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ch05_4773.qxd 118 12/29/06 8:59 AM Page 118 Budgeting Best Practices labor and improve efficiencies. The timing of when these changes will be completed has a major impact on when to budget changes in labor and efficiencies into the forthcoming budget. • Personnel budget. There must be a separate budget that outlines all the staff positions needed, their average pay rates, and the associated payroll burden. This number will vary based on the revenue volumes that were previously determined, not to mention any automation projects. • Capital budget. The automation budget will feed into the capital budget, since these projects usually require a considerable amount of funding. There may be other capital projects that do not run through the engineering department, such as for office equipment, so this budget is not normally completed until all departments have submitted their budgets. • Departmental budget. Each department must note its expected expenditures, as well as personnel requirements. • Cash flow budget. After all the previous budgets are returned, the accounting staff loads them into the budget model, which determines any resulting profits or losses, working capital changes, and capital requirements, all of which feed into the cash flow budget. • Funding and investments budget. The cash flow budget feeds into the funding and investments budget. This one is used by the chief financial officer, who determines either the sources and cost of funds (if cash is needed) or where it is to be invested and the expected returns from doing so (if there will be a cash surplus). The results of this budget will also feed back into the interest expense and investment income line items elsewhere in the budget. • Employee performance budget. Finally, after the budget is completed, the human resources manager uses it to create an employee performance budget that links pay levels and bonus payments to the performance levels noted elsewhere in the budget, such as completing automation projects or attaining budgeted sales levels. Also, some companies may want to include an acquisitions budget, which is closely linked to the funding and investments budget, since this activity will have a major impact on cash flows. The preceding list of budget modules makes it obvious that the budget process flows in a very specific sequence, with one part of the budget being used as a basis for the next part. The budget procedure and timetable must be built around this budget flow; specific dates of completion for one piece of the budget tie into the start date of the next part of the budget that requires information from the first part. It is wise to include a buffer of a few days between the completion date of one part and the start of the next, so that inevitable completion troubles can still be ironed out, leaving sufficient time to complete the overall budget by the targeted date. Do not be surprised if the timetable is not accurate in the first year it is used, since it is difficult ch05_4773.qxd 12/29/06 8:59 AM Page 119 5–18 Adopt Two-Stage Capital Budgeting 119 to estimate completion times. Just be sure to note actual completion dates in the first year and adjust the timetable accordingly in the following year. Only by constant adjustment over a long period of time will the budget procedure and timetable become fine-tuned tools for the efficient and orderly completion of the budget. Cost: Installation time: 5–17 Preload Budget Line Items The traditional way to create budgets at the department level is to send each department manager a copy of the year-to-date department financials, and a blank budget form for the next year, with a detailed procedure for how to fill out the budget form for every line item in the department’s budget. By doing so, department managers are taken away from their operational duties for an extended period of time, while they read through the procedure and make a series of educated guesses about what their revenues and expenses will be for the upcoming year. The considerable amount of time taken up by budgeting activities is one of the main reasons why the budgeting cycle is roundly detested by many managers. This level of aversion can be mitigated by having the accounting staff preload many of the budget line items. Most expenses are relatively fixed from year to year, or are easily linked to key drivers, such as head count. Consequently, the accounting staff can probably arrive at more accurate budget numbers than a department manager for most line items. This approach leaves only a few of the larger and more variable accounts for managers to enter in the budget form. In some cases where a department is anticipating no major changes for the next budget year, it may even be possible for the accounting staff to create the entire department budget, so the department manager only has to make revisions to it. However, total preloading tends to shift responsibility (and blame) from the department managers to the accounting department, and so should only be used with caution. Procedurally, the accounting staff should negotiate with each manager the number of budget line items they are to fill out, and the basis upon which they are to arrive at their numbers. The basis used could be the previous year’s numbers multiplied by the current inflation rate, or a set dollar amount per department employee. Once this agreement is set up, it can usually be rolled forward over multiple years with little subsequent change. Cost: Installation time: 5–18 Adopt Two-Stage Capital Budgeting The average operations manager does not have a degree in finance, and does not want one. And yet, part of the capital budgeting process requires them to fill out a funds application that requires justification based on such discounted cash flow ch05_4773.qxd 12/29/06 120 8:59 AM Page 120 Budgeting Best Practices models as net present value or an internal rate of return, as well as cash flow modeling during each year of the proposed project. The typical manager will require a great deal of time to complete this application, and there is a significant risk that it will not be completed correctly, given the low expertise level of the user. A better approach is to split the capital budgeting procedure in two—only expensive capital requests are still required to follow a comprehensive application process, while lower-cost ones can follow a simplified application process that is easier for managers to complete. The more comprehensive approach will still be needed for the 20% of capital requests that require about 80% of all funding, leaving the simplified approach for all remaining requests, which should be about four out of every five requests. A simplified capital request should not require a discounted cash flow analysis; a simplified matrix showing when cash expenditures are anticipated should form the core of the financial analysis. Also, those managers still required to wade through the more comprehensive application form should receive some help—the accounting manager can assign a budgeting specialist to each manager who is filling out this form and assist the manager with the creation of a discounted cash modeling part of the application. This assistant can also review the application for mistakes, which will reduce the number of iterations to which the application is likely to be subjected. Cost: Installation time: 5–19 Purchase Budgeting and Planning Software The vast majority of businesses create and maintain their budgets using an electronic spreadsheet such as Excel. Though this approach works fine for small organizations, it is quite unwieldy for large ones. The trouble is that individual departments create their own budget models using formats that vary from the one used by the budgeting department. When the budgeting staff receives these models from the various departments, they must manually reinput the information into a master spreadsheet, which is quite labor-intensive. Also, when any significant variable is added to the model, all related formulas must be manually altered and then tested to ensure that the model still operates properly. Further, it is difficult to track which department has submitted budget information or when it made its last update. For these reasons, larger companies have considerable difficulty using spreadsheets as the basis for a budgeting system. The solution is to purchase budgeting and planning (B&P) software. This software maintains a central database of budgeting information that is automatically updated when users enter information. They can enter information in a variety of ways—via dial-up modem, through a local or wide area network, or the Internet (depending on what software is purchased). The software can also be maintained off-site by an application service provider (ASP). In addition, the soft- ch05_4773.qxd 12/29/06 8:59 AM Page 121 5–20 Reduce the Number of Accounts 121 ware generates templates for data-entry use by each department, as well as issuing all pro forma financial reports at the press of a button. The better systems also have workflow management capabilities that reveal who has not yet submitted a budget. Variance analysis tools issue warnings to the budgeting staff when submitted budgeting information exceeds predetermined levels or when other preset rules are violated. Some systems are designed with links to customer relationship management (CRM) systems, so that real-time sales information can be shifted into the budget model for additional analysis. A variety of other capabilities are available, such as automatically calculating line-of-credit projections, designing what-if scenarios, determining inventory requirements based on sales and turnover levels, and conducting ratio analysis. Examples of the companies that produce B&P software are Cognos, Hyperion Software, and GEAC. Most of the enterprise resources planning (ERP) systems already include a B&P module. These are complex software systems that require customized installation, so one should expect to pay more than $100,000 for the larger systems. A pay-as-you-go ASP solution will be significantly less expensive in the short term, and may be a better solution if a company wants to see how the system works before investing in an in-house installation. A more advanced version of budgeting and planning software is called business performance management (BPM) software. A BPM system is usually layered on top of a company’s data warehouse and is useful for measuring the performance of an entire organization, and then connecting the analysis to budgets and forecasts. Though separate software packages are available for both budgeting and performance measurement, the BPM systems are capable of seamlessly connecting the two areas, resulting in less software maintenance and the elimination of data inconsistencies among multiple systems. Hyperion Software, Applix, SAS Institute, and OutLookSoft are some of the suppliers of BPM systems. Cost: Installation time: 5–20 Reduce the Number of Accounts Some budget models are astoundingly complex because there are so many account line items in which to record budgeting information. This is nearly always the fault of the controller, who has allowed the chart of accounts to grow to an excessive degree. Once there are too many accounts in the general ledger, it becomes obligatory to budget for the contents of each one. This presents the dual problems of adding new lines to the budget every year, and of forcing managers to do extra analysis to determine the budgeted amounts for the upcoming year. The solution is to eliminate as many accounts as possible from the chart of accounts. This takes a long time, since one must be careful to shift account balances to surviving accounts, verify that inactivated accounts are not used for some special purpose, and confirm that there will be no impact on the resulting financial reports. ch05_4773.qxd 12/29/06 8:59 AM Page 122 122 Budgeting Best Practices Given the intricacies of eliminating accounts, it is usually best to do so in small groups of just a few per month, with an overall reduction in the number of accounts taking as long as a year to complete. Once this is done, it is a simple matter to eliminate the same accounts from the budget. Another approach that is not only quicker, but also bypasses the need for a lengthy reduction in the chart of accounts, is to eliminate the accounts in the budget model, but to keep them in the actual chart of accounts. This option will result in no budget in the upcoming budget period for those accounts that have been excluded from the budget model, so it is only useful for those accounts with very small balances. Thus, this is only good for a few accounts and is not as definitive a solution as eliminating accounts from the chart of accounts for good. Cost: Installation time: 5–21 Revise Budgets on a Quarterly Basis Most organizations create new budgets just once a year. By doing so, they make estimates of sales volume for a number of months into the future that are extremely difficult to meet, and then build a “house of cards” of projected expenses and capital purchases that are justified by these weak sales numbers. Because of the difficulty of estimating sales, managers tend to err on the conservative side, estimating revenues that are too low. Furthermore, when the budget year has been completed, the management team tends to waste time arguing about why actual performance did not meet the expectations set within the budget. Finally, any unexpected changes in the business during the year, such as an acquisition or the elimination of a product, will not be included in the budget, so all budget-versus-actual analyses will be off by the amount of these changes, rendering the analyses worthless. One can incrementally revise budgets on a quarterly or even a monthly basis in order to avoid these problems. By doing so, all key revenue and related expense or capital decisions can be revised to reflect short-term changes in the business, making the budget a much more relevant document. The difficulty with this best practice is the greatly increased number of required budgeting iterations. Since this is generally considered to be a difficult process to complete just once a year, imagine the consternation of management if the process is done again every three months! To reduce the pain of this process, one should consider shifting away from the use of electronic spreadsheets for budgeting calculations, instead using commercially sold budgeting packages that allow for direct updating of budget information in the model over the Internet or the company intranet, while also allowing for easy changes to the budget model without the attendant calculation errors that are so common in an electronic spreadsheet. By making this change, budgeting iterations are much easier to complete. Cost: Installation time: ch05_4773.qxd 12/29/06 8:59 AM Page 123 5–22 Simplify the Budget Model 123 5–22 Simplify the Budget Model A company that has used the same budgeting model for many years will find that it gradually becomes more complicated. This is because there are incremental changes each year—a new analysis page here, extra departments there, perhaps some assumptions as well. Though the changes seem minimal if looked at for just one year, the accumulation over many years makes the model very cumbersome, difficult to understand, and prone to error. For example, if formulas are added to the budget that require inputting the final balance sheet numbers from the previous year, it is possible that no one will remember this when the next budgeting cycle arrives in the following year, especially if the person who made the change in the previous year is no longer with the company, or if the change was not documented anywhere. As the number of these changes pile up over the years, it becomes increasingly difficult to complete the budget on time. The person managing the budget model becomes increasingly indispensable, for no one else knows how to use it. To avoid these problems, it is necessary to regularly simplify the budget model. This does not mean that the simplification can be done once and then dropped. On the contrary, the standard budget procedure should begin with a review of the model from the previous year to ensure that all budget line items and calculations are thoroughly documented and understandable, and that they are still needed. There should also be a step that specifically requires the budget manager to review the need for extra line items and formulas, with an eye to eliminating as much as possible from the budget model every year. Though it may not be possible to completely streamline the budget model in one year, a continuing effort in this area will yield excellent results as long as the review is continual. An added benefit of simplifying the budget model is that less budgetary “gaming” arises. For example, when a large number of expense categories are used, managers tend to resort to all kinds of expense juggling as the budget year progresses in order to ensure that actual expenses incurred exactly match the amounts budgeted. These games are a waste of corporate resources, since they take management time away from the corporate mission. By summarizing many revenue and expense line items into just a few budgetary line items, managers will have the leeway to run the business in response to ongoing developments in the marketplace, rather than in accordance with the dictates of the budget. Though the main focus of this best practice is to reduce the complexity of the budget model, it is sometimes sufficient to ensure that the model is adequately documented. Some businesses really become more complex over time and therefore require more detailed budget models. This is particularly true of companies on a fast growth track, especially if they are growing by acquisition and must account for the operations of many new businesses. In these cases, the budget manager should review the model at the end of each budget cycle to see what has been added to the model this year, and verify that complete and thoroughly understandable descriptions have been included in the budget procedure that note ch05_4773.qxd 12/29/06 124 8:59 AM Page 124 Budgeting Best Practices the reasons for the changes, how they work, and the resulting impact on the entire budget model. This step may be all that is needed for some companies. Cost: Installation time: 5–23 Store Budget Information in a Central Database Too often, a budget manager assembles all of the information needed to create the annual budget, has done so with days to spare, and yet somehow cannot release the budget on time. The reason is that the budget pieces cannot be easily put together, requiring a great deal of labor to rekey them all into a central budget model. The information is especially difficult to assemble if department heads have added new line items for new types of expenses, or deleted or merged existing ones. When this happens, someone must contact the department managers to request a clarification, sometimes resulting in last-minute changes to the underlying budget model that may introduce errors into the budget formulas, resulting in incorrect cost or revenue summarizations. When there are many departments or subsidiaries, it is possible for all these issues to add up to more time to assemble the data than it took for the rest of the company to complete its part of the budget! The solution is to centralize the budget into a single database. Department managers are issued templates for the budget that are derivatives of this database and they must fill in the blanks provided—no exceptions allowed. When these budget forms are turned in to the budget manager, it is easier to peruse them and determine which revenue or expense line items have been left blank and which additions have been made that do not fit into the standard template; managers can be contacted at once and asked to revise their budgets to fit the existing model. It may even be possible to give managers on-line access to the budget model (see the ‘‘Use On-Line Budget Updating” section, next), so that managers are forced to enter information into the existing database. This approach is a quick and easy way to greatly reduce the back-end work by the accounting department to assemble incoming budget information. The only problem with this best practice is that sometimes there will be new company activities that cannot be easily shoehorned into the existing budget model. This is an especially common circumstance when a company acquires another corporation that operates in an entirely different industry. For example, the expenses in a freight-hauling company will vary significantly from those of a mail-order business. In these cases, the budget model obviously must be changed. The best way to do so is to have the budget manager be informed of decisions by senior management to acquire or start up businesses, so the manager can make changes to the budget model in advance, which eliminates the need for any lastminute alterations. Cost: Installation time: ch05_4773.qxd 12/29/06 8:59 AM Page 125 5–25 Use Video Conferencing for Budget Updating 125 5–24 Use On-Line Budget Updating One of the most difficult problems for a budget manager in a large company is bringing together the budget information arriving from a multitude of outlying company locations. For example, a location may send budget updates on paper or a compact disc, either of which requires the manual translation of this information into the budget model by the budget manager’s staff. If there are many locations reporting budget information, this can result in a flood of work for several days. Also, the person reentering the budget information may make a typing error, thereby altering a budgeted amount from what a subsidiary intended, or may misconstrue the submitted data and list a budget number in the wrong account. In either case, the budget must be reviewed by the subsidiary and a request made to adjust the error, which takes still more time and effort. An excellent best practice that entirely eliminates this problem is to give subsidiaries direct on-line access to the budget model. They can then enter it themselves, make any necessary changes, and review the results. By doing so, all errors are made, and must be corrected, by the subsidiaries, taking this chore away from the central accounting group. There are two problems with this best practice. One is that all subsidiaries must acquire on-line access to the budget model. The second item is more critical: Anyone from any subsidiary can now have access to the entire budget model, with the ability to delete it, alter information for other parts of the company, or just observe the numbers budgeted for other divisions or departments, which can be confidential. To avoid this problem, it may be necessary to split the budget into different files, one for each subsidiary, and then give password access only to the portion of the budget assigned to each subsidiary. Another option is to keep the budget model in one piece, but to restrict access by passwords to just those account codes that apply to each subsidiary. The first option allows a company to use an electronic spreadsheet to contain the model, but the latter approach requires that it be stored in a database with better password protection than is typically available for an electronic spreadsheet. A company can pick either option based on its overall need for securing budget information. Cost: Installation time: 5–25 Use Video Conferencing for Budget Updating Companies with many locations have the added budgeting cost of bringing together managers from outlying locations, sometimes for a number of meetings. Given the high price of travel and lodging, this can be a significant expense. Further, the activities in which those people are normally engaged will stop while they are traveling to and from budget meetings, so there is an added degree of waste. ch05_4773.qxd 12/29/06 126 8:59 AM Page 126 Budgeting Best Practices Technology can be used to eliminate these costs. The latest innovation is to use video conferencing to hold meetings, thereby avoiding all travel costs and taking up people’s time only for the duration of an actual meeting. The range of options for a video conferencing system runs from a company-owned video production room that has projection screens and television cameras down to a small device that mounts on top of one’s computer, allowing for transmission of the image of whomever is sitting in front of it. The larger and more complex option is recommended for the budgeting chore, since it has the added features of allowing for the video transmission of documents to other sites, much better video quality, and the option to have simultaneous conferences with up to two other locations. The main problem with using a quality video conferencing system is that it can cost $100,000 per location, though this cost is rapidly coming down. The smallest video units only cost about $100, though the video quality is quite poor. One must choose the system that fits a company’s ability to pay (which may be high if there are other applications to which such a system can be put, such as for the transmission of engineering meetings). It is also possible to rent video conferencing centers, which may be considerably less expensive than purchasing one. This is an especially good option if there are few other uses to which a company-owned video conferencing center can be put. In addition, there must be very tight scheduling of meetings, requiring everyone to be on-line at the same time. Otherwise, some very expensive equipment will be tied up while waiting for someone to arrive at his or her conferencing site. The underlying problem is system cost, so a careful analysis of all expenses is necessary before buying a video conferencing system. Cost: Installation time: Total Impact of Best Practices on the Budgeting Function Most of the best practices discussed in this chapter are noted in Exhibit 5.4, where they are clustered around the three main budgeting activities—creating the budget model, implementing it, and using it. Most of the best practices impact the creation of the budget model, either by increasing its simplicity or by improving the information that goes into it. For example, reducing the number of accounts and budgeting by groups of staff positions reduce the size of the model, while using activity-based budgeting improves the resulting information. Other best practices improve the ability of the company to quickly and effectively input data into the budget model or to discuss changes to it, either through video conferencing, a budget procedure, or on-line budget updating. Finally, several methods are available for closely linking the resulting budget model to company operations, so that most activities cannot be completed without some interaction with budget information. What all of these changes amount to is a highly efficient budgeting process that can be completed in less time than the previous budgeting system, while providing much better information to the management team. ch05_4773.qxd 12/29/06 8:59 AM Page 127 Total Impact of Best Practices on the Budgeting Function Exhibit 5.4 Impact of Best Practices on the Budgeting Function 127