Profit Planning Organization’s Budget

Chapter 9 (Garrison Text)                                                                                                              

Dr.M.S. Bazaz

Profit Planning: Organization’s Budget

• Master budget is a summary of a company’s plans that sets specific targets for sales, production, distribution, and financing activities.  It generally culminates in a cash budget, a budgeted income statement, and a budgeted balance sheet.  In short, it represents a comprehensive expression of management’s plans for the future and how these plans are to be accomplished.

• Planning involves developing objectives and preparing various budgets to achieve these objectives.

• Control involves the steps taken by management to increase the likelihood that the objectives set down at the planning stage are attained, and to ensure that all parts of the organization function in a manner consistent with organizational policies.

• Advantages of Budgeting:
• Budgets provide a means of communicating management’s plans throughout the organization.
• Budgets force managers to think about and plan for the future.  In the absence of the necessity to prepare a budget, too many managers would spend all of their time dealing with daily emergencies.
• The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively.
• The budgeting process can uncover potential bottlenecks before they occur.
• Budgets coordinate the activities of the entire organization by integrating the plans of the various parts.  Budgeting helps to ensure that everyone in the organization is pulling in the same direction.
• Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.

• Responsibility accounting is that a manager should be held responsible for those items – and only those items – that the manager can actually control to a significant extent.  That manager is held responsible for subsequent deviations between budgeted goals and actual results.
• The manager should take the initiative to control any unfavorable discrepancies, should understand the source of significant favorable or unfavorable discrepancies, and should be prepared to explain the reasons for discrepancies to higher management.

• A continuous or perpetual budget is a 12-month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed.   This approach keeps managers focused on the future at least one year ahead.

• Self-imposed budget or participative budget – is a budget that is prepared with the full cooperation and participation of managers at all levels.  This budget approach is generally considered to be the most effective method of budget preparation.

• Several points on participative budgets:  (See page 382 of your book for detail)
• If no control and system of check & balance is present, self-imposed budget may be too loose and allow too much “budgetary slack.”  The result will be inefficiency and waste.  Therefore, immediate superiors must carefully review any self-imposed budget.

• Budget Committee will usually be responsible for overall policy matters relating to the budget program and for coordinating the preparation of the budget itself.  This committee generally consists of the president, VP in charge of various functions such as sales, production and purchasing.

• Master budget interrelationships: (see p.381)
• Sales Budget
• Production budget
• Purchasing budget
• Cash budget
• budgeted income statement
• budgeted balance sheet
• etc.

• Zero-Based Budgeting – managers are required to justify all budgeted expenditures, not just changes in the budget from the previous year.  The baseline is zero rather than last year’s budget.  It is costly and time consuming.

• Considerations of budgeting at international level:
• Foreign currency exchange rate
• High inflation rates
• Local economic conditions
• Governmental policies and restrictions.

• Economic Order Quantity (EOQ) and the Reorder point:
• Costs Associated with Inventory:
• Inventory ordering costs.
• Inventory carrying costs.
• The costs of not carrying sufficient inventory.

• EOQ  -- is the order size that minimizes the sum of the costs of ordering inventory and the costs of carrying inventory will be determined by:
• The tabular approach.
• The formula Approach:  EOQ = sq. root of (2QP/C), where:
• Q = Annual quantity used in units
• C = Annual cost of carrying one unit in stock.
• P = Cost of placing one order. (or setup cost to switch production from one product to another).

• Just-in-time (JIT) and the EOQ.: 
• By examining the EOQ formula, it is clear that EOQ will decrease if:
• The cost of placing an order, P, decreases, or
• The cost of carrying inventory in stock, C, increases.

• Reorder Point and Safety Stock:
• The basic idea is to minimize the costs of holding inventory while ensuring that there will be no stockouts.
• Reorder point tells the manager when to place an order or when to initiate production to replenish depleted stocks.
• It is dependent on three factors:
• the EOQ
• the lead time, and
• the rate of usage during the lead time.
• The lead-time defined as the interval between the time that an order is placed and the time when the order is finally received from the supplier or from the production line.
• Safety stock = (Maximum expected usage per period – Average usage) X Lead time
• Reorder Point = (Lead time X Average daily or weekly usage) + Safety stock