Document created: 6 February 03
Air University Review, March-April 1977

Variable Budgets

Application and Theory

THE budget squeeze and the need to do more with less are common themes in today's Air Force. An equally common theme is the need for improved resource management. If resource and financial management is to improve, then management systems must provide incentives for good management and must have clearly visible goals of improved efficiency. General David C. Jones, in an address to the American Society of Military Comptrollers, said, " . . . we have to find some way to provide the incentives to do the job in the most efficient manner. And if somebody does well, and doesn't spend all his resources, we should be able to say, 'All right, you managed well and therefore you can take that money and use it to do other things.' "¹

Robert C. Moot, Assistant Secretary of Defense (Comptroller), speaking to a 1973 Financial Management Conference, called for development of systems and techniques to assist managers. In so doing he wondered whether our system of incentives placed a premium on the wise use of resources. ² The emphasis on incentives for better resource management in no way reflected on the motivation or integrity of Air Force managers. Without question those managers strive to reach the goal that is set for them. The question of incentives concerns whether the right goal is set. Are managers rewarded for using resources efficiently? There is some basis for answering no to that question. ³ But, General Jones and Mr. Moot have called for solutions, not recriminations or accusations.

The call is for systems that provide incentives to efficient management and the information to act on those incentives. This article presents such a system. All prerequisites for its use exist; development of new accounting systems or new staff capabilities are unnecessary; it recognizes, in quantitative terms, price changes, program changes, and managerial efficiency. This system is variable budgeting.

The preceding paragraph raises more questions than it answers. What is variable budgeting? How does it provide incentives to efficient management? Will it really work? The remainder of the article is devoted to answering those questions and also to an explanation of how variable budgets fit into the Planning-Programming-Budgeting System and the control process. Every effort is made to present a comprehensive description that will allow the reader to evaluate for himself the utility of variable budgeting. Poorly defined subjects are difficult to describe and equally difficult to evaluate; therefore, the first item in this description of variable budgeting is a definition.

The American Heritage Dictionary defines budget as "An itemized summary of probable expenditures and income for a given period, usually embodying a systematic plan for meeting expenses." A budget is more commonly thought of as a list of expenses that total the sum of money available; a control against overspending. A variable budget is more than that and also more than just" . . . an itemized summary of probable expenditures. . . . .. Variable budgets deal explicitly with the adjective probable and its complement uncertain. For if expenditures are probable, then they are not certain--but uncertain. One uncertainty recognized by variable budgets is the rate of activity. In complex organizations the rate of activity can seldom be accurately forecast. ⁴ If the activity rate changes from that which was budgeted, then expenses will also change. Consequently, the budgeted and actual expenses will lose comparability. The comparison of plans and realizations, an essential part of the control process, is thereby complicated, as is budget administration. If activity increases, the decision to allocate additional funds is required. Conversely, if activity decreases, then a decision to withdraw and reallocate funds is required.

If costs are expected to vary substantially with the activity rate, then it makes sense for the budget to vary with the activity rate also. The budget may then include a cost-volume relationship such as a fixed amount plus an additional amount for each unit of volume. ⁵ Furthermore, if significant price changes are expected, then a price-cost relationship should be part of the variable budget. The budget would then automatically adjust for price changes.

Obviously, neither activity increases nor price changes can be allowed to drive unlimited budget changes. The resource constraint still exists, and ceilings or upper bounds on the budget must be established. However, that activity rates do act to increase fund availability should be recognized in. establishing the upper bounds. *

*These increases may derive from reimbursements or from an undistributed amount or "pot" at the next higher echelon.

Variable budgets are defined as budgets that vary in actual amount with activity rates and price levels, on the basis of cost-volume and price-cost relationships that are explicitly incorporated in the budget. The explicit incorporation of the relationships is essential if proper incentives are to result and good faith is to be maintained.

The Variable Budget and PPBS

The Planning-Programming-Budgeting System (PPBS) was initiated in 1962 to provide a mechanism for top-management decision in the Department of Defense. Then Secretary of Defense Robert S. McNamara stated the purpose of PPBS as follows:

1. It provides the mechanism through which financial budgets, weapons programs, force requirements, military strategy and foreign policy objectives are all brought into balance with one another.

2. It produces the annual Five-Year Defense Program, which is perhaps the most important single management tool for the Secretary of Defense and the basis for the annual proposal to Congress.

3. It permits the top management of the Defense Department, the President and the Congress to focus their attention on the tasks and missions related to our national objectives, rather than on the tasks and missions of a particular service.

4. It provides for the entire Defense Establishment a single approved plan, projected far enough into the future to ensure that all the programs are both physically and financially feasible. ⁶

Mr. McNamara also recognized that,

. . . in the end, economy and efficiency in the day-to-day execution of the Defense program rests largely in the hands of tens of thousands of military and civilian managers in the field. How to motivate them to do their job more efficiently, and how to determine whether or not they do so, have always been among the most difficult and elusive problems facing the top management of the Defense Department. ⁷

PPBS has been characterized as a good decision-making process with potential for becoming great. ⁸ Its evolution has continued since 1962 and is continuing, but it is still a top-management system. One of the necessary steps from good to great is the development of management systems that improve the " . . . day-to-day execution of the Defense program. . ." and aid in determining the efficiency of those programs.

The idea that program budget systems, including PPBS, are top-management systems and that appropriate day-to-day budget systems are differently structured is not new.⁹ One of the major benefits of program budgets is the aggregation of details into logically structured groups (programs) suitable for top-management review and planning. Such a program is clearly of little use to managers far down in the hierarchy who have just a little piece of one or several programs. These managers need a budget tailored to their decisions rather than to top-management decisions.

In terms of detail there are essentially three different kinds of budgets: object classification budgets, performance budgets, and program budgets. The object classification budget is most detailed and least abstract while the program budget is aggregated and abstract. Performance budgets hold the middle ground. An object classification budget presents the costs of classes (groups) of physical or conceptual objects. For example, the Air Force Element of Expense, Investment Codes (EEIC) are as detailed as packaged petroleum, oils, and lubricants; per diem; and military pay, airman.

Program budgets aggregate the organization's activities into coherent, related groups or programs that contribute to the broad objectives and goals of the organization. Top management can then conceptually manipulate a reasonable number of programs in balancing resource allocations rather than in trying to balance thousands of activities. DOD has ten programs in its PPBS.

Performance budgets are in terms of activities and are intended for use by managers of activities. They allow the manager to budget for the performance of specific activities and, then, to assess whether he performed those activities for the planned cost. Performance budgets are for the use of those " . . . tens of thousands of military managers in the field."

A variable budget is a performance budget especially useful in times of changing programs and prices; it makes possible the assessment of managerial efficiency and should therefore have a major role in the financial management system of the Air Force. PPBS is a vehicle for top-management trade-offs between programs--underpinning it is the implicit assumption that those programs are operating efficiently. (For if major inefficiencies exist, then their correction must also be considered as a trade-off.) Validation of the implicit assumption of efficiency is the role of variable budgeting in PPBS.

The Variable Budget and
 the Control Process

Variable budgets playa significant role in the function of control. Control is the comparison of events to plans: the identification and measurement of deviations and feedback to the other four management functions (planning, organizing, staffing, and directing).¹⁰ Based on the feedback, adjustments are made in plans, organization, staff, or directives to eliminate, or at least reduce, the deviations; to bring together future events and plans. Neglect of the control process may allow the organization to travel a different path than is its objective.

The financial management control process is essentially the comparison of actual expenses to budgeted expenses. The immediate purpose is to determine whether the budgeted resources are either excessive or inadequate. A less immediate but pressing purpose is to determine the degree of managerial control over any deviations of expenses from the budget. The essence of financial management control is to ensure that the funds are expended as budgeted. However, that is not the same as ensuring that expenditures do not exceed the budget. For adequate control one must know not just that the budgeted funds were expended but also that the types and quantities of goods purchased were as budgeted. The comparison is not simple because both requirements and prices change and those changes must be considered in the comparison.

The variable budget allows identification of deviations resulting from production volume changes, price changes, and the residual deviation that is attributed to managerial actions or estimating error. The process of identifying the deviations is called "variance analysis." Variance analysis provides information for feedback into the planning, organizing, staffing, and directing functions. The control process is incomplete without that feedback.

Variance Analysis

Variance analysis is the analysis of the difference between planned and realized costs (budget and expenses). The analysis separates the variance due to deviations of expected and actual prices, planned and actual quantities, and the unexplained or residual variance.

The variance is succinctly stated by the

following equation: 

I - A = V + P + e + E

where

I = initial budget,

A = actual expenses,

V = volume variance,

P = variance resulting from price increases,

e = the estimating error of the variable budgets cost-volume relationship, and

E = the unexplained variance.

Volume variance is the difference in the initial budget and the actual expenses resulting from changes in the program size or production volume. If production (flying hours in the case of aircraft maintenance) is less than was estimated in the budget, then actual expenses should be less than the budget provided, of course, that prices did not change.

Price variance is the difference in the initial budget and the actual expenses resulting from price changes. If prices go up and production volume is as planned (budgeted), then he actual expenses should exceed the budget.

Estimating error is the inherent inaccuracy of the cost-volume relationship. Generally speaking, estimating relationships have an estimating error associated with them. If relationships are carefully derived, there is a good idea of the size of the estimating error, providing a standard for recognizing those that are unreasonably large. A common way to state estimating errors is in terms of confidence intervals.

Unexplained variance is the difference between the initial budget and the actual expenses that is not attributable to column variance, price variance, or the estimating error. The dollar results of managerial actions that enhance the efficiency of the process will be concentrated in the unexplained variance. Decreases in the efficiency of the process will show up as an unexplained variance causing actual expenses (A) to be larger than the initial budget (I). It is clear that explicit adjustments for volume variance and price variance may reveal some efficiency changes which might have been masked by changes in production levels or price increases.

SUPPOSE THE aircraft maintenance budget for a KC-135 Stratotanker wing is computed on the basis of $10,000 per unit equippage (UE) per year and $70 per flying hour (FH). For simplicity, assume a five UE wing and a flying program of 1000 hours. The initial budget (I) for such a wing would be

5 UE @ $10,000 1000 FH @ $70

$ 50,000   $ 70,000 $120,000

Imagine that near the year's end the wing had flown just 900 flying hours (FH), had maintained the expected unit equippage (UE) of five aircraft, and that prices had increased 10 percent during the year. The actual expenses for this hypothetical wing were $100,000.

Doing the variance analysis, we see that the initial budget is $20,000 more than the actual expenses. That is,

I - A = $20,000

The budget provided for 1000 flying hours but only 900 were flown. The volume variance is 100 flying hours at $70 each or $7000.

That is,

V = $7000

The price increase of ten percent is approximately equivalent to a five percent cost increase since the purchase of items is spread throughout the year. The price variance then is five percent of the $100,000 actual expenses or $5000. Since prices increased, the price variance tended to cause actual expenses to exceed the initial budget. But the total variance is stated as I - A; therefore, the price variance is negative. That is,

P = -$5000

The volume variance (V = $7000) is positive, and the price variance (P= -$5000) is negative; the logic for determining the sign, plus or minus, derives from the definition of total variance as I--A. By this definition things that would cause the actual cost (A) to exceed the initial budget (I) are negative, for example, price increases.

From the total variance we can now remove (deduct or subtract) the volume variance (V) and the price variance (P). What remains is the sum of the estimating error and the unexplained variance. Making the subtraction, we see that

I - A = V + P + e + E
$20,000 = $7000 - $5000 + e + E
$18,000 = e + E

Suppose that the estimating error of the cost-volume relationship is plus or minus ten percent. (For the statistically minded, let's say that is a 90 percent confidence interval.) The estimating error then may be as large as 10 percent of the $100,000--the actual expense. That is,

e = $10,000

at its largest. That means the unexplained variance is $8000. That is,

E = $18,000 - $10,000 = $8000

Somebody at our hypothetical wing may have managed to increase the efficiency of the maintenance process. A flag is up that says, "Hey! The maintenance organization at Wing___ appears to be unusually efficient."

If we manage the budget as General Jones has suggested, then the wing keeps the $8000 to spend as they wish. The remaining $12,000 of the $20,000 total variance belongs to the MAJCOM for reallocation. These savings did not result from actions of wing management but from the volume decrease and the estimating error, offset by the price increase.

The example provides substantial answers to the call for systems that help identify efficient managers and provide sufficient information to judge which budget savings should be retained by managers.

Benefits

Variable budgets provide an incentive to do the job in the most efficient manner because variance analysis makes possible recognition of changes in the efficiency of the production process. The explicit treatment of volume and price variance is essential to that recognition but, equally essential is the use of a cross-sectional cost-volume relationship. A cross-sectional relationship is one that compares bases or units; it does not treat each base as a unique individual. Characteristics that cause costs to differ among bases are represented in the equation. One existing cost-volume relationship recognizes that quantity of aircraft and flying hours and weather cause cost differences among bases; but given those differences, the maintenance cost of anyone type of aircraft is assumed to be equal at each base.¹¹ It is that equality assumption that allows the comparison of bases and substitutes for the effect of competition in the market economy.

Use of cross-sectional relationships does not preclude recognition of cost-driving differences not included in the cost-volume relationship; however, they do shift the responsibility for establishing such differences from the headquarters staff to the base. Any differences that a base can support will be recognized, but the shift of responsibility for establishing or demonstrating differences is significant. It is based on recognition of two factors: we are a bureaucracy, and the base staff has more information than does the headquarters. Bureaucracies are childlike in many ways; they do not naturally operate as logic or economics would seem to dictate. For example, if a manager in a bureaucracy is pressured to change procedures, he may resist. Logic would seem to demand that a manager pressured to reduce cost because others in apparently similar situations operate at lower cost would explicate the differences between his operation and those others. It is an uncommon reaction. In bureaucracies the common reaction is to cite unexplicated differences and the dire consequences of unfounded fund reductions. However, a cross-sectional cost-volume relationship, because it quantitatively recognizes certain cost-driving variables and explicitly assumes no further differences, places squarely on the base the responsibility for identifying further differences. The base or local manager is better equipped than the headquarters to identify such differences because he has better information than does the headquarters. Headquarters typically know how bases are similar--not how they differ.

The process of identifying differences is obviously iterative and requires information flows from headquarters to base and base to base, but it is only by providing the local managers sufficient incentive that the process will have enough "voltage" to work. Variable budgets, providing that voltage through cross-sectional relationships, tend to surface previously unrecognized base characteristics that cause cost differences. Some of these characteristics may themselves be, or result from, policies of either the base or the command. Cost-benefit studies mayor may not result in changed policies, but, to the extent deliberate decisions are better than unintended ones, things will have improved. Surely some policy choices which have cost-benefits will occur.

A further benefit is the recognition of changes in the efficiency of the production process that implies recognition of efficient managers.

A variable budget is easily adjusted for program or price changes because the relationships preclude the need to negotiate a basis for the adjustment; they are the basis. The idea that efficient managers are penalized through withdrawals of "surplus" funds should fall before the logic of a variable budget. Specific procedures for deciding which "surplus" funds are efficiency savings and may be retained are provided and were demonstrated in the example.

VARIABLE BUDGETS are applicable to areas other than aircraft maintenance; vehicle maintenance is another likely candidate. Basically, variable budgets are applicable whenever some activity variable can be identified. An essential thought is that if activity variables which adequately explain personnel costs cannot be found then variable budgets may still be applied to nonpersonnel costs. The reader is left to consider the implication of a failure to relate activity rates and personnel costs.

Again quoting General Jones:

. . . we have to find some way to provide the incentives to do the job in the most efficient manner. And if somebody does well, and doesn't spend all his resources we should be able to say, "all right, you managed well and therefore you can take that money and use it to do other things. "¹²

Variable budgets do that.

Air Command and Staff College

Notes

1. David Jones, "General David Jones, USAF Chief of Staff, Discusses Control," Armed Forces Comptroller Magazine, July 1975, pp. 6-7.

2. Robert C. Moot, "The Role of the Financial Manager in the Decision-making Process," Armed Forces Comptroller Magazine, Summer 1973, pp. 11-16.

3. Allen Bunger, Capt., USAF, "Spend More-Get More?" Air Force Comptroller Magazine, October 1973, pp. 28-9. Leland G. Jordan, Incentive-Oriented Resource Allocation Systems," Proceedings of the Ninth Meeting of the Southeastern Chapter of the Institute of Management Sciences, October 1973, pp, 87-92.

4. Francis E. Moore and Howard F. Stettler, Accounting Systems for Management Control (Homewood, Illinois: Richard D. Irwin, Inc., 1963), p. 55.

5. Robert N. Anthony, Management Accounting (Homewood, Illinois: Richard D. Irwin, Inc., 1970), p. 493.

6. Robert S. McNamara, The Essence of Security (New York: Harper & Row, 1968), p. 95.

7. Ibid., p. 100.

8. John W. Cooley and Calvin R. Nelson, "The Arrival, Evolution and Prospects of PPBS at the Pentagon," Armed Forces Comptroller Magazine, April 1975, pp. 10-13.

9. Jesse Burkhead, Government Budgeting (New York: John Wiley Sons, 1956), pp. 139-42.

10. Joel E. Ross, Management by Information System (Englewood Cliffs, New Jersey: Prentice-Hall, 1970), pp. 51, 97.

11. Anthony Wilbur, Major, USAF, "A Model for Forecasting Flying Hour Costs" (Offutt AFB, Nebraska: Hq SAC/ ACME, July 1975).

12. Jones, loc. cit.

Contributor

Leland G. Jordan (M.S., Air Force Institute of Technology) is an economist with Headquarters Air Force Cost and Economic Analysis Division. Prior to joining the Air Staff he was Chief, Cost and Economic Analysis Division, DCS Comptroller, Hq SAC. While on active duty Mr. Jordan served at various Air Force bases throughout the world. He is a graduate of Air Command and Staff College and a former contributor to the Review.

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