BUDGETING

Many organizations prepare budgets that they use as a method of comparison when evaluating their actual results over the next year. The process of preparing a budget should be highly regimented and follow a set schedule, so that the completed budget is ready for use by the beginning of the next fiscal year. Here are the basic steps to follow when preparing a budget: Update budget assumptions.  Review the assumptions about the company's business environment that were used as the basis for the last budget, and update as necessary. Review bottlenecks. Determine the capacity level of the primary bottleneck that is constraining the company from generating further sales, and define how this will impact any additional company revenue growth. Available funding. Determine the most likely amount of funding that will be available during the budget period, which may limit growth plans. Step costing points. Determine whether any step costs will be incurred during the likely range of business activity in the upcoming budget period, and define the amount of these costs and at what activity levels they will be incurred. Create budget package. Copy forward the basic budgeting instructions from the instruction packet used in the preceding year. Update it by including the year-to-date actual expenses incurred in the current year, and also annualize this information for the full current year. Add a commentary to the packet, stating step costing information, bottlenecks, and expected funding limitations for the upcoming budget year. Issue budget package. Issue the budget package personally, where possible, and answer any questions from recipients. Also state the due date for the first draft of the budget package. Obtain revenue forecast. Obtain the revenue forecast from the sales manager, validate it with the CEO, and then distribute it to the other department managers. They use the revenue information as the basis for developing their own budgets. Obtain department budgets. Obtain the budgets from all departments, check for errors, and compare to the bottleneck, funding, and step costing constraints. Adjust the budgets as necessary. Obtain capital budget requests. Validate all capital budget requests and forward them to the senior management team with comments and recommendations. Update the budget model. Input all budget information into the master budget model. Review the budget. Meet with the senior management team to review the budget. Highlight possible constraint issues, and any limitations caused by funding limitations. Note all comments made by the management team, and forward this information back to the budget originators, with requests to modify their budgets. Process budget iterations. Track outstanding budget change requests, and update the budget model with new iterations as they arrive. Issue the budget. Create a bound version of the budget and distribute it to all authorized recipients. Load the budget. Load the budget information into the financial software, so that you can generate budget versus actual reports. The number of steps noted here may be excessive for a smaller business, where perhaps just one person is involved in the process. If so, the number of steps can be greatly compressed, to the point where a preliminary budget can possibly be prepared in a day or two. Related Topics How many budget scenarios should I prepare? Should I use a rolling forecast? What are the objectives of budgeting? What is continuous budgeting? What is incremental budgeting? What is participative budgeting? OBJECTIVES OF BUDGETING Many companies go through the budgeting process every year simply because they did it the year before, but they do not know why they continue to create new budgets. What are the objectives of budgeting? They are: Provide structure. A budget is especially useful for giving a company guidance regarding the direction in which it is supposed to be going. Thus, it forms the basis for planning what to do next. A CEO would be well advised to impose a budget on a company that does not have a good sense of direction. Of course, a budget will not provide much structure if the CEO promptly files away the budget and does not review it again until the next year. A budget only provides a significant amount of structure when management refers to it constantly, and judges employee performance based on the expectations outlined within it. Predict cash flows. A budget is extremely useful in companies that are growing rapidly, that have seasonal sales, or which have irregular sales patterns. These companies have a difficult time estimating how much cash they are likely to have in the near term, which results in periodic cash-related crises. A budget is useful for predicting cash flows, but yields increasingly unreliable results further into the future. Thus, providing a view of cash flows is only a reasonable budgeting objective if it covers the next few months of the budget. Allocate resources. Some companies use the budgeting process as a tool for deciding where to allocate funds to various activities, such as fixed asset purchases. Though a valid objective, it should be combined with capacity constraint analysis (which is more of an industrial engineering function than a financial function) to determine where resources should really be allocated. Model scenarios. If a company is faced with a number of possible paths down which it can travel, you can create a set of budgets, each based on different scenarios, to estimate the financial results of each strategic direction. Though useful, this objective can result in highly unlikely results if management lets itself become overly optimistic in inputting assumptions into the budget model. Measure performance. A common objective in creating a budget is to use it as the basis for judging employee performance, through the use of variances from the budget. This is a treacherous objective, since employees attempt to modify the budget to make their personal objectives easier to achieve (known as budgetary slack). Conversely, budgeting may not be of much use for a well-established business that has a consistent track record of performance. In this case, a better approach may be to manage the organization from a rolling forecast that is updated on a regular basis. Doing so reduces the work associated with financial predictions, and also allows the business to shift its operational focus on short notice. WHAT IS A BUDGET A budget forecasts the financial results and financial position of a company for one or more future periods.  A budget is used for planning and performance measurement purposes, which can involve spending for fixed assets, rolling out new products, training employees, setting up bonus plans, controlling operations, and so forth. At the most minimal level, a budget contains an estimated income statement for future periods. A more complex budget contains a sales forecast, the cost of goods sold and expenditures needed to support the projected sales, estimates of working capital requirements, fixed asset purchases, a cash flow forecast, and an estimate of financing needs. This should be constructed in a top-down format, so a master budget contains a summary of the entire budget document, while separate documents containing supporting budgets roll up into the master budget, and provide additional detail to users. Many budgets are prepared on electronic spreadsheets, though larger businesses prefer to use budget-specific software that is more structured and so is less liable to contain computational errors. A prime use of the budget is as a performance baseline for the measurement of actual results. It can be misleading to do so, since budgets typically become increasingly inaccurate over time, resulting in large variances that have no basis in actual results. To reduce this problem, some companies periodically revise their budgets to keep them closer to reality, or only budget for a few periods into the future, which gives the same result. Another option that sidesteps budgeting problems is to operate without a budget. Doing so requires an ongoing short-term forecast from which business decisions can be made, as well as performance measurements based on what a peer group is achieving. Though operating without a budget can at first appear to be too slipshod to be effective, the systems that replace a budget can be remarkably effective. Related Topics What is a flexible budget? What is a rolling budget? What is a static budget? What is continuous budgeting? Participative budget