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Planning, Budgeting & Forecasting - I CMA Part I

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Agenda

Budgeting Concepts

Forecasting Techniques

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Budgeting Concepts

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Content

I. Budgeting

II. Budget Cycles

III. Benefit of Budgeting

IV. Economic Considerations in the Budgeting Process

V. Operations & Performance Goal

VI. Components of a Master Budget

VII. Successful Budgeting – Characteristics

VIII. Successful Budget process – Characteristics

• Budget Period

• Budget Process

• Budget Participants

• Budgeting Steps

• Cost Standards

• Types of Standard Costs

• Standard Cost for Material & Labour

• Sources for Standard Setting

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Planning: Determining the future course of action for a firm to achieve desired goals;

Budget:

• Operational Plan for a specified period; • Set specific performance goals wrt Turnover, Profits, Cash-flows etc; • Acts as a control tool in case of substantial variation;

Budgeting: • Critical for Planning; • Allocation of company’s resources in line with its strategy; • Includes end to end budget preparation process;

Budgetary Control:

• Ensures achievement of budget; • Systematic budget approval process before finalization; • Analyzing variances and providing feedback to respective department;

Proforma Statement: Budgeted financial statement based on historical performance adjusted for extra-ordinary events;

Difference between Forecast & Budget: Unlike budgets, forecasts have lower accountability and are not evaluated against variances

Budgeting

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Budget Cycle

5

Create Master Budget and sub-budgets for each

Dept/sub-unit

1

Approval from Unit heads and

Company Management

before finalization

2

Take corrective steps where

possible 5

Examine reasons for variations for

each sub-unit 4

Evaluate actual performance

against Budgeted on monthly/qtrly

basis

3 Collect feedback and revisit the

budget if required 6

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Planning: • Visibility of Growth, Income, Profits, Cash-flows;

• Input of new ideas and different view-points from various units;

• Framework to achieve overall goals;

• Pro-active approach;

Promotes Communication & Coordination:

• Increases communication amongst different units on their plans and needs; Eg: Production, Marketing, HR and Finance divisions should work closely and communicate their plans during the budget period. This helps in a coordinated effort towards achieving common goals.

• Coordinated activities to attain budgeted goals; Eg: For a new product, production dept. should know raw material requirements; HR department should know additional staff required and marketing division should know sales target and funds available for advertising

• Company-wide communication of goals: helps in achieving common goals

Budgeting- Benefits

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Monitoring:

• Acts as a benchmark to monitor actual performance vis-à-vis the goals;

• Evaluation of each unit’s performance even though overall budget is on track;

• Timely action can be taken to address negative variances;

• Exploit business opportunities in case of positive variances;

Evaluation: • Easy to delegate responsibilities;

• Evaluation of Managers/Unit Heads performance;

• Motivates employees to achieve their targets by rewarding them for good performance (appraisals, bonus etc.)

Budgeting- Benefits

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Economic Considerations in the Budgeting Process

Budgeting

Macro-economic Condition

Industry Situations

Competition &

Market Trend

Strategy &

Business-Plan

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Master Budget is a business plan for controlling an organization’s operations for a specified period of time. Sets quantitative goals for all dept./Units

Based on long and short term plans, long and short term budgets are prepared.

Based on strategy, long term action-plan is chalked out eg: raising capital, discontinuing a product line, resource allocation to new line of business etc. Involve capital budgeting exercise

9

Long & Short Term Plans

Long & Short Term Budgets

Master Budget & its Components

Operations & Performance Goal

Identify the strengths, weaknesses, opportunities and threats; Develop a strategy to match company’s strength to market opportunities.

Strategic Analysis: (Objectives, Potential Markets,

Competitors, Economy)

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Characteristics of Successful Budgeting

Should be in sync with the corporate strategy and organization goals.

Budget process should be kept separate but should reflect company’s long term strategic goals and forecasts.

Helps in identifying bottlenecks and resolving them. Also helps in routing of resources towards more efficient and effective operations.

Should be based on technically correct and factual information and should have reasonably accurate projections.

Unit Heads as well as Senior Management must approve the budget and accept full responsibility to achieve the budgeted projections.

Should motivate the employees to work hard to achieve the targets and not exert unnecessary pressure.

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Characteristics of Successful Budgeting

Should be detailed so that the key assumptions can be understood.

Budget should be finalized post a thorough review and diligence.

Act as an internal control device to keep a check on controllable or discretionary costs.

Final Budget should not be easy to change but should be flexible to revisit assumptions.

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Components of a Master Budget

12

Operating Budget Financial Budget

• Identifies and procures resources required for operations

• Eg: Production Budget, Purchasing

Budget, Sales Promotion Budget, Staffing Budget

• Matches sources and uses of funds to achieve organization’s goals

• Eg: Company wants to expand its business, launch new products and expand capacity. Financial Budget will look into the potential sources to raise capital to fund such investment

• Capital Budget: Helps in planning resource allocation to support investment with long term implications

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Example

13

Strategy of a FMCG company - to be a market leader in skin care

Long term objective - to have a significant market share in rural areas

Long term plan - to develop strong sales and distribution network in rural areas

Short term objective - to add sales force to increase its reach

Master Budget shall account for the funding requirements for the additional resources post cost-benefit analysis

Human Resource team shall recruit the resources

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Successful Budget Process

Budget Period: • Usually a financial/fiscal year (1 year), further segregated into monthly and quarterly budget;

• Sometimes prepared for shorter (3 or 6 months) or longer term (3, 5 and 10 years);

• Management to decide the suitable term based on company needs;

• Budgeting for fiscal year is preferred due to ease of comparing budgets with the financial statements;

• Continuous (Rolling or Perpetual) Budget: A continuous budget is for a particular period (month, quarter or year) and as each budget period ends, budget for a similar term is added, thereby making it a 12 month budget at any given time.

Budget Process:

• Budget preparation method varies from company to company but fall between the two extremes, entirely authoritative or entirely participative;

• Authoritative Budget (Top-Down): Highly centralised. Top management sets overall and unit level budgeted targets in line with the Company’s strategy and expect Unit managers and employees to follow these budgets.

• Participative Budget (Bottom-up or Self-imposed): Unit heads and other key employees set budgets for their respective departments, subject to the final approval of top management.

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Combination Approach to prepare Budget: Most Preferred approach • Budget participants (Unit/Dept Heads and key employees) are identified;

• Top management communicates strategic directions to all participants;

• Draft budget is prepared by participants and submitted to the next managerial level for their perusal;

• Budget goes through multiple iterations between various levels of management;

• Post review and approval at every level, budget is finalized;

Successful Budget Process

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Comparison of Various Budgeting Approaches

Parameters Authoritative Approach Combination Approach

Participative Approach

Communication Flow

Top-down (Top management finalizes the budget and communicates to Dept heads to follow)

2-way (Top to Bottom for strategic goals; Bottom to top for budget)

Bottom-up (Lower level management share their perspective of product, industry, competitors etc.) with top management)

Strategic Goals Focal-point of budgeting Strategic targets are aligned with the dept level budgets

Strategic goals do not receive any weightage

Employees Resentful and unmotivated Wide level acceptance and personal commitment

Involved and empowered

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Comparison of Various Budgeting Approaches

Parameters Authoritative Approach Combination Approach

Participative Approach

Budget Type Budget may not be strictly followed at lower levels

Tight budget due to review and multiple iterations at various levels

Slack budget due to easy approvals

Control Better control over decisions

Longer process; Control retained and expertise gained;

Informed budget decisions

Suitability Could work in small or slowly changing environments

Best Approach for most companies; Provides balance between strategic and tactical inputs

Best where divisional managers have the best information and expertise

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Budget Participants

1. Board of Directors:

• Reviews and approves the budget;

• Appoints members of the budget committee;

2. Top Management:

• Responsible for the budget preparation;

• Communicates strategic goals and budget guidelines to every unit/dept.

• Ensures every unit understands the importance of budgeting function and supports the budget;

• Top management should endorse the budget for other depts to follow;

• Should reward employees for making accurate budgets, thereby avoiding creative budgeting risk;

• Budget Slack (Form of creative accounting): The variance between budgeted and actual performance is because managers have built-in some buffer to deal with the unexpected. Slackness at various unit levels can lead to a highly inaccurate master budget;

3. Budget Committee:

• Usually formed by large corporations;

• Composed of senior management;

• Led by a CEO or a VP;

• Supervises the budget process (Preparation, Review, Approval, Monitoring, Comparison with actuals. Revision if required);

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Budget Participants

4. Middle & Lower Management:

• Involve in Unit/Dept. level budget preparation;

• Based on the broad guidelines provided by the top management or budget committee;

• Guidelines could be in respect of preparation methods, layouts Reviews and new events;

5. Budget Coordinator: coordinates between various units for preparation of budget. Also identifies and resolve discrepancies.

6. Process Experts:

• Preparation of budget, using participative or combination approach, considers inputs from lot of non-managerial employees.

• Such employees are called Process Experts since they understand the costs for a specific area, which can be extremely complex.

• Wider participation while formulating budget helps in accounting for granular details and employees take ownership of the budget.

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Budgeting Steps

• CEO/ MD decides the strategy

• Shares it with the Unit heads

• Unit Heads prepare a draft budget considering various internal and external factors*

Budget Proposal

• Draft budget is reviewed by the management to see if it meets organization’s and unit’s goals, achievable etc.

Budget Negotiation

Budget Approval

• Rigid Budget: potential for disaster due to changing market dynamics

• Regular Revisions**: Provides better guideline but compromise on quality

Budget Revision

*Internal Factors include changes in price, availability, manufacturing processes, new products or services, staff changes etc.

*External Factors include changes in the economy, labor market, industry trend, action of competitors etc.

**Higher threshold for budget revision should be maintained so that employees take budgeting process seriously

• Post review and negotiations, budget is approved by the budget committee

• All the unit budgets are combined to make master budget

• Submitted to BOD for approval

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Standard = Benchmark; Could be used for Price, Quantity, Cost or service level.

A standard cost is an expected cost for a product or a service assuming smooth operations. Also used by budget planners. Standard cost changes with the change in circumstances.

Costs can be classified into Direct & Indirect costs and Committed & Controllable/Discretionary costs.

Committed costs: fixed costs such as admin salaries, rent etc. Controllable costs: variable costs under manager’s control such as worker’s hours, use of cheap material, advertising cost etc. Useful for performance evaluation.

Types of Standards:

Authoritative: Determined by the management without consulting with middle/lower level management or process experts. Speedily set and are closer to company goals. Lead to resentment.

Participative: All interested parties are involved. High acceptance. More time consuming and require negotiations to ensure operating goals are still met.

These standards can be further sub-divided into Ideal and Reasonably Attainable standards.

Cost Standards

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Specific Type of Standard Costs

Ideal Standards Reasonably Attainable Standards

• Assumes all the variables in favour of the firm

• Does not account for any work delays, interruptions, waste or machine break-down

• Difficult to achieve practically but encourages employees to work on a continuous improvement strategy and total quality management philosophy

• Can be demotivating

• Some firms measure progress towards an ideal standard instead of deviation to reward success

• Closer to historical standards

• Attainable goals for trained employees

• Allow for downtime, delays, employee rest periods

• Variance between these standards and actuals represent extraordinary event/abnormal conditions

• These standards can be used for forecasting and planning purposes

• Discourages continuous improvement strategies

• Low standards will lead to slackness in employees

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Standard cost for Direct Materials:

• Based on quality, quantity and price

• Should allow for losses, spoilage, scraps and waste in the normal course of business

• Vendor shortlisting process- lowest cost vendor vs one reliable vendor

Standard cost for Direct Labor:

• Affected by product complexity, personnel skill levels, type and condition of equipment, and the nature of manufacturing process

• Allow for normally expected equipment downtime and workers break.

• Cost is based on gross base pay

• Fringe benefits, overtime and shift premiums are normally considered labor related overhead costs.

Standard Cost for Materials & Labour

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Direct Cost per unit

= No. of units of material to get 1 unit of output x Per unit cost of material

+ No. of labour hours to get one unit of output x Per hour labour cost

Example:

If one unit of output requires 10 units of material and one unit of material costs Rs15, then the direct material cost of manufacturing one unit of output is Rs150 (10 x 15).

Similarly, if one unit of output needs 2 manufacturing labour hours and labour hours cost Rs15, then the standard labour cost would be Rs30 (2 x 15) per output unit.

Total direct costs for one unit of output = Rs180 (150 + 30)

Standard Cost for Materials & Labour

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Sources for Standard Setting

Activity Analysis Historical Data Market Expectations & Strategic Decisions

Benchmarking

Most Expensive Inexpensive

Thorough Less Reliable

Evaluates the activities needed to finish a job

Direct costs of the inputs and indirect costs are allocated

Can be used to find average or median historical cost

Determines max. cost level that is allowed for a product (Target Costing*)

High standards should be set to accomplish continuous improvement

Continuous process of evaluating products/services against the best levels of performance.

Best levels could be external (Industry leaders) or Internal

Positive: Mistakes and problems occurred in the past are automatically factored

Negative: Fails to factor in change in technology

*Target Costing is a product design technique in which the product reaches a particular target cost at the end of the production process.

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1. Which approach to budget preparation is most preferred?

A. Participative

B. Authoritative

C. Combined

2. A CEO is evaluating the performance of competitors of his company to set the standards for his firm. He is considering the most efficiently-run company for the year in which it recorded its highest ever profit margins. Which type of standards is he setting?

A. Ideal

B. Authoritative

C. Reasonably Attainable Standards

3. Under which of the approaches is the risk of a company’s strategic targets getting ignored the highest?

A. Participative

B. Authoritative

C. Combined

Questions

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Solution:

1. C. Combined approach is most preferred since it aligns strategic targets with the dept level budgets

2. A. Since the CEO is considering the performance of the best company during the best period, he is setting ideal standards.

3. A. The risk of strategic targets getting ignored is the highest in participative approach since targets of individual divisions are not aligned to the organisation’s targets.

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4. Which of the following groups is most likely to build slackness into a budget?

A. Budget Committee

B. Board of Directors

C. Top Management

D. Middle & Lower Management

5. Which of these is not a sub-head of a Master Budget?

A. Promotion Budget

B. Financial Budget

C. Operating Budget

Questions

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Solution:

4. D. Middle & Lower Management

5. A. Promotion Budget

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6. Unlike budgets, forecasts have lower accountability and are not evaluated against variances . Is this statement correct?

A. Both the reasons are correct.

B. Both the reasons are wrong.

C. One of the reasons is correct.

7. What are the economic considerations in the budgeting process?

8. What are the four sources of information to set standards?

9. To manufacture one unit of X, 25 units of material and 5 labour hours are required. The material cost per unit is Rs. 10 and wages per hour is Rs. 50. What would be the direct cost per unit?

A. 250

B. 500

C. 90

Questions

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Solution:

6. A. Both the reasons are correct.

7. Macro economic scenario, industry outlook, competitor’s strategy, internal strategy and plans

8. Activity Analysis, Historical Data, Market Expectations and Benchmarking

9. B. Rs. 500 (Direct Material Cost Rs. 250 (25x10) + Direct labour cost Rs. 250 (5x50))

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Forecasting Techniques

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Content

I. Forecasting Techniques

II. Regression Analysis

III. Timeseries

IV. Smoothing

V. Learning Curve Analysis

VI. Expected Value

VII. Sensitivity Analysis

33

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Forecasting Techniques: Quantitative Methods, used for forecasting future financial performance. Also helps in decision-making.

Forecasting Techniques

Data Analysis Model Building Decision Theory

• Analysis of historical data to establish RELATIONSHIP and/or PATTERN

• Eg Regression Analysis, Time Series Analysis, Smoothing etc.

• Mathematical model to establish a relationship between different variables

• Eg Learning Curve Analysis

• Analysis potential outcomes and their probabilities

• Eg Expected Value and Sensitivity Analysis

Quantitative Methods

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Linear Regression Analysis: determines impact of one or more independent variable (Y) on another dependent variable (X). Eg: • Forecasting sales (dependent variable) based on advertising spend (independent variable) • Forecasting total production (dependent variable) based on machine hours available (independent

variable) Key Assumptions: 1. Linear relationship between the variables 2. Independent variables should not be correlated in case of multiple linear regression (correlation

of 0.7 or less) 3. No correlation between the actual value of dependent variable and its predicted value 4. Explanatory variable must be stationary.

Types: 1. Simple Regression Analysis – Only 1 independent variable 2. Multiple Regression Analysis – 2 or more independent variable

Regression Analysis

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Y= a + bX

Y = Dependent variable, i.e. annual sales for our ex

a = Y intercept. Y = a when x=0

X = Independent variable, i.e. advertising spend in our ex

b = Regression coefficient, i.e. multiplier impact X will have on Y.

Equation for Simple Linear Regression

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A retail firm is trying to forecast sales for third year based on its advertising budget. Historical data for sales and advertising cost is outlined below. The advertising cost for Q1 in year 3 is expected to be Rs. 75,000.

Example

Quarter Advertising Cost (Rs.) Year 1 Year 2

Sales (Rs.) Year 1 Year 2

Q1 50,000 100,000 48,000 89,000

Q2 30,000 90,000 40,000 105,000

Q3 40,000 80,000 62,000 73,000

Q4 60,000 110,000 75,000 105,000

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Coefficients

Intercept 18,450

Advertising Cost 0.8

Solution

Regression values for advertising cost

The regression equation for our example will be: Y = Rs. 18,450 + 0.8 (75,000) Estimated advertising cost will be Rs. 78,450

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Three common statistical measures to test the accuracy of regression results are:

R Squared (Coefficient of Determination)

- Explains the extent of dependence of Y on X

- Ranges between 0 and 1

- High R Squared values (closer to 1) indicate higher dependence and data points lie along the regression line

- Low R squared values (closer to 0) show scattered data points

Standard Error of Estimate

- Measures relationship between Y and X on the basis of dispersion around regression line

- Confidence interval should be made to check the accuracy

Test of Regression Analysis

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T-Value

- Measures relationship between Y and X

- Value should be >2

- High T-value indicates significant relationship between X and Y

- Low T-value indicates absence of relationship between X and Y. Such independent variables should not be used as a basis to forecast

Test of Regression Analysis

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Multiple Linear Regression

A dependent variable, eg sales can be dependent on multiple factors (such as macro-economic scenario, competitive scenario, pricing, demand for substitute products, income levels etc). Hence while forecasting, all these factors should be taken into account and should be built in regression equation. Such analysis is called Multiple Linear Regression.

As mentioned earlier, Independent variables should not be correlated in case of multiple linear regression (correlation of 0.7 or less)

Y = a + b1X1 + b2X2 + b3X3

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1. Outliers can distort the results of regression analysis. Should be checked to ensure that any data recording error or an extraordinary event is not impacting the analysis

2. In some cases, relationship between X and Y can be non-linear

3. Relationship between X and Y should be evaluated

4. Degree of dependence of Y on X can change with the change in circumstances

5. Regression analysis cannot be used for forecasting if independent variable lies outside the historical data set

Regression Analysis – Key Issues

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Forecast is based on patterns in historical series of data taken at a particular time-interval

Pattern Types:

1. Trend

2. Cycles

3. Seasonality

4. Irregular Variations

Key Issues:

1. Uses historical data for forecasting. Past patterns are expected to occur in future

2. Extraordinary or non-recurring events can not be factored for forecasting

Time Series Analysis

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1. Trend:

- Can be upward or downward sloping

- Result of change in technology, customer preference, pricing, competition etc.

- Forecasts for dependent variable can be made based on trend line

- Informed decision-making on expansion related decisions

2. Cycles:

- Repetitive pattern of data points lying above or below the trend line

- Can last for more than a year

- Result of macro-economic conditions

- Improved decision-making in the light of macro-economic conditions

Pattern Types

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3. Seasonality:

- Peak and Trough pattern during a year

- Can occur due to seasonal change in preference and activities

- Assists in inventory management

4. Irregular Variations:

- Any outlier data points which don’t form a trend, seasonality or cyclical pattern

- Can occur due to non-recurring, extraordinary event

- Such factors can not be accounted for in the forecasts

Pattern Types

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Example

Quarter Sales (Rs.) Year 1 Year 2 Year 3

Q1 50,000 100,000 170,000

Q2 75,000 150,000 200,000

Q3 60,000 160,000 210,000

Q4 80,000 150,000 225,000

A retail firm is trying to track its sales to establish a pattern. The timeseries data is outlined below for reference:

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Solution

0

50,000

100,000

150,000

200,000

250,000

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12

The time series data indicates an upward sloping trend. This will help the management in planning for the future eg procurement of raw material, setting marketing budgets, hiring sales staff etc.

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- An extension of Time series

- Mostly used when time series do not indicate any set pattern due to irrelevant data points

- Highly accurate for short term forecasts

Methods of Smoothing:

- Moving Average

- Weighted Moving Average

- Exponential Smoothing

Key Issues:

Smoothing can be used only when time-series data is stable and does not establish any pattern.

Smoothing

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Simple average of the recent values of the same variable for a specific period

Moving Average = Sum of the recent values/ No. of values

Example: Advertising cost for the last three quarters is Rs. 50,000, Rs. 65,000 and Rs. 45,000.

The Moving average will be (50,000+64,000+45,000)/3 = Rs. 53,000. This will help in forecasting advertising cost for the next quarter.

Weighted Moving Average

Moving average gives equal weightage to all values while weighted moving average assigns higher weight to recent values.

Example: If weights for the three quarters in the ex above are 20%, 30% and 50%, the weighted moving average will be 50,000X0.2+65,000X0.3+45,000X0.5 = Rs. 52,000

Moving Averages

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Weighted average of the historical and forecasted value of a most recent data point. Minimum data requirement

F t+1 = aY1 + (1-a) Ft

F t+1 = forecast for the period t+1

a = smoothing constant (ranges between 0 and 1 depending on variability)*

Yt = Actual value for the period t

Ft = forecast for the period t

*Higher variability would mean a smaller value for smoothing constant and vice versa.

Exponential Smoothing

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Estimates costs based on the assumption that productivity will improve over time. Helps in efficiently run operations and reducing costs. Also helps in decision making eg performance evaluation, product pricing

For example: With the doubling of production every time, if costs fall by 10% then it is called 90% learning curve.

Types:

- Incremental unit-time learning model ( Crawford Method): More suited for large scale firms

- Cumulative average-time learning model (Wright Method): Simple and most commonly used

Key Issues:

- Applies only for labour-intensive operations

- Assumption of constant learning rate

- Productivity improvement can be due to factors other than learning so unreliable conclusions

Learning Curve Analysis

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Time taken to manufacture every incremental unit is added to the previous total time and then the sum is divided by the total no. of units. This results in a lower average production time per unit. Learning improves efficiency up to a certain point after which learning curve flattens.

For example, lets assume the following:

-Hours required to manufacture first unit: 20 hours

-90% learning curve

A 90% learning curve implies hours required per unit will reduce by 10% every time the production doubles. Thus, hours required for producing the second unit = 18 (20 x 90%). Similarly, hours required for producing the fourth unit = 16.2 (Rs 18 x 90%).

Average time when two units are manufactured = (20+18)/2 = 19 hours

Incremental unit-time learning model

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Cumulative total time is calculated by multiplying cumulative average time per unit with incremental units.

In the previous example, time taken to manufacture second unit was 18 hours.

Cumulative total time for two units = 18 x 2 = 36 hours

Individual unit time for the last (second) unit = 16 hours (36 hours for two units less 20 hours for first unit).

The difference

Under incremental unit-time learning model, the second unit required 18 hours to produce (with the average time for two units being 19 hours).

Under cumulative average-time learning model, the second unit requires only 16 hours since 18 hours (time required for the last unit) is multiplied by total units produced (two units in this case).

Cumulative average-time learning model

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Forecast for a given variable is based on estimates of the same variable under different economic conditions and the probability of each condition. Assists in decision-making in case conditions are highly uncertain.

Expected Value = Estimate1 X P1 + Estimate2 X P2 + Estimate3 X P3

Key Issues:

1. Estimation and probabilities assigned under different conditions can be subjective

2. Decision cannot be made in case of unreliable estimates

3. Will not be suitable for risk-taker or risk-averse decision makers

Expected Value

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ABC wants to forecast its sales for 2015 but the sales can vary depending on the macro economic condition. The sales estimate under different economic scenarios and their probabilities are as follows:

Example

Economic Condition Sales Estimate (Rs.) Probability

Good 5,000 0.15

Bad 2,000 0.15

Average 4,000 0.70

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ABC’s expected sales for 2015 will be:

5,000x0.15+2,000X0.15+4,000X0.70 = Rs. 3,850

Solution

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Checks impact of changes in other variables (independent variable) on the dependent variable. Helps to determine the variables, which are critical for decision making

Key Issues:

Independent variables may be correlated and may not impact dependent variable individually but mutually result in substantial different outcome.

Sensitivity Analysis (What If Analysis)

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Continuing from the previous example, ABC has assigned different probabilities to the sales estimates under three macro economic scenarios. The sales estimate under different economic scenarios and their probabilities are as follows:

Example

Economic Condition

Sales Estimate (Rs.)

Most Likely Scenario (Prob 1)

Booming Economy (Prob 2)

Recessionary (Prob 3)

Good 5,000 0.15 0.65 0.10

Bad 2,000 0.15 0.10 0.65

Average 4,000 0.70 0.25 0.25

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Solution

ABC’s expected sales for 2015 under most likely scenario will be: 5,000x0.15+2,000X0.15+4,000X0.70 = Rs. 3,850 Scenario A: If the economy is booming, ABC’s expected sales for 2015 will be: 5,000x0.65+2000x0.10+4,000x0.25 = Rs. 4,450 Scenario B: Under recessionary conditions, ABC’s expected sales will be: 5,000x0.10+2,000x0.65+4,000x0.25 = Rs. 2,800 The significant variations in the sales forecast under the two scenarios shows that it is highly sensitive to the economic conditions of the country.

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1. Which of these is least likely a data analysis tool?

A. Learning Curve Analysis

B. Time Series

C. Smoothing

2. Incremental unit-time learning model is most suitable for-

A. Small scale firms

B. Start-ups

C. Large scale organizations

3. Which of these is not a measures to test regression analysis?

A. R Square

B. Standard Error of Estimates

C. Weighted Moving Average

Questions

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Solution:

1. A. Learning Curve Analysis

2. C. Large scale organizations

3. C. Weighted Moving Average

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4. What are the four patterns observed under time-series analysis?

5. Sales for the last three quarters is Rs. 100,000, Rs. 150,000 and Rs. 125,000. What would be the moving average of sales?

6. In the example above, the weights assigned for the sales of last 3 quarters are: Q1 = 0.2, Q2= 0.3 and Q3=0.5. What will be the weighted moving average?

7. ABC is planning to launch a new product however the launch may get delayed due to some factors. How much advertising cost should be budgeted given the following probabilities?

Questions

Launch of a product Advertising Cost (Rs.) Probability

Yes 150,000 0.65

No 75,000 0.35

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Solution:

4. Trend, Cycle, Seasonal and Irregular Variation

5. Rs. 125,000

6. The weighted moving average will be Rs. 127,500

7. The advertising budget is expected to be Rs. 123,750

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Recap Budgeting Concepts

Budget Cycle: Preparation Approval Evaluation Corrective Action Feedback

Budgeting Approach: Authoritative, Participative & Combination

Master Budget- Operating & Financial

Budget Participants: Board Top Management Budget Committee Middle & lower Management Budget Coordinator Process Expert

Budgeting Steps: Proposal Negotiation Approval Revision

Cost Standards: 1. Authoritative & Participative 2. Ideal & Reasonably Attainable Standard cost for material & labour: Direct Cost per unit = No. of units of material to get 1 unit of output x Per unit cost of material + No. of labour hours to get one unit of output x Per hour labour cost

Sources for Standard Setting: Activity Analysis Historical Data Market Expectation Benchmarking

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Recap Quantitative Methods for Forecasting

Data Analysis – Regression, Smoothing & Time-series

Model Building – Learning Curve Analysis

Decision Theory - Expected Value & Sensitivity Analysis

Regression – Simple (Y = a+bx) & Linear (Y=a+b1x1+b2x2….) Test: R Sq, T-Value & Standard error

Test Series - Trend, Cycles, Seasonality & Irregular variations

Smoothing – Moving Average*, Weighted Moving Average & Exponential** Smoothing

- Incremental unit-time learning model ( Crawford Method): More suited for large scale firms

- Cumulative average-time learning model (Wright Method): Simple and most commonly used

Expected Value = Estimate1 X P1 + Estimate2 X P2 + Estimate3 X P3

**Exponential Smoothing F t+1 = aY1 + (1-a) Ft

*Moving Average = Sum of the recent values/ No. of values

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