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Turning budgets into business: how to use an Excel-based budget to analyze company performance.

Budgeting. We can spend hours carefully crafting an adaptable Excel-based budget, but if we can't use that budget to answer actual questions about our products and our business, the whole thing is worthless. A budget is only as useful as the information we get out of it, so if we don't have the tools to convert budget data into useful information about our policies and operating choices, we might want to spend our time on something that matters more (like improving our golf game). And it isn't enough for just accountants to get something out of a budget. We have to create a budget that provides useful information for all of the decision makers in our company if we really want to make a difference.

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In a previous series of articles, we walked step-by-step through the creation of an Excel-based Master Budget (see Strategic Finance, February-July 2010). At the end of the process, we talked about two basic ways to use that budget to provide value to a company: creating pro forma financial statements and performing cost-volume-profit (CVP) analysis. In this series of three articles, we expand our discussion of how to use an Excel-based budget for making managerial decisions and investigating variances.

In this first article, we'll walk you through how to add a Contribution Margin Income Statement to your existing Master Budget. Using the fixed- and variable-cost information provided by this Income Statement, we'll calculate the breakeven point and margin of safety and discuss how these two important numbers can be used in decision making. In the second and third articles, we'll discuss key steps in a comprehensive variance analysis, comparing our budgeted revenues and expenses to actual results.

Let's get started.

Creating a Contribution Margin Income Statement

A Contribution Margin Income Statement is very different from a U.S. Generally Accepted Accounting Principles (GAAP)-style Income Statement. First, the expenses are broken down into variable and fixed costs because those classifications typically are more useful for internal decision-making techniques than the classifications used in a normal Income Statement. Second, instead of calculating a gross margin, we subtract variable costs from revenues to calculate a contribution margin. We can use the contribution margin to make managerial decisions quickly since it shows how much additional money each sale contributes toward increasing profit. Third, we add more details that may be useful for making business decisions. For example, we may choose to provide specifics on quantity and type of production inputs and per-unit costs, as well as total expenses. For Bob's Bicycles, our example company, we've chosen to create a detailed Contribution Margin Income Statement that will provide the information necessary to perform both an overall breakeven analysis and a detailed variance analysis (see Figure 1). This detailed statement is sometimes referred to as a "flex budget," a useful summary budget that you can easily adjust to show the estimated costs for any particular level of sales.

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To begin adding a Contribution Margin Income Statement to our Master Budget, we need to create a new tab in Excel. Since the purpose of this Income Statement is different from the budgets already created, We want to keep it separate from our earlier work (if you don't have a copy of the Bob's Bicycles Master Budget spreadsheet yet, you can receive one by e-mailing either author). As we get started, keep in mind that a Contribution Margin Income Statement doesn't follow U.S. GAAP, so the result won't match up with the Pro Forma Income Statement we've already created (see Figure 2 and the June 2010 article). But when we've finished the Contribution Margin Income Statement, we can reconcile the two net incomes to ensure the accuracy of our work.

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After we've created the new tab, we first need to calculate net sales, so we start the statement with each type of unit we sell (in our Bob's Bicycles example, those are the basic and deluxe bicycles) and how many of each unit we plan to sell during the year. These quantities are the ones we'll "flex" to see how variable costs and contribution margin change for various sales levels or assumptions we make. Next, we list the budgeted sales price per unit and calculate the overall sales revenue as the number sold times the price per unit. The total number of units Bob's budgeted to sell and the price per unit can be found in the Data Input Sheet (Figure 1, February 2010). In our example, we don't have any sales returns or discounts, so net sales is simply total sales revenue. At this point, the total revenue shown in column D of Bob's Contribution Margin Income Statement (Figure 1 in this article) should match total revenue in the Sales Budget (Figure 4, February 2010).

The next step in creating a Contribution Margin Income Statement is subtracting the variable costs. In a manufacturing firm such as Bob's Bicycles, variable costs include direct materials, direct labor, variable manufacturing overhead, and the variable portion of selling and administrative expenses. Since we're creating a detailed Contribution Margin Income Statement, we list the per-unit costs separately for each type of bicycle Bob's manufactures. As with sales, the second column is calculated as the per-unit cost times the budgeted number of units sold.

The per-unit direct materials and direct labor costs are already available in the Ending Inventory Budget (Figure 3, April 2010). Per-unit manufacturing overhead requires a little more work. The per-unit overhead on the Ending Inventory Budget uses Bob's predetermined overhead rate (POHR), which includes both variable and fixed overhead costs. While the POHR is appropriate for setting sales price and calculating U.S. GAAP net income, we only want to include the variable portion of manufacturing overhead in this part of the Contribution Margin Income Statement. To get only the variable overhead allocated to each type of bike, we take the variable overhead rate, available in the Overhead Budget (Figure 1, April 2010), times the variable cost driver required for each type of bike--direct labor hours for our example. The drivers per unit are available in the Ending Inventory Budget.

Variable selling and administrative costs, the next set of variable costs, are found in the variable section of the Selling and Administrative (S&A) Budget (Figure 4, April 2010). But the allowance for bad debt requires a bit more thought. Basically, we need to multiply net sales on account by the estimate for uncollectible accounts. Both of these estimates can be found on the Data Input Sheet. In our Bob's Bicycles example, we assumed that 70% of net sales would be on account and that 1% of those credit sales would be uncollectible. The product of these three estimates is the Allowance for Bad Debt for each model of bicycle. For example, for every basic bike Bob's sells, approximately $1.05 will be uncollectible ($150 sales price times 70% credit sales times 1% uncollectible). Obviously, this isn't a "per bike" amount; most bikes will be paid in full. But bad debt essentially can be amortized over the budgeted unit bike sales in this manner. Alternatively, you could use the total estimated bad-debt expense reported in the Schedule of Cash Collections (Figure 4, February 2010) as a fixed expense. You also could put income taxes in either variable or fixed costs, depending on how you choose to make your estimates. For the sake of our demonstration, we chose to leave taxes in fixed costs and treat bad-debt expense as a variable cost.

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Once we've gathered the per-unit variable costs and calculated the overall variable costs for each type of bike, we can add up the overall values to get the total spent on direct materials, the total spent on direct labor, and so on. Finally, we add up each type of per-unit cost to get the total variable cost for each unit we make. For example, the total variable cost for basic bicycles is $125.55: $78 in direct materials (DM), $28 in direct labor (DL), $3.50 in manufacturing overhead (OH), $15 in variable S&A, and $1.05 of allocated bad-debt expense. We calculate the overall total variable costs in the same way to determine how much Bob's is spending to sell 16,486 basic bicycles (approximately $2,069,872).

Now that we've budgeted revenues and variable costs, we can calculate the contribution margin--or how much each unit contributes toward increasing net income. To calculate the per-unit contribution margin, we simply subtract the variable costs per unit from sales price per unit. The overall contribution margin is total sales minus total variable costs. Even without any additional calculations, we now have some important information about how our company actually makes its money each period. In the Bob's Bicycles example, we can see that, although the company sells many more basic bicycles, it's now very obvious that the company makes much more profit by selling deluxe bikes.

The final step in creating Bob's Contribution Margin Income Statement is to add in the fixed costs. These costs are the same if Bob's produces 10 units or 10,000. Because they don't change based on production, we don't have to list a per-unit cost. Instead, we simply put the overall cost in our totals column. These costs include fixed salaries, property taxes, depreciation, and other items that don't change based on production, even if they do change each period. Bob's has fixed manufacturing costs of $250,000, fixed S&A costs of $234,300, interest expense of $49,880, and income tax expense of $259,080. The fixed production and S&A costs are in the Master Budget and can be found in the Overhead Budget and Selling and Administrative Budget, respectively. Interest expense and income tax expense are also in the Master Budget, and both can be found on the Pro Forma Income Statement. Now we can calculate the total contribution margin income (loss) by subtracting the total fixed costs from the total contribution margin.

The Contribution Margin Income Statement that we've created goes into a great deal of detail, but you don't have to make this statement so comprehensive. Some companies choose to use only summary numbers (such as total sales from the Pro Forma Income Statement). The type of Contribution Margin Income Statement you choose to create will depend on the questions you want to answer. The detailed version we're creating is most appropriate for companies that want to do a full variance analysis. If all you want to calculate is the breakeven point and margin of safety, then you could use a more condensed version.

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Comparing a Contribution Margin Income Statement to a GAAP-based Pro Forma Income Statement

Regardless of the format you use for your Contribution Margin Income Statement, you'll quickly notice that the contribution margin net income doesn't match the GAAP net income reported on the Pro Forma Income Statement that's part of the traditional Master Budget. Bob's budgeted contribution margin net income is $603,748, but the budgeted Pro Forma Income Statement shows net income of $604,520. This difference, about $772, comes from how fixed costs are treated in the two income statements.

You probably remember that income can be calculated using either "variable" or "absorption" costing. Variable costing is what we do in a Contribution Margin Income Statement when we show all fixed production costs as an expense as they are incurred. Absorption costing, on the other hand, records all production costs as inventory first, then moves them to Cost of Goods Sold (COGS) when units are sold. Absorption costing is the method required by U.S. GAAP. If we produce more units than we sell, some of the fixed costs will still be in inventory at the end of the period under the absorption costing method, but they will all appear in fixed costs in the variable costing method. On the other hand, when we produce less than we sell, COGS will include fixed costs from production in previous periods under absorption costing, and only the current period's costs will be included under variable costing. The only time the variable and absorption net incomes match is when sales are equal to production.

Let's look at a simple example. Suppose that fixed overhead cost per unit, the fixed portion of the POHR, is $3 per unit and that we made 1,000 units and sold 800 of them. In this case, absorption net income would exceed variable or contribution margin income because production exceeded sales. The amount of the difference would be 200 units (the difference between production and sales) times $3 per unit, or $600. In the second year, if we produced 800 units but sold 1,000 units, the difference would still be $600, but this time the absorption net income would be smaller because production was less than sales. Of course, total net income would be the same over the two years since we produced a total of 1,800 units and sold all of them during that same period of time.

This process is demonstrated for Bob's Bicycles in Figure 3. We reconciled the difference between the two net incomes by first taking the difference between production and sales. The number of units produced is available in the Production Budget (Figure 2, February 2010), and the number of units sold is available in the Sales Budget. We then calculated the total fixed cost allocated to each model as the fixed overhead rate (total POHR less the variable overhead rate; both are available in the Overhead Budget) times the direct labor hours required for each type of bicycle, as reported in the Ending Inventory Budget. Finally, we multiplied the difference in units produced and units sold by the total fixed cost allocated to each unit to get the total difference between variable and absorption costs for the two types of bicycles. The sum of the subtotals per bike is the total $772 difference mentioned earlier. If this calculation doesn't work when you do this for your company, then there's a good chance that something was missed or double counted in the Contribution Margin Income Statement.

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Calculating Breakeven Point and Margin of Safety

Now that we have a Pro Forma Contribution Margin Income Statement, we can use the numbers to calculate some useful information about our business. Two of the most useful calculations are the breakeven point and margin of safety. Breakeven and margin of safety are both part of a cost-volume-profit analysis, which means that we have to make some basic assumptions in order to perform and interpret our calculations. The primary assumption we must make is that the sales mix ratio is constant over time. We must also assume that all costs can be portrayed accurately as fixed or variable (mixed costs are split into fixed and variable portions). Finally, we must assume that we're staying within the "relevant range" (the range of production where total fixed costs and variable costs per unit remain constant) and that the time value of money isn't material.

To calculate the breakeven point, we first need to calculate the weighted average contribution margin, which is the contribution margin for each type of unit we sell times that unit's percentage of total unit sales. In our example, Bob's Bicycles plans to sell a total of 16,486 basic bicycles and 8,620 deluxe bicycles, or about 25,107 units. Based on these numbers, basic bicycles make up about 66% of Bob's sales, and deluxe bikes make up the other 34%. To get the weighted average contribution margin, we multiply the 66% times the basic bike's $24.45 contribution margin and the 34% times the deluxe bike's $115.30. The sum of these two products (without rounding) gives Bob's a weighted average contribution margin of $55.65.

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Once you have the weighted average contribution margin, the breakeven point is an easy calculation: simply divide total fixed costs ($793,260 for Bob's) by the weighted average contribution margin. In our example, Bob's has a total breakeven point of 14,255 (see Figure 4). The actual result is 14,254.45, but since we can't sell 0.45 units of a bike, we have to round the breakeven point up to the nearest unit to ensure that Bob's will break even. If we set Excel to round to the nearest whole unit, it would round down in this case, and Bob's would be slightly below breakeven. Since we want to round up, we chose to use Excel's ROUNDUP function: = ROUNDUP("total fixed costs"/"average contribution margin",0). Of course, we actually linked in the fixedcost amount and weighted average contribution margin cell references rather than using words. The zero at the end indicates that we want zero numbers after the decimal; that is, we want a whole number. Linking the cells ensures that our calculations will automatically update each period when we update our assumptions and that future calculations will use the real numbers instead of rounded amounts. We've shown the formulas for Bob's Bicycles in Figure 5. If you look closely, you'll see that we also use the ROUND function for the weighted average contribution margin since we're really looking to display to the nearest penny, the ROUNDUP for the breakeven point in units as we discussed, and the ROUNDDOWN function for the margin of safety in order to be conservative.

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The breakeven point is a good summary number for managers to have in their heads. But keep in mind that, for most companies, the basic assumption when calculating the breakeven point is that the current sales mix won't change. If it does, you need to calculate a new breakeven point. Of course, that's one of the benefits of having the calculation in a spreadsheet. Just type in the new sales assumptions, and the new value is automatically calculated for you, even in the middle of a meeting!

With the breakeven point calculated, the final calculation is the margin of safety. To get the margin of safety, we first take the total breakeven point of 14,255 units times the weighted average percentage for each unit. Based on this calculation, Bob's needs to sell 9,361 basic bicycles and 4,895 deluxe bicycles each period in order to break even. The margin of safety is the difference between budgeted sales and the breakeven point. Bob's Bicycles has 7,125 basic bicycles and 3,725 deluxe bicycles as its margin of safety. Figures 4 and 5 show these results and the Excel formulas we used to calculate them. Remember that the margin of safety includes both types of bicycles with a constant sales mix. Another way to look at it would be that the margin of safety is 10,850 bikes at Bob's budgeted sales mix. If that sales mix varies significantly from the budget, then you have to reevaluate your breakeven point. For example, if Bob's sold no basic bicycles, then instead of needing to sell 4,895 deluxe bikes to break even, they would need to sell 6,880 instead.

Both of these calculations provide numbers that management can use to track company progress, especially over time. Though the breakeven point provides information about the bare minimum we need to cover fixed costs, the margin of safety, as mentioned previously, gives us a feel for not only how well we're doing but also how many units we're selling each period that provide actual profit. We would like to see a steady drop in the breakeven point as we control costs, but that isn't always possible, especially in a period of inflation. Yet we should see a definite increase in the margin of safety over time as we improve sales and grow the business. Dips in the margin of safety provide important signals that we need to dig into the sales prices, competition, and sales force incentives to see what isn't working properly. The margin of safety can also provide information about the effectiveness of the current sales mix. For example, the deluxe bikes provide a higher contribution margin, yet with Bob's current sales mix they are only about a third of the company's margin of safety on a per-unit basis. It might be wise to increase advertising or promotions to increase the sales of those bicycles. Dropping the price a little to better compete in the marketplace might also be a wise move since the deluxe bike has such a large contribution margin compared to the basic model.

Benchmarking Analysis

Now that we have the basic foundation through our creation of a Contribution Margin Income Statement, we're ready to really dig into our performance. Future installments of this series will include a discussion of creating a Flexible Budget in the Contribution Margin format, gathering actual performance numbers, calculating profit and contribution margin variances, and calculating cost variances. We'll automate the results as we go so when we type in the budgeted values and actual results for each year, Excel will automatically perform the calculations for us. If we set this up carefully enough, the resulting tables will provide sufficient detail and clarity that we can easily hand them to other managers for use in company decision making.

Developing and using an Excel-based budget can be a challenge, but once you've created the basic format, you can use it for many years with only minor modifications. Once you have the basics of your budget working well, you can extend that budget to automatically make additional calculations about your performance. By using your budget to provide real-time feedback, you can help other managers see the value of your work and help them improve their processes and generate more profit for the company. This is where budgeting stops being an exercise and starts being an integrated part of business! In our next installment, we'll discuss the first, and perhaps most important, set of variances: the sales variances. Until then, happy budgeting!

By Jason Porter and Teresa Stephenson, CMA

Jason Porter, Ph.D., is assistant professor of accounting at the University of Idaho and is a member of IMA's Washington Tri-ities Chapter. You can reach him at (208) 885-7153 or jporter@uidaho.edu.

Teresa Stephenson, CMA, Ph.D., is associate professor of accounting at the University of Wyoming and is a member of IMA's Denver-Centennial Chapter. You can reach her at (307) 766-3836 or teresas@uwyo.edu.

Note: A copy of the example spreadsheet, including all the formulas, is available from either author. IMA members can access all previous articles in the first series via the IMA website at www.imanet.org after logging in.
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Title Annotation:Part 1 of 3
Author:Porter, Jason; Stephenson, Teresa
Publication:Strategic Finance
Geographic Code:1USA
Date:Jul 1, 2011
Words:3786
Previous Article:5 Barriers to BI success and how to overcome them.
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