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About this lesson

Business budgets are the financial plan of the business.  They are normally created for one year at a time and allocate the spending and revenue across business units, departments and accounts.

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Business Budgeting
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Quick reference

Business Budgeting

Business budgets are the financial plan of the business.  They are normally created for one year at a time and allocate the spending and revenue across business units, departments and accounts.

When to Use Business Budgeting

Most businesses create a budget annually.  If a significant event occurs during the year that changes some of the basic assumptions upon which the budget was built, a revised budget will be created.  Examples would be a merger or acquisition, a national or international crisis event that changes market conditions, or a business reorganization.

Instructions

  • A business budget is a financial plan used to estimate the results of future operations.
    • Plan – Intention of what to do or how to react to a problem.
    • Estimate – a guess, hopefully an informed and educated guess.
    • Future Operations – unknown conditions, based upon assumptions and desires.  It includes all business functions such as sales, development, production, maintenance and general administration.
  • It provides guidance to operating managers, and sets limits of spending authority; but it does not provide strict control on day-to-day decisions.
  • Mangers will normally strive to meet the sales and spending targets set in the budget; but the actual business sales and spending seldom exactly matches the budget.
  • There are many ways in which budgets can be set.  These vary based upon the personalities of managers, business systems and processes in place, and experience of those involved.  Some methods are quick, some are slow.  They generally follow one, or a combination, of these approaches:
    • Golden rule – the senior manager or owner decides what money to spend where.
    • SWGO (Squeaky Wheel Gets the Oil) – whichever department or individual lobbies the best for money gets what they want, the rest is split among the others.
    • SWAG (Stupid, wild, awful guess) – those making the budget don’t know what it should be so they just assign an amount in order to allocate something.
    • ETOB (Every Tub on its Own Bottom) – each budgeted amount must full stand alone; it can’t not rely on any other business process or operation.
    • ZBB (Zero-Based Budgeting) – every department starts with a budget of zero.  They must provide justification for the amounts that are allocated in any of their accounts.  No justification – no money.
    • FMLA (Formula) – a formula or simulation is used that estimates sales and spending based upon a set of business assumptions.
    • Extrapolation – the budget is based upon what has been budgeted or spent in previous years with appropriate business trends factored in.
    • Spent – an organization gets the same out of money next year as they actually spent this year.
    • TD (Top Down) – senior management uses the strategy to estimate sales and allocate spending in a manner consistent with strategic goals.
    • BU (Bottom Up) – individuals and line managers estimate what they believe will be required to implement the elements of the strategy for which they are responsible.
    • TD – BU – TD (Top down, button up, top down) – senior management does a top down draft budget, individuals and line managers do a bottom up draft budget, the two are reconciled, strategies are updated and targets revised.  Senior management then issues the budget.  This cycle can be repeated several times.
  • The result of the budgeting process is the annual business budget, normally known as the Operating Plan or Op Plan.
  • Ideally the Op Plan is the management intent of how to sustain the business and implement the strategy.
  • It is often expressed as projected quarterly and annual financial statements such as Earnings Statements, Balance Sheets, and Cash Flow Statements.  In publically traded companies, these will often be shared investors.
  • This business level plan is used by the department managers to create detailed sales and spending plans for their department that are allocated into sub-accounts and spread across the 12 months of the year.
  • The Op Plan is the financial target used to measure management’s performance during the year.

 

Hints and Tips

  • Any of the budgeting can be used.  I prefer TD – BU – TD in order to get both maximum insight and buy-in; but it takes time and effort. 
  • Don’t tell an organization that you will be doing a bottom up budget (meaning their input maters) if you aren’t really going to use that approach.  The organization will feel that they have been cheated and lied to.  If using one of the other approaches, acknowledge it.  The organization will at least appreciate the honesty.
  • It is OK to change Op Plans in the middle of the year if something unusual happens.  A business I was working with in 2001 had four Op Plans during the course of the year.  The original, a second one when an acquisition occurred, a third one for a reorganization, and the fourth one following the bombing of the World Trade Center in New York City.
  • Don’t change Op Plans in the middle of the year just because you missed a target.  You will be rightly accused of manipulating financial data to avoid responsibility.
  • Take time to spread the money in the accounts in the pattern you think the money will be spent – don’t just spread it evenly across the 12 months unless you think that is what will happen.  Otherwise, you will find yourself constantly explaining variances with the excuse of being late or early on spending.  Soon the senior management in the organization will come to the conclusion that either you can’t plan or you can’t control your organization.  A few minutes to spent spreading the sales and spending appropriately across the year will save time and improve your credibility. 
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  • 00:02 Hello, this is Ray Sheen.
  • 00:04 I'd now like to discuss the business budgeting process.
  • 00:08 Let's start with the definition of a business budget.
  • 00:13 A business budget is a financial plan that is used to estimate the results
  • 00:16 of future business operations and decisions.
  • 00:19 It provides guidance to business managers on what they're expected to do.
  • 00:22 It provides a level of control by setting some boundaries on how much they can spend
  • 00:26 and for what purpose.
  • 00:28 It's also used to measure how well they manage by comparing
  • 00:31 actual business results to the budget.
  • 00:33 But with that said, there are some challenges with respect to the budget.
  • 00:37 First, it is a plan.
  • 00:38 That means it is the intent of what business managers should do,
  • 00:42 given an assumed set of assumptions.
  • 00:44 It is an estimate, it is just a guess.
  • 00:47 Hopefully, it is an informed guess leading to an accurate forecast.
  • 00:50 It is for future operations, but these activities have not yet occurred.
  • 00:54 So, again, we have assumptions about both the business and industry conditions and
  • 00:58 some will probably turn out to be incorrect.
  • 01:00 It is no surprise then that although budgets are management's intent
  • 01:04 of what should happen in the business.
  • 01:06 It's seldom works out exact;u like that.
  • 01:08 There's just too much uncertainty.
  • 01:10 However, we still use budgets to communicate our intent and
  • 01:13 inform the day to day management decisions.
  • 01:16 Let me go through a few approaches used to create business level budgets.
  • 01:20 I've seen all of these in use.
  • 01:22 While each has a strong point, all of them have a downside.
  • 01:25 I'll highlight the strengths and weaknesses of each.
  • 01:28 Golden rule.
  • 01:29 Whoever has the gold sets the rules.
  • 01:31 This is a fast method and when the person with the gold is experienced,
  • 01:35 it can be very accurate.
  • 01:36 However, there will be little buying from the organization.
  • 01:39 Squeaky wheel gets the oil.
  • 01:41 Whoever complains and lobby's the loudest, gets the most money.
  • 01:45 If the squeaks are based upon real problems, this is helpful.
  • 01:48 But can quickly turn into personal politics, not sound business management.
  • 01:53 Swag, this acronym has several definitions, but
  • 01:56 they're always of describing a guess.
  • 01:59 When entering new markets or using new processes, this is your only option.
  • 02:03 A guess is better than not allocating anything.
  • 02:06 Every tub on its own bottom,
  • 02:08 each estimate is done although nothing else in the budget will be done.
  • 02:12 There's nothing else to build on.
  • 02:14 When budgeting projects, this maybe a good idea, but not for sustaining operations.
  • 02:19 Zero based budgeting.
  • 02:21 This will be the best documented approach, but is the most work and takes time.
  • 02:25 Every budget estimate whether for sales or spending must be supported with data.
  • 02:30 The number starts at zero.
  • 02:31 Until the manager can prove another number, it stays at zero.
  • 02:36 Formula, in this case a formula or simulation is used to generate the budget.
  • 02:41 A set assumptions or constraints are fed into the formula, and
  • 02:44 a budget estimate comes out.
  • 02:46 If, but only if, the formula and simulation are built upon a large database
  • 02:49 of actual experience, this could be fast and accurate.
  • 02:53 Extrapolation, uses the previous year's budget or spending and
  • 02:56 applies trends and factors.
  • 02:58 This is good for continuing operations, but does not work well with projects.
  • 03:03 Spent, this gives an organization the same amount of money they actually spent
  • 03:07 the previous year.
  • 03:08 It's quick and based upon reality.
  • 03:10 But it is also an incentive to overrun.
  • 03:13 The more I spend, the more I get.
  • 03:16 Top down, this is different from golden rule.
  • 03:19 In this case, senior management creates a budget that they believe will sustain
  • 03:22 operations and implement the strategy.
  • 03:25 Both the budget and the strategy are communicated.
  • 03:28 Bottom up, same approach but from the opposite direction of top down.
  • 03:33 In this case, individuals and line managers are given the strategy and
  • 03:36 targets.
  • 03:37 They estimate what they will need to implement the strategy, and
  • 03:40 achieve the targets.
  • 03:42 Top Down, Bottom Up, Top down.
  • 03:44 This is a combination of the last two, and is my favorite for accuracy, buy in, and
  • 03:48 communication.
  • 03:50 But it can take a long time.
  • 03:51 The top down budget and bottom down budgets are reconciled, the strategy and
  • 03:55 targets are modified when necessary, and a new budget is approved that
  • 03:59 has accommodated input from both the bottom and the top.
  • 04:03 Whichever approach you use, the result is the annual operating plan, or op-plan.
  • 04:08 The op-plan is next year's plan for revenue and
  • 04:11 spending by the business operations.
  • 04:14 It displays managements intent for how they will run the business and
  • 04:17 implement the strategy.
  • 04:18 At the business level this will be expressed as a set of financial reports,
  • 04:22 a balance sheet, earning statement and a cash flow statement.
  • 04:25 It should include all sales, spending and unusual items that are forecasted for
  • 04:28 the next year.
  • 04:30 These are used for several things.
  • 04:32 One is for investors.
  • 04:33 It shows them what the senior management thinks will be the outcome
  • 04:36 of implementing their business strategy.
  • 04:38 Investors use these to make their investment decisions.
  • 04:42 From an operating managers perspective,
  • 04:44 the Op Plan is what is used to generate the detailed department budgets.
  • 04:47 The sales, operational spending, and project spending
  • 04:50 are allocated across sub-accounts and over the 12 months of the year.
  • 04:55 The Op Plan and
  • 04:55 departmental budgets are used as targets to measure the performance of managers.
  • 05:00 Did they effectively lead and manage the operation and
  • 05:03 did they implement the strategy and achieve the targets?
  • 05:07 Budgeting is a crucial part of financial management.
  • 05:10 It includes the financial targets and
  • 05:12 management's intent for how they'll implement the business strategy.

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