Take, as an example, a manufacturing company which converted its budgetary procedures to the bandwidth method, briefly outlined in section 5. To better appreciate the concept, think of a normal distribution characterizing each budget- ary chapter, like that in Figure 9.2. The limits are set at a 90% level of confidence.
The classical approach to budgeting will only consider the expected value. By contrast, with budgetary bandwidth at each departmental and divisional level, management must specify by what percentage a given higher or lower value can deviate from expected value. Also, what would be changed by such variation in regard to profits and losses. This company decided to use residual incomeas the reference for profits, as does GE.
● Tribute is calculated from the rate of interest, multiplied by the average capital requirement of a given project.
● The result indicates how much the new profit, decreased by capital inter- est, is influenced through deviations from expected value.
This is the first basic step. The second part of the planning formula contains a probability analysis of turnover, highlighting costs and revenues. Besides the most probable result, the highest and lowest limits are indicated within a 90%
probability range.
● Probabilistic examination at 90% might show that the profit can change to a loss.
FREQUENCY
EXPECTED VALUE SOME 90% OF ASSET CLASSES
OCCUR HERE
CONFIDENCE INTERVALS
Figure 9.2 The budgetary bandwidth method is based on expected value and confidence intervals
● This immediately leads to much closer scrutiny of this particular item of business, in terms of variation from expected value.
A third step in the methodology specifies the assumptions underpinning the budget, as well as the degree of probability which they have. For instance, the head of a product line must decide on product-related values, and integrate them into the financial plan for the next year. In this regard, he must specify not only the most probable values but also their expected range. This is a refined form of flexible budgeting, of which we spoke in section 4.
The Vice-President Manufacturing has a similar job to do, in terms of budgetary bandwidth chores. Each factory must prepare a budget proposal and send it to headquarters. Factory budgets will be integrated by the VP Manufacturing, and this integration should include their expected value and limits. The best approach is to use expert systems which, at corporate levels:
● Screen budgetary proposals
● Verify their chapters, one-by-one, and
● Compare likely items bringing deviations to attention.
Knowledge artifacts should be used to integrate the forecasts sent by the sales divi- sion to total sales by product and by marketing territory. Other expert systems should compare sales projections with production plans. While the factories have (most likely) used data similar to such projections, it is always advisable to make a higher level integrative control. A good deal of this effort must be automated through knowledge engineering.
For evident reasons, the finance department should have a role in this evaluation of production plans versus sales forecasts. And the input of the firm’s econom- ics research unit will be valuable in estimating the effect of economic conditions on market demand, as well as the cost of materials and labour.
The fourth step is aggregating several factory budgets with their bandwidth (expected value and limits) into an integrated manufacturing budget. A good approach for doing so is the use of possibility theory – the stochastic method we have examined in Chapter 4. Possibility theory is superior to probability theory in accomplishing this objective because it provides an efficient tool to integrate different budgets into one, while probability theory has no means for doing so.
Some people would say that a top-down budgetary solution would not have pre- sented integrated problems. However, this chapter has pressed the point that the best policy is to ask for input from those executives, and their units, who have
to live with the budget. The goal of an interactive effort is to provide the best approximation to what would be revealed, in the future, as real budgetary requirements, therefore guaranteeing more satisfactory results by:
● Elaborating an organization-wide cost distribution
● Showing variables in sales, production processes and costs
● Helping to control expenses by pinpointing overruns through Plan/Actual analysis, including expected value and limits.
There are, also, other issues that can benefit from the outlined methodology. The cash budget forecasts direct and indirect cost outlays, balancing them against receipts or other sources of funds. Before the estimated income statement and future balance sheet can be prepared, account must be taken of effects of opera- tions upon the cash position of the organization. This is necessary for two reasons:
● The timing of cash receipts and disbursements will have an important bearing on the amounts of receivables and payables in the projected bal- ance sheet.
● The amounts of money needed to execute transactions, and for financing costs, must be determined if the estimated income account is to be complete.
The capital outlays budget defines the investments the organization plans to make during the coming financial period. It is possible to forecast such disburse- ments by estimating projected investments as well as accrued direct and indirect costs at the end of each month of the budgeted period. Here, again, a methodol- ogy of expected value and limits improves the accuracy of the capital budget.
Only tier-1 companies take this approach. The others assume that only slight dif- ferences will exist between the budgetary estimates (at the end of the various months) and the different disbursements. Ifonly minor differences exist between the successive accruals, disbursements will tend to equal the budgeted labour, materials, and other costs. But nothing can guarantee that if.
The need for cash forecasts and cash outlays which allow for a bandwidth is one of the key references that help document the fact that the process of budget preparation entails the making of many analytical decisions. These concern rela- tionships and functions which should be maintained in the operations of any company – whether a financial institution or a manufacturing firm.
Regarding manufacturing proper, a basic premise in drawing up the production budget is that production costs are made up of the outlay spent on materials, labour and overhead. The materials estimate can be obtained by taking the
quantity already decided upon when drawing up production schedules, and transforming it into costs by using standard cost figures – with tighter limits than in sales.
The purchasing budgetis based on the quantity necessary for production, plus a small allowance for losses, scrap, substandard goods, and so on. Estimates should take into consideration the stocks of raw materials expected at the begin- ning of the period and at the end of it, using mathematical models to minimize investments in inventories.
Take the sales budget as another example. The best way is to budget the quantity and not the value of the goods to be sold, in view of the effect of possible price fluctuations. This quantity must be brought down to salesman level, by means of individual quotas, where expected value is the assigned quota. Projected sales figures should be calculated:
● By single product and for groups of products
● By territory in which the company operates, and by salesman in this territory.
Grouping should be based on similarities in product description and selling channel, and can vary according to the firm’s line of business. One overriding factor in budgeting the sales quantity is to be very detailed as well as objective, based on:
● Sales forecasts validated through appropriate studies, and
● Translated into individual quotas and higher commissions beyond the assigned quota.
Overheads should be determined with the aid of the rule that administrative costs must rise much slower than production and be absorbed by the cost centre to which they belong. Each department must prepare a budget of the nonrecov- erable expenses it will incur in the form of costs connected to trivia and admin- istration. (The sense of overhead in manufacturing is not the same as that in banking, discussed in the Introduction.)
Finally, a crucial policy regarding budgetary practice is the unification process which should bring together the different departmental budgetary estimates. It has already been stated that no divisional accounting system is an island. There must be a master budgetwhich:
● Summarizes all estimates for all departments
● Portrays the anticipated result of all forecasts
● Leads to a projected profit and loss statement, and
● Establishes a balance sheet which will result from the fulfilment of those estimates.
This master budget will be transmitted to the financial department and from there to the senior executives who constitute the budget committee, for their con- sideration. The budget committee may approve the estimate as made, or optimize expenditures in connection to expected results. Optimization does not mean sav- ing a piece of coal, but using its heat the best way while it burns.