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These changes may halt all production for extended periods, and so must be carefully planned for. This is the responsibility of the industrial engineering staff. The expense items included in the production budget should be driven by a set of subsidiary budgets, which are the purchasing, direct labor, and overhead budgets. These budgets can be simply included in the production budget, but they typically involve such a large proportion of company costs that it is best to lay them out separately in greater detail in separate budgets.

Comments on these budgets are as follows: Purchasing budget. These bills must be accurate, or else the purchasing budget can include seriously incorrect information.

In addition, there should be a plan for controlling material costs, perhaps through the use of concentrated buying through few suppliers, or perhaps through the use of long- term contracts. If materials are highly subject to market pressures, comprise a large proportion of total product costs, and have a history of sharp price swings, then best-case and worst-case costing scenarios should be added to the budget so that managers can review the impact of costing issues in this area.

It is also worthwhile to budget for a raw material scrap and obsolescence expense; there should be a history of costs in these areas that can be extrapolated based on projected purchasing volumes. Direct labor budget. Do not make the mistake of budgeting for direct labor as a fully variable cost. The direct labor budget should also account for any contractually mandated changes in hourly rates, which may be itemized in a union agreement.

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Such an agreement may also have restrictions on layoffs, which should be accounted for in the budget if this will keep labor levels from dropping in proportion with budgeted reductions in production levels. Such an agreement may also require that layoffs be conducted in order of seniority, which may force higher-paid employees into positions that would normally be budgeted for less expensive laborers.

Thus, the presence of a union contract can result in a much more complex direct labor budget than would normally be the case. For example, one possible pay arrangement is to pay employees based on a piece rate, which directly ties their performance to the level of production achieved. If so, this will probably apply only to portions of the workforce, so the direct labor budget may involve pay rates based on both piece rates and hourly pay. Overhead budget. Included in this category are machine maintenance, utilities, supervisory salaries, wages for the materials management, production scheduling, quality assurance personnel, facilities maintenance, and depreciation expenses.

Under the no-change scenario, themost likelybudgetary alterations will be to machinery or facilities maintenance, which are dependent on the condition and level of usage of company property. Of particular concern is the number of overhead-related personnel who must be either laid off or added when capacity levels reach certain critical points, such as the addition or subtraction of extra work shifts.

Costs also tend to rise substantially when a facility is operating at very close to percent capacity, since this tends to call for an inordinate amount of effort to maintain on an ongoing basis. The purchasing, direct labor, and overhead budgets can then be summarized into a cost-of-goods-sold budget. This budget is referred to constantly during the budget creation process, since it tells management whether its budgeting assumptions are yielding an acceptable gross margin result.

Since it is a summary- level budget for the production side of the budgeting process, this is also a good place to itemize any production-related statistics, such as the average hourly cost of direct labor, inventory turnover rates, and the amount of revenue dollars per production person.

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Thus far, we have reviewed the series of budgets that descend in turn from the revenue budget and then through the production budget. However, there are other expenses that are unrelated to production. These are categories in a separate set of budgets. This includes the expenses that the sales staff must incur in order to achieve the revenue budget, such as travel and entertainment, as well as sales training.

Of particular concern in this budget is the amount of budgeted headcount that is required to meet the sales target. This is a common problem, for companies will make the false assumption that the existing sales staff can make heroic efforts to wildly exceed its previous-year sales efforts.

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In some industries, this learning curve may be only a few days, but it can be the better part of a year if considerable technical knowledge is required to make a sale. The marketing budget is also closely tied to the revenue budget, for it contains all of the funding required to roll out new products, merchandise them properly, advertise for them, test new products, and so on. A key issue here is to ensure that the marketing budget is fully funded to support any increases in sales noted in the revenue budget.

It may be necessary to increase this budget by a disproportionate amount if one is trying to create a new brand, issue a new product, or distribute an existing product in a new market. These costs can easily exceed any associated revenues for some time. Another nonproduction budget that is integral to the success of the corporation is the general and administrative budget.

Since this is a cost center, the general inclination is to reduce these costs to the bare minimum. Similarly, a major change in the revenue volume will alter the budget for the accounting department, since many of the activities in this area are driven by the volume of sales transactions. Thus, the general and administrative budget generally requires a number of iterations in response to changes in many other parts of the budget.

By centralizing this cost information, the human resources staff can more easily update budget information. Since salary-related costs tend to comprise the highest proportion of costs in a company excluding materials costs , this tends to be a heavily used budget. The facilities budget is based on the level of activity that is estimated in many of the budgets just described. For this reason, it is one of the last budgets to be completed.

This budget is closely linked to the capital budget, since expenditures for additional facilities will require more maintenance expenses in the facilities budget. This budget typically contains expense line items for building insurance, maintenance, repairs, janitorial services, utilities, and the salaries of the maintenance personnel employed in this function.

It is crucial to estimate the need for any upcoming major repairs to facilities when constructing this budget, since these can greatly amplify the total budgeted expense. Another budget that includes input from virtually all areas of a company is the capital budget. This topic is addressed in greater detail in Chapter 2, Capital Budgeting Decisions. Typical measurements in this area can include revenue and income per person, inventory turnover ratios, and gross margin percentages.

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The cash forecast is of exceptional importance, for it tells company managers whether the proposed budget model will be feasible. The assumptions that go into the cash forecast should be based on strict historical fact, rather than the wishes of managers.

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This stricture is particularly important in the case of cash receipts from accounts receivable. The cash forecast is a particularly good area in which to spot the impact of changes in credit policy.


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The other key factor in the cash forecast is the use of delays in budgeted accounts payable payments. One is the possible loss of key suppliers who will not tolerate late payments. Another is the risk of being charged interest on late payments to suppliers.

A third problem is that suppliers may relegate a company to a lower level on their lists of shipment priorities, since they are being paid late. Finally, suppliers may simply raise their prices in order to absorb the cost of the late payments.

Consequently, the late payment strategy must be followed with great care, using it only on those suppliers who do not appear to notice, and otherwise doing it only after prior How Does the System of Interlocking Budgets Work? This is not strictly a budget, though it will contain a single line item, derived from the cash forecast, which itemizes funding needs during each period itemized in the budget. In response this question, we will review several variations on how a budget can be constructed, using a number of examples.

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It contains revenue estimates for three different product lines that are designated as Alpha, Beta, and Charlie. This format is most useful when there are not so many products that such a detailed delineation would create an excessively lengthy budget. It is a very useful format, for the sales staff can go into the budget model and alter unit volumes and prices quite easily.