That is why sometimes is difficult to evaluate how much of the favorable cost variance is due to lower activity, and how much is due to good cost control?

To answer the question, we must flex the budget to the actual level of activity.

The concept of Budgeting through Flexible Budgets is: if the level of activity for the period is known, there is possible to find out what costs and revenue should have been.

To flex a budget for different activity levels, we must know how costs behave with changes in activity levels.

• Total variable costs change in direct proportion to changes in activity.

• Total fixed costs remain unchanged within the relevant range.

• The result of flexing the budget is the possibility to compare budgeted figures with actual results.

The Flexible Budgets have the following advantages:

• Show revenues and expenses that should have occurred at the actual level of activity.

• May be prepared for any activity level in the relevant range.

• Reveal variances due to good cost control or lack of cost control.

• Improve performance evaluation.

Sales Budget (Step # 1)

Sales can be budgeted taking into consideration the following aspects:

- Sales for previous period

- Production capacities

- Customers’ purchasing power

- Marketing research

- Marketing mix

- Competition

- Seasonal fluctuations

- Product life cycle

* The most precise forecasts can be performed for existent products placed on existent markets.

Inflows will directly depend on Sales Budget. It should also be taken into consideration the collection period of receivables.

Commercial Expenses Budget (Step # 2)

- Normally Commercial Expenses Budget should be correlated with Sales Budget

- It would be hardly possible to have a sales increase while promotional expenses are cut down

- Usually Commercial Expenses are budgeted as a percentage of Sales Budget.

- This percentage will depend on the product life cycle

- Do not forget at this stage about cost related to packing, storage

- The variable and fixed part will be reflected separately

Production Budget (Step # 3)

Production Budget will be elaborated on the Sales Budget basis:

Production Budget = Inventory level at the end of period + Sales for the period -Inventory level at the beginning of period

Inventory Budget (Step # 4)

Inventory Budget contains necessary information for elaborating 2 of the 3 final financial statements:

- Income Statement Pro-Forma, where it influences the cost of the goods sold

- Balance Sheet Pro-Forma, where it determines the Inventory part (materials, work in process and finished products)

Materials Budget (Step # 5)

Materials used in production can be related to direct costs and variable costs as well at the same time.

Materials Budget will be elaborated starting from Production Budget and Sales Budget. The payment period to suppliers should also be taken into consideration because it has direct influence on Cash Flow. Purchases will be calculated using the formula:

Purchases = Production Necessities + Inventory at the end of the period – Inventory at the beginning of the period

Labour Budget (Step # 6)

Labour needs are calculated according to Production Budget, taking into consideration Labour productivity and fees.

Labour expenses can be split into Fixed and Variable part.

Production Indirect Expenses Budget (Step # 7)

As in previous case expenses will be split into Fixed and Variable part.

The fixed part of Production Indirect Expenses will be budgeted for a certain operational level.

The variable part will depend on a chosen cost drive (ex. Production Budget, Direct Labour)

Typical components:

- Equipment and production buildings depreciation

- Rent of equipment and production buildings

- Salary of maintenance personnel

- Auxiliary services costs

Overheads Budget (Step # 8)

Overheads Budget includes expenses that a not directly related to productivity level or sales, but are compulsory for a good functionality of business. Main components are:

- Administrative personnel salary

- Costs related to personnel, law, financial departments, etc.

- Representational expenditures, per diems

- Communication expenditures

- Taxes and interest

- Rent of administrative buildings and transportation means

- The main part of Overheads are fixed costs.

Income Statement (Step # 9)

Income Statement Pro-Forma is the first financial statement elaborated. It contains information on total revenues and expenditures of the 3 activities. For planning purposes the Statement can be more detailed The information for it is produced along the Steps # 1 – 8

It is important that the Steps # 5 – 6 – 7are calculated on the basis of the Budgeted Sales!!!

Balance Sheet (Step # 10)

Balance Sheet is the balance between financial sources and their use. The Balance Sheet projections derive from the necessity of Working Capital (Inventory and Receivables) that are estimated at Steps # 1 and 5, as well as from the principle of Positive Cash Balance.

Current liabilities are calculated at Step # 5 and 6.

At the first stage there will be no modifications in Negative Cash Balance.

The difference between assets and liabilities serves for calculation of cash deficit or surplus.

Modifications in Balance Sheet influence the Cash Flow.

Cash Flow Statement (Step # 11)

The Cash Budget calculation is the most important and the most difficult step at the same time.

The staring point is the Sales Budget.

Payments are determined at Steps #2, 5, 6, 7and 8.

Inflows and payments for Investment and Financial Activities are calculated separately. Depreciation is excluded from all categories of expenditures, when using the direct method of Cash Flow calculation.

Budget a detailed plan, expressed in quantitative terms, that specifies how resources will be acquired and used during a specified period of time.

Purposes of budgeting systems:

- Planning

- Facilitating Communication and Coordination

- Allocating Resources

- Controlling Profit and Operations

- Evaluating Performance and Providing Incentives

Using a budgeting system companies can:

- Improve cash flow;

- Optimize product portfolio;

- Minimize salary adjournment;

- Increase the operational level;

- Eliminate breaks in production process;

- Stabilize debts level;

- Precisely determine the real financing needs.

Types of Budgets

Long-Range Budgets – capital budgets dealing with the acquisition of building and equipment normally cover several years.

Continuous or Rolling Budget – this budget is usually a twelve-month budget that rolls forward one month as the current month is completed.

Operating Budget – the annual operating budget may be divided into quarterly or monthly budgets.

Budgeting comprises 3 obligatory financial statements:

- Income Statement

- Cash Flow Statement

- Balance Sheet

Budgeting comprises 2 components:

Operational Component

- Sales Budget

- Commercial Expenses Budget

- Production Budget

- Inventory Budget

- Materials Budget

- Labour Budget

- Production Indirect Expenses Budget

- Overheads Budget

- Income Statement

Financial Component

- Investment Budget

- Balance Sheet

- Cash Flow Statement

There are some principles to be taken into consideration when developing a Budget. Budgeting is reasonable when:

- There are realistic objectives

- There is a profitable business

- There is a financial diagnosis as base for determining trends

- There is an integrity with Management Informational System

- You can use what-if analysis

Normally it is figured monthly for the first year of activity, quarterly for the second year and annually for the rest of the years.

• (a) should provide for visibility as to how types of cost (e.g. employee salaries) spent for an assisting function (e.g. mechanical repairs) serve the production activities.
• (b) should, if changes occur in the productive activity (e.g. productive activity 1 increases or decreases), be able to at least approximately determine the impact on the assisting functions, and on the individual cost categories (e.g. what is the impact on the mechanical repair function and on the headcount in this function, if productive activity 1 increases, or decreases by 10%).
• (c) should clearly indicate what contribution an individual product (symbolized in the example as output from an activity) makes to recoup the cost of the assisting functions.

Due to confidentiality reasons, the Excel indirect manufacturing cost budgeting for the two sample companies does not reproduce the full detail of the manufacturing overhead planning process, but only the resulting summary sheets.

In planning this way, the quantities, simultaneously, represent the planned capacity utilization, i.e. the use which is planned to be made of the available equipment. The degree of capacity utilization, as can be easily understood, influences the amount and structure of indirect cost which has to be planned.

Indirect cost planning, as in the example on Excel sheet TB, is therefore only valid for the capacity utilization planned.

The decision which costs at the given capacity utilization level behave “variable” and which behave “fixed” requires the design of a model which should not be too complicated. Such models are generally built assigning a certain variable/fixed behaviour to cost categories and using this assigned behaviour across the board for all functions. The example uses such a concept: costs have been assigned as 100% fixed, 50% variable/50% fixed or 100% variable (marked through colours) and the split has been calculated accordingly.

All those costs are associated with 17 activities/functions– 4 productive activities, 10 assisting functions, other costs, sales/marketing and administration.

Through the function to which they are related (e.g. UAH 376,000 are related to auxiliary function 2), indirect cost can be budgeted in assessing the contribution which the subject assisting function has to make in order to permit the realization of the production plan.

In the case of mechanical repairs for instance, this analysis would consist of an assessment of the number, and kind of repair jobs which the repair manager deems necessary to keep the production running at the budgeted activity level of 36,000 machine hours in production activity 1, of 90,000 m2 in production activity 2, of 180,000 kg in production activity 3, and of 18,000 operator hours in production activity x. during. The total budgeted mechanical repair cost (i.e. repair material, repair labour, and repair department overheads) can then be distributed in accordance with the material and labour cost planned to be spent for the four productive activities. The distribution base in this case is the sum of direct repair material cost and direct repair labour cost.

It has to be noted that this methodology can be used only if the mechanical repair cost structure for the different production activities is similar. Should the mechanical repair activity be characterized by the situation that repairs for one production activity consist primarily of unproblematic replacement of expensive material, whereas the other production activities require complex manual repair work using insignificant and inexpensive material, such a distribution practice could not be applied because it would overly burden the material-intensive repairs with indirect repair cost. Another distribution method would have to be selected in this case.

The general message which this discussion of alternative methods wants to convey is that there is no simple and uniform way for distributing indirect cost to the productive activities. The correct distribution method is the one which distributes the indirect cost in a way that the distributed costs most closely reflect the effective use caused by the production process.

Generally, the following distribution bases can be expected to lead to an adequate distribution of the cost of auxiliary functions:

Auxiliary services performed within the assisting functions area should be consolidated, and only the services leaving the auxiliary function area should be shown in the distribution.

Because the different products cause different labour cost in the workshops which contribute to the manufacturing process, the planning has to be done by workshop. The technical documentation as to the work to be carried out – how many minutes of direct work have to be spent in the different work shops, and at what rate – serves as basis for calculating the direct labour cost budget in using the formula:

Attention has to paid to the fact that in the case of work which is not paid “by piece”, the time per unit (the norm) might be over-, or understated, i.e. not be established in accordance with the principle of “attainable performance under efficient operating conditions”. Using such norms for budgeting will automatically lead to a wrong direct material cost budget.

In the case of the sample company Eurotransform, the direct labour budget calculation is carried out for 14 workshops by month in accordance with the planned delivery date of the final product, and in splitting the labour cost into “incentive paid work” (paid per piece), and “straight paid work” (paid by hour). This calculation shows which direct labour cost are caused in the different workshops by the final products due for delivery in January, February, March, etc. The calculation, however, does not indicate at what point in time of the production cycle the labour cost becomes cash outflow effective. (for example, in the case of delivery by the end of June, production has to be launched for category II – III products in April, for category IV – VI products in March). A direct labour payment pattern, therefore, has to be assumed similar to the one used for direct materials (%age distribution of cash outflows during the production cycle time for transformer sizes II-III, and IV-VI).

The problem of budgeting overheads (or indirect cost) stems from the fact that overhead cost are not connected directly to individual products, orders or services, as are the direct cost.

Some indirect costs, however, are still relatively close to direct costs. The labour cost caused by a workshop supervisor, certainly, cannot be related to individual work operations, as can the labour cost of direct workers. Each workshop, carrying out productive work has to bear such indirect cost of its own. But the supervisor’s cost, and other indirect cost incurred, can be related to the productive work done by the workshop, and via the productive work, to the products.

Other indirect cost are spent in departments which only carry out indirect activities, e.g. building maintenance and repair. These functions are referred to as auxiliary functions. The costs of auxiliary functions, too, have to be put in relation to the productive functions in order to relate them to products. This putting in relation is referred to as “distribution” and “allocation”

• the cost of auxiliary activities, recorded in accounting by type of cost and by organizational function, are distributed to the direct activities who have to carry them in an accordance with the contribution they make to their work.
• the total indirect cost identified as belonging to one productive activity (i.e. the indirect cost of the productive activity plus the distributed cost of the auxiliary activities) are then allocated to products, or processes.

This is explained in more detail in the following.

To be useful, the material budget has to be established in some detail using material consumption standards denominated in quantities (i.e. so much g, kg, m, items etc. are needed to manufacture a certain quantity of product). These material consumption standards should be engineered and be realistic (i.e. reflect attainable performance under efficient operating conditions). The quantities so obtained are then multiplied by the purchase prices which the company, realistically, can expect to obtain on the market.

A material budget which is built up in this way lists, by month, the main materials, by item, the quantities needed and the purchase prices which the company wants to achieve to purchase them. The advantages which such a material budget offers to management are evident: because a material budget prepared in this way is a detailed simulation of the future purchase activity and of the future material consumption, the budget numbers can be directly used to measure during the year the performance of the purchasing function and the efficiency of manufacturing as far as material usage is concerned. The establishment of a material budget which fully covers the above mentioned two aspects – income forecasting and management controlling with regard to purchasing efficiency and material usage – however, is a relatively complex and time consuming task going beyond the immediate objective to obtain information as to the monthly balance sheet and cash flow data which prevails here. The methodology described, due to this, is not paying particular attention to the task to establish budget data for measuring the efficiency of purchasing and material utilization.

In the case of Eurotransform, all transformers are being planned as customer specific versions. The direct material lists (bills of material) compiled when working out the proposal for the customer, therefore can be used to budget the material requirements. These lists show the needed quantities and “LIFO” – purchase prices. This information, in accordance with the planned delivery dates, is collected by month, and classified in accordance with six raw material categories (2 types of copper wire, magnetic steel, oil, isolation paper, others). Direct materials are loaded with material acquisition cost which cover purchasing, incoming inspection, and the transportation to the workshop.

An further important material cost element of transformers are the purchased components, as they are often imposed by the customer. These components are planned specifically too, classified in accordance with the components type as listed below, and shown with the planned transformer type to which they belong.

In order to determine the points in time when materials, and components become due for payment during the production cycle (and, consequently, cause cash outflows), a consumption pattern has to be established. The scenario developed for this purpose links the payments for materials to the transformer size (2 classes: size II-III, and size IV-VII); to the types of raw materials, and purchased components, to the production cycle time (3 months for size II-III, 4 months for size IV-VI), and to an assumed typical payment pattern indicating at what point in time of the production cycle payments are made. The production cycle is counted backwards from the planned delivery date.

Essentially, the same methodology has been used to prepare the material budget for the tannery business. The material consumption standards are here related to the 15 planning units used for sales planning.

The following assumptions have been made with regard to raw material inventories and the cash out flows caused by material purchases:

• material inventory at end of each month should be equal to the next month’s consumption;
• 50% of the monthly purchases are paid in the same month, the remaining 50% in the following months.

The sales budget – what products at what prices plans the company to sell – is, as pointed out earlier, the starting point for preparing a budget. Three basic rules have to be observed when preparing the sales budget.

• The sales budget must be compiled by multiplying product quantities with unit prices. This principle originates from the fact that the costs which have to be budgeted (material, production, sales and administrative costs ) are determined by the sold/produced quantities, and not by the sales/production value. Due to this, previous year sales numbers multiplied by factors are not a sales budget!

In practice, the adherence to this rule is not always easy. Companies manufacture what the market demands, and the ability of a company to meet specific demands, priced with specific prices, represents a competitive advantage. This means that a sales budget which strictly adheres to the “quantity multiplied by unit price principle” in many cases has to deal with a large number of specific products and prices. Specific products, however, are difficult to forecast and experience shows that if forecasted specifically, minor changes in the sales mix can cause big forecasting errors. Therefore, generally, fictitious type products (commonly called planning units) are defined for sales planning purposes which stand for a certain number of specific products. However when using type products for budgeting, certain rules have to be observed. If a brewery, for instance, sells different kinds of beer which essentially all use the same materials, go through the same production process, and have very similar prices, it can be envisaged, to just use the planning unit “hectolitres of beer” with one budgeted average price. If the brewery chooses to add a prestige beer product to its product range, produced with different materials, using a specific production process, and sold at higher prices, a specific planning unit should be created to budget this activity. If this is not done, the impact of this activity on sales and cost will not be adequately reflected in the budget. The decision of which planning units to use, and how to define them, is therefore essential for the informational value of a budget. This leads to the second basic rule:

• Planning units have to be selected in such a way that they reflect closely enough the prices and cost attached to the different products.
• Because of the reason explained in the “Theoretical Background” paragraph, the sales budget – as all other budgets – has to be established by month.

How to do it

Sales have to be budgeted – as explained in the previous paragraph – in planning quantities which are multiplied by unit prices, and in choosing adequate planning units.

Eurotransform’s production programme consists of electrical power transformers which are characterized by a specific technological design and by specific electrical properties which make them fit specific utilizations. Each transformer produced is a specific product for a specific customer. The quantity of products delivered annually is limited (approximately 100 orders each of which comprises one, or several items of a specific transformer type). Due to the limited number of product types which are produced per year, there is no need to define planning units in order to aggregate individual product sales forecasts into easier to handle summary numbers. The decision, therefore, was taken to budget sales by individual – and customer specific – transformer.

In the previous paragraph the comment was made that specific products are difficult to forecast, and that minor misjudgements in relation to future sales of specific products might cause big forecasting errors. In the case of the transformer plant this, for example, would mean that at budget preparation time in October the detailed sales forecast is available until the month of July next year, and that the specific products to be sold would have to be estimated for the remaining five months. This can be extremely difficult because the price of a power transformer can go from 1,000 US$ to 300,000 US$, with production processes for the low end and high end which show important differences. Hence, the risk to commit misjudgements if, for instance, high end transformers are budgeted for the remaining five months, although low end ones, finally, will be ordered.

However, at Eurotransform this problem, normally, does not exist. The project development lead time in this economic sector is long (electrical power plants, electrical distribution networks, large industrial projects) so that at the time of the budget preparation the sales for the coming year are already known in detail.

The planning in accordance with the principles explained above has been done by month. In order to reflect the different price and VAT behaviour, planned sales are split into “domestic”, ”CIS”, and “foreign markets”. The planning is made in UAH. US$ conversion has been done at 5,40 UAH per 1 US$.

Because Eurotransform produces for firm customer orders only (not “on stock”), production has been set equal to sales.

As the objective of budgeting sales is twofold, i.e.

• on the one hand it provides for the quantity base for planning and costing the manufacturing activity, i.e. it determines what is planned to be sold, and what, consequently, has to be produced at what point in time,
• on the other hand it anticipates the cash flow which is to be expected from the sales during the budget period, the cash flow resulting from sales has to be budgeted too. In doing this the procedure has to take into account the timing differences between the physical delivery, the setting up of the invoice, and the point in time when payments are made. Because the payments depend on the agreed upon contractual terms, and on the attitude of the business partners with regards to payments, a multitude of situations can arise which are difficult to anticipate. Therefore, for budgeting purposes, one uses generally a scenario which attempts to reflect the average behaviour with regard to payments, generally by type of customer, or type of business.

In the case of sample company Eurotransform the scenario chosen is relatively simple. A typical behaviour is applied to the two business types “domestic/CIS” and “foreign markets” as follows:

• Domestic/CIS: Production cycle from signing of order till delivery 3 months. Payments: 10% at signature, 90% at delivery.
• Foreign markets: Production cycle from signing the contract till delivery 4 months. Payments: 50% at signature, 50% at delivery.

Using such a scenario does not exclude the possibility to use the contractually agreed payment pattern for those planned sales where such information is available.

If one attempts to apply the basic rules of sales budgeting – planning of quantities which are multiplied by unit prices, and selection of adequate planning units – to the process industry environment of a tannery, one realizes very quickly that the problems here are quite different. Production cycle times here are much shorter (approximately 2 weeks). The company knows it’s detailed sales program only 1-2 months ahead of time, and not 10-12 months ahead of time as in the power transformer activity. The annual budget, therefore, has to be estimated based on the knowledge which the company has about its main customers (shoe, leather goods, and furniture producers; tanneries in the West which subcontract the environmentally-problematic tanning operations). Such estimates are possible because about 90% of the sales are made to customers with which the company maintains regular business relations. However, operating in an industry where the final product is subject to fashion trends, and to fluctuations of consumer demand, there is always a certain degree of uncertainty about the precise products which will be ordered. Theoretically, the number of products, which are the result of possible combinations of leather qualities, and colours, is very high.

The company Top K, initially, attempted to budget sales as much as possible by individual products. This, however, led to high data volumes to handle, and – at the end of the exercise – to little additional knowledge about the future business. As the precise leather types that will be ordered could not be obtained earlier than 1- 2 months before the delivery date, estimating of precise types did not yield any higher budget precision. Therefore, for simplicity reasons, 15 planning units were created for budgeting the sales as follows:

• Chrome leather: 6 planning units, planned in m2: home market, and export each time split into the qualities A, B, C.
• Wet blue (semi-finished product): 4 planning units, planned in kg: related to the four main end-utilizations.
• Split leather, 2 planning units, planned m2: home market and export
• Scrap products, 3 planning units, representing the type of scrap, planned in kg.

Average prices were budgeted for each of the planning units. Domestic and export sales are shown separately in order to permit consideration of the different price levels, different payment terms and different VAT treatment (export sales not submitted to VAT; domestic sales charged with 20%). No advance payments are customary in this industry. Payment terms are 30 days for exports, and 22 days on the home market. Because the numbers have been prepared to test the program, they only cover a 3 months period.

In a market economy, production is not a stand alone objective. Production is justified only to the extent that it can be sold, i.e. meets market demand in relation to quality and prices. Arithmetically, production is connected with sales through the following formula

Whether, or not inventory needs to be budgeted depends on the type of business. In companies working on orders inventory should be at minimum levels, and should be limited to contractually imposed situations (summary shipments), or to instances where cost effective purchasing and/or production requires the building up of some stocks (economic purchase/production lot sizes). No particular inventory planning was therefore defined when preparing the budget for Eurotransform. The fluctuations of inventory over the months result here from the acting together of the planned starting and delivery dates of production orders, and the assumed timing of direct material and direct labour input. In a retail company, and in a company serving the consumer product market, the holding of some inventory generally cannot be avoided. However, one should never forget that any inventory “freezes” working capital, and that one runs a risk to end up with slow-moving, or obsolete stock. On the other hand, if the inventory policy is too restrictive the company might fail to satisfy demand and lose customers.

In the case of the Top K company inventory has been planned for chrome leather. The production budget is expressed in quantities only.

Having determined the sales budget, the inventory budget has to be fixed. The above chart, for simplification reasons, shows only the interrelations between the sales budget, the (finished goods) inventory budget and the production budget. Budgeting, naturally, on the one hand has to take into account whether sales can be made through saleable products which are already in inventory, or whether the company intends to put during the budget period saleable products into inventory

The latter practice should be limited to specific cases e.g. the regrouping of orders of same products with different delivery dates, or the collection of different products to be expedited through one shipment.

The production budget then results from the sales budget minus sales of finished products out of inventory, plus finished products to be produced in order to be put into inventory.

Inventory, in real life, in addition consists of material, and work- in- process. Both these inventory categories have to be budgeted, if the overall company strategy – for whatever reasons – foresees substantial amounts related to them.

The production budget (i.e. the quantities of product planned to be produced) determine the direct material budget, the direct labour budget, and the manufacturing overhead budget. Budgeting here should be done using performance standards (norms) for direct material, direct labour and for the manufacturing overheads. The norms should reflect “attainable performance under efficient operating conditions”. Adequate manufacturing overhead distribution methods and manufacturing overhead absorption methods should be used when budgeting the manufacturing overheads.

The cost of goods sold budget are the total of the direct material cost, the direct labour cost, the manufacturing overheads and the cost of products sold out of inventory.

The sales & administration expense budget is set up taking into account the overall activity level as determined by the planned sales.

The planned investments are collected into an investment budget, the investment concerning in principle all areas of the company.

All budget information is ultimately consolidated into annual and monthly balance sheets, income statements, and cash-flow statements.

Two Excel life examples of a budget preparation are used for demonstration purposes throughout this document. They represent two fictional companies, one illustrating an environment where production is carried out on customer order (company Eurotransform, producing power transformers), the other one representing a process industry (tannery Top K). The two examples have been developed on the basis of real budget development projects in Ukraine – although for confidentiality reasons, details have been adjusted and concealed, and enhanced with additional details.