2010 CMA Part 1 Section A

Planning, Budgeting, and Forecasting

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 1

Section A – Planning, Budgeting, and Forecasting
• 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
– Probability
– Risk, uncertainty and expected value
– Sensitivity analysis
– Top-Level planning and analysis
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 2
 Planning and Budgeting Concepts

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 Planning
• 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 (production).

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External Environment in Planning and Budgeting
• Planning does not occur in a vacuum. It must
consider external influences that will impact the
company´s operations and budgets such as:
– Industry: rivals, the company´s 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.
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 Setting Goals and Objectives
• 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 level.
• 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.

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 Characteristics of Objectives and Goals
• Objectives and goals must be:
– Prioritized,
– 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 reached.
– Efficiency is whether it was reached using the fewest
resources.

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 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 company´s top management
– Looks at strategies, objectives and goals of the company,
and internal/external factors affecting the company
• Intermediate (tactical) plans – one to five years.
Implement specific parts of the strategic plan.
– Made by upper and middle managers

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 Different Types of Plans Cont´d
• 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 managers
– Primary basis for budgets
– Provide the basis to develop programs, policies and
performance expectations required to achieve the
company´s long-term strategic goals

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 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.

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Planning, Budgeting and Performance Evaluation
• 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
management´s 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
adopted.
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Planning, Budgeting and Performance Evaluation Cont´d

• Planning, budgeting, and performance evaluation

are interrelated and inseparable. The process is
(cont´d):
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.

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 Budgeting
• A budget is a quantitative (numerical) expression of
the company’s 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 activities
 Financial budgets identify the sources and uses of fund
for the budgeted operations
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 Advantages of Budgets
• When properly developed and administered,
budgets:
– Provide coordination and communication among
organization units and activities
– Provide a framework for measuring performance
– Provide motivation for managers and employees to
achieve the company´s plans
– Promote the efficient allocation of organizational
resources
– Provide a means for controlling operations
– Provide a means to check on progress toward the
organization’s objectives

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 Characteristics of Successful Budgeting
• The process must start with the company’s plans –
both short-term plans and long-term plans.
• The budget needs management support at all levels.
• 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.
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 Characteristics of Successful Budgeting Cont´d
• The budget should be an accurate representation
of the expected future events.
• 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.

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 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.
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 Who Should Prepare the Budget
• 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
accomplished.
– The budget should also be more realistic.

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 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.

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 The Budget Development Process
• The process for developing the budget is:
1. An appropriate authority, such as senior management
or a budget committee, set and communicate budget
guidelines.
2. Initial budget proposals are prepared by responsibility
centers.
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
directors.
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.
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 The Budget Development Process Cont´d
• The process for developing the budget are (cont´d):
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.

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Best Practice Guidelines for the Budget Process
• 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
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 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.

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 Budgetary Slack and Goal Congruence Cont´d
• 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.
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 Standard Costs and Setting Standard Costs
• 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
– Benchmarking
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 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.

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 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 produced.
– 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
purchased.
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 Establishing Direct Labor Standards
• 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.

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 Establishing Overhead Standards
• 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

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 Establishing Overhead Standards Cont´d
• The allocation rate is established for the full year.
The budgeted overhead rate for the year multiplied
by each month’s budgeted activity level will be used
to calculate the monthly budgeted overhead.
• 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 plant’s output. These are called denominator-
level capacity concepts, because they describe the
denominators that can be used in the calculation of
per unit overhead costs.

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 Denominator Level Concepts
• 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 demand.
– 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 31
 Budget Methodologies

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 The Annual/Master Budget
• The development of an annual budget for a large
corporation may take many months to complete.
• 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.
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 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 prepared.
– The cash budget is the last budget prepared.

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 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 sell.
• This is also the hardest budget to do, because it
based on the decisions and factors not controlled
by the company:
– Consumers
– Competitors
– The economy

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 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.

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 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 another.

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 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.

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 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 basis.
• 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.

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 Operating and Financial Budgets
• 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 budgets.
• The financial budget is the budgeted balance
sheet and statement of cash flows, cash budget
and capital budget.
• These budgets are what the company’s 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 40
 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
plans.

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 The Master Budget
• The individual budgets that make up the operating
and financial budgets together make up the master
budget.
• The master budget is a summary of management’s
operating and financial plans for the period,
expressed as a set of financial statements.

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 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
available.

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 Other Types of Budgets

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 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
commitments.
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 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, pre-production and
post-production costs also need to be covered by
the selling price.

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 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 levels.
• 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.
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 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 period’s 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 justified.
– By looking at every expense each year, management
should be able to eliminate non-value adding expenses
and try to find cheaper alternatives.

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 Budget Reports and the Control Loop
• 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.

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 Budgeting Questions

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 Budgeting Question Formulas
• 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.

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 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.

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 How Many Units to Purchase or Produce?
• 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.

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 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 company).

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 Cash Collected or Paid Question
• 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.

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 Forecasting Techniques

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 Forecasting
• 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 model’s
representation of reality
• Two basic methods of Forecasting
– Time Series Analysis
– Causal Forecasting

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 Time Series Analysis
• In time series analysis we are looking at patterns
over time. There are four patterns:
– Trend
– Cyclical
– Seasonal
– Irregular

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 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.
Sales 1998-2007 with 2008 Forecast

$3,500,000

$3,000,000

$2,500,000

$2,000,000

$1,500,000
1998 2000 2002 2004 2006 2008

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 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
economy.

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 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 component”.

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 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
results.

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 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

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 Smoothing
• 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

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 Smoothing Cont´d
• 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 period’s expected
value is calculated using the last period’s expected
value (as forecasted using exponential smoothing) and
the last period’s actual value.

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 Exponential Smoothing
• Uses two values:
1. The last period’s expected value, as calculated using
exponential smoothing
2. The last period’s actual value
• These two values are averaged together using a
determined weighting
• The last period’s actual value is given a weight of
alpha (a)
– This is between 0 and 1 (usually it is between 0 and .4)
– This is also called the smoothing constant
• The last period’s expected value will be given a
weight of 1-a
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 66
 The Smoothing Constant
• If a is given a value of 1, the projection will be
based only on the actual result of the last period
• If a is given a value of 0, the projection will be
based only on the projected result of the last period
• When values fluctuate greatly, we want to use a
lower value for a
• The accuracy of this process is measured by the
error, called the Mean Squared Error. We want an
a that will minimize this error.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 67

 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
assumptions:
– 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 linear.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 68
 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, inde-
pendent, 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
meaningful.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 69
 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 70

 Inflation Adjustments in Time Series
• 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 71

 Converting Nominal to Real Dollars
• Any conversion needs to use some sort of price
index or other measure of inflation

Real Value =
Nominal Value
Current Year Index / Previous Year’s Index

Or

Nominal Value
1 + Inflation Rate
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 72
 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 73

 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 + ε

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
ε = the error term (the distance between the regression
line and an actual data point)
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 74
 Regression Analysis Assumptions
• 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
distributed,
– 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
term.
• The error term is included because there is always
scope that a measurement was made incorrectly
and there is always some amount of randomness.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 75

 Benefits of Regression Analysis

• The benefits of regression analysis are:

– 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 76

 Limitations of Regression Analysis
• The limitations of regression analysis are:
– Historical data is required – if there is no data,
regression analysis can’t be used
– If there have been changes in the environment or
situation since the data was collected, it will not work
– 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

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 77

 Learning Curves

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 78

 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 79
 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 80
 Cumulative Average Time Learning Model cont.

• 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) …

Where:
– 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 81
 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 . . .
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 82
 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 83
 Limitations of Learning Curves
• 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

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 84

 Probability

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 85

 Probability
• 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 probability:
– 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

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 86

 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”

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 87

 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 88
 Conditional and Joint Probability
Example:
• The probability of sales being $1,000,000 in Year 1
is 30%.
• 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 12%.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 89
 Methods of Assigning Probability
• 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 reasonable

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 90

 Discrete and Continuous Random Variables
• 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 91

 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 value.
• The expected value is a weighted average of all
the possible values, weighted according to their
probabilities.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 92

 Variance and Standard Deviation
• 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting
93
 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 94

 The Distribution of Expected Results
• In a normal distribution
– 68% of the expected values will be within one standard
deviation of the mean.
– 95% of the expected values will be within two standard
deviations of the mean.
– 99.7 of the expected values will be within three standard
deviations of the mean.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 95

 Risk, Uncertainty and Expected Value

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 96

 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 97

 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.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 98

 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 numbers.
– 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
exists.

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 99

 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 100
 Top-Level Planning and Analysis

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 101

 Pro-forma Financial Statements
• 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 company’s 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 102
 Pro forma Financial Statements cont´d
• Pro forma financial statements are used internally
for five general purposes:
1. compare the company’s 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 company’s 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
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 103
 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.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 104
 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 include:
– State of domestic and international economy
– Growth prospects for the market in which the company
operates
– The company´s product line
– The company´s marketing effort

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 105

 Sales Forecasting cont´d
• An accurate sales forecast is critical to avoid
negative business issues:
– if the company´s 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

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 106

 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 growth
– 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
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 107
 Forecasting Future Financing Needs cont´d
• The amount of external financing that will be required
depends upon several factors:
– Company´s rate of sales growth
– Company´s capital intensity ratio (amount of assets
required per dollar of sales)
– Company´s spontaneous liabilities-to-sales ratio
– Company´s net profit margin
– Company´s retention ratio
– Planned changes in policies and procedures (management
decisions)

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 108

 Forecasting Future Financing Needs cont´d
• 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 covered on the exam.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 109
 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 flows
 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)

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 110

Forecasted Financial Statement Method cont´d
• 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 are:
1. Analyze historical ratio such as cash to sales,
inventory to sales, accounts payables to sales, etc
2. Forecast the income statement
3. Forecast the balance sheet
4. Construct a pro forma statement of cash flows

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 111

Analysis of Pro Forma Financial Statements
• Developing the financial forecast alone is not
meaningful unless it is also analyzed to determine
whether the firm´s forecasted financial situation
meets the firm´s 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
redone
• Part of the analysis is an analysis of financial ratios.
Ratio analysis is used to compare the firm’s actual
ratios and projected ratios with target ratios as well
as the latest industry average ratios.
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 112
Analysis of Pro Forma Financial Statements Cont´d
• 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)
2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 113
Analysis of Pro Forma Financial Statements Cont´d
• The primary financial ratios to use for financial
analysis of forecasted financial statements include
(cont´d):
– 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

• 1 Net income = Net income before preferred dividends

2010 CMA Part 1 Section A - Planning, Budgeting and Forecasting 114