targets, but instead looks at the strategies, objectives and goals ofthe company by examining both the internal and external factors affecting the company. Internal factors include current facilities, current products and market share, corporate goals and objectives, long-term targets, technology investment, and anything else in the direct control of the company itself. As already mentioned, external factors also need to be taken into account in strategiC planning. Some of the external factors are the economy, labor market, domestic and international competition, environmental issues, technological developments, developing new markets, and political risk in other countries (or the home country). This process of reviewing the long-term objectives and economic environment of the firm (both internally and externally) will enable the company to identify any threats, opportunities or limitations that it faces. By identifying threats and limitations early, the company will be better prepared to prevent them from occurring or to limit their effect. By identifying opportunities early, the company is in a better position to act appropriately and capitalize on these situations. 7 Planning and Budgeting Concepts CMA Part 1 Part of this strategic plan will be a review of the capacity and the capital resources of the company. Though these two items are related, they will be looked at separately. Capacity is the ability of the company to produce its products or services. Capital resources are the companys fixed assets. Capacity may exceed capital resources if the company has arranged to use another companys resources to produce its product or is using facilities temporarily. In the long term, the company will need to make certain that its capacity will be able to meet the expected demand and also decide how to obtain this capacity. The firm may either purchase or lease the necessary fixed assets, but a plan is required to determine how the company will obtain the necessary financing for whatever option it chooses (this is the process of Capital Budgeting). By taking all of this information into account, the company is in a position to make long-term business plans. These plans may be related to dropping or adding product lines or specific products, making long-term capital investments in increasing capacity or capital resources, or decreasing these. It may also generate a plan that will lead the company into a different business model altogether (for example, a shift from production of a product to servicing and supporting the product, leaving production to another company). Note: Strategic planning is directional, rather than operational. This means the company focuses on where it wants to go instead of specifically how it will get there. Intermediate and Short-Term Plans The strategiC plan is then broken down into intermediate or tactical plans (one to five years), which are designed to implement specific parts of the strategic plan. Tactical plans are made by upper and middle managers. Short-term or operational plans (one week to one year) are developed from the tactical plans. Operational plans focus on implementing the tactical plans to achieve operational goals, and operational plans include budgeted amounts. It is operational plans that drive the day-to-day operations of the company. Operational plans are developed by middle and lower-level managers. The shorter the time frame, the lower the level of management that should make the plan. Thus, strategic plans are developed by top management, tactical plans are developed by upper and middle managers, and operational plans are developed by middle and lower-level managers. This means that the board of directors should not be involved in developing weekly work plans for an assembly line. All shorter-term plans need to work towards the strategiC plans of the company. If the tactical and operational plans are not working towards that goal, the company will not be able to meet the longer-term, strategiC goals that they have set. Short-term or operational plans are the primary basis of budgets. Operational plans refine the overall objectives from the strategiC and tactical plans in order to develop the programs, policies and performance expectations required to achieve the companys long-term strategic goals. Most budgets are developed for a period of one year or less. Thus, the budget formulates action steps from the organizations short-term objectives. The budget reflects the companys operating and financing plans for a specific period: a year or a quarter or a month. The budget contains the action plans to achieve the short term objectives. The one exception to this is the capital expenditures budget. The capital expenditures budget is generally developed for a long period of time and the relevant impact is incorporated into the operating and financial budgets each year. 8 Section A Planning and Budgeting Concepts Other Types of Plans Plans may also be single-purpose plans, which are developed for a specific item such as construction of a fixed asset, the development of a new product or the implementation of a new accounting system. These are also incorporated into the operating and financial budgets during the relevant years. Standing-purpose plans have relevance and use for many different items. Plans such as marketing and operation plans fall into this category. Contingency planning is planning that a company develops to prepare for possible future events (especially negative events). This is in a sense what if? planning. Preparing different plans for different situations is more expensive because it entails developing multiple plans. However, multiple plans for different situations enable the company to be better prepared for what may occur. Companies do this when they think that the cost of contingency planning will eventually lead to greater savings than the cost of the planning itself. Contingency plans are much more important for companies that are more likely to be significantly influenced by outside events. If there is no plan for a situation in which a negative event occurs, the damage will be much greater to the company because it will not be able to react quickly, and its immediate reaction may not be the correct one. A contingency plan enables companies to respond quickly and in the best possible manner. Note: Despite the benefits of having a formal plan, there are also some drawbacks to this process. A plan that is too formal can constrain creativity, or a strict dedication to the plan can cause the company to miss some opportunities that would be beneficial to them. Question 2: Certain phases of the planning process should be formalized for all of the following reasons except that: a) Informal plans and goals lack the necessary precision, understanding and consistency. b) Formal plans can act as a constraint on the decision-making freedom of managers and supervisors. c) Formalization requires the establishment and observance of deadlines for decision-making and planning. d) Formalization provides a logical basis for rational flexibility and planning. (CMA Adapted) Question 3: Strategy is a broad term that usually means the selection of overall objectives. Strategic analysis ordinarily excludes the: a) Trends that will affect the entitys markets. b) Target production mix and schedule to be maintained during the year. c) Forms of organization structure that would best serve the entity. d) Best ways to invest in research, design, production, distribution, marketing and administrative activities. (CMA Adapted) 9 Planning and Budgeting Concepts CMA Part 1 Question 4: Which one of the following management considerations is usually addressed first in strategic planning? a) Outsourcing. b) Overall objectives of the firm. c) Organization structure. d) Recent annual budgets. (CMA Adapted) Budgeting The Relationship Among Planning, Budgeting and Performance Evaluation Planning, budgeting and performance evaluation are interrelated and inseparable. Here is an overview of the process: 1) Management develops the plan, which consists of goals, objectives and a proposed plan of action for the future. The plan includes the companys short-term as well as long-term goals and objectives and its business opportunities and risks. For example, a plan may look at the future from the pers pective of expanding sales, increasing profit margin, or whatever the company sees as long-term goals. In the process of determining its plans and goals, management will look at external economic factors (the expected labor market, tax rates, health of the economy, etc.) as well as what they cur rently do well or need to fix. The plan is a guide showing where the company needs to be in the future. The budget should include performance of the company as a whole as well as the perfor mance of its individual departments or divisions. Managers at all levels need to reach an understanding of what is expected. 2) The plan developed by management leads to the formulation of the budget. The budget expresses managements plans for the future in quantitative terms. The budget also identifies the resources that will be required in order to fulfill managements goals and objectives and how they will be allo cated. 3) Budgets can lead to changes in plans and strategies. Budgets provide feedback to the planning process because they quantify the likely effects of plans that are under consideration. This feedback may then be used by managers to revise their plans and possibly their strategies as well, which will then cause revisions to the budget during the budgeting process. This back and forth exchange may go on for several iterations before the plans and the budget are adopted. 4) Once the plans and the budget have been coordinated and the budget adopted for the coming period, as the organization carries out its plans to achieve the goals it has set, the master budget is the document it relies upon as its operating plan. By budgeting how much money the company ex pects to make and spend, the company creates a series of ground rules for people within the organization to follow throughout the year. 5) Actual results are compared to the plan. The budget is a control tool. Controlling is defined as the process of measuring and evaluating actual performance of each organizational unit of an enterprise and taking corrective action when necessary to ensure accomplishment of the firms goals and objec tives. The budget functions as a control tool because it expresses what measures will be used to evaluate progress. A regular (monthly or quarterly) comparison of the actual results-both revenues and expenditures -with the budgeted results will give the companys manage ment information on whether the companys goals are being met. This comparison should include narrative explanations for variances, discussing the reasons for the differences, so that mid course corrections can be made if necessary. 1 0 Section A Planning and Budgeting Concepts 6) Sometimes, this control will result in the revision of prior plans and goals or in formulation of new plans, changes in operations and revisions to the budget. For example, if changes occur in the com panys external environment that cause variances in revenues and/or costs to become extreme, a new short-term plan and a revised budget covering the remainder of the year may be necessary in order to properly respond to the changes occurring. 7) Changed conditions during the year will be used in planning for the next period. For example, if sales decline, the company may plan changes in its product line for the next period in order to reverse the trend. The master budget is the culmination and the goal of the budgeting process. The master budget is a summarized set of budgeted financial statements, including budgeted balance sheet, budgeted income statement, and budgeted statement of cash flows. A projected financial statement is called a pro forma financial statement; however, the master budget is not called a pro forma financial statement. The term pro forma is used to refer to a forecasted financial statement prepared for a specific purpose, for example to do what if analysis in the process of planning. A company might prepare many different sets of pro forma financial statements for the same period in its planning process. A pro forma financial statement is not used for formal variance reporting as the master budget and the flexible budget are, although if an action that was forecasted is implemented, the company would probably want to compare the actual results with the forecasted, pro forma, ones. But pro forma financial statements are not a part of the formal budgeting process. They are used for planning and decision making purposes, and the amounts in them may be quite different from the amounts in the master budget. Planning and the use of pro forma financial statements is discussed more in the topic of Top-Level Planning and Analysis in this section. The master budget is prepared for just one activity level, and the activity level used is whatever it is projected to be before the period begins. When flexible budgeting is used, the flexible budget is also prepared for just one activity level, but that activity level is the actual activity level achieved during the period. Therefore, the flexible budget amounts cannot be finalized for a reporting period (usually a month at a time) until the period is past and the actual achieved activity level for that period is known. The master budget and the flexible budget will be discussed in detail in the section on Budget Methodologies. The master budget is created using both non-financial and financial assumptions, which come about as a result of the planning process. For instance, companies develop budgets for the number of units of each product that they expect to manufacture and sell, the number of employees they will need, and so forth. The master budget is a result of both operating and financing decisions. Operating decisions are concerned with the best use of the companys limited resources. Financing decisions are concerned with obtaining the funds to acquire the resources the company needs. A budget that is broken down according to departmental lines will provide more feedback and function as more of a control tool than one that is not departmentalized, because each department manager will be responsible for meeting his or her departments budget. Ideally, each department manager will also have been responsible for developing his or her departments budget. These underlying budgets are used in developing the master budget. The master budget is the consolidation of all the departmental budgets. It comprises operating budgets and financial budgets. Operating budgets are used to identify the resources that will be needed to carry out the planned activities during the budget period, such as sales, services, production, purchasing, marketing, and R & D. The operating budgets for individual units are compiled into the budgeted income statement. Financial budgets identify the sources and uses of funds for the budgeted operations. Financial budgets include the cash budget, budgeted statement of cash flows, budgeted balance sheet, and the capital expenditures budget. 1 1 Planning and Budgeting Concepts CMA Part 1 Advantages of Budgets When properly developed and administered, budgets • Promote coordination and communication among organization units and activities, • Provide a framework for measuring performance, • Provide motivation for managers and employees to achieve the companys plans, • Promotes the efficient allocation of organizational resources, • Provide a means for controlling operations, and • Provide a means to check on progress toward the organizations objectives. Coordination and Communication Coordination means balancing the activities of all the individual units of the company in the best way so that the company will meet its goals and the individual units of the company will meet their goals. For example, when the sales manager shares sales projections with the production manager, the production manager can plan and budget to have the needed inventory ready to sell. And the sales manager can make better forecasts of future sales by coordinating and communicating with branch managers, who may be closer to the customers and know what they want. Measuring Performance Budgets make it possible for managers to measure actual performance against planned performance. The current years budget is a better benchmark to measure current performance against than is last years results. Last years results may have been negatively impacted by poor performance and the causes have now been corrected. Using last years results would set the bar too low. Furthermore, the past is never a good predictor of the future, and the budget should reflect the conditions anticipated for the coming period, not the conditions that existed in the past period or periods. Performance should not be compared only against a budget, though, because that can result in lower level managers setting budgets that are too easy to achieve. It is also important to measure performance relative to the performance of the industry and even relative to prior years performance. Motivating Managers and Employees Challenging budgets improve employee performance, because no one wants to fail, and falling short of the budgeted numbers is perceived as failure. Goals should be demanding but achievable. If they are so high that they are impossible to achieve, however, they are de-motivating. Efficient Allocation of Organizational Resources The process of developing the operating budgets for the individual units in the organization includes identifying the resources that each unit will need to carry out the planned activities. For example, the process of developing the production budget requires projections for direct materials and direct labor that will be required to produce the planned output. The process of budgeting for administrative salaries requires forecasts of administrative employees that will be needed by each department. If funds will be available for only a certain number of administrative employees in the organization, some units projections may have to be adjusted. This leads to efficient allocation of organizational resources. 12 Section A Planning and Budgeting Concepts Characteristics of Successful Budgeting There are a number of characteristics involved in successful budgeting, and some of these we have already mentioned. 1) The budget must start with the companys short- and long-term plans. Without input from planning, the budget will usually just recreate the previous years results with minor changes, mak ing it useless as a planning tool. 2) The budget must have the support of management at all levels. The support of top management is critical to gain the support of lower-level managers, and the support of lower-level managers is critical in order to gain the support of the affected employees. 3) The people who are charged with carrying out the budget need to feel ownership of the budget. That means they need to have input into the budgets development rather than having the budget imposed upon them. 4) The budget should be a motivating device. It should help the people in the organization to work toward the organizations goals for the improvement of the company. The budget is more likely to be successful if everyone concerned, from managers to their employees, sees the budget as a tool to help them do a better job, and not as a rigid taskmaster or as a tool for top management to use to assess blame. S) The firms management should assess the future as it pertains to the firms strategic goals and use the budgeting process to minimize the adverse effects that anticipated problems may have on operations. 6) A budget should be flexible. If conditions change during the budget period, the budget should not be used as an excuse for not doing something that is strategically important to the company, such as acting on an unforeseen business opportunity that arises. Or, if an unplanned large maintenance ex pense is needed, the budget should not require a manager to postpone repairs if doing so will hurt the company in the long run. The expression, Its not in the budget should not be used. In situa tions like these, the budget should be able to be changed. 7) To be useful, the budget should be an accurate representation of what is expected to occur. A budget with inaccurate numbers will not have the confidence of the people who are affected by it and will be useless. The accuracy of the budget can be affected by the means used to reward managers. If managers are rewarded according to how far above the budget their revenues are and/or how far below the budget their expenses are, they may be motivated to build budgetary slack into their budgets (budgeting revenues low and expenses high), resulting in an inaccurate budget. It may be more beneficial to reward managers based on how accurate their forecasts have been when com pared with actual results. 8) A budget should be coordinated, and operating activities of diverse business units should be syn chronized. For example, the sales manager will want to make as many sales as possible, whereas the credit manager will want to limit bad debt write-offs. A coordinated effort to establish credit stan dards that both managers can support should be incorporated into the budgeting process. 9) Budgeting should not be rigid. If revenue decreases are anticipated for the coming year, an across the board cost reduction applied to all areas can create additional problems. 10) The time period for a budget should reflect the purpose of the budget. If a new product is under consideration and the purpose is to budget for the total profitability of the product, the capital budgeting period should include the design, manufacturing, sales and after-sales support for the ex pected life of the product. 13 Planning and Budgeting Concepts CMA Part 1 Time Frames for Budgets A budget is generally prepared for a set period of time, commonly for one year, and the annual budget is subdivided into months or possibly quarters. Usually a budget is developed for the same time period as is covered by a companys fiscal year. When the budget period is the same as the fiscal year, budget preparation is easier and comparisons between actual results and budgeted results are facilitated. (This comparison is called a variance report.) Budgets can also be prepared on a continuous basis. At all times, the budget covers a set number of months, quarters or years into the future. Each month or quarter, the month or quarter just completed is dropped and a new month or quarters budget is added on to the end of the budget. At the same time, the other periods in the budget can be revised to reflect any new information that has become available. Thus, the budget is continuously being updated and always covers the same amount of time in the future. This is called a rolling budget or a continuous budget. When continuous budgeting is used, budgeting and planning are always being done. Advantages are: • Budgets are no longer done just once a year. • A budget for the next full period (usually 12 months) is always in place. • The budget is more likely to be up-to-date, since the addition of a new quarter or month will often lead to revisions in the existing budget. • Managers are more likely to pay attention to budgeted operations for the full budget period. Firms usually have longer-term budgets, as well. Budgets for the years beyond the coming year usually contain only essential operating data, though, and do not attempt to present a full operating and financial budget. But having a long-term budget along with the coming years master budget enables management to quantify the effect of its strategic plans on future short-term operations. Who Should Participate in the Budgeting Process All levels of management need to participate in the budgeting process. Management at all levels of the company need to understand and support the budget. For this reason, budgeting needs to be both bottom up and top down. Lower-level managers need to be involved, and this is the bottom up part. • Their knowledge is more specialized and they have the hands-on experience of running the business on a day-to-day basis. • Their participation will make them more committed and more accountable for meeting the budget. Top management support is essential, and this is the top down part. • The support oftop management is needed in order to obtain successful development and administra tion of the budget • Top management support is necessary in order to gain lower-level management participation. If lower level managers feel that top management does not support the effort, they are not likely to support it either. 14 Section A Planning and Budgeting Concepts The Budget Development Process We will discuss specific budgets and their development later. However, the process for developing each budget is the same. 1) Budget guidelines are set and communicated. This may be done by a budget committee or by senior management. The initial budget guidelines govern the preparation of the budget. Information considered in the development of the budget guidelines includes the general outlook for the economy and the markets the company serves, strategic objectives and long-term plans, expected operating result for the current period (since a budget for the coming period is developed toward the end of the current period but not after the current period has been completed), specific corporate decisions for the coming period such as corporate downsizing, response to environmental requirements, and short-term objectives. 2) Initial budget proposals are prepared by responsibility centers. Each responsibility center manager prepares an initial budget proposal, using the budget guidelines as well as their own know ledge about their own area, such as introduction of new products or changes to be made in product design or manufacturing processes. 3) Negotiation, review and approval. The responsibility center managers submit their initial budget proposals to the next level up for review. The initial proposals are reviewed for their adherence to the budget guidelines and to determine whether the budget goals are reasonable and in line with the goals of the next higher unit and with those of other budget units. Any changes that are needed are negotiated between the responsibility center managers and their superiors. The budgets go through successive levels of management and at each point may be re-negotiated. These negotiations are the most important part of the budget preparation process and also the most time-consuming part. Eventually, all of the individual unit budgets are combined into a consolidated master budget (first draft). That consolidated master budget is reviewed at the topmost level to determine whether it meets the requirements without being unachievable, and negotiations begin again for revisions. Fi nally, when the consolidated master budget meets the approval of the budget committee or senior management, the CEO approves the entire budget and submits it to the board of directors for final approval. 4) Revisions. Even after the budget has finally been adopted, it should be able to be changed if the assumptions upon which it was built change significantly. New information about internal or external factors may make revision of the budget necessary. In addition, periodic review of the approved budget for possible changes or use of a continuous budget which is continually being updated might be advisable. Although updating the budget provides better operating guidelines, too-frequent and too-easy budget revisions might encourage responsibility centers to not take the budgeting process seriously enough. Therefore, the budget should be revised only when circumstances have changed significantly and the changes are beyond the control of the responsibility center manager or the or ganization. 5) Reporting on variances. A budget is meaningless unless actual results are compared to the planned results for the same period. The budget needs to be used to monitor and control operations to meet the companys strategic objectives. The comparison between actual and plan is called va riance reporting, and it should take place at every budget unit level. Responsibility center managers should report on variances within their responsibility centers at the end of each reporting period (monthly or quarterly) to their superiors, who then compile the reports they receive into a variance report that is sent to the next level up, and so on. Variance reporting should include not only the amounts of the variances but also the causes of the variances that can be identified. 6) Use of the variance reports. The variance reports should be used at every level to identify prob lem areas and to make adjustments to operations, if necessary. For example, a production variance report might reveal that direct materials usage during the past month was greater than planned for the actual output that was produced. The production manager should be the one to investigate that and determine the cause. The variance may have been caused by inferior materials that included too much defective material. If that is the case, then the purchasing manager may need to get involved in the variance reporting, since the purchasing manager is responsible for the materials purchased. If a change in supplier is needed to correct the situation, that change should be made immediately. 15 Planning and Budgeting Concepts CMA Part 1 Best Practice Guidelines for the Budget Process Best practices in budgeting include the following, most of which we have already discussed: • The development of the budget should be linked to corporate strategy. Linking them gives the managers and employees a clearer understanding of strategic goals, which leads to greater sup· port for goals, better coordination of tactics, and, ultimately, to stronger company performance. • Communication is vital. Management must communicate strategic objectives. But in order to develop those objectives, management needs information from all areas of the organization about customers, competitors, the economy, new technology, and so forth. Much of this information comes from customer contact and support units. Effective communication among all levels of the organiza tion leads to challenging but achievable budgets. • Design procedures to allocate funding resources strategically. This can be done during the review process for the individual responsibility center budgets. Managers reviewing several responsi· bility center budgets can see how changes in one budget will affect other budgets. The companys weighted average cost of capital should be a consideration in the allocation process, as well. The de· gree of risk involved in competing plans, the costs or advantages associated with deferring action, as well as factors such as expected developments in interest rates may also be used to allocate re sources. By using these types of measures to allocate funding, companies can better select plans whose benefits will produce the desired results. And by monitoring the results of their allocations, companies can refine and improve their allocation procedures. • Managers should be evaluated on performance measures other than meeting budget targets. Meeting budget targets should be secondary to other performance measurements. See the topic of Budgetary Slack immediately following this one and the section on Performance Measure ment in this textbook for further discussions of this. • Link cost management efforts to budgeting. Accurate cost information during the budgeting process is basic to budgeting. Companies that use accurate cost management techniques and pro vide managers developing their budgets with access to cost information improve both the accuracy and the speed of their budget process. • The strategic use of variance analysis. Use of variance analysis to identify weaknesses enables managers to identify areas where their organization needs to improve its performance. However, this attention should be focused on those variances that have a significant impact on profitability, so that decision making and budgeting do not get bogged down in insignificant details. • Reduce budget complexity and budget cycle time. The budget process should be streamlined as much as possible through controlling the number of budgets that are needed and by standardizing budgeting methods. Automate budgeting as much as possible through the use of information tech nology, and make sure that the budget developers know how to use new technologies. • Develop budgets that can be revised if necessary. By having a process in place to revise the budget when change is warranted, a company can respond to competitive threats or opportunities more quickly. Furthermore, when budget developers know that the budget will have some flexibility, they will feel less need to pad their budgets with budgetary slack (see below for discussion of budge tary slack), which they otherwise might do in order to cover any possible development. This leads to more realistic budgets. • Review the budget on a regular basis throughout the year. These reviews should report on changes in business conditions and alert managers that new tactics may be called for if they are to meet their targets forthe year. This goes along with revising the budget when necessary. The budg· et should not be revised to cover up for poor performance or poor planning, but best practice companies choose to revise the budget rather than stick with a budget that no longer reflects current conditions.
Posted on: Fri, 18 Oct 2013 06:44:45 +0000
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