The principal tool in planning is called “a budget”. Most of you know what a budget is and what various types of budget are. You probably put one together for your household expenses to figure out, based on what you make, how much you can afford to spend next year. Businesses rely on budgets too for much the same reason. How are budgets put together? This post provides simply understandable five steps on budgeting process. It comes with easy descriptions on budgeting terms, rich in nuances, illustrated with some really easy examples for light-weighted reading. Read on…

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A budget is a collection of predictions. Just because a budget says that a department’s revenue and expenses will balance does not mean that they will. So as the year wears on, companies may require some departments to trim costs to make up for bad revenue or expense predictions.

The Rule of Three In Budgeting: The Rule of Three is simply a method to help companies prepare for such a contingency. This rule of budgeting says that a company or its individual departments ought to divide itself into three parts: one part that is considered essential, another part that is desirable, and a third part that is dispensable. This way, if a division must pare itself down quickly, so as not to run a deficit, it will already know which units to cut.

 

Regardless of the type of budget you’re dealing with, each is assembled in similar ways. The budgeting process requires essentially five steps:

 

Step 1: Determining the Flow of Information

A company gathers the data necessary to compile a budget in one of two ways: 1) It centralizes the process and has senior management establish the company’s priorities and projections; or 2) it directs individual work units and departments to assemble that information on their own. The former is referred to astop-down budgeting“, the latter as “bottom-up“.

In general, budgets that are constructed from the bottom up are preferable, if only for the reason that individual workers and units know more about their departments than central management. On the other hand, bottom-up budgeting requires more time to execute and is difficult to manage.

 

Step 2: Deciding What You’re Going to Measure

Imagine you work for Lie Dharma’s Sporting Goods. But this time, imagine the company is much larger than we first described. In addition to selling basketballs, it sells baseballs and soccer balls, too. And imagine that Lie Dharma’s has operations in North America, Asia, and Europe. When Lie Dharma’s prepares its budget, should it gather information based on its products? For instance; should it make separate sales and cost projections for basketballs, baseballs, and soccer balls no matter which country they are sold in? It could do that. Or should it make projections based on its regions of operations? For instance; should it make separate sales and expense projections for its products based on whether they are sold in North America, Asia, or Europe? It could do that, too. Or should it break down its budget projections based on functions? For instance; should its marketing and manufacturing divisions assemble their own separate budgets that cover all regional operations and all products? Once again, it could.

The answer depends on how your company is organized, or how it wants to be organized. For instance:

  • If Lie Dharma’s is organized in such a way that each of its products are separate profit centers which means that the basketball division would be in charge of its own manufacturing, distribution, marketing, and sales functions completely separate from the functions of the baseball and soccer ball divisions then it will probably budget along its product lines.
  • If the company’s geographic operations are separate profit centers, sometimes called accountability centers, then it may choose to budget by region.
  • And if the company is organized based on traditional functions for instance, there’s a separate sales department that handles all products in all regions, a separate manufacturing department that handles all products in all regions, and a separate distribution department for all products in all regions then it may budget along these lines. The sales department, in this situation, would be referred to as a revenue center, while the manufacturing and distribution divisions would be considered cost centers.

 

Step 3: Gathering Historic Data

After a company decides how it will segment its operations, it turns its attention to gathering historic performance information. The first place to look for historic performance data is the company’s financial statements its balance sheet, income statement, and cash flow statement. Another source would be the financial ratios.

Finally, the managerial reports supplied to company executives throughout the year serve as useful tools in gathering more specific data, such as sales trends for individual products, cost trends for those products, and divisional performance.

[a]. Gathering Sales Information

When it comes to gathering historic sales data, your company ought to know its past performance based on:

  • Product lines. In the case of Lie Dharma’s Sporting Goods, the company should know how its basketball, baseball, and soccer ball sales have done for at least one to two years, but preferably three to five years or more.
  • Regions. Lie Dharma’s should also be able to break down past sales performance based on its regions of operation. For instance, it should know how well basketballs have sold recently in North America. In addition, it should know how sales are doing in specific countries and markets.
  • Customers. It’s not enough for Lie Dharma’s to know how many baseballs it is selling in Mexico. It needs to know who is buying its baseballs. For instance, what percentage of Lie Dharma’s Sporting Goods sales growth is due to its contracts with large retailers as opposed to small independent stores? This information can be useful in making future projections. For instance, let’s assume that the Mexican economy is headed for a recession. And large retailers have historically weathered these recessions better than small independent sporting goods stores. If Lie Dharma’s sells the majority of baseballs in Mexico to large retailers, then its sales might not be altered too much based on changing economic conditions. But if the company sells the majority of baseballs in Mexico to small stores, then it might take that information into account when adjusting its forecasts for its Mexican sales or overall sales of baseballs.

 

[b]. Gathering Expense Information

When it comes to gathering historic expense data, your company should know its past performance based on:

  • Direct costs. This includes raw materials, labor, and inventory costs.
  • Indirect costs. This includes selling, research & development, and general & administrative expenses.
  • Fixed costs. This includes many of the indirect costs of doing business, such as rent and depreciation which are part of G&A expenses.
  • Variable costs. This includes many of the direct costs of doing business, such as raw materials, energy, and labor costs as well as taxes, which are also considered a variable expense.

 

Step 4: Making Projections

The forth step in the budgeting process is for the company to project its performance for the coming year. A budget is only as good as its projections. Establishing budget projections can be as simple or complicated a task as your company makes it. For instance: some companies rely on “incremental budgeting“, in which forecasts are directly tied to past performance and are therefore easy to prepare. Others rely on “zero-based budgeting“, in which forecasts have nothing to do with past performance and are therefore more difficult to prepare. And still others rely on a “hybrid approach“.

Let’s talk about these three budgeting approaches a little bit. Read on…

 

Incremental Budgeting

Imagine you’re preparing your company’s sales budget. Last year, the company spent $10 million on newspaper advertising. How much should your company budget for newspaper ads next year? Some companies would take that $10 million figure, and add to it an additional 10 percent or $1 million to factor in inflation and an acceptable level of growth in spending. This is referred to as incremental budgeting.

Incremental budget projections are the simplest to prepare. All you need to know is what the company spent or made in the previous year. Then you tack on whatever percentage increase or decrease you think is appropriate.

On the other hand, the incremental approach is the least precise method for preparing a budget. Often, companies that rely on incremental budgets repeat past mistakes. Let’s say Lie Dharma’s Sporting Goods budgeted $1 million for general and administrative costs last year. Though the company could get by with just $750,000 this year, it budgets $1.1 million not because it needs it, but because it is about the same amount it spent the previous year.

 

Zero-Based Budgeting

Zero-based budgeting is the antithesis of the incremental approach. Popularized in the 1970s, zero-based budgets operate on the premise that the amount a company budgeted for a line item in one year has little to do with what it should be budgeting in future years. While more accurate than incremental budgets, zero-based budgets require tremendous amounts of information. Thus, they are extremely time-consuming and expensive.

 

The Hybrid Method

Most companies rely on a hybrid approach to budgeting, in which projections are based in part on past performance. However, current industry trends and macroeconomic forces are also considered in part of the equation.

 

Industry Trends

The health of your industry can have a profound impact on your company’s sales projections. For instance, no matter how effective your sales division is and how impressive your products are, larger developments in your industry can destroy your budget projections. Just consider what happened to restaurants that sold beef in England during the Mad Cow Disease scare of the mid- to late 1990s.

Companies turn to a variety of sources to gather this information, including:

  • Trade associations and publications. Most trade associations publish industry-wide sales and expense information based on figures provided by their members. In addition, companies like Dun & Bradstreet publish key financial ratios that can help businesses assess the health of their industries.
  • Available financial statements. Publicly traded companies are required by the SEC to submit quarterly 10-Q reports, annual 10-K reports, and comprehensive annual reports that include financial statements. This information is primarily useful for investors, but competitors can also use it to discover broad trends in the industry.
  • Available government data. Various agencies, such as the Commerce Department, the Agriculture Department, and the Labor Department put out regular reports on industry trends.
  • Internal experts. Companies should also rely on their own officers who are intimately familiar with broad industry trends to contribute to this analysis.

 

Economic Data

The health of the economy can play a dramatic role in the health of your business, too. In fact, a number of outside influences will throw off your company’s budget projections. Those include:

  • Economic downturns. Sales projections are often predicated on a certain degree of overall economic health. A sudden recession, for instance, could reduce overall consumer demand. Local economic slowdowns can be just as devastating. Consider what happened to companies in Southern California as defense contracts were cut during the late 1980s and early 1990s.
  • Inflation. Even a slight increase in inflation can increase a company’s expenses, from energy to raw materials to labor. Just recall the effects of hyper-inflation in the 1970s and early 1980s on U.S. industrial profits. Inflation can also dampen sales, due to increased prices.
  • Interest rates. If the Federal Reserve raises rates, it would increase the cost of borrowing money, which would increase a company’s expenses. So interest rate fluctuations should be factored into budget projections.
  • Consumer confidence. A slight decrease in consumer confidence could hurt consumer demand, which could alter your company’s sales projections.
  • Currency trends. A sudden change in exchange rates could wipe out potential profits for multinationals, exporters, and importers.
  • Politics. President Clinton’s failed attempt at healthcare reform in 1993 boosted the short-term fortunes of HMOs, but crippled medical research companies. When making budget projections, your company ought to keep similar political issues in mind.
  • Natural disasters. Insurers and companies that do business in disaster-prone regions must consider the potential effect of natural disasters-both positive and negative. If your company is a retailer or manufacturer, for instance, a single hurricane can wipe out a major portion of its business. If your company is a contractor, natural disasters can actually boost sales, since communities must rebuild following disasters. These days, many companies consult with independent weather services before forecasting sales and inventory trends.
  • Technology. New technological developments can often boost or reduce demand for your products. They can also impact your costs.
  • Regulatory trends. Businesses must also assess potential changes in the regulatory environment. That’s what healthcare companies were forced to do during the healthcare reform debate of 1993. And that’s what tobacco companies have been forced to do in recent years.

 

The final step is: Determining break-even point. Break-even point determination (calculation) is much more technical than the other steps. Some terms need to be well understood before going to the calculation, such as: Contribution Margin. Break-even point comes with many ways depending on the needs, e.g.: Break Even by Units, Break Even by Sales. On this post I am going to even extend this topic to beyond the break-even point itself. To you who interested in Break-even point, you may want to follow my next post [here].