The budgeting process
• The traditional goals of the planning and control process are:
- to identify the economic goals and how to achieve them
- to measure if the goals have been achieved
- to determine the variance causes between the actual values and
planned valued
- to introduce the necessary correction measures
Two basic steps are analyzed in the next lessons:
- the budgeting process or operative planning;
- the variance analysis.
1
The budgeting process
• The budgeting is included in the more general strategic planning
process which is composed of the following phases:
- identification of the company’s objectives in terms of product/market
segments, strategy and expected development/growing;
- strategic planning, with the definition of the long-term plans necessary
to achieve the objectives (new products introduction, existing products
modify, efficiency or flexibility increasing);
- budgeting which determines the short-term actions to realize the longterm plans; the activity budgeting receives the input of the long-term
strategic planning. From an organizational point of view the coherence
between the three phases requires that in the definition of goals and in
the strategic planning are involved all responsibility centers
2
The budgeting goals
• The final goal of the budgeting phase is the drawing up of the
MASTER BUDGET, document which allows to prepare the expected
Balance sheet (Expected Profit/Loss and Expected Assets and
Liabilities Statement)
• The Master budget is composed by:
- the operative budgets related to the short-term planning of the
operative management;
- the annual investment budget related to the new investment in
tangible/intangible resources necessary to achieve the strategic goals;
- the financial budgets to evaluate the impact on the net cash flow due to
the operative budgets and investment budget
• It can be very complex to draw up a budget which is consistent with
the strategic planning and to achieve a coherence between the plans
which compose the master budget. Very often a “negotiation process”
is necessary (e.g. a growing of the market share through the prices
reduction can not be consistent with the expected return on
investment; investments in Research and Development can not be
consistent with the established dividend distribution; selling choices
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are not consistent with production capacity)
The operative budgets
•
•
•
•
Sales budget
Production budget
Cost of goods sold (purchases, variable and fixed conversion costs)
Period costs budget (commercial costs, general and administrative
costs, discretional costs)
4
Sales budget
• It’s the first budget which is the base for the preparation of the other
operative budgets and the financial budget
• It’s drawing up by the Marketing &Sales function with the support of
the Planning and Control Staff Unit
• Monthly or yearly the sales budget defines the expected revenues in
terms of volumes and prices. Values can be grouped by customer or
geographic area
• Sales budgets are based on the market evolution forecasting, on the
competitive strategy, on the historical growing of sales
5
Sales budget: graphic
Genuary
December
Volume Price Sales …. Volume
Price
Total
yearly sales
Sales
Prod.
A
Prod.
B
Prod.
C
6
Production budget (and ending inventory
budget)
• After identifying the sales, the opening/beginning inventory and the
expected closing/ending inventory in quantity, it is possible to define
the expected production quantity for each product in each relevant
period (e.g. month):
Pi=Vi + (EI - BI)
• It’s necessary to verify the feasibility of the production budget. In other
words for each resource must be:
 Pi*tij <=Tj for i=1,…N
tij is the quantity of the resourse j required by product i unit
Tj is the total quantity of the resource j that is available (e.g. machine
hours, labor hours)
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Production budget non feasibility: actions
• Reviewing sales policy, for example increasing the price and reducing
the quantity
• Reviewing the inventory policy, for example decreasing the expected
level of ending inventory
• Modifying the production capacity through new investment (long-term
action)
• Purchasing a share of production by the market (outsourcing)
8
Cost of goods sold
• After identifying a feasible production plan, the amount of resources
necessary to achieve the production plan must be defined
• The Process Engineering Function and the Purchase Function defines
the standard quantity and the standard price of the raw materials,
direct labor, any other resourced to be used to realize the expected
production level
• Consequently the following budget can be determined:
“consumption” for the production:
- Direct Material budget or consumption of raw material for the
production plan that could be different with respect to Budget of
purchases = consumption of raw material + desired EI – BI of raw
material
- Direct Labor budget, or consumption of labor for the production plan;
- Other Conversion costs (ex. Energy, amortization) budget;
- External working budget (if any)
BUT TO DEFINE OPERATING INCOME (P/L) IT’S RELEVANT THE
COST OF GOODS SOLD (COMPETENCE PRINCIPLE)
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Cost of goods sold
• On the full or variable production cost base it’s possible to
determine the inventory value - raw materials, finished goods (previously it had been determined the quantity) and then the cost of
goods sold as:
Cost of goods sold (variable or full)= raw mat consumption + conversion
costs + BI - EI (finished goods)
Cost of goods sold (variable or full)= purchases + conversion costs + BI EI (raw material and finished goods)
What type of costs can be included in the inventory evaluation?
Production costs as:
Variable approach: raw material, energy, labor if variable according to
production level, usually NO selling, administrative and financial costs.
Selling costs are included in the variable costs, but as period costs.
Full approach: raw material, energy, labor, amortization (overhead):
All production costs, variable and fixed.
Anyway, we need to calculate the production cost per unit, and then
we’ll apply to inventory
10
Cost of goods sold
TWO profit and loss budgeted statements are linked to these different
approaches
1. Contribution margin= Sales- Variable costs (production and selling)
-Fixed costs (production and selling)
Net Operating margin (income)
Note: variable COGS can include also selling costs, but inventory
evaluation does not because they are period costs. Inventory
evaluation includes only variable production costs.
2. Gross (industrial) margin= Sales – Full COGS
- Selling & administrative costs (period costs)
Net Operating margin (income)
Note: Full COGS includes only production costs, all included in
inventory evaluation
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Cost of goods sold
IF EI > BI WE POSTPONE/DEFER COSTS AND COGS < PRODUCTION
SALES < PRODUCTION
IF EI < BI WE UPLOAD COSTS TO THE PERIOD AND COGS > PROD
SALES > PRODUCTION
VITALE CASE TO UNDERSTAND THE COGS (FULL)
IRON (I PART) TO UNDERSTAND THE IMPLICATIONS ON NET
OPERATING INCOME DERIVED BY
USING VARIABLE OR FULL APPROACH
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Cost of goods sold: graphics
Direct Material Budget
Element
Purchased
Quantity
Element
price
Total cost
1 (prod. A)
…..
N (prod. A)
Tot. Purchases
prod. A
1 (prod. B)
…..
N (prod. B)
Tot. Purchases
prod. B
Conversion cost Budget
Direct Labor
Conversion costs
Utilities
……..
Total costs
Prod.
A
Prod.
B
…..
Prod.
N
Total conversion
costs
13
Period costs budget: two possible
approaches
• Costs related to Discretional and support activities such as General
&Administrative costs, Selling costs, Research and Development
costs
• Two possible approaches:
- Incremental approach
- Zero based budget approach
• According to the incremental approach the budget is determined
multiplying the past actual values (of the previous year) by a
coefficient based on the inflation rate and the expansion of activity
company level. This approach has two limits:
- assumes a linear relation between the activity level and the period costs
(it can be wrong for the period costs incurred una tantum)
- derives the budget values from the past year actual values and
consequently causes an amplification of inefficiencies
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Period costs budget: two possible
approaches
• According to the zero based budget approach each year the amount
of period costs is re-defined
• The period costs budget is independent from the past but this
approach is more complex and requires the strong commitment of the
responsibility centers and Planning & Control Staff
• Usually, an incremental approach is used each year and a zero based
budget is used each 3/4 year
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Variance analysis
• The goal of this analysis is the explanations of the difference incurred
between the actual costs/revenues and the expected costs/revenues
• The analysis is different according to the type of the organizational unit
- cost center (responsible on the use of resources to achieve the output)
- revenue center (responsible on the revenue)
- expense center (e.g. administrative unit): for these centers there is only
a total budget control without searching in detail the variance causes
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Variance analysis: revenue centers
• Sales are the relevant entities for responsibility related to these units
• Sales =  Pi*V*Qvi i= 1,…..N
Pi=sale price of product i
V= total sales in quantity for all products
Qvi=% of the sales in quantity for product i (sales MIX)
• to understand the causes of difference between actual and expected
sales 4 entities must be compared.
- budget (standard conditions)
- flexible budget with standard mix
- flexible budget with actual mix
- actual
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Variance analysis: revenue centers
Budget
Flexible budget
standard mix
Flexible budget
actual mix
Actual
Price
standard
standard
Mix
standard
standard
Sales Volume
standard
actual
standard
actual
actual
actual
actual
actual
• Flexible budget standard mix - Budget = variance of volume
• Flexible budget actual mix - Flexible budget standard mix =variance of
mix
• Actual - Flexible budget actual mix = variance of price
EXERCISE
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Variance analysis: cost centers
There are two different levels of analysis:
1° level
Budget
Flexible budget
Actual
Variable costs
for unit of
production
standard
standard
actual
Total fixed costs Production
Volume
standard
standard
actual
standard
actual
actual
Actual - Flexible budget = variance of efficiency (internal cause)
Flexible budget - Budget = variance of volume (external cause)
NOTES: Flexible budget has an actual production level but a standard
consumption of resource (standard efficiency)
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Variance analysis: cost centers
2° level
• for the direct variable costs (Direct material and Direct labor) is
possible to have a higher detail as concerns the variance of efficiency
- 2a) variance of price (basically external, responsible: Purchases Unit)
- 2b) variance of employment (basically internal, responsible: Production
Unit)
• Between the Flexible Budget and the Actual is necessary to to
introduce also the Flexible Budget with ACTUAL consumption
• Actual - Flexible Budget is the total variance of efficiency that is
composed by:
2a) Actual -Flexible Budget with actual consumption = variance of price
q*V*p - q*V*pst= (p -pst)*q*V
q= actual quantity of resource j for unit of production
2b) Flexible Budget with actual consumption - Flexible Budget with
standard consumption = variance of employment
pst*q*V - pst*qst*V= (q -qst)*pst*V
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EXERCISE