The firm replaces the traditional budget with OIS eliminating the widely recognized limitations  of the traditional budget

Three workarounds to the traditional budget’s limitations are also replaced by OIS including the zero-based budget, the activity- based budget and the flexible budget.Two other related fimr applications are also replaced. Specifically sales and operations planning (S&OP) and integrated business planning (IBP).

Summary comparison of the two budgeting processes

Traditional budget

Today’s traditional budgeted income statement starts with the budget being developed jointly by Finance and the departments of the line organization.

Next year’s forecast along with all the assumptions appropriate to next year’s budget(e.g., new products, out/in sourcing decisions, changes in suppliers, manufacturing process improvements including cap ex investments)are sent to departments’ managers. They, in turn, create the departmental cost inputs to the budget.

Thus, the budget’s cost inputs are disparate  because they either have  different drivers or no drivers at all

Accordingly,  the traditional budget  can’t be modeled prescriptively.  Further, it can’t be modeled predictively if any of the departments’ cost inputs have no driver

The results are then entered into the Chart of Accounts (CoA) which reflects the firm’s organizational structure.

• The budget developed is typically 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.

This traditional budgeting process is flow charted in Horgren’s et al Cost Accounting, Chapter 6, “Master Budget and Responsibility Accounting,”  Exhibit 6.2

A static budget differs from a flexible budget.  A flexible budget creates a model which predictively calculates different expenditure levels for variable costs, depending upon changes in the amount of actual revenue or other activity measures (i.e., drivers). Thus, variances are the result from actual expenses which have been normalized for actual revenues and related actual activities.

Operational budget

An activity-based baseline OB model of last year’s p/l is created and its results compared with last year’s actual results; the objective is to be within 2%. The underlying rationale is simple: if history can be reasonably replicated, then the willingness to accept recommendations about the future increases.

As described in the first article, only activities with a variable cost component (See Figure 4 in that article) are included in the model as activities that are 100% fixed have no impact on the model’s solution.

Also, as described in the first article, activity-based drivers allow a prescriptive model to be created of the budget.  This is the same prescriptive modeling technique that has been used for supply chain network design for decades

Next year’s forecast along with all the assumptions appropriate to next year’s budget (e.g., new products, out/in sourcing decisions, changes in suppliers, manufacturing process improvements including cap ex investments) are entered into the baseline model.

In addition, where feasible, all constraints must be relaxed since there is no way of determining what the new forecast volumes will be.  Further, when there are more than one option (e.g., second shift, outsource, build ahead, over time), they all should be included so the best one chosen.  Example of the constraints that  include:

• Procurement availability limits
• Manufacturing capacity limits
• Distribution Center throughput limits
• Storage limits
• Inventory targets
• Customer service limits
• Other transportation link restrictions
• Energy consumption limits
• Carbon emission limits

Finally, the updated baseline model is solved and the OB is the solution.

Problems with the traditional budgeting process and how OIS addresses them

Since Horngren et al does not describe the process of creating the budget in sufficient detail, the author turned to the another budgeting resource, Bragg,  Budgeting, the Comprehensive Guide,  Third Edition.  The following 6 issues with the static annual budgeting process are quoted directly from Stephen Bragg’s book. How OB addresses these issues is shown in bold.

A  seventh problem was added, variance analysis, because Steve Morlidge, a frequent FP&A Trends contributor and a budgeting expert, in his book Future Ready co-authored with Steve Player, commented on page 240 that : “Variance analysis should be eliminated.”

1. 1.  “Inaccuracy: A budget is based on a set of assumptions not too far removed from the conditions under which it was formulated…If conditions change to any significant degree…revenues or cost structures may change so radically…actual results will rapidly depart from original assumptions.” OB is always accurate because it is a model and can be updated in real time when “conditions change to any significant degree.”
   2. “Gaming: …attempt to introduce budgetary slack, which involves deliberately reducing revenue estimates and increasing expense estimates.” Manager has no chance to game because manager has no input.  OB is built on department’s activities and not the manager’s cost input as traditionally.
   3. “Time required:  It can be very time-consuming to create a budget… especially where many iterations of the budget may be required.”  There is no time delay other than that required to update the current OB with whatever assumption changes next year’s plan has introduced. 
   4. “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. See Exhibit 4 in the first article.
   5. “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. While senior management 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 OB.
   6. “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.”  OB is a model; it has no “status quo.” Further, a “status quo” is irrelevant to OB as it is always up to date.
   7. “Variance analysis should be eliminated:” OB accomplishes its variance analysis programmatically because it is a flexible budget and enjoys the major benefit described by Bragg.  Specifically: “Budget vs. actual reports under a flexible budget tend to yield variances that are much more relevant than those generated under a static budget, since both the budgeted and actual expenses are based on the same activity measure…and will also be highly actionable.”  Normalize the plan by replacing the planned volumes in the OB with the actual volumes. OB then calculates what the planned costs would have been had the actual volumes been the planned volumes. Then, compare the two sets of costs.  Where important differences exist, the appropriate cost function(s) are updated (see Figure 3 from first article).  The updated OB is now informed by the  variance analyses; it can’t get much more actionable than that…