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CMA Part 1: Planning, Budgeting and Forecasting

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CMA Part 1: Planning, Budgeting and Forecasting

  1. 1. 2010 CMA Part 1 Section A Planning, Budgeting, and Forecasting 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 1
  2. 2. Section A – Planning, Budgeting, and Forecasting • This section is 30% of the Part 1 Exam • Section A is the largest part of the exam • Primary areas of review include: – Planning and budgeting concepts – Budget methodologies including types of budgets – Budgeting questions – Forecasting techniques – Learning curves – Probability – Risk, uncertainty and expected value – Sensitivity analysis – Top-Level planning and analysis 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 2
  3. 3. Planning and Budgeting Concepts 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 3
  4. 4. Planning • All companies have some form of planning: – Formal or informal – Short-term, long-term, intermediate – Production planning – Project planning • Planning is determination of what should be done, how it should be done, when it should be done, where it should be done and who should do it. • Planning is done for both financial (usually through a budget) and nonfinancial items (production). 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 4
  5. 5. External Environment in Planning and Budgeting • Planning does not occur in a vacuum. It must consider external influences that will impact the company´s operations and budgets such as: – Industry: rivals, the company´s competitive position in the industry, nature of the industry, etc. – Country or international environment: domestic and international political risk, impact of globalization within the industry, possibility of war or expropriation, etc. – Macro-environment: the macroeconomic and social factors that will effect the entire industry or overall economy such as: economic growth, levels of interest rates, inflation or deflation, environmental protection laws, national tax policy, etc. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 5
  6. 6. Setting Goals and Objectives • The bases of the planning process are the goals and objectives of the company. Without these, there can be no efficient or effective planning. – The plan is established to help the company achieve its goals and objectives. • Objectives are generally made at the organizational level and goals at the divisional level. • The objectives do not need to be agreed to by each employee, but they do need to be accepted by everyone. – This means that even if an employee does not agree with the plan, they still need to act in accordance with the plan. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 6
  7. 7. Characteristics of Objectives and Goals • Objectives and goals must be: – Prioritized, – Clearly stated, – Specific, and – Communicated to employees. • Goals and objectives are measured in respect to their efficiency and effectiveness – Effectiveness is whether the goal was reached. – Efficiency is whether it was reached using the fewest resources. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 7
  8. 8. Different Types of Plans • Long-term (strategic) plans – five years or more. Based on long-term objectives and tend not to be specific or detailed. More what is to be done rather than how it is to be done. – Made by company´s top management – Looks at strategies, objectives and goals of the company, and internal/external factors affecting the company • Intermediate (tactical) plans – one to five years. Implement specific parts of the strategic plan. – Made by upper and middle managers 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 8
  9. 9. Different Types of Plans Cont´d • Short-term (operational) plans – less than 1-year in time. Relate usually to production, materials requirements, staffing, cash flows and the income statement. – Developed by middle or low level managers – Primary basis for budgets – Provide the basis to develop programs, policies and performance expectations required to achieve the company´s long-term strategic goals 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 9
  10. 10. Other Types of Plans • Single-purpose plans – plans for a specific project. • Standing-purpose plans – these plans are used multiple times for a recurring project or effort. • Contingency planning – this is planning for disruptions to the business. Also called disaster recovery planning. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 10
  11. 11. Planning, Budgeting and Performance Evaluation • Planning, budgeting, and performance evaluation are interrelated and inseparable. The process is: 1. Management develops the plan consisting of goals, objectives and a proposed action plan for the future 2. The plan developed by management leads to the formulation of the budget. The budget expresses management´s plans in quantitative terms. 3. Budgets can lead to changes in plans and strategies because they provide feedback to the planning process. Managers may revise their plans based on this feedback. This back and forth exchange may occur for several iterations before the plans and budgets are adopted. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 11
  12. 12. Planning, Budgeting and Performance Evaluation Cont´d • Planning, budgeting, and performance evaluation are interrelated and inseparable. The process is (cont´d): 4. Once the plans and budgets are finalized, the company implements the plans to achieve its goals. 5. Actual results are compared to the plan. The budget is a control tool. 6. Sometimes this control will result in the revision of prior plans and goals or in formulation of new plans, changes in operations and revisions to the budget. 7. Changed conditions during the year will be used in planning for the next period. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 12
  13. 13. Budgeting • A budget is a quantitative (numerical) expression of the company’s plans and objectives. • The Master Budget is the final, complete budget for the upcoming time period. • However, the master budget is composed of many, smaller budgets that are developed for departments, divisions, and individual products.  Operating budgets are used to identify the resources that will be needed by the individual units to carry our planned activities  Financial budgets identify the sources and uses of fund for the budgeted operations 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 13
  14. 14. Advantages of Budgets • When properly developed and administered, budgets: – Provide coordination and communication among organization units and activities – Provide a framework for measuring performance – Provide motivation for managers and employees to achieve the company´s plans – Promote the efficient allocation of organizational resources – Provide a means for controlling operations – Provide a means to check on progress toward the organization’s objectives 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 14
  15. 15. Characteristics of Successful Budgeting • The process must start with the company’s plans – both short-term plans and long-term plans. • The budget needs management support at all levels. • The people who are responsible for ‘delivering’ the budget must have input into the development of the budget. This gives them a sense of ownership over the budget. • The budget should be seen as motivational. • The budget should be an accurate representation of what is expected to occur. • The budget should be flexible to allow for changes in the business environment during the year. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 15
  16. 16. Characteristics of Successful Budgeting Cont´d • The budget should be an accurate representation of the expected future events. • Budgeting should not be rigid that it forces actions to be taken without review by appropriate management • The budget should be coordinated among all departments and divisions in the company. • The time period included in the budget should match the purpose of the budget. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 16
  17. 17. Time Frames for Budgets • A budget is generally prepared for a set period of time, usually one year, and it matches the company fiscal year. • Budgets can also be prepared on a continuous basis. This is called a rolling budget or continuous budget. Advantages of this approach are: – Budgets are no longer done just once a year. – A budget for the next full period (usually 12 months) is always in place. – The budget is more likely to be up-to-date, since the addition of a new quarter or month will often lead to revisions in the existing budget. – Managers are more likely to pay attention to budgeted operations for the full budget period. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 17
  18. 18. Who Should Prepare the Budget • The budget should be prepared by the people who are most knowledgeable about the different parts of the budget. – Top management should not be involved in the detailed production budget for each month. – Those who know how much things actually cost need to be consulted in the development of the budget. • Participative budgeting is when the individuals impacted by the budget are involved in the development of the budget. – This helps them feel that the budget is able to be accomplished. – The budget should also be more realistic. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 18
  19. 19. Who Should Prepare the Budget cont. • Top management still has a role in the budget process at all levels, even if they do not prepare the budget at all levels. – They need to set the goals and objectives that the company is trying to achieve in the upcoming period. • And they need to communicate these objectives to everyone in the organization. – They need to ensure that all of the individual budgets are working towards that common objective and goal. – They need to provide support and information so that people have the needed information to budget. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 19
  20. 20. The Budget Development Process • The process for developing the budget is: 1. An appropriate authority, such as senior management or a budget committee, set and communicate budget guidelines. 2. Initial budget proposals are prepared by responsibility centers. 3. Company managers, at all levels from responsibility center managers to the CEO, negotiate, review and approve the budget for submission to the board of directors. 4. Revisions: after the budget is finally adopted, it should be able to be changed if the assumptions upon which it was built change significantly. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 20
  21. 21. The Budget Development Process Cont´d • The process for developing the budget are (cont´d): 5. Actual results should be compared to the budget. This variance reporting is done at all levels of the company. 6. Variance reports should be used at every level of the company to identify problem areas and to make adjustments to operations. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 21
  22. 22. Best Practice Guidelines for the Budget Process • Best practice guidelines for the budgeting process include the following: – Link development of the budget to corporate strategy – Communication is vital – Design procedures to allocate resources strategically – Managers should be evaluated on performance measures other than meeting budget targets – Cost management efforts should be linked to budgeting – Strategic use of variance analysis – Reduce budget complexity and budget cycle time – Develop budgets that can be revised if necessary – Review the budget regularly during the year 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 22
  23. 23. Budgetary Slack and Goal Congruence • Goal congruence is defined as “aligning the goals of two or more groups.” As used in planning and budgeting, it refers to the aligning of goals of the individual managers with the goals of the organization as a whole. • Budgetary slack is the difference between the budgeted performance and the performance that is actually expected. It is the practice of underestimating budgeted revenues and overestimating budgeted costs to make the overall budgeted profit more achievable. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 23
  24. 24. Budgetary Slack and Goal Congruence Cont´d • Managers who develop the budgets they are going to be accountable to meet may build budgetary slack into their budgets in order to make sure their budgets are achievable without any risk of failure. • Budget slack has advantages and disadvantages: – On the positive side, it can provide managers with a cushion against unforeseen circumstances. This can limit their exposure to uncertainty and reduce their risk aversion. – On the negative side, it misrepresents the true profit potential of the company and can lead to inefficient resource allocation and poor coordination of activities within the company. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 24
  25. 25. Standard Costs and Setting Standard Costs • Standard costs are the expected cost for labor, materials, or overhead to produce one unit of product (how much it should cost to produce) • To calculate the standard cost, the company needs to know the expected level of production and usage of the different inputs. There are a number of ways to calculate this: – Activity analysis – Historical data – Target costing – Strategic decisions – Benchmarking 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 25
  26. 26. Standard Setting Process • As with the budget, the standards need to be set by the correct people. • Authoritative standard setting – standards are set from above. – Employees do not feel ownership or a commitment to these standards because they may see them as unrealistic. • Participative standard setting – employees are involved in the standard setting process. – More support from the employees and a greater commitment to meet the standards because they were part of setting them. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 26
  27. 27. Direct Materials Standards • The standard amount and cost of material that is used in the production of one unit is impacted by: – Quality – the higher the quality of material, the more it will cost. Lower quality materials may cost less but may require more materials, as there may be more materials that do not meet the required quality standards. – Quantity – the amount needed for production will depend on how much is needed for each unit (for example, how thick should the covering be) and how many units are to be produced. – Price – obviously the price of the input purchased will impact the standard cost. This is also connected to the quantity purchased (discounts) and quality of what is purchased. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 27
  28. 28. Establishing Direct Labor Standards • As with materials, the standard cost for labor will depend on: – Quantity of labor – this is also connected to the question of the cost of labor vs. the cost of capital. – Price of labor – the more skilled (experienced) the labor the more costly it is. However, more skilled labor may be able to complete the job more quickly or at a higher quality. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 28
  29. 29. Establishing Overhead Standards • Overhead standards are generally based on normal operating conditions, normal volume, and desired efficiency. The total overhead costs come from the budgeted factory overhead costs. These are divided by a predetermined level of activity to calculate a standard overhead rate. • In relation to the allocation rate, the company must decide what activity to use for its budgeted amount of the activity level. – The traditional method uses machine hours or direct labor hours 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 29
  30. 30. Establishing Overhead Standards Cont´d • The allocation rate is established for the full year. The budgeted overhead rate for the year multiplied by each month’s budgeted activity level will be used to calculate the monthly budgeted overhead. • In general, a company has four choices to determine the output level. Two relate to what the plant can supply; and two relate to the demand for the plant’s output. These are called denominator-level capacity concepts, because they describe the denominators that can be used in the calculation of per unit overhead costs. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 30
  31. 31. Denominator Level Concepts • Supply Denominator Level Concepts – Theoretical or ideal capacity – the level of activity if the company produces at its maximum level with no idle time or downtime and no decreases in sales demand. – Practical (currently attainable) capacity – theoretical level reduced by allowances for idle time and downtime but not for a decrease in sales demand. • Demand Denominator Level Concepts – Master budget capacity utilization – the amount of output expected based on expected demand  Normal capacity utilization – the level of activity achieved in the long run, accounting for seasonal and cyclical changes in sales demand. This is the preferable method. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 31
  32. 32. Budget Methodologies 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 32
  33. 33. The Annual/Master Budget • The development of an annual budget for a large corporation may take many months to complete. • Important concepts for the budgeting process are: • One of the most important things in the process of developing the budget is involving all of the correct people (participative budgeting) • bottom-up budgeting: the budget is developed by starting at the lowest levels in the operations systems and building revenues and costs from there. • A budget manual details the budget process. • A planning calendar is the document that sets forth all of the deadlines, policies and procedures of the budgeting process. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 33
  34. 34. The Different Budgets • There are a number of budgets that will need to be prepared. Some of them need to be prepared in a specific order. • This is because some of the budgets build on each other. – The sales budget is the first budget prepared. – The cash budget is the last budget prepared. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 34
  35. 35. The Sales Budget • This is the budget that must be completed first. • Everything else the company will do during the year is based on how many units they expect to sell. • This is also the hardest budget to do, because it based on the decisions and factors not controlled by the company: – Consumers – Competitors – The economy 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 35
  36. 36. The Production Budget • After the sales budget is completed, the company can prepare the production budget. This budget is based on: – The expected level of sales, – Whether the company wants to change the level of inventory, – Any decisions about outsourcing production (if the company will buy finished products or parts from an external supplier). • This budget also needs to include when during the year the units will be produced. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 36
  37. 37. The Next Budgets • Once the production budget is set, the company can create a number of other budgets that are based on the level of production: – Direct materials budget – Labor budget – Overhead budget – Ending inventory budget – Cost of goods sold budget • These are all interrelated so a change in one of these budgets will likely cause a change in another. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 37
  38. 38. Following Budgets • There are also a lot of other budgets that need to be prepared – Selling and marketing budget, – General and administrative budget, – Accounting and finance budget, – Research and development budget, and – Any budget for other type of revenue or expense that the company has during the budgeted period. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 38
  39. 39. The Cash Budget • The cash budget is the last budget prepared because all other budgets go into this budget. • This budget will be prepared on a monthly basis. • By preparing it on a monthly basis the company can identify any future cash shortages before they happen. – Better planning for cash shortages will make the cost of borrowing lower. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 39
  40. 40. Operating and Financial Budgets • The operating budget is the budgeted income statement and its supporting budget schedules. – It is made up of all the revenue budget and the production, purchasing, marketing, and research & development budgets. • The financial budget is the budgeted balance sheet and statement of cash flows, cash budget and capital budget. • These budgets are what the company’s financial statements will look like next year if reality exactly matched the budgeted amounts. – By looking at them now, the company can see what the ratios will be like, and if they would be in violation of any covenants or loan agreements. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 40
  41. 41. The Capital Budget • This is the budget for large, capital expenditures (property, plant and equipment). • Because these are large expenditures, the capital budget is often prepared years in advance. – The company will need to plan for the financing of these purchases. • This budget is often prepared outside of the budgeting process that we have discussed leading to the forecasted financial statements. • Top management is very heavily involved in this budget because it is connected to their long-term plans. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 41
  42. 42. The Master Budget • The individual budgets that make up the operating and financial budgets together make up the master budget. • The master budget is a summary of management’s operating and financial plans for the period, expressed as a set of financial statements. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 42
  43. 43. Flexible Budgeting • Flexible budgeting is the process of producing budgets for different levels of activity. • This makes the evaluation process better and more useful. – The master budget is a static budget. It is produced for one level of activity, and if actual sales are different, it is not as useful to make actual vs. budget comparisons. – Flexible budgeting allows better comparisons because there is a budget for what income should have been at the level of sales that actually occurred. • A flexible budget requires standard costs to be available. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 43
  44. 44. Other Types of Budgets 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 44
  45. 45. Project Budget • A project budget is a budget for a specific project. As such, the time frame of the budget may be very short or more long-term, depending upon the length of the project. • Project budgets are different from the master budget and the flexible budget. – The master budget or the flexible budget covers a distinct time span. In contrast, a project budget covers an identifiable project that has its own time span. • Projects must be planned over their entire life spans and should be viewed as special commitments. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 45
  46. 46. Life-Cycle Budgeting • This is a budget not for a specific time period, but for a specific product. • It traces all of the costs and revenues from the design of the product, through production and includes after sale costs that the company will incur. • This provides a more accurate pricing for the product because the design, pre-production and post-production costs also need to be covered by the selling price. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 46
  47. 47. Activity-Based Budgeting • Activity-based budgets are prepared based on the resource consumption and related costs to perform the budgeted activities. – Activities that drive the costs are identified – A budgeted level of activity for each of these drivers is determined based on a budgeted level of production – Budgets are developed based on budgeted activity levels. • In an activity-based budget system, there is a clear relationship between resource consumption and output. Preparing an activity-based budget brings out information about opportunities for cost reductions and elimination of wasteful activities. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 47
  48. 48. Zero-Based Budgeting • This system starts each year with a blank page, and all items are created new for the year. – In incremental budgeting, the prior period’s budget is just increased by 10%, or some determined amount. • All revenues need to be planned for each year. • All expenses need to be accounted for and justified. – By looking at every expense each year, management should be able to eliminate non-value adding expenses and try to find cheaper alternatives. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 48
  49. 49. Budget Reports and the Control Loop • The budget report is the comparison between the budgeted amount and the actual result. (This is also variance analysis and is covered in more detail in that material). • The steps in the control loop are: – Establish the budget, or standard, – Measure the actual performance, – Analyze and compare actual results with the budget, – Investigate unexpected variances, – Devise and implement needed corrective actions, – Review and revise the standards as needed. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 49
  50. 50. Budgeting Questions 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 50
  51. 51. Budgeting Question Formulas • In this topic, there are three common categories of numerical questions that are asked. If you are comfortable with what these questions as and the formula or concept behind it, these questions will be easy. • These categories of questions are looked at on the following slides. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 51
  52. 52. Flexible Budget Question • In this question, the question will ask “What would the flexible budget have been?” – You will generally be given the master budget at a specific level of output and the actual level of output will be different. – You need to determine what income (or whatever is asked) should have been according to the flexible budget. • Remember that the variable cost per unit does not change as the level of production changes, and • That the total fixed cost does not change as production level increases. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 52
  53. 53. How Many Units to Purchase or Produce? • In this question you need to answer how many units the company must purchase or produce in order to have enough inventory for the expected level of sales and the required ending inventory balance. • The units can come from one of two places: 1. Beginning inventory (which will be given), or 2. Purchased or produced (what is being asked) • Units will be needed for two purposes: 1. The sales or production for the period, and 2. The desired ending inventory balance. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 53
  54. 54. How Many Units Formula • The formula to solve this type of question is: Units needed for the current period + Units needed for ending inventory = Total number of Units needed − Units in beginning inventory = Units needed to be purchased or produced • This formula works for both units purchased (finished goods) and units produced (a production company). 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 54
  55. 55. Cash Collected or Paid Question • In this question they give you a series of information about when credit sales are collected and when payments are made and about bad debts. • These questions are not mathematically difficult, but require you to read the question carefully to determine when the monies are collected and paid. – We recommend that you structure your answer in a table format with a column for each month. By recording what is sold, collected, paid (whatever is asked for) in a table, it makes it very easy to calculate the answer to the question. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 55
  56. 56. Forecasting Techniques 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 56
  57. 57. Forecasting • This is the attempt to determine what the future result will be. • Usually uses some sort of mathematical model or formula. – The prediction is only as good as the model’s representation of reality • Two basic methods of Forecasting – Time Series Analysis – Causal Forecasting 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 57
  58. 58. Time Series Analysis • In time series analysis we are looking at patterns over time. There are four patterns: – Trend – Cyclical – Seasonal – Irregular 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 58
  59. 59. Trend Pattern • This is a gradual shifting to a higher or lower level over time. It may not be constant and consistent, but over time the trend is visible. Sales 1998-2007 with 2008 Forecast $3,500,000 $3,000,000 $2,500,000 $2,000,000 $1,500,000 1998 2000 2002 2004 2006 2008 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 59
  60. 60. Cyclical Pattern • Any fluctuation that recurs over a period of more than one year is a cyclical fluctuation. • This cycle is usually due to the cycles of the economy. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 60
  61. 61. Seasonal Pattern • This is like the cyclical pattern, but the fluctuations are due to the seasons of the year, rather than the business cycle. • These fluctuations usually occur within a one year time period. – If they occur within one day, such as a business that has its busiest time of the day at the same time each day, it is called a “within-the-day seasonal component”. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 61
  62. 62. Irregular Pattern • If the pattern is not repeating, it is called a random pattern. • Because of the randomness of the fluctuations, it is difficult to use historical results to predict future results. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 62
  63. 63. Using Time Series Analysis • There are two main ways in which the information over time may be used to predict future results: 1. Smoothing 2. Trend projection 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 63
  64. 64. Smoothing • Attempts to eliminate the random fluctuations that occur over time • Works well when there is no significant trend, cyclical or seasonal effect • Does not work well when there are long-term trends (upwards or downwards) or cycles 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 64
  65. 65. Smoothing Cont´d • Three methods of smoothing are: – Moving average – the most recent data for a certain number of periods is used, and each period is given the same weight in the calculation – Weighted moving average – the most recent data for a certain number of periods is used, but the data from more recent periods is given more weight in the calculation. – Exponential smoothing – the next period’s expected value is calculated using the last period’s expected value (as forecasted using exponential smoothing) and the last period’s actual value. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 65
  66. 66. Exponential Smoothing • Uses two values: 1. The last period’s expected value, as calculated using exponential smoothing 2. The last period’s actual value • These two values are averaged together using a determined weighting • The last period’s actual value is given a weight of alpha (a) – This is between 0 and 1 (usually it is between 0 and .4) – This is also called the smoothing constant • The last period’s expected value will be given a weight of 1-a 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 66
  67. 67. The Smoothing Constant • If a is given a value of 1, the projection will be based only on the actual result of the last period • If a is given a value of 0, the projection will be based only on the projected result of the last period • When values fluctuate greatly, we want to use a lower value for a • The accuracy of this process is measured by the error, called the Mean Squared Error. We want an a that will minimize this error. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 67
  68. 68. Trend Projection • When a time series is increasing or decreasing consistently, smoothing will not work • In this case we use trend projection. • Trend projection is done by means of simple regression analysis • Simple regression analysis makes two assumptions: – Variations in the value we are forecasting (the dependent variable) are a result of changes in the other variable (the independent variable) - i.e., the passage of time, if a time series – The relationship between the value we are forecasting and the other, independent, variable is linear. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 68
  69. 69. Simple Regression Analysis • This process determines the line of best fit through the values over time. This line minimizes the total differences between the line and the actual values for each period. • Before doing this, we need to make sure that the value we are forecasting and the other, inde-pendent, variable are truly related to each other – This is done through correlation analysis, and the correlation coefficient (represented by R or r) • +1 means a perfect positive relationship • −1 means a perfect negative relationship • 0 means no relationship, so trend analysis would not be meaningful. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 69
  70. 70. Other Measures • The standard error of the estimate measures the range within which the expected result will fall, with a certain level of confidence • The coefficient of determination (r2) measures the percentage of the change in the dependent variable that is explained by changes in the independent variable • You do not need to be able to calculate these, but you need to know what they are. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 70
  71. 71. Inflation Adjustments in Time Series • Over time, dollar values may increase simply because of inflation. In looking at future projections, we need to know how much of past increases were a result of an increase in quantity and how much were a result of inflation. • Nominal dollars are measured in current year dollars • Real dollars are measured in a base year dollars and have had inflation taken out. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 71
  72. 72. Converting Nominal to Real Dollars • Any conversion needs to use some sort of price index or other measure of inflation Real Value = Nominal Value Current Year Index / Previous Year’s Index Or Nominal Value 1 + Inflation Rate 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 72
  73. 73. Causal Forecasting • This is used when we know that the value we are calculating is affected by another variable; for instance, the level of sales is affected by the level of advertising expenditures. • If there is a cause and effect and a linear relationship, we can use projection. • In simple linear regression, there is only one independent variable (the cause) • In multiple linear regression, there is more than one independent variable. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 73
  74. 74. Regression Analysis Formula • The formula that is used in regression analysis to calculate y (the expected value), for a given value of x (the independent variable) is: y = ax + b + ε Where y = the dependent variable (the expected value) a = the slope of the line (called the variable coefficient) b = the y-intercept of the line, or the value of y when x = 0 (called the constant coefficient) x = the independent variable ε = the error term (the distance between the regression line and an actual data point) 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 74
  75. 75. Regression Analysis Assumptions • The model makes the following assumptions: – The relationship between x and y is linear, – The error term has a value close to 0 and is normally distributed, – The variance of the error term is constant, – Errors in different samples are not related to each other, – The independent variable is not related to the error term. • The error term is included because there is always scope that a measurement was made incorrectly and there is always some amount of randomness. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 75
  76. 76. Benefits of Regression Analysis • The benefits of regression analysis are: – It is numerical and quantitative – this makes conclusions easier to draw – It may be used to forecast the fixed and variable portions of costs that contain both fixed and variable components. Thus, it can be used in budgeting. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 76
  77. 77. Limitations of Regression Analysis • The limitations of regression analysis are: – Historical data is required – if there is no data, regression analysis can’t be used – If there have been changes in the environment or situation since the data was collected, it will not work – If the independent variable chosen is not appropriate (i.e., there is a low correlation between the independent variable and the dependent variable), the resulting forecast may be invalid – The conclusions are valid only for the range covered 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 77
  78. 78. Learning Curves 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 78
  79. 79. Learning Curves • Learning curves are used to describe the fact that people are able to accomplish a repetitive task more quickly the more they do it • For example, if something takes 1 hour to do the first time, and only 40 minutes to the second time, there has been a learning curve • There are two learning curve models: – Cumulative average time learning model – Incremental unit time learning model • Learning curves are used in many different types of decisions, such as calculating the cost of a job. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 79
  80. 80. Cumulative Average Time Learning Model • The average time per unit for all units produced decreases by some percentage every time production doubles • If the learning curve is 70% and 2 units take 4 hours, it will take 70% of twice that amount of time (5.6 hours) to make 4 units (4 × 2 × .70). – For 4 units, it takes on average 1.4 hours (5.6 ÷ 4) to make 1 unit, which is 70% of the average time required per unit to produce half as many units. • In order to produce 8 units, it will take in total 7.84 hours (5.6 × 2 × .70). – This is an average time of .98 hours per unit, which is 70% of the average time per unit for half as many units. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 80
  81. 81. Cumulative Average Time Learning Model cont. • The formula to calculate the total amount of time required for the total number of units is as follows: Initial time * (2 * LC) * (2 * LC) * (2 * LC) … Where: – Initial time is the amount of time required for the first lot, first batch or first unit – LC = the learning curve percentage (as a decimal) • Another * (2 * LC) is added to the multiplication each time that the production quantity doubles. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 81
  82. 82. Incremental Unit Time Learning Model • In this model, the amount of time needed to produce the last unit decreases by the learning curve per-centage each time the production quantity doubles, so each unit produced takes less time than the last. • Without a financial calculator, it is possible to calculate only the amount of time that will be required to produce the last unit of each group of doubled units (the 2nd, 4th, 7th, 16th, etc. units). It is not possible to calculate the total number of hours required to produce all the units. • The amount of time required for the last unit is: Initial time * LC * LC * LC . . . 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 82
  83. 83. Benefits of Learning Curves • Decisions such as the following can be aided by learning curve analysis: – Make or buy decisions – analysis of the cost to make – In calculating the cost of a contract over its life, learning curve analysis can lead to better bidding. – In determining a breakeven point, if learning is not considered, the result may be overstatement of the number of units required to break even. – Standard costs can be adjusted regularly to recognize the fact that learning causes labor costs to decrease. – In capital budgeting, labor costs can be projected more accurately over the life of the capital investment. – Production and labor budgets can be adjusted to accommodate learning curves. – More effective evaluation of managers. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 83
  84. 84. Limitations of Learning Curves • It is only applicable in a situation in which experience leads to improvement (labor intensive tasks) • We assume that the learning curve rate is constant, when in reality it probably is not • We assume that all increases in productivity are due to the learning process, when there may be other factors causing the productivity increase 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 84
  85. 85. Probability 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 85
  86. 86. Probability • The probability of an event happening is the chance that it will happen. • The probability of a single event happening must be between 0 (no chance of it occurring) and 1 (it is certain to occur) • There are two basic requirements of probability: – The probability values assigned to each of the possible outcomes must be between 0 and 1 – The probable values assigned to all of the possible outcomes must total 1 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 86
  87. 87. Conditional Probability • The conditional probability is the probability of an event (Event B) occurring, given that (assuming that) another event (Event A) has already occurred • It is shown as P(B|A), read as “the probability of B given A” 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 87
  88. 88. Joint Probability • Joint probability is the probability of one or more events all occurring one after another. • It is calculated as the probability of each individual event multiplied together. • If the occurrence or nonoccurrence of one event does not change the probability of the occurrence of the other event, the two events are said to be independent. • If the occurrence of one event means that another event cannot occur, the two events are said to be mutually exclusive. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 88
  89. 89. Conditional and Joint Probability Example: • The probability of sales being $1,000,000 in Year 1 is 30%. • Assuming that sales are $1,000,000 in Year 1, there is a 40% probability that sales will be $1,500,000 in Year 2. The Conditional Probability that sales will be $1,500,000 in Year 2, assuming that they are $1,000,000 in Year 1, is 40%. The Joint Probability that sales will be $1,000,000 in Year 1 and $1,500,000 in Year 2 is (30% * 40%), or 12%. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 89
  90. 90. Methods of Assigning Probability • There are three main ways of determining the probability of an event: – Classical method – each outcome has an equal chance of occurring. – Relative frequency method – this method may be used when there is factual information from which the frequency can be determined, such as past information or a sample (also called Objective Method) – Subjective method – this is used when there is no past information or sample to use and the decision maker simply assigns probabilities as they seem reasonable 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 90
  91. 91. Discrete and Continuous Random Variables • A random variable is a variable that can have any value within a range of values that occurs randomly and can be described using probabilities. • Discrete random variables are variables that must have a whole number value (for example, 1, 7 or 193). These variables may not be shown as a continuous line. • Continuous random variables may have any value, whole or fractional. As such, 17.392 is a possible result for a continuous random variable, but not for a discrete variable. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 91
  92. 92. Expected Value • In expected value we are trying to determine what the expected result will be in a situation of uncertainty. • This is done by multiplying each of the possible outcomes by the likelihood (probability) of that outcome occurring. All of the results are then added together to determine the expected value. • The expected value is a weighted average of all the possible values, weighted according to their probabilities. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 92
  93. 93. Variance and Standard Deviation • The variance and standard deviation both give us an idea of the variability of the possible values in a probability distribution. • The variance is the sum of the squares of all the differences – or deviations – from the mean (average), weighted according to their probabilities. (The variances are squared to eliminate negative values.) • The standard deviation is the positive square root of the variance. Because it is the square root of the variance and the variance contains squared numbers, the standard deviation is measured in the same units as the values. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 93
  94. 94. The Normal Distribution • In a normal distribution, the results are distributed around the mean (average) in a bell shaped curve • The curve may be tall and narrow or short and flat or anything in between • The standard deviation is a measure of the dispersion of the values. − A high standard deviation means that the results are highly variable and a low standard deviation means the results do not vary much. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 94
  95. 95. The Distribution of Expected Results • In a normal distribution – 68% of the expected values will be within one standard deviation of the mean. – 95% of the expected values will be within two standard deviations of the mean. – 99.7 of the expected values will be within three standard deviations of the mean. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 95
  96. 96. Risk, Uncertainty and Expected Value 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 96
  97. 97. Risk and Uncertainty • Risk is a situation in which there is a chance of the result being different from the expected outcome – it exists when we are not 100% certain of the result. – Risk is measured using the variance and the standard deviation • Uncertainty is risk that cannot be measured. – It exists when we have no way of determining what the expected result is using historical information or other data. The probability distribution must be determined subjectively. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 97
  98. 98. The Coefficient of Variation • The coefficient of variation measures the risk for each unit of expected return. • It is calculated as follows: Standard Deviation Expected Return • The higher the coefficient of variation, the riskier the investment. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 98
  99. 99. The Mean, Median, and Mode • Measures of central tendency are values typical of a set of data. – The mean is the average of a set of numbers. – The median is the halfway value if raw data is arranged in numerical order from lowest to highest. – The mode is the most frequently occurring value. If all values are unique (different from each other), no mode exists. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 99
  100. 100. Sensitivity Analysis • In sensitivity analysis the company is trying to determine which variables influence the end result the most. • By running the model with different variables, the company can identify the variables whose fluctuations cause the greatest change in the fluctuation of the result. • Sensitivity analysis can be used with linear programming to see how the optimal solution to the objective function will change if a coefficient in the objective function or if the right-hand value of one of the constraint functions is changed. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 100
  101. 101. Top-Level Planning and Analysis 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 101
  102. 102. Pro-forma Financial Statements • Pro-forma financial statements contain projected amounts that are expected if a particular course of action is followed. – see what the financial statements of the firm will look like if something that is under consideration or forecasted actually happens. – evaluate the effect on the company’s finances if a particular sales forecast is realized – Used to perform other “what if” scenarios • They include a pro forma income statement, a pro forma statement of financial position (balance sheet) and a pro forma cash flow statement. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 102
  103. 103. Pro forma Financial Statements cont´d • Pro forma financial statements are used internally for five general purposes: 1. compare the company’s anticipated performance with its target performance and with investor expectations. 2. To perform “what if” analysis, to forecast the effect of a proposed change. 3. determine in advance what the company’s future financing needs will be. 4. To prepare various cash flow projections using different assumptions in order to forecast the various capital requirements to maximize shareholder value. 5. determine if the company will remain in compliance with the required covenants on its long-term debt 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 103
  104. 104. Forecasting for Planning • Various approaches to financial forecasting are used, depending upon the situation. The three primary approaches used are: – Experience – Because sales, expenses or earnings have grown at a particular rate in the past, we assume they will continue growing at that rate in the future. This leads to trend projections. – Probability – We assume something will happen in the future because the laws of probability indicate it will. – Correlation – Because there has been a high correlation in the past between one factor and another factor, we use what we know about the first factor to forecast the second factor. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 104
  105. 105. Sales Forecasting • Forecasting sales based upon historical sales information has limited value. • Historical sales growth rates need to be adjusted for any known factors that will affect future sales. Future sales depend upon many events that occur in the future. Examples include: – State of domestic and international economy – Growth prospects for the market in which the company operates – The company´s product line – The company´s marketing effort 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 105
  106. 106. Sales Forecasting cont´d • An accurate sales forecast is critical to avoid negative business issues: – if the company´s market expands more than the company expects it to, the company will not be able to meet the added demand and will lose customers to its competitors – If the forecasted sales are too high, then the company could end up with excess capacity and inventory • Management needs to use its best judgment about the future along with historical information and not simply rely on a forecast made using regression analysis or any of the other forecasting techniques 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 106
  107. 107. Forecasting Future Financing Needs • An increase in company sales means the company will need additional funds: – More inventory will be needed – Accounts receivable increase in proportion to sales growth – Company may need new production equipment • There are three sources for funding this expected asset increase: 1. Spontaneous liability increase (whereby accrued liabilities increase because of increased activity) 2. Profits from the additional sales 3. External sources such as borrowing or the issuance of securities 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 107
  108. 108. Forecasting Future Financing Needs cont´d • The amount of external financing that will be required depends upon several factors: – Company´s rate of sales growth – Company´s capital intensity ratio (amount of assets required per dollar of sales) – Company´s spontaneous liabilities-to-sales ratio – Company´s net profit margin – Company´s retention ratio – Planned changes in policies and procedures (management decisions) 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 108
  109. 109. Forecasting Future Financing Needs cont´d • Short-term cash forecasting covers periods of about 30 days in the future and is based on actual data (i.e. expected receipts from actual accounts receivable etc.) rather than on projected data. • Medium-term forecasting covers periods up to one year in the future. Long-term forecasting covers multiple years. • The Forecasted Financial Statement method is a method of forecasting the additional funds needed that is well suited to medium- and long-term use. It is not the only method, but it is the most flexible method and the one covered on the exam. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 109
  110. 110. Forecasted Financial Statement Method • The forecasted financial statement method (FFS) is an approach to forecasting future financing needs. • The key points regarding this approach are:  It requires a company to forecast a complete set of financial statements including the income statement, balance sheet, and statement of cash flows  All the sources of financing are forecasted including existing debt and equity  The difference between forecasted total assets, liabilities and equity is the additional funds needed (a plug on the balance sheet) 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 110
  111. 111. Forecasted Financial Statement Method cont´d • The FFS method produces a forecast of the entire balance sheet and income statement. The pro forma balance sheet and income statement can then be used to create the pro forma statement of cash flows. • The steps in forecasting using the FFS method are: 1. Analyze historical ratio such as cash to sales, inventory to sales, accounts payables to sales, etc 2. Forecast the income statement 3. Forecast the balance sheet 4. Construct a pro forma statement of cash flows 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 111
  112. 112. Analysis of Pro Forma Financial Statements • Developing the financial forecast alone is not meaningful unless it is also analyzed to determine whether the firm´s forecasted financial situation meets the firm´s targets. – If not, the changes will be need to both the forecast and the operating plans that led to the forecast – The pro forma financial statements will need to be redone • Part of the analysis is an analysis of financial ratios. Ratio analysis is used to compare the firm’s actual ratios and projected ratios with target ratios as well as the latest industry average ratios. 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 112
  113. 113. Analysis of Pro Forma Financial Statements Cont´d • The primary financial ratios to use for financial analysis of forecasted financial statements include: – Current ratio =total current assets/total current assets – Inventory turnover = annual cost of sales/inventory – Days sales in inventory = 365 / inventory turnover OR average inventory / (cost of goods sold/365) – Accounts receivable turnover = annual credit sales / accounts receivable – Days sales in receivables = 365 / accounts receivable turnover OR average accounts receivable /(annual credit sales / 365) 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 113
  114. 114. Analysis of Pro Forma Financial Statements Cont´d • The primary financial ratios to use for financial analysis of forecasted financial statements include (cont´d): – Interest coverage ratio = EBIT / interest expense – Asset turnover = net sales / total assets – Debt to equity ratio = total liabilities / total equity – Gross profit margin = gross profit / net sales – Net profit margin = net income1 / net sales – Return on assets = net income1 / total assets – Return on equity = net income1 / total equity • 1 Net income = Net income before preferred dividends 2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 114

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