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Budgeting for Operations CHAPTER 1 3. 4. 5. 6. of the current year. Request a return date of 10 days in the future for this information. Capital expenditure update. As of mid-November, issue a form to all department heads, requesting information about the cost and timing of capital expenditures for the upcoming year. Request a return date of 10 days in the future for this information. Automation update. As of mid-November, issue a form to the manager of automation, requesting estimates of the timing and size of reductions in headcount in the upcoming year that are due to automation efforts. Request a return date of 10 days in the future for this information. Be sure to compare scheduled headcount reductions to the timing of capital expenditures, since they should track closely. Update the budget model. These six tasks should be completed by the end of November: • Update the numbers already listed in the budget with information as it is received from the various managers. This may involve changing “hard coded” dollar amounts, or changing flex budget percentages. Be sure to keep a checklist of who has returned information, so that you can follow up with those personnel who have not returned requested information. • Verify that the indirect overhead allocation percentages shown on the budgeted factory overhead page are still accurate. • Verify that the Federal Insurance Contributions Act (FICA), State Unemployment Tax (SUTA), Federal Unemployment Tax (FUTA), medical, and workers’ compensation amounts listed at the top of the staffing budget are still accurate. • Add job titles and pay levels to the staffing budget as needed, along with new average pay rates based on projected pay levels made by department managers. • Run a depreciation report for the upcoming year, add the expected depreciation for new capital expenditures, and add this amount to the budget. • Revise the loan detail budget based on projected borrowings through the end of the year. Review the budget. Print out the budget and circle any budgeted expenses or revenues that are significantly different from the 7 SECTION Preparing to Operate the Business I annualized amounts for the current year. Go over the questionable items with the managers who are responsible for those items. 7. Revise the budget. Revise the budget, print it again, and review it with the president. Incorporate any additional changes. If the cash balance is excessive, you may have to manually move money from the cash line to the debt line to represent the paydown of debt. 8. Issue the budget. Bind the budget and issue it to the management team. 9. Update accounting database. Enter budget numbers into the accounting software for the upcoming year. All tasks should be completed by mid-December.1 Once the budget has been completed, there must be a feedback loop that sends budget variance information back to the department managers. The best feedback loop is to complete a budget to actual variance report that is sorted by the name of the responsible manager (see Figure 1.8 on page 24) as soon as the financial statements have been completed each month. The controller should take this report to all of the managers and review it with them, bringing back detailed information about each variance, as requested. Finally, there should be a meeting as soon thereafter as possible between the responsible managers and senior management to review variance problems and what each of the managers will do to resolve them. The senior managers should write down these commitments and return them to the managers in memo form; this document forms the basis for the next month’s meeting, which will begin with a review of how well the managers have done to attain the targets to which they are committed. A key factor in making this system work is the rapid release of accurate financial statements, so that the department managers will have more time to respond to adverse variance information. 1 Reprinted with permission from Bragg, Steven, The Design and Maintenance of Accounting Manuals, 1999 Supplement (New York: John Wiley & Sons, 1999), pp. 64–66. 8 Budgeting for Operations CHAPTER 1 Responsibility Accounting Responsibility accounting means structuring systems and reports to highlight the accountability of specific people. The process involves assigning accountability to departments or functions in which the responsibility for performance lies. Specific responsibility is a necessary concept of management control. Accounting encompasses at least three purposes: financial reporting, product or service cost reporting, and performance evaluation reporting. The third function of accounting, the performance measurement function, is closely related to the operational function of the business. Since many businesses now evaluate and manage employees by objectives, the need for more sophisticated performance measurement tools has increased. In a management-by-objectives (MBO) system, the individual must have the authority necessary to carry out the responsibility he or she is asked to execute. Without the necessary authority, a person cannot, and should not, be expected to meet the responsibilities imposed. Within this level of responsibility, a person can be evaluated only when the performance reporting system is tied to the expected level of performance. A person’s actual performance is keyed to this budget expression of expected performance. Responsibility accounting should not be restricted to any one management level but should measure expected performance throughout the hierarchy of the business. Key indicators can be built into the system to evaluate performance and to trigger reactions to unanticipated results. In this way, management at each level is called on to intervene only when it is necessary to correct problems or substandard performance. This management-byexception system frees up significant time for managers to plan and coordinate other essential business functions. In contrast with financial accounting, responsibility accounting does not simply group like costs but instead segments the business into distinct responsibility centers. A measurement process is established to compare results obtained against objectives established for 9 SECTION Preparing to Operate the Business I the segment prior to the end of a plan/budget period. These objectives are part of the operating budget and comprise the targets of operation for every segment of the business. To be effective, responsibility accounting must be tailored to each individual business. The accounting system must be adjusted to conform with the responsibility centers established. The revenue and expense categories must be designed to fit the functions or operations that management believes are important to monitor and evaluate. For example, the use of electricity by a particular machine may be significant, and excessive use may be an early warning sign of a process problem. Management would want to meter electricity consumption and have the expense reported as a line item to be measured against standard consumption rates by machine or by department. Another function of the responsibility accounting system is to compile the individual centers’ performance reports into successively aggregated collective reports to identify broader categories of responsibility. Behind these groupings is still a great deal of detailed information available for analysis. Developing Responsibility Centers A responsibility center has no standard size. It can be as small as a single operation or machine or as large as the entire business. The business is, after all, the responsibility center of the chief executive of the business. Typically, the business is broken down into a large number of centers or segments that, when plotted in successive layers or groupings, look like a pyramid. This pyramiding represents the hierarchy of authority and responsibility of the business. Various types of responsibility centers may be established for various purposes. The nature of the centers or segments can also vary. If a person is charged with only the responsibility for the costs incurred in a process or operation, a cost center has been established. Cost centers can be line operations (i.e., painting) or staff functions (i.e., recruiting). The emphasis of a cost center is on producing goods or providing specific services in conjunction with other physical measures of performance. Usually there is no direct revenue 10 Budgeting for Operations CHAPTER 1 production measurement by that center because the center does not produce the final product. Another segment is a unit held responsible for the profit contribution it makes. This responsibility center is aptly named a profit center. Profit centers are often larger units than cost centers because a profit center requires the production of a complete product or service to make a contribution to the profit. (However, a salesperson could be considered a profit center.) The establishment of a profit center should be based on established managerial criteria of revenues and costs. Other divisions can be established, such as revenue centers and investment centers. Revenue centers, for instance, are segments of the larger profit centers charged with the responsibility of producing revenue. Sales departments are a typical example. An investment center is a profit center that also has the responsibility of raising and making the necessary investment required to produce the profit. This added investment step would require the use of some rate-ofreturn test as an objective measure of the center’s performance. The appropriate establishment of cost centers, profit centers, and the like is a critical element of the responsibility reporting system, and as such must be performed carefully and accurately. Establishing Costs Another important aspect of responsibility accounting is the accumulation of costs. Accountants have labeled the standard types of costs typically encountered: fixed, variable, and semivariable. Within these classifications, some costs may be incurred at the discretion of specific levels of management whereas others are nondiscretionary at given levels of management. Sometimes costs relate to more than one center and must be allocated between them. The most effective system probably will result when responsible management has been an active participant in the determination of the allocation of costs and the maintenance of the reporting system. One complication of accumulating costs is the problem of transfer pricing. In manufacturing businesses, a cost center’s performance is a function of the added costs and the intracompany 11 SECTION Preparing to Operate the Business I movements of raw materials, work-in-progress, finished goods, and services performed. A market price may not be available or may be too uncertain, because of fluctuations, to use as an objective measure of performance. Some compromise is often necessary to establish transfer prices among departments. Fixed Costs. A fixed cost is one that does not vary directly with volume. Some costs are really fixed, such as interest on debt. Other typically identified fixed costs, such as depreciation expense, may vary under some circumstances. Generally, over a broad range of operations, total fixed costs are represented as step functions because they are incurred in increments as production or the number of services increases. This characteristic of fixed costs should not present any great difficulty. Since production or sales is predicted for a budget period, the level of fixed costs can be established from graphs such as that in Figure 1.1. Unfortunately, fixed costs, because of their apparent static behavior, are not always reviewed regularly and critically to determine reasonableness. Like all other costs, the larger the amount of individual fixed costs, the more frequently they should be reviewed. For example, insurance premiums may vary little, if at FIGURE 1.1 Fixed Costs Fixed Costs that Rise at Specific Volume Levels $ Cost Volume 12 Budgeting for Operations CHAPTER 1 all, from year to year and may be paid without reconsideration, particularly in good times. Figure 1.2 represents the relationship between the magnitude of a particular fixed cost and the frequency with which it should be reviewed. When making such an assessment for yourself, you should be aware of such factors as the cost of reconsideration in setting the time periods for “seldom” through “often.” The process of reevaluating insurance coverage may be a significant task, requiring a major allocation of time and resources. However, the returns could be equally significant if you realize substantial savings resulting from a renegotiation of the insurance policy and rates. Another concern with fixed costs is the method of allocation of those costs among different products or services. Fixed costs are often assigned in an arbitrary manner, creating an unrealistic profit or loss statement for each product. Otherwise, nonprofitable products are sometimes carried by an “average fixed cost” allocation, which may not accurately depict costs associated with the product. Accurate decisions are unlikely without correct information concerning a FIGURE 1.2 Relationship of Cost to Review Frequency Magnitude of Cost High Low Often Seldom Frequency of Review 13 SECTION Preparing to Operate the Business I product’s costs. You should undertake to allocate fixed costs properly through the preparation of an operating budget. Your accountant should have a reasonable understanding of the magnitude of the costs and of which products or services are affecting the amount. Also, you should determine how varying activity levels influence the costs you incur for different products and services. When analyzing fixed costs, you should determine what causes that cost to be incurred and what causes it to change in amount. This analysis will help identify to which product(s) or service(s) the cost should be assigned and in what manner that allocation should be made. For some fixed costs, this will be a very difficult process. Some administrative costs may simply not be identifiable with any one product or service. Successive allocations through your costing hierarchy may be needed to arrive finally at a “product-attributable” status. You may treat such costs as variable and determine a rate at which to assign these costs against labor hours. In determining this burden or overhead rate, such fixed costs are divided by an estimate or projection of the anticipated direct labor hours and are allocated proportionately. However, this method may unfairly assign costs to labor-intensive products, ignoring that more fixed costs should perhaps be allocated to products with large capital or fixed investments. Furthermore, this assignment could underrecover fixed costs by misestimating projected direct labor hours. Or, equally likely, an overrecovery of fixed costs could occur. You should take a realistic approach in the allocation of these costs. If a direct hour allocation is realistic, then use it. If fixed costs can be identified to particular product(s) or service(s), it is appropriate to do so. Variable Costs. In order to be properly classified as variable, a cost should meet two distinct criteria: 1. No cost should be incurred until an activity begins. 2. A direct relationship should exist between the amount of the cost and the level of activity. 14 Budgeting for Operations CHAPTER 1 An example of a purely variable cost is a sales commission. As sales increase or decrease, the amount of commission varies in direct relationship to the level of sales. The relationship between the cost and the level of production may be a straight-line relationship, or the cost rate may increase as the level of output increases. When plotted, this increasing cost relationship will appear as a curvilinear (or curved shape) graph. Although this relationship is common to variable costs, Figure 1.3 is not the usual way it is shown. The more usual case is the straight-line relationship. Often setup costs are spread over production, in which case there is a curvilinear relationship; but that is not the same case. In the setup cost allocation, a fixed cost is spread over varying units of output, decreasing as the length of the production run increases. The earlier example is an increasing cost per unit as the number of units produced increases. Typically, costs such as direct labor, scrap costs, packaging, and shipping are treated as variable costs. However, direct labor and other costs may not be purely variable. For example, the assumption FIGURE 1.3 Actual Relationship between Variable Cost and Level of Production Capacity Dollars Variable Costs Volume 15 SECTION Preparing to Operate the Business I that direct labor varies directly with the number of units produced relies on the divisibility assumption. But labor is not infinitely divisible. If an employee can produce 1,600 units in a standard eight-hour workday but only 1,200 units are required, unless that employee can be used in another operation, he or she has been used at a 75 percent utilization level. Either this idle-time labor can be used effectively in other places or 25 percent of these (unutilized) efforts are assigned to fewer units produced. In most cases, direct labor and direct materials are treated as variable costs for budget purposes even if they are not perfectly divisible. If you have established labor standards for your operations, these can be used for budgeting purposes. By accumulating data and establishing labor standards, you can begin to target costs. The difficulty is establishing objective labor-hour targets for the planning period. Reliance solely on historical data may bias projections, ignore the effects of the learning curve on efficiency, and avoid consideration of past inefficiencies. For planning purposes, remember that the graph of these fixed and variable costs appears reversed when they are assigned on a perunit basis. When variable costs are assigned on a per-unit basis, they are constant and fixed per unit. When fixed costs are assigned on a per-unit basis, they vary as production levels change. Mixed Costs. Mixed costs are those that behave as if they have fixed and variable components. Many items of cost fall into this category. Some people treat mixed costs as fixed costs. If you do so, you must assume an average or projected level of output and allocate the cost over that level. This may over- or underrecover that component of fixed cost. Some might say that it is not important because the over- or underrecovery will be insignificant. If a consistent bias toward underrecovery of the fixed component of one mixed cost exists, underrecovery of the fixed component of every mixed cost, allocated on the basis of that misestimated output level, may exist. If you use these biased data to make capital investment decisions, marketing and pricing decisions, and expansion or contraction decisions, you may experience serious problems. It is sometimes difficult to determine what portion of a mixed cost is fixed and what portion is variable. Fortunately, this allocation 16