Monitoring the Budget

by David A. Curbo, CPA

Many people dismiss budgeting as a waste of time since we can never exactly predict the future. Even the best-prepared budget will normally differ from actual results in very significant ways. Since no budget is ever right, why bother to prepare one? Internally, there are two reasons to prepare a budget: the knowledge gained about the sales and operations of the company during the process of preparing the budget, and the knowledge about the company gained from the analysis performed when the actual results differ from the budget. Even owners and managers who have a good, detailed knowledge of the workings of their business usually learn a lot when preparing a budget, for example, what factors are necessary to predict their sales and expenses. But the biggest benefit of a properly prepared budget is the analysis of differences (variances) between the budgeted amounts and the actual amounts.

Zero-Based Budgeting

A properly prepared budget is the aggregate of a number of factors for each item. Many businesses budget "last year plus x percent." But this is the poorest way to budget. A more useful method is "zero-based budgeting." In this method, the actual individual components of each item are accumulated. To demonstrate the difference, let's attempt to project our cost of sales for a sample company. If we are lazy in our budgeting, we take last year's sales of $909,000, estimate a 10 percent increase in sales and budget $1 million in sales. Our cost of sales historically runs 50 percent of sales so we budget $500,000 for cost of sales. In a zero-based process, we might well project $1 million in sales consisting of 10,000 widgets at $100 each. If our expected cost to purchase the widgets is $50 each, we would expect our cost of sales to be $500,000 (10,000 widgets times $50). There doesn't appear to be any difference - we projected sales of $1 million and cost of sales of $500,000 both ways. What's the big deal? The answer lies in the question "Why?" If we actually attain sales of $1.2 million consisting of 10,000 widgets at $120 each and a cost of sales of $550,000, did we do good or bad? With the historical based budgeting, it appears everything is great. Sales were projected to increase 10 percent; they actually increased 20 percent. Costs have historically been 50 percent of sales and they were only 45.8 percent. But with the zero-based model, we see that our increase in sales was totally due to increased sales price. It is certainly nice to be able to pass on that type of price increase and maintain your unit volume, but I wouldn't count on sustaining it in most situations. While our cost of sales decreased as a percent of sales, it actually increased 10 percent on a per unit basis. Widgets that cost us $50 last year are $55 this year. Analyzed this way we see a 10 percent increase in per unit cost instead of a 4.2 percent decrease in total cost. This conclusion may be totally reasonable but it does present a very different view and may justify some further investigation.

Variances

Variances between actual and budgeted amounts can be analyzed down to the same level of detail that was used to prepare the budget. This analysis is what justifies the effort to develop the budget at the detailed level rather than solely in broad numbers. Why is our cost of sales up? Why are our training costs double what they were last year? To the extent that a business manager can answer the question "Why?", the proper decision can be made about what, if any, corrective action should be taken. Many growing or stable organizations have continued to operate for years with one or more very inefficient functions simply because the costs were always comparable with the previous year. The fact that the cost was always high escaped notice because there was no detail to use for comparison.

Variance Analysis

Assuming your company has a budget prepared in enough detail, how should you use it to monitor results? Variance analyses should be prepared monthly for the key components of the income statement. Sales is always a key component as is cost of sales. Usually, the top three or four items in the operating expenses are analyzed individually and the rest are aggregated unless the variance is unacceptably large. These key variances should be computed each month. Management should identify the major causes of each variance.

Typically, variances are analyzed in terms of volume, price and mix. Other methods of differentiating variances can be used if meaningful. These variances are just what their names suggest. If our sales volume is up 10 percent, we would expect our variable costs to be up 10 percent, so we compute a 10 percent increase in the variable costs and identify it as a volume variance. After we subtract this variance, is the remainder a cost increase or a decrease? Variances may fluctuate either way. Similarly, if we know we budgeted labor at $15 per hour, but after our raises the average rate is $16, we explain that amount of difference as price difference. Lastly, we have mix variance. Most examples are intentionally kept simple and deal only with a single product at a single price. But in reality, virtually everyone has multiple products and different pricing structures for various business reasons. You may sell the expected number of widgets but sell them to your high volume customers who receive a volume discount. You may sell more of your economy models and less of the deluxe. Or, you may sell more of product A than you expected and less of product B. Each of these would be a mix variance.

The Call to Action

What are we going to do differently as a result of this variance? This is ultimately the purpose of the budgeting and the variance analysis – to give you information in enough detail to allow you to make the correct decisions. However, the budgeting process goes only so far as to provide the information. You as a manager must make the decisions and act on them.

About the author

David A. Curbo, CPA, is a partner withCannon & Company, CPAs, a certified public accounting firm in Memphis, Tenn. Curbo is a member of the Tennessee Society of Certified Public Accountants, the state professional organization for more than 8,000 CPAs in government, education, industry, business and public practice, and its Memphis Chapter. TSCPA's Memphis Chapter is one of eight chapters across the state with more than 1,500 members in three counties. For more information on small business issues, visit the Tennessee Society of CPAs' Small Business Resource Center on the Web at www.tscpa.com.