Budgeting Demystified

The Role of Budgeting
A budget is a quantitative expression of the organization’s business plan and strategic goals. The budget turns the words of the plan into dollars and allows the organization to evaluate the feasibility of the plan and make adjustments as necessary. The budget also allows the organization to project its financial performance for the upcoming year.

During the year, performance is measured against the budget and adjustments are made as necessary. The budget, in effect, becomes the financial road map for the business.
It is important to remember, though, that the budget is not the end result; rather, it is a means for achieving the end result, namely, the organization’s goals. At times, the organization may need to deviate from the plan to achieve its goals.

Types of Budgets
From a managerial perspective, budgets fall into two major types:

  • Capital Budget: the organization considers the various investments it could make and whether each investment will produce a return that more than covers the firm’s cost of money.
  • Operating Budget: the organization plans its operation in a particular line of business. It then can monitor results as compared to the plan and expose the various differences that may warrant corrective measures.

The Budgeting Process
A budget is the organization’s business plan spelled out in numbers. Budgeting creates a “shadow” accounting system, operating in parallel with the “real” one used for reporting to outsiders. Each of the following areas is projected month by month and then “rolled up” into the budget for the full year.

The budgeting process involves the following steps:

Sales/Revenue Forecast—Gives the dollars and sometimes units in sales that the organization believes is most likely. This figure is based on accrual accounting and does not reflect what the organization expects to collect in the period.

  • Production and Expense Budgets—Describe the expenses the organization expects to incur during the period. These include the cost of buying or making the product that will be sold or the cost of providing service to the customers, sales and marketing expenses, depreciation expense, and all of the general and administrative expenses of the business. Again, these figures are based on accrual accounting and do not reflect the checks that will be written in the period.

  • Pro Forma Income Statement—Combines the sales forecast and production and expense budgets and allows the organization to predict what its anticipated profit or loss will be.

  • Capital Budget—Projects what the organization expects to spend on capital projects. It affects the sales forecast and expense budgets through any changes to revenues based on capital projects and additional operating costs and depreciation incurred by those projects. The overall amount of the capital budget is affected by the operating cash flow the business expects to generate and the amount of financing it expects to raise from outside sources.

  • Cash Flow Projection—States what the organization expects to collect each period from customers and other sources and the checks that it expects to write. For example, while costs such as taxes, insurance, and bond interest would be “spread” on the expense budgets and income statement, here they are placed in the month they actually occur.

  • Pro Forma Balance Sheet—Essentially a projection of what the organization believes its balance sheet will look like based on the projections above. The ratios discussed earlier in the course can be used to help make the projections. For example, once the sales forecast is made, the target DSO can be used to project the level of receivables the organization should carry. And once there is a projection for cost of goods sold, the target turnover rate can be used to project the amount of inventory the firm should carry.

Thus, the budgeting process yields a complete set of projected financial statements. Besides, the various budgets are all interdependent. This means that any change in any one assumption (e.g., sales or an expense) will create a “ripple” effect across all the financial statements. Linking the components on a spreadsheet program or through specialized budgeting software allows the impact of changes to be more easily incorporated throughout the budget.

Identifying and Resolving Budgeting Variances
Usually, the amount budgeted differs from what actually occurs. The difference is called a budget variance. What are some reasons for budget variances? When and how might a manager attempt to compensate for these variances?

Budgeting for Contingencies
Because the budgeting process is so complex, many organizations start budgeting months before years’ end. As a result, a manager may be budgeting for events 16 to18 months away. The longer the time frame, the greater the risk. For this reason it may be desirable to do some contingency planning when preparing the budget.

Typically, a manager does this by first identifying factors that might cause changes to the revenue forecast during the year—then determining what changes might be made to the budget. For example, if revenues are below forecast, managers may be asked to cut their budgets. Identifying, ahead of time, areas where the budget could be cut with the least possible damage is only prudent. It is advisable to organize possible budget changes by quarter as most organizations reassess their budgets quarterly.

Budgeting Systems in Use Today
Unlike the basic accounting process, budgeting is not governed by rules set by any authorities. Thus, organizations, with the exception of government entities, can generally use whatever system works best to aid in analysis and decision making.

  • Zero-Based Budgeting (ZBB)
    With zero-base budgeting, no expenditure is taken for granted. Each outlay must be justified. This encourages managers to “think outside the box” and not simply add a percent to last year’s expenses. Managers are encouraged to identify the best possible ways to use organizational resources and consider the benefits of various expense alternatives. Existing expenses may be discontinued and new ones added. A zero-base approach is especially useful where there are a variety of methods available to achieve objectives (e.g., the “make or buy” decision). The drawback of this method is that it can become extremely bureaucratic. Also, because some expenditures are essential, time is spent “justifying” obvious outlays.

  • Responsibility Budgeting
    Here, the various areas of an organization are grouped into departments, or even profit  centers or cost centers. Profit centers generally receive revenue from outside the  organization, and cost centers provide services to other parts of the organization. Profit  centers are sometimes called business units or strategic business units (SBUs).  Profit centers and other areas are “charged” for services performed for them by other areas of the organization. This method measures not merely efficiency but also the total costs of running various areas. It shows which profit centers are most profitable. It can help managers to make better “make or buy” decisions or use corporate services more wisely. However, managers need to pay careful attention to the costs allocated to their areas. Allocations may be inaccurate and may not reflect the actual use of the resource.

    A cost center’s responsibility is to provide high-quality services to other areas at a reasonable cost. Although their costs may be charged to other areas, the manager of the cost center is still accountable for managing the costs within the unit.
    Some drawbacks are that the allocation process is somewhat subjective, the internal billing is time-consuming, politically charged, and managers may avoid “buying” services they need just to “save” money.

  • Incremental Budgeting
    In an incremental budget, managers are only required to justify those expenses over and above a pre-established limit, usually defined as a percent change (e.g., 5%), an absolute  dollar increase (e.g., $3,000), or both (e.g., 5% and $4,000) from a base level. The base level can be as the budget, the current year projected actuals or some other reasonable basis. An incremental budget greatly simplifies the budgeting process. By focusing on major deviations to the established limits, management does not review each budgeted item in detail. Incremental budgeting, however, has a major disadvantage, particularly in a continuous improvement environment. This type of budget implicitly accepts that costs will increase from year to year and does not force managers to evaluate what resources they have, how they are being used, and how they support the business strategies. Managers who adopt this preparation method should ensure that it is consistent with the culture and strategic direction of the organization.

  • Flexible Budgeting
    The flexible budget adjusts budgeted costs to reflect actual volume levels. It accurately measures performance by comparing actual costs for a given volume level with the budgeted costs for the same volume level. A flexible budget requires the identification of fixed and variable costs. It adjusts the budgeted costs by changing the total variable costs according to the actual volumes attained. The flexible budget is dynamic and can be used to develop budgets at different levels of activity.

  • Rolling Budgeting
    One of the reasons many budgets are inaccurate is the “time lag” factor. An organization operating on a calendar year may begin budgeting in June or July for the following year. As a result, the organization is looking eighteen months into the future. With a rolling budget, companies obtain a dynamic view of the business. The rolling budget adds a new budget period as the period just ended is dropped. At the end of the first quarter, a manager would update the remaining three quarters and budget a fourth quarter to replace the one just ended. A continuous budget is prepared for a specific time horizon, usually one or two years, either in monthly or quarterly buckets. The major advantage of this budgeting system is that it forces managers to plan the future regardless of the accounting period at hand. It recognizes that the business environment is dynamic and that plans must be updated periodically to reflect change. Therefore, it allows managers to incorporate changes to the business in an organized manner.

  • Activity-Based Budgeting
    Activity-based budgeting is closely linked to activity-based costing. With this system of budgeting, a department identifies the primary activities that it performs and then determines the resources and costs needed to perform those activities. This system has the advantage of focusing on the work a department does—not simply standard accounts such as salaries, benefits, travel, and so forth. It also allows a department to demonstrate the value it provides to the organization. Of course, not all costs are tied to specific activities. Nor does it make sense to cost out in detail activities that occur infrequently. Also, costs must still be allocated to standard accounts, such as salaries, benefits, and so forth.

Tips and Techniques for Budgeting More Successfully

  • Budget for contingencies and unforeseen events.
  • Understand the organizational dynamics when budgeting.
  • Find out in advance any assumptions that should be made, such as a standard inflation increase, hiring limitations, or a forecasted revenue increase.
  • Find out if expenses that vary from month to month should be placed in the month they are anticipated or spread evenly. For example, if $6,000,000 will be spent on a spring ad campaign and $6,000,000 on a fall campaign, should you budget $1,000,000 a month or place the expenditures in the months they will be incurred?
  • Communication is one key to budgeting success. When your budget is affected by other departments’ needs or activities, talk to them and document the information you receive.
  • If the current list of account codes doesn’t meet your needs, ask accounting if new codes can be added or existing ones subdivided into more meaningful categories.

Summary

  • The budget quantifies the organization’s business plan and objectives and provides a “road map” for monitoring financial performance.
  • The budgeting process generates a complete set of projected financial statements.
  • Because budgeting is not part of GAAP and is difficult to do well, many different systems of budgeting exist. Often organizations develop a hybrid approach to budgeting, selecting those features of each system which best meet their needs.
  • Comparing actual performance against budgeted allows the organization to see how closely the plan is being followed and to make appropriate adjustments. The manager should focus on significant variances and consider areas that are under budget, as well as those that are over budget.
  • Activity-based budgeting helps a department determine the cost of performing its various functions and identify ways to improve performance.

The information in this article was adapted from AMA’s best-selling seminar “Fundamentals of Finance and Accounting for Nonfinancial Managers.”


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