BUDGET MANAGEMENT Pearson BTEC Level 5

Strategic Management and Leadership

Table of Contents 1. Understand the impact of internal and external factors on budgetary planning in

a business ......................................................................................................................................................................... 2

Long – term and short – term planning...................................................................................................... 2

Is a Strategic Business Plan? ........................................................................................................................... 3

What Is the Difference Between a Revenue Center & an Expense Center? ......................... 5

Internal and external sources of information......................................................................................... 6

2. Understand how to manage a budget .................................................................................................. 8

Variance ......................................................................................................................................................................... 8

What Is Budget Variance Analysis? .............................................................................................................. 9

How to Reduce the Cost of Doing Business ............................................................................................ 10

Adjustments for Ending Inventory .............................................................................................................. 11

How the Traditional Production Process Is Changing ..................................................................... 12

Ways to Control Overhead Costs .................................................................................................................. 13

Budgetary management controls ................................................................................................................. 14

Tools & Techniques to Identify Problems in the Workplace ........................................................ 15

Organizational Problems in the Workplace ............................................................................................ 16

How to Evaluate the Success of the Business Strategic Process .............................................. 17

3. Understand how to analyses cost information in business ......................................................... 18

Cost ................................................................................................................................................................................. 18

Incremental Cost Vs. Marginal Cost ............................................................................................................ 19

Product Costing vs. Cost Accounting .......................................................................................................... 20

Business Plan Start-up Costs .......................................................................................................................... 21

Variable Cost vs. Flexible Cost ....................................................................................................................... 23

Use of cost data for business planning ..................................................................................................... 24

Costing methods and techniques ................................................................................................................. 27

How to Implement a Standard Cost System .......................................................................................... 28

Advantages & Disadvantages of Payback Capital Budgeting Method .................................... 30

1

1. Understand the impact of internal and external factors on

budgetary planning in a business

Long – term and short – term planning The different time frames of the short, medium and long-term planning processes place the

focus on time-sensitive aspects of the company's structure and environment. You can

differentiate planning based on the time frames of the inputs and expected outcomes.

Business owners develop plans to reach their overall goals, and they usually find it useful to

separate planning into phases. This allows you to track immediate improvements while

evaluating progress toward eventual goals and targets. The different time frames of the planning

process place the focus on time-sensitive aspects of the company's structure and environment.

You can differentiate planning based on the time frames of the inputs and expected outcomes.

Planning Characteristics

Many businesses develop strategic planning within a short-term, medium-term and long-term

framework. Short-term usually involves processes that show results within a year. Companies

aim medium-term plans at results that take several years to achieve. Long-term plans include

the overall goals of the company set four or five years in the future and usually are based on

reaching the medium-term targets. Planning in this way helps you complete short-term tasks

while keeping longer-term goals in mind.

Short-Term Planning

Short-term planning looks at the characteristics of the company in the present and develops

strategies for improving them. Examples are the skills of the employees and their attitudes. The

condition of production equipment or product quality problems are also short-term concerns. To

address these issues, you put in place short-term solutions to address problems. Employee

training courses, equipment servicing and quality fixes are short-term solutions. These solutions

set the stage for addressing problems more comprehensively in the longer term.

Medium-Term Planning

Medium-term planning applies more permanent solutions to short-term problems. If training

courses for employees solved problems in the short term, companies schedule training programs

for the medium term. If there are quality issues, the medium-term response is to revise and

strengthen the company's quality control program. Where a short-term response to equipment

failure is to repair the machine, a medium-term solution is to arrange for a service contract.

Medium-term planning implements policies and procedures to ensure that short-term problems

don't recur.

Long-Term Planning

In the long term, companies want to solve problems permanently and to reach their overall

targets. Long-term planning reacts to the competitive situation of the company in its social,

economic and political environment and develops strategies for adapting and influencing its

position to achieve long-term goals. It examines major capital expenditures such as purchasing

equipment and facilities, and implements policies and procedures that shape the company's

profile to match top management's ideas. When short-term and medium-term planning is

successful, long-term planning builds on those achievements to preserve accomplishments and

ensure continued progress.

2

Is a Strategic Business Plan?

Business planning is necessary for company growth and success. Business plans provide

companies with the tools to track growth, establish a budget and prepare for unforeseen

changes in the market place. A strategic plan includes many elements a business can utilize to

attract financing and manage company objectives. To optimize strategic business planning,

businesses must clearly define company goals and conduct extensive research to properly

understand industry trends.

Definition

A strategic business plan is a written document that pairs the objectives of a company with the

needs of the market place. Although a strategic business plan contains similar elements of a

traditional plan, a strategic plan takes planning a step further by not only defining company

goals but utilizing those goals to take advantage of available business opportunities. This is

achieved by carefully analyzing a particular business industry and being honest about your

company's strength and weakness in meeting the needs of the industry.

Significance

A strategic business plan is necessary to optimize market research and to attain optimum

market share for your business. The plan allows businesses to focus on a particular niche in the

marketplace, which makes sales, advertising and customer management more effective. The

plan allows a company to know as much as possible about the needs of its customers and gaps

in the marketplace that need to be filled. A strategic business plan helps a company provide

better, more targeted service to its clients.

Characteristics

A strategic business plan includes extensive market research, industry trends and competitor

analyses. A strategic plan will include the components of a traditional plan, such as an executive

summary, marketing analysis and financial statements, but a strategic plan will be more specific

on how the company will go about achieving company goals. For example, a strategic business

plan will attempt to identify a target market, narrow it down to a manageable size, and establish

a strategy for acquiring those customers.

Benefits

Writing a strategic business plan has many advantages. The plan can serve as an outline for

successful completion of company milestones. Company owners are in a better position to not

only understand their business but become experts in their industries. A strategic plan helps

executives understand the direction in which their company is headed by reviewing past

progress and making changes to improve and grow. The plan is an organizational tool that helps

to keep a company on track to meet growth and financial objectives.

Misconceptions

Many small business owners feel that strategic business plans are for large companies and big

businesses. However, according to the Small Business Administration, a strategic business plan

can benefit companies of all sizes and can be a great advantage to small businesses. Small

businesses may utilize the document to develop the strategies necessary to attract and retain

the customers it needs to succeed.

3

Functional departments and responsibilities centers

Departments in an organization perform functions or duties for the company, such as

accounting, marketing and production. Individual employees perform a functional role for the

company within those departments. The employees are members of a team who work together

to further the goals of the organization using their particular skills and talents.

Functional Areas or Departments

The functional areas of a company may include human resources, sales, quality control,

marketing, finance, accounting and production. Each area includes a team of employees who

work to meet the needs of the organization. For example, the human resources department

staffs the business with qualified and skilled employees. Human resources employees implement

programs that attract skilled workers to the company, manage employee benefits and maintain

employee records.

Functional Roles

The employees in a functional area of the company have a specific role in the department to

further the goals of the company. For example, the accounting department divides the work

among workers, such as accounts payable and receivable clerks. Human resource employees

may specialize in an area of the functional department, such as compensation, training or

employee benefits.

Cross-Functional Teams

Companies may cross-train employees to perform multiple roles in a functional area of the

business. For example, accounting employees may perform accounts payable and receivable

duties, or production workers may operate a number of different machines in the department.

Advantages of Cross-Functional Teams

When employees perform cross-functional roles within a department, advantages include a

greater flexibility for scheduling and the assignment of duties. In a production or manufacturing

environment, a cross-trained workforce may increase productivity by allowing the company to

place workers in positions to meet customer requirements. Organizations form teams to

complete a special project, such as improving productivity or eliminating scrap and waste. The

team develops and implements a process to accomplish the company's goals. Cross-functional

teams include workers from various departments in the organization, such as engineering,

production, management or accounting. A cross-functional team ensures that a new policy

meets the needs of all areas of the company.

4

What Is the Difference Between a Revenue Center & an Expense Center?

Revenue centers, expense centers and profit centers are elements of a system to control and

measure the performance of different units or departments of a business, according to Harvard Business School. Revenue centers generate revenue through sales and marketing activities. Expense centers are responsible for producing products or providing services against budgeted

cost targets. In traditional management theory, revenue centers contribute to profit while expense centers reduce profit. Recent management thinking is blurring the lines between the

two, as commentators focus on ways in which the performance of expense centers can influence revenue.

Revenue Centers

Sales or marketing departments are the most common forms of revenue centers in small or large businesses. The management team is responsible for selling products or services that the

company produces at a specific cost. The team sets a selling price based on production costs plus a margin for profit. Its objective is to meet or exceed revenue targets while maintaining

agreed profit margins.

Expense Centers

Expense centers are those parts of the company that do not contribute directly to profit. They

fall into two broad categories: cost centers and discretionary expense centers. Cost centers,

such as manufacturing units or service delivery units, are responsible for producing a certain

level of output at an agreed cost. Discretionary expense centers provide internal services, such

as finance, administration or human resources.

Cost Centers

Managers responsible for manufacturing or for providing services produce those products or

services against cost targets calculated by cost accountants. Managers aim to improve

performance by using the inputs of labor, raw materials and energy as efficiently as possible.

Discretionary Expense Centers

Discretionary expense centers provide a business with essential services. There is no recognized

method of measuring their output in financial terms. As with cost centers, the managers of

discretionary expense centers must run their operations as efficiently as possible to meet

budgeted cost targets.

Driving Revenue

By applying specialized metrics to expense centers, managers can recognize their potential

contribution to revenue and profit. A call center, for example, is traditionally categorized as an

expense center, according to American Banker. Companies that only apply metrics such as cost

per call overlook the revenue opportunities. When customers phone in, call center staff can

utilize account information to identify opportunities to offer additional products or services and

generate incremental revenue.

Customer Satisfaction

Expense centers can also contribute to revenue and profit by increasing customer satisfaction.

Production departments that only focus on costs tend to emphasize long, efficient production

runs without considering customer needs, according to Harvard Business School. By taking a

more flexible approach, production departments can meet customer requirements for urgent

deliveries or customized products, increasing customer satisfaction and contributing to higher

levels of repeat business. 5

Internal and external sources of information

Every business needs information to help it succeed. A combination of internal and external

business information resources can provide the background necessary to evaluate current

performance and plan future progress. Knowing the types of information resources that are most

critical to business can help companies plan for capturing, analyzing and using that information

most effectively.

Internal

The first source of information that businesses should turn to is the information they already

have. Every business will have the ability to gather information about employees, about sales

and about customers. Setting up systems and processes for gathering the right information can

help business owners track, trend, analyze and act upon business that gives them clues into

such issues as what drives employee satisfaction, the products most demanded by customers,

areas of employee and customers satisfaction and dissatisfaction.

Industry Information

Every business can consider itself part of at least one industry, if not more. And every industry

has an association connected with it that can serve as a rich source of business information.

Weddles.com is a site where businesses can go to find out about the associations that serve

their industry. Joining the appropriate trade and professional associations can help businesses

gather information about industry trends, best practices and resources.

Competitive Information

No business is without competition and gathering information about competitors is critical.

Fortunately, this is easier than ever to do with the advent of the Internet. Through search and

through participation in social media--sites including Twitter, Facebook and LinkedIn--businesses

can gain competitive intelligence about what others are doing.

Government

The government provides an enormous amount of information of use to small businesses, much

of it available online. Keeping up with legal and regulatory trends is a key area of business

information need and one that can be managed effectively by visiting sites that include

OSHA.gov, EEOC.gov. Virtually every government agency has a website.

Consumer Needs & Marketing

People start companies to satisfy consumer needs. Marketing helps companies make consumers

aware of these products and services, Marketing is made up of all the processes involved in

getting products into the consumer's hands.

Companies must ensure that the consumer's needs and their marketing strategies are well-

suited.

Significance

Consumer needs and marketing are important considerations at all companies. As these needs

change over time, so does the marketing message. For example, when consumers became

aware of health issues with sugar in the early 1950s, their demand for diet soda increased at the

expense of regular soda, according to Vision.com. Companies had to quickly change their

marketing strategy to include diet beverages.

6

Focus Groups

Unfortunately for marketers, consumers have different needs, tastes, and demands.

Understanding what motivates consumers to choose one brand over another is not always

apparent. One marketing tactic that companies use to understand consumer needs is to conduct

a focus group. Focus groups, made up of consumers who give their opinions on products, are

useful in understanding the primary issues influencing consumer brand choices, according to

Lars Perner's 2008 article "Consumer Behavior: The Psychology of Marketing" at

consumerpsycholgist.com.

Types of Surveys

Companies also use market research surveys to better understand consumers needs. These

surveys can include telephone, mail, Internet, or even personal interviews. Market research

managers design questionnaires to determine consumer preferences. Survey results can show

companies a consumer's desired price range or even where they like to shop. Market research

surveys are an important tool for determining a company's optimal product mix or range of

products.

Identification

After companies determine consumers' needs and develop their products, they then must

advertise and distribute their products. An important function of consumer marketing is

identifying key demographics of consumers. A company can better reach consumers through

advertising if they know their customer's gender, age, income, household size, and even

profession.

Prevention/Solution

Companies that properly align their consumers' needs with their marketing efforts can usually

expect greater sales and profits. The most successful businesses evaluate their consumers'

needs on a continuous basis, to meet both the current and future needs of consumers.

7

2. Understand how to manage a budget

Variance Are you a bit confused by financial reports? If so, you're not alone. Many individuals and

professionals review accounting statements, such as budget or other financial statements, and

don't understand the differences between them. All they see are numbers listed with some

descriptions, but they are not very clear about the differences between the financial reports.

Objective

The objective of a budget is different from the objective of other financial statements. The main

goal of a budget is to manage and control revenues and expenses by estimating amounts and

projecting them in the future, following a set strategy. Budgets are financial guidelines for the

business that can be done for one, five or 10 years. Budget numbers, which can be allocated by

month, quarter or year, provide a map for the business to go from where it is to where it wants

to be financially. Other financial statements often have the main goal to present actual, accurate

and reliable information. They present information on actual data, not what the business wants it

to be.

Basis

Budget reports usually have information about estimated amounts. The foundation for budget

reports are projected figures, not actual amounts. Other financial statements may show actual

numbers as compiled by the accounting system. Some financial statements used by outsiders

need to follow the generally accepted accounting principles, while budget preparation is an

internal affair with no official rules or regulations. Be aware that many firms report both actual

and budget numbers on the same reports along with variances, which helps management in

controlling costs and in planning. Another difference in basis is that budget numbers are usually

prepared using the year as the time frame, while other financial statements are prepared on a

monthly or quarterly basis -- after data is available.

Changes

A budget generally stays the same throughout the year. It's a static process, once it's set up.

Numbers are estimated and then they are left alone with no changes. If a major unexpected

event occurs, budgets can be modified, but this is done by exception, not rule. On the other

hand, figures in financial statements are dynamic, changing with every business transaction. For

example, a number for revenues in an income statement for June is likely to be higher than the

number for the revenues in May. Because of these changes, which can be voluminous,

computerized accounting systems are often used, allowing for easy compilations of reports.

Types

Accountants can compile non-budget reports in a variety of ways. You could have the standard

financial statements, such as a balance sheet, income statement and cash flows report. There

are also other reports used by management, such as the "payable aging" reports, which details

vendors, amounts and due dates. On the other hand, accountants prepare budgets and budget

reports for specific sectors, such as operations and capital areas. Operating budgets are used to

control day-to-day activities, while capital budgets are produced to manage construction work or

other major projects not related to operations. Budget reports are usually more limited in

number and format than other accounting reports.

8

What Is Budget Variance Analysis?

Companies prepare budgets so they can plan the evolution of their business. Budgeted costs

allow them to set prices, project sales and estimate profits. For a wide variety of reasons, costs

and revenues can come in higher or lower than calculated. Budget variance analysis addresses

these differences and helps companies adjust budgeting procedures to avoid similar

discrepancies in the future.

Budget Versus Actual

Companies base budgets on historical numbers, similar processes and calculated values. The

budgets predict costs and revenues over a fixed period into the future. Once the budget period is

finished, the company can determine actual costs and revenues as it books sales and pays

invoices. It assigns the actual values to the same cost and profit centers it used for the budget,

and it can compare the budgeted numbers with the actual figures.

Variance

When companies compare budgets with actual figures, there are often differences called

variance. Variance is the number obtained by subtracting the lower of the actual and budget

numbers for a particular item from the higher one. Reasons for variance can include changes in

sales, changes in material cost or changes in labor cost. Variance can be favorable, if costs are

lower or revenue is higher, or unfavorable for higher costs or lower revenue. Variance results

from cost or price changes and from volume changes.

Analysis

Variance analysis looks at revenue, cost of material and labor and how the actual values differ

from the budget. The analysis establishes why there is a variance. For low revenue, it

determines how much of the difference is due to low sales and how much is due to low prices.

For high material costs, it checks unit costs and quantity used. For high labor costs, it compares

the hourly rates and the number of hours worked with the budgeted amounts. Once the analysis

has established the major sources of variance, it looks for the reasons.

Corrective Action

Variance analysis identifies the sources of major actual value to budget differences. Companies

can use this information to take corrective action. If the budget variance analysis shows that

more hours were worked than budgeted, corrective action may be able to streamline the work

process. If sales were lower than projected, corrective action can put in place measures to

increase sales. The company also can adjust subsequent budgets accordingly. Through

corrective action based on budget variance analysis, budgets become more accurate and

planning improves.

9

How to Reduce the Cost of Doing Business

If you want to increase you profit margin, it's smart to reduce the cost of doing business. You

may worry that doing this could reduce the quality of your products or services, but you're likely

to find that you are spending more than you should. You can find a number of areas where you

can significantly reduce your costs or eliminate them altogether, simply by replacing the things

that you use. Determine where your business should spend the most and where you can cut

corners.

1. Audit your business' expenses. Doing this lets you clearly see where you are spending the

most money and can give you ideas about where it's best to cut.

2. Shop around for materials and services. Do this for everything that you purchase--

telecommunications, production materials, coffee for the break room. You may have been

purchasing supplies from the same company for years--this doesn't mean that they are the

cheapest. If you shop around, you can be sure to get the best deal. Your current company may

even offer you a discount when you try to switch.

3. Meet online instead of in person. The cost of doing business globally really adds up, especially

if your staff frequently travels out of town. Using video conferencing services instead can help

you to save on plane fare, hotel and dining charges.

4. Increase staff productivity. Help your workers to be more productive with their time. This

could allow them to take on additional tasks so that you don't have to hire new people. If your

current staff members don't have the abilities to take on certain tasks, it's typically more cost-

effective to train them.

5. Go green to reduce your business costs. Encourage employees to turn their computers off at

night. Replace your light bulbs with energy-efficient ones. Turn your thermostat down 1 degree

in the winter and up 1 degree in the summer. Print on both sides of paper. These small changes

are hardly noticeable, but add up quickly when practiced company-wide.

6. Downsize your workforce. If you suspect that you simply have too many people working, you

can lay off the workers who are unnecessary.

10

Adjustments for Ending Inventory

For a business that sells a product, inventory is tracked using accounting software. Depending

on accounting specifics, the inventory can be tracked in one of two ways. As a result,

adjustments for ending inventory can vary at the end of the year. Some business have other

adjustments that must be made for ending inventory due to the use of discounts, returns and

allowances accounts.

Perpetual Inventory System vs. Periodic Inventory System

Depending on how your accounting software is set up, your inventory tracking system can be

perpetual or periodic. With a perpetual system, changes to the inventory amount are made in

real-time. For example, if you enter in a sales invoice for 15 items in your inventory, the system

automatically reduces your inventory amount by 15. With a periodic inventory, the inventory

amount remains at the year’s starting amount until you update it.

Physical Count

Regardless of your type of inventory system, a physical count of the inventory should be done at

the year’s end. Due to shrinkage, such as employee theft or loss, you may not have the amount

of inventory on hand you think you do. A physical count lets you know exactly how much

inventory the business has at the time of the count. You cannot make any ending inventory

adjustments until you do the count.

Inventory Quantity Adjustment

If you are using the perpetual inventory system and your physical count shows the same

number on hand, you do not have to make an adjustment. However, if the number on hand

differs from what your accounting system shows, you must make a quantity adjustment. The

exact process for entering the adjustment varies by accounting software. Generally you can

make a “new quantity” adjustment.

Cost of Goods Sold Adjustment

When you make an adjustment to the inventory quantity, you must also make a corresponding

adjustment to the cost of goods sold account. To calculate this, you need to know the price paid

for the inventory units you are adjusting. For example, if the unit price is $6 and you are

adjusting by only six, units the cost is $36. The exact process for entering the adjustment varies

by accounting software. Generally you can make a “new value” adjustment.

Less Common Adjustments

If you are using a purchase returns and allowance account or a purchase discounts account, you

need to close these at year's end. You only have these accounts in a periodic inventory system.

The entries you have in each of these accounts is a credit, which you close by debiting the

accounts and issuing a corresponding credit to the inventory account at year's end. A similar

adjustment must be made if you are using a sales returns and allowance account or a sales

discounts account. These accounts can be in either inventory system. Instead of having a credit

in these accounts, you have a debit. Close out the year-end account with a credit to these

accounts and a debit to inventory.

11

How the Traditional Production Process Is Changing

When it emerged in the 18th century, the Industrial Revolution brought massive change to the

world of business. Traditional production processes brought more products to a larger base of

people. As of 2011, small businesses still rely on production processes to create the goods their

customers want. Over time, many changes have affected these systems. Understanding some of

the basic triggers for the changes will help small business managers plan for the future.

Social Expectations

Social responsibility has changed the way companies produce their products. New concerns for

the environment and conservatorship have forced even small businesses to rethink their

production processes. While creating goods, companies must be open about their procedures yet

protective of trade secrets. In traditional processes, the focus was on locating cheaper, not

greener, parts. The use of recycled supplies and earth-friendly components helps businesses

satisfy community concerns but provide desirable goods.

Generic Parts Solutions

Traditional production processes involved expensive assembly line parts. Production could stop if

a part broke or was missing. The availability of generic parts allows small businesses to replace

their equipment quicker and possibly at less cost. Often a replacement part has newer features

that help upgrade the production process. The Internet has helped make finding replacement

and upgrades easier.

Live Production Updates

"Time to market" is a measure of time used to explain a production schedule. In a traditional

production format, it was hard to update all parties on timeline adjustments. In the current

production field, time to market information can be updated by the click of a mouse or a phone

briefing. Technology brings live time production reporting down to larger numbers of employees

and does it faster.

Hierachy Changes

Changes in company hierarchies have prompted production changes. For example, companies,

especially small businesses, don't operate under the board and manager model anymore. Floor

supervisors and line operators make more decisions than ever, concerning how and when

production changes are made.

In some models, immediate supervisors have been replaced by global managers who handle

troubleshooting and decision-making virtually. Close-to-action decisions are made right on the

production floor. Also, company structures are now created around the production process,

helping satisfy customer needs.

12

Ways to Control Overhead Costs

Corporate overhead, if unchecked, can eat up your profits and potentially create a net loss

before you realize it. Without a breakdown of your costs into production and overhead

categories, you might not realize how much you’re actually spending to run your company.

Detailed financial reporting and budget variance analyses will help you keep your overhead to a

manageable level.

Corporate Overhead

The costs you have to run your business and sell your product make up corporate overhead.

These are expenses you have even when you aren’t making your product. They include

expenses such as rent, marketing, phones, insurance, administrative staff, office equipment,

interest and supplies. Like corporate overhead, departmental overhead includes expenses you

have when you’re not producing your product, but they apply directly to one department. For

example, machinery maintenance is an example of departmental overhead.

Identify All Corporate Overhead

The first step in determining your corporate overhead is to identify it. If you don’t record every

expense you have on a budget sheet or other financial report, do so. Start by creating

production and corporate overhead reports. Production expenses are costs that apply directly to

making your product, such as materials and labor. Next, break down your corporate overhead by

function, such as marketing, human resources, information technology, office administration and

sales.

Work With Department Heads

Give each of your managers the list of overhead their department generates. Ask them to look

for ways to reduce their spending without sacrificing productivity, efficiency and quality. Your

department managers might be the most knowledgeable about how to do this. If you don’t

already do it, have your department heads submit an annual budget request each year. Labor is

often one of the largest costs of any business; have department heads compare outsourcing

versus in-house staff for various projects and positions to determine if they can find cost-savings

opportunities.

Create a Purchasing Process

Assign one person to review and approve purchases so that he can see all expenses that

managers plan to make before they are paid. Set policies for spending, such as requiring

competitive bids for purchases over a certain dollar amount. Have your purchasing manager

shop for better deals on common items you buy.

Consider offering a bonus if your purchasing agent meets specific savings targets without

sacrificing quality.

Review Contracts

If you outsource functions or sign leases, rebid your contracts annually, even if you end up using

the same vendors and suppliers each year. Rebidding contracts prevents longtime contractors

from inflating their fees, or encourages them to offer more services to keep your business. If

you haven’t shopped your insurance in the past two years, do so, and discuss with your current

provider how to reduce your premiums. Ask your utilities providers to visit your workplace to

perform an audit and recommend how you can cut your monthly water, gas and electric bills.

13

Budgetary management controls Organizational planning provides a framework within which a company can successfully grow,

compete and react to challenges.

Planning helps an organization chart a course for the achievement of its goals. The process

begins with reviewing the current operations of the organization and identifying what needs to be improved operationally in the upcoming year. From there, planning involves envisioning the

results the organization wants to achieve, and determining the steps necessary to arrive at the intended destination--success, whether that is measured in financial terms, or goals that include being the highest-rated organization in customer satisfaction.

Efficient Use of Resources

All organizations, large and small, have limited resources. The planning process provides the

information top management needs to make effective decisions about how to allocate the resources in a way that will enable the organization to reach its objectives. Productivity is

maximized and resources are not wasted on projects with little chance of success.

Establishing Goals

Setting goals that challenge everyone in the organization to strive for better performance is one of the key aspects of the planning process. Goals must be aggressive, but realistic. Organizations cannot allow themselves to become too satisfied with how they are currently

doing--or they are likely to lose ground to competitors. The goal setting process can be a wake-up call for managers that have become complacent. The other benefit of goal setting comes

when forecast results are compared to actual results. Organizations analyze significant variances from forecast and take action to remedy situations where revenues were lower than plan or expenses higher.

Managing Risk And Uncertainty

Managing risk is essential to an organization’s success. Even the largest corporations cannot

control the economic and competitive environment around them. Unforeseen events occur that must be dealt with quickly, before negative financial consequences from these events become

severe. Planning encourages the development of “what-if” scenarios, where managers attempt to envision possible risk factors and develop contingency plans to deal with them. The pace of change in business is rapid, and organizations must be able to rapidly adjust their strategies to

these changing conditions.

Team Building

Planning promotes team building and a spirit of cooperation. When the plan is completed and

communicated to members of the organization, everyone knows what their responsibilities are,

and how other areas of the organization need their assistance and expertise in order to complete

assigned tasks. They see how their work contributes to the success of the organization as a

whole and can take pride in their contributions. Potential conflict can be reduced when top

management solicits department or division managers’ input during the goal setting process.

Individuals are less likely to resent budgetary targets when they had a say in their creation.

Creating Competitive Advantages

Planning helps organizations get a realistic view of their current strengths and weaknesses relative to major competitors. The management team sees areas where competitors may be

vulnerable and then crafts marketing strategies to take advantage of these weaknesses. Observing competitors’ actions can also help organizations identify opportunities they may have

overlooked, such as emerging international markets or opportunities to market products to completely different customer groups.

14

Tools & Techniques to Identify Problems in the Workplace

The workplace contains a hub of activities that can either produce desirable or business-

wrecking performances. Good relations and equipment in an office can boost a firm’s

performance. On the other hand, bad office relations and bad equipment can mother problems

that result in detrimental performances. Using the right tools and techniques to identify these

issues can help you solve problems in the workplace and help grow your business.

Employee Reviews

Conducting employee performance reviews is an effective technique used to identify problems in

the workplace. The worker should be the most likely person to identify potential issues that need

to be dressed. Some of the methods that can be used to collect this information include

questionnaires, surveys and oral interviews. This information can then be used to identify or

predict workplace issues, such as health and job safety concerns, discrimination, harassment,

work-life balance and remuneration, among others. For instance, health hazards in the

workplace can be identified more effectively when performed informally by supervisory and non-

supervisory employees during the course of daily work activities with technical assistance from

safety and health professionals.

Employee Safety

Healthy employees are more active and productive compared to their sick counterparts. It is

vital that a business owner knows his workplace well enough to offer his employees information

on the hazards associated with their line of work. One way of achieving this is by ensuring that

office equipment is safe for use and meets standards. Reviewing Occupational Safety and Health

Administration regulations can help you determine whether your equipment meets the

standards. Additionally, employers can warn workers of areas where accidents are more prone to

occur.

Group Assessments

Putting your employees together in small groups may help when trying to diagnose problems

within the office. The groups should consist of staff from the same department working toward

acknowledging a common problem. A moderator who is unknown to the employees makes it

easier for the employees to mention problems they frequently encounter. Peer-group

assessment helps the company identify numerous problems within the firm’s departments.

Risk Assessment

Risk assessment is a practical activity that involves a thorough review of the workplace structure

to identify the situations or processes that may cause harm to the people. Risk assessment is

not only limited to collecting information from employees. Other risk factors, such as the

construction design of the workplace, safety of power, lighting systems, and office equipment or

machinery, are also assessed. After identification of risk-enhancing factors is made, evaluation is

done to estimate the likelihood of occurrence and severity of the potential risk in order to decide

what strategies should be in place to effectively prevent or control the harm from happening.

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Organizational Problems in the Workplace

As organizations continue to diversify, the opportunities for workplace problems intensify. Small

business owners and managers typically face one or more of three potential levels of conflict --

employee, team or organization-wide issues. Often the underlying causes of these problems are

the lack of open, flowing communications or using the wrong organizational structure. Many

businesses compound problems by avoiding communicating a clear chain of command path.

Employee Issues

Individual employee problems can be personality conflicts, supervisor issues, personal trauma,

or company structure oriented. Management must learn the cause of the problem and who or

what keeps "fueling the fire." If there is no clear trigger, the answer could fall back to insufficient

or confusing communications. For example, an employee in a decentralized organization may

feel they must answer to multiple supervisors if the chain of command is not communicated

clearly.

Team Problems

To be high performing, teams must be dedicated to working toward an agreed goal. Should they

experience personal disconnect with other team members, the team can become non-functional.

These issues often stem from organizational or management communication breakdowns that

confuse team and personal common goals. Team leaders must offer constant feedback and

foster cohesiveness. When facing team issues, managers must diagnose the problem and take

immediate corrective action to avoid more serious performance breakdowns.

Organization-wide Problems

Simple employee or team issues can quickly expand to your total organization if you don't take

immediate corrective action. You must avoid this situation at all costs, as it often results in your

staff forming two groups, both at odds with each other. Should all your avoidance actions fail, be

ready to take much more dramatic corrective measures. You must prevent these problems from

negatively changing the corporate culture you have carefully cultivated to make your company

and workplace a high performing entity.

Organizational Problem Solving Steps

Many roads can lead to organizational problems at the workplace. Successfully solving these

issues, however, usually follows the same plan. First, manage and resolve the current problem

right away. For example, two or three employees may have interpersonal conflicts. If you are

not part of the problem, you must become the solution. Second, learn the problem's root

causes. Address and correct these issues to avoid a repetition of the problem. This is simple to

state, but often more difficult to accomplish. Yet, it is imperative you take these two steps to

maintain a high-performing staff.

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How to Evaluate the Success of the Business Strategic Process

It's important not to get confused by jargon when trying to navigate the various processes and

procedures involved with running a small business. When you're exploring concerns regarding

the business strategic process, in short, you're evaluating your overall business plan and

process. You can determine the success of your company plan in a few simple steps.

1. Determine your goals for the business. Use the SMART goal method when making this

determination—your goals should be specific, measurable, attainable, realistic, and have a time

period attached to them. Write down all of these goals so that you can review them as you're

evaluating your business strategic process.

2. Review your business plan to familiarize yourself with your initial strategic plan again as

you're navigating the evaluation process.

3. Prepare an income statement for the period that you wish to evaluate, whether it's a year or

one quarter so that you can evaluate sales results. Compare the sales during that period with

the results from the previous period to see if you're making positive progress. Compare the

amounts of your business expenses as well—make sure that your costs aren't trending upward

without reasonable cause.

4. Evaluate the success of your business strategic plan by surveying your customers, employees

and business associates. You can ask direct questions of specific people or create an online

survey to get anonymous responses and gauge if you're getting the type of response you hoped

for from these important parties to your business.

5. Keep track of the results of your advertising and promotional plan using tracking services

offered by the company placing your ads or by researching the sources of your sales. For

instance, some companies create individual websites associated with specific advertising

campaigns to find out which messages and offers work the best. Some online ad serving

companies gather statistics about clicks and interest in your web-based advertisements.

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3. Understand how to analyses cost information in business

Cost Some of the most important short-term and long-term business decisions you make center on

cost considerations. In addition to reviewing costs that vary according to how much you produce

or sell, it’s vital to also consider fixed costs that, for the most part, you can’t control. A short

primer can help you better understand the significance of fixed costs.

Types of Fixed Costs

Fixed costs are those that don’t fluctuate as production levels or sales volumes change. Although

basic and necessary fixed costs occur each month, it's important to understand that some fixed

costs fall under more discretionary spending categories. While fixed costs such as rent, lease and

loan payments, management salaries and depreciation are non-discretionary, other fixed costs,

such as advertising, promotional expenses and subscriptions are among those you can choose to

include -- or not include -- in ongoing business spending. The important thing to remember is

that you’ll continue to incur the non-discretionary fixed costs regardless of variations in

production or sales volume.

Fixed Cost Accounting

Manufacturing businesses that use accrual basis accounting include many of their fixed costs as

part of total production costs and the cost of goods sold. This is necessary to comply with

generally accepted accounting principles. The process, called absorption accounting, shifts fixed

costs allocated to work-in-process inventory over to a finished goods inventory account, then to

the cost of goods sold. The process ensures amounts you report on the balance sheet and

income statement accurately match up fixed costs related to sales made in the same period.

Fixed Cost Behaviors

Although fixed costs generally remain constant regardless of productivity or sales volumes,

discretionary fixed costs can change over time. In addition, while total fixed costs remain

constant as volume increases, fixed costs per unit do fluctuate. For example, if your business

has total fixed costs of $1,000 and manufactures five items, the per-unit fixed cost for each item

is $200. If your business manufactures 10 items, total fixed costs remain the same while the

per-unit cost decreases to $100 for each item.

Fixed Costs and Profitability

Although fixed costs always factor into short- and long-term profitability, some fixed costs affect

short-term profit margins differently than others do. An example is capital investments for

specialized equipment. Unlike auto insurance, which is a fixed cost each month that you fully

expense on the income statement, specialized equipment is generally a substantial investment

with a multi-year life. These types of purchases often involve showing a small amount of

expense each month in the form of a monthy loan payment and depreciation expense on the

income statement, with the bulk of the costs remaining on the balance sheet, to be expensed

and depreciated over the life of the equipment. This spreads the fixed costs out over time, which

smooths profitiability and avoids huge impacts to the bottom line in any given time period.

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Incremental Cost Vs. Marginal Cost

Accurate cost measurement is critical to properly pricing goods or services. Businesses with

accurate cost measurement know whether they are making a profit on current goods and know

how to judge potential investments, new products or other opportunities. Using the correct

costing method for the opportunity is a primary focus of effective cost accounting and financial

control. Incremental and marginal costs are two of the primary tools to evaluate future

investment or production opportunities.

Fixed vs Variable Costs

Fixed vs variable, fully allocated, average, marginal and incremental, each of these cost

definitions address the need to understand a different facet of production. Fixed costs do not

vary with the number of units produced. Variable costs change with production. For example,

the rent paid on a factory would be a fixed cost. The amount of oil used to maintain the

machinery would be a variable cost, because it depends on how much the machinery is being

used. These two costs are generally used to evaluate past performance or project expenses in

the future. By contrast, marginal and Incremental costs are used to help management evaluate

different potential future courses of action.

Incremental Costs

Incremental costs are associated with a choice and therefore only ever include forward-looking

costs. Previously made purchases or investments, such as the cost to build a factory, are called

“sunk” costs and are not included. The Incremental cost can include many different direct and

indirect cost inputs depending upon the situation. However, only costs that will change as a

result of the decision are to be included. When a factory production line is at full capacity, the

incremental cost of adding another production line might include cost of the equipment, the

people to staff the line, electricity to run the line and additional human resources and benefits.

Marginal Costs

Marginal cost is a more specific term, referring to the cost to produce one more unit of product

or service. Originally used to optimize production, products with high marginal costs tend to be

unique, labor intensive or at the beginning of a product life cycle. Low marginal cost items are

often very price competitive. The classic example is the cost to print encyclopedias. It costs a lot

to print the first encyclopedia. Research must be done, entries written, copy typeset. But it

requires very little additional cost to print the 10,000th encyclopedia. Marginal cost may equal

incremental cost when only one additional unit is being considered.

Applications

The strict usage of incremental and marginal costs has been expanded over time to include any

sort of decision that has a cost impact. Public policy, medical trials and even psychologists

frequently use these terms to evaluate the fiscal, medical and emotional costs of different

options. These quantified terms help to guide critical thinking and make for better decision

outcomes.

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Product Costing vs. Cost Accounting

Cost accounting and product costing are two accounting methods for determining the cash

needed to create goods and services. A company's decision to use either accounting technique

can have lasting implications on how the business interprets financial data and makes business

decisions. Product costing may work better for a business lacking modern manufacturing

facilities, while cost accounting better suits a company using large-scale production methods.

Product Costing Definition

Product costing is the accounting process of determining all business expenses pertaining the

creation of company products. These costs can include raw material purchases, worker wages,

production transportation costs and retail stocking fees. A company uses these overall costs to

plan a variety of business strategies, including setting product prices and developing promotional

campaigns. A company also uses product costing to find ways to streamline production costs to

maximize profits. For example, choosing raw materials that are more cost-effective can allow a

company to increase profit from retail sales by lowering its product creation costs.

Problems with Product Costing

The modernization of manufacturing techniques and improvements in product shipping have

greatly changed the ways businesses calculate product cost. According to eNotes, an education

website, manufacturing facilities in the 21st century can assemble products so quickly that

there's little need for component inventories. This renders many old methods of calculating

product cost irrelevant.

Additionally, shifts in manufacturing focus to meet customer needs through production have led

to manufacturing lines with small variances in production techniques. These seemingly small

differences in production techniques create complicated accounting situations where companies

have difficulty determining actual production costs in the short term. Compensating for this lack

of clarity requires companies to make long-term projections regarding costs over the life of

product lines instead of costs leading up to the sale of products.

Cost Accounting Definition

Cost accounting is the process of collecting, classifying and recording all the costs associated

with accomplishing a business objective or particular company project. According to

BusinessDictionary.com, a business uses cost accounting to analyze data collected from

completing a business task to determine the fair value or selling price of the product created

from that task. For example, a company creating a line of snow skis performs cost accounting to

determine a selling price for the skis that both covers the company's costs and allows the

business to return a profit on each sale. Cost accounting can also help a company streamline its

production process to reduce costs and return a greater profit on individual product sales.

Cost Accounting Advantages

Unlike product costing, cost accounting doesn't have the problems associated with adjusting

projections to suit modern manufacturing techniques or counting individual inventory

components. This allows cost accounting to deliver detailed reports regarding the cost of each

phase of production. A business can use these reports to specifically target areas of the company

for cost reduction or efficiency improvement. Additionally, cost accounting focuses solely on the

cash spent to create goods as an economic factor of production. This means a business using

cost accounting views money as the single factor affecting the company's ability to produce

goods and services.

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Business Plan Start-up Costs

Business plan start-up costs effective the success of every new business. All business start-ups

have unique financial needs. Some home businesses can be started with little money while other

businesses require large investments in equipment, inventory and other start-up costs. To

ensure a business is properly financed, business owners can determine the financing and

borrowing needs of the new business by estimating its start-up costs when writing a business

plan. Business plan writing software, the US Small Business Administration and other

organizations offer start-up cost worksheets to help identify these business expenses.

Employee Expenses

Many business start-ups fail to include an estimate of the owner’s salary in their business plan

start-up costs estimate. Omitting this important salary can cause undue stress during the first

year, when the business is unlikely to make a profit. Business owners must include a twelve

month estimate of all employee costs, including payroll withholding taxes, worker’s

compensation insurance, health benefits and salary.

Business Location

Some costs for a business location are considered one-time business plan start-up costs such as

building renovations, down payments on a mortgage, construction costs and landscaping. Other

building costs are monthly expenditures such as the payment of a mortgage or rent, building

and landscaping maintenance, business insurance and office security.

Business Equipment

Monthly expenses for business equipment can include office supplies, equipment leasing or

payments and shipping supplies. One-time expenditures often include the purchase and

installation of computers, office furniture and communication equipment like phones, mobile

communications and networks.

Business Product

Businesses that sell a product must consider start-up costs for such items as initial inventory,

vendor deposits, sales tax and warehousing costs. Businesses that provide a service must

consider ongoing costs such as travel to clients, mobile service and printing costs. Business

product costs differ, based upon the business product and business sales model. Writing a

business plan will help to identify all start-up costs.

Advertising

Marketing and promotion are vital to the success of any business. All businesses must have

advertising budgets based upon their business models. A marketing plan will help determine the

exact costs required for a specific business model. Advertising should be considered a monthly

expense that can include the cost of Internet advertising, postage for mailings, sales brochures,

stationary, printing costs, newspaper advertising and other promotional events.

Operational Costs

Business plan start-up cost estimates must include monthly operational costs. These costs are

budgeted out monthly and are vital to keeping the business open. Estimate costs for utilities,

such as telephone, mobile services, DSL lines, electricity and other vital services for a year,

since the loss of any of these services will directly affect the success of the business.

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Other operational costs include attorney and other professional fees, delivery and transportation

expenses, banking fees, and credit card usage fees.

Permits and Licenses

A business plan start-up cost estimate must include money for attorney fees, legal costs, and

other costs, like obtaining permits and licenses. The plan should include funding to cover

permits, zoning and refitting the place of business to satisfy licensing requirements. For

example, a daycare center must conform to all fire safety regulations and may incur the cost of

fire extinguishers, sprinklers and exit signs.

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Variable Cost vs. Flexible Cost

Being able to determine the behavior of your business costs gives you a better chance to

develop methods to control them. While learning these terms may take a little time, the added

benefit of understanding how costs are flowing through your company can be an asset that

keeps generating rewards as your business expands.

Variable Costs

Strictly variable costs are those that change directly with production. This makes such costs

fixed per unit but variable in total. For example, if you produce candlestick holders, the brass

used in production is a strictly variable cost. This implies that if you stop producing candlestick

holders, you will no longer incur the cost of brass. Also, no matter how many candlesticks are

produced, the price of brass for one candlestick remains unchanged. However, the total price of

brass used for all candlesticks produced increases. This is sometimes referred to as being, "fixed

in unit, variable in total."

Mixed Costs

Mixed costs are a hybrid between variable and fixed costs. This means the cost incurred has a

portion that remains the same regardless of production level and a variable portion that changes

with the level of production. An example of this type of cost is a cellphone contract. Your

contract may give you a set amount of minutes per month for a set price, but if you use more

that amount of minutes, you will have to pay a per-minute charge. The base amount of minutes

is a fixed cost the you incur no matter the usage; the overage is a variable cost that you control

through your use of the phone.

Step Variable Costs

Step variable costs are costs that are variable in nature, but the cost per unit changes as the

company "steps" to higher levels of production. For example, a company that builds houses will

need to buy lumber.

As a builder uses a large amount of lumber, the lumberyard may be willing to negotiate a

discount on the large purchase and offer 10 percent off the purchase for the first 1,000 two-by-

fours, and another 1 percent off for each additional 100 two-by-fours. This cost would be strictly

variable for the first 1,000 two-by-fours and strictly variable at a different rate for every group

of 100 two-by-fours after that. This difference in strictly variable rates for the same product,

based on volume, is a step variable cost.

Flexible Costs

Flexible costs, also called discretionary costs, are costs that are not committed to by the

company. For some costs, such as rent or loan payments, a business is contractually obligated

to make periodic payments and will continue to incur costs until some point in the future.

However, other costs, such as advertising expenses or employee-recognition programs, may be

stopped by the company at any time. These costs are known as flexible costs.

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Use of cost data for business planning Proper business budgeting can help a company chart it's financial future and make strategic

operating decisions.

A business that doesn’t budget sets itself up for a host of financial problems down the road. This

is true for businesses of all ages and sizes. Conversely, a business that develops short- and

long-term business objectives by creating a detailed business plan can create a road map for

financial success and opportunities to expand.

Benefits of Budgeting

Just like a household, a business has certain debt obligations and expenditures it is responsible

for. These may include:

Rent or mortgage

Utilities

Loans or lines of credit

Vendor accounts

Professional services

Insurance

Payroll

Purchasing obligations

Advertising

IT services

Imagine the potential implications if a business isn’t able to meet even just one of the above-

mentioned financial obligations, because of poor budgeting. Being unable to meet payroll means

employees will leave the company; not carrying insurance leaves the company open to liability;

and, failure to pay rent means eviction.

Inability to Plan

A business that doesn’t know where its money is coming from or where it is going to isn’t in a

position to expand, take advantage of investment opportunities or even make long-term

commitments to suppliers or clients. It can also lose existing business if the unforeseen happens

– like the power being turned off or a shipment of goods being delayed. Not having financial

records in order can mean denial of operating loans, the purchase of equipment or the ability to

bid on government contracts.

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Benefits of Budgeting

A carefully constructed budgets allows a business to continually track where they are financially.

This allows for strategic, long-term planning for everything from current operating costs to

potential expansion. Knowing where the budget stands opens up the ability to hire new staffers,

invest in new product lines and set earning goals in line with the organizations’ corporate

financial objectives. Other benefits include:

The potential to attract investors

The ability to set sales goals

The chance to open lines of credit

The ability to make decisions about salaries, bonuses, benefits and overhead operating

expenses

Easier tax preparation

If a company answers to a board of directors or an advisory committee, a detailed budgeting

process will enable the business to provide regular earning reports and status updates, and will

be able to change strategy, when necessary, if projected earnings are outpaced by unanticipated

costs.

Tip

Budgeting is particularly important for small-business owners, who often operate on a

shoestring budget. Being even a little bit off on cost projections or earnings can have a

devastating effect on a small operation.

To ensure budgeting is done accurately, it may be worthwhile to hire an in-house or outside

accountant, or a business manager who has expertise in business finance. This individual can

help establish an accounting system, track expenditures and produce reports that help business

owners make calculated and informed decisions about business operations.

How to Create a Break Even Analysis

For a new business, the information found in the break-even analysis can be the most important

aspects of the business’s operations. This is the point in the business where all the business

expenses and costs are paid and all revenue becomes profit. Though the initial figures will be

forecasted, the break-even analysis can be quickly updated when you have actual figures.

1. Define your company’s net sales. Use the net sales totals from your completed income

statement. Configure your net sales amount, if you do not have the income statement, by

subtracting the total amount of returns and allowances from the company’s gross sales. The

total is your net sales amount.

2. Define your company’s variable expenses. Include expenses such as inventory, sales

commissions, shipping costs, delivery expenses and packaging costs, generally determined by

adding your company’s costs of goods sold to the total amount of selling expenses.

3. Determine the business’s margin by subtracting the total variable expense from the total

amount of net sales. Determine the total margin percentage per dollar by dividing the total

margin by the total amount of net sales. This will show you the percent of each dollar that goes

towards revenue.

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4. Total your company’s fixed expenses. Include items such as insurance costs, rent and utilities

in your fixed expenses. Divide the total fixed expenses amount by the margin percentage to

obtain your company’s break-even point.

5. Use a simple formula to calculate your company’s break-even point: Fixed Expenses / Margin

= Break-Even Point.

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Costing methods and techniques Small businesses that manufacture products are required to account for all of the costs of

production. One of these costs, overhead, is the cost of production that cannot be individually

traced to products. For small-business owners, overhead costs can represent a large portion of

total product costs. Understanding some of the major methods for calculating and assigning

overhead costs to products can help you choose the right method for your company.

Job-order Costing

Small businesses that manufacture more than a few models of goods usually use job-order

costing. This costing method assigns overhead costs to products based upon a predetermined

overhead rate. Company management calculates this rate at the beginning of the year by

dividing the total estimated overhead costs for the year by an allocation base chosen by the

company. An allocation base is a measure of activity that is expected to change in relation to

overhead. For example, a company that makes a product that is labor-intensive would expect to

incur more overhead costs as labor costs rise. In this case, management may choose to use

direct labor cost as the allocation base, because direct labor cost considers the cost of the

employee who's operating the machinery.

Process Costing

Companies that make one homogenous product, such as orange juice or gasoline, tend to use

process costing to assign overhead costs to products. Under this system, overhead costs are

assigned to products based upon processing departments. For example, a juice company might

have four processing departments: sorting, washing, juicing and packaging. In each department,

the company would estimate the total overhead expected for the year in that department and

then divide this amount by an allocation base suitable for that department. If sorting was done

by machine, we would expect an allocation base such as machine hours to be used for sorting.

However, if packaging is done by hand, we would expect a labor-based measure in the

packaging department. This method allows for the most suitable allocation base to be used

during each part of the manufacturing process.

Activity-based Costing

While activity-based costing, or ABC, is not suitable for external reporting, small-business

owners may find that accounting for overhead under an activity-based approach can provide

better information for making production decisions. Under activity-based costing, managers first

determine the activities that go into producing a product. For example, a trophy manufacturer

might have product design, batch setup, production, packaging and customer support activities.

For each activity, the company estimates the amount of overhead related to the activity and

assigns these costs to products based upon what drives the activity.

In our trophy manufacturer, we can imagine that a certain type of trophy would only incur

product design costs once, but each batch of these trophies will incur a batch setup charge and

each individual trophy will need to be packaged. Activity-based costing systems provide small-

business owners flexibility in being able to apply overhead costs to products at a granular level.

Variable Costing

Variable costing techniques, which are not appropriate for external financial reporting, allow

managers to remove the effects of changing production levels on net income to make better

decisions about the profitability of their company. Under job-order costing and process costing,

all overhead costs are included as costs of production. However, changing production levels can 27

distort the amount assigned to each individual item produced. For example, if a company were

to produce one widget in a month and the company's rent was $1,000, the widget would be

assigned $1,000 of rent expense as a cost of production. However, if the company produced

1,000 widgets in that month, each widget would only be assigned $1 of expense. In both cases,

the rent expense is the same, but the product cost is wildly different. Variable costing does not

assign these fixed overhead costs to products and does not have the same cost distortion.

How to Implement a Standard Cost System

Standard costing is an accounting technique that breaks overspending and underspending on

materials, labor and overhead cost into their price and quantity components. For example, a

manager may notice that the company spent too much on materials last month. By

implementing a standard costing system, the manager will be able to determine how much of

the overage is related to the cost of the materials and how much is related to overuse.

Understanding the first step of standard costing, implementation, can help you design a

standard costing system for your small business.

Practical or Ideal Standards

The first step in implementing a standard costing system is to determine the type of standards

that you would like to use in your company. Ideal standards are standards that can only be

attained if absolutely everything goes according to plan. These standards don't account for any

machine problems, work interruptions or employees who aren't working at 100 percent effort.

Some small-business owners believe these difficult standards motivate employees to work at

their best all of the time. However, other managers see this type of standard as a disincentive

and may wish to use more practical standards. These standards are still difficult to attain but

should be attainable by the average worker. Practical standards allow for employee breaks,

machine downtime and the variable efficiency of employees.

Materials Standards

Even businesses that haven't adopted a complete standard costing system usually have some

sort of materials standard. The materials quantity standard is the amount of a material that

should be used when making one unit of product. Often this is determined by examining the

specification or "build sheet" for the product being made. In a food or beverage company the

same process occurs, but we call the specification sheet the recipe and the materials the

ingredients. The materials price standard is the amount that we should be paying for the

materials. Managers should ensure that this amount includes any discounts or other promotions

that are routinely offered by suppliers. While the price standard for materials can be difficult to

determine for new businesses, companies with an extensive purchasing history can look at

historical records to begin estimating.

Labor Standards

Labor quantity and price standards set the standard time to complete one unit of product and

the standard hourly wage rate. Labor quantity standards in larger companies are determined by

time and motion studies. These studies scientifically determine how to minimize extra motion to

reduce task time. However, most small businesses do not have the resources to commission

these types of studies. Instead, small-business owners will often use the most experienced

employees as a benchmark for task completion time. Labor price standards are usually much

easier to set. The average wage rate for production workers is often an appropriate standard,

because this figure accounts for differing production wages among employees but still will show

a variance if overtime costs are incurred.

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Variable Overhead Standards

Unlike labor and materials standards, variable overhead standards can be somewhat difficult to

conceptualize. Some companies use a predetermined overhead rate to allocate overhead to

products. The best way to imagine these standards is to think about the two ways the allocation

process could go wrong. That is, the allocation rate could be inaccurate, or you could apply the

rate too little or too much. The correct allocation rate is known as the variable overhead price

standard, where the correct application of the rate is called the variable overhead quantity

standard. These standards are usually determined at the beginning of the year when overhead

estimates are made. Because of the difficulty in estimating these amounts, smaller companies

will often use the services of a cost accountant. If this is cost prohibitive, the company may only

use materials and labor standard costing, sidestepping the problem altogether.

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Advantages & Disadvantages of Payback Capital Budgeting Method

As businesses expand and grow, managers must decide which projects warrant further

investment. Budgeting of capital expenditures is a crucial skill that managers need to learn to

avoid wasting money on uneconomical investments. A popular tool that managers use to make

these decisions is the payback model.

Definition

The payback method is defined as the time, usually expressed in years, it takes for the cash

income from a capital investment project to equal the initial cost of the investment. The choice

between two or more projects is to accept the one with the shortest payback time. The

determination of the payback period is a simple calculation of dividing the amount of the

investment by the projected cash inflow per year. A shorter payback period equates to a higher

return on the capital investment. Many companies have a maximum acceptable payback period

and will only consider those projects whose payback period is less than the target number of

years.

Advantages

The payback method is popular with business analysts for several reasons. The first is its

simplicity. Most companies will use a team of employees with varied backgrounds to evaluate

capital projects. Using the payback method and reducing the evaluation to a simple number of

years is an easily understood concept. Identifying projects that provide the fastest return on

investment is particularly important for companies with limited cash that need to recover their

money as quickly as possible. Managers use the payback method to make quick evaluations of

projects with small investment. These small projects do not necessarily involve a group of

employees, and it is not necessary to conduct a rigorous economic analysis.

Disadvantages

The payback method ignores the time value of money. The cash inflows from a project may be

irregular, with most of the return not occurring until well into the future. A project could have an

acceptable rate of return but still not meet the company's required minimum payback period.

The payback model does not consider cash inflows from a project that may occur after the initial

investment has been recovered. Most major capital expenditures have a long life span and

continue to provide income long after the payback period. Since the payback method focuses on

short-term profitability, an attractive project could be overlooked if the payback period is the

only consideration.

Applications

Managers often use the payback method as an initial screening tool when evaluating projects. If

a project passes the payback period test, it gets further detailed and sophisticated analysis with

methods that use the time value of money and the internal rate of return.

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