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Chapter 6: Problem 8

Outline the steps in preparing an operating budget.

Short Answer

Expert verified
To prepare an operating budget, follow these steps: (1) Set goals and objectives for the budget period, ensuring alignment with the company's mission, vision, and long-term strategy. (2) Gather historical data and information, analyzing financial statements, sales reports, and market trends to identify patterns. (3) Project sales and revenue, considering factors like seasonality and competition. (4) Estimate the cost of goods sold (COGS) based on projected sales volume and associated costs. (5) Project operating expenses, including salaries, rent, utilities, and marketing. (6) Calculate net operating income (NOI) by subtracting COGS and operating expenses from the projected revenue. (7) Review and finalize the budget, setting targets for key performance indicators (KPIs) that support the objectives. (8) Monitor and adjust the budget as needed, comparing actual results against projections and taking corrective action as necessary.

Step by step solution

01

Set goals and objectives for the budget period

Before starting the process of preparing an operating budget, management must decide on the overall objectives for the budget period. These goals should align with the company's mission, vision, and long-term strategy. They usually revolve around sales growth, cost control, and market expansion.
02

Gather historical data and information

Gather historical information to provide context and form the basis to project the future. Analyze previous financial statements, sales reports, market trends, and other relevant data to identify patterns and trends. This information will help project future revenue and expenses.
03

Project sales and revenue

Estimate expected sales and revenue for the budget period, based on historical data, current market conditions, and company growth goals. Consider factors such as seasonality, competition, economic conditions, and marketing initiatives. Calculate projected sales volume and average selling price to derive the total sales revenue.
04

Estimate the cost of goods sold (COGS)

Estimate the cost of goods sold (COGS) based on the projected sales volume and associated costs such as raw materials, labor, and manufacturing overhead. This step involves understanding the company's production process, inventory policies, and variable and fixed costs that contribute to the production of goods.
05

Project operating expenses

List and estimate all operating expenses for the budget period, including salaries, rent, utilities, marketing, and general administrative costs. These expenses typically have both variable and fixed components. Evaluate the company's cost structure and consider any planned cost-cutting or efficiency initiatives.
06

Calculate net operating income (NOI)

Subtract the cost of goods sold (COGS) and operating expenses from the projected revenue to calculate the net operating income (NOI). The NOI represents the profit generated by the company's primary operations before considering non-operating income, financing costs, and taxes.
07

Review and finalize the budget

Review the budget to ensure the estimated revenue and expenses align with company goals and objectives. Make any necessary adjustments and set targets for key performance indicators (KPIs) that support the budget's objectives. The finalized operating budget should serve as a roadmap for the company, guiding decision-making throughout the budget period.
08

Monitor and adjust the budget as needed

Throughout the budget period, compare actual results against budget projections. Analyze variances to identify areas where adjustments may be necessary, and use this information to improve future budgeting efforts. Regular monitoring allows management to take corrective action as needed to ensure the company stays on track to achieve its objectives.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Budget Period Goals
When creating an operating budget, the first crucial step is to define clear objectives that align with the company's strategic vision. This could include intentions to increase sales, enhance efficiency, or enter new markets. These goals serve as a compass for the budget, guiding the financial planning to support these ambitions. For instance, if the goal is to boost sales by 20%, the budget might include increased marketing expenditures or investment in product development.

It's imperative to set feasibly measurable targets, facilitating the later assessment of the budget's success. Goals should be specific, measurable, achievable, relevant, and time-bound (SMART), ensuring they provide a solid foundation for the preparation of the operating budget.
Historical Data Analysis
The analysis of historical data underpins accurate forecasting. By reviewing past financial statements and market trends, businesses can discern patterns essential for predicting future performance. Historical data provides an insight into sales cycles, customer behavior, and effectiveness of past marketing strategies, which can shape future projections.

Analyzing historical data is not merely a retrospective look but a diagnostic tool that helps in understanding what has worked well or not. This analysis can influence decisions on inventory management, pricing strategies, and can also shed light on areas where cost efficiencies might be achieved.
Sales and Revenue Projection
Accurately projecting sales and revenue is crucial for preparing an effective operating budget. This projection starts with a thorough analysis of market conditions, competition, customer demand, and potential economic factors that could impact sales. By considering these elements, businesses can set realistic sales volume expectations and pricing strategies.

In the projection, factors like seasonality or the introduction of new products should also be taken into account. Estimates should be based on both qualitative insights from sales and marketing teams and quantitative analysis from historical sales data to create a well-rounded and substantiated forecast.
Cost of Goods Sold Estimation
Estimating the cost of goods sold (COGS) is pivotal, as it directly affects the profitability of the business. This estimation includes all direct costs associated with the production of goods, such as raw materials, labor, and overhead costs.

Understanding the company's production process is necessary to differentiate between variable costs that fluctuate with production volume, and fixed costs that remain constant. Accurate COGS calculation is necessary for setting pricing strategies and for the evaluation of gross margin, which is an integral metric of business performance.
Operating Expenses Estimation
Beyond COGS, operating expenses encompass all other costs involved in running a business. These include rent, utilities, salaries, marketing expenses, and more. To estimate these, a detailed listing of all expected expenses should be compiled, differentiating between variable expenses that change with the level of business activity and fixed expenses that do not.

When projecting operating expenses, it's also valuable to consider any scheduled business changes, such as planned expansions or contractions, that could influence these expenditures. The aim is to facilitate as precise a budgeting as possible, reducing the likelihood of unexpected shortfalls.
Net Operating Income Calculation
The net operating income (NOI) is a crucial figure that indicates the company's profitability from its core business operations. To calculate NOI, subtract both the COGS and operating expenses from the projected revenue. This figure is essential because it reflects the company's capacity to generate profit through its primary activities before factoring in non-operating income, interest, or taxes.

It's a key metric used by management to make decisions about investments, expansions, and operational adjustments. It's also a critical indicator for stakeholders to assess the company's operational efficiency and profitability.
Budget Review and Adjustment
A rigorous review process is necessary to ensure the budget aligns with the company's strategic goals. This involves scrutinizing every aspect of the budget, questioning the accuracy of the projections, the assumptions made, and whether the set goals can be realistically met with the planned financial outlay.

Based on this review, adjustments may be required to either the revenue projections, the expense estimates, or both. Possible changes can include cost-saving measures, reallocating resources, or revising sales strategies. The adjustment process ensures the budget is both ambitious and achievable.
Performance Monitoring
The final step in the operating budget cycle is performance monitoring, which involves tracking the actual financial results against the budget projections. Regularly reviewing this performance allows the business to manage and respond to variances promptly.

When discrepancies arise, as they invariably will, it's important to understand why they occurred, and whether they signal a need for change in business operations or strategy. Continued monitoring prevents minor issues from becoming major problems and is an essential practice for maintaining financial control and ensuring the company meets its operational objectives.

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Most popular questions from this chapter

Comprehensive problem; ABC manufacturing, two products. Hazlett, Inc., operates at capacity and makes plastic combs and hairbrushes. Although the combs and brushes are a matching set, they are sold individually and so the sales mix is not 1: 1 . Hazlett's management is planning its annual budget for fiscal year \(2018 .\) Here is information for 2018 : Hazlett uses a FIF0 cost-flow assumption for finished-goods inventory. Combs are manufactured in batches of \(200,\) and brushes are manufactured in batches of \(100 .\) It takes 20 minutes to set up for a batch of combs and 1 hour to set up for a batch of brushes. Hazlett uses activity-based costing and has classified all overhead costs as shown in the following table. Budgeted fixed overhead costs vary with capacity. Hazlett operates at capacity so budgeted fixed overhead cost per unit equals the budgeted fixed overhead costs divided by the budgeted quantities of the cost allocation base. Delivery trucks transport units sold in delivery sizes of 1,000 combs or 1,000 brushes. Do the following for the year 2018 : 1\. Prepare the revenues budget. 2\. Use the revenues budget to: a. Find the budgeted allocation rate for marketing costs. b. Find the budgeted number of deliveries and allocation rate for distribution costs. 3\. Prepare the production budget in units. 4\. Use the production budget to: a. Find the budgeted number of setups and setup-hours and the allocation rate for setup costs. b. Find the budgeted total machine-hours and the allocation rate for processing costs. c. Find the budgeted total units produced and the allocation rate for inspection costs. 5\. Prepare the direct material usage budget and the direct material purchases budget in both units and dollars; round to whole dollars. 6\. Use the direct material usage budget to find the budgeted allocation rate for materials-handling costs. 7\. Prepare the direct manufacturing labor cost budget 8\. Prepare the manufacturing overhead cost budget for materials handling, setup, processing, and inspection costs 9\. Prepare the budgeted unit cost of ending finished-goods inventory and ending inventories budget 10\. Prepare the cost of goods sold budget. 11\. Prepare the nonmanufacturing overhead costs budget for marketing and distribution. 12\. Prepare a budgeted income statement (ignore income taxes). 13\. How does preparing the budget help Hazlett's management team better manage the company?

Comprehensive operating budget. Skulas, Inc., manufactures and sells snowboards. Skulas manufactures a single model, the Pipex. In late 2017 , Skulas's management accountant gathered the following data to prepare budgets for January 2018 : Skulas's CEO expects to sell 2,900 snowboards during January 2018 at an estimated retail price of \(650\) per board. Further, the CEO expects 2018 beginning inventory of 500 snowboards and would like to end January 2018 with 200 snowboards in stock. Variable manufacturing overhead is \( 7\) per direct manufacturing labor-hour. There are also \( 81,000\) in fixed manufacturing overhead costs budgeted for January \(2018 .\) Skulas combines both variable and fixed manufacturing overhead into a single rate based on direct manufacturing labor-hours. Variable marketing costs are allocated at the rate of \( 250\) per sales visit. The marketing plan calls for 38 sales visits during January 2018\. Finally, there are \( 35,000\) in fixed nonmanufacturing costs budgeted for January 2018 Other data include: The inventoriable unit cost for ending finished-goods inventory on December \(31,2017,\) is \( 374.80 .\) Assume Skulas uses a FIF0 inventory method for both direct materials and finished goods. Ignore work in process in your calculations. 1\. Prepare the January 2018 revenues budget (in dollars). 2\. Prepare the January 2018 production budget (in units). 3\. Prepare the direct material usage and purchases budgets for January 2018 4\. Prepare a direct manufacturing labor costs budget for January 2018 5\. Prepare a manufacturing overhead costs budget for January 2018 6\. What is the budgeted manufacturing overhead rate for January \(2018 ?\) 7\. What is the budgeted manufacturing overhead cost per output unit in January \(2018 ?\) 8\. Calculate the cost of a snowboard manufactured in January 2018 . 9\. Prepare an ending inventory budget for both direct materials and finished goods for January 2018. 10\. Prepare a cost of goods sold budget for January 2018 11\. Prepare the budgeted income statement for Skulas, Inc., for January 2018 12\. What questions might the CEO ask the management team when reviewing the budget? Should the CEO set stretch targets? Explain briefly. 13\. How does preparing the budget help Skulas's management team better manage the company?

Kaizen budgeting for carbon emissions. Apex Chemical Company currently operates three manufacturing plants in Colorado, Utah, and Arizona. Annual carbon emissions for these plants in the first quarter of 2018 are 125,000 metric tons per quarter for 500,000 metric tons in 2018 ). Apex management is investigating improved manufacturing techniques that will reduce annual carbon emissions to below 475,000 metric tons so that the company can meet Environmental Protection Agency guidelines by \(2019 .\) costs and benefits are as follows: Apex Management has chosen to use Kaizen budgeting to achieve its goal for carbon emissions. 1\. If Apex reduces emissions by \(1 \%\) each quarter, beginning with the second quarter of \(2018,\) will the company reach its goal of 475,000 metric tons by the end of \(2019 ?\) 2\. What would be the net financial cost or benefit of their plan? Ignore the time value of money. 3\. What factors other than cost might weigh into Apex's decision to carry out this plan?

'Budgeted performance is a better criterion than past performance for judging managers." Do you agree? Explain.

Responsibility and controllability. Consider each of the following independent situations for Prestige Fountains. Prestige manufactures and sells decorative fountains for commercial properties. The company also contracts to service both its own and other brands of fountains. Prestige has a manufacturing plant, a supply warehouse that supplies both the manufacturing plant and the service technicians (who often need parts to repair fountains), and 12 service vans. The service technicians drive to customer sites to service the fountains. Prestige owns the vans, pays for the gas, and supplies fountain parts, but the technicians own their own tools. 1\. In the manufacturing plant, the production manager is not happy with the motors that the purchasing manager has been purchasing. In May, the production manager stops requesting motors from the supply warehouse and starts purchasing them directly from a different motor manufacturer. Actual materials costs in May are higher than budgeted. 2\. Overhead costs in the manufacturing plant for June are much higher than budgeted. Investigation reveals a utility rate hike in effect that was not figured into the budget. 3\. Gasoline costs for each van are budgeted based on the service area of the van and the amount of driving expected for the month. The driver of van 3 routinely has monthly gasoline costs exceeding the budget for van 3. After investigating, the service manager finds that the diriver has been driving the van for personal use. 4\. Regency Mall, one of Prestige's fountain service customers, calls the service people only for emergencies and not for routine maintenance. Thus, the materials and labor costs for these service calls exceeds the monthly budgeted costs for a contract customer 5\. Prestige's service technicians are paid an hourly wage of S22, regardless of experience or time with the company. As a result of an analysis performed last month, the service manager determined that service technicians in their first year of employment worked on average 20\% more slowly than other employees. Prestige bills customers per service call, not per hour. 6\. The cost of health insurance for service technicians has increased by 40\% this year, which caused the actual health insurance costs to greatly exceed the budgeted health insurance costs for the service technicians For each situation described, determine where (that is, with whom) (a) responsibility and (b) controllability lie. Suggest ways to solve the problem or to improve the situation.
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