CHAPTER 6

Operating Budgets

Chapter 5 illustrated long-term financial forecasts covering multiple years. Both internal and external decision makers engage in long-term forecasting. This chapter illustrates the process of short-term financial forecasting—an activity engaged in exclusively by internal decision makers to prepare operating budgets. Unlike long-term forecasts, operating budgets generally cover time horizons of less than a year—usually months or quarters.

Operating budgets are valuable planning tools that help managers avoid cash flow problems, anticipate financing needs, manage working capital, adjust staffing levels, develop tax strategies, and more effectively perform a variety of other important functions. They are referred to as operating budgets because they focus upon recurring operating activities, such as monitoring accounts receivable collections, coordinating payments to creditors, developing production schedules, controlling inventory levels, complying with tax-filing requirements, and managing short-term credit arrangements.

A complete operating budget consists of an integrated set of related forecasts that include, but certainly are not limited to, the following:

• Sales budgets;
• Operating expense budgets;
• Accounts receivable budgets;
• Inventory budgets;
• Trade payable budgets;
• Taxes payable budgets;
• Financing budgets;
• Capital expenditure budgets.

Together, these individual budgetary projections enable managers to prepare:

• Income statement budgets;
• Balance sheet budgets;
• Cash budgets.¹

Designing an operating budget can be a complex endeavor for which numerous approaches are used. Even the simplest approaches must be dynamic and interactive so that projections can be adjusted efficiently as assumptions about the future change. To that end, operating budgets are always prepared using Excel or budgeting software applications.

The operating budget process illustrated in the remainder of this chapter centers on a hypothetical company called Hopping Helga. The illustration is fairly simple and straightforward, yet it is rigorous enough to convey the potential complexities that underlie this important activity.

The Case of Hopping Helga

Hopping Helga is a wholesale distributor of hops used for brewing beer. The company buys its product directly from growers and sells it to microbreweries throughout the Pacific Northwest. In early January of the current year, information was gathered to prepare a quarterly operating budget for January, February, and March.

December’s sales in the previous year were $800,000, and they are budgeted to increase by 5 percent in January, by another 8 percent in February, and by another 10 percent in March. Cost of goods sold and gross profit as percentages of sales are expected to hold steady throughout the first quarter at 70 percent and 30 percent, respectively.

Microbrewery production increases significantly as the weather gets warmer, so Helga’s sales volume always spikes in the second and third quarter of each year. In preparation for its busy season, the company steadily increases its inventory levels throughout the first quarter by purchasing more hops from its growers each month than it sells to its customers. To that end, the cost of inventory purchases is budgeted to exceed by 10 percent the cost of inventory sold in January, February, and March. The company’s January 1st hops inventory carried forward from the prior year is $40,000.

Selling, general, and administrative expenses (SG&A) totaled $200,000 in December, and are budgeted to remain the same each month of the first quarter. Likewise, the company’s $30,000 depreciation expense on its buildings, fixtures, and equipment in December is also budgeted to remain the same throughout the first quarter. On January 1st of the current year, these fixed assets—net of all prior accumulated depreciation expense—are carried in the accounting system at $1,396,200. Land on January 1st is carried in the accounting system at $250,000. The company does not intend to invest in any new fixed assets—nor does it intend to sell any of its existing fixed assets—during the first quarter.

The company’s tax rate used to compute income tax expense is 30 percent. Income tax expense will accrue throughout the first quarter of the current year—meaning it will appear in the budgeted monthly income statements—but it will not be paid until April. Taxes payable carried forward from December of the prior year amount to $2,000, the entire amount of which is due in March.

Helga has a $300,000 line of credit arrangement with its bank. Its annual interest rate is 6 percent, so its monthly rate is only 0.5 percent (6 percent ÷ 12 months = 0.5 percent). Should Helga experience a temporary cash shortfall, it can borrow up to $300,000 on its line of credit without having to ask the bank for approval. The arrangement is interest only—meaning that the company is required only to make the monthly interest payments on its outstanding principal. The outstanding principal is paid only once each year on June 15th. On January 1st, the outstanding unpaid principal amount carried forward from the prior year is $100,000. In anticipation of purchasing a new refrigeration unit in April, the company plans to draw an additional $40,000 on its line of credit in early March. Helga’s January 1st cash balance carried forward from the prior year is $95,500.

All of Helga’s sales are on credit, and its accounts receivable remain outstanding an average of 3 months before being collected (microbreweries are notoriously slow to pay). Accounts receivable on January 1st carried forward from the prior year total $2,100,000. These receivables break down as follows:

• Outstanding accounts from October sales total $600,000.
• Outstanding accounts from November sales total $700,000.
• Outstanding accounts from December sales total $800,000.

Helga’s inventory on January 1st carried forward from the prior year is $40,000. All inventory purchases are made on credit, and trade payables to Helga’s growers remain outstanding an average of 2 months before being paid. Trade payables on January 1st carried forward from the prior year total $910,000. They break down as follows:

• Outstanding accounts for inventory purchased in November total $350,000.
• Outstanding accounts for inventory purchased in December total $560,000.

On January 1st of the current year, Helga’s shareholders’ equity includes common stock of $900,000 and retained earnings of $1,969,700. The company does not plan to issue any additional stock, nor does it intend to pay any dividends, during the first quarter. Thus, the only change to shareholders’ each month of the first quarter will result from budgeted net income being added to retained earnings.

The sequence of steps necessary to prepare Helga’s operating budget for the first quarter of the current year is discussed in the remainder of this chapter. Bear in mind that all of the information was processed using Excel. Any attempt to prepare operating budgets by hand is an exercise in futility.

Sales Budgets

The first step in preparing an operating budget is to create a sales forecast because sales influence so many aspects of financial planning—including inventory requirements, accounts receivable collections, tax payments, and cost of goods sold estimates. It is essential that sales projections be derived thoughtfully by factoring in past trends, general economic conditions, and the competitive environment. Helga’s sales budget for the first quarter of the current year is illustrated in Figure 6.1.

Figure 6.1 Sales budgets: first quarter

As shown in Figure 6.1, January sales of $840,000 are budgeted to exceed the current year’s December sales by 5 percent ($800,000 ×105% = $840,000), and February sales of $907,200 are budgeted to exceed January sales by 8 percent ($840,000 × 108% = $907,200). Likewise, March sales of $997,920 are budgeted to exceed February’s sales by 10 percent ($907,200 × 110% = $997,920).

Selling, General, & Administrative Expense Budgets

SG&A expenses include sales commissions, marketing costs, insurance premiums, office supplies, utilities, payroll, accounting services, and legal fees.² Helga’s SG&A expense budget for the first quarter of the current year is illustrated in Figure 6.2.

Figure 6.2 SG&A expense budgets: first quarter

As mentioned previously, the actual SG&A expense of $200,000 incurred in December is not expected to change throughout the first quarter. As such, the monthly SG&A expense budgeted for January, February, and March is expected to remain constant at $200,000.

Financing Budgets

Helga’s only anticipated financing activity in the first quarter of the current year is related to its line of credit with the bank. As illustrated in Figure 6.3, the actual line of credit balance carried forward from December is $100,000, and no new borrowing is anticipated until early March.

Figure 6.3 Financing budgets: first quarter

As discussed previously, no principal payments are due until June; however, Helga is required to pay interest expense each month on outstanding principal amount. At a monthly interest rate of 0.5 percent, the company’s budgeted interest expense in January and February is $500 ($100,000 × 0.5% = $500). An additional $40,000 draw on the line of credit is planned in early March, so budgeted interest expense in the third month of the quarter is $700 ($140,000 × 0.5% = $700).

Income Statement Budgets

Helga’s income statement budgets are illustrated in Figure 6.4. The sales amounts were taken from the sales budgets in Figure 6.1, of which cost of goods sold is budgeted at 70 percent. The SG&A expenses came from the SG&A expense budget in Figure 6.2, whereas the interest expense amounts came from the financing budgets in Figure 6.3. Its average tax rate used to forecast income tax expense is 30 percent.

Figure 6.4 Income statement budgets: first quarter

Based on these projections, it appears that Helga is expecting a very profitable first quarter. Compared to its budgeted net income in January net income is expected to nearly double in February, even though February sales are budgeted to increase by just 8 percent. Net income in March is expected to be 67 percent higher than February’s net income, even though sales in March are budgeted to increase by just 10 percent. The main reason that Helga’s net income is expected to increase at a faster rate than sales is because the company has a rather high degree of operating leverage. Operating leverage refers to a company’s cost structure. A company’s degree of operating leverage is a measure of the extent to which expenses in the income statement are fixed amounts that do not change as sales levels increase or decrease.

Companies with high levels of fixed costs have high degrees of operating leverage, meaning that percentage changes in their net income can be significantly greater than the percentage changes in their sales. Helga’s depreciation expense and most of its SG&A expenses are fixed costs that contribute to its relatively high degree of operating leverage.³

Accounts Receivable Budgets

Accounts receivable budgets help companies manage their cash flow when timing differences exist between the reporting of revenue in the income statement and the ultimate collection of cash from its customers. Helga’s accounts receivable budget is illustrated in Figure 6.5.

Figure 6.5 Accounts receivable budgets: first quarter

The $2,100,000 balance on January 1st was carried forward from the prior year, and it comprises outstanding account balances for sales made in October, November, and December. All of Helga’s sales are made on credit, so the sales amounts reported in the Figure 6.1 sales budgets are added to the beginning accounts receivable balances each month. The company’s accounts receivable remain outstanding for an average of 3 months, so budgeted collections in January ($600,000) are from October sales, budgeted collections in February ($700,000) are from November sales, and budgeted collections in March ($800,000) are from December sales.⁴

Helga’s accounts receivable are projected to grow at approximately the same rate as its sales. This makes sense, given its annual accounts receivable turnover rate of 4 times is expected to remain constant throughout the first quarter of the current year.⁵ If this rate were to decrease, accounts receivable would grow more quickly than the company’s sales; conversely, if the turnover rate were to increase, sales would grow more quickly than its accounts receivable.

Inventory Budgets

Helga’s inventory budgets are presented in Figure 6.6. January’s beginning inventory balance is the actual balance carried forward from December. Beginning inventory in February is the budgeted ending inventory in January. Likewise, the beginning inventory in March is the budgeted ending inventory in February.

Figure 6.6 Inventory budgets: first quarter

Inventory levels go down as Helga sells hops to microbreweries, and they go up when the company purchases hops from growers. Thus, the beginning inventory balance is reduced each month by cost of goods sold reported in the Figure 6.4 budgeted income statements, and it is increased each month by the budgeted amount hops that the company intends to purchase.

Recall that Helga desires to increase its inventory levels each month of the first quarter in anticipation of high demand in the second and third quarters. To do so, the company anticipates that inventory purchases will be 110 percent of each month’s budgeted cost of goods sold.⁶ As a result, inventory levels will increase, as desired.

Trade Payables Budgets

Helga’s trade payables budgets are presented in Figure 6.7. January’s beginning balance is the actual balance carried forward from December. The beginning balance in February is the budgeted ending balance in January, whereas beginning balance in March is the budgeted ending balance in February.

Figure 6.7 Trade payables budgets: first quarter

Helga purchases all of its hops on credit, so budgeted purchases from the Figure 6.6 inventory budget are simply added to the beginning trade payables balances each month. The company’s trade payables remain outstanding an average of 2 months, so budgeted payments in January ($350,000) are for purchases made in November, whereas budgeted payments in February ($560,000) are for purchases made in December. Budgeted payments in March ($646,800) are for the budgeted purchases that Helga intends to make in January.⁷

Taxes Payable Budgets

Taxes payable increase as a company accrues income tax expense.⁸ Taxes payable go down when it pays income tax expenses accrued previously. Helga’s taxes payable budget is illustrated in Figure 6.8.

Figure 6.8 Taxes payable budgets: first quarter

The $2,000 beginning balance in January is the actual amount carried forward from December for income tax expenses that Helga accrued—but did not pay—in the previous year. The entire $2,000 amount is due in March. This is the only income tax payment that the company will make in the first quarter. The income tax expenses reported in the budgeted income statements in Figure 6.4 are not due until April.

Cash Budgets

Helga’s cash budgets for the first quarter of the current year are illustrated in Figure 6.9. The $95,500 beginning balance on January 1st is the actual amount carried forward from December of the previous year. February’s beginning balance is January’s budgeted ending balance, whereas March’s beginning balance is the ending cash balance budgeted for February.

Figure 6.9 Cash budgets: first quarter

All of Helga’s forecasted cash flow activities are taken directly from five of its supporting budgets prepared previously. Cash collections are reported in the Figure 6.5 accounts receivable budgets, whereas payments of trade payables are reported in the Figure 6.7 trade payables budgets. SG&A payments are reported in the Figure 6.2 SG&A expense budgets and income tax payments are reported in the Figure 6.8 taxes payable budgets.

Budgeted financing cash flows from credit line borrowing and interest expense payments are reported in the Figure 6.3 financing budgets. Had Helga’s first quarter forecasts included any investing activities—such as acquiring buildings, equipment, or land—capital expenditures budgets would have been prepared from which related cash flows in the company’s cash budgets would have been taken. Capital expenditure topics are addressed in Chapter 8.

Notice that Helga’s cash is expected to decline from $145,000 at the end of January, to just $75,000 by the end of the first quarter. Although this trend is potentially troubling, it should subside in the second quarter as cash collections from customers reported in the Figure 6.5 accounts receivable budgets are collected.

Balance Sheet Budgets

Helga’s balance sheet forecasts are illustrated in Figure 6.10. Overall, the company’s total assets are expected to increase by nearly 10 percent in just 2 months, from $4,200,000 at the end of January to $4,608,478 by the end of March. During this period its liabilities are expected to increase by approximately 25 percent, from $1,315,250 at the end of January to $1,646,493 by the end of March, and its shareholders’ equity is expected to increase by approximately 2.7 percent, from $2,884,750 at the end of January to $2,961,985 at the end of March.⁹ The projected changes in the individual balance sheet accounts are discussed next.

Figure 6.10 Balance sheet budgets: first quarter

Total Assets

Anticipated changes in Helga’s current assets are taken from three supporting budgets prepared previously. The cash balances are reported in the Figure 6.9 cash budgets, accounts receivable are reported in the Figure 6.5 accounts receivable budgets, and inventory amounts are reported in the Figure 6.6 inventory budgets.

The company did not budget any purchases or sales of depreciable fixed assets in the first quarter. Thus, its forecast for buildings, fixtures, and equipment each month is simply the previous month’s ending balance, minus the $30,000 depreciation expense reported in the Figure 6.4 income statement budgets. The depreciable asset amount carried forward at the end of December—net of accumulated depreciation—was $1,396,200, so the budgeted amount reported at the end of January is $1,366,200 ($1,396,200 minus depreciation of $30,000). The $1,336,200 February figure is $30,000 less than the January amount, whereas the $1,306,200 March figure is $30,000 less than the February amount. No changes to land were anticipated in the first quarter, so the $250,000 actual amount carried forward from December is held constant each month.¹⁰

Total Liabilities

Helga has no long-term liabilities, so all of its liabilities are classified as current.¹¹ The forecasts for its three liabilities were determined previously. The trade payables amounts are reported in the Figure 6.7 trade payables budgets. The income taxes payable amounts are reported in the Figure 6.8 taxes payable budgets, and the outstanding principal obligations on its line of credit are reported in the Figure 6.3 financing budgets.

Shareholders’ Equity

Helga’s $900,000 common stock figure reported in January is the actual amount carried forward from December. No additional stock issues are expected in the first quarter, so the $900,000 amount is held constant in February and March. The company does not anticipate paying any dividends in the first quarter, so the change in retained earnings each month results from net income reported in the Figure 6.4 budgeted income statements.

Summary

This chapter illustrated short-term financial forecasting methods used exclusively by managers to prepare operating budgets. Operating budgets generally cover time horizons of less than one year. In this chapter, they were illustrated on a monthly basis spanning one quarter. Companies often prepare monthly operating budgets spanning an entire year. With each passing month, budgetary forecasts are updated and rolled forward for another 12 months.

Operating budgets are valuable planning tools that help managers monitor and control activities related to:

• Cash flow;
• Credit policies;
• Inventory levels;
• Financial obligations coming due;
• Fixed asset investment decisions;
• Financing requirements;
• Staffing needs;
• Tax strategies.

Designing an operating budget can be a complex endeavor, but even the simplest approaches must be dynamic and interactive so that forecasts can be adjusted efficiently as assumptions about the future change.

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¹In an operating budget context, a forecasted statement of cash flows often takes a slightly different form referred to as a cash budget.

²SG&A costs are sometimes referred to as operating expenses. SG&A estimates are prepared from separate forecasts submitted by multiple offices and departments throughout the company, including the Marketing Department, Human Resources, the Accounting Department, and the Payroll Office.

³A company’s cost structure influences breakeven points and profitability. Cost structure issues are discussed in Chapter 7.

⁴Most companies prepare detailed aging schedules of their accounts receivable that enable them to more accurately forecast cash collections. Moreover, most companies reduce their receivables by an estimated amount of uncollectible accounts.

⁵Helga’s receivables remain outstanding approximately three months. Thus, its turnover rate is approximately four times (12 months ÷ 3 months = 4 times).

⁶Budgeting inventory for manufacturing companies is more difficult than it is for wholesalers and retailers. Manufactures do not purchase their inventory in ready-to-sell condition. Rather, they create inventory from raw materials. The inventories and cost of goods sold reported in the financial statements of manufacturing companies are composed of material costs, labor costs, and various overhead costs.

⁷Most companies prepare detailed aging schedules of their trade payables that enable them to more accurately forecast cash disbursements, and to more effectively take advantage of purchase discounts offered by vendors for prompt payment.

⁸Accrued taxes are tax expenses that are reported in the income statement before being paid.

⁹These percentage growth rates are for two months only—from the end of January to the end of March. To express them as annual percentage rates, they need to be multiplied by six. For instance, Helga’s 2.7 percent increase in shareholders’ equity is equivalent to an annualized growth rate of 16.7 percent.

¹⁰Land is not depreciated due to its unlimited useful life.

¹¹The company’s trade payables are paid approximately every two months, its income taxes are paid on a regular basis throughout the year, and its outstanding line of credit balance is paid in full annually on June 15th.