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 The budget and its process are without any doubt the main issues that keep awake many managers involved.

The main goal, as we know, consists of setting the “right” targets (financial and non financial) for the next fiscal period accordingly to the objectives of the multi-year planning and in consideration of the perspectives of the dynamic environment where the business operates.

In order to achieve that goal any kind of business “must” move its employees, from managers to the low-level employees in a way that is fair and at the same time motivating, to that direction.

In other terms, if the firm wants to attain the main goal, it cannot neglect the collaboration of its "people" because every entity is not an entity in itself but it works thanks to the commitment of those people involved.

If we want to make a sort of example breakdown of objectives that a budget should pursue with reference to its managers and employees here is a short list:

 

1. Creating the confidence in the attainability of the budget targets.

2. Creating a reason/incentive for achieving those targets.

3. Allowing a given degree of flexibility to the managers involved in the “daily” decision making.

4. Avoiding some arguable behavioural issues put in place to make the targets more easy and be compensated for their achievement.

5. Reducing the costs incurred for internal compliance control

.......

 

The efforts of the top management in relation to these objectives depend, of course, on the kind of business, the industry and the last but not the least the skills of its employees.

There isn’t a “one-size-fits-all” list of rules and considerations to apply  in any case, but some chances of choosing from methods and styles of proceeding that enable the firm to hit its goals exist instead.

I want to put on the table as a first issue the style in managing the budgeting process.

 

Do you prefer an authoritative approach or a participative one?

Some state that if the main objective is the setting of impartial targets in the full accomplishment of the general interest of the whole Business Unit without being affected by egoistic behaviours and manipulations of the managers, the authoritative budget is the favourite.

In order to be more clear, it’s necessary to shed light on what I mean by egoistic behaviours and manipulations of the managers.

 

This phenomenon, known also as budgetary slack, occurs when the targets in terms of revenues are put on a lower level than it is really expected and when the ones in terms of costs are set on a higher level than it is really expected.

That happens to make the task of the managers more easy and make them more easily rewarded if their compensation is also linked to the degree of the budget goal achievement.

By using this approach as a result the continuous improvement culture is also facilitated in consideration of the lack of a high degree of negotiations amongst the several levels of responsibility inside the company.

 

On the opposite side the participative approach, thanks to which the targets are set in full agreement with the all-level managers,  allows the top management to be aware of the reality of the things, to motivate all the levels of the employees towards the achievement of the targets in a spontaneous way because they feel the firm as their own one.

The supporters of this approach maintain that in so doing the goal congruency, that is the alignment between business goals and manager interests, is more easy to be achieved.

Nonetheless, “very attainable” target risk looms large when the participative approach is so to say too participative.

 

The lever for the success of the budgeting process certainly is the goal congruency to get by trying to apply a right mix of the two methods.

In this regard another issue springs up: the linkage between compensation and degree of the achievement of the budget target.

 

Opinion of some professionals is that it is a hurdle when the level of the targets is high and it causes the managers to make controversial behaviours, some of which I want to indicate now:

 

1) Managers are discouraged and slow very much their commitment.

2) They may put in place some manipulations of the performance evaluation indices to make them earn their compensation.

3) Incentive for the budgetary slack discussed above.

 

In consideration of these potential factors, in the case of the fixed-performance contract, as this kind of reward is called, the objectives set into the budget should be balanced, that is motivating but not very hard, and the variable compensation not too high.

Another way not to cause these negative effects and/or make the budget unrealistic is to link the compensation to some external benchmarks or by setting trend of continuous improvement on some indicators, period after period regardless of the respective targets indicated on the budgeting process.

 

My personal opinion is to make use only of the Forecasts, just for performance evaluation purposes.

 

I will be more clear.

I should link the compensation to some percent differences of chosen indicators between the respective values  highlighted in straight Forecasts.

As a guarantee of the reliability of the estimations some statistical techniques should be used, in particular when you deal with overhead expenses.

In so doing the budget validity should be saved and a forward-thinking culture should be facilitated in the daily management of the Business Units with all the following advantages.

 

For further info about this brand-new way, don't hesitate to get in touch.

 

Many of us are convinced to know what the cost of the unused capacity is, achieved by dividing the total fixed costs of a product/service line by the respective theoretical capacity and then multiplying the hourly rate by the  unused capacity.

In case of mass production and when the customization  is not so high so that the time spent on the activities is the main driver of the allocation of the costs, there is a much more precise way to calculate the cost of the unused capacity.

The original formula considers that all the staffed hours are worked and the share of the unused capacity  consists of only the unstaffed ones.

In reality, we must take into account that also a share of the staffed work hours isn’t made and even if made some time it doesn't add value to the customers, becoming non-productive capacity that is different from the idle capacity that consists of the unstaffed work hours.

This distinction have a reflection over the costs that should be attributed to the non-productive capacity on one side and the costs that should be imputed to the idle capacity instead

 

In order to more clear, let’s make one step back, by defining two concepts that are very important to understanding the above categories.

 

Committed Capacity

 

It consists of all the resources  that can be used 24-7, that is all the fixed assets purchased to meet the customer demand and setting the process needed for make it.

The time of reference for it  is the theoretical capacity: 8,760 hrs a year.

These metrics are made with reference to each PRIMARY cost center and within each PRIMARY cost center according to the number of product/ service lines, so that if the lines are three the theeorectical capcity is 8,760 x 3.

The respective costs of the fixed assets define the cost of the Committed Capacity and the Committed Cost per hour is achieved by dividing the total cost of the fixed assets by 8,760 hrs (If one only product line)

 

Examples of the assets falling into Committed Capacity:

 

Buildings

Computers

Software

Tooling

Machines

....

 

Of course, these costs are always incurred regardless of the output produced.

 

Managed Capacity

 

It concerns all the resources deployed to make the process, put in place and set by the resources linked to the Committed Capacity, work.

It refers to the staffed hours because these resources cannot be used, by nature or by other factors, 24 – 7.

 

Examples of resources falling onto Managed Capacity:

Supplies

Labour

Services

Productive Utilities,

Materials

....

If we are obliged to give a volume-based definition of the respective costs, just few are variable because much of it varies at intervals of the volume so that we can define them stepped fixed cost for the most part.

The total cost of these resources define the cost of the Managed Capacity and the Managed Cost per hour is achieved by dividing it by the number of the staffed hrs.

 

Now we turn back to the Idle Capacity and Non productive Capacity concepts.

 

IDLE CAPACITY

 

IDLE CAPACITY: THEORETICAL CAPACITY – STAFFED HOURS

IDLE CAPACITY COST: Committed Cost per hour x IDLE CAPACITY

 

NON-PRODUCTIVE CAPACITY

 

Here we need to recall the value concept that “marks” the activity that brings the product/service to life or makes it valuable for the customers.

The Manufacturing time and the Development one make the Productive Capacity.

All the remaining activities are internal ones that, although carried out to set Manufacturing and the Development  activities, don’t add value to the customers or are even a waste.

 

So we have:

 

NON-PRODUCTIVE CAPACITY: STAFFED HOURS – PRODUCTIVE CAPACITY

NON-PRODUCTIVE CAPACITY COST: NON-PRODUCTIVE CAPACITY X Available Cost per hour (Committed Cost per Hour + Managed Cost per Hour)

 

As we have just seen in the last cost calculation we consider also the Committed Cost per Hour because we make use also of the 24-7 assets to make the process work.

 

We can, of course, determine the PROODUCTIVE CAPACITY COST by multiplying the respective time by the Available Cost per hour:

 

PRODUCTIVE CAPACITY COST: PRODUCTIVE CAPACITY X Available cost per hour (Committed Cost per Hour + Managed Cost per Hour)

 

 

This approach that we call Capacity Cost Management (CCM) can be used not only for the manufacturing companies but also for the service ones wwhen the customization  is not so high so that the process and the time spent on the activities are the main drivers that explain the resource consumption.

 

The strategic implications that leverage these concepts and costs are several and go from asset-investment decisions, product costing, competitiveness improvement to incremental business acceptance and profitability enhancement.

 

These matters will be treated in  future separate dissertations on this website.

 

The Lean Accounting is a costing method and a performance evaluation approach that has been developed to monitor the success in the Lean-Manufacturing system.

That means that in order to fully understand and put the dissertation on the Lean Accounting  into the right frame we should recall those causes of the rising of the Lean Manufacturing and those principles directly linked to the adoption of the Lean Accounting itself.

The remaining technical considerations about the Lean manufacturing method fall beyond the goal of this articles and that’s why they aren’t shown.

The businesses operating in very dynamic environments, where the preferences of the customers change frequently and the actions of the competitors go fast, don’t need to adopt a push approach, that is producing on the basis of a production budget and as a result increasing the inventory level.

Furthermore, this inventory level in view of the changing and dynamic market could be very difficult to be disposed of  in a profitable way.

At the same time the Lead Time (time needed to fulfil a customer order) must be short.

What can the firm do?

Increase the speed of the manufacturing process flow and the productivity ratios, ensuring contemporarily the quality of the product.

About the last aspect of the quality, the perspective adopted by the Lean approach is the value to the customer that means the quality is linked strictly to preferences  of the product users.

As a result, the value stream concept arises.

It is a set of those activities carried out to manufacture  a group of similar products (a product family).

 

The advantages of the Lean Accounting

 

The Lean Accounting makes use of these Value Streams in an appropriate Income Statement that helps managers achieve these kinds of benefits:

 

1) Better and realistic understanding of the profitability of those groups of similar products, Value Streams, interested by the Lean Manufacturing implementation.

Why?

Starting from the consideration that it’s not requested the calculation, in this context, of the cost of each product, the cost allocation process with its uncertainty related to the principles adopted is avoided.

The costs are allocated only to each Value Stream and this results in a higher precision of the calculation of the profitability of the groups of the related products.

Those costs that cannot be traced to the Value Streams in a clear and direct way, because not incurred for the manufacturing of the products considered, are put aside.

This fact marks a clear distinction between the full-cost accounting methods that need also the allocation of the indirect costs to each model/product and the Lean Accounting whose purpose is showing the progress of the Lean Manufacturing implementation, meaning that every cost not traceable to the Value Streams is charged to the whole Business Unit.

When the full-cost accounting method is used and the Lean Manufacturing is in progress, you can identify one of the causes (point a) of the following benefit out of the Lean Accounting.

 

2) Getting immediately the financial results from the adoption of the Lean Manufacturing, otherwise visible only in the long term.

Some of the reasons of this delayed visibility in the usual Financial Reports follow:

 

a) If a full-cost accounting method is used the Income Statement will include all the fixed manufacturing costs in the inventory until the selling/disposal of the products.

The decrease in the inventory resulting from the adoption of the Lean Manufacturing will cause the passage of those fixed manufacturing costs related to previous periods of increase in the inventory to the Income Statement related to the “Lean implementation period” characterized by a decrease.

In simpler terms, a cost in the inventory item will be reported.

The adoption of an appropriate Lean Income Statement will highlight this specific cost, that will be interpreted as a future positive financial result, to be added to the Operating Income shown in the same report (see table 1).

 

b) The focus on the Pull approach that enables the firm to manufacture only when the order is received by the customer causes the firm to reduce the size of the orders (at the same time trying to get the customers accustomed to this new policy).

In financial terms, this means in the first periods lower sales and revenues.

 

c) Of course, such a drastic change to a completely diverse way to manufacture requires a prior period of reorganization and learning, with the costs of training and advisory services hitting high levels in the first stages.

 

d) Over the Lean Manufacturing implementation period much of the capacity of the business unit will become unused and just after the disposal or the redeployment of the related asset/resources the costs savings will be highlighted.

As we have seen about at the previous point a about the cost of the decrease in the inventory, the cost of the unused capacity might be decided to be shown, through appropriate methods, in a Lean Income Statement and interpreted as a future positive financial result (see table 1)

 

The managers unaware of this “delayed visibility”, without Lean Accounting adoption,  will see the financial improvements only some months after the start of the implementation and could make early negative judgements on the Lean Manufacturing and erroneous rushed decisions about the products included in the Value Streams.

 

Here is a realistic example of Lean Income Statement:

Alpha Inc. manufactures several models of TV sets and recently made the decision to implement the Lean Manufacturing method and adopting at the same time the Lean-Accounting Reporting.

As a result, the managers spotted two main Value Streams, each of them gathering similar products with similar features without further breakdown into LED and LCD models and different Sizes: Smart TVs and Tradition TVs

 

Table 1 – Lean Income Statement January 2018

Description	Smart Tvs	Traditional Tvs	Total
Sales                                                                    620,000                                   750,000                                     1,370,000   Operating Costs:                                                                                  Materials                                           145,000                                140,000                                           285,000 Labor                                                152,000                                168,000                                           320,000 Other costs                                         35,000                                 26,000                                             61,000 Total                                                                    332,000                                      334,000                                      666,000 Value-Stream Margin                                            288,000                                      416,000                                      704,000 Other Value-Stream  Costs: Manufacturing                                   152,000                                  175,000                                           327,000 Selling                                                25,000                                    33,000                                            58,000 Total                                                                    177,000                                      208,000                                     385,000 Value-Stream Profit before decrease in Inven.                                    111,000                                      208,000                                     319,000 Decrease in Inventory                        (25,000)                                   (36,000)                                          (61,000) Value-Stream Profit                                              86,000                                        172,000                                  258,000      Cost of the Unused Capacity                                                                                                                                 (45,000) Nontraceable Fixed Costs                                                                                                                                      (75,000) Operating Income                                                                                                                                               138,000

                                                                                                                                                      

Further strategic implications

 

The main advantage of the Lean Accounting is, as we have seen, assessing in financial terms the progress of the Lean Manufacturing.

Nonetheless, some other considerations should be made.

First of all, this costing method isn’t needed in some companies even if the Lean Manufacturing is being applied.

In fact, those firms that work on commodity markets where the change in the customer needs/preferences is not frequent as well as the variety of the products is not high, there isn’t the need for the Value Stream creation and respective financial reports.

Another aspect concerns the lack of the cost allocation at product level that if on one side speeds up the highlighting of the financial results of the Lean Manufacturing, on the other side leads to an average cost for any product included in each Value Stream.

The former aspect enables short-term decisions about the Value-Stream Income and Inventory level; the latter one limits some decision making on the long term that needs accurate cost information at product level.

In this regard the traditional full-cost accounting method is most useful and it could be appropriate to add one of the existing approaches to the Lean-Accounting system.

What about the price?

When the policy of the company is to make the price, not to take it from the market, and this is more frequent when a differentiation strategy is adopted, the managers need an accurate calculation of the model/product costs in order to have a basis on which to set a mark-up and to be profitable.

That is not the case of the Lean Accounting that fits the price taker best.

 

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Introduction

 

One of the main references to measure the operational and financial improvement of the business units is for sure the productivity.

We have been watching any sort of endeavours by managers to measure all the existing ratios concerning the productivity and comparing them to any kind of of benchmark: past ratios, standard ratios, industry ratios.

I want to raise some questions.

Do these measures have an absolute meaning for the achievement of the profitability of the business?

Does  their impact have a long-term horizon?

Before to go into the answers to these questions and other strategic issues, it’d  better deal with the traditional concepts of the productivity.>>>>>>>>>

 

1. Limitations of the productivity ratios

 

The improvement of these measures both with reference to past ratios and with reference to standard or industry ones, is the natural goal of the management of any business.

In terms easy to be understood, it means a better profitability, the other business factors,  beinq equal, since an equal effort (the input unit)has produced a higher output either in physical units or in sales value, depending on the kind of ratio you are watching.

Nonetheless some considerations should be made.

 

Let’s start with the Partial ratios.

 

Example:

Year 2017

Output units for 2017: 70,000

Direct Labour Hours: 20,000

Cost per L hour: $ 40.00

Price: $ 100.00

 

Year 2018 >>>>>>>

>>>>>>>>>> Another option is a new higher level of the salaries resulting from a new collective labour agreement (with a potential decrease in the Financial ratio) and, then, the increase in the operational productivity is really the consequence of the learning curve or some innovation in the work processes.

These solutions just indicated are some examples that are intended to make clear that the productivity ratios should be interpreted all together whilst the single observation of one partial ratio is very limiting and not important to see whether any productivity strategy of the firm is working.

Very useful is quantifying in financial terms the variance due to>>>>>>>>>>

 

2. Potential evolution of the productivity measurement

 

Nowadays the weight of the indirect costs has grown so that most expenses incurred belong to that category and that happens  in almost every industry.

Nonetheless, the productivity measurement is limited to those inputs that have a clear relation between their consumption and the output achieved and make the monitoring of the productivity easier and immediate.

As a result, all the ratios we know focus their attention on the direct and variable costs, excluding at the same time the>>>>>>>>>

 

3. And what about the long term?

 

What we have seen so far, that is the concept of productivity depending on the concept of variability of the inputs with reference to the output lays its foundation on the length of the time considered.

In fact, when we talk about variable inputs/costs and we are aware of main theories of the management control, it will be easy to recall that only in the short term the separation between variable costs and fixed (asset-related) ones makes sense.

That happens because in the long term all the expenses are>>>>>>>>>

 

 

There are cases when the variance analysis is not effective in the most genuine sense.

I mean that the expenses related to the investigations of the causes of the fluctuations could be higher than the resulting benefits and that the indications out of the variance analysis could be ineffective.

Let’s start with the first case.

 

A) Expensive or not

Thanks to the standard variance analysis you get to know whether and to what extent something has gone wrong compared to the estimate.

At this point every manager wants to act in order to investigate the causes, in particular when the resulting variances are negative in order to take the appropriate corrective actions.

A question arises: what if the search for the causes of those variances is “expensive”?

To answer this question we should point out that there are two categories of the differences to be investigated:

 

1) Systematic Variances

2) Random Variances

 

1) Systematic Variances

 

That's the case when the managers acknowledge the process is steadily causing some unpredicted results that are out of control.

In this category there are two courses of action, that is, investigating o not.

If you decide not to investigate the present value of the costs resulting from the ongoing events the business will keep on suffering is indicated with PL (Present Losses).

If you decide to investigate, the cost of this course of action is indicated with D (Do) and the cost of the correction is C.

The correction comprises not only the cost of the mere corrective action but also the losses the business will suffer until it is made.

 

2) Random Variances

 

When the managers state that the process concerning the variance is in control, the fluctuation should be considered Random, result of the causes beyond the influence of the managers.

Under this category if you decide not to investigate, there won’t be any further cost the business will keep on incurring and the total cost will be 0, because there won’t be investigation activities, corrections and any other damaging events.

If you decide to investigate, the respective cost is indicated with D (Do).

 

After making this distinction, let's examine the advised procedure.

 

If you want to calculate the expected cost of both courses of action (investigating or not) a probability percentage must be attributed to each of the categories (systematic variances and random ones).

We indicate with p the probability of the systematic fluctuations and with 1-p that attributable to the random variances.

Cost of investigation = p x (D+C) + (1-p) x D

Cost of not investigating = p x (PL) + (1-p) x 0

 

At this point a question arises.

To what extent is advantageous for the business to investigate?

Until the likelihood of the courses of action is equal.

 

Solving the 2° degree equation above written, we’ll have:

 

p = D/ (PL – C)

 

For instance, if p is 6%, it means that the business will have the advantage to make an investigation, when the probability of the systematic variances is beyond 6%.

When it is lower, the best solution is not investigating.

 

What I have written until now is good for both revenue variance analysis and for cost one.

The power of affecting the factors of the fluctuations or not and the classification of them as random or systematic concern both revenues and expenses.

 

B) Diverting variance analysis

 

An example is better than many words

 

Input

 

Budgeted Fixed Industrial Overheads for January 2019: $ 140,000

Allocation basis to the products: Machine hours

Budgeted Machine hours: 4,300

Standard Mach. Hours per unit: 3,91

Standard Fixed Industrial Overhead Cost per Mach. Hour: $ 32.56 (because 140,000/4,300)

Actual Output: 920

 

 

Let’s calculate the Fixed Industrial Overhead Production Volume Variance

 

Product. Volume Variance =  Budgeted Spending - Standard Fixed Industrial Overheads applied to production

Product. Volume Variance = 140,000 – (Act Output x Standar Mach Hours per Unit x Mach. Hour fixed industrial overhead cost)

Product. Volume Variance = 140,000 – (920 x 3.91 x $ 32.56) = 140,000 – 117,125 =  22,875

 

As a result of this calculation, we see the Industrial fixed Industrial Overheads are uderapplied (unfavourable indication).

The main input data relevant to the following interpretation is the number of Mach. Hours taken into consideration.

If those hours are the ones needed to manufacture the number of units requested in the budget period from the customers, there will be some diverting effects if the budgeted machine hours are lower than the practical capacity of the plant.

 

In fact, the used capacity is hidden from the view of the managers and this fact could erroneously lead to increase the investment for new plant, machinery and other capacity-related resources in case of estimated increase in the demand for the products or new projects that would need additional work.

Then the best solution to have a full visibility of the utilization of the fixed assets is, when the standards must be decided, to set the budget allocation basis on the number that express the potential use of those assets regardless of the  estimated number requested to meet the market demand in the next period-

This way the Fixed Industrial Overhead Production Volume Variance would have the unused capacity (if he hours used are lower than the available ones)and its cost emerged  and lead the managers to better use the capacity available for projected increase in the production without resorting to new investments.

 

Guess that practical capacity is 4,700 Mach. Hours

 

Then

 

Standard Fixed Industrial Overhead Cost per Mach. Hour: $29.78 (because 140,000/ 4,700)

 

And

 

Product. Volume Variance =  Budgeted Spending - Standard Fixed Industrial Overheads applied to production

Product. Volume Variance = 140,000 – (Act Output x Standar Mach Hours per Unit x Mach. Hour fixed industrial overhead cost)

Product. Volume Variance = 140,000 – (920 x 3.91 x $ 29.79) = 140,000 – 107161=  $ 32,839

 

I want to try to explain even better this equation: $ 140,000 (Available Capacity) – $ 107,161 (Used Capacity) =

= $ 32,839 (Unused Capacity).

 

These considerations are good both for Volume-Based cost-accounting systems and for Activity-Based ones

 

In the latter case the complexity of the respective calculations is higher in the start-up stage but once it is implemented, the results are more accurate.

 

 

C) Ineffectiveness of the variance analysis

 

You know that in setting the standards and later on analysing the standard variance for the variable overheads of any kind (administrative, commercial, industrial) you use some volume-based driver or activity-based driver (if activity-based costing is used) to which the fluctuations of those expenses are supposed to be linked.

As a result, you will have the standard/actual variable overhead cost per machine hour, per labor hour, per set up and so on, as the reference terms to calculate the spending variance and the efficiency variance.

For cost-control purposes, there could be the risk of making the indications stemming from the respective variance analysis ineffective.

That may happen when the person in charge of a specific category of overheads isn’t able to manoeuvre the chosen cost drivers.

For instance, if the cost driver is the labour hours and the person responsible for the overhead fluctuations cannot affect anything of the labour hours, it goes without saying that the potential corrective actions he might take would be partially useless.

As a consequence, the overheads won’t be in control and there would be a further negative result: the person whose performance are assessed on the basis of the overheads will be unmotivated just because he knows of the limitation of his scope.

You need to choose the manager in charge of the fluctuations of the cost driver as the person responsible of the linked overheads.

 

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