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180 Financial Analysis: Tools and Techniques

The result is the gross contribution from selling activities, which must be

reduced by estimated departmental period costs (like rent, managers’ salary, and

other items that do not vary with short-term fluctuations in volume) to arrive at

the net contribution provided by the department. After deducting allocated corpo￾rate support costs, which are staff support, advertising, and general overhead, the

FIGURE 5–5

XYZ CORPORATION

Sample Quarterly Sales Budget

For the Year Ended December 31, 1999

Quarter

First Second Third Fourth Total

Basic data:

Unit sales (number of units):

Product A . . . . . . . . . . . . . . . . . . . . . 2,700 2,900 3,000 2,800 11,400

Product B. . . . . . . . . . . . . . . . . . . . . 8,000 8,500 10,000 8,000 34,500

Product C. . . . . . . . . . . . . . . . . . . . . 17,500 18,500 21,000 16,000 73,000

Price level (per unit):

Product A . . . . . . . . . . . . . . . . . . . . . $ 145 $ 145 $ 150 $ 150 —

Product B. . . . . . . . . . . . . . . . . . . . . 92 92 95 95 —

Product C. . . . . . . . . . . . . . . . . . . . . 74 74 74 74 —

Number of salespersons . . . . . . . . . . . 25 25 25 26 —

Operating budget ($000):

Sales revenue . . . . . . . . . . . . . . . . . . . $2,423 $2,572 $2,954 $2,364 $10,313

Less: returns, allowances . . . . . . . . 25 26 28 24 103

Net sales . . . . . . . . . . . . . . . . . . . . . . . 2,398 2,546 2,926 2,340 10,210

Cost of goods sold. . . . . . . . . . . . . . . . 1,916 2,051 2,322 1,868 8,157

Margin before delivery . . . . . . . . . . . . . 482 495 604 472 2,053

Delivery expense . . . . . . . . . . . . . . . . . 56 60 68 54 238

Gross margin . . . . . . . . . . . . . . . . . . . . 426 435 536 418 1,815

Selling expense (controllable):

Salespersons’ compensation. . . . . . 94 94 94 98 380

Travel and entertainment. . . . . . . . . 32 32 32 33 129

Sales support costs . . . . . . . . . . . . . 23 23 26 24 96

Total selling expenses . . . . . . . . . 149 149 152 155 605

Gross contribution . . . . . . . . . . . . . . . . 277 286 384 263 1,210

Departmental period costs. . . . . . . . . . 18 18 18 18 72

Net contribution . . . . . . . . . . . . . . . . . . 259 268 366 245 1,138

Corporate support (transferred):

Staff support . . . . . . . . . . . . . . . . . . . . 23 25 25 27 100

Advertising. . . . . . . . . . . . . . . . . . . . . . 50 50 75 50 225

General overhead . . . . . . . . . . . . . . . . 63 63 63 63 252

Total corporate support . . . . . . . . 136 138 163 140 577

Profit contribution (before taxes) . . . . . $ 123 $ 130 $ 203 $ 105 $ 561

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CHAPTER 5 Projection of Financial Requirements 181

profit contribution for the period is established. In making all of these estimates,

the sales manager can use past relationships and selected ratios, tempered by his

or her judgment concerning changes in future conditions.

In our example, both basic data and dollar elements have been estimated

and set out by the four quarters and the full year of 1999. There’s nothing unique

about the format we have selected here, because many different arrangements of

such information are possible to suit any specific organization. Generally, a com￾pany prescribes the format for its managers to follow in preparing projected ac￾tivity budgets, both to maintain a degree of uniformity and to lessen the

accounting problem of consolidating the projections when preparing overall fi￾nancial forecasts. From the standpoint of financial projection, the sales and con￾tribution data in our example are the raw material which goes into the company’s

total operating plan.

Production Budget

The sales budget we just discussed is basically a projection of profit contribution.

However, companies also must forecast for operations or activities that involve

only costs or expenses. An example of this type of projection, a cost budget for a

factory, is shown in Figure 5–6. This time the data are given for each month.

We’ve included three months and the total for the quarter. The period shown is the

second quarter, during which sales and production are expected to increase.

Again, the amount of detail included and the presentation format are chosen

to suit the particular needs and preferences of the organization. This time we’ve

arranged the headings and data to show that certain cost items (both direct and pe￾riod costs) are under the control of the local manager. (Other costs, like allocated

general overhead, are transferred in from corporate headquarters and thus are be￾yond the local manager’s control.) This arrangement of data will also be useful if

the operating plan serves as a control device with which to measure the unit’s per￾formance.

Both sales and cost budgets commonly include additional columns in which

actual as opposed to projected figures are recorded. In addition, variance columns

are frequently used to measure deviations from plan. We’ll not go into such re￾finements here, because our examples were only meant to show the type of inter￾nal budgeting and projection used formally or informally in most organizations

preparatory to developing an overall financial forecast.

Interrelationship of Financial Projections

It should be obvious by now that the various types of projection presented in

this chapter are closely related. If all three forecasts—pro forma statements, cash

budgets, and operating budgets—are based on the same set of assumptions about

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182 Financial Analysis: Tools and Techniques

receipts and collections, repayment schedules, operating rates, inventory levels,

and so on, they will all precisely fit together as illustrated in Figure 5–7.

The financial plans and the projected funds need or excess will differ only

if different assumptions concerning the various drivers affecting cash flows are

used, particularly between the pro forma statements and the cash budget. It is easy

to reconcile pro forma statements and cash budgets, however, by carefully think￾ing through the key assumptions to be made, one by one, and by laying out for￾mats that contain sufficient detail and properly timed background data.

The diagram shows how the various operational budgets flow into a con￾solidated cash budget, which in turn is reinforced by specific data from the in￾vestment and financing plans. The combined information supports the pro forma

statements at the top of the diagram. Thus, pro forma statements are the all￾encompassing expression of the expected conditions for the projected period. If

FIGURE 5–6

XYZ CORPORATION

Sample Production Budget

For the Quarter Ended June 30, 1999

April May June Total

Basic data:

Number of shifts (5-day week) . . . . . 3 3 3 3

Days worked . . . . . . . . . . . . . . . . . . . 20 21 22 63

Hourly employees per shift . . . . . . . . 33 33 33 33

Number of machines. . . . . . . . . . . . . 35 35 34 —

Unit production:

Product A . . . . . . . . . . . . . . . . . . . 1,000 1,050 1,100 3,150

Product B . . . . . . . . . . . . . . . . . . . 2,400 2,510 2,640 7,550

Capacity utilization . . . . . . . . . . . . . . 94% 94% 96% 95%

Downtime for repairs (hours) . . . . . . 0 36 0 36

Operating budget:

Direct costs (controllable):*

Manufacturing labor . . . . . . . . . . . $57,600 $60,500 $63,400 $181,500

Raw materials . . . . . . . . . . . . . . . . 53,800 56,400 59,200 169,400

Operating supplies . . . . . . . . . . . . 6,500 6,900 7,300 20,700

Repair labor and parts . . . . . . . . . 7,300 12,400 6,500 26,200

Power, heat, light . . . . . . . . . . . . . 4,200 4,500 4,800 13,500

Total direct costs . . . . . . . . . . . . 129,400 140,700 141,200 411,300

Period costs (controllable):

Supervision . . . . . . . . . . . . . . . . . . 5,500 5,500 5,500 16,500

Support labor . . . . . . . . . . . . . . . . 28,500 28,500 28,500 85,500

Insurance, taxes . . . . . . . . . . . . . . 8,700 8,700 8,700 26,100

Depreciation . . . . . . . . . . . . . . . . . 20,500 20,500 20,500 61,500

Total period costs . . . . . . . . . . . 63,200 63,200 63,200 189,600

Total controllable costs . . . . . 192,600 203,900 204,400 600,900

General overhead (allocated) . . . . . . 72,000 72,000 72,000 216,000

Total cost. . . . . . . . . . . . . . . . . . . . . . . . $264,600 $275,900 $276,400 $816,900

*Where appropriate, unit costs can be shown.

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CHAPTER 5 Projection of Financial Requirements 183

we choose for planning purposes to develop a broad overall financial projection

using pro forma statements directly (rather than building them up from the com￾pany’s detailed plans and budgets), the results will in effect imply specific as￾sumptions about all the other elements in the diagram.

We haven’t yet discussed some of the other elements shown in Figure 5–7.

Investment plans (capital budgets) are projections of new outlays for land, build￾ings, machinery and equipment, and related incremental working capital, as well

as major outlays for new products and services, expanding markets, new technol￾ogy, etc. They also contain plans to divest any of the company’s assets. Acquisi￾tions and divestitures of whole companies, lines of business, or activities are

usually part of these projections.

We recall that XYZ Corporation made a minor reduction in its fixed assets

by selling some used machines in 1999, and planned to purchase new equipment

items in 2000. Also, a recently constructed plant was in the final stages of com￾pletion, as evidenced by the amount that had become due and payable to the con￾tractor. This facility investment was already reflected on the actual balance sheet

of September 30, 1999, largely supported by long-term debt raised earlier. Only

the current payment due the contractor was properly scheduled as a pro forma

cash disbursement. Given the size of the plant investment, the company might

consider raising some additional long-term debt to fund the new facility, because

our projections of ongoing operations show insufficient cash flow to pay off the

contractor liabilities.

FIGURE 5–7

Interrelationship of Financial Projections

Investment

plan

Cash

budget

Pro forma

statements

Financing

Plan

Basic data

and drivers

Operational

budgets

Financial

projections

Staff and

support

budgets

Staff and

support

budgets

Financial

records

Human

resource

records

Customer

data

Operational

statistics

Facilities

and equipment

records

Logistics

data

Economic

assumptions

Market and

price data

Competitor

information

Vendor

information

Technology

information

Production

budgets

Sales and

marketing

budgets

Services

budgets

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184 Financial Analysis: Tools and Techniques

Financing plans are schedules of proposed future additions to or reductions

in indebtedness or ownership funds during the forecast period. They might in￾volve significant expansion or restructuring of a company’s capital structure, de￾pending on the projected capital requirements. XYZ Corporation planned no

specific future financing, but provisions will have to be made for financing the

sizable near-term funds need revealed with the help of our pro forma analysis, and

to avoid straining current funds as the plant is paid off.

Staff budgets, as the name implies, are spending plans based on the expected

cost of operating various support functions of a company, such as the finance or￾ganization, human resources, legal and governmental affairs, and so on. These

budgets are prepared and used in the same fashion as other expense budgets, with

personnel expenses usually being the largest element. Services budgets are spend￾ing plans representing such service activities as customer or technical support, de￾livery and communication, online services of various kinds, and so on. Budgetary

categories will differ depending on the nature of the activity, of course.

Underlying the operating budgets and financial projections, Figure 5–7

shows a selection of key data sources, formal or informal, from which the relevant

drivers of physical and financial activities can be derived. Whether they are made

apparent or not, the structure of projections is supported by explicit or implicit

assumptions about such basic data and conditions. In our example of XYZ Cor￾poration we touched on a limited number of these areas, relying in all cases on

information given to us by management—who would have to base their expecta￾tions on their understanding of all the conditions affecting their company.

A word about projection methodology should be added here. Any form of

financial projection involves both an examination of past trends and specific as￾sumptions about future behavior of revenues, costs, expenses, and other receipts

and payments. Past trend analysis can range from simple “eyeballing” of obvious

patterns to applying a variety of statistical methods to the available data in order

to establish a trend line or curve as the basis for judging future conditions. The

projection of key variables might start with such a trend, but hard, informed judg￾ments about likely changes must override the temptation merely to extrapolate

past conditions. The mathematical elegance of statistical methods should not be

allowed to supplant the effort of making realistic future assumptions about spe￾cific company and market conditions, industry performance, and the national and

world economic outlook affecting the likely financial performance of the busi￾ness. The end-of-chapter references and Appendix V are sources of information

on forecasting techniques and other processes that will assist the analyst in tech￾nical and judgmental aspects of financial projection.

Financial Modeling

In recent years, software developed for financial modeling has vastly expanded

the financial analyst’s ability to explore the consequences of different assump￾tions, conditions, and plans. In principle, such software packages are mathemati￾cal representations and templates of key financial accounting relationships, ratios,

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