"Why Budget?"   The President's Message January / February 2001 by Randall D. Holler, Manufactured Structures Corporation

This article will discuss the budgeting process and some implications for manufacturing in our industry. Many of the topics will apply across industry lines. Most of the expense items to be included are discussed as well as cyclical volume fluctuations.

Why Budget?

The budgetary part of a business plan can be a very important part of your company's success. A guideline for such a plan follows. It was initially developed in a graduate level class at Notre Dame under the tutelage of a visiting professor from Harvard. It was then successfully used to create a business plan for the purchase of a manufacturing firm.

The budget forces management to think through the entire process, but is not written in stone. Rather it is a benchmark against which activity is compared. Surprises are immediately known. Hopefully they lead to quick action which enable us to minimize the negative and take full advantage of the positive.

Real Implications

Yet it seems that it has become an annual event for a manufacturer to go out of business in the Midwest and for two to open up at the same time. One must wonder how conditions could be such that an expanding market allows the entry of new competitors at the same time someone else is going broke.

We speculate there are those unable to budget and price appropriately. However, on the surface it seems quite simple. In our industry typically labor and material are the two largest expenses. If material is perhaps 65% of your sales price and labor is 12.5% for example, your other costs better not exceed 22.5% of your revenue/price or you lose money.

In other words, if we expect production this year to be $ 12 million, and material cost $ 7.8 million and labor runs $ 1.5 million, other costs had better not exceed
$ 2.7 million or you will lose money.

Keep in mind that the $ 2.7 million is about $ 225,000 per month. What is this latter amount made of? And what considerations other than just the expense side (income statement) should we be concerned with? We will look at the answers and then specifically at the accounts which comprise this $ 2.7 million.

Don't Just Think of an Expense, Think About Its Impact

Each of the accounts listed presents at least four concerns for us. The first is the cash flow impact of the start up. For example, the initial investment in inventory eats up a lot of money. Until this is used it is not an expense, but it eats up cash when it is paid for. This of course is a serious part of determining the total initial investment and loan requirements.

Another concern revolves around the income statement. Some expenses are fixed. Other expenses vary with the amount of product sold or produced. For example, your workmen's compensation insurance will be based upon total payroll. As you produce more, payroll increases and this is therefore a variable expense. The classic variable expense is material. If you don't sell an item, there is no material expense. Material may even be consumed, but is not usually expensed unless sold, rather it goes into inventory first.

Other costs, such as property taxes, are usually considered fixed. Although inventories will vary with volume and have some impact, fixed costs are not adjusted as volume fluctuates.

You may want to list some expenses as both fixed and variable. For example, salaries are usually fixed. But you may want to tie bonuses and/or commissions to volume.
If we can determine fixed and variable percentages, we can calculate the amount of business necessary to break even.

Next, we must look at balance sheet requirements and company policies. You will find sections asking for future expansion requirements. Even fixed expenses will vary given a large change in volume. For example, a new piece of machinery or an expansion to existing facilities may be required. We call these "sticky", they tend to remain constant over a certain volume and then jump at some point when an addition in required.

Then you will need to consider the company policy and business climate. Invoice terms, payment terms, and seasonal fluctuations in volume affect both cash flow and income.

The emphasis here is on operating income and cash flow. Tax returns may vary due to unusual allowances. For example, the code now allows an annual depreciation for a qualifying investment of $ 17,500 (at the time the article was originally written.)

According to our industry's annual statistical survey, the slowest month of the year is only 40% of the volume of the average manufacturer's largest month. I.e., if a manufacturer's largest month was $ 1.5 million, its weakest month had a volume of only $ 600 thousand.

A manufacturer making only a marginal profit during its average months would likely take quite a beating during its slow month(s).

Annual Estimate of Factory Expenses

Material Costs: Variable as a percent of sales price. For the plan it is good to list primary sources of supply and alternative sources. Be sure to allow for scrap and off-fall.
● Up front investment in stocking ● Variable expense associated with operation/sales

Freight In: The cost of delivery of materials to the plant. ● Variable expense

Freight Out: It is usually an expense offset by revenue and excluded from both. However, if there is potential for making or losing money shipping product to customers, include the revenue in the sales figures given earlier, and give a variable expense estimate here.
● Variable expense

Direct Labor Costs: This section is considered variable. This means that employment levels will fluctuate with business volume. In industries with critical skills this may not be possible and labor may have to be split into both fixed and variable costs when key production employees must be retained. ● Variable expense

Inventory Labor: This section should include the estimated hourly wages used when taking inventory per the company's regular practice, whether monthly, quarterly, or other. ● Usually a fixed expense

R & D Expense: This section should include money spent internally and externally on research and development. ● Up front expenditures (i.e., a contract or retainer fee)
● Fixed expenses ● Variable expenses

Job Site Expense: This section should include any expenses associated with site inspections, site testing, or site finish work. ● Usually a variable expense except for equipment which is asked for elsewhere

Vacation/Holiday Pay: Include the allowance necessary to pay plant employees, maintenance personnel, inspectors, and supervisors the company's benefits for vacation and holidays. If a new start-up, allowances will change annually as employees gain seniority. ● Variable expense

Training/OJT: An allowance for the training of new employees prior to reaching their full productive level. Add an allowance for some initial turnover. ● Initial investment
● Variable expense

Contract Labor: Allowance for the subcontracting of work. This may be work done at the site, or for excess work done during the busiest time of the year instead of hiring and then laying off employees when volume slows to normal levels.

Utilities: This allowance is for all plant utilities. Normally plant utilities are larger than office utilities for a manufacturing concern. If plant and office utilities are not available separately, include all utilities here. ● Heat, lights, power, water ● Electrical, gas, fuel, oil, propane, sewer ● The plant portion is usually considered variable and the office portion (asked for later) is considered fixed ● If your business is energy intensive, consider future inflation ● Are deposits required ● Variable expense

Maintenance & Repair: An allowance should be made for maintenance for the manufacturing facility, equipment, power tools, vehicles used for pick up of material and delivery of finished product.
● Variable expense

Equip Rental: The account is for the rent or lease of equipment. ● Deposits required
● Variable expense

Insurance: An estimate of the following insurance premiums should be quoted by a reputable insurance agent or broker ● Property insurance for the manufacturing facility
● Workmen's comp ● Any special premiums such as boiler coverage if the facility is heated with a boiler ● Be sure to note if the building has an automatic sprinkler and/or alarm system installed ● vehicle Insurance.

Building Lease: Include the cost of the building lease or mortgage payment here. If a lease with an option to purchase, note whether the full lease is tax deductible, or if the building must be capitalized and depreciated. If a mortgage, list beginning principal, APR, and length. ● Depreciation will be calculated ● Initial terms or investment (triple net, or down payment.) ● Monthly cost usually fixed. ● Future expansion plans.

Depreciation Equip: The depreciation of equipment assumes the purchase of will average a five year life. In reality, some will be written off over three years, some over five years, and some over seven years. (Equipment expense asked for later is for equipment costing less than a set amount, usually $ 1,000, which is expenses at the time of purchase, instead of being depreciated.) ● Initial investment ● Future needs ● Considered a sticky, fixed expense

Supplies: Supplies are items consumed in the plant which do not go into the finished product. Examples include degreasers, hand cleaner, sanitary supplies, safety supplies such as protective eye wear, etc. ● Initial expense of purchase price or lease down payment. ● Variable expense

Auto/Truck Exp: Include all costs except insurance.
● Maintenance, gas consumption, etc. ● Initial expense of purchase price, or lease down payment ● Variable expense

Equipment: For equipment purchases which are valued below the cutoff for depreciation. ● Initial stocking investment ● Variable expense

Small Tools: For items such as hammers, tape measures, etc. which are not considered equipment of supplies. These items are normally consumed on a regular basis. ● Initial investment ● Variable expense

Payroll Tax: Special attention should be given only to the portion of payroll taxes which the company pays. Ignore the portion deducted from employee checks. This is their expense. I.e., FICA and unemployment.

Property Tax: Considered a fixed expense annually, adjustment will be made for inflation as taxes normally increase. Make special note of any tax abatement allowed and the period over which taxes are phased in. ● Fixed expense

Group Insurance: Normally a major expense which will vary depending upon actual employee census (age). As such, actual costs may vary. However, due to the size of this expense an estimate should be gotten from a broker or agent. It is not usually wise to self-insure a start up operation. The risk is simply higher than with regular insurance.
● The factory portion of this expense is usually considered variable
● Note coverage quoted, and employee portion of monthly premiums ● Initial down payment ● Monthly invoice per employee

Employee Welfare: A fancy name for the cost for miscellaneous employee benefits. An example would be the estimate for your annual Christmas party, a company picnic, and perhaps a small bonus for the holidays. ● Usually a variable expense

Trash Removal: Usually variable, if you are not producing product, there will be no trash. Make special not of any hazardous material requiring disposal and the licensed transporter and collection/disposal destination. ● Variable expense

Supervisor Wages: Plant supervision. Usually a fixed expense due because it is a salaried expense and these individuals are not typically subject to a reduction in force.

Maintenance Wages: Wages for those maintaining equipment. Usually a variable expense. (A note should be made for any special training expenses required in the training section listed earlier.)

Warranty Repair: Consider your policy. This section is for service or repairs made away from the factory, which are done at no charge. ● Variable expense

Spoilage: An allowance for material scrapped as a result of damage or faulty production.
● Variable expense

Factory Gas and Oil: Gas and oil used to power and maintain forklifts and equipment.
● Variable Expense

Uniforms: Expense associated with supplying uniforms for jobs where employee clothing would be required or offered. For example, some shops supply painters with uniforms so that their clothing is not ruined. ● Variable Expense.

EPA Expenses: Is any special requirement necessary. Are permits required? Will the site of a new plant require an environmental survey prior to a bank loan? If contamination is found, who will pay for remediation? ● Initial expense and explanation ● Annual or variable expenses

Miscellaneous: An allowance for unusual expenses.
● Variable

Administrative

Salaries: Make a schedule showing the salaries of all managerial, sales, and administrative employee positions. Also list employees being paid on an hourly/wage basis and estimate the average number of hours required weekly during the first year. ● Fixed expense: salaries ● Variable expense: hourly admin wages

Salary Reserve Allowance: At some point business volume will require additional office staff. What is this level?
● Variable Expense.

Relocation: An allowance for the relocation of key individuals who must move in order to become a part of the management team. ● Initial investment ● Fixed expense allowance

Employment Fees: An allowance for headhunter fees if necessary to attract key employees. ● Fixed expense

Engineering Expenses: Allowance for the services of engineering firms, or internal engineering department operations. ● Initial expense allowance ● Variable expense

Engineering Supplies: Supplies necessary for reproduction equipment, engineering computer systems (example-CAD), and other supplies, paper and forms.
● Initial expense ● Allowance variable expense

Auto Expenses: Expenses associated with the purchase, rental, or lease and maintenance of any company vehicles used by management, sales, or administrative personnel. Include maintenance. ● Initial investment ● Fixed expense allowance ● Variable Expense allowance

Bad Debts: An allowance for unpaid receivables. ● Variable expense

Utilities: Office utility allowance. ● Heat, lights, power, and water ● Electrical, gas, fuel, oil, propane, sewer ● Fixed expense (see plant comments)

Maint/Repair: Allowance for the maintenance of office facilities, including janitorial services, and for the maintenance of office equipment.

Group Insurance: See plant group insurance notes.

Building and Equipment Depreciation: See depreciation notes for plant facilities and equipment. ● Initial investment in building ● Depreciation ● Initial investment in equipment ● Depreciation ● Variable expense

Equipment Rental: For the rental or lease of equipment such a copy machines and computer systems. Check to see if the equipment value must be capitalized or if the lease is subject to buy out at fair market value and thus can be entirely expensed.

Office Supplies: Staff supplies; from paper clips to printer ribbon. Computer supplies and engineering supplies are listed elsewhere. ● Initial expense allowance ● Variable Expense

Computer Supplies: Because this can become a surprisingly initial investment and up front expense, it is listed as a separate line item. ● Initial expense allowance ● Variable expense

Postage: Allowance for postage associated with invoicing and mailing advertising literature. If a postage meter is purchased or leased, an initial investment is required.
● Initial investment ● Variable expense

Telephone: The hardware and software associated with equipment purchase or lease, maintenance (check on maintenance agreements) and phone bills. ● Initial investment
● Variable expense

Dues/Subscriptions: The expense of belonging to professional organizations, trade organizations, and subscriptions to journals and other periodicals. ● Initial investment ● Fixed expense

Advertising: Include all media advertising expenses as well as the cost to attend and promote at trade conventions and shows. ● Initial investment ● Fixed expense

Computer Hardware: The cost of purchasing or leasing and maintenance agreements for a computer. ● Initial investment ● Fixed expense

Computer Software: Allow for the purchase and/or licensing agreements for the use of software. ● Initial investment ● Fixed expense

Legal/Professional: For services other than Engineering listed earlier. Attorney fees for incorporation and other legal matters, accounting services (most lending institutions require an audited or reviewed statement), and other fees. For example, an advertising agency may be hired or payroll may be written by a contracting firm. ● Initial investment ● Fixed expense

Payroll Taxes: See notes on plant payroll taxes.

Insurance: See notes on the plant insurance requirements and cover the office facilities and employees. In addition add any bonding requirements, general liability coverage, product liability insurance, and consider business interruption insurance. Usually a deposit is required with periodic payments during the year. Many of these policies vary with sales and payroll volume. ● Initial investment ● Variable expense

Employee Welfare: See plant notes. ● Fixed expense

Contributions: A potential source of publicity. Set an amount and do not exceed it.
● Fixed expense

Interest: Interest expense associated with loans and capitalized leases. ● Fixed expense

Travel & Entertainment: The cost of entertaining customers and other business people.
● Fixed expense.

Engineering Certification: An allowance for product testing and certification. For example, a product might be UL tested and then the company pays a fee for each UL label it places on a finished product. ● Fixed expense ● Variable expense

Taxes and Licenses: Estimate the cost of business licensing and miscellaneous taxes not included elsewhere. ● Fixed expense ● Variable expense

Professional Training: The costs of training and licensing fees for maintaining professional status. Examples include CPAs and engineers. ● Fixed expense

Reference Materials: Allow for the purchase of manuals and legal reference materials if desired. For example; building codes, engineering manuals, etc. ● Initial expense ● Fixed expense

Medical Program: The cost of drug screening for new employees. This might also include the cost of preventive health such as stop smoking clinics for employees, or other investments in employee health. ● Initial investment/expense ● Fixed expense

Miscellaneous: Allowance for unusual expenses.

Are there other expenses related to your particular industry or service? List any expenses not covered and note any initial investment or expense and then any ongoing fixed or variable expenses.

Calculating a Breakeven Point

Now that we have estimated expenses we can calculate a breakeven point. In our example let us again use some examples.

Breakeven will occur when fixed expenses total revenue 100% minus variable expenses of 86% or 14%. One and a quarter million dollars is 14% of $ 8,928,571.42. so if we think sales will average $ 1 million per month we are in pretty good shape. In fact, we can estimate profit as follows.
 

The Main Benefit

The main benefit of walking through this lengthy process is that you now have a plan in detail from which to compare actual performance on a real time basis. If I have to hire an extra engineer, I know he/she was extra because I understand what was in the original plan.
 

Randy Holler, president and CEO of Manufactured Structures Corporation in Middlebury, Indiana was elected president of the Modular Building Institute in March 2000.

Copyright © Modular Building Institute, January 2001