the budget system is one of the two major control

8/14/2019 The Budget System is One of the Two Major Control

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1THE BUSINESS M ENTOR Budget ing

Make no mistake about it, it takes greatdiscipline and mental toughness to abide by a budget, particularly in new enterprises, inwhich expenditures are often chaotic andunpredictable.

The new enterprises irregularities cannot beused as an excuse for not diligently developinga good budget system. Entrepreneurs resort toall sorts of excuses for not budgeting. We cant budget. Our revenues are too uncertain. Wehavent time to budget. Thats something big business does. Such excuses are not onlynonsense, but are dangerous to the firmssolvency.

Coordinating activitiesThe budget helps top management coordinatethe activities of all departments. If $500,000 insales is to be shipped, then the shippingdepartment must be allowed enough money todo the job.

Production must be coordinated with sales.The firm cannot ship $500,000 worth ofproducts if they have not been produced. Theproduction budget tells the factory what is to bemade.

If $500,000 sales of product are to be made,the finance department must be prepared to

finance the operation.

s Benefits of budgetings The budgeting processs The budget book s Customize the budgets Management by percentagess Composite budgets

Budgeting

The budget system is one of the two majorcontrol tools for a business. The other is the cashflow plan.

A budget is simply a tool, a financial guide,which a manager uses to plan profitableoperations by anticipating and allotting therevenues and expenditure of funds. Thus, the budget is the basic source of information fedinto the cash flow plan. Once the various budgets have been developed, the cash flowplan naturally follows.

By adopting various budgetary procedures,management hopes to guide the operations to apredetermined enda certain amount of profitfrom a certain volume of sales. Without a budget, management could never be certainwhether operations were going successfully.

Benefits of budgetingBudgeting plays a major role in businessplanning. Five major benefits are realized byusing a good budget system:s It controls expense-revenue ratios.s It coordinates activities in the organization.s It establishes a standard of performance.s It serves as an evaluation tool.s It triggers remedial managerial action.

Control of expense-revenue ratiosMaintaining the desired relationship betweenexpenditures and revenues is the key to profits.Losses result when expenses exceed revenues.The objective of business is to buy revenues inthe market at a reasonable cost, and the budgetestablishes what that cost should be. Thus, the budget helps keep expenses in line withrevenue. In theory, a firm can make money at

almost any level of sales if it keeps its costsproportional to its revenues.


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Establishing performance standardOnce the budget is established, it becomes thestandard of performance for all departments,that is, what is expected of them. Marketing isexpected to sell $500,000 and spend $25,000doing it. The budget becomes the goal. The

name of the game in business is meet the budget. Those people who fail to do so seldomlast long in most organizations.

Evaluation toolNaturally, if a group fails to meet its budget, it isnot looked upon with favor by topmanagement. Thus, the budget becomes ameans for evaluating each units performance.

Obviously, this aspect of budgeting causessome problems. Knowing that the budgets theysubmit may be the rope that hangs them, thedepartment heads can become cautious by

asking for far too much money and promisingfar too little output. Budget meetings can beinteresting as the final budget figures arepounded out between departments and themanagement.

Triggering remedial actionThe months budgetary performance is on theentrepreneurs desk. The telephone budget was$2,800; the actual was $4,700. Thats too muchvariance. What happened? The entrepreneurcalls for the bill and either scans it himself orhands it to someone else to do it. It is importantto know who spent the $1,900 and why. Was itnecessary? If so, OK, those things happen. Themoney will have to be made up elsewhere. Butif the calls were not necessary, they must bestopped.

It is critical for effective cost control thatquick action be taken to remedy unnecessarycost overruns. Allowed to go unchecked, theynot only accumulate a large sum of money, butthey tend to accelerate in amount as employeeslearn that cost overruns dont seem to beimportant and the staff does not focus on the bottom line.

By quickly and forcefully coming down onoffenders, several messages are delivered tostaff members. First, they learn thatmanagement is watching what is spent and thatit is on top of operations. Second, they learn thatmanagement means business about staying

within budget. Third, they learn what happensto people who misuse company money. Oncethe proper tone is set within the company,controls become much easier to administer. Thestaff learns that the very survival of theenterprise depends on staying within andmeeting the budgets.

The budgeting processThe process of budgeting is simple; doing it is alot more involved. The budget begins with thesales forecast, since all activities must be tied tothe anticipated level of sales. Once the sales

forecast has been set, then that figure is given toeach head of a budgetary unitthe marketingmanager, the production manager, for example.In many smaller new ventures, the entrepreneurworks up the entire budget with the help of theaccountant.

Obviously, the more reliable the salesforecast, the easier it is to budget operations. Asthe sales forecast becomes increasingly suspect,the budget-making process becomes moretentative. It is difficult to budget a large sum ofmoney for advertising in advance of sales ifsales are uncertain. It is difficult to budget forhiring new employees in the shipping room ifthe volume of shipments is in doubt.

When developing budgets, the followingkey factors need to be considered:s The role of assumptionss Forecasting sales under uncertain conditionss Expense lead times Budget periodss Line-item budgetings Program budgetings Budget accountss Start-up costs


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The role of assumptionsA word needs to be said about the need formaking assumptions in developing the budget.For example, the sales forecast is developed based on several assumptions about economicactivity, new products coming on line, levels of

competitive activity, prices, and so forth. Theseassumptions should be clearly stated in the budget document. The figures can be no betterthan the validity of the assumptions uponwhich they are based.

Various assumptions underlie many of thefigures in the budget. These should befootnoted in the budget so readers will knowhow each figure was derived. The validity ofthese assumptions affects all planning because aplan can be no better than the assumptionsupon which it is based. The cash flowprojections are similarly based on manyassumptions; a company must assume manythings in projecting its sales and costs.Management must make certain thoseassumptions are clearly recognized and stated.

Underlying all planning are some implicitassumptions that often go unrecognized, suchas the state of the economy, the state of worldpeace, no adverse political or regulatorydevelopments, the continued good health of theentrepreneur, no adverse technologicaldevelopments, and so on. In general, mostplanning assumes a static environment. Anysignificant changes in the environment oftenmake plans go astray.Forecasting salesWhen management cannot forecast sales withany degree of confidence, two approaches can be used. The minimum-budget approach can beused when forecasting sales is difficult, such aswhen the venture is introducing a new productto the marketplace. For example, the owner candraw up a minimum budget that wouldindicate the least money for which eachfunction can be performed. He or she wouldstart out with the minimum amount of moneyneeded for each expense center, and thenallocate more funds to the budgets as saleswarrant. Budgets can be flexible, thus allowingfor changes in a firms fortunes.

The second approach involves developing amust-do budget. Sometimes the founder, in theabsence of good, hard data on which to base theforecasts and the budgets, sets the budget onthe basis of what must happen if the company isto make it. Its pointless to set budgets that

result in failure. Set budgets that result insuccess. No founder wants to budget his or herventure into failure.

Expense lead timeThe flexibility in a budget depends greatly onhow much time is involved between theexpenditure of funds and the receipt of salesdollars from those expenditures. At one extremeis a project in which all funds must be spentlong before any sales revenues can be realized.If a venture is building oil rigs, managementmust spend a lot of money before it ever knows

whether the venture will earn a dollar ofrevenue from a well. For this reason, oiladventurers prefer to use other peoples moneyto drill wildcat wells. Let people who want totake such gambles put up the money.

At the other extreme, there are businesses inwhich revenues are received before muchmoney is spent. Perhaps a customer pays upfront, such as in the cases of insurance,magazines, many direct-mail promotions, andcustom manufacturing. Such instances arefortuitous, for the ventures management knowsits sales volume on which to plan its budgetsystem, and all it must do is stay within budgetfor fulfilling the contract.

If sales volume follows expenses by a shorttime, a month or so, then the budgeter canquickly reduce or expand budgets to reflectsales experience. Risks are minimized. Thelonger the lead time of expenses over sales, thelarger the risk of losses due to spending toomuch money because of over-budgeting by thevarious expense centers.

Budget periodsMost often the budget is prepared for thecoming year by months. Sometimes, in stronglyseasonal businesses such as the apparelindustry, each budget will be for a season.Sometimes, in project-management types of businesses such as defense manufacturing andcontracting, a budget is prepared for eachcontract.


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Start-up costsOne method of determining how much money aventure will need at start-up is to do a mentalwalk-through of what the business will look like. The following questions should be asked todetermine start-up costs:s Where will the business be?s What size will it be initially?s What will the office or retail space look like?s What types of walls and fixtures will it have?s What type of equipment will be needed,

such as computers, furniture, carpet, copymachine, shelving?

s What types of signs will be required?s How much of an opening inventory will the

business need?s How will it be paid for?s What kinds of deposits will be required? Forinstance, how much will deposits cost for

telephone, utilities, and rentfirst and lastmonth?

s What city codes must be complied with, andare there any costs involved?

s What types of government (local, state,federal) business licenses will be required?

s What types of supplies will be needed forcleaning, office correspondence, shipping, boxes?

s What kinds of marketing costs will beincurred before opening for brochures,advertising, stationery, and business cards?

s What are potential costs for recruiting andhiring initial staff?

s What type of staff training is necessary before opening?When estimating these expenses,

entrepreneurs should be as realistic andaccurate as possible. They always discoverhidden costs that are incurred but not plannedfor. Other owners in a similar business can bequeried about what their start-up costs wereand how much money they suggest be reserved before opening doors for business.

Most lenders recommend that entrepreneurshave a minimum of three-months operatingcapital on hand.

Avoid forcing the budget process or tryingto underestimate start-up costs. Let the budgeting process indicate how much moneythe business concept needs.

For example, one entrepreneur wanted tolaunch a venture that involved manufacturingsubmarines and selling them to operators ofunderwater ocean tours at island resorts. Theidea seemed feasible.

After estimating his start-up budget, he

discovered that he needed about $1.2 million foroperating capital to launch the venture. Hecould raise only about $10,000. After estimatingstart-up costs, he determined there was no wayhe could start this business himself.

There is no lack of ideas for launching newcompanies, but venture ideas must match theentrepreneurs personal and business criteria aswell as his or her pocketbook. Problems, such asrunning out of money or realizing enoughmoney cannot be raised to launch a ventureidea, can be avoided by accurately estimatingstart-up costs and preparing an initial start-up budget.The budget bookWhen some entrepreneurs managed the budgetary system of their company, theydeveloped an effective yet simple way ofmonitoring the chains monthly budgetperformance.

First, the entrepreneurs developed abudget book, a loose-leaf ledger or computerprogram containing information for each budget account. Each sheet showed the budgetand actual figures for that account for theprevious 12 months, the projected budget forthe year by months, the current actualperformance, and the variance of the actualfigures from the budgeted figures.

The bookkeeper prepared the data for theentrepreneurs by the 5th of each month. Eachaccount that was over or under budget wascircled in red. The entrepreneurs would glanceat the red circles and decide if the differencewas significant. If so, was it explainable? Didthey know why it happened? If they did notknow the reason for the significant variance, theentrepreneurs would call for the checks or otherdocuments that supported the out-of-lineexpenditures. If problems were identified, planswere made to take immediate action. Manyentrepreneurs claim this system is the only wayto manage a budget for their businesses. It takesonly 15 minutes a month to survey theorganizations budgetary performance.


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Customize the budgetNo two budget systems should be alike. Eachventure should develop one that meets itsneeds, not the needs of the accountant.The accountant is hired to accommodate theventure, not to dictate his or her wants.A venture needs an accounting and budgetingsystem that its personnel can understand andthat provides the needed information in ausable form.

Timeliness is essential. Budget informationtwo months old is of little use. A venture shouldhave its accounting information within at leasttwo weeks after the end of the month. One bigadvantage of having an in-house bookkeeper inaddition to an outside accounting firm is thataccess to needed information is much faster.

Management by percentagesAt the heart of most budget systems is a basicphilosophy called management by percentages.For most businesses, experience has establishedthat a firm can afford to pay only a certainpercentage of its sales for each expense.For example, in the menswear manufacturing business one owner found it difficult to make aprofit if he paid more than 8 percent for rent, or10 percent for sales compensation, or 5 percentfor management salaries. Naturally, theseexpenses depended upon the particularphilosophies and plans of management. Whereone manufacturer may rely heavily onadvertising, budgeting perhaps 10 percent ofsales for it, another may rely on trade shows to bring in the business, thus budgeting only4 percent for advertising.

The budget that the owner eventuallyarrived at left him 9.8 percent of sales for profit.Most percentage budgets are built on operatingexperience. The owner copied the operations ofanother business.

If a venture is just starting out, it is much better off making up the budget in dollaramounts based on actual field determination ofwhat the expenses will be. This is the reasonthat good budget building requires considerabletime and effort. Of course, the entrepreneurs

experience bears greatly upon the amount ofwork that must be done. An experiencedoperator knows the costs and percentages andcan develop a meaningful budget ratherquickly. The inexperienced person must work atit or find some experienced operator to do the budget.

Composite budgetsSome managers prefer to develop several budgets, one for each separate significantsegment of the business, and then combinethem 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 linesand months. It was used not only fordeveloping the cash flow statements andfinancial budgets but was also used by themerchant 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-casescenario represents the budget with which themanagement team thinks it can run thecompany. The worst case is usually the budgetthat reflects the break-even projection. Bankerslike to see a company use this approach, so theyknow what the company has to do to stay in business.

ConclusionThe need for entrepreneurs to master thedevelopment and use of budgets cannot bestressed too strongly. Entrepreneurs will findthat following budgets is really the only waythey can run businesses of any substance withany degree of confidence. Without budgets,ventures will sooner or later meet with troublewhen some expenses run out of control and themanagers know nothing about it until it is toolate.

the budget system is one of the two major control

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