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Many organizations prepare an annual budget. Your role as an executive, owner, or director is to review the annual budget and approve it. So, this lesson is to prepare you to fulfill that duty. Let’s begin by understanding why we budget and how the budget comes together?

Let’s start with the Why. Budgets have many uses in the business and some of these uses actually conflict. Budgets get used to:
-Sets expectations for banks and shareholders about return. Often this version of the budget tends to be more conservative because there is nothing more damaging to credibility than missing your numbers.
-Set the target for senior, middle management and employees to achieve. Often this version of the budget is set more aggressively to keep people sharp and force them to focus more. However, it can’t be too aggressive, lest it lose belief in its achievability.
-Helps managers allocate and coordinate resources. The preparation and review of budgets structures a cross-functional conversation that helps the sales and production function align and the supporting functions to staff accordingly.
-Helps measure and monitor performance throughout the period to identify when things are going better or worse than planned to allow for adjustments to be made.
-Provides a future financial perspective of performance with helps with cash flow management, funding requirements, etc.

These all sounds like really good objectives, however, here in lies some of the challenges you will be confronted with as you go about deciding on where to set the budget for the next year:
-The aforementioned conflict between setting budgets that are either more or less conservative to serve different purposes. This can cause different versions of the budget or set unrealistically high or low targets which erode the effectiveness of the tool.
-Budgets are often prepared months in advance of the coming year. Planning a year or more in advance can be very challenging and often times, budgets quickly become irrelevant in dynamic businesses.
-Budgets tend to align with the fiscal year. Thus, as year progresses, the visibility gets shorter and shorter until the next fiscal year’s budget is approved.

So how does a business address these challenges?

Forecasting is a term you can use when you are looking for any financial forecast that is not a budget. It’s often just an update of the budget assumptions for new or better information. Forecasts can be updated monthly, quarterly, or only after the budget assumptions lose validity. When things start unfolding differently than the budget, often executives, owners and/or directors will request of management a forecast. This can be done as frequently as needed to get a sense of the future. Some businesses use a rolling forecasts to overcome some of the challenges of traditional budgeting. A rolling forecasts maintain a 12 month time horizon and get updated continuously.

Now let’s address the “how” of budgeting. There are two main approaches to budgeting:
1. The traditional approach takes last year’s results and then adjust them for any known changes in sales and operations for the upcoming year. For example, management targets several new customers and factors those into the sales budget, production updates the standard costs to arrive at a target margin, each department determines whether more or less resources are required. One-time items that hit last year’s numbers are also normalized. This is generally a more efficient but less precise approach to preparing a budget.
2. Zero based budgeting takes nothing for granted. Sales are built up by product line and customer. Cost of sales is built up using BOMs and production schedules. Operating expenses are budgeted on a line-by-line basis for all labour and non-labour expense accounts. This approach is time consuming but it most helpful when costs need to be cut and there is concerns about who is accountable for which expenses. Ask management which approach they have used to prepare the budget presented to get a better sense of the precision of the budget assumptions.

The budgeting cycle involves all departments across the organization. It begins at the middle management level, gets aggregated by finance, and then reviewed and approved at the senior management level before being presented by the executive to the owner or board for approval. Finance is most often the leader and coordinator of the budget process, however, bear in mind that the budget should not be owned by finance. Finance is a messenger, the owners of the budget are the various department individually and senior management in its entirety.

The phases of budgeting typically follow this sort of process:
1. Sales prepares a detailed forecast by period for the coming year. This will include by customer, by channel, by product. This information must be budgeted on an activity basis –i.e. when products are delivered, not when cash changes hands.
2. The supply chain will come up with a distribution plan and the inventory requirements to production.
3. The production team will come up with a production and procurement plan to schedule and cost the acquisition of inventory.
4. Then the supporting functions will all submit their labour and non-labour overheads for the year.
5. Capital budgets will be prepared for all maintenance and growth capex spending for the year.
6. Finance will aggregate the information to prepare the budget and add in the financing costs.

The operating budget is a budgeted income statement following GAAP conventions. The cash budget translates the operating budget into cash flow. In fact, a best practice in budgeting is to include the balance sheet along with the budgeted income statement and cash flow statement to give the same fulsome perspective of the expected financial performance of the operation as we learned about when we were reading financial statements. Many organizations overlook budgeting the balance sheet and the cash flow statement and as a result only budget half the story. Once the budget is set, it should be locked in stone. We like this quote, “the budget is the budget and do not budge-it.” This help people stop iterating the budget trying to perfect their view of the coming year. The budget is merely a target at a point in time. As the year gets rolling, your forecasting process allows for managers, executives, owners and directors to iterate different views of future.