You are on page 1of 114

2010 CMA Part 1 Section A

Planning, Budgeting, and Forecasting

Section A Planning, Budgeting, and

This section is 30% of the Part 1 Exam
Section A is the largest part of the exam
Primary areas of review include:
Planning and budgeting concepts
Budget methodologies including types of budgets
Budgeting questions
Forecasting techniques
Learning curves
Risk, uncertainty and expected value
Sensitivity analysis
Top-Level planning and analysis

Planning and Budgeting



All companies have some form of planning:

Formal or informal
Short-term, long-term, intermediate
Production planning
Project planning

Planning is determination of what should

be done, how it should be done, when it
should be done, where it should be done
and who should do it.
Planning is done for both financial (usually
through a budget) and nonfinancial items

External Environment in Planning and


Planning does not occur in a vacuum. It must

consider external influences that will impact the
companys operations and budgets such as:
Industry: rivals, the companys competitive position
in the industry, nature of the industry, etc.
Country or international environment: domestic and
international political risk, impact of globalization
within the industry, possibility of war or
expropriation, etc.
Macro-environment: the macroeconomic and social
factors that will effect the entire industry or overall
economy such as: economic growth, levels of interest
rates, inflation or deflation, environmental protection
laws, national tax policy, etc.

Setting Goals and

The bases of the planning process are the goals
and objectives of the company. Without these,
there can be no efficient or effective planning.

The plan is established to help the company achieve

its goals and objectives.

Objectives are generally made at the

organizational level and goals at the divisional
The objectives do not need to be agreed to by
each employee, but they do need to be
accepted by everyone.
This means that even if an employee does not agree
with the plan, they still need to act in accordance with
the plan.

Characteristics of Objectives and

Objectives and goals must be:
Clearly stated,
Specific, and
Communicated to employees.

Goals and objectives are measured in respect

to their efficiency and effectiveness
Effectiveness is whether the goal was
Efficiency is whether it was reached using the
fewest resources.

Different Types of Plans

Long-term (strategic) plans five years or
more. Based on long-term objectives and tend not
to be specific or detailed. More what is to be done
rather than how it is to be done.
Made by companys top management
Looks at strategies, objectives and goals of the
company, and internal/external factors affecting the

Intermediate (tactical) plans one to five

years. Implement specific parts of the strategic
Made by upper and middle managers

Different Types of Plans


Short-term (operational) plans

less than 1-year in time. Relate
usually to production, materials
requirements, staffing, cash flows
and the income statement.
Developed by middle or low level
Primary basis for budgets
Provide the basis to develop programs,
policies and performance expectations
required to achieve the companys long-

Other Types of Plans

Single-purpose plans plans for a
specific project.
Standing-purpose plans these
plans are used multiple times for a
recurring project or effort.
Contingency planning this is
planning for disruptions to the
business. Also called disaster
recovery planning.

Planning, Budgeting and Performance

Planning, budgeting, and performance evaluation
are interrelated and inseparable. The process is:
1. Management develops the plan consisting of goals,
objectives and a proposed action plan for the future
2. The plan developed by management leads to the
formulation of the budget. The budget expresses
managements plans in quantitative terms.
3. Budgets can lead to changes in plans and strategies
because they provide feedback to the planning
process. Managers may revise their plans based on
this feedback. This back and forth exchange may occur
for several iterations before the plans and budgets are

Planning, Budgeting and Performance

Evaluation Contd
Planning, budgeting, and performance
evaluation are interrelated and inseparable. The
process is (contd):
4. Once the plans and budgets are finalized, the
company implements the plans to achieve its goals.
5. Actual results are compared to the plan. The budget
is a control tool.
6. Sometimes this control will result in the revision of
prior plans and goals or in formulation of new plans,
changes in operations and revisions to the budget.
7. Changed conditions during the year will be used in
planning for the next period.

A budget is a quantitative (numerical) expression
of the companys plans and objectives.
The Master Budget is the final, complete
budget for the upcoming time period.
However, the master budget is composed of many,
smaller budgets that are developed for departments,
divisions, and individual products.
Operating budgets are used to identify the resources that will
be needed by the individual units to carry our planned
Financial budgets identify the sources and uses of fund for the
budgeted operations

Advantages of Budgets
When properly developed and administered,
Provide coordination and communication among
organization units and activities
Provide a framework for measuring performance
Provide motivation for managers and employees to
achieve the companys plans
Promote the efficient allocation of organizational
Provide a means for controlling operations
Provide a means to check on progress toward the
organizations objectives

Characteristics of Successful
The process must start with the companys plans

both short-term plans and long-term plans.

The budget needs management support at all
The people who are responsible for delivering the
budget must have input into the development of
the budget. This gives them a sense of ownership
over the budget.
The budget should be seen as motivational.
The budget should be an accurate representation
of what is expected to occur.
The budget should be flexible to allow for changes
in the business environment during the year.

Characteristics of Successful Budgeting


The budget should be an accurate

representation of the expected future
Budgeting should not be rigid that it forces
actions to be taken without review by
appropriate management
The budget should be coordinated among all
departments and divisions in the company.
The time period included in the budget
should match the purpose of the budget.

Time Frames for Budgets

A budget is generally prepared for a set period of
time, usually one year, and it matches the company
fiscal year.
Budgets can also be prepared on a continuous basis.
This is called a rolling budget or continuous budget.
Advantages of this approach are:
Budgets are no longer done just once a year.
A budget for the next full period (usually 12 months) is
always in place.
The budget is more likely to be up-to-date, since the
addition of a new quarter or month will often lead to
revisions in the existing budget.
Managers are more likely to pay attention to budgeted
operations for the full budget period.

Who Should Prepare the

The budget should be prepared by the people
who are most knowledgeable about the different
parts of the budget.
Top management should not be involved in the
detailed production budget for each month.
Those who know how much things actually cost need
to be consulted in the development of the budget.

Participative budgeting is when the individuals

impacted by the budget are involved in the
development of the budget.
This helps them feel that the budget is able to be
The budget should also be more realistic.

Who Should Prepare the

Budget cont.
Top management still has a role in the budget
process at all levels, even if they do not prepare
the budget at all levels.
They need to set the goals and objectives that the
company is trying to achieve in the upcoming period.
And they need to communicate these objectives to
everyone in the organization.

They need to ensure that all of the individual budgets

are working towards that common objective and goal.
They need to provide support and information so that
people have the needed information to budget.

The Budget Development

The process for developing the budget is:
1. An appropriate authority, such as senior management
or a budget committee, set and communicate budget
2. Initial budget proposals are prepared by responsibility
3. Company managers, at all levels from responsibility
center managers to the CEO, negotiate, review and
approve the budget for submission to the board of
4. Revisions: after the budget is finally adopted, it should
be able to be changed if the assumptions upon which
it was built change significantly.

The Budget Development

Process Contd
The process for developing the
budget are (contd):
5. Actual results should be compared to
the budget. This variance reporting is
done at all levels of the company.
6. Variance reports should be used at
every level of the company to identify
problem areas and to make
adjustments to operations.

Best Practice Guidelines for the Budget

Best practice guidelines for the budgeting process
include the following:
Link development of the budget to corporate strategy
Communication is vital
Design procedures to allocate resources strategically
Managers should be evaluated on performance
measures other than meeting budget targets
Cost management efforts should be linked to budgeting
Strategic use of variance analysis
Reduce budget complexity and budget cycle time
Develop budgets that can be revised if necessary
Review the budget regularly during the year

Budgetary Slack and Goal Congruence

Goal congruence is defined as aligning the
goals of two or more groups. As used in
planning and budgeting, it refers to the
aligning of goals of the individual managers
with the goals of the organization as a whole.
Budgetary slack is the difference between the
budgeted performance and the performance
that is actually expected. It is the practice of
underestimating budgeted revenues and
overestimating budgeted costs to make the
overall budgeted profit more achievable.

Budgetary Slack and Goal Congruence


Managers who develop the budgets they are

going to be accountable to meet may build
budgetary slack into their budgets in order to
make sure their budgets are achievable without
any risk of failure.
Budget slack has advantages and disadvantages:
On the positive side, it can provide managers with a
cushion against unforeseen circumstances. This can
limit their exposure to uncertainty and reduce their
risk aversion.
On the negative side, it misrepresents the true profit
potential of the company and can lead to inefficient
resource allocation and poor coordination of activities
within the company.

Standard Costs and Setting Standard

Standard costs are the expected cost for labor,
materials, or overhead to produce one unit of
product (how much it should cost to produce)
To calculate the standard cost, the company
needs to know the expected level of
production and usage of the different inputs.
There are a number of ways to calculate this:
Activity analysis
Historical data
Target costing
Strategic decisions

Standard Setting Process

As with the budget, the standards need to be
set by the correct people.
Authoritative standard setting standards
are set from above.
Employees do not feel ownership or a
commitment to these standards because they
may see them as unrealistic.

Participative standard setting employees

are involved in the standard setting process.
More support from the employees and a greater
commitment to meet the standards because they
were part of setting them.

Direct Materials Standards

The standard amount and cost of material that is
used in the production of one unit is impacted by:
Quality the higher the quality of material, the more it will
cost. Lower quality materials may cost less but may require
more materials, as there may be more materials that do
not meet the required quality standards.
Quantity the amount needed for production will depend
on how much is needed for each unit (for example, how
thick should the covering be) and how many units are to be
Price obviously the price of the input purchased will
impact the standard cost. This is also connected to the
quantity purchased (discounts) and quality of what is

Establishing Direct Labor

As with materials, the standard cost
for labor will depend on:
Quantity of labor this is also
connected to the question of the cost of
labor vs. the cost of capital.
Price of labor the more skilled
(experienced) the labor the more costly
it is. However, more skilled labor may be
able to complete the job more quickly or
at a higher quality.

Establishing Overhead
Overhead standards are generally based on
normal operating conditions, normal volume, and
desired efficiency. The total overhead costs come
from the budgeted factory overhead costs.
These are
divided by a predetermined level
of activity to calculate a standard overhead rate.
In relation to the allocation rate, the company
must decide what activity to use for its budgeted
amount of the activity level.
The traditional method uses machine hours or direct
labor hours

Establishing Overhead
Standards Contd
The allocation rate is established for the full year.
The budgeted overhead rate for the year
multiplied by each months budgeted activity level
will be used to calculate the monthly budgeted
In general, a company has four choices to
determine the output level. Two relate to what the
plant can supply; and two relate to the demand for
the plants output. These are called denominatorlevel capacity concepts, because they describe the
denominators that can be used in the calculation
of per unit overhead costs.

Denominator Level
Supply Denominator
Level Concepts

Theoretical or ideal capacity the level of activity

if the company produces at its maximum level with no
idle time or downtime and no decreases in sales
Practical (currently attainable) capacity
theoretical level reduced by allowances for idle time
and downtime but not for a decrease in sales demand.

Demand Denominator Level Concepts

Master budget capacity utilization the amount of
output expected based on expected demand
Normal capacity utilization the level of activity
achieved in the long run, accounting for seasonal and
cyclical changes in sales demand. This is the
preferable method.

Budget Methodologies

The Annual/Master Budget

The development of an annual budget for a
large corporation may take many months to
Important concepts for the budgeting process are:
One of the most important things in the process of
developing the budget is involving all of the correct people
(participative budgeting)
bottom-up budgeting: the budget is developed by starting at
the lowest levels in the operations systems and building
revenues and costs from there.
A budget manual details the budget process.
A planning calendar is the document that sets forth all of the
deadlines, policies and procedures of the budgeting process.

The Different Budgets

There are a number of budgets that
will need to be prepared. Some of
them need to be prepared in a
specific order.
This is because some of the budgets
build on each other.
The sales budget is the first budget
The cash budget is the last budget

The Sales Budget

This is the budget that must be completed first.
Everything else the company will do during the
year is based on how many units they expect to
This is also the hardest budget to do, because
it based on the decisions and factors not
controlled by the company:
The economy

The Production Budget

After the sales budget is completed, the
company can prepare the production budget.
This budget is based on:
The expected level of sales,
Whether the company wants to change the level
of inventory,
Any decisions about outsourcing production (if the
company will buy finished products or parts from
an external supplier).

This budget also needs to include when

during the year the units will be produced.

The Next Budgets

Once the production budget is set, the
company can create a number of other budgets
that are based on the level of production:
Direct materials budget
Labor budget
Overhead budget
Ending inventory budget
Cost of goods sold budget

These are all interrelated so a change in one of

these budgets will likely cause a change in

Following Budgets
There are also a lot of other budgets
that need to be prepared
Selling and marketing budget,
General and administrative budget,
Accounting and finance budget,
Research and development budget, and
Any budget for other type of revenue or
expense that the company has during
the budgeted period.

The Cash Budget

The cash budget is the last budget
prepared because all other budgets go
into this budget.
This budget will be prepared on a monthly
By preparing it on a monthly basis the
company can identify any future cash
shortages before they happen.
Better planning for cash shortages will make
the cost of borrowing lower.

Operating and Financial

The operating budget is the budgeted income
statement and its supporting budget schedules.
It is made up of all the revenue budget and the production,
purchasing, marketing, and research & development

The financial budget is the budgeted balance sheet

and statement of cash flows, cash budget and capital
These budgets are what the companys financial
statements will look like next year if reality exactly
matched the budgeted amounts.
By looking at them now, the company can see what the
ratios will be like, and if they would be in violation of any
covenants or loan agreements.

The Capital Budget

This is the budget for large, capital expenditures
(property, plant and equipment).
Because these are large expenditures, the capital
budget is often prepared years in advance.
The company will need to plan for the financing of
these purchases.

This budget is often prepared outside of the

budgeting process that we have discussed
leading to the forecasted financial statements.
Top management is very heavily involved in this
budget because it is connected to their long-term

The Master Budget

The individual budgets that make up
the operating and financial budgets
together make up the master
The master budget is a summary of
managements operating and
financial plans for the period,
expressed as a set of financial

Flexible Budgeting
Flexible budgeting is the process of producing
budgets for different levels of activity.
This makes the evaluation process better and
more useful.
The master budget is a static budget. It is
produced for one level of activity, and if actual sales
are different, it is not as useful to make actual vs.
budget comparisons.
Flexible budgeting allows better comparisons
because there is a budget for what income should
have been at the level of sales that actually occurred.

A flexible budget requires standard costs to be


Other Types of Budgets

Project Budget
A project budget is a budget for a specific project.
As such, the time frame of the budget may be very
short or more long-term, depending upon the
length of the project.
Project budgets are different from the master
budget and the flexible budget.
The master budget or the flexible budget covers a
distinct time span. In contrast, a project budget covers
an identifiable project that has its own time span.

Projects must be planned over their entire life

spans and should be viewed as special

Life-Cycle Budgeting
This is a budget not for a specific time
period, but for a specific product.
It traces all of the costs and revenues from
the design of the product, through
production and includes after sale costs
that the company will incur.
This provides a more accurate pricing for
the product because the design, preproduction and post-production costs also
need to be covered by the selling price.

Activity-Based Budgeting
Activity-based budgets are prepared based on the
resource consumption and related costs to
perform the budgeted activities.
Activities that drive the costs are identified
A budgeted level of activity for each of these drivers is
determined based on a budgeted level of production
Budgets are developed based on budgeted activity

In an activity-based budget system, there is a

clear relationship between resource consumption
and output. Preparing an activity-based budget
brings out information about opportunities for cost
reductions and elimination of wasteful activities.

Zero-Based Budgeting
This system starts each year with a blank page,
and all items are created new for the year.
In incremental budgeting, the prior periods budget
is just increased by 10%, or some determined amount.

All revenues need to be planned for each year.

All expenses need to be accounted for and
By looking at every expense each year, management
should be able to eliminate non-value adding expenses
and try to find cheaper alternatives.

Budget Reports and the Control

The budget report is the comparison between the
budgeted amount and the actual result. (This is
also variance analysis and is covered in more
detail in that material).
The steps in the control loop are:
Establish the budget, or standard,
Measure the actual performance,
Analyze and compare actual results with the budget,
Investigate unexpected variances,
Devise and implement needed corrective actions,
Review and revise the standards as needed.

Budgeting Questions

Budgeting Question
In this topic, there are three common
categories of numerical questions
that are asked. If you are
comfortable with what these
questions as and the formula or
concept behind it, these questions
will be easy.
These categories of questions are
looked at on the following slides.

Flexible Budget Question

In this question, the question will ask What
would the flexible budget have been?
You will generally be given the master budget at
a specific level of output and the actual level of
output will be different.
You need to determine what income (or whatever
is asked) should have been according to the
flexible budget.
Remember that the variable cost per unit does not
change as the level of production changes, and
That the total fixed cost does not change as production
level increases.

How Many Units to Purchase or

In this question you need to answer how many
units the company must purchase or produce in
order to have enough inventory for the
expected level of sales and the required ending
inventory balance.
The units can come from one of two places:
1. Beginning inventory (which will be given), or
2. Purchased or produced (what is being asked)

Units will be needed for two purposes:

1. The sales or production for the period, and
2. The desired ending inventory balance.

How Many Units Formula

The formula to solve this type of question is:
Units needed for the current period
+ Units needed for ending inventory
= Total number of Units needed
Units in beginning inventory
= Units needed to be purchased or produced
This formula works for both units purchased
(finished goods) and units produced (a production

Cash Collected or Paid

In this question they give you a series of
information about when credit sales are
collected and when payments are made and
about bad debts.
These questions are not mathematically
difficult, but require you to read the question
carefully to determine when the monies are
collected and paid.
We recommend that you structure your answer in a
table format with a column for each month. By
recording what is sold, collected, paid (whatever is
asked for) in a table, it makes it very easy to
calculate the answer to the question.

Forecasting Techniques

This is the attempt to determine what
the future result will be.
Usually uses some sort of
mathematical model or formula.
The prediction is only as good as the
models representation of reality

Two basic methods of Forecasting

Time Series Analysis
Causal Forecasting

Time Series Analysis

In time series analysis we are
looking at patterns over time. There
are four patterns:


Trend Pattern
This is a gradual shifting to a higher or lower
level over time. It may not be constant and
consistent, but over time the trend is visible.

Cyclical Pattern

Any fluctuation that recurs over a period of

more than one year is a cyclical fluctuation.
This cycle is usually due to the cycles of the

Seasonal Pattern
This is like the cyclical pattern, but
the fluctuations are due to the
seasons of the year, rather than the
business cycle.
These fluctuations usually occur
within a one year time period.
If they occur within one day, such as a
business that has its busiest time of the
day at the same time each day, it is
called a within-the-day seasonal

Irregular Pattern
If the pattern is not repeating, it is
called a random pattern.
Because of the randomness of the
fluctuations, it is difficult to use
historical results to predict future

Using Time Series Analysis

There are two main ways in which
the information over time may be
used to predict future results:
1. Smoothing
2. Trend projection

Attempts to eliminate the random
fluctuations that occur over time
Works well when there is no
significant trend, cyclical or
seasonal effect
Does not work well when there are
long-term trends (upwards or
downwards) or cycles



Three methods of smoothing are:

Moving average the most recent data for a
certain number of periods is used, and each period
is given the same weight in the calculation
Weighted moving average the most recent
data for a certain number of periods is used, but
the data from more recent periods is given more
weight in the calculation.
Exponential smoothing the next periods
expected value is calculated using the last periods
expected value (as forecasted using exponential
smoothing) and the last periods actual value.

Exponential Smoothing
Uses two values:
1. The last periods expected value, as calculated using
exponential smoothing
2. The last periods actual value

These two values are averaged together using a

determined weighting
The last periods actual value is given a weight of
alpha ()
. This is between 0 and 1 (usually it is between 0 and .4)
. This is also called the smoothing constant

The last periods expected value will be given a

weight of 1-

The Smoothing Constant

If is given a value of 1, the projection will be
based only on the actual result of the last period
If is given a value of 0, the projection will be
based only on the projected result of the last
When values fluctuate greatly, we want to use a
lower value for
The accuracy of this process is measured by the
error, called the Mean Squared Error. We want
an that will minimize this error.

Trend Projection

When a time series is increasing or decreasing

consistently, smoothing will not work
In this case we use trend projection.
Trend projection is done by means of simple
regression analysis
Simple regression analysis makes two
Variations in the value we are forecasting (the
dependent variable) are a result of changes in the
other variable (the independent variable) - i.e., the
passage of time, if a time series
The relationship between the value we are
forecasting and the other, independent, variable is

Simple Regression Analysis

This process determines the line of best fit through
the values over time. This line minimizes the total
differences between the line and the actual values
for each period.
Before doing this, we need to make sure that the
value we are forecasting and the other, independent, variable are truly related to each other
This is done through correlation analysis, and the
correlation coefficient (represented by R or r)

+1 means a perfect positive relationship

1 means a perfect negative relationship
0 means no relationship, so trend analysis would not be

Other Measures
The standard error of the estimate
measures the range within which the
expected result will fall, with a certain level
of confidence
The coefficient of determination (r2)
measures the percentage of the change in
the dependent variable that is explained by
changes in the independent variable
You do not need to be able to calculate
these, but you need to know what they are.

Inflation Adjustments in Time

Over time, dollar values may increase
simply because of inflation. In looking at
future projections, we need to know how
much of past increases were a result of an
increase in quantity and how much were a
result of inflation.
Nominal dollars are measured in current
year dollars
Real dollars are measured in a base year
dollars and have had inflation taken out.

Converting Nominal to Real

Any conversion needs to use some sort of price
index or other measure of inflation
Real Value =
Nominal Value
Current Year Index / Previous Years Index
Nominal Value
1 + Inflation Rate

Causal Forecasting
This is used when we know that the value we
are calculating is affected by another variable;
for instance, the level of sales is affected by
the level of advertising expenditures.
If there is a cause and effect and a linear
relationship, we can use projection.
In simple linear regression, there is only
one independent variable (the cause)
In multiple linear regression, there is more
than one independent variable.

Regression Analysis Formula

The formula that is used in regression analysis to
calculate y (the expected value), for a given value
of x (the independent variable) is:
y = ax + b +
Where y = the dependent variable (the expected value)
a = the slope of the line (called the variable coefficient)
b = the y-intercept of the line, or the value of y when x =
0 (called the constant coefficient)
x = the independent variable
= the error term (the distance between the regression
line and an actual data point)

Regression Analysis
The model makes the following assumptions:
The relationship between x and y is linear,
The error term has a value close to 0 and is normally
The variance of the error term is constant,
Errors in different samples are not related to each other,
The independent variable is not related to the error

The error term is included because there is always

scope that a measurement was made incorrectly
and there is always some amount of randomness.

Benefits of Regression
The benefits of regression analysis
It is numerical and quantitative this
makes conclusions easier to draw
It may be used to forecast the fixed and
variable portions of costs that contain
both fixed and variable components.
Thus, it can be used in budgeting.

Limitations of Regression
The limitations of regression analysis are:
Historical data is required if there is no data,
regression analysis cant be used
If there have been changes in the environment or
situation since the data was collected, it will not
If the independent variable chosen is not
appropriate (i.e., there is a low correlation between
the independent variable and the dependent
variable), the resulting forecast may be invalid
The conclusions are valid only for the range covered

Learning Curves

Learning Curves
Learning curves are used to describe the fact that
people are able to accomplish a repetitive task
more quickly the more they do it
For example, if something takes 1 hour to do the
first time, and only 40 minutes to the second time,
there has been a learning curve
There are two learning curve models:
Cumulative average time learning model
Incremental unit time learning model

Learning curves are used in many different types

of decisions, such as calculating the cost of a job.

Cumulative Average Time Learning Model

The average time per unit for all units
produced decreases by some percentage
every time production doubles
If the learning curve is 70% and 2 units take 4
hours, it will take 70% of twice that amount of
time (5.6 hours) to make 4 units (4 2 .70).
For 4 units, it takes on average 1.4 hours (5.6 4)
to make 1 unit, which is 70% of the average time
required per unit to produce half as many units.

In order to produce 8 units, it will take in total

7.84 hours (5.6 2 .70).
This is an average time of .98 hours per unit,
which is 70% of the average time per unit for half
as many units.

Cumulative Average Time Learning Model


The formula to calculate the total amount of time

required for the total number of units is as follows:
Initial time * (2 * LC) * (2 * LC) * (2 * LC)
Initial time is the amount of time required for the first
lot, first batch or first unit
LC = the learning curve percentage (as a decimal)

Another * (2 * LC) is added to the multiplication

each time that the production quantity doubles.

Incremental Unit Time

Learning Model
In this model, the amount of time needed to
produce the last unit decreases by the learning
curve per-centage each time the production
quantity doubles, so each unit produced takes less
time than the last.
Without a financial calculator, it is possible to
calculate only the amount of time that will be
required to produce the last unit of each group of
doubled units (the 2nd, 4th, 7th, 16th, etc. units). It is
not possible to calculate the total number of
hours required to produce all the units.
The amount of time required for the last unit is:
Initial time * LC * LC * LC . . .

Benefits of Learning Curves

Decisions such as the following can be aided by

learning curve analysis:
Make or buy decisions analysis of the cost to make
In calculating the cost of a contract over its life,
learning curve analysis can lead to better bidding.
In determining a breakeven point, if learning is not
considered, the result may be overstatement of the
number of units required to break even.
Standard costs can be adjusted regularly to recognize
the fact that learning causes labor costs to decrease.
In capital budgeting, labor costs can be projected more
accurately over the life of the capital investment.
Production and labor budgets can be adjusted to
accommodate learning curves.
More effective evaluation of managers.

Limitations of Learning
It is only applicable in a situation in which
experience leads to improvement (labor
intensive tasks)
We assume that the learning curve rate is
constant, when in reality it probably is not
We assume that all increases in
productivity are due to the learning
process, when there may be other factors
causing the productivity increase


The probability of an event happening is the
chance that it will happen.
The probability of a single event happening
must be between 0 (no chance of it occurring)
and 1 (it is certain to occur)
There are two basic requirements of
The probability values assigned to each of the
possible outcomes must be between 0 and 1
The probable values assigned to all of the possible
outcomes must total 1

Conditional Probability
The conditional probability is the
probability of an event (Event B)
occurring, given that (assuming
that) another event (Event A) has
already occurred
It is shown as P(B|A), read as the
probability of B given A

Joint Probability
Joint probability is the probability of one or more
events all occurring one after another.
It is calculated as the probability of each
individual event multiplied together.
If the occurrence or nonoccurrence of one event
does not change the probability of the
occurrence of the other event, the two events
are said to be independent.
If the occurrence of one event means that
another event cannot occur, the two events are
said to be mutually exclusive.

Conditional and Joint

The probability of sales being $1,000,000 in Year 1 is
Assuming that sales are $1,000,000 in Year 1, there
is a 40% probability that sales will be $1,500,000 in
Year 2.
The Conditional Probability that sales will be
$1,500,000 in Year 2, assuming that they are
$1,000,000 in Year 1, is 40%.
The Joint Probability that sales will be $1,000,000 in
Year 1 and $1,500,000 in Year 2 is (30% * 40%), or

Methods of Assigning
There are three main ways of determining the
probability of an event:
Classical method each outcome has an equal
chance of occurring.
Relative frequency method this method may be
used when there is factual information from which the
frequency can be determined, such as past
information or a sample (also called Objective Method)
Subjective method this is used when there is no
past information or sample to use and the decision
maker simply assigns probabilities as they seem

Discrete and Continuous Random

A random variable is a variable that can have any
value within a range of values that occurs
randomly and can be described using probabilities.
Discrete random variables are variables that must
have a whole number value (for example, 1, 7 or
193). These variables may not be shown as a
continuous line.
Continuous random variables may have any value,
whole or fractional. As such, 17.392 is a possible
result for a continuous random variable, but not for
a discrete variable.

Expected Value
In expected value we are trying to determine
what the expected result will be in a situation
of uncertainty.
This is done by multiplying each of the possible
outcomes by the likelihood (probability) of that
outcome occurring. All of the results are then
added together to determine the expected
The expected value is a weighted average of
all the possible values, weighted according
to their probabilities.

Variance and Standard

The variance and standard deviation both
give us an idea of the variability of the

possible values in a probability distribution.

The variance is the sum of the squares of all
the differences or deviations from the
mean (average), weighted according to their
probabilities. (The variances are squared to
eliminate negative values.)
The standard deviation is the positive square
root of the variance. Because it is the square
root of the variance and the variance contains
squared numbers, the standard deviation is
measured in the same units as the values.

The Normal Distribution

In a normal distribution, the results are

distributed around the mean (average) in a
bell shaped curve
The curve may be tall and narrow or short
and flat or anything in between
The standard deviation is a measure of the
dispersion of the values.
A high standard deviation means that the
results are highly variable and a low
standard deviation means the results do
not vary much.

The Distribution of Expected Results

In a normal distribution
68% of the expected values will be
within one standard deviation of the
95% of the expected values will be
within two standard deviations of the
99.7 of the expected values will be
within three standard deviations of the

Risk, Uncertainty and Expected


Risk and Uncertainty

Risk is a situation in which there is a chance
of the result being different from the
expected outcome it exists when we are
not 100% certain of the result.
Risk is measured using the variance and the
standard deviation

Uncertainty is risk that cannot be measured.

It exists when we have no way of determining
what the expected result is using historical
information or other data. The probability
distribution must be determined subjectively.

The Coefficient of Variation

The coefficient of variation measures the
risk for each unit of expected return.
It is calculated as follows:
Standard Deviation
Expected Return
The higher the coefficient of variation,
the riskier the investment.

The Mean, Median, and Mode

Measures of central tendency are
values typical of a set of data.
The mean is the average of a set of
The median is the halfway value if raw
data is arranged in numerical order
from lowest to highest.
The mode is the most frequently
occurring value. If all values are unique
(different from each other), no mode

Sensitivity Analysis
In sensitivity analysis the company is trying to
determine which variables influence the end result
the most.
By running the model with different variables, the
company can identify the variables whose
fluctuations cause the greatest change in the
fluctuation of the result.
Sensitivity analysis can be used with linear
programming to see how the optimal solution to
the objective function will change if a coefficient in
the objective function or if the right-hand value of
one of the constraint functions is changed.

Top-Level Planning and


Pro-forma Financial
Pro-forma financial statements contain
projected amounts that are expected if a
particular course of action is followed.
see what the financial statements of the firm will
look like if something that is under consideration or
forecasted actually happens.
evaluate the effect on the companys finances if a
particular sales forecast is realized
Used to perform other what if scenarios
They include a pro forma income statement, a pro
forma statement of financial position (balance sheet)
and a pro forma cash flow statement.

Pro forma Financial

Statements contd
Pro forma financial statements are used internally
for five general purposes:
1. compare the companys anticipated performance with its
target performance and with investor expectations.
2. To perform what if analysis, to forecast the effect of a
proposed change.
3. determine in advance what the companys future
financing needs will be.
4. To prepare various cash flow projections using different
assumptions in order to forecast the various capital
requirements to maximize shareholder value.
5. determine if the company will remain in compliance with
the required covenants on its long-term debt

Forecasting for Planning

Various approaches to financial forecasting are
used, depending upon the situation. The three
primary approaches used are:
Experience Because sales, expenses or earnings have
grown at a particular rate in the past, we assume they
will continue growing at that rate in the future. This
leads to trend projections.
Probability We assume something will happen in the
future because the laws of probability indicate it will.
Correlation Because there has been a high correlation
in the past between one factor and another factor, we
use what we know about the first factor to forecast the
second factor.

Sales Forecasting

Forecasting sales based upon historical sales

information has limited value.
Historical sales growth rates need to be
adjusted for any known factors that will affect
future sales. Future sales depend upon many
events that occur in the future. Examples
State of domestic and international economy
Growth prospects for the market in which the
company operates
The companys product line
The companys marketing effort

Sales Forecasting


An accurate sales forecast is critical to avoid

negative business issues:
if the companys market expands more than the
company expects it to, the company will not be able
to meet the added demand and will lose customers to
its competitors
If the forecasted sales are too high, then the company
could end up with excess capacity and inventory

Management needs to use its best judgment

about the future along with historical information
and not simply rely on a forecast made using
regression analysis or any of the other
forecasting techniques

Forecasting Future Financing Needs

An increase in company sales means the

company will need additional funds:

More inventory will be needed

Accounts receivable increase in proportion to sales
Company may need new production equipment

There are three sources for funding this

expected asset increase:
1. Spontaneous liability increase (whereby accrued
liabilities increase because of increased activity)
2. Profits from the additional sales
3. External sources such as borrowing or the issuance
of securities

Forecasting Future Financing Needs


The amount of external financing that

will be required depends upon several
Companys rate of sales growth
Companys capital intensity ratio (amount
of assets required per dollar of sales)
Companys spontaneous liabilities-to-sales
Companys net profit margin
Companys retention ratio
Planned changes in policies and procedures
(management decisions)

Forecasting Future Financing Needs


Short-term cash forecasting covers periods of

about 30 days in the future and is based on
actual data (i.e. expected receipts from actual
accounts receivable etc.) rather than on
projected data.
Medium-term forecasting covers periods up to
one year in the future. Long-term forecasting
covers multiple years.
The Forecasted Financial Statement method is
a method of forecasting the additional funds
needed that is well suited to medium- and
long-term use. It is not the only method, but it
is the most flexible method and the one

Forecasted Financial Statement Method

The forecasted financial statement method
(FFS) is an approach to forecasting future
financing needs.
The key points regarding this approach are:
It requires a company to forecast a complete set of
financial statements including the income
statement, balance sheet, and statement of cash
All the sources of financing are forecasted including
existing debt and equity
The difference between forecasted total assets,
liabilities and equity is the additional funds needed
(a plug on the balance sheet)

Forecasted Financial Statement Method


The FFS method produces a forecast of the

entire balance sheet and income statement.
The pro forma balance sheet and income
statement can then be used to create the pro
forma statement of cash flows.
The steps in forecasting using the FFS method
1. Analyze historical ratio such as cash to sales,
inventory to sales, accounts payables to sales,
2. Forecast the income statement
3. Forecast the balance sheet
4. Construct a pro forma statement of cash flows

Analysis of Pro Forma Financial Statements

Developing the financial forecast alone is not
meaningful unless it is also analyzed to
determine whether the firms forecasted
financial situation meets the firms targets.
If not, the changes will be need to both the forecast
and the operating plans that led to the forecast
The pro forma financial statements will need to be
Part of the analysis is an analysis of financial ratios.
Ratio analysis is used to compare the firms actual
ratios and projected ratios with target ratios as well as
the latest industry average ratios.

Analysis of Pro Forma Financial Statements


The primary financial ratios to use for financial

analysis of forecasted financial statements include:
Current ratio = total current assets/total current assets
Inventory turnover = annual cost of sales/inventory
Days sales in inventory = 365 / inventory turnover OR
average inventory / (cost of
goods sold/365)
Accounts receivable turnover = annual credit sales /
accounts receivable
Days sales in receivables = 365 / accounts receivable
turnover OR average
accounts receivable /(annual
credit sales / 365)

Analysis of Pro Forma Financial Statements


The primary financial ratios to use for financial

analysis of forecasted financial statements include
Interest coverage ratio = EBIT / interest expense
Asset turnover = net sales / total assets
Debt to equity ratio = total liabilities / total equity
Gross profit margin = gross profit / net sales
Net profit margin = net income1 / net sales
Return on assets = net income1 / total assets
Return on equity = net income1 / total equity

Net income = Net income before preferred dividends