The steps in preparing a budget

A budget is a financial blueprint for achieving business goals. Your unit’s budget is part of the company’s overall strategy, so you need to understand the company’s strategy in order to create a useful budget. There are several steps you can take to increase your strategic understanding: The audience, not the presenter, is the heart of any presentation. To figure out what makes it tick, answer these questions:

• Pay attention to communications from senior management. Most companies try to communicate at least the basics of their strategy to the entire organization.

• Watch the overall economic picture. A company’s strategy during a recession will differ from its strategy in a booming economy. Listen to your manager’s and colleagues’ views on sales and the economy, and make your own observations as well. Are you deluged by résumés, or is good help hard to find? Are prices rising or falling?

• Stay on top of industry trends. Even when the economy is booming, some sectors may be in trouble. Your budget should reflect realities in your own industry.

• Steep yourself in company values. Every company has values, sometimes formalized and sometimes just “the way we do things around here.” Savvy managers factor those values into their decisions. Say your budget calls for layoffs. If the company views layoffs as counterproductive, your proposal will be dead on arrival.

• Conduct SWOT analyses. What are your company’s strengths, weaknesses, opportunities, and threats? Keep them in mind as you build your budget. All these techniques should help you understand the context in which you’ll develop your budget.

Top-down versus bottom-up budgeting

In top-down budgeting, senior management sets specific goals for such items as net income, profit margins, and expenses. Each department may be told, for example, to limit expense increases to 6% above the previous year’s levels. As you prepare your budget, observe such parameters and look at the company’s overall plans for sales and marketing and for costs and expenses. Those objectives provide the framework within which you must operate. For instance, many companies strive to improve profitability every year by reducing expenses as a percentage of revenue.

In bottom-up budgeting, managers aren’t given specific targets. Instead, they put together budgets that they feel will meet the strategic needs and goals of their respective departments. These budgets are “rolled up” into an overall company budget. The company budget is then adjusted, with requests for changes sent back down to individual departments. This process can go through multiple iterations. Often it means working closely with departments that may be competing against yours for limited resources. It’s good to be as cooperative as you can during this process, but don’t hesitate to lobby aggressively for your own unit’s needs.

Getting started

Budgets should be ambitious but realistic. Don’t map out a budget that you can’t meet?—?but don’t underestimate the possibilities. Here’s how to begin. First, list three to five goals that you hope to achieve during the period for which you are budgeting.

For example:

• Increase gross sales by 5%.

• Decrease administrative costs as a percentage of revenue by 3 points.

• Reduce inventories by 2% by the end of the fiscal year.

Make sure those goals line up with the organization’s strategic priorities. Next, figure out how you’ll achieve them. (Remember that a budget is just a plan with numbers.) How can you generate more revenue? Will you need more sales representatives? Where can you cut costs or reduce inventories? The smaller the unit you’re focusing on, the more detail you need.

If you’re creating a budget for a 12- person sales office, you typically won’t have to worry about capital expenditures such as major upgrades to the building. But you should include detailed estimates for travel costs, telephones and utilities, and office supplies. As you move up in the organization, the scope of your budget will broaden.

You can assume that the head of the 12-person office has thought about printer cartridges and gasoline for the sales reps’ cars. Your job now is to look at big-picture items such as computer systems and to determine how all the smaller-scale budgets fit together. Other issues to consider when you’re preparing a budget:

• Term. Is the budget just for this year, or is it for the next five years? Most budgets apply only to the upcoming year and are reviewed every month or every quarter.

• Assumptions. At its simplest, a budget creates projections by adding assumptions to current data. Look hard at the assumptions you’re making. Let’s suppose you think sales will rise by 10% in the coming year if you add two more people to your unit.

Explain what you’re basing that assumption on, and show a clear connection to at least one strategic goal (in this case, it’s probably to increase sales by a certain percentage).

Role-playing may help you here. Put yourself in the position of a division manager with limited resources and many requests for funding: Under those circumstances, what would persuade you to grant a request for two additional staff members

TIP: TRACK YOUR THOUGHT PROCESS

As you put your budget into the required format, document your assumptions. It’s easy to lose track of them during the budgeting process, and you’ll need to explain them?—?and revise them. Don’t look only at specific revenue or cost line items, because revenue and costs are closely linked. Instead, ask yourself what the budget shows about last year’s operations. As the table shows, the Standard Upright and the Moose Antler Standard exceeded sales expectations in 2013.

Perhaps it would make sense to increase your sales projections for those products, particularly if your sales reps are optimistic about the prospects for more sales. The Standard Upright might be a particularly good choice since it beat its 2013 projection by 9%.

Could you increase the anticipated sales for this model by 5% or 10% in 2014? How much more would you have to spend on sales or marketing to achieve this increase? To make the decision, you’ll need as much data as you can get about pricing, competitors, new sales channels, and other relevant issues. Alternatively, you might plan to eliminate some products.

The Electro-Revolving model, for example, is faring poorly. Would it be better to cut

this line and promote the newer Hall/Wall model? That would eliminate $81,250 in sales, but the Electro-Revolving is expensive to produce, so discontinuation might not have much impact on the bottom line. Other questions to ask yourself:

• Will you keep prices the same, lower them, or raise them? A price increase of 3% might offset the budget’s 2013 sales shortfall, provided that it doesn’t dampen demand.

• Do you plan to enter new markets, target new customers, or use new sales strategies? How much additional revenue do you expect these efforts to bring in? How much will these initiatives cost? • Will your cost of goods change? For example, perhaps you plan to cut down on temporary help and add full-time employees in the plant. Or perhaps you hope to reduce wage costs through automation. If so, how much will it cost to automate?

• Are your suppliers likely to raise or lower prices? Are you planning to switch to lowercost suppliers? Will quality suffer as a result? If so, how much will that affect your sales?

• Do you need to enhance your product to keep your current customers? • Does your staff need further training? • Are you planning to pursue other special projects or initiatives? Articulating your answers to questions like these ensures that your assumptions won’t go unexamined.

It will help you create budget numbers that are as realistic as possible.

Calculating Return on Investment

Imagine that Amalgamated Hat Rack is considering two investment options: buying a new piece of machinery and creating a new product line.

The new machine is a plastic extruder with a price tag of $100,000. Amalgamated hopes it will save time and money over the long term, and that it will be safer than the current equipment. The second possibility, launching a line of coatracks, will require a $250,000 investment in design, production equipment, and marketing.

How will Amalgamated decide whether these options make economic sense? And if it can afford only one of them, how will it decide which to choose?

By figuring out the return on investment, or ROI. This means evaluating how much money the investment will generate compared with its cost. Before you begin any ROI analysis, it’s important to understand the costs and benefits of the status quo. You want to weigh the relative merits of each investment against the consequences, if any, of not proceeding with it.

Don’t assume that the costs of doing nothing are always high. Even if the new investment promises a significant benefit, it still carries risk. The short-term cost?—?and the short-term risk?—?of doing nothing is usually close to zero. Of course, the benefits, too, are close to zero.

Costs and benefits

ROI calculations always involve the following steps: 1. Identify all the costs of the new purchase or business opportunity. 2. Estimate the savings to be realized. 3. Estimate how much cash the proposed investment will generate. 4. Map out a time line for expected costs, savings, and cash flows, and use sensitivity analysis to challenge your assumptions. 5. Evaluate the unquantifiable costs and benefits. The first three steps are fairly straightforward in theory, though they may be complicated in practice.

When calculating the costs of an investment, you include up-front costs (the purchase price of a machine, say) and also costs to be incurred in subsequent years (maintenance and upgrades for the new machine). Savings may come from a variety of sources, such as greater throughput per hour, higher quality (and thus less rework), or a decrease in labor requirements. The cash generated typically comes from new sales. If you are calculating the ROI of a marketing campaign, for instance, you will need to estimate the campaign’s effect on the company’s revenue.

It can be tricky to create a time line for your costs, savings, and increased cash flow, so you may want to turn to your finance department for help with this. Step five is really just a check on the other four: Which costs or benefits can’t you quantify, and how will they affect your decision? For example, would a particular investment help or harm your company’s reputation in the community or with prospective employees?

Once you have completed these steps, you are ready to use one or more of the analytical tools described in this chapter: payback period, net present value, internal rate of return, break-even analysis, or sensitivity analysis. We’ll look at the strengths and weaknesses of each tool to give you a basic understanding. But you may want a colleague from the finance department to assist with the calculations.

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