Piele SA started a budget committee consisting of the chief accountant, a cost accountant, a technical director, and heads of the production departments. The committee was formed to help develop a budget using the zero-based budgeting system. Piele SA’s budget was based on the expected level of activity in sales that the firm expected to generate during the year. Piele SA started its budget from zero, and continued to re-evaluate and adjust targets throughout the operating year; an example of this is shown in the adjusted columns in Exhibits 6 to 9. By using zero-based budgeting, Piele SA was forced to examine operations and expenses in order to plan and forecast for the upcoming year.
Piele SA used sales as the main driver behind its budget. By having accurate forecasted sales, Piele SA would have a solid foundation for all other budgets, including Direct and Indirect Cost of Goods Sold, Administrative, and Commercial categories. Sales did not achieve budgeted targets, and Piele SA attempted to adjust budgets accordingly, even if the nature of the cost was fixed.
Cost of goods sold is the only cost directly variable to revenue. All of the other costs have other drivers that are unrelated to revenue, and are fixed in nature. For example, when you look at the other cost areas in the Piele SA case; Indirect Costs (Exhibit 6), Commercial Costs (Exhibit 8), and Administrative Costs (Exhibit 9), the variable costs in these areas are not adjusted in the flex budgets in proportion to changes in revenue. Piele SA tried to flex budget these costs in relation to sales, which resulted in management’s attempt to measure performance inaccurately. For example, when sales were adjusted to decrease 33%, Exhibit 6 costs were also decreased the same rate, even though the majority of the costs were indirectly linked to sales.
Fixed and variable costs in Exhibits 6-9 would act as fixed costs as Revenue is not their cost driver. Piele SA should treat only Cost of Goods Sold as directly linked to revenue, and alter all other costs on an exclusive basis. By using zero-based budgeting, Piele could re-evaluate these costs and create a more accurate forecast for the next budget year.
Our team created a Contribution Income Statement based on the first six months of performance in 1999 for Piele SA (Exhibit I). We compared performance to budget, analyzed costs, and gained a better perspective of what is happening at Piele SA. The following is our analysis of Piele SA’s financial performance.
In Exhibit I, Revenues are showing an unfavourable variance behind budget (-10623.3). Piele has achieved 41.1% of original sales budget for 1999. At the beginning of the fiscal, management made the decision to change the outputs of their mix, by lowering production of soft and hard leather goods, and expand outputs of intermediate goods such as wet-blue and crust. The result is about 55% of the total output of Piele SA was not exported outside the Soviet Republic – Piele lost market share. There could be lower demand for intermediate goods such as Consumer Goods and Crust, and Wet-Blue.
Cost of Goods Sold
Costs of Goods Sold are variable to sales, therefore showing an unfavourable actual dollar variance of $7739.1. Please refer to Exhibit II regarding actual variance by product produced. Wet-Blue is the highest revenue driver, with a loss of fourteen cents per unit. Contribution Margins on Soft and Hard Leathers are 29% and 33% respectively, and Consumer Goods posting a healthy Contribution Margin of 83%. Total Cost of Goods Sold is 72.9% of total revenue, which is driving a low Contribution Margin of 27.1%.
The decision to change outputs of Piele SA’s mix is puzzling as management 1) did not know the costs allocated for all the outputs when making this decision, and 2) did not understand the impact on revenues.
Reviewing Exhibit 5 in the case, we wonder if the steering committee...