Four Planning Approaches to Operating Budgeting

URL: http://accounting-financial-tax.com/2012/02/four-planning-approaches-tooperating-budgeting-four-planning-approaches-to-operating-budgeting/
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A companys annual financial plan is called a budget. In short words; a budget is a set of pro-forma statements about the companys finances and operations. Before a company or other organizations can develop operating budgets, management must decide what planning approaches to budgeting will be used for the various revenue and expenditure activities and organizational units. What are the four approaches? A budget is a tool for both planning and control. At the beginning of the period, the budget is a plan or standard; at the end of the period, it serves as a control device to help management measure the firms performance against the plan so that future performance may be improved. The budget itself is classified broadly into two categories: the operational budget, which reflects the results of operating decisions; and the financial budget, which reflects the financial decisions of the firm. The operating budget consists of: (a) Sales budget; (b) Production budget; (c) Ending inventory budget; (d) Direct materials budget; (e) Direct labor budget; (f) Factory overhead budget; (g) Selling and administrative expense budget; and (h) Pro forma income statement. So what are the four planning approaches to the operating budget? Widely used planning approaches to budgeting include the input/output, activity-based, incremental, and minimum level approaches which are discussed through this post. Read on

Output/Input Approach
The output/input approach budgets physical inputs and costs as a function of planned unit-level activities. This approach is often used for service, merchandising, manufacturing, and distribution activities that have defined relationships between effort and accomplishment. For example, if each unit produced requires 2 pounds of direct materials that cost $5 each, and the planned production volume is 25 units, the budgeted inputs and costs for direct materials are 50 pounds (25 units X 2 pounds per unit) and $250 (50 pounds X $5 per pound). The budgeted inputs are a function of the planned outputs. The output/input approach starts with the planned outputs and works backward to budget the inputs. The downside of the output/input approach is, that its difficult to use this approach for costs that do not respond to changes in unitlevel cost drivers.

Activity-Based Approach

The activity-based approach is a type of output/input method, but it reduces the distortions in the transformation through emphasis on the expected cost of the planned activities that will be consumed for a process, department, service, product, or other budget objective.

Overhead costs are budgeted on the basis of the cost objectives anticipated consumption of activities, not based only on some broad-based cost driver such as direct labor hours or machine hours. The amount of each activity cost driver used by each budget objective (for example, product or service) is determined and multiplied by the cost per unit of the activity cost driver. The result is an estimate of the costs of each product or service based on cost drivers such as assembly-line setup or inspections, as well as the traditional volume based drivers such as direct labor hours or units of direct materials consumed. Activity-based budgeting predicts costs of budget objectives by adding all costs of the activity cost drivers that each product or service is budgeted to consume. In evaluating the proposed budget, management would focus their attention on identifying the optimal set of activities rather than just the output/input relationships.

Incremental Approach
The incremental approach budgets costs for a coming period as a dollar or percentage change from the amount budgeted for (or spent during) some previous period. This approach is often used when the relationships between inputs and outputs are weak or nonexistent. For example, it is difficult to establish a clear relationship between sales volume and advertising expenditures. Consequently, the budgeted amount of advertising for a future period is often based on the budgeted or actual advertising expenditures in a previous period. If budgeted advertising expenditures for 2011 were $200,000, the budgeted expenditures for 2012 would be some increment, say 5 percent, above $200,000. In evaluating the proposed 2012 budget, management would accept the $200,000 base and focus attention on justifying the increment. The incremental approach is widely used in government and not-for-profit organizations. In seeking a budget appropriation, a manager using the incremental approach need only justify proposed expenditures in excess of the previous budget. The primary advantage of the incremental approach is that it simplifies the budget process by considering only the increments in the various budget items. A major disadvantage is that existing waste and inefficiencies could escalate year after year.

Minimum Level Approach

As the portion of non-variable costs increased for most companies throughout the twentieth century, an increasing portion of costs was budgeted using the less precise incremental approach. This lack of good budgetary controlled to further increases in costs. Management attempted to better control costs by employing a number of variations on the incremental approach. The minimum level approach is representative of these attempts to control the growth of costs not responding to unitlevel drivers. Using the minimum level approach, an organization establishes a base amount for budget items and requires explanation or justification for any budgeted amount above the minimum (base). This base is usually significantly less than the base used in the incremental approach. It likely is the minimum amount necessary to keep a program or organizational unit viable. For example, the corporate director of product development would need some basic amount to avoid canceling ongoing projects. Additional increments might also be included, first to support the current level of product development and second to undertake desirable new projects.

Some organizations, especially units of government, employ a variation of the minimum level approach, identified as zero-based budgeting. Under zero-based budgeting every dollar of expenditure must be justified. The essence of zero-based budgeting is breaking an organizational units total budget into program packages with related costs. Management then ranks all program packages on the basis of the perceived benefits in relationship to their costs. Program packages are then funded for the budget period using this ranking. High-ranking packages are most likely to be funded and low-ranking packages are least likely to be funded. Budgeting for objectives is a variation on the minimum level approach that combines elements of activity-based and zero-based budgeting with a need to live within fixed financial constraints. The minimum level approach improves on the incremental approach by questioning the necessity for costs included in the base of the incremental approach, but it is very time consuming. All three approaches are often used within the same organization. A manufacturing company might use the output/input or the activity-based approach to budget distribution expenditures, the incremental approach to budget administrative salaries, and the minimum level approach to budget research and development.

Essential Five Steps On Budgeting Process

URL: http://accounting-financial-tax.com/2009/02/essential-five-steps-onbudgeting-process/
FEBRUARY 25, 2009 1:06 AM 13 COMMENTSVIEWS: 10,720

The principal tool in planning is called a budget. Most of you know what a budget is and what various types of budget are. You probably put one together for your household expenses to figure out, based on what you make, how much you can afford to spend next year. Businesses rely on budgets too for much the same reason. How are budgets put together? This post provides simply understandable five steps on budgeting process. It comes with easy descriptions on budgeting terms, rich in nuances, illustrated with some really easy examples for light-weighted reading. Read on A budget is a collection of predictions. Just because a budget says that a departments revenue and expenses will balance does not mean that they will. So as the year wears on, companies may require some departments to trim costs to make up for bad revenue or expense predictions.

The Rule of Three In Budgeting : The Rule of Three is simply a method to help companies prepare for such a contingency. This rule of budgeting says that a company or its individual departments ought to divide itself into three parts: one part that is considered essential, another part that is desirable, and a third part that is dispensable. This way, if a division must pare itself down quickly, so as not to run a deficit, it will already know which units to cut.

Regardless of the type of budget youre dealing with, each is assembled in similar ways. The budgeting process requires essentially five steps: Step 1: Determining the Flow of Information A company gathers the data necessary to compile a budget in one of two ways: 1) It centralizes the process and has senior management establish the companys priorities and projections; or 2) it directs individual work units and departments to assemble that information on their own. The former is referred to as top-down budgeting, the latter as bottom-up. In general, budgets that are constructed from the bottom up are preferable, if only for the reason that individual workers and units know more about their departments than central management. On the other hand, bottom-up budgeting requires more time to execute and is difficult to manage.

Step 2: Deciding What Youre Going to Measure Imagine you work for Lie Dharmas Sporting Goods. But this time, imagine the company is much larger than we first described. In addition to selling basketballs, it sells baseballs and soccer balls, too. And imagine that Lie Dharmas has operations in North America, Asia, and Europe. When Lie Dharmas prepares its budget, should it gather information based on its products? For instance; should it make separate sales and cost projections for basketballs, baseballs, and soccer balls no matter which country they are sold in? It could do that. Or should it

make projections based on its regions of operations? For instance; should it make separate sales and expense projections for its products based on whether they are sold in North America, Asia, or Europe? It could do that, too. Or should it break down its budget projections based on functions? For instance; should its marketing and manufacturing divisions assemble their own separate budgets that cover all regional operations and all products? Once again, it could. The answer depends on how your company is organized, or how it wants to be organized. For instance: If Lie Dharmas is organized in such a way that each of its products are separate profit centers which means that the basketball division would be in charge of its own manufacturing, distribution, marketing, and sales functions completely separate from the functions of the baseball and soccer ball divisions then it will probably budget along its product lines. If the companys geographic operations are separate profit centers, sometimes called accountability centers, then it may choose to budget by region. And if the company is organized based on traditional functions for instance, theres a separate sales department that handles all products in all regions, a separate manufacturing department that handles all products in all regions, and a separate distribution department for all products in all regions then it may budget along these lines. The sales department, in this situation, would be referred to as a revenue center, while the manufacturing and distribution divisions would be considered cost centers. Step 3: Gathering Historic Data After a company decides how it will segment its operations, it turns its attention to gathering historic performance information. The first place to look for historic performance data is the companys financial statements its balance sheet, income statement, and cash flow statement. Another source would be the financial ratios. Finally, the managerial reports supplied to company executives throughout the year serve as useful tools in gathering more specific data, such as sales trends for individual products, cost trends for those products, and divisional performance. [a]. Gathering Sales Information When it comes to gathering historic sales data, your company ought to know its past performance based on:

Product lines. In the case of Lie Dharmas Sporting Goods, the company should know how its basketball, baseball, and soccer ball sales have done for at least one to two years, but preferably three to five years or more. Regions. Lie Dharmas should also be able to break down past sales performance based on its regions of operation. For instance, it should know how well basketballs have sold recently in North America. In addition, it should know how sales are doing in specific countries and markets. Customers. Its not enough for Lie Dharmas to know how many baseballs it is selling in Mexico. It needs to know who is buying its baseballs. For instance, what percentage of Lie Dharmas Sporting Goods sales growth is due to its contracts with large retailers as opposed to small independent stores? This information can be useful in making future projections. For instance, lets assume that the Mexican economy is headed for a recession. And large retailers have historically weathered these recessions better than small independent sporting goods stores. If Lie Dharmas sells the majority of baseballs in Mexico to large retailers, then its sales might not be altered too much based on changing economic conditions. But if the

company sells the majority of baseballs in Mexico to small stores, then it might take that information into account when adjusting its forecasts for its Mexican sales or overall sales of baseballs. [b]. Gathering Expense Information When it comes to gathering historic expense data, your company should know its past performance based on:

Direct costs. This includes raw materials, labor, and inventory costs. Indirect costs. This includes selling, research & development, and general & administrative expenses. Fixed costs. This includes many of the indirect costs of doing business, such as rent and depreciation which are part of G&A expenses. Variable costs. This includes many of the direct costs of doing business, such as raw materials, energy, and labor costs as well as taxes, which are also considered a variable expense.

Step 4: Making Projections The forth step in the budgeting process is for the company to project its performance for the coming year. A budget is only as good as its projections. Establishing budget projections can be as simple or complicated a task as your company makes it. For instance: some companies rely on incremental budgeting, in which forecasts are directly tied to past performance and are therefore easy to prepare. Others rely on zero-based budgeting, in which forecasts have nothing to do with past performance and are therefore more difficult to prepare. And still others rely on a hybrid approach. Lets talk about these three budgeting approaches a little bit. Read on

Incremental Budgeting Imagine youre preparing your companys sales budget. Last year, the company spent $10 million on newspaper advertising. How much should your company budget for newspaper ads next year? Some companies would take that $10 million figure, and add to it an additional 10 percent or $1 million to factor in inflation and an acceptable level of growth in spending. This is referred to as incremental budgeting.

Incremental budget projections are the simplest to prepare. All you need to know is what the company spent or made in the previous year. Then you tack on whatever percentage increase or decrease you think is appropriate.
On the other hand, the incremental approach is the least precise method for preparing a budget. Often, companies that rely on incremental budgets repeat past mistakes. Lets say Lie Dharmas Sporting Goods budgeted $1 million for general and administrative costs last year. Though the company could get by with just $750,000 this year, it budgets $1.1 million not because it needs it, but because it is about the same amount it spent the previous year.

Zero-Based Budgeting Zero-based budgeting is the antithesis of the incremental approach. Popularized in the 1970s, zero-based budgets operate on the premise that the amount a company budgeted for a line

item in one year has little to do with what it should be budgeting in future years. While more accurate than incremental budgets, zero-based budgets require tremendous amounts of information. Thus, they are extremely time-consuming and expensive. The Hybrid Method Most companies rely on a hybrid approach to budgeting, in which projections are based in part on past performance. However, current industry trends and macroeconomic forces are also considered in part of the equation.

Industry Trends The health of your industry can have a profound impact on your companys sales projections. For instance, no matter how effective your sales division is and how impressive your products are, larger developments in your industry can destroy your budget projections. Just consider what happened to restaurants that sold beef in England during the Mad Cow Disease scare of the mid- to late 1990s. Companies turn to a variety of sources to gather this information, including: Trade associations and publications. Most trade associations publish industry-wide sales and expense information based on figures provided by their members. In addition, companies like Dun & Bradstreet publish key financial ratios that can help businesses assess the health of their industries. Available financial statements. Publicly traded companies are required by the SEC to submit quarterly 10-Q reports, annual 10-K reports, and comprehensive annual reports that include financial statements. This information is primarily useful for investors, but competitors can also use it to discover broad trends in the industry. Available government data. Various agencies, such as the Commerce Department, the Agriculture Department, and the Labor Department put out regular reports on industry trends. Internal experts. Companies should also rely on their own officers who are intimately familiar with broad industry trends to contribute to this analysis. Economic Data The health of the economy can play a dramatic role in the health of your business, too. In fact, a number of outside influences will throw off your companys budget projections. Those include:

Economic downturns. Sales projections are often predicated on a certain degree of overall economic health. A sudden recession, for instance, could reduce overall consumer demand. Local economic slowdowns can be just as devastating. Consider what happened to companies in Southern California as defense contracts were cut during the late 1980s and early 1990s. Inflation. Even a slight increase in inflation can increase a companys expenses, from energy to raw materials to labor. Just recall the effects of hyper-inflation in the 1970s and early 1980s on U.S. industrial profits. Inflation can also dampen sales, due to increased prices. Interest rates. If the Federal Reserve raises rates, it would increase the cost of borrowing money, which would increase a companys expenses. So interest rate fluctuations should be factored into budget projections. Consumer confidence. A slight decrease in consumer confidence could hurt consumer demand, which could alter your companys sales projections. Currency trends. A sudden change in exchange rates could wipe out potential profits for multinationals, exporters, and importers.

Politics. President Clintons failed attempt at healthcare reform in 1993 boosted the shortterm fortunes of HMOs, but crippled medical research companies. When making budget projections, your company ought to keep similar political issues in mind. Natural disasters. Insurers and companies that do business in disaster-prone regions must consider the potential effect of natural disasters-both positive and negative. If your company is a retailer or manufacturer, for instance, a single hurricane can wipe out a major portion of its business. If your company is a contractor, natural disasters can actually boost sales, since communities must rebuild following disasters. These days, many companies consult with independent weather services before forecasting sales and inventory trends. Technology. New technological developments can often boost or reduce demand for your products. They can also impact your costs. Regulatory trends. Businesses must also assess potential changes in the regulatory environment. Thats what healthcare companies were forced to do during the healthcare reform debate of 1993. And thats what tobacco companies have been forced to do in recent years.

The final step is: Determining break-even point. Break-even point determination (calculation) is much more technical than the other steps. Some terms need to be well understood before going to the calculation, such as: Contribution Margin. Break-even point comes with many ways depending on the needs, e.g.: Break Even by Units, Break Even by Sales. On this post I am going to even extend this topic to beyond the break-even point itself. To you who interested in Break-even point, you may want to follow my next post [here].

Why Budgeting Kills Your Company

URL: http://hbswk.hbs.edu/item/3623.html
Published: August 11, 2003

Executive Summary:
Why doesnt the budget process work? Read what experts say about not only changing your budgeting process, but whether your company should dispense with budgets entirely.

About Faculty in this Article:

William J. Bruns is the Henry R. Byers Professor of Business Administration, Emeritus, at Harvard Business School.

The average billion-dollar company spends as many as 25,000 person-days per year putting together
the budget. If this all paid off in shareholder return, that would be fine. But few organizations can make that claim. In fact, many firms now question the ROI of traditional budgeting altogether and are looking for alternatives that reduce time and better align spending with strategy.

Look at your own company's budget process: Has it really helped you do a better job of belt tightening during the current slowdown? Many companies have reverted to more centralized command-and-control procedures to keep a tight rein on costsbut the dynamics of the budgeting process often undermine this effort.

"In tough times like these, any significant real cost growth feels imprudent and is hard to justify for most businesses," writes Mike Baxter, a partner in the consulting firm Marakon Associates (New York City), in a recent company publication. "Business units have used their budgets as a bargaining chip, bidding high to get a larger slice of the pie while keeping their cards close to their chest.

"The CEO has had no choice but to get them back into shape, though he lacks any clear line of sight for identifying and challenging the least valuable resources," Baxter continues. All too often, the CEO must opt for across-the-board cutseven though he knows that this approach penalizes the high-performing units and props up the underperforming ones. The result is a decoupling of the company's resource allocation process from the highest-value strategic opportunities.

The answer, some experts say, is to dispense with budgets entirely.

The answer, some experts say, is to dispense with budgets entirelyand replace them with a system of rolling forecasts and key performance indicators that shifts strategic decision making to customer-facing edges of the organization. Others advocate less sweeping but still significant changes: Housing the budgeting and strategic planning functions in one office, establishing top-down goals three to four years out, and requiring all business units to explore the budget implications of several strategic alternatives.

The following discussion will help stimulate your thinking about how your own company's budgeting process can be transformed from an exasperating exercise in pork barreling and interdepartmental brinksmanship to a tool for achieving strategic alignment.

How fixed-performance contracts ensure underperformance

At its simplest, a company's budget process consists of each unit producing a sales forecast (assuming it's a profit center) and a capital needs forecasts. "I've seen some annual budget processes that didn't take any time at all," says William J. Bruns Jr., Henry R. Byers Professor of Business Administration, Emeritus, at Harvard Business School and a visiting professor at Northeastern University. After each unit's sales and capital needs forecasts are complete, "senior management holds a three-day meeting to discuss them and then makes its decisions. Of course, at the other end of the spectrum, you have these 200-page budget books that get produced, requiring months of meetings."

In some instances, the budget process consumes up to six months and 20 percent of management's time.

Most companies' approach to budgeting increases the chances that the process will be arduous, expensive, and frustrating, says Jeremy Hope, coauthor with Robin Fraser of Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap (Harvard Business School Press, 2003).

The culprit is what he calls the fixed-performance contract. "The targets for sales, costs, and key ratios that are spelled out in the budget become an implicit contract," he says. A recent Hackett survey found between 60 percent and 90 percent of the top 2,000 global companies have this sort of contract. "And there are usually financial incentives attached: Career prospects and bonuses ride on this contract incentives for hitting the targets amount to as much as 97 percent of a U.S. manager's annual salary.

"There's terrific pressure on everyone to make those targets; hence the distortion, misrepresentation, and gaming that can happen in even the most ethical companies," Hope continues. "If you're a manager trying to increase spending or get a capital project approved, you put in for 50 percent more than you need, knowing you'll get argued down by senior management to what you originally wanted."

At the same time, the fixed-performance contract fosters the fear in managers that if they don't spend what's left over in their budgets at the end of the year, their funding for the next year will be reduced. Cost discipline thus takes a back seat to turf protection. The budget process may help establish a ceiling on costs, but the internal politics of the fixed-performance contract ensure that there is also a cost floorin other words, that the cost savings aren't as sizable as they might be.

As long as budgeting, a vestige of the old command-and-control approach to management, remains in place, the newer tools designed to decentralize strategic decision making will never achieve their full potential, Hope and Fraser argue. The solution is not better budgeting "but rather abandoning budgeting entirely and building an alternative management model," they write. Among the features of the approach they recommend, which is currently being used by organizations in a range of industries and countries, are the following:

Goals based on longer-term external benchmarks instead of internally negotiated annual targets.Adopt benchmark goals based on "industry best-in-class performance measures or direct competitors," Hope and Fraser write; and give teams "an extended period of time to reach them"two to three years. Atlanta-based eye-care company CIBA Vision found that the move to competitor and market performance benchmarkschief among them sales growth, return on sales, and economic value-added (EVA) growthnot only helped it shorten and simplify its budgeting process, it also reduced the amount of budget gaming.

Evaluation and rewards based on relative-improvement contracts. Such contracts involve "a whole team setting and meeting a range of performance benchmarks over a period of time," write Hope and Fraser. "Performance is then evaluated by a peer review group (using relative measures) with the benefit of hindsight." At the Swedish bank Svenska Handelsbanken, the company's eleven regions compete like teams in a league, trying to beat one another's return on equity. Similarly, the 550 branches compete on two other key performance indicators: Cost to income and profit per employee. The relative standings are publicized throughout the company. The uncertainty of this relative-performance approach drives success. Each manager knows from the outset "what has to be done to improve his or her usual performance," Hope and Fraser write. But it is only in hindsight that they know how well they have performed relative to the other managers. This leads them to focus on "maximizing profits at all times rather than playing games with the numbers" to meet artificial annual targets.

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Continuous and inclusive action planning. A five-quarter rolling forecast that provides projections for each of the five subsequent quarters can help eliminate the distortion caused by having financial incentives to meet a fixed target for a single fiscal year. A typical rolling forecast may have only a few line items: Orders, sales projections, costs, profitability, cash flow, and capital investment. But this information is enough to enable managers to focus on long-term issues that are fundamental to the business's successfor example, why customers are leaving or what's wrong with a particular product.

Resources that are made available as needed, instead of allocated in advance. Handelsbanken gives its branch managers the freedom to decide which products to sell and to set their own prices and discounts. (Branch managers know that whatever decisions they make about prices and products, their costs must be about 40 percent of income.) Similarly, each branch manager gets to decide what resources the unit needs.

To make its central services more responsive to market demands, Handelsbanken conducts an annual round of negotiations in which cost estimates and the services underpinning them are discussed by all involved. Regional and branch managers can challenge the prices and even choose to go with outside

vendors. Since the early 1990s, branch managers have had the authority to determine staffing levels and set staff salaries. At first, senior managers predicted that it would lead to an increase in the number of workers. But the opposite has occurred; Hope cites this as evidence that the further out toward the customer-facing nodes of an organization you push the profit responsibility, the more cost-conscious and innovative the employee behavior you get. Indeed, since Handelsbanken abandoned budgeting in the early 1970s, it has bested its Scandinavian rivals on return on equity, total shareholder return, cost-toincome ratio, and customer satisfaction.

The budget as an agent of strategic alignment

Other experts are not as eager for a complete overhaul. Harvard's Bruns suggests keeping budgets but restructuring compensation programs so that managers no longer have an incentive to favor short-term goals over the longer-term health of the company. By getting rid of the inflexible approach to short-term targets, you answer the problem that lies at the heart of Hope and Fraser's critique of budgeting.

Although Marakon's Baxter also doesn't advocate the wholesale replacement of traditional budgeting, he does believe that changes must be made to reforge the link between a company's strategic planning and resource allocation.

"Budgeting and performance are typically overseen by the finance department," he says, "whereas planning is coordinated by a strategy department. Often, the two processes aren't well integrated, resulting in strategies that are often dictated by the budget process instead of vice versa. When it comes time for senior management to review the units' investment proposals, their decisions are often blind to their impact on long-term value.

"Resource allocation should be about putting funds behind the right high-value opportunities," Baxter continues. He recommends creating an all-in-one process in which the CEO takes the lead in setting the strategic planning goals for all units, reviewing alternative strategies with business units, and linking resources to delivery of the alternatives with the highest value and best performance characteristics. With this approach, you're more likely to get not only the level of performance you're seeking, but also the particular implementation path that you're after.

Although you want to encourage bottom-up thinking about how best to achieve the desired performance, you also need to create some discipline. "Many business unit managers are overly optimistic about the long-run performance potential of their strategies, leading them to overinvest in the near term," says Baxter. Senior management can provide valuable top-down guidance here by using three- to five-year strategic plans to define the boundaries of these discussions and then making sure they're clearly communicated at the outset of the resource allocation process. Next, charge each business unit with developing several alternatives as a way of helping the corporate center understand the highest-value, highest near-term profit, and lowest-cost options that exist in each unit. This helps create a genuine dialogue between the corporate center and the units about the resource and performance tradeoffs involved in choosing a particular alternative.

When you're clear on your strategic goals and have a process that integrates strategic planning with resource allocation and performance management, budgeting can actually work, Baxter says. It becomes a mechanism for ensuring not only that funds flow first to the strongest opportunities, but also that those opportunities actually deliver on their promise.