THE FINANCIAL STATEMENTS
KEY FINANCIAL INDICATORS
ACCOUNTING ISSUES
WHAT-IF ... SENSITIVITY MODELS
TIMING MATTERS
JUSTIFYING INVESTMENT
SCORECARDS AND VALUE MANAGEMENT

Budgets

A budget is a detailed projection of future income, expenses and / or investment. It provides a framework to achieve the organisation’s objectives, ensuring funds are properly allocated in line with strategy. The ambit of a budget may be based on product, market, department, location and so on. There is no standard budget structure – it depends on the needs of the organisation. A consolidated, master budget will bring all the budgets and, in theory, balance the needs of the various parts of the organisation, manage the flow of money over time and orchestrate action.

In practice the budgeting process can often develop into a power struggle and a battle of wits. It can become political with the result that people lose sight of the end goal. Operational managers become frustrated and disillusioned. They sense a disconnect between senior management words (“customer service is our top priority”) and budget allocation (reducing spend on call centres). As time moves on, managers can feel constrained and unable to respond to changing circumstances. And then there is the ridiculous end of year dash to spend what remains of the budget so that the following year’s budget is not cut.

I think that sometimes the dissatisfaction with budgeting comes from a disconnect between actions and numbers. The budgeting process can often begin with a directive to managers to, “cut costs by 10%”. This can appear arbitrary and unrelated to the needs of the business. Of course, managers are not always aware of the thinking that may have gone on at higher levels but then this reflects a failure to communicate.

Like most things in life budgets are a compromise. Although they are restrictive they also provide many benefits:

  • enable the organisation to secure funding.
  • give resource certainty for managers
  • if things don’t go as planned they provide a variance check
  • focus managers on financial performance
  • help to identify bottlenecks and constraints

In a small organisation the budgeting approach is likely to be based on the type of sensitivity analysis that we will cover in a later module. In essence, the ‘master’ budget is the best guess or most likely scenario. By duplicating the budget spreadsheet and removing the forecast figures, we can create an ‘Actual’ spreadsheet which is updated over time with the actual figures from the accounts. Duplicating a third time, we create a ‘Variance’ spreadsheet which captures the difference between our forecast and actual performance, alerting us to areas that may need attention.

The same fundamental principles apply in larger organisations with a larger cast of characters involved. The master budget is a consolidation of a number of components, which themselves may be subdivided. A typical budgetary structure may comprise the following components: sales, production, direct materials, labour, production overheads, sales general and administrative (SG&A). There will also be a cash budget and forecast financial statements – just like our sensitivity model.

Advances in technology mean that companies have at their disposal much more real-time information. This allows companies to adopt a more flexible approach to budgeting. Thus if sales exceed expectations, the materials budget ought to be increased, together with, possibly, the budget for customer service staff salaries, distribution, production and so on. And, naturally, vice versa; a downward adjustment when things don’t go so well.

In managing budgets there are varying degrees of responsibility:

  • cost centre – here there is a lack of control over revenue generation. Into this category fall areas such as human resources, accounting and administration.
  • profit centre – valuation here encompasses both revenues and costs. A branch sales office may fall into this group.
  • investment centre – at higher levels a manager may also be responsible for funding and capital purchase decisions.

Before moving on we should emphasise that a manager with budgetary responsibility should not only be managing the financial numbers. They also need to be aware of the impact of, for instance, customer satisfaction on sales, culture and motivation on labour turnover and efficient processes on reducing wastage. Non-financial metrics can be if just as important since they provide insight into the drivers of performance, often acting as an early warning system.