Budget for Homogeneous Products - Ultimate Guide to Budgeting

Updated: May 14



Welcome back to our new "Ultimate Guide to Budgeting" series, where we discuss the strategic budgeting process. Budgeting is central to any corporate financial planning process. Other than the usual operational issues like revenue, expense and profit planning, we will be taking the holistic perspective by also discussing strategy, capital budgeting and variance analysis, etc.


For this article, we will discuss the Budgeting system. The system is applicable when a company manufactures homogeneous products and/or similar services, which is the case with Green Food Inc from our case study. A quick refresher on our case study before we move on. Zhao Feiyan and Yang Yuhuan have set up Green Inc., a holding company with 2 wholly-owned subsidiaries, Green Food Inc., which sells an initial 2 products, Tofu Chicken and Gluten Duck, and Green Life Inc., which carries out special projects to help upstream producers move into sustainable farming.


A quick reminder before we dive into the uncharted waters of operational budgeting. The process of budgeting is the process of translating business strategy into actionable plans by allocating the necessary corporate resources to make the realization of business objectives happen. With that in mind, let's get moving!



TABLE OF CONTENT


  1. What Is Budgeting?

  2. Part I - Standardization & Revenue Budget

  3. Part II - Production, Purchase, Labour & Overhead Budgets

  4. Part III - Standard Costing, Raw Material & Inventory Budgets

  5. Part IV - COGS, SG&A Budgets & Loan Amortization

  6. Part V - Cash Budgets

  7. Part VI - The 3 Proforma Statements

  8. Conclusion


WHAT IS BUDGETING?


Budgeting is the allocation of resources in a strategic manner which makes the achievement of business goals possible. It is a 3-step process that comprehensively covers the topics of performance planning, control and evaluation. For this article, we will be covering the topic of performance planning and the step is best elaborated with using Green Food Inc. as a case study.



The illustration below is a roadmap on the budgeting process. The process starts with the company's strategy. It is followed by the allocation of corporate resources to make achievement of objectives possible. A company undertaking the differentiation strategy might allocate relatively more resources to research and development and marketing to enhance its competitive edge and brand, while another firm undertaking the cost-leadership strategy might devote resources geared to make the company more efficient and save costs, such as digitization and automation.




PART I - STANDARDIZATION & REVENUE BUDGET


Our entrepreneurial protagonists, Ms Zhao Feiyan and Yang Yuhuan have set the strategic tone for their start-up in the previous article and after considering the risks and rewards of outsourcing, they have decided to make the products in-house by setting-up the production line.


1. STANDARDIZING THE PRODUCTION PROCESS


To kick-start the budgeting process, they sat down to map the process from raw material sourcing to delivery. This process is one of the most important step where assumptions are challenged and the level of performance is planned. For example, instead of 10% planned wastage, can the buffer level be lowered down to 5%? Instead of $1.00 per kg of Gluten and Tofu from ABC Supplier Pte Ltd, can the price be lowered or can a cheaper supplier be sourced without compromise to quality and timeliness? Can the time used to prepare a product be reduced to 0.10min from 0.15 min? As the labour rate for Team B is relatively cheaper, can they assume more responsibilities in the production process? Can the production process be tweaked or redesigned to make the process more efficient? These are some questions that can be asked at this stage before kick-starting the budgeting process.



2. REVENUE BUDGET


After standardization, the dynamic duo proceeds to determine the price and forecasts the sales quantity. After studying various market research reports, they intend to sell at a slight premium above the next-best substitute product sold in the market and set a price of $4 for Tofu Chicken and $5 for Gluten Duck. They proceed to forecast the level of sales at the respective price level for each quarter.


Sales = Volume x Price



PART II - PRODUCTION, PURCHASE, LABOUR & OVERHEAD BUDGETS


3. PRODUCTION BUDGET


Using the information from the revenue budget, the business partners proceed to construct the production budget. At this stage, it is essential for Zhao Feiyan and Yang Yuhuan to determine the level of inventory to be set aside as safety stock to meet unexpected production disruptions and demand surges. The more confident they are in the estimate, a lower buffer is needed. Taking into consideration that this is a startup and the sales demand is uncertain, they decide to set aside 25% of the period's sales forecast as the buffer inventory.


Production Target = Sales Volume + Projected END Inventory - BGN Inventory


4. MATERIAL PURCHASE BUDGET


The dynamic duo proceeds to compute the quantity of raw material to meet the production targets using inputs from the Standardized Production Process and Production Budget. Again, they have to set aside a buffer to meet the challenges from unexpected supply disruptions and demand surges. The more confident they are in their sales estimates and ability of the supplier to deliver, the lower the level of buffer to be planned, saving working capital, storage and handling costs. Separate purchase budgets have to be drafted for each material.


Material for Production = Production Volume x Quantity Per Unit

Material to Purchase = Material for Production + Projected END Material - BGN Material

Purchase Budget = Material to Purchase x Unit Rate





As 3 different factors-of-input are needed to produce Tofu Chicken and Gluten Duck, 3 purchase budgets are drawn up. For more complex products with thousands of parts, separate Material Purchase Budgets can be done with the aid of computer software.


5. DIRECT LABOUR BUDGET


Next, again using inputs from the Production Budget and Standardized Production, the heroes of our story proceeds to determine the amount of labour needed to produce the budgeted production quota.


Labour Budget = Production Volume x Labour Needed Per Unit x Labour Rate



The information will be very useful when the entrepreneurs are doing manpower planning. It will be handy in situations such as determining the number of production-line employees needed, their production scheduling, training and specialization of labour, the amount of administrative support required, etc.


6. PRODUCTION OVERHEAD BUDGET


The production overhead accounts for expenses that are incurred in the production which are not linked to direct material and labour. Items such as production equipment depreciation, equipment maintenance, supplies such as lubrication oil, supervisory, utilities incurred for production, rental for factory, etc, are included in this segment. For highly automated production lines, production overhead will occupy a higher proportion relative to direct labour.



To calculate the quarterly depreciation expense for the production equipment, the ladies use a Depreciation Schedule for the Production Equipment for the one-year period.



Total Manufacturing Overhead (coloured in orange) is the amount that is incurred under the matching principle of accounting. The rule mandates that an expense must be charged in the corresponding periods where it is incurred to generate revenue. Therefore, the depreciation expense of a long-lived production machine is allocated over its useful economic life.


However, Manufacturing Overhead Cash (coloured in yellow) calculates the amount of cash expense related to manufacturing overhead. This figure excludes depreciation, as well as other non-cash income and expense, as the machine is already paid in full within the quarter after its installation.



PART III - STANDARD COSTING, RAW MATERIAL & INVENTORY BUDGETS


7. STANDARD COSTING


With the direct material, labour and overhead cost information in hand, the standard cost for each unit produced can be calculated. The variable and fixed overhead rate per unit can be calculated by applying the activity-based costing (ABC) principles and divide the total expected overhead cost with the total level activity. ABC, in short, is a way to assign overhead costs to products and services by using cost-drivers.


For our case study, the entrepreneurs decide that the direct labour hours is an appropriate cost-driver. However, a manager can also use other cost drivers such as machine hours, etc, if they think that some overheads are primarily driven by it.



Note: Many managers may also assign SG&A overhead costs using Lifecycle Costing, in addition to production overheads. For example, the total cost for advertising and promotion, which is incurred under SG&A, can be assigned to different products or services depending on their usage of the marketing budget. If Product A requires more advertising, more marketing cost should be allocated to the product to reflect its higher cost. If Product B requires more after-sales support, more customer service cost should be allocated to the product.


8. RAW MATERIAL BUDGET


Using the expected level of ending raw material, Zhao Feiyan and Yang Yuhuan aggregate the data into the Raw Material Budget, which will then be presented in the Proforma Balance Sheet. Generally, proforma data will be useful during financial ratio analysis. Management and other stakeholders will be very interested in the data.


END Raw Material Value (For the period) = Projected END Raw Material Quantity x Standard Cost



9. INVENTORY BUDGET


Using data from the Production Budget, they continue to compute the expected level of inventory at the end of each period in the Inventory Budget. The information will then be presented in the Proforma Balance Sheet.


END Inventory Value (For the period) = Projected END Inventory Quantity x Standard Cost



PART IV - COGS, SG&A & LOAN AMORTIZATION SCHEDULE


10. COST OF GOODS SOLD BUDGET


Using data from the Revenue Budget and Standard Costing, the Cost of Goods Sold (COGS) is computed and the numbers will then be presented in the Proforma Income Statement. COGS represents the cost of the items sold within the period while inventory represents the cost of the items that remain unsold at the end of the period.


COGS = Projected Sale Quantity x Standard Cost



11. SELLING, GENERAL & ADMINISTRATIVE BUDGET


The Selling, General and Administrative (SG&A) Budget represents the rest of the operating expenses that are expended to ensure the everyday smooth-running of the business (excluding production-related activities). This includes selling, distribution, administrative, marketing and other general expenses.


To calculate the quarterly depreciation expense for the depreciation for Leasehold Improvements, the team supplements the budget with a Depreciation Schedule for the period.


Total SG&A (coloured in orange) is the amount that is incurred under the matching principle of accounting, which mandates that an expense must be charged in the corresponding periods where it is incurred to generate revenue. It, therefore, includes depreciation as the cost of the leasehold improvement is allocated over its useful life.


However, SG&A Payment (coloured in yellow) calculates the amount of cash expense related to SG&A overhead. It excludes depreciation as the cost of the leasehold improvement is already paid in full within the quarter after its completion. If there are other non-cash expenses and incomes, they should be excluded as well.


12. LOAN AMORTIZATION SCHEDULE


To fund working capital and capital expenditure needs, the super duet decides to borrow $20,000 from the bank. The amortizing loan has an interest rate of 5% per annum, a term of 5 years and requires payment of $1,038 by the end of each quarter. The schedule below shows the amortization for year 1 using the Effective Interest Method. The END Carry Value will be presented in the Balance Sheet, Interest Expense in Income Statement and the BGN Balance and Principal Repaid presented in the Cash Flow Statement.


Effective Interest Method via Microsoft Excel


Periodic Payment =PMT()

where Rate = 0.0125 [5% p.a. / 4 periods per year]

Nper = 20 [5 years x 4 periods per year]

PV = -20,000 [Amount borrowed]

FV = 0 [Fully paid-off at maturity]

Type = 0 [Payable by the End of Period]


Interest Expense = Periodic Interest Rate 0.0125 x BGN Balance

Principal Repaid = Periodic Payment - Interest Expense

END Balance = BGN Balance - Principal Repaid


PART V - CASH BUDGETS


13. CASH RECEIPT FROM SALES


Before estimating the amount of cash to be received and paid in each period, Zhao Feiyan and Yang Yuhuan have to make some assumptions on the timing of cash flow. To estimate the cash receipt from sales at each period, they estimate the percentage of cash sales, the percentage of credit sales to be settled in cash within the current period and subsequent periods, etc.


Cash from Revenue = Cash Sales + Cash Collected Within Current Period + Cash Collected in Future Periods


Our entrepreneurs have decided on a credit policy for their customers and based on that, they estimate that 20% of sales are cash sales, 80% of credit sales are to be collected within the quarter and the remaining 20% will be collected by the next quarter. Trade receivables can also be calculated by summing the amount to be collected in the subsequent period(s) and the amount will be presented in the Balance Sheet.


14. CASH PAYMENT FOR DIRECT MATERIAL PURCHASE


Next, they continue by computing the cash payment for the direct material purchase. To estimate the cash payment for each period, they have to take into consideration the credit terms extended to them by suppliers.


Cash Paid for Direct Material = Cash Paid Within Current Period + Cash Paid for Payables from Previous Periods



Using approved credit terms as a basis, they estimate that 75% of purchases will be settled in cash within the quarter and the remaining in the next. Trade Payables can also be calculated by using the value of purchases becoming due for settlement in future periods


15. CASH PAYMENT FOR DIRECT LABOUR


Subsequently, they proceed to calculate the cash payment for direct labour expenses and to achieve that, they have to take into consideration the human resource remuneration policy and payroll cycle.



As the wages for production workers are paid on the last working day of each month, 100% of the wages are paid within the quarter. Therefore, the Cash Paid for Direct Labour equals to the Direct Labour Expense for the period.


16. CASH PAYMENT FOR PRODUCTION OVERHEADS


To round of the cash disbursement for production activities, the entrepreneurs move on to work out the cash payment for production overhead expenses. To do that, they have to account for the respective billing and payment cycles.



As much of the production overheads are post-paid, which expenses incurred are billed at next period, they gauge that 90% of the expenses incurred will be settled within the quarter and the remaining in the next. The value of the amount to be paid in the next period is recorded as accrued expenses, which are presented in the Balance Sheet.


17. CASH PAYMENT FOR SELLING, GENERAL & ADMINISTRATIVE OVERHEADS


Rounding off the cash payment for operating activities, Zhao Feiyan and Yang Yuhuan continue by determining the cash payment for support-level selling, administrative and other general activities. To fulfil that, they have to account for the payroll cycle for sales and administrative staff and the respective billing and payment cycles.



As much of the production overheads are post-paid, which expenses incurred are billed at next period, they gauge that 90% of the expenses incurred will be settled within the quarter and the remaining in the next. The value of the amount to be paid in the next period is recorded as accrued expenses, which are presented in the Balance Sheet.


18. CASH RECEIPT & PAYMENT FROM CORPORATE FINANCE ACTIVITIES


Other than cash disbursed and received from operating activities, there are also other sources of cash receipts and payments for investing and financing activities. For this case study, we will collectively term them as "Corporate Finance Activities".



The entrepreneurs intend to invest $30,000 of their personal capital collectively into the company in exchange for 300 shares and raise $20,000 in bank loans at the start of Q1. These monies represent cash inflows from corporate finance activities.



They also intend to invest in production equipment and leasehold improvement totalling $12,000 at the beginning of Q1. They also agree to distribute $1,000 in dividend in Q2 and Q4. The principal repayments on the bank loan can be found in the loan amortization schedule.


19. CASH BUDGET


The Cash Budget can be drawn using the numbers from the accompanying cash payment and receipt schedules.



Our protagonists can also augment the Cash Budget by adopting a Minimum Cash Balance. Some organizations set aside a cash buffer to meet unexpected cash needs and capital of unanticipated opportunities, such as a sudden price drop of a key factor-of-input. However, there should be a balance between buffer cash and the opportunity costs of idle cash. Too little cash buffer may leave the firm exposed to unexpected cash crunch while maintaining too much cash buffer locks up capital so they are not deployed in other uses to earn higher returns.



Cash deficit below the Minimum Cash Balance will be financed by firstly, liquidating any marketable securities at hand and secondly, financed by approved lines-of-credit. Cash surplus will be firstly used to pay off any outstanding lines-of-credit and secondly, invested in marketable securities. The Cash Budget is an essential key to Cash Management.



PART VI - THE 3 PROFORMA STATEMENTS


20. PROFORMA INCOME STATEMENT


After the budgets are done, the information arises then ported to the Proforma Income Statement. Proforma Income Statement is immensely useful as it provides a guide on the amount that is expected to be earned and which areas of the organization are the monies expected to be spent. After deducting losses and expenses from sales and incomes, Zhao Feiyan and Yang Yuhuan will arrive at the expected level of profits.



The Net Interest Expense can be calculated by deducting Interest Income from Cash in Bank and Marketable Securities from Interest Expense from Bank Loans, Bonds, and Lines-of-Credit. In our case study, the ladies decide against setting aside a minimum cash balance, the net interest expense for each period can be calculated using the table below.



The business account that Green Food Inc. uses pays an interest rate of 1% per annum for monies deposited in the bank while the interest expenses for each period are already calculated in the Loan Amortization Schedule.


21. PROFORMA BALANCE SHEET


The entrepreneurs then proceed to prepare the Proforma Balance Sheet by porting the information over from the respective schedules. The Proforma Balance Sheet gives an excellent overview of the business' liquidity and solvency positions. In addition, it also shows the composition of the firm's working capital and long-lived assets.


The difference between Assets and Gross Liabilities + Equity is the Plug. This will be further elaborated in the next section.


22. PROFORMA CASH FLOW STATEMENT


Lastly, they move on to conclude the budgeting exercise by completing the Proforma Cash Flow Statement. This statement is important as it illustrates the inflows and outflows from everyday operating, financing and investing activities. For a startup, it is normal for it to have negative operating cash flow (CFO) but for a matured company, it is a must for it to generate cash from everyday operating activities. The surplus can then be used to finance capital investments and/or returned to providers of capitals such as shareholders and creditors.



The Plug is the amount of funding shortfall to be met for the company to achieve the planned performance level. Therefore, the dynamic duo has to 1) reduce cash expenditures and/or 2) invest more capital through fundraising.


23. FINANCIAL RATIO ANALYSIS


Although not part of the 3 proforma statements, it is good practice for the team to conduct ratio analysis for each period. Firstly, it provides a clear and succinct overview of expected performance to internal and external stakeholders. Secondly, if a firm assumes a bank loan, they will have to abide by conditions set forth in the loan agreement, like maintaining a certain financial ratio. Thirdly, it can serve as a KPI for managers. For more information on financial ratios, please refer to our articles on ratio analysis.



CONCLUSION


This 23-step process for budgeting system allows a company that sells homogenous products and services to conduct performance planning and cash management functions. Stay tuned for the next article where we will conduct project budgeting for Green Life Inc., the other firm in the project that specializes in producing and delivering relatively-dissimilar projects. Hope you find this article informative and stay safe amidst this COVID-19 outbreak.

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