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 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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