Chapter 2
Part 4
Master Budgets
Creating a Sales Budget
A sales budget shows an estimate of the goods to be sold and the revenue to be derived from those sales. Since you cannot see into the future, you will have to make a number of assumptions when creating a sales budget. Assumptions are factors you consider to be real, true, or certain. The assumptions will emerge from an analysis of forecasts made by your company or gathered from external sources. You can use the following sources of information to obtain forecasts that will be helpful in creating your sales budget. Plant capacity. You can determine your plant's sales future by examining its capacity to see if it can handle an increase in sales. For example, if you predict that sales will increase by 15 percent, and your plant is currently running at full capacity, then you will not be able to handle the increase. Proposed selling expenses. You can determine how many units you must produce from the selling expenses. For example, if it costs you $10 to produce a unit and $3 to sell one, you can determine how many units you will have to produce to turn a profit. Predictions of unit sales. If your company predicts that sales will increase by 10 percent this quarter, you know that your sales budget must be able to cover the increase in sales. Forecasted economic and market conditions. If the economy is weak, sales of nonessential items will be low. Also, if you are producing a seasonal item, your sales budget must take into account the time of year for which the budget was created.
The sales budget is the starting point for creating both the operating budgets and the master budget. The other individual budgets that are part of the operating budgets use the figures found in the sales budget. A sales budget is usually created for a three-month period and will contain the following headings. 1. Budgeted Unit Sales The first heading, Budgeted Unit Sales, contains the number of units that will be sold for this budget period. To calculate budgeted unit sales for the first month, you need to know the number of units sold in the previous month and the amount of increase forecasted. Multiply these two together and add the result to the actual units. For example, Sol-Car Automotive Manufacturers sold 1,670 units in September. An increase of 10 percent has been forecasted for October. To determine the number forecasted, multiply the actual sales by the forecast: 1,670 x .10 = 167. Then add the actual units to the forecasted units: 1,670 + 167 = 1,837. The budgeted unit sales for October will be 1,837. The second and third months are calculated the same way, but instead of using actual units sold for the previous month, you use the number of the budgeted unit sales for the prior month. For example, to calculate the budgeted unit sales figure for December, you would start with the budgeted unit sales figure you calculated for November. After you have calculated the budgeted unit sales for each month, you must calculate the total for the quarter in which the budget was created. To do this, you add the amounts found in the budgeted unit sales column. Remember, add only the amounts for the threemonth period, and not the actual sales from the first month, September. 2. Budgeted Unit Price The next heading, Budgeted Unit Price, is forecasted by management. It is the actual selling price of each unit. The finance committee determines the budgeted unit price by calculating the cost of producing each unit, the selling expenses involved, and the percentage of profit expected. This figure is entered under the Budget Unit Price heading for each of the three months in the quarter.
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3. Budgeted Total Sales The final heading in the sales budget is Budgeted Total Sales. This is the figure that shows the revenue that will be derived from the planned sales. In other words, Budgeted Total Sales = Revenue. Determining the budgeted total sales is the last step in creating a sales budget. It is done last because you need the budgeted unit sales and budgeted unit price to perform the calculation necessary to obtain the total. The formula for calculating the budgeted total sales is: Budgeted Unit Sales x Budgeted Unit Price = Budgeted Total Sales. Finally, when creating your sales budget, you should ensure that all of your figures are accurate. Remember, the other individual budgets found in the operating budgets depend on the sales budget for their figures.
Creating a Merchandise Purchases Budget
Anyone who is responsible for inventory or merchandise purchases should know how to create a merchandise purchases budget. A merchandise purchases budget is a plan that shows you the number of units that need to be purchased to meet the expected sales demand during a budget period. It will help you make sound decisions that will result in an accurate inventory. Before you can create a merchandise purchases budget, you must determine the amount of inventory you have on hand. This is known as the beginning inventory. You should also identify which method your company uses to maintain its inventory. Two methods of maintaining inventory are described below. Company policy determines which system is used. 1. Just-in-time inventory systems Companies that use this system keep the minimum amount of inventory on hand. The goal of a just-in-time inventory system is to meet the immediate sales demand. Managers use just-in-time inventory systems to cover sales budgets that have very short durations. This system has two advantages—inventory on hand is held at a minimum or zero in an ideal situation, and the costs of maintaining inventory are kept to a minimum It is important to remember that just-in-time inventory systems are practical only if customers are content to order in advance or if managers can accurately determine short-term sales demand. Also, suppliers must be able and willing to ship small quantities regularly and promptly. 2. Safety stock inventory systems Market conditions and manufacturing processes may make a just-in-time inventory system impossible to use. Instead, companies may decide they need to keep enough inventory on hand to reduce the risk of running short. This is known as a safety stock inventory system. The advantages to using this system are that it satisfies the budgeted sales amount, it maintains additional quantities of inventory, and it provides protection from lost sales caused by unfulfilled demands or delayed shipments. The only disadvantage of using the safety stock inventory system is that cash is tied up in inventory and is not readily accessible. You can easily tell which system a company is using. Just look at the figures of next month's inventory that company policy states you should keep on hand. A just-in-time inventory system will have very low figures, while a safety stock system will have very high figures. Once you know the type of inventory system your company uses, you can create a merchandise purchases budget. To create this budget, you would use the following two formulas. You can follow the five processes described below to complete these formulas. Budgeted Ending Inventory + Budgeted Unit Sales - Budgeted Beginning Inventory = Inventory to be Purchased Inventory to be Purchased x Budgeted Unit Price = Budgeted Cost of Merchandise Purchases 1. Determine the budgeted ending inventory. To determine the amount of ending inventory, you first must obtain the budgeted unit sales for each month from the sales budget. Next, determine the ratio by which you should multiply the budgeted unit sales. The ending inventory for a given month is equal to a
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ratio of the next month's expected sales. For example, inventory at the end of May should equal 90 percent of April's budgeted sales. Use this ratio as the multiplier. The ratio depends on the type of inventory system you use, since the percentage of inventory you need to keep on hand differs vastly between the two systems. This is why, when creating the merchandise purchases budget, it's so important for you to know the type of inventory system your company uses. Then to determine the ending inventory, multiply the budgeted unit sales for the month by the ratio. This will give you the figure for the ending inventory for each month. 2. Determine required units of available merchandise. After you have determined the ending inventory, you must calculate the required units of available merchandise. To do this, you simply add the budgeted unit sales for last month to the ending inventory. In other words, Budgeted Ending Inventory + Budgeted Unit Sales = Required Units of Available Merchandise. 3. Determine number of units to be purchased. The next process completes the first formula by determining the number of units to be purchased. To do this, deduct the beginning inventory from the required units of available merchandise. In other words, Required Units of Available Merchandise - Budgeted Beginning Inventory = Inventory to be Purchased. 4. Determine budgeted cost of merchandise purchases. The next process is to calculate the budgeted cost of merchandise purchases. This is done using the formula: Number of Units to be Purchased x Budgeted Cost Per Unit. The budgeted cost per unit is obtained from the sales budget. 5. Determine the total cost for the quarter. The final process is to add the budgeted cost of merchandise purchases for each of the three months in the budget period to obtain the total for the quarter. Remember, the type of inventory system you use will affect your merchandise purchases budget. If you use a just-in-time system, you'll only need to purchase a small amount. If you use a safety stock system, you'll need to purchase a larger amount. Only you or your company can decide which system is best for you.
Creating a Production Budget
A merchandise purchases budget can help you determine how many units your company needs to purchase to maintain its inventory, so that it can accurately meet sales demand. But would a company that manufactures its own product use a merchandise purchases budget to determine how many units to produce? Unlike a merchandising company, a manufacturing company cannot use a merchandise purchases budget for production planning. It needs another way to plan how many units it must produce. An important planning tool available to manufacturers is the production budget. It shows how many units a company must manufacture in order to meet predicted sales from the sales budget. For example, since the managers of Sol-Car Automotive Manufacturers purchase some parts for their solar-powered car, they use a merchandise purchases budget to determine the number of parts they need to buy and the cost. But when they want to determine how many cars to produce to meet the predicted sales demand, they use a production budget. Keep in mind that the production budget identifies only the number of units to be produced and not the associated costs. A production budget is always expressed in units of product and is usually created for a three-month period. Before you can create a production budget, you need to obtain the budgeted unit sales and the budgeted unit price from the sales budget and the desired ratio of ending inventory from management. You then can follow the steps listed below to create the budget. An example of each step is provided, using the budget created by SolCar Automotive Manufacturers.
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1. Calculate the ending inventory. Sol-Car's company policy states that 80 percent of the next month's predicted sales must be kept on hand as ending inventory. To determine the ending inventory for the month of October, they will use November's predicted sales of 2,021 units. They then perform the following calculation: 2,021 x 80 percent = 1,617. The ending inventory for October should be 1,617 units. 2. Calculate the required units of available production. Sol-Car has budgeted for sales of 1,837 units for the month of October. They add the ending inventory to the budgeted sales to obtain the required units of available production. They perform the following calculation: 1,617 + 1,837 = 3,454. The required units of available production is 3,454 units. 3. Calculate the number of units to be produced. Deduct the beginning inventory from the required number of units available. The beginning inventory for a month is the ending inventory for the prior month. So, September's ending inventory of 1,200 units becomes the beginning inventory for October. Sol-Car makes the following calculation: 3,454 - 1,200 = 2,254. The number of units to be produced is 2,254. Remember, a production budget is a plan to determine how many units a manufacturing company must produce. Retailers, meanwhile, should use a merchandise purchases budget for making inventory purchases.
Creating a Manufacturing Budget
You've created a production budget to determine how many units your company needs to produce to meet sales demands. But how do you know how much it will cost to produce these units? You can create a manufacturing budget to determine the costs of producing the units found in the production budget. A manufacturing budget consists of the three sub-budgets listed below, which show the total cost of goods to be produced. 1. Direct materials budget The first sub-budget you need to create is the direct materials budget. This shows the total costs of the materials needed to satisfy the production requirements. To create the direct materials budget, follow the four-step process listed below. Calculate materials needed for production. To perform this calculation, you need to know the number of units to be produced, or budget production units, which you can get from the production budget. You also need to know the amount of materials required to produce each unit, or the cost to produce each unit. Then multiply the budget production units figure by the material requirements per unit (unit cost) to arrive at the materials needed for production. Calculate the total materials requirement. To determine this, you need to know the desired ending inventory. This is set by management and is a percentage of the next month's budgeted material requirements. You also need to know the materials needed for production figure. Add the materials needed for production figure to the desired ending inventory figure to arrive at the total materials requirement. Calculate the units of material to be purchased. To calculate the number of units to be purchased, deduct the beginning inventory, which is the previous month's ending inventory, from the total materials requirement. Calculate the total cost of direct material purchased. Finally, multiply the material price per unit, which is determined by management, by the number of units to be purchased to arrive at the total cost of direct materials to be purchased.
2. Direct labor budget The next sub-budget you create for the manufacturing budget is a direct labor budget. The direct labor budget is a plan for the number of labor dollars needed to produce the number of units required in the production budget. The steps to creating a direct labor budget are described below. Calculate total labor hours. The total labor hours are calculated by multiplying the production budget units, which you can get from the production budget, by the amount of time it takes to create one unit. Calculate the labor dollars needed. The labor dollars are calculated by multiplying the total labor hours needed by the labor rate set by the company.
3. Manufacturing overhead budget The last sub-budget you need to create for the manufacturer's budget is the overhead budget. This is a plan to budget for the cost of the
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overhead needed to produce the number of units found in the production budget. Before you can create a manufacturing overhead budget, you should be familiar with the following terms. Budgeted production units. This is the number of units to be produced. It is obtained from the production budget. Variable manufacturing overhead rate. This term refers to those business costs associated with providing and maintaining the manufacturing or working environment, and that usually fluctuates dependent upon manufacturing or sales volume. It is determined by management when setting acceptable overhead rates. Budgeted fixed overhead. This term refers to those business costs associated with providing and maintaining the manufacturing or working environment and that remain constant. These costs also are predetermined by management.
To calculate the manufacturing overhead budget, you can follow two steps. First, calculate the budgeted variable overhead. To do this, multiply the budgeted production units by the variable manufacturing overhead rate. Then add the budgeted fixed overhead to the budgeted variable overhead to determine the budgeted total overhead. Remember, the manufacturing budget shows the budgeted costs for the direct materials, direct labor, and the manufacturing overhead. It will enable you to determine the total cost of goods to be produced.
Creating a Depreciation Budget
Did you know that when you buy a brand new car and drive it off the lot, it loses a couple of thousand dollars in value? This is known as depreciation. Almost everything depreciates, whether it is a car, an appliance, or a piece of plant equipment. To handle the decline in value of your company's assets, you can create a plan called a depreciation budget. Because the lives of all plant assets, except for land, are tangible and limited, the usefulness and value of these assets decrease as you use them. The depreciation budget allocates the cost of a plant asset to the expense account in the periods that benefit from its use. Say, for example, your company has recently purchased a new conveyor belt for use in your plant's assembly line. The total cost of the assembly line will include the cost of the conveyor belt, less the proceeds you expect to receive when the conveyor belt is sold at the end of its useful life. This net cost is allocated to the accounting periods that benefit from the conveyor belt's use. This is known as depreciation. Three factors are relevant when determining depreciation. These three factors are cost, salvage value, and useful life. Cost. The cost of an asset consists of all necessary and reasonable costs to acquire it and to prepare it for use. Salvage value. The salvage value is an estimate of the asset's value at the end of its usefulness. It is the amount you expect to receive when you sell or trade-in the asset once you no longer can use it. Useful life. The useful life of an asset is the length of time it can be productively used by the company. Useful life, which is predetermined by management, is often in the eye of the beholder. For example, a company may trade its cars every two years. The cars are still good, but their useful lives to the company are over.
Although there are many methods of calculating depreciation, the most common method used by accountants is the straight-line method. This is because it is so simple to use. In the straight-line method, the cost of the asset is written off in yearly installments, equal to a percentage of the cost. This allows the same amount to be charged to expenses for each budget period of the asset's useful life. The straight-line method involves a two-step process to calculate the amount of depreciation to be deducted yearly. This process, which is described below, also can be written as the formula: (Cost - Salvage Value) ÷ Useful Life in Year = Yearly Depreciation. First, subtract the salvage value from the equipment cost. Then calculate the yearly depreciation by dividing the cost, minus the salvage value, by the useful life in years.
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Remember, a depreciation budget enables you to create a plan to handle the decline in value of your assets, which will allow you to allocate the cost of a plant asset to the expense account in the periods that benefit from its use.
Creating a Selling Expense Budget
If you are planning a business trip, you need to know how much the trip will cost you, so you calculate how much expense is involved. You add things such as estimates of the cost of train tickets, car rentals, hotels, and meals. What if you had to deal with these or similar expenses when selling your product? What kind of budget would you need to create? Any expenses that have to do with selling are identified in the selling expense budget. This is a detailed plan for the costs involved in selling a company's product or products. Although the selling expense budget is normally created by the marketing or sales department, it can be created by anyone in the company. Its purpose is to make sure there is enough money to cover the expenses associated with the sales predicted in the sales budget. The selling expense budget details all of the expenses associated with storing and preparing the merchandise for sale, advertising and promoting sales, and the actual sale itself. Included in the selling expense budget are expenses for: sales commissions wages for salespeople delivery telephone utilities sales department's payroll taxes depreciation expenses advertising equipment supplies used.
The first step in creating a selling expense budget is to calculate the sales commission. Management determines how much each salesperson is paid. Commissions are paid as a percentage of the total sales. For example, if salespersons were paid 10 percent commission, and sales for the month totaled $150,000, you would perform the following calculation: $150,000 x .10 (or 10 percent) = $15,000. Next, the sales manager's salary is added to the sales commission. This amount is a fixed amount, unlike commissions, which depend on sales. If, for example, the sales manager's salary was $1,100 per month, you would perform the following calculation: $15,000 + $1,100 = $16,100. Then, each of the expenses relating to sales is added on in turn. For example, if the monthly sales phone bill was $387, the depreciation on the sales delivery van was $822, and the monthly payroll taxes were $333, all these expenses would be added as follows: $16,100 + $387 + $822 + $333 = $17,642 . After you have added on each expense, the final amount is the total selling expense for the month, $17,642. Typically, selling expense budgets are created for three-month periods, with the final budget showing the quarterly totals. Remember, a selling expense budget is used only for the expenses involved in selling a product. By following the steps described above, you can create a selling expense budget for your company.
Creating a General and Administrative Budget
Isn't it much easier to manage your personal finances when you follow a budget? Businesses also need to create budgets in order to manage their finances.
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One type of budget that a business uses is a general and administrative budget. It includes all expenses incurred in the general office, accounting department, and the personnel department. Sometimes it's hard to determine which expenses fall under which budget. As a general rule of thumb, when an expense cannot be identified as a selling expense, treat it as a general and administrative expense. Below is a list of expenses that would normally be found in the general and administrative budget. They would include expenses incurred by any department that is not directly involved in sales. These expenses include: wages and salaries for each department payroll taxes for each department's salaries property taxes utilities phone bills for each department office supplies insurance depreciation on buildings depreciation on a department's equipment.
The general and administrative budget is usually created by the office manager or administrator, but it can be created by anyone in the company. To create a general and administrative budget, you can follow the three-step process described below. 1. Calculate monthly expenses. First, add the yearly expenses. Generally, yearly expenses include everything except the depreciation. Then divide the yearly expenses by 12 to determine the monthly expenses. 2. Calculate monthly depreciation. Next, divide the yearly depreciation by 12 to determine the monthly depreciation. 3. Calculate the total general and administrative expenses. Finally, add the monthly expenses and monthly depreciation to determine the total expenses. Keep in mind that a general and administrative budget is usually created for a three-month period, with the final budget showing the quarterly totals. Remember, the key to having an accurate budget is to record the entries properly. If it's not a selling expense, then it must be a general and administrative expense.
Calculating the Payback Period
Have you ever taken out a loan? The time you have to pay back the loan is known as the payback period (PB). For example, a car loan that will be paid off in three years has a three-year payback period. Although payback periods can mean the same thing in the business world, they also can mean something different. In business, a payback period can mean the number of years it takes a business to recover its original investment through its net cash flows. For example, a company invested $45,000 in equipment. Based on the net cash flow, it will take the company six years to recoup its investment of $45,000. The company calculated the payback period using the payback method. Before using the payback method, a company must decide what an acceptable rate in years will be for it to recoup an investment. This is known as the anticipated life of the project. The company also can base its decision on the decision rule. The decision rule for using the payback model is: if the payback period (PB) is equal to or less than the acceptable payback period that your company has established, accept the project. In general, the project with the lowest payback period will be selected. The two methods used to calculate the payback period are described below. It's important that you use the correct method for your calculations. Which method your company will use is predetermined by management.
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1. Even cash flows The first method is used when your company has even cash flows. When you have even cash flows, you can expect to receive the same amount of money every year for the length of time you will make use of the investment, known as the investment's useful life. The formula used to calculate even cash flows is: PB = NINV ÷ CF. In this formula, PB equals the initial investment (NINV) divided by cash flow (CF). For PB, you round answers off to the second decimal place. Sol-Car Automotive Manufacturers is calculating the PB for producing all-terrain vehicles (ATVs). The initial investment is $125,000 with an even cash flow of $82,000 per year. They perform the following calculation: 125,000 ÷ $82,000 = 1.52. The payback period will be 1.52 years. Sometimes the number of years plus the exact number of days in the PB period is required. To determine the exact number of days, you can use the formula: PB = Number of Years + (365 x Percentage of the Year) days. For example, 1 year + (365 x .052) days = 1 year, 190 days. Management has set the acceptable payback period at two years. Since the payback period of 1 year, 190 days is less than the acceptable two-year payback period set by management, Sol-Car will accept the project. 2. Uneven cash flows In the first method, Sol-Car Automotive Manufacturers had an even cash flow. How different would the payback period be if the cash flow was uneven? For example, Sol-Car anticipates net cash flow of $51,000 in year one, $69,00 in year two, $67,000 in year three, $71,000 in year four, and $68,000 in year five. Considering the same NINV of $125,000, Sol-Car calculates the payback for uneven cash flows as follows. The company anticipates receiving $51,000 in year one. This will not pay back NINV at $125,000. They add $69,000 for year two: $51,000 + $69,000 = $120,000. This still is not enough, but since it is very close to $125,000, they know that the payback period will be at least two years. They subtract the total of year one and year two cash flows from the NINV: $125,000 - $120,000 = $5,000. Next, they divide the $5,000 by the CF for year three, $67,000. PB = $5,000 ÷ $67,000 = 0.07 To obtain an exact length of time, they calculate the number of days: 2 years + (365 x 0.07) days = 2 years + 25.55 days. PB is 2 years, 26 days.
Note the difference in the results of the payback period when you use the even and uneven cash flow methods. This is why it is important for management to predetermine what kind of cash flow your investment will have. Remember the decision rule. Once you've calculated the payback period, you can use it to determine whether to accept or reject the project. For example, Sol-Car Automotive set its acceptable rate at two years for its uneven cash flow example. Since its payback period will be two years, 26 days, the company will reject the investment. You can use the payback period and the decision rule to compare investments and determine which one would be better for your company. When comparing investments by their payback periods, you should ask yourself two questions. First, do both investments meet the decision rule? Second, which payback period is shorter? Remember, the payback period deals with cash flows instead of profits or losses. It will give you the number of years you will need to recover your initial investment.
Calculating Net Present Value
With inflation rates changing daily, how can you plan an expenditure for the future when you don't know what your dollar will be worth in five or 10 years? You can use a process called net present value (NPV). Net present value enables you to determine the value in today's dollars of a sum of money to be received in the future, after taxes and minus your initial investment. Calculating NPV can help you make important investment decisions. For example, you can compare NPV for different investment projects and then include the project with the highest NPV in your capital expenditures budget.
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When deciding to accept or reject an investment project using NPV, you can use the NPV decision rule. This rule states that if NPV is greater than or equal to 0, accept the investment project. However, if NPV is less than 0, reject the investment project. To calculate NPV, you can follow the three-step process described below. 1. Find the present value. The first step is to calculate the present value (PV). Present value is the value in today's dollars of a sum of money to be received in the future. The formula for calculating PV is, PVo = FVn [1 ÷ (1 + i) to the power of n]. In this formula, PV stands for the present value of the future sum of money, while the o represents the number of years to be calculated. The n stands for the number of periods until payment is received, while FVn represents the future value of the investment at the end of n. Finally, i is the discount rate per period. You can use a Present Value Interest Factor (PVIF) table when performing this calculation. This will make the calculation simpler to perform. 2. Total the PVs for the useful life of the investment. Now that you know how to calculate PV, you can calculate the total present value (TPV). TPV is the total of the PVs of the cash flow for each year of the investment's useful life. Useful life is the length of time the company will make use of the investment. This is something that is predetermined by management. For example, Sol-Car Automotive Manufacturers is considering a new acquisition that will cost it $620,000. The company anticipates that the acquisition will have a useful life of three years, with uneven cash flows of $115,000 for year one, $122,000 for year two, and $135,000 for year three. The discount rate is 6 percent. Sol-Car performs the following calculations to determine the TPV for the investment. First, Sol-Car calculates the PV for year one. To do this, they can use the formula described above, or they can use the PVIF table to perform the calculation. They determine that the PV for year one is $108,445. Next, they calculate the PV for year two in the same manner. The PV for year two is $108,580. Then they calculate the PV for year three, which is $113,400. Finally, they add the three PVs together to arrive at the TPV of $330,425. 3. Subtract the total PVs from the initial investment to obtain the NPV. The final step in calculating the NPV is to subtract the initial investment from the TPV to obtain the NPV. In the example from SolCar Automobile Manufacturers, the TPV was $330,425 and the initial investment was $620,000. To obtain the NPV, they subtract $620,000 from $330,425. This results in an NPV of ($289,575), or negative $289,575. If you remember the NPV decision rule—if it's less than 0, reject it—then you know Sol-Car will not be proceeding with this investment. NPV is a great tool for comparing investments. When you are comparing investments based on the NPV, you accept the one with the highest NPV. In order to compare NPVs, though, it is important that both investments are mutually exclusive, or similar. For example, you wouldn't compare a $1,000 investment to a $100,000 one. Remember, net present value enables you to determine the value in today's dollars of a sum of money to be received in the future. You and your company can use net present value to compare investments and determine which investment is the best one for you.
Calculating the Internal Rate of Return
Have you heard of a return on investment? This is the amount of money you expect to earn when you make an investment. It is calculated using rates of return, which can be found in a capital expenditures budget. The internal rate of return (IRR) found in the capital expenditures budget is used to evaluate new or potential investment projects. IRR equals the rate that yields a net present value (NPV) of zero for an investment.
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In other words, if you calculate the total present value (TPV) of a project's cash flow using the IRR as the discount rate, and then subtract the initial investment from the TPV, you would get an NPV of zero. The two steps for calculating the IRR are described below. For your calculations to be accurate, IRR is never rounded off to a whole number. Instead, round it off to the fourth decimal place. 1. Calculate the present value factor. PVo (in which PV stands for the present value of the future sum of money and o represents the number of years to be calculated) is calculated using the formula: Present Value Factor = Amount Invested ÷ Net Cash Flow. For example, you invest $12,000 in a project with a net cash flow of $5,000. PVo = $12,000 ÷ $5,000 = 2.4. Note that the figures are not rounded when calculating PVo. 2. Determine IRR. To determine IRR, you must use an annuity table called the Present Value of an Annuity Interest Factor. For example, if your investment has a useful life of three years and a PVo of 2.4, you would look up those factors in the table and follow them to the result. In this case, IRR is 12 percent. Now that you have calculated the IRR for the investment, you must decide whether to accept or reject it. To decide which investments to accept or reject, you can use the IRR decision rule. This rule states that if IRR is greater than or equal to the required rate of return, accept the project. If IRR is less than the required rate of return, reject the project. In the previous example, the IRR was 12 percent. Should you accept or reject the project based on the IRR decision rule if the acceptable IRR rate is 14 percent? Since the IRR is less than the required rate of return of 14 percent, you should reject the project. When cash flows for an investment are uneven, the procedure for using the formula for IRR is a little different and a lot harder. You must use trial and error and the Present Value Interest Factor table to determine the IRR. You do this by selecting any reasonable discount rate and computing the NPV. If the amount is positive, you calculate the NPV using a higher discount rate. If the amount is negative, you calculate the NPV using a lower one. You continue until you have two consecutive results that have different signs—a positive and a negative. Since the NPV is zero for IRR, you know that the IRR lies between those two discount rates. When comparing investments, you can use IRR to help you decide which one would be best for your company. As long as the IRRs are both above the company's acceptable rate of return and mutually exclusive, you can compare investments. Any amount less than the acceptable rate would be rejected. For example, a company has a choice of two investments, one with an IRR of 13 percent and one with an IRR of 16 percent. If both are above the acceptable rate, you would accept the investment with the higher IRR, which is the second one. The IRR is a great tool for evaluating new or potential investment projects or comparing investments. By following the steps described above, you can calculate the IRR for investments your company is considering.
How to Create a Cash Budget
A cash budget is a plan that shows the amount of money your company expects to receive and pay out during a budget period. This is known as cash inflow and cash outflow. You and your company can use a cash budget to help you make financial decisions. For example, you can arrange for a loan if the cash budget is inadequate, or if your company has excess cash, you can pay off your loans. A cash budget also helps management avoid a cash balance that is too large. Having too much money on hand means the money is not earning interest.
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Most importantly, a cash budget is a plan that helps a company meet its financial obligations. If your company can't pay its bills, it can't continue to operate. Information for preparing the cash budget is taken primarily from the operating and capital expenditures budgets. However, other information and calculations are sometimes necessary to determine the final amounts. When preparing a cash budget, you add the cash you expect to receive to the beginning cash balance and deduct any cash you expect to pay out. This is done using the four steps described below. 1. Calculate the total cash available. To perform the calculations for the first step, you will need to know the amount of cash you expect to receive from customers. Once you have determined the cash receipts, you can determine the total cash available by adding the beginning cash balance to the cash receipts. The beginning cash balance is a preset amount that management determines. It is the least amount of money that a company can start the month with. 2. Calculate the preliminary balance. Step two, calculating the preliminary balance, involves information found in the operating and capital expenditures budgets. An example of this information is sales from the sales budget, which is found under the operating budget. This information is used to calculate the total cash disbursements needed to determine the preliminary balance. Some examples of cash disbursements are: payments for merchandise salaries and sales commissions income tax payable purchase of equipment.
Once you have calculated the total cash disbursements, you subtract them from the total cash available. This will give you the preliminary balance. 3. Calculate the ending cash balance. The third step, calculating ending cash balance, involves determining whether additional loans have to be taken out to meet the minimum beginning cash balance, or whether existing loans can be paid off. Once you have determined whether you should pay off a loan or take out a new one, you can calculate the ending cash balance. This is done by adding new loans to the preliminary balance or subtracting the ones you paid off. The conditions for paying off loans or taking out new ones are listed below. Paying off a loan. If the preliminary balance is greater than the minimum beginning balance plus the balance of the existing loan, you can pay off that loan. Taking out a new loan. If any cash shortages appear in the cash budget, you can take out a short-term loan to cover the anticipated shortage.
4. Calculate the loan balance. Finally, calculate the final loan balance. Remember to carry any loan balances over to the next month and to add any additional loans for that month to the loan balance at the end of the month. Used correctly, a cash budget can be an important tool you and your company can use when making financial decisions. In addition, it can help your company ensure that it can meet its financial obligations.
Creating a Budgeted Income Statement
You've heard of an income statement before, but have you ever heard of a budgeted income statement? A budgeted income statement is a prediction of the revenues, expenses, and net income that will be gained if a financial budget is followed. The net income is used to calculate future earnings, which in turn will be used to create a profit plan, which determines what will be done with future profits.
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You are probably wondering what the difference is between a regular income statement and a budgeted income statement. Although their formats are identical, a budgeted income statement is a forecast of what may happen, while a traditional income statement identifies what has happened. It contains facts from the period for which the statement was created. The information contained in a budgeted income statement is obtained from previously prepared budgets, such as the sales, general and administrative, and depreciation budgets. Like the traditional income statement, the budgeted income statement uses the formula: Revenue - Expenses = Net Income. The steps to follow to create a budgeted income statement are described below. 1. Calculate the gross profit. In the first step, calculate gross profit, you need to obtain the total predicted sales and the budgeted unit price from the sales budget. Multiply the number of units by the unit price to obtain the total predicted sales. Next, you need to obtain the total cost of goods sold. To do this, multiply the cost per unit by the number of units sold. Finally, subtract the cost of goods from the sales to obtain the gross profit. 2. Calculate the net income before taxes. The next step is to add the operating expenses, such as sales commissions, sales salaries, administrative salaries, and depreciation on equipment. Then subtract the operating expenses from the gross profit to obtain the net income before taxes. 3. Calculate the net income after taxes. The last step is to calculate the net income after taxes. To calculate the amount of taxes to be paid, deduct the percentage of income tax to be paid, set by your state, from the net income. What happens if a loss occurs? Remember, a loss results when the expenses are greater than the revenue. If this occurs, there is no point in continuing with the creation of a budgeted income statement, since you would be planning a loss. Remember, the budgeted income statement is a prediction of the revenues, expenses, and net income that will be gained if a financial budget is followed. It is a tool you can use to determine what will be done with future profits.
Creating a Budgeted Balance Sheet
The final document that needs to be created for the master budget is the budgeted balance sheet. This shows the estimated financial position of the company at the end of the period for which the master budget was created. The budgeted balance sheet is similar to the regular balance sheet. However, the budgeted balance sheet contains predictions about the effects of the other budget plans, and of operations on assets, liabilities, and owner's equity in a business. Since it depends on the other budgets for its information, it must be prepared last. The budgeted balance sheet contains the same headings as the regular balance sheet. Specifically, it contains the following headings. Total assets. Any monies the company plans to receive during the budget period will be added together. Any depreciation will be subtracted from the result to obtain total assets. Assets can be cash, accounts receivable, inventory, or equipment. Total liabilities. Any money the company is planning to pay out during this budget period is added together to obtain total liabilities. Liabilities can be accounts payable, income taxes the company owes, rent, payments, or mortgages.
The budgeted balance sheet calculates the forecasted owner's equity using the formula: Revenue - Expenses = Owner's Equity. This is the same formula used when calculating the regular balance sheet. Remember, the purpose of the budgeted balance sheet is to show the estimated financial position of the company at the end of the period for which the master budget was created. By using the formula described above, you can create a budgeted balance sheet for your company.
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