Budgeting can require the investment of thousands of hours. That’s an effective investment. Right? Well perhaps, but only if there’s a return on this investment, and that’s the real issue. Budgeting is an important exercise, but the instant a budget is published it is no longer accurate and therefore relevant.
The problem is really quite simple. Business conditions change and there is no way to look into the future and get it all correct. Sometimes it isn’t even remotely accurate. The budget may be accurate today, but one month from now revenue or costs may not be as forecasted. What’s to be done?
You could reopen the budgeting process each quarter (please not on a monthly basis!). You could adopt the more modern continuous planning and rolling forecasts budgeting process. You could do nothing and just let the actual results go wherever it wants to. Each of these budget revision options require time and therefore cost to take what was never accurate and revise it, knowing in advance that whatever you do the budget is going to be instantly out of date.
Budgeting Tips – Budgets Are Never Accurate, But That’s Not the Point
If the budgeting process creates budgets that are inaccurate by definition, what’s the use of budgeting in the first place? Budgeting is absolutely required if you are going to come anywhere close to achieving your financial objectives.
The payback isn’t the budget comparison two months or six months from now. Budgeting is the process of planning a firm’s immediate future and determining exactly what is needed to achieve that vision.
The revenue forecast drives the entire budgeting process, but these monetary objectives must be justified by a very detailed Action Plan.
The Action Plan is a narrative that addresses several critical issues. Where have we been (last year)? Where are we today? Where do we need to be tomorrow (the end of the fiscal year coming)? How do we get there?
Let’s use marketing as an example. The Action Plan provides a detailed breakdown of projected revenues and expenses. That’s the expected budgeting information. Of greater importance the Action Plan describes where the revenue is coming from, what specific programs are going to generate that revenue, what the marketing program is going to cost, the ROI for these investments and what staffing and other admin costs are going to be required.
The detailed description (justification) of the steps that are going to need to be taken to achieve the budgeting revenue forecasts then becomes the Action Plan for the sales and marketing department.
The dollar forecast and Action Plan of the sales and marketing department (as an example) will then set the tone for the distribution activities of the firm. Distribution managers will translate the relevant sales forecast information into objectives, Action Plans and budgets that allow them to meet their own set of challenges. The budgeting dollars are then just a monetary refection of these Action Plans.
As you can see the budgeting process starts at the top and trickles down to successively smaller business units, each of which supports the efforts of other business units.
Now you have complete and very detailed budgeting information that is already out of date. That’s OK though. The Action Plan and its detailed justification of expenditures is the key outcome of the budgeting process, not the dollar forecast.
Budgeting Tips – Associate Action Plans With Controllable Activities
Action Plans describe and justify the specific steps each business unit is going to take to achieve its objectives. Action Plans also describe the costs to achieve these objectives.
Action Plans and their resulting budgeting forecasts are effective tools, but they don’t really describe how the business units are going to be managed. Every person in a business unit does some form of “work” or “activity”. It is these activities that need to be managed.
Activities lend themselves to measurement. As an example warehouse activities (and there probably are several) can be expressed in terms of labor as a percentage of revenue or other distribution activity. Each business unit needs to identify their critical activities and set targets that lend themselves to measurement.
If an activity can be measured, it can be managed. The real trick is deciding precisely what form of measurement needs to take place for each activity.
Budgeting Tips – Create Performance Metrics to Monitor Key Activities
Rather than continuously updating the budgeting information, business unit managers should invest their time more effectively by identifying their key activities. Then a numerical value can be created that represents the performance of each activity and that metric can be tracked over time. Now you have a complete system of Key Performance Indicators (KPIs) that will help you monitor, control and improve each business unit’s performance.
If you monitor the KPIs for your most important business activities, the Income Statement will take care of itself. Why drill down or drill sideways from the Income Statement to try to figure out what’s going on when the answer may be right in front of you?
While the business unit manager may have invested a significant amount of precious time creating the original dollar budgeting information, transforming this information into a series of KPIs will enhance the manager’s ability to monitor, control and improve the unit’s productivity.
As you are creating each unit’s KPIs please keep in mind one critical issue. If an improvement (cost savings) has a negative impact on customer service, you need to tread very carefully.
Budgeting Tips – Effective KPI Display Format
If you are going to effectively control your day-to-day business affairs (including operations), you need to know where you have been, where you are today and where you appear to be heading. Row and column reports, pie charts and bar charts paint but an instantaneous picture of a business condition at a single point in time and therefore do not help you make any form of decision.
Performance Metrics are graphical representations of KPIs that give you a complete picture of whatever you are tracking. Further they allow you to see in an instant whether you need to take action. If you are interested, I wrote a more in depth article regarding Performance Metrics that addresses this entire subject. (http://www.accountinglibrary.com/blog/business-intelligence-tools-a-path-to-effective-business-decisions-3/).
Performance Metrics are best displayed as a line chart that displays a particular KPI over whatever period of time that best suits your operational analysis. One glance at the chart will enable you to decide whether further analysis is required. That’s really the key here, but you also need to decide which KPIs you should evaluate.
If you want to improve your control even further, you should add a second line that displays your target values. Seeing where you are is a tremendous improvement, but the KPI values don’t tell you whether you are within your target range.
You might want to get really sophisticated and use forecasting equations to extend the line charts into the future. Proactive control is much more effective than reactive control.
One final suggestion. KPIs can become powerful management tools, but guard against defining KPIs that are too generalized. Tracking gross margin seems like a reasonable activity, but if gross margin is lower than expected, what should you do. Drilling down is the usual answer, but why “hunt” for the information you really need? Before you set your KPIs dive deeply into your operations and define a KPI that is not influenced by other activities. It’s a bit like finding the lowest common denominator. Don’t follow too generalized KPIs. Instead define the “core” KPIs that stand by themselves.
Summary
Budgeting represents the monetary cost of implementing Action Plans that drive an organization into its future. While the process of budgeting is time consuming and the budgets are instantly out of date, the budgeting process is a valuable exercise. If you don’t create detailed plans to achieve your business objectives, then chaos will follow.
Creating the budget and its associated Action Plans is just the first step. Each business unit must then identify the specific activities that drive that unit forward. Finally some form of numerical value needs to be created to monitor each activity. These numerical values are also known as KPIs and it is these KPIs that will help people monitor, control and improve the business unit’s activities.
Properly crafted KPIs represent what has happened, what is happening and what may happen and that gives managers the information they need in their drive to achieve excellence.
Additional Reading
Is Your Budgeting Process Killing Your Strategy?
The beauty of business budgeting
When It Comes to Planning and Budgeting, Lose the Tradition
Business Budgeting
About Charles Chewning
Charles Chewning is the publisher of The Accounting Software Library a FREE accounting software and ERP software selection web site that assists users easily and quickly find best suited accounting and ERP products.
