THE STRUCTURE OF THE BUDGET BASIC INFORMATION AND TUTORIALS

The budget is classified broadly into two categories: the operational budget, which reflects the results of operating decisions; and the financial budget, which reflects the financial decisions of the firm.

The operating budget consists of:

1. Sales budget, including a computation of expected cash receipts
2. Production budget
3. Ending inventory budget
4. Direct materials budget, including a computation of expected cash disbursements for materials
5. Direct labor budget
6. Factory overhead budget
7. Selling and administrative expense budget
8. Pro forma income statement


The financial budget consists of:

1. Cash budget
2. Pro forma balance sheet

The major steps in preparing the budget are:

1. Prepare a sales forecast
2. Determine production volume
3. Estimate manufacturing costs and operating expenses
4. Determine cash flow and other financial effects
5. Formulate projected financial statements

THE CAPITAL BUDGETING DECISION BASIC INFORMATION AND TUTORIALS

Capital budgeting decisions are central to the company’s success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion.

The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May 1994. Instead of providing profits on the investment, accumulated losses on the park by that date were more than $200 million.

Contrast that with Boeing’s decision to “bet the company” by developing the 757 and 767 jets. Boeing’s investment in these planes was $3 billion, more than double the total value of stockholders’ investment as shown in the company’s accounts at the time.

By 1997, estimated cumulative profits from this investment were approaching $8 billion, and the planes were still selling well.

Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value.

Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeing’s investment produced a stream of cash flows that were worth much more than its $3 billion outlay.

Not all investments are in physical plant and equipment. For example, Gillette spent around $300 million to market its new Mach3 razor. This represents an investment in a nontangible asset—brand recognition and acceptance. Moreover, traditional manufacturing firms are not the only ones that make important capital budgeting decisions.

For example, Intel’s research and development expenditures in 1998 were more than $2.5 billion.4 This investment in future products and product improvement will be crucial to the company’s ability to retain its existing customers and attract new ones.

Today’s investments provide benefits in the future. Thus the financial manager is concerned not solely with the size of the benefits but also with how long the firm must wait for them. The sooner the profits come in, the better.

In addition, these benefits are rarely certain; a new project may be a great success but then again it could be a dismal failure. The financial manager needs a way to place a value on these uncertain future benefits.

We will spend considerable time in later material on project evaluation. While no one can guarantee that you will avoid disasters like Euro Disney or that you will be blessed with successes like the 757 and 767, a disciplined, analytical approach to project proposals will weight the odds in your favor.

ADMINISTRATION OF CAPITAL BUDGETING BASIC INFORMATION

How Capital Budgeting Works?

Although the administrative process of capital budgeting may differ from one firm to another, it involves five basic steps. The first step is the planning, or origination and specification, of capital investments.

Because capital investments are considered essential to a firm’s profitable long-run growth, managers constantly search for new methods processes, plants, and products. These projects usually come from various sources, including the following:

1. New products or markets, and the expansion of existing products or markets.

2. Research and development.

3. Replacement of fixed assets.

4. Other investments to reduce costs; improve the quality of the product; improve morale; or comply with government orders, labor agreements, insurance policy terms, and so forth.

The second step in capital budgeting is the evaluation of the proposed capital investments. Firms differ in their routine for processing capital budgets, but most evaluate and approve the projects at various managerial levels. For example, a request for capital investment made by the production department may be examined, evaluated, and approved by:

(1) the plant managers, (2) the vice president for operations, and (3) a capital budget committee or department, which may submit recommendations to the president.

The president, after adding recommendations, may submit the project to the board of directors. This routine is often complemented and simplified by a uniform policy and procedure manual presenting in detail the firm’s capital budgeting philosophy and techniques.

The third step in capital budgeting is the decision making based on the results of the evaluation process. Depending on the size of the projects, some decisions may be made at a high level, such as the board of directors (if they are large projects), or at a lower level if they are small to medium-sized projects.

The fourth step is control. The firm includes each of the accepted projects in the capital budget and appropriates funds. Periodically, control is exercised over the expenditures made for the project. If the appropriated funds are insufficient, a budgetary review can be initiated to examine and approve the estimated overrun.

The control step can be extended to include a continuous evaluation process to incorporate current information and check the validity of the original predictions.

The fifth capital budgeting step is the post audit. This involves a comparison of the actual cash flows of a capital investment with those planned and included in the capital budget.