Definition of Profit Planning
Profit planning aims to set a profit objective for a budgeting period. Also, to establish the main policy decisions on how to achieve the objectives. The profit objective will normally be related to the ‘return’ required on the investment in the business. Profit planning evaluates alternatives to select the most likely to give the required profit objective. Managers can plan their budgets on this basis.
Purpose of Profit Planning
The main purposes of profit planning are to:
- set profit objectives for the budget period
- state the policy decisions, and the course of action to be followed during the budget period
- give planning directives for preparing detailed operating plans.
The profit objectives will reflect the expected return on capital employed. This will depend on:
- the commercial environment in the budget period
- projected sales of the company
- past profit record
- maintenance of liquidity.
The main factors which must be specified in planning guidelines include:
- changes needed in volume, price and cost
- availability of funds for investment
- capital expenditure proposals
- changes needed in the level of working capital
- limits on discretionary expenditure, e.g. Research and Development.
Return required on capital employed
After the capital employed has been determined, then specify the required rate of return. Criteria include:
- what return could we get from alternative forms of investment?
- what degree of risk is involved in the company’s activities?
- are the owners influenced by considerations other than profit, e.g. environmental, ethical concerns?
- comparison with competitor’s performance in the same industry sector
- company’s immediate past record
- expected trading conditions for the period of the profit plan.
The end result of this process is a statement of the profit objective and how it is to be achieved. This statement is the starting point for budgeting.
Profit Planning Techniques
The following chart clearly demonstrates the techniques of profit planning.