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CHAPTER 8 Budgeting: The Planning

and Control Process
This chapter looks at the development and use of the operating budget. This
is management's plan of action in the short term, usually one year. The
operating budget includes all expensed production costs (i.e., all costs
reported as cost of goods sold) but does not include expenditures on capital
equipment, which are usually justified using discounted cash flow techniques.
OBJECTI VES
,,,,---.. \..-.. Budgets are used for planning, motivation, and control.
,,Objectives of budgets-..&
"XC -"
1. Planning
The budget is the formal plan
of action.
The budget details the needed
resources and expected cash
flows.
2. Motivation
The budget acts as the
standard against which actual
performance is measured.
3. Control
The budget allows managers to
direct specific actions.
Controllable costs must be
distinguished from
noncontrollable costs.
Planning
The budgeting process begins with the determination (by management) of
the firm's anticipated products, prices, production volumes, and other busi-
ness factors for the upcoming year. These decisions and parameters are
turned into a formal plan of action that describes the activities and
resources necessary to achieve these goals. This plan, termed the budget,
describes the magnitude and timing of cash flows that may be expected for
the business. This is important for cash and profit planning.
The process of developing the budget forces the firm to examine the feasi-
bility of its goals and its ability to coordinate its different activities to
achieve these goals. Management receives an integrated picture of the
effects of its decisions on the overall firm.
When developed for use as a planning tool, budgets are generally static-
they are developed using a single level of activity each period (for mining
firms, typically a specified production volume each month). Multiple sce-
narios are often examined by preparing a budget for each individual
scenario.
Budgeting: The Planning and Control Process
Motivation
Budgets can act as standards against which performance is measured. Budgets
can motivate employees if standards are chosen that are tight yet attainable
with reasonable performance.
If the budget developed for planning purposes is also used for performance
measurement, a single financial reporting system can be used to track
actual performance on an ongoing basis. This is a common approach in
industry, although there may be significant shortcomings from using a single
set of cost statements for multiple purposes (see chapter 1). In these cases,
it is more effective to use the budget as a planning tool to describe what is
expected to occur and use production and financial statements as a stan-
dard for expected performance.
Control
Because the budget sets standards for expected performance, it serves as a
benchmark by which to evaluate results. By comparing actual results to
budgeted projections, past performance can be evaluated and future action
directed. This is done most effectively at the responsibility center level (usu-
ally the lowest organizational level for which an operating budget is pre-
pared, such as the department level). The performance of each
responsibility center can then be evaluated individually.
It is important to distinguish between controllable and noncontrollable
costs when using budgets for control and evaluation. Managers' perfor-
mance should not be based on factors they cannot influence. For example, a
mill manager may not be in a position to alter the amount of ore shipped to
the mill in a given month. Mill performance can instead be analyzed
through the use of a flexible budget, discussed later in this chapter.
PHI LOSOPHY
/"\
ProFms w~t h the budgqing
/and forecasting process-..
i. ---A
Process can take up to 6
months to complete.
- Time lapse reduces validity
of budget.
Budgets are often far too
detailed.
- The average budget contains
230 line items (Hackett,
1998).
Budgeting is not tied to
strategic planning or
performance measurement.
- Strategy is not linked to
operational plans.
Effectiveness is reduced by
tradition of negotiation and
horse trading.
Budgeting has historically suffered from a perception that budgets are diffi-
cult to prepare and yield results that are of little use. Factors that reduce the
value of budgeting are shown in Figure 8.1. However, these factors can be
managed effectively if the firm chooses to do so.
The budget summarizes management's plans for a specific time period. It
usually requires the participation of at least some of the managers in the
production organization. Once approved, the budget provides the authority
to operate the mines and plants as described, hire or lay off people, pur-
chase equipment and supplies, and so on.
Broadly speaking, firms construct their budgets in one of two generic ways.
Budget targets can be set in reference to historical performance, in which
case future goals are extrapolations of past performance. Alternatively,
aggressive targets can be set in an attempt to drive the organization to sig-
nificantly improve performance. These stretch targets can be motivating or
disempowering, depending on how management conducts its business.
Mechanics of Budgeting Processes 93
Lack a well-defined strategy
Lack linkage between strategy and operational plans
Lack individual accountability
Lack meaningful performance measures
Lack pay for performance (senior positions)
Lack data
Ongoing performance not compared to plan
Lack of decision support from finance
Lack accurate data
(from Lazere, 'Planning Patterns: What the Stats Reveal," CFO Magazine, Feb. 1998, p. 31)
FIGURE 8.1 Factors that reduce the value of the budgeting process
Trend-based projections
Scenario evaluation
Contingency planning
Benchmarking
Activity-based management
Business life cycle
Zero-based budgeting
Probabilistic analysis and simulations
Technology "S" curve
(from The Hackett Group, quoted inmPlanning Patterns: What the Stats Reveal," CFO Magazine, Feb. 1998, p. 36)
FIGURE 8.2 Most frequently used planning tools
Other planning methods may be used to augment the standard budgeting
process. These are shown in Figure 8.2.
MECHANI CS OF BUDGETI NG PROCESSES
Budgets for a department, division, or company can be developed using two
approaches: "top-down" or "bottom-up" budgeting.
TopDown Budgeting
Top-down budgets multiply projected activity levels by unit prices and
costs. The unit costs typically come from historical cost performance data,
although they may be adjusted to anticipate changes in business conditions.
Top-down budgets then project past cost behavior on future levels of activity.
94 Budgeting: The Planning and Control Process
/,+--%
- -.
,Mechanics of budgeting,,
..- - - - -- - - - -
Two generic approaches.
1. "Top-down"budget~ng
Constructed from projected
activity levels multiplied by unit
costs and prices
= Managerial focus i s generally
on incremental changes from
the previous budget
2. "Bottom-up" budgeting
9 Constructed from cost
For example, the total cost for a mine department might be projected as the
cost per ton from the most recent period multiplied by the number of tons
to be mined.
In the normal top-down process, managers make adjustments to the current
budget to obtain the budget for the future period. These budget changes
result from changed operating conditions. In making these adjustments,
managers normally like to increase their scope of activity in future periods.
This, along with increasing prices, leads to budgeted costs that tend to climb
over time. In the budget approval process, the approval authorities assume
the next period's business will be carried out in the same manner as it was
projections for each projected
in the past period, and so they tend to focus only on the incremental changes.
activity
Also called "zero-based"
budgeting Bottom-Up (Zero-Based) Budgeting
Every expenditure is reviewed;
generally more effective when
Bottom-up budgets are constructed from cost projections for each discrete
strivinq to reduce costs action expected to occur. These are also known as zero-based budgets: indi-
vidual costs are identified and then added to determine a total cost for the
entity. For example, the costs of diesel fuel, tires, lubricants, replacement
bed liners, replacement mechanical parts, and similar items will be quanti-
fied and added to determine the ore hauling cost for a mine department.
The hauling cost is added to the drilling cost, blasting cost, and so on, to
determine the total expected cost for the mine.
In zero-based budgeting, every projected dollar of expenditure is reviewed
rather than just incremental spending changes. Marginal programs and
projects are more likely to be identified; the cancellation of these programs
generally has a far greater impact on total cost levels than a top-down analysis
can identify. It is increasingly likely that cost-effective methods of managing
activities will be identified and implemented using zero-based budgeting.
The Master Budget (Profit Plan)
At the corporate or divisional level, the budgeting process includes the esti-
mation of revenues as well as costs. Revenues are projected using sales
forecasts and anticipated sales prices. Production costs are added to explo-
ration, marketing, administrative, and other costs to determine pretax and
after-tax income. This comprehensive budget is often termed the master
budget, or profit plan. It presents a complete picture of the activities of the
organization as they are expected to occur. Corporations will use the master
budget to project cash flows and profitability. This profit plan is used by the
corporation's treasury department to determine financing needs.
The preparation of the master budget is usually a time-consuming, complex
process that involves management at numerous levels. The many interrela-
tionships among individual departments must be quantified: changes in
sales volume, for example, may result from changes in equipment availability
at the production unit level. The budgeting process can be valuable because
Mechanics of Budgeting Processes 95
it requires managers to examine their assumptions about the nature of their
business: what they can produce, how much it will cost, whether existing
capacity is adequate, and so on.
In addition to their "most likely" results, managers may project optimistic
and pessimistic production and cost estimates. While the most likely values
are used for the master budget, the other quantities are often useful to iden-
tify specific areas of risk or opportunity. These are known as best-case and
worst-case budgets.
After the budget is completed, it is reviewed by corporate management to
determine if the projected result is satisfactory. If it is not, the budget may
be returned to the production organization for further work to identify
other methods of achieving higher production levels or lower costs.
Production Budgets
The production budget usually begins with either an estimate of sales vol-
ume or an estimate of production tonnage from the mine. Because most
mining companies attempt to maximize production volume, the latter situa-
tion is more common. Mine production can come from engineering esti-
mates of the amount of material that can be physically removed, given the
constraints of the mine's design. Estimates may also come from a longer-
term mine plan that specifies certain production rates to maximize the rate
of return on the capital invested in the mine. In some cases, planned
changes in finished-product inventories will result in adjustments to the
production volume.
The resources necessary to produce and process the mandated volume of
material are then determined. These are based on engineering estimates or
historical consumption rates and include labor, power, equipment, and sup-
plies components. The cost associated with each of these resources is quan-
tified, again through estimates, history, and suppliers' quotes.
Direct Materials. Direct materials are those materials used or consumed
in the production process that are directly traceable to specific units of pro-
duction (such as tons of ore or pounds of product). The quantities to be con-
sumed over the period being budgeted are estimated and the costs of these
quantities determined. The costs of direct materials are nearly always vari-
able, and the unit cost (for example, the cost per ton of ore or pound of
product) of each material is multiplied by the production volume. Other
measures of activity can be used as well. Examples of direct materials are
fuel for mining equipment, explosives for blasting, and reagents for
processing.
Direct Labor. Direct labor is the labor associated with work directly trace-
able to specific units of production. This is the work required to physically
produce the product, such as the labor costs for production drilling, blasting,
96 Budgeting: The Planning and Control Process
hauling, processing, and shipping of the product. It can be generalized as
being the labor expended by production operators and maintenance
personnel, but it does not include costs associated with mine or plant man-
agement. (Whether supervisors are considered as direct labor depends on
the specific nature of their positions.) Direct labor includes standard and
overtime wages, fringe benefits, and payroll taxes.
Production Overhead. As discussed in chapter 5, overhead cannot be
traced to individual units of production. However, it does have both vari-
able- and fixed-cost components. The variable-cost components vary with
the production activity but are not directly traceable to individual units of
production. For example, costs associated with road maintenance in open
pit mines increase as the production rate (number of haul truck cycles)
increases. However, the specific costs for equipment (road graders, water
trucks, and bulldozers) and people (equipment operators and mechanics)
cannot be linked with specific volumes of shipped rock.
Fixed and variable overhead costs can be projected using engineering esti-
mates and past experience. The effects of any proposed changes in operat-
ing practices are included in this estimate.
The variable component of overhead may be related to changes in activity
levels of factors other than production volume. For example, vehicle main-
tenance is often scheduled according to individual vehicles' operating
hours. Statistical analysis of overhead costs can identify these relationships,
which in turn will increase the accuracy of the budget estimate.
Many fixed costs are discretionary in nature: their expenditure is not abso-
lutely necessary for production operations to continue in the short run.
Examples of discretionary fixed costs are training, travel, and some mainte-
nance costs. These are frequently targeted by cost reduction programs
when budgeted profitability levels are not being reached. Depending on the
nature of the expense, however, the across-the-board elimination of discre-
tionary fixed costs can be extremely damaging. For example, production
levels would eventually fall if maintenance expenditures ceased.
MEASURI NG AND CONTROLLING PERFORMANCE USI NG THE BUDGET
At periodic intervals (usually each month), actual production performance
is compared to the budget targets. Differences in physical production quan-
tities and costs are calculated, and these variances are detailed on a sum-
mary report. Managers use this summary to identify areas that performed
better or worse than expected. They can then put together plans to capital-
ize on activities or processes where performance was better and implement
corrective actions in areas where performance was worse.
A monthly cost report often is presented in a format similar to the cost center
summaries discussed in chapter 2. Table 8.1 shows examples for a mine and
mill. The report presents the difference between actual and budgeted per-
formance in both absolute and percentage terms.
Measuring and Controlling Performance Using the Budget 97
TABLE 8.1 Monthly cost report for a mine and a mill
Variance
Actual Budaet Amount Percent
Mine department
Production
Ore tons mined 1,120,000 1,250,000 -1 30,000 90%
Waste tons mined 2,017,000 2,005,000 12,000 101%
Ore arade (% Cu) 0.80% 0.78% 0.02% 103%
Cost
Operating labor
Mechanical labor
Salary labor
Fuel $947,000 $976,000 $29,000 97%
Operating supplies $876,000 $894,000 $1 8,000 98%
Mechanical supplies $1,002,000 $808,000 ($1 94,000) 124%
Misc. and administrative $1 4,000 $28,000 $ 14,000 50%
Allocated overhead $420,000 $393,000 ($27,000) 107%
Total $5,040,000 $4,858,000 (5 182,000) 104%
Mill department
Production
Recovery 87.8% 88.3% -0.5% 99%
Product grade 96.4% 96.3% 0.1% 100%
Pounds copper produced 15,733,760 17,218,500 -1,484,740 91%
Cost
Operating labor $ 187,000 $ 189,000 $2,000 99%
Mechanical labor $205,000 $21 2,000 $7,000 97%
Salary labor $52,100 $49,600 ($2,500) 105%
Power $530,000 $565,000 $35,000 94%
Operating supplies $1 64,000 $1 76,000 $1 2,000 93%
Mechanical supplies $ 107,500 $ 105,000 ($2,500) 102%
Misc. and administrative $ 15,000 $21,000 $6,000 71%
Allocated overhead $1 16,000 $1 13,000 ($3,000) 103%
Total $1,376,600 $1,430,600 $54,000 96%
The corresponding master budget, or profit plan (Table 8.2), presents this
information in the form of an income statement. The production volume is
multiplied by a unit price ($l/lb.) to determine sales. Notice the mining
and milling costs have been included in this statement in individual lines.
In addition to the production departments, this statement shows the finan-
cial performance of the other business groups, such as marketing or
administration. This report can also be presented in variable costing form
(Table 8.3), which is more useful for managers.
98 Budgeting: The Planning and Control Process
TABLE 8.2 Monthly income statement: Full absorption costing basis
Variance
(Full absorption costing basis; $000) ,Actual Budget Amount Percent
Sales (at $l/lb. Cu) $1 5,734 $17,219 $1,485 91%
Less: Cost of goods sold
Mining cost $5,040 $4,858 ( $ 182) 104%
Milling cost $1,377 $1,431 $54 96%
Gross margin $9,317 $10,930 $1,613 85%
Less: Selling, general, and $8,143 $7,725 ($41 8) 105%
administrative costs
Operating profit $1,174 $3,205 $2,031 37%
TABLE 8.3 Monthly income statement: Variable costing basis
Variance
(Variable costing basis; $000) Actual Budget Amount Percent
Sales (at $l/lb. Cu) $1 5,734 $17,219 $1,485 91%
Less: Variable costs
Mining cost $4,217 $4,073 (5 144) 104%
Milling cost $1,097 $1,138 $41 96%
Variable selling, general, and $6,5 14 $6,180 ($334) 105%
administrative costs
Contribution margin $3,905 $5,827 5 1,922 67%
Less: Fixed costs
Mining cost $823 $785 ($38) 105%
Milling cost $280 $292 $13 96%
Fixed selling, general, and 5 1,629 $1,545 ($84) 105%
administrative costs
Operating profit $1,174 $3,205 $2,031 37%
CONVENTI ONS FOR REPORTI NG VARI ANCES
Variance: the difference between
an actual expenditure and its
budgetary target
Conventions for reporting
variances:
Identified as"favorable"(leads
to higher operating profit) or
"unfavorable"(leads t o lower
profit)
The difference between an actual expenditure and its corresponding target
is termed a variance. As Tables 8.2 and 8.3 show, variances can be reported
in dollars or as a percentage of the target value.
Variances are labeled as "favorable" or "unfavorable." A favorable variance
is one malung operating profit greater than planned, all other things
remaining equal. Unfavorable variances result in decreased profit. Favor-
able variances are generally labeled with a "+" or "F," and unfavorable vari-
ances are labeled as "-" or "U."
Favorablevariances:labeledrrF
Care is necessary in interpreting favorable and unfavorable variances.
or 'I+"
Favorable variances are not always "good" and unfavorable variances are
Unfavorable variances: labeled
"U"or "-"
not always "bad." For example, total variable costs will increase if produc-
. On cost reports,variance often
tion volume is higher than planned. This will result in an unfavorable cost
expressed as a percentage variance, even though overall sales are higher than expected. The interpre-
tation of variances is explored in detail in chapter 9.
Flexible Budgets 99
FLEXI BLE BUDGETS
" * &
.-
kd flexible budge~
--
When used for control,flexible
budgets are considerably more
powerful than static budgets.
The flexible budget adjusts for
changes in activity level.
Flexible budgets have two
components for each
responsibility center:
- A fixed cost
- A variable unit cost
Particularly when used for control purposes, flexible budgets offer signifi-
cant advantages over static budgets. Static budgets-the budgets normally
prepared for profit planning at the beginning of each year-assume fixed
levels of expected activity, such as tons of ore mined or pounds of product
produced. These budgets do not recognize the effects of changes in activity
levels as the year proceeds.
Flexible budgets, on the other hand, recognize the difference between fixed
and variable costs and the impact of changes in activity on cost perfor-
mance. These budgets have two components for each responsibility center:
1. A fixed cost that is expected to be incurred regardless of activity level
2. A variable cost per unit of activity that will change as activity levels change
The fixed cost is static; the total variable cost is flexible. Because the flexible
budget explicitly recognizes the effects of changes in activity, it is a power-
ful tool for measuring and controlling cost performance.
Example:
The manager of a pump maintenance shop knows that historically the shop
has incurred a monthly fixed cost of $13,500 and a variable cost of $275 per
pump. As the manager prepares the shop's budget for the coming year, he
projects that 30 pumps will be repaired during each month. The total pump
shop cost is therefore projected to be $13,500 + ($275 per pump x 30
pumps), or $21,750. This value is put into the budget.
As the year progresses, demand for pump repairs is lower than had been
anticipated. In one month, 23 pumps are repaired rather than the budgeted
30. As a result, the shop's total monthly cost is lower than expected. To
assess the impact of this change in activity, a flexible budget is used. The
fixed cost does not change. The variable cost decreases due to the fewer-
than-expected repairs. The month's cost is expected to be $13,500 + ($275
per pump x 23 pumps), or $19,825.
The actual cost incurred for the month can then be compared to the flexible
budget amount to measure the cost performance of the shop. If the actual
cost is less than $19,825, the shop's personnel have successfully decreased
either the fixed or the variable cost. This is discussed at length in chapter 9.
Notice that the fixed and variable costs are used in both the static and flexi-
ble budgets. The only difference between the costs anticipated in the two
budgets is due to changes in activity.
Example:
Looking at the mine and mill cost reports in Table 8.1, we see that actual
production volume during the month was lower than budget: 15.7 million
pounds of copper were produced versus a target of 17.2 million pounds. The
budgeted and actual unit prices were the same, so the variance in sales reve-
nue was due exclusively to the variance in production volume. (This is
usually not the case. See chapter 9 for a discussion on variance analysis
when prices are changing.)
100 Budgeting: The Planning and Control Process
TABLE 8.4 Measuring performance using the flexible budget
Mining Milling SG&A
Variable cost (per Ib) $0.237 $0.066 $0.359
Fixed cost ($000; per month) $785 $292 $1,545
Variance
(Variable costing basis, $000) Actual Flexible budget Amount Percent
Sales $1 5,734 $1 5,734 $0 100%
Less: Variable production costs
Mining cost $4,217 $3,722 ($495) 113%
Milling cost $1,097 $1,040 ($57) 105%
Variable selling, general, and $6,514 $5,647 ($867) 115%
administrative costs
Contribution margin $3,905 $5,325 $1,419 73%
Less: Fixed production costs
Mining cost $823 $785 ($38) 105%
Milling cost $280 $292 $13 96%
Fixed selling, general, and $1,629 $1,545 ($84) 105%
administrative costs
Operating profit $1,174 $2,703 $1,528 43%
The revenue and cost targets for the month were based on the values shown
in Table 8.4. The variable and fixed costs of mining, milling, and SG&A are
used to determine the targets for individual line items in the flexible budget.
This example analysis used pounds of product as the relevant measure of
activity. The tons of ore mined and milled could also have been used. By
using ore tons instead of pounds of product, the effects of changes in head
grade are reduced. The issue then becomes one of control: Do the miners
have the ability to accurately control grade?
The choice between ore tons and pounds of product is also influenced by
the intended audience. Corporate managers and external observers are
interested in product-related information, and therefore pounds is used as
the basis for information reported to these parties. Within the production
organization, tons is usually more relevant because workers usually have
greater control over throughput.
In this example, sales volume was assumed to be equal to production volume.
If it is not, then inventory valuation issues must also be considered.
It should be noted the flexible budget shows the impact of changes in vol-
ume on total revenue, costs, and operating profit. It does not show the
impact of changes in unit revenue, unit costs, and fixed costs.
Comparison of Actual Results with the Flexible and Master Budgets 101
TABLE 8.5 Comparison of flexible and static budgets
(Variable costing basis, $000) Actual Flexible budget Master budget
Pounds sold (000) 15,734 15,734 17,219
Sales $1 5,734 $15,734 $17,219
Less: Variable production costs
Mining cost $4,217 $3,722 $4,073
Milling cost $1,097 $ 1,040 $1,138
Variable sellinq, qeneral, and administrative costs $6.514 $5.647 $6.180
Contribution margin $3,905 $5,325 $5,827
Less: Fixed production costs
Mining cost $823 $785 $785
Milling cost $280 $292 $292
Fixed selling, general, and administrative costs $1,629 $1,545 $1,545
Operating profit $1,174 $2,703 $3,205
COMPARI SON OF ACTUAL RESULTS WI TH THE FLEXI BLE
AND MASTER BUDGETS
Actual results can be compared to the flexible and master budgets as shown
in Table 8.5. By definition, the fixed cost targets were the same for the flexi-
ble budget and the master budget.
Whether measured by the master budget or the flexible budget, the division
clearly underperformed during the month. There are performance issues
around production levels that are not shown in the financial figures, such as
tons mined and plant recovery, among others. The flexible budget shows
that cost performance was also poor, although not as poor as comparison
with the master budget would indicate. Variable production costs were
greater than expected in all three areas (mine, mill, and SG&A).
A more detailed discussion of variances between actual results and budget
targets appears in chapter 9.