Quantitative Analysis in Budgeting Standard Costing

Quantitative Analysis in Budgeting analyses fixed and variable cost elements from total cost date using high/ low method; explains how to estimate the learning rate and learning effect; applies the learning curve to a budgetary problem; discusses the reservation with the learning curve; applies expected values and explains the problems and benefits and explains the benefits and dangers of using spreadsheets in budgeting.

Quantitative Analysis in Budgeting

1. Analyse fixed and variable cost elements from total cost data using high/low method.

The high-low method is a “quantitative technique for analyzing costs into their fixed cost and variable cost elements.” It is used to separate the total cost into fixed and variable costs.

Here are the steps to be followed when using the high-low method:

Step 1: Review records of costs in previous periods

• Select the period with the highest activity level
• Select the period with the lowest activity level

Step 2: Adjust by indexing up or down

Step 3: Determine the following:

• Total costs at high activity level
• Total costs at low activity level
• Total units at high activity level
• Total units at low activity level

Step 4: Find the variable cost per unit (v)

• Formula: (Total cost at high activity level – Total cost at low activity level) ÷ (Total units at high activity level – Total units at low activity level)

Step 5: Find the fixed cost

• Formula: (Total cost at high activity level) – (Total units at high activity level x variable cost per unit)
• Estimate the learning rate and learning effect

Learning curve theory is used in situations where the workforce improves in efficiency when they gain more experience. Where there is a learning curve, there is a learning rate and a learning effect.

The learning rate is “expressed as a percentage value.”

The learning effect is that “as the workforce learns from experience how to make the new product, there is a big reduction in the time to make additional units.”

Apply the learning curve to a budgetary problem, including calculations on steady states.

There are two main approaches that are used to calculate the learning curve:

• The Tabular approach: uses a table to calculate the cumulative average time per unit and the total time to produce all the units produced so far
• The Algebraic approach

To calculate the learning curve using the algebraic approach, the following formula is used:

Formula: Y = axᵇ

• Y is the cumulative average time per unit to product x units
• x is the cumulative number of units
• a is the time taken for the first unit of output
• b is the index of learning (logLR/log2)
• LR is the learning rate as a decimal

Importance of Budget

Before we get into adding a new system, let’s review some of the basics of goals and uses of a budget.

1. Financial Resource Allocation

Money is the lifeblood of a company. Having enough of it to support operations, new business initiatives and acquisitions is vitally important. The budgeting process is essentially matching what is possible with the resources that exist.

Strategic Plan Support: The budgeting process should focus on the important steps you must take during the year to support your strategic plan. It should lay out the coordination of the departments and set the benchmarks to signal if the plan is succeeding.

Initiative Tracking: New initiatives are often the basis for growth. As they are an unknown territory, the assumptions made for revenues and costs usually have a wider range of possibilities. Once the year begins, the budget serves the purpose of tracking chosen initiatives to gauge their success or failure.

Expense Control: Budgets provide feedback to managers as to their performance and should incentivize them to take corrective actions when necessary, and identify overperformance and possible opportunities.

Some Basic Budgeting Best Practices

Before we get into an example of adding a quantitative methodology, I want to go over some best practices for budgeting in general. While certainly not exhaustive, I have found that these steps will save time and resources by reducing budget iterations and improving department coordination.

Set a Timeline: While obvious, the timeline should be detailed enough to allow for individual department budgeting, cross-departmental reviews and consolidated working budget reviews. I have seen companies doing budget consolidation reviews only days before a board meeting.

Convey Topline Guidance Early: Having a budgeting process commence by clarifying all top and bottom line goals and distributing the information to managers can save a lot of time later in the process. As a recent example, a COO told me about having done a budget with 8% growth, but the firm’s PE investor wanted to see 20%, so they had to go through the whole process again.

Team Collaboration: Siloed budgeting runs counter to the goal of a budget rigorously vetting the operational goals of supporting the strategic plan. Marketing, Sales, Product, HR, and Operations all rely on each other’s functions. Cross-team meetings early on with defined agendas and shared assumptions are helpful in this regard.