10.1. Exploring the Reasons for Budgeting

Business budgeting requires setting specific goals and developing the detailed plans necessary to achieve them. Business budgeting should be built on realistic forecasts for the coming period. A business budget is an integrated plan of action — not simply a few trend lines on a financial chart. Budgeting is much more than slap-dashing together a few figures. A budget is an integrated financial plan put down on paper — or, more likely these days, entered in computer spreadsheets. (Many budgeting computer programs are on the market today; ask your CPA or other financial consultant which one he or she thinks is best for your business.)

Business managers don't just look out the window and come up with budget numbers. Budgeting is not pie-in-the-sky wishful thinking. Business budgeting — to have practical value — must start with a broad-based critical analysis of the most recent actual performance and position of the business by the managers who are responsible for the results. Then the managers decide on specific and concrete goals for the coming year. (Budgets can be done for more than one year, but the first stepping stone into the future is the budget for the coming year — see the sidebar "Taking it one game at a time.")

In short, budgeting demands a fair amount of managers' time and energy. Budgets should be worth this time and effort. So why should a business go to the trouble of budgeting? Business managers do budgeting and prepare budgeted financial statements for three main reasons: modeling, planning, and control.

Taking it one game at a time A company generally prepares one-year budgets, although many businesses also develop budgets for two, three, and five years out. Whenever you reach out beyond a year, what you're doing becomes more tentative and iffy. Making forecasts and estimates for the next 12 months is tough enough. A one-year budget is more definite and detailed in comparison to longer-term budgets. As they say in the sports world, a business should take it one game (or year) at a time. Looking down the road beyond one year is a good idea, to set long-term goals and to develop long-term strategy. But long-term planning is different than short-term budgeting.

10.1.1. Modeling reasons for budgeting

Business managers should make detailed analyses to determine how to improve the financial performance and condition of their business. The status quo is usually not good enough; business managers are paid to improve things — not to simply rest on their past accomplishments. For this reason managers should develop good models of profit, cash flow, and financial condition for their business. Models are blueprints or schematics of how things work. A financial model is like a roadmap that clearly marks the pathways to profit, cash flow, and financial condition.

Don't be intimidated by the term model. Simply put, a model consists of variables and how they interact. A variable is a critical factor that, in conjunction with other factors, determines results. A model is analytical, but not all models are mathematical. In fact, none of the financial models in this book is the least bit mathematical — but you do have to look at each factor of the model and how it interacts with one or more other factors. Here's an example of an accounting model, which is called the accounting equation: Assets = Liabilities + Owners' equity

This is a very condensed model of the balance sheet. The accounting equation is not detailed enough for budgeting, however. More detail about assets and liabilities is needed for budgeting purposes.

Chapter 9 presents a profit and loss (P&L) report template for managers (see Figure 9-1). This P&L report is, at its core, a profit model. This model includes the critical variables that drive profit: sales volume, sales price, product cost, and so on. A P&L report, such as the one I show in Figure 9-1, provides the essential feedback information on profit performance of the organizational unit (a profit center in the example). The P&L report also serves as the platform and the point of departure for mapping out the profit strategies and goals for the coming year.

Likewise, business managers need a model for planning cash flow from operating activities. (I explain this important source of cash flow in Chapter 6.) Managers should definitely forecast the amount of cash they will generate during the coming year from making profit. They need a reliable estimate of this source of cash flow in order to plan for other sources of cash flow they will need during the coming year — to provide the money for replacing and expanding the long-term operating (fixed) assets of the business and to make cash distributions from profit to owners. Managers need a model that provides a clear trail of how the sales and expenses of the business drive its assets and liabilities, which in turn drive the cash flow from operating activities.

Most business managers see the advantages of budgeting profit for the coming year; you don't have to twist their arms to do this. At the same time, many businesses balk at budgeting changes in assets and liabilities during the coming year, which means they can't budget cash flow from operating activities. All their budget effort is focused on profit, and they leave cash flows and financial condition in the dark. This is a dangerous strategy when the business is in a tight cash position. The business should not simply assume that its cash flow from operating activities will be adequate to its needs during the coming year.

The best advice is to prepare all three budgeted financial statements:

• Budgeted income statement (profit report): The P&L report shown in Figure 9-1 serves as a hands-on profit model — one that highlights the critical variables that drive profit. This P&L report separates variable and fixed expenses and includes sales volume, margin per unit, and other factors that determine profit performance. The P&L report is a schematic that shows the path to operating profit. It reveals the factors that must be improved in order to improve profit performance in the coming period.

• Budgeted balance sheet: The key connections and ratios between sales revenue and expenses and their corresponding assets and liabilities are the elements in the model for the budgeted balance sheet. These vital connections are explained throughout Chapters 4 and 5. The budgeted changes in operating assets and liabilities provide the information needed for budgeting cash flows during the coming year.

• Budgeted statement of cash flows: The budgeted changes during the coming year in the assets and liabilities used in making profit (conducting operating activities) determine cash flow from operating activities for the coming year (see Chapter 6). In contrast, the cash flows of investing and financing activities depend on the managers' strategic decisions regarding capital expenditures that will be made during the coming year, how much new capital will be raised from debt and from owners' sources of capital, and the business's policy regarding cash distributions from profit.

In short, budgeting requires good working models of making profit, financial condition (assets and liabilities), and cash flow. Budgeting provides a strong incentive for business managers to develop financial models that help them make strategic decisions and exercise control — and do better planning.

10.1.2. Planning reasons for budgeting

One main purpose of budgeting is to force managers to create a definite and detailed financial plan for the coming period. To construct a budget, managers have to establish explicit financial objectives for the coming year and identify exactly what has to be done to accomplish these financial objectives. Budgeted financial statements and their supporting schedules provide clear destination points — the financial flight plan for a business.

The process of putting together a budget directs attention to the specific things that you must do to achieve your profit objectives and optimize your assets and capital. Basically, budgets are a form of planning that push managers to answer the question "How are we going to get there from here?"

Budgeting can also yield other important planning-related benefits:

• Budgeting encourages a business to articulate its vision, strategy, and goals. A business needs a clearly stated strategy guided by an overarching vision, and it should have definite and explicit goals. It is not enough for business managers to have strategies and goals in their heads. Developing budgeted financial statements forces managers to be explicit and definite about the objectives of the business, as well as to formulate realistic plans for achieving the business objectives.

• Budgeting imposes discipline and deadlines on the planning process. Busy managers have trouble finding enough time for lunch, let alone planning for the upcoming financial period. Budgeting pushes managers to set aside time to prepare a detailed plan that serves as a road map for the business. Good planning results in a concrete course of action that details how a company plans to achieve its financial objectives.

10.1.3. Management control reasons for budgeting

The board of directors of a corporation focuses its attention on the master budget for the whole business: the budgeted income statement, balance sheet, and cash flow statement for the business as a whole for the coming year. The chief executive officer (CEO) of the business focuses on the master budget as well, but the CEO must also look at how each manager in the organization is doing on his or her part of the master budget. As you move down the organization chart of a business, managers have narrower responsibilities — say, for the business's northeastern territory or for one major product line. A master budget consists of different segments that follow the business's organizational structure. In other words, the master budget is put together from many pieces, one for each separate organizational unit of the business. For example, the manager of one of the company's far-flung warehouses has a separate budget for expenses and inventory levels for his or her bailiwick.

By using budget targets as benchmarks against which actual performance is compared, managers can closely monitor progress toward (or deviations from) the budget goals and timetable. You use a budget plan like a navigation chart to keep your business on course. Significant variations from the budget raise red flags, in which case you can determine that performance is off course or that the budget needs to be revised because of unexpected developments.

For management control, a budgeted profit report is divided into months or quarters for the coming year. The budgeted balance sheet and budgeted cash flow statement may also be put on a monthly or quarterly basis. The business should not wait too long to compare budgeted sales revenue and expenses against actual performance (or to compare actual cash flows and asset levels against the budget). You need to take prompt action when problems arise, such as a divergence between budgeted expenses and actual expenses.

Profit is the main thing to pay attention to, but accounts receivable and inventory can also get out of control (become too high relative to actual sales revenue and cost of goods sold expense), causing cash flow problems. (Chapter 6 explains how increases in accounts receivable and inventory are negative factors on cash flow.) A business cannot afford to ignore its balance sheet and cash flow numbers until the end of the year.

10.1.4. Additional benefits of budgeting, and a note of caution

Budgeting has advantages and ramifications that go beyond the financial dimension and have more to do with business management in general. Consider the following:

• Budgeting forces managers to do better forecasting. Managers should be constantly scanning the business environment to spot changes that will impact the business. Vague generalizations about what the future may hold for the business are not good enough for assembling a budget. Managers are forced to put their predictions into definite and concrete forecasts.

• Budgeting motivates managers and employees by providing useful yard-sticks for evaluating performance. The budgeting process can have a good motivational impact by involving managers in the budgeting process (especially in setting goals and objectives) and by providing incentives to managers to strive for and achieve the business's goals and objectives. Budgets provide useful information for superiors to evaluate the performance of managers and can be used to reward good results. Employees may be equally motivated by budgets. For example, budgets supply baseline financial information for incentive compensation plans. And the profit plan (budget) for the year can be used to award year-end bonuses according to whether designated goals were achieved.

• Budgeting can assist in the communication between different levels of management. Putting plans and expectations in black and white in budgeted financial statements — including definite numbers for forecasts and goals — minimizes confusion and creates a kind of common language. As you know, the "failure to communicate" lament is common in many business organizations. Well-crafted budgets can definitely help the communication process.

• Budgeting is essential in writing a business plan. New and emerging businesses need to present a convincing business plan when raising capital. Because these businesses may have little or no history, the managers and owners must demonstrate convincingly that the company has a clear strategy and a realistic plan to make profit. A coherent, realistic budget forecast is an essential component of a business plan. Venture capital sources definitely want to see the budgeted financial statements of a business.

In larger businesses, budgets are typically used to hold managers accountable for their areas of responsibility in the organization; actual results are compared against budgeted goals and timetables, and variances are highlighted. Managers do not mind taking credit for favorable variances, when actual comes in better than budget. But beating the budget for the period does not always indicate outstanding performance. A favorable variance could be the result of manipulating the budget in the first place, so that the budgeted benchmarks can be easily achieved.

Likewise, unfavorable variances have to be interpreted carefully. If a manager's budgeted goals and targets are fair and reasonable, the manager should be held responsible. The manager should carefully analyze what went wrong and what needs to be improved. Stern action may be called for, but the higher ups should recognize that the budget benchmarks may not be entirely fair; in particular, they should make allowances for unexpected developments that occur after the budget goals and targets are established (such as a hurricane or tornado, or the bankruptcy of a major customer). When managers perceive the budgeted goals and targets to be arbitrarily imposed by superiors and not realistic, serious motivational problems can arise.

Budgeting is not without its problems. Budgeting looks good in theory, but in actual practice things are not so rosy. Here are some issues to consider:

• Budgeting takes time, and the one thing all business managers will tell you is that they never have enough time for all the things they should do.

• Budgeting done from the top down (from headquarters down to the lower levels of managers) can stifle innovation and discourage managers from taking the initiative when they should.

• Unrealistic budget goals can demotivate managers rather than motivate them.

• Managers may game the budget, which means they play the budget as a game in which they worry first and foremost about how they will be affected by the budget rather than what's best for the business.

• There have been cases in which managers resorted to accounting fraud to make their budget numbers.