Respond to a Scenario

Accounting There are several potential reasons for a decline in profits under this scenario. First, there is the cost of goods sold. Even if operating costs are being held in line, the gross margin could be declining. That would result in a reduction of profit. There are other items that could be part of the problem as well. These include writedowns on bad acquisitions or a higher tax rate.

Basically any item that is one the income statement but not part of the operating costs that Sally is looking at could be a contributing factor to a reduction in profits. One also has to consider what the phrase "met in terms of the budget" actually means. This depends on how the budget was created. There are a number of different forecasting methods, including incremental budgeting, zero-based budgeting, and flexed budgeting (Victor, 2013). The choice of budget methodology will affect whether being on budget is relevant to maintaining profits.

For example, Sally Supervisor is clearly thinking that the budget is set using the same cost percentages as the prior year. So she is thinking that if administrative expense was 14% of revenues last year that the budget had it at 14% this year. If that was the case, and was applied to everything from cost of goods sold to taxes, then the profit should go up. But that is a simplistic budget model and chances are that the company has used a different model.

Additionally, we could have sold part of our business, or acquired another business. Acquisitions are likely to mess with performance, especially if they were not built into the budget that you are using as a comparable. Discontinued operations are usually listed as an exceptional item on the income statement, rather than in the regular expenses and revenues. If the budget was set in a different way, for example using the incremental method, costs could potentially be rising faster than the profits.

So she would need to look at how the budget was created to see if that was a possible contributor to this apparent disconnect. It is entirely possible that the budget creation method is the reason for this. Sally also needs to realize that she is using two different benchmarks here, which really does not make sense. She is evaluating the costs against the budget but she is evaluating the profits against the prior year's performance.

Intuitively, one would have to think that this does not make a whole lot of sense. She needs to compare apples to apples and oranges to oranges. Thus, it is not a question of whether profit is lower than last year, it is a question of whether profit is lower than the budgeted profit. Like to like comparisons are always smarter. She could also simply compare actual costs to last year's.

Again, though, it does not make much sense to compare costs against the budget and then compare profits against last year since the two are not the same. A disconnect is easy to create when there is only a loose connection between the things she is comparing together. Of course, it is easier to figure out what is.