Introduction To Budgeting

 Budgeting : 

A budget is a document that forecasts the financial results and financial position of a business for one or more future periods.

▪ Performance baseline 

▪ Bonus plans 

▪ Tax planning and treasury planning 

Advantages :

◆ Planning orientation 

◆ Model scenarios 

◆ Profitability review 

◆ Assumptions review 

◆ Performance evaluation 

◆ Predict cash flows 

◆ Cash allocation 

◆ Cost reduction analysis 

◆ Shareholder communication

Disadvantages :

◆ Inaccuracy 

◆ Rigid decision making 

◆ Time required 

◆ Gaming the system 

◆ Blame for outcomes 

◆ Expense allocation 

◆ Use it or lose it 

◆ Only consider financial outcomes

The Command and Control System

◆ Revenue target: specific product, product line, geographic region 

◆ Expense target: single block expense or expenditures for individual line items 

◆ Profit target: revenue increases or expense reduction 

◆ Cash flow target: producing a specific amount of net positive cash flow 

◆ Metric target: ROA or ROE

Budget + bonus system → Extremely tight command and control

Behavioral Impacts

 Unethical accounting and business practices: 

◆ Recording revenue that was shipped after the month-end deadline 

◆ Using a discount offer to stuff sales into a sales channel during bonus period 

◆ Overbilling customers 

◆ Not entering supplier invoices during a bonus period 

◆ Taking unwarranted discounts from supplier invoices 

◆ Firing employees and using contractors to avoid headcount targets

Bureaucratic Support 

◆ Human resources 

◆ Accounting 

◆ Analysts 

◆ Investment community

 Information Sharing No knowledge of the budget, no acceptance of it by employees, little chance it will be achieved

Contribution Margin

It is useful for: 

◆ Determining whether to allow a lower price in a special pricing situations. 

◆ Determining the profits that will arise from various sales level 

◆ Deciding which of several products to sell if common bottleneck resource, so that the product with highest contribution margin is sold

Example :

The Iverson Drum Company sells drum sets to high schools. In the most recent period, it sold $1,000,000 of drum sets that had related variable costs of $400,000. Iverson had $660,000 of fixed costs during the period, resulting in a loss of $60,000

Example : 

The president of Giro Cabinetry is examining the gross margins on the five products that his company sells. A summary of this information is:

A contribution margin income statement is an income statement in which all variable expenses are deducted from sales to arrive at a contribution margin, from which all expenses are then subtracted to arrive at the net profit or lost for the period.