A budgeting approach that leads to action.

Most organizations use budgeting to plan, monitor, and evaluate their operations. Developing realistic budgets and comparing the budget plan to the actual results consumes a significant amount of time and resources. By casting budgets in terms of traditional absorption costing and analyzing deviations from static budgeted amounts, many organizations fail to realize the full potential benefit of this process. This article examines the budgeting process at a Kentucky distillery to illustrate how economic realities such as changes in sales volume, cost, and price provide much more managerial information if they are analyzed formally in terms of deviations from budgets prepared in terms of throughput income.

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In the Sept. 2, 2003 issue of the Wall Street Journal, author Kimberly Palmer states that "Like country boys squeezed uncomfortably into tuxedos, bourbon makers have long felt like wallflowers beside glitzy vodkas and scotches that dominate the domestic spirits market. But now, at least in Europe and Japan, bourbon is coming into its own."

Bourbon makers, of course, have reason to shift their focus overseas. Sales in the United States fell about 38 percent during the last two decades. During the same period, however, sales in Japan, France, Australia, Spain and Italy more than doubled. Impact Databank Research reported that the United States made up 91 percent of the overall bourbon sales in 1985 but only 64 percent in 2001. In addition, there are signs of a demographic shift among bourbon drinkers. In bourbon tastings across the country, 30 to 40 percent are now women compared to 15 percent five years ago. (1)

From a budgeting standpoint, such events and their impact on corporate profits are usually handled from an intuitive standpoint. The purpose of this article is to argue that economic realities such as changes in sales volume, cost initiatives and price provide much more managerial information if they are analyzed formally in terms of deviations from budget. This article examines this contention by examining the budgetary process at a Kentucky distillery.

The Company

Old Bloomfield Distiller, located in scenic central Kentucky, manufactures a six-year-old 90 proof bourbon under the distillery name. In addition to the bourbon, Old Bloomfield produces an 80 proof gin and a similar vodka. The production and administrative facilities are contained in one location in Bloomfield, Kentucky. The existing reporting system provided a traditional absorption costing income statement (Example 1) where overhead was applied to production based on material consumption. Although direct labor was traced directly to the product lines, management was cognizant that the tracing was highly inaccurate due to the shifting of workers among the three products and the use of common facilities. The products were marketed through wholesale distributors via a sales force that works solely on a 5 percent commission basis. The remaining selling and administrative costs were allocated to the product lines based on sales dollars. Old Bloomfield's inventories do not vary significantly from year to year. (2)

The problem with Example 1 is that it is difficult to formally evaluate deviations from budget in terms of volume, price and cost control because no attempt is usually made to prepare flexible budgets in the aggregate. As a result, deviations from static budgets developed at the beginning of the year are usually visceral or intuitive. By reformulating the income statement, however, in terms of cost behavior, the deviations from budget can be explained in terms of volume, price and cost.

Example 2 illustrates a reformulation under the arguable assumption that the only variable costs within the company are materials and commissions. Some companies may have other variable costs such as distribution. You can test for variability in the workplace by performing regression analysis on the questionable cost as it relates to production or sales. When we have performed regression analysis in recent years, the standard error of costs other than materials and commission was usually so great that it was obvious that it was a step fixed cost. In essence, the relative amount of truly variable cost in today's environment is eroding and has been replaced by step fixed costs. A plant manager, for example, recently told the authors that production could be increased by about 20 percent in his and most plants without substantially increasing costs other than material.

Example 2 reformulates the existing income statement by classifying costs into variable and fixed. We believe that this provides a more accurate estimate of product contribution margin than traditional approaches, which treat a myriad of costs as being variable and numerically emphasizes that future success is highly correlated with revenue growth.

After the contribution margin is identified, we would segregate the remainder of the costs into direct and indirect fixed costs. Direct fixed costs can be traced to the cost objects and identified with the objects. In our example, Old Bloomfield does no generic advertising but advertises the three product lines independently. These discretionary fixed costs can be identified with the product line and after they are subtracted will provide the organization a numerical rationale for determining whether a particular product line should be dropped or retained.

Comparison of Budgeted vs. Actual Costs

Example 3 shows the actual operating results of Old Bloomfield. Management, of course, is nonplussed with a loss exceeding $2 million for the period when budgeted results showed a profit of almost $7 million. The answer to management's concerns can be provided with a three-pronged approach--volume, price and cost control--which lend themselves to corrective action and which employs the budgeted results as the starting point of analysis.

Sales Volume Variance

Born in the backwoods, bourbon has lost some of its appeal in recent years because of its bite and because gin and vodka are chic. The sale volume variance captures the magnitude of the profitability problems stemming from volume using our static budget as the point of departure. The sales volume variance = (Actual Gallons Sold - Budgeted Gallons Sold) Budgeted Contribution Margin from Table 2.

Bourbon                      (28,000 - 30,000)2.275 = $4,550 Unfavorable
Gin                          (17,000 - 15,000)1.737 = 3,473 Favorable
Vodka                        (16,000 - 15,000)1.497 = 1,497 Favorable
Total Sales Volume Variance                           $420 Favorable

Many businesses erroneously refer to the bourbon sales volume variance as a mix problem. Mix, however, assumes perfect substitutability of product lines and this is a specious analysis. Bourbon has a volume problem that has negatively impacted budgeted profitability by over $4 million.

While the problem has been offset by gin and vodka, the viability of the line must be questioned if we employ the static budget as the point of departure.

The formal calculation of sales volume variances is normally an eye opener for corporate management and invites initiative such as Maker's Mark bill-boards, which depicted a bottle on its side with the caption "Disappears Faster than a Big Five Accounting Firm." We strongly believe that volume is the most important determinant of corporate potential and the recent emphasis on sales price ratios by financial analysts buttresses our position. Because most companies do not formally calculate a sales volume variance, a changing world is often minimized.

For example, overall domestic bourbon sales have dropped more than 50 percent in the last 25 years with per capita consumption decreasing by about 60 percent. The days when Thomas Jefferson referred to bourbon as "ardent spirits" and a visitor to the state of Kentucky defined breakfast as "three cocktails and a chaw of terbacker" have long gone! (3) Sales volume variances are prescient predictions of such changes.

The market share of P & G's Pampers, for example, has recently increased at the expense of Huggies. As the Wall Street Journal pointed out in its Sept. 5, 2003 issue, Kimberly Clark reacted by attempting to sneak in a 5 percent price increase by cutting the number of diapers in each pack of its Huggies. Similarly, sales volume concerns prompted Procter & Gamble to drop the "oil" from Oil of Olay in an attempt to make its $500 million product line more appealing to younger women.

Those in the bourbon industry who have thrived have engaged in similar innovation, such as upscale Maker's Mark with a hand dipped red seal on each bottle. Other innovative approaches to volume have been small batch and single-barrel bourbon that possess a more refined taste. (4) If the world is changing, the calculation of a sales volume variance will hasten the recognition of emerging trends.

Sales Price Variance 

Sales Volume Variances are often accompanied by selling price variances as management attempts to combat volume problems with decreases in selling price. The selling price variance is calculated as follows:

(Actual Price - Budgeted Price) Actual Quantity Sold

Bourbon                       (3.25-3.50) 28,000 = $7,000 Unfavorable
Gin                           (2.60-2.60) 15,000 = -0-
Vodka                         (2.50-2.40) 16,000 = 1,600 Favorable
Total Selling Price Variance                      $5,400 Unfavorable

In a recent survey, executives listed an inability to increase selling price as the primary problem that confronts them. A major paper company recently told the authors that it was operating at 50 percent of capacity. No matter what your political views, it is evident that free trade has provided alternatives that have held prices down.

The budgetary process advocated here mandates that management refute the Pollyanna pricing approach embodied in budgets since they will ultimately be held accountable when the selling price variance is calculated. Bourbon is an apt illustration of that Pollyanna approach but it is pervasive.

Calculations of formal selling price variances also provide a methodology to test an emerging dictum in business. Competitors will respond to significant changes in a firm's pricing strategy. A metal-cutting company, for example, attempted to combat volume problems by making substantial price cuts on certain standard products. While the company was inundated with orders initially, the competitors eventually lowered their prices as well and the whole industry wound up worse than before. (5) The calculation of formal selling price variances forces management to confront issues such as these.

Variable Cost Variance

The variable cost variances are defined as: (Actual Cost - Budgeted Cost) Actual Gallons sold. The material costs for bourbon were unfavorable due to a drought that struck Kentucky and increased grain costs during production for bourbon.

Bourbon            (1.10 - 1.05) 28,000 = $1,400 Unfavorable
Gin                 (.73 - .73) 17,000 = -0-
Vodka               (.78 - .78) 16,000 = -0-
Material Variance                       $1,400 Unfavorable

Since the salesmen were remunerated at the rate of 5 percent for each dollar of sales, the selling price decrease for bourbon generated a favorable commission variance for bourbon and unfavorable variance for vodka, which experienced a price increase.

Bourbon              (.1625 - .175) 28,000 = $350 Favorable
Gin                  (.13 - .13) 17,000 = -0-
Vodka                (.125 - .12) 16,000 = 80 Unfavorable
Commission Variance                        $270 Favorable

Fixed Cost Variances

The fixed cost variances are merely the difference between the actual fixed costs and the budgeted fixed costs incurred.

Direct Fixed Costs -- Advertising

         (Actual - Budget)

Bourbon  (3,200 - 3,000) = $200 Unfavorable
Gin      (1,600 - 1,500) = 100 Unfavorable
Vodka    (1,500 - 1,400) = 100 Unfavorable
                           $400 Unfavorable

A consultant was hired to examine the label for bourbon, which had been criticized, while additional advertising had been incurred for the other two product lines. In regard to the indirect fixed costs, a new software system had been installed in the plant with consulting expenses far surpassing budget.

Indirect Fixed Costs

                               (Actual - Budget)

Marketing                       (9,000 - 8,950) = $50 Unfavorable
Administrative                 (12,500 - 12,450) = 50 Unfavorable
Production                     (85,000 - 82,750) = 2,250 Unfavorable
Indirect fixed cost variances                     $2,350 Unfavorable

We are proponents of worker empowerment and best practices in dealing with cost control and reductions. We are particularly enamored with the Toyota approach at Georgetown, Kentucky to worker empowerment since it incorporates a formal empowerment program with substantial incentives. The two problems that we have encountered with worker empowerment are that there is either no formal program or that the incentives are limited to a $100 gift certificate or something nominal of that nature. At Toyota, a day shift suggestion goes to the employee's supervisor, the supervisor's immediate report, and the corresponding shift leader on the night shift. The employee idea is either rejected or accepted with no further review. Constant review of employee ideas and/or the lack of a formal empowerment program negate the benefits of empowerment programs.

In addition, nominal rewards for suggestions lead to worker apathy also. At Toyota, employee ideas and perfect attendance generate the inclusion of one's name in a drawing for a substantial number of Camrys at the company's annual picnic. Once an employee idea has been accepted, the name is never removed from the pool. During our annual sojourn to Toyota, one employee had his name "in the hat" nine times and his excitement was palpable.

At Toyota, we also experienced best practices being operationalized. Confronted with sitting next to male production types or a distinguished attendee, one of the authors selected the latter. He quickly discovered that she was employed by one of the major American auto manufacturers and spent the majority of her time traversing the United States attempting to glean best practice ideas from competitors.

Conclusion

The culmination of the analysis appears as follows:

Budgeted Operating Income  $6,700
Actual Operating Income    <2,160>
Difference                 $8,860

Explained by:

Sales Volume Variance           $420 Favorable
Selling Price Variance         5,400 Unfavorable
Variable Cost Variance         1,130 Unfavorable
Direct Fixed Cost Variance       400 Unfavorable
Indirect Fixed Cost Variance   2,350 Unfavorable
  Total Variances             $8,860

The above analysis can be augmented by a product line analysis, which explains the difference between the budgeted segment margin and the actual segment margin.

                               Bourbon   Gin       Vodka     Total

Sales Volume Variance          $4,550 U  $3,473 F  $1,497 F    $420 F
Selling Price Variance          7,000 U         0   1,600 F   5,400 U
Variable Cost Variance          1,050 U         0      80 U   1,130 U
Direct Fixed Cost                 200 U     100 U     100 U     400 U
Difference in Segment Margin  $12,800 U  $3,373 F  $2,917 F  $6,510 U

Most of the companies we have dealt with do not calculate appropriate sales volume, selling price and cost control variances when analyzing deviations from the original budget because traditional budgets do not lend themselves to this analysis. By reformulating the budgets in the suggested manner, deviations from the budget can be determined quantitatively to provide more concerted management action than the obfuscating, intuitive responses that characterize many organizations.

(1) Kimberly Palmer, "Rustic Bourbon: A Hit Overseas, Ho-Hum in U.S.," The Wall Street Journal, Sept. 2, 2003, p. B-1.

(2) Steve Demmy and John Talbott, "Improve Internal Reporting with ABC and TOC," Management Accounting, Nov. 1998, pp. 18-20.

(3) R. W. Apple Jr. "Bourbons in the Cognac League," The New York Times March 15, 1998, p. B1.

(4) Apple, p. B10.

(5) Eric Noreen, Debra Smith, and James T. Mackey, "The Theory of Constraints and Its Implications for Management Accounting," The North River Press, 1995, PO Box 567, Great Barrington, Mass., p. 17.

J. Gregory Bushong, Ph.D., CPA, CMA is associate professor of accountancy, University of North Carolina-Asheville.

Susan S. Lightle, Ph.D., CPA is professor of accountancy, Wright State University.

John C. Talbott, DBA, CMA is professor of accountancy, Wright State University.

By J. Gregory Bushong, Ph.D., CPA, CMA, Susan S. Lightle, Ph.D., CPA, John C. Talbott, DBA, CMA

EXAMPLE 1: Old Bloomfield Budgeted Income Statement Under Traditional
Absorption Costing (in Thousands)

                  Bourbon       Gin          Vodka        Total

Sales             $105,000      $39,000      $36,000      $180,000
Materials          $31,500      $11,000      $11,750       $54,250
Labor               11,000        3,600        3,050        17,650
Production Ovhd     37,800       13,200       14,100        65,100
Cost of Sales      $80,300      $27,800      $28,900      $137,000
Gross Margin       $24,700 24%  $11,200 29%   $7,100 20%   $43,000
Advertising          3,000       $1,500       $1,400        $5,900
Commissions          5,250        1,950        1,800         9,000
Marketing-Other      5,221        1,939        1,790         8,950
Administrative       7,263        2,697        2,490        12,450
Total Expenses     $20,734       $8,086       $7,480       $36,300
Operating Income    $3,966       $3,114        ($380)       $6,700
Total Gallons       30,000       15,000       15,000

EXAMPLE 2: Old Bloomfield Budgeted Income Statement (Revised) (in
Thousands)

                       Bourbon        Gin          Vodka        Total

Sales                  $105,000       $39,000      $36,000      $180,000
Materials               $31,500       $11,000      $11,750       $54,250
Commissions               5,250         1,950        1,800         9,000
Throughput              $68,250 65%   $26,050 67%  $22,450 62%  $116,750
Advertising-Direct        3,000         1,500        1,400         5,900
Segment Margin          $65,250       $24,550      $21,050      $110,850
Indirect Fixed Costs:
Marketing-Other                                                   $8,950
Administrative                                                    12,450
Production Ovhd                                                   82,750
Operating Income                                                  $6,700
Total Gallons            30,000        15,000       15,000
Contribution/Gallon          $2.27         $1.74        $1.50
Variable Cost/               $1.23         $0.86        $0.90
Gallon (Mtl. &
Commissions)
Selling Price                $3.50         $2.60        $2.40

EXAMPLE 3: Old Bloomfield Actual

                        Bourbon      Gin          Vodka        Total

Sales                   $91,000      $44,200      $40,000      $175,200
Materials               $30,800      $12,467      $12,533       $55,800
Commissions               4,550        2,210        2,000         8,760
Throughput              $55,650 61%  $29,523 67%  $25,467 64%  $110,640
Advertising-Direct        3,200        1,600        1,500         6,300
Segment Margin          $52,450      $27,923      $23,967      $104,340
Indirect Fixed Costs:
Marketing-Other                                                  $9,000
Administrative                                                   12,500
Production Ovhd                                                  85,000
Operating Income                                                <$2,160>
  (loss)
Total Gallons            28,000       17,000       16,000
Contribution/Gallon          $1.99        $1.74        $1.59
Variable Cost/Gallon         $1.26        $0.86        $0.91
Selling Price                $3.25        $2.60        $2.50