10.3. 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 about 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 to mark a clear path 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.

Most businesses, or the major divisions of a large business, sell a mix of several different products. General Motors, for example, sells many makes and models of autos and light trucks, to say nothing about its other products. The next time you visit your local hardware store, take the time to look at the number of products on the shelves. The assortment of products sold by a business and the quantities sold of each that make up its total sales revenue is referred to as its sales mix. As a general rule, certain products have higher profit margins than others. Some products may have extremely low profit margins, so they are called loss leaders.

Figure 10.1. P&L report for the year just ended.

The marketing strategy for loss leaders is to use them as magnets, so customers buy your higher profit margin products along with the loss leaders. Shifting the sales mix to a higher proportion of higher profit margin products has the effect of increasing the average profit margin on all products sold. (A shift to lower profit margin products would have the opposite effect, of course.) Budgeting sales revenue and expenses for the coming year must include any planned shifts in the company's sales mix.

10.3.1. Developing your profit strategy and budgeted profit report

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 costs 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.

Figure 10.2. Budgeted profit report for coming year.

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.

10.3.2. 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 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 (minus, perhaps, 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.