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Capital Expenditures and Cash Budgets
I. Capital Project Budgeting
A. A master budget includes a forecasted income statement (known as the planned operating budget) and a forecasted balance sheet (known as the financial budget), outlining the organization's goals and proposed methods for achieving them.
B. The budgeting process begins with management outlining plans and objectives for the upcoming period. These plans consider various policy decisions regarding factors like selling prices, distribution channels, advertising spending, and external influences, which help the company predict its sales for the period (broken down by product or product line). Managers determine the sales budget in terms of dollars by multiplying the expected sales units by the sales price per unit. They then use anticipated production, sales volume, and inventory policies to estimate the cost of goods sold. Following this, managers forecast operating expenses such as selling and administrative costs.
C. Capital projects usually start with proposals and an approval process often referred to as "capital budgeting." This process typically includes three main aspects.
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Financial analysis of capital budgeting projects commonly uses tools like net present value (NPV), internal rate of return (IRR), payback period, and return on investment (ROI).
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Risk analysis of capital projects involves evaluating uncertainties in inputs and outcomes. Advanced analytical tools can show the possible outcomes for a capital project proposal.
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Qualitative analysis is vital to ensure that capital project decisions consider non-quantitative aspects related to core strategic goals of the organization. These goals often include factors like quality, culture, brand, environment, and ethics.
D. Once capital project planning is finished for a master budget cycle and resources are committed, management needs to carefully monitor and evaluate the development and launch of each project. Depending on the project's scale and scope, various budgets, schedules, and oversight procedures can be established to monitor progress.
II. The Cash Budget
A. The foundation of the budgeting process lies in the sales budget since the effectiveness of the entire operating budget hinges on it. The sales budget entails estimating or predicting the demand for a company's products and determining whether a realistic and achievable profit can be made based on this demand. Sales forecasting can involve formal methods, informal methods, or a combination of both.
B. Formal sales forecasting methods often utilize statistical tools. For instance, management might employ economic indicators (or variables) like gross national product or gross national personal income, along with other factors such as population growth, per capita income, new construction, and population migration, to predict sales for the upcoming period. To utilize economic indicators for sales forecasting, there must be a relationship between the indicators (referred to as independent variables) and the sales being forecasted (referred to as the dependent variable). Subsequently, management can apply statistical methods to forecast sales based on the economic indicators.
C. To demonstrate this process, let's consider an example with Daniel's management forecasting sales for the year at 100,000 units (where each pair of shoes is considered one unit). Quarterly sales projections are as follows: 15,000 units in the first quarter, 40,000 units in the second quarter, 20,000 units in the third quarter, and 25,000 units in the fourth quarter. This pattern reflects increased demand for shoes in late spring and again around Christmas. The projected selling price for each pair of shoes is $40. Daniel's sales budget is then prepared by multiplying the projected sales units for each quarter by the budgeted sales price to determine the sales in dollars. Finally, the totals for the entire year are obtained by summing up the sales from each quarter.
D. The materials budget, also known as the materials purchases budget, maps out the required raw materials to fulfill the budgeted production. Similar to the production budget, this budget determines the desired raw materials inventory at the end of each quarter, usually as a percentage of the next quarter's material requirements. The materials budget initially deals with units and later incorporates the budgeted cost. Additionally, the quantity of direct materials needed for each unit is essential.
E. For instance, in the case of Daniel Company, the budgeted cost per pound is $2, with 5 pounds of materials needed for each unit. They aim to retain 25% of next quarter's production needs in ending inventory. Beginning raw materials inventory stands at 20,000 pounds ($2 per pound), with an expected ending inventory of 30,000 pounds.
F. The direct labor budget is straightforward. It requires the units specified in the production budget and the labor hours and cost per hour to complete one unit. Multiplying the production units by the direct labor per unit yields the number of direct labor hours, which are then multiplied by the hourly rate.
G. For example, in Leed Company, each unit demands 0.5 hours of direct labor, with an hourly rate of $12. The direct labor budget calculation involves multiplying the production units by the direct labor per unit and then by the hourly rate. This budgeted direct labor dollar amount is later utilized in the cash disbursement section of the cash budget.
H. Lastly, the manufacturing overhead budget is formulated based on the company's chosen overhead allocation method, which can include predetermined rates, departmental rates, or activity-based costing. Daniel Company, for instance, allocates variable overhead at $1.50 per direct labor hour and fixed overhead at $75,000 per quarter, which includes $10,000 quarterly depreciation on factory machinery. The information from the overhead budget is applied in the cash disbursement section of the cash budget.
I. Once the previous analyses are complete, we can gather adequate data to compile the cash budget and determine the Cash account balance for each quarter. Creating a cash budget entails gathering details about cash receipts and cash disbursements from all other operating budget schedules.
J. For cash receipts, we establish a schedule based on the company's expectations regarding sales collections. By reviewing past records, we can discern the proportions of cash and credit sales, as well as the typical payment timeline for credit sales.
K. For instance, Daniel Company has concluded that all sales are on credit with no cash sales. Based on past trends, Daniel expects to collect 60% of sales in the same quarter and the remaining 40% in the subsequent quarter. Despite the practical challenge of collecting 100%, Daniel opts to budget for full collection. Beginning Accounts Receivable for the year is $200,000, projected to be collected in the 1st Quarter. Here's how Daniel Company plans its cash receipts:
L. Regarding cash disbursements, companies need funds for various expenses such as purchases, wages, rent, and taxes. We can derive the disbursement amounts from other budget sections.
M. Since Daniel Company is a manufacturing firm, it must first utilize data from the materials purchases budget. All material purchases are made on credit, with 80% paid in the same quarter and the remaining 20% in the subsequent quarter. Beginning Accounts Payable for the year is $80,000, anticipated to be paid in the 1st Quarter. Here's how cash payments for material purchases are calculated:
