Second in a series of three articles, “Budget Building Blocks,” Reprinted with permission by Donald Keninitz, CPA.
In our previous issue we discussed the importance of developing a comprehensive operating budget. We also discussed some common obstacles and objections raised by companies to the process of budgeting. One of these objections centered on the professed inability of a company to predict future events, such as contract activity and the level of related costs. In this regard we noted that the purpose of an operating budget is less to predict events than to set organizational financial goals and then set in motion the processes for achieving them. In this article, we’ll discuss how to begin the process of building a comprehensive operating budget.
For a typical service-oriented government contractor the basic budget building block is labor cost. That is, how many people, at what level of compensation, and for what period of time, will be required to perform the activities of the business? A second building block relates to the kinds of facilities and support that will be needed by these people to effectively and efficiently perform their work. The process of answering these questions can be broken down into several components.
The first step is to construct a direct labor budget. This can be viewed as consisting of two elements. The first entails estimating the direct labor requirements for contracts already on board. The second relates to determining labor requirements for potential new contract awards, options, and follow-on’s. Obviously, the former presents less of a challenge than the latter.
In estimating direct labor requirements for existing contracts, the process usually will begin with the responsible project or program managers. Each project manager should be required to prepare a direct labor budget for the current fiscal year. Often, this information will be readily available from budgets prepared at the time individual contract proposals were generated; however, it is crucial that the information be updated to reflect current reality. In estimating requirements, it is important that managers realize that the budget constitutes a commitment to which they will be held accountable. Additionally, budgets prepared by project managers should be subject to review and approval by executive management so as to avoid the inclusion of amounts which are either excessively optimistic or pessimistic. The former can lead to unforeseen cost overruns that will compromise contract profitability, sometimes to the point of losses. The latter can lead to inflated costs that could compromise price competitiveness (when such cost estimation is used to price proposals or add-on’s) or create performance targets that are too easily achieved and thus not reflective of truly superior performance if and when met.
It generally is helpful if project managers identify the specific individuals who will be working on each contract, and the expected number of hours required from each. In cases where a specific individual cannot be identified, standard labor categories should be substituted. Labor requirements should be scheduled by cost accounting period (typically each month equals an accounting period). The identification of specific employees and the related work requirements for each period will permit the preparation of a preliminary master budget for direct labor which lists actual employees and their monthly workloads, as well as demand for unspecified persons in standard labor categories. The master direct labor budget should also reflect indirect hours for items such as vacation, holidays, sick leave, training, supervision and administration, etc. Two versions of the master labor budget should be prepared: one reflecting hours and another reflecting dollars. The conversion of hours to dollars will normally require the involvement of executive management with regard to compensation levels. The preliminary master budget for direct labor will facilitate the following:
Identification of schedule and workload conflicts for specific employees
Identification of excess demand for particular employees or occupational classes, resulting in the need for additional hiring
Identification of slack demand for particular employees or occupational classes, providing for review of utilization levels and the possible need for either rescheduling of employees or workforce adjustment.
Estimation of basic direct labor costs, by accounting period. Because direct labor is strongly correlated to overall business volume for most companies, it is the major driver of indirect costs and forms the basis for estimating many of those costs. Thus, the volume and pattern of direct labor is an essential building block in constructing the rest of the budget.
The second step in completing the direct labor budget is to consider potential new contracts, options, etc. Normally, this will involve the use of some form of probability theory. One means of assigning probability is to rate all outstanding proposals as having either a high, medium or low chance of success. A high rating might equate to virtual certainty of acceptance; medium might represent proposals thought to have a 50/50 chance of being accepted; and a low rating could be used to represent long-shots.
Proposals with a high rating would be incorporated into the direct labor budget much as if the contracts had already been awarded. For proposals receiving a medium rating, a direct labor allowance could be made by taking a conservative percentage (for example, 30% to 40%) of the hours and dollars of direct labor that would be incurred if all of the contracts were awarded. This approach assumes that some of the proposals in this class will be successful, and incorporates this expectation into the planning process on a cautious basis.
Special consideration will need to be given to the possibility of obtaining new business for which RFP’s have not yet been identified. One possible approach is to estimate the number and magnitude of proposals expected to be issued and apply the average success rate for proposals generally. Based on the result, an expected value can be calculated for such potential new business. This can then be incorporated into the direct labor budget, usually as a separate line item so that it can be monitored separately.
The foregoing represents only a basic outline for a typical scenario. Each company’s situation is unique and factors contributing to that uniqueness need to be identified and incorporated into a specific company plan.
In summary, the first step in preparing a comprehensive operating budget is to prepare a direct labor budget based on expected as well as existing contracts. Labor budgets for individual contracts, tasks, etc., can then be summarized into a company-wide direct labor budget which will serve as the primary budget building block. In the next article, we’ll examine the creation of budgets for other direct costs and indirect costs.