Building a Profit Plan: Budgeting and Strategic Planning

Introduction to Profit Planning

What is the primary goal of a person entering into, or already engaged in, a business? In a heartbeat, the answer is simply "to earn profit." It is tradition. However, earning profit is actually not as simple as it sounds. In the present business environment, organizational and environmental factors must be carefully considered, as they greatly influence an organization's strategy. Failure to account for these factors means the ambition of profitability will plummet. An organization that cannot adapt to current situations is one that is stagnating rather than meeting an ever-changing business environment.

Management should establish standards in order to measure progress toward achieving profitability and implement effective controls to minimize costs and maximize profit — without the risk of compromising the market through, for example, an increase in retail prices for goods sold or services rendered. Management should also set specific objectives that serve as a medium for evaluating the output and performance of personnel and of the business entity itself. Objectives vary depending on intended results, and they may be effectively achieved through strategic profit planning.

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

How does a person earn profit? Through doing business — but for how long? A better question is: how does a person continue to earn profit? A well-thought-out profit plan is the answer.

Strategic planning requires that the latest information regarding the economy, the 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 — a commitment to planned activities, resource acquisition, and resource use based on predictions, protocols, and a collective promise to accomplish the agreed-upon results. A budget is a plan for a future period during which it will be effective. Budgets are commonly used in large companies that typically have formal and sophisticated systems of operation, and the process becomes significantly more complex in entities with higher levels of funds and resources.

Objectives of a Budget

The main objective of budgeting may be generalized into two important functions: planning and control. The entire budgeting process involves planning, which provides the basis for control. Control involves comparing actual results against established standards and allows management to take necessary corrective actions in unfavorable situations.

A budget requires a substantial amount of time and effort from the person who prepares it. Managers must remember that organizational departments interact with one another, 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.

Profit does not simply arrive on its own. Its realization cannot be left to chance. Businesspeople cannot stay in their offices, wait for customers, and simply hope that enough sales will be generated to yield a desired profit. Profit can be planned. A certain amount of profit may be set as the goal for a period, and strategies may be devised to attain that goal.

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

A profit plan establishes the key indicators of financial performance and the milestones used to measure and control 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 that return, with the profit objective coming first. Another approach has management draw up plans and then set the target profit as a result of those plans — here the profit objective emerges from the plan itself. Lastly, management may use an acceptable and reasonable profit standard set based on the company's own business experience.

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

The Profit Wheel and Profit Planning Process

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

The process begins with estimating the level of sales or services based on expected demand and profit to be earned per unit of output. The profit plan establishes the profit multipliers and billing rates to be used. The first step is to prepare the sales budget in units and in pesos. The projected sales figure will serve as the basis for the desired profit that managers are planning to achieve. Sales volume will also form the basis for preparing a production budget, which will be part of the overall cost structure. Revenue may be expressed as:

Revenue = Sales Volume in Units × Sales Price per Unit

Using trend analysis, managers will then adjust sales — whether upward or downward — in order to achieve the profit target based on previous budgets. The sales budget will also determine how much cash the company expects to flow in, based on existing credit and collection policies.

Costs may be classified in many ways depending on management's need for cost information. According to function, costs are classified as either direct or indirect.

Direct costs, or production and manufacturing costs, are related to acquiring and making products or rendering services that directly generate a business entity's revenues. They are composed of three elements: direct materials, direct labor, and overhead. Indirect costs, or expenses, are those related to other business functions such as administration or selling.

These costs and expenses are further classified as variable or fixed. A variable cost varies in total in direct proportion to changes in the level of activity. Variable cost is extremely important in a company's total profit picture: every time a product is produced and sold, or a service is rendered, a corresponding amount of variable cost is incurred. A fixed cost remains constant in total within a relevant range of activity; such costs are incurred to provide a company with production capacity regardless of activity level. In building a profit plan, it is best to identify specific cost items as variable or fixed in order to give due consideration to their effect on profit and to determine areas where necessary controls must be applied.

Once the sales level and target profit have been established, the next step is to prepare projected or budgeted cost plans covering all direct and indirect costs, whether variable or fixed.

A production budget shows the number of units a company wants to produce and the costs it expects to incur for that production. It is composed of a materials budget, a direct labor budget, and an overhead budget. Production targets are established based on the desired profit as well as the desired volume of units sold or services rendered needed to achieve the profit goal. The production budget then serves as the basis for budgeted cash outlays the company expects to incur in fulfilling production.

Operating expenses include selling and administrative expenses. A forecast or budget for selling expenses is ordinarily prepared together with the sales budget or profit target, because selling efforts — such as promotions, commissions, and sales staff salaries — are directly related to sales. Selling expenses may be either variable or fixed. Administrative expenses include projected costs for activities other than production or selling and are mostly composed of fixed costs such as research and development, insurance payments, and government taxes.

Profit is the excess of revenue over total costs and expenses incurred in generating that revenue during the period of operation. Profit can be expressed as:

Profit = Sales − Total Costs and Expenses

With costs accounted for, the budgeted profit plan may now be established. Applying the concept of revenue less expenses equals profit, the calculation follows this structure:

Budgeted Sales
Less: Direct / Product / Manufacturing Costs
Less: 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 determined the profit target initially, the required revenue may be derived using a bottom-up budgeting procedure that starts from the target profit and adds both direct and indirect costs. In this procedure, the profit objective comes first before the entire planning process. The required revenue is meant 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 within the current setup and implement control accordingly.

Operating assets are resources of the business used for current operations. These include unrestricted cash and cash equivalents, assets held for trading purposes or short-term use that are expected to be realized within one year from the balance sheet date, and assets expected to be realized, sold, or consumed in the normal course of the enterprise's operating cycle. All other assets are classified as long-term assets, which include property, plant, and equipment (tangible assets), intangible assets, and long-term investments.

The budgets included in the master budget focus on the short-term or upcoming fiscal period. However, managers must also assess long-term needs such 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 overall budgeting process — particularly the cash budget.

With a well-prepared profit plan, managers are better positioned to foresee the changes that may be applied in order to achieve the profit goal — changes that would result in maximizing profit through minimized costs, increased revenue, or both. A profit plan makes managers more aware of the risks involved in their decisions and fosters greater competence and cooperation among managers across departments, since they all share the common goal of organizational profitability. Failing to adjust to the standards set by the present situation of the organization could lead the company to a possible loss, or at minimum a decreased profitability rate.

The Statement of Cash Flows discloses the components of cash and cash equivalents and presents a reconciliation of the amounts in the cash flow statement with the equivalent items reported on 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 the business environment, and undertake new commitments. Because the statement of cash flows identifies the relationship between net income and net cash flow from operations, it also assists managers in judging the quality of the company's earnings.