W&WP September 2002

The Budget - a Plan You Can Work

By Tom Dossenbach

How many times have you heard this: "Plan your work and work your plan?" This is such simple but profound advice that I want to discuss the subject this month.

Every woodworking company and each supervisor and manager therein needs to develop a plan from time to time to be effective. I have mentioned in this column many times the need for planning that results in a vision and mission for a company and then for follow-up action to put these plans to work. Planning is not an easy task. The process itself consists of analyzing a situation, identifying possible solutions and making decisions based on sound judgment. A plan's real value is demonstrated once it is enacted and the necessary changes take place to generate the end result.

The Budget Process

One of the most effective planning tools in a company is the operating budget. A budget is simply the financial expression of the coming year's plans and the desired outcome.

A budget actually results from making a corporate plan. Too often the problem is that many smaller companies do not have a plan nor a budget for that matter. On these pages I will present five basics of budgeting - not accounting - that can become powerful management tools for you and your company.

1. Commitment

The first essential element in generating a meaningful budget is a commitment by top management - including the chief financial officer - to lead in the preparation of the budget with the widespread involvement of employees throughout the company. Management must obtain a commitment by the majority of employees that they will participate in the preparation of a budget and will then strive to see that the budget is met.

2. Involvement

The second essential element in the budget process is involvement. As stated earlier, budgeting is the financial expression of a company's plans for the coming year. Everyone that has an impact on the implementation of the plan must be involved in making it. For example, the plant manager of a turning plant must be involved in setting the staffing budget for the direct and indirect labor in that plant. Without his or her input, the figures will be flawed or even useless. Simply stated, everyone responsible for implementing and controlling a budget must have some say in its development.

This principle applies to supervisors and department managers as well. The materials manager or purchasing agent has to be involved. After all, approximately 40% of a product's cost is going to flow through this department. Obviously, the sales manager and even the salespeople out in the field need to provide input regarding the sales goals that the company's management has set. Before the process is over, even the janitor will know his part in controlling expenses for his area of responsibility.

Total involvement throughout the company will generate a leaner budget than one that concentrates on just a few areas. Leaner budgets have little fat and by their nature will result in greater profits by year's end.

3. Analysis

Now that we have agreed to get everyone involved in the budgeting process, analysis is the next step in our quest to generate a budget. Hopefully, the company has periodic (monthly) financial statements. These statements should be broken down into logical categories. Then the managers and supervisors responsible for these areas can begin analyzing prior performance to help generate a leaner budget for next year. (A simple illustration of a partial operating statement with budget columns can be found below.)

The accounts listed in the chart are obviously incomplete and for illustration only. They also must be expanded to cover all expense accounts in order to become a complete income (or operating) statement. A complete statement will give the information necessary for meaningful operational analysis and budgeting. Each company's CEO and CFO must decide how much detail he or she wants to include.

4. Generate Budget

The fourth step is to actually generate a budget based on the analysis that was made of the company's goals for the coming year and the analysis of past performance (the operating statements from previous periods). Assume that Ajax Millwork has decided to increase sales by 20% next year. At the same time, the company's president wants cost of goods sold to be reduced by 7%.

Phil, the plant manager, and Mary, the panel department supervisor, look at the indirect labor in the panel department. They determine that the department can operate at a 20% increase in production to support the growth in sales with fewer materials handlers. This could reduce the indirect labor cost to help meet or exceed the company goals.

Phil and Mary then document the new figure they expect to spend on indirect labor in the panel department and forward that figure to the CFO to be included in the budget for 2003.

This process will be repeated in every expense category in each department in order to generate a budget to meet the company goals.

The most important line item in the budget is the "bottom line" profit figure. However, the plant manager may be more interested in Gross Profit generated by his factory while the Net Operating Income will be the ultimate indicator of the company's success. As stated earlier, it is essential that the entire company work together to create and meet the budget goals. The degree to which this is accomplished will be a measure of success for the budget period.

5. Make Changes

It is easy for Phil and Mary to put numbers on a piece of paper, but the budget process doesn't stop here. Making the actual numbers match the budget numbers (or goals) is another matter altogether. This is where a fifth step is needed in the budgeting process - change. Making the necessary changes to meet the budget goals is essential for success. Last month, we discussed resistance to change and the four types of change. The changes that need to be made to meet a budget fall in the proactive category. (See August 2002 Wood & Wood Products.)

Mary has got to decide which indirect labor position to eliminate. Phil has to decide whether to move this person to a direct labor position somewhere in the company, to another indirect labor position or to lay off that person. Since he has responsibility for the entire manufacturing budget, he is in a good position to make the right decision. The critical point is that he will do it now (proactive) and not six months later when it is obvious he is over budget (reactive).

Putting It to Use

I stated earlier that the budget can be an effective management tool. However, if left in a file cabinet in the CFO's office, it is all but meaningless.

The budget should define operating ratios that can be placed on the monthly income statements as a good measure of success during the year. A good example is to express the direct labor budget as a percent of net sales. Then, if sales are above or below the budget, a quick glance at the labor percentage will give an indication of performance.

For example, assume that Ajax budgets $12 million in sales for the year and a direct labor cost of 12% of sales. In this case the direct labor budget would be $1,440,000 for the year. (See the chart below and note that sales equals production since Ajax builds only to order.)

If the sales (production) for the month of August was $950,000 and direct labor payroll was $144,000, the direct labor would be 15.2% of sales (production), which is higher than the budget. If Ajax had not developed its budget, it would not know to what extent it was meeting the company goals in this area. Wisely, the financial statement of Ajax shows the performance for year-to-date. Last year's performance can also be included.

A glance at the direct labor line reveals that Ajax is $95,000 over budget for the first eight months of the year. Also note that 25% of that occurred last month (August). Thus, an immediate investigation and further analysis is called for to identify the reason for this excessive labor. Left ignored, it could reduce the bottom line profit number by $120,000 by year's end.

Again, I remind the reader that this has not been an exercise in accounting but rather one in utilizing a powerful management tool - the budget. Every company needs to use the budgeting process to drive performance and to monitor progress during the year. The shorter the time it takes to get feedback from the operating statements, the more time there is to make corrections. Many times a company doesn't know its operating effectiveness until it is history because they do not get timely income statements. Instead they generate one on a quarterly basis or every six months and that is too late.

There are many ways to plan but one of the most effective is the budgeting process. Make sure your company - even if your sales are but $250,000 per year - uses this management tool so you and your company have a financial plan to work. Start building your 2003 budget now.

  Current Period % of Net Sales Year to Date % of Net Sales
Account Description Aug. 2002 Budget Variance Actual Budget Actual Budget Variance Actual Budget
Net Sales 950 1000.0 -50.0   100.0% 8150.0 8000.0 150.0   100.0%
Materials 330.0 350.0 -20.0 34.7% 35.0% 2780.0 2800 -20.0 34.1% 35.0%
Direct Labor 144.0 120.0 24.0 15.2% 12.0% 1055.0 960 95.0 12.9% 12.0%
Indirect Labor 33.0 30.0 3.0 3.5% 3.0% 255.0 240 15.0 3.1% 3.0%
Operating Dept Expenses 20.0 20.0 0.0 2.1% 2.0% 146.0 160 -14.0 1.8% 2.0%
Production Administration 77.0 80.0 -3.0 8.1% 8.0% 642.0 640 2.0 7.9% 8.0%
Quality Assurance 10.0 10.0 0.0 1.1% 1.0% 78.0 80 -2.0 1.0% 1.0%
Continuous Improvement 14.8 15.0 -0.2 1.6% 1.5% 119.0 120 -1.0 1.5% 1.5%

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