Chapter 3

Financial Forecasting,
Planning, and Budgeting
Slide Prepared by:
Abdullah Al Yousuf Khan
Assistant Professor - IUBAT

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 3.1 Financial Forecasting
• Financial forecasting, an essential element of planning, is the
basis for budgeting activities and estimating future financing
needs. Financial forecasts begin with forecasting sales and
their related expenses.
• The basic steps involved in projecting financing needs are:
• Project the firm’s sales. Most other forecasts (budgets) follow the sales
forecast. The statistical methods of forecasting sales include:
(a) Time-series analysis
(b) Exponential smoothing
(c) Regression analysis
(d) Box-Jenkins method
• Project variables such as expenses.
• Estimate the level of investment in current and fixed assets that is
required to support the projected sales.
• Calculate the firm’s financing needs.
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 3.2 Percent-of-sales Method Of
Financial Forecasting
• When constructing a financial forecast, the sales
forecast is used traditionally to estimate various
expenses, assets, and liabilities.
• The most widely used method for making these
projections is the percent-of-sales method, in which
the various expenses, assets, and liabilities for a
future period are estimated as a percentage of sales.
• These percentages, together with the projected sales,
are then used to construct pro forma (planned or
projected) balance sheets.

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 3.2 Percent-of-sales Method Of
Financial Forecasting
• The calculations for a pro forma balance sheet are as follows:
1. Express balance sheet items that vary directly with sales as a percentage of
sales. Any item that does not vary directly with sales (such as long-term debt) is
designated not applicable (n.a.).
2. Multiply the percentages determined in step 1by the sales projected to obtain
the amounts for the future period.
3. Where no percentage applies (such as for long-term debt, common stock, and
capital surplus), simply insert the figures from the present balance sheet in the
column for the future period.
4. Compute the projected retained earnings as follows:
Projected retained earnings = present retained earnings
+ projected net income - cash dividends paid (You’ll need to know the percentage
of sales that constitutes net income and the dividend payout ratio.)
5. Sum the asset accounts to obtain a total projected assets figure. Then add the
projected liabilities and equity accounts to determine the total financing
provided. Since liability plus equity must balance the assets when

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 Example 3.1 For the following pro forma balance sheet, net
income is assumed to be 5 percent of sales and the dividend
payout ratio is 4 percent.

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Example 3.1

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Computations of Example 3.1

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 3.3 The Budget, Or Financial Plan
• A company’s annual financial plan is called a budget. The
budget is a set of formal (written) statements of
management’s expectations regarding sales, expenses,
production volume, and various financial transactions of the
firm for the coming period.
• Simply put, a budget is a set of pro forma statements about
the company’s finances and operations.
• A budget is a tool for both planning and control.
• At the beginning of the period, the budget is a plan or
standard; at the end of the period, it serves as a control device
to help management measure the firm’s performance against
the plan so that future performance may be improved.

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 3.4 The Structure Of The Budget
• The budget is classified broadly into two categories: the
operational budget, which reflects the results of operating
decisions; and the financial budget, which reflects the
financial decisions of the firm.
• The operating budget consists of:
1. Sales budget, including a computation of expected cash receipts
2. Production budget
3. Ending inventory budget
4. Direct materials budget, including a computation of expected cash
disbursements for materials
5. Direct labor budget
6. Factory overhead budget
7. Selling and administrative expense budget
8. Pro forma income statement
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 3.4 The Structure Of The Budget
• The financial budget consists of;
1. Cash budget
2. Pro forma balance sheet
• The major steps in preparing the budget are:
1. Prepare a sales forecast
2. Determine production volume
3. Estimate manufacturing costs and operating expenses
4. Determine cash flow and other financial effects
5. Formulate projected financial statements.

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 The Sales Budget
• The sales budget is the starting point in preparing the operating budget,
since estimated sales volume influences almost all other items appearing
throughout the annual budget. The sales budget gives the quantity of each
product expected to be sold. (For the Johnson Company, there is only one
product.)
• Basically, there are three ways of making estimates for the sales budget:
1. Make a statistical forecast (using any one or a combination of the methods
mentioned in Section 3.1) on the basis of an analysis of general business conditions,
market conditions, product growth curves, etc.
2. Make an internal estimate by collecting the opinions of executives and sales staff.
3. Analyze the various factors that affect sales revenue and then predict the future
behavior of each of those factors.
• After sales volume has been estimated, the sales budget is constructed by
multiplying the estimated number of units by the expected unit price.
Generally, the sales budget includes a computation of cash collections
anticipated from credit sales, which will be used later for cash budgeting.
See Example 3.3.
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 Example 3.3
• Assume that of each quarter’s sales, 70 percent is collected in
the first quarter of the sale; 28 percent is collected in the
following quarter; and 2 percent is uncollectible.

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Schedule of Expected Cash Collection

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 The Production Budget
• After sales are budgeted, the production budget can
be determined.
• The number of units expected to be manufactured to
meet budgeted sales and inventory is set forth.
• The expected volume of production is determined by
subtracting the estimated inventory at the beginning
of the period from the sum of units to be sold plus
desired ending inventory.
• See Example 3.4.

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 Example 3.4
• Assume that ending inventory is 10 percent of
the next quarter’s sales and that the ending
inventory for the fourth quarter is 100 units.

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 The Direct Materials Budget
• When the level of production has been computed, a direct
materials budget is constructed to show how much material
will be required and how much of it must be purchased to
meet production requirements. The purchase will depend on
both expected usage of materials and inventory levels. The
formula for computing the purchase is

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 Example 3.5
• Assume that ending inventory is 10 percent of
the next quarter's production needs; the
ending materials inventory for the fourth
quarter is 250 units; and 50 percent of each
quarter's purchases are paid in that quarter,
with the remainder being paid in the following
quarter.
• Also, 3 pounds of materials are needed per
unit of product at a cost of $2 per pound.

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Direct Materials Budget

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Schedule of Expected Cash
Disbursement

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 The Direct Labor Budget
• The production budget also provides the
starting point for the preparation of the direct
labor cost budget. The direct labor hours
necessary to meet production requirements
multiplied by the estimated hourly rate yields
the total direct labor cost.

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 Example 3.6
• EXAMPLE 3.6 Assume that 5 hours of labor are
required per unit of product and that the
hourly rate is $5.

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 The Factory Overhead Budget
• The factory overhead budget is a schedule of all
manufacturing costs other than direct materials and
direct labor.
• Using the contribution approach to budgeting requires
the development of a predetermined overhead rate for
the variable portion of the factory overhead.
• In developing the cash budget, remember that
depreciation does not entail a cash outlay and therefore
must be deducted from the total factory overhead in
computing cash disbursements for factory overhead.

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 Example 3.7
• For the following factory overhead budget, assume that:
• 1. Total factory overhead is budgeted at $6,000 per quarter plus $2 per hour of
direct labor.
• 2. Depreciation expenses are $3,250 per quarter.
• 3. All overhead costs involving cash outlays are paid in the quarter in which
they are incurred.

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 The Ending Inventory Budget
• The ending inventory budget provides the
information required for constructing
budgeted financial statements.
• First, it is useful for computing the cost of goods
sold on the budgeted income statement.
• Second, it gives the dollar value of the ending
materials and finished goods inventory that will
appear on the budgeted balance sheet.

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 EXAMPLE3.8
• For the ending inventory budget, we first need to compute the
unit variable cost for finished goods, as follows:

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 The Selling and Administrative
Expense Budget
• The selling and administrative expense budget
lists the operating expenses involved in selling
the products and in managing the business.
• EXAMPLE 3.9 The variable selling and
administrative expenses amount of $4 per unit of
sale, including commissions, shipping, and
supplies; expenses are paid in the same quarter in
which they are incurred, with the exception of
$1,200 in income tax, which is paid in the third
quarter.

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Example 3.9

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 The Cash Budget
• The cash budget is prepared in order to forecast the
firm’s future financial needs.
• It is also a tool for cash planning and control. Because
the cash budget details the expected cash receipts
and disbursements for a designated time period, it
helps avoid the problem of either having idle cash on
hand or suffering a cash shortage.
• However, if a cash shortage is experienced, the cash
budget indicates whether the shortage is temporary
or permanent, i.e., whether short-term or long-term
borrowing is needed.
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 The Cash Budget
• The cash budget typically consists of four major
sections:
1. The receipts section, which gives the beginning cash
balance, cash collections from customers, and other
receipts.
2. The disbursements section, which shows all cash payments
made, listed by purpose.
3. The cash surplus or deficit section, which simply shows the
difference between the cash receipts section and the cash
disbursements section.
4. The financing section, which provides a detailed account of
the borrowings and repayments expected during the
budget period.
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 EXAMPLE 3.10
• Assume the following:
1. The company desires to maintain a $5,OOO minimum cash
balance at the end of each quarter.
2. All borrowing and repayment must be in multiples of $500 at an
interest rate of 10 percent per annum. Interest is computed and
paid as the principal is repaid. Borrowing takes place at the
beginning and repayments at the end of each quarter.
3. The cash balance at the beginning of the first quarter is $10,000.
4. A sum of $24,300 is to be paid in the second quarter for
machinery purchases.
5. Income tax of $4,OOO is paid in the first quarter.

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EXAMPLE 3.10

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 The Budgeted Income Statement
• The budgeted income statement summarizes
the various component projections of revenue
and expenses for the budgeting period.
• For control purposes, the budget can be
divided into quarters, for example, depending
on the need.

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Example 3.11

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 The Budgeted Balance Sheet
• The budgeted balance sheet is developed by
beginning with the balance sheet for the year just
ended and adjusting it, using all the activities that are
expected to take place during the budget period.
• Some of the reasons why the budgeted balance sheet
must be prepared are:
1. To disclose any potentially unfavorable financial conditions
2. To serve as a final check on the mathematical accuracy of
all the other budgets
3. To help management perform a variety of ratio calculations
4. To highlight future resources and obligations
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Example 3.12

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Example 3.12

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Computation for 19x2

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 3.5 A Shortcut Approach To
Formulating The Budget
• Example 3.3 to 3.12 show a detailed procedure for formulating a budget.
However, in practice a shortcut approach to budgeting is quite common
and may be summarized as follows:
1. A pro forma income statement is developed using past percentage relationships
between relevant expense and cost items and the firm's sales. These
percentages are then applied to the firm's forecasted sales. This is a version of
the percent-of-sales method discussed in Section 3.2.
2. A pro forma balance sheet is estimated by determining the desired level of
certain balance sheet items, then making additional financing conform to those
desired figures. The remaining items, thus, are estimated to make the balance
sheet balance. There are two basic assumptions underlying this approach:
1. The firm's past financial condition is an accurate predictor of its future
condition.
2. The value of certain variables such as cash, inventory, and accounts receivable
can be forced to take on specified desired values.

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 3.6 Computer-based Models For Financial
Planning And Budgeting
• More and more companies are developing
computer-based quantitative models for constructing
a profit planning budget.
• The models help managerial decision makers answer
a variety of what-if questions.
• The resultant calculations provide a basis for choice
among alternatives under conditions of uncertainty.
• There are primarily two approaches to modeling the
corporate budgeting process: simulation and
optimization.

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