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SECTION Preparing to Operate the Business I existing sales staff can make heroic efforts to wildly exceed previousyear sales efforts. Furthermore, the budget must account for a sufficient time period in which new sales personnel can be trained and form an adequate base of customer contacts to create a meaningful stream of revenue for the company. In some industries, this learning curve may be only a few days, but it can be the better part of a year if considerable technical knowledge is required to make a sale. If the latter situation is the case, it is likely that the procurement and retention of qualified sales staff is the key element of success for a company, which makes the sales department budget one of the most important elements of the entire budget. The marketing budget is also closely tied to the revenue budget, for it contains all of the funding required to roll out new products, merchandise them properly, advertise for them, test new products, and so on. A key issue here is to ensure that the marketing budget is fully funded to support any increases in sales noted in the revenue budget. It may be necessary to increase this budget by a disproportionate amount if you are trying to create a new brand, issue a new product, or distribute an existing product in a new market. These costs can easily exceed any associated revenues for some time. Another nonproduction budget that is integral to the success of the corporation is the general and administrative budget, which contains the cost of the corporate management staff, plus all accounting, finance, and human resources personnel. Since this is a cost center, the general inclination is to reduce these costs to the bare minimum. However, there must be a significant investment in technology in order to achieve reductions in the manual labor usually required to process transactions; thus, there must be some provision in the capital budget for this area. There is a feedback loop between the staffing and direct labor budgets and the general and administrative budget, because the human resources department must staff itself based on the amount of hiring or layoffs anticipated elsewhere in the company. Similarly, a major change in the revenue volume will alter the budget for the accounting department, since many of the activities in this area are driven by the volume of sales transactions. Thus, the general and 32 Budgeting for Operations CHAPTER 1 administrative budget generally requires a number of iterations in response to changes in many other parts of the budget. Although salaries and wages should be listed in each of the departmental budgets, it is useful to list the total headcount for each position through all budget periods in a separate staffing budget. By doing so, the human resources staff members can tell when specific positions must be filled, so that they can time their recruiting efforts most appropriately. This budget also provides good information for the person responsible for the facilities budget, since he or she can use it to determine the timing and amount of square footage requirements for office space. Rather than being a stand-alone budget, the staffing budget tends to be one whose formulas are closely intertwined with those of all other departmental budgets. A change in headcount information on this budget will translate automatically into a change in the salaries expense on other budgets. It is also a good place to store the average pay rates, overtime percentages, and average benefit costs for all positions. By centralizing this cost information, the human resources department can update budget information more easily. Since salaryrelated costs tend to comprise the highest proportion of costs in a company (excluding materials costs), this budget tends to be heavily used. The facilities budget is based on the level of activity that is estimated in many of the budgets just described. For this reason, it is one of the last budgets to be completed. This budget is closely linked to the capital budget, since expenditures for additional facilities will require more maintenance expenses in the facilities budget. This budget typically contains expense line items for building insurance, maintenance, repairs, janitorial services, utilities, and the salaries of the maintenance personnel employed in this function. When constructing this budget, it is crucial to estimate the need for any upcoming major repairs to facilities, since these can greatly amplify the total budgeted expense. Another budget that includes input from virtually all areas of a company is the capital budget. This budget should comprise either a summary listing of all main fixed asset categories for which purchases are anticipated or else a detailed listing of the 33 SECTION Preparing to Operate the Business I same information; the latter case is recommended only if there are comparatively few items to be purchased. The capital budget is of great importance to the calculation of corporate financing requirements, since it can involve the expenditure of sums far beyond those that are normally encountered through daily cash flows. It is also necessary to ensure that capital items are scheduled for procurement sufficiently far in advance of related projects that they will be fully installed and operational before the scheduled first activity date of the project. For example, a budget should not itemize revenue from a printing press for the same month in which the press is scheduled to be purchased, because it may take months to set up the press. The end result of all the budgets just described is a set of financial statements that reflects the impact of the upcoming budget on the company. At a minimum, these statements should include the income statement and cash flow statement, since these are the best evidence of fiscal health during the budget period. The balance sheet is less necessary, since the key factors on which it reports are related to cash, and that information is already contained within the cash flow statement. These reports should be directly linked to all the other budgets, so that any changes to the budgets will immediately appear in the financial statements. The management team will closely examine these statements and make numerous adjustments to the budgets in order to arrive at a satisfactory financial result. The budget-linked financial statements are also a good place to store related operational and financial ratios, so that the management team can review this information and revise the budgets in order to alter the ratios to match benchmarking or industry standards that may have been set as goals. Typical measurements in this area can include revenue and income per person, inventory turnover ratios, and gross margin percentages. This type of information is also useful for lenders, who may have required minimum financial performance results as part of loan agreements, such as a minimum current ratio or debt-to-equity ratio. The cash forecast is of exceptional importance, for it tells company managers if the proposed budget model will be feasible. If cash projections result in major cash needs that cannot be met by 34 Budgeting for Operations CHAPTER 1 any possible financing, then the model must be changed. The assumptions that go into the cash forecast should be based on strictly historical fact, rather than the wishes of managers. This stricture is particularly important in the case of cash receipts from accounts receivable. If the assumptions are changed in the model to reflect an advanced rate of cash receipts that exceeds anything that the company has ever experienced, it is very unlikely that it will be achieved during the budget period. Instead, it is better to use proven collection periods as assumptions and alter other parts of the budget to ensure that cash flows remain positive. The last document in the system of budgets is the discussion of financing alternatives. This is not strictly a budget, although it will contain a single line item, derived from the cash forecast, that itemizes funding needs during each period itemized in the budget. In all other respects, it is simply a discussion of financing alternatives, which can be quite varied. Alternatives may involve a mix of debt, supplier financing, preferred stock, common stock, or some other, more innovative approach. The document should contain a discussion of the cost of each form of financing, the ability of the company to obtain it, and when it can be obtained. Managers may find that there are so few financing alternatives available, or that the cost of financing is so high, that the entire budget must be restructured in order to avoid the negative cash flow that calls for the financing. There may also be a need for feedback from this document into the budgeted financial statements in order to account for the cost of obtaining the funding and any related interest costs. Need for Budget Updating Flexible or variable budgets should be kept current so that targets are realistic and accurately reflect deviations from expected costs. Budgets, however, may lose their effectiveness as a measuring and control device if they are adjusted for every small change in operating costs. There is no rule of thumb for triggering a budget adjustment. However, budgets should be adjusted for changes in product mix, major changes in cost levels, and schedule variations that significantly alter cost relationships. 35 SECTION Preparing to Operate the Business I On a departmental level, budget performance reflects actual departmental cost behavior, and budget gains or savings directly result in improvements in profits. The budget becomes an individual department’s profit and loss expectation based on responsibility accounting. One area in which potential problems may not be recognized is deferred maintenance. When increased output or profit is being emphasized, periodic maintenance is often deferred to “keep the wheels turning.” This may be shortsighted, resulting instead in deferred costs when breakdowns occur. Summary The operating budget is a tool that can be integrated into overall operations. It can give an indication about the delays between cash outlays for manufacturing and sales receipts. This delay can be quantified in the budget and thereby permit you to plan for carrying or acquiring additional cash for predictable periods. As with any good planning tool, the operating plan and related budget points up the opportunity for capital expenditures or the need for tightening capital investments. Because sales predictions are the driving force behind budget numbers, you will plan sales forces, marketing objectives, advertising budgets, sales quotas, credit policies, and many other factors as parts of operational budgeting/planning. Finally, manpower planning and allocation can be computed from the production schedule and direct labor rates. The formula is simply a direct allocation of hours per operation per product times the number of units of product scheduled for production, summed over all operations. For example, in the Fruit Crate case: • The total labor hours per crate was .158 hours in May. • In May, the firm scheduled 2,300 crates (equivalent) for production, which represents 363.4 direct labor hours. • There were 176 hours (gross) per worker available in the month. The firm planned for 81 percent utilization in hours as a result of breaks, sickness, leave, and fatigue. 36 Budgeting for Operations CHAPTER 1 • The firm calculates 142.6 hours per man per month effective work time. • By dividing 363.4 by 142.6, the firm arrives at 2.5 direct laborers necessary to produce the crates. Using such an analysis, the firm can also break out, by operation, the number of employees needed for each task. As a control device, an operating plan or budget can provide needed information and direct attention where variances have occurred. 37 Chapter 2 Investing in Long-Term Assets and Capital Budgeting M ost capital investment decisions should be made in two parts: first, the investment decision; then, the financing decision. You should first decide what facilities, equipment, or other capital assets you will acquire, when to acquire them, and what to do with them. Then you should decide where and how to get the money. This chapter will consider only the investment decision; the financing issues are left to Chapter 5. The term capital budgeting may be defined as planning for an expenditure or outlay of cash resources and a return from the anticipated flow of future cash benefits. The necessary elements to be considered for this decision are: • Expected costs and their timing • The flow of anticipated benefits • The time over which those funds will flow • The risk involved in the realization of those benefits Each of these elements has distinct characteristics associated with a company’s management philosophy. Tools have been developed that use the numbers generated by management to help answer questions and to make reasoned decisions among competing 39 SECTION Preparing to Operate the Business I business opportunities for the use of scarce investment dollars. In this chapter, we look at the capital budgeting process as part of a cycle, not as an isolated exercise. We begin with an idea for a new product and proceed through to the discontinuance of that product and into the next generation. Definitions Before attempting an explanation of the capital budgeting process, we need to be familiar with several terms. The common financial terms used in this chapter are: Present value. The present value of an item is the value today of an amount you expect to receive or to pay at some future date. For example, if you expect to receive $100 one year from today, and you can get 12 percent for your money, that stream of income has a present value of $89.29 because $89.29 invested today at 12 percent return will be $100.00 one year from today. Annuity (regular or ordinary). The receipt or payment of a series of equal payments made at the end of each of a number of fixed periods. The receipt of $100 on December 31 of each year for 10 years is an ordinary annuity. (An “annuity due” means payments are received at the beginning of each period rather than at the end.) Payback period. The payback period indicates how long it takes for you to get your money back. In other words, it is the time necessary for net cash inflows to amortize an original investment. Interest or the time value of money often is not considered in simple payback calculations. However, a more appropriate form of payback calculation, called the discounted payback period, does consider the time value. In discounted payback, the present value of the inflows is considered in determining how long it takes to get the investment back. Net present value (NPV). The present value of inflows of cash minus the present value of the outflows of cash. This is normally after-tax cash flows. 40 Investing in Long-Term Assets and Capital Budgeting CHAPTER 2 Present value index. The net present value divided by original investment. (This index is useful only for positive net present values.) Internal rate of return (IRR). The discount (interest) rate, which when used in calculating NPV results in NPV being zero. This is sometimes called the true rate of return. Overview and Use of Capital Budgeting Budgets, a frequently used tool, have been around for a long time. Operating budgets seem to be the most common. Although seldom used to their potential, operating budgets are ordinarily among the first budgets attempted. The numbers for these budgets are not difficult to obtain, and most managers will give at least some credence to their usefulness. Operating budgets are discussed in detail in Chapter 1. Cash budgets are not greatly different from operating budgets in their preparation and use. In cash budgeting, attention is focused on the receipt and expenditure of cash. However, cash budgets often are limited to use by fewer people within a business and often are not formalized until required by shortages of cash or the high cost of maintaining cash reserves. In periods of better financial conditions, the inefficiency of having too much cash often is overlooked. As a result, cash budgets sometimes fall into disuse during periods of prosperity. Capital budgeting, however, does not fare well with many businesspeople. This is due in part to the difficulties of preparing a capital budget. Estimates of cash flows must be pushed farther into the future and unfamiliar terms, such as weighted average cost of capital and internal rate of return, creep into the terminology. The calculations associated with these terms are often unfamiliar; many businesspeople have learned to operate with no formal capital budget. However, used properly, a capital budgeting process can help to reduce the risk of making the wrong decision. Capital budgeting is useful as a decision tool. Accountants, and some of your staff and some managers, probably have been trained to make the calculations necessary for determinations of present 41