Budget Building a Profit Plan

Budget

BUILDING a PROFIT PLAN

Entrepreneurship 101: What is the primary goal of a person entering into or is already engaged in a business? In a heartbeat, the answer is simply "to earn profit." It is tradition. However, "to earn profit" is actually not as simple as it is said. In the present business environment, organizational and environmental factors should be considered. Such factors greatly influence an organization's strategy. To consider otherwise, the ambition of profitability will go into a plummet. Not being able to adapt to current situations and probably means that the organization is stagnating and not facing the ever changing business environment.

Management should establish standards in order to measure any progress towards achieving profitability and implement effective controls to minimize costs and maximize profit without the risk of compromising the market such as an increase in retail price for goods sold or services rendered. Another is to set specific objectives that would serve as a medium for evaluation of output or performance of personnel and of the business entity itself. Objectives vary depending on intended results which may be effectively achieved through strategic profit planning.

Translating the organization's goals and objectives into the specific activities and resources is called planning. The dynamic plan that dictates how the organization's goals and objectives will be fulfilled reflects strategy. Strategic profit plans are developed to give detailed information about the time-honored mission of achieving the desired profit margin.

How does a person earn profit? Through doing business a person can earn profit, but for how long? A better question would go, how would a person continue to earn profit? A well-thought profit plan is the answer.

I. Objectives of a budget

Strategic planning requires that the latest information regarding the economy, environment, technological developments and available resources be incorporated into the setting of goals and objectives. The process of formalizing plans and translating company goals and objectives into a documented, quantitative format is called budgeting. The end result of this process is a budget, which expresses a commitment. It is a commitment to planned activities, resource acquisition and use of resources based on predictions, protocols and a collective promise to accomplish the agreed-on results. A budget is a plan for the future or period of time where the budget will be effective. Budgets are commonly used in large companies which usually have formal and sophisticated systems of operation. The process becomes significantly complex in entities having a higher level of funds and resources.

The main objective of budgeting may be generalized into two important functions that it serves: planning and control. The entire budgeting process involves planning. Planning provides the basis for control which involves comparison of actual results from established standards. Control allows management to make necessary corrective actions under unfavorable cases.

A budget requires a substantial amount of time an effort form the person who prepares it. In preparing a budget, managers must remember that organizational departments interact with each other, and the budget for one department may form the basis of or have an effect on the budgets of other departments. Therefore, budgets for all departments must be consistent with the established profit plan of the entity.

II the Profit Wheel

Profit does not just come. Its realization cannot be left to chance. Businessmen cannot just stay in their office, wait for customers, then hope and pray that enough sales be generated to yield the desired profit. Profit can be planned. A certain amount of profit may be set s the goal for a period, and strategies may be thought of to attain the goal set. It seems easy to accomplish, theoretically speaking.

Budgeting and profit planning are often interchanged because they are viewed as synonymous. However, profit planning is a broader term than budgeting. Profit planning is a well thought out operational plan which involves setting of goals and objectives as well as the methods or programs by which such goals are to be achieved. Profit planning encompasses sales planning programs, programs for control of all manufacturing and non-manufacturing costs, programs affecting working capital and plant investment, and a review of all factors affecting the return on investment.

A profit plan establishes the key indicators of financial performance and milestones used to measure and control the progress toward the profit goal. Certain procedures are used in the practice of profit planning. One is a bottom-up budgeting process that begins with the operating profit target. Management specifies a desired profit and then draws up plans to achieve such return. The profit objective comes first before the entire planning process. Another is when management draws up plans and then sets the target profit as a result from the plans drawn. In this case, the profit objective results from the entire plan itself. Lastly, management uses an acceptable and reasonable profit standard that is set based on the company's own business experience.

A profit wheel is a tool or guide for profit planning. Factors involved in the determination of profit are the volume or number of units, selling price, variable cost and fixed cost. Any change in these factors will involve a change in profit.

1. Estimate the level of sales

The profit plan establishes the required revenue and profit target and level of expense necessary to support the budget and attain the profit plan goal. Planning for a desired profit would be considered alongside the determination of sales of revenue since profit is directly related to revenue. A merchandising or manufacturing concerned business would determine profit per final goods sold while a service concerned business would determine profit per service rendered. At this point, managers must take into consideration the company's past experiences in setting a target profit and other standards. The organizational structure, organizational and environmental constraints must also be considered since they play a major role in income realization.

The process begins with the estimate level of sales or services based on expected demand and profit to be earned per output. The profit plan establishes the profit multipliers and billing rates to be used.

In estimating the level of sales, the first step is to prepare the sales budget in units and in pesos. The projected sales will be the basis of the desired profit managers are planning to achieve. The sales in volume will be the basis in preparing a production budget which will be part of costs. Revenue may be expressed as:

Revenue = Sales volume in units X Sales volume in peso (sales price)]

Using trend analysis, managers will now adjust, whether increase or decrease, sales in order to achieve the profit target based on the previous budgets. Also using the trend analysis, the sales budget will also determine how much cash the company is expecting to flow into the company based on existing credit and collection policies.

2. Forecasting operating expenses

Costs may be classified in a lot of ways depending on the management's need for cost information.

According to function, costs are classified as direct or indirect costs.

Direct cost, or production / manufacturing costs, are related to acquiring and making the products or rendering services that directly generate the revenues of a business entity. It is composed of three elements namely, direct materials, direct labor and overhead. Indirect cost or expenses are those related to other business functions such as administrative or selling.

These costs or expenses are further classified into variable and fixed costs.

Cost that varies in total in direct proportion to changes in the level of activity is a variable cost. Variable cost is extremely important in the total profit picture of the company. Every time a product is produced and sold or a service has been rendered, a relative amount of that variable cost is incurred. A cost that remains constant in total within a relevant range of activity is a fixed cost. Such costs are incurred to provide a company or firm with production capacity regardless of the level of activity. In building a profit plan, it is best to identify specific cost items into variable and fixed costs in order to give due consideration on the effect on profit and costs and determine areas where necessary controls must be applied. To accomplish this, managers would need to apply their experience in the business particularly the in the industry that they operate.

When the sales level and target profit is established, the next step is to make projected or budgeted cost plans. The cost plans would cover all direct and indirect cost, whether variable or fixed.

A production budget shows the number of units a company wants to produce and the cost that it expects to incur for such production. It is composed of a materials budget, direct labor budget and an overhead budget. Production is established based on the desired profit and as well as the desired volume of units sold or service rendered needed to achieve the profit target. The production budget will then serve as basis for budgeted cash outlays the company is expecting to shell out in fulfillment of production.

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:

Budgeted Sales

Less: Direct/Product/Manufacturing Costs

Add: Indirect Costs (Administrative and Selling)

Target Profit

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.

5. Analysis

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.