Chapter 14
Using Basic Budgeting
In This Chapter
Examining the budgeting process
Working out how budgets are created
Understanding the importance of monthly budget reports
Putting internal budget reports to work
No matter how good the numbers look, you don’t know how well a company is doing until you compare the actual numbers with the company’s expectations. Expectations (the budget targets a company hopes to meet) are spelled out during the budgeting process, in which the company projects its financial needs for the next year. At different times throughout the year these budgets are used, along with periodic financial reports, by managers looking to determine how close the company is to meeting its budget targets.
A well-planned budgeting process not only helps a company plan for the next year, but it also provides managers with key information throughout the year to be sure that the company is meeting its goals and raising red flags when it doesn’t reach its goals. The sooner managers recognise a problem, the greater their ability is to fix it before the end of the year. This chapter discusses the budgeting process and how it complements financial reporting.
Peering Into the Budgeting Process
The budget that a company sets for itself relies on a lot of careful calculations – and some guesswork – in order to predict the revenue that can be expected from the sales of products and services during the forthcoming year, and the expenses that will be incurred, including manufacturing and purchase of materials as well as other operating costs. Creating a budget is a lot more complicated than just making a list of expected revenues and expenses. We talk more about the basics of revenue and expenses in Chapters 4 and 7.
Two approaches to budgeting are used:
Top-down approach: Budgets are set by key executives and given to department heads to meet. Most employees are not involved in the budgeting process; instead, the numbers are imposed on the employees by those at the top, and the employees are expected to meet them. The big problem with this type of budget process is that the employees don’t feel any ownership of the budget presented by the executives and frequently complain that the budget handed down to them was unrealistic, which is why they couldn’t meet expectations.
Few large corporations use the top-down approach today. You are more likely to find this approach in small businesses run by one person or a small group of partners.
Bottom-up approach: Budgets are created at the department level based on overall companywide goals and guidelines set by the board of directors and top executives. This approach encourages employee participation in the budgeting process, so the employees have more of a sense of ownership in the budget. Because they helped develop the budget, they can’t later claim that the budget was unrealistic if it turns out that they couldn’t meet expectations.
Most management studies have shown that the bottom-up approach works better because managers and staff members are more likely to take a budget seriously and follow that budget if they have some involvement in developing it. We focus on the process for bottom-up budget development, which is the most commonly used budgeting process in large corporations today.
Working out who does what
Everyone has a role to play in bottom-up budgeting. Top executives who are part of a budget committee set companywide goals and objectives. In some companies, the budget committee may consist of the entire board of directors with other staff seconded. Then, starting at the lowest staff levels, each department determines its budget needs. These budgets work their way through the management tree to the top, where numbers from each department are pulled together to develop a companywide budget.
The budget committee manages the entire process and is responsible for determining budget policies and co-ordinating budget preparation among departments. Usually this committee includes the chairman, chief financial officer (CFO), financial controller, and directors of various functions, such as marketing, sales, production, and purchasing.
Even before the departments start to develop their budgets, the budget committee develops rules that all departments must follow. These rules are likely to include a request to hold all budgets to a certain percentage increase in costs and possibly even a reduction in costs. These guidelines help departments develop budgets that meet company needs while proposing something they can live with throughout the year.
The budget committee doesn’t mandate what the actual departments’ budgets should be or how the departments should find a way to keep their costs down; that decision is left to each individual department. One department might decide it can cut costs by reducing staff; another may determine to cut costs by getting better control of the use of supplies; another might decide that cutting back on the use of rental equipment or temporary help can meet its cost-cutting goals. By leaving these choices to the departments rather than mandating the numbers from the top, companies give employees a stake in meeting their budget goals. After the budgets are developed at the section and department levels, the budget committee gives final approval for all budgets.
The budget committee also resolves any disputes that may arise in the budget process. Budget disputes can occur when different departments have conflicting goals to meet. For example, say the manufacturing department is mandated to cut costs, while the sales department must increase sales to meet its goals. The manufacturing manager may make a decision to cut costs in a way that lowers product-quality standards. However, the sales manager may believe that this cost-cutting method will create problems in maintaining customer satisfaction and damage sales. The budget committee acts as the mediator for this decision-making process.
Setting goals
To develop companywide budget guidelines, the budget committee must first determine the goals for the company. Before they can set those goals, they gather information about where the company stands financially, how the company fits into the bigger economic picture, and how it stacks up against its competitors. This information forms the basis for what the committee determines it needs to accomplish during the next year, such as increasing market share, increasing profit, or entering a new market area completely. Sections and departments can then estimate the resources they need to meet those goals.
The first critical step for goal setting is to develop a sales forecast (a projection of the number of sales the company will make during the year), usually involving the staff of several departments, including marketing, sales, and finance. Much of the data collected by these people is from industry research reports as well as from actual company numbers from the accounting, finance, and marketing departments.
Past sales success: By looking at a breakdown by product of sales for the past three to five years, a company can look for trends and make a best guess about future sales growth potential.
Potential pricing policy: By looking at past sales, companies can determine whether the current pricing policy is viable or whether changes are needed. Products that are moving quickly off the shelves may be able to sustain a price increase, while those that are not moving may need a price cut to stimulate sales. Pricing isn’t set solely by sales success or failure, of course. Costs for producing the product are a key factor as well.
Data about unfilled orders and backlogs: This information helps companies determine which product lines may need to be modified to meet demand.
Market research: This research includes potential sales and competitive data for the entire industry, as well as the forecasts for the individual company. This information lets the committee know where the company fits in the industry and what potential the industry may have in the next year.
Information about general economic conditions: This research gives the budget committee an overview of expected economic conditions for the next year so they know whether there is potential for growth or a possible reduction in sales. For example, if the economy has seen a slowdown during the past three years, but economists are now predicting a market recovery, the company may need to increase manufacturing goals to meet anticipated increasing demand.
Industry economic conditions: A company monitors these conditions to determine whether the industry or industries in which it operates are set for a growth spurt or a downturn or are expected to perform at the same level in the next year.
Industry competition data: Reviews of competitors’ marketing strategies, advertising, and other competitive factors must also be considered when developing future goals in order to stay competitive within the industry. This information must be reviewed to determine where the company sits in relation to its competitors and whether new competitors are on the horizon that could challenge the company’s products.
Market share data: A company collects this data, which is the percentage of the market held by the company’s products and services, to help set goals – whether to increase market share or maintain current levels. Growth potential is dependent on increasing market share, but if a company already holds nearly 100 per cent of the market, like Microsoft more or less does in the operating systems market for personal computers, room for growth may not exist. In that case, marketing strategists focus on tactics for maintaining that market share.
In addition to the hard numbers, information from staff members at all levels of the organisation is collected to get a first-hand view of what is actually happening in the field. This information includes reports about discussions with customers, suppliers, and contractors. Real world data collected from sales staff, customer-service staff, purchasers, and other employees gives a company additional information and allows it to test the numbers collected.
Building Budgets
After the budget committee finishes data collection (see the preceding section), the committee can determine sales goals for the company. After the committee determines goals, it uses them to develop strategies – the actual methods used to reach the goals – and build budgets that reflect the resources needed to carry out the strategies. Although the budget committee sets companywide goals and global strategies, each section and department translates these broad goals and strategies into specific goals and strategies for their own people.
Common budget categories include the following, organised according to the order in which they’re produced:
Sales budget: Sales managers start their budget planning by forecasting sales levels and the gross revenue they anticipate to be generated by these levels. Most other budgets depend on the goals set by sales, so this budget is usually the first to be developed. Without a sales budget, production managers don’t know how many products to produce, and purchasing managers don’t know how many items to buy.
Production budget: If the company manufactures its own product, the next budget to be developed is the production budget. The production department looks at the beginning inventory left over from the previous planning period and then plans what additional inventory is needed, based on the forecasts in the sales budget. Production planning can be a difficult development task. Making sure that they have just the right level of inventory means that production managers must plan for the right amount of raw materials, the efficient use of production facilities, and the appropriate number of staff members to produce the products to meet customer needs on time.
Product purchasing budget: For companies that don’t manufacture their own products, the budgeting process focuses on purchasing needed products and being sure that they’re delivered on time to meet customer needs. Similar issues to those the production team faces drive purchasing concerns because a company wants to be sure it has enough product on hand to meet customer demand. But at the same time, it doesn’t want too many products left over because that means resources were wasted on inventory and could have been better used to meet other company needs.
Direct materials budget: This budget controls the raw materials needed to meet the production schedule. The last problem any company wants to face is not having enough materials on hand to keep the product line moving, thus risking a shutdown of the factory. But the company also wants to avoid keeping too many materials on hand, because doing so increases warehousing expenses. Also, holding raw materials too long can result in material spoilage.
Direct labour budget: The direct labour budget is unique to manufacturing companies and is dependent on the production budget. Companies work hard to determine how much staff they need to meet production needs. If they hire too few people, they have to deal with overtime charges or, in the worst cases, they face production shortfalls. Hire too many people and companies end up spending more than necessary on salaries or have to lay off employees – which is a huge blow to morale.
Selling and administrative expense budgets: Many smaller departments are involved in getting a product or service to market and supporting those sales. These departments include accounting, finance, marketing, human resources, administration, and materials management. After sales revenue is known and the costs of selling those goods have been determined, the remaining resources are divided up among the selling and administrative needs of the company.
Master budget: After everyone signs off on each of the department and section budgets, the accounting department prepares a master budget for the company. The company uses this budget as a road map to test how well each department is doing in meeting its budget expectations.
Cash budget: After all the budgets are completed and combined into a master budget, the accounting department develops a cash budget that estimates the monthly cash needs for each department. Based on this budget, the finance department determines whether enough cash will be generated by operations to meet the cash needs or whether other financing is needed to maintain the company’s cash flow.
When all the budget planning is complete, a budgeted income statement (refer to Chapter 7 for more information on income statements) is developed by the accounting department to test whether the budgeting process has created a budget that truly meets profit-planning goals. If the answer is no, the budget committee then has to decide where budget changes are needed to meet company goals. A lot of negotiating between the budget committee and its top managers is often necessary to determine budget changes.
Providing Monthly Budget Reports
No matter how thoroughly prepared, a budget is useless if it’s not matched to actual revenue and expenses. So throughout the budget period, the accounting department prepares monthly internal financial reports (reports that summarise financial results) for each of the managers who use these reports to identify where the budget is going right or wrong. Many of these internal financial reports have a system of red flags that identify areas where the actual results aren’t meeting budget expectations.
Each company has its own style for internal reports, but most reports include similar types of information. The report is usually broken into five columns:
Red flag: A symbol, such as an asterisk, is usually used in the first or last column to identify problem items in a budget.
Line item: This column lists the budget categories as they appear on the section or department budget.
Budget amount: This column states the amount allocated for the period of the internal financial report.
Actual amount: This column states how much the company actually spent during the period of the internal financial report.
Variance: This column shows how close (or far apart) the actual and budgeted numbers are.
Many companies also include a year-to-date section on internal financial reports that shows the same information on a year-to-date basis in addition to the information specific to the month or quarter.
Figure 14–1 shows an internal report for March 2008 for a fictitious company called the ABC Company. In this example, a flag appears automatically on the report if the variance is greater than £100,000, but in real life, each company determines its own designated levels for red flags. A small company may flag items for a variation of just £5,000, and a large corporation may flag items for variations at much higher levels. An alternative approach to variances is to set a percentage variance above which the red flag applies.
|
Figure 14–1: A sample income statement. |
|
Although Figure 14–1 uses an income statement format, internal reports have no required format, and each company develops its own report format depending on what works best for the company.
In Figure 14–1, you can see that flags have been marked next to Sales, Gross Margin, and Net Income. Flags were thrown because those line items show differences of more than £100,000, and therefore, need to be investigated by management.
A glance at Figure 14–1 shows that the key problem is lower-than-expected sales revenue. Sales were budgeted for £1.4 million, and the actual sales were £200,000 less at £1.2 million. That difference is shown on the first line of the internal report. Management first needs to determine why sales are lower than forecast and then develop strategies for correcting the problem. Given the fact that cost of goods sold and administrative expenses are lower than budgeted, this could be a sign that management recognised the problem after a previous month’s report and had already initiated cost-cutting programmes.
After looking at the report in Figure 14–1, managers have to determine what the problem is and what other changes may be needed to get the budget back in line. If external factors, such as economic conditions, are to blame, the best the company can do is revise the budget to meet current economic conditions so that further slippage in net income can be avoided.
If conditions change from expectations, companies can more easily make a mid-year correction if budgets have been accurately prepared. The company knows what was expected, and it can tweak its revenues or expenses to correct a problem long before the shortfall becomes disastrous for the company.
In Chapter 17, we talk about strategies companies use to keep cash flowing when internal financial reports don’t meet expectations.
Using Internal Reports
Inside your company, you probably see much more detailed reports than the sample in Figure 14–1. A department head sees only the budget line items related to his or her department, and only the board, budget committee, and departments responsible for developing budget reports have access to companywide internal reports.
The internal financial report you receive as a manager is usually based on the budget you developed. The line items listed are those directly related to your department functions. Any line item whose difference exceeds those allowed by the company is flagged, and you need to find out why. Sometimes, the answer is clear. For example, if you know sales were higher or lower than expected, you simply need to report why and what you are doing to correct any problems. At other times, the answer will require some digging on your part.
After a report arrives at your office, you don’t have much time to figure out what the variances are and what they mean for your department. If the differences are big, you can probably expect a call from your manager as soon as she or he sees a copy. When one of the authors of this book was managing the finances for five departments, she knew that she could expect a call from her manager even before her manager had received her copy of the report. An entire day’s activities could be changed if a major variance showed up on an internal financial report, and she had to find out why.
Your best bet is to keep a good working relationship with someone in the accounting department who can help you sort through the details. Hopefully, you’ll find that the variance was solely based on a coding error, and the revenue or expense was just put in the wrong place. When that’s not the case, you’ll have to come up with some solution to correct the problem rather quickly.