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COST OF SALES AND
Costs involve marketing, bad debt, professional services, rent, maintenance, tele- phone, and utilities. During budgeting, companies usually want to lower their costs, but they are not sure of how to accomplish this feat. It is vital for organizations to understand where their expenses are being generated, or they can get out of control in a hurry.
CUSTOMER NEEDS
The customer in this case refers to the managers and the executives. In terms of cost of sales, for consistency, you should budget in a way comparable to revenue. Thus, if revenue is budgeted by product and region, then it would be beneficial to budget similarly for cost of sales. Profitability by product is typically a very useful report for managers and executives; therefore, you should budget cost of sales by product, at the minimum.
Most companies want the managers to budget and forecast each expense line item on the profit and loss statement, whether at a summarized or an account level.
An example of a summarized account would be travel and entertainment; an exam- ple at the account level would be air travel, lodging, and car travel. Beyond this, it is important to enable the managers to view extra detail for certain line items. This is typically called line-item detail. For example, spending $10,000 on air travel does not tell you a lot about the future budget; but, if you list each air expense, all of which total $10,000, then it may be more beneficial during and after the budget process.
If, then, for example, an executive tells you to lower the air travel expense by 10 per- cent, you will have some detail to support the need to budget $10,000 and, possibly, to refute the decrease.
Not all accounts need line-item detail. The following are those for which com- panies typically use line-item detail:
• Advertising
• Professional services
• Travel and entertainment
• Industry-specific accounts
DIMENSIONS AND CHART OF ACCOUNT CONSIDERATIONS
In terms of dimensions, cost of sales is very similar to revenue. If you budget revenue by product and customer, then typically you will budget cost of sales the same way.
After all, what good is budgeting revenue at this level if you can’t determine what the profit margin will be by customer or product? In terms of expenses, you can use line-item detail to budget below an account number; therefore, expenses usually do not need an additional dimension. Typically, your cost of sales start with digit 5 and your expenses start with digit 6.
TOP-DOWN OR BOTTOM-UP APPROACH
You may take either a top-down or bottom-up approach to cost of sales budgeting.
In the top-down approach, executives may set a certain percentage by which to calculate the cost of sales per product. If this format is used, then it is best to use a his- torical percentage and adjust that percentage based on the strategic plan of the com- pany. If a bottom-up approach is used, then the managers would need to determine the costs per product, but this will only work if the managers understand how to de- termine the total costs of sales per product.
In a manufacturing company, the bottom-up approach is best since there will be many more costs associated with the production of each product; in a service com- pany, however, it may be more beneficial to use a top-down approach. For expenses, a hybrid approach is best. Many expenses have consistent amounts, such as rent and utilities, so these accounts can be determined or allocated from the finance depart- ment prior to a manager or employee entering expenses. This will cut down on the number of accounts to be budgeted and ensure that there is consistency for these ac- counts across all departments in the budget. All other expenses should be entered by the manager in a bottom-up approach; that said, there should also be some direction from the top, such as to cut expenses by 10 percent or to ensure that expenses are not more than 30 percent of revenue.
DRIVERS
Not only is it imperative to know what the cost of sales drivers are, but it is also im- portant to comprehend how the drivers can affect your organization, since a small change in a cost driver can have a major or minor consequence on the business. By knowing and understanding your cost drivers, you will be able to enhance your or- ganizational performance, because you will be able to find the opportunity to improve certain cost drivers after evaluating each of them. For example, though you may have the staff to do the payroll, you may find that it is cheaper and more efficient to out- source the job. You would not be able to make this determination without knowledge of the payroll process and the costs involved.
Typically, costs are broken into three categories: necessary production, processes, and common price levels. Necessary production entails the cost of goods sold. Costs increase as more products are sold, services are performed, or as pro- duction becomes more complex. For a manufacturing business, costs will be driven by inventory, employees to fill the orders, and the cost of order processing. In other words, costs are driven by revenue.
Processes, the next class of cost, describe how the work gets completed. Two of the main drivers of processes are automationandoutsourcing. These will enable the company to have more fixed, as opposed to variable, costs relative to volume of the products sold. The two main costs of automation are maintenance on the system being used and amortization; but labor costs would be more substantial without automation. The other driver in processes depends on whether you manufacture
in-house or outsource production. Your company will have greater control of costs if it manufactures its own product, but control may come at a substantial cost to the or- ganization. In the former decision, labor would typically be the most expensive cost, whereas this cost typically would decrease if you decide to outsource the manufac- turing process. Also, your organization will be able to lower the amount of capital investment if it outsources production.
The third category of driver is the price of raw materials. This is the one category that is beyond managers’ control because they cannot always control the cost of raw materials, rent, or new equipment. Consequently, it is imperative to have a handle on the other cost drivers within the organization.
ASSUMPTIONS
The costs of sales and expense assumptions will be based on how you will enable the users to budget this data. Some companies will simply calculate the cost of sales based on the volume entered by each product; therefore, the users will have less data to enter, which reduces human error. The company can make an assumption on the percentage of costs of sales per unit sold. Another option is based on how revenue is calculated. If revenue is calculated on volume, then the users can enter a dollar amount per unit purchased for each line item. For example, you can enter $1 a unit for direct employee costs and $1.25 for raw materials. Then the system should be able to calculate the total cost of sales by account.
Normally, expenses will not be based on revenue. Many of the expenses at your organization will not change dramatically, even if revenue does. Expenses, such as marketing and travel, will change based on the company’s strategy for the coming year. Your company may want to spend more to promote and advertise its product, or spend additional money on travel for its salespeople. These assumptions should be determined priorto the budget process and be communicated to the managers.
SPECIAL CONSIDERATIONS
Companies naturally want to cut costs, but there are a few things to consider before attempting to do this. Let’s say, for example, that an executive communicates that the travel costs be cut by 5 percent for all salespeople, but he or she does not give any indication as to how to achieve this. It is unrealistic to assume that you can cut 5 per- cent of travel costs without a decrease in revenue. In reality, the only way to cut costs is to find more efficient ways to complete tasks or to find the products that your com- pany needs at a cheaper price.
Managers need to understand certain cost relationships when budgeting for ex- penses. If, for example, your company wants to cut consulting services by 10 per- cent in the coming year, but will still have consultants working on a project during that time frame, possibly the only way to lower costs is to hire and train an employee to do the work. But keep in mind that the new hire will then add to the employee costs. In the end, then, though the consulting fees were reduced, the overall costs were not cut by 10 percent.
USERS
Normally, though companies budget many line items, it is beneficial to the users to keep the number of cells they have to enter to a minimum. If the users have to enter 12 months of data for more than 50 expense accounts, the time it takes to budget will be considerable. Instead, because many expense accounts are consistent over time, you can offer an allocation chart that lists the percentage of expenses per month. For example, an even allocation would be 100/12, which would equal 8.5 percent; there- fore, each month would receive 8.5 percent of the annual expense for that account.
This way, the users would only have to enter a total dollar amount and an allocation method, thereby cutting down approximately 500 entries on 50 accounts.
BEST PRACTICES
Cost of sales should be completed in a manner similar to revenue. In general, it will be beneficial for your company, from a reporting and analysis standpoint, to budget costs of sales by product or service, not by customer. Your costs of sales should not change by customer. For example, the costs of sales for a product should be the same whether your company is building this product for company A or company B. From budgeting revenue, you will already have the volume of sales; you should then use this same volume to determine the cost of sales. All of the costs associated with gen- erating the product or service, such as raw materials and labor, should be calculated from the volume (see Exhibit 12.1).
The expenses can be overwhelming if you expect users to enter data for all ac- count numbers. Thus, this is not a best practice. Instead, we recommend that you bud- get only the most pertinent accounts. That said, it is not realistic to assume that all companies can do this; therefore, the best practice is to have the corporate finance department predetermine the budget amount for as many line items as possible. This can be accomplished through an allocation calculation or by some calculation from the previous year’s data. Otherwise, you will have many users intimidated by a bud- get form with more than 100 items to budget for, after finishing budgeting for rev- enue and employees. Try to limit the amount of information that the users have to enter on the forms. Add allocation scales (even seasonal or user-defined) that will en- able the users to enter an annual amount (see Exhibit 12.2).
Finally, ask questions of the senior managers. If they tell you that you must lower expenses or cost of sales by 5 percent, but you see a future trend indicating these factors will be rising, ask how you are supposed to accomplish this. Ask if they have a plan to get new suppliers, or if they are signing long-term contracts to lower the costs. You are ultimately responsible, so you have to voice your concerns.
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COST OF SALES—SAMPLE BUSINESS UNIT 001 Currency: USD JanFebMarAprMayJunJulAugSepOctNovDec Product 1 Volume50,00050,00050,00052,50052,50052,50053,00053,00053,00053,00053,00053,000 Raw Material Cost1.101.261.221.111.071.321.321.411.361.631.661.57 Total Raw Material55,00063,00061,00058,27556,17569,30069,96074,73072,08086,39087,98083,210 Labor Cost1.061.071.051.051.051.081.081.091.101.101.121.10 Total Labor53,00053,50052,50055,12555,12556,70057,24057,77058,30058,30059,36058,300 Product 2 Volume18,50018,50018,50018,50018,50018,50019,25519,25519,25519,25519,25519,255 Raw Material Cost5.035.645.465.435.336.335.966.346.187.127.276.91 Total Raw Material93,055104,340101,010100,45598,605117,105114,760122,077118,996137,096139,984133,052 Labor Cost2.252.252.252.252.252.252.332.332.332.342.342.34 Total Labor41,62541,62541,62541,62541,62541,62544,86444,68444,86445,05745,05745,057
117 Product 3 Volume35,00035,00035,00035,50035,50035,50035,50035,50035,50036,00036,00036,000 Raw Material Cost0.6340.7180.6910.6730.6600.7930.8000.8520.8310.9440.9640.916 Total Raw Material22,17525,14524,20023,89023,41828,14328,41330,23529,49333,97534,71832,963 Labor Cost0.350.350.350.350.350.350.350.350.350.350.350.35 Total Labor12,25012,25012,25012,42512,42512,42512,42512,42512,42512,60012,60012,600 Total Raw Material170,230192,485186,210182,620178,198214,548213,132227,042220,568257,461262,681249,225 Total Labor106,875107,375106,375109,175109,175110,750114,529115,059115,589115,957117,017115,957 Total Cost of Sales277,105299,860292,585291,795287,373325,298327,661342,101336,158373,417379,698365,181 EXHIBIT 12.1Cost of Sales Example
Expense Line-Item Detail Acct#Account DescriptionAllocationTotalJanFebMarAprMayJunJulAugSepOctNovDec 6400Water UtilityE12,5001,0421,0421,0421,0421,0421,0421,0421,0421,0421,0421,0421,042 6400Power in Building 1E22,0001,8331,8331,8331,8331,8331,8331,8331,8331,8331,8331,8331,833 6400Power in WarehouseE10,500875875875875875875875875875875875875 6400 Total Expenses 64003,7503,7503,7503,7503,7503,7503,7503,7503,7503,7503,7503,750 118
EXPENSES—SAMPLE BUSINESS UNIT 001 Currency: USD AllocationsJanFebMarAprMayJunJulAugSepOctNovDec EvenE8.3%8.3%8.3%8.3%8.3%8.3%8.3%8.3%8.3%8.3%8.3%8.3% SeasonalS17.5%5.0%5.0%5.0%5.0%5.0%5.0%5.0%15.0%17.5%17.5%7.5% SeasonalS25.0%5.0%5.0%7.5%12.5%15.0%15.0%15.0%7.5%5.0%5.0%2.5% User-DefUD5.0%6.5%6.5%7.5%8.5%10.0%11.5%11.5%11.5%9.0%7.5%5.0% Acct#Account DescriptionAllocationTotalJanFebMarAprMayJunJulAugSepOctNovDec 6000Expense 6000E45,0003,7503,7503,7503,7503,7503,7503,7503,7503,7503,7503,7503,750 6100Expense 6100S135,0002,6251,7501,7501,7501,7501,7501,7501,7505,2506,1256,1252,625 6200Expense 6200S255,7502,7882,7882,7884,1816,9698,3638,3638,3634,1812,7882,7881,394 6300Expense 6300UD12,7506388298299561,0841,2751,4661,4661,4661,148956638 Total Allocation Expenses9,8009,1169,11610,63813,55315,13815,32915,32914,64813,81013,6198,406 EXHIBIT 12.2Expense Example
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