BUDGETING CONCEPTS AND FORECASTING TECHNIQUES

BUDGETING CONCEPTS

BUDGET THEORY
The purpose of this chapter of The Guide is to explain the definition and purpose of budgets, describe the budget cycle, discuss budgeting concepts and practices by fund, and to identify and understand budget information on financial reports.

BASIC CONCEPTS IN BUDGETING

There are 3 main elements of a budget. These are: Sales Revenue This is the cornerstone of a budget. It is crucial to estimate future sales as accurately as possible because everything else in the budget revolves around these figures. Your estimates of future sales can be based on past sales figures and track record. Once you have your target sales in place you can calculate all the related expenses necessary to achieve those sales figures. Total Costs Total costs include the main areas of fixed and variable. Fixed costs are the costs incurred whether or not the business turnover increases or decreases. Variable costs are the costs that vary with the level of business turnover. When you are estimating these costs you need to take into account the changes, which come about due to the various market forces, including inflation and rising prices. Profit Profit is the amount left over after all the costs have been deducted from the sales. Your profit should be sufficient to at least make a return

The Cash Flow Budget

1 To identify cash flow budgeting as a tool for financial decision making & business analysis 2 To understand structure & component of cash flow budget 3 Illustrate the procedure for completing a cash flow budget 4 To describe both the similarities and differences between a cash flow budget and an income statement 5 Discuss advantages & potential uses of a cash flow budget 6 To show how to use a cash flow budget when analyzing a new investment

Characteristics of a Cash Flow Budget

1. Records sales, production and expenses according to when they are received or paid: CFB shows amount & timing of cash expected to flow in & out of the firm during budget period. i.e. its a summary of projected cash inflows & outflow for a business over a given period of time. a. Cash Inflows: Come from sales, services, borrowing, sale of capital items, & from payments on accounts receivable. b. Cash Outflows: Include payments for goods and services purchased, debt, taxes, salaries, and capital assets.

Characteristics of a Cash Flow Budget

2. CFB shows Cash Receipt & Disbursements: Shows when cash should be available and when cash payments must be made i.e. assist mgmt plan when cash will be in surplus/ deficit 3. CFB is a forward which cash planning tool for investing excess cash and borrowing needed cash: CFB allows mgmt to invest surplus cash to earn extra income or help to decide when & how much to borrow in deficit periods & ability to repay loans

Budget Benefits
It helps managers better understand their business It provides a "yardstick" by which business performance can be measured by others.

1. Should be checked frequently to see progress. 2. If negative deviations are found, it permits quick corrective action before things get worse.

Summary
A. Budgeting is a critical step in business planning B. It puts ideas into numbers for profit or loss measurement C. Budgets are valuable tools in good management

CORRELATION AND REGRESSION

Correlation
Correlation coefficient: It measures the closeness of the linear (or straight line) association between two continuous variables. The correlation coefficient values are always number between 1 and +1. It will be zero if the variables are not correlated. The maximum value of 1 is obtained if there is a straight line in the scatter plot. The association is positive if the values of X axis and Y axis tend to be high or low together (positive relationship). Conversely, the association is negative if the high Y axis values tend to go with low values of X axis (i.e inverse relationship). Whether correlation coefficient (i.e., r value) is significantly different from zero can be tested. The significance depends on the size of r value and the number of observations(n). Larger the r, stronger is the association. A weak correlation may be statistically significant if the number of observations is large. Sometimes, r value may be artificially low (if the relationship between two variables is curved), or high (due to few extreme observations). For this reason, it is desirable to draw a scatter plot of the data before drawing conclusion on the significance or importance of the correlation coefficient value. It is to be remembered that a correlation between 2 variables does not necessarily suggest a cause and effect relationship. Correlation tests are normally used for forming a hypothesis or suggesting areas of further research.

CORRELATION
This test assesses the strength of association between two variablesis suitable for assessing the linear correlation onlyrequires x and y variables to be normally distributedrequires scatter plot to be made for visual assessment of the linearity (to rule out curved relationship)does not indicate cause and effectis used to form hypothesis rather than testing it.

REGRESSION
Simple Regression analysis: It gives the equation of the straight line and enables prediction of one variable value from the other. Normally, the dependent variable is plotted in Y axis and the independent variable in X axis. There are 3 major assumptions. First, any value of x and y are normally distributed. Second, the variability of y should be the same for each value of y. Third, the relationship between the two variables is linear. The equation of a regression line is: y=a + bx where a is the intercept, b is the slope, x is the independent variable and y is the dependent variable. The slope b is sometimes called regression coefficient and it has the same sign as correlation co-efficient (i.e., r). The above equation can be used for predicting y variable from x variable. Some of the improper usages of the above equation are predicting the y value from outside the range of the original data set (i.e., extrapolation), fitting of a straight line when the data shows curvature, prediction of x value from y and use of simple regression where there are heterogeneous subgroups.

REGRESSION
This test is used to estimate a dependence relationships used to predict one variable (dependent) from another (independent) within a range is suitable if the relationship is linear requires y variables to be normally distributedrequires the variability of all y values to be similar not suitable where there are heterogeneous subgroup (s)

LEARNING CURVE ANALYSIS

Learning Curve Spreadsheet

This learning curve spreadsheet will give you a way to calculate the numbers for your situation. This is all about human learning. We tend to improve our performance as we repetitively do a task. Learning curves quantify that improvement. This method can be applied to any activity that is repeated many times (tasks and units of production are used interchangeable). Typical industries using it are manufacturing and service, although there are applications in many others as well.

Learning Curve Spreadsheet

The Learning Curve Spreadsheet

This spreadsheet will calculate the slope s and the common term of percent of time required for a doubled number of units of production. This is calculated from your input of the 2 points of production. An example would be the 40th unit and the 92nd unit produced and the times required to produce them. The second step which relies on the results of the 1st step, predicts the time required for an nth unit of production. Unit time 40 20.0 90 6.0 S= -0.268 83.1% Learning curve Unit Time 125 14.7 190 13.2

The Formula
The formula for learning curve is: Tn=time required for nth item produced C=constant, which is equal to the time to produce the 1st unit s=slope constant, always negative On a graph with normal axes the curve will look like this: When plotted on log-log coordinates(meaning both the axes are logarithmic), the plot is a straight line.

Time Series Analysis

Time series analysis accounts for the fact that data points taken over time may have an internal structure (such as autocorrelation, trend or seasonal variation) that should be accounted for. Applications: The usage of time series models is twofold: Obtain an understanding of the underlying forces and structure that produced the observed data Fit a model and proceed to forecasting, monitoring or even feedback and feed forward control.

Single Moving Average

An alternative way to summarize the past data is to compute the mean of successive smaller sets of numbers of past data as follows: Recall the set of numbers 9, 8, 9, 12, 9, 12, 11, 7, 13, 9, 11, 10 which were the dollar amount of 12 suppliers selected at random. Let us set M, the size of the "smaller set" equal to 3. Then the average of the first 3 numbers is: (9 + 8 + 9) / 3 = 8.667. This is called "smoothing" (i.e., some form of averaging). This smoothing process is continued by advancing one period and calculating the next average of three numbers, dropping the first number. The next table summarizes the process, which is referred to as Moving Averaging. The general expression for the moving average is Mt = [ Xt + Xt-1 + ... + Xt-N+1] / N

Single Exponential Smoothing

This smoothing scheme begins by setting S2 to y1, where Si stands for smoothed observation or EWMA, and y stands for the original observation. The subscripts refer to the time periods, 1, 2, ..., n. For the third period, S3 = y2 + (1-) S2; and so on. There is no S1; the smoothed series starts with the smoothed version of the second observation. For any time period t, the smoothed value St is found by computing This is the basic equation of exponential smoothing and the constant or parameter is called the smoothing constant.

EXPECTED VALUE
most likely value of a random variable: the value of a random variable that is most likely to occur, calculated by multiplying the sum of every possible value by a factor representing the probability of its occurrence Expected value is the value of an intervention when the outcomes of that intervention are averaged over many patients. An "expectedoutcome decision maker" chooses the treatment that gives the best outcome when averaged over many patients. An expected-outcome decision maker would decide between medical management of stable angina, coronary angioplasty, or coronary artery bypass surgery by calculating a patient's life expectancy, expressed in years in good health, after undergoing each of these treatment options.

SENSITIVITY ANALYSIS
A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond's price.

Example of sensitivity analysis

Using scenario analysis software, you can quickly see the potential impact of a change in assumptions, without having to generate new forecasts for each budget item such as raw materials or selling and administrative costs. The following example shows how sensitivity analyses for one company might be reported.

Why Sensitivity Analysis

So far: find an optimum solution given certain constant parameters (costs, demand, etc) How well do we know these parameters?
Usually not very accurately - rough estimates

Do our results remain valid?

If the parameters change ... ... how much does the objective function change? ... how much do the optimal values of the decision variables change?