The Budget System Is One Of The Two Major Control

Budgeting

The budget system is one of the two major control tools for a business. The other is the cash flow plan. A budget is simply a tool, a financial guide, which a manager uses to plan profitable operations by anticipating and allotting the revenues and expenditure of funds. Thus, the budget is the basic source of information fed into the cash flow plan. Once the various budgets have been developed, the cash flow plan naturally follows. By adopting various budgetary procedures, management hopes to guide the operations to a predetermined end—a certain amount of profit from a certain volume of sales. Without a budget, management could never be certain whether operations were going successfully.

Benefits of budgeting Budgeting plays a major role in business planning. Five major benefits are realized by using a good budget system: ■ It controls expense-revenue ratios. ■ It coordinates activities in the organization. ■ It establishes a standard of performance. ■ It serves as an evaluation tool. ■ It triggers remedial managerial action. Control of expense-revenue ratios Maintaining the desired relationship between expenditures and revenues is the key to profits. Losses result when expenses exceed revenues. The objective of business is to buy revenues in the market at a reasonable cost, and the budget establishes what that cost should be. Thus, the budget helps keep expenses in line with revenue. In theory, a firm can make money at almost any level of sales if it keeps its costs proportional to its revenues.

THE BUSINESS MENTOR — Budgeting

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Benefits of budgeting The budgeting process The budget book Customize the budget Management by percentages Composite budgets

Make no mistake about it, it takes great discipline and mental toughness to abide by a budget, particularly in new enterprises, in which expenditures are often chaotic and unpredictable. The new enterprise’s irregularities cannot be used as an excuse for not diligently developing a good budget system. Entrepreneurs resort to all sorts of excuses for not budgeting. “We can’t budget. Our revenues are too uncertain. We haven’t time to budget. That’s something big business does.” Such excuses are not only nonsense, but are dangerous to the firm’s solvency. Coordinating activities The budget helps top management coordinate the activities of all departments. If $500,000 in sales is to be shipped, then the shipping department must be allowed enough money to do the job. Production must be coordinated with sales. The firm cannot ship $500,000 worth of products if they have not been produced. The production budget tells the factory what is to be made. If $500,000 sales of product are to be made, the finance department must be prepared to finance the operation.

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Establishing performance standard Once the budget is established, it becomes the standard of performance for all departments, that is, what is expected of them. Marketing is expected to sell $500,000 and spend $25,000 doing it. The budget becomes the goal. The name of the game in business is meet the budget. Those people who fail to do so seldom last long in most organizations. Evaluation tool Naturally, if a group fails to meet its budget, it is not looked upon with favor by top management. Thus, the budget becomes a means for evaluating each unit’s performance. Obviously, this aspect of budgeting causes some problems. Knowing that the budgets they submit may be the rope that hangs them, the department heads can become cautious by asking for far too much money and promising far too little output. Budget meetings can be interesting as the final budget figures are pounded out between departments and the management. Triggering remedial action The month’s budgetary performance is on the entrepreneur’s desk. The telephone budget was $2,800; the actual was $4,700. That’s too much variance. What happened? The entrepreneur calls for the bill and either scans it himself or hands it to someone else to do it. It is important to know who spent the $1,900 and why. Was it necessary? If so, OK, those things happen. The money will have to be made up elsewhere. But if the calls were not necessary, they must be stopped. It is critical for effective cost control that quick action be taken to remedy unnecessary cost overruns. Allowed to go unchecked, they not only accumulate a large sum of money, but they tend to accelerate in amount as employees learn that cost overruns don’t seem to be important and the staff does not focus on the bottom line.

THE BUSINESS MENTOR — Budgeting

By quickly and forcefully coming down on offenders, several messages are delivered to staff members. First, they learn that management is watching what is spent and that it is on top of operations. Second, they learn that management means business about staying within budget. Third, they learn what happens to people who misuse company money. Once the proper tone is set within the company, controls become much easier to administer. The staff learns that the very survival of the enterprise depends on staying within and meeting the budgets.

The budgeting process The process of budgeting is simple; doing it is a lot more involved. The budget begins with the sales forecast, since all activities must be tied to the anticipated level of sales. Once the sales forecast has been set, then that figure is given to each head of a budgetary unit—the marketing manager, the production manager, for example. In many smaller new ventures, the entrepreneur works up the entire budget with the help of the accountant. Obviously, the more reliable the sales forecast, the easier it is to budget operations. As the sales forecast becomes increasingly suspect, the budget-making process becomes more tentative. It is difficult to budget a large sum of money for advertising in advance of sales if sales are uncertain. It is difficult to budget for hiring new employees in the shipping room if the volume of shipments is in doubt. When developing budgets, the following key factors need to be considered: ■ The role of assumptions ■ Forecasting sales under uncertain conditions ■ Expense lead time ■ Budget periods ■ Line-item budgeting ■ Program budgeting ■ Budget accounts ■ Start-up costs

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The role of assumptions A word needs to be said about the need for making assumptions in developing the budget. For example, the sales forecast is developed based on several assumptions about economic activity, new products coming on line, levels of competitive activity, prices, and so forth. These assumptions should be clearly stated in the budget document. The figures can be no better than the validity of the assumptions upon which they are based. Various assumptions underlie many of the figures in the budget. These should be footnoted in the budget so readers will know how each figure was derived. The validity of these assumptions affects all planning because a plan can be no better than the assumptions upon which it is based. The cash flow projections are similarly based on many assumptions; a company must assume many things in projecting its sales and costs. Management must make certain those assumptions are clearly recognized and stated. Underlying all planning are some implicit assumptions that often go unrecognized, such as the state of the economy, the state of world peace, no adverse political or regulatory developments, the continued good health of the entrepreneur, no adverse technological developments, and so on. In general, most planning assumes a static environment. Any significant changes in the environment often make plans go astray. Forecasting sales When management cannot forecast sales with any degree of confidence, two approaches can be used. The minimum-budget approach can be used when forecasting sales is difficult, such as when the venture is introducing a new product to the marketplace. For example, the owner can draw up a minimum budget that would indicate the least money for which each function can be performed. He or she would start out with the minimum amount of money needed for each expense center, and then allocate more funds to the budgets as sales warrant. Budgets can be flexible, thus allowing for changes in a firm’s fortunes.

THE BUSINESS MENTOR — Budgeting

The second approach involves developing a must-do budget. Sometimes the founder, in the absence of good, hard data on which to base the forecasts and the budgets, sets the budget on the basis of what must happen if the company is to make it. It’s pointless to set budgets that result in failure. Set budgets that result in success. No founder wants to budget his or her venture into failure. Expense lead time The flexibility in a budget depends greatly on how much time is involved between the expenditure of funds and the receipt of sales dollars from those expenditures. At one extreme is a project in which all funds must be spent long before any sales revenues can be realized. If a venture is building oil rigs, management must spend a lot of money before it ever knows whether the venture will earn a dollar of revenue from a well. For this reason, oil adventurers prefer to use other people’s money to drill wildcat wells. Let people who want to take such gambles put up the money. At the other extreme, there are businesses in which revenues are received before much money is spent. Perhaps a customer pays up front, such as in the cases of insurance, magazines, many direct-mail promotions, and custom manufacturing. Such instances are fortuitous, for the venture’s management knows its sales volume on which to plan its budget system, and all it must do is stay within budget for fulfilling the contract. If sales volume follows expenses by a short time, a month or so, then the budgeter can quickly reduce or expand budgets to reflect sales experience. Risks are minimized. The longer the lead time of expenses over sales, the larger the risk of losses due to spending too much money because of over-budgeting by the various expense centers. Budget periods Most often the budget is prepared for the coming year by months. Sometimes, in strongly seasonal businesses such as the apparel industry, each budget will be for a season. Sometimes, in project-management types of businesses such as defense manufacturing and contracting, a budget is prepared for each contract.

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Line-item budgeting Most budget systems start out by identifying expense centers for those areas over which management wants controls established. Thus, department budgets are set up for such departments or activities as production, marketing, and general and administrative Then the individual budget accounts under each of those departments are determined, such as those for marketing. Or budget accounts may be built along the lines of more traditional accounting systems of accounts. Such budgets are often called line-item budgets because each expense category is a separate line in the total budget. Obviously, line-item budgets go into great detail, so much so that it is their weakness. Seldom can anyone plan expenses in that much detail. Thus, in operations, such budgets are conducive to all sorts of budget games, as managers rob one budget to pay for costs incurred elsewhere. It is marvelous what can be considered advertising or field-selling expenses. If a business runs out of postage, the manager can have the sales representative buy some and put it on his expense account for approval. Such budget games have given the budgetary process a bad reputation. They can be avoided if flexibility is built into the system. The manager needs a slush fund to meet emergencies. Program budgeting In a system of program budgeting, larger sums of money are dedicated to programs, with their expenditure and distribution left to the discretion of the program manager. The marketing program would be budgeted for $500,000 in total; how that amount is spent is up to the marketing manager. Obviously, management must have great faith in its marketing manager, although the breakdown of marketing expenses is usually reviewed by top management. The theory is that management should not tie the marketing manager’s hands by dictating how marketing funds will be spent, while holding the manager responsible for the final sales results.

THE BUSINESS MENTOR — Budgeting

However, after the program has been awarded its budget, its manager must then apportion the total among the traditional lineitem expense categories. Budget accounts The number of budget accounts and the kinds of costs lumped into each account are solely matters for managerial discretion. However, there are some general guidelines. Do not use so few accounts that all sorts of costs are lumped together. If advertising-media costs are lumped together with direct-mail costs, then it becomes more difficult to tell which expense is out of control. Enough detail should be budgeted in that when the manager looks at the performance of a budget, he or she knows he/she is judging one activity that needs control. For example, if both postage and telephone costs are included together in a communication budget, the manager would not know whether someone was stealing stamps or making unauthorized telephone calls. A large budget variance should focus attention to one area of expenditures. For the sake of accounting convenience, the budget accounts should parallel the ledger accounts so that posting results is easy. With the advent of computerized accounting, the monthly output for the budget book is a simple matter. Department budget accounts: ■ Sales-reps compensation ■ Field-selling expenses ■ Sales-office expenses ■ Advertising ■ Printing ■ Communications ■ Sales-management salaries ■ Trade show expenses Traditional accounts: ■ Travel ■ Auto ■ Entertainment ■ Supplies ■ Telephone ■ Salaries ■ Printing

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Start-up costs One method of determining how much money a venture will need at start-up is to do a mental “walk-through” of what the business will look like. The following questions should be asked to determine start-up costs: ■ Where will the business be? ■ What size will it be initially? ■ What will the office or retail space look like? ■ What types of walls and fixtures will it have? ■ What type of equipment will be needed, such as computers, furniture, carpet, copy machine, shelving? ■ What types of signs will be required? ■ How much of an opening inventory will the business need? ■ How will it be paid for? ■ What kinds of deposits will be required? For instance, how much will deposits cost for telephone, utilities, and rent—first and last month? ■ What city codes must be complied with, and are there any costs involved? ■ What types of government (local, state, federal) business licenses will be required? ■ What types of supplies will be needed for cleaning, office correspondence, shipping, boxes? ■ What kinds of marketing costs will be incurred before opening for brochures, advertising, stationery, and business cards? ■ What are potential costs for recruiting and hiring initial staff? ■ What type of staff training is necessary before opening? When estimating these expenses, entrepreneurs should be as realistic and accurate as possible. They always discover hidden costs that are incurred but not planned for. Other owners in a similar business can be queried about what their start-up costs were and how much money they suggest be reserved before opening doors for business. Most lenders recommend that entrepreneurs have a minimum of three-months’ operating capital on hand. Avoid forcing the budget process or trying to underestimate start-up costs. Let the budgeting process indicate how much money the business concept needs.

THE BUSINESS MENTOR — Budgeting

For example, one entrepreneur wanted to launch a venture that involved manufacturing submarines and selling them to operators of underwater ocean tours at island resorts. The idea seemed feasible. After estimating his start-up budget, he discovered that he needed about $1.2 million for operating capital to launch the venture. He could raise only about $10,000. After estimating start-up costs, he determined there was no way he could start this business himself. There is no lack of ideas for launching new companies, but venture ideas must match the entrepreneur’s personal and business criteria as well as his or her pocketbook. Problems, such as running out of money or realizing enough money cannot be raised to launch a venture idea, can be avoided by accurately estimating start-up costs and preparing an initial start-up budget.

The budget book When some entrepreneurs managed the budgetary system of their company, they developed an effective yet simple way of monitoring the chain’s monthly budget performance. First, the entrepreneurs developed a “budget book,” a loose-leaf ledger or computer program containing information for each budget account. Each sheet showed the budget and actual figures for that account for the previous 12 months, the projected budget for the year by months, the current actual performance, and the variance of the actual figures from the budgeted figures. The bookkeeper prepared the data for the entrepreneurs by the 5th of each month. Each account that was over or under budget was circled in red. The entrepreneurs would glance at the red circles and decide if the difference was significant. If so, was it explainable? Did they know why it happened? If they did not know the reason for the significant variance, the entrepreneurs would call for the checks or other documents that supported the out-of-line expenditures. If problems were identified, plans were made to take immediate action. Many entrepreneurs claim this system is the only way to manage a budget for their businesses. It takes only 15 minutes a month to survey the organization’s budgetary performance.

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Customize the budget No two budget systems should be alike. Each venture should develop one that meets its needs, not the needs of the accountant. The accountant is hired to accommodate the venture, not to dictate his or her wants. A venture needs an accounting and budgeting system that its personnel can understand and that provides the needed information in a usable form. Timeliness is essential. Budget information two months old is of little use. A venture should have its accounting information within at least two weeks after the end of the month. One big advantage of having an in-house bookkeeper in addition to an outside accounting firm is that access to needed information is much faster.

Management by percentages At the heart of most budget systems is a basic philosophy called management by percentages. For most businesses, experience has established that a firm can afford to pay only a certain percentage of its sales for each expense. For example, in the menswear manufacturing business one owner found it difficult to make a profit if he paid more than 8 percent for rent, or 10 percent for sales compensation, or 5 percent for management salaries. Naturally, these expenses depended upon the particular philosophies and plans of management. Where one manufacturer may rely heavily on advertising, budgeting perhaps 10 percent of sales for it, another may rely on trade shows to bring in the business, thus budgeting only 4 percent for advertising. The budget that the owner eventually arrived at left him 9.8 percent of sales for profit. Most percentage budgets are built on operating experience. The owner copied the operations of another business.

THE BUSINESS MENTOR — Budgeting

If a venture is just starting out, it is much better off making up the budget in dollar amounts based on actual field determination of what the expenses will be. This is the reason that good budget building requires considerable time and effort. Of course, the entrepreneur’s experience bears greatly upon the amount of work that must be done. An experienced operator knows the costs and percentages and can develop a meaningful budget rather quickly. The inexperienced person must work at it or find some experienced operator to do the budget.

Composite budgets Some managers prefer to develop several budgets, one for each separate significant segment of the business, and then combine them into a composite overall budget. For example, a menswear merchant developed three budgets: sales, capital, and expenses. The sales budget was developed in great detail by lines and months. It was used not only for developing the cash flow statements and financial budgets but was also used by the merchant as the basis for his buying. If separate budgets are developed in detail, then the overall budget is a simple one, consisting of a few lines. Some companies will develop a best-case/ worse-case projected budget. The best-case scenario represents the budget with which the management team thinks it can run the company. The worst case is usually the budget that reflects the break-even projection. Bankers like to see a company use this approach, so they know what the company has to do to stay in business.

Conclusion The need for entrepreneurs to master the development and use of budgets cannot be stressed too strongly. Entrepreneurs will find that following budgets is really the only way they can run businesses of any substance with any degree of confidence. Without budgets, ventures will sooner or later meet with trouble when some expenses run out of control and the managers know nothing about it until it is too late.

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