Chapter 10

Budgeting

In This Chapter

Defining the benefits of budgeting

Budgeting profit and cash flow

Determining whether budgeting is worth it

Keeping budgeting in perspective

Staying flexible with budgets

A business can’t open its doors each day without having a pretty good idea of what to expect. And it can’t close its doors at the end of the day not knowing what happened. Recall the Boy Scouts’ motto: “Be prepared.” A business should follow that dictum: It should plan and be prepared for its future, and it should control its actual performance to reach its financial goals.

Business managers can wait for results to be reported to them on a “look back” basis, and then wing it from there. Or, they can look ahead and carefully plan profit, cash flows, and financial condition of the business, to chart its course into the future. The plan provides invaluable benchmarks; actual results can be compared against the plan to detect when things go off course.

Planning the financial future of a business and comparing actual performance against the plan are the essences of business budgeting. Budgeting is not an end to itself but rather a means or tool of financial planning and control.

But keep in mind that budgeting costs time and money. The business manager should put budgeting to the classic technique: the cost versus benefit test. Frankly, budgeting may not earn its keep and could actually cause serious problems that contradict the very reasons for doing it.

Budgeting offers important benefits, but a business may decide not to go to the effort of full-scale budgeting. I can’t argue with a minimal budgeting strategy for some businesses. However, a business should not throw out the budgeting baby with the bath water. Certain techniques used in budgeting are very useful even when a business doesn’t do formal budgeting.

Exploring the Reasons for Budgeting

The financial statements included in the financial reports of a business are prepared after the fact; they’re based on transactions that have already taken place. (I explain business financial statements in Chapters 4, 5, and 6.) Budgeted financial statements, on the other hand, are prepared before the fact and reflect future transactions that are expected to take place based on the business’s strategy and financial goals. Budgeted financial statements are not shared outside the business; they are strictly for internal management use.

Business budgeting requires setting specific goals and developing the detailed plans necessary to achieve them. Business budgeting should be built on realistic forecasts for the coming period. Realistic means attainable and probable. (In larger organizations managers may set their budget objectives too low and easy, in order to achieve them.) A business budget is an integrated plan of action — not simply a few trend lines on a financial chart. Budgeting is much more than slap-dashing together a few figures. A budget is an integrated financial plan put down on paper — or, more likely these days, entered in computer spreadsheets. (There are several good budgeting software programs on the market today; your CPA or other consultant can advise you on which ones are best for your business.)

Business managers don’t (or shouldn’t) just look out the window and come up with budget numbers. Budgeting is not pie-in-the-sky wishful thinking. Business budgeting — to have practical value — must start with a broad-based critical analysis of the most recent actual performance and position of the business by the managers who are responsible for the results. Then the managers decide on specific and concrete goals for the coming year. (Budgets can be done for more than one year, but the first stepping stone into the future is the budget for the coming year — see the sidebar “Taking it one game at a time.”)

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In short, budgeting demands a fair amount of managers’ time and energy. Budgets should be worth this time and effort. So why should a business go to the trouble of budgeting? Business managers budget and prepare budgeted financial statements for three main reasons: modeling, planning, and control.

Modeling reasons for budgeting

Business managers should make detailed analyses to determine how to improve the financial performance and condition of their business. The status quo is usually not good enough; business managers are paid to improve things — not to simply rest on their past accomplishments. For this reason managers should develop good models of profit, cash flow, and financial condition for their business. Models are blueprints or schematics of how things work. A financial model is like a roadmap that clearly marks the pathways to profit, cash flow, and financial condition.

Don’t be intimidated by the term model. Simply put, a model consists of variables and how they interact. A variable is a critical factor that, in conjunction with other factors, determines results. A model is analytical, but not all models are mathematical. In fact, none of the financial models in this book is the least bit mathematical — but you do have to look at each factor of the model and how it interacts with one or more other factors. Here’s an example of an accounting model, which is called the accounting equation:

Assets = Liabilities + Owners’ equity

This is a very condensed model of the balance sheet. The accounting equation is not detailed enough for budgeting, however. More detail about assets and liabilities is needed for budgeting purposes.

Chapter 9 presents a profit template for managers (see Figure 9-1). This template is, at its core, a model. It includes the critical variables that drive profit: sales volume, sales price, product cost, and so on. A profit model, such as the one in Figure 9-1, provides the framework for understanding and analyzing profit performance. A good profit model also serves as the platform and the point of departure for mapping out profit strategies for the coming period.

Likewise, business managers need a model, or blueprint, in planning cash flow from operating activities. (I explain this vital source of cash flow in Chapter 6.) Managers should definitely forecast the amount of cash they will generate during the coming year from making profit. They need a reliable estimate of this source of cash flow in order to plan for other sources of cash flow they will need during the coming year — to provide the money for replacing and expanding the long-term operating (fixed) assets of the business and to make cash distributions from profit to owners. Managers need a model, or map if you prefer that provides a clear trail of how the sales and expenses of the business drive its assets and liabilities, which in turn drive the cash flow from operating activities.

Most business managers see the advantages of budgeting profit for the coming year; you don’t have to twist their arms to convince them. At the same time, many business mangers do not carry through and do not budget changes in assets and liabilities during the coming year, which means they can’t budget cash flow from operating activities. All their budget effort is focused on profit, and they leave cash flows and financial condition unattended. This is a dangerous strategy when the business is in a tight cash position. The business should not simply assume that its cash flow from operating activities would be adequate to its needs during the coming year.

Generally, a business should prepare all three budgeted financial statements:

Budgeted income statement (profit report): A profit analysis model, such as the one shown in Figure 9-1, highlights the critical variables that drive profit. Remember that this model separates variable and fixed expenses and focuses on sales volume, margin per unit, and other factors that determine profit performance. These are the key factors that must be improved to enhance profit performance in the coming period. The highly condensed basic profit model provides a useful frame of reference for preparing the much more detailed, comprehensive profit budget.

Budgeted balance sheet: The key connections and ratios between sales revenue and expenses and their corresponding assets and liabilities are the elements in the model for the budgeted balance sheet. These vital connections are explained throughout Chapters 4 and 5. The budgeted changes in operating assets and liabilities provide the information needed for budgeting cash flows during the coming year.

Budgeted statement of cash flows: The budgeted changes during the coming year in the assets and liabilities used in making profit (conducting operating activities) determine cash flow from operating activities for the coming year (see Chapter 6). In contrast, the cash flows of investing and financing activities depend on the managers’ strategic decisions regarding capital expenditures that will be made during the coming year, how much new capital will be raised from debt and from owners’ sources of capital, and the business’s policy regarding cash distributions from profit.

In short, budgeting requires good working models of making profit, financial condition (assets and liabilities), and cash flow. Budgeting provides a strong incentive for business managers to develop financial models that help them make strategic decisions, exercise control, and do better planning.

Planning reasons for budgeting

One purpose of budgeting is to force managers to create a definite and detailed financial plan for the coming period. To construct a budget, managers have to establish explicit financial objectives for the coming year and identify exactly what has to be done to accomplish these financial objectives. Budgeted financial statements and their supporting schedules provide clear destination points — the financial flight plan for a business.

The process of putting together a budget directs attention to the specific things that you must do to achieve your profit objectives and optimize your assets and capital. Basically, budgets are a form of planning that push managers to answer the question, “How are we going to get there from here?”

Budgeting can also yield other important planning-related benefits:

Budgeting encourages a business to articulate its vision, strategy, and goals. A business needs a clearly stated strategy guided by an overarching vision, and it should have definite and explicit goals. It is not enough for business managers to have strategies and goals in their heads. Developing budgeted financial statements forces managers to be explicit and definite about the objectives of the business, as well as to formulate realistic plans for achieving the business objectives.

Budgeting imposes discipline and deadlines on the planning process. Busy managers have trouble finding enough time for lunch, let alone planning for the upcoming financial period. Budgeting pushes managers to set aside time to prepare a detailed plan that serves as a road map for the business. Good planning results in a concrete course of action that details how a company plans to achieve its financial objectives.

Control reasons for budgeting

I deliberately put this reason last, after the modeling and planning reasons for budgeting. Many people have the mistaken notion that the purpose of budgeting is to rein in managers and employees, who otherwise would spend money like drunken sailors. Budgeting should not put the business’s managers in a financial strait jacket. Tying the hands of managers is not the purpose of budgeting. Having said this, however, it’s true that budgets serve a management control function. Management control, first and foremost, means achieving the financial goals and objectives of the business, which requires comparing actual performance against some sort of benchmarks and holding individual managers responsible for keeping the business on schedule in reaching its financial objectives.

The board of directors of a corporation focuses its attention on the master budget for the whole business: the budgeted income statement, balance sheet, and cash flow statement for the business for the coming year. The chief executive officer (CEO) of the business focuses on the master budget as well, but the CEO must also look at how each manager in the organization is doing on his or her part of the master budget. As you move down the organization chart of a business, managers have narrower responsibilities — say, for the business’s northeastern territory or for one major product line. A master budget consists of different segments that follow the business’s organizational structure. In other words, the master budget is put together from many pieces, one for each separate organizational unit of the business. For example, the manager of one of the company’s far-flung warehouses has a separate budget for expenses and inventory levels for his or her bailiwick.

By using budget targets as benchmarks against which actual performance is compared, managers can closely monitor progress toward (or deviations from) the budget goals and timetable. You use a budget plan like a navigation chart to keep your business on course. Significant variations from the budget raise red flags, in which case you can determine that performance is off course or that the budget needs to be revised because of unexpected developments.

For management control, a budgeted profit report is divided into months or quarters for the coming year. The budgeted balance sheet and budgeted cash flow statement may also be put on a monthly or quarterly basis. The business should not wait too long to compare budgeted sales revenue and expenses against actual performance (or to compare actual cash flows and asset levels against the budget). You need to take prompt action when problems arise, such as a divergence between budgeted expenses and actual expenses.

Profit is the main thing to pay attention to, but accounts receivable and inventory can also get out of control (become too high relative to actual sales revenue and cost of goods sold expense), causing cash flow problems. (Chapter 6 explains how increases in accounts receivable and inventory are negative factors on cash flow.) A business cannot afford to ignore its balance sheet and cash flow numbers until the end of the year.

Additional Benefits of Budgeting

Budgeting has advantages and ramifications that go beyond the financial dimension and have more to do with business management in general. Consider the following:

Budgeting forces managers to do better forecasting. Managers should be constantly scanning the business environment to spot changes that will impact the business. Vague generalizations about what the future may hold for the business are not good enough for assembling a budget. Managers are forced to put their predictions into definite and concrete forecasts. For example, a recent issue of a business newsletter listed the following costs that a business has to (or should) forecast (Barbara Weltman Big Ideas for Small Businesses, October 1, 2012):

• Wages and salaries

• Insurance (health, business owner policies, workers’ compensation)

• Energy costs

• Postage and shipping costs

• Interest rates

• Travel and entertainment

• Technology (software, hardware, and consultants)

• Legal fees, rents, and audits

Budgeting motivates managers and employees by providing useful yardsticks for evaluating performance. The budgeting process can have a good motivational impact by involving managers in the budgeting process (especially in setting goals and objectives) and by providing incentives to managers to strive for and achieve the business’s goals and objectives. Budgets provide useful information for superiors to evaluate the performance of managers and can be used to reward good results. Employees may be equally motivated by budgets. For example, budgets supply baseline financial information for incentive compensation plans. And the profit plan (budget) for the year can be used to award year-end bonuses according to whether designated goals were achieved.

Budgeting can assist in the communication between different levels of management. Putting plans and expectations in black and white in budgeted financial statements — including definite numbers for forecasts and goals — minimizes confusion and creates a kind of common language. As you know, the “failure to communicate” lament is common in many business organizations. Well-crafted budgets can definitely help the communication process.

Budgeting is essential in writing a business plan. New and emerging businesses need to present a convincing business plan when raising capital. Because these businesses may have little or no history, the managers and owners must demonstrate convincingly that the company has a clear strategy and a realistic plan to make profit. A coherent, realistic budget forecast is an essential component of a business plan. Venture capital sources definitely want to see the budgeted financial statements of a business.

In larger businesses, budgets are typically used to hold managers accountable for their areas of responsibility in the organization; actual results are compared against budgeted goals and timetables, and variances are highlighted. Managers do not mind taking credit for favorable variances, when actual comes in better than budget. But beating the budget for the period does not always indicate outstanding performance. A favorable variance could be the result of gaming the budget in the first place, so that the budgeted benchmarks can be easily achieved.

Likewise, unfavorable variances have to be interpreted carefully. If a manager’s budgeted goals and targets are fair and reasonable, the manager should be held responsible. The manager should carefully analyze what went wrong and what needs to be improved. Stern action may be called for, but the higher ups should recognize that the budget benchmarks may not be entirely fair; in particular, they should make allowances for unexpected developments that occur after the budget goals and targets are established (such as a hurricane or tornado, or the bankruptcy of a major customer). When managers perceive the budgeted goals and targets to be arbitrarily imposed by superiors and not realistic, serious motivational problems can arise.

Is Budgeting Worth Its Costs?

As you have undoubtedly heard, there’s no such thing as a free lunch. Budgeting has its costs, which managers should take into account before rushing into (or continuing with) a full-scale budgeting process. Whether or not to engage in budgeting is a prime example of how managers make tough decisions: comparing costs versus benefits. Budgeting has many benefits, but managers have to weigh these against the costs of budgeting. And by costs, I don’t mean just the monetary out-of-pocket costs. The costs of budgeting are in several different dimensions.

Budgeting is not without several serious problems on the practical level. Budgeting looks good in theory, but in actual practice things are not so rosy. Here are some concerns to consider:

Budgeting takes time, and the one thing all business managers will tell you is that they never have enough time for all the things they should do. The question always is: What else could managers do with their time if budgeting were eliminated or scaled down?

Budgeting done from the top down (from headquarters down to the lower levels of managers) can stifle innovation and discourage managers from taking the initiative when they should.

Unrealistic budget goals can demotivate managers rather than motivate them.

Managers may game the budget, which means they play the budget as a game in which they worry first and foremost about how they will be affected by the budget rather than what’s best for the business.

There have been cases in which managers resorted to accounting fraud to make their budget numbers.

There has always been grumbling about budgeting. A well-known adage in the advertising profession is that half of a company’s advertising cost is wasted; the problem is that managers don’t know which half. Likewise, you could argue that half the cost of budgeting is wasted; although it’s difficult to pinpoint which particular aspects of budgeting are not cost effective.

A recent article makes a strongly worded case against budgeting. See Freed from the Budget, by Russ Banham, which was posted on the www.CFO.com website and taken from the September 1, 2012 issue of CFO magazine. This polemic offers several reasons for not budgeting, including the following:

Budgeting prevents rapid response to unpredictable events

Budgeting stifles initiative and innovations

Budgeting protects non value-adding costs

Budgeting demotivates people

The article makes a good case against budgeting, but in my mind it doesn’t provide a very convincing answer to the question: If not budgeting, then what? Quite clearly business managers must plan and control. The trick is how to carry out these tasks in the most effective and efficient manner.

Realizing That Not Everyone Budgets

Most of what I’ve said so far in this chapter can be likened to a commercial for budgeting — emphasizing the reasons for and advantages of budgeting by a business. So every business does budgeting, right? Nope. Smaller businesses generally do little or no budgeting — and even many larger businesses avoid budgeting, at least in a formal and comprehensive manner. The reasons are many, and mostly practical in nature.

Avoiding budgeting

Some businesses are in relatively mature stages of their life cycle or operate in a mature and stable industry. These companies do not have to plan for any major changes or discontinuities. Next year will be a great deal like last year. The benefits of going through a formal budgeting process do not seem worth the time and cost.

At the other extreme, a business may be in an uncertain environment, where attempting to predict the future seems pointless. A business may lack the expertise and experience to prepare budgeted financial statements, and it may not be willing to pay the cost for a CPA or outside consultant to help.

But what if your business applies for a loan? The lender will demand to see a well-thought-out budget in your business plan, right? Not necessarily. I served on a local bank’s board of directors for several years, and I reviewed many loan requests. Our bank did not expect a business to include a set of budgeted financial statements in the loan request package. Of course, we did demand to see the latest financial statements of the business. Very few of our smaller business clients prepared budgeted financial statements.

Relying on internal accounting reports

Although many businesses do not prepare budgets, they still establish fairly specific goals and performance objectives that serve as good benchmarks for management control. Every business — whether it does budgeting or not — should design internal accounting reports that provide the information managers need in running a business. Obviously, managers should keep close tabs on what’s going on throughout the business. Some years ago, in one of my classes, I asked students for a short definition of management control. One student answered that management control means “watching everything.” That’s not bad.

Even in a business that doesn’t do budgeting, managers depend on regular profit reports, balance sheets, and cash flow statements. These key internal financial statements should provide detailed management control information. These feedback reports are also used for looking ahead and thinking about the future. Other specialized accounting reports may be needed as well.

Making reports useful for management control

Most business managers, in my experience, would tell you that the accounting reports they get are reasonably good for management control. Their accounting reports provide the detailed information they need for keeping a close watch on the 1,001 details of the business (or their particular sphere of responsibility in the business organization).

What are the criticisms I hear most often about internal accounting reports?

They contain too much information.

All the information is flat, as if each piece of information is equally relevant.

Managers are busy people and have only so much time to read the accounting reports coming to them. Managers have a valid beef on this score, I think. Ideally, significant deviations and problems should be highlighted in the accounting reports they receive — but separating the important from the not-so-important is easier said than done.

Making reports useful for decision making

If you were to ask a cross-section of business managers how useful their accounting reports are for making decisions, you would get a different answer than how good the accounting reports are for management control. To improvise on the tag line of the airline I recently flew on: Management decision-making is a whole different animal than management control.

Business managers make many decisions affecting profit: setting sales prices, buying products, determining wages and salaries, hiring independent contractors, and purchasing fixed assets, for example. Managers should carefully analyze how their actions would impact profit before reaching final decisions. Managers need internal profit reports that serve as good profit models — that make clear the critical variables that affect profit. (Figure 10-1 in the next section presents an example). Well-designed management profit reports are absolutely essential for helping managers make good decisions.

Keep in mind that almost all business decisions involve non-financial and non-quantifiable factors that go beyond the information included in accounting reports. For example, the accounting department of a business can calculate the cost savings of a wage cut, or the elimination of overtime hours by employees, or a change in the retirement plan for employees — and the manager would certainly look at this data. But such decisions must consider many other factors, such as effects on employee morale and productivity, the possibility of the union going on strike, legal issues, and so on. In short, accounting reports provide only part of the information needed for business decisions, though an essential part for sure.

Making reports clear and straightforward

Needless to say, the internal accounting reports to managers should be clear and straightforward. The manner of presentation and means of communication should get the manager’s attention, and a manager should not have to call the accounting department for explanations.

Designing useful management accounting reports is a challenging task. Within one business organization, an accounting report may have to be somewhat different from one profit center to the next. Standardizing accounting reports may seem like a good idea but may not be in the best interests of the various managers throughout the business — who have different responsibilities and different problems to deal with.

Many of the management accounting reports that I’ve seen could be improved — substantially! Accounting systems pay so much attention to the demands of preparing external financial statements and tax returns that managers’ needs for good internal reports are often overlooked or ignored. The accounting reports in many businesses do not speak to the managers receiving them; the reports are voluminous and technical and are not focused on the most urgent and important problems facing the managers. Designing good internal accounting reports for managers is a challenging task, to be sure. But every business should take a hard look at its internal management accounting reports and identify what should be improved.

Watching Budgeting in Action

Suppose you’re the general manager of one of a large company’s several divisions, which is a major profit center of the business. (I discuss profit centers in Chapter 9.) You have broad authority to run this division, as well as the responsibility for meeting the financial expectations for your division. To be more specific, your profit responsibility is to produce a satisfactory annual operating profit, which is the amount of earnings before interest and income tax (EBIT). (Interest and income tax expenses are handled at the headquarters level in the organization.)

The CEO has made clear to you that she expects your division to increase EBIT during the coming year by 10 percent, or $256,000 to be exact. In fact, she has asked you to prepare a budgeted profit report showing your plan of action for increasing your division’s EBIT by this target amount. She also has asked you to prepare a summary for the budgeted cash flow from operating activities based on your profit plan for the coming year.

Figure 10-1 presents the P&L report of your division for the year just ended. The format of this accounting report follows the profit report template explained in Chapter 9, which is designed for understanding profit behavior and how to increase profit. Note that fixed operating expenses are separated from the two variable operating expenses. (Your actual reports may include more detailed information about sales and expenses.) To keep number crunching to a minimum, I assume that you sell only one product in this example. Most businesses sell a range of products, not just one. So, they have to apply profit analysis to each product, department, product line, or other grouping of the company’s sources of profit. See the sidebar “Keeping an eye on sales mix.”

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Figure 10-1: P&L report for the year just ended.

Developing your profit improvement strategy and profit budget

Being an experienced manager, you know the importance of protecting your unit margins. Your division sold 260,000 units in the year just ended (see Figure 10-1). Your margin per unit was $32. If all your costs were to remain the same next year (you wish!), you could sell 8,000 more units to reach your $256,000 profit improvement goal:

$256,000 additional margin needed ÷ $32 margin per unit = 8,000 additional units

The relatively small increase in your sales volume (8,000 additional units ÷ 260,000 units = 3.1 percent) should not increase your fixed expenses — unless you’re already operating at full capacity and would have to increase warehouse space and delivery capacity to take on even a small increase in sales volume. But realistically, some or most of your costs will probably increase next year.

Let’s take this one step at a time. First, we look at your fixed expenses for the coming year. You and your managers, with the assistance of your trusty accounting staff, have analyzed your fixed expenses line by line for the coming year. Some of these fixed expenses will actually be reduced or eliminated next year. But the large majority of these costs will continue next year, and most are subject to inflation. Based on careful studies and estimates, you and your staff forecast total fixed operating expenses for next year will be $6,006,000, which is $286,000 more than the year just ended.

Fortunately, you think that your volume-driven variable expenses should not increase next year. These are mainly transportation costs, and the shipping industry is in a very competitive, hold-the-price-down mode of operations that should last through the coming year. The cost per unit shipped should not increase.

You have decided to hold the revenue-driven operating expenses at 8 percent of sales revenue during the coming year, the same as for the year just ended. These are sales commissions, and you have already announced to your sales staff that their sales commission percentage will remain the same during the coming year. On the other hand, your purchasing manager has told you to plan on a 4 percent product cost increase next year — from $55 per unit to $57.20 per unit, or an increase of $2.20 per unit.

Summing up to this point, your total fixed expenses will increase $286,000 next year, and the $2.20 forecast product cost will drop your margin per unit from $32.00 to $29.80 if your sales price does not increase. One way to achieve your profit goal next year would be to load all the needed increase on sales volume and keep sales price the same. (I’m not suggesting that this strategy is a good one, but it serves as a good point of departure.)

So, what would your sales volume have to be next year? Remember: You want to increase profit $256,000 (orders from on high), and your fixed expenses will increase $286,000 next year. So, your margin goal for next year is determined as follows:

$8,320,000 margin for year just ended + $286,000 fixed expenses increase + $256,000 profit improvement goal = $8,862,000 margin goal

Without bumping sales price, your margin would be only $29.80 per unit next year. At this margin per unit you will have to sell over 297,000 units:

$8,862,000 total margin goal ÷ $29.80 margin per unit = 297,383 units sales volume

Compared with the 260,000 units sales volume in the year just ended, you would have to increase sales by more than 37,000 units, or more than 14 percent.

You and your sales manager conclude that sales volume cannot be increased 14 percent. You’ll have to raise the sales price to compensate for the increase in product cost and to help cover the fixed cost increases. After much discussion, you and your sales manager decide to increase the sales price 3 percent, from $100 to $103. Based on the 3 percent sales price increase and the forecast product cost increase, your unit margin next year would be as follows:

At the budgeted $32.56 margin per unit, you determine the sales volume needed next year to reach your profit goal as follows:

$8,862,000 total margin goal next year ÷ $32.56 margin per unit = 272,174 units sales volume

This sales volume is about 5 percent higher than last year (12,174 additional units over the 260,000 sales volume last year = about a 5 percent increase).

You decide to go with the 3 percent sales price increase combined with the 5 percent sales volume growth as your official budget plan. Accordingly, you forward your budgeted profit report for the coming year to the CEO. Figure 10-2 summarizes this profit budget for the coming year, with comparative figures for the year just ended.

The main page of your budgeted profit report is supplemented with appropriate schedules to provide additional detail about sales by types of customers and other relevant information. Also, your budgeted profit plan is broken down into quarters (perhaps months) to provide benchmarks for comparing actual performance during the year against your budgeted targets and timetable.

Figure 10-2: Budgeted profit report for coming year.

Budgeting cash flow for the coming year

The budgeted profit plan (refer to Figure 10-2) is the main focus of attention, but the CEO also requests that all divisions present a budgeted cash flow from operating activities for the coming year. Remember: The profit you’re responsible for as general manager of the division is the amount of operating earnings before interest and income tax (EBIT).

Chapter 6 explains that increases in accounts receivable, inventory, and prepaid expenses hurt cash flow from operating activities and that increases in accounts payable and accrued liabilities help cash flow. In reading the budgeted profit report for the coming year (refer to Figure 10-2), you see that virtually every budgeted figure for the coming year is higher than the figure for the year just ended. Therefore, your operating assets and liabilities will increase at the higher sales revenue and expense levels next year — unless you can implement changes to prevent the increases.

For example, sales revenue increases from $26,000,000 to the budgeted $28,033,968 next year (refer to Figure 10-2) — an increase of $2,033,968. Your accounts receivable balance was five weeks of annual sales last year. Do you plan to tighten up the credit terms offered to customers next year —a year in which you will raise the sales price and also plan to increase sales volume? I doubt it. More likely, you will attempt to keep your accounts receivable balance at five weeks of annual sales.

Assume that you decide to offer your customers the same credit terms next year. Thus, the increase in sales revenue will cause accounts receivable to increase by $195,574:

5/52 × $2,033,968 sales revenue increase = $195,574 accounts receivable increase

Last year, inventory was 13 weeks of annual cost of goods sold expense. You may be in the process of implementing inventory reduction techniques. If you really expect to reduce the average time inventory will be held in stock before being sold, you should inform your accounting staff so that they can include this key change in the balance sheet and cash flow models. Otherwise, they will assume that the past ratios for these vital connections will continue next year.

Assuming your inventory holding period remains the same, your inventory balance will increase more than $317,000:

13/52 × $1,268,378 cost of goods sold expense increase = $317,055 inventory increase

Figure 10-3 presents a brief summary of your budgeted cash flow from operating activities based on the information given for this example and using your historical ratios for short-term assets and liabilities driven by sales and expenses. Note: Increases in accrued interest payable and income tax payable are not included in your budgeted cash flow. Your profit responsibility ends at the operating profit line, or earnings before interest and income tax expenses.

Figure 10-3: Budgeted cash flow from operating activities for the coming year.

You submit this budgeted cash flow from operating activities (see Figure 10-3) to headquarters. Top management expects you to control the increases in your operating assets and liabilities so that the actual cash flow generated by your division next year comes in on target. The cash flow of your division (perhaps minus a small amount needed to increase the working cash balance held by your division) will be transferred to the central treasury of the business. Headquarters will be planning on you generating about $3.2 million cash flow during the coming year.

Considering Capital Expenditures and Other Cash Needs

This chapter focuses on profit budgeting for the coming year and budgeting the cash flow from that profit. These are the two hardcore components of business budgeting, but not the whole story. Another key element of the budgeting process is to prepare a capital expenditures budget for your division that goes to top management for review and approval. A business has to take a hard look at its long-term operating assets — in particular, the capacity, condition, and efficiency of these resources — and decide whether it needs to expand and modernize its property, plant, and equipment.

In most cases, a business needs to invest substantial sums of money in purchasing new fixed assets or retrofitting and upgrading its old fixed assets. These long-term investments require major cash outlays. So, each division of a business prepares a formal list of the fixed assets to be purchased, constructed, and upgraded. The money for these major outlays comes from the central treasury of the business. Accordingly, the overall capital expenditures budget goes to the highest levels in the organization for review and final approval. The chief financial officer, the CEO, and the board of directors of the business go over a capital expenditure budget request with a fine-toothed comb (or at least they should).

A major factor in analyzing capital expenditures is the cost of capital, or the return on investment (ROI) that a business must earn. Cost of capital refers to the time value of money, and is measured based on interest rates and return on equity (ROE) expectations. (See Chapter 13 for more on ROE.) A company’s cost of capital depends on its mix of debt and equity and the respective costs of these two capital determinants. The cost of capital is used in capital budgeting analysis (another term for capital expenditures analysis), which is beyond the scope of this book. It involves calculating the internal rate of return (IRR) and present value (PV) of the future cash flows from an investment of capital.

At the company-wide level, the financial officers merge the profit and cash flow budgets of all profit centers and cost centers of the business. (A cost center is an organizational unit that does not generate revenue, such as the legal and accounting departments.) The budgets submitted by one or more of the divisions may be returned for revision before final approval is given. One concern is whether the collective cash flow total from all the units provides enough money for the capital expenditures that will be made during the coming year — and to meet the other demands for cash, such as for cash distributions from profit. The business may have to raise more capital from debt or equity sources during the coming year to close the gap between cash flow from operating activities and its needs for cash. This is a central topic in the field of business finance and beyond the coverage of this book.

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