Every financial professional should understand the basics of budgeting, whether they are personal financial planners or corporate financial analysts.
Budgeting is a critical aspect of financial planning that provides a roadmap to achieving financial goals. Budgets, both personal and corporate, serve as a translating tool to help guide financial decision-making. Corporate budgeting can be viewed as a larger and more comprehensive personal budget, with the business acting as the individual. In either case, a budget serves to assist in managing cost and forms a basis by which to measure progress towards a business’ objectives.
What Is Budgeting?
At its core, a budget is a device that is used for planning and governing business activities.
A corporate budget is a comprehensive estimation of what a business’ expenses and revenues will be for a given fiscal period. Many times, people think of a budget in terms of expenses, but that is only part of a budget.
Every corporate budget will include both revenue guidance and expense estimates, each being derived from historical results adjusted for assumptions about the future. Budgets are a major priority for finance departments, and every business requires a budget, to some extent, in order to run efficiently.
In today’s environment, business budgeting is one of the primary activities in corporate performance management (CPM). CPM is an approach to business planning, budgeting, and forecasting that integrates all functional areas of a business and links its strategies to its plans, then monitors how the plans were executed. Budgeting is one of the pillars of CPM.
Modern developments in the software are allowing businesses to develop budgets with greater confidence and accuracy. Many ERP systems utilize software applications that can integrate budgets with performance monitoring, allowing for greater visibility on how well a budget is being followed throughout the period.
Goals of Budgeting Within CPM
After a business has set its goals for the upcoming period, it will then focus on creating a budget. The budget will then serve as the basis of the business’ various plans to achieve the desired outcomes of the budget itself.
For example, the budget might take into account new sub-markets that are now accessible, thereby boosting revenue guidelines. Therefore, the budget serves as a target for sales departments to design marketing tactics around.
On the opposite end, perhaps an organization has consolidated its operations and expects to see cost reductions as a result. The budget will provide the targets for operations teams to strive for. In both cases, the budget acts as a resource to reference when designing the individual goals of each department.
A good budget should always be detailed and thorough, resulting in a useful guide to achieve the goals of a business’s strategic plan, and should result in clear performance indicators by which to measure the business’s progress.
The core goal of a budget is to aid in planning. A budget process forces leaders to consider what might occur in the coming period and requires that they plan accordingly. As a result the budget helps to coordinate and facilitate the various activities of a business. This is because managers are often forced to understand the needs of each department and how they interact with one another.
One goal of a budget is to help motivate managers and staff to achieve the desired outcome by aligning their goals with the goals of the business. As a result, managers are left with key metrics by which to evaluate the performance of their department and staff. Consequently, managers can then be evaluated based on how well they executed the plan.
The Budgeting Process
Perhaps the biggest challenge business leaders face is developing a strategy and then converting that strategy into tangible targets. Those targets then trickle down into the budget.
Once the objectives are in stone, strategies can be developed to achieve them. Once a strategy is designed, it will be important to track the effectiveness of the strategy, which means a set of relevant measurements will need to be created. At the conclusion, targets can be identified that will maintain progress towards the objectives and that can be effectively measured.
The process typically starts several months before the start of the fiscal year. Most businesses set budgets and then track them through a process called “variance analysis.” While each budget methodology results in slightly different budgeting processes, each budget will usually follow the same systematic path.
As you might imagine, a systematic approach to budgeting yields the most benefit. This is because a well-rounded budget takes into account past results, which must be viewed through the lens of what was happening in the business at that point in time.
That means that a budget needs to account for historical revenue and expenses without taking into account certain extraordinary situations that might have led to extreme circumstances that are abnormal.
The budgeting process serves as a systemic approach to setting goals, gathering historical data, and interpreting that data to build a budget around those goals. This means that the first step in building any budget is to consider the goals of the organization.
Steps in the Budgeting Process
- Communicate with management
- Establish goals and targets
- Develop a detailed budget to support goals and targets
- Compile and revise the budget model
- Review the budget and make changes as needed.
- Approve the budget
Although some budgets might have other steps or exclude certain steps, almost every budget will follow this framework.
The 4 Primary Approaches To Budgeting
Since budgets are a dynamic plan, it makes sense that there should be different approaches that a business might adopt.
Some considerations to make when choosing the appropriate budget methodology are:
● how much time can be devoted to budgeting
● how much historical data is available
● how accurate do you need the budget to be
● what type of budget best serves your business model
The 4 primary approaches to budgeting are:
● incremental budgeting
● activity-based budgets (ABB)
● value propositions
● zero-based budgets (ZBB)
The most common form of budgeting is incremental budgeting, which takes historical actual results and adds a percentage increase or decrease to arrive at a current year budget. It is by far the simplest form of budgeting and can be easily executed by small organizations and large organizations.
The primary reason for adopting this form of budgeting is if the business does not experience a change in its primary cost drivers.
One criticism of incremental budgets is that they tend to ignore external factors that impact cost.
For example, the cost of steel might increase substantially over the prior year, but the budget only accounted for a minor percentage increase in cost.
It is also likely to result in less active management of cost drivers and can sometimes lead to budget bloat because it does not address inefficiencies.
ABB is a form of top-down budgeting that attempts to determine the number of resources required to achieve the targets set by management. In a “top-down budget,” the budget is created by leadership and then sent down to the departments for implementation.
This method of budgeting is named after the process of taking into account activities that incur cost throughout the production process and then analyzing those activities to maximize efficiency.
The budget is an attempt to maximize cost-benefit by thoroughly examining each activity that results in an output. It is a more rigorous form of budgeting because of the level of scrutiny that goes into each activity.
Value Proposition Budgets
This method of budgeting is an attempt to determine whether or not an item in the budget results in value. The value proposition budget at its core is asking if the cost of the item in question is justified by the value it creates for customers and/or stakeholders.
The goal is to eliminate unnecessary expenses, but not to the extent of a zero-based budget.
Rather a value proposition budget is a way of implementing an environment of value creation by constantly asking why an amount is being included in the budget.
The second most commonly adopted method of budgeting is zero-based budgets, which begin the process by assigning every department a zero budget and forces the department to justify every cost it incurs.
ZBB is a practice that sets its sights on reducing any expense that is not absolutely necessary to the company’s success.
ZBB is a form of “bottom-up” budgeting in which departments create their own budgets, which are then compiled into one overarching budget that is reviewed and adjusted by management.
The most appropriate time to implement this extreme form of budgeting is when there is a significant need to reduce or contain expenses. It is time-consuming, and the benefits of this approach must be weighed against the cost of implementing it.
Modern Budgeting Tools and Software
Most finance departments operated in Excel, which is slowly becoming antiquated in how it handles complex budgets and presentations.
Modern ERP systems are integrating departmental information and translating that data into real-time monitoring, resulting in far less time spent on data requests by finance professionals.
Still, Excel maintains itself as being the most user-friendly and comfortable interface for most finance professionals. This is not to say that other tools are not used. A budget is only one component in the financial planning process that ultimately results in a forecast.
Forecasting is perhaps the most labor intensive process, which includes building comprehensive models that are flexible enough to react to dynamic changes while still using the budget as a foundation.
Because of this, more robust software applications are being used to assist not only in the budget process but also in the forecasting, monitoring, and reporting processes.
The most common approach in modern planning and analysis is the use of dashboards, which aim to take data requests off of the hands of finance departments and give users the power to answer their own inquiries instantaneously.
This shift represents an important change in the way the industry is utilizing software to not only assist in planning and forecasting but also to increase the efficient use of data for real-time monitoring against budgets by the appropriate parties.
Using DataRails to Build a Your Budget
Every finance department knows how tedious building a budget can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails is an enhanced data management tool, a FP&A solution that can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.