Business Budgeting Article

Written by Drew Coles, member of the chartered institute of Management Accountants.

Why should a business produce a budget? The main purpose of a budget is to help control the organisation and achieve its goals in the coming year. If the budget is set correctly it will be a powerful tool to check performance against actual results using variance analysis on a monthly, quarterly and annual basis. The budget is also used as a communication device to convey the objectives of the company to employees and to relay feedback when results are not as expected.

Starting the budget

A good place to start is to gather information for the current financial year. The future budgeted financial year will need to be produced before the current year end ends therefore it is important to build an idea of sales, purchases, operations variances to this year’s budget. This information can be gathered from discussions with managers about forecasts, results, targets and from previous year’s results, the current budget, financial forecast and financial statements. It will also be worth having discussions with the sales team to devise the outlook for the next year.

New companies

Before moving onto established businesses, it is worth noting that new companies will need to forecast their first budget based on several assumptions such as:
1. Sales forecasts
2. Competitor benchmarking
3. Expert predictions
4. Production and purchase forecasts based on the number of sales
5. Capital purchases forecast based on production
6. Human resource forecasting based on production
Once these assumptions are made the company can put together the figures for their budget. This is essentially the same process as zero-based budgeting which I will go into more detail about later.

Types of budgets

There are several approaches to budgeting which a business can adopt. The most important aspects to consider when deciding on approach is the company size, time to produce and the cost of producing the budget all of which will differ depending on the budgeting method used. Some of the most widely used methods can be found below

Zero Based budgeting

With zero based budgeting each year the company produces the budget from scratch based on previous experience, results and forecasts. This has the benefit of reducing budgetary slack and eradicating unnecessary expenditure. The issue is it is time exhaustive and therefore increases costs in preparation.
Incremental – Incremental is a simple technique widely used in business today. An incremental percentage will be added to last year’s financial results. This budget is of course quick and simple to produce but lacks real insights. There is also the issue of building on the previous year’s unnecessary costs and budgetary slack.

Activity Based budgeting

This budget is driven by the company’s activities where the costs are allocated to cost pools and absorbed in the organisation’s products through cost drivers. ABB is notoriously labour intensive to set up but once established can provide the company with great insights on what is driving the operations costs.

Rolling budgets

A rolling budget has the advantage that it is constantly updating and adding a further year onto the budget and therefore being updated based on actual results. This is another budgeting strategy which is time intensive but has the advantage of being more accurate than the incremental budget mentioned above.

Combining budgeting methods

One of the most common ways to produce the budget is to combine the methods. For instance, certain aspects of the budget can be incremental such as costs which stay fixed despite some inflation and are assumed as low risk. Other cost areas may need a zero-based approach. These may be cost pools which vary from year to year or the company sees as a high risk of producing unnecessary expenditure.

Number of different budgets

The types of budgets include and are not limited to:
Sales, purchase, operations, Human resource and master budget. These need to be created in order as they lead onto each other. For instance, the sales budget will be used to produce the operational budget which will then lead to the creation of the purchase budget.
The number of budgets required also depends on the company size with smaller companies only needing one master budget because of the smaller scale of the organisation.

Forecasting for the next year

One of the most important aspects of producing the budget is forecasting. The budget needs to be prepared on a solid forecast to produce the most realistic outcome for the next financial year. There is always the chance that the forecast will not be as expected.
Tools in forecasting
1. Previous year results – Previous year and current year results will provide a basis for the business which can be followed onto the next financial year.
2. Time series analysis – The assumption that what has happened in the past can be forecast into the future. Time series analysis uses the figures from the previous x number of years to produce a forecast for the future.
3. Qualitative techniques – These techniques consider the view of experts, government forecasts and consumers in forecasting company sales and inflation on purchases.
4. Pushing techniques – The company can push the forecast to include a larger portion of the market share. For instance, the company may hold a 2% market share and wants to push this in the next financial year to 4% this will be the basis of the forecast to be included in the budget.

Performance measurement

Once the figures are generated in the budget it should be expanded slightly to allow for performance measurement.
Key performance indicators
Key performance indicators (KPI’s) should be set and used to judge against actual performance. These should be based on the critical success factors of the business. These may include but are not limited to the following:
Profitability KPI’s
1) Gross profit margin
2) Operating profit margins
3) Departmental profit margins
4) Return on capital employed
5) Return on investment
Quality KPI’s (checked against total production)
1) Number of components returned
2) Number of internal failures
3) Number of external failures
4) Appraisal and prevention costs as percentage against total quality spend
Human resource KPI’s
1) Employee turnover
2) Number of training courses completed
The key performance indicators will allow the business to check against actual performance quickly in variance analysis per month, quarter and annually.

Balanced scorecards – to set non-financial performance indicators

In order to aid the development of Key performance indicators the balanced scorecard can be a powerful tool. The scorecard looks at four different perspectives in the business to ensure the key performance indicators are set balanced and are aligned with the organisation’s critical success factors, this ultimately ensures not only a financial perspective but an overall organisational view.
The perspectives of the balanced scorecard are:
· Financial
· Customer
· Education and Growth
· Internal processes

Time periods

As mentioned above the budget should be compared against actual performance every month, quarter and annually to ensure the business is performing as expected. This approach allows the business sufficient time to change future results for instance, if poor performance is found in the first months of the financial year.

Controllable and non-controllable variables

When it comes to analysing actual performance to the budget it is important to understand the controllable and non-controllable costs. Managers and budget holders should only be judged on the performance of controllable costs. For example, non-controllable costs could be an apportion of a business shared service centre and controllable costs are more likely to be direct variable purchases.

Flexing the budget

When analysing performance flexing the budget is extremely important to ensure a like for like comparison of results. It is likely the actual results will differ from the forecast therefore the budget should be flexed to produce a like for like comparison of number of units sold and produced. This will then allow for a true comparison.

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