Chapter 14

How Reports Help with Basic Budgeting

In This Chapter

Examining the budgeting process

Figuring out how budgets are created

Understanding the importance of monthly budget reports

Putting internal budget reports to work

No matter how good the numbers look, you don't know how well a company is really doing until you compare the actual numbers with the company's expectations. Expectations (the budget targets a company hopes to meet) are spelled out during the budgeting process, in which the company projects its financial needs for the next year. At different times throughout the year, managers use these budgets, along with periodic financial reports, to determine how close the company is to meeting its budget targets.

As an outsider, you don't have access to the company's budgets or the reports related to them. But if you're seeking to find out more about internal financial reports and how to use them effectively, understanding the budgeting process is critical.

This chapter discusses the budgeting process and how it complements financial reporting. A well-planned budgeting process not only helps a company plan for the next year, but also provides managers with key information throughout the year to be sure the company is meeting its goals — and raising red flags when it doesn't reach its goals. The sooner managers recognize a problem, the greater their ability to fix it before the end of the year.

Peering into the Budgeting Process

The budget a company sets for itself relies on a lot of careful calculations and some guesswork about the amount of revenue it expects from the sale of products and services, as well as the expenses it will incur to manufacture or purchase the products it sells and to cover the other operating expenses during the next year. Creating a budget is a lot more complicated than just making a list of expected revenues and expenses. I talk more about the basics of revenue and expenses in Chapters 4 and 7.

Companies use one of two approaches to budgeting:

• Top-down approach: Key executives set budgets and give them to department heads to meet. Most employees aren't involved in the budgeting process; instead, the bigwigs impose the numbers on the employees, who are expected to meet them. The big problem with this type of budget process is that the employees don't feel any ownership of the budget and frequently complain that the budget handed down to them is unrealistic, which is why they can't meet expectations.

  Few large corporations use the top-down approach today. You're more likely to find this approach in small businesses run by one person or a small group of partners.

• Bottom-up approach: Budgets are created at the department level based on overall companywide goals and guidelines that the board of directors and top executives set. This approach encourages employee participation in the budgeting process, so the employees have more of a sense of budget ownership. Because they help develop the budget, they can't later claim that the budget is unrealistic if it turns out that they don't meet expectations.

Most management studies show that the bottom-up approach works better because managers and staff members are more likely to take a budget seriously and follow it if they have some involvement in developing it. In this chapter, I focus on the process for bottom-up budget development, which is the most commonly used budgeting process in large corporations today.

Understanding who does what

Everyone has a role to play in bottom-up budgeting. Top executives who are part of a budget committee set companywide goals and objectives. Then starting at the lowest staff levels, each department determines its budget needs. These budgets work their way through the management tree to the top, where the bigwigs pull together numbers from each department to develop a companywide budget.

The budget committee manages the entire process and is responsible for determining budget policies and coordinating budget preparation among departments. Most often this committee includes the president, chief financial officer (CFO), controller, and vice presidents of various functions, such as marketing, sales, production, and purchasing.

Even before the departments start to develop their budgets, the budget committee develops rules that all departments must follow. These rules likely include a request to hold all budgets to a certain percentage increase in costs, and possibly even a reduction in costs. These guidelines help departments develop budgets that meet company needs while proposing something the departments can live with throughout the year.

The budget committee doesn't mandate what the department's actual budget should be or how the department should find a way to keep its costs down; it leaves those decisions to each individual department. One department may decide it can cut costs by reducing staff, another may determine that it can cut costs by better controlling the use of supplies, and yet another may decide that cutting back on the use of rental equipment or temporary help can meet its cost-cutting goals. By leaving these choices to the departments instead of mandating the numbers from the top, companies give employees a stake in meeting their budget goals.

After the budgets are developed at the section and department levels, the budget committee gives final approval for all budgets. The committee also resolves any disputes that may arise in the budget process. Budget disputes can occur when different departments have conflicting goals to meet. For example, say the manufacturing department is mandated to cut costs, while the sales department must increase sales to meet its goals. The manufacturing manager may decide to cut costs in a way that lowers product-quality standards. However, the sales manager may believe that this cost-cutting method will create problems in maintaining customer satisfaction and will ultimately hurt sales. The budget committee acts as the mediator for this kind of decision-making process.

Setting goals

To develop companywide budget guidelines, the budget committee must first determine the goals for the company. Before the committee can set those goals, it gathers information about where the company stands financially, how the company fits into the bigger economic picture, and how it stacks up against its competitors. This information forms the basis for what the committee determines it needs to accomplish during the next year, such as increasing market share, increasing profit, or entering a new market area. Sections and departments can then estimate the resources they need to meet those goals.

The first critical step for goal setting is to develop a sales forecast (a projection of the number of sales the company will make during the year), usually involving the staff of several departments, including marketing, sales, and finance. Much of the data this staff collects is from industry research reports, as well as from actual company numbers from the accounting, finance, and marketing departments.

These factors must be considered to develop an accurate sales forecast:

• Past sales success: By looking at a breakdown of sales by product or service for the past three to five years, a company can look for trends and make a best guess about future sales growth potential.
• Potential pricing policy: By looking at past sales, a company can determine whether the current pricing policy is viable or whether changes are needed. Products that are moving quickly off the shelves may be able to sustain a price increase, and products that aren't moving may need a price cut to stimulate sales. Pricing isn't set solely based on sales success or failure, of course; costs for producing the product or providing the service are a key factor as well.
• Data on unfilled orders and backlogs: This data helps a company determine which product lines or services it may need to modify to meet demand.
• Market research: This research includes potential sales and competitive data for the entire industry, as well as forecasts for the individual company. This information lets the committee know where the company fits in the industry and what potential the industry may have in the next year.
• Information about general economic conditions: This research gives the budget committee an overview of expected economic conditions for the next year so it knows whether there's potential for growth or a possible reduction in sales. For example, if the economy has seen a slowdown during the past three years but economists are now predicting a market recovery, the company may need to increase manufacturing goals to meet anticipated increasing demand.
• Industry economic conditions: A company monitors these conditions to determine whether the industry in which it operates is set for a growth spurt or a downturn, or is expected to perform at the same level in the next year.
• Industry competition data: Reviews of competitors’ marketing strategies, advertising, and other competitive factors must also be considered when developing future goals to stay competitive within the industry. The company must review this information to determine where it sits in relation to its competitors and whether new competitors on the horizon may challenge the company's products or services.
• Market share data: A company collects this data, which is the percentage of the market held by the company's products, to help set goals — whether to increase market share or maintain current levels. Growth potential depends on increasing market share, but if the company already holds nearly 100 percent of the market, as Microsoft does in the operating systems market for personal computers, room for growth may not exist. In that case, marketing strategists focus on tactics for maintaining that market share.

In addition to the hard numbers, a company collects information from staff members at all levels to get a firsthand view of what's actually happening in the field. This information includes reports about exchanges with customers, vendors, and contractors. Real-world data that a company collects from sales staff, customer service staff, purchasers, and other employees gives the company additional information and allows it to test the numbers.

Building Budgets

After the budget committee finishes data collection (see the preceding section), it can determine sales goals for the company. After the committee establishes goals, it uses them to develop strategies — the actual methods used to reach the goals — and build budgets that reflect the resources needed to carry out the strategies. Although the budget committee sets companywide goals and global strategies, each section and department translates those broad goals and strategies into specific goals and strategies for its own staff.

Armed with its goals and strategies, each department develops its specific budget. Not all departments develop their budgets at exactly the same time because some departments depend on others to make budget decisions. For example, sales revenue must be projected before the company can make decisions about production levels and just about every other aspect of its operations.

Common budget categories include the following, which I organize according to the order in which they're produced:

• Sales budget: Sales managers start their budget planning by forecasting sales levels and the gross revenue they anticipate those levels will generate. Most other budgets depend on the goals set by sales, so this budget is usually the first to be developed. Without a sales budget, production managers don't know how many products to produce, and purchasing managers don't know how many items to buy.
• Production budget: If the company manufactures its own product, this budget is the next one to be developed. The production department looks at the beginning inventory left from the previous planning period and plans what additional inventory is needed, based in part on the forecasts in the sales budget. Production planning can be a difficult development task. Making sure they have a just-right level of inventory means that production managers must be sure they plan for the right amount of raw materials, the efficient use of production facilities, and an appropriate number of staff members to produce the products to meet customer needs on time.
• Inventory purchases budget: For companies that don't manufacture their own products, the budgeting process focuses on purchasing needed inventory and being sure it's delivered on time to meet customer needs. Similar issues drive purchasing concerns because a company wants to be sure it has enough product on hand to meet customer demand. At the same time, it doesn't want too many products left over, because that means resources were wasted on inventory and could have been better used to meet other company needs.
• Direct materials budget: This budget controls the raw materials needed to meet the production schedule. The last problem any company wants to face is not having enough materials on hand to keep the product line moving, thus risking a factory shutdown. But the company also wants to avoid keeping too many materials on hand because doing so increases warehousing expenses. Also, holding raw materials too long can result in material spoilage.
• Direct labor budget: This budget is unique to manufacturing companies and depends on the production budget. Companies work hard to determine how much staff they need to meet production needs. If they hire too few people, they have to deal with overtime charges or, in the worst cases, production shortfalls. If companies hire too many people, they may end up spending more than necessary on salaries or may have to lay off employees — which is a huge blow to morale.
• Selling and administrative expense budgets: Many smaller departments are involved in getting a product to market and supporting those sales. These departments include accounting, finance, marketing, human resources, mailroom, and materials management. After sales revenue is known and the cost of selling those goods has been determined, the remaining resources are divided up between the company's selling and administrative needs.
• Master budget: After everyone signs off on each of the department and section budgets, the accounting department prepares a master budget, which the company uses as a road map to test how well each department is doing in meeting its budget expectations.
• Cash budget: After all the budgets are completed and combined into a master budget, the accounting department develops a cash budget that estimates the monthly cash needs for each department. Based on this budget, the finance department determines whether operations will generate enough cash to meet needs or whether the company needs other financing to maintain its cash flow.

When all the budget planning is complete, the accounting department develops a budgeted income statement (see Chapter 7 for more information on income statements) to test whether the budgeting process has created a budget that truly meets profit planning goals. If the answer is no, the budget committee has to decide where budget changes are needed to meet company goals. A lot of negotiating is often necessary between the budget committee and the company's top managers to determine budget changes.

If the budget committee imposes unrealistic changes on the budget for a department, little budget compliance from that department is likely to happen, and financial difficulties may develop throughout the year. Budgets that department and section managers can live with have a better chance of producing expected results and meeting goals.

Providing Monthly Budget Reports

No matter how thoroughly prepared it may be, a budget is useless if it's not matched to actual revenue and expenses. So throughout the budget period, the accounting department prepares monthly internal financial reports (reports that summarize financial results) for the managers, who use these reports to identify where the budget is going right or wrong. Many of these internal financial reports have a system of red flags that identify areas where the actual results aren't meeting budget expectations.

Each company has its own style for internal reports, but most reports include similar types of information. The report is usually broken into five columns:

• Red flag: A symbol, such as an asterisk, is usually used in the first or last column to identify problem line items in a budget. Some companies skip the symbol and instead add a column with an explanation of the variances between actual and budgeted numbers.
• Line item: This column lists the budget categories as they appear on the section or department budget.
• Budget amount: This column states the dollar amount allocated for the period of the internal financial report.
• Actual amount: This column states how much the company spent during the period of the internal financial report.
• Difference: This column shows how close (or far apart) the actual and budgeted numbers are.

Many companies also include a year-to-date section on the internal financial reports that shows the same information on a year-to-date basis in addition to the information specific to the month or quarter. See Table 14-1 for a sample income statement.

Table 14-1 shows an internal report for March 2013 for a fictitious company called ABC Company. In this example, a flag appears automatically on the report if the difference is greater than $100,000, but each company determines its own designated levels for red flags. A small company may flag items for a difference of just $5,000, and a large corporation may flag items for differences at much higher levels.

Although Table 14-1 uses an income statement format, internal reports have no required format; each company develops its own report format, depending on what works best for the company.

In Table 14-1, you can see that flags have been marked next to the line items Sales, Gross margin, and Net income. Flags were thrown because those line items show differences of more than $100,000; therefore, management needs to investigate them.

A glance at Table 14-1 shows that the key problem is lower than expected sales revenue. Sales were budgeted for $1.4 million, and the actual sales were $200,000 less, at $1.2 million. That difference is shown on the report's first line. Management first needs to determine why sales are lower than forecast and then must develop strategies for correcting the problem. The fact that cost of goods sold and administrative expenses are lower than budgeted could be a sign that management recognized the problem after a previous month's report and already initiated cost-cutting programs.

After looking at the report in Table 14-1, executives have to determine what the problem is and what other changes may be needed to get the budget back in line. If external factors such as economic conditions are to blame, the best the company can do is revise the budget to meet current economic conditions so that it can avoid further slippage in net income.

Internal financial reports aren't important just to find out about the bad news; good news can also require critical actions. For example, if sales are much higher than expected, a company may need to put plans in place to be sure it can meet the unexpected demand without losing sales. After all, customers don't want to wait weeks or months to get their products, and they may seek out a competitor to fulfill their needs if products aren't available when they're ready to buy.

If conditions change from expectations, a company can more easily make a midyear correction if budgets have been accurately prepared. The company knows what was expected, and it can tweak its revenues or expenses to correct a problem long before the shortfall becomes disastrous.

In Chapter 17, I talk about strategies companies use to keep cash flowing when internal financial reports don't meet expectations.

Using Internal Reports

Inside your company, you probably see much more detailed reports than the sample in Table 14-1. Department heads see only the budget line items related to their own departments, and only the budget committee and departments responsible for developing budget reports have access to companywide internal reports.

The internal financial report managers receive are usually based on the budget they develop. The line items listed are directly related to their department functions. Any line item whose difference exceeds the difference allowed by the company is flagged, and you need to find out why. Sometimes the answer is clear. For example, if you know sales were higher or lower than expected, you simply need to report why and tell what you're doing to correct any problems. Other times, the answer requires some digging on your part.

After a report arrives at your office door, you don't have much time to figure out what the differences are and what they mean for your department. If the differences are big, you can probably expect a call from your manager as soon as he sees his copy. When I was managing the finances for five departments, I knew I could expect a call from my manager even before I got my copy of the report. An entire day's activities could be changed if a major difference showed up on an internal financial report, and I had to find out why.

Your best bet is to keep a good working relationship with someone in the accounting department who can help you sort through the details. Hopefully, you'll find that the difference was based solely on a coding error, and the revenue or expense was just put in the wrong place. Otherwise, you'll likely have to come up with some solution to correct the problem rather quickly.