The annual budget process is often a game of liar’s poker, with one side (finance) out to find savings and the other side (manufacturing/operations) determined to protect resources and flexibility; or budgeting can be a frustrating compliance exercise to concoct the numbers and stories to fit a top-down directive, but that also leaves some wiggle room. In the end, neither scenario is a pleasant experience. Both diminish the integrity of everyone involved and the ethical culture of the organization. This outcome is the typical result of a static annual budget, particularly when tied to performance evaluations.
When facts, data, integrity, and causality are applied to the budget process, better scenarios can exist. It is important to think of budgeting as planning for a most likely scenario, understand that scenario will not happen, and expect to regularly revisit and revise the plan as events unfold. Part of the solution is to incorporate the ideas of flexibility to respond to business drivers and continuous rolling re-evaluations/forecasts into the budgeting and planning processes.
Now, the challenge for many executives and finance personnel particularly, is overcoming the sense of “loss of control” and “accountability” for specific financial statement results, for a period. The challenge is to acknowledge what everyone knows on some level, though it is really a façade of certainty and control. Fact based, continuous planning results in the entire organization developing a deeper knowledge of the business drivers and operations and enables long-term learning and sustainable success. And it is much healthier for organizational culture than a game of liar’s poker.
Traditionally, a budgeted target for a period is compared to actual results for the period. This is problematic because the budgeted target is seldom adjusted for the actual level of activity that occurred.
A good first step for improvement is to include a third figure, let’s call it a “plan”. The plan is a calculation that shows how costs or revenues should change with reduced or increased levels of activity in business drivers—like the level of production, for example. If production increases, costs will be well above budget, but calculations for the plan will show what they should be at the higher levels. Performance evaluation becomes the plan vs. the actual, since the original budget target is useless, but this is harder to implement than it is to explain.
Most organizations don’t have a manufacturing process cost model constructed to flex in this manner with credibility for both manufacturing and finance. Traditional standard costing for financial reporting is typically very limited and an often-distorting model for reflecting changes in activity levels. Why? Because they do a poor job of tracing and applying fixed and variable costs.
Traditional models only support variability based on a relationship with a product or final output. Many, perhaps most, groups of resources produce outputs for internal consumption; they support other groups of resources. Modeling consumption in this manner uses the concept of responsiveness defined by the Institute of Management Accountants’ Conceptual Framework for Managerial Costing. Responsiveness is most comprehensively implemented by Resource Consumption Accounting or the German management accounting approach known as GPK.
Consider a machine maintenance group. Greater production means technicians are busier with more routine—and probably casualty maintenance—because of increased machine hours, more supplies, and parts consumed; and they may use more overtime or outsourcing. However, some elements remain largely the same: unless more technicians are hired, basic salaries are still the same; vacations and sick time still accrue or occur normally; and the shop still takes up the same floor space and utilities. Some costs may decrease—less external training may occur and they defer special projects. The machine maintenance group does not experience a cost increase proportional to the increased production; the group has fixed, proportional, and perhaps even inverse expense items in its budget that can’t be modeled simplistically. Situations like this exist in every work group in your factory.
Advanced costing methods facilitate logical budgeting, flexible planning, and realistic control that clearly reflect operational realities, improve knowledge of operations, and result in better decisions.