FINANCIAL

PLANNING AND
BUDGETING
MODULE 4
OBJECTIVES:

 Discuss the basic concepts of the financial planning process;

 Differentiate the budget used in financial planning;
 Explain the step-by-step procedure of budgeting;
 Compute budget for sales, inventories, and inventories, and variable and fixed
expenses; and
 Prepare the pro-forma cash budget, balance sheet and income statement.
FINANCIAL PLANNING

 Financial planning covers the process of setting the primary

objective, identifying the alternative courses of action, and choosing
the best alternative to achieve the objective. It also involves
systematically thinking about the possible barriers a firm has to
confront.

Dimensions of Financial Planning

 For planning purposes, it is always better to think that the future has
to be categorized as short-range and long-range. These dimensions
of plans differ not only in the period covered but also in purpose,
orientation, financial strength, and degree of detail.
Short Range plan

 A short-range plan usually covers the next twelve months.

 It focuses on the goals needed to be achieved in the coming year.
 Companies tend to look at the volatility of the market, the stability of their opera and the rate of
change in technology in the coming year that would affect their product lines and production
processes.
 A short-range plan provides a great deal of details and direct guidelines from time to time of different
heads of the organization
Con’t.

 A short-range plan requires forecasting all activities of the firm affecting its balance sheet, in
statement, and cash flow.
 The sales, raw materials requisition, raw materials purchase, desired balanced inventories for the
beginning and ending of the period, salaries and wages, and other operating expense are some of the
details that should be in the plan.
 At the start of the accounting period, as serves as a guide on what to achieve. At the end of the year,
it serves as a control or measuring dev helps the firm analyze any difference in the action plan and
actual performance so that future perform is improved
Long-range plan

 This is a plan that has a time frame of two to five, or more, years and does not require a great a of
detail.
 The contents of the financial statements have to be identified as part of long-term fin management,
although the financial statements are to be presented in terms of years and not m The long-range
plan, as compared with the short-range plan, is more difficult and more prone to because of the time
frame involved.
 Covering more than a year, environmental changes, people's nerd management composition, and
even political stability affect the long-range planning.
Financial plan

 With the short-range and long-range plans in place, financial plan is then prepared.
A financial plan is also known as a budget.
 Budgeting is the process of transforming and planned courses of action into
quantitative terms, i.e., on the form of money.
 Thus, the financial plan becomes a formal statement prepared by the company with
regards to the expected sales, expenses, production, and other relevant financial
transactions for a certain period.
Approach to financial planning

1. Zero-based approach.
From the name itself, “zero” means the budget baseline is zero. The previous year’s budget
is irrelevant in allocating financial resources for the current year. Managers preparing budget.
One common disadvantage of this approach is that it requires a lot of documentation. Aside from the schedules
required in the normal structure of the budget, it should identify all activities and operations in decision packages
ranked in accordance with relative importance (Garrison, Noreen & Brewer, 2006). Other disadvantages of zero-
based budgeting are its execution that normally takes a long period of time and its cost that is too expensive to
justify on a yearly basis.
 Example:
The previous year's budget on the firm's advertising expense was P15,000 which is 10% of the budgeted sales of
P150,000. Using the zero-based approach, a percentage of the budgeted sales will not be applied. That is, if the
current year's budgeted sales is P250,000, the advertising expense will not follow the supposedly 125.000
budgeted expense but rather, the firm has to come up with a figure based on certain conditions and assumptions.
2. Incremental-based approach.
 This is the traditional approach in budgeting. The budget starts with the previous year's
budget and then an amount is added or subtracted according to the anticipated needs. In this type of
approach, an increment is always subject to justification.
 Example:
Using the example from zero-based approach, the advertising expense for the current year
in incremental-based approach will be P25,000. The increase by P10,000 in the budgeted
advertising expense has to be justified in order to be approved.
Objectives of financial planning:

 1. Planning. Financial planning helps the firm determine its objectives and courses of action. With the
clear set of objectives, the firm looks forward to placing itself as one of the major players in the
industry.
 2. Coordination. Financial planning creates a harmonious relationship among the different units of
the organization. Though departments are created with different functions with a clear set of
objectives, departments learn to coordinate, communicate, and work with each other.
 3. Control. A financial plan becomes an important tool in enhancing and measuring the performance
of the company. With the diligent preparation of summarized reports containing comparisons with the
planned objectives, differences are analyzed for improvements. It is also used as a basis to evaluate
individual performance
Master budget

 The budget is a combined budget of different units of the organization is a control measure that helps
the firm determine if the set objectives are attained. The master budget is classified into two
categories:
Operating budget
This budget shows the plan of operations where the details of sales, production, and expenses are laid Out. The
operating budget takes the form of the budgeted income statement showing the operating results of the firm in the
coming year. It is composed of the following:
1. Sales budget. This refers to the planned volume of production that the company is expected to sell based on
forecasted sales.

2. Production budget. This identifies the number of units to be produced after the sales budget has been
established and the ending inventory has been set.
3. Ending inventory budget. This is a budget that specifies the number of units that the company desires to have
in their balance sheet at the end of the period.
Operating…

4. Direct materials budget. This shows the quantity of materials required to meet the
production units and the number of units that must be purchased. It determines first how many units
of materials are needed per unit of production.
5. Direct labor budget. This refers to the budget that provides the total cost of labor to meet
the production requirements.
 6. Factory overhead budget. This is a schedule of all manufacturing costs other than direct material and
direct labor.
 7. Selling and administrative budget. This details the sales and administrative expenses in selling the
products of the company.
 8. Pro-forma income statement. This is one of the major schedules in financial planning showing the
projected income of the company
Financial Budget

The financial budget shows the budgeted financial resources of the firm. Prepared right after
the operating budget, it consists of the following:
1. Cash budget. It is prepared to determine the financial needs of the company. It shows the
detailed lists of all cash receipts and expenses for a particular period.
 2. Pro-forma balance sheet. This budget presents the forecasted components
of the balance sheet at future date. The actual balance sheet of the previous period is
the starting point of the pro-forma balance sheet
Basic Steps in Preparing the Budget
 Budget preparation is done in a sequential manner. Leaving out one of the processes could result in a
material error in preparing a budget. The budget normally identifies the following items:
 1. Firm's sales
 2. Production volume
 3. Materials' cost
 4. Materials purchased
 5. direct labor cost
 6. factory overhead
 7. inventory level
 8. cost of goods sold
 9. selling and administrative expenses
 10. cash budget
 11. pro-forma income statement
 12. Proforma balance sheet
Sales Forecast
 This is the process of estimating the volume of sales. It serves as the mother of all the budgets that
every subsequent operating and financial budget will rely on.
 It is prudent to make the sales forecast to be as reasonable and accurate as possible to be useful.
Having an inaccurate sales forecast puts the company in limbo and in a difficult situation.
 Actions undertaken by the company in carrying out its operations always rely on the usefulness of its
sales forecast.
 Having an accurate forecast makes the cash budget, production budget, and disbursement budget
meaningful.
 In forecasting the firm's sales, the different methods discussed in the chapter on forecasting could be
used.
Sales Budget
 This refers to the planned volume that the company is expected to sell based on forecasted
sales. It also begins the operating budget and financial budget.
 Sales estimates may be made based on the analysis of the general business condition,
market conditions, political conditions, product growth curves, etc.
 In making the sales forecast, a qualitative forecast may also be used. There are certain
things in forecasting which cannot be supported by mathematical applications.
 Thus, applying qualitative forecasting like group opinions, sales force polling, and
consumer market surveys could be very useful
 Example:
Assume that the firm is expecting to have the following quarterly sales:

First quarter 1,200 units

Second quarter 1,050 units
Third quarter 1,350 units
Fourth quarter 1,450 units
Assuming further that 65% of the expected sales were collected in the first quarter of the sale, 30% were
collected in the quarter after the sale, and 5% were uncollectible, the selling price per unit is P120.
 The cash collection are computed as follows:

 For the first quarter sales,

 P144,000 x 0.65 = P93,600 presented in the first quarter
 P144,000 x 0.30 = P43,200 presented in the second quarter
 P144,000 x 0.05 = P7,200 uncollectible account


The same procedure shall be applied for the second to fourth quarters. However, the second
collection for the fourth quarter sale will not be reflected in the schedule of cash collections since it will
be collected in the first quarter of the succeeding year.
 The expected volume of production is determined as follows:


 Planned sales Pxxx

 Add: Desired ending inventory xxx
 Total needs Pxxx
 Less: Beginning inventory xxx
 Units to be produced Pxxx
Direct Materials Budget
 The cash payments are computed as follows:
 For the first quarter purchases,


 P10,486 x 0.75 = P7,865 presented to the first quarter

 P10,486 x 0.25 = P2,622 presented in second quarter


 The same procedures are to be applied for the second to fourth quarter purchases. However, the
second payment for the fourth quarter purchased is not affected in the schedule of cash payments since it will
be paid in the first quarter of next year.
Direct Labor Budget
Factory Overhead Budget
 The factory overhead budget provides schedules for indirect materials, indirect labor,
and all other manufacturing costs that cannot be conveniently charged to specific
units, jobs, or products. Indirect materials refer to those needed or the completion of
the product but whose consumption with regard to the product is either so small or o
complex that it would be futile to treat it as a direct material item. Glue, paint,
varnish, thread, nails, sacks, rivets, and other items usually belong to this category.
Indirect labor is an expense which does not affect the construction or the
composition of the finished product. Examples are labor of foremen, shop clerks,
general helpers, and cleaners.
 The variable cost varies in direct proportion to the unit produced. The total
variable cost increases as the production increases. Examples are supplies, fuel,
power, small tools, spoilage, salvage, and reclamation expenses; receiving,
hauling within plant, royalty, travel, and communication costs; overtime premium;
and payroll taxes. Fixed cost, on the other hand, is a cost that does not vary in
direct proportion to the unit produced.

 The total fixed cost does not change but the unit cost becomes smaller as
production increases Examples are salaries of production executives, depreciation,
taxes on real estate, taxes on plant equipment, patent amortization, wages of
watchmen and janitors, maintenance and repairs of building and grounds,
insurance, and rent.
Example
Selling and administrative Expense Budget
The selling and administrative expense budget lists the overall budgeted operating expenses
in areas other than those included in manufacturing
Cash Budget
 The cash budget is composed of four major sections:
 1. The cash receipts section lists all the cash inflows, except for financing, during the covered period
of the budget. Cash receipts start with the beginning balance where the cash collections from sales
are added.
 2. The cash payments section consists of all cash outflows in the budget period. Included in the cab
payments are direct material purchases, direct labor, factory overhead, and other cash payments
 3. The cash surplus or deficit section simply shows the difference between the cash receipts secti and
the cash payments section. This section indicates if the firm needs to borrow funds to supp the
operations of the company or use the excess money for paying their obligations or investing other
profitable activities.
 4. The financing section shows the borrowings and payments made by the company.
 To prepare the cash budget of Lucky Merchandising, further assume the following information:
 1. The cash balance at the beginning of the first quarter is $10,000.
 2. The management desires to maintain a f10,000 minimum cash balance at the end of each quarter.
 3. Lucky Merchandising has a credit line with RCBC that enables it to borrow at an interest rate of 12%
per year. All borrowings and repayments must be in multiples of 1,000 and take place at the beginning
and at the end of each quarter, respectively.
 4. Additional equipment amounting to P25,000 is to be acquired in the third quarter.
 5. The board of directors approved a cash dividend of 11,500 per quarter.
 6. The income tax payable amounting to P6,000 was paid in March of 2010.
Budget Income Statement

 From the various budgets prepared, the pro-forma income

statement can then summarize the various component of
planned revenue and expenses for the budgeting period. In a
sense, the pro-forma invoice statement serves as a control device
in measuring the firm’s performance by means of comparing the
actual outcome with the budgeted figures.
The projected income statement for Lucky Merchandising follows. Assume a tax rate of 32%.
Budgeted balance sheet
The illustrated balances from the previous year’s balance serve as the starting point of the pro-forma balance
sheet. The changes on the accounts together with the source budget or schedules are as follows:
 Much of the cash flows of the Lucky Merchandising come from its operating
activities totalling P46,230. Despite a planned acquisition of an equipment worth
P25,000 and cash dividend payment of P6,000, Lucky Merchandising is able to
increase its cash by 15,230.