OIS Budgeting Process and Benefits

OIS Budgeting Process

As described in the page titled Current Budgeting Process and Issues, “The budgeted income statement is then created by appropriately aggregating the line item budget detail in the CoA” and is illustrated with Horngren’s master budget flow chart,Exhibit 6.2.

The OIS budgeting process proceeds in exactly the opposite direction: from OIS to the traditional budget. See OIS master budget flow chart.

Further, as indicated in the OIS  master budget flow chart, the user has a choice of whether to use the traditional budget at all and to rely on OIS  instead. In support of this option, Bragg, Budgeting, The Comprehensive Guide, AccountingTools, page 8,  concludes his introductory chapter on budgeting by saying: “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. The choice is yours.”  The considerations of operating with out a budget are summarized below.  For the details, see Chapter 21, ” Operating without a Budget“,ibid.  Included, also, is Chapter 22, “Rolling Forecast”.  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. For details, for details, see Operating without a Budget: OIS’s Benefits

Meanwhile, if the user wants to continue with a traditional budget, as described in the OIS master budget flow chart, it is required that the user “dis-aggregate” OIS’s results into the CoA line item detail. The process benefits of so doing are described below. These are process benefits that accrue in addition to the very significant functional ones, described here.

OIS Budgeting Process Benefits

If the firm has decided to retain it’s traditional budgeting process, the benefits OIS creates are shown in bold.

Static budgeting issues

  1. Line managers only do it once/year thus inexperienced: The budget is created without their involvement; Finance dis-aggregates the OIS results into the CoA line item detail.
  2. Gaming: an attempt: to introduce budgetary slack, which involves deliberately reducing revenue estimates and increasing expense estimates.” Gaming is eliminated per (1) above
  3. Time required developing and updating; are all line items in synch? “It can be very time-consuming to create a budget, especially in a porly-organized environment where many iterations of the budget may be required.”  There is no time delay other than that required for (1) above.  Nor are there any iterations as the budget is optimized. See OIS Functional benefits.
  4. Becomes obsolete quickly
    • Variances get bigger and therefore the is budget ignored.  OIS is one big flexible income statement.  So, actual results can be entered at the end of each period and normalized for results creating much smaller variances.  
  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.”  OIS is a model so all that has to happen is the model updated by Finance for revised costs, forecasts, etc and re-optimized.  A new income statement is immediately available.
  6. Connection with strategy?  As described elsewhere, the strategic and annual OIS models are just variations of the same model.
  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.” OIS employs NO such allocations.
  8. Revenue impact on capacity See (12) and Summary, below
    • 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. OIS is a model and the only possible corporate meddling is with the initial forecast.  While corporate can certainly over-ride the model’s results, it seems very unlikely it would do so since it has gone to the expense and time commitment of implementing OIS.
  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.” It is paramount that it is understood  OIS is NOT a financial model; it is an operational model.  It is built, not of aggregated expense line items from the CoA; in fact it has nothing to do with the CoA.  It is built of the operations that are, in essence, the firm.  These are transitive verbs like procure, make, pick/pack, ship, install.  These verbs are the cause that create the effect of the expenses.  NOTE: These operations can just as easily be thought of as activities, production lines or processes. In fact they are frequently referred to by such nouns in the trade press.
  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. OIS is a model;  it has no “status quo.” The results are the results and don’t need support from HR or Accounting. or analysts.  Further, the analysts and the  investment community should be delighted with the results OIS  has produced for the firm.
  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.  It is just as paramount that it is understood  that  OIS, in addition to being to being built of operations: i) capacitates EVERY operation and ii) relieves every capacity constraint with, if possible, iii) a variety of relief options. For example, a production operation can be relieved with building product ahead, over time, a second shift, outsourcing production.

So, if the new forecast exceeds the operations’s capacity, OIS not only i) relieves it so the new forecast can be produced, ii) it also chooses the best production relief option.

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.” See 12 (1) above.  ALL products are included in the model.  And, in fact, a variation of the production schedule is created for the entire budget period, month by month.  This is required, per 12 (1) above.

    13.Sales/marketing budget driven by forecast:  “construct this budget after most of the other departments have completed their preliminary          budgets:”  For an OIS model, it is exactly the opposite. 

Flexible budgeting issues

  1. Formulation: difficult to formulate and administer; great deal of time to develop cost formulas: The OIS cost formulas,  specifically cost functions and response functions, are developed only once when the baseline model is created.  After that, they are updated only as the underlying operation changed (e.g., new machine tool installed).
    1. so flexible budget tends to include only a small number of variable cost formulas: OIS cost formulas are created for the ENTIRE income statement
  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. If the firm decides the delay is unacceptable, it can keep its traditional budget, there is no delay.
  3. Many costs not fully variable:  Doesn’t matter.  OIS‘s  cost and response functions have fixed and variable components and span the necessary quantity range.
    1. they have fixed and variable components
    2. they vary across quantity rang
  4. Costs vary by a variety of things including labor, purchase quantities, product batch sizing, time and experience:  OIS’s cost and response functions can vary by quantity, volume or weight and can be tailored, as required, to mimic other variables  
  5. No revenue comparisons: “In a flexible budget there is no comparison of budgeted to actual revenues, since the two numbers are the same. Again, if the firm decides the revenue comparison is important, it can to keep its traditional budget.
  6. Applicability: few variable costs for the firm:

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.” See 12 above.
  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. Exactly what OIS enables.