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 post provides answers to a key questions: “How to make interlocking budgets system work?“
A properly designed budget is a complex web of spreadsheets that account for the activities of virtually all areas within a company. The budget begins in two places, with both the revenue budget and research and development (R&D) budget. Read on…
Interlocking the Revenue 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 that 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 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.
Interlocking The Research and Development (R&D) 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.
Interlocking The Production Budget
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 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.
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 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.
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 long-term 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.
- 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 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. 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.
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 summary level 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. Next is the General and Administration (G&A) Budget.
Interlocking General and Administration (G&A) Budget
Another non-production 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 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.
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.
Interlocking The Capital Budget
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.
Turning Interlocked Budget System Into the Financial Statement Sets
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.
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