Operating expenses include selling and administrative expense. Ordinarily, a forecast or budget for selling expenses is prepared together with the sales budget or profit target because selling efforts such as promotions, commissions and salaries of the sales staff are directly related to sales. Selling expenses may either be variable or fixed. Administrative expenses include projected administrative costs for other than production or selling activities. These expenses are mostly composed of fixed costs such as research and development, insurance payments and government taxes.
3. Calculate expected profits
Profit is the excess of revenue over total costs and expenses incurred in generating such revenue during the period of operation. Profit can be expressed in the mathematical equation:
Profit = Sales - Total Costs and Expenses]
Costs having been considered, the budgeted profit plan may now be established. Injecting the concept of 'revenue less expenses equals profit,' the profit may be calculated as follows:
Less: Direct/Product/Manufacturing Costs
Add: Indirect Costs (Administrative and Selling)
This may be applied using a downstream budgeting procedure where the product of profit planning is the target profit itself. However, if managers have the profit target initially determined, then the required revenue may be determined using a bottom up budgeting procedure starting from target profit and adding both direct and indirect costs. As earlier mentioned, in this procedure, the profit objective comes first before the entire planning process. The required revenue is to support the current budget at the desired operating profit and vice versa. At this point, managers consider all aspects where changes can be made with the current set up and implement control.
4. Investment in new assets
Operating assets are those resources of the business used for current operations. These include unrestricted cash and cash equivalents, those held for trading purposes or for the short-term and expected to be realized within one year from the balanced sheet date, and assets which are expected to be realized, sold or consumed in the normal course of the enterprise's operating cycle. All other assets not falling under operating assets are long-term assets. Long-term assets include property, plant and equipment or tangible assets, intangible assets and long-term investments.
The budgets included in the master budget focus on the short-term or upcoming fiscal period. Managers, however, must also assess such long-term needs as plant and equipment purchases and budget for those expenditures in a process called capital budgeting. The capital budget is prepared separately from the master budget, but because expenditures are involved, capital budgeting does affect the budgeting process particularly the budget of cash.
With a well prepared profit plan, managers of a company will likely to foresee the changes that may be applied in order to achieve the profit goal. Changes that would result to maximizing profit through a minimized cost or increased revenue or both. A profit plan would best make managers aware of the risks involved in their decisions and bring more competence and cooperation with managers with other departments because they share a common goal which is profitability of the organization. Otherwise, not being able to adjust with the standards set with present situations of the organization would lead the company to a possible loss, if not a decreased profitability rate.
IV. Cash flows
Statement of Cash flows disclose the components of cash and cash equivalents and presents a reconciliation of the amounts in the cash flow with the equivalent items reported in the balance sheet. This statement can assist managers in judging the company's ability to handle fixed cash outflow commitments, adapt to adverse changes in business environment, and undertake new commitments. Further, because the statement of cash flows identifies the relationship between net income and net cash flow from operation, it assists managers in judging the quality of the company's earnings.
V. Cash flow-forecasting for operations
Planning cash flows is as important as profit planning for all business enterprises. Profitability is a major objective of all business firms, but this alone is not enough for the firm to survive. Liquidity, which is different from profitability, must likewise be achieved.
Maintaining a good cash position is not an easy task. It requires good foresight and careful planning. The objective is not to accumulate as much cash as possible. Instead, good cash management intends to optimize cash balances which mean having enough cash to meet liquidity needs, but an excessive balance for this may sacrifice profitability. Excess cash must be invested in income generating assets or projects and should not be kept idle in a vault or in a low-interest paying savings account. In attaining the objectives of good cash management, preparing a cash budget may prove to be useful.
Whereas the cash budget is essential to current cash management, the budgeted statement of cash flows gives the managers a more global view of cash flows by rearranging them into three distinct major activities - Operating, Investing and Financing Activities. Such rearrangement permits management to judge whether specific anticipated flows are consistent with the company's strategic plans. In addition, it would incorporate a schedule or narrative about significant non-cash transactions if any have occurred, such as exchange of stock for land, that are disregarded in the cash budget.
Computing for cash flow has two methods: Direct and Indirect method.
The operating section of the cash flow prepared on either the direct or an indirect basis is acceptable.
The direct basis uses the full cash flow information (cash collections and cash disbursements) for operating activities. The operating section for the statement of cash flows prepared on an indirect basis begins with the net income and makes reconciling adjustments to arrive at cash flow from operations.
Budgeted cash flows would help managers to optimize their cash to satisfy existing financial obligations or in case of idle cash, what to do with it in order not to be stagnant.
V. Evaluation methods
1. Return on Assets and Return on Equity
Return on Total Assets (ROA) is a measure of operating efficiency. It indicates how well the firm's management has used the assets under its control to generate income. Naturally, the business firm would be more profitable if its assets would be used in a more productive or efficient manner.
Return on Owner's Equity (ROE) measures the amount earned on the owner's or stockholder's investment. It is an important indication of the firm's profitability because it determines how well the company is performing with the investment contributed by owners. Owners or stockholders are concerned with the return on their investment, which is affected not only by operations but also by the amount of debt and preferred stock in the firm's capital structure.
2. Asset Utilization (Return of Capital Employed or Return on Investment)
As mention earlier, a business firm's goal is to earn the highest amount of profit possible, given certain economic or business conditions. Without profit, it is impossible to attract potential stockholder's and creditors to invest capital in the firm. Hence, a business firm can survive and continue to exist as a going concern if it can earn enough revenue to satisfy all obligations and provide a satisfactory return on owner's investment. Profitability can be measured in absolute peso terms or in terms of ratio. When profit is expressed in a ratio, we relate profit to the amount of investment acquired or used in generating such return. That ratio would be the managers rate or in profit planning, desired rate or return.
Comparing the company's rate of return to the industry average, managers then may see whether the utilization of their investment were optimized to its full potential given its present environment where competitors also take its risks.
VI. Budgeting is important
The budgeting process nowadays is an indispensable element in decision making. A budget serves primarily as a guide to help managers align operating activities, mainly sales and purchasing or production, the organizational goal of earning and maximizing profit. It is a basis on which to sharpen management responsiveness to changes in both internal and external factors. It is also a tool to enhance the conduct of the managerial functions of planning, controlling, and problem solving and performance evaluation. A company cannot grow effectively without a well-conceived strategy and supporting budget, yet many companies invest inordinate time, energy and financial resources to develop such…