An Introduction to Corporate Budgeting

Introduction

Corporate budgeting is an essential planning tool for estimating a company’s future revenue, expenses and profits. It helps control spending and identify potential problem areas where revenue might not cover spending. Budgeting helps identify potential growth opportunities and where extra cash can be invested to develop new opportunities.?This article is designed to explain key concepts for corporate budgeting. I present different methodologies, styles and types of budgeting commonly utilized. And I will explain some of the advantages and disadvantages of each method.?The following topics will be covered:

Please read this article in its entirety to gain a full understanding of corporate budgeting. Please feel free to reach out to me if you have any questions.

1)????Budgeting Basics

What is Budgeting?

A budget is the plan developed by an organization as its benchmark to achieve its financial goals and objectives for a period of time. A budget helps a firm control cost by setting cost guidelines. A budget helps management allocate resources efficiently and ensure that one business units’ objectives are consistent with those of other business units and of the organization as a whole. A budget help management to evaluate the assumptions and the objectives identified in the budgetary process.

Budgets can also reveal the progress of highly effective managers and the lack of progress for very ineffective managers. A budget helps a firm control cost by setting cost guidelines.?These guidelines reveal the efficient or inefficient use of a company’s resources. A budget provides real-life constraints to strategic planning and provides resources to realize strategic plans. A budget process must set targets, align incentives, agree on actions, allocate resources and coordinate plans to be successful.

Budget Alignment, Priorities & Particpaiton

The budget is a means of communicating to employees what needs to be accomplished at a firm from an operational perspective. A budget can help tell employees what goals the firm is attempting to accomplish and helps motivate. As shown in the following Dilbert cartoons budgets must be credible to employees and align with corporate priorities or they will be ineffective. A budget must be seen as being realistic by employees before it can become a good motivational tool.

The major participants in a budgeting process typically include the following individuals:

2)????Budgeting Leadership Principals & Styles

12 ?Leadership Budgeting Principles

There are 12 basic leadership budgeting principals that are critical to the success of any company’s budgeting processes regardless of company size, maturity level or whether they are privately owned or are publicly traded. ??These principals can be broken down into 4 key categories. Following these principals will help ensure that you budgeting process is successful both over the short-erm and long-term. (1)

Top-Down vs. Bottom-Up Budgeting Leadership Style

There are two common types of budgeting leadership styles Top-down Budgeting and Bottom-Up Budgeting that are typically used by companies. Each of them has their advantages and disadvantages.

Top-down budgeting (also called Authoritative Budgeting) is imposed by upper management and therefore has less of a chance of acceptance by those on whom the budget is imposed. The company’s senior management prepares a high-level budget based on its objectives and then passes it on to department heads for implementation. During top-down budgeting, the company’s management considers past experiences and current market conditions. They use the previous year’s budget and financial statements as a benchmark for making allocations to departments and business units.

Bottom-up budgeting (also called Participative Budgeting) is characterized by general guidance from the highest levels of management, followed by extensive input from middle and lower management. Bottom-up budgeting is a budgeting method that starts at the business unit level, moving upwards to the top levels of management. Each business unit within a company is required to compile a list of the things it needs, the projects it plans to carry out in the next financial period, and cost estimates. The estimates of business units and company departments are then summed up to develop the overall company budget.

Too often senior management teams disclose financial targets and KPIs to investors and Wall Street analyst that are often impossible to meet or are unrealistic given current operating environments or economics conditions.?They fail to consider what is realistically achievable. Based on my experience a bottom-up budgeting approach is always the better of the two budgeting styles because from the ground-up the methodology incorporates what can be done. I have seen top-down budgeting lead to very dysfunctional budgeting processes. Top-down budgeting is authoritative and basically tells employees this is what you must achieve vs. the more participative and inclusive bottom-up approach. Top-down budgeting often leads to sub-optimal budgets that are not realistic nor achievable.

3)????Types of Budgets

There are several different types of budgeting methodologies commonly utilized by companies. Some of these budgeting types are used individually but more often they are combined.?Below are some of the 7 of the more common budgeting types.

1)?????Project Budgeting

Project budgets must be completed and approved before the start of a project. They are used for creating a budget for specific projects rather than for an entire company. Project budgets are estimates of the costs of an entire project that may span several years.?The current years project (capital) budget is included in the annual operating budget.

2)?????Flexible Budgeting

Flexible budgets are used by most businesses where the budget adjusts or flexes for changes in the volume of activity. ?A flexible budget is one based on different volumes of sales. A flexible budget flexes the static budget for each anticipated level of production. This flexibility allows management to estimate what the budgeted numbers would look like at various levels of sales The flexible budget is more sophisticated and useful than a static budget, which remains at one amount regardless of the volume of activity. It serves as a control mechanism that evaluates the performance of managers by comparing actual revenue and expenses to the budgeted amount for the actual activities.

3)?????Activity-Based Budgeting

Activity-based budgeting (ABB) is a budgeting method where activities are thoroughly analyzed to predict costs.?It focuses on classifying costs based on activities rather than based on departments or products. There are three main steps in ABB: identifying cost drivers, projecting total units, and estimating the cost per unit. Activity based budgeting involves defining the activities that drive indirect costs. A cost pool is established for each activity, and a cost driver is identified for each pool. Activity-based budgeting is only different from traditional budgeting in that it looks at desired outcomes and works backwards from there to determine resources needed.

4)?????Incremental Budgeting

Incremental budgeting is a type of a budgeting process that is based on the concept that a new budget can best be developed by making only some marginal changes to the current budget or prior periods budget. In other words, the current budget is used as a base to which incremental assumptions are added or subtracted from the base amounts to determine new budget amounts. Among all budgeting methods, incremental budgeting is commonly considered as the most conservative approach. This is the traditional budgeting method whereby the budget is prepared by taking the current period's budget or actual performance as a base, with incremental amounts then being added for the new budget period. This methodology is the opposite of the zero-based budgeting.

5)?????Zero-Based Budgeting (ZBB)

Under zero-based budgeting, a manager must build the budget every year from a base of zero. Each new budgeting cycle starts from scratch as though they are prepared for the first time. All expenditures must be justified regardless of variance from previous years. Zero-based budgeting assumes that there has been no history and no presumptions on future performance. Zero-based budgeting can be very time consuming and expensive as you start from scratch each year. I only recommend utilizing this methodology if you are rebuilding a company’s budgeting process and using it for the first year only.

6)?????Rolling Budgeting (RB)

A rolling budget often refers to a company's operating budget which presents the future monthly budgets for the next 12 months or 4 quarters. A rolling budget is also known as a continuous budget, perpetual budget, or rolling horizon budget. It allows the budget to be continually updated by removing information for the period just ended and adding estimated data for the same period next year. The rolling budget or forecast provides a continuous, extended view of expected performance. Rolling budgets are best for firms in the manufacturing or consumer products industries whose revenues are based on productions of goods or equipment and are volumetric related.

A major problem with rolling budgets is that they are time consuming. You are basically doing budgeting year-round and spending you time doing re-forecasts rather than spending time fixing the operational issues that causes budgeting variances. The Dilbert cartoon below indicates a key problem with rolling forecasts. The more that you do doesn’t necessarily mean they will be more accurate.

7)?????Driver-Based Budgeting

Diver-Based budgeting involves the selection of drivers and costing data to predict future business performance. Budgets are developed with model-based calculations using operational business drivers and standard costing data, where applicable. Each company performs a driver analysis to determine the level of detail in which these drivers need to be managed. Effective KPI’s enable communication of strategic goals into operations and then measure the effectiveness of operations at meeting those goals. Ability to see the cause-and effect relationship between the defined drivers.

4)????Budgeting Timelines

Budgeting timelines will dramatically different from one company to the next. However, a traditional budgeting process usually starts with a strategic planning process that starts in the beginning of the month of April in Q2 and from runs for approximately 2-3 months until June.?

Companies usually start the actual annual budgeting process sometime in late June or early July at the end of Q2 or beginning of Q3. The actual budgeting process on average takes 4-6 months depending on the size of a company, number of business units or departments, number of employees and countries it operates in. This annual budgeting process usually involves a back-and-forth and iterative process with business units and department head and the budgeting team to finalize their budget plans.

A competed budget is usually sent to the senior management team and Board of Directors before the end of November or in early December before the holidays. Best practices is for the senior management team and the board of directors to approve the budget before Christmas in their last board meeting before the end of the calendar year. For a budget to be useful, it must be finalized before the next fiscal year begins.

5)???Budgeting Best Practices

For a budgeting process to be successful the overall goals and baseline budget assumptions must be announced and clearly communicated to individual departments before the can begin formulating their numbers. The budget planning calendar is the schedule of activities for the development and adoption of the budget. It includes a list of dates indicating when specific information is to be provided to others by each information source.

The budget department is responsible for compiling the budget and managing the budget process. However, the budget director and department are not responsible for actually developing the estimates on which the budget is based. The actual estimates need to come from the business unit head or departments. Everyone involved in preparing the budget at all levels must be educated on the detailed procedures for preparing and submitting their part of the overall budget. Employees involved in the budgeting process need to follow standard procedures and process at all time to ensure consistency and conformity.

Operational plans need to be carefully linked and aligned to financial plans and KPI target. If operational plans are out of synch with financial targets, then it will be impossible for the company to meet its budgeting goals. The budget must be aligned with the corporate strategy. The budgeting process should be kept separate but should flow from the strategic planning and forecasting process. The support of top management is crucial to the budgeting efforts. This is because the single most important factor in ensuring the success of a budget process is for senior management to demonstrate that it takes the project seriously and considers it vital to the organization’s future.

6)???Budgeting Challenges

Corporate budgeting processes face many challenges. Often employees have concerns and complaints some of which include:

Conclusion

Understanding the roles, priorities and participant in the budgeting process is critical for success. FP&A is an integrated process involving many parts of a company. I recommend a bottom-up approach for planning and budgeting with active engagement from senior management to promote support and accountability at all levels. It is very important to clearly link strategy to planning and budgeting by defining a set of targets that tackle the most significant performance drivers. ?Successful budgeting must be aligned with corporate strategy and must be fully endorsed by management and communicated to and understood by employees at all levels

Alternative methodologies such as driver-based budgeting & zero-based budgeting are helpful but not for long-term budgeting cycles. Reduce the level of detail where there is clear control and materiality for budget decisions. Following a rigid calendar for budgeting with set timelines is important to ensuring that the budget is properly developed, structured and signed-off on by all participant. Rolling budgets are good for certain industries but for the majority of industries is overly time consuming and costly to utilize.

Reforecast as market conditions change, avoid relying on old data and ?consider scenario modeling to challenge assumptions and improve decision making. Consider advanced budgeting ERP systems and ?tools as part of an integrated performance management solution to simplify the process, reduce errors, save time, enhance analysis and create accurate/meaningful budgeting reports.?For the budgetary process to serve effectively as a control function, it must be integrated with the accounting system and the organizational structure. Please reach out to me if you have any questions.

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