OIS process benefits significantly modify the traditional budgeted Income Statement process

Current Process for creating the traditional, budgeted income statement

Today’s traditional budgeted income statement starts with the budget being developed jointly by Finance and the line organization.  The results are then entered into the Chart of Accounts (CoA).  NOTE: The CoA is the finest detail at which the firm’s actual expenses are recorded and also the detail at which the budget is created. The CoA in turn mirrors the firm’s organizational structure for accountability reasons.

The budget so developed is referred to as a static budget.  It does not change even if the underlying activity level of the business differs during the budget period from the level assumed when the budget was constructed. A static budget differs from a flexible budget.  A flexible budget creates a model which calculates different expenditure levels for variable costs, depending upon changes in the amount of actual revenue or other activity measures.  The actual revenues or other activities are entered into the flexible budget model once an accounting period has been completed, and it generates a budget that is specific to the inputs.  Thus, variances are the result from actual expenses  which have been normalized for actual revenues and related related activities.

The budgeted income statement is then created by appropriately aggregating the line item detail in the CoA.  Thus, necessarily the traditional income statement is limited to the information contained in the CoA.  This is described in a simplified fashion in Horgren’s et al Cost Accounting, Chapter 6, “Master Budget and Responsibility Accounting.”   For Horngren’s master budget flow chart, see Exhibit 6.2. This flow chart is all but identical with the one illustrated in Bragg, Budgeting, the Comprehensive Guide, published by AccountingTools  Chapter 3, “System of Budgets, ” page 23.  He also comments on the same page: “The master budget is essentially an income statement.” Elsewhere, on page 128, he comments: “The core of the master budget is the budgeted income statement.” NOTE:  It is the author’s opinion Bragg’s book is very much worth the $20 the pdf download version costs.  The soft copy is $30.

Horngren does not describe any of the factors that determine how the budgeted line item detail is aggregated into the traditional income statement.  For a more detailed discussion, see Bolton’s, Painting With Numbers: Presenting Financials and Other Numbers so People Will Understand You, Chapter 11, “The One Report Every Organization Needs.”  On page 208, his counsel includes:

  1. One Page!
  2. Decision-focused line items
  3. Appropriate dollar amounts, neither too big nor too small
  4.  Intuitive organization of line items
  5. Understandable categories, meaningful to all users
  6. Plain-English terminology
  7. Consistent look and feel
  8. Key results equal to the corresponding numbers in the accounting system (or an explanation why not)

Elaborating on (2), he goes on to say: “A well-designed report, where each line item has a different set of driving factors influencing success or failure can really help here.  Understanding which factors need management attention is a critical first step toward fixing your problems.”

Issues with the current process for creating the budget

Neither Horngren nor Bolton describe the process of creating the budget itself, however.  For that, the author turned to Steven Bragg’s excellent book,  Budgeting, the Comprehensive Guide.  It was of interest because not only as pointed out above, the budget is the source of the line item detail from which the income statement is created but also because issues and problems associated with the process for creating the budget will, obviously, end up in the income statement.

Turns out, according to Bragg, there are a variety of issues and problems with both of the two kinds of budgets he describes: static and flexible. A static budget is: “A budget that is completed prior to the budgeted periods being forecasted, and which is fixed for the entire period covered by the budget, with no changes based on actual activity.”  In turn, a flexible budget is: “A budget that calculates different expense levels based on changes in the amount of actual revenue.”  Similarly, Horngren describes a flexible budget as: “Budget developed using budgeted revenues and budgeted costs based on the actual output in the budget period.”  BTW, the Bragg concludes the introductory chapter on budgeting: “Finally, we will address the concept of operating with no budget at all, and how a company can remain competitive (if not improve) in such a situation.”

  1. Static budgeting issues
    1. Line managers only do it once/year thus inexperienced
    2. Gaming: an attempt: to introduce budgetary slack, which involves deliberately reducing revenue estimates and increasing expense estimates.”
    3. Time required developing and updating; are all line items in synch? “It can be very time-consuming to crete a budget, especially in a porly-organized environment where many iterations of the budget may be required.”
    4. Becomes obsolete quickly
      • Variances get bigger and therefore the is budget ignored
    5. Always wrong since it is static
      • ” If the business environment changes to any significant degree, then the company’s revenues or cost structures may change so radically  the actual results will rapidly depart from expectations delineated in the budget.”
    6. Connection with strategy?
    7. Expense allocations: “The budget may prescribe that certain amounts of overhead costs be allocated to various departments, and the managers of those departments may take issue with the allocation method used.”
    8. Revenue impact on capacity
      • step functions
      • timing
    9. Command and Control System:  “The single most fundamental problem underlying the entire concept of a budget is that it is designed to control a company from the center.  The basic under pinning of the system is that senior management forces managers throughout the company to agree to a specific outcome.”   Examples include targets for revenue, expenses, profit, cash flow or metrics.
    10. Only considers financial outcomes: “The nature of the budget is numeric, so it tends to focus management attention on the quantitative aspects of  a business;”
    11. Bureaucratic support: Once the budget and bonus plan system takes root within a company, a bureaucracy develops around it that has a natural tendency to support the status quo.”  Examples cited include human resources, accounting, analysts and investment community.
    12. Production budgeting:
      1. capacity constraints: “When formulating the production budget, it is useful to consider the impact of proposed production on the capacity of any bottleneck operations in the production area.”  Possible bottlenecks cited include machine time, skilled labor, availability of raw materials and step costs.  “All of the factors noted in this section are major concerns, and should be considered when you evaluate the viability of a production budget.” (Bold added.) The example cited is that of machine time (page 47) and involves a manual calculation of the solution: “However, Quest can increase production in earlier periods to make up the shortfall since there is adequate capacity available at the bottleneck in the earlier periods.”  NOTE: In the trade press, this is referred to as build ahead.  There are a variety of other possible solutions including OT, a second shift, outsourcing and adding machine capacity.
      2. for multiple products: “How do you create a production budget if you have multiple products?  The worst solution is to attempt to re-create in the budget a variation on the production schedule for the entire budget period.” (Bold added.)  Solutions suggested include bottleneck focus, product line focus, 80/20 rule and MRP II planning.”
    13. Sales/marketing budget driven by forecast
      • “construct this budget after most of the other departments have completed their preliminary budgets.”
  2. Flexible budgeting issues:
    1. Formulation
      1. difficult to formulate and administer
        1. many costs are not fully variable
          • they have fixed and variable components
          • they vary across quantity ranges
        2. costs vary by a variety of things including labor, purchase quantities, product batch sizing, time and experience
      2. great deal of time to develop cost formulas
        1. so flexible budget tends to include only a small number of variable cost formulas
    2. Closing delays: “you cannot pre-load a flexible budget into the accounting sw for comparison to the financial statements. Instead you must wait until a financial reporting period has completed, then input revenue and other activity measures into the budget model, extract the results from the model.,  Only then can you issue financial statements that contain budget vs. actual information, with the variances between the two.  This delays the issuance of financial statements.”
    3. No revenue comparisons: “In a flexible budget there is no comparison of budgeted to actual revenues, since the two numbers are the same.:
    4. Applicability: few variable costs for the firm
  3. In summary, the two keys to either a static or a flexible budget model are cost variability (discussed above) and constraint analysis
    1. Constraint analysis: “…a company is a single production system and that the only issue that matters is maximizing the throughput…  passing through the bottle neck operation.”
    2. If you aware OF BOTH, you will have an excellent understanding of how a company creates profit and how to structure a budget to show which actions or events will change profit.

 

  1. It creates a driver-based model of the entire budgeted income statement where the driver is quantity; an operational income statement, if you will.  As you well know, these relationships are referred to by Horngren et al as cost functions. “A cost function is a mathematical description of how a cost changes with changes in the level of an activity relating to that cost.”

It is very important to note these “activities” may or may not be line items in the CoA.  What they all are, though, are operations, transitive verbs that  do something (e.g., procure, make, pick, pack, ship, install etc.) the collective result of which is profit.

  1. Thus, since these cost functions don’t change often, subsequent annual operational income statements and updates are quickly accomplished
  2. Further, it allows Finance to pre-load the entire income statement all but eliminating gaming
  3. It eliminates any problems with step costs and capacity constraints as they are integral to the model.  As are, also, the constraint relief options (e.g., capital expenditures, overtime, another shift, inventory build ahead) for ALL possible constraints.  This is required because, as described in (5) below, the new forecast is an unknown.
  4. It optimizes the operational income statement, creating not only a new forecast which is the maximally profitable forecast but also the optimally feasible supply chain required to make and fulfill the new forecast including, when required, the optimal constraint relief option(s)
  5. Finally, it works.  We built a  simplified model using data gathered during an activity-based consulting engagement at Zippo.  It demonstrated, depending on the scenario, that the firm had left a profit upside on the table of between 25-150%.

 

It’s NEW and it’s REVOLUTIONARY; it obsoletes the traditional, budgeted Income Statement and IT WORKS!. As CFO, don’t just control the firm’s expenses; GUIDE the management of the OPERATIONS that DRIVE those expenses.

What is an operational income statement? It is a second income statement; one that speaks the second language of business: not the CoA/organizational dollars of doing but the production/activity dollars of doing.

  • Turning numbers from a cause to an effect

It requires the managerial accounting folks to reformulate the data in the budgeted income statement to build a model of the operational income statement.  This  model relaxes the assumption of a fixed forecast.  This, in turn, allows sophisticated analytics to be applied to the model creating a variety of first ever income statement functinality including max revenue or profit, max ROI of sales/marketing expenditures and a truly optimal supply chain.  A management accounting opportunity to add more value if there ever was one I think.