Corporate Finance: Part 6 – Budgeting
Introduction
This blog is the sixth in a series I am producing once a week. There are many topics we can discuss under Corporate Finance. This series will include a subset of topics, including the following:
- Chart of Accounts
- Project Costing
- Reporting
- Model Set Up
- Forecasting
- Budgeting
- Program Based Fixed Asset Management
I probably should have talked Budget before Forecast because the budget is the benchmark forecast for each year. But doing it this way, you can reference the forecast blog to understand how to approach a budget. So be sure to read that blog for important considerations. In this blog we will talk about when and how to conduct a budget, and how to monitor against it.
My approach is based on my experience, what is yours? I write these blogs in hopes that it may help others. I prefer to blog what I have learned from experience, not just a rewrite of what I found on the internet. I also prefer collaboration over critique, so please comment only if you have something constructive to add.
Budgeting
Timing: I can’t tell you how many times I see companies conducting a budget in November and December for the following year..no, no, no. A budget for the next year should start process in August and have final approval, entry in the system and ready to track against by the end of November. A good budget needs time to cook, needs multiple iterations to refine and understand. Here is a high-level timeline:
- August: Identify the corporate goals for next year. This should include newly approved projects, a review of current projects, sales trends, and targets.
- September: Run the last 12 months’ actuals and start overlaying the new projects, finishing projects and strategic changes for next year (cost cutting, revenue increasing, balance sheet improvements). Start meeting with department leads to get familiar with the numbers and discussions around direction for next year.
- October: Run the last 12 months actuals again, continue meetings with department managers/directors and get a summary for executives to review. By the end of October, you should have buy-in from all levels of the operations, getting ready for final approvals.
- November: Final review of numbers, followed by meeting of the board or managing members for budget approval. By the end of this month, the budget numbers should be in a system for tracking and be verified against the original report.
Good Budget: As a quick reminder from the last blog, a good forecast (in this case budget) requires:
- Executive Alignment: Agree on Scenarios
- Risk Identification: Understand the high risk areas
- Assign Ownership: Inputs only from department leads
- Reasonable: Have comparables as baselines to justify numbers
- Analysis: Seek trending, analysis, and outlier information
- Verify: Always validate your numbers and review with others
All are important, read my prior blog for more details on each point.
The budget is a larger project than a forecast because it establishes the overall strategy of an entire year into the financials of all areas, setting a baseline. Whereas a forecast is tracking the changes against a budget, so it requires a variance with explanation.
What to include in a budget:
- All approved projects: new and existing projects across all areas. Be sure to split the costs based on how accounting will allocate through the PO’s and ultimately through the supplier billings.
- New strategic department directives: cost cutting, known cost increases and department growth to support initiatives, be sure to list what impacts on each department.
- Revenue impacts: New competitors, product changes, new complimentary products, product lifecycle, pricing pressures.
- COGS impacts: Supply chain changes, warranty issues (accrual), product changes
- Government regulations: New regulations that will drive price, taxes, costs and volume changes.
- Economics: Inflation, demand shifts and supply shifts
- Balance Sheet Impacts: Already mentioned warranty, but also should discuss turns on items like receivables and inventory, also discuss accounts payable and any other financial strategies around cash and liabilities to maximize earnings and cashflow…just be reasonable. Speaking of being reasonable, how do we check if a number is reasonable? Read my prior blog on forecasting 😊
- Contingency: Debated by some, there are those who want to budget only what the departments provide. But as we all know, nothing happens to plan. I prefer to add contingency for new projects or unanticipated overruns. Some people budget contingencies in the department, but I disagree with that model. I prefer the contingency is owned and managed by the project lead for a major project, or by the CFO for Operations. The contingency is then approved during the forecasting process by the lead or CFO, by reducing the contingency and transferring funds to the line item in question. When I add a contingency to a company budget, I typically go between 5-10% depending on my assessment of risk in the budget for the next year.
What not to include in a budget (but may require footnoting):
- Pending (not approved) projects: these are the projects not approved yet but may be running in the budgeted year. When deciding on a contingency percentage, these projects that are not approved need enough coverage to cover what may get approved. This takes a judgement call from the executive team based on amounts and merits.
- Worst/Best Case: There is only one budget to run baseline, though if you want to give a stretch target then that can be good too. I like to tie rewards to areas who achieve a stretch target, of course without compromise to quality and timing. Don’t make your budget too difficult to achieve, because cashflow depends on it! But you can show a stretch target in your tracking to see if the company can go further.
- Dreams: A budget should have as much support for the numbers as you can provide. Balance the numbers on solid support whenever possible, and always try to be reasonable. If you tend to be more ‘aggressive’ in your budget, then find a respectful person who is ‘conservative’ to review with you. Together you can make a better budget, don’t work in a silo.
It’s been a pleasure sharing my learnings with you. If you have other insights for budgeting, please share.