CHAPTER 9

FOR STRATEGIC GROWTH FINANCIAL FORECASTING

Expected Learning Outcomes
After studying Chapter 9, you should able to:
1. Understand the concept and perspective of financial planning.
2. Explain the benefits that can be derived from financial planning.
3. Know the elements of a basic financial planning model.
4. Understand the determinants of a firm’s growth rates.
5. Know and apply the financial planning process using the Projected Financial
Statement Method (Percent of Sales Method).

Chapter 9: Financial Forecasting for Strategic Growth

INTRODUCTION
A lack of effective long-range planning is a commonly cited reason for financial distress and
failure. Long range planning is a means of systematically thinking about the future and
anticipating possible problems before they occur. Planning is said to be a process that at best
helps the firm avoid stumbling into the future backward.

Financial planning establishes guidelines for change and growth in a firm. It focuses on the
big picture, which means that it is concerned with the major elements of a firm’s financial and
investment policies without dealing with the individual components of those policies in detail.

9.1 WHAT IS FINANCIAL PLANNING?

Financial planning formulates the way in which financial goals are to be achieved. A financial
plan is thus, a statement of what is to be done in the future. Many decisions have a long lead
time which means they take a long time to implement. In an uncertain world, this requires that
decision made far in advance of their implementation. For instance, if a firm wants to build a
factory in 2018, it might have to begin lining up contractors and financing in 2016 or even
earlier.

9.2 GROWTH AS FINANCIAL MANAGEMENT GOAL

As discussed in the earlier chapters, the appropriate goal is for the financial manager is
increasing the market value of the owner’s equity and not just growth by itself. If the firm is
successful in doing this then growth will usually result. Growth may thus be a desirable
consequence of good decision making but it is not an end unto itself. However, while growth
rate is used in the planning process, it is considered a convenient means if summarizing
various aspects of a firm’s financial and investment policies. Likewise, if we think of growth
as growth in the market value of the equity in the firm, then goals of growth and increasing
the market value of the equity in the firm are not all that different.
9.3 PERSPECTIVE OF FINANCIAL PLANNING
For planning purposes, it is often useful to think of the future as having a short-run and a
long-run. The short-run planning, in practice, usually covers the coming 12 months while
financial planning over the long-run is takes to be the coming two to five years. This time
period is referred to as the planning horizon and this is the first dimension of the planning
process that must be established.

The second dimension of the planning process that needs to be determined is the level of
aggregation. Aggregation involves the determination of all of the individual projects together
with the investment required that the firm will undertake and adding up these investment
proposals to determine the total needed investment which is treated as one big project.

After planning horizon and level of aggregation are established, a financial plan requires
inputs in the form of alternative sets of assumptions about important variables. This type of
planning is particularly important for cyclical businesses or business firms whose sales are
strongly affected by the overall state of the economy or business cycles.

9.4 WHAT ARE THE BENEFITS THAT CAN BE DERIVED FROM FINANCIAL
PLANNING?
Due to the amount spent in examining the different scenarios and variables that will
eventually become the basis for a company’s financial plan, it seems reasonable to ask what
the planning process will accomplish.

Among the more significant benefits of derived from financial planning are the following.
1. Provides a rational way of planning options or alternatives.
The financial plan allows the firm to develop, analyse and compare many different business
scenarios in an organized and consisted way. Various investment and financing options can be
explored, and their impact on the firm’s shareholders can be evaluated. Questions concerning
the firm’s future lines of business and optimal financing arrangements are addressed. Options
such as introducing new products or closing plants might be evaluated.

2. Interactions or Linkages between investment proposals are carefully examined.

The financial plan enables the proponents to show explicitly the linkages between investment
proposals for the different operating activities of the firm and its available financing choices.
For example, if the firm is planning on expanding or undertaking new investments and
projects, all other relevant variables such as source, terms and timing of financing are
thoroughly examined.

3. Possible problems related to the proposal projects are identified actions to

address them are studied.
Financial planning should identify what may happen to the firm if different events take place.
Specifically, it should address what actions the firm will take if expectations do not
materialize and more generally, if assumptions made today about the future are seriously in
error. Thus, one objective of financial planning is to avoid surprises and develop contingency
plans.

4. Feasibility and internal consistency are ensured.

Financial planning is a way of verifying that the goals and plans made for specific areas of a
firm’s operations are feasible and internally consistent. The financial plan makes explicit the
linkages between different aspects of a firm’s business such as the market share, return on
equity, financial leverages, and so on. It also imposes a unified structure for reconciling goals
and objectives.

5. Managers are forced to think about goals and establish priorities.

Through financial planning, directions that the firm would take are established, risks are
calculated and educated alternative courses of action are considered thoroughly.

9.5 FINANCIAL PLANNING MODELS

Financial planning process will differ from firm to firm, just as companies differ in size and
products. However, basic financial planning model will have the following common elements;
(a) economic environment assumptions, (b) sales forecast, (c) pro forma statements, (d) asset
requirements, (e) financial requirement, and (f) additional funds needed.

1. Economic Environment Assumption. The plan will have to state explicitly the
economic environment in which the firm expects to reside over the life of the plan.
Among the more important economic assumption that will have to be made are the
inflation rates, level of interest rates and the firm’s tax rate.

2. Sales Forecast. An external supplied sales forecast considered the “driver” shall be
the “heart” of all financial plans. The user of the planning model will supply this value
and most other values will be calculated based on it. Planning will focus on projected
future sales and the assets and financing needed to support those sales.

Oftentimes, the sales forecast will be given as the growth rate in sales rather than as an
explicit sales figure. Perfect sales forecast is not possible, of course, because sales depend on
the uncertain future state of the economy. To come up with its projections, firms could consult
with some businesses which specialize in macroeconomic and industry projections. Also,
evaluating alternative scenarios does not require sales forecast to be very accurate because the
financial planner’s goal is to examine the interplay between investment and financing needs at
different possible sales level, not to pinpoint what we expect to happen.

Determinants of Growth Rates

A firm’s ability to sustain growth depends explicitly on the following factors:

• Profit Margin. An increase in profit margin will increase the firm’s ability to generate
funds internally and thereby increase its sustainable growth.

• Dividend Policy. A decrease in the percentage of net income paid out as dividends will
increase the retention ratio. These increases internally generated equity and thus
increases sustainable growth.

• Financial Policy. An increase in the debt-equity ratio increases the firm’s financial
leverage. Because this makes additional debt financing available, it increases the
sustainable growth rate.

• Total Asset Turnover. An increase in the firm’s total asset turnover increases the sales
generated for each peso in assets. This decreases the firm’s need for new assets as
 sales grow and thereby increases the sustainable growth rate. Notice that total asset
turnover is the same thing as decreasing capital intensity.

The sustainable growth rate is a very useful planning number. What it illustrates is the explicit
relationship between the firm’s four major areas of concern: (a) its operating efficiency as
measured by profit margin, (b) its asset use efficiency as measured by total asset turnover, (c)
Its dividend policy as measured by the retention ratio, and (d) Its financial policy as measured
by the debt-equity ratio.

1. Pro forma Statements. A financial plan will have a forecast statement of financial
position, income statement, statement of cash flows and statement of stockholders’
equity. These are called pro forma or projected statements which will summarize the
different events projected for the future.

2. Asset Requirements. The financial plan will describe projected capital spending. At a
minimum, the projected statement of financial position will contain changes in total
fixed assets and net working capital. These changes are effectively the firm’s total
capital budget. Proposed capital spending in different areas must thus be reconciled
with the overall increases contained in the long-range plan.

3. Financial Requirements. The financial plan will include a section about the
necessary financing arrangements. This part of the plan should discuss dividend policy
and debt policy. Sometimes firms will expect to raise cash by selling new shares of
stock or by borrowing. In this case, the plan will have to consider what kinds of
securities have to be sold and what methods of issuance are most appropriate.

4. Additional Funds Needed (AFN). After the firm has a sales forecast and an estimate
of the required spending on assets, some amount of new financing will often be
necessary because projected total assets will exceed projected total liabilities and
equity. In other words, the statement of financial position will no longer balance.

Because new financing may be necessary to cover all the projected capital spending, a
financial “plug” variable must be selected. The plug is the designated source(s) of external
financing needed to deal with any shortfall (or surplus) in financing and thereby bring the
statement of financial position into balance.

For example, a firm with a great number of investment opportunities and limited cash flow
may have to raise new equity. Other firms with few growth opportunities and ample cash flow
will have a surplus and thus might pay an extra dividend. In the first case, external equity is
the plug variable; and the second, the dividend is used.

9.6 FINANCIAL PLANNING PROCESS

Well run companies generally base their operating plans on a set of forecasted financial
statements. The planning process begins with a sales forecast for the next five or so years.
Then the assets required to meet the sales targets are determined, and decision is made
concerning how to finance the required assets. At that point, income statements and
statements of financial position can be projected, and earning per share, as well as the key
ratios can be forecasted.
Once the “base-case” forecasted statements and ratios have been prepared, top managers will
ask questions such as:

 Are the forecasted results as good as we can realistically expect, and if not, how might
we change our operating plans to produce better earnings and a higher stock price?

 How sure are we that we will be able to achieve the projected results? For example, if
our base-case forecast assumes a reasonably strong economy but a recession occurs,
would we be better off under an alternative operating plan?

9.7 THE PROJECTED FINANCIAL STATEMENT METHOD

Any forecast of financial requirements involves: (a) Determining how much money the firm
will need during a given period, (b) Determining how much money the firm will generate
internally during the same period, and, (c) Subtracting the funds generated from the funds
required to determine the external financial requirements.

The projected financial statement method is straightforward, one simply projects the asset
requirements for the coming period, then projects the liabilities and equity that will be
generated under normal operations, and subtracts the projected liabilities/capital from the
required assets to estimate the additional funds needed (AFN).

The steps in the procedures are as follows:

Step 1. Forecast the Income Statement.
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding production costs; direct
materials, direct labor and overhead.
c. Estimate selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.

Step 2. Forecast the Statement of Financial Position.

a. Project the assets that will be needed to support projected sales.
b. Project funds that will be spontaneously generated (through accounts payable and
accruals) and by retained earnings.
c. Project liability and stockholders’ equity accounts that will not rise spontaneously with
sales (e.g., notes payable, long-term bonds, preferred stock and common stock) but
may change due to financing decisions that will be made later.
d. Determine if additional funds will be needed by using the following formula.

The additional financing needed will be raised by borrowing from the bank as notes payable,
by issuing long-term bonds, by selling new common stock or by some combination of these
actions.
Step 3. Raising the additional funds needed.
The financing decision will consider the following factors:
a. Target capital structure.
b. Effect of short-term borrowing on its current ratio.
c. Conditions in the debt and equity markets, or
d. Restrictions imposed by existing debt agreements.

The additional financing needed will be raised by borrowing from the bank as notes payable,
by issuing long-term bonds, by selling new common stock or by some combination of these
actions.

Step 4. Consider financing feedbacks.

Depending on whether additional funds will be borrowed or will be raised through common
stocks, consideration should be given on additional interest expense in the income statement
or dividends, thus decreasing the retained earnings.

Apply the iteration process using the available financing mix until the AFN would become so
small that the forecast can be considered complete.

Illustrative Case 9.7.1 Financial Forecasting (Percent of Sales Method)

The Millennium Company has the following statements which are representative of the
company’s historical average.

Income Statement
Sales ₱2,000,000
Cost of sales 1,200,000
Gross Profit 800,000
Operating expenses 380,000
Earnings before interests and taxes 420,000
Interest expenses 70,000
Earnings before taxes 350,000
Taxes (35%) 122,000
Earning after taxes ₱227,500
Dividends ₱136,500

Statement of Financial Methods

Assets
Cash ₱50,000
Account receivable 400,000
Inventory 750,000
Current assets ₱1,200,000
Fixed assets (net) 800,000
Total assets ₱2,000,000

Liabilities and Equity

Accounts payable ₱250,000
Accrued wages 10,000
Accrued taxes 20,000
Current liabilities ₱280,000
Notes payable – bank 70,000
Long-term debt 150,000
Ordinary shares 1,200,000
Retained earnings 300,000
Total liabilities and equity ₱2,000,000

The firm is expecting a 20 percent increase in sales next year, and management is concerned
about the company’s need for external funds. The increase in sales is expected to be carried
out without any expansion of fixed assets, but rather through more efficient asset utilization in
the existing store. Among liabilities, only current liabilities vary directly with sales.

Using the percent-of-sales method, determine whether the company has external financing
needs or a surplus of funds.
Solution:

Step 1. Forecast the Income Statement.

The projected income statement will show the following:
Sales ₱2,400,000
Cost of sales 1,440,000
Gross profit 960,000
Operating expenses 456,000
Earnings before interests and taxes 504,000
Interest expenses 70,000
Earnings before taxes 434,000
Taxes (35%) 151,900
Earnings after taxes 282,100
Dividends (36%) payment ₱101,600

Step 2. Forecast the Statement of Financial Position.

The projected income statement will show the following:

Assets
Cash (1) ₱60,000
Account receivable (2) 480,000
Inventory (3) 900,000
Total current assets 140,000
Fixed assets (net) (4) 800,000
Total assets ₱2,240,000

Liabilities and Equity

Accounts payable (5) ₱300,000
Accrued wages (6) 12,000
Accrued taxes (7) 24,000
Current liabilities ₱336,00
Notes payable – bank (4) 70,000
Long-term debt (4) 150,000
Ordinary shares (4) 120,0000
Retained earnings (8) 480,500
Total ₱2,236,000
Additional financing required 3,500
Total ₱2,240,000

Supporting computations:
1. Cash = 2.5% x P 2.4M sales.
2. Accounts receivable = 20% of 2.4M sales
3. Inventory = 37.5% x 2.4M
4. No percentages are computed for fixed assets, notes payable, long-term debt, ordinary
shares and retained earnings because they are not assumed to maintain a direct
relationship with sales volume. For simplicity, depreciation is explicitly considered.
5. Accounts payable = 12.5% of P2.4M
6. Accrued expenses = 0.5% of P2.4M
7. Accrued expenses = 1% of P2.4M
8. Retained earnings = P300,000 + P282,100 – P101,600

Formula Method
*Additional financing needed (AFN) may also be computed as follows:

Where

Applied Millennium Co., AFN is computed as follows:

Illustrative Case 9.7-2 Projected Financial Statements with Financing Feedback.

For Tamarind Company, the following data have been made available:

Tamarind Company
Income Statement
Year 20x4
(Thousands of Pesos)

Addition to retained earnings:

Tamarind Company
Statement of Financial Position
December 31, 20x4
(Thousands of Pesos)
Assets
Cash
Account receivable
Inventories

Liabilities and Equity

Additional information follows:
Historical sales for the last five years (In Thousand Pesos).
Assets and spontaneous liabilities will increase by 10%.
Ordinary shares outstanding, 50,000.
Ordinary share dividends are projected at ₱2.50 per share.
Market value per share at the end of 2012 is ₱46.67.

REQUIRED:
I. Construct the pro forma financial statements using the projected financial statement
method. How much additional capital will be required? Assume the firm operated at full
capacity in year 2014. Do not include financing feedback.

Solution:
Based on the data and assumptions given, the following projections are made, and the
additional financing needed determined.

DISCUSSION:
Figure 9-1 shows Tamarind’s actual 2014 and forecasted 2015 income statement. For year
2015 earnings before interest and taxes are projected at ₱625,000 and earnings after taxes of
₱269,000. Dividends to preference shares and ordinary shares are projected at ₱8,000 and
₱125,000, respectively.

Figure 9-2 contains Tamarind’s 2014 actual and projected 2015 statements of financial
position. Total assets are projected at ₱4,400,000 while the forecasted liability and equity
accounts total to only ₱4,176,000. Since the resources or assets requires to support the higher
shares level exceed the available sources, it means that additional funds will have to be
obtained. The AFN of ₱224,000 will be raised by borrowing from the bank as notes payable
or by issuing long-term bonds or by selling new ordinary shares, or by some combination of
these actions.
II. Assume that after considering all the relevant factors, Tamarind decided on the following
funds financing mix to raise the AFN of ₱224,000:

Percent Amount Interest Rate

Notes payable 25% ₱ 56,000 8%
Long-term debt 25 56,000 10%
Ordinary shares* 50 112,000 -
Total 100% ₱ 224,000 2,400 shares

Construct the pro-forma income statement and statement of financial position to incorporate
the financing feedback which results from adopting the financing mix Given above.

Solution:
Figure 9-3.
Projected Income Statement (Second Pass)
For 2023
20x4 Actual | 20x5 Forecast | First Pass | Feedback | Second Pass

Sales
Operating Costs (inclusive of ₱200 depreciation)
Earnings before interest
And taxes
Less: Interest expense
Earnings before taxes Taxes(40%) Net income before
Preference dividend Dividends to preference
Net income available to ordinary
Dividends to ordinary
Addition to retained earning

Projected Income Statement (Second Pass)

For 2023
20x4 Actual | 20x5 | First Pass | Feedback | Second Pass
Actual First Pass Feedback Second Pass
₱ 6,000 ₱ 6,600 ₱ 6,600
5,432 5,975 5,975
568 625 625 - 176 176 + 10 186
392 449 439
157 180 -4 176
235 269 263 8 8 8
₱ 227 ₱ 261 ₱ 255
116 125 +6 131 136 124

Figure 9-4.
Projected Statement of Financial Position (Second Pass)
(Thousands of Pesos)

20x4 Actual | 20x5 | First Pass | Feedback | Second Pass

Assets
Cash ₱ 20 ₱ 22 ₱ 22
Accounts Receivable 750 825 825
Inventories
Total Current Assets ₱ 1,230 2,000 ₱ 1,3532,200 ₱ 1,353 2,200
Net plant and equipment 2,000 2,200 2,200
Total Assets ₱ 4,000 ₱ 4,400 ₱ 4,400

Liabilities and Equity

Accounts Payable ₱ 120 ₱ 132 ₱ 132
Notes payable 220 220 + 56 276
Accruals 280 308 308
Total current liabilities ₱ 620 ₱ 660 ₱ 716
Total Liabilities
Preference shares
Ordinary shares (50,000 shares)
Retained Earnings
₱ 2,128
₱ 80 260 1,532 ₱ 2,168
₱ 80 260 1,668 + 112 ₱ 2,280
₱ 80 372 1,656
Long-term bonds 1,508 1,508 + 56 1,564
Total Equity ₱ 1,872 ₱ 2,008 ₱ 2,108
Total Liabilities and Equity
Before AFN ₱ 4,000 ₱ 4,176 ₱ 4,388
Additional Funds Needed (AFN) ₱ 12
Total Liabilities and Equity ₱ 4,400
Cumulative AFN ₱ 236

In Figure 9-4 the second pass 2015 Statement of Financial Position shows that a shortfall of
₱12,000 will still exist as a result of financing feedback effects due to the additional interest
(net of taxes) and dividend payments that reduced the projected retained earnings. This
amount raises the cumulative AFN from ₱224,000 to ₱236,000.

If additional iterations are done (9.e., 3rd, 4th, 5th, etc.), the additional financing needed would
become smaller and smaller until the forecast would be considered to be completed. Making a
spreadsheet using Lotus 1-2-3 or some other program can facilitate the iteration process and
arrive at the final forecast.

ANALYSIS OF THE FORECAST

Next year’s forecast as developed above is only the first part of total forecasting process.
Forecasting is an iterative process, both in the way the financial statements are generated and
in the way the financial plan is developed. For planning purposes, the consultant or financial
staff develops a preliminary forecast based on a combination of past policies and trends. This
will serve as a starting point or “baseline” forecast. The model is then modified to see what
effects alternative operating plans would have on the firm’s earnings and financial condition.
Likewise, alternative operating plans are examined under different sales growth rate scenarios
and linked to the firm’s dividend policy and capital structure decisions. The revised forecast
or model can also be used to analyse alternative working capital policies.
CHAPTER 10
FORECASTING SHORT-TERM (OPERATING)
FINANCIAL REQUIREMENTS

Expected Learning Outcomes

After studying Chapter 10, you should be able to:

Understand the relationship between financial planning and control.

Know the nature, purposes and limitations of the budget.

Enumerate the types of budgets.

Understand and apply the steps in developing a master budget.

Chapter 10 Forecasting Short-Term Operating Financial Requirements

10.1 FINANCIAL PLANNING AND CONTROL PROCESS

Business is becoming increasingly competitive and corporate profitability is increasingly

dependent upon operating efficiency. This situation is desirable from a social standpoint, for
consumers are getting higher quality goods at lower prices but intense competition does make
life tough on corporate managers.

In the previous chapter, focus was given on financial forecasting emphasizing how growth in
sales requires additional investments in assets which in turn generally requires the firm to
raise new external capital.

This chapter will now consider the planning or budgeting and control or evaluation systems
used by financial managers covering a period of one year or less.

Financial planning involves making projections of sales, income, and assets based on
alternative production and marketing strategies and then deciding how to meet the forecasted
financial requirements. In the financial planning process, managers should also evaluate plans
and identify changes in operations that would improve results. Financial control moves on to
the implementation phase dealing with the feedback and adjustment process that is required
(a) to ensure that plans are followed and, (b) to modify existing plans in response to changes
in the operating environment. The process begins with the specification of the corporate goals,
after which management lays out a series of forecasts and budgets for every significant area of
the firm’s activities, as shown in Figure 10-1.

Financial forecasting analysis begins with projections of sales revenues and production costs.
In standard business terminology, a budget is a plan which sets forth the projected
expenditures for a certain activity and explains where the required funds will come from.
Thus, the production budget presents a detailed analysis of the required investments in
materials, labor, and plant necessary to support the forecasted sales level. Each of the major
elements of the production budget is likely to have a sub-budget of its own; thus, there will be
a materials budget, a personnel budget and a facilities budget. The marketing staff will also
develop selling and advertising budgets. Typically, these budgets will be set up on a monthly
basis, and as time goes by, actual figures will be compared with projected figures for the
remainder of the year will be adjusted if it appears that the original projections were
unrealistic.

During the planning process, the projected levels of each of the different operating budgets
will be combined, and from this set of data the firm’s cash flow will be set forth in its cash
budget. If a projected increase in sales leads to a projected cash shortage, management can
make arrangements to obtain the required funds in the least-cost manner.

After all the cost and revenue elements have been forecasted, the firm’s projected statements
can be developed. These projected statements are later compared with the actual statements
such as; comparisons can help the firm pinpoint reasons for deviations, correct operating
problems, and adjust projections for the remainder of the budget period to reflect actual
operating conditions. Through its financial planning and control processes, management seeks
to avoid cash squeezes and to improve the profitability of the individual divisions and thus the
entire company.

10.2 BUDGETING DEFINED

Budgeting is the act of preparing a budget. A budget is a financial plan of the resources
needed to carry out tasks and meet financial goals. It is also a quantitative expression of the
goals the organizations wishes to achieve and the cost of attaining these goals. The use of
budgets to control a firm’s activities is known as budgetary control.

10.3 THE PURPOSES OF THE BUDGET

A budget is a description in quantitative – usually monetary – terms of a desired levels to

focus on the future of the business entity. The benefits that may be realized from a budgeting
program are

1. Defining broad objectives and goals and formulating strategies to achieve such
objectives;

2. Coordinating the activities of the organization by integrating the plans of the various
parts thereby pulling everyone in the same direction;

3. Allocating resources to those parts of the organization where they can be used most
effectively;
 4. Communicating management’s approved plans throughout the organization;

5. Uncovering and preparing for potential bottleneck in the operations before they occur;

6. A motivating manager to achieve the desired results; and

7. Setting a standard or benchmark for evaluating actual performance.

10.4 ADVANTAGES AND LIMITATIONS OF BUDGETS

The advantages of budgeting include:

1. It forces planning and exposes situations in which plans of subcomponents are

inadequate to attain the total organization’s objectives.

2. It allows a reiterative process to bring the goals of the organization and the
subcomponents into agreement.

3. It provides a means of communicating organization goals down through the

organization and sub-unit operational limitations up though the organization.

4. It provides a basis for financial planning, sub-unit coordination, resource acquisition,

inventory policy, scheduling and output distribution.

5. It provides a basis by which activity can be monitored, with actual results being
compared to the planned results.

The limitations of budgeting are:

1. Budgets tend to oversimplify the real situation and fail to allow for variations in
external factors. They do not reflect qualitative variables.

2. It is difficult to prepare a detailed budget for an organization that has never existed or
for a new division, product, or department of an existing firm.
 3. There may be lack of higher and lower management commitment because of lack of
understanding of the fundamentals of budget preparation and utilization.,

4. The budget is only a representation of future plans or a means to the goal of profitable
activity and not an end in itself. It may interfere with the supervisor’s style of
leadership and can therefore stifle initiative.

5. Budget reports usually emphasize results, not reasons.

10.5 TYPES OF BUDGETS

The types of budgets or the major composition of the master budget are: (a) Operating Budget
(b) Financial Budget and; (c) Capital Investment Budget

The following is a simplified sub classification of the abovementioned types of budgets for a
manufacturing firm:

10.5.1 The Operating Budget

1. Budgeted Income Statement

a. Sales Budget – The sales budget contains an itemization of a company’s sales

expectations for the budget period, in both units and dollars. If a company has
a large number of products, it usually aggregates its expected sales into a
smaller number of product categories or geographic regions; otherwise, it
becomes too difficult to generate sales estimates for this budget.

b. Production budget

 Materials cost budget – The materials cost budget calculates the materials that must be
purchased, by time period, in order to fulfil the requirements of the production budget.
It is typically presented in either a monthly or quarterly format in the annual budget. In
a business that sells products, this budget may contain a majority of all costs incurred
by the company, and so should be compiled with considerable care. Otherwise, the
result may erroneously indicate excessively high or low cash requirements to fund
materials purchases.
 Direct labor cost budget – The direct labor cost budget is used to calculate the number
of labor hours that will be needed to produce the units itemized in the production
budget. A more complex direct labor budget will calculate not only the total number of
hours needed, but will also break down this information by labor category. The direct
labor budget is useful for anticipating the number of employees who will be needed to
staff the manufacturing area throughout the budget period. This allows management to
anticipate hiring needs, as well as when to schedule overtime, and when layoffs are
likely. The budget provides information at an aggregate level, and so is not typically
used for specific hiring and layoff requirements.

 Factory overhead budget – The factory overhead budget contains all manufacturing
costs other than direct materials and direct labor. The information in this budget
becomes part of the cost of goods sold line item in the master budget. The total of all
costs in this budget are converted into a per unit overhead allocation, which is used to
derive the cost of ending finished goods inventory, and which in turn is listed on the
budgeted balance sheet. The information in this budget is among the most important of
the various departmental budget models, since it may contain a large proportion of the
total amount of a company’s expenditures.

 Inventory levels – The inventory levels calculate the cost of the finished goods
inventory at the end of each budget period. It also includes the unit quantity of
finished goods at the end of each budget period, but the real source of that information
is the production budget. It contains an itemization of the three main costs that are
required to be included in the inventory asset under both generally accepted
accounting principles and international financial reporting standards. These costs and
their derivation are direct materials, direct labor and overhead allocation.

6. Cost of Sales budget – Cost sales budget or also called cost of goods sold (COGS)
budget is essentially part of your operating budget. COGS is the direct expense or cost
of the production for the goods sold by a business. These expenses include the costs of
raw material and labor but do not include indirect costs such as that of employing a
salesperson.

7. Selling and Administrative expenses budget – The selling and administrative expense
budget lists the operating expenses involved in selling the products and in managing
the business. Just as in the case of the factory overhead budget, this budget can be
developed using the cost-volume (flexible budget) formula in the form of (y = a + bx).

8. Financial expense budget – A financial budget in budgeting means predicting the

income and expenses of the business on a long-term and short-term basis. Accurate
projections of cash flow help the business achieve its targets in the right way.
10.5.2 The Financial Budget

1. Budgeted Statement of Financial Position

a. Budgeted financial statements may comprise the complete set of financial

statements, which are: These statements are compiled from the annual
budgeting model of a business. They are useful for estimating the financial
results, financial position, and cash flows of a business as of various dates in
the future.

b. Cash budget – A cash budget represents the expected future cash flow of an
organization over a defined period of time. It is an estimate of the cash receipts
expected in the future over the budget period, the expenditure to be incurred in
cash, and finally, the cash balance with the company at the end of the period.

2. Budgeted Statement of Sources and Uses of Funds

 The statement of sources and uses of funds is a statement that condenses the financial
statements and financial plan in one statement. It displays the sources from which an
organization or a company manages to generate cash and all the areas where the
obtained cash is used during an accounting period.

10.5.3 The Capital Investment Budget

 Capital investment budget is the process of making investment decisions in long term
assets. It is the process of deciding whether or not to invest in a particular project as all
the investment possibilities may not be rewarding. Thus, the manager has to choose a
project that gives a rate of return more than the cost financing such a project.

10.6 STEPS IN DEVELOPING A MASTER BUDGET

The major steps in developing a Master Budget may be outlined as follows:

1. Establish basic goals and long-range plans for the company. These will serve as
guidelines in the preparation of budget estimates.

2. Prepare a sales forecast for the budget period.

 3. Estimate the cost of goods sold and operating expenses.

4. Determine the effect of budgeted operating results on assets, liabilities and ownership
equity accounts. The cash budget is the largest part of this step, since changes in many
asset and liability accounts will depend upon the cash flow forecast.

5. Summarize the estimated data in the form of a projected income statement for the
budget period and the projected statement of financial position as of the end of the
budget period.

Figure 10-2 depicts the sequence and types of budgets commonly

Found.

Illustrative Case 10.1. Comprehensive Master Budget Preparation

Gilbert Manufacturing Company manufactures a special line of tools. As of December 31,

20X4, the Statement of Financial Position of the firm is as follows:

Additional information:

The treasurer’s office also provided the following information and estimates:

All sales are on account and collections from customers are expected to amount to
P5,185,000.

Equipment costing P300,000 with accumulated depreciation of 1275,000 will be sold at its net
book value, New equipment costing P320,000 will be purchased during the year.
Accounts payable will increase by P15,000 and assumed to be for materials purchases only.

Income taxes will be provided at an average rate of 35% of income before taxes while
P252,000 will be paid during the year.

Dividends amounting to P140,000 will be paid during the year and the current portion of the
long-term debt shall also be settled at the end of the year. Interest rate is 8% per annum.

REQUIRED: Prepare the Master Budget for Gilbert Company for the year ending December
31, 20XS. Based on the above preliminary data, each of Gilbert Company’s budgets will now
be discussed and illustrated.

Sales Budget

The sales budget showing what products will be sold in what quantities at what prices, is the
foundation on which all other short-term budgets are built. The sales budget triggers a chain
reaction that leads to the development of many other budget figures in an organization. The
sales budget provides the revenue predictions from which cash receipts from customers can be
estimated and supplies the basic data for constructing budgets for production costs and selling
and administrative expenses. In short, the sales forecast is the keystone of the budget
structure. The accuracy and reasonableness of the sales data will affect the whole budget.

The sales forecast is made after consideration of the following factors:

Past sales volume

General economic and industry conditions

Relationship of sales to economic indicators

Relative product profitability

Market research studies and competition

Pricing, advertising and other promotion policies

Production capacity 8. Quality of sales force

Quality of Sales Force

Seasonal variations

Long-term sales trends for various production

For Gilbert Company, the Sales Budget is presented follows:

Production Budget

After the sales budget has been set, a decision can be made on the level of production that will
be needed for the period to support sales and the production budget can be set as well. The
production budget becomes a key factor in the determination of other budgets, including the
direct materials budget, the direct labor budget and the manufacturing overhead budget. These
budgets in turn are needed to assist in formulating a cash budget.

Using the data from the previously prepared sales budget as well as the inventory summary
information, the following production budget is

Raw Materials Budget

After determining the number of units to be produced, the Raw Materials Purchases can now
be prepared, as follows:

Direct Labor Budget

The preliminary data show that the budgeted direct labor cost per unit produced is P146. This
must have been arrived at after considering such factors as skills level of the workers, labor
rate per hour, time requirement, conditions of union contracts, etc.

The direct labor is therefore budgeted as follows:

Overhead Cost Budget

Study of past records will show how the cost reacts to changes in volume or in relation to
other factors. Some overhead items may be projected on the basis of direct labor hours or on
materials costs or on machine hours.

The overhead costs budget for 20X5 is illustrated below using the basic information from the
preliminary data previously established.

Budgeted Cost of Sales

The Budgeted Cost of Sales Statement can now be developed using the data from the
following:
Marketing and Administrative Expense Budget

As with overhead costs, marketing and administrative expenses are also made up of fixed and
marketing variable components. The marketing and administrative expense budget for 20X5
is shown on the next page.

SCHEDULE 7

Budgeted Marketing and Administrative Costs for 20x5

Variable marketing costs

Sales commission (6,400 @ P40.625) P260,000

Others (6,4000 @ P16.25 104,000

Total P364,000

Fixed marketing costs

Sales salaries
Advertising

Others

Total

Total marketing costs

Administrative costs (all fixed)

Administrative salaries

Data processing services

Legal and other professional fees

Depreciation – building, furniture and equipment

Taxes – other than income

Others

Total

Total marketing and administrative costs P1,500,000

Cash Budget Cash Receipts

Normally, the bulk of a firm’s cash receipts come from customers. The possibility of cash
from other sources (such as additional investments, sales of assets, borrowings) should
likewise be considered when cash receipts are being budgeted.

Cash Disbursements

Data converted from individual budgets previously illustrated supply the basic information for
the cash disbursements budget. However, various adjustments and additions will have to be
made when preparing the budget for prepayments, accruals as well extraneous items (such as
the purchase of new equipment, dividend payment) that do not show up in any of the
individual budgets already prepared. If the financial policy of the company requires that is a
minimum cash.

Budgeted Income Statement

After the cash budget has been completed, Gilbert Company prepares the budgeted income
statement showing the net income that is to be expected during the budget period. The
information needed to prepare the budgeted income statement comes from the previously
provide preliminary data as well as from the company’s other budgets.

Budgeted Statement of Financial Position

The budgeted statement of financial position is developed by beginning with the current
statement of financial position and adjusting it for the data contained in the other budgets.
Gilbert Company’s budgeted statement of financial position is presented below: