What a late budget costs

In this lesson: You will learn to measure what a late budget costs, keeping money committed early separate from value the delay destroys.

This lesson counts working days from 1 January, and a year has about 252 of them. On that count, Brenlow's sign-off in the third week of January falls on about working day 14.

Exposure and value forgone

A late budget has two effects that you must measure separately.

Exposure is money committed before an approved plan exists. It is not a loss, and the money may be well spent.

Value forgone is a benefit that the plan expected but that the delay takes away. Forgone means given up. This is a real loss.

Do not add them together, because exposure is not lost money.

Variable cost, contribution and gross profit

To value a lost sale, you need three terms. A variable cost is a cost that rises and falls with the number of units made, such as materials. A fixed cost stays the same when the number of units changes, such as rent. Contribution is the selling price less the variable cost. It is what each extra sale adds to profit while fixed costs stay the same.

A Brenlow instrument sells for GBP 80,000 on average. Its variable cost is GBP 34,000. So each sale contributes 80,000 − 34,000 = GBP 46,000. That is before selling costs, such as sales commission: the pay salespeople earn on the orders they book. Brenlow holds commission in its operating costs, not in the GBP 34,000.

Brenlow's accounts value each instrument at its full standard cost. For the average instrument, that is GBP 47,200: the variable cost of GBP 34,000 plus GBP 13,200 of the factory's fixed costs. Sharing out fixed costs over the units built in this way is called absorption. Across 725 units, the factory's fixed costs are 725 × 13,200 = GBP 9.57m. So reported gross profit per unit is 80,000 − 47,200 = GBP 32,800, which is 41% of the price. Each of Brenlow's two instruments has its own standard cost (Lesson 4.2). At the budget mix, they average these figures.

The full standard cost is right for the accounts, but not for forecasting a change in volume. At the budget mix, the factory can build about 875 units and built 725, so it has about 150 units of spare capacity (Lesson 1.4). With spare capacity, the GBP 9.57m of fixed costs is paid whether the factory builds a few units more or a few less. So one sale more or less moves profit by its contribution of GBP 46,000, not by GBP 32,800.

Worked example 10: What Brenlow's late sign-off costs

We will measure the exposure and the value forgone from signing the budget off on 21 January.

Step 1 measures operating costs run before approval. Operating costs are GBP 33,240,000 a year, spread over 252 working days. Sign-off falls on working day 14. So 33,240,000 / 252 × 14 = GBP 1,846,667 is spent before the plan is approved.

Step 2 measures materials committed before approval. Materials take 12 weeks to arrive, so the first quarter's materials must be ordered before the year starts. Variable cost for the year is 725 × 34,000 = GBP 24,650,000. Materials are 62% of that: GBP 15,283,000. One quarter is 15,283,000 / 4 = GBP 3,820,750. The table adds up the exposure.

Brenlow commits GBP 5.67m, or 6.6% of revenue, before its plan exists.

Step 3 measures the sales lost from late hiring. The plan includes 14 new salespeople, due to start on 1 January. Each salesperson sells about 725 / 68 = 10.66 instruments a year. Recruitment cannot start until approval on 21 January, and hiring takes 11 weeks. So the new salespeople start on about 8 April, 97 days later than planned.

In their first year, new salespeople sell only about half as much as experienced ones. The time a new person takes to reach full productivity is called the ramp. So each lost day would have produced only half a day of normal sales.

The lost sales are 14 × 10.66 × 97 / 365 × 50% = 19.83 units. At GBP 80,000 each, that is 19.83 × 80,000 = GBP 1,586,400 of revenue.

Step 4 values those lost sales at contribution, because the factory has spare capacity. Each lost sale costs GBP 46,000: 19.83 × 46,000 = GBP 912,180.

Step 5 measures the factory savings lost. A factory investment in the plan saves GBP 600,000 a year once it is in use. The savings were due to start on 1 April. With approval on 21 January, the plan now expects them to start on 1 July. So three months of savings are lost: 600,000 × 3 / 12 = GBP 150,000. The table adds up the value forgone.

Step 6 states the cost in the measure the executive team is judged on: 1,062,180 / 7,500,000 = 14.2% of operating profit.

Step 7 checks what is left out. The late hires are also paid later. Do not deduct that pay from the value forgone. The pay has only moved to later months, but the lost sales do not come back.

Watch out: Do not value a lost sale at gross profit per unit while the factory has spare capacity. The average GBP 13,200 of fixed costs in each unit's full standard cost is paid anyway.

A third cost

A late plan has a third cost that is hard to measure. A plan agreed in late January was written for the world as it looked in October, so it is already out of date.

An earlier sign-off does not always help. A decision may also wait for something else, such as a supplier's price list, a contract end date or a committee meeting. It can be taken only when the last thing it waits for is ready (Lesson 1.8). If that thing is ready later than the budget, an earlier sign-off saves nothing.

A spreadsheet workbook follows this lesson. It works out what it costs to delay seven decisions that wait for Brenlow's budget sign-off.

In the exam: Read what a question asks for. Money spent before approval is exposure. A benefit the delay removes is value forgone.

Key points

• Exposure is spend committed before approval: GBP 5,667,417 at Brenlow. It is not a loss.
• Value forgone is the benefit the delay removes: GBP 1,062,180, or 14.2% of operating profit.
• With spare capacity, a lost sale costs its contribution of GBP 46,000, not GBP 32,800 of gross profit. The average full standard cost of GBP 47,200 is for the accounts, not for forecasting volume.