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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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