Prentice Hall's one-day MBA in finance & accounting (40 page)

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Two common methods for allocating fixed expenses.

Method A: Fixed Expenses Allocated on Basis of Sales V

Sales revenue

Cost-of-goods-sold expense

Gross margin

Variable expenses

Contribution margin

Fixed expenses

Profit (loss)

Method B: Fixed Expenses Allocated on Basis of Sales Revenue
Sales revenue

Cost-of-goods-sold expense

Gross margin

Variable expenses

Contribution margin

Fixed expenses

Profit (loss)

FIGURE 17.3

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basis of sales volume (method A), and the second on the basis of sales revenue of each product (method B). Total profit for the product line is the same for both, but the operating profit reported for each product differs between the two allocation methods.

Both sales volume and sales revenue for allocating fixed costs have obvious shortcomings; furthermore, both methods are rather arbitrary. Either method rests on a dubious premise. Method A assumes that each and every unit has the same fixed cost. Method B assumes that each and every sales revenue dollar has the same fixed cost. Recent attention has been focused on the theory of
cost drivers
to allocate fixed expenses, which goes under the rubric of
activity based costing
(ABC). This approach should really be called activity based cost
allocation,
because it’s a method to allocate indirect costs to products.

Activity Based Costing (ABC)

The ABC method challenges the premise that fixed expenses are truly and completely indirect. Total fixed expenses are subdivided into separate cost pools; a separate cost pool is determined for each basic activity or support service. Instead of lumping all fixed costs into one conglomerate pool of general support, each basic type of support activity is identified with its own separate cost pool. Each product is then analyzed to determine and measure the usage the product makes of each activity for which separate fixed-expense pools are established.

In this example, for instance, all products except the generic model are advertised, and all advertising is done through the advertising department of the corporation. The advertising department is defined as one separate fixed-cost pool, and its activity is measured according to some common denominator of activity, such as number of ad pages run in the print media (newspapers and magazines). Each product is allocated a share of the total advertising department’s cost pool based on the number of ad pages run for that product.

The number of ad pages is called a
cost driver.
This activity drives, or determines, the amount of the fixed-cost subpool to be allocated to each product.

Alternatively, different types of advertising (print versus
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electronic media, for example) could be identified and each product line charged with its share of the advertising department’s cost based on two separate cost drivers—one for the number of print media pages and a second for the number of minutes on television or radio.

Some fixed expenses are quite indirect and far removed from particular products. Examples include the accounting department, the legal department, the annual CPA audit fee, the cost of security guards, general liability insurance, and many more. The cost driver concept would get stretched to its limit for these fixed expenses. Also, the number of separate activities having their own expense pools can get out of hand.

Three to five, perhaps even seven to ten separate cost drivers for fixed-cost allocation may be understandable and feasible, but there is a limit.

Returning to the title of this section, the fundamental management question is whether
any
allocation scheme is worth the effort. What’s the purpose? Does allocation help decision making? The basic management purpose should not be to find the true or actual profit for each product or other sales revenue source. The fundamental question is whether management is making optimal use of the resources and potential provided by the division’s fixed operating expenses.

The bottom line is finding which sales mix maximizes total contribution margin. Allocation of indirect fixed expenses in and of itself doesn’t help to do this. Indirect fixed expenses may have to be allocated for legal or contract purposes. If so, the method(s) for such allocation should be spelled out in advance rather than waiting until after the fact to select the allocation rationale.

Sometimes a business may allocate fixed expenses to minimize the apparent profit on a product. I was hired to be an expert witness for the plaintiff in a patent infringement lawsuit against a well-known corporation. The defendant had already lost in the first stage, having been found guilty of patent infringement. For three years the defendant corporation had manufactured and sold a product on which the plaintiff owned the patent without compensating the plaintiff. The second stage was to assess the amount of damages to be awarded to the plaintiff.

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The plaintiff was suing for recovery of the profit made by the defendant corporation on sales of the product. The defendant allocated every indirect fixed cost it could think of to the product—including part of the CEO’s annual salary—to minimize the profit that was allegedly earned from sales of the product. The jury threw out this heavy-handed allocation and awarded $16 million to the plaintiff.

BUDGETING OVERVIEW

It goes without saying that managers should plan ahead and formulate strategy and tactics for the coming year—and longer. The future does not take care of itself. Any manager will tell you of the importance of forecasting major changes, adapting the core strategy of the business to the new environment, developing and implementing initiatives, and in general keeping ahead of the curve. One tool for planning is budgeting. The technical aspects and detailed procedures of a comprehensive budgeting system are beyond the scope of this book. The following discussion focuses on fundamentals.

Reasons for Budgeting

Management decisions taken as a whole should constitute an integrated and coordinated strategy and an overarching plan of action for achieving the profit and financial objectives of a business. Decisions are like the blueprint for a building; control should be carried out in the context of the decision blueprint.

Budgeting is one very good means of integrating management decision making and management control, akin to constructing a building according to its blueprint.

Decisions are made explicit in a budget, which is the con-crete plan of action for achieving the profit and financial objectives of the business according to a timetable. Actual results are then evaluated against budget, period by period, line by line, and item by item. Variances have to be explained.

They serve as the catalyst for taking corrective action or for revising the plan as needed.

Lack of budgeting doesn’t necessarily mean that there is no management control. Budgeting is certainly helpful but not absolutely essential for management control. Many businesses
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do little or no budgeting, yet they make a good profit and remain solvent and financially healthy. They depend on the management control reports to track their actual profit performance, financial position, and cash flows. But they have no formal or explicit budget against which to compare actual results. More than likely they use the previous year as the reference for comparison.

The master budget is made up of the separate profit and other budgets for each organizational unit—such as sales territories, departments, product lines, branches, divisions, or subsidiaries. Each subunit’s budget is like a building stone in a large pyramid that leads up to the master budget at the top. Starting at the bottom end, sales and expense budgets dovetail into larger-scale profit budgets, which in turn are integrated with cash flow and financial condition (balance sheet) budgets.

The larger the organization, the more likely you’ll find a formal and comprehensive financial budgeting process in place. And the more bureaucratic the organization, the more likely that it uses a budgeting system. The budget is one primary means of communication and authorization down the line in the organization. The budget provides the key benchmarks for evaluating performance of managers at all levels.

Actual is compared against budget, and significant variances are highlighted, investigated, and reported up the line. Managers are rewarded for meeting or exceeding the budget, and they are held accountable for unfavorable variances.

A complete budget plan requires a profit budget (income statement) and cash flow budget for the coming period and a budgeted financial condition report (balance sheet) at the end of the period. As explained in previous chapters, the financial condition of the business is driven mainly by the profit-making operations of the business. Capital expenditures for replacements and expansions of long-term operating assets of the business must be included in the cash flow budget and the budgeted year-end financial condition.

A total financial plan in which a profit budget is integrated with the financial condition and cash flow budgets is a very convincing package when you’re applying for a loan or renewing an existing line of credit. It shows that the company’s total financial plan has been thought out.

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Costs and Disadvantages of Budgeting

There are persuasive reasons for and advantages of budgeting. On the other side of the coin, budgeting is costly and may lead to a lot of game playing and dysfunctional behavior. Some reasons for budgeting are not highly applicable to smaller businesses or even to midsized businesses. Smaller businesses do not need budgets for communication and coordination purposes, functions that are much more important in larger organizations, where top management is distant from its far-flung, day-to-day operations.

Profit budgeting depends heavily on the ability of managers to provide detailed and accurate forecasts of changes in the key factors that drive profit. Nothing is more counterproduc-tive and discouraging than an unrealistic profit budget built on flimsy sales projections. If no one believes the sales budget numbers, the budget process becomes a lot of wasted motion or, worse, an exercise in hypocrisy.

The profit budget should be accepted as realistically achievable by those managers responsible for meeting the objectives and goals of the profit plan and as a realistic benchmark against which actual performance can be compared. If budget goals are too unrealistic, managers may engage in all sorts of manipulations and artificial schemes to meet their budget profit targets. There are enormous pressures in a business organization to make budget, even if managers think the budget is unfair and unrealistic.

Then there are always unexpected developments—events that simply cannot be foreseen at the time of putting together a budget. The budget should be adjusted for such developments, but making budget revisions is not easy; it’s like changing horses in the middle of the stream. Once adopted, budgets tend to become carved in stone. Higher levels of management quite naturally are suspicious that requests for budget adjustments may be attempts to evade budget goals or excuses for substandard performance. Budgeting works best in a stable and predictable environment.

As mentioned previously, management control entails thousands of details. Control deals with detail, detail, and more detail. Day to day and month to month the manager has to
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pay attention to an avalanche of details. Keeping all the details in perspective is a challenge, to say the least. Control reports comparing actual with budget should not let the details take over, which can easily cause managers to lose sight of the overall progress toward profit goals.

The whole point of budgeting, which is easy to lose sight of, is to achieve profit and other financial objectives. Budgeting is not an end but a means. Detailed expense and cost reporting is required so that managers can keep close watch on the total effect of the key expense and cost factors that were forecast in the profit budget. Often, managers ask for reams of detailed expense and cost reports, but they do not necessarily read all the detail.

s

END POINT

Managers do not simply make decisions and then assume that their decisions put into motion everything that has to be done to achieve the goals of the business. Managers must follow through and exercise management control throughout the period. There is no such thing as putting a business on auto-matic pilot. Managers have to watch everything. Management control depends on feedback information about actual performance, which managers compare against the plan.

Management control begins with a solid foundation of internal accounting controls. These forms and procedures are absolutely essential to ensure the reliability of the information recorded by a business’s accounting system. Internal accounting controls also serve a second duty—to deter and detect fraud and other dishonest behavior. Most fraud can be traced to the absence or breakdown of internal accounting controls.

These controls should be enforced vigilantly. Many larger business organizations use internal auditors to evaluate and improve their internal accounting controls and to perform other functions.

The chapter offers guidelines for management control reports. These reports should resonate with the decision-making analysis methods and models used by managers. These reports should provide the most relevant benchmarks against which actual performance is compared. Control reports contain a great amount of detail, but key factors and variances should be
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