lecture recording on 05 March 2025 at 18.56.20 PM

Importance of Budgeting

• Understanding Financial Resources

  • Knowing expected income sources: work, scholarships, financial aid, car payments, utility bills, and tuition.

  • Example: If you have $250 and expect $500 in expenses this month, you need to calculate how many hours to work based on your hourly wage.

Cash Flow Calculation Example

• Monthly Expenses:

  • Current month expenses: $500

  • Next month expenses: $100

  • Total projected expenses: $600

• Net Cash Requirement:

  • Starting cash: $250

  • Net cash requirement: $600 - $250 = $350

• Hours to Work:

  • At $25/hour, need to work: $350 ÷ $25 = 14 hours.

• Conclusion: This simple calculation demonstrates future cash flow needed for budgeting.

Building an Economic Model

• Purpose of Economic Modeling:

  • To create a representation of the economic realities for effective decision-making.

  • Involves pulling together economic data and forecasts.

• Budgeting Timeline:

  • Typically formalized around October to strategize for next fiscal year.

• Modeling Functionality:

  • Serves as a guide for expected company performance and growth.

Control Function of Budgets

• Monitoring Performance:

  • Budgets act as control metrics, comparing actual results with forecasts to detect issues early.

  • Use of performance standards for effective tracking.

• Mitigating Risks:

  • Allows a close check on manufacturing costs, production hours, and sales targets.

• Proactive Management:

  • Quick identification of issues enables timely resolutions, like the example of a significant gross margin drop.

Coordination and Communication

• Standardized Format:

  • Budgets aid in maintaining clarity across the organization by providing a common framework for goals and expectations.

• Engaging Employees:

  • Clear budgets help employees understand their contributions, fostering engagement and ownership of goals.

• Building Commitment:

  • Individuals who feel valued and important are more likely to engage productively at work.

Motivational Factors in Budgeting

• Bonuses Tied to Budgets:

  • Performance-related bonuses can incentivize employees to meet or exceed targets.

• Stretch Goals:

  • Budgets should be challenging to encourage growth while avoiding excessive stress.

• Potential Risks:

  • If pressured too much, unethical behavior may occur, exemplified by Wells Fargo's issue with false account openings.

Human Behavior in Budgeting

• Risk Aversion:

  • People naturally tend to project higher expenses or lower sales, complicating initial budget preparations.

• Sample Budgets:

  • Budget intramurals often occur, where departments give high estimates out of caution rather than reality.

• Leaders' Role:

  • Adjust expectations and encourage accuracy to create realistic budgets.

Rolling Budgets

• Definition:

  • A rolling budget is continually updated, adjusting for each month completed (less common in practice).

• Feedback Loop:

  • Expectation adjustments based on previous months’ performance can help align forecasts with current realities.

Budget Components and Structure

• Sales Forecasting:

  • Begin with projecting sales to predict revenue accurately.

• Production Planning:

  • Determine needed inventory to meet sales and account for lead times in production.

• Material and Labor Needs:

  • Calculate raw material requirements and labor costs based on production targets.

• Factory Overhead:

  • Directly linked to production volumes, requiring understanding of fixed vs. variable costs.

Performance Indicators

• Cost Per Unit Calculation:

  • Factor in all costs (direct materials, labor, fixed and variable overhead) for cost per unit analysis.

• Creating P&L Statements:

  • Each unit's cost contributes to the overall profitability and informs future pricing strategies.

Cash Flow Management

• Sales Timing:

  • Not all sales translate to immediate cash due to credit sales roles.

• Payments Reconciliation:

  • Manage timing of receipt and payment to maintain liquidity, adjusting for upfront costs versus credits.

• Banking Relationships:

  • Establish strong ties with bankers before needing loans.

Summary

• Budgets are crucial planning, control, and motivational tools in a business context.

• Understanding how financial forecasting works aids in making informed business decisions and achieving strategic goals.