More budgeting

Moving on from the last post, let’s talk more about how budgets work and what they’re made of.

Standard costs and variances

Standard costs are the planned cost (per unit) of products or services produced. You can also have standard revenues that work the same way.

Variances are the difference between the standard costs and revenues that were included in the budget and the actual costs and revenues. They are said to be favourable if the profit is higher than budgeted, and adverse if they’re lower.

Standard costs and revenues are of course based on estimates. To keep the estimates as accurate as possible there’s a number of steps you can take:

• Review them frequently to keep them up to date
• Use the right people — people with the right specialist knowledge for the area
• Use past information where it’s available, or if it’s not available try to extrapolate from similar scenarios, or even run a model / simulation

Problems

There are some issues with using standard costing:

• Standards can become dated quickly
• Some of the things that affect variance might be outside of the manager’s control
• It’s not always easy to have a clear line between different budgeting areas
• Lack of incentive to achieve beyond the standard

Analysing variance

The actual profit is the budgeted profit plus favourable variances minus adverse variances. It’s written neatly below.

Actual Profit

=

Budgeted Profit

+

Favourable Variances

Example

Here’s some data about what a company did in July:

There is a problem with this data that we should address before doing the analysis. You will notice (highlighted in blue!) that the units produced was different. The solution to this is easy however, we just have to ‘flex’ the budget, which which means adjust it for the actual volume of activity.

So we’ll add an extra column to the table showing how the budget has been flexed. It’s easy to do, you just take the amount and scale it to the actual, so in this case for each item it is just scaled back 20% to match the 20% different in budgeted and actual production.

The only part that we don’t flex is ‘fixed overheads’, as they are fixed and do not change depending on output volume.

Now the next step is just to work out the different between budget and actual for each thing:

If variances are large, and/or happen a lot they should probably be investigated. Of course the value of ‘large’ depends on the size of the business. If the variances are small but rising, then that can be a sign of a long term issue.

Divisional performance measurement

It’s not unusual for management to divide their business up into centres or divisions, for example:

• Profit centres — Managers can control sales volume and pricing but not investment
• Cost centres — Managers only have control over costs incurred
• Investment centres — Like a business within a business. Managers have control over investments

There are two common ratios used to measure how a division is performing:

Budget criticisms

• They encourage only focusing on the short term
• They cause power to be concentrated high up the chain of management
• They make departments think about themselves alone and do not consider other departments
• They don’t encourage taking risks that might pay off or be necessary

Praise of budgets

Studies have shown that budgets…

• improve job performance
• improve job satisfaction
• that are demanding budgets motivate better than easier less demanding ones
• that are unrealistic have a negative effect on performance
• improves motivation and performance if managers are involved in setting the targets

Dysfunctional behaviour

• Only focusing on aspects of the job that are measured (like the budget)
• Quick fixes might be used to meet the budget at a pinch that might have a negative effect later
• Setting the budget higher than needed to accomodate for any failures