3.1.2 Budgets in relation to Profit and Productivity

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3.1.2 Budgets in relation to Profit and Productivity

One objective of budgeting is to provide a basis for measuring actual performance. Such is worth doing if action will be taken as a result. In too many an organisation, the production of results compared to budget is viewed as the end of the process. However, if no action would be taken on the basis of management accounts, there is little value in producing them and even less in wasting management time discussing these.

To understand the relevance of budget in relation to both profit and productivity, there are a number of financial terminologies you ought to understand.

Profit and Loss Budgets

For measuring profit and determining if you are able to meet your profit-related objectives, the profit and loss budget merits discussion. This type of budget is used to define and forecast the income and expenses of your business for an upcoming time period, often the upcoming financial year. It helps you set targets and provides you with an operational platform.

To create your profit and loss budget, you must align it with your strategic and operational plans. Moreover, it is advised that you use past profit and loss statements, figures, and pertinent financial information in ensuring feasibility and accuracy in your budgeting. Once your budget has been finalised and approved, you must continuously monitor its usage throughout the set time period. If you have made a budget for the financial year, check monthly figures and results. 

It is essential that you observe the profit-related variances that would emerge. Variances refer to the differences or changes that would occur in your figures through time. Some key variances you must note include:

  • Revenue Variances

Observe your total revenue and the individual figures that relate to it. Check if some of these line items generate more revenue than others and determine if the revenue you’ve generated is more or less than what you had projected.

With this, try to figure out what reasons would cause such a result. Could it be emerging trends? Is there a need for you to take action? Contextualise this and determine what can be done to make more profit.

  • Cost of Goods Sold Variances

These variances would include labour, material and other project costs that fall under the ‘direct resources’ discussed in Chapter 2.2. Like your revenue variances, you ought to check if your figures are more or less than what you had projected. 

If your expenses were higher than expected, what can be done to lower expenses? If they were lower, what initiatives or factors did you take that led to this?

  • Gross Profit Variances

Gross profit refers to what you have earned for your work. Check if you made more or less than you projected and try to understand the factors that led up this result. Much like revenue variances, your figures could indicate emerging trends that you need to consider. If so, you must act accordingly and adjust your forecasts.

If you earned less than expected, determine the reasons for this and find actionable ways of correcting or preventing what could have gone wrong. If you earned more, try to determine what led to this and bank on these factors to continuously increase your growth. Moreover, don’t forget to celebrate with your team. You deserve it!

  • Expense Variances

Finally, expenses concern the costs you have had to allocate for general operations, administration, marketing, research and development, and the like. Should you find that you have variances in this category, it is important to determine the nature of this expense. Was it a one-time expense or is it something you should expect and plan for in the future? Is it worth the investment, and should you continue to invest in it?

Calculating Productivity 

Productivity measures the efficiency of a person, machine or organisation in producing useful outputs (i.e. goods and services). Along with profit, this is the principal goal of most any organisation. Moreover, the achievement of such is used to determine the progress of an operational plan. For you to fully assess the relative success of your plan in relation to achieving profit, productivity and set targets, it is essential to employ an integrative approach that involves technical and financial perspectives.

Productivity is usually measured using the following formula:

Productivity = Quantity produced / Amount of resources used

To simplify this even further, you may notice that there are two sides to the productivity equation – the amount of production and the amount of resources used. Productivity varies in the amount produced relative to the amount of resources used. The productivity of each resource can and should be measured. 

To determine levels of productivity, you can use measures such as the following:

  • Capital – the number of products produced divided by the asset value 
  • Materials – the number of products produced divided by dollars spent on materials 
  • Direct labour – the number of products produced divided by direct labour-hours 
  • Overheads – the number of products produced divided by dollars spent on overheads 

Such measures are not perfect. For example, the measure of materials productivity includes price. This is generally not desirable, but there is no other practical way to combine the many different units of measurement for the diverse materials used in production. Although such measures of productivity have their shortcomings, they do provide a starting point for tracking productivity so that managers are aware of productivity trends. 

In the past, when labour cost was the predominant cost of production, productivity was only measured by the output per hour of direct labour. Today, however, there is a need to look beyond merely direct labour costs and develop a multi-factor perspective. Our view of productivity must be towards improving the productivity of all the factors of production – labour, capital, materials and overhead. 

The trouble with measuring productivity through output direct labour hours only is that the productivity of one factor can easily be increased by replacing it with another factor. For example, if a factory that previously bought castings and machined them in-house decides to purchase the castings pre-machined, then the company can lay off skilled workers and sell the machine tools. What happens to productivity? The output will remain the same, but the number of workers will fall so that labour productivity will increase. Capital productivity will also increase because the investment will be less, and production levels will be unchanged. Still, materials productivity will decline because the value of purchased materials will increase while productivity levels will not change. By merely looking at one aspect of the productivity equation, therefore, you are getting a false view of the overall productivity of a business. In order to fully understand the productivity of the firm in relation to its resource use, you must combine several productivity measures. 

In order to establish whether or not your current production process is operating at its most efficient for your business, you need to develop review systems against which you can compare your current performance. Any variances between your ‘ideal’ results and your ‘actual’ results should be carefully examined to determine the reason. 

Earlier in the development process, you examined the need to develop measurable objectives. It is at the review stage where these measures become increasingly important. These objectives can be used as a form of ‘ideal result’; that is a result which is closest to a situation which would be the best you could hope for given the current resources being used. You may also find it useful to obtain historical data on productivity within your firm; this may assist in making the objectives you are striving for more realistic. Although it is impossible to get data from your competitors to use as a means of analysis, you may be able to obtain industry-wide figures from the trade association which covers your industry. In essence, these may be useful in establishing how well you compare to similar companies. 

You then use the formula mentioned earlier to determine the actual productivity of your firm. You may decide to sample productivity at various stages of the production process, and over a number of different days to get a broader view of current productivity rather than just a snapshot of the situation at one particular point. Look at conducting regular reviews of productivity. You may decide to conduct such an analysis once a month, or even more frequently. The key to remember is that you are gathering actual data on the productivity of your firm. The final stage involves comparing the actual results with your desired results and then evaluating how well you are meeting the current objectives of your organisation in terms of productivity. You ought to determine the variance using a percentage difference of where you want the organisation to be on each productivity measure. The higher the percentage figure obtained, the worse the variance is. There are two types of variance figure you can obtain, namely positive variances and negative variances. 

Continually reviewing the production processes is vital as it means that you can ensure the productivity levels that you desire are firstly achieved. Once you have achieved the desired levels, you must then ensure that they are maintained by regularly reviewing the production processes. 

Further Reading

You will find sample budget templates and actual financial information on the simulated business website of Bounce Fitness under the Documents tab.