S5. K- V ;s D'^E on the last f SOUTHERN BRANCH, I'NIVERSITY OF CALIFORNIA, LIBRARY, ILOS ANGELES, CALIF. Budgetary Control By JAMES O. McKINSEY, A.M., LL.B. Certified Public Accountant; Member of the firm of Frazer & Torbet; Assistant Professor of Accounting, University of Chicago Second Printing 488H5 NEW YORK THE RONALD PRESS COMPANY 1923 Copyright, 1922, by The Ronald Press Company All Rights Reserved H Y PREFACE Although much has been written of budgetary control as appHed to particular phases of a business, this is the first attempt, so far as the author is aware, to present the sub- ject as a whole, and cover the entire budgetary program. It is to be regarded as an effort to state clearly the problems involved, rather than to offer full solutions. It is hoped that the discussion will stimulate thought, and constructive criticism will be gladly received. One obvious difficulty has been the problem of what to include and what to omit. The budgetary procedure in- jr . volves administrative policies on the one hand, and admin- ^ istrative routine on the other. The discussion might easily cover the whole field of business administration, ranging over a wide variety of topics about which no one individual can be expected to have expert knowledge. In the present work, however, the reader is addressed throughout, not as a technical expert, but rather as a student of the broad prob- ^^ lem of administration. The advertising man, for example, ^ may be aided in handling his own problems through under- r standing the method of applying budgetary control to the "^ operations of all other departments of the business, as ex- plained in the other chapters of the book. So with the other departmental executives ; it is hoped that each of them will be helped by a comprehensive picture of the problem as a whole. The discussion has been kept sufficiently elemen- tary, it is believed, to be easily understandable by those who are not experts on the technical subjects discussed. With this thought in mind, there has been no effort to prescribe an arbitrary procedure. In some cases, assump- tions have been made and definite procedures discussed, but iii iv PREFACE only for the purpose of making the treatment concrete ; the definite procedures given are intended to be suggestive only. Similarly, the various forms given are merely indicative. All of them have been used by the author at some time in his professional practice, but he by no means regards them as standard forms. He has found it necessary to design forms to meet each particular case. Finally, no attempt has been made to discuss in detail the many problems which may arise in the installation and operation of budgetary control. To do so would be to make the volume less useful to those for whom it is primarily in- tended. It is thought that the reader who has a compre- hensive picture of the entire problem will be able to make his o\\Ti applications and to work out the special adjust- ments required for his own situation. The text is based primarily on the rather wide experience of the author in professional work, but material assistance has been received from various business men, accountants, and instructors. Particular acknowledgment is due to the following: Mr. W. V. Lindblom, executi\^e in charge of the budgetary procedure of the Walworth Manufacturing Com- pany, and Mr. Albert S. Keister, Lecturer on Business Finance, University of Chicago, who have read all the manuscript and given many useful suggestions; Mr. N. L. McCully, executive in charge of the budgetary procedure of the Lewis Manufacturing Company, who prepared the chart on budgetary procedure given in Chapter XXIII ; and Mr. George E. Frazer, C.P.A., the author's partner, to whose counsel and assistance the author is especially in- debted. . James O. McKinsey Chicago, Illinois, June 20, 1922 CONTENTS Chapter Page I The Meaning of Budgetary Control 3 II The Need for Budgetary Control 12 III Preliminary Steps in Installation 28 IV Organization for Budgetary Control 43 V The Sales Budget 54 VI The Sales Budget (Continued) 71 VII The Selling Expense Budget 87 VIII The Advertising Budget 106 IX The Production Budget 124 X The Materials Budget 145 XI The Labor Budget 165 XII The Welfare Expense Budget 178 XIII The Manufacturing Expense Budget 188 XIV The Purchases Budget 210 XV The Purchases Budget (Continued) 228 XVI The Plant and Equipment Budget 245 XVII The Plant and Equipment Budget (Continued) . . . 261 XVIII The Expense Budgets 273 XIX The Financial Budget 295 XX The Financial Budget (Continued) 316 XXI The Estimated Balance Sheet 333 XXII The Estimated Statement of Profit and Loss . . . 359 XXIII Manual of Budgetary Procedure 374 XXIV Administrative Reports 396 XXV Advantages and Limitations of Budgetary Control 416 XXVI Budgetary Control for Non-Commercial Enter- prises 425 Appendix A — The Budget and Accounting Act 439 B — Administrative Code for the State of Ohio. . 450 C — A Trust Company Budget System 456 V ILLUSTRATIONS Figure Page 1. Chart Showing Corporate Form of Organization 21 2. Form Showing Factory Requirements for Use in Preparing Sales Estimate 73 3. SelHng Expense Budget 103 4. Report on Selling Expense Budget 103 5. Advertising Appropriation Report 117 6. Advertising Appropriation Report (monthly cumulative) 121 7. Advertising Expenditures Report 122 8. Monthly Finished Stock Budget Report 141 9. Balance of Stores Sheet 153 10. Materials Budget 161 11. Periodic Materials Budget Report 161 12. Labor Budget 175 13. Monthly Labor Budget Report 175 14. Welfare Expense Budget 185 15. Monthly Welfare Expense Report 185 16. Manufacturing Expense Budget 205 17. Monthly Manufacturing Expense Report 205 18. Schedule of Deliveries to Stock 221 19. Monthly Report on Purchases Budget 225 20. Estimate of Purchases Disbursements 231 21. Showing Merchandise Plan of Each Department of a Department Store 239 22. Plant Ledger 254 23. Plant and Equipment Budget 263 24. Monthly Report on Appropriations for Plant and Equipment. . . 269 25. Organization Chart for a Manufacturing Business 275 26. Another Form of Organization for a Manufacturing Business . . . 277 27. Expense Budget 292 28. Monthly Expense Appropriation Report 293 29. Graph Showing Accumulated Sales and Collecions 304 30. Estimate of Cash Receipts 308 31. Simple Estimate of Cash Disbursements 311 32. More Elaborate Estimate of Cash Disbursements 313 33. Summary of Financial Requirements 317 34. Financial Program for Bank Loans 318 35. Monthly Collections Report 321 36. Monthly Cash Receipts Report 322 37. Monthly Cash Disbursements Report 323 38. Balance Sheet 339 39. Comparative Balance Sheet, with Preliminary Estimate 351 40. Comparative Statement of Profit and Loss, with Preliminary Esti- mate 363 41. Comparison of Actual and Estimated Balance Sheets 369 42. Comparison of Actual and Estimated Statements of Profit and Loss 371 43. Chart of Budget Procedure (opposite) 394 44. Monthly Sales Report 402 vii viii ILLUSTRATIONS 45. Monthly Selling Expense Report 403 46. Monthly Net Profits Report 405 47. Monthly Stock Report 407 48. Monthly Comparative Summary 408-40^ 49. Monthly Summary of Operations 412 50. Monthly Group Pound Cost 413 51. Monthly Factory Inventories Report 414 52. Departmental Salary Budget of a University 434-435 A Trust Company Budget System (Appendix C) Monthly Summary of Expenses 459 Monthly Expenses of Securing Business 460 Monthly Expenses of Transacting Business — Main Office . . . 461-462 Yearly Summary of Expenses 463 Request for Appropriation 464 Yearly Appropriation Sheet 465 Budgetary Control CHAPTER I THE MEANING OF BUDGETARY CONTROL Planning of Business Operations That comprehensive planning is necessary for efficient administration may be regarded as an axiom of the present- day philosophy of business administration. Business executives have come to realize that they can perform properly the tasks of today only if they have already planned those tasks yesterday, and planned also the tasks of tomorrow. There are many who do not yet plan scientifically, but there are few who will deny the merits of the system. The planning which may be done in connection with any particular business may be classified into three broad over- lapping groups : 1. That which deals with the operations of the separate depart- ments, such as production, sales, and finance. Such planning has been described loosely in the past, as "industrial engineer- ing." 2. That which deals with the coordination of the operations of the several departments to the end that a well-formulated program may be made, for the business as a whole. Such planning may well be termed "budgetary control." 3. That which deals with the determination of future conditions as reflected in the business cycle and the shaping of the plans of the business to meet these conditions. Such planning is known as "forecasting" or "business predicting." While the discussion in the following pages is restricted primarily to a consideration of planning of the second kind, it must be realized of course that these various kinds of plans are all very closely related and must be coordinated if 3 ^/: 4 BUDGETARY CONTROL proper results are to be obtained. The budgetary plans are vitally affected by the business cycle, and the departmental plans are equally affected by the budgetary plan. The reader "will notice that in the following pages it will be neces- sary to discuss to some extent all three kinds of planning. Popular Conception of Budgetary Control In the past, budgetary control has been considered pri- marily in connection with governmental units. There has been much discussion of the "budgets" of cities and states, and during recent years much interest has been manifested in the budget of the national government. This interest has been greatly increased by the passage of the National Budget Act and the submission to Congress of the first budget prepared under this act. The budgets of govern- mental units are discussed frequently in the daily press and by aspirants for political office, and are thus called constantly to the attention of the public. As a consequence many people have come to think of budgetary control as an instru- ment for governmental administration. Not only is this the popular view but practically all the literature on budgetary control is confined to a discussion of governmental budgets. Although practically all people who have given thought to the subject will admit that there should be budgetary control of public finances, very few have thought of budg- etary control with reference to the individual business unit. It is thepurpose of these chapters to showthat theprinciples of budgetary control are as applicable to the individual business unit as to the governmental unit, and to explain the method by which these principles may be applied. As a first step it is necessary to see (i) what budgetary control is, and (2) why it is needed in business administration. The present chapter and the chapter immediately following will be devoted to a consideration of these topics. THE MEANING OF BUDGETARY CONTROL 5 Procedure for Budgetary Control 'fo^bablythe be&fe-way^o show ' ' what budgetary control Js.lMa to outline how it operates. The procedure to be fol- lowed by a business firm in the installation and operation of budgetary control will of necessity vary, depending pri- marily on the organization of the business and the nature of its operations. Apossible procedure, stated briefly and in ■-outline form, is as follows:- "^V ^ - i f- "s^ Each department prepares an estimate of its activi- ties for the budget period. The method of stating these activities depends on the nature of the operations of the de- partment, the sales department stating the sales it expects to make and the estimated expenses it will incur in making these sales ; the production department stating the estimated production for the period and the estimated requirements in materials, labor, and manufacturing expenses to meet this estimate; the service departments, such as the personnel department, the traffic department, the accounting depart- ment, and the office manager's department, stating the esti- mated expenditures of their departments. Because of the interdependence of these departments, some will need to use the estimates of other departments in making their own estimates. For instance, the production department must know the estimated sales before it can estimate the produc- tion necessary to meet the sales demands; the treasurer must know the plans of all the departments before he can estimate his cash receipts and cash disbursements. Con- sequently a procedure must be set up which provides for a proper scheduling of the estimates with reference to prepa- ration and distribution. % The departmental heads will transmit the depart- mental estimates to an executive who has supervision of the budgetary procedure. Sometimes the controller acts in this capacity, while in many cases the duty is delegated to a 6 BUDGETARY CONTROL member of the staff of the general manager or president. SirLC€-«ra:ny businesses do not have a controllery itrwill be assumed -during the present discussion that an assistant to- the president acts in this capacity. This official combines the estimates of all the departments into a proposed finan- cial budget for the business. In preparing this estimate he will be assisted by the treasurer, though in some cases this budget is prepared by the treasurer alone. The proposed financial budget should show the estimated receipts from all sources and the estimated expenditures by all depart- ments of the business. 5. The executive in charge of the budget procedure makes a comparison between the estimated receipts and the estimated expenditures as shown by the proposed budget. If the estimated expenditures exceed the estimated receipts, one of the following courses of action must be taken : (a) The departmental expenditures may be reduced. In making such reductions a problem arises due to the fact that the reduction of expenditures may result in a reduction of receipts. For instance, if the expenditures of the adver- tising department are reduced, this may result in a reduction of sales, with a consequent reduction of receipts from col- lections. In the same manner, a reduction of the expendi- tures of the production department may result in a reduc- tion of production, with a consequent lack of goods to meet sales demands which will result in a reduction of receipts from sales. Care must be taken, therefore, in the reduc- tion of expenditures to see that receipts are not reduced more than proportionately. (b) Additional receipts may be secured. It may be possible by speeding up operations and securing more effi- cient administration to secure additional receipts without incurring a proportionate increase of expenditures. (c) Additional capital may be secured. If it is not THE MEANING OF BUDGETARY CONTROL 7 deemed wise to reduce expenditures, plans must be made to secure additional capital with which to finance the excess of expenditures over receipts. It is understood, of course, that this condition cannot continue for long, otherwise the business will find it necessary to liquidate. The executive in charge of the budgetary procedure may make recommendations with reference to possible pro- cedures, but he is usually not invested with authority to determine the plans to be followed. 24^ The executive in charge of the budgetary procedure prepares from the departmental estimates an estimated balance sheet and an estimated statement of profit and loss, showing respectively the anticipated financial condi- tion at the end of the budget period and the anticipated result of the operations of the period. 5, The departmental estimates, together with the pro- posed financial budget, and the estimated financial state- ments, are submitted by the executive in charge of the budg- etary procedure to a budget committee, composed of the principal executives of the company and presided over by the president. This committee considers the proposed esti- mates and makes such revisions as it thinks necessary. In case the proposed budgets involve important changes in the company's policy, or require the securing of additional capital for a material amount, it may be necessary to submit them to the board of directors for consideration, -fedeed, in some businesses all budgetary plans are submitted to the board of directors for approval. After the proposed esti- mates have been approved, they constitute the working program for the budget period. The budgets as adopted set limits upon the expenditures of all the departments, and these limits cannot be exceeded without the permission of the budget committee. The budgets also set up standards of performance for certain departments. For instance, the 8 BUDGETARY CONTROL sales budget states the sales that are to be made by the sales department, and the production budget states the estimated production of the production department. -6. Each department makes plans which will enable it to carry out its program as outlined by its budget. For in- stance, the advertising department makes contracts for advertising space; the sales department sets quotas for its salesmen; the production department sets up schedules of production. 7^ Records are established so that the performance of each department may be properly recorded and comparisons made between the estimated and the actual performance. Periodic reports, showing a comparison between the estimat- ed and the actual performance of each department for the budget period, are made to the executive in charge of the budgetary procedure and are by him transmitted to the budget committee and in some cases to the board of direc- tors. On the basis of these reports the budget committee or board of directors may make such revisions of the budg- etary program as it may deem desirable. Essential Features The foregoing procedure is intended to be suggestive only. Each organization must adopt a procedure which is fitted to its particular needs. The purpose of the foregoing outline is to indicate what budgetary control is by suggest- ing how it operates. From this outline it can be seen that budgetary control involves the following: 1. The statement of the plans of all the departments of the business for a certain period of time in the form of estimates. 2. The coordination of these estimates into a well-balanced pro- gram for the business as a whole. 3. The preparation of reports showing a comparison between the actual and the estimated performance, and the revision of the original plans when these reports show that such a revision is necessary. THE MEANING OF BUDGETARY CONTROL 9 Budgetary Control Not a New Idea All businesses practice budgetary control to a greater or lesser degree although many of them do not realize the fact. The newsboy estimates his probable sales before mak- ing his purchases, and every business man must do like- wise if he is to continue to operate long. Even the farmer, who usually scorns the use of formal methods of control, estimates the probable returns from land used for various kinds of crops and the cost of producing each, and on this basis decides upon the crop which he will plant. During the war the Red Cross, the Y.M.C.A., and Liberty Loan committees used the budgetary idea in their "drives" by setting up quotas for each territory. These quotas were based on estimates of the sales possibilities in these terri- tories. Budgets for governmental units have been in use for many years, and the "family budget" has long been a matter of discussion. Many business firms which deny that they operate a budgetary program will be found to make and use estimates. In this connection the author recalls a visit he made to the merchandise manager of a large wholesale store several years ago. This executive derided the idea of preparing a sales estimate and stated that he did not care to discuss such an academic question. A few minutes later the author inquired if the merchandise manager permitted his buyers to use their own judgment in deciding on the quantity of goods to purchase. He emphatically replied that to permit the buyers to purchase all they desired would bankrupt the firm in six months. In response to the request to explain how the buyers' purchases were controlled, he stated that the executives of the firm first obtained the average sales for the past three years and added to this average the per- centage of increase which they expected during the next year. After they determined in this manner their "ex- 10 BUDGETARY CONTROL pected " sales, they "calculated " the purchases necessary to meet these sales and instructed the buyers accordingly. It took the author some minutes to show the manager that his firm was preparing both a sales estimate and a purchases estimate. Further investigation showed that it was the practice of the treasurer of the company to obtain a copy of the sales estimate and purchase estimate and to use these as a means of making estimates of cash receipts and disburse- ments. In other words, the company had an informal and imperfect system of budgetary control. Similar investigations will show that all other profitable businesses make plans for future operations, and however informal these plans may be, they are in essence budgetary control. Modern Tendency Towards Budgetary Control Modern business administration tends more and more to become a standardized routine. In a large organization such standardization is essential to the maintenance of a uni- fied business policy and to the coordination of the activities of the several departments ; and coordination means subordi- nation to a common head. Business men are gradually coming to realize that this can best be accomplished by the formulation of plans submitted for approval in black and white, if indeed coordination can ever be accomplished in any other way for a great length of time. Not that plans have not always been made, but they have commonly been carried around in someone's head. Because of the increase, however, in the volume of business performed by the typical industrial unit, with the corresponding complexity in busi- ness organization, it is coming to be less and less possible to maintain a business organization that depends upon the intuitive faculties of a single individual developed by years of experience, faculties which perish with the individual. THE MEANING OF BUDGETARY CONTROL II The organization must be independent of any single indi- vidual in it. All of which goes to show that there should be some systematic method of gathering information trom the past and formulating on this basis plans for the future, and of subsequently reporting how these plans have been carried out. Such an accounting and statistical organization we may call a budget system. CHAPTER II THE NEED FOR BUDGETARY CONTROL Why Budgetary Control Is Needed In the preceding chapter it has been explained that budgetary control has long been practiced in an informal way but that only in recent years has it been introduced as a formal and comprehensive procedure. In fact the firms are largely in the minority which have formally adopted budgetary control at the present time. It is the belief of the author that the delay of business firms to adopt budg- etary control as a definite part of their administrative methods is due to one of two causes : Either they do not fully realize its need, or they do not understand how to install and operate it. It is the purpose of the present chapter to explain its need as an instrument of administration, while the remain- ing chapters of this book are devoted to an explanation of its installation and operation. Budgetary control is urgently needed in administrative control for two purposes : 1. As a means of coordinating the activities of the various functional departments. 2. As a basis for centralized executive control. Perhaps its use for these purposes can best be shown by sketching the method by which administrative control is exercised in the modern type of business organization, the problems which arise therefrom, and the need for a compre- hensive method of planning ahead as a basis for solving these problems. Much that is said in the remainder of this chap- ter, though perhaps more or less familiar to the reader, is 12 THE NEED FOR BUDGETARY CONTROL I3 stated here in order to present a comprehensive picture of the problems which give rise to a need of budgetary control. Interdependence of Business Activities It is the author's experience that executives often be- come so engrossed with what they regard as the larger administrative policies of their business, that they fail to give sufficient attention to many of the administrative problems to realize their significance. They are easily im- pressed with the value of a sales campaign which will result in a large increase in the volume of sales, but they may fail to realize the importance of working out methods by which to coordinate the sales campaign with the production pro- gram so that the goods sold will be ready for delivery at the proper time. They are keenly interested in the enlargement of manufacturing facilities and the increase of production, but may fail to realize the significance of maintaining a care- ful check on inventory to avoid the accumulation of unsal- able merchandise. It is worth while for the executive to make a comprehen- sive survey of the whole problem of administrative control from time to time to see that he is not overemphasizing some phases of the problem at the expense of others. If this chapter serves to impress upon the reader the inter- dependence of all the activities of a business, it will have served a useful purpose regardless of his reaction to the argument presented in behalf of the need for budgetary con- trol as a means of coordinating these activities. Functional Activities — Their Coordination The operations of businesses vary widely and the varia- tions in operations produce a divergence in organization, but in every business there are certain functional groups of activi- ties which must be performed. These functions are: 14 BUDGETARY CONTROL 1 . The sales function 2. The production or purchasing function 3. The personnel function 4. The finance function 5. The standard and record function Since these functions are found combined in a single business unit, it is fair to suppose that there must be a close relation- ship between them. A very brief study will show that there is such a close interrelation that it is impossible to perform one of them unless the others are also being properly per- formed. It is true that some businesses emphasize one of these functions and other businesses emphasize another, but in no business can any of these functions be safely neglected. A few illustrations of the interrelationship will make this clear. Balancing Production and Sales Goods are purchased or produced in order to be sold. It is unwise and unprofitable to purchase or produce more goods than can be sold within a reasonable time after their purchase or production. To do so results in tying up capi- tal in a non-income producing investment, for excess inven- tories yield no profit. A second danger arising from this procedure is the deterioration which may take place in the surplus stock due to time or obsolescence. It is obvious, therefore, that wise administration will take into considera- tion sales expectancies in planning purchases or production. The failure to limit purchases and production to correspond with sales possibilities has caused many firms heavy losses during recent years. On the other hand, it is unwise to sell goods in excess of the possibilities of supply. To sell more than can be pur- chased or produced leads to an unnecessary expense both in securing the sale and in handling the inevitable complaints THE NEED FOR BUDGETARY CONTROL 1 5 which arise from failure to fill orders. An additional loss may arise from the ill-will of the disappointed customer. It is better to refuse an order in the beginning than to accept the order and fail to satisfy it. Many firms lost prestige by such actions during the years 191 8 and 191 9. It is necessary, therefore, to consider production or purchasing possibilities in planning the sales campaign. In other words, the sales function and the production or purchasing function are so closely interrelated and interdependent that they must be considered jointly in planning executive policies. Planning for Equipment and Personnel Not only must sales and production be correlated, but this correlation must be planned sufficiently in advance of the time when it is to be effected to make possible the secur- ing of the necessary equipment and personnel to produce the goods required. In a manufacturing business plant and equipment are essential to the production of goods, and in considering increased production the possible increase in plant and equipment requirements resulting therefrom must be taken into account. But the quantity of production is determined by the volume of sales; so in the end the sales campaign determines the plant and equipment program. The relation between these two functions can be easily seen. Loss will result from the sale of more goods than the present equipment cau produce or than it is possible or profitable to purchase equipment to produce. In this connection three questions must be asked: 1. Can the desired amount of goods be produced with the present plant and equipment? 2. If not, can additional plant and equipment be secured in time to produce goods to supply the present demand? 3. If so, can such plant and equipment be secured and operated profitably? I6 BUDGETARY CONTROL It is equally unwise to secure plant and equipment beyond that needed to satisfy the present or the anticipated demands of customers. Consequently the plant and equipment pro- gram is closely related to both the sales and production programs. But equipment cannot be operated without workers and it is necessary to know the production requirements suffi- ciently in advance of the time of their fulfilment to make possible the securing of the necessary amount of personnel. Where skilled labor is employed the securing of the proper personnel is a problem of major importance. Planning of Finances The making of sales, the producing of goods, and the securing of equipment and personnel, all involve sAi expend- iture of funds. All these operations must be financed and they can be carried on only to the extent to which the finan- cial resources of the business will permit. It is unwise indeed for a business to plan a sales campaign with the con- sequent production requirements without considering the financial possibilities of the business. A lack of coordination of the sales and production programs may lead to loss, but a lack of coordination of the various departmental programs of the business with its financial program will lead to bank- ruptcy. Coordination — Special Problems The foregoing illustrations point out the interrelation- ship of the primary functions of the business and show the necessity for their correlation. But in the securing of this correlation many things must be considered. For instance, emphasis has been placed upon the desirability of not pro- ducing beyond sales requirements because of the consequent loss arising from the capital invested and the possible de- THE NEED FOR BUDGETARY CONTROL 1 7 terioration of the goods. There may be other factors, how- ever, which make it desirable to produce beyond sales ca- pacity for a certain period of time. For instance, if the sales fluctuate from period to period, it may not be desirable to have the production fluctuate accordingly. There are sev- eral reasons for this, one of the principal being the problem of maintaining a proper labor supply if wide fluctuations in production take place. If production fluctuates it is neces- sary to discharge laborers whom it may be difficult to replace later, especially in the case of skilled labor, or it is necessary to retain laborers not employed for full time, which is unde- sirable and uneconomical. It may be preferable to main- tain a uniform production and thereby accumulate in a period of slack sales an inventory which may be used to meet the excess demands during the rush period. The loss of the excess capital tied up in the inventory may be less than the loss which would result from fluctuating produc- tion. This is but one illustration of the many problems which arise in planning coordination of the operations of the functional departments. Many more will undoubtedly occur to the reader. Cooperation among Functional Officers From the few illustrations given, the interrelation of the various functions of the business should be evident and the necessity for the coordination of these functions should be apparent. But business administration can be discussed only in terms of business organization, and ''functions'* of the business can be discussed only in terms of the ''function- aries " who are responsible for them. The discussion of the coordination of functions, therefore, resolves itself into a discussion of the coordination of functionaries, and a brief study of the prevailing conditions in large business estab- lishments will show that such coordination is the most 1 8 BUDGETARY CONTROL urgent need for effective business organization at the present time. A conservative estimate would attribute a majority of the business failures of the present time to a lack of co- ordination of the functions of the business due to a lack of cooperation on the part of the functional officers. That this lack of cooperation is not intentional and is due primarily to a lack of information which would make such cooperation possible, does not change the situation. Reason for Present Lack of Coordination It is quite easy to see how the present situation came about. When the business enterprise was small, with a simple organization and its acti\ities local, the owner, who was also the manager, was able to exercise direct control of all the functions of the business. He acted as the executive head of each of the functional departments; he was sales manager, production manager, treasurer, and controller, all in one. Because of this condition he was able to bring about the proper correlation without difficulty. In his ca- pacity of sales manager he knew the sales which he estimated possible, so that he knew what purchases to make when he was acting as merchandise manager or purchasing agent. As treasurer he knew the funds which were available so that he could make his sales and purchasing plans accordingly. When the business unit increased in size and its organiza- tion became more complex, the executive was forced to delegate certain of his duties to assistants, and the present plan of functional organization developed, with a separate executive in charge of each function. The change in condi- tions is apparent. The sales manager devotes his entire time, thought, and energy to the securing of sales, and he has no direct contact with the production department. The production manager has become engrossed in the problems of production and has little or no means of becoming THE NEED FOR BUDGETARY CONTROL I9 familiar with the operations of the sales department. The treasurer secures the needed funds as best he can and has little information upon which to make his plans. And thus the coordination which formerly was brought about by the centralization of control in the hands of the chief executive is lacking. Mere Study of Past Records Inadequate During the past few years the functional staff officers of many large businesses have realized the necessity for a co- ordination of the activities of the various departments of a business and have attempted to bring about this coordina- tion by studying past results and trying to correct the worst evils which were revealed. For instance, the production manager may find that on certain articles large inventories have been carried, so that he plans to cut down the produc- tion of these articles during the coming year, thereby reduc- ing the inventories. The treasurer may find that during certain months his bank balances are very low because of the demand on the part of the purchasing or production de- partment for funds, consequently he may plan to increase his bank loans at that time during the coming year. In the same manner each department may study its past activities and plan to correct the difficulties of the past. In some cases the departmental heads may go farther and study the past operations of the other departments so as to see the cause for the difficulties incurred in their own department. This method of attacking the problem accomplishes some results; but even if carried out very completely it usually is subject to two serious objections: I. It is basing future plans on past results and not taking into con- sideration possible changes. This is almost sure to lead to inaccuracies, since a business does not remain stationary; it either advances or goes backward. 20 BUDGETARY CONTROL 2. It is a negative rather than a positive program. It plans to try to remo\e the difficulties of last year; its goal is to try to do this year what it should have done last year. It is only an attempt to reach a past goal, not an attempt to reach a new goal which should have been set for this year. New Method Needed It is contended, therefore, that a new method and a new poHcy is needed, different from that followed by many firms at present, a policy which will provide correlation and com- pel progress. Such a policy will involve dealing with future plans rather than with past results, although plans must of necessity be formed in the light of results. Administrative control necessitates the use of estimates. The past is gone and cannot be changed. It is only future operations over which control can be exercised. If the departmental estimates are to be used efficiently and effectively, it is necessary that a procedure be developed for their preparation, coordination, and operation. This procedure when established constitutes budgetary control. Centralization of Executive Control If efficient administration is to be accomplished, it is necessary to provide not only for the making of plans to secure coordination of departmental activities, but also for administrative control of these activities so that the plans made wall be carried out. The tendency in business admin- istration during the past half century has been towards centralization of control in the hands of a few executives and the delegation of duties by these to subordinates who are responsible to the primary executives for the performance of the tasks thus delegated. This method has important advantages, but it also gives rise to certain significant prob- lems. In ofder to see the nature of these problems and the need of budgetary control in their solution, let us sketch THE NEED FOR BUDGETARY CONTROL 21 briefly the method of exercising administrative control in a typical organization. Although the tendency during the past several years has been towards the centralization of administrative con- trol, the number of people who exercise influence in the administration of the typical business is quite large. The ultimate control of a business is with the owners, but In the modem corporate enterprise their control in the main is exercised only Indirectly. Most of their authority Is dele- gated to a board of directors, who in turn delegate a large part of their authority to the general oflicers of the corpora- tion. The general oflicers in turn entrust the execution of GO ■^ cc UJ Ll_W w""^ -J o ID s ceo m Method of Enforcing Budgets After the departmental estimates have been approved it is necessary for each department to formulate plans to carry out its estimate. Unless this is done the budgetary PRELIMINARY STEPS IN INSTALLATION 41 program is apt to result In failure. Many firms have made estimates of d epartmental activities but have failed to formu- late a plan for their attainment, with the result that the actual has varied widely from the estimated performance and consequently the executives have tended to feel that the budgets had little or no significance. A well thought- out plan for the enforcement of the departmental estimates should be formulated before the introduction of the budg- etary program. The method by which the departmental estimates will be enforced will vary w4th the different departments. For instance, the sales department may find it necessary to set up quotas for the different sales units and for salesmen at each unit in order to secure the amount of sales called for by its estimate. The production department will find it neces- sary to set up balance of stores records so that the inventory schedules called for by the production budget may be main- tained, and to operate a planning department so that its schedule of finished goods may be enforced. Other depart- ments will find it necessary to use similar means to carry out their programs. Some part of this procedure may be developed as the budgetary program proceeds, but it is necessary to remem- ber that it is useless to set up a budgetary program unless means for its enforcement are provided, and it is necessary that the means be developed as early as possible in the installation of the budgetary procedure. Cooperation of Executives and Employees In order that the budgetary program be properly formu- lated and executed it is necessary that all the executives and employees of the business cooperate to that end ; and in order to secure their cooperation it is necessary that they be instructed with reference to the budgetary plans so they 42 BUDGETARY CONTROL may understand the relation of the duties delegated to them to the general plans of the business. Although previous to its installation it is impossible to secure a complete realiza- tion by all the executives and employees of what the budget- ary program involves, as mach as possible should be done to this end before the budget program commences. If di- plomacy and tact are used much can be accomplished. After the budgetary program is installed, it is desirable to have prepared a manual on budgetary procedure outlining the purpose of the budget program and the procedure to be followed by all departments and units of the business in its preparation. If this manual is placed in the hands of all those responsible for the performance of duties in connection with the budget program, it will aid them to see the necessity and desirability for prompt and efficient cooperation on their part. The contents of such a manual is discussed and " illustrated in Chapter XXI 11. Much more might be said with reference to the impor- tance of securing the cooperation of executives and em- ployees, but it is thought that the necessity for this coopera- tion is evident., The method which should be employed to secure their cooperation will depend on the circumstances of each case. Tact, courtesy, and patience are all neces- sary, and these should be backed up by determination based on confidence in the program and comprehensive knowledge of the method of executing it. CHAPTER IV ORGANIZATION FOR BUDGETARY CONTROL Need for Organization The preceding chapters have shown that in the operation of budgetary control it is necessary to formulate a com- prehensive procedure which will govern the preparation, correlation, and enforcement of the departmental estimates. To insure the carrying out of the budgetary procedure, it is necessary to set up an organization responsible for its enforcement; and it is desirable that this organiza- tion be effected before the budgetary program is initiated, for otherwise there will be no fixed responsibility for its enforcement, and delays and errors are almost sure to occur. These errors and delays tend to lessen the interest and en- thusiasm of the executives and employees in the budgetary program, and this in turn renders its successful completion more difficult. It is the purpose of this chapter to indicate the nature of the organization which many business firms have found desirable. Head of the Budgetary Program Previous chapters have emphasized the interrelation of the activities of the functional departments and the need of a correlation of these activities. Since it is the purpose of budgetary control to effect this correlation, the budgetary program is as broad and comprehensive as the business itself. Inasmuch as the budgetary program involves the activities of all the departments, it is not expedient to dele- gate its execution to any one department. Rather, it is necessary to set up an organization which, although it must 43 44 BUDGETARY CONTROL include the executives of all departments, has a central head which is independent and superior to the departmental executives. In harmony with this conclusion, it is desirable that the president or chief executive of the business should have direct control of all matters pertaining to the budgetary program. He must of necessity delegate most of the duties imposed on him by this program to subordinate officers, but these officers should act as his agents and be directly re- sponsible to him for the proper performance of the duties delegated to them. In case of disagreement between de- partments with reference to the coordination of estimates, the decision of the president must be final. Disadvantages of Not Having Chief Executive at Head The importance of having the chief executive in direct and immediate control of the budgetary program cannot be overemphasized, for unless this be done two undesirable situations may develop : 1. The departmental executives and their subordinates will fail to realize the importance of the budgetary work and will not give it the time and attention necessary to make it worth while. If they are required to submit estimates and to make reports regarding their execution to some subordi- nate official, or even to the head of some other functional department, such as the general auditor's, they are apt to resent what they will regard as an undue interference with their activities by one who is not directly concerned with them. 2. Disagreements will arise with reference to the co- ordination of departmental programs. For instance, the sales department may desire to sell more than the produc- tion department thinks it can produce profitably, or the production department may desire to produce articles which ORGANIZATION FOR BUDGETARY CONTROL 45 the sales department does not think it can sell, or both the sales and production departments may desire to increase their activities beyond what the financial department thinks can be financed. Obviously the only authority who can decide these questions is the chief executive who is superior to all the executives interested in the controversy. These departmental executives will not accept as final the decision of an officer of equal or lower rank to themselves. Further- more, if the executives in charge of the preliminary work on the budget are the direct representatives of the chief execu- tive they are apt to be given more consideration than if they are members of a subordinate department. Direct Control of Governmental Budgets by Chief Executive In the preparation of governmental budgets it has usually been assumed that final control and responsibility is vested in the chief executive. Consequently he is usually required to submit to the legislative body the proposed budget with his personal approval, and he is held directly accountable for its contents. In the enactment of the recent legislation creating budgetary control for the United States govern- ment, there was much discussion with reference to the rela- tion of the President to the budgetary organization. The Senate desired to place the Budget Bureau in the Treasury Department, while the House desired to make it independ- ent of any department and answerable directly to the President. The New York Evening Post discussing the proposed law very ably sets forth the arguments for placing the President in direct control of the Budget Bureau, in the following editorial entitled "The Right Kind of Budget": Passage by the Senate of the McCormick budget bill is gratify- ing as a forecast of the early establishment of a budget system at Washington. But it is highly desirable that we get the right kind of budget system. Otherwise the work will have to be done over. 46 BUDGETARY CONTROL One of the prime essentials of a proper budget isthat it be placed directly under the President. The McCormickbill places the system in the Treasury Department. On the other hand, the Good bill, which has been introduced in the House, places the Budget Bureau directly under the President. This undoubtedly is the course that should be followed. The McCormick arrangement, if not fatal to the right function of a budget system, would greatly hamper it. The reasons lie on the surface. One of the most important duties of the chief budget officer will be to cut the estimates submitted to him by Cabinet officers. It takes no great stretch of the imagination to see the situation that will be created if an official connected with a par- ticular department cuts the estimates that come from other depart- ments. Think of a budget official passing upon the estimates of his chief. Inevitably there will be a feeling that the department to which the budget system is attached is being favored. I n order that the system may have a fair chance, it must be in exactly the same relation to all the departments. With respect to it, just as with re- spect to the President and Congress, the departments must be on the same plane. A budget officer representing the President will be in a very different position from a budget officer representing the Treasury. The argument is no less strong with reference to the relation be- tween the budget and the President. No matter where the budget system is placed, the President will be the final arbiter in important differences between the budget officer and the department heads. It will be much easier for him to settle these differences if the budget is part of his office than if it is connected with one of the departments. In the latter case appeal would first be taken from the budget officer to the head of the department and then to the President. This would put the President in the delicate position of having to decide between two of his Cabinet officers. With the budget officer a part of the President's Staff, the final conference would consist of the President, the budget officer, the department head and perhaps the head of the bureau affected — a much more promising assemblage for an objective consideration of the case. The budget officer will not be a mere reducer of figures. To be of the greatest usefulness, he will make it his business to keep the President informed of the activities of the various departments. He will follow up his work on the estimates each year by observing the way in which the appropriations are spent, continually reporting to ORGANIZATION FOR BUDGETARY CONTROL 47 the President. This valuable service, it is obvious, can be rendered much better by an officer attached to the President's Staff, than by one attached to a department. Under the latter arrangement, in- deed, it would be rendered at a maximum of difficulty. As is well known, the Senate and the House compro- mised their differences by placing the Budget Bureau nomi- nally in the Treasury Department, but with the Director of .the Bureau reporting directly to the President. Since the appointment of the present Director, the President has taken care to emphasize to the departmental heads that the Director is the representative of the President and that his requests should be treated as if the President himself made them. The arguments set forth in the foregoing quotation apply with slight modification to the organization for budgetary control of the private enterprise. The chief executive must be both the nominal and active head of the budgetary organ- ization. The Budget Committee In all businesses where a functional organization exists the budgetary program will usually be expedited and bene- fited by the establishment of a budget committee. This committee will consist of the principal functional executives, with the president as chairman. In a manufacturing busi- ness it will usually be satisfactory to have it composed of the president, the sales manager, production manager, treasurer, personnel manager, and controller or general auditor. In a merchandise business the president, merchandise manager, treasurer, personnel manager, and controller may be suffi- cient. Under the authority and direction of the president the budget committee considers all departmental estimates and makes changes and revisions as it may think desirable. No 48 BUDGETARY CONTROL estimate Is to be effective until it has received the approval of the budget committee. In case the budget committee cannot agree with reference to any estimate, the question in dispute is left to the president and his decision is final. In case the judgment of the president does not agree with that of the majority of the committee, he has the privilege of overruling them since he Is the head of the budgetary organi- zation. A wise executive would take such a step, however, only in extreme cases, for the success of the budgetary pro- gram depends to a considerable degree upon the cooperation of the executives. In the consideration of the departmental estimates the budget committee may call on departmental heads to ex- plain reasons for the variations in their estimates from the estimates for past periods, or to explain why changes cannot be made which the committee thinks desirable. By this means the committee obtains full Information on the sub- ject before making its decisions. When the departmental estimates have been approved by the committee and the president, they then become the working budgets for the departments. Of course they may have to be submitted to the board of directors for approval before becoming effective. At the end of stated periods of time, preferably monthly, the committee will receive reports showing a comparison of the performance for the period with the estimated perform- ance. For instance, it will receive a comparison of the sales for the month with the estimated sales for the month ; of the actual production with the estimated production ; and of the actual expenses of each department with the estimated ex- penses. On the basis of these reports it may make revisions in the budgets for the remainder of the budget period if it deems such revisions necessary. The receiving of such reports and the making of such revisions are a very impor- tant part of the committee's duties. ORGANIZATION FOR BUDGETARY CONTROL 49 It is of little value to make budgets unless a check is maintained on those who are responsible for their execution, and unless such a check is maintained, proper attention will not be given to the preparation or the execution of the budgets. Furthermore, budgets deal with future operations and are therefore apt to be inaccurate. It is essential that these inaccuracies be discovered and corrected as quickly as possible. It is exceedingly unwise to make plans covering any considerable period of time and to follow these plans blindly without taking into consideration the changing con- ditions which could not be foreseen when the plans were made. Executive in Charge of Budgetary Procedure If the departmental estimates and theperiodic reportsare to reach the budget committee at the proper time for their consideration, a definite procedure must be established for their preparation and submission; and after this procedure is established, there must be an executive responsible for its execution. Although the president is the head of the budg- etary program, he cannot assume responsibility for the direct supervision of the budgetary procedure and therefore must delegate this duty to some other executive. In a business where there exists a controller he may very well be charged with the direct supervision of the budgetary procedure. In many businesses there is no controller, and in many where there is an executive known by that title he in fact acts only as head of the accounting department and is not a controller in the correct sense of the word. In those busi- nesses where there is no controller the supervision of the budgetary procedure may well be delegated to a member of the staff of the president. This executive may be given a distinctive title or he may merely be termed "staff assist- ant to the president." Since the businesses which have a 50 BUDGETARY CONTROL controller are by far in the minority, it will be assumed in the remainder of this discussion that a staff assistant of the president is the executive in charge of the budgetary pro- cedure. Duties of Executive in Charge of Budgetary Procedure Under the authority and direction of the president, the staff assistant to the president has general control and su- pervision over the preparation and execution of the budg- etary program. His general duties are indicated by the following summarized outline: 1 . To receive from the departmental heads the periodic estimates which will be discussed and illustrated in the following chap- ters. In order that these estimates may be made in the proper form for his use, he may design forms for the use of the de- partments in the submission of their estimates. 2. To transmit these estimates to the budget committee with such recommendations as he may think necessary. He may com- bine and summarize these estimates so that they may be sub- mitted to the budget committee in the form which will make them most useful to it. It is usually his function to prepare from the departmental estimates an estimated balance sheet and an estimated statement of profit and loss for submission to the budget committee and the board of directors. These show the estimated effect of the contemplated program on the financial condition and earnings of the company. 3. To supply the budget committee with all the information avail- able which will assist it in the consideration of the estimates. He should have assistants whom he should use in the collecting of statistical data and the translating of these data into the form of reports and charts which will be useful to both the budget committee and the department heads. 4. To receiv'e from the budget conmiittee the estimates as approved and transmit these to the departmental heads. 5. To receive periodic reports prepared by the operating depart- ments or the accounting department showing the performance of each department during the budget period. ORGANIZATION FOR BUDGETARY CONTROL 5 1 6. To transmit periodic reports to the budget committee showing a comparison between the estimated performance and the actual performance for the period for each department, and to make any recommendations with reference to revisions which he thinks necessary. 7. To transmit to the departmental heads any revisions in the original estimates which have been made by the budget com- mittee. 8. To recommend to the president and to the budget committee any changes in the budget procedure which he may think necessary ; and to enable him to make these recommendations, he should be continually making studies and doing research. The staff assistant usually acts as secretary to the budget committee, and in this capacity is constantly available for consultation with the members of the committee. He has the implied authority to do everything necessary to the proper performance of the duties expressly stipulated for him. Importance of Staff Assistant's Work It is important that the staff assistant in charge of the budgetary procedure should not be regarded as doing work of a clerical nature. His function is something more than the supervision of the budgetary routine. In the operations of the budgetary program many questions of policy will arise. The departmental executives will often differ with reference to these questions. It is the duty of the staff assistant to study these and be able to offer to the budget committee and the president the matured judgment of an impartial observer. His work brings him in touch with all the departments of the business and should enable him to have a more comprehensive view of it than is usually pos- sessed by the line executives. As a result he should be able to make recommendations and suggestions as to new methods and policies which will be beneficial to the business. He 52 BUDGETARY CONTROL should also make a practice of collecting data which will serv'e as a basis of more accurate estimates. By these means he can become one of the most important executives in the organization. Departmental Executives The executive heads of the functional departments are responsible for the preparation of the estimates of their departments at the time and in the manner prescribed by the adopted procedure. They are also responsible in some cases for the periodic reports showing the performance for the period. Some of the periodic reports are obtained from the accounting department, while some are obtained from the operating departments. Usually the operating depart- ments will submit reports more quickly than the accounting department, and promptness is necessary in order to use the reports effectively. Any recommendations which a depart- mental executive desires to make with reference to changes in budgetary procedure will be transmitted in writing to the staff assistant to the president, who in turn will transmit it to the budget committee for consideration. There is a difference of opinion among executives with reference to the extent to which the departmental head should delegate the duty of preparing the estimates of his department. As explained in Chapter III, it is the opinion of the author that the preparation of the original estimate should be delegated as far as possible to the one who will be responsible for the carrying out of the estimate after it has been adopted. Board of Directors In many businesses the budgetary program after it has been formulated and approved is submitted to the board of directors. In case the program involves a radical change ORGANIZATION FOR BUDGETARY CONTROL 53 in policy or the acquirement of a large amount of capital, they may deem it necessary to modify it. The staff assist- ant to the president should have available data which will serve to show the modifications which are possible and their effect on the program as a whole. If modifications are necessary, the board of directors may instruct the chief executive to prepare a budget giving effect to the changes which they desire. In this case all the departments may be required to submit new estimates, or the changes may be such that they can be made by the budget committee. In any case the changes as made must be transmitted to the departmental heads by the staff assistant to the president. Although it is well and proper to have the budgets sub- mitted to the board of directors for consideration and approval, they should be transmitted to it only after they have been put into completed form. It is obvious that the directors are not interested in the details of preparation, and therefore the budget committee should have completed its work before the budgets are sent to the directors. Un- doubtedly the tendency for the board of directors to give consideration to the budgetary program will be increased in the years to come. CHAPTER V THE SALES BUDGET Importance of Sales Information In the preceding chapters the fact has been emphasized that all of the functional departments of a business are closely related and that the activities of each department are dependent to a considerable extent upon the activities of all the other departments. In fact it is because of this inter- relation and interdependence of departmental activities \that budgetary control is necessary. It is difficult to con- sider the activities of any one department without consider- ing to some extent their effect on the activities of all the other departments, and vice versa. In the formulation of the plans of any one department for the ensuing budget period, it is necessary to consider at every stage of their development their effect upon the plans of every other de- partment. Modifications and revisions are often necessary in order to effect coordination. It will be necessary in the present chapter and in those which are to follow to discuss the functional departments separately, but it is deemed wise to emphasize again the interdependence of the activities of these departments, so that the reader will keep this characteristic of business organization constantly in mind. The initial step in the budgetary program is usually made by the sales department. The reason for this is easily seen. The object of the operations of a business is to make a profit, and sales conclude the process which results in the making of a profit. Until the sales take place, consequently no profit is realized. Whenever the sales are profitable, the 54 THE SALES BUDGET 55 executives of a business desire to increase their sales, and they try to coordinate all the activities of the business to accomplish this end. It follows that the activities of the sales department exercise a very important influence over the activities of all the other departments. This influence is of primary importance in both a mercantile and a manu- facturing business. It is customary, therefore, for the sales department to prepare a sales estimate which sets forth the sales which are desired and deemed possible during the next budget period. This estimate must then be studied in comparison with the future possibilities of the other departments as set forth in their estimates, in order to arrive at a properly coordinated budget for the entire business. The revised sales estimate or the "sales budget" then becomes the working program of the sales department. Need and Importance of the Sales Estimate The owners or officers of either a trading or a manufac- turing industry of necessitymust estimate the probable sales of their business for each season or fiscal period. These estimates may be made very unscientifically and be recorded quite informally, or they may be made as the result of a very careful analysis of all the factors involved and presented by means of a formal report. But, in any case, an estimate of sales must be prepared as a basis of planning for the future. In a trading business, the nature and amount of goods to be purchased depends upon the plans of the sales depart- ment. In a manufacturing business, the volume and nature of production is dependent on the sales estimated. If a sales estimate is not made by the sales department, the probable sales must be estimated by the purchasing depart- ment or the production department; otherwise these de- 56 BUDGETARY CONTROL partments have no basis for their plans. It is the purpose of the present discussion to emphasize the point that it is properly the function of the sales department to prepare this estimate, and to explain the method by which it is pre- pared. It is evident that in a mercantile store goods must be bought and placed on the shelves or in the warerooms before they can be sold. It will later be explained how in a manu- facturing business goods may sometimes be sold before they are produced, but such is not the case in the typical mercan- tile business. Consequently, in this type of business, before the buyers can make contracts and select the qualities and kinds of goods that are to be offered for sale, the manage- ment must make estimates, however scientific or unscien- tific, as to the volume and character of sales expected for any given period. The small retailer whose business is restricted to one particular specialized commodity, say a dealer in rare oriental rugs, may say that he will buy what he can and plan for the sale of the merchandise after he has it in his pos- session. But a large retail business, such as a department store, that sells many thousands of different items of mer- chandise, must set up a program of what sales are expected to be, if purchases are to be made intelligently in source markets all over the world and deliveries to the shelves of the store completed before the customers of the store come to buy. Even in the case of the dealer of oriental rugs it is probable that he will learn by experience that certain kinds or types of rugs sell more readily than others. When he makes his purchases, he will be guided by that experience and will seek the popular kinds of rugs for his antici- pated sales. In so far as he does this, he is estimating his future sales. In other words, he is making an infonnal sales estimate. THE SALES BUDGET 57 Anticipated Sales the Basis for Action for All Departments Not only does the volume and nature of the sales antici- pated, as reflected in the sales estimate, affect the buyers in their selection of goods, but it also vitally affects the opera- tions and plans of the various functional managers of the business. The officers of the store who are responsible for providing proper space for counter stocks, for reserve stocks, and for wareroom stocks, must have before them some tangible data as to when such stocks will be purchased, when sold, and what volume of sales will be made. In de- partment stores and mail-order houses, where large stocks are carried, this is especially important. The operating managers above mentioned must work with an estimate of sales in mind, so that they may secure the proper sales persons and then train them to meet the needs of the organization. Similarly the operating officials must anticipate the volume and character of sales to a fairly accurate degree, if they are to employ an economical num- ber of packers, wrappers, telephone operators, delivery men, and the like, and if they are to train these employees into an efficient working force animated with the service ideals of the store, and thoroughly familiar with the operations, proc- esses, procedures, and schedules in retail selling and order buying. The treasurer or other officer charged with the responsi- bility of financing the purchases and expenses of the store must have very definitely in mind the volume of revenue from sales that the store may reasonably expect to receive from week to week, and even from day to day. The owners themselves, or the president or general manager as their agent, must carefully study expected sales in investing capital in new divisions or departments of the store, in making additions or extensions of physical plant, or in mak- ing decisions concerning new forms of customers' credits. 5B BUDGETARY CONTROL Place of Sales Estimate in a Wholesale or Retail Store In short, the owners and officers of a wholesale or retail store of appreciable size must set up a sales program for each season or fiscal period in order that the customer may receive service resulting from coordinated purchasing, oper- ating, financing, and plant maintenance and extension. For instance, in a department store, if the various depart- mental buyers who are purchasing goods in different markets are to work as a unit, they must know not only what volume of sales in their own particular lines they are anticipating by their contracts, but they must also know something of the character and volume of sales expected in all the other lines of the store, so that they may select and purchase qualities and quantities complementary and sup- plementary to the other lines of goods handled by the store. But the departmental buyers must not only work in harmony with each other; they must work in harmony with the traffic manager, the superintendent of warehouses, and the superintendent of delivery service. The one vital point of contact between the selector of merchandise and the operating man who handles the order for the customer, is that they both promise their work on the same expectancy or estimate as to volume and character of business. It can be readily seen, therefore, that comprehensive and accurate information with reference to sales anticipated is of utmost importance in the internal control and management of a modern wholesale or retail store. The Sales Estimate in a Manufacturing Business In a manufacturing business the sales estimate is as necessary for coordination of departmental activities as in the case of a mercantile establishment. The production manager must base his production program on the antici- pated sales ; otherwise excess stocks will accumulate or orders THE SALES BUDGET 59 will go unfilled. The plant engineer must plan his building and equipment program to meet the production program demanded by the sales estimate. The employment or per- sonnel department must consider the increased or decreased demand for employees which will result from the program of the next budget period. The purchasing agent must make contracts for raw materials and supplies and schedule de- liveries in order to meet the demands of the production budget. The shipping department must adjust its capacity to meet the demands of the sales program. The treasurer must know the estimated revenue from sales as well as the probable disbursements arising from the financing of the sales program and the consequent production program, in order to provide for the necessary funds. Thus each de- partment of the business is affected by the volume of busi- ness and the volume of businessisdetermined by the amount of the sales. Consequently a knowledge of the amount of the sales anticipated is necessary in order to plan the opera- tions of the business in such a manner as to secure coordina- tion, and without coordination efhcient administration is impossible. Th3 Revised Estimate, or "Budget," the Result of Cooperation It may be well to state again that it is not intended to imply by the emphasis placed on the importance of the sales estimate that the sales department should determine the policies of the business as a whole. The following discus- sion will show that though the sales estimate is usually pre- pared originally by the sales department, the sales depart- ment in its preparation should take into consideration the plans and possibilities of the other departments. In any case, the revised estimate, or "budget," which serves as the basis for future operations, is the result of the coopera- tive efforts of all the functional departments of the business. 6o BUDGETARY CONTROL It is revised and modified by the functional officers and the budget committee before it is adopted in its final fonn. The purpose of the preceding discussion is to emphasize the need and importance of the sales estimate. It is now necessary to discuss its preparation and the method by which it is used. Threefold Basis of the Sales Estimate The sales estimate is a report which gives in a sum- marized but comprehensive form the sales which the sales department desires and deems possible during the next budget period. In the preparation of this estimate, infor- mation of various kinds must be considered, which informa- tion may be classified under the following general headings : 1. Knowledge of general plans and policies of the business. Such in- formation is obtained from the decisions of the executive offi- cers and the board of directors. 2. Knowledge of trade conditions. Such information is obtained as a result of market analysis. 3. Knowledge of the amount and nature of previous sales, as shown by the accounting records. Such information involves sales analysis and comparisons. It is necessary to discuss each of these briefly. I. The General Plan and Policies of the Business In most businesses, plans are made from time to time which affect the sales policies and the volume of sales of the business. A few examples will suffice to make clear the importance of considering such plans in making the sales estimate. In many businesses there is a special department called by various names, such as sales engineering, sales promo- tion, sales development, or sales research department, whose function it is to study sales possibilities and to recommend THE SALES BUDGET 6 1 changes In sales policies and methods. As a result of such recommendations new lines may be added ; old lines may be dropped ; new territories may be entered ; new agencies or branches established ; new methods of distribution put into effect; changes in prices or terms of sale made; additional advertising carried on ; more salesmen added ; and numerous other changes made. Whether or not a separate department is maintained to carry on work of the sort mentioned, such changes are made from time to time by all progressive firms, and the effect of such changes must be given careful consideration In the preparation of the sales estimate. In some cases such changes are decided upon by the chief executive of the sales department, but since they affect to some extent the activi- ties of all the other departments, it is customary for them to be considered by all the functional executives before they are adopted. In the case of some sales policies which will vitally affect the business, it may be necessary for the board of directors to judge if so radical a change as that suggested by the program is desirable for the business. In a business where proper methods of management are followed, the effect of new policies will be considered before they are adopted. Therefore it is not difficult to give effect to these policies in the sales estimate. The importance of giving careful consideration to their effect cannot be overestimated. 2. Market Analysis Although the questions concerning market analysis are primarily problems of the larger one of sales management, they are nevertheless inseparably interwoven with a con- sideration of budget-making and control. In fact, neither market analysis nor sales analysis can be intelligently con- sidered apart from the other. Each serves as a check upon the other. Market analysis and statistical records show to 62 BUDGETARY CONTROL what extent the potential demand has been satisfied and whether or not it is profitable to try to satisfy it. As has been pointed out before, the purpose of making sales is to gain a profit. But not every demand for goods is one which can be satisfied on a profitable basis. It is the function of accounting and statistics to assist in the determination of the results of past sales and thus to indicate the probable results of anticipated sales. To mention all the factors which must be considered in making an analysis of the market in the case of a retail, wholesale, or manufacturing business is of course impossible. The buying power of the community, as reflected in its savings bank deposits; the industrial growth of the com- munity, as reflected in its pay-rolls ; the condition of crops and the profits of the farmer and stock-raiser in the surround- ing agricultural region; transportation conditions in their relation to the delivery of goods; climatic changes and their effect on seasonable lines ; these and many other general and local trade factors will each have a bearing on the sales to be expected for a retail store. Then the store will have to con- sider many local factors of importance to itself, such as new buildings and street improvements near the store; fire hazards; relationship of management to state officials with reference to state laws of employment, etc. ; new forms of taxes adopted or proposed ; character of store management ; and the like. In a wholesale or manufacturing business many of the factors above mentioned will have to be taken into account, and in addition others of a more general nature. For in- stance, general industrial and agricultural conditions throughout the territory reached by the retailers or jobbers to whom the company sells must be considered, and in de- ciding on methods of selling and advertising, and in estimat- ing results, the density and character of the population in THE SALES BUDGET 63 both old and potential territory must be taken into account. It will be understood that the "business cycle" must be given careful consideration in the determination of the sales possibilities of both a mercantile and a manufacturing firm. In some businesses it is the function of the sales engineer- ing department, or some other department performing the same function, to make the market analysis and present the data which serv^e as a basis for the sales estimate. In any case these data must be available if accurate forecasts are to be made. It is beyond the scope of this discussion to treat of all the problems involved in sales administration and management. The purpose of the present discussion is to emphasize the necessity for the careful and scientific consideration by the salesdepartment of all the factors which may influence future sales, if the sales department is to pre- pare a sales estimate which will serve as a proper basis for coordination of departmental activities. 3. Sales Analysis Having in mind that only a few of the usual factors in sales management ha\e been mentioned, it seems at first thought as if it were impossible to use accounting records and reports to any advantage in estimating what the volume and character of sales are likely to be. The outstanding fact is that a sales program must be made, and in fact is made in the conduct of all businesses. Even if the presi- dent only "hopes to do slightly better this period than the preceding one," the sales program is the result of taking the revenue accounts of the last period with an additional margin of possibly 5 per cent. The directors who ask their officers to "hold your own despite the decline in the mar- ket or other conditions," are setting up a very definite standard of performance and accountability. The estimate of sales is based on the actual sa'es of the preceding period, 64 BUDGETARY CONTROL or periods, plus or minus certain amounts or percentages. This modification is due to a more or less careful consid- eration of various general trade factors and various trade conditions peculiar to the business itself. In some businesses it is the custom to take past sales and apply a more or less arbitrary percentage in order to arrive at the estimated sales of the following period . This method is unscientific and is usually inaccurate, for it does not take into account trade conditions or changes in market policies on the part of the business, and such changes occur almost continuously in most businesses. It is highly important that past sales be considered very carefully in making the sales program, but it is not wise to follow such statistics slavishly. The sales accounts of a business tell the owner what past sales have been. If the total sales are credited to one account only, there is still the very valuable analysis by days, weeks, and months, of cash and accounts receivable gained by the store through creating sales, although this information may not be classified in a convenient form, and so may be difficult to obtain. If a proper analysis of sales is maintained by means of accounting or statistical records, there will be available information not only of value in mak- ing the sales estimate, but also of service to the various departmental managers. Although it is not safe to assume without investigation that the same ratio between various classes of sales will continue year after year, if the past tendency is known a fair estimate of the future ratio can be made. For instance, if the sales analysis shows that for the past five years the cash sales have averaged 25 per cent of the total, and the sales on account 75 per cent, the treasurer can usually assume that approximately the same ratio will hold good during the next year unless there are conditions which it is known will change the ratio. THE SALES BUDGET 65 Various Kinds of Sales Information Desired After the probable ratios between the various classes of sales are known, the departmental executives can use them in estimating the effect of the proposed program on their activities. To understand the analysis which should be made, it is necessary to consider briefly the nature of the information which may be desired. If the problem is to estimate the sales for a retail store for the three months beginning June i, the first question asked of the accountant is likely to be: What were the sales of last summer by days and weeks? The representa- tive, or representatives, of the sales department who are responsible for the preparation of the sales estimate asks this in order to be able to make an estimate for the current period. The sales department, in turn, must answer the question of the amount of sales anticipated for this summer. In the preparation of the sales estimate, this information must be obtained and made available. The merchandise manager asks the question of the sales department in order that he may be equipped to fix delivery dates in his con- tracts with manufacturers and wholesalers. The operating superintendent asks it because he must estimate the number of employees required through the normal vacation period. The treasurer asks it because he must finance the purchase invoices, the store pay-rolls, etc. Even the finance com- mittee of the board of directors may ask it if they are plan- ning certain changes in the financial plans of the company. In addition to this information, each officer may ask for data on last year's sales from the viewpoint of his particular responsibility. The operating superintendent asks, "What percentage of sales last summer were counter sales? What percentage of sales were over the telephone?" The treas- urer asks for data as to cash sales, sales on monthly accounts, and instalment sales. The traffic manager asks for the 66 BUDGETARY CONTROL amount of sales to out-of-town customers by express and by freight. These and many other questions of a similar nature will be asked of the accounting department, and, in order to be able to answer them, a proper analysis and classi- fication of sales data is necessary. Classification of Sales Data No arbitrary classification of sales data can be given, f(jr the analysis and classification made is determined by the information desired by the various functional managers. But it is safe to say that in planning for the future the offi- cers and managers will desire sales to be classified in some or all of the following ways : 1. By commodity or department 2. By terms of sales 3. By method of sale 4. By method of delivery 5. By territory of customers 6. By salesmen 7. By volume of sales to individual customers 8. By nature of customers 9. By rush vs. normal deliveries The purpose of each of these classifications should be evi- dent to the reader. In a manufacturing business a shorter classification may be required. This is due to the fact that it handles and sells its commodities more directly than a trading company. Where goods are sold in large quantities, as is usually the case in the disposition of products by a manufacturing busi- ness, the problems of selling are less complicated. In such a business sales may be classified as follows: 1. By commoaities or groups 2. By territories 3. By salesmen 4. By customers THE SALES BUDGET 67 In a manufacturing business the terms of sale, method of sale, and method of delivery are usually uniform for all classes sold. Where this is true, no classification to indicate these is necessary. The classifications of sales stated above are intended to be suggestive rather than all-inclusive. They are indica- tive of what may be done in the classifying of sales in order to make available information for the preparation of the sales estimate and for the use of the departmental managers in making their plans. Terms in Which Estimate Is Made The terms in which the estimate should be made are dependent on the nature of the business and the purpose for which the estimate is to be used. In the past, estimates of sales and purchases and expenses have been made by some businesses for the purpose of financial control only. As a consequence they have been made in terms of value. For the purposes of financial control all estimates must be stated in terms of value; but for the purpose of sales, production, and purchases control, estimates must be stated in terms of physical quantities and not in terms of value only. There are possibly a few cases where sales and purchasing control may be effected in terms of value, but these cases are rare. In a manufacturing business it is essential that the sales estimate be made in terms of physical quantities, for pro- duction orders are issued for a certain 7iumber of each item of goods produced and not in terms of dollars and cents. It is not enough for the production department to know that the estimated sales for the budget period are $3,000,000. It must know how many hundred of each of the items which the company offers for sale will be sold during the period, so it will know how many must be produced to meet the sales requirements. It is necessary that the sales estimate not 68 BUDGETARY CONTROL only state the sales to be made, in terms of physical quanti- ties, but it is also necessary that it state separately the sales of each item of goods which is offered for sale. Some com- panies make estimates in terms of sales classes or groups. These are of little value from the viewpoint of coordinating sales and production. Planning Sales in Terms of Items Sales orders are made in terms of particular items of commodities, and if these items are to be available, produc- tion must be planned in terms of these items. A factory may have a large inventory and yet be unable to fill sales orders if the particular items called for by these orders are not on hand. To make the sales estimate serve as a basis for the coordination of sales and production, it is essential that the planning of sales be in tenns of items and not in terms of values or groups or classes. In most cases the same principle holds true in the retail or wholesale store. A customer does not want a pair of shoes but the pair of shoes of his particular size and shape. In order that the merchant may know how many customers want each particular make, size, and style and that he may procure the goods in advance to meet these demands, it is necessary to have records which will give such information with reference to past sales, and will furnish a basis for mak- ing accurate estimates of future requirements. Thus it is in all lines of merchandise — the demands of the customers call for particular items, and the sales and purchase budgets must be made accordingly. It is of course true that, in the case of goods subject to wide changes in fashion, estimates by items cannot be made accurately. But even in this case past statistics will show a fair indication of the customers* demands for different styles and kinds. The necessity for making the sales estimate in terms of THE SALES BUDGET 69 Items makes the task of preparing the estimate much more complex in many cases. The different Items of merchandise sold by some firms run Into the thousands. To estimate sales and plan production In connection with each of these items Is a very difficult problem. In some cases the number of items may be so great that this Is well-nigh Impossible. Under such conditions some method must be devised which will obtain the necessary results without the incur- rence of prohibitive labor. In most cases a study of the sales of a firm handling thousands of Items will show that the bulk of its sales is composed of a comparatively few Items and that the remainder are slow-moving Items of which the number of sales are few. This may make it possible to select a list of "significant" items which will contain those which constitute the bulk of the sales. In a recent case on which the author was employed, it was found that of 20,000 Items, 682 constituted approximately 75 per cent of the total sales. Use of "Key" Items in Sales Estimates In some cases it is found that there are certain "key" Items of which the fluctuations In sales govern the fluctua- tions In a number of similar Items. For Instance, there may be a group of items which are the same except for size, and there may be one particular size in the group for which there Is the greatest demand. It may be found that the sales of the less popular sizes fluctuate year by year in proportion to the fluctuation in the sales of the most popular size ; and If this condition can be shown to be approximately correct It Is then necessary to have the sales department estimate only the sales of the " key " Items, the statistical department estimating the sales of the remaining Items. It Is only In certain businesses handling certain lines of merchandise that there exists a probability of such a condition arising, but 70 BUDGETARY CONTROL where it does arise it greatly facilitates the preparation of the sales estimate. When it is possible to select significant or key items, the sales and production budgets may be made, in terms of items, for the items on the significant list. The remaining items can be grouped by classes and the budgets prepared on them in terms of classes. Although the budgets on the groups will be in most cases unsatisfactory from the view- point of coordination of sales and production, this is not of so great importance for these items, which have a low turn- over and are slow-moving, inasmuch as it is not difficult to provide sufficient inventory to meet the sales. By a proper system of inventory control, excess quantities can be avoided. For the purpose of the financial budget, the group budget on the non-significant items will usually serve satisfactorily. It is not intended to imply by the foregoing discussion that budgets prepared in terms of classes or groups of items are desirable. It is intended only to suggest that this is one method of procedure when the items sold by a company are exceedingly numerous. If such a plan is followed, it will usually be found expedient to add gradually more and more items to the significant list as the work proceeds. If such a study is begun, it will usually result in the elimination of many of the "non-significant" items which it will be found are unprofitable and unnecessary. In the end this process will result in the proper budgeting of all items. CHAPTER VI THE SALES BUDGET (Continued) Responsibility for Preparing the Sales Estimate As stated in the preceding chapter, the sales estimate is prepared by the sales department. As to which particular unit of the sales organization should be responsible for its preparation, an arbitrary rule cannot be formulated. In each case the organization of the company and its selling methods must be taken into consideration. In a department store the departmental managers are usually held responsible for the preparation of the depart- mental estimates, and these are combined by the merchan- dise manager to make the estimate for the entire business. The departmental manager of course will consult with his assistants in the preparation of his estimate. In a wholesale or manufacturing business which employs traveling salesmen, each salesman may be asked to make an estimate of the sales in his territory for the budget period. Such estimates will of course have to be checked very closely and revised by the central sales office in the light of the data which it should have available. In a business which sells its products through branches, each branch may be requested to make an estimate of its sales. These estimates, like those of the salesmen, should be carefully checked by the central sales office. When either salesmen or branches are requested to make an estimate of their sales, they should be provided with a record of their sales for one or more past periods, in order to be able to use these data in making an estimate of future sales. 71 72 BUDGETARY CONTROL Those who favor the making of estimates by salesmen and branches contend that those in closest touch with the customers are best able to judge future demands. There are some companies, however, who will not rely at all upon the estimates of the sales force. Instead, they favor the collection of data by the central sales office and the employ- ment of special investigators who make a survey of the sales territory and report on possibilities. Using the data with reference to population, industrial conditions, etc., and the reports of the special investigators, in connection with past sales, they formulate the sales estimate. In some cases, after the estimate is prepared by the central office, it is sent to the branches or to the salesmen for criticism. Relation of Inventory Requirements to Sales Estimate If a business has branches which carry an inventory of merchandise, a further complication arises in connection with estimating their requirements, since the amount de- sired by them from the parent company is dependent not only upon their anticipated sales, but also upon the condi- tion of their stocks. Their inventories may be below normal on some items and show an excess on others. This condi- tion is especially apt to exist at the time a system of budget- ary control is installed. After the system becomes effective, material excesses or shortages in inventories should be eliminated, except in rare cases. Each branch must of necessity report the condition of its inventories for each budget period, whether or not it is held responsible for initiating the sales estimate. Since the sales estimate must be submitted previous to the beginning of the budget period in order that the production budget or pur- chase budget may be prepared for use by the beginning of the period, it is necessary for each branch or selling unit which carries an inventory to estimate its inventory at both THE SALES BUDGET 73 "2 >» / — » c / O 3 O S S / H^^ S ^-' / K "^ « «< c o o £E f^ :^ Q Qz w — ■« 1 0-5 og s P (j*^^ > <£ "> ■o >i ID a-^ ■" O CO »- z s UJ s u 1 QC tf\ K *j OCO 3 O w 11 = 2 UJ cc o to eg >- eg 3 o O o < u. 10 ill Estimated Sales Jan, 1 to Mar. 31 « o> •o o to *J^ « ^ C3 (1) cn CO « g ,_^ •«c 1 2 cfl c: ■^ 00 QJ 1- ° ^ 1x1 Q £ *" ~ w ^_^ 3 ■^ ° S -^ 1 1 w UJ ol UJ « _o c .2 CD u a> ~' a. X a- 0. LU c z ,^ _J 1 UJ (/) = ^ 'S •s •#-o-a,-^ S.'S n x: ^ " ^ c 2 J2 ,-. 2 :5.| •< CN 00 s 3. ^— ir"ta — 1 1 / / >- C/3 03 •i: — c 1 1"*^ 00 'ra i: _o -X *- i_ iZ ° <2 ° S S T3 "C O) S ra ■§ S 0? = M 00 ^ 3 i^ C= £ " a> 01 u _3 c CD 1 "S H ^ c „ LjJ C5 edit •sm( oun able - Q =3 ra '"' =3 ■s s. °- \ UJ '^ M CO c 1 z ■g i UJ C3 J2 CD Q. " 3 .a "^ X « UJ 5 M z c -J 15 ,2 ^^.^ _l •— o. 10 UJ *-^ ■^"^ t/) a. z i- 5 cc ^ '^ ^ "^ Q_ C3 UJ CC « _o CO •S c .0 = !s ^^ ■q S. 'C ^ 1 ■< / CO / s ^ UJ — 1 1— 1 \ Pi 104 BUDGETARY CONTROL possible a proper check of Its operation. These reports may be divided broadly into two classes: 1. Those which are used by the sales department in the enforcement of its budget. 2. Those used by the executives and the budget committee to judge how well the sales department has succeeded in the enforce- ment of its budget. The first class of reports may be well illustrated by those required in enforcing the salesmen's expense budget. The reports used for this purpose may in turn be divided broadly into two classes: (a) Those which are used primarily by the general sales office. (b) Those which are used primarily as reports to salesmen. For the use of the general office it is useful to make a report showing for each salesman the following compar- isons: (a) Actual sales and estimated sales (b) Expense and sales (c) Actual expense and standard (d) Expense with average of territory If in addition to the amounts these comparisons are ex- pressed in percentages, the report is much more useful. If this report shows wide variations between the standard and the actual, supplementary reports should be prepared explaining the variations. Reports may be sent to the salesmen monthly, or even weekly if desired, showing a comparison between the esti- mated expense and the actual and also the profit earned by their sales. In some cases the gross profits by lines may be shown on these reports, so as to indicate to the salesmen the lines of merchandise which they should push. For the use of the general executives and the budget committee a report may be made in the form of Figure 4. THE SELLING EXPENSE BUDGET 105 The purpose and value of each of the columns shown on this report should be apparent to the reader. In case this report shows wide variations between the actual and the estimated, supplementary reports should be submitted explaining the variations. CHAPTER VIII THE ADVERTISING BUDGET Relation of Advertising to Selling Expense There has long been an argument among the executives in the marketing field as to the relation of advertising and selling — principally as to the proper relation between the advertising manager and the sales manager. Some have contended that the advertising manager should be the executive head of an independent department, while others have insisted that he should be subordinate to the sales manager. There is no intention of entering into this dis- cussion here, but it is desired to emphasize that regardless of the organization by which the advertising is carried on, the advertising program must be considered as a part of the sales program as a whole and the advertising expense must be considered as a part of selling expense. It should not be difficult for the reader to see why this is true. The purpose of the advertising and of the sales force is the same — to secure the maximum of profitable sales with a minimum of cost. There are some services in the marketing of a product which commonly can be performed more effectively by advertising than by the sales force, and the opposite is equally true. The advertising campaign must be planned with reference to the specific work which it is expected to perform in relation to the other sales work of the company. Consequently, neither the amount of the advertising expense nor the amount of the other items of selling expense can be determined independently. The advertising budget must be presented as a part of the larger selling expense budget. 1 06 THE ADVERTISING BUDGET I07 The Advertising Appropriation It has long been the practice of many firms to make an annual "appropriation" for advertising expense. It may seem strange that a firm will make an advertising appro- priation but will not make an appropriation for any other purpose. We rarely hear of an accounting appropriation, a manufacturing appropriation, a traffic appropriation, etc. It may at first be thought, since definite appropriations are made for advertising expense, that this class of expense is more effectively and scientifically controlled than are the expenses of the various other departments. Further study will lead one to doubt if this be true. Rather one is apt to find that the practice of establishing definite appropriations for advertising expense is based upon two reasons : 1. Outside counsel, in the form of advertising agencies, have often been employed to direct the advertising and it was necessary to have a definite agreement with them with reference to the amount which they were permitted to spend. 2. Business executives have not regarded advertising expense as they have the other expenses of the business, but rather as an additional expense which while it might be beneficial was not necessary for sur\-i\-al. As they knew no definite way of deter- mining the amount of the advertising expense, they guessed at a lump sum which they thought they could afiford, and took a chance on obtaining results from it. In many cases it was a policy of cast your bread on the waters and trust it to return. The professional advertising agency has rendered a service by teaching business executives the necessity for formulating an advertising program and coordinating this program with the sales program. It is but natural, how- ever, for these specialists to be enthusiasts for advertising and it is open to question whether they have always given as much attention to scientific methods of calculating the amount of the advertising appropriation as they have to the attempt to make it as large as possible. In many cases this I08 BUDGETARY CONTROL proved a short-sighted policy because it produced a reaction when the management failed to see adequate returns for the money expended. This remark is not intended as a criticism of advertising agencies, for many of them have rendered very useful service in advising executives with reference to the amount of the advertising which they should do, as well as the kind of advertising which would be most effective. Their errors have probably not been greater or more numerous than those of the professional accountant or the engineer. Methods of Calculating Advertising Cost In recent years both advertising experts and business executives have come to realize, first, that advertising ex- pense is a necessary expense of operation, no less than the expense incurred in carrying on any of the other functional activities of the business; second, that the advertising pro- gram is closely related to the program of the business as a whole and that therefore the amount of the advertising expense should be based on contemplated plans of the busi- ness as a whole. As a result considerable attention has been given to the proper method of calculating advertising ex- pense. The following methods are those in most current use : 1 . The advertising expense of the current period may be based on the expense of the previous period, adding or sub- tracting a certain percentage depending on the opinion of the executives with reference to the success of the advertis- ing program of the preceding period. The general manager may say to the advertising manager, "Last year we spent $1 10,000 for advertising expenses; this year you may spend 5 per cent more." Such a budget refers the advertising manager to the expense accounts of the preceding year for his working program. 2. The advertising expense of the current period may THE ADVERTISING BUDGET 109 be based on the estimated sales of the current period, deter- mining the amount by taking a certain percentage of the total volume of sales. For instance, the general manager may say to the advertising manager, ' ' Last year we spent 5 per cent of sales for advertising expense. Here is our sales expectancy for this year. We expect you to secure the sales at an advertising cost of 5 per cent or less." This method is more scientific than that suggested in (i) for it requires the advertising manager to connect cause with effect — advertising expense with sales to be secured. It should be apparent that the advertising expense should not be based on past sales. The advertising of the current period can have no effect on, or no relation to, the sales of past periods. It is to make possible the attainment of the current sales program that the advertising program is in- tended, and the amount to be expended under the adver- tising program can only be determined properly by con- sidering the current sales program. 3. The advertising expense of the current period may be based on the estimated sales of the current period, deter- mining the amount by allowing for advertising so much per unit of the product which it is planned to sell. For instance, it may be agreed that so many cents will be spent for adver- tising for each crate, ton, dozen — or other unit used in the estimate — which is expected to be sold. Readers interested in other methods of calculating ad- vertising cost may well read articles by John A. Murphy, in December 9, 1920 and December 16, 1920 issues of Printers' Ink. Advantages and Disadvantages Opinion differs with reference to the merits of these dif- ferent methods. No definite rule can be laid down to govern the policy to be followed by all businesses. In the no BUDGETARY CONTROL Opinion of the author the first method is the one least to be desired. It is apt to result in careless planning of adver- tising cost, since it is so very easy to add or subtract a cer- tain percentage of past expenses and not to consider the question further. It is also apt to result in basing present expenses on past expenses without giving proper considera- tion to the contemplated changes in the sales program. At least it fails to compel a consideration of present plans.>4^ The ideal in the designing of methods of administrative control is to secure those which will compel coordination and at the same time promote progress. To base the advertising appropriation on a percentage of the volume of sales tends to simplicity, and in a business where the fluctuation in sales is not great may give satis- factory results. This condition is more apt to prevail in a business handling a staple and well-established line than in a business handling specialties. In a business having many and varied lines it may be the only feasible method, since calculation of the unit cost of advertising for each item of goods sold may not be practicable. This method has the disadvantage of fluctuating unduly in some cases because of the fluctuation in the price of purchases of materials, sup- plies, and labor, and consequent fluctuation of the selling price./ In a period of depression as many units of commodity may be sold as before the depression, but at a price which will greatly decrease the total sales in terms of dollars and cents. In this case if the advertising appropriation is based on the sales volume expressed in terms of dollars and cents, it will be greatly decreased, whereas it may be desirable to keep up the advertising campaign in order to maintain the sales volume in spite of the adverse conditions. There is something to be said for the possibility that if the sales price of the commodities sold has decreased, the cost of advertis- ing will decrease also. / If advertising is calculated as so much per unit of product THE ADVERTISING BUDGET III sold, it tends to concentrate attention on the purpose for which the advertising is incurred and incidentally to call attention to the unit cost and unit profit realized on the articles sold. This method is also apt to cause the advertis- ing appropriation to fluctuate less, since the units sold are apt to vary less than the returns from sales. There may be some argument for having the advertising fluctuate as the sales fluctuate. At least there are occasions when this is true. There are also other occasions where the advertising may fluctuate in reverse order to the fluctuations in sales. A financially strong enterprise may increase its advertising during a period of depression in order to reduce the decrease in sales to a minimum and to establish itself in the market so as to take advantage of the contemplated period of pros- perity. It would seem, regardless of whether the unit costs or the percentage method is used, that revisions will have to be made in case of changing conditions which affect the general plans made at the time the advertising appropriation is determined. The advertising appropriation should be re- garded as only an estimate and subject to revision no less than the other estimates. Of course, in making such re- visions outstanding commitments must be considered. ^ There is reason to bclie\^e that advertising managers have placed great emphasis on the basis of determining the amount of the advertising appropriation, because it has been difficult to get appropriations approved and conse- quently it was desirable to get a definite basis established which would give them the maximum amount under all cir- cumstances. ^ ^ Regardless of the basis adopted for calculating the ad- vertising appropriation, each individual business must make constant study of its advertising program with the object of revising it as soon as the necessity is indicated./' 112 BUDGETARY CONTROL Determining the Amount of the Advertising Appropriation — After the basis on which the advertising appropriation Is to be calculated is decided, it is necessary to determine the desired amount in dollars and cents. Theoretically the rate may be determined without consideration of the total, but it is doubtful if this is ever done. A firm may decide that it can well afford to spend one cent per article sold for advertising, but if the total thus determined runs beyond the amount necessary to pay for the advertising plans con- templated, the rate per unit will be reduced. If a percent- age of sales is used as the basis the same procedure will be followed. After the total is determined the rate will be revised, if necessary, to make the total somewhat near the amount which the executives think desirable. In determining the amount of the appropriation two important factors must be given consideration : 1. What is the purpose of the advertising — what is to be accom- plished by it? 2. How is the advertising appropriation to be expended — how is the purpose of the advertising to be accomplished? Purpose of Advertising If we assume that a business has previously done no advertising, the selling price of its commodity will be com- posed of the following items: manufacturing or purchase cost, selling expense, administrative expense, and profit. Expressed In the form of an equation we have : Cost of goods sold+selling expense + administrative expense +profit = selling price Obviously, if It is determined to Incur expenditures for ad- vertising, some of the members of this equation will be changed. Either the left-hand members must be decreased, or the right-hand member must be increased. THE ADVERTISING BUDGET 1 13 The competitive condition of the market may be such that by the advertising a sufficient demand can be created for the product to make possible an increase in the selling price. If this be true, the cost of the advertising may be consumed by the increase in selling price and the other members of the equation left undisturbed. This condition is not apt to exist in many cases under present competitive conditions. In fact, only in the case of a monopoly can such a result be expected to be obtained permanently. If the purpose of the advertising is to maintain the pres- ent volume of sales during a period of bitter competition, the expense may be met out of profits. The company may desire to maintain its position in the trade even though smaller profits are to be secured at the present time. It may be thought that the lessened profits at this time will be more than compensated for by increased profits in the future. Similarly a company may incur advertising in order to ward off hostile public opinion and to prevent undesirable legis- lation. Public utilities have done considerable advertising of this nature during past years. More recently some of the packing companies have followed the same practice. Advertising of this nature may well be met out of profits because it is thought that it will prevent lessened profits in the future. Again, a firm may incur expenditures for adver- tising which will lessen current profits but build up good- will which in turn will result in larger future profits. In some cases advertising is incurred because it is thought that it will increase the volume of sales and thus result in a decrease of the cost of goods sold, the selling expense, or the administrative expense. In a manufacturing business, an increase in the volume of sales, with the consequent increase in the volume of pro- duction, will usually decrease the cost of production because of the decrease in the unit cost of overhead. It may also 114 BUDGETARY CONTROL make possible a more economical use of labor and materials./ For instance, the production may become of sufficient vol- ume to make possible the use of scrap in the production of a by-product. (■''In a mercantile business the increased volume of sales may make possible more economical purchasing with a lower unit cost for goods purchased, but the savings in this connection are rarely comparable with the decrease in the unit cost of goods manufactured when the volume of production is increased. / The increased volume of sales may reduce the unit sell- ing cost. If the advertising enables each salesman to sell more with the same amount of effort and expense, the unit selling cost will be decreased accordingly. In addition to the cost of salesmen, the overhead expense incurred in main- taining the sales manager and his staff is usually an appre- ciable amount, and an increase of sales will not usually cause this expense to increase in proportion. Finally, an increase in volume of sales should have a de- sirable result on the administrative expense. There is every reason why the ratio of administrative expense to sales should decrease as the volume of sales increases. Importance of Defining Purpose in Advance The foregoing discussion shows that there may be sev- eral reasons why advertising should be undertaken. /The primary purpose of pointing out these various purposes is to emphasize that the results which it is expected to obtain as a result of the advertising should be clearly in mind before the advertising is begun. So far as possible, data should be prepared to show the possible results of the advertising. The most difficult problem is that of determining the effect of the advertising on the volume of sales. If this can be forecast it is usually possible to estimate the approximate effect of the advertising on the manufactur- THE ADVERTISING BUDGET II5 ing cost, selling expense, administrative expense, and net profity/ "Unfortunately, some firms make advertising appropria- tions expecting to obtain a large increase in volume of sales, without stopping to determine whether the increase in vol- ume which is anticipated would produce satisfactory results — that is, whether the savings resulting from the increase will be equal to the cost of the advertising./ Only recently a manufacturing firm entered into a large contract for ad- vertising and the president showed the author the estimated Increase in sales which he expected to obtain as a result of this advertising. A few moments' calculation showed that if the anticipated volume of sales was obtained the factories of the company would not be able to produce goods to satisfy 75 per cent of the sales orders. In this case, regard- less of whether the advertising failed or succeeded so far as producing the contemplated volume of sales, the firm was bound to lose as a result of the contract. This is but another instance of lack of coordination, which a proper program of budgetary control would rectify. /All of which is to say that advertising is merely a means and not an end in itself. It is a potent force in modern management but it produces satisfactory results only when it is used with judgment and is coordinated with the other functional activities of a business. Method of Accomplishing Desired Purpose After deciding that it is desirable to use advertising for some particular purpose, it is necessary to determine the most effective way of accomplishing this purpose. It is not enough to decide that there are many people who need and can afford the product which you sell and that you can profitably spend a certain amount in order to get them to purchase a certain volume. It is also necessary to decide Il6 BUDGETARY CONTROL in what way they can be reached so as to persuade them to purchase. In other words, it is necessary to decide upon the medium of advertising to be used. There is a multipHcity of ways in which advertising may be accompHshed. To the layman the various possibihties present a confusing complexity. Because of this very com- plexity it is necessary that very careful consideration be given to the contemplated program. Although the adver- tising department should be given considerable freedom of judgment, this freedom should be manifested in the main before, instead of after, the advertising appropriation is approvedy^ It does not seem desirable that the department be given a lump sum without any conditions being attached to its use. In addition, it is impossible to judge the amount to be appropriated until the method in which it is to be spent has been determined. Alt is only by balancing the two fac- tors — the purpose to be accomplished by the advertising and the method of accomplishing this purpose — that it is possi- ble to work out a well-balanced advertising program. Preparation of the Advertising Budget The preliminary estimate of advertising expenses should be prepared by the advertising manager. He should have before him the contemplated sales plans of the business, and also be familiar with the general plans and policies of the business as a whole. If the advertising manager is sub- ordinate to the sales manager, he will submit his estimate to the latter for approval. In any case he must work in cooperation with the sales manager in formulating the ad- vertising program, as the advertising program is but one part of the sales program. The sales manager, or the adver- tising manager, depending on whether the latter is subordi- nate to the former, will transmit the advertising program to the executive in charge of the budgetary procedure, who THE ADVERTISING BUDGET 117 I- QC O Q. LU DC Z o I- < Q. O DC Q. Q. < a z w H DC UJ > < 0. UJ"* o at 3 C •a o Q ? S c Q.< a O CO 3 c ■a o a Q. IS •- a-- 0< Q « a, a < Il8 BUDGETARY CONTROL will in turn submit it to the budget committee which will make such changes as it thinks necessary before approving it. f As will be shown in the manual on budgetary pro- cedure discussed in Chapter XXIII {the budget committee will have before-it all the proposed budgets at one time so that it can consider them as a whole. If the committee thinks that important changes in the estimate are neces- sary, it will call the advertising manager before it and give him an opportunity to defend his requests. After the estimate has been approved by the budget committee it may be submitted to the board of directors for consideration and approval. When it has been finally approved, it then becomes the advertising budget for the current budget period. It will be transmitted by the execu- tive in charge of the budgetary procedure to the advertising manager and will constitute his working program for the period. Form of the Advertising Budget The advertising estimate should be made in such form as to show: 1. The lines of goods which are to be advertised and the amount to be spent on each of them. 2. The methods by which the appropriation is to be spent and the amount to be spent by each method. The budget as approved will show the same information as the estimate and this makes possible the exercise of a proper control of advertising expenditures (i) by purposes and (2) by methods of expenditure. The executive in charge of the budgetary procedure is responsible for seeing that supplementary data are prepared and submitted to the budget committee with the advertising budget which will enable it to judge the possible results of the proposed advertising program. It is expected that a THE ADVERTISING BUDGET II9 considerable portion of these data will be prepared by the advertising manager in support of his request. He should at least present data to show the anticipated effect of the proposed program on the volume of sales. The executi\'e in charge of the budgetary procedure will usually have to supply the data showing the effect of the increased volume of sales on the manufacturing, selling, and administrative cost. In preparing this he may be assisted by the controller and his staff. Control of the Advertising Budget After the advertising budget is adopted It is necessary to take measures to secure its enforcement. The advertis- ing budget may be thought of as a fixed amount of money voted to the advertising manager by the budget committee or board of directors. So it is — the advertising budget is at once an estimate and a limitation of authority to spend. We have seen, however, that the sales program is based on trade conditions and must be currently modified and amended as trade conditions change. Similarly, the adver- tising budget is based on the sales program to a considerable degree and may need to be modified and amended when the sales program is changed. In order that the relation between the advertising program and the sales program may be clearly seen, it is desirable that there be prepared at the end of each month a report similar in form to Figure 5. Mr. W. A. McDermid, in Administration for July, 192 1, suggests the following method of controlling the advertising appropriation: The physical control of the appropriations — the forms by means of which the advertising executive knows where he stands day by day — are relatively simple. They have been modified in many details for different concerns, but a majority are based on the following; 120 BUDGETARY CONTROL 1. The budget sheet: Regardless of the method by which the appropriation has been determined, there is laid out an estimate, roughly distributed month by month, with subtotals at con- venient intervals. 2. Detail sheet: (a) For space. These sheets show, with as much detail as may seem advisable, the publications, dates of insertion, size of space, and cost. The advertising agency usually works this out in compact form both for its guidance and approval. (b) For sundry costs. These sheets are usually more of a guess than the space sheets, but they cover esti- mates for literature, printing, engraving, and innu- merable incidental costs. They should be binding only as to outside limits. 3. Budget control sheet (see Figure 6) : With this before him and his general budget approved, the manager knows where he stands all the time. If the appropriation or scale of expenditure warrants, this could be made weekly or even daily. The advertising budget presents a plan under which the advertising manager may engage expert labor, make news- paper contracts, etc. As such contracts are made and obli- gations incurred, the advertising budget comes by degrees to a stage where amendments are difficult. For example, after a contract has been made for printing a shoe catalogue, it is of little use to decide that the money involved can be expended to better purpose in street-car advertising. A report is needed, therefore, which will show the amounts under each appropriation item still available for contract or for transfer to other purposes. Such a report may be made in the form of Figure 7. A little consideration of this report should make apparent the value and purpose of each of the columnar headings. Columns (i) to (4) inclusive show original plans and the THE ADVERTISING BUDGET 121 c o CO o li. ~ UJ < H O o z o (n < Ul o u> o> e ■o o 0) m n « 1- w cc « o 1 Q. o^ UJ Z o CC U 9o l-:S >o^ ^ J5 9 p a. = CE >• o a.£ "D Q. § & ^ DC UJ 1- > Q r < o S^ JC in » c o Ul s a Z c o _c 1- a. • 'sVsi 3 a o c 1 ^ (^ CB C9 1 E (- CO Si 5 E -a o CO •o a. — r- "5 Q.=i 1 .2 g guj^ a *2 a> 05^ — cj'|:= = " 1-5 s f 1 1 J "(3 Q S zi2h:s 2 --^f oiz =S o£ ii a ii s c^Ss 2 S f2 -1 ^ h- h- V- to to Di a < bo 122 BUDGETARY CONTROL CO lij Q Z Ul Q, X Lli o z CO h- Ul > Q < I- o Dl LU cc » ; • ; CL ™ ; ; ; U.OO 8 q 8 ill C> 3 t' — ' ■*■ 12!- a. 3 T- . • c a i Q , 9. <= c ^^ ac '- 10 ; IT in w ICl If i ; i 01 C3> C3 (d W ; CO rsT CO CO (M i i i " H CQ ^~ »- LU LU I ?T in "O 00 1 W "S 7 7? OJ 1 T ? I 1 i CO Q 4 4 44 4 1 1 in itj 111 DC I- co ^ ; ! (-^ Q d CO r-, C\J 03 CM 0) (C i M N j : : z i i ; ^ LU UJ ^ z (T, ; ; i 3 CO CO >• ~ ~ ' i i DC — l^ c Q : ; i UJ III c nl i R : : ! Q : : : cc Q < _1 3 i f *" "* i i i 00 UJ Q ! 00 < LU ; i 1 .0 < 00 Q -1 UJ gUj _5 ^s UJ ^ 1-2 ca c nj d i i i ^ Mi 80 ! i ; 1-0 ^ 17. 1- to in < I z d (M CM -^ r^ (O ; ; ; . -CM : ; -o X CM 1 : 15 < '■ I ■ . ^ 73 '• '. : ^ Q UJ >• a i ; i cc '^ a • UJ Q cr C a c M i 88 S> in .CM T- r- CM z *" 15 1 1 1 2 Q ■* 'f in m 154 BUDGETARY CONTROL column. This column shows at all times the amount on hand. After looking through the files of factory requisitions it is found that all requisitions for this particular commodity have been filled so that the quantity of 12,500 is available for use. This quantity would be entered, therefore, in the Available or Shortage column. An examination of the pur- chase order files shows that there is outstanding a purchase order for 10,000 pieces of this commodity, this amount being the Quantity to Order. The 10,000 on order is entered in the ordered column. The record is now ready for the receipt of the current entries. On April 5 a factory requisition, No. E 6784, is received for 4,000 pieces. The number 4,000 is entered in the Applied column and substracted from the amount in the Available or Shortage column, thereby reducing the balance in this column to 8,500. On April 10 the quantity specified on requisition E 6784 is delivered to the factory and an entry is made in the Issued column, reducing the Balance column to 8,500. The other entries for requisitions received, bal- ance on hand, and quantities delivered to factory, are simi- lar to the ones described above. On May i, 10,000 pieces of stock are received from the vendors to whom purchase orders have previously been issued. This quantity is en- tered in the Received column and added to the quantity in the Balance column and the Available or Shortage column. The value of the Applied column lies in the fact that it makes possible the reserving of materials for use on an order though it may not be desirable to requisition them from stock at once. In a factory operated under a proper plan- ning system, a "bill of materials" showing the materials required for the entire order is prepared for each production order issued. On the basis of this bill of materials entries are made on the materials balance of stores resei'ving the materials needed for the order. Some of these materials THE MATERIALS BUDGET 155 may not be taken out of stock for several days, but it is de- sirable that they be reserved so that there will be no danger that the order may be delayed because of the lack of ma- terials. If this method is not followed, materials may be on hand when the order is issued but before the materials are requisitioned from stock they may have been used on another order. Relation of Purchasing Policies to Materials Budget In the preceding discussion it has been assumed that the materials budget is based on the production requirements and that the purchases will be scheduled to correspond with the production schedule. The only deviation from this assumption which has been recognized in the foregoing dis- cussion, is that in establishing quantities to order care must be taken to see that the quantities stated are sufficient to constitute economical purchases. In determining what con- stitutes an economical purchase it is necessary to consider (i) the possibility of getting lower prices or better terms by making larger purchases, and (2) the possibility of saving in freight costs by purchasing in large lots instead of small ones. In each case it is necessary to balance the savings which may be made by purchasing in large quanti- ties against (i) the loss incurred by tying up capital in excess inventories, (2) the possible loss due to deterioration or de- crease in price of the inventory, and (3) the possible financial embarrassment which may result from having capital in- vested in inventory which cannot be quickly realized. There are many factors which may affect the purchasing policy of a firm, and there are some of these which are op- posed to the control of purchases by budget. For instance, some firms think it is a function of the purchasing depart- ment to speculate on market changes and tendencies. In these firms, during periods of rising prices, large quantities 156 BUDGETARY CONTROL of materials will be purchased and deliveries scheduled far in excess of production demands. It is undoubtedly true that under these circumstances a firm may make large sav- ings by placing large orders while the prices are increasing. It obtains materials for future use at a lower price than it could obtain them if it waited to purchase them when needed. It is also more assured of their delivery than if it waited until their purchase is indicated by the materials budget. This policy is apt to prove a dangerous one if careful control is not exercised. If the purchasing department is once given the opportunity to purchase in large quantities, unrestrained by the limitations of present requirements as shown by the materials budget, it is apt to make the most of its opportunity and continue the policy of quantity buy- ing as long as prices continue to rise. When the turn in prices comes, the firm is apt to find itself burdened with an inventory far beyond its needs, with large deliveries sched- uled to be made for several months, all of which has been purchased at the peak of prices. In many cases, even if the firm escapes serious financial embarrassment it loses more on its high-priced inventories than it gained from the quan- tity buying during the period of rising prices. A falling price level often has the opposite effect on the purchasing policy of many firms. The possibility of buying materials in the near future at reduced prices and the ease with which goods can be procured tend toward "hand-to- mouth" buying. It is very desirable to exercise caution during a period of declining prices, but the purchasing policy may be so conservative that it will result in a decided loss. Parsimonious buying may result in unbalanced inventories and make it impossible to give proper service to customers, with the consequent loss of trade. Small purchases may also result in higher prices and freight rates. THE MATERIALS BUDGET 1 57 It is the author's opinion that the purchasing depart- ment is not equipped to speculate and that it is not its function to attempt to do so. We have not yet developed methods of forecasting with sufficient accuracy to make it possible to speculate on market trends without the incurring of great risk. As Mr. Arthur E. Swanson very well says in the November, 192 1 Administration: "The difficulty which even very experienced and well-trained business men en- counter in predicting even approximately the trend of price levels and business activity, has caused many to follow a sort of straddling policy in reference to economic trends. They do not buy very far in advance when the level ap- pears to be on a long upward swing, or very close when the level appears to be on a downward swing. They are satisfied with an average buy." Whatever may be the purchasing policy of a firm, it is the function of the materials budget to show the materials required by the production program, and to show a schedule of deliveries which will meet the needs of this program. If the management desires to disregard the purchasing pro- gram shown by the budget in order to carry into effect pur- chasing policies which it has adopted, that is its privilege. It is the opinion of the author that it is only in exceptional cases that it is wise for it to do so. The "Stores" Budget The purchasing department purchases not only the ma- terials which become a part of the manufactured product, but also numerous "supplies" which are used in carrying on the manufacturing operations. It also purchases the sup- plies used by all the operating departments. Under a well- developed system of inventory control it is customary to term as " stores " all the materials purchased for all purposes and to place them in a storeroom from whence they are 158 BUDGETARY CONTROL requisitioned for use. When the requisitions are issued it is indicated whether the stores for which they call are to be charged as "materials" or as "supplies." Because of this method of handling materials and sup- plies, it is the practice of some finns to prepare a stores budget which takes the place of the materials budget. The stores budget includes the estimated purchases for both materials and supplies. It is claimed that it is easier for the purchasing agent to make a stores budget than it is to estimate separately the materials and supplies. It is also claimed that it is easier to compare the estimated with the actual performance if the materials and supplies are shown in one budget. This contention is based on the fact that both the materials and supplies are charged to a Stores account when purchased and are not distributed as between materials, manufacturing expense (manufacturing supplies are charged to manufacturing expense when consumed) and departmental expenses, until they are requisitioned from the storeroom for use. Consequently the stores accounts give a ready means of checking the estimate of purchases, while the materials and manufacturing expense accounts do not, since purchases do not correspond with consumption during any specific period. There is considerable merit in these contentions, and the author has found it advisable in some cases to prepare two budgets, the first based on purchases and the second on con- sumption. The consumption budget is essential if standard costs are to be established for material, labor, and manufac- turing expense, and it is the belief of the author that such standards are essential for effective production control. Preparation of Materials Budget After the production budget is prepared, the production department can prepare an estimate of the materials re- THE MATERIALS BUDGET 159 quired to produce the goods called for by this budget. If a well-developed planning department is in operation, it will have available data which will make it possible to prepare this estimate without difficulty. In such cases it is custo- mary to delegate the preparation of the materials estimate to the planning department. After its preparation, the materials estimate is carefully examined by the production manager and his staff. If there is not a planning depart- ment in operation, the estimate of materials requirements will be prepared by the staff of the production manager. After the estimate of materials has been approved by the production manager it will be transmitted to the purchasing department, which will make an estimate of the purchases which must be made to meet the estimate of materials. The foregoing procedure is not always followed. In some businesses the production budget is sent to the pur- chasing department, and it is required to estimate both the materials required and the purchases which are necessary to meet these requirements. It is the author's opinion that the estimate of materials can best be made by the produc- tion department, since it usually has available the informa- tion which is necessary for its preparation, or if it does not, it can obtain the information easily. It should be evident that if the production department, through the planning department or otherwise, prepares bills of material for pro- duction orders, it must have available data from which it can estimate material requirements. If the purchasing de- partment collects the data necessary to make this estimate, it will usually lead to a duplication of data, the same infor- mation being collected and recorded by both the production and the purchasing departments. In other businesses the production department prepares both the estimate of materials and the estimate of pur- chases. This procedure leads to equally undesirable results. I60 BUDGETARY CONTROL The purchasing department must have available for its own use the data necessary for the preparation of the estimate of purchases ; and if this task is undertaken by the produc- tion department, it will be necessary for it to collect dupli- cate data which it is not as well qualified to interpret and use as is the purchasing department. Furthermore, the purchasing department may rightly resent what it regards as an undue usurpation of its functions. One of its primary functions is to collect data and formulate a purchasing pro- gram which will meet the needs of all the departments and result in the most profit to the company. If the production department prepares the estimate of materials which usually constitutes the major part of the purchases made, it is depriving the purchasing department of its initiative and judgment. Materials Budget Form As in the case of all other forms used in budgetary con- trol, it is not feasible to prescribe a form for the materials budget which will satisfy all conditions. The author has found the form shown in Figure lo serviceable in most cases. The illustration is designed for use when the budget period is three months in length. If the period is for a longer period of time, further columns may be added. In most cases the materials budget will need to be pre- pared prior to the beginning of the budget period ; therefore, all the information shown on the budget report, including the beginning inventory, must be estimated. The estimated beginning inventory can be obtained from the budget report of the previous period, since the ending inventory of one period will be the beginning inventory of the next period. The estimated purchases will be based on the estimate of materials submitted by the production department, with such modifications as the purchasing department may think THE MATERIALS BUDGET i6i T) 1 n- 6 2--= = = ^■^C Wo O J25e|'s= ^ , ^ „ M « 3^^ 2> o-c i|i2^>l I 1- Z -o >. o ^ 2 ■= 5 § £ uj UJ — -O M I w ra H II ? = 2 '= c _c li EstIm Olsbu ments Purch, ol Cur Mom "=i5SS 1- X LU Z O ujo Eq--^ ■o >» Q CQ 2 1 ll5 CO Z o UJ — ol _l o V u < Ul CO 1 1 a: W 3 LjJ UJ Q_ >, " < 2 c 2 c c — OO •o . .- « — 5seIo^ ■o . i_ — OT *=*-= 1 =;22'Ec I t- z ■o >, o fla — C 2 e 5 UJ fe « c ^ a: u. 1-= Ui Q- >. o> £ = — m CO 2 u h- m u O Q m o Q- LlI DC O Q O q: UJ Q. »- ° « ^ < > 'oi 3 CQ U l62 BUDGETARY CONTROL necessary. For instance, the purchasing department may purchase more during the month than called for by the materials estimate because the latter amount may not con- stitute an economical purchase. The estimated inventory at the end of the month is obtained by adding the estimated purchases to the beginning inventory, and substracting the estimated consumption of materials as shown by the esti- mate of materials submitted by the production department. If the quantity of purchases and the quantity of materials consumed are the same, the beginning and ending inventories will be the same. A comparison of the beginning and end- ing inventories is of significance to the budget committee, since in case of an increase in inventory the purchasing de- partment may be asked to explain the cause. The estimated disbursements for purchases of previous months can be obtained from the unpaid invoice file. The accounts payable section of the accounting department may be asked to supply this information, since this section main- tains the unpaid invoice file. The estimated disbursement for purchases of the current month will be determined by estimating the time of delivery of the purchases and allow- ing for the usual discount period. It can be readily seen that the information shown in this column can be only approximately correct, but this does not destroy its use- fulness, since the purpose of showing the estimated dis- bursements on the materials budget is only to indicate, in a convenient form for the use of the treasurer and the budget committee, the probable financial requirements of the contemplated purchasing program. As will be explained in the discussion of the financial budget, these estimates will be checked and revised, if necessary, by the executive in charge of the budgetary procedure and the treasurer in the preparation of the monthly estimates of cash receipts and disbursements. THE MATERIALS BUDGET 1 63 After the estimate of material purchases is prepared by the purchasing department, it is forwarded to the executive in charge of the budget procedure and is transferred by him to the budget committee, together with the other depart- mental estimates and the estimates of cash receipts and dis- bursements which are prepared from the departmental esti- mates. After the estimate of materials is approved by the budget committee, it is transferred by the executive in charge of the budget committee to the purchasing depart- ment, whose working program it constitutes for the budget period, subject, however, to monthly revisions which may be made by the budget committee. Control of Materials Budget The materials budget, like all other budgets, must be checked up at frequent intervals in order that errors in the original budget may be detected and corrections made as quickly as possible. To make this possible it is necessary to have a monthly report which will provide comparisons be- tween the estimated and the actual purchases. The report illustrated in Figure 1 1 will ser\'e this purpose. The purpose and value of the information shown in each column of this report should be evident. The executives should study this report in the light of the production for the month compared with the estimated production. They should also give consideration to the comments shown in column (8), since there may be special considerations which have brought about a deviation from the materials budget. Such deviations should be made as a general rule, however, only in response to executive direction or permission. This report will be submitted to the executive in charge of the budget procedure, and will be transferred by him to the budget committee with such recommendations as he may think desirable. By a study of this report the budget com- I64 BUDGETARY CONTROL mittee will be able to make such revisions as are necessary in the materials budget for the remainder of the budget period. These revisions will be communicated to the pur- chasing department by the executive in charge of the budget procedure. It is evident that the budget committee and the treasurer will want, in addition to the report shown in Figure 1 1 , a report which will show the disbursements for material pur- chases during the month compared with the estimated dis- bursements for the month. CHAPTER XI THE LABOR BUDGET Need for Estimate of Labor After the finished goods which are to be produced during the budget period are determined by means of the produc- tion budget, it is necessary to estimate the labor required to produce these goods. This estimate Is necessary in order: 1. That the personnel department may make plans to have avail- able the necessary workmen at the time they are needed in production, 2. That the treasurer may know the probable disbursements re- quired by the labor program and can make plans to obtain funds for these disbursements. 3. That the budget committee may be able to see the financial re- quirements of the proposed sales and production programs at the time they are submitted to it for consideration. The labor budget must be combined with the selling expense budget, the materials budget, and the other budgets requiring disburse- ment of funds, in order to show the total disbursements of the budget period, before the budget committee or the board of directors can judge the advisability of undertaking the financial obligations imposed by the proposed budget program. 4. The estimate of labor is also required in preparing the "general budget" or estimated balance sheet and statement of profit and loss. It is particularly important that the personnel depart- ment have information with reference to the labor require- ments considerably in advance of the time when it is neces- sary for these requirements to be satisfied. To obtain an efficient working force is not an easy task, and capable workmen cannot be secured by issuing a purchasing order as can materials. If skilled laborers are required, the task 165 l66 BUDGETARY CONTROL of supplying them is usually not an easy one. In many cases they must be trained before their services can be used effectively. A well-organized personnel department will gather information of its own accord, which will afford it an approximate estimate of the labor requirements, but it docs not have an approved program on which to work until it receives the labor budget. Determining Labor Requirements by Analysis of Each Product In the same manner in which the production department maintains an analysis of each of its products to show the manufacturing operations and materials required in its pro- duction, it should maintain an analysis which will show the labor required in the production of each commodity. If a planning department is in operation this analysis will prob- ably be maintained by this department, for the analysis is necessary for its use in preparing time tickets for distribu- tion to the different departments when production orders are being scheduled. If this information is not available in the planning department, it may be available in the estimat- ing department, the pay-roll department, or the personnel department. If none of these departments have such records, it is necessary that the records be prepared by the staff of the production manager. By the use of this analysis it is possible to estimate, on the basis of the production budget, the labor which will be required to produce the goods called for by the production program. The preferable way of making this estimate is to take each item on the finished goods or production budget and determine the amount of labor of each kind which will be required to produce it. To illustrate: The production budget calls for the manufacture of i ,000 units of articles X of Y size. The product analysis shows that article X passes through four processes. Process A requires four hours of THE LABOR BUDGET 167 labor, process B two hours, process C three hours, and process D five hours. It takes, therefore, a total of four- teen hours to produce one unit of article X. If 1,000 are to be produced it will take a total of 14,000 hours. It is, of course, probable that the labor used in the different processes will not be of the same grade, in which case the total labor re- quired for each process will need to be estimated separately. If each item on the production budget is considered in this manner, it will be possible to determine the total labor re- quirements of the production program. Other Methods of Estimating Labor Requirements It is easy to see that this method of determining the labor requirements may in some circumstances be quite difficult. There may be so many commodities produced and so many different kinds of labor may enter into each, that it may require an immense amount of clerical work to determine the labor requirements of each commodity. In some cases it is thought expedient to use the budget of machine capacity, discussed in connection with the pro- duction budget, as a basis for estimating labor requirements. The number of * ' machine hours ' ' required by the production budget having been obtained, an estimate is then made of the workmen who will be required to operate these ma- chines. In other cases it has been found expedient to obtain the ratio between the production volume for several periods and the volume of labor of each kind required for this production, and apply these ratios to the production budget of the current period to obtain the probable labor requirements. These estimates will be more accurate if separate ratios are determined for the different classes of product manufactured. The reason for this is ap- parent, for different quantities of labor will be required for different classes of finished product, and the ratio 1 68 BUDGETARY CONTROL between the different classes is apt to vary from period to period. The illustration given on page i6i in connection with the discussion of the method of estimating material require- ments is equally applicable to the determination of labor requirements. In some businesses the estimate of labor requirements is made by determining the labor cost per unit of produc- tion for several periods, and then applying this unit cost to the estimate of production for the current period. For instance, it may be determined that the average labor cost as shown by the records for several periods is $30 a ton. The estimate of production calls for the manufacture of 1,000 tons; therefore the estimate of labor is $30,000. If the unit cost is determined carefully and is calculated sepa- rately on each product, an estimate made in this manner may serve satisfactorily for purposes of financial control; but it does not provide satisfactory information for the use of the personnel department. In a business where the vol- ume of production is fairly uniform and the working force stable, it is not so important that the personnel department receive a report showing labor in terms of hours. It must always be remembered that the cost of obtaining informa- tion must be balanced against its value. Budgetary con- trol is no exception to the general rule that profit and loss is the ultimate test of the merit of any method of administra- tive control. Use of Standard Labor Rates Some of the most valuable work of industrial engineers has been in the establishment of standards by which to judge labor. The first work performed by the exponents of "scien- tific management" was the establishment of standard time limits for the performance of tasks. These rates were first THE LABOR BUDGET 169 established in connection with factory labor and were used to speed up production. There seems to be no good reason why such standard rates with proper modifications might not be applied to all departments of a business and used very extensively in the enforcement of administrative con- trol. It is interesting to note that a large manufacturing firm in the East is now scheduling very definitely its sales- men and making a careful study of how each employs his time with the intention of developing standards by which to judge salesmen's activities. Standard labor rates serve three useful purposes: 1. They can be used in the estimating of costs and in the establish- ment of prices on special orders and contracts. 2. They serve as a means of judging the efficiency of workmen. If the rates are fair and equitable, a workman's efficiency can be judged by his ability to reach the standard. In many cases his wages are based on the standard, so that he has an incen- tive to reach or exceed the standard if possible. 3. They give important service in estimating labor requirements and in formulating a labor program. Where standard rates of labor to be used in the man- ufacture of each product are established, the task of prepar- ing the labor budget is greatly lessened. It must be remem- bered, however, that varying conditions may make the actual labor cost more or less than the standard, and it is the actual as near as it can be estimated which is necessary for budgetary control purposes. Relation of Labor Requirements to Production and Labor Policies The preceding discussion has explained the method of determining the amount of labor required to produce the amount of goods called for by a production program based on a sales program. It might seem from the discussion that it is the intention to advocate that the production program always fluctuate in harmony with the sales program and lyo BUDGETARY CONTROL that the labor supply be made to fluctuate with the produc- tion program. If this could be done, the determination of the labor requirements, once the sales requirements were obtained, would be merely a mathematical process. But the formulation of a labor program, which is a prerequisite to the maintenance of an effective working force, is not so simple as this. In the establishment of a labor program it is necessary to consider not only the immediate but also the long-time labor requirements of a firm. This leads to a consideration of both the production and labor policies of the firm in question. One or two simple illustrations will assist to make this more apparent. Previous mention has been made of the fact that the production program may not be varied in all cases to cor- respond with the fluctuations in the sales program. It may be impossible to control the fluctuations in the sales, al- though some businesses, notably department stores, have done much towards accomplishing this end. But the vol- ume of production is under the control of the firm, and within the limits of its resources can be varied to suit its needs. It may be found more profitable to maintain a uniform production, building up during the dull season an inventory to meet the excess demands of the rush season, than to cause the production program to fluctuate in har- mony with the sales program. This procedure may provide for a better use of equipment and make possible the main- tenance of a more stable and better trained working force. If this policy is to be followed it must be kept in mind when the personnel department is formulating its labor program. It is apparent that the labor program must be based on a "long look ahead " rather than on a "flash-light glimpse" of the present condition. Some business firms provide homes for the use of their workers, charging in many cases a nominal rent for their THE LABOR BUDGET 171 use. In some cases the business is located in a village and most of the inhabitants work for the firm ; and in case work- men are laid off during dull seasons, it is necessary that they journey to another village to obtain work. If they remain in the village it is necessary for them to continue to live on the property of the firm unless they suffer considerable hardship. In many cases the workmen regard the houses in which they live as their permanent homes. In fact one of the reasons for their being willing to work for the small wages they usually receive in these cases is because they expect to have a permanent home. In such cases a firm may attempt to provide some work for all its employees during each month of the year if possible. If necessar^^ it will reduce wages or work the laborers in shifts, so that each may work part time, but it will attempt to retain the full personnel on the pay-roll, so long as it expects to need them for future use. In carrying out this policy, it may pile up inventory during dull seasons which will be used during the rush seasons. In addition, in the formulation of its labor program each firm must consider its relations to labor unions, the state labor laws, and similar agencies. More than all, it must consider its attitude towards its workmen, its welfare pro- gram, and the long-run policy it desires to maintain in handling its labor force. Like any other administrative device, a budget should not restrain the management from exercising its legitimate functions; it should only aid the management by providing information which will serve as the basis for judgments. This is particularly true of the labor budget. The Pay-Roll Budget The personnel department contracts not only for the personnel which is necessary to perform the operations 172 BUDGETARY CONTROL required in the manufacture of the product of the firm, but also the personnel which is necessary to perform the supple- mentary operations which are required in order that the manufacturing operations can be performed. For instance, it employs janitors and repair men as well as machine opera- tors. In addition it employs personnel for all the other departments of the business as well as for the production department. In consequence of this situation it is the practice of some firms to prepare a pay-roll budget which takes the place of the labor budget. The pay-roll budget includes an estimate of the entire pay-roll of the company. The pay-roll budget probably arose from the practice of having the labor budget prepared by the pay-roll department. This department found it easier to make an estimate of its total pay-roll than to analyze it and present separate estimates. Reasons Against Employment of Pay-RoU Budget It is the opinion of the author that usually this plan is not desirable for the following reasons: 1. It is very apt to lead to inaccurate estimates. It is so very easy to add or substract a certain amount from the total and report the result as an estimate. The method usually results in the employment of ratios between pay- roll and volume of business, and such comparisons are un- satisfactory because the pay-roll does not fluctuate in pro- portion to volume of business. 2. The pay-roll budget is apt to make difficult an accu- rate check on the estimates. If it contains the cost of the entire pay-roll of the company, it is difficult to determine the cause of the variations between the actual and estimated, which are bound to occur. Furthermore, the amounts shown on the budget will not correspond with the amounts shown in the records, since the pay-roll in the latter is classi- THE LABOR BUDGET 1 73 fied by departments, and in the production department direct labor is recorded under labor, while indirect labor is recorded as manufacturing expense. 3. It is desirable to have each functional department prepare an estimate of its total expense, including its pay- roll. This procedure requires the head of each department to consider what his costs have been and what he plans they will be in the future. This is one of the important purposes of the budgetary program, and the budgetary procedure should be designed so as to obtain this result. The present chapter is restricted to a consideration of the "direct" labor employed in production. "Indirect" labor will be considered in connection with the manufac- turing expense budget, and the personnel cost of the func- tional departments will be considered in connection with the budgets of these departments. Preparation of Labor Budget — Approved Procedure After the production budget is prepared, the production department can prepare an estimate of the labor required to produce the goods called for by this budget. If a well- developed planning department is in operation, it will have available data which will make it possible to prepare this estimate without difficulty. In such cases it is customary to delegate the preparation of the labor budget to the plan- ning department. After it is prepared it is carefully exam- ined by the production manager and his staff. If there is not a planning department in operation, the estimate of labor may be prepared by the staff of the production depart- ment, the pay-roll department, or the personnel department. In any case it must be approved by the production manager. After the estimate of labor requirements is approved by the production department, it will be transmitted to the personnel department, which will make an estimate of the 174 BUDGETARY CONTROL cost of the labor required. In some cases the personnel de- partment makes an estimate of the labor requirements and then transmits the estimate to the pay-roll department, where the estimated cost is entered. Thereafter the esti- mate of labor requirements is returned to the personnel department for review. Less Satisfactory Methods of Preparing Labor Budget The foregoing procedure is not always followed. In some businesses the production budget is sent to the per- sonnel department, or to the pay-roll department, which must estimate both the labor required and the cost of secur- ing it. It is the author's opinion that the estimate of labor required can best be made by the production department, since it usually has available the information necessary for its preparation. If the personnel department collects the data necessary to make this estimate, it will usually lead to a duplication of data, since the same information will be collected and recorded by both the production and personnel depart- ments. It is admitted that some of this information is useful and even necessary for the personnel department, but it is not necessary to have it in as great detail as is required for making the estimate of labor. In other businesses the production department prepares both the estimate of labor requirements and the estimate of labor costs. This procedure leads to equally undesirable results. The personnel department must have available for its own use the data necessary for the preparation of the estimate of labor costs, and if this task is undertaken by the production department, it will be necessary for it to collect duplicate data which it is not as well qualified to interpret and use as is the personnel department. Furthermore, the personnel department may rightly resent what it regards THE LABOR BUDGET 175 ^ s / -0 / ^ 1 2 1— (- c 3 CO s -0 cc H CO 00 Q j- c s ! 1 •^ ^ '^ Q.«-( tf).— > ° ^ %. L. H id Q « 2 3 .§-ic2 CQ •525 DC uja.>^ m < ■a -J Estimate Amount f Present Period / ^ «>»-• 3 0) a c o-a (0 311 i- -r SE-s;a> <- ® 3 « U0505 c o Q. - Q c s 11 < qI •0 s <».5 rt Q E 3 uji H z UJ S H cr < Q. UJ / Q 1 C4 « 176 BUDGETARY CONTROL as an undue usurpation of its functions. One of its primary functions is to collect data on labor requirements and form- ulate a labor program which will meet the needs of all the departments and result in the most profit to the company. "Labor program" is here used in a broad sense, and does not refer to estimating labor costs only. If the production department prepares the estimate of labor cost, it may be such as to conflict with the general program of the personnel department. Form of Labor Budget The author has found the form shown in Figure 12 of service in the presentation of the labor budget. It can be modified to suit the needs of each particular case. This form is intended for use in presenting the labor budget to the budget committee. The production and personnel de- partments will need more detailed reports in preparing the estimate. The illustration is designed for -use when the budget period is three months in length. If the period is for a longer period of time, additional columns can be added. If the estimate is prepared in this form, it will be possible for the budget committee to determine whether the current estimates are in excess of past expenditures, and, if so, what the cause of the increase is. If this increase is deemed unjustifiable, the estimate can be revised accordingly. The value of the monthly distribution to the treasurer in the preparation of his cash budget is quite evident. It may be desirable to show an analysis of the labor costs of each department. At least the production and personnel departments will employ such an analysis. Approval by Budget Committee After the estimate of labor is approved by both the pro- duction and personnel departments, it will be forwarded to THE LABOR BUDGET 177 the executive in charge of the budget procedure. He will transmit it, with such recommendations as he may think necessary, to the budget committee. The latter will con- sider it in connection with the other budgets submitted to it, and will make revisions if it thinks they are necessary. It will return the budget as approved to the executive in charge of the budget procedure, who will transmit a copy of it to the production and personnel departments. Control of Labor Budget The labor budget, like all other budgets, must be kept under effective control, and this involves the preparation at frequent intervals of reports which provide a comparison between the actual and estimated performance. It is usually desirable to have a monthly report which shows these comparisons. A report in the form sho^\^l in Figure 13 will serve this purpose. The purpose and value of the information shown in each column of this report should be evident. The executives should study this report, giving particular attention to the effect of any variations in the production program on the labor cost. This report will be submitted to the executive in charge of the budget procedure, and will be transferred by him to the budget committee with such recommendations as he may think desirable. By a study of this report the budget committee will be able to make such revisions as are neces- sary in the labor budget for the remainder of the period. These revisions will be communicated to the personnel and production departments by the executive in charge of the budget procedure. 12 CHAPTER XII THE WELFARE EXPENSE BUDGET Relation of Welfare Expense to Labor Cost The preceding chapter has dealt with the method of esti- mating and controlling the cost of labor used in manufac- turing operations, in so far as that cost is represented by the wages paid to workmen. But all firms incur some expense in the securing and maintenance of the labor force, in addition to the compensation paid to the members of this force. This expense for the purpose of budget making may be divided into two groups : 1 . " Welfare ' ' expense 2. Administrative expense of the personnel department It is the purpose of the present chapter to treat of the first of these, while the second will be discussed in Chapter XVIII in the treatment of the expense budgets. It is not always easy to make a clear line of demarcation between these two classes of expenses, but the following discussion will serve to show certain distinguishing features between the two. Practically all large industrial and mercantile firms now place considerable emphasis upon desirable working condi- tions for their employees as a basic factor in labor expense control. The welfare of the employee is studiously consid- ered from the standpoint of his loyalty to the employer as well as from the standpoint of his efficiency as a productive workman. His health and personal habits have an impor- tant bearing also upon his availability for service now and in the future as a trained employee. 178 THE WELFARE EXPENSE BUDGET 1 79 Classification of Welfare Expense The large corporations, under their welfare plans, incur various kinds of expense. Programs for better conditions of employment usually include at least medical inspection, first-aid medical services, and restrooms for women em- ployees. These programs may include any or all of the following classes of expense : 1. Medical inspection 2. Medical attendance and hospital expense 3. Payment of wages while on sick leave 4. Dental inspection and dental work 5. Inspection of the eyes and fitting of glasses 6. Picnics, dances, and other entertainments 7. Night classes in English, civics, arithmetic, and other elemen- tary subjects 8. Tuition in evening schools of commerce 9. Restrooms 10. Gymnasiums 11. Prizes for athletic and literary contests 12. Lunches free or at cost 13. Books and magazines 14. Contributions to savings fund 15. Contributions to pension and old-age retirement funds The foregoing list is intended to be suggestive of the kinds of expenditures which may be incurred in improving the working conditions of the employee. It is not the func- tion of this discussion to pass judgment on the nature of this work or the kind of expenditures which it should include. That problem lies in the field of personnel management. But granting that certain kinds of expenses exist, it Is the province of the budgetary program to effect their control. It is also unnecessary to enter here Into a discussion of the title by which these expenses should be known. There are some who object to the term "welfare expense" because it is thought that It has an Improper connotation. From I80 BUDGETARY CONTROL the viewpoint of our problem the title of this expense is immaterial. Relation of Welfare Expense to Functional Departments The welfare expenses are largely impersonal. The basis for welfare work must be democratic if it is to result in in- creased loyalty and self-improvement on the part of the average employee. This requirement leads to the opening of all the advantages to each employee alike, whether the employee is an ofhcer of the company or a machine helper. It is sometimes necessary to make exceptions to this rule, but they should be as few as possible. All employees alike are required to submit to medical inspection, all employees alike are given medical service, all are permitted to use the gymnasium, and all share in the pension fund, although their share may be affected by their previous earning power. Because of this impersonal character of practically all welfare expense, it is not possible to charge any particular item of it as a part of the direct cost of a particular job or as a direct charge to the expenses of a particular operating de- partment of the business. It may be that more employees of the production department avail themselves of the use of the bowling alley than employees of the sales department, but this does not warrant charging the major part of the expenses of maintaining the bowling alley to production expense. In most cases the clerical employees will make greater use of the books and magazines than will the manual laborers ; but so long as the publications are available for the use of all the departments, they cannot be treated as an expense of any particular department. The independent nature of the welfare expense of any of the departments is seen also if the purpose of the expense is considered. For example, a physical examination of each employee may be required to prevent possible poor health THE WELFARE EXPENSE BUDGET l8l or breakdown of any necessary or trained employee. All this is general expense. We cannot say accurately that any part of this expense has been incurred for the benefit of a particular laborer or even for the benefit of a particular pro- ductive unit or operating department. All departments are benefited by the maintenance of an efficient working force. Again a part of welfare expense is incurred with the idea of creating loyalty on the part of the employees towards the company. It is desired that they should be stimulated to a definite feeling of cooperative Interest in their fellow em- ployees. Thus, the bowling club prize, awarded by the president of the company to the winner of the individual high score in the contest open to all employees, is by no means to be charged directly to the department where the winner is employed. The foregoing discussion and illustrations should be sufficient to show that welfare expense is general in nature and is seldom particular to any employee or department. The welfare expense budget is discussed in connection with the several budgets prepared for manufacturing operations, because it is in connection with manufacturing industries that the administration of personnel has been most difficult and the need for welfare work has been most felt; but it is not intended to imply that this expense is primarily for the benefit of the production department. In a manufacturing business the bulk of the personnel will usually be in the pro- duction department and the greatest fluctuations in the number of personnel will also occur here, so that in esti- mating the amount of the welfare expense it is necessary to give careful consideration to the production program. Estimating Welfare Expense — Per Capita Cost Method Welfare expense will be incurred in the case of any par- ticular concern to the extent that the concern finds it profit- 1 82 BUDGETARY CONTROL able to improve Its conditions of employment so as (i) to compete with other concerns as a place of continuous em- ployment, and (2) to improve the efficiency of its workmen. A business with a factory located in a country town will not find it necessary to incur certain expenses to so great an extent as will a business whose factory is located in a con- gested tenement district. The former will incur less for medical services and in the maintenance of sanitary condi- tions. On the other hand, it may find it worth while to maintain homes for its employees in order to attract a better class of workmen to live in the semi-rural locality, and thus incur an expense not common to industrial firms located in cities. There is no means by which welfare expense can be de- termined exactly. It will vary with the number of employ- ees, and will also vary from month to month and year to year, given the same number of employees. For in- stance, an epidemic may break out at any time which will require additional expense for medical inspection and service. Perhaps the best method of estimating the amounts for a budget on welfare expense is to determine the per capita cost of each class of expense, and then to multiply the aver- age per capita cost of past years by the estimated average number of employees for the coming period. If the per capita method is employed as a basis for estimating welfare expense, it is desirable to have a report showing the amount of each class of expense in past years. Then if statistics can be had as to the average number of employees in past years, the amount of money spent, say, for doctors and nurses in 192 1, can be divided by the average number of employees for 1921 to obtain the per capita expense during this year. If it is thought that the same per capita cost should be maintained during the year 1922, the per capita THE WELFARE EXPENSE BUDGET 183 cost of 1 92 1 will be multiplied by the estimated average number of employees for 1922 to obtain the estimated total expense for 1922. I twill be noticed that by this method it is assumed that the expense is for the benefit of all employees alike. It would seem that this is proper, since doctors and nurses are employed not for the benefit of any particular employees, but for the welfare of all as a productive group. Points to be Allowed for in Estimating Welfare Expense It may be desirable to work out two per capita figures for the past year: first, a per capita cost of all employees; and second, a per capita cost based on the number of only those employees who have been directly benefited by the kind of welfare expense under consideration. Thus the per capita cost in 1921 for entertainments should be the per capita cost for all employees whether or not they have attended the entertainments. The per capita cost should be figured on the average number of employees, since enter- tainments are open to all employees. As a secondary figure, it mc.y be useful to have the per capita cost of entertainment expense based on the actual number of employees who have attended the entertainments. If the plant is subject to periodical shut-downs due to irregular volume of business, or to seasonal strikes resulting from adjustments of wage scales, or for other reasons, it will be necessary to distinguish between (i) per capita average for continuing expense, such as the salaries of the head sur- geon, the head nurse, the librarian, etc., and (2) per capita per diem average for all expenses that are incurred only during the days of actual plant operation. For example, a per capita per diem limitation may be set on free lunches, gymnasium operating expenses, and similar expenses which are incurred day by day according to the fluctuating num- ber of employees. 184 BUDGETARY CONTROL It Is necessary to use the average number of employees In arriving at per capita cost. In any large industrial or mercantile business there will be a larger number of individ- ual names that have appeared on the pay-rolls during the year than the average number continuously employed. Thus one man may be employed on a job from January to March inclusive, another man from March to August inclu- sive, and still another man from September to December inclusive. This gives three employees, if we are consider- ing the total number of employees actually engaged during the year. From the standpoint of the average number of employees, these three men constitute only one employee, since taken together their services have equaled the serv- ices of one man employed continuously throughout the year. If it is possible to do so, labor turnovers should be figured from two different standpoints. First, the turnover of labor on account of irregular volume of business should be determined. For example, a thousand men may be dis- charged in May simply because there is no work for them, and a thousand new men may be employed in September, because a new volume of work has been obtained. This labor turnover is due to Irregularity of volume of sales and production, and should be distinguished from the labor turnover caused by dissatisfaction of employees. In estimating the average number of employees for a particular year, consideration should first be given to the sales program of that year as an index to the labor program that will probably result from irregular volume of business. The result thus obtained must be modified by consideration )f the labor turnover in the year In question, that may pre- sumably result from nonnal dissatisfaction of Individual employees or from strikes and other manifestations of labor jnrest. THE WELFARE EXPENSE BUDGET 185 TD Q ;= .tr o a. 'Z u o. a. _2 LJ Q 3 ffl UJ CO z LlI a. X UJ UJ UJ E = 5 M w 2 c3 a. ^ — •« 5" ~^ Q. ° <>>"S T3 — w S Sect: ^ 3 U U 0. Q. -«E^- "" " "S — ,_ 03 « fa 2 >* C ^_^ E 'S. o. C3 -* = E^ ZUJ"^ Slo, = UJ Q- £ " =s CO Per Last tor Din Bern 55 u S UJ "i- ^^ d: ";S £ [^ < 1- Q. U. ^- Ul ^ 2 ■ql _ -O z LU Z UJ (^ -J X ■0 1- S -2 z III ^ _^^ ^ 2 Ave Nurr Emp Last_ "v " .° B aoi CO K E " J3-« := ►- c -o =3 w .S CN E-J £ w ^ t w l86 BUDGETARY CONTROL Preparation of "Welfare Expense Budget The control of welfare expense or the expense of condi- tions of employment, like the control of any other activity in the business, demands first of all that a budget, or estimate, or program, or quota, be set up, indicating the plans for welfare expense for the coming period. This budget should show information for each distinctive class of welfare expense. For instance, it may show the welfare expense classified under the fifteen headings given on page 179. In form the welfare expense budget may be as shown in Figure 14. The purpose of each of thecolumn headings is apparent. The welfare expense budget should be prepared by the personnel department. It should be based on the general plans of the business as shown by its various departmental estimates, and should be in harmony with the general poli- cies which have been adopted by the company. The per- sonnel manager should discuss with the budget committee prior to the preparation of the estimate of welfare expense, any new plans which he desires to inaugurate, so that he may have the benefit of the judgment of the principal execu- tives of the company in its preparation. The personnel manager will transmit the welfare budget with his approval to the executive in charge of the budget procedure. The latter will transmit it to the budget com- mittee with any comments he thinks necessary. The budget committee will make any revisions which it may think are required and return the budget, with its approval, to the executive in charge of the budget procedure. The latter will return it to the personnel manager. Control of Welfare Expense Budget The budget on welfare expense is effective only if a monthly report is prepared, showing the information given in the seven columns of the welfare budget contrasted with THE WELFARE EXPENSE BUDGET 1 87 actual number of employees reported, and actual amount of expense for each class of welfare expense, and actual per capita cost. This report may be made in the form shown in Figure 15. It is quite likely that the actual per capita will vary to a considerable degree from the estimated per capita, but the budget report does furnish a basis for planning welfare expense and also offers the means whereby the management responsible for welfare expense can keep such expense within reasonable control. The monthly report will be submitted by the executive in charge of the budget procedure to the budget committee, and the latter may, if it thinks this report shows the neces- sity, make revisions in the welfare expense budget. The executive in charge of the budget procedure will communi- cate these changes to the personnel manager. CHAPTER XIII THE MANUFACTURING EXPENSE BUDGET Need for Estimate of Manufacturing Expense After the finished goods which are to be produced during the budget period are determined by means of the pro- duction budget, it is necessary to estimate the manufactur- ing expenses which are necessary to produce these goods. This estimate is necessary in order — 1. That the various departments which are responsible for securing the "services" which compose manufacturing expense, may make plans to have these services by the time they are needed in production. The nature of these services and the departments responsible for their procurement will be explained later in this chapter. 2. That the treasurer may know the probable disbursements re- quired by the manufacturing expense program and can plan to obtain the funds needed for these disbursements. 3. That standard rates for manufacturing expense may be estab- lished more accurately. The method of establishing such rates is discussed later. 4. That the budget committee and the board of directors may be able to see the financial requirements of the proposed sales and production programs at the time they are submitted for consideration, and that they may see the effect of the manu- facturing expense cost on the estimated financial statements. In addition they should be able to see the relation of the volume of production to the manufacturing expense. The significance of this relationship will be explained later in the chapter. The reader will notice that the estimate of manufactur- ing expense combined with the estimate of labor and the estimate of materials constitutes the estimated cost of 188 THE MANUFACTURING EXPENSE BUDGET 1 89 the manufactured product, since the elements of manu- facturing cost are materials, labor, and manufacturing expense. Definition of Manufacturing Expense The costs incurred in the production of the finished product are divided into two broad classes, "direct" costs and "indirect" costs. Direct costs are payments or charges for labor and material expended upon a definitely determined unit or product. Small costs, however, are not charged directly to the product, even when the latter can be determined, unless the increased accuracy of the records justifies the clerical work entailed. It follows, therefore, that indirect costs are those which cannot be charged economically or directly to the product. An example of a direct cost is the cost of the raw material in a chair. Indirect costs arise from the fol- lowing sources: 1. Indirect material — good examples of which are rags used to wipe off chairs and tools; or new tools used to replace those discarded. 2. Indirect labor — for instance, wages of foremen who super- vise the employees in several departments where chairs are made. 3. Fixed charges — depreciation, taxes, insurance, etc. Adherence to the above cost classification adds to the accuracy of the records for this reason: By charging items directly to the cost units (when economical), the remaining costs (indirect costs) are less than if certain items legitimately "direct" were treated as indirect costs. Indirect costs are distributed over the product in as accurate a manner as possible, but such charging is less accurate than direct charging. For instance, raw material can be accurately measured and charged directly against the chair. The depreciation of the equipment used in manufacturing the chair cannot be deter- mined with any measuring de\ice. It must be estimated. Con- sequently the total depreciation of equipment is distributed over all units of product (chairs) made. Any charging, therefore, which reduces the distributable costs, thereby increases automatically the 190 BUDGETARY CONTROL accuracy cf the cost records. The growing observance of the princi- ple of direct — that is to say correct — charging has done much to improve the exactness of cost accounting.^ It is the purpose of the present chapter to treat under the heading of "manufacturing expenses " the items termed "indirect costs" in the foregoing quotation. "Indirect expenses," "burden," and "overhead" are other tenns by which these expenses are known. Components of Manufacturing Expense The items which compose manufacturing expense will vary in different businesses, depending on the nature of their operations. The following are those which appear in most cases: 1. Indirect material 8. Maintenance 2. Supplies 9. Depreciation 3. Indirect labor 10. Power 4. Supervision 11. Heat and light 5. Inspection 12. Small tools 6. Experimental work 13. Taxes 7. Repairs 14. Insurance The foregoing items are sufficient to indicate the nature of those which generally compose manufacturing expense. The reader can probably supply other items of manufactur- ing expense from his experience. Some accountants would combine such items as "indirect labor," "supervision," and "inspection." From the viewpoint of estimating their amount, it is desirable to have them separate. Classification of Manufacturing Expense It is usually desirable that manufacturing expense be classified by departments and that subclassifications be maintained for each department. Detailed departmental ' Jordan and Harris, Cost Accounting, page 23. THE MANUFACTURING EXPENSE BUDGET 19I classifications are necessary as a basis for effective control. The departmental classification makes possible the fixing of responsibility, and the classification within the depart- ment makes possible the meeting of the responsibility. It also affords a more comprehensive basis for judging the success with which the responsibility has been met. To illustrate concretely, the X Manufacturing Company has four departments and manufactures one commodity. In 1 91 8 the unit cost of the commodity was $12, while in 1919 it was $15. In attempting to find the cause of the increase, the first analysis will be to determine how much of the total cost is material cost, how much is labor cost, and how much is manufacturing expense. This analysis shows that the manufacturing expense per unit was $3 in 1 91 8, and $4 in 1919. An analysis of the cost of manu- facturing expense by departments for the two years shows the following: Year Dept. A 1918. $.80 1919 1 .20 This analysis shows that the principal increases in manufacturing expenses are in Departments A and D. The responsibility for the increase is fixed on specific de- partments, but it is now necessary to determine whether the increase is due to inefficiency of the departmental heads or to causes over w^hich they had no control. To ascertain this, it is necessary to examine the analysis provided by the departmental accounts. This examination shows that in Departments A and D a large amount of miscellaneous supplies and indirect labor is necessary. Owing to the increase in the price of supplies and labor during the year 191 9, the manufacturing expense of these departments was increased. If it is shown that Dept. B Dept. C Dept. D $.90 $.60 $.70 ■95 ■65 I .20 192 BUDGETARY CONTROL approximately the same quantity of supplies and labor was used as previously but its price had greatly increased, the departmental foreman cannot be held responsible. If, on the other hand, it is found that the increase in manufactur- ing expense in these departments was due to the use of an increased quantity of supplies and labor per unit of product, there is then circumstantial evidence of inefficiency on the part of the departmental foreman, and he should be re- quired to show cause for the condition. This simple illustration serves to show the necessity for a detailed analysis of the expenses of each major group if responsi- bility is to be fixed and variations explained. A proper classification of expenses is of importance both from the viewpoint of accounting records and budget reports. Determination of Manufacturing Expense Requirements The estimate of manufacturing expense, like the esti- mate of materials and of labor, is based on the estimate of production. It is somewhat more difficult to correlate the manufacturing expenses with the production, than it is to correlate materials and labor with production. This is due to two reasons: I. The various items which go to make up the manu- facturing expenses are secured from various sources and their procurement is not centralized under one individual, like materials and labor. For instance, the indirect mate- rial is obtained by the purchasing agent, the indirect labor by the personnel department, the taxes are paid by the treasurer, the repairs made by the maintenance depart- ment, and so on. This lack of centralized responsibility makes it difficult to fix the duty for the preparation of the manufacturing expense budget on those who are responsible for the expenditures which result in the procurement cf the "services" of which it is composed. THE MANUFACTURING EXPENSE BUDGET 193 2. Manufacturing expenses do not vary as a rule in proportion to the variation in production. Usually they do not increase or decrease as rapidly as production. This is due to the fact that there are "fixed" charges which are affected little if at all by the volume of production. For instance, taxes and insurance on machinery will be the same whether the machine is run at full or half capacity. There are other charges such as depreciation and supervi- sion which will be affected by the volume of production but not in proportion. If production is sufficient to em- ploy ten men in a department, it is necessary to have a foreman, and the same foreman may be able to supervise properly twenty men when production increases to the point where they are needed. Because of this condition it is impossible to estimate manufacturing expenses in lump by means of the ratio between manufacturing expense and production, if the production varies from one budget period to another. The cost accounting department is the one place where all the items of manufacturing expense are shown. Its records show what the manufacturing expenses of the past periods have been and it is possible for it to prepare on the basis of these records an estimate of what the manu- facturing expenses will be. The estimate, of course, must take into consideration the production program for the period as shown by the estimate of production. To do this properly the cost department should classify the manu- facturing expenses as "fixed" and "variable." These terms must be used with caution, for there are few if any expenses which may be literally termed as "fixed." If this classification is made, it will not be difficult to estimate the fixed charges, but very careful attention must be given to the effect of the production volume on the variable charges. 13 194 BUDGETARY CONTROL It tends to simplicity and economy to have the estimate of manufacturing expense prepared by the cost accounting department. The chief objection to this procedure is that this department is apt to place too much emphasis on the statistics of past performance and too Httle emphasis on the contemplated performance. One method of correcting this difficulty is to have the cost department classify its estimate so as to show the expenses to be incurred by each unit or department, and then have each unit or department approve that part of the estimate for which it is responsible. For instance, the purchasing department could approve the estimate on indirect materials, the personnel department the estimate on indirect labor, the treasurer the estimate on taxes and insurance, and so on. It is, of course, possible to have each separate unit or department make an estimate of that part of the manu- facturing expense for which it is responsible, and then have these combined to make up the complete estimate. The separate estimates may be checked against the ac- counting records to test their accuracy. This method requires a great amount of care in getting the necessary information needed by each department for making its estimate and in seeing to it that each prepares the estimate properly. When it is possible to do so, there are decided advantages in having the estimate of manufacturing ex- pense prepared by the staff of the production department, since this department is responsible for its enforcement. The only disadvantage of this procedure is that this department often does not have the data to make possible the preparation of an accurate estimate. Distribution of Manufacturing Expenses One of the most difficult problems with which engineers and accountants have had to deal in the attempt to as- THE MANUFACTURING EXPENSE BUDGET I95 certain costs of manufactured product, is the allocation of the manufacturing expenses to the various classes or units of product. This problem gives rise to two questions: 1. What expenses should be allocated to the product? 2. What method should be employed in allocating these expenses? For many years accountants as a whole assumed that all manufacturing expenses should be allocated to the product and therefore gave their undivided attention to the answering of the second question. A number of methods of allocating manufacturing ex- penses were developed. These ranged from the simple method of using a percentage on direct labor cost, to the complex method of using a machine rate plus the "supple- mentary" rate. The reader is doubtless familiar with these various methods since they have been well explained in many texts on cost accounting and articles in magazines.^ The purpose of all these methods as originally developed is to allocate as accurately as possible all the manufacturing expenses of a period to the goods produced during that period. During recent years engineers and accountants have come to realize that it may not be desirable to allocate all the manufacturing expenses to the product produced. No doubt they were first led to see this by the fact that if all expenses during a period of depression are charged to the product produced during that period, the cost of the product is exorbitant. It is easy to see that if a plant is running at 60 per cent capacity and all the fixed charges of the plant are allocated against the 60 per cent of normal production, the costs will be greatly increased. If these costs are used as a basis for establishing sales prices, the ' Those readers who may desire a discussion of the various methods of distributing overhead may well read one or more of thj following: Jordan and Harris, Cost Accounting; Nicholson and Rohrbach, Cost Accounting; Scoville, Cost Accounting and Burden Application; Eggleston and Robinson, Business Costs; Church, Manufacturing Accounts and Costs. 196 BUDGETARY CONTROL competitors are very apt to get the business; and as sales fall off there will be a further decrease in production with a further increase in cost, with the consequent increase in sales price, which results in a decrease in sales, and so on around the circle. Faced by this situation, accountants and engineers real- ized the necessity of developing some method of handling manufacturing expenses which would prevent the charging to product of expenses which were not the result of the production of this product. To this end, predetermined or standard rates were established by which the product was charged only with the same amount of expenses which it would have been charged if the plant was running at its normal capacity. In the establishment of normal capacity the production of past years when the plant was operating under what was thought to be normal conditions was taken as a basis. The manufacturing expense not absorbed by the standard rates was charged direct to the profit and loss account. Those who are interested in the historical de- velopment of the use of the standard rate will be interested in reading pages 397-399, "Cost Accounting," by Jordan and Harris. Relation of Standard Rates to Manufacturing Expense Budget From the viewpoint of administration, the importance of the standard rates for manufacturing expense is obvious. These standard rates may also be of considerable significance from the viewpoint of budgetary control. It has been pointed out in the discussion of materials and labor, that if standard rates have been set, it is only necessary to multiply these by the quantity of finished goods called for by the production budget to obtain the estimate of materials or estimate of labor. If standard expense rates have been set, a similar procedure may be followed in pre- THE MANUFACTURING EXPENSE BUDGET 197 paring the estimate of manufacturing expense. The standard expense rate for each product may be multipHed by the quantity of this product called for in the production budget in order to obtain the estimated manufacturing expense. If the product passes through two or more de- partments, it will probably be necessary to use a different rate for each department. It is obvious that the actual expenses may be greater or less than the standard, and this variation must be given consideration in preparing the estimated statement of profit and loss and the financial budget. One objection to this method from the viewpoint of administrative control, is that if the production varies in quantity, the standard rate should be made to vary also. In the establishment of standard costs it has been the practice of accountants to select one or more periods during which they think there has been normal production, and use the costs of these periods as standard costs, or at least to regard the production of these periods as standard pro- duction and determine the standard costs on the basis of the quantity of production. For the purpose of distribut- ing the costs of production evenly over all periods and thereby determining a uniform cost, there is decided merit in this method. It would seem, however, from the view- point of administrative control, that it would be much more accurate to have the standard costs based on the anticipated production of the period under consideration. The manufacturer does not care so much to know how his costs compare with what they should be if he produced the quantity which he produced during some previous period, as he desires to know: I. At the beginning of the period, what his costs will be if he manufactures what he plans to manufacture during the period. 198 BUDGETARY CONTROL 2. During the period, how his actual costs compare with what he estimated they would be. 3. At the end of the period, why there is a variation between the estimated and the actual, if such a variation exists. It is not intended to imply that the use of standard rates as a means of equalizing costs may not be desirable, but only to emphasize that standard costs based on past pro- duction may not give the manufacturer the infonnation he most needs in judging the desirability of contemplated plans or of controlling these plans after they are put into operation. Relation of Budget Program to Standard Rates If the manufacturing expenses are allocated by means of the "machine rate," the estimated activity of the plant can be given effect in the establishment of the standard machine rates. Mr, E. O. Sommer in Industrial Manage- ment, January, 1920, discusses one method by which this is done in the following quotation : The object in establishing a machine hour rate is to determine the cost of running a machine one hour. This can be done by: 1. Classifying and dividing the machines into units of like opera- tion. 2. Estimating the percentage of activity at which the plant is expected to operate. 3. Determining the operating expenses of each unit for a given period. In classifying machines, the department may be taken as a unit if all the machines perform the same operation ; should, however, the department include machines of unlike operation, we shall have to go a step further and subdivide the department into various machine groups, each machine in a group perfonning the same operation. This subdivision may lead us so far as to consider a single machine as a unit. Thus, having classified the processing machines of the plant into units, our concern is to collect all expenses which will be incurred THE MANUFACTURING EXPENSE BUDGET 199 in the operation of these individual units during a given period. These expenses we may place into two main groups: 1. Comprising such items as can be directly charged against certain units, as labor, floor space, current repairs, etc., necessary for the operation of that unit. 2. Representing indirect expenses, which although they are largely direct charges against the department, still cannot be allocated to individual units, but are to be prorated on a suit- able basis. The percentage of acti\'ity, the third factor in the calculation of predetermined rates, must be estimated with utmost care. If we could assume that the plant will be able to work at and maintain a 100 per cent activity, our task of calculating an hourly rate would be a simple one. We would obviously divide the total working hours of the week, or month, or year, into the total operating cost for that period and arrive at a cost per hour. Since, however, an activity of 100 per cent can hardly be realized, a method must be found to ascertain the highest possible percentage of activity (budget acti^ity) at which the management may expect to keep the plant working. Should the statement reveal that the plant will not be kept operating at full capacity it will be the problem of the management to investigate the cause of this condition and to find a way to bring the activity to a normal level. Overequipment, decrease in the demand for the product, or competition may account for reduced activity. Many expenses, as rent, depreciation, etc., accrue as time goes on whether the machine be acti\e or idle, and the cost per hour will naturally increase in the same proportion as the activity decreases. To illustrate this, let us assume that these fixed overhead expenses for a group of machines be $2,400 per year. Taking the year at 50 weeks of 48 hours each, or 2,400 working hours, the overhead would be, at 100 per cent activity, $2,400 for 2,400 hours — $1 per hour; at 90 per cent activity, $2,400 for 2,160 hours — $i.il per hour; at 85 per cent activity, $2,400 for 2,040 hours — $1.18 per hour. Should the budget activity for the ensuing period be 90 per cent, it would be a serious error to distribute the operation cost on a basis of 100 per cent activity. Assume for example that the budget rate has been based on a 200 BUDGETARY CONTROL 90 per cent activity and assume further that the actual activity during a period be 90 per cent, all expenses then will be gradually charged to the process, and the debit and credit side of the operating account of this particular machine group will be in balance. Should, however, the actual acti\ity fall below the percentage used in the calculation of the machine rate (budget rate), there would remain in the operating account a balance of imdistributed ex- penses. This balance, which is due to curtailed production, should not be debited to the production account either directly or by increasing the budget rate, but be charged to profits. Any increase over the budget activity would result in a credit balance on the operation account and be a credit to profit and loss. If a comparison of the actual and budget figures of the individual cost factors should reveal that a fluctuation is due to change in prices, a revision of the budget will be necessary and a new rate must be determined. A difference between the actual and budget activity would indicate either an increase or decrease in the production. Since a loss or gain due to fluctuations in the activity does not result from the manner of operating a unit, any difference due to this cause should be eliminated from the operation account. This can be accomplished best by calculating an "idle time" and "overtime" rate, which will represent the hourly cost of all those charges which are incurred regardless of whether the machine group is active or idle. We shall credit the operation account at the "idle time" rate for the total idle hours in the budget period, and charge an account called " Idle and Overtime." Inversely, we shall debit the operation on account at the "overtime" rate for the total active hours in excess of the budget hours, and credit the "Idle and Overtime" account. A balance, left in this account at the end of the budget period, which will then either show a loss due to curtailed production or a gain due to increased activity, is closed into the sales account. The author does not intend to endorse the general application of the particular method described in this quotation, but the general principle it illustrates, that standard rates should be related to the budget program, is worth emphasis. THE MANUFACTURING EXPENSE BUDGET 201 Relation of Standard Rates to Volume of Production It should of course be understood that in the setting of standard rates based on estimated activity as explained in the foregoing quotation, only the expenses which are prop- erly applicable to the estimated production should be included. To accomplish this end the following procedure Is neces- sary: 1. Determine the "normal" production of the plant. This of course cannot be established with exactness. Generally speak- ing, the normal production is that which would be accomplished if the plant was operating so that the equipment as a whole would be used at the greatest efficiency, at which it can reason- ably be expected to be used. Normal production is usually less than the maximum production. In determining normal production, all parts of the equipment must be given careful consideration. The old adage that "a chain is no stronger than its weakest link" is approximately true of the equipment of a plant. For instance, the melting department of a foundry may be able to turn out sufficient melt to produce loo tons of castings during a certain period, but if the moulding floor is only large enough to make possible the moulding of 75 tons, the normal capacity of foundry cannot exceed 75 tons. 2. Determine the manufacturing expenses which would be incurred if the factory operated at normal capacity. 3. Determine the estimated production under the budget program for the current period. 4. Determine the ratio of (3) to (i) and apply this ratio to (2), to obtain the manufacturing expenses applicable to the current period. Judgment will have to be used in doing this because of the changing price level and other factorswhich may necessi- tate modifications of this mathematical result. 5. On the basis of the result obtained in (4) and the estimated activity of the current period, establish standard machine rates. There is a difference of opinion as to what should be included in the establishment of machine rates. It is not worth while to enter into this discussion here. 202 BUDGETARY CONTROL Modification of the Standard Machine Rate Plan The author fully realizes that there are many businesses which will find it impracticable to follow the plan for estab- lishing standard expense rates which has been outlined in the foregoing discussion. Many manufacturing firms do not find it expedient to establish machine rates at all. Nevertheless the general principles developed by the fore- going are applicable to all manufacturing firms, namely: 1. That the product of each period should be charged only with the manufacturing expenses which contribute to its production, and should not be burdened with the expenses arising from unused capacity or idle time. 2. That a standard rate for charging the expense to the product should be established and that the undistributed burden should be charged directly to profit and loss. In case of production above the normal, the excess should be credited to profit and loss. These principles can be applied regardless of the method employed in the distribution of manufacturing expenses. The "Miscellaneous" Expense Budget In the discussion of the materials budget it was explained that some businesses prepare a "stores" budget which in- cludes both direct and indirect material, and in the discussion of the labor budget it has been explained that sometimes a "pay-roll" budget is prepared which includes both direct and indirect labor. When this procedure is followed, two of the large items of manufacturing expense are eliminated from the manufacturing expense budget. In this case there may be prepared a "miscellaneous" expense budget which will include all the expenses other than indirect labor and indirect material. It is easier to prepare the miscellaneous expense budget and to have the Indirect materials and labor included In the THE MANUFACTURING EXPENSE BUDGET 203 stores and pay-roll budget respectively. But It is doubtful if this method gives as effective control of manufacturing expenses. It is desirable that all manufacturing expense be shown as a total and that standards be set up by which to judge its amount. It is of course possible to set up these standards independent of the budgets, but it is much more effective if they are correlated so that each will check the other. It is emphasized throughout this book that the budgets should be prepared in terms of "units of responsi- bility." The production department is responsible for all the manufacturing expense and it is better that its total amount be shown in one budget — the manufacturing expense budget. It is admitted that this procedure necessitates the purchasing agent to make up an estimate of purchases for the indirect materials included in the manufacturing expense budget. Obviously the purchases of these materials will not correspond with their consumption, and it is the latter which is shown on the manufacturing expense budget. In some cases the purchasing agent may find it necessary, in order to secure an economical purchase, to buy at one time sufficient to last for a considerable number of periods. For the purpose of the financial budget it is the disburse- ments which are desired, but for the purpose of the esti- mated balance sheet and estimated statement of profit and loss the consumption is necessary. It is thought best, therefore, to have the composite budget for manufacturing expenses prepared, and to support this with the estimate of purchases with the consequent disbursements. Preparation of the Manufacturing Expense Budget The method of preparing this budget has been indicated by the preceding discussion. If it is assumed that the 204 BUDGETARY CONTROL original estimate of manufacturing expense is prepared by the cost accounting department, a copy of it will be sent by this department to each department responsible for incurring expenditures under it. Each of these depart- ments will indicate any changes which it thinks necessary, and return the estimate with its approval to the cost de- partment. The purchasing agent will attach to the esti- mate of the cost department an estimate of purchases of materials which are necessary to supply the indirect mate- rials called for by the program. The cost accounting department will prepare an esti- mate for submission to the executive in charge of budgetary procedure. On this estimate it will give effect to the revisions which have been made by the various depart- ments. If it does not approve of these revisions, it will show both its estimates and the revisions, and make such comments as it thinks appropriate. If the original estimate is prepared by the production department, it will follow the same procedure as outlined above for the cost department. As previously explained, it is desirable that the estimate be prepared by the produc- tion staff, but it is more frequently prepared by the cost department. The executive in charge of budgetary procedure will transmit the estimate received from the cost accounting department or the production department to the budget committee. He may accompany it with such comments as he thinks appropriate. The budget committee will consider the estimate of manufacturing expense in con- nection with all the other estimates which it receives at the same time, and will make any revisions it deems necessary. It will transmit the estimate as approved to the executive in charge of the budget procedure, who will transfer a copy of it to each of the departments which are interested in its THE MANUFACTURING EXPENSE BUDGET 205 ■o£ ."- c ^^ z 1- -0 r- Z) m ir w^ &5 a « H ^ UJ C3 Q =) m « .9 -o Ul i = ~ CO z •^i: UJ Q. ^ C3 j_ Z Cd e § 2 1 13 5|^- ^ 3 ~ Z < t- E = « 2 Average A Last Fo Period E -5 CO 2 iij H « u. j;So|g ^ Io of C nutact xpensi luction e Last Perlo SX £- *. ~ ^ ** "0 t) " « ^ - c = " 1 s 1*^ •a i" 2 TJ = " .1 ~ S .1 -g Ul S CO z LJ Q. c g 1 X u ""3 £ H £ ^ Q z q: a 3 c H -^"5= S = — So s ^ •^0 c UJ ID Z S < CB Z Imated DSt ol itacturi pense j3"|l2 1- £ Q:: a. ?: » S LJ "^ «o ir ^0 1 o£ >- cl! ^ -I X H Z _o a. _ e ^ E ^ "ot uji: CO s UJ 206 BUDGETARY CONTROL enforcement. In form the manufacturing expense budget may be made as shown in Figure 1 6. Control of Manufacturing Expense Budget The cost accounting department will prepare monthly reports showing a comparison between the actual and estimated manufacturing expense. This report may be in the form shown in Figure 17. The columnar headings on this report are self-explanatory. This report will be submitted to the executive in charge of the budget procedure and will be transferred by him to the budget committee. The committee will study this report in connection with the other monthly reports, and will make any revisions in the manufacturing expense budget which it thinks are necessary as indicated by the reports. Any changes it makes will be transmitted to the departments concerned by the executive in charge of the budgetary procedure. In addition to the general report on the budget as a whole, there should be prepared a separate report for each department in the factory, showing a comparison between the actual and standard performance. In case the general report shows a wide variation between the actual and the estimated expenditures, these detailed reports will provide information which the executive in charge of the budget procedure can use in explaining these variations to the budget committee. Review and Summary of Production Control In Chapters IX to XIII, inclusive, an attempt has been made to outline the procedure necessary to effect a coordination of sales and production, and to prepare and execute a production program. Previously in Chapters V and VI the method by which the sales requirements THE MANUFACTURING EXPENSE BUDGET 207 are determined has been explained. In suminar>^ form the procedure discussed in these chapters may be outlined as follows : I. Preparation of Sales Budget 1. Estimates prepared by sales units. 2. Revised by general sales office. 3. Revised by the production department in the light of production possibilities and desirabilities. 4. Revised by the controller or other officer in the light of profit possibilities. 5. Forwarded to the budget committee for final revision and approval. II. Preparation of "Production" Budgets 1. Finished Goods Budget: (a) Estimate of finished goods requirements prepared by the production department from the sales estimates. (b) Revision and approval of finished goods estimates by the budget committee. (c) Enforcement of this budget through the means of the balance of stores records operated under maximum and minimum standards. 2. Materials Budget: (a) Estimate of materials requirements prepared from tlu finished goods estimate by the production department (the duty of preparing this estimate is usually delegated by the head of the production department to the planning department). (b) Estimate of material requirements, after approval by the head of the production department, is transmitted to the purchasing department and this department prepares an estimate of the material purchases required and the disbursements resulting therefrom. (c) Estimate of materiais and purchases revised and approved by the budget commi ttee. (d) Enforcement of materials budget through the means of the materials balance of stores records operated under maximum and minimum standards. 208 BUDGETARY CONTROL 3. Labor Budget: (a) Estimate of labor requirements prepared from the finished goods budget by the production department (the duty of preparing this estimate is usually delegated by the head of the production department to the planning department). (b) Estimate of labor requirements, after approval by the head of the production department, is transmitted to the personnel department and this department makes an estimate of the cost of supplying this labor. (c) Estimate of labor requirements and labor cost revised and approved by the budget committee. (d) Enforcement of the labor budget by the production department with the assistance of the personnel de- partment, through the agency of a centralized produc- tion control system. 4. Manufacturing Expense Budget: (a) Estimate of manufacturing expense requirements made by cost accounting department or production depart- ment. (b) Estimate of manufacturing expense requirements ap- proved by the production manager and the head of the various departments responsible for the incurrence of the expenditures for which it provides. (c) Estimate as approved in (b) transmitted to budget com- mittee for revision and approval. (d) Enforcement of the estimate by the production de- partment through the agency of a centralized control system. III. Monthly Reports for Control and Revision of Budgets 1. Report on finished stock budget as shown in Figure 8 (page 141 ). 2. Report on materials budget as shown in Figure 11 (page 161). 3. Report on labor budget as shown in Figure 13 (page 175). 4. Report on manufacturing expense budget as shown in Figure 17 (page 205). IV. Monthly Revision of Budgets I. Budget committee receives monthly reports on all departmental estimates, including those outlined under (III). THE MANUFACTURING EXPENSE BUDGET 209 2. The committee considers these reports with reference to their relation to each other and makes such revisions as are deemed necessary. 3. Any revisions made in the budgets outhned in (II) will be com- municated to the production department and the other de- partments concerned. It should be understood that the procedure given in this outline is intended to be suggestive and not arbitrary. Each firm must adopt a procedure to fit its particular needs. It is thought that if the foregoing procedure is understood properly, it will not be difficult to make the adaptations required in any particular case. 14 CHAPTER XIV THE PURCHASES BUDGET Relation of Purchases Budget to the Sales Budget In the preceding chapters considerable attention has been given to the method by which the manufacturer plans a production program which will result in a proper coordi- nation between production and sales. But the merchant has a similar problem of coordination, which he can solve only by formulating a purchasing program which will per- form the same function for him as the production program performs for the manufacturer. The amount of goods which is to be purchased by a merchant is determined primarily by his estimate of future sales. Goods are purchased only to be sold, and sales can be consummated only when goods are available for sale. The general manager of a mercantile store is charged with a double responsibility. He must maintain such stocks of goods as will enable the store to fill customers' orders, and at the same time he must avoid the accumulation of stock beyond the sales demands, as such excessive accumulation results in loss from tied up capital, and probably also from the obsolescence and deterioration of the merchandise. The general manager can meet this responsibility only by anticipating sales demands and setting up as nearly as possible a schedule of deliveries to stock which will satisfy but not exceed these demands. In merchandise planning, therefore, the first step is the determining of the amount of future sales; the second step Is the determining of the purchases necessary to meet these sales; and the third step Is the setting up of a jnirchaslng program which will coordinate the deliveries of purchases 210 THE PURCHASES BUDGET 211 ^^Ith the sales deliveries required by the sales program. The first step has been previously discussed. The second and third will be dealt with in this chapter. Determination of Purchases Requirements The ideal purchases program, from the viewpoint of the economical use of capital, would be one which provided for the delivery to stock each day of the exact amount of mer- chandise w^hich will be sold that day. Such a program is not feasible for two reasons: 1. In a mercantile store, it is necessary to have some merchandise on hand for display purposes. The customer desires an assort- ment from which to select his purchases. This necessitates the keeping on hand of a considerable quantity of merchandise. The amount which must be kept is dependent on the extent of the sizes, varieties, and grades of the merchandise which is kept for sale. 2. It is impossible to estimate sales demands or to plan purchases deliveries with sufficient accuracy to have the same amount delivered each day as is sold on that day. To provide against a failure to meet sales demands it is necessary to keep a cer- tain amount of merchandise on hand, which is termed the merchandise inventory. The principal problem in merchandise planning is to determine the size of the inventory which should be main- tained, and to set up a purchases program which will schedule deliveries to stock in such quantities and at such times as to provide for its maintenance at this amount. The problem of purchases requirements resolves itself, therefore, into a problem of finished stock requirements. The problem of setting up an estimate of finished stock requirements necessitates : 1. An estimate of the sales that will be made of each kind and class of goods. This estimate is provided by the sales program. 2, A statement of the inventory of finished goods that has proved sufficient in meeting the sales requirements of preceding periods. 212 BUDGETARY CONTROL This Information is used as a basis for the preparation of an estimate of the finished goods inventory requirements throughout the coming selHng period. Method of Determining Inventory If inventory figures are to be available for prompt use in the preparation of the purchases budget, it is necessary that a definite method by which inventory is to be secured be determined and the appropriate procedure for the enforce- ment of this method be established. There are three methods in current use by which inven- tories may be obtained. These will be discussed under the following headings: 1. Perpetual inventory 2. Estimated inventory 3. Physical inventory Perpetual Inventory All the information required in setting up a system of finished goods stock requirements is contained in a merchan- dise account that shows the quantities of each merchandise item received at cost contra to the amounts of the item sold, the sales being also computed at cost. The resulting bal- ance shows the amount of each item of merchandise on hand at cost. Such a merchandise account is commonly known as a perpetual inventory. If a perpetual inventory is maintained on the goods in stock, it will show the cost of such goods as they are shipped from the vendor, and will also show the value at cost of goods shipped under sales invoices. The net figures in such an inventory will indicate at all times the goods on hand. It is possible to keep the inventory record in terms of quantities rather than in terms of value, if desired. A form of inventory record suitable for use in connection with raw THE PURCHASES BUDGET 213 materials is shown in Figure 9 (page 153). The record for general merchandise is usually more simple than this form, but the same principles govern its construction and use. Estimated Inventory The experience of merchants is that perpetual inven- tories are often expensive in their operation. This is espe- cially true where many small items are bought and sold, and where the average turnover of the stock is high. Many mer- chants content themselves with estimated inventories of merchandise on hand, and these estimates are proven as to their accuracy by actual inventory once or twice a year. The estimated inventory is determined on the basis that the actual inventory at the beginning of the period, plus purchases for the period, plus the estimated gross profit subtracted from the sales at sales price, equals the ending inventory. The method of arriving at this formula will be seen easily if the organization of the trading section of the pro forma statement of profit and loss is considered. It may be assumed that the trading section of the state- ment of profit and loss of the Brown Mercantile Company for the month of December appears as follows : The Brown Mercantile Company Statement of Profit and Loss For Month Ended December 31, 192- Sales $51,000.00 Inventory, December i $16,500.00 Purchases for month 34,100 .00 Total Merchandise in Stockroom during month $50,600.00 Inventory, December 31 13,200.00 Cost of Goods Sold 37,400 . 00 Gross Profit on Sales $13,600.00 214 BUDGETARY CONTROL From the foregoing statement, it is possible to prepare the following equation : Sales — Beginning I nventory — Purchases + Ending I nventory = Gross Profit Ordinarily when a statement of profit and loss is made, the only unknown quantity is the gross profit, and it is obtained by this equation. When it is desired to use this formula for estimating the ending inventory, there are two unknown quantities — the ending inventory and the gross profit. One of these must be determined before the equa- tion can be solved. This is accomplished by estimating the gross profit. To make the estimate, the ratio of the average gross profit to sales during the past periods is determined, and this percentage is applied to the sales of the current period to obtain the estimated gross profit for this period. To illustrate, it is found that the average gross profit of the Brown Mercantile Company during the past three years has been 26.66 per cent of sales. It is thought that the average gross profit of these years is indicative of the gross profit of the month of December of the current year. By taking this percentage of the sales for this month, the estimated gross profit is calculated to be $ 1 3 ,600. By using this figure, the equation given above can be stated as follows: $51 ,000 — $16,500 — $34,100 + Ending Inventory = $13,600 By transposition and solving, the ending inventory is de- termined to be $13,200. Since the gross profits on dif- ferent lines of goods varies, it is necessary to perform the foregoing calculation for each line of goods if an accurate estimated inventory is to be obtained. It should be evident that estimated inventories can be only approximately correct. If the merchandise manager has before him only estimated inventories as at the close of THE PURCHASES BUDGET 215 each month or fiscal period, he must use his judgment in basing his actions on them. In any case frequent tests should be made to verify the accuracy of the estimate. Physical Inventories In those businesses where it is not feasible to maintain a perpetual inventory because of the cost involved, and where it is impossible to obtain an accurate estimated inventory because of the widely var>dng rates of gross profit, it may be necessary to resort to actual inventories taken at fre- quent intervals. This necessitates the taking of a physical count of the goods on hand. Some department stores take an inventory in certain departments every two weeks. Such a check-up at frequent intervals is especially desirable in the case of variety goods, where fashion and styles play an important part. Practi- cally all businesses take a physical inventory yearly, and there is a decided tendency towards semiannual and quar- terly inventories. It has been found that if a standardized procedure for' the taking of inventories is properly worked out, the task is not so great as it was formerly thought to be. Relation of Inventory Planning to Statistics of Past Periods In estimating inventory requirements it is necessary to refer to the statistics of previous periods as sho\vn by the accounting records. As to how many past periods should be considered will depend on the circumstances of each case. The statistics desired are those which will most nearly indi- cate the probable condition of the current year. It may be that conditions have changed so rapidly that it is deemed wise to use only the statistics available for the preceding period, or, on the other hand, the preceding period may be considered as abnormal and may be disregarded entirely. In some cases a weighted average of three or more past 2l6 BUDGETARY CONTROL periods is taken. In any case, the object is the same — to obtain the statistics with reference to past operations which will be most helpful in planning future operations. For the sake of brevity in the following discussion, reference will be made to the "past period" or "past periods" without defining the length of this period, or periods, unless such definition is necessary to make the meaning of the discus- sion clear. Determination of "Normal" Inventory In the preceding discussion it has been explained that the next step in merchandise planning after the sales esti- mate is prepared , is to determine the ' ' average " or " normal ' ' inventory which is necessary to meet sales demands. To accomplish this it is necessary : 1. To determine the average inventory during past periods. 2. To determine the ratio of the average inventory of past periods to the sales of those periods, that is, determine the merchan- dise turnover of those periods. 3. To apply the turnover of past periods to the estimated sales of the current period to obtain the average inventory for the present period. Determination of Inventory of Past Periods If any rational control has been exercised over stock investments during the past periods, inventory of stock on hand must have been taken at frequent intervals. This inventory may have been obtained by any of the methods discussed in the preceding paragraphs. If it was deemed necessary to know the value of the stock on hand only at the beginning and the end of the period a physical inventory may have been taken. If it was deemed desirable to have the value of the stock on hand at more frequent intervals, it is probable that either an estimated inventory was determined at regular intervals or THE PURCHASES BUDGET 217 stock records established which made possible a perpetual or continuous inventory. It is apparent that the more frequently the inventory' is determined, the more useful are the statistics obtained thereby in determining average inventory and in planning stock investment control. In any case the desire for accuracy must be balanced against practicability. Calculation of Turnover Whatever method of taking inventory has been followed during the past periods, it should be possible to determine at least approximately the average inventory and the ratio of the average inventory of each period to the sales for the same period. In other words, the turnover for each of the past periods can be determined. If the turnover computa- tions are to be of value, it is necessary that care be exercised to calculate them properly. In practice it will be found that several methods are used in the determination of merchandise turnover. There are in fact but two methods of determining turnover accurately. They are as follows: I. Di\'ide the cost of the goods sold during the year by the cost of the average inventory of the year. For instance, a retail store carries on the average a stock of goods the cost price of which is $20,000 and makes during the year sales of $100,000 on which a gross profit of twenty per cent is made. The cost of the goods sold is $80,- 000 and the turnover is four. In other words, in this store, on an average, the articles sold re- main in stock three months after they are purchased before they are sold. It will, of course, be realized that it is rather dangerous to try to determine the average turnover on all goods carried in stock. It is more accurate to determine if possible the turnover for each kind of goods, since the turnover varies on each kind. 2. The turnover may be determined by dividing the average in- ventory for the year at sales price into the sales at sales price. For instance, taking the illustration given above, where the average in- ventory at cost is $20,000 and the sales for the year are $100,000 on which an average gross profit of twenty per cent is made ; if the inven- 2l8 BUDGETARY CONTROL tory is taken at sales price, it will be seen that it will amount to $25,000, and dividing the sales of $100,000 by $25,000, a turnover of four will be obtained. It will be seen that the same result is obtained as in the first case where the inventory at cost is divided into the sales at cost. Either method can be used, whichever is the more convenient.^ The error is sometimes made of dividing the sales at selling price by the inventory at cost. This obviously gives a turnover larger than the actual one. When a firm relies on a physical inventory taken once a year, it may determine its average inventory by taking one- half of the sum of the beginning and ending inventories. If the sales of the business are subject to seasonal fluctuations, this method will not give satisfactory results, since it does not give effect to the fluctuations in inventory which must inevitably result from the fluctuations in sales. The proper method is to obtain the average of the monthly inventories. Use of Turnover Figures Turnover figures are very useful in merchandise control. As Nystrom, in his "Economics of Retailing," very aptly says: One of the productive factors of a retail store is the capital in- vested in its stock of goods. When this capital is borrowed for use in the store, interest must be paid for it, and interest should be entered as an expense charge in any case regardless of whether the manager of the store borrows or supplies capital from his own funds. Efficiency in its use depends upon its activity. By activity is meant the num- ber of times it can be used over and over again in the course of a year. Each complete use of the capital invested in merchandise is known as a "turnover." If expenses and profits per sale remain the same, the greater the number of turnovers within a year, the' greater the net profit resulting. This fact has long been recognized. There is an old maxim that expresses the idea exactly; "A nimble sixpence is better than a slow shilling." ' McKinsey, Bookkeeping and Accounting, Vol. I. THE PURCHASES BUDGET 219 From the viewpoint of our present discussion we are interested in turnover primarily as a basis for determin- ing inventory requirements. After the turnover of past periods is calculated, it is necessary to give it careful consid- eration before using it as a basis for merchandise planning. Whether or not the turnover of past periods w^IU be used as a basis for planning stock control for the current period, will depend upon whether the average inventory of the past periods is deemed to be satisfactory or not for the purpose. It may be that the inventory during the past periods was too large and the turnover too slow. Or it may be that the inventory was too small for the volume of sales which w^ere possible. The merchandise manager may know that in the case of many articles a much larger inventory was carried than was necessary to meet the volume of sales, and he esti- mates that a smaller inventory may be carried during the coming year and the same volume of sales be obtained. On the other hand, he may know of many articles the sales of which could have been increased if a larger variety or assortment had been carried, or if the goods desired by the customer had always been on hand when called for. He may rightly decide that the turnover of past periods must be modified before it can be used as a basis in deter- mining the average inventory to be maintained during the current year. The foregoing discussion indicates two facts of Impor- tance in connection with inventory and turnover. First, it indicates that it is unsafe to take average turnover, that is, the average turnover of all lines carried, especially if goods of many different varieties are carried in stock. As pre- viously suggested, it is usually necessary to determine the turnover of each different class of merchandise carried. Secondly, it indicates the need for the intelligent consid- 220 BUDGETARY CONTROL eration of statistics with reference to past operations and their modification in the light of past experience before they are used as a basis of future plans. Whether the turnover of the past periods is deemed satisfactory or is modified as suggested above, a figure is finally determined which is used in connection with the esti- mated sales of the current period, to arrive at the average inventory deemed necessary to meet these sales. The proc- ess involved is illustrated by the following steps : 1. Sales for the past period $500,000 2. Average inventory for the past period $100,000 3. Turnover for the past period 5 4. Estimated sales for the current period $600,000 5. The estimated average inventory for the current period is $120,000 It is, of course, assumed in the foregoing illustration and discussion that the inventory and sales are both stated at the same price, either both at selling price or both at cost price. The Buying Budget When the estimated inventory has been determined, it is then necessary to make a schedule of deliveries and pur- chases which will maintain this inventory. If the sales of the period fluctuate to any great extent, it will probably be necessary to determine the inventory desired at the begin- ning of each month-. Then, to determine the deliveries to stock which must be made during the month, it will be necessary to add the estimated sales at cost for the month to the estimated inventory at the end of the month, and subtract the inventory at the beginning of the month. It can be seen from the foregoing that the normal Inven- tory, that Is, the inventory which it Is estimated will have to be carried to meet the sales demands, may not be an average or uniform inventory, but may fluctuate from THE PURCHASES BUDGET 221 month to month as the sales fluctuate owing to seasonal demands, etc. It should also be realized that in many cases it may be desirable to make the finished goods schedule in terms of the number of items required rather than in terms of value. To illustrate.the preparation of a schedule of deliveries of finished goods, it may be assumed that the New York De- partment Store, which makes a specialty of high-grade NEW YORK DEPARTMENT STORE Furniture Department X-Y PIANO Month Stock Beginnings Sales Stock End Deliveries to Stock Memorandum Nov. 16 su li 32 Xmas season begins Nov. 15 Dec. U 21 10 n Xmas season ends Dec. 18 Jan. 10 17 15 22 Jan. Bargain sales begin Jan. 1920 Feb. 15 32 S 25 Bargain sale ends Feb. 20 Figure i8. Schedule of Deliveries to Stock pianos in its furniture department, desires to set up a sched- ule of deliveries to stock of a certain grade of piano during the months of November, December, January, and Feb- ruary. Such a schedule may be in the form shown in Figure i8. A similar schedule of finished goods deliveries will need to be prepared for each item of finished stock. If the sched- 222 BUDGETARY CONTROL ule is made in terms of value, the only difference will be the method of stating the quantity in each column. Responsibility for Preparation of Estimate of Purchases As to the unit of the organization which should be held responsible for the preparation of the estimate of pur- chases, no arbitrary rule can be established. The nature, size, and organization of the business must be considered in each case. In so far as possible the purchases estimate, like all other estimates, should be made by those who are responsible for its enforcement. In a business with branches which handle resale ma- terial, the branch manager may make the purchases which his branch needs, under the supervision and functional con- trol of the general purchasing agent of the company. In this case each branch manager should be held responsible for making an estimate of the purchases of his branch. These original estimates of the branch managers will be gone over by the general purchasing agent, who will transmit them with his approval to the executive in charge of the budgetary procedure, who in turn will transfer them to the budget committee for consideration and approval. Although revisions may have to be made in the estimates submitted by the branch managers, it is desirable that they prepare these for two reasons: 1. They will take more interest in their execution if they are re- sponsible for their preparation. If they receive an estimate prepared by someone else, they may not feel the proper amount of responsibility for any variations between the actual and the estimated figures. 2. In the making of their estimates the branch managers must study past operations and plan future ones. This study and planning will be of much value to them; it will bring to their attention many things which they would otherwise not notice. THE PURCHASES BUDGET 223 In a department store the head of each department is responsible for the preparation of the estimate of purchases for his department. In preparing this, he may employ the assistance of the various buyers in his department. After being prepared, these departmental estimates will be ex- amined by the merchandise manager, who will make such revisions as he deems necessary. In a business where all purchases are made by a central purchasing department under the control of a general pur- chasing agent, the estimate of purchases may be prepared under his direction, but he will usually obtain the assistance and advice of subordinates in its preparation, and his esti- mate will be based on the estimated requirements submitted by the various departments. Whatever is the origin of the original estimate, it will be transferred to the executive in charge of the budgetary pro- cedure, and by him submitted to the budget committee for consideration and approval. Purchases Budget Control The purchases budget provides a working program for the current period. But this program is based on estimates which, however carefully made, may prove inaccurate be- cause of market conditions that could not be foreseen at the time these estimates were made. If the estimates prove incorrect, it is necessary to change as soon as possible the plans which were based on them. If it is estimated that the sales for the current year will be 25 per cent more than they were for the past year, a purchases budget will provide for a corresponding increase in purchases. But if at the end of the first month the sales have not increased and mar- ket conditions indicate that the anticipated increases will not materialize, it would be very unwise to continue to fol- low the original purchases budget. It is necessary, there- 224 BUDGETARY CONTROL fore, to have certain records and reports to make possible a revision of the purchases budget throughout the year, if the results during the year make such a revision necessary. A revision of purchase quotas to meet changing trade conditions is not a simple task in the case of a department store where quotas are made out months in advance on thousands of different items. Perhaps the simplest way to make changes on numerous quotas is to compute the per- centage that the delivery quota for the month is to the esti- mated sales for the month. Thus, if the estimated sales are 43 units and the delivery quota is 38 units, we may express the quota as 88.3, so that if the actual sales are 51 units we may permit, without being criticized, the delivery into stock of 88.3 per cent of 51 units, or 45 units. For reasons that are obvious, this percentage method does not give us a quota that will result in the exact inventory at the end of the month for which we originally planned. But this use of per- centages is decidedly useful for revising large numbers of quotas to meet discrepancies between estimated and actual sales. There should be prepared monthly for the use of the executives responsible for the purchasing program and for the budget committee, a report similar in form to Figure 19. Interpretation of Illustration The amounts given for each item or line of goods in the first money column will be taken from the last revision of the sales program. In columns (4) and (5) a comparison is given between the delivery to stock quota on each item and the estimated sales at cost for the item. It must be remem- bered that estimated sales are taken at cost so that there may be this comparison between sales at cost and purchase quotas at cost. In column (6) a percentage of the quota to sales at cost is shown for each item. The data for column THE PURCHASES BUDGET 225 nee In ta Not red or ;ss of lered Quota \ Balai Quo Orde Exce Ore over ' a «.= -0 5^ CO — J; •r~ 1 30i2 a» ^ Q. 3^ Q § T3 ra 2f =""0 2 g— g S " § /-, |<5|^|? — °" z -Oj: = S <„'^ 1 H S|s-il § 1 LU Deliv to S urinfl Taker Pure Ace Q ■0 ■ — / 2^ / 3 QQ "Ss ^^"^ S .^ 00 c^ CO .SO- "n CO < £S 1 « \ I ^x: •- asg'^2 r^ QC -^=s" 3 _J Q. z °2 — oC Cen uota ales Cost SI2 H Sc>«> » in DC CL. °"^ Q. S ra ^ 1 U 5 S c ^ \ DC \ |o~S >- -1 3: T3 £„ H TS 2 ^^ E13StJ ^ Z ■Bw^- ,2 £" S CO "O »- a; ■^s-i CO ^ .2 -0 — -s ^^ 1'^ = CM LU CO 1 s r-v Ul 3 H 1 CQ 226 BUDGETARY CONTROL (6) is not taken from the accounts, but is the result of divid- ing estimated sales at cost into quotas. The actual sales for the month shown in column (7) will be taken from the sales as reported in the sales accounts of the month. From the sales, as reported in the sales accounts, estimated gross profit is subtracted. When actual inventory has been taken at the end of the month, actual gross profits, as shown by the accounts, should be subtracted. The revised quotas given in column (8) may be made by applying the quota percentage given in column (6) to actual sales at cost as given in column (7) . The amounts of deliveries into finished stock, as shown in column (9), will be taken from the pur- chase accounts. The orders outstanding as shown in col- umn (11) wnll be taken from an order register if a book record of orders is maintained, or they may be found by adding the unfilled orders on file. If a monthly quota system is maintained on stock de- liveries, the unfilled orders at the end of a month furnish useful information to use as a basis for purchase control. It may be that unfilled orders represent poor buying, or it may be that they represent a lack of coordination of the activities between the purchase and other departments of the business. In any case, the reason for such unfilled orders should be determined and such executive action taken as is necessary to remedy the condition. Use of Control Reports Control reports are a necessity to the head buyer of a store if the activities of the various assistant buyers are to be coordinated so that they may all work towards a common end. He makes use of purchase quotas and the subsequent reports on these quotas for the unification of the plans of his buying organization. The quota set up on article S485, a shoe, is coordinated with the quotas set up on article H563, THE PURCHASES BUDGET 227 a silk stocking, because both the shoe and silk stocking are of a certain color, shade, and quality, and are expected to be sold together in many cases. In like manner, there will be planning on quotas of staple articles with reference to certain proposed bargain sales, and also on quotas of certain specialties with reference to their use as liners. In the same manner, quotas on various lines and variety of goods are considered in connection with each other to the end that a well-coordinated sales and purchase program may be formulated. And then reports are made on these quotas which serve as a means of correcting errors of judgment on the original quotas and of detecting failures to execute prop- erly the program based on these quotas. CHAPTER XV THE PURCHASES BUDGET (Continued) Disbursements for Purchases The discussion in the preceding chapter has dealt primarily with the method of securing a coordination be- tween purchases and sales. This is essential, but in addi- tion it is necessary to provide for the coordination of purchases with finances. To do this it is necessary to determine the monthly expenditures in payment of pur- chases. The finished goods budget shows the deliveries to stock. From the viewpoint of financial requirements, it is necessary to determine when the goods delivered are to be paid for. The method of doing this will depend on the volume of purchases to be made, and the terms on which they are to be purchased. It may be necessary to classify all purchases made by credit terms so as to obtain the data by means of which an estimate can be made as to the amount of the estimated purchases which will be made on such terms. It will then be possible to estimate the disbursements which will be made for the purchases made on each kind of terms. To illustrate, if it is found that 50 per cent of the pur- chases during the past three years have been on terms 2/10, n/30, ancl that the payment is always made within the discount period, it may be estimated that 50 per cent of estimated purchases for the next period will be paid within ten days after the receipt of the invoice. On this basis it may be estimated that two-thirds of the merchandise pur- chased on these terms which is to be delivered during the next month, will be paid during that month, and that in 228 THE PURCHASES BUDGET 229 addition it will be necessary to pay during the month for one-third of the merchandise purchased on these terms during the preceding month. In the same manner, estimates can be made for dis- bursements to be made in payment for merchandise pur- chased on each class of terms. The errors which may arise in making such estimates are apparent. There are a num- ber of factors which influence their exactness. It is well to remember, however, that cash receipts and disbursements can never be estimated with absolute exactness. The cash balance is maintained to provide for this inaccuracy in the same way as the inventory of finished goods is carried to ' provide for the inaccuracy of the sales and purchases esti- mates. Further discussion of the method of estimating disbursements will be found in Chapter XIX in connection with the treatment of the financial budget. Report on Disbursements for Purchases As a means of controlling the disbursements for pur- chases and of providing data for the financial budget, it is well to have an estimate made as shown in Figure 20. The form as given is premised on a budget period of three months in length. It can of course be adapted for use for a budget period of any length, but the longer the period, the more inaccurate the estimates for the latter part of the period are apt to be. In any case, it should be revised monthly on the basis of the monthly reports, show- ing actual sales, actual purchases, and actual disbursements. Use of Estimate of Disbursements for Purchases The report shown in Figure 20 provides information which is of value not only in judging the advisability of the contemplated purchasing program, but also the advisability of the contemplated sales and financial programs. The 230 BUDGETARY CONTROL most important items of information which it shows are the following : 1. The estimated deliveries to stock during the month. This can be checked against the same item on the schedule of deliveries to finished goods to determine the accuracy of the amount. 2. The estimated orders to be placed during the month. This provides a check on the amount of orders which are to be placed for future delivery. This enables the executives to know the plans of the merchandise or purchasing department so that they can curtail these plans if they deem this necessary. It indicates to the treasurer the possible demand for funds for the payment of vendors' claims. 3. It shows the estimated inventory at the end of the period. By comparing this with the inventory at the beginning of the period, it can be seen whether the purchasing program con- templates an increase in inventory. If so, the reason for this increase can be ascertained. It may of course be desirable for the inventory to be increased for several reasons which are no doubt apparentto the reader, but it is well forthe contemplated increase to be called to the attention of the principal executives for their approval. 4. It shows the disbursements to be made during the month for purchases made during previous months. These are disburse- ments which presumably must be met, since the contracts are already made. This is useful information for the treasurer. 5. It shows the estimated disbursements for purchases made during the month. This amount is of course subject to change in case the estimated purchases are changed. The estimate of purchase disbursements as a whole provides information which is useful in estimating the financial requirements of the contemplated sales program. If such requirements are too great, a revision of the sales program may be necessary. Classification of Purchase Data for Control Purposes The discussion in the preceding chapter has pointed out the necessity for records and accounts for purchases, and THE PURCHASES BUDGET 231 232 BUDGETARY CONTROL the need for records and files for unfilled orders if informa- tion is to be available for the preparation and control of the purchase program. But this information must not only be available, it must be available in such form as to make this control comprehensive and not unduly burden- some. For that, it is necessary that a proper classification of purchase accounts and purchase orders be maintained. The classification which is necessary for the preparation of the monthly report shown in Figure 19 (page 225) is indi- cated by the report itself. For the purpose of this report the purchase accounts must analyze the purchases into the same classes by which they are shown on the purchases budget, and outstanding orders must be classified in the same manner. For In- stance, if the purchases budget states a separate quota for twenty different types of purchases, there must be twenty different accounts maintained with purchases, or some supplementary record must be kept which provides for such a classification if the monthly report shown in Figure 19 is to be used effectively. The outstanding orders must also be subject to such a classification if the desired in- formation for column (10) is to be obtained. But if this report is to be properly interpreted after it is made, ad- ditional information with reference to purchases made and orders Issued Is necessary, and to obtain this information other classifications must be maintained. Classification of Purchase Invoices Purchases, in addition to being classified to correspond to the analysis shown on the purchases budget, may be analyzed as follows: /' 1. By departments or units of responsibility 2. By terms of credit 3. By buyers THE PURCHASES BUDGET 233 In a business where there is any attempt toward func- tional organization and control, both sales and purchases are usually classified according to the units of organization for responsibility. Expenses are classified similarly, and consequently the efficiency of the functional managers can be judged in terms of profit and loss. For instance, in a department store the departmental managers are held responsible for the operations of their departments, and consequently the sales and purchases are analyzed by de- partments so that departmental profit and loss can be determined. In such a business the sales estimates and purchasing estimates are usually made separately for each department, so that the departmental analyses serve a double purpose in that they serve not only as a check upon the efficiency of departmental heads, but also as a basis for the preparation and control of the departmental estimates. In a business with branches, the responsibility for the management of each branch is imposed on the branch manager, and in order to determine his efficiency an analysis of purchases, sales, and expenses by branches is necessary. In planning the financing of a firm's operations, it is of considerable value to the financial executive to know the terms on which the estimated purchases will be made. It has been explained above that the terms of purchase must be taken into consideration in the preparation of the esti- mate of purchases. If that is done, the purchase invoices may be analyzed by terms of credit so that statistics will be available to show the purchases made on each kind of terms. This analysis can then be used in estimating the proportion of the total estimated purchases which will be made on each kind of terms during the budget period. Often this classification is not shown on the ledger accounts, but only in a supplementary record. In a large business 234 BUDGETARY CONTROL where several analyses are to be made, it will probably be obtained by a tabulating equipment. Sometimes it is desirable to know the quantity of pur- chases made by different buyers, and the purchase invoices are analyzed accordingly. Such an analysis may be of value in assigning quotas to buyers and keeping a check on the amount purchased by different buyers or judging as to the wisdom of continuing the services of particular buyers. There may be various other classifications of purchases under different circumstances, such as commodity classifi- cation, classification by vendors, etc. The classification shown on the purchase budget is usually by commodities or by groups of commodities. Classification of Unfilled Orders The unfilled purchase orders, in addition to being classi- fied according to the analysis shown on the purchases budget, should be classified so as to show the following: 1. Month of delivery 2. Contract orders 3. Orders subject to cancellation It should be apparent that it is quite important to know the month of delivery of the goods for which orders are outstanding. Without this information, it is Impossible to determine the proper delivery dates of goods still to be ordered. If orders are outstanding for goods to be delivered six months hence, this can have no effect on purchases necessary to satisfy the needs of the current month. The time of delivery is also of value to the financial executive in arranging for the payment of the goods delivered, and to the operating superintendent in planning to store and handle them. It is also important in planning future deliveries to THE PURCHASES BUDGET 235 know the amount of contract orders, the period covered thereby, and the extent to which deliveries under such contracts are subject to shifting. It may be desirable to speed up deliveries or to delay them, depending on the ex- tent to which the sales program may exceed or fail to reach the estimated program. The amount of those orders that are subject to cancella- tion Is also quite important, especially if It becomes neces- sary to reduce the buying quota because of a failure of the sales program to attain the estimated goal. In order that the amount of each class of purchase orders mentioned may be readily available, supplementary records may be kept which classify the orders as issued and show them as filled when goods are received. But if these records are to be of the greatest service, they must be accurate, and to this end periodical audits should be made to test their accuracy. Oftentimes, because these records are not a part of the general financial records, proper care is not given to their operation and verification. Relation of Purchasing Budget to Merchandise Policies The discussion in the preceding chapter has explained the method of determining the "normal " inventory and the formulation of a purchasing program based on this inven- tory. A brief consideration of the method employed in determining the normal inventory will show that it rep- resents what would be a satisfactory inventory under the conditions of the preceding period. It should be apparent to the reader that it is not always safe to assume that these same conditions will continue during the current period. Consequently the estimated average inventory, as deter- mined by the method sho^vTl in the preceding chapter, may be modified by a consideration of the anticipated market conditions of the current period. 236 BUDGETARY CONTROL There are many considerations which may make such modifications desirable. It may be thought desirable to purchase a large amount of stock early in the period because of an anticipated increase in price, or because it is anticipated that there may be congested traffic later, or because of other conditions. On the other hand, it may be thought desir- able to let the resen^e stock fall below normal because of an anticipated fall in the market price. The merits of this procedure have been considered in Chapter X, in discuss- ing the raw materials budget. In some cases, changes in personnel of customers may be expected to increase turnover, making a smaller inven- tory possible. For instance, a large inflow of war workers during the war period increased the sale of certain grades of goods in some cases, and made a more rapid turnover possible. On the other hand, an attempt to cater to a more fastidious trade may tend to necessitate a large inventory in order to provide the proper variety. The foregoing are but a few of the many changes in market conditions which may affect the purchasing pro- gram. Comparisons of statistics of past years by lines of goods, territories, and personnel of trade will help in de- termining the modifications necessary to arrive at the proper estimated inventory for the current period. Use of Purchases Budget to Control Conditions of Stock The purchases budget may be used in many ways td assist in the control of various conditions of stock. If the warehousing facilities are limited, the purchases budget, by providing for a more or less uniform inventory, and conse- quently uniform deliveries Into stock, will prevent the arrival of stock to an amount greater than can be properly stored. It can be seen readily that if there is not coopera- tion between the purchasing department and the operating THE PURCHASES BUDGET 237 or warehouse department, very undesirable situations may arise. Again, if the purchases budget is properly made and is faithfully followed, it will be possible to have a well-formu- lated system of reserve and forward stocks, and there will be little danger of the reserv' e stocks being exhausted when it is necessary to replenish the forward stock. In some lines of business, such as mail-order houses and wholesalers of standard lines of clothing, this is a matter of prime im- portance. A properly controlled buying budget will eliminate the necessity of making omissions or substitutions in filling orders. The demands of the orders are anticipated in the sales estimate and the correlated buying budget, and the goods are on hand when the orders arrive. Such a budget will also eliminate the need for holding unfilled sales orders until goods are purchased with which to fill them. In short, the purchases budget, like the sales budget, is one of the connecting links between the various departments and serves as a basis for coordination of all the activities of the business. Relation of Purchasing Program to Merchandise Policies The purchasing program is but one part of the merchan- dise program and in the formulation of the latter a number of factors must be considered. Some of these factors are external to the business organization, while others are mat- ters of internal policy. Illustrations of the former were given in the discussion of the relation of market conditions to the purchases budget. Some of the most important internal factors which must be given consideration in merchandise planning are: 1. Sales 3. Turnover 5. Mark-downs 2. Inventory 4. Purchases 6. Expense 238 BUDGETARY CONTROL Each of these factors must be given careful consideration in making the merchandise plans of each department, and the policy of the firm with reference to each given proper emphasis. It may be said, by way of caution, that "external" and "internal" factors which affect the merchandise plans are closely related. Each may have an effect on the other. For instance, the market conditions may be such that the company may find it necessary to alter its usual policy with reference to inventory, purchases, or expense. Importance of a Consideration of Expense In the preceding discussion it has been assumed that all the plans of the business are based on the sales program. It has been explained, however, that the sales program is based not alone upon sales possibilities, but also upon production or purchasing capacity, expense requirements, and profit potentialities. As the expense factor is an im- portant one in a mercantile business, it seems worth while to emphasize again the importance of giving it very careful consideration in forming the sales program and the relative purchasing program. It is important to see the anticipated expenses of each department and to determine if the sales program is suffi- cient to warrant the expenses planned. If that program is not sufficient, it is necessary to plan either for an increase in sales or for a decrease in expense. It is beneficial to the department head to have the relationship between his sales and expenses brought forcibly to his attention. After the estimated expenses of the department are determined, it is well to show the amount of sales which are necessary to make possible the incurrence of these expenses with a satisfactory margin of profit. To make this calculation it is necessary to consider (i) THE PURCHASES BUDGET 239 DEPT.-lL PRELIMINARY SIX MONTHS' PLANS Period from JmU.2222 ,0 Jul£Li922 Retail Stock On Hand at Beoinnino ot Period- Desired at End of Period Retail Maximum Stock. Minimum Stock. Mark-Downs Allowed. Initial Mark-Up Required MONTH SALES: Last Year Estimated Result Inventory Last Year Estimated Result TURNOVER: Last Year Estimated Result Purchases: Last Year Estimated Result Mark-Downs: Last Year Estimated Result EXPENSE: Last Year Estimated % Result ?_ Jan, Feb. Mar April May June TOTAL REMARKS Figure 21. Showing Merchandise Plan of Each Department of a Department Store 240 BUDGETARY CONTROL the estimated sales, (2) the average mark-up, (3) the aver- age mark-down, and (4) the expected profit. If we assume that the estimated expenses of Department A are $7,000, the average mark-up 40 per cent, the average mark-do\vn 2 per cent, and the expected profit 3 per cent, then the necessary sales will be obtained by the following calculation : $7,000 -^ [40% - (2%-l-3%)] = $20,000 If the sales program of Department A calls for sales of less than $20,000, it must be revised or else the expense or profit estimate must be revised. If a merchandise plan is made based on a close correla- tion between the sales, purchasing, and expense program, there will be less likelihood of disappointments at the end of the period. Report on Merchandise Plan The merchandise plan of each department of a depart- ment store or wholesale house can be very effectively pre- sented for executive consideration by the use of a report made in the form shown in Figure 21. The information shown on this report is self-explanatory. It serves not only as a basis for formulating plans, but can also be used as a means of checking their performance since it provides for a comparison of the estimated and the actual. If desired, sufficient space may be left in con- nection with each section so that at the end of each month revisions may be shown for each of the following months. It will of course be understood that this general report will be supplemented by a number of detailed reports which will serve to explain the summary figures shown on it. If desired, this report may be so designed as to show comparisons by percentages. THE PURCHASES BUDGET 24I Review and Summary In Chapters V and VI the formation and execution of the sales budget has been discussed. In Chapters XIV and XV an attempt has been made to outline the procedure involved in the correlation of purchases with sales, and in the preparation and execution of the purchases budget. In summary form this procedure may be stated as follows : I. Preparation of Purchases Budget First. An estimate of sales is made for the period. To recapitulate wfiat has been said in a preceding chapter, this requires: 1. An analysis of the sales of preceding periods. The sales accounts should furnish this analysis. But several analyses may be of value in arri\-ing at the final sales program, and it may be necessary to refer back to sales tickets or other vouchers for data in making this analysis. Thus if the sales accounts lead to a report of sales by lines of goods, it may be of value to refer to analyses of sales by terms, by territories, etc. 2. Use of sales analysis comparisons in estimating sales under existing or future trade conditions. 3. Revision of original sales estimates in the light of purchasing possibilities, expense requirements, and profit potentialities. 4. Comparison of estimates of sales with actual sales accounts dur- ing the period, and correction of first estimate as actual sales accounts show errors of judgment in setting up the sales pro- gram. Second. An estimate of turnover for the period is made. To do this requires : 1. Use of inventory accounts and sales accounts of past periods in arriving at average turnover for each line of goods in com- parable past periods. 2. Use of past average turnover in estimating probable turnover under the existing or future trade conditions. Third. Estimated average inventory for the coming period is computed for each item or line of finished stock to be sold in the period. For control purposes, these estimates are set up in schedules of finished stock inventory 16 242 BUDGETARY CONTROL requirements. As the period advances, comparisons are made between schedules and the amounts shown by the inventory accounts, and the schedules are corrected where errors of judgment are apparent through such comparisons. Fourth. A schedule of deliveries of finished stock is made. To be effective as a basis for management control, this schedule or estimate of deliveries should specify the amount of each line of goods that is to be placed in stock each week or each month of the period. If the period covers six months commencing on January i, the delivery quotas may be computed as follows: Estimated sales for the month of January at cost. Plus inventory expected on January 31. Less actual inventory on December 31. Equals delivery into stock quota for the month of January. Then for the month of February. Estimated cost of sales for February. Plus inventory expected on February 28. Less estimated inventory on January 31. Equals delivery into stock quota for month of February. And so on for each of the six months. If the volume of sales is large and fairly constant, as in a mail-order furniture line, such a monthly quota will furnish reasonably close limits on purchases. But if the volume of the sales in the line is subject to great seasonal variations, as in a department store wall-paper line, a weekly quota should be set up for deliveries into stock during rush seasons. Fijth. An estimate of purchases which will satisfy the schedule of finished goods deliveries is set up. This will show estimated orders to be placed each month, estimated deliveries to be made, and estimated dis- bursements to be made in settlement of vendors' claims. Sixth. The schedule of finished goods deliveries and the estimate of purchases is approved by the controlling executive authority with whom final approval rests. II. Reports Used in Preparation and Execution of Purchases Budget If it is assumed that the buying budget for 1922 is under consideration, the name of each report with the money column headings of each which would be used in its preparation and execution may be as follows: THE PURCHASES BUDGET 243 First. Weighted Average of Sales for three years for each class of goods: 1. Sales for the year 1919. 2. Sales for the year 1 920. 3. Sales for the year 1921. 4. Arithmetical average. 5. Weighted average — to be used as a basis for the sales estimate. Second. Sales program for the year 1922 for each item sold: 1. Weighted average for the three years preceding. 2. Per cent of 1922 estimated increases and decreases. 3. Sales estimate for 1922 on each item. Third. Monthly Report of Actual Sales under sales program: 1 . Sales estimated for period to date. 2. Actual sales for period to date. 3. Per cent of increase or decrease of actual over estimated. 4. Add or deduct from sales program for the rest of the period. Fourth. Estimated Average Inventory by Classes or Goods and Items: 1. Actual sales for 1919, 1920, 1921. 2. Less actual gross profit for 1919, 1920, 192 1. 3. 1919-1920-1921 sales at cost. 4. Rate of turnover on each item for 1919, 1920, 192 1. 5. Estimated sales for 1922. 6. Estimated gross profit for 1922. 7. Estimated sales at cost for 1922. 8. Estimated turnover rate for 1922. 9. Estimated average inventory for 1922. Fifth. Estimate of Finished Goods: 1. Month. 2. Estimated inventory at beginning of the month. 3. Estimated sales at cost. 4. Estimated inventory at the end of the month. 5. Estimated deliveries to stock during the month. 6. Comments. Sixth. Estimate of Purchases: 1. Item. 2. First month: (a) Estimated inventory at beginning of month. (b) Estimated deliveries to stock during the month. 244 BUDGETARY CONTROL (c) Estimated orders to be placed during the month. (d) Estimated inventory at the end of the month, (e) Estimated cash disbursements for purchases made during previous months. (f) Estimated cash disbursements for purchases made during the current month. 3. Second month: The same as for first month, and so continued for each month. Seventh. Monthly Inventory Comparison Report: 1. Estimated sales. 2. Actual sales. 3. Per cent of increase or decrease. 4. Estimated average inventory. 5. Actual inventory. 6. Per cent of increase or decrease. Eighth. Monthly Report on Quotas : 1. Estimated sales for month. 2. Estimated gross profit. 3. Estimated sales at cost. 4. Purchase quota. 5. Ratio of (4) to (3). 6. Actual sales for month. 7. Revised quota, per cent shown in (5) taken of actual sales shown in (6). 8. Delivered into stock during the month — taken from the purchase accounts. 9. Balance of quota not delivered or excess of quota d«livered. 10. Purchase orders outstanding under quota, not delivered. 11. Balance in quota not ordered or excess ordered over quota. Ninth. Report on Merchandise Plans of Each Department: This report may be made in the form in Figure 21. CHAPTER XVI THE PLANT AND EQUIPMENT BUDGET Need for Consideration In every business there is need for certain equipment to be used in carrying on its operations. The amount and nature of this equipment depends on the size and the nature of those operations. The professional firm needs little equipment and very rarely owns the building in which it is housed. The mercantile firm uses a limited amount of equipment, depending on its size, and in many cases does not own the building in which it operates. The manufac- turing firm usually employs a large amount of equipment, and in most cases owns the plant in which it carries on its manufacturing operations. Consequently a large part of the capital of most manufacturing firms is invested in their plant and equipment. It can be seen, therefore, that expenditures for plant and equipment are most important in connection with an industrial concern, but that they are of some significance in the case of all businesses. The following discussion will be devoted primarily to a consideration of the control of expend- itures for the plant and equipment of a manufacturing business, but the same principles will apply to the control of expenditures for plant and equipment of any other type of business. Classification of Plant and Equipment Expenditures The expenditures made in connection with the plant and equipment of a business may be classified into the following general groups: 245 246 BUDGETARY CONTROL 1. Expenditures which are necessary to maintain the present plant and equipment at its normal efficiency. No matter how care- fully equipment is selected or how carefully it is used, certain expenditures must be made from time to time to keep it in such condition that it can be operated efficiently. Such expendi- tures are called "repairs." 2. Expenditures which are made to replace with new equipment, old equipment that is worn out and discarded. Regardless of the amount spent in the way of repairs, equipment will in time be in such a condition that it can no longer be operated profitably. It is necessary to purchase new equip- ment to take its place. Such expenditures are termed replacements. 3. Expenditures in connection with present equipment which add to its life or efficiency. For instance, a machine may be entire- ly overhauled; old and worn parts are replaced by new ones, ■ with the result that it will continue in use longer than was originally estimated. Or a new patent may be added to the machine which will not prolong its life but will increase its efficiency during its life. Such expenditures are termed "betterments." 4. Expenditures which are made to obtain new equipment which does not replace other equipment but which represents an addi- tion to the sum total of the equipment employed by the busi- ness. As a business expands, it is necessary to secure addition- al equipment to carry on the increased volume of business. Expenditures for this purpose are termed "additions." Treatment of Different Classes of Expenditures From the viewpoint of both accounting and financial management, the classes of expenditures explained in the foregoing discussion are distinctly different and must be recorded carefully to show properly their effect on the finan- cial condition and operating efficiency of the business. A proper record is necessary also for use as a basis in planning and executing an effective control of these expenditures. It will be necessary to discuss separately the method of recording and reporting each class. THE PLANT AND EQUIPMENT BUDGET 247 Repairs Repairs are usually considered as a current expense of the business, which must be provided for out of the income of the fiscal period in which they occur. This is on the theory that repairs are necessitated because of the operations of the period when they occur and that consequently their cost should be borne by that period. In opposition to this theory it is sometimes urged that repairs are not the result necessarily of the operations of the period when they occur, but may be necessitated because, in part at least, of the operations of previous periods. In other words, the operations of one period may cause a ma- chine to be so worn that it is almost ready to break down at the end of the period, but the break with the consequent repair may not actually occur until the beginning of the next period. The customary practice assumes, however, that repairs "even up" from period to period, since each period suffers repairs caused in part by the operations of previous periods, and in turn transfers "potential repairs" to the next period. Consequently, it Is argued that the cost of repairs tends to be approximately uniform from period to period. If, for any reason, the cost of repairs fluctuates to any extent from period to period, and it is desired to distribute their cost evenly, this may be accomplished by estimating the average cost of repairs on the basis of past experience and future plans, and setting up a reserve for repairs. Under this method there will be charged to expense and credited to a reserve for repairs an amount equal to the estimated cost of repairs. As the repairs take place they are charged to the reserve for repairs. If standard rates for repairs are established, the prepa- ration of the manufacturing expense budget is facilitated. 248 BUDGETARY CONTROL This procedure also assists in the estabHshment of standard expense rates such as were discussed in Chapter XIII. Replacements The cost of replacements is not an expense of the period when the replacement takes place, but is an expense of all the periods during which the equipment which is replaced has been used. If a machine costing $ i ,000 is purchased in 1 92 1, the year 1 921 should not bear the entire cost of the new machine, neither should it bear the difference between the cost and the scrap value of the old machine. Each of the six years during which the machine has been used has received a benefit from its use, and consequently, each of the six years should be charged with a part of its cost. If the scrap value of the machine is $100, the six years during which the machine has been used must be charged with $900 for its use. As to whether each year should be charged an equal amount, there is no unanimity of opinion. It depends upon the method of "depreciation" that is adopted. It is not deemed desirable at this time to enter into a discussion of the different methods which may be employed. It is important to see, however, that the estimated decrease in value of the asset due to the operations of the business each year must be charged against the income derived from these operations. Since the actual expenditures for any particular equip- ment take place at one time, and not during each year of its use, it is customary to credit the estimated depreciation of each period to a reserve for depreciation account and to debit an expense account for the same amount. When the asset is sold or discarded, it is charged against the reserve account. By this means the cost of equipment is charged against the income of the periods which benefit from its use. THE PLANT AND EQUIPMENT BUDGET 249 The new equipment which is purchased to take the place of the old is charged to the asset account. Betterments When betterments are made, future periods will be benefited either through the increased efficiency of the equipment concerned, or through its longer life, and hence replacement costs are postponed. In either case, since future periods are to receive the benefit of such better- ments, they should bear the cost of the betterments. Hence betterments are charged to asset accounts and are not reflected in the expense accounts of the period in which they are incurred. It is often difficult to distinguish between a betterment and a repair. In many cases an expenditure is partly one and partly the other. To take a classic illustration, if a wooden roof is replaced by a slate roof, so much of its cost as would have been incurred if a wooden roof had been used will be treated as a repair, while the excess of the cost of the slate over a wooden roof will be treated as a betterment. In case of doubt, it is the practice of accountants to be con- servative and treat the expenditure as a repair. Additions Additions to plant and equipment are made for the bene- fit of future periods. Hence their cost is not charged to the period in which they are obtained but is distributed, by means of the periodical depreciation charge, over the pe- riods during which they are used. Consequently, additions are a capital and not a revenue charge. It must be realized, however, that as soon as additions are secured they give rise to revenue charges, since a charge for depreciation must be made at the end of each fiscal period to provide for their replacement. 250 BUDGETARY CONTROL Capital vs. Revenue Charges From the foregoing discussion it can be seen that from the viewpoint of accounting, plant and equipment gives rise to two kinds of charges: 1. Those which are made to maintain the present equipment. Re- pairs and replacements are included in this group. These may be termed " maintenance " costs. They must be included in the periodical expense accounts; or to use technical termi- nology, they are "charged against revenue." Many authori- ties do not include provision for replacements (that is, the periodical depreciation allowance) as an item of maintenance cost. From the viewpoint of a maintenance budget, this in- clusion is desirable and no difficulty arises if the definition of maintenance precedes its use. 2. Those charges which represent an addition to the assets of the business. Betterments and addition^ are included in this group. These are termed "plant and equipment costs." They are charged to the asset, or to use technical terminology, they are "charged to capital." Method of Handling Maintenance Charges The preceding discussion has dealt with the method of recording these two classes of charges. The following dis- cussion will deal primarily with the method of exercising control over their amount. Maintenance charges on plant and equipment used in production are a part of manufacturing expenses and should be included in the manufacturing expense budget. This is necessary in order to judge the effect of the contemplated production program on the amount of the manufacturing expense. It is also necessary in determining costs of manu- facturing product and in the establishment of standard rates. It is desirable that the maintenance costs also be shown on the plant and equipment budget, since this makes it possible to obtain a comprehensive picture of the plant and THE PLANT AND EQUIPMENT BUDGET 251 equipment program as a whole. Their appearance on the plant and equipment budget also facilitates the establish- ment of appropriations for them. If the manufacturing expense budget and the plant and equipment budget are prepared by different units of the organization, which is usually the case, the maintenance charges appearing on the two budgets can be checked against each other, which will tend to correct errors made by either party in making the estimate. If there is a disagreement between the estimates shown on the two budgets, this should be reconciled, if pos- sible, by the parties responsible for it. If this cannot be done, it will be necessary to submit the disagreement to the budget committee for settlement. It must of course be remembered that in preparing the financial budget and also the estimated statement of profit and loss, the cost of maintenance must be taken from only one budget. Requirements for Plant and Equipment Control To exercise effective control over disbursements for plant and equipment, three things are necessary : 1. There must be available data which will show results of past operations and serve as the basis of future plans. 2. After all the available data have been considered, the plans which have been formulated must be expressed in workable form by means of a budget on plant and equipment. Sometimes two budgets are made, one on maintenance costs and one on the cost of betterments and additions. The requirements for each are sufficiently similar to make their joint discussion possible. 3. After the budget is made, it is necessary to have records and re- ports prepared which will make possible the control of such expenditures and the enforcement of the budget plans. Data Required as Basis of Control The data required to serve as a basis for control of plant and equipment expenditures may be classified as follows: 252 BUDGETARY CONTROL 1. That which is obtained from the accounting and statistical rec- ords with reference to past experience. 2. That which is obtained by a mathematical calculation based on predetermined factors. 3. That which is determined by a consideration of future plans. 4. That which is obtained as a result of the investigation and study of experts. Accounting and Statistical Data To make plans which will serve to control expenditures for plant and equipment, it is necessary that a proper classi- fication of the plant and equipment be made and that proper records be maintained which reflect this classifica- tion. This classification is necessary to make an accurate estimate of plant and equipment expenditures. To illustrate, in a manufacturing business the plant and equipment expenditures will vary with the production pro- gram. If production is to be increased it will be necessary to do one or both of two things : ( i ) secure additional equip- ment; (2) use present equipment more intensively. In either case, additional expenditures will be incurred, and to estimate accurately the amount of these expenditures it is necessary to consider carefully the various kinds of equip- ment used in production. If additional equipment is to be secured It will be neces- sary to determine the units of equipment used in the past and the amount of production which has been accomplished with this equipment. On this basis, the additional equip- ment required to secure the increased production capacity can be estimated. That the past production capacity may be obtained accurately, a record of each unit of equipment is necessary. If the present equipment is to be used more intensively, this win increase the maintenance cost, and an estimate of this increase must be made. It should be obvious that a THE PLANT AND EQUIPMENT BUDGET 253 change in the production program will not affect all the equipment of the business to the same extent. For instance, it may be planned to increase the output of one department, while the output of all the remaining departments is to re- main the same. This increase in the output of one depart- ment is very apt to increase the maintenance expense of this department, and if the previous expense is shown sepa- rately from that of all the other departments, a more accu- rate estimate of the increase can be made. It will be necessary, however, to know more than the total cost of the maintenance of the department. The new program will probably affect some units of equipment in the department more than it will others. It is desirable, therefore, to have records which will show each unit of equipment in the de- partment, and the maintenance expense incurred on it. This is accomplished by keeping a plant ledger. Plant Ledger A plant ledger is a record which contains an account with each unit of plant and equipment. It serves as a subsidiary record to the controlling account or accounts with plant and equipment which are kept on the main ledger. The plant ledger is usually kept on cards or loose-leaf sheets, each card or sheet providing a record of one unit of equipment. The size of this unit will vary, depending on conditions. There may be a separate account for each machine, or if several machines of the same pattern and size are purchased at the same time, they may all be recorded in one account. Each account in the plant ledger should show at least three things: 1. The original cost of equipment and the date of purchase. 2. The amount of depreciation which has accrued on the equipment to date. 3. Its present book value. 254 BUDGETARY CONTROL In addition the account may show the amount of the repairs which have been made on the equipment to date. It will be understood that the repairs entered on the plant ledger account will not affect the value of the equip- ment, since they are treated as an expense and are never PLANT LEDGER aker' RMp Our Plant No. Made M Name of Item Bv s Acct. Nn. Dept. Indicate below whether machine proper, accessories, foundation, or additions, etc. FIXED ASSETS DEPRECIATION RESERVE Detail Total Date Rate Annual Total Figure 22. Plant Ledger added to the asset. It is useful to have them entered on the plant ledger account for memorandum purposes, so that in making future estimates it will be possible to obtain infor- mation of the past costs of repairs, not only in total but also by departments and by units. It is not within the province of this discussion to treat of the accounting features in- volved in the operation of a plant ledger, but it is necessary THE PLANT AND EQUIPMENT BUDGET 255 to emphasize its usefulness in making plans for the control of maintenance cost. Figure 22 shows a typical form of plant ledger. Data Calculated from Predetermined Factors Later chapters will show that the various departmental estimates are combined for two purposes: 1. To determine the estimated cash receipts and the estimated cash disbursements, and thereby formulate a financial budget. 2. To determine the estimated revenues and the estimated expenses, and thereby formulate an estimated statement of profit and loss. In making all the departmental estimates, it should be borne in mind that every business desires to formulate a program which it is capable of financing and which will re- sult in the greatest possible profit. A financial budget and the estimated statement of profit and loss are the state- ments which answer the two questions which are most sig- nificant with reference to the budgetary program. And all departmental estimates must be made so that these two statements can be prepared. In the preparation of the es- timated statement of profit and loss, the periodical deprecia- tion charge is an important factor. Consequently it must be given careful consideration in the preparation of the plant and equipment budget. All equipment wears out in time and its replacement must be provided for. This provision is accomplished by charging a certain amount to the expenses of each budget period, and crediting a like amount to a reserv^e for depre- ciation. The accounting technique involved in the opera- tion of such a reserve account need not be dealt with here. It is sufhcient at this time to see that the amount of such depreciation is an important element of the expense of operation and must be included in the plant and equipment 256 BUDGETARY CONTROL budget. In the calculation of the depreciation charge, three things are considered : the original cost of the asset, its antici- pated life, and its estimated scrap value. By subtracting the scrap value of the asset from its original cost, it is possi- ble to determine the cost of the use of the asset during its period of life. This cost must be distributed over the period of its life in such a way that each budget period will be charged with its equitable share. Distribution of Depreciation Cost There is a difference of opinion as to how this cost should be distributed. Some contend that each budget period should be charged an equal amount; others contend that the earlier period should be charged more than the later periods, since the equipment is more efficient when it is new and the cost of repairs is less, while, when it becomes older, its efficiency decreases and the cost of repairs becomes greater. Other methods are also suggested, but it is not thought advisable to discuss them here. Whatever method of determining the periodical charge is used, once adopted it should be followed throughout the life of the equipment. The determination of the periodical charge is, therefore, merely a mathematical calculation. If it is decided to charge each period a uniform amount, it is only necessary to take the figures of past periods as a basis of the present period budget charge. If some other method is followed, the charge for the current period may be more or less than that of the previous period, but it will be a uniform increase or decrease and can be determined by a consideration of the predetermined factors previously mentioned. Effect of the Budget Program The accounting and statistical records show the past expenditures for plant and equipment, but as suggested by THE PLANT AND EQUIPMENT BUDGET 257 the preceding discussion, a change in the volume of produc- tion affects both the maintenance charges and the charges for additions and betterments. It is necessary, therefore, to consider the effect of the budget program on each of these. There are many plans which may affect cost of mainte- nance. If a large increase in production is planned, the increased cost of maintenance arising from this increased production must be estimated. If new methods of manu- facture are to be employed, the consequent change in main- tenance cost must be calculated. If new equipment is to take the place of old, the maintenance cost will be affected. If it is planned to inaugurate a policy of keeping the equip- ment in better repair so as to make it more efficient and to prolong its life, this change must be considered. These as well as other factors affect the cost of maintenance, and all these factors must be considered. In considering the relation of maintenance cost to future plans, various comparisons should be made. This is due to the fact that some items of maintenance cost will vary in proportion to certain factors, while others will vary in pro- portion to different factors. To estimate these, it is neces- sary to determine the ratio of the volume of production to these costs during the past period or periods. By applying this ratio to the estimated volume of production for the current period, an estimate of these items of maintenance expense for this period can be obtained. Some items of maintenance cost will vary more nearly with the floor space used than with the production volume. Therefore, the ratio of floor space used in the past period to these items of maintenance expense during the same periods will be ob- tained, and this ratio applied to the estimated floor space of the current period. Other items of maintenance costs may vary in proportion to the number of units of equipment 17 258 BUDGETARY CONTROL which are used. Hence the amount of these items will be increased as the number of the units of equipment are in- creased. In the same manner in which the general plans of the business, as reflected in the departmental estimates, affect the cost of maintenance, they determine the amount of new equipment to be purchased. In a manufacturing business the amount of equipment required is determined primarily by the volume of production. If records are available which show machine capacity, such as were discussed in connection with the production budget, it is not difficult to estimate the requirements of the increased production in terms of number of machines or units of equipment. If proper records are maintained, it is possible to estimate the total requirements of the production program and the total production capacity of the factory. By a comparison the excess of requirements over capacity can be determined, and from this the new equipment required can be calculated. Information Obtained by the Investigation and Study of Experts It is desirable that a periodical check be made on the accuracy of the value of the plant and equipment as shown by the records. If a plant ledger is maintained in the form described in the preceding discussion, it is possible to obtain the original cost, the accrued depreciation, and the repairs incurred on each unit of plant and equipment. The depre- ciation shown as accrued is only an estimate, however, and the expenses which have been incurred may have been more or less than those required to maintain the equipment in an efficient condition. Unless some steps are taken to deter- mine the accuracy of the estimated depreciation and the sufficiency of the repairs which have been made, it may be determined in the future that both the depreciation and the repairs have been inadequate, and consequently there will THE PLANT AND EQUIPMENT BUDGET 259 be an unduly heavy charge against the earnings of future years. To avoid this it is desirable that a periodical inventory or appraisal be made of plant and equipment and used as a means of checking the plant ledger and as a basis for budg- etary plans. By this means inaccuracies in depreciation estimates and inadequate repairs can be discovered and corrected. It is also possible that too liberal depreciation may be allowed or too extensive repairs are being made. Such appraisals will serve to disclose this. They will also show when it is better to purchase a new machine rather than repair an old one. Although an appraisal of plant and equipment is quite valuable to use in the way indicated in the preceding para- graph, it must be used with discretion, especially if it is made by professional appraisers. The viewpoint of the professional appraiser is not always that of the accountant or that of the financial executive. The appraiser tries to determine the present value of the article he is appraising. He is concerned with its original cost and past use, only as they assist him in determining present value. As a con- sequence, market fluctuations are apt to be reflected in his appraisal. The accountant and financial executive, on the other hand, are not interested in the market value of the equipment. They are interested only in apportioning the original cost and the cost of repairs over the periods which will benefit from its use, in as equitable a manner as possible. An increase in the market value of the asset does not increase its life or its efficiency; neither does a decrease in its market value decrease its life or its efficiency. Because of these reasons, the value of the appraiser may not agree with the book value, and yet the book record may be satisfactory. The chief importance of the appraisal is not the value which it places on the asset, but rather the 26a BUDGETARY CONTROL appraiser's estimate of the length of Hfe and efficiency of the asset as reflected in the value placed on it. The Plant Engineer Many manufacturing companies have on their staff a plant engineer, who is responsible for the production, use, and maintenance of plant and equipment. As indicative of the function of the plant engineer, the following responsi- bilities may be mentioned : 1. The study of improved methods of factory construction. 2. The study of present factory layouts, and presentation for the approval of the executive in charge of production, of proposals for improvements based on costs involved and savings made. 3. The study of machinery, equipment, and tools, and the presenta- tion for the approval of the executive in charge of production, of proposals for changes, based on costs involved and savings to be made. 4. The presentation of a periodical plant and equipment program, based on studies made in collaboration with the works plan- ning department and the works engineering department. 5. The presentation of the plant and equipment program to the executive in charge of production, for approval and transmis- sion to the budget committee. 6. The preparation of a periodical maintenance program as prepared by the works maintenance department and detailed by the works engineering department. 7. The presentation of the maintenance program to the executive in charge of production, for approval and transmission to the budget committee. 8. The supervision over the execution of the plant and equipment and the maintenance programs as approved by the budget committee. Where there is an efficient plant engineer performing the functions suggested in the above outline, the services of professional appraisers can usually be dispensed with under normal conditions. CHAPTER XVII THE PLANT AND EQUIPMENT BUDGET (Continued) Preparation of Plant and Equipment Budget The preceding discussion explained in considerable detail the data which serve as a basis for the preparation of the plant and equipment budget. It is now necessary to see how these data are formulated into a budgetary pro- gram which serves as a means of controlling plant and equipment expenditures. This involves a consideration of: 1. The contents of the plant and equipment budget. 2. The responsibility for its preparation. 3. The form in which it is made. 4. The manner in which it is used. Contents of the Plant and Equipment Budget The plant and equipment budget can be made to show any information which the executives think is desirable for their use. It is usually thought desirable that it contain the following : 1. The value of present equipment at the beginning of the period. 2. The estimated depreciation and repairs on present equipment. 3. The estimated cost of new equipment which should show : (a) Cost of factory equipment, and (b) Cost of equipment for administrative and selling units of the business. 4. Estimated depreciation and repairs on new equipment. 5. Total depreciation and total repairs on both old and new equip- ment. 6. Value of total equipment at end of period. 261 262 BUDGETARY CONTROL Responsibility for Preparation of Plant and Equipment Budget The executive in charge of production is responsible for the preparation of the plant and equipment budget so far as it relates to the factory. This responsibility he will dele- gate to the plant engineer, who in turn will employ the assistance of the works maintenance department and the works engineering department. In calculating the depre- ciation charges he will avail himself of the services of the accounting department as well. The cost records will also be of service in estimating the cost of repairs and construc- tion of new equipment. The purchasing department will assist in estimating the cost of new equipment which it is planned to purchase. In estimating the amount of equipment required it is necessary to make use of the estimate of production, since the quantity of production will affect the equipment re- quirements. If a plant engineer is not employed, the plant and equipment budget may be prepared by the staff of the production manager or by the planning department. The cost of repairs and depreciation will be estimated by the cost accounting department in the estimate of manufactur- ing expense, and this estimate may be used in preparing the estimate of plant and equipment, but it is preferable that a separate estimate be prepared by some unit of the produc- tion department. The office manager is responsible for the preparation of the estimate of equipment for the administrative and selling units. In its preparation he will employ the assistance of the heads of the departments and executive units. Each of these will submit a request to the office manager for the equipment which he desires during the next budget period. The office manager will consolidate these into one estimate and transmit it with his recommendations to the executive in charge of the budgetary procedure. THE PLANT AND EQUIPMENT BUDGET 263 \ — c \ (d5 » 0"° 3 E^ .2 ^ "SH am-o J; '^ >^3 ^^Q. ^ U m 5« ^-^ a ^-' « s t— a, Q / ■a . Qj 05 \ \ 1 "^'5 eS 03 :;; a> ' — ' h- ^'^ \ UJ Q CQ 1- Z UJ ■S.5 fN. Z a. CO '^ UJ u c'S 5 Ji-S ^^ D. UI f H 2 3 z C UJ Q S £ i: •^ 2 a) Q 3 10 1 Z — a- "^ / < ^■^ 1?°^ / ^£ < Q. 1- z s E a Ui •* •D — Q. 0.5 3 III 2 ' Ui Q -1 CB ,— V «.E 5 CM < s CQ Q. 3 ^_^ ^•m 0= w/ / m 6 .2* '3 cr W Ph 264 BUDGETARY CONTROL The production manager will transmit the estimate of manufacturing plant and equipment to the executive in charge of the budgetary procedure, and the latter will transmit it together with the estimate of the office manager to the budget committee. After the committee has ap- proved these estimates, they will be returned to the pro- duction manager and the office manager, respectively. Form of the Plant and Equipment Budget No standard form for the plant and equipment budget can be described, for its form will depend upon the method employed in its preparation and use. Figure 23 is indicative of the information that the budget should contain. A sep- arate form may be used for factory equipment and for office equipment, but the information desired in the two cases Is sufficiently similar to make the same form satisfactory in most cases. In filling in columns (4) and (8) the plant engineer will consult the works engineering department with reference to the cost of repairs. The w^orks maintenance department will supply information with reference to the amount of repairs to be made. If the company produces its equip- ment, the works engineering department will supply the data needed for column (5). If the new equipment is to be purchased from outside vendors, the purchasing agent will supply these data. Column (6) on the plant and equipment budget states when the new equipment is desired. With this as a basis the purchasing agent will state the terms on which the goods will be purchased and show the date of payment. This information is necessary for the preparation of the financial budget. If the equipment is to be produced by the com- pany, an estimate must be made of the disbursements necessary for its production. The date given in column (6) THE PLANT AND EQUIPMENT BUDGET 265 is the date when the complete equipment is desired. It may require a considerable period of time for its production. During the process of its construction expenditures for labor and possibly for materials will need to be made. Under such circumstances, the estimated expenditures pre- ceding the completion of the equipment must be determined and allocated to the proper period for the purpose of the financial budget. Execution of the Plant and Equipment Budget The budget for plant and equipment consists of an esti- mate of the expenditures necessary for maintaining the present equipment and the securing and maintenance of the additional equipment demanded by the budget program. Its approval is followed by the making of various appropria- tions for the necessary amount to cover the cost of the vari- ous items included in the budget. After these appropria- tions are made, it is necessary to establish a procedure which will effect their enforcement. This procedure usually requires the following: 1. That expenditures under any appropriation be made only after requisitions for these expenditures, accompanied by proper estimates of cost, have been submitted and approved by the proper authority. 2. That careful costs be kept on all work done under appropriations. 3. That reports be prepared showing a comparison between the estimated and actual cost of all such work performed. 4. That reports be prepared monthly showing the status of all appropriations. Requisitions for Expenditures It is customary to delegate to some official of the com- pany the authority to grant expenditures under each ap- propriation. In many cases the expenditures are divided into two groups, known as "minor" and "major." For 266 BUDGETARY CONTROL instance, any expenditure of less than $ioo may be termed a "minor" expenditure, and any expenditure of more than $ioo may be termed a "major" expenditure. Tliehead of the production department may be given the authority to approve all minor expenditures for the production de- partment, and the office manager to approve all minor expenditures of the other departments. For the major expenditures the approval of the budget committee may be required. That the proper executives may exercise effective con- trol over the disbursements made under appropriations, it is necessary that the disbursements be made only as a result of a requisition or request on the part of the one desiring that repairs be made or additional equipment secured. When repairs or additions to plant or equipment are desired by any department, the head of this department should transmit a requisition to the production manager or the office manager, as the case may be. Such requests should be accompanied by an estirnate of the cost of the repairs or additions. If equipment is to be purchased from outside vendors, it is easy to obtain the purchase cost and submit it with the requisition. If addi- tions to plant or equipment are to be constructed by the company, an estimate of the cost of the construction must be made. The estimate of the cost of repairs or construction which is to be done by the company can be made in two ways. If the business maintains an engineering department, this department can be asked to make an estimate. A compe- tent engineer learns by experience to estimate costs accu- rately. His estimates should be checked by statistics of past costs. If it is not possible or not desirable to have engineers make the estimate, it can be made by the cost accounting department, which will make the estimate on the basis of THE PLANT AND EQUIPMENT BUDGET 267 the statistics obtained from the records of previous costs. These estimates may be erroneous if the one making them is not trained in mechanics. If cooperation between the accounting department and the engineering department is secured, more accurate estimates will be obtained. Costs of Construction and Repairs If the requisition calls for construction of repairs or equipment by the factory, there should be careful record? kept of the cost of the construction. The method of de- termining these costs is very similar to the m.ethod of determining the cost of goods manufactured for sale. Each requisition, after it has been approved, is given a number, and a construction order is issued authorizing the construction called for by the requisition. The construc- tion order has the same number as the requisition. An account is opened on the cost records for the construction order and all costs incurred in the construction are charged to this account. It must be remembered that in arriving at the cost of construction a business cannot derive a profit from work done for itself. Hence no profit must be allowed on con- struction work performed by the company for itself. It may be possible that the company performs this work for less than it can secure it from outsiders. This results in a saving to the company, but it does not result in a profit. Reports on Construction Costs When a construction order is completed, a report is made to the executive having supervision over the expendi- tures for construction, showing the estimated cost and the actual cost. If there is any considerable variance, it is due to inaccurate estimates or excessive cost. With the comparative figures available it is possible to determine the 268 BUDGETARY CONTROL cause of the variation. Unless such comparisons are made, it is impossible to exercise any effective control over the cost of construction work. A copy of these reports should go to the controller or head accountant, as well as to the production manager and budget committee. This procedure will provide a com- prehensive check on the costs of construction. Report on Appropriations To exercise effective control over the plant and equip- ment budget, it is necessary to have periodical reports which will make possible a comparison between the amount appropriated for each class of expenditures and the actual amount expended. A report should be made monthly, giving this comparison. This report should provide the information shown in Figure 24. A report made in this form is of service not only to the executive who is exercising control over the purchases and construction of plant and equipment, but also to the finan- cial executive. It shows the former the amount which he has available for future construction, and the latter the amount which he must plan to finance. The tenth column gives the treasurer information of special value, since it states the payments which must be made in the near future. Column (13) shows the amount which may be diverted to some other purpose in case of financial stringency. If the budget committee receives this report each month, it can exercise an effective control over all disbursements for plant and equipment. Reserve for Contingent Expenditures It is usually not possible to estimate exactly each item of plant and equipment cost which must be met during the budget period. There will usually be need for expenditures THE PLANT AND EQUIPMENT BUDGET 269 ^ sf»^ ^ cs c3 5 ■ 00 cr> siH _ >- s H ^ / Z L-eo '*-' UJ "-s^ 2 |i => u. 3 C ^ O* ^CD ^-' liJ I Q ^ =3 2 ^ h- •t H M = DC 0-* s ( ^^ \ Q. LJ • _ CC 5 >■ -1 "o tt ^ •0 ' X _o S J z UJ -1 Q < z CO K Pi o U _>> 2 ^ Q " LU .2 ^ z < 7- til tj T X X X X z oc z z 111 < ^ ^ ^ ^ H m 09 OQ m m < m Q u S s 322 BUDGETARY CONTROL Length of Cash Period Although the financial budget may be made for a quar- ter, a half, or a whole year, it is necessary to make a com- parison between the cash receipts and cash disbursements over shorter periods of time than is represented by the budget; otherwise there may be times during the period MONTHLY REPORT ON CASH RECEIPTS MONTH OF iq? SOURCE Amount Received Estimated Receipts Per Ceni Increase or Decrease Comments Figure 36. Monthly Cash Receipts Report when there will not be sufficient cash on hand to meet cur- rent obligations. For instance, the cash receipts from ac- counts receivable and miscellaneous sources from January i to April I may exceed the cash disbursements for the same period, but there may not be sufficient cash to meet cur- rent demands at one or more times during that period. The demand for cash is an imperative one and care must be exercised to see that it is forthcoming at the time needed. THE FINANCIAL BUDGET 323 In the preceding discussion It has been assumed that such comparisons will be made monthly. The estimated receipts for each month are compared with the estimated disbursements for the month, and the excess of disburse- ments which must be financed determined. Usually this procedure is satisfactory, but there may be cases where the MONTHLY REPORT ON CASH DISBURSEMENTS Month of -192- PURPOSE Amount Disbursed Estimated Disbursement Decrease COMMENTS Figure 37. Monthly Cash Disbursements Report receipts and disbursements fluctuate so violently that it is necessary to have a comparison on the basis of ten- or fifteen-day periods. In such businesses the fluctuating demand for cash is usually satisfied by arranging a "re- serve line" of credit at banks so that additional funds can be obtained immediately at any time when they are needed. 324 BUDGETARY CONTROL Formulation of a Financial Program In the foregoing discussion the procedure by which the financial budget is prepared has been explained. It should be apparent that this procedure can be effective only when it is exercised as a part of a well-formulated financial pro- gram. It is not only necessary to know what the financial requirements of a business are, so that plans to meet them can be made, but it is also necessary to know that these requirements are what they should he. In other words, it is desirable to know whether the financial program called for by the financial budget is the one which will be the most profitable to the business. A consideration of what con- stitutes a proper financial program would necessitate a discussion of the whole program of financial management which is beyond the province of this discussion. There are one or two phases of the financial program, however, which are so vitally connected with the deter- mination of cash requirements that it is worth while to mention them here. Constant and Variable Capital Requirements Bankers have given considerable attention to the analy- sis of the assets and liabilities of business firms in connec- tion with the granting of loans. From the viewpoint of credit granting, they have found it desirable to differentiate between fixed assets and current assets, and between fixed liabilities and current liabilities. This distinction is made largely on the basis of turnover. An asset with a slow turnover is termed a "fixed" asset, while one with a rapid turnover is termed a "current" asset. Liabilities are classified in the same manner. Since bankers have em- phasized this classification in their relations with business men, the latter have come to regard it as fundamental. Many bankers have insisted on the use of the "rule-of- THE FINANCIAL BUDGET 325 thumb" financial standard of the "2 to I " ratio, and busi- ness men have come to believe that so long as they succeed in keeping their current assets twice their current liabilities, they are successful financial managers. The classification of assets and liabilities as current and fixed is very useful in many cases, but it sometimes leads to a confusion of thought. Because any particular piece of merchandise will presently be converted into cash again, it is felt that it is a less permanent form of investment than a building. From the viewpoint of credit this is true, but from the viewpoint of capital requirements it may not be so. If a concern never allows its merchandise inventory to fall below $20,000 that twenty thousand dollars is as truly a permanent investment in the business as is the cost of the longest-lived of its permanent assets. The same may be true of current liabilities. Many concerns never pay off all of their short-time loans at once. A business that always owes at least $50,000 on short-time loans, though it may clear up its account at each bank once a year, is obtaining that much permanent capital on commercial loans. From the viewpoint of financial administration, there is a distinct difference between permanent assets and assets which involve a permanent investment. During any partic- ular period of time a given asset or liability, whether per- manent or current, whether an accrued or a deferred item, may vary in amount. The proprietorship may also change. Of course the variations in different assets may not all be in the same direction at the same time, so that some will serve to offset others and the same is true of liabilities and proprietorship. For the purposes of financial requirements, what is of primary importance are the changes in the totals. Usually the total of each of these items fluctuates constantly. These fluctuations may be due to seasonal operations, in 326 BUDGETARY CONTROL which case they are confined between certain maximum and minimum Hmits. Or they may be due to the expan- sion or contraction of the operations of the business, in which case there may be a constant increase or decrease for a certain period of time. Even here a minimum or maxi- mum will sooner or later be reached. In the case of a decrease a minimum will be reached below which the business cannot continue to operate. In the case of an increase or expansion of business, in time a state of diminish- ing returns will be reached beyond which it will be unprof- itable for the business to expand and consequently the assets of the business will cease to increase. The minimum total of assets of a business during the period under consideration, such as a year, may be termed the "constant" assets of that business, and the amount in excess of this minimum may be termed the "variable" assets. In analogous fashion, constant and variable lia- bilities and proprietorship may be defined. Thus, if the balance sheet of the King Manufacturing Company on June I, 1 92 1, shows: Assets $200,000 Liabilities 120,000 Proprietorship $80,000 and the lowest value for the total assets during the year is $160,000, this will be the constant assets and also the con- stant liabilities and proprietorship. The variable assets will be $40,000 on June i, and this will be also the amount of the variable liabilities and proprietorship. The varia- tions in the proprietorship total taken by itself will not ordinarily be large. It will usually Increase gradually through an accumulation of profits and then drop off at the time when dividends are paid. If the profits are left THE FINANCIAL BUDGET 327 in the business, there will be a permanent increase in the proprietorship, and if losses are incurred there may be a decrease. Proprietorship may be increased by a sale of stock, but this occurs rarely in the life of any particular business. The assets of a business at all times are equal to the proprietorship plus the liabilities. Since the proprietorship in most businesses under normal conditions fluctuates but little, it follows that the fluctuations in the assets usually result in like fluctuations in the liabilities. In other words, the variable assets tend to be offset by the variable liabili- ties. To illustrate, by the foregoing example of the King Manufacturing Company, it is evident that if the pro- prietorship remains approximately at $80,000 throughout the year and the assets are reduced to $160,000 at the time of the "slack season" of the year, then the liabilities at that time of the year will be reduced to $80,000. The relation between the variable assets and the varia- ble liabilities is significant in that it points out the relation between the financial budget and the financial condition of a firm as showTi by its balance sheet. An illustration will make this clear. It may be assumed that the assets of the King Manufacturing Company reach the minimum amount of $160,000 on January i, and that they then gradually increase until they reach the maximum amount of $200,000 on June l, after which they gradually decrease until the minimum is reached again on January i. The increase in assets between January i to June I will probably be shown in the main by an increase in accounts receivable and mer- chandise inventor>^ To carry the increase in these items the firm will in all probability increase its borrowings from banks, although some part of the increase in inventory may be offset by an increase in accounts due to trade creditors. 328 BUDGETARY CONTROL In so far as the increase in assets is offset by an increase in bank loans, the financial budget during this period will show an excess of disbursements over receipts, since it is to meet such an excess that bank loans are contracted. During the period from June I to January I , the accounts receivable and merchandise inventory will be decreasing and the bank loans will be decreasing likewise. During the same period the financial budget will show an excess of receipts over disbursements and with this excess the bank loans are paid. Relation of Financial Budget to the Business Cycle The variable assets, and consequently the variable liabilities, will increase during the busy season of a season- able business, and will increase for all businesses during the upward trend of the business cycle when the operations of a business are expanding. They will decrease during the dull season and during the downward trend of the business cycle. In the same manner the financial budget should normally show an increase of disbursements in proportion to receipts during the busy season or upward trend of the business cycle, and it should show the opposite condition during the dull season and the downward trend of the cycle. Because of the non-liquid condition of the variable assets, this "normal" condition may not exist during the downward trend of the business cycle. For instance, dur- ing the year 1 92 1 many firms were ' ' hard pressed " for funds because their variable liabilities became due, and their variable assets were not converted. In other words, it was impossible to reduce their assets to the minimum when it became desirable to reduce their liabilities. This condition, however, does not offset the general principle that during the downward trend of the cycle the cash receipts from the THE FINANCIAL BUDGET 329 operations of the business should exceed the disbursements other than for bank loans and that this excess should be used in paying these loans. The condition during 1921 merely indicates that because of inadequate planning ahead many businesses were in such a condition when the down- ward trend of the cycle came that they could not do what the conditions of the times demanded. Relation of Financial Budget to Estimated Financial Statements The primary purpose of the foregoing discussion with reference to variable assets and liabilities and the financial budget is to show the close relationship between this budget and the financial condition of the business as shown by its balance sheet. The budget sets forth the results of the contemplated operations of the business in terms of finan- cial requirements. To interpret this budget properly and to judge properly of its desirability, the executives should have before them an estimated balance sheet showing the anticipated financial condition at the end of the period for which the budget is made. But the purpose of the operations of a business is to secure a profit. A contemplated program of expansion or contraction, as shown by the financial budget and estimated balance sheet, is desirable only if it will produce profitable results. To determine whether this result will be achieved, it is necessary to have an estimated statement of profit and loss showing the anticipated results of the contemplated program in terms of profit and loss. The financial budget, the estimated statement of profit and loss, and the estimated balance sheet, are the three statements which show the goal towards which the contemplated operations of the business, as reflected in the departmental estimates, are leading. If these statements are properly made and properly correlated, a basis for 330 BUDGETARY CONTROL sound and efficient management is laid. The latter two statements will be discussed in the following chapters. Difficult Problems in Preparing Financial Budget The preparation of the financial budget is not an easy matter. In most businesses, problems of considerable magnitude and difficulty are encountered. Some of these are inherent in the problem of financial control and some are the result of circumstances which exist in particular businesses owing to personnel or to the nature of the opera- tions of the business. The nature of these problems has been indicated to some extent in the previous discussion. In order that it may not be thought that these difficulties have been disregarded or minimized, it is desirable to sum- marize them here. They may be stated as follows : 1 . The financial budget is a budget covering all the activities of the business; therefore it requires the cooperation of all the departments of the business. Without this cooperation it is impossible to prepare an accurate budget or to enforce it after it is prepared. 2. The cash receipts and the cash disbursements in many cases are separated from the activities which produce the receipts or cause the disbursements by a certain interval of time, and it is difficult to estimate accurately the length of this interval. For instance, the collections from sales are not made until some time after the sales take place, and the payments for purchases are not made until some time after the purchases are contracted for. 3. The planning of finances is in most cases in the hands of the principal executive of the company or of the treasurer who acts as his confidential assistant. The financial methods which these executives employ are regarded as highly con- fidential. Consequently there is little or no exchange of information between companies with reference to financial methods, and no standardized i)rocedure has been developed. In undertaking, therefore, the introduction of scientific THE FINANCIAL BUDGET 33I financial planning, each firm is dependent largely on its own experiences and resourcefulness. 4. The executives in charge of the financial operations of a business are usually loath to delegate any duties with reference to them to others, and hesitate to commit their plans to a definite form for fear that they will be hampered in their freedom of action and that important information may be divulged. None of these difficulties Is Insurmountable, and for- tunately the present tendency indicates a rapid removal of the latter two and the development of scientific methods of overcoming the first two. Summary In the preceding pages an attempt has been made to outline the procedure necessary for the preparation and control of the financial budget. In summary form this procedure may be stated as follows: 1. Preparation of a Preliminary Estimate of Cash Receipts. This requires the determination of the proba- ble receipts from all sources. The principal source of cash receipts is the collections from accounts receivable, and the estimate of collections must be based on the estimate of sales which has been prepared in the manner previously explained. 2. Preparation of a Preliminary Estimate of Cash Disbursements. This requires the determination of prob- able disbursements needed to finance the operations of all the departments of the business. Consequently the esti- mate of disbursements must be based on the various de- partmental estimates which h^ave been explained in previous chapters. 3. Preparation of the Cash Budget. The prelimi- nary estimates of cash receipts and disbursements explained in (1) and (2) are submitted, together with all the other 332 BUDGETARY CONTROL estimates, to the budget committee. After the various departmental estimates have been approved, the pre- Hminary estimates of cash receipts and disbursements will be revised, if necessary, to give effect to any changes made in the departmental estimates by the budget committee. After the revised cash estimates are approved, they con- stitute a cash budget. 4. Preparation of the Financial Program. Based on the preliminary estimates of cash receipts and disburse- ments, there will be prepared a suggested financial program which will indicate the financial procedure by which the requirements of the proposed financial program are to be met. This program will be revised, if necessary, to corre- spond to the revised financial budget and will then con- stitute the working program of the financial department. 5. Preparation of an Estimated Balance Sheet AND Estimated Statement of Profit and Loss. These financial statements, discussed in the chapters immediately following, are studied in connection with the financial budg- et to determine the effect of the contemplated financial program on the financial condition and income of the busi- ness. CHAPTER XXI THE ESTIMATED BALANCE SHEET The Need for Financial Statements Business management can be exercised in a rational manner only when it is based on accurate and comprehen- sive information with reference to the operations of the busi- ness which is to be administered. Not only must informa- tion be available, but it should be in the form in which it will be the most serviceable to the business manager. A large part of the information used by the business executive is in the form of statistical data, and experience has shown that these data are most useful when presented by means of reports which show them in a summarized and classified form. Consequently, business men have long been accus- tomed to using statistical reports. The nature of these reports has been determined largely by necessity. When the executive has found that he must have certain information to carry on some activity which it has been necessary to perform, he has devised, or has had devised, a report which will provide him with this informa- tion. The balance sheet and the statement of profit and loss are the two reports with which the executive is most familiar and which are most widely used. The reason for the extensive use of these reports is not difficult to see if the development of accounting records and reports is considered. Balance Sheet Every business finds it necessary in the course of its de- velopment to borrow funds from banks and to purchase merchandise on account. In the not distant past both bank and merchandise creditors often granted credit on the 333 334 BUDGETARY CONTROL basis of the general reputation of the applicant and the in- formation which they could obtain from him in an informal manner. During recent years, however, they have found it necessary to have more exact information and, to obtain this, have required a formal report showing the financial condition of the business. Consequently, the standard form of balance sheet has been developed for their use. The executive, being required to prepare this report for his creditors, gradually learned to make some use of it himself. Statement of Profit and Loss For many years creditors satisfied themselves with the information obtained from the balance sheet, but recently they have found it expedient to ask for additional informa- tion which will show the nature of the operations of the busi- ness and the result of these operations. They hsLxe found it desirable to have this information because they realize that, though the balance sheet shows the financial condition of the business at the time credit is requested, what the cred- itor is primarily interested in is its financial condition at the end of the period of credit. For instance, if a bank grants a loan for three months, it desires to know that the business will be able to pay the loan at maturity ; hence it is interested to know its financial condition three months from now. If it knows its present financial condition and the result of Its past operations, it can estimate roughly the effect of its future operations on its present condition and arrive at an estimate of its financial condition three months in the future. The standard form of the statement of profit and loss has been designed to present to creditors and others the information with reference to the past operations of the business which they desire. Since the executive must pre- pare it for the use of others, he has learned, as in the case of the balance sheet, to use it for his own purposes. ESTIMATED BALANCE SHEET 335 Standard Forms of Financial Statements The balance sheet and the statement of profit and loss have become, therefore, the two standard reports which are usually prepared by all businesses and which are used by the creditors, stockholders, and executives of the business in the making of decisions and the formulation of policies with reference to the business. Through the influence of national associations, such as the American Bankers' Asso- ciation and the National Association of Credit Men, as well as the writings and teachings of accountants, more or less standard forms for these statements have been developed. It is assumed that the form and content of these widely used and orthodox statements are familiar to the reader. Use of the Financial Reports The standard form of balance sheet and the standard form of statement of profit and loss show respectively the present financial condition of a business and the results in terms of profit and loss of its operations over a certain period of time. This information serves two purposes: 1. It indicates the efficiency with which the business has been man- aged during the past, and 2. It indicates the possible result of its future operations. The second purpose of the information provided by the financial reports has not been emphasized by writers and practitioners, and yet a little thought will show that it is the primary purpose for which this information is desired. It is true that these reports are usually discussed in terms of past results, but the principal purpose of studying past results is to be able better to control future results. Just as the credi- tor desires a statement of profit and loss, so that he can esti- mate the changes in financial condition which will probably take place as a result of the future operations for a certain 336 BUDGETARY CONTROL period of time — in the same manner the executive is prima- rily interested in both the balance sheet and statement of profit and loss in order that he may be able to judge whether future operations will result in favorable changes in the financial condition of the business. It is true that both the creditor and the executive make their estimates informally and incompletely. Neither one may be conscious that he is making such an estimate at all. His thought may proceed no farther than to reason that the operations for the past period have resulted in a profit and a favorable financial condition, and if the same policies are followed during the next period, equally favorable results will follow. If the results of the past period are undesirable, he may try to locate the cause and determine some means to remove it. If he succeeds in making changes which he thinks will remove the difficulties of the past period, he may assume that the results of the next period will be more satis- factory without working out in detail what these results will be. For instance, the executive may find that his small profits for the year are due to increased production cost, and that the increased cost is the result of wasteful and inefiicient methods of handling materials and supplies in certain depart- ments of the factory. He changes the methods of these departments so as to lower the cost of materials and supplies, and assumes that as a result he will have a satisfactory profit without determining just what the change in profits will be. If he finds that the small profits are due to decreased sales, and the decreased sales are due to the failure of salesmen in specific territories, he may replace these salesmen with those who are thought to be efftclent and estimate that as a result of these changes favorable profits will be made. In both of these cases the executive may carry his think- ing a step farther. He may estimate the reduction in cost ESTIMATED BALANCE SHEET . 337 of materials which will be effected by the new methods, and then calculate what the profits of the business will be for the next fiscal period if the other results of operation are the same as for the past period. In the same manner he may estimate the increased sales which will be secured from the changes in sales personnel and the consequent results in profits. If he makes a number of changes and estimates the results of each of these, he is led to make a more or less detailed estimate of the result of future operations. Need for Estimated Financial Statements The foregoing discussion and illustrations should be suffi- cient to show that the standard forms of balance sheet and statement of profit and loss are used as a basis of planning future operations and estimating the results of these opera- tions. It should also be apparent that these plans and estimates are usually made in a very informal manner, and consequently are apt to be incomplete and inac- curate. In fact, they are little more than "expert guess- work." In the discussion of the various departmental budgets, it has been emphasized that if estimates are to be made they will be most serviceable if they are prepared in a systematic, complete, and formal manner. In pursuance of this policy, it is desirable that there be prepared an estimated balance sheet or "budget" of assets, liabilities, and proprietorship, and an estimated statement of profit and loss, or "budget" of income and expense, in the same manner that there is prepared a budget of sales, purchases, expenses, etc. It is the purpose of the present chapter to discuss the construction and use of the estimated balance sheet. The estimated statement of profit and loss will be discussed in the chapter immediately following. 22 338 BUDGETARY CONTROL Relation of the Departmental Estimates to the Estimated Finan- cial Reports The departmental estimates show the contemplated operations of the several departments. The profits of the company and its financial condition are dependent on these operations. After the departmental estimates are prepared , it is then necessary to prepare a preliminary estimated balance sheet showing the effect of the contemplated pro- gram on the financial condition of the business, and a pre- liminary estimated statement of profit and loss showing the result of the program in terms of profit and loss. By studying these two statements and comparing them with the statements at the beginning of the period, it is possible to judge the desirability of the proposed program. If the execution of the proposed program will lead to undesir- able results, it will be necessary to revise the departmental estimates. After these revisions are made, the preliminary estimated financial reports should be revised, to give effect to the changes in the departmental budgets. Although the budget period may be three, six, or twelve months in length, it is desirable that the estimated balance sheet and state- ment of profit and loss be made so as to show the anticipated results at the end of each month. Monthly comparisons can be made, then, between the estimated and the actual results. In the following discussion the method by which the estimated financial reports are made will first be considered, and then the method by which they are studied to see if they show the necessity of a revision in the departmental budgets will be explained. The Estimated Balance Sheet To make the discussion of the preparation of the esti- mated balance sheet more concrete, a simple balance sheet ESTIMATED BALANCE SHEET 339 NATIONAL MANUFACTURING COMPANY BALANCE SHEET December 31, 1921 Current Assets: Cash ^ 48,000 Notes Receivable 80,000 Accounts Receivable $200,000 Less: Reserve for Bad Debts 4,000 Inventory: Raw Materials % 40,000 Goods in Process 120,000 Finished Goods 560,000 196,000 720,000 Accrued Items 500 Total Current Assets §1,044,500 Fixed Assets: Office Equipment $ 40,000 Less: Reserve for Depreciation. . . . 8,000 Machinery and Equipment . . ._ $200,000 Less: Reserve for Depreciation .... 40,000 Buildings $160,000 Less: Reserve for Depreciation .... 48,000 $ 32,000 160,000 112 ,000 Land 240,000 Total Fixed Assets . . , 544,ooo Deferred Charges to Expense 27,000 Good-Will. . . __8o^ Total Assets $1,695,500 Current Liabilities: Notes Payable $ 100,000 Accounts Payable 150,000 Accrued Liabilities 10,000 Total Current Liabilities ^ 260,000 Fixed Liabilities: Mortgages Payable $ 80,000 Bonds Payable 80,000 Total Fixed Liabilities 160,000 Proprietorship: Capital Stock Outstanding $1,000,000 Surplus 275,500 Total Proprietorship i,275,500 Total Liabilities and Proprietorship $1.605,500 Figure 38. Balance Sheet 340 BUDGETARY CONTROL showing the financial condition of a business at the begin- ning of a fiscal period will be given, and on the basis of as- sumed departmental budgets an estimated balance sheet, as of the end of the period, will be prepared. For the sake of simplicity a budget period one year in length will be assumed, and only the estimated balance sheet at the end of the year will be given. The reader will understand that an estimated balance sheet at the end of each month is desirable. The balance sheet of the National Manufacturing Com- pany as of December 31, 1921, is shown in Figure 38. To show the preparation of the estimated balance sheet as of December 31, 1921, it will be necessary to take each item which appears on the balance sheet at the beginning of the period and see the method by which the changes which w^ill occur in it are determined. Cash The cash which it is estimated will be received from the operations of the business during the budget period, will be shown by the estimate of cash receipts (Figure 30, page 308) which is prepared as part of the financial budget. The esti- mate of cash receipts does not show the cash to be received from bank loans, for the purpose of the estimate of cash re- ceipts and disbursements is to show the loans required. The amount of these loans can be determined from the financial program (Figure 34, page 318), which is prepared on the basis of the financial budget. The estimate of cash receipts also does not show the cash which may be received from new financing such as the sale of stock or bonds. The amount of such cash must be obtained by a consideration of the plans of the directors. The estimated disbursements for operating purposes can be obtained from the estimate of cash disbursements (Figure 3 1 , page 311). The estimate of cash disbursements ESTIMATED BALANCE SHEET 34I does not show the disbursements for paying bonds or retir- ing long-term notes. Such disbursements can be easily de- termined from the plans of the directors and the terms under which the bonds or notes were issued. After the estimated cash receipts from all sources and the estimated cash disbursements for all purposes are deter- mined, the estimated cash balance can be determined. Although this is the method by which the estimated cash balance is finally obtained, it is customary to decide what cash balance is deemed necessary and use this in preparing the summary of financial requirements (Figure 34, page 318), from which the bank loans required are determined. Of course, if the bank loans required as shown by the prelimi- nary summary of financial requirements are larger than it is thought desirable or possible to obtain, revisions are neces- sary, and in making these revisions the estimated cash bal- ance may be cut do\^m. Based on the financial budget of the National Manufac- turing Company, it is estimated that its cash balance on December 31, 1922, will be $20,000. Notes Receivable To determine the amount of the notes receivable which will be on hand at the end of the period, it is necessary to consider the following: (a) Notes receivable on hand at the beginning of the period. (b) Estimated notes receivable which will be received in payment of goods sold during the period. (c) Estimated notes receivable which will be received in payment of accounts during the period. (d) Estimated cash receipts from notes receivable during the period. It should be apparent to the reader that a-j-b-fc— d equals the notes receivable on hand at the end of the period. If a business has but a few customers, it will be possible to 342 BUDGETARY CONTROL determine the amount of b, c, and d by considering each customer separately. If there are numerous customers, it may be necessary to obtain the ratio between accounts re- ceivable and notes receivable for the past several years, and assume that this ratio will continue during the current year if no changes in terms or of general business conditions are anticipated. If new lines are to be introduced, which are to be sold on different terms, or if business conditions are such that clients are apt to give notes in payment of accounts in greater quantities than usual, these facts must be considered, and the estimated ratio between notes receivable and ac- counts receivable revised accordingly. After this ratio is determined, it will be applied to the estimated balance of unpaid claims against customers at the end of the period to obtain the estimated notes receivable outstanding. The National Manufacturing Company sells several classes of products. Some of these are sold on account, and some are sold on terms which provide for the receipt of trade acceptances and notes in payment. The tendency for the past three years has been for an increase of the sales of the latter in proportion to the former. The sales program for the year 1922 calls for an increase in this tendency during the next year. It is also anticipated that general business conditions are such that more than the usual number of notes will be received from customers in settlement of due accounts. It is estimated that under these conditions the notes receivable on hand on December 31 , 1922, will amount to $120,000. Accounts Receivable The amount of the accounts receivable at the end of the budget period is estimated in a manner very similar to that employed in determining the amount of the notes receivable as explained in the preceding paragraph. It is necessary to ESTIMATED BALANCE SHEET 343 consider (a) the balance outstanding at the beginning of the period ; (b) the accounts receivable resulting from, the sales during the period; (c) cash receipts from accounts receivable during the period. It is apparent that a+b — c is equal to the accounts receivable at the end of the period. On this basis it is estimated that the accounts receivable of the National Manufacturing Company on December 31, 1922, will be $180,000. Reserve for Bad Debts The reserv^e for bad debts at the beginning of the period is 2 per cent of the accounts receivable, and it is estimated that the same ratio will exist at the end of the year. Con- sequently it is estimated that the reserve will be $3,600. Inventories The inventory of raw materials at the end of the period can be obtained from the materials budget, since this budget shows not only the deliveries to stock for each month, but also the balance on hand at the end of each month. The inventory of goods in process can be determined by a con- sideration of the following: (a) inventory at beginning of period ; (b) cost of the materials, labor, and manufacturing expense put into process during the period ; (c) finished goods transferred from factory to stock during the period. The inventory of goods in process at the end of the period is equal to a+b — c. The items in (2) will be obtained from the estimate of raw material requirements, the labor budget, and the manufacturing expense budget. Item (c) will be obtained from the finished goods budget. The inventory of finished goods can be obtained by a consideration of the following: (a) inventory at the begin- ning of the period ; (b) finished goods transferred from fac- tory to stock during the period; (c) stock sold during the 344 BUDGETARY CONTROL period. The inventory of finished goods at the end of the period is equal to a+b — c. Usually, in making up the esti- mate of finished goods required, the inventory desired of each separate item at the end of the period is estimated, since this inventory constitutes a part of the requirements for the period. If the inventory of the separate items which it is planned to have is extended at cost price, the total inventory can be obtained. In some cases it may be easier to reduce the sales estimate by the amount of the average gross profit and substitute the result in the equation given above. Either method may be followed and approximate accuracy obtained. On the basis of the present inventories and the various budgets, it is estimated that the inventories of the company on December 31, 1922, will be as follows: Raw materials $ 70,000 Goods in Process 230,000 Finished Goods 1,100,000 Total $1 ,400,000 Accrued Income The chief source of accrued income is accrued interest on notes receivable. The estimated increase in the amount of the notes will cause a corresponding increase in the amount of this item. Accordingly it is estimated to be $1,000 on December 31, 1922. Fixed Assets The plant and equipment budget shows the following for each class of fixed assets : (a) balance of asset and reserve for depreciation accounts at the beginning of the period; (b) estimated cost of assets to be acquired during the period ; (c) estimated depreciation for the period on both old and new assets; (d) balance of asset and depreciation accounts ESTIMATED BALANCE SHEET 345 at the end of the period. It is very easy, therefore, to obtain from the plant and equipment budget the desired informa- tion for the estimated balance sheet with reference to both the fixed assets and the depreciation thereon. From the plant and equipment budget it is estimated that the fixed assets and reserv^es for depreciation of the company on December 31, 1922, will be as follows: Office Equipment $ 60,000 Less: Reserve for Depreciation 14,000 $ 46,000 Machinery and Equipment $280,000 Less: Reserve for Depreciation 100,000 180,000 Building $200,000 Less: Reserve for Depreciation 58,000 142,000 Land 240,000 Total Fixed Assets $608,000 Deferred Charges to Expense The deferred charges to expense consist of organization expenses, unexpired insurance, and prepaid interest. The organization expenses disappear from the balance sheet, since this is the last year of the period over which they are being allocated. The unexpired insurance can be deter- mined by a consideration of (a) the insurance which it is planned to place during the year, and (b) the insurance un- expired at the beginning of the year. The latter can be obtained from the insurance policy record, while the former must be obtained from the estimate on insurance. Usually there is one officer who is responsible for all insurance con- tracts. In many cases this responsibility is placed on the treasurer. The responsible official will prepare an estimate of the contracts to be made and their length of life. The prepaid interest will arise largely from the notes of custom- 346 BUDGETARY CONTROL ers which are discounted. The amount of the notes to be discounted can be determined from the financial program, which is prepared in connection with the financial budget. It is estimated that the deferred charges of the company on December 31, 1922, will be $35,000. Good-Will The book value of the good-will will not change during the year. Notes Payable The amount of the notes payable at the end of the year will depend on the following : (a) notes payable at beginning of the period; (b) notes issued in payment of merchandise; (c) notes issued in payment of accounts; (d) notes issued to bank for loans; (e) notes paid during the period. The notes outstanding at the end of the period equal a+b + c+ d — e. The notes to be issued to merchandise creditors in payment for merchandise can be determined by a consid- eration of the materials budget. This budget shows the purchases to be made during the period, classified under at least major groups or classes. Usually it is for only certain classes of merchandise that notes are given or trade accept- ances issued, and the amount of these classes of merchan- dise which is to be purchased can be obtained from the ma- terials budget. If notes or trade acceptances are issued for part of the purchases in different lines, it is then necessary to obtain the ratio between the purchases made for notes and the total purchases during past periods, and apply this percentage to the estimated purchases for the current period. In most businesses few, if any, notes are issued in payment of ac- counts. If such notes are issued, it is necessary to obtain the ratio between them and the total purchases on account, ESTIMATED BALANCE SHEET 347 and apply this ratio to the estimated purchases on account for the current period. The amount of the notes to be issued to banks can be obtained from the financial program (page 318), prepared in connection with the financial budget. The disbursements made in the payment of notes payable are shoAvn in the financial program and in the estimate of cash disbursements. In addition to the notes discussed above, notes payable may be issued to ofhcers, employees, and friends of a com- pany. A separate estimate must be made of their amount. On the balance sheet it is desirable to state the notes issued for separate purposes and to different parties as separate items. For the sake of brevity they will be stated as one item in the present case. The notes payable of the company as of December 31, 1922, will be $450,000, according to the estimate. Accounts Payable The amount of the accounts payable at the end of the period will be determined from the following: (a) accounts payable at the beginning of the period ; (b) purchases on ac- count during the period; (c) payments made on account during the period. The accounts payable at the end of the period equal a+b — c. The amount of the purchases on account will be obtained from the materials budget. The amount of the payments on account will be obtained from the estimate of cash disbursements. The accounts payable of the company as of December 31, 1922, are estimated to be $200,000. Accrued Liabilities The principal items of accrued liabilities are accrued interest on notes payable and accrued wages. Since the company is planning to increase greatly the amount of its 348 BUDGETARY CONTROL notes payable, this will result in an increase in the accrued interest. Since it also plans to increase very much its in- ventory of finished goods, this will result in an increase in production, with an enlarged labor force, which in turn will probably result in a larger item of accrued wages. It is estimated that the accrued wages and accrued interest on December 31, 1922, will amount to $20,000. Mortgages and Bonds Payable The anticipated increase in fixed assets will necessitate additional capital, and the treasurer recommends to the board of directors that the mortgages on real estate be in- creased by $40,000, and that $60,000 additional bonds be issued. Accordingly the fixed liabilities of the company on December 31, 1922, will be as follows: mortgages payable $120,000, bonds payable $140,000. Capital Stock The enlarged operations which are planned for the year will necessitate the procurement of additional capital. The president and the treasurer recommend to the board of di- rectors that $250,000 of additional stock be sold. The esti- mated capital stock of the company on December 31, 1922, therefore, will be $1,250,000. Surplus The amount of the surplus at the end of the period will be determined from the following: (a) surplus at the begin- ning of the period; (b) profits for the period; (c) dividends to be declared. The surplus at the end of that period will equal a+b — c. The profits for the period are determined from the estimated statement of profit and loss. The dividends to be paid will be determined by the board of directors. Taking these factors into consideration it is esti- ESTIMATED BALANCE SHEET 349 mated that the surplus of the company on December 31, 1922, will be $170,000. Interpretation of Estimated Balance Sheet On the basis of the information given in the preceding paragraphs, it is possible to construct a preliminary esti- mated balance sheet for the National Manufacturing Com- pany as of December 31 , 1922. The contents of this report is shown in Figure 39. As previously explained, the purpose of the preliminary estimated balance sheet is to show the effect on the financial condition of the business of the proposed plans for the next period, as expressed in the departmental budgets. After it is prepared, it is necessary to study it to see w^hether it shows a desirable tendency, and, if it does not, revisions in the budgets should be made, if possible, so as to remedy the undesirable tendency. The easiest way to see the effect of the proposed budgets is to show the estimated balance sheet as of the end of the period in comparison with the actual bal- ance sheet at the beginning of the period. This comparison for the National Manufacturing Company is shown in Figure 39. The most significant comparisons shown by Figure 39 will be considered. Cash It is estimated that the cash balance at the end of the year w411 be but slightly more than 40 per cent of the cash balance at the beginning of the year. A decrease in the cash balance is not in itself undesirable. In some cases it may be desirable, for the cash balance at the beginning of the period may have been too large. The important ques- tion to determine is whether the cash balance at the end of the year is sufficient. Although this question cannot be 350 BUDGETARY CONTROL answered definitely, since there are no definite standards by which to judge the cash balance which a business should have, there are indications that the estimated balance for the company is too small. In the first place the current liabilities are $760,000, and it is safe to assume that these are maturing each day. The current assets are also presumably being converted into cash every day, but it is not difficult to conceive of a situa- tion where the liabilities maturing on a particular day may be more than the f imds received from current assets on that day, plus a cash balance of $20,000. Then, of course, it is impossible, or at least impractical, to pay out the total cash balance. The primary purpose of the cash balance is to take up the possible slack between cash receipts and cash disbursements, and it is unwise to reduce this balance to too small an amount, especially if, as in this case, the excess of current assets over current liabilities is not large. A more important indication of the inadequacy of the estimated cash balance is the ratio between the cash balance and the notes payable. The latter item is not analyzed, but it is safe to assume that it is expected that a considerable part of the notes outstanding on December 31, 1922, will be in the hands of the bankers of the firm. Practically all banks require that a customer maintain a bank balance which bears a certain ratio to the loans made to the customer by the bank. Many banks require that the balance shall be 20 per cent of the loans granted to the customer. If such a cash balance is required by the bankers of this company, its maximum bank loans on December 31, 1922, would be $100,000. It is hardly to be conceived that less than one- fifth of the notes issued by the firm are to bankers. It is probable that the estimated balance sheet calls for an impossible condition by planning for larger bank loans than the cash balance will make possible. In any case a ESTIMATED BALANCE SHEET 351 COMPARATIVE BALANCE SHEET FOB THE NATIONAL MANUFACTURING COMPANY ASSETS 1921 Current Assets: Cash $ 48,000 Notes Receivable ' 80,000 Accounts Receivable $200,000 Lfss: Reserve for Bad Debts. 4,000 196,000 Inventories: Raw Materials $ 40,000 Goods in Process 120,000 Finished Goods 560,000 720,000 Accrued Items 2,000 Total Current Assets $1,046,000 Fixed Assets: Office Equipment $ 40,000 Leas: Depreciation 8,000 $ 32,000 Machinerv and Equipment $200,000 Less: Depreciation 40,000 160,000 Building $160,000 Less: Depreciation 48,000 112,000 Land 240,000 Total Fixed Assets 544,000 Deferred Chargss TO Expe-jse.. 24,000 Good- Will 80,000 Total Assets $1,694.000 LIABILITIES Current Lubilities: Notes Payable $ 100,000 Accounts Payable 150,000 Accrued Liabilities 10,000 Total Current Liabilities. . . $ 260.000 Fixed Lubilities: Mortgages Payable $ 80.000 Bonds Payable 80.000 Total Fixed Liabilities 160,000 Proprietorship: Capital Stock Outstanding $1,000,000 Surplus 274,000 Total Liabilities and Pro- prietorship 1.274,000 Total Lubilities $1,694,000 $ 180,000 3,600 $ 20,000 120,000 176,400 $ 70,000 230,000 1,100,000 1.400,000 $1,717,400 60,000 14,000 $ 46,000 280,000 100,000 $ 200,000 58.000 180,000 142,000 240,000 608,000 35,OOo 80.000 $2,440,400 < 540.000 200.000 20.400 $ 760,400 $ 120,000 140,000 $1,250,000 170,000 260.000 1,420.000 $2,440,400 Figure 39. Comparative Balance Sheet, with Preliminary Estimate 352 BUDGETARY CONTROL business doing the volume of business which this balance sheet indicates, should not at any time be in such a condi- tion as to be unable to borrow more than $100,000 from its banks. The estimated statement of profit and loss which will be given later will confirm the inadequacy of this cash balance. Revisions in the budgetary program which will accomplish its increase will be discussed subsequently. Notes Receivable and Accounts Receivable The notes receivable show an estimated increase of 50 per cent, while the accounts receivable show a decrease. This is rather an unusual situation, since an increase in the volume of business should produce a corresponding increase in both. In the preceding discussion of the method of de- termining the amount of the notes receivable, it has been ex- plained that the statistics of past periods show a tendency for the sales for which notes are received in payment to increase faster than the sales on account. There may be conditions under which this tendency will not be regarded as undesir- able, but usually notes received in payment of merchandise are non-interest-bearing and are for a considerably longer length of time than the usual credit period granted on open account sales. Consequently the seller is reciuired to bor- row funds with which to carry these notes or must discount them to obtain funds. In either case the interest charge must be borne by him which in turn reduces his profit. Unless a higher sales price is obtained for goods sold on notes, less profit is obtained usually than for goods sold on account. The estimated balance sheet shows such a radical change in the ratio of accounts receivable to notes receivable, that a careful examination should be made of the tendency shown by the comparisons of past periods to see whether the tend- ency for the notes receivable to increase more than in pro- ESTOIATED BALANCE SHEET 353 portion to the accounts receivable should be permitted to continue, or whether strenuous efforts should be made to correct it by enforcement of stricter credit terms or by plac- ing more sales effort on other lines. Inventories The estimated inventories of December 31, 1922, are almost twice what the inventories are at the beginning of the year. The estimated increases in the inventories of raw materials and goods in process are no doubt the result of the estimated increase in production which is required to build up and maintain the large increase in finished goods for which the estimated balance sheet calls. Such an estimated increase in finished goods may result from the following : 1. A large increase in sales may be estimated and this calls for an increased inventory. Whether the increase called for is jus- tified can be determined to some extent by considering the turnover shown by the estimated statement of profit and loss, and comparing this turnover with the turnover shown by pre- vious statements. 2. It may be due to careless and inaccurate planning on the part of the production department. This department may not esti- mate accurately the required inventory of each item to be man- ufactured, not basing this estimate on the estimate of sales, but rather making a lump estimate of the inventory desired. A very careful investigation should be made to see (i) whether the estimated inventory is necessary in order to meet the estimated sales; (2) whether it is possible to finance such an inventory, even if it is necessary to meet estimated sales; and (3) whether it is desirable to tie up so much capital in inventory, with the consequent carrying charges and the possibility of a large loss being incurred due to falling prices. It may be found more profitable and better financial policy to reduce sales and carry a smaller inventory. 23 354 BUDGETARY CONTROL There is usually great danger attendant on such a rapid expansion as the increase in the inventories indicates that this company is contemplating. It is also significant to note that though the notes receivable and accounts receiva- ble have increased less than 8 per cent, the inventory of fin- ished goods has increased almost loo per cent. This would seem to indicate that it is planned to increase the inventory of finished goods faster than is required by the sales program, since increased sales, without a change in terms or collection methods, will result in an increase in the accounts receivable and notes receivable. A statement of the suggested procedure for the company to follow in connection with its inventories will be postponed until after the estimated statement of profit and loss is con- sidered. Fixed Assets The estimated balance sheet shows a considerable increase in office equipment, machinery and equipment, and build- ings. In determining the propriety of these increases, it is necessary to consider the following: 1. Whether the increases shown represent anticipated expenditures which can properly be chargeable to the asset accounts. Care must be taken to see that they do not represent estimated appreciation on the assets or estimated expenditures for repairs or replacements. If these increases are based on the plant and equipment budget, it should be easy to determine their accuracy. 2. Whether the estimated increases in these assets are necessary to carry on the contemplated program of the year. 3. Whether, if they are necessary, it will be possible to finance them. 4. Whether it will be profitable to incur these increases in order to carry on the contemplated program. The estimated depreciation should be investigated to see if it is calculated at the proper rate. The figures shown ESTIMATED BALANCE SHEET 355 would seem to be reasonable in view of the estimated in- crease in assets. Deferred Charges to Expense The increase in the deferred charges would seem to be reasonable in view of the estimated increase in value of the assets on which insurance should be carried and the prob- ability of an increase in prepaid interest. To determine the desirability of the amount of the deferred charges to expense, it is necessary to consider the advisability of incurring the expenses which give rise to these charges. Notes Payable and Accounts Payable Turning to the liability side of the comparative balance sheet, it will be noticed that a larger increase in the notes payable is estimated. The notes payable of December 31 are estimated to be almost five and one-half times the amount outstanding at the beginning of the year. An in- crease in the accounts payable is also estimated, but this increase is by no means in proportion to the contemplated increase in notes payable. An analysis should be made to show to whom it is planned to issue these notes. It is re- garded as good financial management to borrow funds on notes issued to banks and to use these funds to discount accounts payable. An inspection of the item of purchases discount on the comparative statement of profit and loss which will be shown in Figure 40 (page 363), will ser\^e to show whether this procedure is contemplated. If it is, the estimated purchases discount should show a large increase over the amount of last year. There are indications that it is contemplated to con- tract large bank loans in order to pay accounts payable contracted to secure the large increase in inventories. If this be true, there is considerable doubt of the advisability 356 BUDGETARY CONTROL of the contemplated large increase in bank loans. In the first place, it is doubtful whether banks would loan the amount called for by the estimated balance sheet on the strength of the financial condition shown by this statement. In the second place it is doubtful if the firm should contract such a large amount of loans in order to carry large inven- tories. If the inventories are not converted very rapidly, the firm may be unable to meet the notes at maturity. Fixed Liabilities It is estimated that the bonds payable and mortgages payable will both increase during the year. Presumably the funds to be secured from these increases are to be used in making the increase to the fixed assets. If the increases in fixed assets are found to be justifiable, it may not be im- proper to increase the fixed liabilities correspondingly. However, the more desirable procedure is for a business to increase its permanent assets out of profits. A rapidly ex- panding business will often find this impossible, and if there is assurance that a rapid expansion will be profitable, no objection can be made to the procedure contemplated by this company. It must be remembered, however, that fixed liabilities impose upon a business fixed charges w^hich must be met if the business is to continue to operate, and that fixed liabilities are not subject to rapid contraction as are current liabilities. A business should therefore be cautious in adopting a program which necessitates an Increase in its fixed liabilities. Capital Stock The estimated balance sheet shows an increase in capital stock of $250,000. This increase strengthens the indications of the other comparisons that the company is embarking on ESTIMATED BALANCE SHEET 357 an extensive program of expansion. If its plans are depend- ent on the sale of stock, it should be assured, before em- barking upon its year's program, that the stock can be sold. Otherwise it may find itself greatly embarrassed because the estimated balance sheet shows that the company has used practically every other available source of additional capital. Surplus The estimated balance sheet shows a large decrease in the surplus for the year. This decrease may result (a) from a loss being incurred during the year; (b) from the pay- ing of dividends in excess of the profits of the year. Either condition indicates an undesirable situation. To incur a loss is always undesirable. There are times when it may be desirable to pay dividends from accumulated profits, but the balance sheet of this company does not indicate such a procedure is desirable for it. In the first place, the surplus of the company is not large in comparison to its capital stock. Secondly, the company is planning to issue new stock and additional bonds to obtain necessary capital. It is also planning to contract large liabilities in the fonn of notes payable. Under such condi- tions it is doubtful if it is expedient to use funds to pay dividends which are declared from profits of preceding years. Ratio of Current Assets to Current Liabilities A final comparison which is of considerable significance is that of the ratio of current assets to current liabilities. On December 31, 1921, this ratio is slightly more than 4 to I, while the estimated balance sheet of December 31, 1922, shows a ratio of only 23^ to i . It can be seen, therefore, that there is a decided decrease in this ratio. Although the ratio on December 31, 1922, does not in itself appear unfa- 358 BUDGETARY CONTROL vorable, the tendency indicated by the decrease in this ratio during the year is decidedly undesirable. If possible, changes should be made to prevent this decided decrease in this ratio. In any case, care must be exercised to see that this tendency does not continue. It is of course realized that no standard ratio of current assets to current liabilities can be established. This ratio will vary from business to business, and will vary in the same business at different stages of the business cycle. CHAPTER XXII THE ESTIMATED STATEMENT OF PROFIT AND LOSS Contents of the Estimated Statement of Profit and Loss The estimated statement of profit and loss is prepared in the same form as the periodical statement. Its contents is classified into the following principal groups: 1. Returns from sales 2. Cost of goods sold 3. Operating expenses 4. Non-operating income 5. Non-operating expense It is necessary to discuss briefly the method of estimating the amount of each of these. Returns from Sales The estimated sales for the period are shown by the sales estimate. The estimate shows the gross sales, and for the purpose of the estimated statement of profit and loss it is necessary to arrive at the net sales. This makes it necessary to determine the amount of the sales returns and sales allowances. An estimate of these can be made by ob- taining their ratio to sales during past periods, and apply- ing this ratio to the estimated sales for the current period. If there are conditions which will affect this ratio during the coming period, these will need to be given consideration. The estimated sales and the estimated returns and allowance of the National Manufacturing Company are shown in the comparative statement of profit and loss shown in Figure 40. 359 36o BUDGETARY CONTROL Cost of Goods Sold In calculating the cost of goods sold of a manufacturing business, several items have to be considered. These in- clude the beginning and ending inventories of finished goods, materials, and goods in process. In addition it is necessary to know the purchases of materials, labor, and manufactur- ing expense. The method of calculating the inventories has been explained in the discussion of the estimated balance sheet. The estimated purchases of materials, labor, and manufacturing expense can be taken from the materials, labor, and manufacturing expense budgets, respectively. In a mercantile business the problem is much simpler than in the manufacturing business. It is necessary to consider only the beginning and ending inventories and the purchases of finished goods. If a finished goods schedule such as that discussed in Chapter XIV is prepared, all this information can be taken directly from it. The estimated cost of goods of the National Manufactur- ing Company is shown in the comparative statement of profit and loss given in Figure 40. Operating Expenses The amount of each class of expense can be obtained from the various expense budgets. The only difficulty which may arise in this connection is that the expense classification shown by the expense budgets may not correspond with that usually shown on the statement of profit and loss. This is particularly true if the expense budgets are made according to the classification of expenses suggested in Chapter XVIII, For instance, under cor- porate and financial expenses will be included items which are often shown as non-operating expenses. It is the author's belief that some such classification as that suggested in the discussion of the expense budgets is ESTIMATED PROFIT AND LOSS 361 desirable for control purposes, and that it is preferable that the estimated statement of profit and loss show the same classification. If desirable a different classification may be shown on the financial statements submitted for public use. The statement presented below shows the estimated expenses of National Manufacturing Company, classified under the principal headings suggested in Chapter XVIII. The expense estimates will supply the supporting data to make possible a judgment as to the propriety of these amounts. Non-Operating Income The non-operating income can be obtained by simple calculations based on the information contained in the various budgets. For instance, the purchases discount can be estimated by applying the ratio of purchases discount to the total purchases of previous years, to the estimated pur- chases of the current year. Interest earned can be cal- culated on the basis of the sales estimate and the ratio of interest received to sales during preceding years. This method is based on the assumption that the terms of sales and rate of interest on notes receivable will remain the same. Contemplated • changes in policy must be given effect in making these estimates. Such changes are contemplated by the National Manu- facturing Company, which accounts for a decrease in the amount of these items on its estimated statement of profit and loss, as shown in Figure 40. Non-Operating Expense If the expense classification previously suggested is maintained, there will not be many items under non-operat- ing expense. Those that are shown here can be easily 362 BUDGETARY CONTROL estimated. For instance, if it is desired to show sales dis- count as a non-operating expense, its amount can be esti- mated by applying the ratio of sales discount to the total sales during previous years, to the estimated sales of the current year. Interpretation of the Estimated Statement of Profit and Loss The most convenient and effective way to show the effect of the proposed budgets on the profits of the business is to show the estimated statement of profit and loss as of the end of the period, in comparison with the actual statement of profit and loss at the beginning of the period. The statement of profit and loss of the National Manu- facturing Company as of December 31, 1921, and its esti- mated statement of profit and loss as of December 31, 1922, are shown in Figure 40. The most important comparison shown by the statements will be considered. Sales The estimated sales show an increase of 50 per cent. This in itself looks very favorable, but the result of these sales in terms of profit and loss must be considered before a final conclusion can be made. Turnover The merchandise turnover for the year 192 1 is 3.4, while for the year 1922 it is estimated to be only 2.5. This comparison shows a decided decrease in the rate of turnover which should be given careful consideration. The relation of this decrease in turnover to the inventories will be ex- plained later in this discussion. Gross Profits on Sales The gross profits on sales In 192 1 are approximately 123^ per cent of sales, while the estimated gross profits for 1922 ESTIMATED PROFIT AND LOSS 363 COMPARATIVE STATEMENT OF PROFIT AND LOSS rOR THE NATIONAL MANUFACTURING COMPANY 19 21 $1,600,000 16,000 19 40,000 962,000 22 $2,400,000 24,000 $2,376,000 Net Sales $1,584,000 $ Cost op Goods Sold: . . $ 18,000 $ 932,000 1,130,000 700,000 Purchases . . 600,000 S 618,000 40,000 $1,002,000 70,000 $ 578,000 625,000 575,000 Manufacturing Expense $1,778,000 50,000 $2,762,000 120,000 Work in Process, December 31 $1,828,000 120,000 $2,882,000 230,000 $1,708,000 . 240,000 $2,652,000 560,000 $1,948,000 560,000 $3,212,000 1,100,000 Cost of Goods Sold $1,388,000 $2,112,000 Gross Profit on Sales Operating Expenses: Selling Expenses $ 196,000 $ 264,000 $ 44,000 30,500 25,000 18,000 10,500 $ 85,000 47,500 41,500 23,000 19,000 $ 128,000 $ 68,000 24,800 $ 216,000 $ 48,000 20.800 $ 92,800 31,000 $ 68,800 53,600 Net Income $ 61,800 $ 15,200 .. Figure 40. Comparative Statement of Profit and Loss, with Preliminary Estimate 364 BUDGETARY CONTROL are only 1 1 per cent of sales. This indicates that the esti- mated production cost of goods sold increases faster than the estimated sales price of sales. Or if falling prices are anticipated, it may be estimated that the sales price will fall faster than the production cost. This may be a situa- tion which is unavoidable, but careful scrutiny should be made to determine some means by which it may be remedied. The tendency indicated by this comparison is a dangerous one, and one which is apt to occur if there is not close co- operation between sales and production departments. Ratio of Selling Expenses to Sales The selling expenses are .027 of sales for the year 1921, but according to the estimated statement of profit and loss are to be .035 for the year 1922. This shows that though the sales are expected to increase, the proposed marketing plans are such that it will cost more to secure each dollar of sales than during the last year. An analysis of the sales expense will probably show that this increase is due to the estimated extra cost of salesmen's salaries and expenses and of advertising. It may be planned to incur these increased expenses to obtain additional business and build up good- will for the company. It may be proper to increase these, but the tendency for such expenses to increase faster than sales increase is a dangerous one, and care should be taken that it does not continue too long. Operating Expenses The total operating expenses for 1921 are 8 per cent of sales, while for the year 1922, it is estimated that they will be 9 per cent. Although this increase is not large it shows an undesirable and a dangerous tendency, and a careful examination should be made to see if it is possible to change this condition before the budgets are approved. ESTIMATED PROFIT AND LOSS 365 Net Operating Profit The net operating profit for 192 1 is 4 per cent of sales, while it is estimated to be but 2 per cent of sales for the year 1922. It is also estimated to be smaller in amount in 1922 than in 1 92 1. This is the most discouraging informa- tion shown on the comparative statement of profit and loss. When it is estimated that the sales will increase 50 per cent, it is decidedly unsatisfactory to find an estimated decrease in net profit. It may of course be found that some of the expenses to be incurred during the coming year are expected to result in increased business during future years. If this be true, there may be some excuse for the unprofitable showing, but a careful examination should be made to ascertain if this is the situation. Non-operating Expense It is estimated that there will be a large increase in the non-operating expenses for the year. This increase is probably due to the anticipated increase in interest result- ing from the additional bonds and notes which are to be issued, and the increase in the amount of the mortgages payable. Net Income The estimated net Income for 1922 is approximately one-fourth of the net income for the year previous. This indicates that the proposed program for the year is not a proper one, since a 50 per cent increase in volume of busi- ness leads to a 75 per cent decrease in net income. Relation of Estimated Balance Sheet to Estimated Statement of Profit and Loss If the comparative balance sheet given in Chapter XXI is studied in connection with the comparative state- 366 BUDGETARY CONTROL ment of profit and loss shown in this chapter, a few signifi- cant indications are shown : 1. The comparative statement of profit and loss con- firms the indications of the comparative balance sheet that a large increase in business is contemplated. It shows that the budgets are all based on a policy of expansion, 2. The comparative balance sheet shows a large antici- pated increase in inventory of finished goods and an increase which is much larger proportionally than the anticipated increase in sales, as shown by the comparative statement of profit and loss. Whereas it is estimated that the sales will increase 50 per cent, it is estimated that the inventory of finished goods will increase almost 100 per cent. The comparative statement of profit and loss shows a decrease in the merchandise turnover. It is hard to conceive of conditions which would necessitate such a change in the rate of turnover in one year. These comparisons show rather conclusively that the proposed production program is out of harmony with the sales program and should be cut down. 3. The comparative balance sheet shows an estimated decrease in surplus of $104,000. The comparative state- ment of profit and loss shows a profit for the year of $15,200. It is evident, therefore, that it is planned to pay dividends which will necessitate the distribution of a considerable part of the accumulated surplus. The financial condition of the business, as shown by the comparative balance sheet, indicates that such a procedure would be unwise. Revision of Departmental Estimates It is very probable that a study of the estimated balance sheet and the estimated statement of profit and loss would lead to a revision of the departmental estimates on which these statements are based. This revision is necessary for three reasons: ESTIMATED PROFIT AND LOSS 367 1. The estimated balance sheet shows that the contemplated pro- gram for the year will result in the firm's showing an unsatis- factory financial condition at the end of the year. 2. The estimated statement of profit and loss shows that the con- templated program will result in an unsatisfactory profit for the year. 3. The financial budget shows that the financial requirements of the proposed program would probably be larger than the firm could finance. As already pointed out, the financial condition of the firm, as shown by its estimated balance sheet, does not warrant the procurement of the quantity of loans for which the balance sheet calls. Some of the revisions which may possibly be made are : 1. The sales program will be scrutinized very carefully to determine if all the sales for which it calls can be made profitably. If not, those which are not profitable will be eliminated. 2. The sales program will also be examined to see if it is not possi- ble to increase sales to be made on short-term credit and to reduce those made on long-term credit. Any possible changes will be made. 3. The estimated inventory of finished goods will be cut down to be in harmony with the sales program. This will result in a decrease in the production program, with a consequent decrease in labor, materials, and manufacturing expense cost. 4. If possible, the plant and equipment program will be cut down. This will be all the more possible because of the decrease in the production program. 5. The proposed dividend may be passed. 6. The operating expense estimates will be reauced, if possible, so that the ratio of operating expenses to sales will not be in excess of the previous >'ear, and, if possible, so that it will be smaller. 7. Based on the foregoing revisions, the financial budget will be revised. Preparation of the Estimated Financial Reports The preceding discussion has indicated the method by which the estimated balance sheet and statement of profit 368 BUDGETARY CONTROL and loss are prepared and the manner In which they may be interpreted. In order to make the discussion as concrete as possible, assumed statements were taken and an interpre- tation of these made. It should be evident to the reader that such an interpretation may lead to erroneous con- clusions when taken by itself. The foregoing case is given to indicate the method by which statements should be analyzed rather than to emphasize the value of the particular conclusions drawn from the analysis. There may be a difference of opinion with reference to the placing of the responsibility for the preparation of the estimated statements. It is necessary to use the various departmental estimates in their preparation, and the execu- tive in charge of the budgetary procedure is the only one to whom all these come automatically. A saving of time results, therefore, if this executive is held responsible for their preparation. After they are completed he may well submit them to the controller and the treasurer for con- sideration and suggestions. The executive in charge of the budgetary procedure will prepare preliminary estimated financial statements and submit them to the budget committee at the time he sub- mits the departmental estimates and the estimates of cash receipts and disbursements. After the budget committee has approved the departmental estimates, he will revise the estimated financial statements to give effect to the changes which have been made in the departmental budgets. Control of the Estimated Financial Statements The estimated financial statements, like all other esti- mates, must be compared with results obtained at frequent intervals, if effective control is to be exercised over their use. Both the estimated balance sheet and the estimated ESTIMATED PROFIT AND LOSS 369 statement of profit and loss should be compared at the end of each budget period with the actual balance sheet and actual statement of profit and loss as of that date. This comparison will be more significant if the actual financial statements at the beginning of the year are included. NATIONAL MANUFACTURING COMPANY Actual and Estimated Balance Sheet as of the Dates Stated Actual Dec. 31. 1921 Estimated Dec, 31, 1922 Actual Dec. 31, 1922 Current Assets Deferred Charges Fixed Assets Intangible Assets Total Assets Current Liabilities Fixed Liabintfes Defierred Credits Total Liaibiirties Propi1etors;hip Total LfabilTties and Proprietorship Figure 41. Comparison of Actual and Estimated Balance Sheets A report showing proper comparisons for the balance sheet may be made in the form shown in Figure 41. A similar report can be made on the statement of profit and loss in the form shown in Figure 42. 24 370 BUDGETARY CONTROL The reports shown in Figures 41 and 42 should be pre- pared by the executive in charge of the budgetary proce- dure and submitted to the budget committee at the time the other budget reports are transferred to it. The "General Budget" Both practitioners and writers sometimes refer to the "general budget." The estimated balance sheet and esti- mated statement of profit and loss is the most convenient form in which to prepare the general budget. These state- ments show the effect of the pr^i^oseS-^rogram, as expressed In the departmental estimates, on the financial condition and earnings of the firm, and this is the information which the executives and board of directors need in order to judge the advisability of the contemplated plans. If the budget committee and the board of directors study carefully the financial budget and the estimated financial statements, together with departmental estimates which support these, they should have no difificulty in secur- ing the information necessary for effective administrative control. Branch and Division Budgets Where a business has branches, divisions, or subsidiary companies, it may desire to have separate budgets prepared for each. In this case separate sales estimates, production estimates, plant and equipment estimates, etc., may be prepared for each unit and these may be consolidated to form a financial budget and estimated financial statements for each. The estimates of each unit will be submitted separately to the budget committee, and in addition they will be com- bined to form the estimates for the company as a whole. This procedure enables the budget committee and board of ESTIMATED PROFIT AND LOSS 371 NATIONAL MANUFACTURING COMPANY Actual and Estimated Statements of Profit and Loss as of the Dates Slated Actual 1921 Estimated 1922 Actual 1922 GROSS Sales Returns and allowances Net Sales Cost of goods Sold GROSS Profit on sales operating Expenses Sellino Expenses Financial Expenses Executive Expenses Corporate Expenses Total Operating Expenses NET Operating Profit Non-operating Income Gross income Non-operating Expense Net Income Figure 42. Comparison of Actual and Estimated Statements of Profit and Loss 372 BUDGETARY CONTROL directors to judge better the contemplated program, since they can pass judgment on each unit separately. It also facilitates the enforcement of the estimates, since responsi- bility for the variations between the estimated and the actual can be definitely fixed. Summary The purpose of the foregoing discussion is to explain and illustrate the use of the estimated balance sheet and estimated statement of profit and loss in business planning and administration. More particularly it attempts to show their relation to the general budgetary plans of the business. The development of the use of financial reports as a basis of management may be divided into three stages : 1. Business men learned to use the balance sheet which shows them where they are at a specific date. 2. They learned to use the statement of profit and loss which shows them how they got to where they are. 3. They are just now learning to use the estimated balance sheet and estimated statement of profit and loss which shows them where they are going and how they are to get there. The slow growth of the use of the estimated balance sheet and estimated statement of profit and loss has no doubt been due in part to the attitude maintained by public accountants that the function of the accountant is to make statements showing the results of past operations, and not to prophesy as to what will happen in the future. This attitude is due probably to the realization that, since they are not connected with the business, they have no control over its future operations, and therefore cannot safely pre- dict their result. They feel that such statements on their part might be used to mislead the public and this would react to their disfavor. Although the public accountant may be justified in this attitude because of the particular ESTIMATED PROFIT AND LOSS 373 relations existing between him and his client, this in no way detracts from the value of the estimated financial statement as a basis of managerial control. The bookkeeper has also failed to prepare estimated financial reports because he makes up his reports from the accounts, and the accounts do not reflect the decisions of the executives of the company with reference to results expected. No doubt in the not distant future both the accountant and the business man will come to realize that all financial statements are but estimates, and although estimates of past results as shown by the standard balance sheet and statement of profit and loss may be more exact, estimates of future results may be equally useful. CHAPTER XXIII MANUAL OF BUDGETARY PROCEDURE Need for Manual As shown by the discussion in the preceding chapters, the procedure involved in the preparation and execution of the various departmental budgets is a comprehensive and complex one. It requires the cooperation of the various functional executives, and a very definite coordination of the activities of the functional departments. The success of the budgetary program is dependent on this cooperation and coordination. If any part of the procedure fails, it dis- rupts the remainder. For these reasons it is desirable that the budgetary pro- cedure be very carefully worked out and reduced to written form, so that all executives and employees concerned may be fully cognizant of it. This can be most easily done by the preparation of a manual on budgetary procedure. Contents of Manual The contents of a manual on budgetary procedure will vary from business to business, depending on the volume and nature of the operations performed and upon the organization by which the operations are carried on. In a manufacturing business it is usually desirable that the manual discuss the following: 1. Organization for Budgetary Control 2. The Sales Budget 3. The Production Budget 4. The Labor Budget 5. The Manufacturing Expense Budget 374 MANUAL OF BUDGETARY PROCEDURE 375 6. The Materials Budget 7. The Plant and Equipment Budget 8. The Expense Budgets 9. The Financial Budget 10. The Estimated Financial Statements Illustration of Manual To show concretely the possible contents of a manual on budgetary procedure, there is given below the manual of a manufacturing company. The company has sales of about $6,000,000 a year. Part of the product of the com- pany is sold direct to the consumer, while the remainder is sold to merchants. Branches are used to market part of the goods. The president, who is also treasurer, does not reside in the city where the company is located but maintains an active interest in its affairs. The assistant treasurer is gen- eral manager; the other principal executives are the sales manager and works manager. The assistant to the general manager serves as office manager and head of the account- ing and statistical departments. The company's accounting period is four weeks and its budget period is three accounting periods. I. Organization for Budgetary Control 1. The President The President of the Company is to have direct control of all matters pertaining to the budgetary program. All officers to whom authority is delegated in this manual are acting as his agents and are responsible to him for the proper performance of the duties delegated to them. In all cases of disagreement between departments with reference to the coordination of estimates, the decision of the President will be final. 2. The General Manager The General Manager will be the representative of the President in all matters pertaining to the budgetary program and will have such authority in connection therewith as the President may see fit to delegate to him. 376 BUDGETARY CONTROL In all matters so delegated, the decision of the General Manager will have the same authority as that of the President. 3. The Budget Committee The General Manager, the Works Manager, and the Sales Manager will constitute a Budget Committee which will have supervision of the budgetary program. The Assistant to the General Manager will be secre- tary of this committee. Under the authority and direction of the President, the Budget Com- mittee is to consider all departmental estimates and to make such changes and revisions as it may think desirable. No estimate is to be effective until it has received the approval of the Budget Committee. The Committee will receive all estimates from the Assistant to the General Manager and will transmit the estimates as approved by it to him. In case the Budget Committee cannot agree with reference to any estimate, the question in dispute is to be submitted to the President and his decision will be final. In the consideration of the departmental estimates, the Budget Com- mittee may call on departmental heads to explain the reasons for the varia- tions in their estimates from the estimates of past periods. The Committee will receive through the Assistant to the General Man- ager periodic reports showing comparisons of the performance for the past period with the estimated performance of that period. On the basis of these reports, it may make revisions in the budgets for the remainder of the budget period, if it deems such revisions necessary. 4. The Assistant to the General Manager Under the authority and direction of the General Manager, the Assist- ant to the General Manager will have general control and supervision over the preparation and execution of the budgetary program. His general duties are outlined in the several sections of this manual. These duties may be summarized as follows: (i) To receive from the departmental heads the periodic estimates as provided for in this manual. (2) To prepare from these estimates (a) estimate of cash receipts, (b) estimate of cash disbursements, (c) estimated balance sheet, and (e) estimated statement of profit and loss. (3) To transmit all the estimates to the Budget Committee with such recommendations as he may think necessary. (4) To receive from the Budget Committee the estimates as ap- proved and to transmit these to the departmental heads. MANUAL OF BUDGETARY PROCEDURE 377 (5) To receive periodic reports prepared by the operating depart- ments or the accounting department showing the depart- mental performance for the month. (6) To transmit the periodic reports to the Budget Committee showing the comparison between the estimated performance and the actual performance for the period for each depart- ment, and to make such recommendations as he may deem necessary. (7) To transmit to departmental heads any revisions in the original estimates w'hich have been made by the Budget Committee. (8) To recommend to the General Manager and to the Budget Committee such changes in the budgetary procedure as he may deem desirable. He has the implied authority to do all things which are necessary to the proper performance of these duties. 5. The Departmental Heads The executive heads of the various departments are responsible for the preparation of the estimates of their departments at the time and in the manner prescribed in this manual. They are also responsible for the prep- aration of the reports called for in this manual. Any recommendations which any departmental executive desires to make with reference to changes in budgetary procedure will be transmitted in writing to the Assistant to the General Manager. It will be referred by him to the Budget Committee for consideration. The responsibility for the preparation of the departmental estimate and the periodic report is in each case placed upon the head of the department. He may employ his assistants in their preparation at his discretion, but the responsibility rests on the executive head in each case. II. The Sales Budget I . Preparation of Sales Estimate The Sales Manager will prepare for each budget period the estimate of the sales for that period. In the preparation of this estimate he will take into consideration: (i) The sales of past periods (2) The present market conditions (3) The contemplated plans and policies of the business for future periods 378 BUDGETARY CONTROL 2. Form of Estimate The estimate of sales will be made in such form as to show the antici- pated sales to : (i) Hospitals (2) Merchants It will also show the anticipated sales of each principal grade of goods sold. The first classification is necessary in order that the financial budget may be made, since the sales to hospitals are of different terms than the sales to merchants. The second classification is necessary in order that production may be planned so as to have on hand the proper quantity of the different grades. A form to be used in the submission of the sales esti- mate will be provided by the Assistant to the General Manager. 3. When Submitted The Sales Manager will transmit the sales estimate with his approval to the Assistant to the General Manager on or before the first day of the third week preceding the beginning of the budget period. 4. Procedure by the Assistant to the General Manager The Assistant to the General Manager will transmit a copy of the sales estimate to the Works Manager within two days after the receipt of the original estimate from the Sales Manager. He will transmit the origi- nal estimate, together with all the other estimates called for in this manual, to the Budget Committee on or before the first day of the first week preced- ing the beginning of the budget period. 5. Approval by the Budget Committee The Budget Committee will make such revisions as it thinks necessary in the sales estimate, and will transmit the revised estimate with its ap- proval to the Assistant to the General Manager within two days after it receives this estimate. In making its revisions the Budget Committee will make specific changes of particular amounts instead of making a percent- age revision of the estimate as a whole. 6. Transmission to the Selling Department The Assistant to the General Managerwill transmit the revised estimate to the Sales Department immediately upon its receipts from the Budget Committee. This estimate as revised and approved by the Budget Com- mittee will constitute the budget of the sales department for the next budget MANUAL OF BUDGETARY PROCEDURE 379 period. Copies of this estimate should be sent by the Sales Department to the Manager of each branch, indicating the quota of the branch based on this estimate. 7. Periodic Report from the Statistical Department At the end of each period the statistical department will send to the Assistant to the General Manager a report showing the s;iles made during the period. This report will be forwarded on or before the fifth working day of the period following the period for which it is made. 8. Periodic Report to the Budget Committee On or before the tenth day of each period, the Assistant to the General Manager will transmit to the Budget Committee a report showing a com- parison of the estimated and actual sales for the past period. He will ac- company this report with any recommendations which he may think de- sirable. 9. Revision of Sales Budget by Budget Committee On or before the twelth day of the period, the Budget Committee will consider the report recei\-ed from the Assistant to the General Manager, and will make such changes as it deems desirable in the sales budget for the remainder of the budget period. These changes \vill be communicated to the sales department by the Assistant to the General Manager on or be- fore the fifteenth day of the period. III. The Production Budget I. Estimate OF Finished Goods On or before the third day of the third week preceding the beginning of the budget period, the Works Manager will receive from the Assistant to the General Manager the estimate of sales prepared by the Sales Manager. Based on this estimate the Works Manager will prepare an estimate of the finished goods which must be produced in the next budget period to meet sales demands. In making this estimate the estimated inventory of fin- ished goods on hand at the beginning of the period and the desired inven- tory of finished goods at the end of the period will be taken into consid- eration. The requirements of the sales department for the period plus the estimated inventory at the end of the period, minus the estimated inven- tory at the beginning of the period, will equal the estimated production of finished goods for the period. 38o BUDGETARY CONTROL 2. Transmission to the Assistant to the General Manager The Works Manager will transmit the estimate of production as pre- pared under the preceding section, to the Assistant to the General Manager within one week after the receipt of the sales estimate from the Assistant to the General Manager. 3. Approval by the Budget Committee The Assistant to the General Manager will transmit the estimate of production to the Budget Committee on or before the first day of the first week preceding the beginning of the budget period. He may ac- company this estimatewith such suggestions or recommendations as he may think desirable. The Budget Committee will make such changes as it may deem desirable in the estimate, and return it with the Committee's approval to the Assistant to the General Manager within two days after its receipt by the Committee. The Assistant to the General Manager will imme- diately transmit it to the Works Manager. 4. Periodic Report from the Production Department At the end of each period, the Works Manager will send to the Assist- ant to the General Manager a report showing the production for the period. This report will be forwarded on or before the fifth working day of the' period following the period for which it is made. 5. Periodic Report to the Budget Committee On or before the tenth day of each period, the Assistant to the General Manager will transmit to the Budget Committee a report showing a com- parison of the estimated with the actual production for the past period. He will accompany this report with any recommendations which he may think desirable. 6. Revision of Production Budget by Budget Committee On or before the twelfth day of the period, the Budget Committee will consider the report received from the Assistant to the General Manager and will make such changes as it deems desirable in the production budget for the remainder of the period. These changes will be communicated to the Works Manager by the Assistant to the General Manager. IV. The Labor Budget I . Estimate of Labor Cost On or before the tenth day preceding the beginning of the budget period, the Works Manager will send to the Assistant to the General Manager an MANUAL OF BUDGETARY PROCEDURE 381 estimate of the cost of factory labor for each month of the next budget period. This estimate will be based on the estimate of production which is pre- pared by the production department in the manner indicated in Section 1 1 1 of this manual. The Works Manager will be assisted by the Employment Department in the preparation of this estimate. The estimate of labor cost will be made on a form provided by the Assistant to the General Man- ager. It will have the following columnar headings: (i) Department (2) Same period last year (3) Average for last four budget periods preceding the one during which the budget is prepared (4) Estimated cost for this period (5) Distribution: (a) First period (b) Second period (c) Third period Columns (2) and (3) will be filled in by the Assistant to the General Manager prior to sending the form to the Works Manager. 2. Approval by the Budget Committee On or before the first day of the first week preceding the beginning of the budget period, the Assistant to the General Manager will transmit the estimate of labor costs as prepared by the Works Manager to the Budget Committee, with such recommendations as he may deem necessary. The Budget Committee will make such changes as it may deem expedient, and return the estimate with its approval to the Assistant to the General Man- ager within two days after its receipt by the Committee. The Assistant to the General Manager will return the estimate of labor cost as approved by the Budget Committee, to the Works Manager imme- diately upon its receipt from the Committee. 3. Periodic Report on Labor Costs On or before the eighth day of each period, the Works Manager will send to the Assistant to the General Manager a report showing the cost of factory labor for the preceding period. The Assistant to the General Man- ager will supply the form for the submission of this report. On or before the tenth day of the period, the Assistant to the General Manager will transmit a report to the Budget Committee showing a com- parison between the estimated labor costs for the past period and the actual costs as reported by the Works Manager. If the Budget Committee de- 382 BUDGETARY CONTROL sires to make any recommendations to the Production Department with reference to labor cost during the remainder of the budget period, these recommendations will be communicated to the Works Manager through the Assistant to the General Manager on or before the twelfth day of the period. V. Manufacturing Expense Budget 1. Estimate of Manufacturing Expense On or before the tenth day preceding the beginning of the budget period, the Works Manager will send to the Assistant to the General Manager an estimateofmanufacturingexpenseforeach month of the nextbudgetperiod. In preparing this estimate he will be assisted by the cost accounting department. This estimate will be based on the estimate of production which is prepared by the production department in the manner indicated in Section III of this manual. The estimate of manufacturing expense will be made on a form provided by the Assistant to the General Manager. It will have the following columnar headings: (i) Department (2) Same period last year (3) Average for last four budget periods preceding the one during which the budget is prepared (4) Estimated cost for this period (5) Distribution: (a) First period (b) Second period (c) Third period Columns (2) and (3) will be filled in by the Assistant to the General Manager prior to sending the form to the Works Manager. 2. Approval by the Budget Committee On or before the first day of the first week preceding the beginning of the budget period, the Assistant to the General Manager will transmit the estimate of manufacturing expense as prepared by the Works Manager to the Budget Committee, with such recommendations as he may deem neces- sary. The Budget Committee will make such changes as it may deem expedient and return the estimate with its approval to the Assistant to the General IVIanager within two days after its receipt by the Committee. The Assistant to the General Manager will return the estimate of man- ufacturing expense as approved by the Budget Committee to the Works Manager immediately upon its receipt from the Committee. MANUAL OF BUDGETARY PROCEDURE 383 3. Periodic Report on Manufacturing Expense On or before the eighth day of each period, the Accounting Department will send to the Assistant to the General Manager a report showing the manufacturing expense for the preceding period. The Assistant to the General Manager will supply the form for the submission of this report. On or before the tenth day of the period, the Assistant to the General Manager will transmit a report to the Budget Committee showing a com- parison between the estimated manufacturing expenses for the past period and the actual costs as reported by the Accounting Department, If the Budget Committee desires to make any recommendations to the Produc- tion Department with reference to manufacturing expense during the re- mainder of the budget period, these recommendations will be communi- cated to the Works Manager through the Assistant to the General Manager on or before the twelfth day of the period. VI. The Materials Budget I . Estimate of Cost of Purchases The Works Manager will prepare an estimate of the materials required for each budget period. This estimate will be based on the estimate of production prepared by the Works Manager as outlined in Section III of this manual. The Works Manager will transm.it the estimate of materials required to the Assistant to the General Manager on or before the tenth day preceding the beginning of the budget period. The Assistant to the Gen- eral Manager will transmit the estimate immediately to the General Pur- chasing Agent. On receipt of the estimate of raw materials requirements, the General Purchasing Agent will prepare an estimate of purchases to be made during the budget period. The General Purchasing Agent will make this estimate on the form supplied by the Assistant to the General Manager, which will contain the following columnar headings: (1) Item (2) First Period : (a) Estimated inventory at beginning of period (b) Estimated purchases (c) Estimated inventory at end of period (d) Estimated cash disbursements for purchases made during this period (e) Estimated cash disbursements for purchases made in pre- vious periods 384 BUDGETARY CONTROL (3) Second Period: (a) Estimated inventory at beginning of period (b) Estimated purchases (c) Estimated inventory at end of period (d) Estimated cash disbursements for purchases made dur- ing this period (e) Estimated cash disbursements for purchases made during previous period (4) Third Period: (a) Estimated inventory at beginning of period (b) Estimated purchases (c) Estimated inventory at end of period (d) Estimated cash disbursements for purchases made during this period (e) Estimated cash disbursements for purchases made in previous periods The General Purchasing Agent will transmit this estimate to the Assist- ant to the General Manager on or before the last day of the second week preceding the beginning of the budget period. 2. Approval By the Budget Committee The Assistant to the General Manager will at once transmit the esti- mate of purchases to the Budget Committee. The Budget Committee will make any changes it may deem necessary, and return the revised estimate with its approval to the Assistant to the General Manager within two days after its receipt by the Budget Committee. The Assistant to the General Manager will send the estimate of purchases as approved by the Budget Committee to the Purchasing Agent immediately upon its receipt from the Budget Committee. 3. Periodic Report on Purchases At the end of each period, the Assistant to the General Manager will make a report to the Advisory Committee showing the actual purchases of the period compared with the estimated purchases and the actual inven- tory at the end of the period compared with the estimated inventory at the end of the period. This report will be submitted to the Budget Committee on or before the tenth day of the period. If the Budget Committee desires to make any changes in the purchases budget for the remainder of the budget period, MANUAL OF BUDGETARY PROCEDURE 385 it will communicate its directions to the General Purchasing Agent through the Assistant to the General Manager on or before the twelfth day of the period. VII. Plant and Equipment Budget 1 . Estimate of Plant and Equipment Cost On or before the tenth day preceding the beginning of the budget period, the Works Manager will send to the Assistant to the General Manager an estimate of the expenditures for plant and equipment for each month in the next budget period. This estimate will be submitted on a form pre- pared by the Assistant to the General Manager. 2. Approval by Budget Committee On or before the first day of the first week preceding the beginning of the budget period, the Assistant to the General Manager will transmit the estimate of plant and equipment expenditures as prepared by the Works Manager to the Budget Committee, with such recommendations as he may deem necessary-. The Budget Committee will make such changes as it may deem expedient, and return the estimate with its appro\al to the Assistant to the General Manager within two days after the receipt of the estimate by the Committee. The Assistant to the General Manager will immedi- ately transmit the estimate as approved by the Budget Committee to the Works Manager. 3. Periodic Report on Plant and Equipment Expenditures On or before the eighth day of each period, the Accounting Depart- ment will send to the Assistant to the General Manager a report show- ing the expenditures for plant and equipment during the past period. The Assistant to the General Manager will supply the form for this report. On or before the tenth day of the period, the Assistant to the General Manager will transmit a report to the Budget Committee showing a com- parison between estimated plant and equipment expenditures for the past period and the actual expenditures as reported by the Accounting Depart- ment. If the Budget Committee desires to make any recommendations to the Production Department with reference to plant and equipment ex- penditures during the remainder of the budget period, these recom- mendations will be communicated to the Works Manager through the Assistant to the General Manager on or before the fifteenth day of the period. 25 386 BUDGETARY CONTROL 4. Estimate of Furniture and Fixtures Required by General Offices On or before the fifteenth day preceding the beginning of the budget period, the head of each department will submit to the General Manager an estimate of expenditures for Furniture and Fixtures during the next budget period. The General Manager after consultation with the General Pur- chasing Agent will make such revisions as he deems necessary and transfer the estimate with his approval to the Assistant to the General Manager on or before the tenth day preceding the beginning of the budget period. 5. Approval by the Budget Committee On or before the first day of the first week preceding the begmning of the budget period, the Assistant to the General Manager will transmit the esti- mate of furniture and fixtures as required by the general ofiices to the Budget Committee with such recommendations as he may deem necessary. The Budget Committee will make such changes as it may deem expedient and return the estimate with its approval to the Assistant to the General Man- ager within two days after its receipt by the Committee. The Assistant to the General Manager will return the estimate of furni- ture and fixtures to the heads of the various departments immediately upon its receipt by him from the Budget Committee. 6. Periodic Report on Furniture and Fixtures On or before the tenth day of the period, the Assistant to the General Manager will transmit a report to the Budget Committee showing a com- parison between the estimated expenditures for furnitures and fixtures for the general offices for the past period and the actual expenditures as sub- mitted by the Accounting Department, If the Budget Committee desires to make any recommendations to the departmental heads with reference to furniture and fixture costs for the general ofiices for the remainder of the budget period, these recommendations will be communicated to the de- partmental heads through the Assistant to the General Manager. VIII. The Expense Budgets I. Control of Departmental Expense In order to provide an effective control of the expenses of the various departments, as well as to provide the necessary data for the quarterly cash budget, the following procedure is prescribed for all departments and executive units of the business: MANUAL OF BUDGETARY PROCEDURE 387 (i) Before the beginning of each budget period, an estimate will be prepared by the executi\e head of each department or unit showing the anticipated expenses of this department or unit for the next budget period, and sent to the Assistant to the General Manager. (2) These estimates will be submitted by the Assistant to the Gen- eral Manager to the Budget Committee and after being re- vised by it where deemed necessary, an appropriation will be made to meet the expenses called for by each estimate. (3) The amou nt of the appropriations, as determined by the Budget Committee, will be communicated to the executive respon- sible for the original estimate by the Assistant to the General Manager. (4) A monthly report will be made to the Budget Committee through the Assistant to the General Manager, showing the status of each of these appropriations. (5) The original appropriation will not be exceeded without per- mission of the Budget Committee. 2. Classification of Departments and Units For the purpose of expense control the various departments and units may be classified as follows: A. Administration (i) General Manager's Office (2) Credit Department (3) Purchasing Department (4) Accounting Department (5) Statistical Department (6) Stenographic Department (7) Personnel Department B. Selling (i) General Office (a) Office of the Sales Manager (b) Advertising and Sales Promotion (2) Direct Sales Units (a) Each Sales Office C. Production (i) Office of the Works Manager (2) Subsidiary Production Departments 388 BUDGETARY CONTROL 3. Procedure for the Preparation of Expense Budgets The procedure to be followed in the preparation and control of the ex- pense budgets of the various departments and executive units given in the foregoing outline will be as follows: Group A. Administration (1) Preparation of Estimate On or before the fifteenth day preceding the beginning of the budget period, the executive head of each of the departments listed under Group A will submit to the Assistant to the General Manager an estimate of the expenses of this department during the next budget period. The form to be used in the submission of the estimates will be provided by the Assistant to the General Manager and will con- tain the following columnar headings: (i) Department (2) Same period last year (3) Average for last four budget periods preceding the one dur- ing which the budget is prepared (4) Estimated cost for this period (5) Distribution: (a) First period (b) Second period (c) Third period Columns (2) and (3) will be filled in by the Assistant to the General Manager prior to sending the form to the executive head of each department. (2) Approval by the Budget Committee On or before the first day of the first week preceding the beginning of the budget period, the Assistant to the General Manager will submit the estimate of the expenses of the departments listed in Group A as prepared by the executive heads of the departments, to the Budget Committee with such recommendations as he may deem necessary. The Budget Committee will make such changes as it may deem necessary, and return the estimate with its approval to the Assistant to the General Manager within two days after the receipt of the estimate by the Committee. MANUAL OF BUDGETARY PROCEDURE 389 The Assistant to the General Manager will return immediately the estimates as approved by the Budget Committee to the executive heads of departments listed under Group A. (3) Periodic Report On or before the eighth day of each period the Accounting Department will send to the Assistant to the General Manager a report showing the expenses for the past period for each of the departments listed under Group A. The Assistant to the General Manager will supply the form for the submission of this report. On or before the tenth day of the month, the Assistant to the General Manager will transmit a report to the Budget Committee showing the comparison between estimated expenses for each of the depart- ments under Group A for the past period and the actual expenses as submitted by the accounting department. If the Budget Com- mittee desires to make any recommendations to the executive heads of the departments with reference to their expenses during the re- mainder of the budget period, these recommendations will be com- municated to the executive heads through the Assistant to the General Manager. Group B, Sales (i) Preparation of Estimates On or before the tenth day preceding the beginning of the budget period, the Sales Manager will transmit to the Assistant to the General Manager an estimate of the expenses of his department including: (a) The expenses of himself and staff (b) The expenses of the direct selling units (c) The expenses of the advertising and sales promotion depart- ment This estimate will be submitted on a form provided by the Assistant to the General Manager. (2) Approval by the Budget Committee On or before the first day of the first week preceding the beginning of the budget period, the Assistant to the General Manager will sub- mit the estimate of the expenses of the departments listed under Group B as prepared by the Sales Manager, to the Budget Com- mittee with such recommendations as he may deem necessary. The 390 BUDGETARY CONTROL Budget Committee will make such changes as it may deem neces- sary and return the estimate with its approval to the Assistant to the General Manager within two days after the receipt of the estimate by the Committee, The Assistant to the General Manager will return immediately the esti- mates as approved by the Budget Committee, to the Sales Manager. (3) Periodic Report On or before the eighth day of each period the Accounting Department will send to the Assistant to the General Manager a report showing the expenses for the past period for each of the divisions of the de- partment listed under Group B. The Assistant to the General Manager will supply the form for the submission of this report. On or before the tenth day of the period the Assistant to the General Manager will transmit a report to the Budget Committee showing the comparison between estimated expenses for each of the depart- ments under Group B for the past period and the actual expenses as submitted by the Accounting Department. If the Budget Com- mittee desires to make any recommendations to the Sales Manager with reference to the expenses of his department during the re- mainder of the budget period, these recommendations will be com- municated to the Sales Manager through the Assistant to the Gen- eral Manager, Group C. Production (i) Preparation of Estimate On or before the tenth day preceding the beginning of the budget period, the Works Manager will submit to the Assistant to the General Manager an estimate of the expenses of his department. The ex- pensesshownon thisestimatewillbeexclusiveof the expenses shown on the estimate of manufacturing expenses prepared as directed under Section V. This estimate will be submitted on a form pro- vided by the Assistant to the General Manager. (2) Approval by the Budget Committee On or before the first day of the week preceding the beginning of the budget period, the Assistant to the General Manager will submit the estimate of the expenses of the Production Department as pre- pared by the Works Manager, to the Budget Committee with such recommendations as he may deem necessary. The Budget Com- MANUAL OF BUDGETARY PROCEDURE 39 1 mittee will make such changes as it may deem necessary and return the estimate with its approval to the Assistant to the General Man- ager within two da}s after the receipt of the estimate by the Com- mittee. The Assistant to the General Manager will return immediately the esti- mate as approved by the Budget Committee to the Works Manager. (3) Periodic Report On or before the eighth day of each period, the Accounting Department will send to the Assistant to the General Manager a report showing the expenses for the past period of the Production Department. The Assistant to the General Manager will supply the form for the sub- mission of this report. On or before the tenth day of the month, the Assistant to the General Manager will transmit a report to the Budget Committee showing the comparison between estimated expense for the Production De- partment for the past period and the actual expenses as submitted by the Accounting Department. If the Budget Committee desires to make any recommendations to the Works Manager with refer- ence to the expenses of his department during the remainder of the budget period, these recommendations will be communicated to the Works Manager through the Assistant to the General Manager. IX. The Financial Budget I. Preliminary Estimates of Cash Receipts and Cash Disburse- ments The Assistant to the General Manager, working in conjunction with the Assistant Treasurer, will prepare a preliminary estimate of cash receipts and a preliminary estimate of cash disbursements for each budget period based on the following: (i) The estimates submitted by the various departments. (2) An estimate of the disbursements for taxes, insurance, and other items which are under the control of the Assistant Treasurer. (3) Estimate of the collections from accounts receivable outstand- ing at the beginning of the period. (4) Estimate of the disbursements on accounts payable outstanding at the beginning of the period. 392 BUDGETARY CONTROL The Assistant to the General Manager will transmit these preliminary estimates of cash receipts and cash disbursements to the Budget Committee on or before the first day of the first week preceding the beginning of the budget period. This will enable the Budget Committee to consider the financial requirements of the various estimates submitted to it. 2. Revision of Preliminary Estimates After the departmental estimates have been approved by the Budget Committee, the Assistant to the General Manager will revise the prelimi- nary estimates of cash receipts and cash disbursements giving effect to the revisions in the departmental estimate which were made by the Budget Committee. The revised estimates will be submitted to the Treasurer on or before the third day preceding the beginning of the budget period. 3. Periodic Reports Periodic reports will be submitted to the Budget Committee showing a comparison between estimated receipts and actual receipts and estimated disbursements and actual disbursements. If the Budget Committee desires to revise other budgets because of the financial condition, these revisions will be submitted to the departments concerned by the Assistant to the General Manager. The revisions made in the financial budget will be communicated to the Treasurer. X. Preliminary Estimated Financial Statements 1. Preliminary Estimates of Financial Condition and Results of Operation The Assistant to the General Manager will prepare from the departmen- tal budgets an estimated balance sheet showing the estimated financial condition at the end of each accounting period during the budget period. He will also prepare in the same manner an estimated statement of profit and loss showing the anticipated results of the operations for each period. The Assistant to the General Manager will transmit these preliminary estimates to the Budget Comnnttee on or before the first day of the first week preceding the beginning of the budget period. This will enable the Budget Committee to consider these at the same time that it is considering the departmental estimates. 2. Revision of Preliminary Estimates After the departmental estimates have been approved by the Budget Committee, the Assistant to the General Manager will revise the prelimi- MANUAL OF BUDGETARY PROCEDURE 393 nary estimated financial statements giving effect to the changes made by the committee in the dei)artmental estimates. 3. Periodic Reports Periodic reports will be submitted to the Budget Committee by the Assistant to the General Manager, showing a comparison between the actual and the estimated financial statements. These reports will be sub- mitted at the same time as the other budgetary reports. Comments on Manual — Manual Confined to Interdepartmental Procedure It win be noticed that the manual is confined to the pro- cedure involved in the interdepartmental relations arising from the budgetary program. It does not outline in detail the procedure to be followed by each department in the preparation of its estimate or the carrying out of its budget. Since the manual is to be placed in the hands of all of the executives, it is not thought worth while to encumber it with the detail of departmental procedures. It is thought better that these be issued as departmental orders. Central Control of Estimates It is important to notice that the manual requires the estimates of all departments to be submitted to the budget committee at one time (on or before the first day of the first week preceding the beginning of the budget period) ; the consideration and approval of these estimates within two days after their receipt ; and the return of the approved esti- mates to the departmental heads immediately upon their approval. This enables the budget committee to have before it, at one time, the estimates of all the departments and units of the company, and provides a central control of all the ac- tivities of the business. The monthly reports which are to 394 BUDGETARY CONTROL be submitted to the budget committee provide a means of control over the execution of the budgets. Authority of Budget Committee It will be noted that the budget committee is given au- thority to pass on estimates. Although the manual does not so state, the financial budget and the estimated balance sheet and statement of profit and loss are submitted to the board of directors at the beginning of each budget period. Dates for Submission of Estimates and Reports It will be noticed that particular attention is given to the dates on which reports and estimates are submitted. This is especially important, as otherwise there will be a lack of coordination in the budgetary procedure. For instance, the production department cannot prepare the finished goods estimate until it receives the sales estimate ; the purchasing department cannot prepare the estimate of purchases until it receives the estimate of materials requirements ; and the assistant to the general manager cannot prepare the estimated financial statements until he receives all the esti- mates. These illustrations show that if one department is tardy in the preparation of its estimate or report, the entire program Is delayed as a consequence. Chart of Budget Procedure A manual prepared In the form of the foregoing example contains a considerable amount of detail and it Is some- what difficult to obtain a comprehensive view of the pro- cedure as a whole. A chart prepared in the form shown in Figure 43, enables the executives to see the relationship between the various budgets and the duties of each executive with reference to each budget. A. ! C. D. E. F. SI G. AC H. PI e A. SALES MANAGER SALES BUDGET from B^wi^or u«ror ductlon UudBc* to 11 on or before 3 days atwr receipt flroin E — 3. Recolvo comparison of tsti day atlcr clu«> of period. i.lia««B from E— ropon any roil sluiiit In Stor-> lurclia&t Oudgit t F on or bi-foro IZtb day after diij" afWr receipt troai E— rituru or i« foro I2tli day aftw doso of period -;:■ ■-"'^^"'^-^^ E, ASSISTANT TO THE GENERAL MANAGER l. Stil)nilt cony of aHtlcIpaltd Mi™ to 11 wllltln 3 days aruir ^"'■2 ()ruViiul <»tlii)Ato to D on or 1,.(..r<; tli<- IM day of 1st wwU 1. Rwwlvp and irsnsmll txi\- iDB bU ■>ri r aclual' pay-roil Ui li ..n bofOro ISth day aflor doso of ;:,S PMI ^ 1 F. STATISTICAL DEPT. 1. IteiKirt of actual sales fur the uorklnR (lay afior close of pvrlixl. 1 0. ACCOUNTING DEPT. E on or bcforo Stb day aKtr i^Ioso of period. ^^{-"■■"' - 1. Keiion actual «|wndUitf«. fot plani and i^iOpmeut (o B on w a^SSS»'"" "''"'■'■■■■■ H. PURCHASING AGENT :£" , ■ FIGURE 4.^- CHART OF BUDGET PROCEDURE O MANUAL OF BUDGETARY PROCEDURE 395 The chart is prepared from the manual given in this chapter with a few modifications. It w^U be noticed that the chart calls for a "stores purchased " budget and a "mis- cellaneous expense" budget, instead of a manufacturing ex- pense budget and departmental expense budgets. It also omits the procedure for the preparation of the estimated financial statements. CHAPTER XXIV ADMINISTRATIVE REPORTS Need for Administrative Reports The previous chapters have emphasized the need for the collection of data to serve 1. As the basis of formulating plans of operation, and 2. As the basis of enforcing plans which have been adopted. This information is most serviceable when it is presented in a summarized and classified form by means of properly de- signed reports. Reports should be used by all the executives and em- ployees of a business. We usually think of reports in con- nection with the general ofhcers, for their actions are based largely on reports and the reports which they receive are of a formal nature. Nevertheless, all employees except those engaged in routine manual tasks are receiving reports daily. These reports may come to them as business forms on which they perform certain tasks and then transmit them to others. They are nevertheless reports in the sense in which that term is used in this discussion. Classification of Administrative Reports The reports used in administrative control may be clas- sified broadly into the following groups: I. Reports showing present financial condition. The standard form of balance sheet with its various subsidiary schedules is used for this purpose. This is the oldest and most widely used of administrative reports. The reasons for its origin and extensive use have been explained in a preceding chapter. 396 ADMINISTRATIVE REPORTS 397 2. Reports showing the results of past operations in terms of ex- pense and income. The various forms of expense and income analyses, and the standard form of statement of profit and loss, with subsidiary schedules, are used for this purpose. Next to the standard form of balance sheet, these are the reports most widely used. For internal control they are used more widely than the balance sheet and are decidedly more serviceable. 3. Reports showing pertinent information which is necessary for the daily actions of executives and employees. These reports may consist of a statement for the treasurer, showing the accounts payable falling due on a current day; of a report to the collec- tion manager, showing accounts thirty, sixty, and ninety days past due; of a report to the sales manager, showing the slow- moving items of stock; and various other reports of a similar nature. These reports are not so widely discussed as the standard financial statements, yet they serve a very vital function in the internal administration of a business. 4. Reports showing anticipated results of future operations. These reports include estimates of sales, estimates of purchases, estimates of production, estimates of financial condition, esti- mates of income, expense, and net profit, and similar reports. These estimates serve as a basis for future plans in the manner explained in preceding chapters. 5. Reports shoVing a comparison between the actual performance and the estimated or standard perfomiance. Such reports make possible the enforcement of budgets and provide data which serve as a means of revising the budgets when this is found necessary. Essentials of Executive Reports In the foregoing discussion administrative reports have been defined broadly to include the reports used by all the executives and employees of a business. But in every busi- ness it is desirable to prepare some formal reports for the use of the principal executives only. In contradistinction to the broad group of administrative reports, these may be termed "executive " reports. During the remainder of this 398 BUDGETARY CONTROL chapter we shall be concerned primarily with the latter group, although most of the discussion is equally applicable to the general group. Since executive reports are intended to serve as a basis for the formulating of executive decisions, which in turn result in executive actions, it is expedient that they be made so as to present accurate and comprehensive information and to present it in such form that correct judgments can be formed with as little sacrifice of effort as possible. If this end is to be attained, executive reports must have the fol- lowing characteristics : First, they should present summarized information. Details should be eliminated as much as possible. Each report should show a few essential items of information. They should be constructed so as to show variations between the standard performance and the actual performance. In case of significant variations, the executive should receive an explanation of the cause from the controller or some other official designated for this purpose. If the executive re- ceives a few condensed reports he will be able to study care- fully each report. Details are of value only to explain variations. Many details serve only to confuse. Second, executive reports should show the following: 1. Actual performance for the current period. 2. Comparison of the performance of the current period with the estimated or standard performance for the period. 3. Comparison of the current performance with the performance of past periods. 4. Comparison of the current performance with the results of the performance. Actual Performance Each executive should know at frequent intervals what the performance has been of his own department and of each of the other departments the activities of which affect the ADMINISTRATIVE REPORTS 399 activities of his own department. Reports presenting in- formation of this kind have long been in use and Httle more need be said here with reference to them than to emphasize the following: 1 . That care must be taken that these reports be made accurately. 2. That they be sufficiently comprehensive to serve as a basis for proper action. 3. That they should be made promptly. 4. That they are more effective if modified so as to include the comparisons indicated by the following discussion. Estimated Performance Most if not all executives will admit the need of a state- ment of the current performance, but many do not realize the importance of establishing estimates of performance and comparing the actual with the estimated. The dis- cussion in the preceding chapters has emphasized the im- portance of preparing budgets and using them as control devices. The reports which are used in preparing and con- trolling these budgets have been discussed in connection with each of them. In addition to these reports it is de- sirable that the effect of the budgetary program should be shown on all the executive reports. This can be done most easily ty designing these reports so that they will show a comparison between the estimated and the actual per- formance. By way of emphasis it is worth while to state the follow- ing benefits to be derived from the establishment of the estimates : 1 . In order to make the estimates it will be necessary for the executives responsible for them to study past perform- ance and to consider future possibilities. This study will undoubtedly increase the efficiency of these executives. 2. The estimates will set up a goal for attainment. They will constitute a "bogie" which the executives will try to 400 BUDGETARY CONTROL attain. A comparison between the actual and the estimated will provide a check on the activities of the executives and will ser\^e as an incentive towards the attainment of the estimated. 3. A study and comparison of the estimates will make possible a better coordination of the activities of the various functional departments, since each department can deter- mine from the estimates the plans of other departments and guide its activities accordingly. 4. The preparation and use of the estimates will make possible the elimination of much detail in the reports to the executives. Details instead of being presented for the con- sideration of the executives each month, will be presented in the original estimates when they are presented for execu- tive approval. After the estimates have been considered and approved, it will not be necessary for the executive to receive detailed reports during the period covered by the estimates. If he receives a summary report which shows a comparison between the results attained and the estimate, it will be sufficient. Executives should consider details with reference to operations before the operations take place rather than after they are performed. Of course, if variations be- tween the estimated and the actual are shown by the reports, they may ask for sufficient detail to explain the changes. Past Performance Although past performance alone is not a satisfactory standard by which to judge current performance, a com- parison between current performance and past performance is very useful in that It shows whether the tendency is desira- ble or undesirable. If statistics with reference to past per- formance and current performance are compiled by means of reports for a considerable number of periods, very useful data will be available for use in making future estimates. ADMINISTRATIVE REPORTS 401 Results of Performance Whenever possible, a comparison should be made be- tween performance and results. For instance, selling ex- pense may be compared with sales; gross profits and net profits with sales; volume of production with cost of pro- duction ; and various other comparisons which will occur to the reader. These comparisons should be shown not only for the current period but also for past periods, so that tendencies may be easily seen. Comparisons of this nature make it possible to obtain a true perspective of results. Obviously increased sales are desired only when increased profits will result. Illustration of Reports It is obviously impossible to discuss and illustrate all the various reports which may be used in executive control. These will vary in number and form from business to busi- ness. Some of these reports have been illustrated in previous chapters. For instance, in Chapters XXI and XXII the estimated balance sheet and estimated statement of profit and loss with the proper comparisons were illustrated. In earlier chapters reports showing a comparison between the actual and estimated performance were shown. In the present discussion it is thought sufficient to illus- trate a few of the reports which may be used in sales and production control. Using these as types and applying the general principles given in the foregoing discussion, the reader should be able to design reports to fit any particular needs. Sales Reports The reports which may be used in sales control are too numerous to mention. They will vary greatly from busi- 26 402 BUDGETARY CONTROL •-5 w liJ _l < CO u. o I- cc o Q. UJ I O e2 C^ in ^ tt, CQ oa CQ m CQ < CQ O Q u ADMINISTRATIVE REPORTS 403 £ ^ *- 7 1 •2 3i o>^ CI 0= Q. S S •^M 2 ~ •- Q QJ "— • OJ ■■5 = 3 OC g^ <» ~ M ■2 J «-^ f.- ir "^ 2 « / UJ 1 U} < u. w ■0°T3 1 2: I Ratio timate pense timate Sales Ul Q. 1- z X UJ s. UUjliJ 1 \ _J \ _J 1.0 " Ul a>cQ Q.— ^ CO / / -^ :;; 0) Q. u;! LlJ DC >- \ 1 -1 I \ X H Z \ 1- z z tn 5 I / H Z z g z CO UJ > UJ > _l 5 < z X X X X X X X CO Z ir UJ 1- Ul z z z z z z z LiJ 1- < IT < ^ ^ ^ 5 ^ < UJ DQ DQ CO CO m m CQ ^ < oa Q UJ u. 03 \ X w 2 ^ 404 BUDGETARY CONTROL ness to business depending on the volume of sales, nature of product sold, and method of marketing. But it is thought that in every business the principal executives of the busi- ness should have reports which show the following : 1. Volume of sales 2. Selling expenses 3. Net profits 4. Inventory of finished goods Typical reports for each of these will be illustrated. Monthly Report on Volume of Sales If a business markets its product through branches or divisions, this report will show the total sales of each selling unit for the current period compared with the estimated sales and the sales of previous periods. If the sales are all made from a central office, it may show the same compari- sons for sales territories, or it may show the sales classified by groups, departments, or products. In any case the com- parisons should be the same. A typical form for this report is shown in Figure 44. This report is designed for the use of a manufacturing com- pany marketing its product partly through division sales offices and partly through sales branches. This report shows useful comparisons for each selling unit and in addi- tion provides a means of comparing the results attained by the different units. Monthly Report on Selling Expenses If a business markets its product through divisions or branches, a monthly report should be made to show the total selling expense of each selling unit with a comparison of this expense with the sales obtained. If the sales are made from a central sales department, this report may show the same comparisons by territories. If selling expenses ADMINISTRATIVE REPORTS 4^5 CO H U. O DC Q. H liJ o Q. UJ X I- z O 2< a o en O Ui -(-> 0) _>» IS < m OQ CO Q Ui U. CD 406 BUDGETARY CONTROL are allocated to lines of product, the report may be made to show the result of this allocation. In a department store it may show sales and expenses by departments. In this latter case judgment must be used in interpreting the re- port, for it is to be expected that the ratio of expense to sales will vary between departments which sell different kinds of goods. A typical form for this report is shown in Figure 45. The report provides a means of: 1. Checking actual expenses against estimated expenses. 2. Comparing the ratio of expenses to sales during the current and past periods. This comparison is of especial importance, as increases and decreases in selling expenses are of significance only in comparison with the results obtained. 3. Comparing the ratio of expenses to sales in different selling units. This comparison is significant in judging the efficiency of branch executives. Monthly Report on Net Profits This report may show net profits of selling units, terri- tories, departments, or by lines of goods. In a business marketing its product through branches or division offices, it shows the net profits made by each selling unit and the ratio of net profits to sales with the proper com- parisons. A typical form for this report is shown in Figure 46. This report affords a means of: 1 . Checking actual net profits against estimated net profits. 2. Comparing the ratio of net profits to sales during the current year with the same ratio for the past year. This comparison is a very important one, since it is not an increase of sales, but an increase of profits that is the goal. 3. Comparing the ratio of profits to sales in different selling units. This comparison is important in judging the efficiency of the management of the various units. ADMINISTRATIVE REPORTS 407 1 1 1 P c 5 C « "O , co >- .§s _l I Hi — 1- z \\ z Ui > z \ .... Q. \ 1 3 CE CD / fc. CO w < -I 1 \\ p< 4o8 BUDGETARY CONTROL CO cc o o £ m ^ z _l Z Ul < O Q. 5 Sd: Ul jj - 0. > o to > Q. ADMINISTRATIVE REPORTS 409 I (M 1^.2 Ol « Q.^ "^ ) QC ti"-' < 2 c UJ >- 1- = I < •- 1- -1 -, UJ s t- < "■ 1 Q ^ E 6 CO LU ^ T3 w OJ ^ oc -a a. Ul 0^ Q DC a> c Q LU — -J / -J Crt U. z 3 QC < — Z Ul I— > 1- CO I D H Q UJ a. < Q / OC a. •2 CO ^- E 2 CO Ul S D. "O X ys CO -■^ •« CO ,, — -J .— ■^' ^ °c / UJ / Q / QC / L y H 6 3 C/3 a E o U Jj-i 4IO BUDGETARY CONTROL Monthly Stock Report This report should show the total inventory in stock classified according to the major groups maintained for sales and inventory. It should show the comparisons indi- cated by form in Figure 47. It is desirable that a standard or estimated inventory be determined which can be used as a means of judging the size of the inventory on hand. It is important that careful consideration be given to turnover figures; so it is well to have them shown on the periodical reports. If the turn- over for each quarter is shown this should be sufficient. Production Reports The reports which may be used in production control are too numerous to mention. They will vary greatly from business to business, depending on the volume of production, the nature of the production process, and the organization by which the production is carried on. But it is thought that in every business the executives should have reports which show the following : 1. Summary of Orders Received, Shipments, Production, and Shortage or Surplus 2. Summary of Operations 3. Unit Costs 4. Factory Inventories Monthly Summary of Orders Received, Shipments, Production, and Shortage or Surplus This report shows the orders received, the shipments, the production and the unfilled orders for the current period and for past periods, in such form that comparisons can be easily made. Each of these items will be classified according to the major groupings maintained for sales, production, and inventory. It is preferable that it be ADMINISTR-^TIVE REPORTS 41I made in terms of physical units rather than in terms of value. A typical form for this report is shown in Figure 48. As indicated by the illustration, totals are shown at the bot- tom of the form so that the totals of the groups can be com- pared. If a company has two or more factories a separate report will be made for each factory. If desired, a separate report can be prepared for each of the items which appear on the combined report, that is, orders received, shipments, production, and unfilled orders. Each of these reports should show the following compari- sons: 1. Group (name or number) 2. This month 3. Estimated this month 4. Per cent of increase or decrease 5. Last month 6. Per cent of increase or decrease 7. Same month last year 8. Per cent of increase or decrease 9. Total to date this year 10. Total to date last year 11. Per cent of increase or decrease The additional information which these subsidiary reports provide is evident. Monthly Summary of Operations It is desirable that both the production and other execu- tives of the company should have a comprehensive picture of the factory operations for each period. A possible form for a report which will provide this is shown in Figure 49. The purpose of the data shown in this report is apparent. In some cases the classification of cost elements shown in the first column will need to be changed. It can be made to suit the needs of each case. 412 BUDGETARY CONTROL o w CO z o < DC UJ OL o Efe o < CO I 3i I O 6 e D « "S _l S -I «< CO UJ Q = U. ■5^ «>^-- «>^" -5 Li.oS5-»- «— !SO 2~ !20 " « c o o Q o a* o ai5 ? ADMINISTR.\TIVE REPORTS 413 UJ N C3 o> < tr. Ul > < a. UJ < a: u > < ~ a» u. '" X UJ 1- H Ui > < a> H *" (f> . . DC UJ rf Q ^>- 3 UJ Q. Q. D I 52 QC ^i 2 >- X H X Z UJ|_ f§ S ^S _J ■0 T3 ■0 ^ ^ -0 ■"^~ ^ s ■0 » -0 "o s T) S ■0 S -0 TJ s ■0 3 c ^ C 3 c 3 3 3 -0 3 3 S. 2 ^ £ ol ^ a. '^ ai t i cu *^ i ^ ol ^ a^ a Q. -0 O. =• -o Q. -o Q. -0 0. 0. ■0 ■0 c c c W 3 3 3 3 UJ (1. a_ •^ a. !^ CL. CJ Q- " tj °- (« d Q. 2 UJ K z < z > -1 < U CO 1- Z3 Q CO z a) UJ £ cc 1- > >■ Q UJ > -I < > C/> < _j UJ u. CD (/> CC u UI -1 Q. -i _j Q. UJ ^ z a. -1 CO > d cc ^ Q. < 2 ^ .~ Q "o" z M m " O V- o 414 BUDGETARY CONTROL UJ CD z >- CC o h- o < u. DC o a. UJ CC UK ;$< uio ^- I co DC O 3 S CO :^ DC O Pi > o o 2 I H Z o S Z ADMINISTRATIVE REPORTS 415 Monthly Report on Unit Costs This report shows the volume of production as well as the unit costs. The volume of production is significant in comparing unit costs, since the quantity produced may affect the unit costs. A typical form for this report is shown in Figure 50. In the illustration the volume of production is stated in terms of tons, and pounds are used as the basis of stating unit costs. In many businesses it would be necessary to use other units for both of these. Monthly Report on Factory Inventories This report shows the total inventories carried at the factory with appropriate comparisons. The classification of inventory will depend on the nature of the product manu- factured, but should always indicate clearly the inventories of (i) raw materials, (2) work in process, and (3) finished goods. It should also show plant and equipment in process as a separate item. It is preferable that both the physical amount and the value of the inventories be stated. A possible form of this report is shown in Figure 51. Varied Kind of Reports It is desired to emphasize once more that the few reports Illustrated in this chapter are intended to be suggestive only. These few are given primarily for the purpose of showing concretely the application of the principles discussed in the first part of this chapter. The reports needed for any par- ticular business can be designed only after a careful study of its operations and of its organization and administrative methods. CHAPTER XXV ADVANTAGES AND LIMITATIONS OF BUDGET- ARY CONTROL Advantages of Budgetary Control Why Discussion Is Postponed In most texts on accounting, cost accounting, auditing, and similar subjects, the authors explain at the beginning of their texts the advantages to be derived from the applica- tion of the methods which they are to discuss. This un- doubtedly is good propaganda, but it is the author's impres- sion that the reader can better understand the advantages of any administrative procedure or device after he under- stands its nature and its method of operation. Conse- quently, he has deemed it expedient to postpone the discus- sion of the advantages of budgetary control until the end of the text. The advantages which are thought to be most significant vJ^ill now be discussed. Coordination of Sales and Production Goods can be sold only when produced, and they should be produced only when they can be sold. To obtain sales orders which cannot be filled leads to loss in several ways, of which the following are the most apparent: 1 . It causes the incurrence of unnecessary expenses in getting orders which cannot be filled. 2. It causes the expense of recording the orders when received. 3. It causes the expense of answering the inevitable complaints of the customers who fail to receive the goods when promised. 416 advy\ntages and limitations 417 ' 4. It causes the expense of reversing the entries made for the order when the customer finally cancels it. 5. It incurs the ill-will of the customer, which may result in the loss of his trade in the future when it may be needed. On the other hand, the production of goods in excess of sales orders leads to even more undesirable results, of which the following are the most important: 1. It ties up capital in unsalable goods, with the consequent cost incurred in securing the capital. 2. It ties up capital which may be needed badly in carrying on other operations, and in some cases the loss of the use of this capital may result in serious financial embarrassments. 3. It results in the procurement of goods which may physically de- teriorate or become obsolete before they can be sold. If a sales estimate is prepared, and this estimate is approved by the production department and used as a basis of its program, these difficulties can in the main be elimi- nated. Any disagreement between the sales and production departments is settled by the budget committee, which is qualified to render impartial judgment. What is said here with reference to the coordination of sales and production in a manufacturing business, applies equally to the coordination of sales and purchases in a mer- cantile business. Formulation of a Profitable Sales and Production Program The sales department does not always desire to sell the goods which can be produced to the best advantage, and the production department does not always prefer to pro- duce the goods for which there is the most ready and prof- itable market. If left to itself each department will follow the line of least resistance. There has long been an argument as to whether the sales or production department should exercise the greater influ- 27 4l8 BUDGETARY CONTROL ence in deciding the commodities which a business produces and offers for sale. Production executives often contend that the production department should decide what it is best equipped to produce and that the sales department should then be instructed to find a market for these products. On the other hand, sales executives often contend that it is the function of the production department to serve the sales department and to produce the goods which the latter can sell. A little consideration will show that neither of these views is correct. It is the function of each of these depart- ments to serve the business as a whole to the end that as much profit as possible may be made. The hundreds of idle factories in the country e\cn in normal times is a testimonial to the fallacy of attempting to produce without a proper consideration of the market, and the many discarded ma- chines of factories still operating, as well as the hundreds of items sold at a loss, is evidence of the impropriety of trying to change the production program to meet the passing whims of the sales department. A proper coordination of sales and production, not only from the viewpoint of quantity, but also from the viewpoint of profit, is essential. The production equipment should be as flexible as possible so that changes can be made to meet market conditions, but a certain amount of standard- ization is essential to well-regulated production, and the sales department by proper effort can do much to in- crease the sales of those lines which can be produced most efficiently. Although it is usually convenient for the sales depart- ment to take the first step in the budgetary process, the sales estimate must be gone over from the viewpoint of the production possibilities, profit potentialities, and financial requirements. ADVANTAGES AND LIMITATIONS 419 Coordination of Sales and Production Programs with Finances No sales and production progrc.m, regardless of its profit potentialities, is desirable if its financial requirements cannot be met by the particular firm under consideration. It is necessary that careful consideration be given to the financial requirements of all plans contemplated. As stated m Chapter II, a lack of coordination between sales and pro- duction will lead to a loss, but a lack of coordination between sales, production, and finance will lead to bankruptcy. It must be remembered, however, that the capital pos- sibilities of a firm may be materially affected by the length of time which is available for planning to meet require- ments. If the financial requirements of the contemplated program are known for a sufficient length of time prior to its initiation, capital may be secured which would not be obtain- able on short notice. The budgetary program, therefore, is especially signifi- cant in financial planning and financial planning is the essence of financial administration. Proper Control of Expenses A proper control of expenses is necessary to profitable operations. The purchase and sales prices of commodities are usually determined largely by competition. The dif- ference between the expenses incurred and the gross profit determines the margin of net profit. To secure an effective control of expenses and yet not to affect the volume of profitable operations is one of the most important and diffi- cult tasks of management. If the estimated expenses of each department are sub- mitted for the consideration of a central budget committee, composed of the principal executives of the company, and the departments are limited in their expenditures to the amount of the appropriations made by the budget commit- 420 ■ BUDGETARY CONTROL tee after consideration of the departmental estimates, an effective method of control is available. Formulation of a Financial Program The demand for capital is an imperative one. When funds are needed their procurement cannot be long delayed. To insure that it will be possible to secure them when needed, it is necessary to determine in advance the amount required and the time when required, so that plans may be made for their procurement. It is possible to do this in a systematic way only when comprehensive and accurate statements of the plans of all the departments are available, so that estimates of cash re- ceipts and disbursements which will result from these plans can be made and a program formulated for the procurement of any excess of disbursements over receipts. Coordination of All the Activities of the Business The previous discussion has emphasized the close rela- tionship between the activities of all the departments of a business. This relationship is so close that no one depart- ment can carry on its activities properly without a consid- eration of the activities of one or more of the other depart- ments. Neither can the executive^ of a business judge properly the past or contemplated activities of any one de- partment independently of the activities of the other depart- ments. To make possible the formulation of k^ well-balanced program for the business as a whole, it is essential that the plans of all the departments be presented for executive con- sideration and that the plans of the several departments be modified, if necessary, in order to bring about coordination. This can best be accomplished by the submission of formal estimates to a budget committee, and the formulation of ADVANTAGES AND LIMITATIONS 42 1 these into a budgetary program, which will be enforced and controlled in some such manner as that discussed in the pre- ceding chapters. The Limitations of Budgetary Control ITeetHor Consideration It is as essential that the limitations of budgetary con- trol be understood as that the benefits which may be derived from it be realized. Unless this be true the following re- sults are apt to happen: 1. Too much will be expected from the budgetary program, and when it fails to fulfil expectations it may be thought useless and abandoned. 2. Too much reliance may be placed on its operation which may result in too little emphasis on other methods of administrative control. 3. It may be followed blindly which may bring results more detri- mental than those which arise from its absence. Important Limitations The most important and significant limitations of budg- etary control are the following : 1. The budget program is based on estimates. Esti- mates cannot be made which are entirely accurate, and con- sequently they must be used with judgment and not fol- lowed arbitrarily. It is also necessary that provision be made for frequent revisions of these estimates as actual performance shows variations from the estimated perform- ance. 2. Budgetary plans will not execute themselves. After budgets are prepared, every possible effort must be made to equal or exceed them. Detail plans must be made for their attainment and these plans must be enforced rigidly. 3. Budgetary control cannot take the place of admin- 422 BUDGETARY COxNTROL istration. It is not Its purpose to deprive executives of the necessary freedom of action which Is essential to progressive management. Its purpose Is to provide the information on which administrative decisions and administrative con- trol are based. 4. Budgetary control cannot be perfected immediately. The procedure called for by the budgetary program is usually new to executives and it takes time to train them to make and use properly estimates of future operations. Too much should not be expected at the beginning of budgetary control. In many cases it is desirable to install budgetary control gradually so that the executives may be educated to its needs and purposes. Summary The advantages to be derived from budgetary control may be stated in outline form as follows : 1. Coordination of Sales and Production: (a) By estimating sales possibilities and planning production to produce the goods necessary to meet these pos- sibilities. (b) By limiting the production to the amount necessary to meet probable sales demands as shown by the sales esti- mate, thus preventing an excess of inventory of finished product. 2. Formulation of a Profitable Sales and Production Pro- gram: (a) By determining the lines of goods most desirable for a well-rounded sales program and adapting production, in so far as is consistent with the following paragraph, to produce the necessary quantity of these lines. (b) By determining the lines of goods most desirable for a well-rounded production program and planning sales, in so far as is consistent with the preceding paragraph, to sell the amount of these lines necessary to secure eco- nomical production. ADVANTAGES AND LIMITATIONS 423 3. Coordination of Sales and Production with Finances: (a) By considering the contemplated sales and production programs in terms of financial requirements and revising these programs, if necessary, to reduce the financial requirements to correspond to the financial program which is deemed possible and desirable. (b) By determining the financial requirements of the sales and production programs as revised in the manner pre- scribed in the preceding paragraph, and planning to se- cure funds to meet these requirements. 4. Proper Control OF Expenditures: (a) By requiring the preparation by each department head of an estimate of the expenditures of his department during the budget period. (b) By requiring the submission of these estimates to the budget committee for consideration and approval. (c) By the prohibition of any expenditures in excess of the departmental estimates without the permission of the budget committee. (d) By requiring the submission of monthly reports showing a comparison between the actual expenditures for the month and the estimated. 5. Formulation of a Financial Program : (a) By the estimating of cash receipts for each month based on the sales program and the estimate of col- lections. (b) By the estimating of cash disbursements for each month based on the production, purchasing, plant and equipment, and departmental expense budgets. (c) By determining the excess of disbursements over receipts and the preparation of a financial program which will secure funds to provide for this excess. 6. Coordination of All the Activities of the Business-. (a) By the preparation by each department of an estimate of its activities during the budget period. (b) By the study of these departmental estimates by the departmental executives and the budget committee. 424 BUDGETARY CONTROL (c) By the modification of the activities of each department to the end that they coordinate with the activities of each other department. (d) By the preparation of an estimated balance sheet and an estimated statement of profit and loss showing the anticipated results of the operations provided for by the budgetary program. (e) By the formulation of plans and policies which will make possible the attainment of the estimated results as shown by the estimated financial reports prepared as directed in the preceding paragraph. The limitations of budgetary control may be stated in outline form as follows: • 1. The budgetary program is based on estimates. 2. Budgetary plans will not execute themselves. 3. Budgetary control cannot take the place of administration. 4. Budgetary control cannot be perfected immediately. CHAPTER XXVI BUDGETARY CONTROL FOR NON-COMMERCIAL ENTERPRISES Scope of Previous Chapters The discussion in the preceding chapters has been con- fined to a consideration of the use of budgetary control in the administration of the commercial or profit-seeking enter- prise. This has been done for the following reasons : 1. It is for such enterprises that budgetary control is most urgently needed at the present time. 2. The development of budgetary control in connection with such enterprises has been very slow and standard methods have not been formulated. 3. The literature dealing with the application of budgetary control of these enterprises is limited. There is considerable litera- ture dealing with the various parts of the budgetary procedure, but so far as the author is aware this text is the first attempt to discuss the budgetary process as a whole. On the other hand, there is a considerable body of literature dealing with budgetary control of non-commercial enterprises. For these reasons it is thought that this text will best serve its purpose by emphasizing the possible uses of budget- ary control by the commercial enterprise and the possible methods by which its installation by such businesses may be effected. It is well to see, however, the other uses which may be made of it. Varied Uses of Budgetary Control Budgetary control has long been practiced by govern- mental units, educational institutions, and similar organiza- tions. Religious, social, and charitable institutions, such 425 426 BUDGETARY CONTROL as churches, Y. M. C. A.'s, and social service agencies, are accustomed to prepare budgets, although in some cases they are not carefully prepared nor rigidly enforced. There has been a considerable body of literature produced treating of its use for these purposes and this literature is readily avail- able to the reader. Although it is not thought worth while to enter into a detailed discussion of budgetary control for non-commer- cial enterprises, a brief description is given in this chap- ter of its use in connection with governmental units and educational institutions, with the hope that some benefit may be obtained by a comparison between the methods employed in these cases and those suggested for commercial enter- prises in the preceding chapters. Budgetary Control for Governmental Units A possible procedure to be followed in the formulation and execution of a budget for a city, state, or national gov- ernment, stated in outline form, is as follows: 1 . Some time before the beginning of the fiscal year each department prepares an estimate of its expenditures for the year. For Instance, in a state government, the State De- partment, the Treasury Department, the Department of Justice, etc., will prepare such an estimate. The depart- ment head will base his estimate on the estimates submitted by the bureau chiefs within his department. 2. The head of the department will transmit this esti- mate with his approval to some official, usually the Treas- urer, Comptroller, Director of Finance, or Director of the Budget, who is designated by the law to receive the separate estimates and formulate them into a combined estimate for all departments. For brevity, we shall refer to this execu- tive as the Director of the Budget in the following discussion. 3. The Director of the Budget, prepares an estimate of NON-COMMERCIAL ENTERPRISES 427 the revenue for the fiscal year. He then submits a report to the chief executive (the Mayor, Governor, or President) showing a comparison of the estimated expenditures with the estimated revenues. ■ - 4. The chief executive, and in many cases a Board of Review, Board of Estimate and Review, or Cabinet, con- sider the estimates received from the Director of the Budget. The departmental heads may be called into con- ference to give reasons for any increases requested by their departments. 5. If the estimated expenditures exceed the estimated revenues, one of the following must be done: (a) Expenditures may be reduced. This invoh'cs a decrease in the estimates of one or more departments. The Chief Executive or his advisory board must decide which of the departmental estimates should be decreased. (b) Revenue may be increased. This necessitates the devising of new methods of taxation or the increasing of the present rates of taxation. (c) Additional funds may be secured from loans. This results in an increase of the indebtedness of the government. 6. The chief executive transmits the budget as approved by him to the legislative body responsible for transforming it into law. He may accompany it with recommendations with reference to methods of raising new revenue if this is necessary, or with reference to the decrease of taxes if this is possible. 7. The proposed budget is considered by the legislative body and such changes made as it deems fit. Usually the changes permitted are limited by law. In some cases the legislative body is given authority to decrease and strike out items, but cannot increase or add items. 8. When the budget is approved by the legislative body, it becomes the working program for all the departments for 428 BUDGETARY CONTROL the fiscal period. No department is permitted to exceed its budget allowance without a special dispensation of the legislative body. In some cases there is an "emergency fund" included in the budget and put at the disposal of the chief executive. He may make allowances from this fund to departments which in his opinion are in need of additional funds. The amount of this fund is usually small. 9. Proper records are kept that all expenditures of each department may be charged against its budget or "appro- priation." Periodic reports are made to a representative of the chief executive, showing a comparison between estimated expenditures and actual expenditures. It will be understood, of course, that the procedure stated in the foregoing outline is intended to be indicative only. The procedure varies somewhat in different govern- mental units. Budgetary Control of the National Government The "Budget and Accounting Act," which establishes budgetary control for the federal government, was approved by the President on June 10, 1921. The complete act is given in Appendix A. The most important features of this act for our purposes are the following: 1 . It places the final authority and responsibility for the preparation and enforcement of the budget in the Presi- dent who is the chief executive of the administrative divi- sion of the government. 2. It sets up a Budget Bureau which is responsible for the preparation and enforcement of the budgetary procedure. The executive head of this bureau is termed the Director of the Budget, and reports directly to the President. In this sense he may be termed a staff assistant to the President. In so far as the President delegates to him authority in the NON-COMMERCIAL ENTERPRISES 429 enforcement of the budget, he acts as an executive assistant instead of a staff assistant. 3. It sets up a budget officer in each bureau who is re- sponsible for preparing the original estimate for his bureau. This results in placing the responsibility for initiating each budget on the unit which is responsible for its per- formance. 4. It prescribes that each bureau chief will consider the budget as prepared by his budget officer and after he has approved it transmit it to the department chief. The de- partment head revises the estimates of the bureaus if he thinks this is necessary, and then combines these to make the estimate of his department. 5. It prescribes that each department head will transmit the estimates of his department to the Director of the Budget. The latter will revise the departmental estimates if necessary, and will then combine these to make the com- plete estimate on expenditures. He will transmit this to- gether with the estimate of revenues to the President, who will make any changes which he thinks necessary and sub- mit them with his approval to Congress. 6. It creates a Comptroller General who is responsible for the form of the records and the procedures of the various departments, and for exercising control over the disburse- ments made under the appropriations which are made in response to the budget. It can be seen from the foregoing that the act sets up in general terms the procedure to be followed in the prepara- tion and enforcement of the national budget. Budgetary Control of State Governments The budgetary procedure of the several states varies to a considerable degree. The modem tendency is towards a more complete and comprehensive planning of financial 430 BUDGETARY CONTROL Operations than that formerly employed. In recent years there has been some tendency towards a classification of the administrative activities of the state on a functional basis, and the creation of functional departments to carry on these activities. In those few states which have followed this plan there is usually created a department of finance in which is vested inter alia the responsibility for the prepara- tion and enforcement of the budget. Appendix B gives an extract from the "Administrative Code " of the state of Ohio, which was approved by the Gov- ernor of the State on April 26, 1921. This extract shows the duties of the Department of Finance as defined in the law. This extract is interesting not only from the view- point of budgetary control, but also from the viewpoint of administrative control in general. Budgetary Control for Educational Institutions Budgetary procedure will vary somewhat as between the small college and the large university, and it will be slightly different in the endowed institution from that of the institution supported by public funds. To indicate briefly the principal considerations Involved in the adoption of a procedure for an educational institution, a state university will serve our purpose. Budgetary Control for University The president of the university is responsible for the preparation of the annual budget and its submission to the board of trustees for approval. In its preparation he may employ various subordinates. The subordinates which may be employed and the procedure which they may fol- low in performing their tasks may be understood better by considering separately (a) the estimate of income, and (b) the estimate of expenditures. NON-COMAIERCIAL ENTERPRISES 43 1 The Estimate of Income The income of a state university may be derived from the following sources : 1 . United States land grants 2. Student fees 3. Departmental sales 4. Gifts 5. Appropriations The income to be derived from United States land grants is not difficult to determine, for it is usually fairly uniform in amount. The income from student fees is dependent on the number of students enrolled. Since the attendance of a state university almost invariably increases each year, it is not difficult to determine the minimum amount of this item of income. It is, of course, impossible to determine the exact amount to be received from this source. Departmental sales arise chiefly from sales of the school of agriculture, and the income from this source must be based on an estimate of the quantity of product and services offered for sale and the probable price to be obtained for them. Possible sales of all departments and colleges must be considered. The income from gifts is ordinarily not large and is usually restricted in its uses; so it has little effect on the general budget. The income from appropriations cannot be determined until after the action of the legislature. The university ordinarily requests appropriations for sufficient amounts to meet the excess of disbursements over receipts as shown by its budget. In most cases more is requested than is obtained, and this necessitates a reduction in the original estimate of expenditures. The business manager or comptroller can best make the estimate of income. He may consult other executives In its preparation. After its completion he will transmit it to the 432 BUDGETARY CONTROL president, who will combine it with the estimate of expend- itures to form the budget which he submits to the board of trustees. Estimate of Disbursements The expenditures of a university may be grouped broadly as follows: 1. General Administration, including the salaries of "business" employees and clerical and stenographic assistants in all de- partments. 2. Physical Plant Operation and Maintenance 3. Capital Additions 4. Teaching and Research (a) Library (b) Supplies (c) Instruction General Administrative Expenses The estimate of general administrative expense will be prepared by the controller. As a basis for this estimate he will receive an estimate from each department and ad- ministrative unit. The controller will indicate such revi- sions as he thinks are necessary and transmit the combined estimates to his superior officer, which may be the president or the business manager. In any case the president will make such revisions as he thinks are necessary and submit the estimate with his recommendations to the board of trustees. Physical Plant Operation and Maintenance The superintendent of buildings and grounds will pre- pare the original estimate for expenditures for physical plant operation and maintenance. In its preparation he will be assisted by the purchasing agent, who will indicate the cost of materials and supplies needed by the program. NON-COMMERCIAL ENTERPRISES 433 If the university has a plant engineer he may also assist in the preparation of the estimate. This estimate will be transmitted to the business man- ager who makes such revisions as he thinks necessary and transfers it to the president, who treats it likewise and sub- mits it to the board of trustees. Capital Additions The additions to property are usually made as the result of appropriations which are granted for the procurement or construction of specific property. Usually the president presents a building program to the board of trustees, and if it is adopted an attempt is made to secure appropriations for the construction of the buildings called for by the pro- gram. In many cases the program covers a period of several years but indicates the buildings which are most urgent. Appropriations may be requested in the order indicated by the program. In presenting the program to the board of trustees and later to the legislature, it is necessary to show estimates of cost. These estimates may be prepared by the university architect in cooperation with the university en- gineer and the purchasing agent. In some cases outside counsel may be employed to make these estimates. After appropriations are secured, contracts will be let for construction and the controller and business manager will supervise the expenditure of funds under the appropriation. Teaching and Research The expenditures under this heading may be subdivided to show separately the cost of the following : 1. Maintenance of library 2. Supplies and equipment 3. Instruction 28 434 BUDGETARY CONTROL a^ ^ J, UJ» pw CJIE q: < 3 o I 0. h-- w ac 3 o 2 H 5^ s ^ co IT QC 3 =o O 1- o s u lll± \ « = o tr < 3 O 1- o Ul z — ^ (3 o = n Ul 3 / GQ nrw «•: ai — K < 3 o 3 / / N OC^ QC o 1- c> ' 3 IT K ^n m / t-" O cc < 1 i 3 M ® s \ 2 = « 2i Im £ S I-- WX UQ CC 3 o "-£ d K „ \ 0) 1 \ \ Kn o Ul^ 1- CO CO 1- UJ llJ C3 eg § m < UJ >- o o o d „ o ^1 2 - ^ o Q Z < U Z w < < O — CO u iZ Q« *3 o ^ ■? O Z-' ux o m i Z 8 "■ UJ \ WZ d CM CM o> CCn o Qc5 < UJ > g 1- < 3 O u O^ 5? ~ __ o l-~- ux 'ment for rent in the District of Columbia, traveling expenses, the purchase and exchange of law books, books of reference, and for all necessary miscella- neous and contingent expenses. Sec. 316. The General Accounting Office and the Bureau of Accounts shall not be construed to be a bureau or office created since January 1,1916, so as to deprive employees therein of the additional compensation allowed civilian employees under the provisions of section 6 of the Legislative, Executive, and Judicial Appropriation Act for the fiscal year ending June 30, 1922, if otherwise entitled thereto. Sec. 317, The provisions of law prohibiting the transfer of employees of executive departments and independent establishments until after serv- THE BUDGET AND ACCOUNTING ACT 449 ice of three years shall not apply during the fiscal year ending June 30, 1922, to the transfer of employees to the General Accounting Office. Sec. 318. This Act shall take effect upon its approval by the Presi- dent: Provided, That sections 301 to 317, inclusive, relating to the General Accounting Office and the Bureau of Accounts, shall take effect July I, 1921. Approved, June 10, 1921. 29 APPENDIX B ADMINISTRATIVE CODE FOR THE STATE OF OHIO Department of Finance Sec. 154-28. The department of finance shall have power to exercise control over the financial transactions of all departments, offices and insti- tutions, except the judicial and legislative departments, as follows: (1) By prescribing and requiring the installation of a tmiform system of accounting and reporting, as to accruals of revenue and expenditures neces- sary in certifying that funds are available and adequate to meet contracts and obligations. (2) By prescribing and requiring uniform order and invoice forms and forms for financial reports and statements, and by requiring financial re- ports and statements. (3) By requiring itemized statements of expenditures proposed for any specified future period to be submitted to the department, and by approv- ing or disapproving all or any part of such proposed expenditures. (4) By requiring orders, invoices, claims, vouchers or payrolls to be submitted to the department, where such submission is prescribed by law or where the governor shall deem such submission necessary, and by ap- proving or disapproving such orders, invoices, claims, vouchers or payrolls. (5) By supervising and examining accounts, the expenditures and re- ceipts of public money and the disposition and use of public property, in connection with the administration of the state budget. (6) By prescribing the manner of certifying that funds are available and adequate to meet contracts and obligations. (7) By prescribing uniform rules governing forms of specifications, advertisements for proposals, opening of bids, making of awards and con- tracts, governing purchases of supplies and performance of work. (8) By reporting to the attorney general for such action, civil or crimi- nal, as the attorney general may deem necessary all facts showing illegal expenditures of the public money or misappropriation of public property. (9) By prescribing rules and regulations for carrying into effect any or all of the other powers herein granted. 450 ADMINISTRATIVE CODE FOR OHIO 45 1 No provision of law authorizing or requiring any department, office, or institution to keep accrual, encumbrance or cost accounts or to exercise fiscal management and control over or with respect to any institution, activity or function of the state shall be so construed as to exclude such department, office or institution from the control of the department of finance herein specified, but the power of the department of finance herein provided for shall apply and relate to such accounts and reports of all such departments, offices and institutions. Sec. 154-29. As used in section 154-28 of the General Code: "Order" means a copy of a contract or a statement of the nature of a contemplated expenditure, a description of the property or commodity to be purchased or service to be performed, other than services of officers and regular employes of the state, and per diem of the national guard, and the total sum of the expenditures to be made therefor if the same is fixed and ascertained, otherwise the estimated sum thereof. "Invoice" means and includes estimates or contracts, or a statement showing delivery of the commodity or performance of the service described in the order, and the date of the purchase or rendering of the service, or a detailed statement of the things done, material supplied or labor furnished, and the sum due pursuant to the contract or obligation. "Voucher" means the order and invoice as herein defined ; and where- ever in the General Code the word "voucher" is used it shall be held to have the meaning herein defined. " Public money " shall have the meaning defined in section two hundred and eighty-six of the General Code. All orders and invoices shall specify the appropriation account from which they are payable. Sec. 154-30. If any requirement of the department of finance re- specting the submission of statements of proposed expenditures, or orders, invoices, claims, vouchers or payrolls is not complied with, or if any state- ment of proposed expenditures, or any order, in\oice, claim, voucher or payroll is submitted to and disapproved in whole or in part by the depart- ment of finance, the department shall have authority to notify the auditor of state thereof, and such auditor shall not issue any warrants on the treasury in payment of such expenditure, claim or voucher. The department of finance may certify to the auditor of state any order or statement of proposed expenditures approved by it, and direct the proper appropriation account or accounts to be charged therewith, or with the estimated amount thereof, in which event the sinn so certified shall be a prior charge on such appropriation account or accounts, available only for 452 APPENDIX the payment of invoices issued against such order, or expenditures within such statement, until the final invoice therefor is filed with the auditor of state, or until the department of finance shall certify that such order and the obligation recited therein have ceased to be an obligation against the state, or such proposed expenditures have been made or abandoned in whole or in part. Whenever any commodity or service included in such order or statement so certified is delivered or performed, or whenever any payment is due upon any contract or obligation covered thereby, an invoice shall be filed with the auditor of state therefor. The total of all invoices issued against any such order shall not exceed the sum of such order or the estimated sum appearing on such order. Sec. 154-31. The department of finance shall : (1) Prepare and report to the governor, when requested, estimates of the income and revenues of the state, and devise new fomis of revenue for the state; (2) Prepare and submit to the governor biennially, not later than the first day of January preceding the convening of the general assembly, state budget estimates; (3) Publish, from time to time, for the information of the several de- partments and of the general public, bulletins of the work of the depart- ment; (4) Investigate duplication of work of the departments and the effi- ciency of the organization and administration of departments, and formu- late plans for the further coordination of departments. Sec. 154-32. In the exercise of any of the powers mentioned in section 154-28 of the General Code, the department of finance shall have the power to compel the attendance and testimony of witnesses, to administer oaths and to examine such persons as it may deem necessary, and compel the production of books and papers. The orders and subpoenas issued by the department in pursuance of the authority in it vested by this section may be enforced, on the application of the director of finance, by any court of common pleas by proceedings in contempt therein as provided by law. Sec. 154-33. In the preparation of state budget estimates the direc- tor of finance shall, not later than the fifteenth day of September in the year preceding the regular session of the general assembly, distribute to all departments, oifices and institutions of the state government, the blanks necessary for the preparation of budget estimates, which shall be in such form as shall be prescribed by the director of finance, to procure, among other things, information as to the revenues and expenditures for the two ADMINISTRATIVE CODE FOR OHIO 453 preceding fiscal years, and appropriations made by the previous general assembly, the expenditures therefrom, encumbrances thereon, and the amounts unencumbered and unexpended ; an estimate of the revenues and expenditures of the current fiscal year, and an estimate of the revenues and amounts needed for the respective departments, ofhces, and institutions for the two succeeding fiscal years for which appropriations have to be made. Each department, office and institution shall, not later than the first day of November, file in the ofifice of the director of finance its esti- mate of receipts and expenditures for the succeeding biennium. Such estimate shall be accompanied by a statement in waiting giving facts and explanations of reasons for each item of expenditure requested. The director of finance may in his discretion make further inquiry and in- vestigation as to any item desired. He may approve, disapprove or alter the estimates, excepting those for the legislative and judicial departments of the state government. Such estimates as revised by him shall con- stitute the state budget estimates which the department of finance is required by this chapter to submit to the governor. Sec. 154-34. Thegovernorshall,assoonaspossibleandnot later than four weeks after the organization of the general assembly, submit a pro- posed state budget in the form of an appropriation bill or bills and a state- ment showing the amounts recommended by him to be appropriated to the respective departments, offices and institutions and for all other public pur- poses, the estimated revenues from taxation, the estimated revenues from sources other than taxation, and an estimate of the amount required to be raised by taxation. Sec. 154-35. Each department, office and institution of the state government, other than the legislative and judicial departments thereof, shall, before any appropriation to such department becomes available for expenditure, prepare and submit to the department of finance an estimate of the amount required for each specific purpose within the appropriation, or items of appropriation, as made by the general assembly, and accounts shall be kept and reports rendered to the department of finance showing the expenditure for each such purpose. The department of finance shall exercise such control over items of appropriation accounts created by the general assembly, with respect to changes and adjustments therein within the general scope of a specific appropriation, as may be committed to it by any act making appropriations, and shall in general exercise such control over the expenditure of appropriations, in addition to that specifically pro- vided for in this chapter, as may be so committed to it. Sec. 154-36. The papers, statements and copies thereof required by 454 APPENDIX section 270-6 of the General Code to be filed in the office of the president of the "Sundry Claims Board" therein provided for shall be hereafter de- livered to and filed in the office of the department of finance, and such de- partment shall discharge all the duties provided for in said section of the General Code with respect to the filing, delivery and preservation of such papers, statements and copies thereof. The director of finance shall in- clude all claims allowed by the "Sundry Claims Board " in the state budget estimates. Sec. 154-37. The department of finance shall succeed to and exercise all powers and perform all duties vested by sections one thousand eight hundred and forty-six and one thousand eight hundred and forty-seven of the General Code jointly in the secretary of state and the auditor of state, which said powers are hereby transferred to and vested in said department. The department of finance shall succeed to and exercise all powers of the state purchasing agent in the office of the secretary of state, and the secre- tary of state and auditor of state with respect to the purchase of supplies and equipment required for the use and maintenance of state officers, boards and commissions, the commissioners of public printing and the supervisor of public printing, and shall exercise all powers and perform all duties as to purchases heretofore vested in the Ohio board of administra- tion under the provisions of section one thousand eight hundred and forty- nine of the General Code. Wherever powers are conferred or duties im- posed upon any such departments, offices or officers with respect to the matters and things herein mentioned, such powers and duties shall be con- strued as vested in the department of finance. In addition to the powers so transferred to it, the department of finance shall have power to purchase all other supplies, material and equipment for the use of the state depart- ments, offices and institutions, excepting the military department and in- stitutions, administered by boards of trustees, and, excepting as to such department and institutions, to make contracts for and superintend the telephone and telegrai)h ser\ice for the state departments, offices and in- stitutions. So far as practicable, the department of finance shall make all purchases under authority of this chapter from the department of public welfare in the exercise of the functions of said department in the manage- ment of state institutions. Sec. 1 54-38. The tax commission of Ohio shall be a part of the depart- ment of finance for administrative purposes, in the following respects: The director of finance shall be ex officio the secretary of said commission, shall succeed to and perfomi all of the duties of the secretary of said commission, and shall exercise all powers of said secretary as provided by law; but such ADMINISTRATIVE CODE FOR OHIO 455 director may designate any employe of the department as acting secretary to perform the duties and exercise the powers of secretary of the commis- sion. All clerical and other agencies for the execution of the powers and duties vested in said tax commission of Ohio shall be deemed to be in the department of finance, and the employes thereof shall be deemed to be employes in said department and shall have and exercise all authority vested by law in the employes of such commission. But the tax com- mission of Ohio shall have direct supervision and control over, and power of appointment and removal of, such employes whose positions shall be desig- nated by the governor as fully subject to the authority of such commission. APPENDIX C A TRUST COMPANY BUDGET SYSTEM By Stuart H. Patterson, Comptroller of the Guaranty Trust Company of New York The Guaranty Trust Company has received a number of requests for an explanation of its budget system for expenses. Thinking that possibly other of its correspondents might desire to utilize this method, the following brief description of the system has been prepared. The first step in this matter is to make a careful classification of the va- rious expenses, so that it will be possible to locate readily any differences between the budget allowance and the actual expenditures. The second step is to estimate carefully the probable expenditure under each classifi- cation, by months, for the coming year; and after the estimates have been duly approved by the Executive Officers, to distribute them by months on an Appropriation Sheet, the notations being made thereon in pencil. The purpose of preparing the Appropriation Sheet in pencil is to permit changes to be made from time to time during the year, either because of additional appropriations, or because some appropriation, say, for adver- tising, may not be expended until a later month than was anticipated, and consequently the appropriation should be carried along until such time as the expenditure actually takes place. The amounts should be distributed as well as possible over the probable months the expenditures will take place, with a notation on the budget to "carry along" such item, that is, to carry it along as an appropriation until required. As soon as a month is closed, the appropriations applicable to that month are inserted in ink. Each month the appropriations are carried from the Appropriation Sheet to the Expense Statements, and entered opposite the actual expenditures under each classification. The Expense Statements are divided into a Monthly Statement and a Cumulative Statement from January i to the end of the month just closed. The Cumulative Statement carries a memorandum column of the budget for the entire year for each classification. With this arrangement the state= ment shows at all times the amount each department or classification may spend, and, should the budget exceed its limit during one month, the lee- way that exists for making up tlie deficiency i:i some other month. 456 A TRUST COMPANY BUDGET SYSTEM 457 The budget system is really very simple, but it is effective in indicating the probable expenses for a year before the expenditures are incurred, in- stead of giving an unsatisfactory review of them after the year is closed. This system also promotes economies which might otherwise be overlooked. A copy of the instructions regarding the 1919 Budget, which were sent to Department Heads, follows: 1919 Budget It is desired that the budget for conducting the business for the year 1919 shall be in the hands of the Managing Committee by December i, 191 8, and the Officers in charge of all departments are requested to have the figures carefully prepared by that date and delivered to Mr. In preparing the budget each department shall show separately by months the amounts of salaries, suppers, postage and stationery, and other items. They shall also show the details which go to make up the "other items. " An illustration of the budget form is as follows: Budget Statement of Department FOR Year 191 9 Other Salaries Suppers Postage Stationery Items January $1,950 $ 5.00 $40.00 $80.00 $35.00 February l,950 5 00 40.00 80.00 35 00 March 1,950 10.00 40.00 80.00 3500 April 1,950 5.00 50.00 80.00 3500 May 1,950 5.00 40.00 80.00 3500 June 1,950 10.00 50.00 80.00 35 00 July 1,950 5.00 40.00 80.00 3500 August 1,950 5.00 40.00 80.00 3500 September i,950 10.00 50.00 80.00 35 00 October i,950 5.00 40.00 80.00 3500 November i,950 5.00 40.00 80.00 3500 December i,950 10.00 50.00 80.00 3500 $23,400 $ 80.00 $520.00 $960.00 $420.00 Detail of Other Items Repairs to coin wrapping machine $ 60 .00 Rental of Telautograph machines 210.00 Inspection of adding machines 12 .00 Photostatic expenses 1 20 . 00 Repairs to money truck 1 2 . 00 $414.00 458 APPENDIX Each department should keep a copy of its budget, and if during the year it becomes necessary to expend money for some item not included in the budget, it should be the duty of the Officer in charge of such department to see that an additional appropriation be granted before the expenditure is incurred. Requests for additional appropriations should be made to the Comp- troller in writing on the form prepared for that purpose, together with a memorandum showing why the additional expense is necessary. The Comptroller has authority to grant such additional appropriations but should he decline to approve any appropriation either because he believes it to be unnecessary, or because he thinks the matter should have the atten- tion of the Officers Meeting, it may be presented to the Officers Meeting through the Vice-President responsible for the operation of the department making the request. A TRUST COMPANY BUDGET SYSTEM 459 Guaranty Trust Company of New York «=^ "" ' Summary of Expenses for Month of 192 a^t... 1 .^,«3 'st7"o«bT ss ■IPBNSIB APPfiO- '"o^™ BAMSUOHTH LAST TUB EXPENSE OF SECURING BUSINESS New BasiaeaB Department See Sheet 2 Publicity Department See Sheet 2 Bond Department See Sheet 2 5lh Ave. Office See Sheet E Madison Ave. Office See Sheet 6 1. Officen' Salaries 2. " Lunches 3. Foreign Representatives 4. General Traveling after Business 5. General Entertaining 0. Library 7. Income Tax DepL ». EXPENSE OF TRANS- ACTING BUSINESS ClTBRSNT OPKBATINa Main Office See Sheet 3 6th Ave. Office See Sheet S Madison Ave. Office See Sheet 6 FlUD BI POUCT Main Office See Sheet 3 5th Ave. Office See Sheet 6 Madison Ave. Office See Sheet 6 Main Office ■ See Sheet 4 Slh Ave. Office See Sheet 6 Madison Ave. Office BeeSheete 310. Officers' Salariea 311. " Lunchu Main Office See Sheet 4 Sth Ave. Office See Sheet 6 Madison Ave. Office See Sheet e TOTAL EXPENSES 1 1 1 i 1 i 1 1 1 ^ i 1 i 1 r- - 1 L 1 1 L BEMABKS 460 APPENDIX Expenses of Securing Business Month of SHEET No.t 192 NEW BUSINESS 30. SalnruB 31. Addjtjoul Wu Com- peiuatioD 32. Supprn 33. Sutionery i Suppliel 34. PoetMO 35. TravelmgEipenMoN.Y, Meu . Telegranu & Telephooe Tolls 37. EotertsinmeDt 38. Other Eipeosn Out of Town Men 3». Stlai 40. a. Rent ExpenflOB Travel mg ToUl PUBLICITY 60. Salaries ei. Additional Wu Com- pensation 62. Suppers 63. Stationery A Supplies 64. Postase 65. Traveling Expenses 68. Printing 4 Circulare 67. Telegrams <1 Telepbon Tolls . Entertainment . Other Expenses 70. Advertising in PublicE tions 71. General Advertising i Publicity 72. 73. 74. ToUl BOND DEPARTMENT 100. Trading Div. 101. Distributing Di». 102. City Salesmen 103. UuUide Dealers 104. Municipal Div. 105. Special Sales Div. 106. Cforreepondence Div. 107. Executive Secretaries 103. Corporation 4 Neo Busi- nos Div. 109. Administration Accounting, 4c. 110. Undistributed Salaries 113. Statistical 114. Investigation Div. 115. Outside Investigations & ExaminatioDB U9. Out of Town Offices- Rent Salaries Private Wires Traveling Expenses 121. 122. 123. 124. Suppers 125. Additional War Com- pensation 126. Tdepbone Tolls— Tele- grams & Cables 127. etationery 4 Supplies 128. Circuisrs 4 Printed Matter 129. Postage 130. Traveling Expenses 131. Entertainment 132. Advertising 133. Stock Ticker A TRUST COMPANY BUDGET SYSTEM 461 Expenses of Transacting Business — Main Office Month of CUKRENT OPERATING Dmpartmxnt 160. AecouDtiDg 161. Ai;a)yBis 162. Auditing 163. Anbives 164. Bookifepiiig 165. CollcctioD 166. Telle™ 167. Coupon ' ■, Crwfit 16». Chief Clerk's 170. Emergency 171. General Fsgea 172. Filing 173. Loan 174. Mailing 175. Measengere 176. Reorganisation 177. RegiatratioD 178. Securitin 179. Stenographers— General 180. Secretaries— Executive 181. Supply Dept Operating 182. Special OSeen and Watchmen 183. Stock Bookkeeping Undistributed ToUi , Trust , Vault . Exprenage & Mail la- Foreign Department SJaria Suppera Travel Telegrama, Cables & •Tel. Calls Postage d Express 6tationery it SuppUi 197. eundries Ml »& MS. S'- MS. Mill 110. 311. 212. 313. Total Fixm 8T PoUCT 230. Resident Attorney 231. Legal dfcProreasioaal Fees 232. Directors & Committee Fees . 233. Examinations & Eleo- 234. Insurance Liability it Fire 235. Fidelity Bonds 336. Dimng Room 237. Customer' Check Books free 23». 340. 241. M3. Ml. M«. to. 462 APPENDIX Expenses of Transacting Quainess — Main Office (Continued) Month of SHEET Ko. 4 192 208. Rent — 140 Broadway Salaiies Elec. Current . Stcim Materiala & Repairt Taies, Real Eetat« Water fiurslar AtanD Other Items Postage & Stationery 270. Rents Reeei»ed 271. Other N. Y. Rentals 272. Stock 4 News Tickers 273. Drinking Water i Ice 274. Laundry A Towels 275. Clearing House & Fed. Reserve Charges 276. N. Y. 4 Other Banking Dept. Fees 277. Furniture and Fi^rt Undritributed Items; Stationery 4 Books Supplies Other Than Stationery Postage Suppers 282. Traneling Incident to Current Business 233. Loss 00 Obsolete SU- 284. General 28i. Ne» Furniture, Fiitures 4 Equipmejlt 286. Alt Form L4H^'i I iri ,'-,*'r"'ORNIA-LOS ANGELi L 008 244 390 4 ^^ 001013 2^'^ mm^