SHORT- AND LONG-TERM
BUDGETING
(PLANNING AND MONITORING)
Financed by
Financed by
Supported by
Supported by
Implemented in cooperation with
Implemented in cooperation with
WHAT IS A BUDGET?
 A budget is a detailed plan of actions for a future period expressed in
numbers
 Forward-looking, but often in consideration of historical patterns
Financed by
Supported by
Implemented in cooperation with
WHY BUDGETING?
Any small business owner intent on planning a successful future for his or her business
must take into account how to fund that plan.
Put simply, maintaining a good short- and long-term financial plan enables you to
control your cash flow instead of having it control you.
1. Budgeting forces management to plan for the future—to develop an overall
direction for the organization, foresee problems, and develop future policies.
2. Budgeting helps convey significant information about the resource capabilities of
an organization, making better decisions possible. Example: A cash budget points
out potential shortfalls.
3. Budgeting helps set standards that can control the use of a company’s resources
and control and motivate employees.
4. Budgeting improves the communication of the plans of the organization to each
employee. Budgets also encourage coordination because the various areas and
activities of the organization must all work together to achieve the stated
objectives.
Financed by
Supported by
Implemented in cooperation with
CLASSIFICATION OF BUDGET BY TIME
Short-term Budgeting




prepared for a period of one
year or less
divided into quarterly or monthly
budgets
typically for continuing
operations
Example: master budget,
operational budgets, cash
budget
Financed by
Supported by
Long-term Budgeting
 prepared for longer than one year,
normally for a period of 5 to 10
years
 generally for assets and projects
 Example: Capital budget,
research and development
budget, long term finances etc.
Implemented in cooperation with
MASTER BUDGET
The master budget has two components, the operating budget and the financial budget. The
operating budget focuses on the budgets that produce income, translating into a budgeted
income statement as its outcome. Financial budgets focus on the flow of cash into and out of
an organization and produce a cash budget and balance sheet. The diagram below illustrates
the relationships between the operating and financial budgets and the products they produce
in the end.
Financed by
Supported by
Implemented in cooperation with
OPERATING BUDGET
The operating budget consists of the following 11 budgets in sequence that covers all
income and revenue from organizational operations:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Sales Budget
Production Budget
Direct Materials Purchases Budget
Direct Labor Budget
Overhead Budget
Ending Finished Goods Inventory Budget
Cost of Goods Sold Budget
Marketing Expense Budget
Research and Development Budget
Administrative Expense Budget
11.
Budgeted Income Statement
The operating budget’s purpose is to predict an accurate picture of the organization’s
expenses so that operations are financed throughout the budget cycle. It is critical to define
an accurate sales picture and align it with the appropriate workflow to produce efficient,
overall profitable operations.
Financed by
Supported by
Implemented in cooperation with
OPERATING BUDGET
All operating budgets for a commercial companies follow this structure:
Sale / Turnover
- Variable costs / used goods
= Gross profit
- Fixed costs
- Depreciation
- Interests
= Profit
Below you can find different types of expenses. Maybe your company does not have all the expenses.
Then just delete the expense (the account) in your budget.
Maybe you have another expense. Then just put it in the budget. The budget must reflect your company.
Sale / Turnover
Sale of product / service no. 1
Sale of product / service no. 2
Sale of product /service no. … Estimate sale for each major product /service
Interest
Write-off/depreciation
Interest on bank loan
Plant/buildings
Interest on overdraft facility
Machinery
Other interest
Other things ...
Financed by
Supported by
Implemented in cooperation with
OPERATING BUDGET
...Variable costs
Materials - raw materials and finished products which you use for production or sale
Salary - only for workers in production
Transport costs - and any costs related to transport of the raw materials and finished products
Fixed costs
Wages - for staff in shops and offices
Rent - for buildings
Electricity, heat, water
Renovation and maintenance of buildings
Cleaning
Car service/mileage allowance
Travel costs
Stationary telephone
Postage and charges
Mobile phone
Internet-connection
Website subscription/hosting and upgrading
Financed by
Supported by
Marketing/advertisement/advertising
Meeting expenses
Insurances
Computer equipment
Computer network
Leasing-expenses
Minor purchases
Maintenance
Accountant
Lawyer
Other consultancy
Unexpected costs (5% of costs)
Implemented in cooperation with
SALES BUDGET
•
•
The sales budget is the most important component of the operating budget. It has to be
produced first since other budgets depend on the output. If the sales budget is not as
accurate as possible, it will lead to larger discrepancies in the remainder of the
operating budgets.
usually presented in either a monthly or quarterly format; presenting only annual sales
information is too aggregated, and so provides little actionable information.
Factors that has to be taken into consideration while preparing:
Organizational
Environmental factors





Past sales figures and trends
Salesmen’s estimates
Plant capacity
Orders on hand
Proposed expansion or
discontinuation of products
 Availability of material or supplies
 Financial aspect
 Cost of distribution of goods
Financed by
Supported by




General trade prospects
Seasonal fluctuations
Degree of competition
Government controls and rules
Sales = Units × Unit selling price
Implemented in cooperation with
SALES BUDGET - Example
ABC Company plans to produce an array of plastic pails during the upcoming budget year,
all of which fall into a single product category. Its sales forecast is outlined as follows:
Sales Budget - For the Year Ended December 31, 20XX
Forecasted unit sales
x Price per unit
Total gross sales
- Sales discounts & allowances
= Total net sales
Quarter 1
Quarter 2
Quarter 3
Quarter 4
5,500
6,000
7,000
8,000
$10
$10
$11
$11
$55,000
$60,000
$77,000
$88,000
$1,100
$1,200
$1,540
$1,760
$53,900
$58,800
$75,460
$86,240
ABC's sales manager expects that increased demand in the second half of the year will allow it to
increase its unit price from $10 to $11. Also, the sales manager expects that the company's
historical sales discounts and allowances percentage of two percent of gross sales will continue
through the budget period.
Financed by
Supported by
Implemented in cooperation with
PRODUCTION BUDGET
 The production budget takes the output from the sales budget, unit sales, and adds
desired ending inventory and then subtracts beginning inventory to obtain the number of
units to be produced for each period. Special attention should be paid to planning desired
ending inventory, whether a particular number of units are given or decided, or if an
inventory rule is to be followed. Lost sales or work stoppages in production can occur if
there is not enough ending inventory and excess ending inventory utilizes finances that
may be needed elsewhere in the organization.
Units to be produced =
Ending inventory units + Units sales – Beginning inventory units
 basic calculation used by the production budget is:
+ Forecasted unit sales
+ Planned finished goods ending inventory balance
= Total production required
- Beginning finished goods inventory
= Products to be manufactured
Financed by
Supported by
Implemented in cooperation with
PRODUCTION BUDGET - Example
Production Budget For the Year Ended December 31, 2009
Budgeted sales
1 Quarter 2 Quarter
3 Quarter 4 Quarter
Year
10,000
30,000
40,000
20,000
100,000
8,000
-----------38,000
6,000
-----------32,000
4,000
-----------44,000
8,000
-----------36,000
3,000
----------23,000
4,000
-----------19,000
3,000
----------103,000
2,000
-----------101,000
Add desired ending inventory of finished goods* 6,000
-----------Total needs
16,000
Less Beginning inventory of finished goods
2,000
-----------Required production
14,000
*Twenty percent of the next quarters sales. The ending inventory of 3,000 cases is assumed
The beginning inventory in each quarter is the same as the prior quarter's ending inventory
Mmanagement believes that an ending inventory equal to 20% of the next quarter's sales strikes the appropriate
balance. The total needs for the first quarter are determined by adding together the budgeted sales of 10,000 cases
for the quarter and the desired ending inventory of 6,000 cases. The ending inventory is intended to provide some
cushion in case problems develop in production or sales increase unexpectedly. Since the budgeted sales for the
second quarter are 30,000 cases and management would like the ending inventory in each quarter to 20% of the
following quarter's sales, the desired ending inventory is 6,000 cases (20% of 30,000 cases). Consequently, the total
needs for the first quarter are 16,000 cases. However, since the company already has 2,000 cases in beginning
inventory, only 14,000 cases need to be produced in first quarter.
Financed by
Supported by
Implemented in cooperation with
DIRECT MATERIALS BUDGET
 The direct materials purchases budget can be developed once the production
budget is complete. The direct materials purchases budget converts the raw
materials per unit to a total amount of materials for unit production. Similar to
the production budget, desired ending inventory is added to this total amount of
materials and beginning inventory is subtracted. This calculation give the total
units to be produced for the period and multiplying the cost per unit of material
(lbs, gram, ounces, etc) produces the total purchase cost for the period
Expected DM usage = DM units needed per unit of output × Units of output
Budgeted DM purchases in units =
Desired ending DM units + Expected DM usage – Beginning DM units
DM purchase costs = Budgeted DM purchases in units × Unit price
Financed by
Supported by
Implemented in cooperation with
DIRECT MATERIALS BUDGET - Example
Hampton Freeze, Inc. Direct Materials Budget For the Year Ended December 31, 2009
1 Quarter
2 Quarter
3 Quarter
4 Quarter
Year
Required production in cases
14,000
32,000
36,000
19,000
101,000
Raw materials needed per case (pounds)
15
15
15
15
15
Total needs
----------210,000
48,000
-----------258,000
----------480,000
54,000
-----------534,000
----------540,00
28,500
-----------568,500
----------285,000
22,500
-----------307,500
----------1,515,000
22,500
-----------1,537,500
Less beginning inventory of raw materials
21,000
48,000
54,000
28,500
21,000
Raw materials to be purchased
Cost of raw materials per pound
-----------237,000
$0.20
------------
-----------486,000
$0.20
------------
-----------514,000
$0.20
------------
-----------279,000
$0.20
------------
-----------1,516,500
$0.20
------------
Cost of raw materials to be purchased
$47,400
$97,200
$102,900
55,800
$303,300
Production needs (pounds)
Add desired ending inventory of raw material 1
% of purchases paid for in the period of the purchase
% of purchase paid for in the period after purchase
50%
50%
50%
50%
1 Ten
percent of the next quarter's needs. For example, the second-quarter production needs are 480,000 pounds. Therefore,
the desired ending inventory for the first quarter would be 10% 480,000 pounds = 48,000 pounds. The ending inventory of
22,500 pounds for the quarter is assumed
Financed by
Supported by
Implemented in cooperation with
DIRECT MATERIALS BUDGET - Example cont.
Cont. Hampton Freeze, Inc. Direct Materials Budget For the Year Ended December 31, 2009
Schedule of Expected Cash Disbursement for Materials
Accounts payable, beginning balance2
$25,800
First-quarter purchase3
Second-quarter purchases4
23,700
$25,800
$23,700
48,600
Third-quarter purchase5
$48,600
51,450
$51,450
102,900
27,900
---------$301,200
Fourth-quarter purchase6
Total cash disbursement
----------
---------
----------
27,900
----------
$49,500
$72,300
$100,050
$79,350
2Cash
payments for the last year's fourth-quarter materials
purchases.
× 50%; $47,500 × 50%.
× 50%; $97,200 × 50%.
5$102,900 × 50%; $102,900 × 50%.
6$55,800 × 50%. Unpaid fourth quarter's purchases appear as
accounts payable on the company's end of year balance sheet
3$47,500
4$97,200
Financed by
Supported by
47,400
97,200
Direct materials budget is usually accompanied by a
schedule of expected cash disbursements for raw
materials. This schedule is needed to prepare the
overall cash budget. Disbursement of raw materials
consist of payments for purchases on account in
prior periods plus any payments for purchases in the
current budget period.
Implemented in cooperation with
DIRECT MATERIALS BUDGET – Example cont.
Explanation of the Direct Materials Budget for Hampton Freeze Inc.
In this case, management would like to maintain ending inventories of raw materials equal to 10% of the following
quarter's production needs.
The first line in the direct materials budget contains the required production for each quarter, which is taken
directly from the production budget. Looking at the first quarter, since the schedule of production budget calls for
the production of 14,000 cases of popsicles (finished goods of Hampton Freeze Inc.) and each case requires 15
pounds of sugar, the total production needs are for 210,000 pounds of sugar (14,000 cases × 15 pounds per
case). In addition, management wants to have ending inventories of 48,000 pounds of sugar, which is 10% of the
following quarter's needs of 480,000 pounds. Consequently the total needs are for 258,000 pounds (210,000
pounds for the current quarter's production plus 48,000 pounds for the desired ending inventory). However, since
the company already has 21,000 pounds in beginning inventory, only 237,000 pounds of sugar (258,000 pounds –
21,000 pounds) will need to be purchased. Finally, the cost of the materials purchases is determined by
multiplying the amount of raw materials to be purchased by the cost per unit of the raw materials. In this case,
since 237,000 pounds of sugar will have to be purchased during the first quarter and sugar costs $0.20 per
pound, the total cost will be $47,400 (237,000 pounds × $0.20 per pound).
As with the production budget, the amounts listed under the year column are not always just the sum of the
quarterly amounts. The desired ending inventory of raw materials for the year is the same as the desired ending
inventory of raw materials for the fourth quarter. Likewise the beginning inventory of the raw materials for the year
is the same as the beginning inventory of raw materials for the first quarter.
Financed by
Supported by
Implemented in cooperation with
DIRECT LABOR BUDGET
 The direct labor budget is similar to the direct materials budget as it depends on production output.
Multiplying the direct labor cost per unit times the units produced each period produces the direct labor
hours needed. Multiplying the total times the direct labor cost per hour provides the total direct labor
cost for the period.
Expected DL hours = DL hours needed per unit of output × Units of output
DL costs = Expected DL hours × Wage rate
Example of Direct Labor Budget
Hampton Freeze, Inc. Direct Labor Budget For the Year Ended December 31, 2003
Required production in cases
Direct labor hours per case
Total direct labor hours needed
Direct labor cost per hour
Total direct labor cost*
1 Quarter
2 Quarter
3 Quarter
4 Quarter
Year
14,000
0.40
-------5,600
$15.00
--------
32,000
0.40
--------12,800
$15.00
--------
36,000
0.40
-------14,400
$15.00
--------
19,000
0.40
-------7,600
$15.00
--------
101,000
0.40
-------40,400
$15.00
--------
$84,000
$192,000
$216,000
$114,000
$606,000
* This schedule assumes that the direct labor work force will be fully adjusted to the total direct labor hours needed each quarter.
Financed by
Supported by
Implemented in cooperation with
OVERHEAD BUDGET
 The overhead budget provides the cost of all non-labor and non-material items
used during the production process for each defined period. Total overhead cost
is calculated by adding variable and fixed overhead costs. Variable overhead is
calculated by multiplying the variable overhead rate times the direct labor hours.
Total overhead = (Variable overhead rate × Activity level per chosen cost driver)
+ Budgeted total fixed overhead
Financed by
Supported by
Implemented in cooperation with
OVERHEAD BUDGET – Example
Hampton Freeze Inc. Manufacturing Overhead Budget For the Year Ended December 31, 2003
Budgeted direct labor hours
Variable overhead rate
Variable manufacturing overhead
Fixed manufacturing overhead
Total manufacturing overhead
Less depreciation
Cash disbursement for manufacturing overhead
Total manufacturing overhead (a)
Budgeted direct labor-hours (b)
Predetermined overhead rate for the year (a) / (b)
1 Quarter
5,600
$4.00
--------$22,400
60,600
83,000
15,000
$68,000
=======
2 Quarter
12,800
$4.00
--------$51,200
60,600
111,800
15,000
$96,800
=======
3 Quarter
14,400
$4.00
--------$57,600
60,600
118,200
15,000
$103,200
=======
4 Quarter
7,600
$4.00
--------$30,400
60,600
91,000
15,000
$76,000
=======
Year
40,400
$4.00
--------$161,600
242,400
404,000
60,000
$344,000
=======
$404,000
40,400
$10.00
Because the variable component of the manufacturing overhead depends on direct labor, the first line in the
manufacturing overhead budget consists of the budgeted direct labor hours from the direct labor budget . The
budgeted direct labor hours in each quarter are multiplied by the variable rate to determine the variable component of
the manufacturing overhead. For example, the variable manufacturing overhead for the first quarter is $22,400 (5,600
direct labor hours × $4.00 per direct labor-hour). This is added to the fixed manufacturing overhead for the quarter to
determine the total manufacturing overhead for the quarter. The total manufacturing overhead for the first quarter is
$83,000 ($22,400 + $60,600).
Financed by
Supported by
Implemented in cooperation with
ENDING FINISHED GOODS INVENTORY BUDGET
 Calculating ending finished goods inventory is needed for input for the cost of
goods sold budget. Total ending inventory cost is calculated by multiplying the
unit cost (direct materials cost per unit, direct labor cost per unit, overhead cost
per unit) x the number of units in ending inventory.

Financed by
It provides information for the unit cost of a finished product and the
cost of the expected inventories.
Supported by
Implemented in cooperation with
ENDING FINISHED GOODS INVENTORY BUDGET – Example
Freeze Inc. Ending Finished Goods Inventory Budget Absorption Costing Bases For the Year
Ended December 31, 2009
Production Cost Per Case:
Direct materials
Direct labor
Manufacturing overhead
Unit product cost
Budgeted finished goods inventory:
Ending finished goods inventory
Unit production cost (see above)
Ending finished goods inventory in dollars
Quantity
Cost
Total
15 Pounds
0.40 hours
0.40 hours
$0.20 per pound
15.00 per hour
10.00 per hour
$3.00
6.00
4.00
--------$13.00
3,000
$13.00
----------$39.00
For Hampton Freeze Inc. the absorption costing unit product cost is $13 per case of popsicles (finished goods of
Hampton Freeze Inc.)--costing of $3 of direct materials, $6 of direct labor, and $4 of manufacturing overhead. The
manufacturing overhead is applied to units of product on the basis of direct labor-hours at the rate of $10 per
direct labor-hour. The budgeted carrying cost of the expected inventory is $39,000.
Financed by
Supported by
Implemented in cooperation with
MARKETING EXPENSE BUDGET
 The marketing expense budget is used to define all costs associated with sales/distribution of an
organization’s products. Expenditures can be fixed or variable. Variable marketing expense is
calculated by multiplying the unit variable marketing expense times the unit sales.
Total marketing expense = (Variable marketing rate × Sales activity level)
+
Budgeted total fixed marketing expenses
Typical general marketing
expenses:
• Advertising agency commissions
• Salaries for marketing managers
• Salaries for marketing support e.g.
marketing assistants.
• Office space
• Fixtures and fittings
• Travel costs
• Other direct and indirect marketing
costs, including marketing
communications costs
Financed by
Supported by
Typical marketing communications costs:
• Personal Selling
• Public Relations
• Printing & Mailing
• Website Development & Hosting
• Brochure Design & Advertising
• Television Advertising & Radio Advertising
• Direct Marketing
• Newspaper Advertising
• Proposal Development/bid submittal
• Networking
• Event Attendance
• Sales Promotion
• Many other marketing communications tools.
Implemented in cooperation with
ADMINISTRATIVE EXPENSE BUDGET
 Administrative expenses are not production related and are mostly fixed
in nature. Examples include: salaries, legal fees, accounting fees,
equipment depreciation, building depreciation, office supplies, travel
expenses, insurance, rent, etc.
Financed by
Supported by
Implemented in cooperation with
ADMINISTRATIVE EXPENSE BUDGET - Example
Freeze Inc. Selling and Administrative Expense Budget For the Year Ended December 31, 2009
Budgeted sales in cases
Variable selling and administrative expenses per case
Budgeted variable expense
Budgeted fixed selling and administrative expenses:
Advertising
Executive salaries
Insurance
Property taxes
Depreciation
Total budgeted fixed selling and administrative exp.
Total budgeted selling and administrative expenses
Less depreciation
Cash disbursements for selling and administrative exp.
1 Quarter
10,000
$1.80
$ 18,000
2 Quarter
30,000
$1.80
$54,000
3 Quarter
40,000
$1.80
$72,000
4 Quarter
20,000
1.80
$36,000
Year
100,000
$1.80
$180,000
20,000
55,000
20,000
55,000
1,900
20,000
55,000
37,750
20,000
55,000
80,000
220,000
39,650
18,150
40,000
397,800
-----------577,800
40,000
$537,800
10,000
85,000
-----------103,000
10,000
$93,000
10,000
86,900
-----------140,900
10,000
$130,900
10,000
122,750
-----------194,750
10,000
$184,750
18,150
10,000
103,150
-----------139,150
10,000
$129,150
In the above example the variable selling and administrative expense is $1.80 per case. Consequently, budgeted
sales in cases for each quarter are entered at the top of the schedule. These data are taken from the sales budget.
The budgeted variable selling and administrative expenses are determined by multiplying the budgeted sales in
cases by the variable selling and administrative expense per case. For example, the budgeted variable selling and
administrative expense for the first quarter is $18,000 (10,000 cases × $1.80 per case). The fixed selling and
administrative expenses (all given data) are then added to the variable selling and administrative expenses to arrive
at the total budgeted selling and administrative expenses. Finally, to determine the cash disbursement for selling
and
administrative
items, total budgeted
and administrative expense is adjusted Implemented
by adding
back non-cash
Financed
by
Supportedselling
by
in cooperation
with
selling and administrative expenses (in this case, just depreciation).
BUDGETED INCOME STATEMENT
 Completing the operating budgets above produces the budged income statement. It gives an accurate
picture of the profitability of organizational operations and a tool for maximizing operational strengths
and reducing deficiencies.
Freeze Inc. Budgeted Income Statement For the Year Ended December 31, 2009
Other Budgets References
Sales
Sales budget
$2,000,000
Less cost of goods sold*
Sales budget, Ending finished goods inventory budget
1,300,000
--------------
Gross margin
700,000
Less selling and administrative expenses
Selling and administrative expense budget
577,800
--------------
Net operating income
122,200
Less interest expense
Cash budget
14,000
--------------
Net income
Financed by
$108,200
Supported by
Implemented in cooperation with
CASH BUDGET – Financial Budget
 contains an itemization of the projected sources and uses of cash in a future period.
 allows the financial manager to identify short-term financial needs and whether company
operations and other activities will provide a sufficient amount of cash to meet projected
cash requirements.
 The idea of the cash budget is simple: it records estimates of cash receipts (cash in) and
disbursements (cash out). The result is an estimate of the cash surplus or deficit.
Cash Inflows:
Cash collections = Beginning accounts receivable + Sales
Cash Outflows: Total cash disbursements= Payment of accounts +
Wages,taxes, and other expenses + Capital Expenditures +
Interest and Dividends
The Cash Balance:
Net cash inflow = Total cash collections - Total cash disbursements
Financed by
Supported by
Implemented in cooperation with
CASH BUDGET - Example
Everson Manufacturing
Week 4
Week 1
Week 2
Week 3
$25,000
$55,000
-$24,000
-$63,000
+10,000
+12,000
+15,000
+18,000
+180,000
+185,000
+180,000
+192,000
+30,000
0
+10,000
+25,000
$245,000
$252,000
$181,000
$172,000
-$87,000
-$91,000
-$99,000
-$107,000
- Direct labor
-19,000
-20,000
-23,000
-25,000
- Manufacturing overhead
-29,000
-30,000
-34,000
-37,000
- Selling & administrative
-35,000
-35,000
-38,000
-38,000
- Asset purchases
-20,000
0
-50,000
0
- Dividend payments
0
-100,000
0
0
= Total uses of cash
-$190,000
-$276,000
-$244,000
-$207,000
$55,000
-$24,000
-$63,000
-$35,000
Beginning cash
Cash Inflow
+ Cash sales
+ Accounts receivable collected
+ Asset sales
= Total cash available
Cash Outflow
- Direct materials
Net Cash Position
Financed by
Supported by
Implemented in cooperation with
LONG-TERM BUDGETING
 helpful in business forecasting and forward planning.
 cover a period of more than one year on a quarterly basis, or even
an annual basis.
 should be updated when the short-term plan is prepared
Capital budgeting
Research and
development
budget
Financed by
Supported by
outlines the estimated
expenditures of research and
development activities for the
coming year
Implemented in cooperation with
CAPITAL BUDGET
 The process of planning and managing a firm’s long-term investments
 Preparation of capital budget plans includes forecasting profits of many years in
advance so as to judge the profitability of projects.
 Capital expenditure plans rivet a huge investment in fixed assets.
 Capital expenditure once approved signifies long-term investment which cannot be
withdrawn or reserved without sustaining a loss.
The criteria used to evaluate proposed investments:
1. Payback period
2. Net present value (NPV)
3. Internal rate of return (IRR)
What services will we offer or what will we sell? In what markets will we compete? What new
products will we introduce? The answer to any of these questions will require that the firm
commit its scarce and valuable capital to certain types of assets.
Financed by
Supported by
Implemented in cooperation with
CAPITAL BUDGET
Payback period:
represents the amount of time that it takes for a project to recover its initial cost.
The use of the Payback Period as a Capital Budgeting decision rule specifies that
all independent projects with a Payback Period less than a specified number of years
should be accepted.
Paypack =
Period
Last year with
a negative NCF
+
(Absolute Value of NCF in that year)
(total cash flow in the following year)
Example:
Financed by
Year
Cash Flow
Net Cash Flow
0
-1000
-1000
1
500
-500
2
400
-100
3
200
100
4
200
300
5
100
400
Supported by
Payback Period = 2 + (100)/(200)
= 2.5 years
Implemented in cooperation with
CAPITAL BUDGET
The Net Present Value (NPV):
indicates the expected impact of the project on the value of the firm. The NPV
decision rule specifies that all independent projects with a positive NPV should be
accepted.
where
CFt = the cash flow at time t and
r = the cost of capital
Project
Example:
The cost of capital for the project is 10%.
Financed by
Supported by
Year
Cash Flow
0
$-1000
1
500
2
400
3
200
4
200
5
100
Implemented in cooperation with
CAPITAL BUDGET
The Internal Rate of Return (IRR)
is the discount rate at which the NPV of a project equals zero. The IRR decision rule specifies
that all independent projects with an IRR greater than the cost of capital should be accepted.
where
CFt = the cash flow at time t and
Example:
From the equation, we find IRR= 16.82%
Financed by
Supported by
Project
Year
Cash Flow
0
$-1000
1
500
2
400
3
200
4
200
5
100
Implemented in cooperation with
CAPITAL BUDGETING PROCEDURE
The preparation of capital budgeting can be done in the following procedure:
1.
Organization of Investment Proposal - The primary step in capital budgeting is conception of a
profit making idea.
2.
Screening the Proposals- In big organizations, a capital expenditure planning committee is instituted
for the purpose of screening the various proposals received.
3.
Evaluation of projects - The next step involves evaluating the various proposals in terms of cost of
capital, expected returns from alternative investment opportunities, and the assets’ life through
different techniques.
4.
Establishing priorities - Unprofitable or uneconomic projects are dropped off after the screening of
projects has been done.
5.
Final approval - The proposals which are finally recommended are passed on to the top
management accompanied by the detailed report about the capital expenditure as well as the sources
of funds to congregate them.
6.
Evaluation - As a final step, an evaluation of the program, after being implemented completely, is
carried out to assess the profitability.
Financed by
Supported by
Implemented in cooperation with
KEY STEPS IN DRAWING UP A BUDGET
 Make time for budgeting
 Use last year's figures - but only as a guide - Collect historical information on sales
and costs if they are available - these could give you a good indication of likely sales
and costs. But it's also essential to consider what your sales plans are, how your sales
resources will be used and any changes in the competitive environment.
 Create realistic budgets - Use historical information, your business plan and any
changes in operations or priorities to budget for overheads and other fixed costs.
 Make sure your budgets contain enough information for you to easily monitor the key
drivers of your business such as sales, costs and working capital. Accounting software
can help you manage your accounts.
 Involve the right people - It's best to ask staff with financial responsibilities to provide
you with estimates of figures for your budget
Financed by
Supported by
Implemented in cooperation with
REVIEW YOUR BUDGET REGULARLY
Two main areas to consider:
Your actual income - each month compare your actual income with your sales budget,
by: analyzing the reasons for any shortfall - for example lower sales volumes, flat
markets, underperforming products considering the reasons for a particularly high
turnover - for example whether your targets were too low comparing the timing of your
income with your projections and checking that they fit
Your actual expenditure - regularly review your actual expenditure against your budget.
This will help you to predict future costs with better reliability. You should: look at how
your fixed costs differed from your budget check that your variable costs were in line with
your budget - normally variable costs adjust in line with your sales volume analyze any
reasons for changes in the relationship between costs and turnover analyze any
differences in the timing of your expenditure, for example by checking suppliers' payment
terms
Financed by
Supported by
Implemented in cooperation with
CONTROL RATIOS
To compare actual performance with the budgeted performance
Activity Ratio: a measure of the level of activity attained over a period of time.
Activity Ratio =
Standard hours for actual production
Budgeted hours
x 100
Capacity Ratio = indicates whether and to what extent budgeted hours of activity are
actually utilized.
Capacity Ratio =
Actual hours worked x 100
Budgeted hours
Efficiency Ratio = indicates the degree of efficiency attained in production.
Efficiency Ratio =
Financed by
Standard hours for actual production
Actual hours worked
Supported by
x 100
Implemented in cooperation with