Commercial Budgeting – Midterm PDF

Commercial Budgeting – Midterm Midterm structure: Knowledge Qs on Chapters 1 & 2. Exercises for Chapters 3-6. 30% of the total grade. Closed book with standardized formula sheet on Toledo. Chapter 1: Definitions and applications Budgeting is important becau...

Commercial Budgeting – Midterm Midterm structure: Knowledge Qs on Chapters 1 & 2. Exercises for Chapters 3-6. 30% of the total grade. Closed book with standardized formula sheet on Toledo. Chapter 1: Definitions and applications Budgeting is important because analysis and preparations are key to strategic decisions. Types of budgets: They generally proceed from top-bottom, respectively as: - Commercial/Top Line: o Includes Sales & Marketing budgets. - Operating: o Includes Production, Project, R&D, Overheads and Capital budgets. - Financial: o Includes Cash Flow and M&A budgets. A budget is a control instrument – to determine cost evaluations, trends, cost inclusions and realism of forecasts. A budget is a tool for continuous improvement, to measure actuals v targets. It is not a legal requirement, but it is a useful communication tool that differs by industry and aims to provide clarity and control. It is very helpful when done well, but can, of course, be detrimental when overly strict. Bottom-up participation is key for realistic and “doable” budgets; however, goals should be set top-down. They require recurring efforts and must be refined to be successful long-term. Benefits of budgets include transparency, coordination, responsibility (& motivation), evaluation opportunities, more knowledgeable decision making, as well as faster detection of early internal/external change signals. Drawbacks of budgets include lack of manager ownership, budgetary slack/padding, and gamesmanship. This may lead to penalization of ambitious goals, budget restrictions that damage opportunities such as new ideas / existing initiatives. People may also look at the budget as some magical script – it is only an estimate. Budget Padding = purposefully underestimating revenue or overestimating costs, leading to Budgetary Slack = the difference between the given estimate and realistic estimate. This is done to make performance seem more impressive and praised. Budgets can be - Imposed – top-down approach and very authoritative – may be little goal congruence. - Negotiated – Combination of top-down and bottom-up, more employee involvement. - Participative – Employees work to recommended targets. Operations are more autonomous and are given freedom to set up the budget.  4 Budget Processes: - Input-based / Incremental: o Take last year’s budget and manipulate it by a certain %. Most common technique and is useful when factors aren’t volatile. o However, it is likely to create slack, will perpetuate inefficiencies and ignore external drivers. - Activity-based: o A top-down approach that determines the amount of inputs required to meet corporate goals, the budget is then set accordingly. - Value Proposition: o Budgeting where every figure should provide value to the business in some way. Aims to avoid unnecessary figures. Very mindful, very value-creating, very… - Zero-based: o Everything starts at ZERO. Everyone must have a good reason to include something into the budget – used when cost containment is important, but extremely time consuming, so only used occasionally. Behavioral aspect: - Motivational: Targets should be challenging but attainable – to not be demotivating. - Participation: Sense of belonging and ownership is gained through participation. - Feedback: Should be related to responsibility level and be constructive. - Power struggles are likely. Budget padding and budgetary slack should be minimized. Chapter 2: Strategic Planning A strategic plan is a 5 to 30-year plan for a company that revolves around the mission of the company. They incorporate many external factors. Long-term strategic plans are then created, with usually a 3 to 10-year time frame. They cover all areas of business with details on how to accomplish the overall strategic plan. Operational plans, however, are plans with a detailed outline on what a department or business will focus on in the upcoming year. While strategic plans are reported every quarter/year and don’t generally need revision, operational plans have monthly reporting and can be reevaluated. Operational plans focus on efficiency, while strategic plans focus on differentiation and forward- thinking. After strategic plans (1) and operational plans (2), budgeting is the 3rd step. It includes production capacity, pricing, and marketing strategy choices, i.e. sales budgets. Budgets allow firms to see the impact of decisions made, and therefore detect potential problems earlier, secure financing, coordinate actions and act as benchmarks for evaluation. Chapter 3: Sales Forecasts and Budgeting The sales budget is the first part of a budget. Elements to consider for a sales budget: Past trends, sales force estimates, trade prospects, product improvements, customers, government, and competition. Five methods of sales forecasting: 1. Executive Opinion ▪ Quick and easy, but subjective and not analytical. ▪ Best used for new products 2. Sales Force Composite ▪ Relevant, simple, and accurate; but time consuming, counts on salespeople’s honesty (either too optimistic, or purposefully low estimates). ▪ Best used when sales reps are high caliber and serve a smaller no. of customers. 3. Survey of Buyer Intentions ▪ Most relevant, but time-consuming and high costs; customers may be uncooperative. ▪ Best used for new products when there aren’t many customers. 4. Trend Projections: ▪ Objective and low-cost, but unforeseen market changes can lead to inaccuracy. ▪ Best used in stable and predictable markets and market factors. 5. Test Markets: ▪ Very accurate, but time consuming and expensive. ▪ Best used for new products which don’t require high investment. Ideally, you will use more than one approach and choose them based on product/market or industry. The idea is to minimize market factors to provide the most accurate forecasts. The Sales Funnel: Example – Gold bracelet 1. People who buy jewelry – Market – 100% 2. People who buy gold jewelry – Target – 40% 3. People who want to buy gold bracelet – Suspects – 20% 4. People who will likely buy a gold bracelet – Prospects – 7% 5. Customers – 2% Where: you calculate the $$ amount (customers) if given the funnel %s and 100% value. You may assess the probability of lead conversion by attributing points to customer categories, where full points amount to 100% success rate. You can then budget sales forecasts by multiplying the probability with their respective total amounts. Chapter 4: Breakeven & Contribution Margins The breakeven point is the point at which your costs are covered as a business. It can be calculated in both units and $. In simple terms, no profit or loss is being made at this point. Contribution margin is the excess of total sales over total variable costs of a product. C = S-VC Unit Contribution Margin = Unit Selling Price (P) – Variable Cost per Unit (V) CM Ratio is CM to Sales, = CM/Sales OR (S-VC)/S OR 1 – (VC/S) Operating Profit = Total Sales – Total Costs, OR Contribution Margin – Total Fixed Costs *Average Sales Price is NOT calculated by adding up all sales prices and dividing by number of values; rather, it is calculated by dividing total revenue by volume of total sales! Breakeven point in units = Fixed Costs / Unit CM Breakeven point in CASH MONEYYY = Fixed Costs / CM Ratio OR Breakeven Units * Price ^The lower the breakeven point, the higher the profit and the lower the operational risk. An example of what this looks like: Luxurystreet SARL Total Per Unit Percentage Sales (S) EUR 400,000 (4000 Units @) EUR 100 100% (Minus) Variable Costs (VC) EUR 100,000 EUR 25 25% = Contribution Margin (CM) EUR 300,000 EUR 75 75% (Minus) Fixed Costs (FC) EUR 150,000 - - = Net Income EUR 150,000 - - In this example, Breakeven Units = 150,000 / 75 = 2000 Units; OR, 2000 units (BE Units) * 100 EUR (selling price) = EUR 200,000 breakeven in EUR. What If Analysis: Breakeven point is useful here, as it can quickly determine if a decision is worth implementing, or to determine the impact of a certain number changing in the formula. Breakeven analysis makes the following assumptions: - The selling price is the same - All costs are perfectly sorted into either fixed or variable - The variable cost is constant - There is only one product or a constant sales mix - Inventories don’t change - Volume is the only factor that impacts variable cost It is important to sort costs into fixed or variables, to identify effects of certain events on breakeven point, net income, and more. Chapter 5: Sales Mix In budgeting, it is common that actual outcomes are different from the expected (budgeted) outcomes. Such differences are classified in two categories: - Adverse / Unfavorable: When the change reflects negatively on the business. - Favorable: When the change reflects positively on the business. It is important to note that adverse ≠ lower number, and favorable ≠ higher number. (Context!) What if we have multiple products? We use sales mix for this. Sales mix differentiates between products, by comparing a product to overall total sales (revenue). Let’s look at an example: Luxurystreet SARL Budgeted Product Watch Sneaker T shirt Total Sales (S) EUR 200,000 EUR 120,000 EUR 80,000 EUR 400,000 Sales Mix 50% 30% 20% 100% Variable Costs (VC) EUR 90,000 EUR 50,000 EUR 20,000 EUR 160,000 45% 41.7% 25% 40% Contribution EUR 110,000 EUR 70,000 EUR 60,000 EUR 240,000 Margin (S-VC) CM Ratio 55% 58.3% 75% 60% (CM/S) Fixed Costs (FC) EUR 35,000 Net Income EUR 205,000 (CM-FC) Here, each product is given a Sales Mix percentage, respective of its sales to total sales, i.e. the watch product carries 50% of total sales, at EUR 200,000. Unfortunately, nothing in life goes as expected: Luxurystreet SARL Actuals Product Watch Sneaker T shirt Total Sales (S) EUR 150,000 EUR 100,000 EUR 100,000 EUR 350,000 Sales Mix 42.86% 28.57% 28.57% 100% Variable Costs (VC) EUR 70,000 EUR 45,000 EUR 25,000 EUR 140,000 46.67% 45% 25% 40% Contribution EUR 80,000 EUR 55,000 EUR 75,000 EUR 240,000 Margin (S-VC) CM Ratio 53.33% 55% 75% 68.57% (CM/S) Fixed Costs (FC) EUR 50,000 Net Income EUR 190,000 (CM-FC) Here, we can see the actuals have differed from the budgeted: - Sales have gone down for Watch, Sneaker and Total. This is an unfavorable change. - Fixed costs have increased. This is an unfavorable change. - Net income has decreased. This is an unfavorable change. - Contribution margin for Watch and Sneaker has decreased – unfavorable. - However, variable costs for Watch, Sneaker and Total have decreased – favorable. - Contribution margin for t shirt has increased – favorable. It is important that differences in budgets are acknowledged and considered for upcoming budgets. Chapter 6: Cost Behavior and Variance Analysis I lied, there are actually three types of costs:  1. Fixed: These costs don’t change based on output. For example, advertising, salaries, insurance, property taxes, … 2. Variable: These costs change based on output. For example, direct materials, sales commissions, supplies, fuel, overtime premiums, … 3. Mixed / Semi variable: These are a mix of the two; for example, salespeople who receive both salary and commission, supervision costs, utilities, delivery truck rentals, … The cost function: y= a + bx, where: Y = mixed cost X = activity measure (labor hours, production volume, …) A = fixed cost B = variable rate per unit This can be used in: High-Low Analysis: You choose the highest and lowest pairs to measure the difference between the highest and lowest pairs. Take difference in cost (y) and divide it by the difference in activity (x). For example, let’s look at the staff of entirely fictional Luxurystreet and their hours/overheads: Max worked 135 hours, and the variable overheads were EUR 2920, shoutout Max for being #1. However! Lorenzo worked only 88 hours, and the variable overheads were, luckily, only EUR 2080. We phrase this as: 2920-2080 for Y, and 135-88 for X. This gives us 840 and 47, 840/47=17.8723 variable rate per hour, or B. Therefore, if we: - Take the highest hours (135)/x and multiply by our rate of 17.8723/B = 2412.7605 - Do the same for the lowest (88)/x and multiply by 17.8723/B = 1572.7624 - Behold the magic as you subtract both the lowest and highest from their respective totals, giving you the same fixed cost component: o 2920 - 2412.76 = 507.234; 2080 - 1572.76 = 507.234 o 507.234 is therefore our fixed cost unit, or A o As such, Total cost = y = 507.234 + 17.8723 * X here. Regression Analysis: You create a line of best fit through the given data points, to estimate A and B – then, you apply the cost function to determine total costs based on the estimated values. This statistical method is more complex, and time consuming, but is the superior method. It is unlikely that it will be a topic on the exam to calculate it due to its complexity, for commercial budgeting. When we have variance, we must be able to evaluate the performance; this can be done easily: - Sales Price Variance = (Actual Price – Budgeted/Standard Price) * Actual Sales (Units) - Sales Volume Variance = (Actual Sales Vol – Standard Sales Vol) * Standard Price  - Cost Price Variance = (Actual Cost – Standard Cost) * Actual Sales (Units) - Cost Volume Variance = (Actual Sales – Standard Sales) * Standard Cost per Unit Profit Variances: Total Volume Variance = Sales Mix Variance + Sales Quantity Variance; where Sales Mix Variance = (Actual Sales Units at Actual Mix – Actual Sales Units at Budget Mix) * Budget Contribution Margin per Unit Sales Quantity Variance = (Actual Sales Units at Budget Mix – Budget Sales Units at Budget Mix) * Budget Contribution Margin per Unit So, if you have two products; Budgeted Sales Mix Actual Sales Mix Watch 55% 60% Sneaker 45% 40% Budgeted Units Actual Units Contribution Margin Watch 1000 1300 EUR 50 Sneaker 1100 1000 EUR 30 Total 2100 2300 / We use the formula for example here for Watch: Sales Mix Variance = (2300 – (2300*55%)) = 1035; 1035 * 50EUR = 51750 EUR Favorable variance. Sales Quantity Variance = ((2300*55%) – 1000) * 50EUR = 13250 EUR Favorable variance. Therefore, Tot Vol Var = 51750 + 13250 = 65000 EUR, Favorable. Variances to evaluate sales and marketing efforts: Standard marketing cost = the predetermined cost of marketing an item during a given period. They vary based on geography, advertising cost standards, etc. Essentially, they can be calculated the same way as any other cost by breaking it down into fixed and variable costs. Good luck with the exam. Best regards, @omarmlux @luxurystreetlu – your source for your luxury needs of every kind. Since 2019 – Luxembourg to the world