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MANAGEMENT. ACCOUNTING. BEST PRACTICES. A Guide for the Professional . Accountant. STEVEN M. BRAGG. John Wiley & Sons, Inc.

MANAGEMENT ACCOUNTING BEST PRACTICES A Guide for the Professional Accountant STEVEN M. BRAGG

John Wiley & Sons, Inc.

Management Accounting Best Practices A Guide for the Professional Accountant

MANAGEMENT ACCOUNTING BEST PRACTICES A Guide for the Professional Accountant STEVEN M. BRAGG

John Wiley & Sons, Inc.

1 This book is printed on acid-free paper.  Copyright # 2007 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Wiley Bicentennial Logo: Richard J. Pacifico No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data: ISBN: 978–0471–74347–7

Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

To the crew at Wiley, with whom I have worked since the previous century: Sheck, John, Judy, Natasha, Helen, and Brandon.

Contents Preface

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About the Author

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Free Online Resources by Steve Bragg 1 Budgeting Decisions

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How Does the System of Interlocking Budgets Work? 1 What Does a Sample Budget Look Like? 10 How Does Flex Budgeting Work? 28 What Best Practices Can I Apply to the Budgeting Process? 29 How Can I Integrate the Budget into the Corporate Control System? How Do Throughput Concepts Impact the Budget? 37 2 Capital Budgeting Decisions

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How Does a Constrained Resource Impact Capital Budgeting Decisions? What Is the True Cost of a Capacity Constraint? 45 How Do I Identify a Constrained Resource? 47 When Should I Invest in a Constrained Resource? 49 Should I Increase Sprint Capacity? 49 How Closely Should I Link Capital Expenditures to Strategy? 50 What Format Should I Use for a Capital Request Form? 51 Should I Judge Capital Proposals Based on Their Discounted Cash Flows? 51 How Do I Calculate the Cost of Capital? 54 When Should I Use the Incremental Cost of Capital? 58 How Do I Use Net Present Value in Capital Budgeting? 60 What Proposal Form Should I Require for a Cash Flow Analysis? 62 Should I Use the Payback Period in Capital Budgeting? 64 How Can a Post-Completion Analysis Help Me? 65 What Factors Should I Consider for a Site Selection? 67 3 Credit and Collection Decisions

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How Do I Create and Maintain a Credit Policy? 70 When Should I Require a Credit Application? 72 How Do I Obtain Financial Information About Customers? How Does a Credit Granting System Work? 74 What Payment Terms Should I Offer to Customers? 76

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Contents

When Should I Review Customer Credit Levels? 77 How Can I Adjust the Invoice Content and Layout to Improve Collections? 78 How Can I Adjust Billing Delivery to Improve Collections? 80 How Do I Accelerate Cash Collections? 81 Should I Offer Early Payment Discounts? 82 How Do I Optimize Customer Contacts? 82 How Do I Manage Customer Contact Information? 83 How Do I Involve the Sales Staff in Collections? 85 How Do I Handle Payment Deductions? 86 How Do I Collect Overdue Payments? 88 When Should I Take Legal Action to Collect from a Customer? 90 4 Control System Decisions

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Why Do I Need Controls? 92 How Do I Control Order Entry? 93 How Do I Control Credit Management? 94 How Do I Control Purchasing? 95 How Do I Control Procurement Cards? 96 How Do I Control Payables? 100 How Do I Control Inventory? 101 How Do I Control Billings? 102 How Do I Control Cash Receipts? 103 How Do I Control Payroll? 104 How Do I Control Fixed Assets? 106 5 Financial Analysis Decisions

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How Do I Calculate the Breakeven Point? 110 What Is the Impact of Fixed Costs on the Breakeven Point? 112 What is the Impact of Variable Cost Changes on the Breakeven Point? 113 How Do Pricing Changes Alter the Breakeven Point? 114 How Can the Product Mix Alter Profitability? 115 How Do I Conduct a ‘‘What-If’’ Analysis with a Single Variable? 116 How Do I Conduct a ‘‘What-If’’ Analysis with Double Variables? 118 How Do I Calculate Cost Variances? 121 How Do I Conduct a Profitability Analysis for Services? 128 How Are Profits Affected by the Number of Days in a Month? 130 How Do I Decide Which Research and Development Projects to Fund? 131 How Do I Create a Throughput Analysis Model? 133 How Do I Determine whether More Volume at a Lower Price Creates More Profit? 135 Should I Outsource Production? 137

Contents

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Should I Add Staff to the Bottleneck Operation? Should I Produce a New Product? 139 6 Payroll Decisions

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How Can I Automate Time Clock Data Collection? 144 How Do I Collect Time Information by Telephone? 145 How Can I Simplify Payroll Deductions? 146 How Do Employees Enter Their Own Payroll Changes? 147 How Do I Automate Payroll Form Distribution? 148 Should I Pay Employees via Direct Deposit? 149 How Do Paycards Compare with Payments by Direct Deposit? 150 What Issues Should I Consider When Setting Up a Paycard Program? 152 How Do I Make Electronic Child Support Payments? 152 How Do I Automate Payroll Remittances? 153 Should I Outsource Payroll? 153 Can I Outsource Employment Verifications? 155 Can I Outsource Benefits Administration? 156 How Many Payroll Cycles Should I Have? 157 How Can I Reduce the Number of Employee Payroll–Related Inquiries? 158 7 Inventory Decisions

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How Do I Manage Inventory Accuracy? 160 How Do I Identify Obsolete Inventory? 165 How Do I Dispose of Obsolete Inventory? 167 How Do I Set Up a Lower of Cost or Market System? 169 Which Inventory Costing System Should I Use? 170 Which Inventory Controls Should I Install? 183 What Types of Performance Measurements Should I Use? 186 How Do I Maintain Service Levels with Low Inventory? 192 Should I Shift Inventory Ownership to Suppliers? 194 How Do I Avoid Price Protection Costs? 195 8 Cost Allocation Decisions

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What Is the Basic Method for Calculating Overhead? 197 How Does Activity-Based Costing Work? 199 How Should I Use Activity-Based Costing? 206 Are There Any Problems with Activity-Based Costing? 207 How Do Just-in-Time Systems Impact Cost Allocation? 209 How Does Overhead Allocation Impact Automated Production Systems? 211 How Does Overhead Allocation Impact Low-Volume Products? 211 How Does Overhead Allocation Impact Low-Profit Products? 211 How Do I Allocate Joint and Byproduct Costs? 213

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Contents

9 Performance Responsibility Accounting Decisions

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What Is Responsibility Accounting? 217 What Are the Types of Responsibility Centers? 218 Should Allocated Costs Be Included in Responsibility Reports? What Is Balanced Scorecard Reporting? 222 How Does Benchmarking Work? 224 10 Product Design Decisions

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How Do I Make Funding Decisions for Research and Development Projects? 227 How Does Target Costing Work? 229 What Is Value Engineering? 230 How Does Target Costing Impact Profitability? 233 Are There Any Problems with Target Costing? 235 What Is the Accountant’s Role in a Target Costing Environment? 236 What Data is Needed for a Target Costing Analysis? 237 How Do I Control the Target Costing Process? 239 Under What Scenarios Is Target Costing Useful? 240 How Can I Incorporate Target Costing into the Budget? 241 How Can I Measure the Success of a Target Costing Program? 241 11 Pricing Decisions

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What Is the Lowest Price that I Should Accept? 243 How Do I Set Long-Range Prices? 245 How Should I Set Prices Over the Life of a Product? 247 How Do I Determine Cost-Plus Pricing? 249 How Should I Set Prices Against a Price Leader? 249 How Do I Handle a Price War? 250 How Do I Handle Predatory Pricing by a Competitor? 252 How Do I Handle Dumping by a Foreign Competitor? 253 When Is Transfer Pricing Important? 254 How Do Transfer Prices Alter Corporate Decision Making? 255 What Transfer Pricing Method Should I Use? 256 12 Quality Decisions

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What Are the Various Types of Quality? 264 How Do I Create a Quality Reporting System? 269 What Is the Cost of Scrap? 277 How Should I Measure Post-Constraint Scrap? 279 Where Should I Place Quality Review Workstations? Index

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Preface The typical accountant receives a thorough grounding in accounting standards in school, but then arrives on the job and asks—What do I do now? The unfortunate realization strikes that only a small proportion of the accounting job involves that painfully acquired knowledge of accounting standards. Instead, many other questions arise, with no obvious answers:               

How do I create a budget? What is a bottleneck asset, and should I invest in it? Should I approve a request for a capital expenditure? How do I grant credit to customers? How do I accelerate cash collections? Which controls should I set up? How do I conduct a throughput analysis? Should we outsource work? How do I collect payroll information? How do I achieve accurate inventory records? How do I allocate costs? What kinds of responsibility reports should I use? Should I set up a target costing system to assist the development of a new product? How do I set product prices? Where do I place quality review stations to improve profitability?

Management Accounting Best Practices provides the answers to all of these questions (and over 100 more) that show both the aspiring and seasoned accountant how to set up and manage an accounting department. Furthermore, when other members of the management team come calling with questions, the answers now lie on the accountant’s bookshelf. The information in this book is culled from eight of the author’s best-selling books: Accounting Control Best Practices, Billing and Collections Best Practices, Cost Accounting, Financial Analysis, Inventory Accounting, Payroll Best Practices, Throughput Accounting, and the Ultimate Accountants’ Reference. The new question-and-answer format in which this information is presented makes it easier to locate information on key accounting topics, and should make Management Accounting Best Practices a well-thumbed addition to any accountant’s library. STEVEN M. BRAGG Centennial, Colorado February 2007 xi

About the Author Steven Bragg, CPA, CMA, CIA, CPIM, has been the chief financial officer or controller of four companies, as well as a consulting manager at Ernst & Young and auditor at Deloitte & Touche. He received a Master’s degree in Finance from Bentley College, an MBA from Babson College, and a Bachelor’s degree in Economics from the University of Maine. He has been the two-time President of the Colorado Mountain Club, and is an avid alpine skier, mountain biker, and certified master diver. Mr. Bragg resides in Centennial, Colorado. He has written the following books through John Wiley & Sons: Accounting and Finance for Your Small Business Accounting Best Practices Accounting Control Best Practices Accounting Reference Desktop Billing and Collections Best Practices Business Ratios and Formulas Controller’s Guide to Costing Controller’s Guide to Planning and Controlling Operations Controller’s Guide: Roles and Responsibilities for the New Controller Controllership Cost Accounting Design and Maintenance of Accounting Manuals Essentials of Payroll Fast Close Financial Analysis GAAP Guide GAAP Implementation Guide Inventory Accounting Inventory Best Practices Just-in-Time Accounting Management Accounting Best Practices Managing Explosive Corporate Growth Outsourcing Payroll Accounting Payroll Best Practices Revenue Recognition Sales and Operations for Your Small Business The Controller’s Function xiii

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The New CFO Financial Leadership Manual The Ultimate Accountants’ Reference Throughput Accounting Also: Advanced Accounting Systems (Institute of Internal Auditors) Run the Rockies (CMC Press)

About the Author

Free Online Resources by Steve Bragg Steve issues a free accounting best practices newsletter and an accounting best practices podcast. You can sign up for both at www.stevebragg.com, or access the podcast through iTunes.

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Chapter 1

Budgeting Decisions The most common method for creating a budget is to simply print out the financial statements, adjust historical expenses for inflationary increases, add some projected revenue adjustments, and voila—instant budget. Unfortunately, this rough method ignores a massive number of interlocking factors that would probably have resulted in a very different budget. Without a carefully compiled budget, there is a strong chance that a company will find itself acting on budget assumptions that are so incorrect that it may find itself in serious financial straits in short order. To avoid these problems, the accountant must determine the proper format of a budget, find the best way to adjust it when revenue volumes change, ensure that the budgeting process is efficient, factor bottleneck operations into the budget, and use it to improve company control systems. This chapter provides answers to all of these key questions. The following table itemizes the section number in which the answers to each question can be found: Section 1-1 1-2 1-3 1-4 1-5 1-6

Decision How does the system of interlocking budgets work? What does a sample budget look like? How does flex budgeting work? What best practices can I apply to the budgeting process? How can I integrate the budget into the corporate control system? How do throughput concepts impact the budget?

1-1 HOW DOES THE SYSTEM OF INTERLOCKING BUDGETS WORK? A properly designed budget is a complex web of spreadsheets that account for the activities of virtually all areas within a company. As noted in Exhibit 1.1, the budget begins in two places, with both the revenue budget and research and development (R&D) budget. The revenue budget contains the revenue figures that the company believes it can achieve for each upcoming reporting period. These estimates come partially from the sales staff, which is responsible for estimates of sales levels for existing products within their current territories. Estimates for the sales of new products that have not yet been released, and for existing products in new markets, will come from a combination of the sales and marketing staffs, who will use their experience with related product sales to derive estimates. The greatest fallacy in any budget is to impose a revenue budget from the top management level without any input from the 1

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Exhibit 1.1 The System of Budgets

Research Department Budget

Research & Development Budget

Overhead Budget

Inventory Budget

Financing Requirements

Budgeted Financial Statements & Cash Forecast

Capital Budget

Facilities Budget

Direct Labor Budget

Cost-of-Goods-Sold Budget

Purchasing Budget

Production Budget

Revenue Budget

Staffing Budget

Sales Department Budget

Marketing Department Budget

General & Administrative Budget

1-1 How Does the System of Interlocking Budgets Work?

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sales staff, since this can result in a companywide budget that is geared toward a sales level that is most unlikely to be reached. A revenue budget requires prior consideration of a number of issues. For example, a general market share target will drive several other items within the budget, since greater market share may come at the cost of lower unit prices or higher credit costs. Another issue is the compensation strategy for the sales staff, since a shift to higher or lower commissions for specific products or regions will be a strong incentive for the sales staff to alter their selling behavior, resulting in some changes in estimated sales levels. Yet another consideration is which sales territories are to be entered during the budget period—those with high target populations may yield very high sales per hour of sales effort, while the reverse will be true if the remaining untapped regions have smaller target populations. It is also necessary to review the price points that will be offered during the budget period, especially in relation to the pricing strategies that are anticipated from competitors. If there is a strategy to increase market share as well as to raise unit prices, then the budget may fail due to conflicting activities. Another major factor is the terms of sale, which can be extended, along with easy credit, to attract more marginal customers; conversely, they can be retracted in order to reduce credit costs and focus company resources on a few key customers. A final point is that the budget should address any changes in the type of customer to whom sales will be made. If an entirely new type of customer will be added to the range of sales targets during the budget period, then the revenue budget should reflect a gradual ramp-up that will be required for the sales staff to work through the sales cycle of the new customers. Once all of these factors have been ruminated upon and combined to create a preliminary budget, the sales staff should also compare the budgeted sales level per person to the actual sales level that has been experienced in the recent past to see if the company has the existing capability to make the budgeted sales. If not, the revenue budget should be ramped up to reflect the time it will take to hire and train additional sales staff. The same cross-check can be conducted for the amount of sales budgeted per customer, to see if historical experience validates the sales levels noted in the new budget. Another budget that initiates other activities within the system of budgets is the research and development budget. This is not related to the sales level at all (as opposed to most other budgets), but instead is a discretionary budget that is based on the company’s strategy to derive new or improved products. The decision to fund a certain amount of project-related activity in this area will drive a departmental staffing and capital budget that is, for the most part, completely unrelated to the activity conducted by the rest of the company. However, there can be a feedback loop between this budget and the cash budget, since financing limitations may require management to prune some projects from this area. If so, the management team must work with the R&D manager to determine the correct mix of projects with both short-range and long-range payoffs that will still be funded. The production budget is largely driven by the sales estimates contained within the revenue budget. However, it is also driven by the inventory-level assumptions in

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the inventory budget. The inventory budget contains estimates by the materials management supervisor regarding the inventory levels that will be required for the upcoming budget period. For example, a new goal may be to reduce the level of finished goods inventory from 10 turns per year to15. If so, some of the products required by the revenue budget can be bled off from the existing finished goods inventory stock, yielding smaller production requirements during the budget period. Alternatively, if there is a strong focus on improving the level of customer service, then it may be necessary to keep more finished goods in stock, which will require more production than is strictly called for by the revenue budget. This concept can also be extended to work-in-process (WIP) inventory, where the installation of advanced production planning systems, such as manufacturing resources planning or just-in-time, can be used to reduce the level of required inventory. Also, just-in-time purchasing techniques can be used to reduce the amount of raw materials inventory that is kept on hand. All of these assumptions should be clearly delineated in the inventory budget, so that the management team is clear about what systemic changes will be required in order to effect altered inventory turnover levels. Also, be aware that any advanced production planning system takes a considerable amount of time to install and tune, so it is best if the inventory budget contains a gradual ramp-up to different planned levels of inventory. Given this input from the inventory budget, the production budget is used to derive the unit quantity of required products that must be manufactured in order to meet revenue targets for each budget period. This involves a number of interrelated factors, such as the availability of sufficient capacity for production needs. Of particular concern should be the amount of capacity at the bottleneck operation. Since this tends to be the most expensive capital item, it is important to budget a sufficient quantity of funding to ensure that this operation includes enough equipment to meet the targeted production goals. If the bottleneck operation involves skilled labor, rather than equipment, then the human resources staff should be consulted regarding its ability to bring in the necessary personnel in time to improve the bottleneck capacity in a timely manner. Another factor that drives the budgeted costs contained within the production budget is the anticipated size of production batches. If the batch size is expected to decrease, then more overhead costs should be budgeted in the production scheduling, materials handling, and machine setup staffing areas. If longer batch sizes are planned then there may be a possibility of proportionally reducing overhead costs in these areas. This is a key consideration that is frequently overlooked, but which can have an outsized impact on overhead costs. If management attempts to contain overhead costs in this area while still using smaller batch sizes, then it will likely run into larger scrap quantities and quality issues that are caused by rushed batch setups and the allocation of incorrect materials to production jobs. Step costing is also an important consideration when creating the production budget. Costs will increase in large increments when certain capacity levels are reached. The management team should be fully aware of when these capacity levels will be reached, so that it can plan appropriately for the incurrence of added costs. For example, the addition of a second shift to the production area will call for added costs

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in the areas of supervisory staff, an increased pay rate, and higher maintenance costs. The inverse of this condition can also occur, where step costs can decline suddenly if capacity levels fall below a specific point. Production levels may also be impacted by any lengthy tooling setups or changeovers to replacement equipment. These changes may halt all production for extended periods, and so must be carefully planned for. This is the responsibility of the industrial engineering staff. The accountant would do well to review the company’s past history of actual equipment setup times to see whether the current engineering estimates are sufficiently lengthy. The expense items included in the production budget should be driven by a set of subsidiary budgets, which are the purchasing, direct labor, and overhead budgets. These budgets can be simply included in the production budget, but they typically involve such a large proportion of company costs that it is best to lay them out separately in greater detail in separate budgets. Comments on these budgets are as follows: 

Purchasing budget. The purchasing budget is driven by several factors, first of which is the bill of materials that comprises the products that are planned for production during the budget period. These bills must be accurate, or else the purchasing budget can include seriously incorrect information. In addition, there should be a plan for controlling material costs, perhaps through the use of concentrated buying through few suppliers, or perhaps through the use of longterm contracts. If materials are highly subject to market pressures, comprise a large proportion of total product costs, and have a history of sharp price swings, then best-case and worst-case costing scenarios should be added to the budget so that managers can review the impact of costing issues in this area. If a just-in-time delivery system from suppliers is contemplated, then the purchasing budget should reflect a possible increase in material costs caused by the increased number of deliveries from suppliers. It is also worthwhile to budget for a raw material scrap and obsolescence expense; there should be a history of costs in these areas that can be extrapolated based on projected purchasing volumes.



Direct labor budget. Do not make the mistake of budgeting for direct labor as a fully variable cost. The production volume from day to day tends to be relatively fixed, and requires a set number of direct labor personnel on a continuing basis to operate production equipment and manually assemble products. Further, the production manager will realize much greater production efficiencies by holding onto an experienced production staff, rather than by letting them go as soon as production volumes make small incremental drops. Accordingly, it is better to budget based on reality, which is that direct labor personnel are usually retained, even if there are ongoing fluctuations in the level of production. Thus, direct labor should be shown in the budget as a fixed cost of production, within certain production volume parameters. Also, this budget should describe staffing levels by type of direct labor position; this is driven by labor routings, which are documents that describe the

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exact type and quantity of staffing needed to produce a product. When multiplied by the unit volumes located in the production budget, this results in an expected level of staffing by direct labor position. This information is most useful for the human resources staff, which is responsible for staffing the positions. The direct labor budget should also account for any contractually mandated changes in hourly rates, which may be itemized in a union agreement. Such an agreement may also have restrictions on layoffs, which should be accounted for in the budget if this will keep labor levels from dropping in proportion with budgeted reductions in production levels. Such an agreement may also require that layoffs be conducted in order of seniority, which may force higher-paid employees into positions that would normally be budgeted for less expensive laborers. Thus, the presence of a union contract can result in a much more complex direct labor budget than would normally be the case. The direct labor budget may also contain features related to changes in the efficiency of employees, and any resulting changes in pay. For example, one possible pay arrangement is to pay employees based on a piece rate, which directly ties their performance to the level of production achieved. If so, this will probably apply only to portions of the workforce, so the direct labor budget may involve pay rates based on both piece rates and hourly pay. Another issue is that any drastic increases in the budgeted level of direct labor personnel will likely result in some initial declines in labor efficiency, since it takes time for new employees to learn their tasks. If this is the case, the budget should reflect a low level of initial efficiency, with a ramp-up over time to higher levels that will result in greater initial direct labor costs. Finally, efficiency improvements may be rewarded with staff bonuses from time to time; if so, these bonuses should be included in the budget. Overhead budget. The overhead budget can be a simple one to create if there are no significant changes in production volume from the preceding year, because this involves a large quantity of static costs that will not vary much over time. Included in this category are machine maintenance, utilities, supervisory salaries, wages for the materials management, production scheduling, quality assurance personnel, facilities maintenance, and depreciation expenses. Under the no-change scenario, the most likely budgetary alterations will be to machinery or facilities maintenance, which are dependent on the condition and level of usage of company property. If there is a significant change in the expected level of production volume, or if new production lines are to be added, then one should examine this budget in great detail, for the underlying production volumes may cause a ripple effect that results in wholesale changes to many areas of the overhead budget. Of particular concern is the number of overhead-related personnel who must be either laid off or added when capacity levels reach certain critical points, such as the addition or subtraction of extra work shifts. Costs also tend to rise substantially when a facility is operating at very close to 100 percent capacity, since this tends to call for an inordinate amount of effort to maintain on an ongoing basis.

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The purchasing, direct labor, and overhead budgets can then be summarized into a cost-of-goods-sold budget. This budget should incorporate, as a single line item, the total amount of revenue, so that all manufacturing costs can be deducted from it to yield a gross profit margin on the same document. This budget is referred to constantly during the budget creation process, since it tells management whether its budgeting assumptions are yielding an acceptable gross margin result. Since it is a summarylevel budget for the production side of the budgeting process, this is also a good place to itemize any production-related statistics, such as the average hourly cost of direct labor, inventory turnover rates, and the amount of revenue dollars per production person. Thus far, we have reviewed the series of budgets that descend in turn from the revenue budget and then through the production budget. However, there are other expenses that are unrelated to production. These are categories in a separate set of budgets. The first is the sales department budget. This includes the expenses that the sales staff must incur in order to achieve the revenue budget, such as travel and entertainment, as well as sales training. Of particular concern in this budget is the amount of budgeted headcount that is required to meet the sales target. It is essential that the actual sales per salesperson from the most recent completed year of operations be compared with the same calculation in the budget to ensure that there is a sufficiently large budget available for an adequate number of sales personnel. This is a common problem, for companies will make the false assumption that the existing sales staff can make heroic efforts to wildly exceed its previous-year sales efforts. Furthermore, the budget must account for a sufficient time period in which new sales personnel can be trained and form an adequate base of customer contacts to create a meaningful stream of revenue for the company. In some industries, this learning curve may be only a few days, but it can be the better part of a year if considerable technical knowledge is required to make a sale. If the latter situation is the case, it is likely that the procurement and retention of qualified sales staff is the key element of success for a company, which makes the sales department budget one of the most important elements of the entire budget. The marketing budget is also closely tied to the revenue budget, for it contains all of the funding required to roll out new products, merchandise them properly, advertise for them, test new products, and so on. A key issue here is to ensure that the marketing budget is fully funded to support any increases in sales noted in the revenue budget. It may be necessary to increase this budget by a disproportionate amount if one is trying to create a new brand, issue a new product, or distribute an existing product in a new market. These costs can easily exceed any associated revenues for some time. A common budgeting problem is not to provide sufficient funding in these instances, leading to a significant drop in expected revenues. Another nonproduction budget that is integral to the success of the corporation is the general and administrative budget. This contains the cost of the corporate management staff, plus all accounting, finance, and human resources personnel. Since this is a cost center, the general inclination is to reduce these costs to the bare minimum. However, in order to do so, there must be a significant investment in

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technology in order to achieve reductions in the manual labor usually required to process transactions; thus, there must be some provision in the capital budget for this area. There is a feedback loop between the staffing and direct labor budgets and the general and administrative budget, because the human resources department must staff itself based on the amount of hiring or layoffs that are anticipated elsewhere in the company. Similarly, a major change in the revenue volume will alter the budget for the accounting department, since many of the activities in this area are driven by the volume of sales transactions. Thus, the general and administrative budget generally requires a number of iterations in response to changes in many other parts of the budget. Though salaries and wages should be listed in each of the departmental budgets, it is useful to list the total headcount for each position through all budget periods in a separate staffing budget. By doing so, the human resources staff can tell when specific positions must be filled, so that they can time their recruiting efforts most appropriately. This budget also provides good information for the person responsible for the facilities budget, since he or she can use it to determine the timing and amount of square footage requirements for office space. Rather than being a standalone budget, the staffing budget tends to be one whose formulas are closely intertwined with those of all other departmental budgets, so that a change in headcount information on this budget will automatically translate into a change in the salaries expense on other budgets. It is also a good place to store the average pay rates, overtime percentages, and average benefit costs for all positions. By centralizing this cost information, the human resources staff can more easily update budget information. Since salary-related costs tend to comprise the highest proportion of costs in a company (excluding materials costs), this tends to be a heavily used budget. The facilities budget is based on the level of activity that is estimated in many of the budgets just described. For this reason, it is one of the last budgets to be completed. This budget is closely linked to the capital budget, since expenditures for additional facilities will require more maintenance expenses in the facilities budget. This budget typically contains expense line items for building insurance, maintenance, repairs, janitorial services, utilities, and the salaries of the maintenance personnel employed in this function. It is crucial to estimate the need for any upcoming major repairs to facilities when constructing this budget, since these can greatly amplify the total budgeted expense. Another budget that includes input from virtually all areas of a company is the capital budget. This should comprise either a summary listing of all main fixed asset categories for which purchases are anticipated, or else a detailed listing of the same information; the latter case is recommended only if there are comparatively few items to be purchased. The capital budget is of great importance to the calculation of corporate financing requirements, since it can involve the expenditure of sums far beyond those that are normally encountered through daily cash flows. This topic is addressed in greater detail in Chapter 2, Capital Budgeting Decisions.

1-1 How Does the System of Interlocking Budgets Work?

9

The end result of all the budgets just described is a set of financial statements that reflect the impact on the company of the upcoming budget. At a minimum, these statements should include the income statement and cash flow statement, since these are the best evidence of fiscal health during the budget period. The balance sheet is less necessary, since the key factors upon which it reports are related to cash, and that information is already contained within the cash flow statement. These reports should be directly linked to all the other budgets, so that any changes to the budgets will immediately appear in the financial statements. The management team will closely examine these statements and make numerous adjustments to the budgets in order to arrive at a satisfactory financial result. The budget-linked financial statements are also a good place to store related operational and financial ratios, so that the management team can review this information and revise the budgets in order to alter the ratios to match benchmarking or industry standards that may have been set as goals. Typical measurements in this area can include revenue and income per person, inventory turnover ratios, and gross margin percentages. This type of information is also useful for lenders, who may have required minimum financial performance results as part of loan agreements, such as a minimum current ratio or debt-to-equity ratio. The cash forecast is of exceptional importance, for it tells company managers whether the proposed budget model will be feasible. If cash projects result in major cash needs that cannot be met by any possible financing, then the model must be changed. The assumptions that go into the cash forecast should be based on strict historical fact, rather than the wishes of managers. This stricture is particularly important in the case of cash receipts from accounts receivable. If the assumptions are changed in the model to reflect an advanced rate of cash receipts that exceeds anything that the company has heretofore experienced, then it is very unlikely that it will be achieved during the budget period. Instead, it is better to use proven collection periods as assumptions and alter other parts of the budget to ensure that cash flows remain positive. The cash forecast is a particularly good area in which to spot the impact of changes in credit policy. For example, if a company wishes to expand its share of the market by allowing easy credit to marginal customers, then it should lengthen the assumed collection period in the cash forecast to see if there is a significant downgrading of the resulting cash flows. The other key factor in the cash forecast is the use of delays in budgeted accounts payable payments. It is common for managers to budget for extended payment terms in order to fund other cash flow needs, but there are several problems that can result from this policy. One is the possible loss of key suppliers who will not tolerate late payments. Another is the risk of being charged interest on late payments to suppliers. A third problem is that suppliers may relegate a company to a lower level on their lists of shipment priorities, since they are being paid late. Finally, suppliers may simply raise their prices in order to absorb the cost of the late payments. Consequently, the late payment strategy must be followed with great care, using it only on those suppliers who do not appear to notice, and otherwise doing it only after prior

10

Management Accounting Best Practices

negotiation with targeted suppliers to make the changed terms part of the standard buying agreement. The last document in the system of budgets is the discussion of financing alternatives. This is not strictly a budget, though it will contain a single line item, derived from the cash forecast, which itemizes funding needs during each period itemized in the budget. In all other respects, it is simply a discussion of financing alternatives, which can be quite varied. This may involve a mix of debt, supplier financing, preferred stock, common stock, or some other, more innovative approach. The document should contain a discussion of the cost of each form of financing, the ability of the company to obtain it, and when it can be obtained. Managers may find that there are so few financing alternatives available, or that the cost of financing is so high, that the entire budget must be restructured in order to avoid the negative cash flow that calls for the financing. There may also be a need for feedback from this document back into the budgeted financial statements in order to account for the cost of obtaining the funding, as well as any related interest costs.

1-2 WHAT DOES A SAMPLE BUDGET LOOK LIKE? In response this question, we will review several variations on how a budget can be constructed, using a number of examples. The first budget covered is the revenue budget, which is shown in Exhibit 1.2. The exhibit uses quarterly revenue figures for a budget year rather than monthly, in order to conserve space. It contains revenue estimates for three different product lines that are designated as Alpha, Beta, and Charlie. The Alpha product line uses a budgeting format that identifies the specific quantities that are expected to be sold in each quarter, as well as the average price per unit sold. This format is most useful when there are not so many products that such a detailed delineation would create an excessively lengthy budget. It is a very useful format, for the sales staff can go into the budget model and alter unit volumes and prices quite easily. An alternative format is to reveal this level of detail for only the most important products, and to lump the revenue from other products into a single line item, as is the case for the Beta product line. The most common budgeting format is used for the Beta product line, where we avoid the use of detailed unit volumes and prices in favor of a single lump-sum revenue total for each reporting period. This format is used when there are multiple products within each product line, making it cumbersome to create a detailed list of individual products. However, this format is the least informative and gives no easy way to update the supporting information. Yet another budgeting format is shown for the Charlie product line, where projected sales are grouped by region. This format is most useful when there are many sales personnel, each of whom has been assigned a specific territory in which to operate. This budget can then be used to judge the ongoing performance of each salesperson.

11

Statistics: Product Line Proportion: Alpha Beta Charlie

Product Line Charlie: Region 1 Region 2 Region 3 Region 4

Product Line Beta:

100.0%

100.0%

24.5%

23.3%

Quarterly Revenue Proportion

Product Line Total

$1,912,850

$1,821,000

Revenue Grand Total

16.3% 55.3% 28.4%

$544,000

$563,000

Revenue Subtotal

11.5% 57.6% 30.9%

$95,000 $89,000 $95,000 $265,000

$1,057,000

$311,850

$210,000

$1,048,000

$14.85 21,000

Quarter 2

$15.00 14,000

Quarter 1

$123,000 $80,000 $95,000 $265,000

Revenue Subtotal

Revenue Subtotal

Revenue Budget for the Fiscal Year Ended xx/xx/07

Product Line Alpha: Unit Price Unit Volume

Exhibit 1.2

100.0%

18.6% 53.2% 28.2%

25.6%

$1,993,000

$562,000

$82,000 $95,000 $65,000 $320,000

$1,061,000

$370,000

$14.80 25,000

Quarter 3

100.0%

22.1% 50.8% 27.1%

26.6%

$2,072,250

$562,000

$70,000 $101,000 $16,000 $375,000

$1,053,000

$457,250

$14.75 31,000

Quarter 4

100.0%

17.3% 54.1% 28.6%

100.0%

$7,799,100

$2,231,000

$370,000 $365,000 $271,000 $1,225,000

$4,219,000

$1,349,100

— 91,000

Totals

12 Exhibit 1.3

Management Accounting Best Practices Production & Inventory Budget for the Fiscal Year Ended xx/xx/07 Quarter 1 Quarter 2 Quarter 3 Quarter 4

Inventory Turnover Goals: Raw Materials Turnover W-I-P Turnover Finished Goods Turnover

Totals

4.0 12.0 6.0

4.5 15.0 6.0

5.0 18.0 9.0

5.5 21.0 9.0

15,000

21,000

20,000

15,000



Unit Sales Budget

14,000

21,000

25,000

31,000

91,000

Planned Production Ending Inventory Units

20,000 21,000

20,000 20,000

20,000 15,000

27,375 11,375

87,375

Bottleneck Unit Capacity Bottleneck Utilization

20,000 100%

20,000 100%

20,000 100%

40,000 68%

Planned Finished Goods Turnover

15,167

15,167

11,375

11,375

Product Line Alpha Production: Beginning Inventory Units

4.8 16.5 7.5

These revenue reporting formats can also be combined, so that the product line detail for the Alpha product can be used as underlying detail for the sales regions used for the Charlie product line—though this will result in a very lengthy budget document. There is also a statistics section at the bottom of the revenue budget that itemizes the proportion of total sales that occurs in each quarter, plus the proportion of product line sales within each quarter. Though it is not necessary to use these exact measurements, it is useful to include some type of measure that informs the reader of any variations in sales from period to period. Both the production and inventory budgets are shown in Exhibit 1.3. The inventory budget is itemized at the top of the exhibit, where we itemize the amount of planned inventory turnover in all three inventory categories. There is a considerable ramp-up in work-in-process inventory turnover, indicating the planned installation of a manufacturing planning system of some kind that will control the flow of materials through the facility. The production budget for just the Alpha product line is shown directly below the inventory goals. This budget is not concerned with the cost of production, but rather with the number of units that will be produced. In this instance, we begin with an onhand inventory of 15,000 units, and try to keep enough units on hand through the remainder of the budget year to meet both the finished goods inventory goal at the top of the exhibit and the number of required units to be sold, which is referenced from the revenue budget. The main problem is that the maximum capacity of the bottleneck operation is 20,000 units per quarter. In order to meet the revenue target, we must run

1-2 What Does a Sample Budget Look Like?

13

that operation at full bore through the first three quarters, irrespective of the inventory turnover target. This is especially important because the budget indicates a jump in bottleneck capacity in the fourth quarter from 20,000 to 40,000 units—this will occur when the bottleneck operation is stopped for a short time while additional equipment is added to it. During this stoppage, there must be enough excess inventory on hand to cover any sales that will arise. Consequently, production is planned for 20,000 units per quarter for the first three quarters, followed by a more precisely derived figure in the fourth quarter that will result in inventory turns of 9.0 at the end of the year, exactly as planned. The production budget can be enhanced with the incorporation of planned machine downtime for maintenance, as well as for the planned loss of production units to scrap. It is also useful to plan for the capacity needs of nonbottleneck work centers, since these areas will require varying levels of staffing, depending on the number of production shifts needed. The purchasing budget is shown in Exhibit 1.4. This contains several different formats for planning budgeted purchases for the Alpha product line. The first option summarizes the planned production for each quarter; this information is brought forward from the production budget. We then multiply this by the standard unit cost of materials to arrive at the total amount of purchases that must be made in order to adequately support sales. The second option identifies the specific cost of each component of the product, so that management can see where cost increases are expected to occur. Though this version provides more information, it occupies a great deal of space on the budget if there are many components in each product, or many products. A third option is shown at the bottom of the exhibit that summarizes all purchases by commodity type. This format is most useful for the company’s buyers, who usually specialize in certain commodity types. The purchasing budget can be enhanced by adding a scrap factor for budgeted production, which will result in slightly higher quantities to buy, thereby leaving less chance of running out of raw materials. Another upgrade to the exhibit would be to schedule purchases for planned production some time in advance of the actual manufacturing date, so that the purchasing staff will be assured of having the parts on hand when manufacturing begins. A third enhancement is to round off the purchasing volumes for each item into the actual buying volumes that can be obtained on the open market. For example, it may be possible to buy the required labels only in volumes of 100,000 at a time, which would result in a planned purchase at the beginning of the year that would be large enough to cover all production needs through the end of the year. The direct labor budget is shown in Exhibit 1.5. This budget assumes that only one labor category will vary directly with revenue volume; that category is the final assembly department, where a percentage in the far right column indicates that the cost in this area will be budgeted at a fixed 3.5 percent of total revenues. In all other cases, there are assumptions for a fixed number of personnel in each position within each production department. All of the wage figures for each department (except for final assembly) are derived from the planned hourly rates and headcount figures noted

14

Management Accounting Best Practices

Exhibit 1.4

Purchasing Budget for the Fiscal Year Ended xx/xx/07 Quarter 1 Quarter 2 Quarter 3 Quarter 4

Inventory Turnover Goals: Raw Materials Turnover

4.0

4.5

5.0

5.5

Product Line Alpha Purchasing (Option 1): Planned Production 20,000 Standard Materials Cost/Unit $5.42

20,000 $5.42

20,000 $5.67

27,375 $5.67

Total Material Cost

$5.42

Product Line Alpha Purchasing (Option 2): Plastic Commodities Molded Parts Units 20,000 Molded Parts Cost $4.62 Adhesives Commodity Labels Units 20,000 Labels Cost $0.42 Fasteners Commodity Fasteners Units 20,000 Fasteners Cost $0.38 Statistics: Materials as Percent of Revenue

4.8

$108,400 $108,400 $113,400 $155,216 $485,416

Product Line Alpha Purchasing (Option 2): Planned Production 20,000 Molded Part $4.62 Labels $0.42 Fittings & Fasteners $0.38 Total Cost of Components

Totals

36%

20,000 $4.62 $0.42 $0.38

20,000 $4.85 $0.42 $0.40

27,375 $4.85 $0.42 $0.40

$5.42

$5.67

$5.67

20,000 $4.62

20,000 $4.85

27,375 $4.85

20,000 $0.42

20,000 $0.42

27,375 $0.42

20,000 $0.38

20,000 $0.40

27,375 $0.40

36%

38%

38%

at the bottom of the page. This budget can be enhanced with the addition of separate line items for payroll tax percentages, benefits, shift differential payments, and overtime expenses. The cost of the final assembly department can also be adjusted to account for worker efficiency, which will be lower during production ramp-up periods when new, untrained employees are added to the workforce. A sample of the overhead budget is shown in Exhibit 1.6. In this exhibit, we see that the overhead budget is really made up of a number of subsidiary departments, such as maintenance, materials management, and quality assurance. If the budgets of any of these departments are large enough, it makes a great deal of sense to split them off into a separate budget, so that the managers of those departments can see their budgeted expectations more clearly. Of particular interest in this exhibit is the valid

1-2 What Does a Sample Budget Look Like? Exhibit 1.5

15

Direct Labor Budget for the Fiscal Year Ended xx/xx/07 Quarter 1 Quarter 2 Quarter 3 Quarter 4

Machining Department: Sr. Machine Operator Machining Apprentice Expense Subtotal Paint Department: Sr. Paint Shop Staff Painter Apprentice Expense Subtotal Polishing Department: Sr. Polishing Staff Polishing Apprentice Expense Subtotal Final Assembly Department: General Laborer Expense Subtotal

Expense Grand Total Statistics: Union Hourly Rates: Sr. Machine Operator Machining Apprentice Sr. Paint Shop Staff Painter Apprentice Sr. Polishing Staff Polishing Apprentice Headcount by Position: Sr. Machine Operator Machining Apprentice Sr. Paint Shop Staff Painter Apprentice Sr. Polishing Staff Polishing Apprentice

Totals

Notes

$15,120 $4,914

$15,372 $4,964

$23,058 $9,929

$23,058 $9,929

$76,608 $29,736

$20,034

$20,336

$32,987

$32,987 $106,344

$15,876 $5,065

$16,128 $5,216

$16,128 $5,216

$16,128 $5,216

$64,260 $20,714

$20,941

$21,344

$21,344

$21,344

$84,974

$16,632 $4,360

$11,844 $4,511

$11,844 $4,511

$11,844 $4,511

$52,164 $17,892

$20,992

$16,355

$16,355

$16,355

$70,056

$63,735

$66,950

$69,755

$72,529 $272,969 3.5%

$63,735

$66,950

$69,755

$72,529 $272,969

$125,702 $124,985 $140,441 $143,215 $534,343

$15.00 $9.75 $15.75 $10.05 $11.00 $8.65

$15.25 $9.85 $16.00 $10.35 $11.75 $8.95

$15.25 $9.85 $16.00 $10.35 $11.75 $8.95

$15.25 $9.85 $16.00 $10.35 $11.75 $8.95

2 1 2 1 3 1

2 1 2 1 2 1

3 2 2 1 2 1

3 2 2 1 2 1

16

Management Accounting Best Practices

Exhibit 1.6

Overhead Budget for the Fiscal Year Ended xx/xx/07 Valid Capacity Range

Quarter 1

Quarter 2

Quarter 3

Quarter 4

Totals

Supervision: Production Manager Salary Shift Manager Salaries

$16,250 $22,000

$16,250 $22,000

$16,250 $23,500

$16,250 $23,500

$65,000 — $91,000 40%–70%

Expense Subtotal

$38,250

$38,250

$39,750

$39,750

$156,000

$54,000 $56,500 $58,000 $60,250 $8,250 $8,250 $8,500 $8,500 $225,000 $225,000 $275,000 $225,000 $78,000 $29,000 $12,000 $54,000

$228,750 $33,500 $950,000 $173,000

Maintenance Department: Equipment Maint. Staff Facilities Maint. Staff Equipment Repairs Facility Repairs Expense Subtotal

40%–70% 40%–70% 40%–70% 40%–70%

$365,250 $318,750 $353,500 $347,750 $1,385,250

Materials Management Department: Manager Salary $18,750 Purchasing Staff $28,125 Materials Mgmt. Staff $28,000 Production Control Staff $11,250

$18,750 $18,750 $35,000 $11,250

$18,750 $18,750 $35,000 $11,250

$18,750 $18,750 $35,000 $11,250

$75,000 — $84,375 40%–70% $133,000 40%–70% $45,000 40%–70%

Expense Subtotal

$86,125

$83,750

$83,750

$83,750

$337,375

Quality Department: Manager Salary Quality Staff Lab Testing Supplies

$13,750 $16,250 $5,000

$13,750 $16,250 $4,500

$13,750 $16,250 $4,500

$13,750 $24,375 $4,500

Expense Subtotal

$35,000

$34,500

$34,500

$42,625

$146,625

$14,000 $60,000 $3,200

$15,750 $55,000 $3,200

$15,750 $55,000 $3,200

$15,750 $60,000 $3,200

$61,250 — $230,000 40%–70% $12,800 —

$77,200

$73,950

$73,950

$78,950

$304,050

Other Expenses: Depreciation Utilities Boiler Insurance Expense Subtotal

Expense Grand Total

$55,000 — $73,125 40%–70% $18,500 40%–70%

$601,825 $549,200 $585,450 $592,825 $2,329,300

1-2 What Does a Sample Budget Look Like?

17

capacity range noted on the far-right side of the exhibit. This signifies the production activity level within which the budgeted overhead costs are accurate. If the actual capacity utilization were to fall outside of this range, either high or low, a separate overhead budget should be constructed with costs that are expected to be incurred within those ranges. A sample cost-of-goods-sold budget is shown in Exhibit 1.7. This format splits out each of the product lines noted in the revenue budget for reporting purposes, and subtracts from each one the materials costs that are noted in the purchases budget. This results in a contribution margin for each product line that is the clearest representation of the impact of direct costs (usually direct material costs) on each one. We then summarize these individual contribution margins into a summary-level contribution margin, and then subtract the total direct labor and overhead costs (as referenced from the direct labor and overhead budgets) to arrive at a total gross margin. The statistics section also notes the number of production personnel budgeted for each quarterly reporting period, plus the average annual revenue per production employee—these statistics can be replaced with any operational information that management wants to see at a summary level for the production function, such as efficiency levels, capacity utilization, or inventory turnover. The sales department budget is shown in Exhibit 1.8. This budget shows several different ways in which to organize the budget information. At the top of the budget is a block of line items that lists the expenses for those overhead costs within the department that cannot be specifically linked to a salesperson or region. In cases where the number of sales staff is quite small, all of the department’s costs may be listed in this area. Another alternative is shown in the second block of expense line items in the middle of the sales department budget, where all of the sales costs for an entire product line are lumped together into a single line item. If each person on the sales staff is exclusively assigned to a single product line, then it may make sense to break down the budget into separate budget pages for each product line, and list all of the expenses associated with each product line on a separate page. A third alternative is shown next in the exhibit, where we list a summary of expenses for each sales person. This format works well when combined with the departmental overhead expenses at the top of the budget, since this accounts for all of the departmental costs. However, this format brings up a confidentiality issue, since the compensation of each sales person can be inferred from the report. Also, this format would include the commission expense paid to each sales person; since commissions are a variable cost that is directly associated with each incremental dollar of sales, they should be itemized as a separate line item within the cost of goods sold. A final option listed at the bottom of the example is to itemize expenses by sales region. This format works best when there are a number of sales personnel within the department who are clustered into a number of clearly identifiable regions. If there were no obvious regions or if there were only one salesperson per region, then the better format would be to list expenses by salesperson.

18 Exhibit 1.7

Management Accounting Best Practices Cost-of-Goods-Sold Budget for the Fiscal Year Ended xx/xx/07 Quarter 1

Product Line Alpha: Revenue Materials Expense

Quarter 2

Quarter 3

Quarter 4

Totals

$210,000 $108,400

$311,850 $108,400

$370,000 $113,400

$457,250 $1,349,100 $155,216 $485,416

Contribution Margin $$

$101,600

$203,450

$256,600

$302,034

$863,684

Contribution Margin %

48%

65%

69%

66%

64%

Product Line Beta: Revenue Materials Expense Contribution Margin $$ Contribution Margin %

$1,048,000 $1,057,000 $1,061,000 $1,053,000 $4,219,000 $12,000 $14,000 $15,000 $13,250 $54,250 $1,036,000 $1,043,000 $1,046,000 $1,039,750 $4,164,750 99%

99%

99%

$563,000 $268,000

$544,000 $200,000

$562,000 $220,000

$562,000 $2,231,000 $230,000 $918,000

Contribution Margin $$

$295,000

$344,000

$342,000

$332,000 $1,313,000

Contribution Margin %

52%

63%

61%

Revenue—Product Line Charlie: Revenue Materials Expense

99%

59%

99%

59%

Total Contribution Margin $$ $1,432,600 $1,590,450 $1,644,600 $1,673,784 $6,341,434 79%

83%

83%

$125,702 $601,825

$124,985 $549,200

$140,441 $585,450

$143,215 $534,343 $592,825 $2,329,300

Total Gross Margin $$

$705,073

$916,265

$918,709

$937,744 $3,477,791

Total Gross Margin %

39%

48%

46%

45%

23 $316,696

22 $347,791

22 $362,364

23 $360,391

Total Contribution Margin % Direct Labor Expense: Overhead Expense:

Statistics: No. of Production Staff* Ave. Annual Revenue per Production Employee *

81%

81%

44%

Not including general assembly staff.

At the bottom of the budget is the usual statistics section. The sales department budget is concerned only with making sales, so it should be no surprise that revenue per salesperson is the first item listed. Also, since the primary sales cost associated with this department is usually travel costs, the other statistical item is the travel and entertainment cost per person.

1-2 What Does a Sample Budget Look Like? Exhibit 1.8

19

Sales Department Budget for the Fiscal Year Ended xx/xx/07 Quarter 1

Quarter 2

Quarter 3

Quarter 4

Totals

$500 $750 $2,945 $38,500 $1,500

$500 $600 $5,240 $68,500 $1,500

$500 $650 $5,240 $68,500 $1,500

$500 $600 $8,186 $107,000 $2,000

$2,000 $2,600 $21,611 $282,500 $6,500

$44,195

$76,340

$76,390

$118,286

$315,211

Product Line Alpha:

$32,000

$18,000

$0

$21,000

$71,000

Expenses by Salesperson: Jones, Milbert Smidley, Jefferson Verity, Jonas

$14,000 $1,000 $7,000

$16,500 $9,000 $9,000

$17,000 $8,000 $14,000

$12,000 $12,000 $12,000

$59,500 $30,000 $42,000

$22,000

$34,500

$39,000

$36,000

$131,500

$52,000 $8,000 $11,000

$71,000 $14,000 $10,000

$15,000 $6,000 $12,000

$0 $12,000 $24,000

$138,000 $40,000 $57,000

Expense Subtotal

$71,000

$95,000

$33,000

$36,000

$235,000

Expense Grand Total

$137,195

$205,840

$148,390

$190,286

$681,711

Statistics: Revenue per Salesperson T&E per Salesperson

$607,000 $500

$637,617 $500

$664,333 $500

$690,750 $667

$2,599,700 $2,167

Departmental Overhead: Depreciation Office Supplies Payroll Taxes Salaries Travel & Entertainment Expense Subtotal

Expense Subtotal Expenses by Region: East Coast Midwest Coast West Coast

Exhibit 1.9 shows a sample marketing budget. As was the case for the sales department, this one also itemizes departmental overhead costs at the top, which leaves space in the middle for the itemization of campaign-specific costs in the middle. The campaign-specific costs can be lumped together for individual product lines, as is the case for product lines Alpha and Beta in the exhibit, or with subsidiary line items, as is shown for product line Charlie. A third possible format, which is to itemize marketing costs by marketing tool (e.g., advertising, promotional tour, coupon redemption, etc.) is generally not recommended if there is more than one product line, since there is no way for an analyst to determine the impact of individual marketing costs on specific product lines. The statistics at the bottom of the page attempt to compare marketing costs to sales; however, this should be treated as only an

20

Management Accounting Best Practices

Exhibit 1.9

Marketing Budget for the Fiscal Year Ended xx/xx/07 Quarter 1

Quarter 2

Quarter 3

Quarter 4

650 200 4,265 $55,750 5,000

750 200 4,265 $55,750 6,500

850 200 4,265 $55,750 7,250

1,000 200 4,265 $55,750 7,250

3,250 800 17,060 223,000 26,000

65,865

67,465

68,315

68,465

270,110

14,000 18,000

26,000 0

30,000 0

0 24,000

10,000 5,000 2,000 2,750

0 25,000 4,000 5,250

20,000 2,000 4,500 1,250

0 0 1,200 0

70,000 42,000 0 30,000 32,000 11,700 9,250

Expense Subtotal

51,750

60,250

57,750

25,200

194,950

Expense Grand Total

117,615

127,715

126,065

93,665

465,060

6.5%

6.7%

6.3%

4.5%

6.0%

25.3%

27.5%

27.1%

20.1%

100.0%

Departmental Overhead: Depreciation Office Supplies Payroll Taxes Salaries Travel & Entertainment Expense Subtotal Campaign-Specific Expenses: Product Line Alpha Product Line Beta Product Line Charlie Advertising Promotional Tour Coupon Redemption Product Samples

Statistics: Expense as Percent of Total Sales Expense Proportion by Quarter

Totals

approximation, since marketing efforts will usually not result in immediate sales, but rather will result in sales that build over time. Thus, there is a time lag after incurring a marketing cost that makes it difficult to determine the efficacy of marketing activities. A sample general and administrative budget is shown in Exhibit 1.10. This budget can be quite lengthy, including such additional line items as postage, copier leases, and office repair. Many of these extra expenses have been pruned from the exhibit in order to provide a compressed view of the general format to be used. The exhibit does not lump together the costs of the various departments that are typically included in this budget, but rather identifies each one in separate blocks; this format is most useful when there are separate managers for the accounting and human resources functions, so that they will have a better understanding of their budgets. The statistics section at the bottom of the page itemizes a benchmark target of the total general and administrative cost as a proportion of revenue. This is a particularly useful statistic

1-2 What Does a Sample Budget Look Like? Exhibit 1.10

21

General & Administrative Budget for the Fiscal Year Ended xx/xx/07 Quarter 1 Quarter 2 Quarter 3 Quarter 4

Accounting Department: Depreciation Office Supplies Payroll Taxes Salaries Training Travel & Entertainment

Totals

4,000 650 4,973 $65,000 500 0

4,000 650 4,973 $65,000 2,500 750

4,250 750 4,973 $65,000 7,500 4,500

4,250 750 4,973 $65,000 0 500

16,500 2,800 19,890 260,000 10,500 5,750

75,123

77,873

86,973

75,473

315,440

450 1,000 6,598 $86,250 4,500 5,000 2,000

500 850 6,598 $86,250 4,500 0 500

550 750 6,598 $86,250 4,500 0 500

600 1,250 6,598 $86,250 4,500 0 0

2,100 3,850 26,393 345,000 18,000 5,000 3,000

105,798

99,198

99,148

99,198

403,343

7,284 500 450 2,869 $37,500 5,000 2,000

7,651 500 8,000 2,869 $37,500 0 1,000

7,972 500 450 2,869 $37,500 7,500 3,500

8,289 500 450 2,869 $37,500 0 1,000

Expense Subtotal

55,603

57,520

60,291

50,608

224,021

Expense Grand Total

236,523

234,591

246,411

225,278

942,804

13.0%

12.3%

12.4%

10.9%

12.1%

11.5%

11.5%

11.5%

11.5%

11.5%

Expense Subtotal Corporate Expenses: Depreciation Office Supplies Payroll Taxes Salaries Insurance, Business Training Travel & Entertainment Expense Subtotal Human Resources Department: Benefits programs Depreciation Office Supplies Payroll Taxes Salaries Training Travel & Entertainment

Statistics: Expense as Proportion of Revenue Benchmark Comparison

Notes

31,196 0.4% 2,000 9,350 11,475 150,000 12,500 7,500

to track, since the general and administrative function is a cost center, and requires such a comparison in order to inform management that these costs are being held in check. A staffing budget is shown in Exhibit 1.11. This itemizes the expected headcount in every department by major job category. It does not attempt to identify individual

22

Management Accounting Best Practices

Exhibit 1.11

Staffing Budget for the Fiscal Year Ended xx/xx/07 Quarter 1

Quarter 2

Quarter 3

Quarter 4

Average Salary

Overtime Percent

Sales Department: Regional Sales Manager Salesperson Sales Support Staff

1 2 1

2 4 1

2 4 1

3 6 2

$120,000 $65,000 $34,000

0% 0% 6%

Marketing Department: Marketing Manager Marketing Researcher Secretary

1 2 1

1 2 1

1 2 1

1 2 1

$85,000 $52,000 $34,000

0% 0% 6%

General & Administrative: President Chief Operating Officer Chief Financial Officer Human Resources Mgr. Accounting Staff Human Resources Staff Executive Secretary

1 1 1 1 4 2 1

1 1 1 1 4 2 1

1 1 1 1 4 2 1

1 1 1 1 4 2 1

$175,000 $125,000 $100,000 $80,000 $40,000 $35,000 $45,000

0% 0% 0% 0% 10% 8% 6%

Research Department: Chief Scientist Senior Engineer Staff Junior Engineer Staff

1 3 3

1 3 3

1 3 3

1 4 3

$100,000 $80,000 $60,000

0% 0% 0%

Overhead Budget: Production Manager Quality Manager Materials Manager Production Scheduler Quality Assurance Staff Purchasing Staff Materials Mgmt Staff

1 1 1 1 2 3 4

1 1 1 1 2 2 5

1 1 1 1 2 2 5

1 1 1 1 3 2 5

$65,000 $55,000 $75,000 $45,000 $32,500 $37,500 $28,000

0% 0% 0% 0% 8% 8% 8%

39

42

42

48

Total Headcount

positions, since that can lead to an excessively lengthy list. Also, because there may be multiple positions identified within each job category, the average salary for each cluster of jobs is identified. If a position is subject to overtime pay, its expected overtime percentage is identified on the right side of the budget. Many sections of the budget should have linkages to this page, so that any changes in headcount here will be automatically reflected in the other sections. This budget may have to be restricted from general access, since it contains salary information that may be considered confidential information.

1-2 What Does a Sample Budget Look Like? Exhibit 1.12

23

Facilities Budget for the Fiscal Year Ended xx/xx/07

Facilty Expenses: Contracted Services Depreciation Electricity Charges Inspection Fees Insurance Maintenance Supplies Payroll Taxes Property Taxes Repairs Sewage Charges Trash Disposal Wages—Janitorial Wages—Maintenance Water Charges Expense Grand Total Statistics: Total Square Feet Square Feet/Employee Unused Square Footage

Quarter 1

Quarter 2

Quarter 3

Quarter 4

Totals

$5,500 $29,000 $4,500 $500 $8,000 $3,000 $1,148 $0 $15,000 $250 $3,000 $5,000 $10,000 $1,000

$5,400 $29,000 $3,500 $0 $0 $3,000 $1,148 $5,000 $0 $250 $3,000 $5,000 $10,000 $1,000

$5,000 $28,000 $3,500 $0 $0 $3,000 $1,148 $0 $29,000 $250 $3,000 $5,000 $10,000 $1,000

$4,500 $28,000 $4,500 $500 $0 $3,000 $1,186 $0 $0 $250 $3,000 $5,500 $10,000 $1,000

$20,400 $114,000 $16,000 $1,000 $8,000 $12,000 $4,628 $5,000 $44,000 $1,000 $12,000 $20,500 $40,000 $4,000

$85,898

$66,298

$88,898

$61,436

$302,528

52,000 839 1,200

52,000 813 1,200

78,000 1,219 12,500

78,000 1,099 12,500

The facilities budget tends to have the largest number of expense line items. A sample of this format is shown in Exhibit 1.12. These expenses may be offset by some rental or sub-lease revenues if a portion of the company facilities is rented out to other organizations. However, this revenue is shown in this budget only if the revenue amount is small; otherwise, it is more commonly found as an ‘‘other revenue’’ line item on the revenue budget. A statistics section is found at the bottom of this budget that refers to the total amount of square feet occupied by the facility. A very effective statistic is the amount of unused square footage, which can be used to conduct an ongoing program of selling off, renting, or consolidating company facilities. The research department’s budget is shown in Exhibit 1.13. It is most common to segregate the department-specific overhead that cannot be attributed to a specific project at the top of the budget, and then cluster costs by project below that. By doing so, the management team can see precisely how much money is being allocated to each project. This may be of use in determining which projects must be canceled or delayed as part of the budget review process. The statistics section at the bottom of the budget notes the proportion of planned expenses among the categories of overhead, research, and development. These proportions can be examined to see whether the company is allocating funds to the right balance of projects that most effectively meets it product development goals.

24

Management Accounting Best Practices

Exhibit 1.13

Research Department for the Fiscal Year Ended xx/xx/07 Quarter 1

Quarter 2

Quarter 3

Quarter 4

Totals

500 750 9,945 $130,000 0

500 2,000 9,945 $130,000 0

400 1,500 9,945 $130,000 0

400 1,250 11,475 $150,000 0

1,800 5,500 41,310 540,000 0

Expense Subtotal

141,195

142,445

141,845

163,125

588,610

Research-Specific Expenses: Gamma Project Omega Project Pi Project Upsilon Project

20,000 5,000 14,000 500

43,500 6,000 7,000 2,500

35,000 7,500 7,500 5,000

12,500 9,000 4,500 0

111,000 27,500 33,000 8,000

Expense Subtotal

39,500

59,000

55,000

26,000

179,500

28,000 14,000 20,000 6,250

29,000 14,500 25,000 12,500

30,000 15,000 15,000 25,000

15,000 7,500 10,000 50,000

102,000 51,000 70,000 93,750

68,250

81,000

85,000

82,500

316,750

248,945

282,445

281,845

271,625

1,084,860

2

0

1

1

4

56.7% 15.9% 27.4%

50.4% 20.9% 28.7%

50.3% 19.5% 30.2%

60.1% 9.6% 30.4%

217.5% 65.8% 116.6%

100.0%

100.0%

100.0%

100.0%

400.0%

Departmental Overhead: Depreciation Office supplies Payroll Taxes Salaries Travel & Entertainment

Development-Specific Expenses: Latin Project Greek Project Mabinogian Project Old English Project Expense Subtotal

Expense Grand Total Statistics: Budgeted Number of Patent Applications Filed Proportion of Expenses: Overhead Research Development Total Expenses

The capital budget is shown in Exhibit 1.14. This format clusters capital expenditures by a number of categories. For example, the first category, entitled ‘‘bottleneck-related expenditures,’’ clearly focuses attention on those outgoing payments that will increase the company’s key productive capacity. The payments in the third quarter under this heading are directly related to the increase in bottleneck capacity that was shown the production budget for the fourth quarter. The budget also contains an automatic assumption of $7,000 in capital expenditures for any net

1-2 What Does a Sample Budget Look Like? Exhibit 1.14

25

Capital Budget for the Fiscal Year Ended xx/xx/07 Quarter 1

Quarter 2

Bottleneck-Related Expeditures: Stamping Machine Facility for Machine Headcount-Related Expenditures: Headcount Change x $7,000 Added Staff

$0

$21,000

$0

$8,000

$3,000 $5,000

$42,000

$106,000

$63,000

$50,000 $27,000

$3,000

$6,000 $13,000

$42,000

$42,000

Other Expenditures: Tool Crib Expansion $8,000

Totals $150,000 $72,000

$50,000 $27,000

Required Expenditures: Clean Air Scrubber

Total Expenditures

Quarter 4

$150,000 $72,000

Profit-Related Expenditures: Blending Machine Polishing Machine Safety-Related Expenditures: Machine Shielding Handicapped Walkways

Quarter 3

$267,000

$18,500

$18,500

$60,500

$441,500

increase in non–direct labor headcount, which encompasses the cost of computer equipment and office furniture for each person. If the company’s capitalization limit is set too high to list these expenditures on the capital budget, then a similar line item should be inserted into the general and administrative budget, so that the expense can be recognized under the office supplies or some similar account. The capital budget also includes a category for profit-related expenditures. Any projects listed in this category should be subject to an intensive expenditure review to ensure that they return a sufficient cash flow to make their acquisition profitable to the company. Other categories in the budget cover expenditures for safety or required items, which tend to be purchased with no cash flow discounting review. An alternative to this grouping system is to list only the sum total of all capital expenditures in each category, which is most frequently done when there are far too many separate purchases to list on the budget. Another variation is to list only the largest expenditures on separate budget lines, and cluster together all smaller ones. The level of capital purchasing activity will determine the type of format used. All of the preceding budgets roll up into the budgeted income and cash flow statement, which is noted in Exhibit 1.15. This format lists the grand totals from all preceding pages of the budget in order to arrive at a profit or loss for each budget quarter. In the example, we see that a large initial loss in the first quarter is gradually

26 Exhibit 1.15

Management Accounting Best Practices Income and Cash Flow Statement for the Fiscal Year Ended xx/xx/07 Quarter 1

Quarter 2

Quarter 3

Quarter 4

$1,821,000 $1,912,850 $1,993,000 $2,072,250 Revenue: Cost of Goods Sold: Materials Direct Labor Overhead Supervision Maintenance Department Materials Management Quality Department Other Expenses Total Cost of Goods Sold Gross Margin Operating Expenses: Sales Department General & Admin. Dept. Accounting Corporate Human Resources Marketing Department Facilities Department Research Department Total Operating Expenses Net Profit (Loss)

Ending Cash

$7,799,100

$388,400 $125,702

$322,400 $124,985

$348,400 $140,441

$398,466 $143,215

$1,457,666 $534,343

$38,250 $365,250 $86,125 $35,000 $77,200

$38,250 $318,750 $83,750 $34,500 $73,950

$39,750 $353,500 $83,750 $34,500 $73,950

$39,750 $347,750 $83,750 $42,625 $78,950

$156,000 $1,385,250 $337,375 $146,625 $304,050

$996,585 $1,074,291 $1,134,506

$4,321,309

$705,073

$916,265

$918,709

$937,744

$3,477,791

$137,195

$205,840

$148,390

$190,286

$681,711

$75,123 $105,798 $55,603 $117,615 $85,898 $248,945

$77,873 $99,198 $57,520 $127,715 $66,298 $282,445

$86,973 $99,148 $60,291 $126,065 $88,898 $281,845

$75,473 $99,198 $50,608 $93,665 $61,436 $271,625

$315,440 $403,343 $224,021 $465,060 $302,528 $1,084,860

$826,176

$916,888

$891,609

$842,290

$3,476,963

$121,103

$624

$27,100

$95,455

$828

$1,115,927

Quarter 1 Cash Flow: Beginning Cash Net Profit (Loss) Add Depreciation Minus Capital Purchases

Totals

Quarter 2

Quarter 3

Quarter 4

$100,000 $20,497 $34,627 $223,727 $121,103 $624 $27,100 $95,455 $49,600 $51,500 $50,800 $51,000 $8,000 $106,000 $267,000 $60,500 $20,497

Totals

$828 $202,900 $441,500

$34,627 $223,727 $137,772

offset by smaller gains in later quarters to arrive at a small profit for the year. However, the presentation continues with a cash flow statement that has less positive results. It begins with the net profit figure for each quarter, adds back the depreciation expense for all departments, and subtracts out all planned capital expenditures from the capital budget to arrive at cash flow needs for the year. This tells us that the company will

1-2 What Does a Sample Budget Look Like? Exhibit 1.16

27

Financing Budget for the Fiscal Year Ended xx/xx/07

Cash Position:

Quarter 1

Quarter 2

Quarter 3

Quarter 4

$20,497

$34,627

$223,727

$137,772

Financing Option One: Additional Debt

$225,000

Financing Cost

9.5%

Financing Option Two: Additional Preferred Stock

$225,000

8.0%

Financing Option Three: Additional Common Stock

$225,000

18.0%

400,000

9.0%

Existing Capital Structure: Debt Preferred Stock

$150,000

7.5%

Common Stock

$500,000

18.0%

Existing Cost of Capital

11.8%

Revised Cost of Capital: Financing Option One

10.7%

Financing Option Two

11.2%

Financing Option Three

12.9%

Note: Tax rate equals 38%.

experience a maximum cash shortfall in the third quarter. This format can be made more precise by adding in time lag factors for the payment of accounts payable and the collection of accounts receivable. The final document in the budget is an itemization of the finances needed to ensure that the rest of the budget can be achieved. An example is shown in Exhibit 1.16, which carries forward the final cash position at the end of each quarter that was the product of the preceding cash flow statement. This line shows that there will be a maximum shortfall of $223,727 by the end of the third quarter. The next section of the budget outlines several possible options for obtaining the required funds (which are rounded up to $225,000)—debt, preferred stock, or common stock. The financing cost of each one is noted in the far-right column, where we see that the interest cost on debt is 9.5 percent, the dividend on preferred stock is 8 percent, and the expected return by common stockholders is 18 percent. The third section on the page lists the existing capital structure, its cost, and the net cost of capital. This is quite important, for anyone reviewing this document can see what impact the financing options will have on the capital structure if any of them are selected. For example, the management team may prefer the low cost of debt, but can

28

Management Accounting Best Practices

also use the existing capital structure presentation to see that this will result in a very high proportion of debt to equity, which increases the risk that the company cannot afford to repay the debt to the lender. The fourth and final part of the budget calculates any changes in the cost of capital that will arise if any of the three financing options are selected. A footnote points out the incremental corporate tax rate; this is of importance to the calculation of the cost of capital, because the interest cost of debt can be deducted as an expense, thereby reducing its net cost. In the exhibit, selecting additional debt as the preferred form of financing will result in a reduction in the cost of capital to 10.7 percent, whereas a selection of high-cost common stock will result in an increase in the cost of capital to 12.9 percent. These changes can have an impact on what types of capital projects are accepted in the future, for the cash flows associated with them must be discounted by the cost of capital in order to see if they result in positive cash flows. Accordingly, a reduction in the cost of capital will mean that projects with marginal cash flows will become more acceptable, while the reverse will be true for a higher cost of capital. The budgeting examples shown here can be used as the format for a real-life corporate budget. However, it must be adjusted to include a company’s chart of accounts and departmental structure, so that it more accurately reflects actual operations. Also, it should include a detailed benefits and payroll tax calculation page, which will itemize the cost of Social Security taxes, Medicare, unemployment insurance, worker’s compensation insurance, medical insurance, and so on. These costs are a substantial part of a company’s budget, and yet are commonly lumped together into a simplistic budget model that does not accurately reflect their true cost. Though the budget model presented here may seem excessively large, it is necessary to provide detailed coverage of all aspects of the corporation, so that prospective changes to it can be accurately modeled through the budget. Thus, a detailed format is strongly recommended over a simple, summarized model.

1-3 HOW DOES FLEX BUDGETING WORK? One problem with the traditional budget model is that many of the expenses listed in it are directly tied to the revenue level. If the actual revenue incurred is significantly different from the budgeted figure, then so many expenses will also shift in association with the revenue that the comparison of budgeted to actual expenses will not be valid. For example, if budgeted revenues are $1 million and budgeted material costs are $450,000, one would expect a corresponding drop in the actual cost of materials incurred if actual revenues drop to $800,000. A budget-to-actual comparison would then show a significant difference in the cost of materials, which would in turn cause a difference in the gross margin and net profit. This issue also arises for a number of other variable or semivariable expenses, such as salesperson commissions, production supplies, and maintenance costs. Also, if there are really large differences between actual and budgeted revenue levels, other costs that are more fixed in nature will also change, such as the salaries, office supplies, and even facilities maintenance (since

1-4 What Best Practices Can I Apply to the Budgeting Process?

29

facilities may be sold off or added to, depending on which direction actual revenues have gone). These represent large step cost changes that will skew actual expenses so far away from the budget that it is difficult to conduct any meaningful comparison between the two. A good way to resolve this problem is to create a flexible budget, or ‘‘flex’’ budget that itemizes different expense levels depending upon changes in the amount of actual revenue. In its simplest form, the flex budget will use percentages of revenue for certain expenses, rather than the usual fixed numbers. This allows for an infinite series of changes in budgeted expenses that are directly tied to revenue volume. However, this approach ignores changes to other costs that do not change in accordance with small revenue variations. Consequently, a more sophisticated format will also incorporate changes to many additional expenses when certain larger revenue changes occur, thereby accounting for step costs. By making these changes to the budget, a company will have a tool for comparing actual with budgeted performance at many levels of activity. Though the flex budget is a good tool, it can be difficult to formulate and administer. One problem with its formulation is that many costs are not fully variable, instead having a fixed cost component that must be included in the flex budget formula. Another issue is that a great deal of time can be spent developing step costs, which is more time than the typical accounting staff has available, especially when in the midst of creating the standard budget. Consequently, the flex budget tends to include only a small number of step costs, as well as variable costs whose fixed cost components are not fully recognized. Implementation of the flex budget is also a problem, for very few accounting software packages incorporate any features that allow one to load in multiple versions of a budget that can be used at different revenue levels. Instead, some include the option to store a few additional budgets, which the user can then incorporate into the standard budget-to-actual comparison reports. This option does not yield the full benefits of a flex budget, since it allows for only a few changes in expenses based on a small number of revenue changes, rather than a set of expenses that will automatically change in proportion to actual revenue levels incurred. Furthermore, the option to enter several different budgets means that someone must enter this additional information into the accounting software, which can be a considerable chore if the number of budget line items is large. For these reasons, it is more common to see a flex budget incorporated into an electronic spreadsheet, with actual results being manually posted to it from other accounting reports.

1-4 WHAT BEST PRACTICES CAN I APPLY TO THE BUDGETING PROCESS? The budgeting process is usually rife with delays, which are caused by several factors. One is that information must be input to the budget model from all parts of the company—some of which may not put a high priority on the submission of budgeting

30

Management Accounting Best Practices

information. Another reason is that the budgeting process is highly iterative, sometimes requiring dozens of budget recalculations and changes in assumptions before the desired results are achieved. The typical budgeting process is represented in Exhibit 1.17, where we see that there is a sequential process that requires the completion of the revenue plan before the production plan can be completed, which in turn must be finished before the departmental expense budgets can be finished, which then yields a financing plan. If the results do not meet expectations, then the process starts over again at the top of the exhibit. This process is so time-consuming that the budget may not be completed before the budget period has already begun. There are a number of best practices that can be used to create a more streamlined budgeting process, which are as follows: 

Reduce the number of accounts. The number of accounts included in the budget should be reduced, thereby greatly reducing the amount of time needed to enter and update data in the budget model.



Reduce the number of reporting periods. Consolidate the 12 months shown in the typical budget into quarterly information, thereby eliminating two-thirds of the information in the budget. If the budget must later be reentered into the accounting system in order to provide budget-to-actual comparisons, then a simple formula can be used to divide the quarterly budget back into its monthly components—which is still much less work than maintaining 12 full months of budget information.



Use percentages for variable cost updates. When key activities, such as revenues, are changed in the budget model, one must peruse the entire budget in order to determine what related expenses must change in concert with the key activities. A much easier approach is to use percentage-based calculations for variable costs in the budget model, so that these expenses will be updated automatically. They should also be color-coded in the budget model, so that they will not be mistaken for items that are manually changed. Report on variables in one place. A number of key variables will impact the typical budget model, such as the assumed rate of inflation in wages or purchased parts, tax rates for income, payroll, and worker’s compensation, medical insurance rates, and so on. These variables are much easier to find if they are set up in a cluster within the budget, so that one can easily reference and alter them. Under this arrangement, it is also useful to show key results (such as net profits) on the same page with the variables, in order to make alterations to the variables and immediately see their impact without having to search through the budget model to find the information.





Use a budget procedure and timetable. The budget process is plagued by many iterations, since the first results will nearly always yield profits or losses that do not meet a company’s expectations. Furthermore, it requires input from all parts of a company, some of which may lag in sending in information in a timely manner. Accordingly, it is best to construct a budgeting procedure that specifically identifies

1-4 What Best Practices Can I Apply to the Budgeting Process?

31

Start

No

Strategic Objectives

Marketing & Advertising Plan

Detailed Sales Plans by Region & Salesperson

Revenue Plan

Sales Department Staffing Plan

Inventory Plan

Production Plan

Production Department Staffing Plan

Facilities Plan

Engineering, MIS, Support Staff, and Infrastructure Plans

Support Group Staffing Plan

Capital Expenditures Plan

Working Capital Plan

Financing Plan

Achieve Profit Goal?

Exhibit 1.17

Traditional Budgeting Process

Yes

End

32

Management Accounting Best Practices

what job positions must send budgeting information to the budget coordinator, what information is required of each person, and when that information is due. Furthermore, there should be a clear timetable of events that is carefully adhered to, so that plenty of time is left at the end of the budgeting process for the calculation of multiple iterations of the budget. In addition to these efficiency-improvement issues, there are other ways to modify the budgeting process so that it can be completed much more quickly. The following changes should be considered: 

Preload budget line items. Rather than requiring department managers to fill out a blank budget form for the upcoming budget year, have the accounting staff preload many of the budget line items with information from the current year. Most expenses are relatively fixed from year to year, or are easily linked to key drivers, such as headcount. Consequently, the accounting staff can probably arrive at more accurate budget numbers than a department manager for most line items. This approach leaves only a few of the larger and more variable accounts for managers to enter in the budget form. In some cases where a department is anticipating no major changes for the next budget year, it may even be possible for the accounting staff to create the entire department budget, so the department manager has only to make revisions to it.



Itemize the corporate strategy. The strategy and related tactical goals that the company is trying to achieve should be listed at the beginning of the budget model. All too frequently, management loses sight of its predetermined strategy when going through the many iterations that are needed to develop a realistic budget. By itemizing the corporate strategy in the budget document, it is much less likely that the final budget model will deviate significantly from the company’s strategic direction.



Identify step-costing change points. The budget model should have notations incorporated into it that specify the capacity levels at which expenses are valid. For example, if the production level for product A exceeds 100,000 per year, then a warning flag should be generated by the budget model that informs the budget manager of the need to add an extra shift to accommodate the increased production requirements. Another example is to have the model generate a warning flag when the average revenue per salesperson exceeds $1,000,000, since this may be the maximum expectation for sales productivity, and will require the addition of more sales personnel to the budget. These flags can be clustered at the front of the budget model, so that problems will be readily apparent to the reader. Specify maximum amounts of available funding. One of the warning flags just noted should include the maximum level of funding that the company can obtain. If an iteration of the budget model results in excessively high cash requirements, then the flag will immediately point out the problem. It may be useful to note next to the warning flag the amount by which the maximum funding has been exceeded, so that this information is readily available for the next budget iteration.



1-4 What Best Practices Can I Apply to the Budgeting Process? 





33

Base expense changes on cost drivers. Many expenses in the budget will vary in accordance with changes in various activities within the firm. As noted earlier in this section, expenses can be listed in the budget model as formulas, so that they vary in direct proportion to changes in budgeted revenue. This same concept can be taken a step further by listing other types of activities that drive cost behavior, and linking still other expenses to them with formulas. For example, the amount of telephone expense is directly related to the number of employees, so it can be linked to the total number of employees on the staffing budget. Another example is the number of machine setup personnel, which will change based on the planned number of production batches to be run during the year. This level of automation requires a significant degree of knowledge of how selected expenses interact with various activities within the company. Budget by groups of staff positions. A budget can rapidly become unwieldy if every position in the company is individually identified—especially if the names of all employees are listed. This format requires constant updating as the budget progresses through multiple iterations. A better approach is to itemize by job title, which allows one to vastly reduce the number of job positions listed in the budget. Rank projects. A more complex budget model can incorporate a ranking of all capital projects, so that any projects with a low ranking will be automatically eliminated by the model if the available amount of cash drops below the point where they could be funded. However, this variation requires that great attention be paid to the ranking of projects, since there may be some interrelationship between projects—if one is dropped but others are retained, then the ones retained may not be functional without the missing project.



Issue a summary-level model for use by senior management. The senior management team is primarily concerned with the summary results of each department, product line, or operating division, and does not have time to wade through the details of individual revenue and expense accounts. Further, they may require an increased level of explanation from the budgeting staff if they do choose to examine these details. Accordingly, the speed of the iteration process can be enhanced by producing a summary-level budget that is directly linked to the main budget, so that all fields in it are updated automatically. The senior management team can more easily review this document, yielding faster updates to the model.



Link budget results to an employee goal and reward system. The budgeting process does not end with the final approval of the budget model. Instead, it then passes to the human resources department, which uses it as the foundation for an employee goal and reward system. The trouble is that if budget approval is delayed, the human resources department will have very little time in which to create its goal and reward system. Accordingly, this add-on project should be incorporated directly into the budget model, so that it is approved alongside the rest of the budget. For example, a goals and rewards statement added to the budget can specify a bonus payment to the manager of the production department if he or she can create the number of units of product specified in the production budget. Similarly, the

34

Management Accounting Best Practices

Substitute Formulas for Manual Entries for Revenue-Based Expenses

Itemize Corporate Strategy within the Budget

List Major Variables in a Central Location in the Budget

Incorporate Variables into the Budget Model

Base Expenses on Cost Drivers

Specify Maximum Funding Available

Identify Step Costing Change Points

Rank Projects

Issue a SummaryLevel Budget

Profits OK?

Yes

Link to Employee Goal & Reward System

Exhibit 1.18

Streamlined Budgeting Process

No

1-5 How Can I Integrate the Budget into the Corporate Control System?

35

sales manager can receive a bonus based on reaching the sales goals noted in the revenue budget. By inserting the bonus amounts in this page of the budget, the model can automatically link them to the final targets itemized in the plan, requiring minimal further adjustments by the human resources staff. As a result of these improvements, the budgeting process will change to the format shown in Exhibit 1.18, where the emphasis moves away from many modeling iterations toward the incorporation of a considerable level of automation and streamlining into the structure of the budget model. By following this approach, the budget will require much less manual updating; this will allow it to sail through the smaller number of required iterations with much greater speed.

1-5 HOW CAN I INTEGRATE THE BUDGET INTO THE CORPORATE CONTROL SYSTEM? There are several ways in which a budget can be used to enhance a company’s control systems so that objectives are more easily met and it is more difficult for costs to stray from approved levels. One of the best methods for controlling costs is to link the budget for each expense within each department to the purchasing system. By doing so, the computer system will automatically accumulate the total amount of purchase orders that have been issued thus far against a specific account, and will refuse any further purchase orders when the budgeted expense total has been reached. This approach can involve the comparison of the monthly budget to monthly costs, or compare costs with annual budgeted totals. The latter approach can cause difficulty for the inattentive manager, since actual expenses may be running well ahead of the budget for most of the year, but the system will not automatically flag the problem until the entire year’s budget has been depleted. Alternatively, a comparison to monthly budgeted figures may result in so many warning flags on so many accounts that the purchasing staff is unable to purchase many items. One workaround for this problem is to use a fixed overage percentage by which purchases are allowed to exceed the budget; another possibility is to compare cumulative expenses only with quarterly budget totals, which reduces the total number of system warning flags. Another budgetary control system is to compare actual with budgeted results for the specific purpose of evaluating the performance of employees. For example, the warehouse manager may be judged based on actual inventory turnover of 12, which compares unfavorably to a budgeted turnover rate of 15. Similarly, the manager of a cost center may receive a favorable review if the total monthly cost of her cost center averages no more than $152,000. This also works for the sales staff, who can be assigned sales quotas that match the budgeted sales levels for their sales territories. In this manner, a large number of employees can have their compensation levels directly tied to the achievement of budgeted goals. This is a highly effective way to ensure that the budget becomes a fixture in the lives of employees.

36

Management Accounting Best Practices

However, there is also a problem with linking employee pay to performance levels as outlined in the budget. If employees realize that they will fall short of their bonus targets, they will be more likely to hoard their resources or possible sales for the next period, when they will have a better opportunity to achieve better performance and be paid a bonus. The result is wild swings in corporate performance from period to period as employees cycle through the hoard-to-splurge circuit. Employees may also stretch or break the accounting rules in a variety of ways to achieve the target. The solution is to link the budget to a sliding performance scale that contains no ‘‘hard’’ performance goals. The best example of the sliding bonus scale is what it is not—there are no specific goals at which the bonus target suddenly increases in size. Instead, the bonus is a constant percentage of the goal, such as 1 percent of sales or 5 percent of net after-tax profits. Also, there should be no upper boundary to the sliding scale, which would present employees with the disincentive to stop performing once they have reached a maximum bonus level. Similarly, there should theoretically be no lower limit to the bonus either, though it is more common to see a baseline level that is derived from the corporate breakeven point, on the grounds that employees must at least ensure that the company does not lose money. The sliding scale approach also makes it much easier to budget for the bonus expense at various activity levels, rather than trying to budget for the more common all-or-nothing bonus payment. Yet another budgetary control system is to use it as a feedback loop to employees. This can be done by issuing a series of reports at the end of each reporting period that are specifically designed to match the responsibilities of each employee. For example, Exhibit 1.19 shows a single revenue line item that is reported to a salesperson for a single territory. The salesperson does not need to see any other detailed comparison with the budget, because he is not responsible for anything besides the specific line item that is reported to him. This reporting approach focuses the attention of many employees on just those segments of the budget over which they have control. Though this approach can result in the creation of dozens or even hundreds of reports by the accounting department, they can be automated on most packaged accounting software systems, so that only the initial report creation will take up much accounting time. An additional control use for the budget is to detect fraud. The budget is usually based on several years of actual operating results, so unless there are major changes in activity levels, actual expense results should be fairly close to budgeted expectations. If not, variance analysis is frequently used to find out what happened. This process is an excellent means for discovering fraud, since this activity will usually result in a sudden surge in expense levels, which the resulting variance analysis will detect. The two instances in which this control will not work is when the fraud has been in existence for a long time (and so is incorporated into the budgeted expense numbers Exhibit 1.19 Account No. 4500-010

Line ltem Budget Reporting for Specific Employees Description

Actual Results

Budgeted Results

Variance

Arizona Revenue

$43,529

$51,000

$7,471

1-6 How Do Throughput Concepts Impact the Budget?

37

already) or the amount of fraud is so low that it will not create a variance large enough to warrant investigation.

1-6 HOW DO THROUGHPUT CONCEPTS IMPACT THE BUDGET? In a traditional budget, the entire budget model is driven by the revenue forecast, since this information is needed to derive materials purchases, inventory and staffing levels, and operating expenses. The revenue forecast is usually summarized in one of two ways: either by total revenue dollars for each product, or by total revenue dollars by customer (which is more common when dealing with labor hour billings). Though a valid way to obtain top-line revenue projections, this information lacks any clear linkage to directly variable costs, so managers cannot tell from the revenue budget alone how revenue projections will impact profitability. In addition, it does not show the impact of sales projections on the company’s capacity constraint. A better approach is to develop a throughput forecast, either by product or customer, that clearly shows the impact on both profits and the capacity constraint. Exhibit 1.20 shows a traditional revenue forecast for several products, followed by a revised forecast that reveals the individual and cumulative throughput levels for the same products and product quantities shown in the original forecast. The traditional product revenue budget shown at the top of Exhibit 1.20 presents the usual itemization of estimated product sales that many of us are accustomed to seeing. However, this view has serious shortcomings when compared with the much richer set of information listed in the bottom half of the exhibit for throughput-based information. The latter portion of the exhibit reveals that the company is incapable of meeting its revenue budget, because there is not a sufficient amount of capacity available (based on 260 working days, at three shifts, assuming 80% efficiency) to meet its sales goals. A traditional budget would not have flagged this constraint problem anywhere, so the company would have constructed a fundamentally unsound budget and proceeded to implement it, with an essentially guaranteed revenue shortfall being the only possible outcome. In addition, the enhanced budget shows that the company earns the least throughput per minute on its top-of-the-line carbon and titanium bikes; depending on the marketing effect of this decision, management could elect to drop production of both bikes, thereby bringing remaining estimated bike sales within range of the constraint limitation, while minimizing the resulting negative impact on throughput. Thus, the throughput approach to the revenue budget not only reveals problems with the initial forecast, but also presents a possible solution regarding how the sales mix might be modified. A further note on the use of the throughput-based product revenue budget is to list the same product multiple times if it is forecasted to be sold to different customers at different prices (in which case it is useful to identify the customers in the budget for each line item). This makes it easier to see the throughput per unit at each price point.

38 2,850 5,100 4,800 450 8,750 650 22,600

1-speed road bike 3-speed road bike 24-speed road bike 24-speed carbon road bike 3-speed dual-shock mountain bike 24-speed titanium mountain bike

Totals

$250 $400 $800 $4,000 $1,000 $2,500

Price/ Each

2,850 5,100 4,800 450 8,750 650 22,600

1-speed road bike 3-speed road bike 24-speed road bike 24-speed carbon road bike 3-speed dual-shock mountain bike 24-speed titanium mountain bike

Totals

$250 $400 $800 $4,000 $1,000 $2,500

Throughput-Based Product Revenue Budget: Product Name

Unit Sales

Traditional Product Revenue Budget

Product Name

Exhibit 1.20

$18,767,500

$712,500 $2,040,000 $3,840,000 $1,800,000 $8,750,000 $1,625,000

$18,767,500

$712,500 $2,040,000 $3,840,000 $1,800,000 $8,750,000 $1,625,000

Extended Revenue

$180 $275 $575 $2,250 $650 $1,350

Throughput per Unit

$12,253,000

$513,000 $1,402,500 $2,760,000 $1,012,500 $5,687,500 $877,500

Total Throughput

5 11 13 80 22 65

Constraint Time/Unit

Maximum available constraint time (minutes)

$70 $125 $225 $1,750 $350 $1,150

Variable Cost/Unit

299,520

403,500

14,250 56,100 62,400 36,000 192,500 42,250

Total Time on Constraint

$36.00 $25.00 $44.23 $28.13 $29.55 $20.77

Throughput per Minute

1-6 How Do Throughput Concepts Impact the Budget?

39

The same approach can be taken with a revenue budget that is based on sales by customer. The example shown in Exhibit 1.21 assumes that sales are based on billable hours to customers. The traditional revenue budgeting model shown in Exhibit 1.21 shows an estimate of revenues by customer, with no additional interpretive information. However, the throughput-based version at the bottom of the exhibit reveals a great deal more information. When variable costs (in this case, labor) are subtracted from the budgeted revenue to arrive at throughput, we find that there is a loss on the work being done for the Mining Safety Engineers customer, which may prompt a discussion of repricing this work or of dropping the customer. In addition, the model then summarizes the labor used in the various customer projects by labor category and calculates the amount of staffing required, based on the estimate of billable hours and an 80 percent billable percentage for each employee. This information tells management that it must hire additional staff in several labor categories in order to have sufficient staff to meet its revenue budget. The main reason for a budget is to give management a model of how the company should operate during the budget period, based on the impact of operational and financial changes that management wants to implement during the budget period. However, the traditional budget model is designed to show results based on the local optimization of resources, rather than systemwide resources, which usually results in counterproductive budgeting decisions. For example, if expenses are projected to be too high, management may mandate an across-the-board 10 percent budget cut for all departments, which will likely both reduce the capacity of the constrained resource and shrink operating expenses to such an extent that the ability of the entire system to support the current level of throughput has now been reduced. Unfortunately, it is very difficult to create a quantitative format for how a change in operating expenses will impact total system throughput, since in many cases there does not appear to be a direct or even an indirect link between some costs and the generation of throughput. Consequently, the creation of a budget where expenses support throughput generation requires an extremely detailed knowledge of how the entire system works together to create throughput. In many cases where no link between an expense and throughput can be found, management is still able to wield a sharp budgeting axe in cutting expenses. Thus, there are considerable differences in how various budget line items should be treated, based on their impact on throughput. Any expense supporting throughput should be cut only after detailed review by a process analyst, while other expenses can be cut with much less review. This interpretation of the budget model results in a change in the budgeting format, which is shown in Exhibit 1.22. The exhibit shows a before-andafter department budget where the first version ignores the impact of throughput, while the second version splits operating expenses into those impacting throughput and those that do not. The expenses in the second version can be shifted between the two categories based on whether they affect the company’s throughput capacity. However, the exhibit clearly shows that most expenses will be attributable in some manner to throughput capacity, since most corporate expenses involve departments

40 2,000 8,000 2,700 4,100 10,500 500 27,800

Amber Distribution Corporation Bi-Way Valve Specialties Breaker Breaker Radio Design Hippo Weight Loss Clinics Mining Safety Engineers Vessel Insurance Brokers

Totals

Assumes 80% billable hours.

*

Labor Category Aggregation Expert Consultant Senior Consultant Junior Consultant

Totals

Amber Distribution Corporation Bi-Way Valve Specialties Breaker Breaker Radio Design Hippo Weight Loss Clinics Mining Safety Engineers Vessel Insurance Brokers $85 $65 $125

4,100 10,500 500

27,800

5,200 12,100 10,500

125 85 65

$85 $125

8,000 2,700

27,800

$125

$125 $85 $125 $85 $65 $125

Price/ Hour

2,000

Throughput-Based Customer Revenue Budget:

Billable Hours

Traditional Customer Revenue Budget:

Customer Name

Exhibit 1.21

$2,361,000

$650,000 $1,028,500 $682,500

$2,361,000

$348,500 $682,500 $62,500

$680,000 $337,500

$250,000

$2,361,000

$250,000 $680,000 $337,500 $348,500 $682,500 $62,500

Extended Revenue

$ 81.75 $ 72.35 $ 66.50

$72.35 $66.50 $81.75

$72.35 $81.75

$81.75

Variable Cost/Hour

$43.25 $12.65 $1.50

$12.65 $1.50 $43.25

$12.65 $43.25

$43.25

Throughput per Hour

$362,215

$224,900 $153,065 $15,750

$362,215

$51,865 $15,750 $21,625

$101,200 $116,775

$86,500

Total Throughput

3.1 7.3 6.3

Staff Required*

2 7 4

Staff Available

1-6 How Do Throughput Concepts Impact the Budget? Exhibit 1.22

41

Before-and-After Throughput Expense Budget 1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

3,000 15,000 82,000 85,000 105,000 190,000 20,000 280,000 150,000 17,500 65,155 0 10,500

4,500 18,500 0 87,000 110,000 200,000 21,000 275,000 175,000 16,000 68,138 100,000 14,500

2,500 32,000 48,000 87,000 143,000 203,000 21,000 285,000 180,000 13,500 72,142 0 17,000

4,000 19,000 28,500 91,000 141,000 205,000 22,000 290,000 195,000 19,000 74,104 0 12,000

14,000 84,500 158,500 350,000 499,000 798,000 84,000 1,130,000 700,000 66,000 279,539 100,000 54,000

1,023,155

1,089,638

1,104,142

1,100,604

4,317,539

Version 2: Throughput-related: Promotional materials Salaries, engineering Salaries, marketing Salaries, production Salaries, sales Trade shows Travel & entertainment

82,000 190,000 20,000 280,000 150,000 0 8,000

0 200,000 21,000 275,000 175,000 100,000 10,000

48,000 203,000 21,000 285,000 180,000 0 16,000

28,500 205,000 22,000 290,000 195,000 0 6,000

158,500 798,000 84,000 1,130,000 700,000 100,000 40,000

Subtotal

730,000

781,000

753,000

746,500

3,010,500

Not throughput-supportive: Bank fees Legal fees Salaries, accounting Salaries, corporate Supplies Taxes, payroll Travel & entertainment

3,000 15,000 85,000 105,000 17,500 65,155 2,500

4,500 18,500 87,000 110,000 16,000 68,138 4,500

2,500 32,000 87,000 143,000 13,500 72,142 1,000

4,000 19,000 91,000 141,000 19,000 74,104 6,000

14,000 84,500 350,000 499,000 66,000 279,539 14,000

Subtotal

293,155

308,638

351,142

354,104

1,307,039

1,023,155

1,089,638

1,104,142

1,100,604

4,317,539

Version 1: Bank fees Legal fees Promotional materials Salaries, accounting Salaries, corporate Salaries, engineering Salaries, marketing Salaries, production Salaries, sales Supplies Taxes, payroll Trade shows Travel & entertainment Total

Grand total

Total

that are directly related to the production of revenue, such as engineering, production, marketing, and sales. Only such classic overhead expenses as accounting, general corporate costs, and legal expenses can be reduced with some assurance that the reductions will not impact throughput.

42

Management Accounting Best Practices

Thus far, the discussion of operating expenses has primarily focused on a company’s ability to cut expenses. However, how should the budgeting process handle requests for increased operating expenses? The primary guideline should be that the existing level of operating expenses is sufficient to handle not only existing but also any projected increases in throughput. If not, then some elements of operating expenses become the constraint, at which point increases in those expenses should be included in the budget. The standard ways to budget for production staffing levels are to (1) incrementally adjust existing staffing levels based on forecasted revenue changes or (2) extrapolate labor requirements derived by multiplying the forecasted revenue for the budget period by the labor routings for each product listed in the forecast. Many companies start with the latter method and compare it with the results obtained from the first approach, and then adopt a hybrid solution. These techniques will yield reasonably accurate staffing levels for a company attempting to create locally optimized manufacturing operations. However, they will likely result in inadequate staffing levels when capacity constraints are taken into account. When throughput is taken into account, it is necessary to hire additional employees when either of the following two circumstances arise: 1. When the sprint capacity of key workstations positioned upstream from the constrained resource is insufficient to recover from system downtime to such an extent that buffers are repeatedly penetrated 2. When the constrained resource could generate more throughput with the addition of more staff It is entirely possible that the constrained resource is not in the production area or the marketplace at all (the two most common areas), but rather in the sales department. This problem is most evident when the company’s sales funnel begins with a large number of prospective sales, but narrows down to a small number of completed sales due to a bottleneck somewhere in the sales conversion process. The identification of the constrained resource within the sales funnel can be determined as part of the budgeting process, usually with an analysis similar to the one shown in Exhibit 1.23. Exhibit 1.23

Sales Funnel Bottleneck Identification

Steps in Sales Funnel Initial identification Customer qualification Needs assessment Letter of understanding Product demonstration Solution proposal Negotiation Closing

Actual Time Used (hours) 450 120 300 50 620 2,400 280 100

Theoretical Capacity (hours) 700 240 300 80 800 3,100 400 200

1-6 How Do Throughput Concepts Impact the Budget?

43

The exhibit shows the basic steps needed to advance through the sales funnel, from initial identification of the customer through closing the deal. For each step, the table shows the actual time used on various steps in the process, as compared with the theoretical amount of staff capacity available for each step. The table reveals that the constrained resource is the needs assessment, for which the actual time used has matched the theoretical maximum available. Thus, for budgeting purposes, management should bolster the ranks of the sales engineers who are responsible for creating needs assessments. If a company does not perform this analysis, then it may budget for increases in the wrong types of sales positions, which will yield no new sales if the additions do not address the constraint.

Chapter 2

Capital Budgeting Decisions The accountant is usually trained in the use of discounted cash flows to analyze funding requests for capital projects. A newer approach is constraint management, which instead focuses attention on allocating funding to bottleneck (constrained) operations. Both capital budgeting methodologies are presented in this chapter. If the accountant were to use constraint-based capital budgeting, some key questions would involve how to determine the cost of a bottleneck operation, how to locate that operation, whether investments should be made in the operation, and when investments should be made outside of the bottleneck operation. If the accountant were to instead use the traditional discounted cash flow method, some key questions would involve how to calculate and use the cost of capital, how to derive a project’s net present value, and when to use payback periods and postcompletion project analyses. This chapter provides answers to all of these key questions. The following table itemizes the section number in which the answers to each question can be found: Section 2-1 2-2 2-3 2-4 2-5 2-6 2-7 2-8 2-9 2-10 2-11 2-12 2-13 2-14 2-15

Decision How does a constrained resource impact capital budgeting decisions? What is the true cost of a capacity constraint? How do I identify a constrained resource? When should I invest in a constrained resource? Should I increase sprint capacity? How closely should I link capital expenditures to strategy? What format should I use for a capital request form? Should I judge capital proposals based on their discounted cash flows? How do I calculate the cost of capital? When should I use the incremental cost of capital? How do I use net present value in capital budgeting? What proposal form should I require for a cash flow analysis? Should I use the payback period in capital budgeting? How can a post-completion analysis help me? What factors should I consider for a site selection?

2-1 HOW DOES A CONSTRAINED RESOURCE IMPACT CAPITAL BUDGETING DECISIONS? Pareto analysis holds that 20 percent of events cause 80 percent of the results. For example, 20 percent of customers generate 80 percent of all profits, or 20 percent 44

2-2 What Is the True Cost of a Capacity Constraint?

45

of all production issues cause 80 percent of the scrap. The theory of constraints, when reduced down to one guiding concept, states that 1 percent of all events cause 99 percent of the results. This conclusion is reached by viewing a company as one giant system designed to produce profits, with one constrained resource controlling the amount of those profits. Under the theory of constraints, all management activities are centered on management of the bottleneck operation, or constrained resource. By focusing on making this resource more efficient and ensuring that all other company resources are oriented toward supporting it, a company will maximize its profits. The concept is shown in Exhibit 2.1, where the total production capacity of four work centers is shown, both before and after a series of efficiency improvements are made. Of the four work centers, the capacity of center C is the lowest, at 80 units per hour. Despite subsequent efficiency improvements to work centers A and B, the total output of the system remains at 80 units per hour, because of the restriction imposed by work center C. This approach is substantially different from the traditional management technique of local optimization, where all company operations are to be made as efficient as possible, with machines and employees maximizing their work efforts at all times. The key difference between the two methodologies is the view of efficiency: Should it be maximized everywhere, or just at the constrained resource? The constraints-based approach holds that any local optimization of a nonconstraint resource will simply allow it to produce more than the constrained operation can handle, which results in excess inventory. For example, a furniture company discovers that its drum operation is its paint shop. The company cannot produce more than 300 tables per day, because that maximizes the capacity of the paint shop. If the company adds a lathe to produce more table legs, this will only result in the accumulation of an excessive quantity of table legs, rather than the production of a larger number of painted tables. Thus, the investment in efficiencies elsewhere than the constrained operation will only increase costs without improving sales or profits. The preceding example shows that not only should efficiency improvements not be made in areas other than the constrained operation, but it is quite acceptable to not even be efficient in these other areas. It is better to stop work in a nonconstraint operation and idle its staff than to have it churn out more inventory than can be used by the constrained operation.

2-2 WHAT IS THE TRUE COST OF A CAPACITY CONSTRAINT? If the use of the capacity constraint is not maximized, what is the opportunity cost to the company? In a traditional cost accounting system, the cost would be the forgone gross margin on any products that could not be produced by the operation. For example, a work center experiences downtime of one hour, because the machine operator is on a

46 95 units/hour

120 units/hour

135 units/hour

160 units/hour

Exhibit 2.1 Impact of the Constrained Resource on Total Output

Work center B

Work center A

Add 40 units/hour of capacity

Scenario Two :

Work center B

Work center A

Scenario One:

80 units/hour

Work center C

80 units/hour

Work center C

180 units/hour

Work center D

180 units/hour

Work center D

Total output = 80 units/hour

Total output = 80 units/hour

2-3 How Do I Identify a Constrained Resource?

47

scheduled break. During that one hour, the work center could have created 20 products having a gross margin of $4.00 each. Traditional cost accounting tells us that this represents a loss of $80. Given this information, a manager might very well not backfill the machine operator, and allow the machine to stay idle for the one-hour break period. However, throughput accounting uses a different calculation of the cost of the capacity constraint. Since the performance of the constraint drives the total throughput of the entire system, the opportunity cost of not running that operation is actually the total operating expense of running the entire facility, divided by the number of hours during which the capacity constraint is being operated. This is because it is not possible to speed up the constrained operation, resulting in the permanent loss of any units that are not produced. For example, if the monthly operating expenses of a facility are $1.2 million and the constrained resource is run for every hour of that month, or 720 hours (30 days  24 hours/day), then the cost per hour of the operation is $1,667 ($1,200,000 divided by 720 hours). Given this much higher cost of not running the operation, a manager will be much more likely to find a replacement operator for break periods. Thus, knowing the substantial cost of not running a constrained resource is extremely important when determining how much capital funding should be allocated to that resource.

2-3 HOW DO I IDENTIFY A CONSTRAINED RESOURCE? The constrained resource may not be immediately apparent, especially in a large production environment with many products, routings, and work centers. It is this ‘‘noise in the system’’ that prevents us from easily identifying constraints. Here are some questions to ask that will help locate it: 





Where is there a work backlog? If there is an area where work virtually never catches up with demand, where expeditors are constantly hovering, and where there are large quantities of inventory piled up, this is a likely constraint area. Where do most problems originate? Management usually finds itself hovering around only a small number of work centers whose problems never seem to go away. Continuing problems are common at constrained resources, because they are so heavily utilized that there is never enough time to perform a sufficient level of maintenance, resulting in recurring breakdowns. In addition, there tends to be a fight over work priorities when there is not sufficient capacity, which also means that managers will be regularly called upon to determine these priorities among competing orders. Where are the expediters? An expediter physically steers a high-priority job through the production process. Because they frequently wait while their

48





Management Accounting Best Practices

assigned jobs are being processed, their presence (especially several of them together) is a good indicator of a bottleneck where they must wait for available production time. Which work centers have high utilization? Many companies measure the utilization level of their work centers. If so, review the list to determine which ones have a continually high level of utilization over multiple months. If a work center only briefly attains high utilization, it could still be the constraint if the reason for the lower utilization is ongoing maintenance problems or employee absenteeism. What happens to total throughput when the constraint capacity changes? If we add to the capacity of the suspected constraint, is there a noticeable increase in throughput? Conversely, if we deliberately reduce the capacity of the targeted work center (not recommended as a testing technique!), does overall throughput decline? If throughput does alter as a result of these changes, then we have probably located the constrained resource.

If, after this analysis, a company picks the wrong operation as its constrained resource, the real constraint will soon appear because of changes in the inventory buffers in front of the real and fake constraints. If the real constraint is upstream from the fake constraint, then the inventory buffer in front of the fake constraint will disappear. This happens because management will focus its attention on improving the efficiency of the fake resource, thereby wiping out its backlog of work. The real constraint will be readily apparent, because it still has an inventory backlog. Conversely, if the real constraint is downstream from the fake constraint, then a larger inventory backlog will build in front of it. This happens because the same improvement in efficiency at the fake resource will result in a flood of additional inventory heading downstream, where it will dam up at the real constraint. If products are engineered to order, then consider the engineering department to be part of the production process. This is important from the perspective of locating the constraint, because the constraint may not be in the traditional production area at all, but rather in the engineering department. Similarly, and for all types of product sales, the constraint may also reside in the sales department, where there may not be enough staff available to convert a large proportion of sales prospects into orders. This constraint is most evident when there are clearly many sales prospects at the top of the sales funnel, but there is a choke point somewhere in the sales conversion process, below which few orders are received. If this is the case, the solution is to enhance staffing for the sales positions specifically needed to improve handling of sales prospects at the choke point in the sales funnel. Another constraint can also be raw materials. This problem arises during periods of excessive industry demand, resulting in materials allocations from suppliers. The location of this constraint will be immediately apparent to the materials management staff, which will have to reschedule production based on the shortage. However, this problem tends to be a short-term one, after which the constraint shifts back from the supplier and into the company.

2-5 Should I Increase Sprint Capacity?

49

It is also possible to designate a work center as the constrained resource. Taking this proactive approach is most useful when a work center requires a great deal of additional investment or highly skilled staffing to increase its capacity. By requiring that the constraint be focused on this area, management can profitably spend its time ensuring that the work center is fully utilized. It is also useful to avoid positioning the constraint on a resource that requires considerable management to operate properly, such as one where employee training or turnover levels are extremely high. Thus, positioning the constrained resource can be a management decision, rather than an incidental occurrence.

2-4 WHEN SHOULD I INVEST IN A CONSTRAINED RESOURCE? At what point should a company invest in more of the constrained resource? In many cases, the company has specifically designated a resource to be its constraint, because it is so expensive to add more capacity, so this decision is not to be taken lightly. The decision process is to review the impact on the incremental change in throughput caused by the added investment, less any changes in operating expenses. Because this type of investment represents a considerable step cost (where costs and/or the investment will jump considerably as a result of the decision), management must usually make its decision based on the perceived level of long-term throughput changes, rather than smaller expected short-term throughput increases.

2-5 SHOULD I INCREASE SPRINT CAPACITY? Sprint capacity is excess capacity built into a production operation that allows the facility to create excess inventory in the short term, usually to make up for sudden shortfalls in inventory levels. Sprint capacity is extremely useful for maintaining a sufficient flow of inventory into the constrained resource, since the system can quickly recover from a production shortfall. If there is a great deal of sprint capacity in a production system, then there is less need for an inventory buffer in front of the constrained resource, since new inventory stocks can be generated quickly. It is not only useful, but necessary to have excess capacity levels available in a system. This controverts the traditional management approach of eliminating excess capacity in order to reduce the costs associated with maintaining that capacity. Instead, management should invest in nonconstraint resources when those resources have so little excess capacity that they have difficulty recovering from downtime. This can be a major problem if the lack of capacity constantly places the constrained resource in danger of running out of work. In this case, a good investment alternative is to invest in a sufficient amount of additional sprint capacity to ensure that the system can rapidly recover from a reasonable level of downtime. If a manager is applying for a

50

Management Accounting Best Practices

capital investment based on this reasoning, he should attach to the proposal a chart showing the capacity level at which the targeted resource has been operating over the past few months, as well as the amount of downtime this has caused at the constrained resource. Most companies do not experience a sudden increase in product sales; rather, they are subject to a slow, steady increase in demand that gradually fills the available amount of capacity throughout the production area. When this happens, management attention is rightly focused on maintaining a high level of throughput at the constrained resource. However, the increased demand also tends to gradually absorb excess capacity levels elsewhere in the plant. If this phenomenon continues for some time, management may be blindsided by what appears to be a sudden decrease in sprint capacity. If sprint capacity declines to an excessive extent, it is likely that occasional upstream production problems will eventually result in shortages at the constraint and a reduction of throughput. To guard against the onset of this creeping reduction in capacity, the accountant should monitor nonconstraint usage levels, and warn management when there is a long-term reduction of sprint capacity that is not abating. This may very well call for additional capital investments in order to maintain a sufficient level of sprint capacity.

2-6 HOW CLOSELY SHOULD I LINK CAPITAL EXPENDITURES TO STRATEGY? Companies tend not to spend money where their strategies indicate they should spend it. Instead, they tend to support their existing infrastructures with continuing investments in those areas. This tendency is largely due to the way in which the capital budgeting approval process is structured, whereby the managers in charge of this infrastructure are responsible not only for submitting capital requests, but also for approving them. The inevitable result is that the managers of new business units that are more closely tied to the company’s long-term strategy will find themselves crowded out in the competition to obtain a limited amount of corporate funding. Another form of evidence of this tendency is when a company continually increases its asset base in an existing business in order to increase its efficiency levels, while competition forces its prices downward. The result is an inferior or negative return on investment. A greatly preferable alternative is to have the senior management team that is responsible for setting strategy also be solely responsible for allocating funding to the various capital requests. By doing so, a company can more readily focus its capital funding on those potentially large markets with good growth rates, and in which the company stands the best chance of competing. From a purely financial perspective, this means that the company will be investing where its return on investments exceeds its cost of capital by the greatest amount, and eliminating assets where the return is negative.

2-8 Should I Judge Capital Proposals?

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2-7 WHAT FORMAT SHOULD I USE FOR A CAPITAL REQUEST FORM? The summary-level capital budgeting form shown in Exhibit 2.2 splits capital budgeting requests into three categories: (1) constraint-related, (2) risk-related, and (3) nonconstraint-related. The risk-related category covers all capital purchases for which the company must meet a legal requirement, or for which there is a perception that the company is subject to an undue amount of risk if it does not invest in an asset. All remaining requests that do not clearly fall into the constraint-related or risk-related categories drop into a catchall category at the bottom of the form. The intent of this format is to clearly differentiate among various types of approval requests, with each one requiring different types of analysis and management approval. The approval levels vary significantly in the throughput-based capital request form. Approvals for constraint-related investments include a process analyst (who verifies that the request will actually impact the constraint), as well as generally higher-dollar approval levels for lower-level managers—the intent is to make it easier to approve capital requests that will improve the constrained resource. Approvals for risk-related projects first require the joint approval of the corporate attorney and chief risk officer, with added approvals for large expenditures. Finally, the approvals for non-constraint-related purchases involve lower-dollar approval levels, so the approval process is intentionally made more difficult. Once approved as part of the budgeting process, capital requests can be segregated in the budget into the three categories just noted. The basic format of this portion of the budget is shown in Exhibit 2.3. The capital budget example shows more expenditures for risk-related projects, but in most cases the bulk of funding should be focused squarely on constraint-related projects, with only minimal funding reserved for non-constraint-related projects. Also, the example contains an additional section at the bottom, in which is listed the incremental additional capacity of the constrained resource resulting from the new investments. In this section, the new capacity is listed with a time delay, so that a capital expenditure is fully installed before the resulting capacity is assumed to be available. Though most of the budget contains nothing but financial information, this operational information may have an impact on the company’s ability to increase its sales later in the budget period, and so is extremely useful reference information.

2-8 SHOULD I JUDGE CAPITAL PROPOSALS BASED ON THEIR DISCOUNTED CASH FLOWS? The traditional capital budgeting approach involves having the management team review a series of unrelated requests from throughout the company, each one asking for funding for various projects. Management decides whether to fund each request based on the discounted cash flows projected for each one. If there are not sufficient funds available for all requests having positive discounted cash flows, then those with

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Management Accounting Best Practices Project name: Name of project sponsor: Submission date:

Project number:

Constraint-Related Project Initial expenditure:

Approvals

$

All Process Analyst

Additional annual expenditure:

$ $100,000

Impact on throughput:

$

Impact on operating expenses: Impact on ROI:

Supervisor $

$100,001– $1,000,000

President

$ $1,000,000+ (Attach calculations)

Board of Directors

Risk-Related Project Initial expenditure:

Approvals $ Corporate Attorney

Additional annual expenditure:

$

< $50,000 Chief Risk Officer

Description of legal requirement fulfilled or risk issue mitigated (attach description as needed): $50,001+

President $1,000,000+ Board of Directors

Non-Constraint-Related Project Initial expenditure:

Approvals

$

All Process Analyst

Additional annual expenditure:

$