Financial Planning and Budgeting - Lighthouse Ltd - Case Study Example

Financial Planning and Budgeting

Introduction

• Introduction

This is a financial planning and budgeting for Lighthouse Ltd. Lighthouse Ltd is a manufacturing company, specializing in local production and sales of sports and casual shoes. In order to manufacture shoes, the company requires human labor hours, leather as the core material, marketing costs, administrative costs and several others. The company also has to pay tax and insurance. This paper creates a budgeting plan for Lighthouse, starting from a sales forecast, production and budgeted inventory, considers production costs, administrative and marketing budget. An Income Statement, Budgeted Balance Sheet and a Cash Budget are given at the end (Anthony, pg. 23). The paper ends with a brief conclusion. Lightshoes Ltd does financial planning as an ongoing process that flows alongside strategic decisions. The Financial Plan and the Operating Plan will both provide support to the Strategic Plan. For Lightshoes Ltd, I started preparing the budget through the sales which is the main driving activity of the shoes company. However, a number of factors were considered before writing the final budget (Barfield et al., pg. 34). The designed budget company for Lighthouse Ltd is flexible ensuring that some changes can be done when they are required. For instance, the budget will be impacted by the following n the l0ng term; general economic conditions, technology trends in the fashion industry, the business financial conditions, the business life cycle, availability of resources, and the competition in the market.

• Budgeting needs to be both bottom up and top down, for example, the middle level management, and the upper level management needs to work together as a unit to finalize the budget. Al model can be created to streamline the process of budgeting for the organization. The financial models can help in answering other questions that manual calculations do ignore and help in making the appropriate decisions for forecasting. This will help a lot in enhancing the process of budgeting. One of the major problems faced in budgeting and financial planning is how to develop it to bring value. Budgeting calls for clear channels of communication, participation of all the different departments in an organization, upper-level-management support, and predictive characteristics. Budgeting is meant to help in making critical decisions, and the accuracy is not the main factor. Focusing too much on the accuracy of the budgets and the financial positions sometimes leads to loss of focus, away from the main concern of the management and as a result leading to loss of time and excessive costs incurred. The objective is to create a financial planning that adds value that helps the organization to meet its goals and objectives.
• sales

In order to develop a budget for Lightshoes Ltd, first, we I will begin with a forecast of the things that drive much of the shoe company financial activities, which are sales. To estimate the company sales, the past sales have to be examined and the different factors that determines them. For instance, the marketing research may show that the future sales are expected to be more stable. Maybe there will be a slowdown in the economy in the following year which will lead to decline in sale or maybe the growing sales will not be met due to limited capacity in production. Several factors are considered before arriving at the sales forecast (Ganeson and Kalavathi pg. 30-32).

After all the relevant information have been collected and analyzed, it is time to estimate the sales volume for the budgeting plan period. It is critical to that a good estimate is created since it will be applied for several other calculations and estimates in the other budgets. The sales forecast needs to consider the expected sales and the expected sales price.

Exhibit 1: Sales Forecast, End Year 30th June 2016

ProductQuantityPriceSales

Shoes16,000$ 45.00$ 720,000

• Percent of Sales
• After doing the sales forecast, it is now possible to estimate the account changes due to the estimated sales. The Percentage of Sales Method can be used to compute the account balances. By examining the past account balances and past sales changes, it is possible to establish the relationship in percentage. For instance, most of the current assets, the variable costs and the current liabilities do vary as sales changes over time.

Sample 1: Accounts Receivable

We will assume that from history the accounts receivables are about 30%. It has already been estimated that the sale for 2017 will be $ 160,000. This means that the accounts receivables will be $ 48,000 (0.30 x $ 160,000).

• Production and Budgeted Inventory
• Budget Details
• It is now time to create a detail budget which will help in developing a budgeted income statement. For example, I have estimated the sales to be 16,000 units and I will need to plan for its production. Lightshoes Ltd Production Department will need to budget for labor, materials and overhead based on the expected sales and inventory.

Exhibit 2: Production Budget, End Year 30th June 2016

Expected Sales (Exhibit 1)16,000

Expected Ending Inventory 1,500

Total No. of nits17,500

Less Starting Inventory(3,000)

Expected Production14,500

• After estimating the level of production, as can be seen in exhibit 2, it is possible to prepare Material budget. The Materials Budget tries to forecast and estimate the level of required purchases, considering the account required materials for production and the levels of inventory. The materials required for purchase can be summarized using this formula:
• Materials Purchased = Materials Required + Ending Inventory - Beginning Inventory

Exhibit 3: Materials Budget, End Year 30th June 2016

Casual and sports Shoes require a leather of 0.25 square yards. The leather is approximated to costs about $ 5.00 per yard in 2017. The required materials is therefore = 14,500 (Exhibit 2) x .25 = 3,625 yards.

Total Materials Needed for Production is3,625

Desired Ending Inventory 375

Total Materials4,000

Less Starting Inventory(500)

Total Materials Required3,500

Unit Cost for Materials x $ 5.00

Total Purchased Materials $ 17,500

• Labor is second element of production. The next step is to forecast the labor requirement based on the expected shoes production. The labor budget reaches the expected cost of labor by adopting the expected labor rate to the required hours of labor.

Exhibit 4: Labor Budget, End Year 30th June 2016

Sport and casual shoes require .50 hours to manufacture a single unit.

14,500 units x .50 = 7,250 hours

The desired hourly labor rate in the following year is $ 12.00.

Approximated Production Hours 7,250

Hourly Labor Rate x 12.00

Total Cost of Labor $ 87,000

• Direct Materials and Labor
• As the level of production moves down or up, the support services and other required costs related to manufacturing will also change. The overhead costs always represent the third major production costs. Every item that constitutes overhead may call for independent analysis to enable determining of the specific costs of every item.

Exhibit 5: Overhead Budget, End Year 30th June 2016

The overhead budget is estimated for every line of shoe in the following manner:

Indirect Labor Costs *$ 12,000

Depreciation 3,000

Utilities , 5000

Taxes and Insurance 4,000

Maintenance 1,000

Total Overhead Costs$ 25,000

*Production Inspection and Supervision

• Factory Overheads
• Once the production costs are budgeted appropriately (direct labor, overhead and direct material), those numbers can be worked into the beginning/ opening inventory levels for work in progress, direct materials and finished inventory. The opening inventory levels are the actual amounts obtained from the last reporting period. The costs should be applied based on what the ending/ closing inventory is required to be. This will yield the Budget for Cost of Goods Sold, which will be later adopted in creating the Forecasted Income Statement.

Exhibit 6: Cost of Goods Sold, End Year 30th June 2016

DirectWork InFinished

MaterialsProgressInventory

Beginning Inventory$ 2,500$ 16,000$ 46,000

Purchases (Exhibit 3) 17,500

Ending Inventory-Less (1,875)

Required Materials 18,125

Overhead (Exhibit 5) 25,000

Direct Labor (Exhibit 4) 87,000

Total Manufacturing Costs$ 130,125 130,125

Total Work In Progress 146,125

Less Closing Inventory (12,000)

Cost of Goods Produced$ 134,125 134,125

Cost of Goods Available for Sale 180,125

Less Closing Inventory (36,000)

Cost of Goods Sold (COG)$ 144,125

• It is time to complete the estimation of the expenses by examining the other operating expenses that have not been considered. Marketing I the first critical operating expense. Sales and Marketing Managers are responsible for submitting their marketing budget to be approved by the upper level management.

Exhibit 7: Marketing Budget, End Year 30th June 2016

Estimated for every line of shoes according to the Marketing Department:

Marketing Personnel$ 75,000

Marketing Research 12,000

Advertising & Promotion 42,000

Travel & Individual Expenses 6,500

Total Marketing Expenses $ 135,500

• Selling and Administration Budget
• The administrative costs are the last area of the operating expenses which are required for running the overall business. The administrative expenses are often estimated based on what is expected to happen in the future. For instance, if the business plans to have a new printing machine, then there is needed to plan for additional technology related to printing like networking. Preparation of Administrative and General Expenses Budget is done by several managers from different departments (Barfield et al., 3).

Exhibit 8: Administrative and General Budget, End Year 30th June 2016

Estimated for every product line per Department Managers:

Management Personnel$110,000

Technology Personnel 45,000

Supplies 15,000

Accounting Personnel 55,000

Utilities & Rent 25,000

Legal Personnel 40,000

Miscellaneous 7,500

Total G & A Expenses $ 297,500

• Master Budget:
• Income Statement
• Based on the estimations of the budget that have been conducted, running from Exhibit 1 to 8, the budgets can now be compiled in the form of Budgeted Income Statement. Some new line items will be added for the non-operating items, for instance, the financing costs and the income received on investments. The Tax and Finance Department will help in estimating the elements like income tax and finance expenses. The Budgeted Income Statement will assemble together all the expense and revenue estimates doe from the earlier prepared detail budgets (Anthony, 44).

Exhibit 9: Income Statement (Budgeted), End Year 30th June 2016

Revenues (Exhibit 1)$720,000

Less Cost of Goods Sold (Exh 6) (144,125)

Gross Profit (GP) 575,875

Less Marketing Exp. (Exhibit 7) (135,500)

Less G & A (Exh 8) (297,500)

Operating Income 142,875

Less Debt Interest ( 8,000)

Income before Taxes 134,875

Taxes at 37.5% (50,578)

Net Income (NI)$ 84,297

Sample 2: Income Statement (Budgeted), End Year 30th June 2016

Lightshoes Ltd has gathered the following information:

The expected sales are 50,000 units going at a sales price of $ 110.00 per shoe.

The starting Inventory constitutes 5,000 shoes at a cost of $ 60.00 per unit.

The projected production is 55,000 shoes with the following cost of production:

Direct Materials: $ 18.50 per unit

Required Direct Labor is 4 hours per unit @ a cost of $ 12.00 per hour

Overhead is estimated at 20% of the Direct Labor Cost

Expected Closing Inventory is 6,000 units when using the LIFO Method.

The Marketing Expenses are estimated at $ 350,000

Administrative & General Expenses are estimated at $ 400,000

< - - - - - - - - - - - - - - - Budgeted Income Statement - - - - - - - - - - - - - - >

Sales ($ 110 x 50,000)$ 5,500,000

Less Cost of Goods Sold:

Beginning Inventory ($ 60.00 x 5,000)$ 300,000

Direct Labor (55,000 x $ 12.00 x 4 hours) 2,640,000

Direct Materials ($ 18.50 x 55,000) 1,017,500

Overhead (0.20 x $ 2,640,000) 528,000

Cost of Available Sales 4,485,500

Less Closing Inventory (1) ( 380,500)

Cost of Goods Sold(4,105,000)

Gross Profits (GP) 1,395,000

Less Operating Expenses:

Marketing Expenses( 350,000)

Administrative & General( 400,000)

Net Income(NI)$ 645,000

• Through LIFO, last costs in are: $ 1,017,500 + $ 528,000 + $ 2,640,000 = $ 4,185,500 / 55,000

= $ 76.10 x 5,000

Last costs = $ 380,500.

• After preparing the Budget Income Statement, it is now possible to create a Budgeted Balance Sheet. The Budgeted Balance Sheet will furnish us with the estimate of the amount of external financing required to support the approximated sales (Garrison and Noreen pg. 12).
• Retained Earnings is the main link between the Balance Sheet and the Income Statement. Therefore, the Budgeted Balance Sheet preparation begins with an estimate of Retained Earnings closing balance. To estimate the closing Retained Earnings, the future dividends needs to be estimated based on the present dividend policies and the projections by the management of the levels of pay in the next planning period.

Exhibit 10: Estimated Retained Earnings, End Year 30th June 2016

Opening Balance $270,000

Budgeted Net Income (Exhibit 9) 84,297

Less Approximated Dividends (55,000)

Closing Retained Earnings $ 299,297

The next step is to account for the fixed assets acquisition. As a company depletes its asset base, it requires re-invest the proceeds to sustain assets which are the building blocks for generating revenues. For instance, the company needs to ask the questions like, does it require investing in new machinery, computer systems, or expanding on the production facilities? It is the work of the upper management and the operating personnel to determine the future capital spending. The future capital expenditures are provided in the Capital Expenditures Budget.

Exhibit 11: Capital Expenditures Budget, End Year 30th June 2016

Buy new Leather Cutting Machine 8,500

Buy New Office Equipment $ 16,000

Total Capital Expenditures $ 24,500

• Based on the capital assets budget and the opening balance (Exhibit 11), the ending asset balance can now be computed for the Budgeted Balance Sheet.

Exhibit 12: Fixed Assets Changes, End Year 30th June 2016

Opening Balance $ 886,000

New Acquisitions (Exhibit 11) 24,500

Less Depreciation(33,500)

Closing Fixed Assets $ 877,000

• I assume that the interest expense and the liabilities will not change. However, after determining the level of required external financing, these amounts will be revised accordingly. Besides, there is need to analyze the ratios and trends in order to ascertain the figures that do not change as the sales changes. For example, the prepared expenses are categorized as current assets and have almost nothing to do with the sales.
• Balance Sheet is a onetime year end estimate; it therefore assumes that all the other estimates have already been met. The yearly forecasts in a rapidly changing business are rarely close. I will therefore simplify my preparation of the Budgeted Balance Sheet by depending on the relationships. Relationships which are stable for the last five years are definitely very helpful. The budget will show either deficit (extra financing needed to cover assets) or surplus (excess financing over business assets) (Barfield et al., pg. 26).
• The difference can be obtained from the Accounting formula: Assets = Liabilities + Equity.
• Balance Sheet

Exhibit 13: Budgeted Balance Sheet, End Year 30th June 2016

Cash $ 36,000 5% of Sales

Inventory 50,400 7% of Sales

Accounts Receivable 86,400 12% of Sales

Fixed Assets 877,000 Exhibit 12

Prepaid Expenses 11,000 5 year trend analysis

Total Assets $1,060,800

Accounts Payable 79,200 11% of Sales

Long Term Debt 60,000 Can be revised

Current Portion of LT Debt 6,000 Paid Principal

Total Liabilities 145,200

Retained Earnings 299,297 Exhibit 10

Common Stock450,000 unchanged

Total Equity749,297

Total Equity and Liab. 894,497

Required External Financing $ 166,303

• The EFR (External Financing Required) can also be computed based on the relationship between the sales, liabilities and assets using the following method:
• EFR = (A / S x Sales) - (L / S x Sales) - (PM x FS x (1 - d))
• Where;
• A / S: Assets that change provided a change in sales, expressed as sales percentage
• Sales: Change in sales between the forecasted sales the last reporting period.
• L / S: Change in liabilities given a change in sales, expressed as sales percentage.
• FS: Forecasted Sales
• PM: Sales Profit Margin; for instance (net income / sales).
• (1 - d): Retained Percent of earnings after paying out the dividends; dividend payout ratio is represented by d.

Sample 3: The Required External Financing, End Year 30th June 2016

Lightshoes Ltd has provided the following information:

A $ 900 asset (mainly current assets) from the last season change with sales. A $ 300 liability from the last period change with sales. For the last period, the estimated sales were $ 3,000. The forecasted sales will be $ 3,900. Sales profit margins are 6% and earnings of 4% paid-out as dividends.

L / S = $ 300 / $ 3,000

= .10

A / S = $ 900 / $ 3,000

= .30

Change in Sales = $ 3,900 - $ 3,000

= $ 900

EFR = 0.30($ 900) - 0.10($ 900) - 0.06($3,900) x (1-.40)

= $ 270 - $ 140.4 - $ 90= $ 39.6

Sample 4: Preparing Budgeted Balance Sheet, End Year 30th June 2016

Gilmer Company has compiled the following information:

• Reporting period Sales were $ 600,000
• Projected sales are $ 800,000
• Dividend Payout Ratio is 40%
• Profit Ratio is 5% of sales
• Retained Earnings Current Balance is $ 200,000
• Accounts Receivable as a % of sales 10%
• Cash as a % of sales is 4%
• Inventory as a % of sales is 30%
• Accounts Payable as a % of sales is 7%
• Net Fixed Assets are $ 300,000
• Accrued Liabilities as a % of sales is 15%
• Common Stock stands at $ 220,000

Budgeted Balance Sheet

Cash (0.04 x $ 800,000)$ 32,000

Inventory (0.30 x $ 800,000) 240,000

Accounts Receivable (0.10 x $ 800,000) 80,000

Net Fixed Assets 300,000

Total Assets$ 652,000

Accrued Liabilities (0.15 x $ 800,000) 120,000

Accounts Payable (0.07 x $ 800,000)$ 56,000

Common Stock 220,000

Retained Earnings (1)

Required Total Additional Financing 32,000

Total Equity & Liabilities 620,000

Total Equity & Liabilities after financing$ 652,000

(1): Opening Balance $ 200,000

New Income Increase:

0.05 x $ 800,000 (profit margin) 40,000

Less Dividends:

$ 40,000 x 0.40 Net Income (16,000)

Closing Balance $ 224,000

• After successfully preparing the budgeted financial statements, it is crucial that these statements are carefully reviewed by the management. For instance, as demonstrated in Exhibit 13, can the business truly be in a position to raise a capital of $ 166, 303? Again, will the budgeted financial statements meet the shareholders expectations? Before finalizing the budgeted financial statements, it is important to ask several of such critical questions.
• Additionally, this budget was made on a yearly basis. Multiple events that are unplanned for can occur at any time during the year, making the estimated annual budget very inaccurate and inappropriate. As a result, the financial planning is always enhanced by simply forecasting on a quarterly or a monthly basis as opposed to the yearly estimation.
• Quarterly Cash Budget

• Cash budget is a good illustration of a short-term financial planning. The Cash Budget is an estimation of the future outflows and inflows in a business. The Budgeted Balance Sheet is often included with the Cash Budgets. However, it is important to realize that the Cash Budgets are not often used as tools for general forecasting since they are specific to only one account called cash. Instead, the Treasury personnel and the Cash Manager do use the Cash Budgets for managing cash.
• The previous forecasts can now be sued to help in preparing the Cash Budget. For example, the manufacturing payable disbursements can be obtained by looking at Labor Budget (Exhibit 4), Materials Budget (Exhibit 3), and the Overhead Budget (Exhibit 5). A Cash Budget can now be prepared by simply examining the stable cash flow pattern, for insa6nce the account payable, accounts receivable, payroll, amongst others. There are also numerous predictable transactions like loan payments, insurance debts amongst others.

Lighthouse Ltd

4 Quarters, 2015/ 2016

Quarter 1

Quarter 2

Quarter 3

Quarter 4

Beginning cash

$10,000

$8,000

$5,000

$5,000

Sources of Cash

 + Cash sales (4000 units every quarter)

180000

180000

180,000

180,000

Cash collections of sales

17000

10,000

10,000

10,000

 + Asset sales

3000

0

0

0

 = Total cash available

$210,000

$198,000

$195,000

$195,000

Uses of Cash

Direct materials

$4,375

$4,375

$4,375

$4,375

Direct labor 

21750

21,750

21,750

21,750

Manufacturing overhead

6,250

6,250

6,250

6,250

Marketing Expenses

33,875

33,875

33,875

33,875

Administrative Expenses

74,375

74375

74,375

74375

Total uses of cash

$140,625

$140,625

$140,625

$140,625

Net Cash Position

$69,375

$57,375

$54,375

$54,375

• So far, I have looked at the simple approaches for preparing budgets for the company, like examining the relationship between the sales and account balances. There is also the need to clearly understand the past performance of the company in terms of its financials to help in the prediction of the coming or future financial performance. It is a recognized method and reliable way to extend the past financial trends and adjust them appropriately to clearly forecast the company position. However, there are several methods that can be used to improve on forecasting in a company. The initial step is to recognize the principles about forecasting:
• Forecasting depends on the past relationship and the available historical data. If there is a big change in the relationship, then there is an inaccurate forecasting
• Since forecasts may not always yield accurate results due to uncertainty, there is need to create numerous forecasts done depending on different scenarios. Different possibilities can be assigned to each scenario and then reach the targeted goals
• The longer the period for planning, the more inaccurate the forecast results are likely to be. In order to increase the forecasts reliability, there is need to consider only shorter planning periods. The periods for planning always depends on how regular or frequent the current plans needs to be studied and evaluated. Again, this will depend on the stability of sales for the business, the financial position of the business and business risks amongst others.
• It is ideal to forecast using the larger and overall context. One is more likely to get more accurate results when forecasting using several inter-connected units/ items as opposed to forecasting using a single unit (DFID pg. 45). For instance, we are more likely to get more accurate results when forecasting using economic figures as opposed to when forecasting in a specific industry.

Conclusion

• Lightshoes Ltd does financial planning as an ongoing process that flows alongside strategic decisions. The Financial Plan and the Operating Plan will both provide support to the Strategic Plan. For Lightshoes Ltd, I started preparing the budget through the sales which is the main driving activity of the shoes company. However, a number of factors were considered before writing the final budget. The designed budget company for Lighthouse Ltd is flexible ensuring that some changes can be done when they are required. For instance, the budget will be impacted by the following n the l0ng term; general economic conditions, technology trends in the fashion industry, the business financial conditions, the business life cycle, availability of resources, and the competition in the market (Decoster and Elden, pg. 56-70).
• Budgeting needs to be both bottom up and top down, for example, the middle level management, and the upper level management needs to work together as a unit to finalize the budget. Al model can be created to streamline the process of budgeting for the organization. The financial models can help in answering other questions that manual calculations do ignore and help in making the appropriate decisions for forecasting. This will help a lot in enhancing the process of budgeting. One of the major problems faced in budgeting and financial planning is how to develop it to bring value. Budgeting calls for clear channels of communication, participation of all the different departments in an organization, upper-level-management support, and predictive characteristics. Budgeting is meant to help in making critical decisions, and the accuracy is not the main factor. Focusing too much on the accuracy of the budgets and the financial positions sometimes leads to loss of focus, away from the main concern of the management and as a result leading to loss of time and excessive costs incurred. The objective is to create a financial planning that adds value that helps the organization to meet its goals and objectives.