Budgets Overview
Long-term planning
is essential for both for-profit and not-for-profit organizations. A strategic plan establishes an
organization’s overall goals and objectives and charts a course of action for achieving those objectives over a period of
time. Detailed financial plans and
budgets are developed to provide a road map to accomplish the goals of the strategic plan.
Budgeting
formalizes and quantifies management’s long-term plans, goals and objectives covering all aspects of the business’s
operation. The budget not only expresses the
organization’s plan but also provides guidance and coordination on what
to do to meet the plan. Budgeting
enables coordination and collaboration between operating units. It provides a measure against which to judge
performance and a means to motivate that performance.
In addition, budgets are used in most organizations in the management of incentive compensation plans (e.g.,
bonuses, equity, etc.).
Part II discusses
the process of creating forecasts and projections. There you will learn that forecasting quantifies the future
by:
●
Analyzing historical data
●
Analyzing the present environment
●
Defining and testing assumptions
As part of the
regular planning and budgeting cycle, financial statement projections are created using the forecasting process.
What you need to know now is that when financial statement projections are produced with the intention of
creating a budget, management’s goals
are factored in. When management identifies a forecast (which includes their
goals) as the official plan, it
becomes the budget. Budgets are a final output of a forecasting process. Budgets provide organizations
with a focus of what the financial goals are and what needs to be done to achieve the goals, and they document
actions required to deliver on the
goals.
Budgets
communicate management expectations down to the departmental level. They provide
clear guidance on what each department needs
to do to be a part of achieving the
organization’s
overarching goals. This means that every manager in every department knows what he or she needs to do.
Budgets typically
cover periods ranging from one month to two years; long-range financial plans extend the process out many years.
Most organizations use a detailed annual budget
for planning and control purposes. The annual budget provides specific details underlying the first year of the
long-range plan. It usually is organized further into shorter time divisions, such as months or
quarters. An annual budget for an entire organization is called the master budget.
Budgeting Process
These are the main steps in a
typical budgeting cycle:
● The forecasting process is used to create iterative versions of financial forecasts, reflecting management’s financial goals for the period.
● Management sets the budget expectations by formalizing the final forecast.
● Specific, detailed budget
expectations are communicated to subordinate
managers.
● Variance from the budget
expectations is analyzed on an ongoing basis and adjustments to operations are made if possible or necessary.
● Feedback and results are
gathered for the next round of forecasting and
budgeting.
The first step in
the budgeting cycle can be driven from the top down or the bottom up. Senior management can lay out the specific
results that divisions must meet, or, more commonly,
they can lay out high-level expectations and allow the line managers to decide the specifics of how to meet them. In
this case, each department identifies what it needs to meet the high-level expectations.
These top-down or
the bottom-up collaborations almost always result in a gap between management expectations and what line
managers believe they need to meet those expectations.
For example, say the high-level
expectations are
a five percent increase in sales and improved profitability. Each department would quantify what resources
they need to meet the five percent increase in
sales, holding their costs as low as possible. When the individual
results are rolled up into the
total, most likely the goal of improving profitability won’t be met. The
FP&A professional contributes to
the expectation-setting process by suggesting solutions to close this gap. These could be to hold
hiring in certain areas, use consultants rather than
permanent
employees, etc. Generally these solutions must be complex and refined since there is a dynamic balance between costs
and sales.
One common method
of creating the forecast/budget is to start with business-as-usual (BAU) financial results. To this, management’s
high- level expectations are added. Let’s return
to our example of a high-level expectation of a five percent increase in sales
while improving profitability. For
some organizations, some increase in sales will occur without any changes to the operations. But to achieve a five percent increase,
FP&A professionals
creating the forecast will begin to overlay discrete assumptions to the BAU in the model to meet the five percent
goal. These assumptions may be new products, new customers, price changes or other initiatives. These overlays
help close the gap between what will
happen without business changes and the expressed objectives. The initiatives overlaid in this way not only close the
gap but also document how the management expectation
is going to be met. This allows FP&A to track performance against each overlay, making variance analysis easier
and more targeted.
Once any gaps
have been closed and management is satisfied with the forecast, it is published as the budget and its details
are communicated down to the departmental managers.
After the budgeted period, FP&A analyzes the variances from budget to
actual and begins work on the next
round of forecasting and budgeting.
What follows here is a
high-level summary of the forecasting steps specific to budgeting.
To begin the
budget cycle, the master budget is developed. The master budget for an organization has two main components: the operating budget
and the financial budget.
Constructing the Operating
Budget
The operating budget
is also known as the profit plan. It is focused on day-to-day operations and is constructed from the
sales budget and the expenses necessary to
support the budgeted sales. There are two main steps to constructing an
operating budget:
● Step
1—Develop the sales budget. Because the costs that must be
budgeted depend upon the expected
sales level, the first step in developing an operating budget is to generate a sales budget. If
management has a specific goal for sales results, it is
factored in here.
● Step
2—Develop the production, purchases and operating expense budgets. The expenses necessary to support
operations for the expected sales volume are
forecasted after the sales budget is established.
Constructing the Financial
Budget
The second part
of a master budget is the financial budget. This budget addresses the organization’s financing and investing
activities. It includes a capital budget, a cash budget and a plan for financing the cash needs. There are three main
steps to constructing a financing
budget:
● Step
1—Develop the capital budget. The capital budget details the
forecasted costs of expected
investments. Capital investments may be necessary to acquire new facilities, replace aging or obsolete
equipment, or initiate longer-term projects required under the long- range plan.
● FP&A professionals may
have involvement in analyzing potential capital investments before they become a part of the long-term
strategic plan.
● Step
2—Develop the cash budget. The cash budget translates information from the operating and capital budgets into
sources and uses of cash.
● If the cash budget projects
a surplus, then management must decide whether to use the cash for future investments, pay down debt, distribute
cash to shareholders through
dividends or increase the share price through stock repurchases. These decisions can be reflected in the budget
through the iterative process of creating and
refining the budget. If the cash budget projects a deficit, then
management must decide how to
finance the deficit and/or reduce costs.
● Step
3—Identify financing sources. The final step in constructing a
financial budget is to identify
financing sources for any forecasted cash needs.
When combined,
the operating and financial budgets form the master budget, which constitutes a set of pro forma financial
statements for the budget period.
Types of Budgets and Their Uses
Budgets are used
for various purposes, but most are used for either planning or control-related purposes. Budgets
discipline managers to plan and assess what resources
are needed and how they will be funded. Because managers often are evaluated based on their ability to manage
their budgets within plan, the budgeting process also requires managers
to anticipate changing
conditions and contingencies.
Another use of
budgets is resource allocation. All organizations encounter constraints on their resources. Budgets
are enlisted to assist in allocation decisions. For example, local,
state and federal government agencies use budgets to allocate funds
raised from taxes and other sources
as well as provide the requisite authority for the use of funds.
Finally, a budget
serves as a communication and coordination tool, informing all areas of an organization of each department’s
plans during a given budget period.
While the
planning aspects of budgeting are forward-looking, the control aspects of budgeting are retrospective. A budget
serves as the primary benchmark against which
actual results are compared. Any difference between actual results and
the budgeted figure is called a
variance. The process of identifying and analyzing budget variances is referred to as variance analysis.
FP&A professional are often involved in or responsible for variance analysis.
Small variances
are inevitable in the course of running a business. Large variances, however, may be an early indication of
more serious problems, such as changes in economic
conditions, the competitive environment or customer buying patterns.
Variances also
may indicate a flaw in the forecasting method used. A company’s optimal performance can be maintained only if
the causes of the variances are identified and
addressed quickly and effectively.
Budgets are
created in a variety of ways and to provide information for a variety of purposes. Some examples of types of
budgets are:
● Fixed
Period Budgets. The master budget previously discussed is generally a fixed annual budget. Annual budgets are
broken into smaller time periods, such as quarters
or months, to assist in planning and control. In addition, budget periods can
be chosen based on what is being
monitored and controlled. For example, if a new product is being monitored, the budget period can
be based on a logical time period to cover the
product rollout and return on the original
investment or any other time period management finds useful.
Usually fixed
period budgets are developed with the prior year’s data as a starting point. Another way to develop fixed period
budgets it to create them from scratch, without using any prior period data. These are called zero-based budgets.
Most budgets are
static plans that are frozen or fixed as a frame of reference to help manage the organization. Static budgets
can encourage management to look at budget periods
in isolation, without considering the longer-term impacts of decisions. To be
truly effective, budgets should be
updated continually to reflect changes in the underlying economy and market conditions. To address these issues
organizations often use rolling budgets,
within-year budget updates or flexible budgets.
● Rolling
Budgets. Also called continuous budgets, rolling budgets always
present budget data for a fixed
number of months or years. To do this, a month or quarter is added to the end of the budget period as
each month or quarter ends. These budgets maintain
management focus on the full term of the period (e.g., a year) rather than just
a fixed period in time (e.g.,
fiscal 2013). They also have the advantage of providing a continually updated view of the business,
allowing constant adjustments to reflect changes
in market and other conditions. If a business is changing rapidly or is in a dynamic market, rolling budgets are more
relevant and current. Since the budgets are continually
updated, there isn’t a major annual project taking up FP&A resources. However, the flip side is that some
FP&A resources are continually devoted to the process.
● Within-
year budget updates. While rolling budgets add time periods to the end of the completed budget period,
within-year budget updates take the performance to date and combine it with the remaining budget to arrive at an
adjusted budget for the time period.
As the budget period progresses, the accuracy of the budget improves. This is similar to, but more focused than, a
rolling budget and is very useful for providing accurate period end information.
A variation of
the within-year budget blends actual results to date with the remaining budgeted
amounts but also amends the budgeted amounts
for new information, such as
market,
competitor or cost information. This gives a very realistic view of what the
status and results will be at the
end of the period.
● Flexible
budgets. Flexible budgets are often developed after the budget period based on the actual volume of sales.
Flexible budgets reflect the same unit price, unit variable cost and fixed cost as other budgets, but they use the
actual sales volume reached during
the period. The actual sales volume most likely will differ from the budgeted sales volume. Flexible budgets
provide a more detailed variance analysis, allowing
the FP&A professional to separate the sales volume variance from other
sources of variance.
Flexible budgets
can also be used during the budget period, changing goals as new information is received. This allows the
budget to remain relevant if some basic assumptions
or facts have changed.
● Stretch
budgets. Stretch budgets are used by management to motivate performance and are based on sales or
production forecasts that are higher than estimates.
These budgets are not used for budgeting expenses.
Application to FP&A Professionals
FP&A
professionals generally own the budgeting process. Just as they manage the forecasting process, they shepherd
forecast iterations through the process and support management in formalizing a final budget.
FP&A has
specific expertise and perspectives that contribute to the budgeting process. For example, FP&A professionals are
particularly suited to analyze impacts across
functional areas. If R&D has a budget to develop a new product,
FP&A can broaden and improve
the cost projection with the inclusion of marketing, engineering and other
costs. When budgets are prepared for
projects, products or other sub-categories of the overall operation, FP&A can assist in making
sure all costs are considered.
FP&A professionals can also contribute to the budgeting process by providing scenario
analysis as part of the
iterative process of creating forecasts.
Finally, FP&A
professionals usually perform variance analysis. This analysis drives improvement in the organization and informs the next round of forecasting and budgeting.
To provide these
contributions, the FP&A professional must understand the operational drivers, risks and opportunities related
to the organization. The FP&A professional must develop an ongoing understanding of the budget process of the
organization by assessing the
accuracy and quality of the previous forecasts and budgets and the budgeting process itself. They should
understand the budget history, including the events that have driven budget revisions in the past.
https://www.southpointfinancial.com/how-to-start-a-budget-and-stick-to-it/
https://en.wikipedia.org/wiki/Budget
https://www.nerdwallet.com/article/finance/what-is-a-budget
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