Complete Guide to Financial Budgeting and how it will help you achieve Organization Goals

Complete Guide to Financial Budgeting: Financial planning, forecasting and budgeting process is an ART, not a science and there is a saying “If you fail to plan, you plan to fail”

Budgeting and Responsibility Accounting – Financial Planning

Why go through this process?:

Investor confidence
Insight to top management
Manage and drive business performance
Better understanding of business risks
Responsibility & accountability

The task of determining how a business will afford to achieve its strategic goals and objectives. The Financial Plan describes each of the activities, resources, equipment and materials that are needed to achieve these objectives, as well as the timeframes involved.

It provides the rigor by confirming that the objectives set are achievable from a financial point of view. It also helps to set financial targets for the organization, and reward staff for meeting objectives within the budget set.

What is Financial Budgeting and Why Is It Important?

Financial budgets allow us to plan our business income and expenses in order stay ahead of any adverse scenarios in future. Budget planning also helps us to mitigate risks involved if a certain revenue levels are not achieved.

Forecasting

Forecasting is a decision-making tool used by many businesses to help in estimating future. In the simplest terms, forecasting is the attempt to predict future outcomes based on past events and management insight.

There are two forecast types: judgment-based and quantitative (e.g. statistics). The most trustworthy forecasts combine both methods to support their strengths and mitigate their weaknesses through Financial Planning, Forecasting and Budgeting Training in Dubai.

Judgment Forecasting

Uses intuition and experience.
Our minds are able to make connections and understand context in a way that no computer can
Prone to certain biases
Difficult to analyze large amounts of data
Best where there is little to no historical data

Quantitative Forecasting

Uses analytics on large amounts of historical data to discern trends and patterns
Less prone to biases
Excellent at analyzing large amounts of data
Weakest when there is little to no historical data

How to Get Started with Budgeting

If you are in process of creating a monthly or yearly budget you must have proper training/ knowledge on how create a budget in excel or any budgeting application.

METHOD DESCRIPTION EXAMPLES

Judgment Gut feel / Intuition • Launch of new product

New business area
Competitor action
Moving Average Average of past actuals to project future • Sales for a product with steady demand

Expense budgets of routine items (office supplies etc.)

Exponential

Smoothening Capture trends and patterns.
Gives weightage to recent data • Sales for a product with seasonality / fluctuating demand
Periodic expense items

Regression

Analysis Relationship between factors
Marketing spend and sales
% of sales / cost etc.
Statistical Tools Many computerized tools Multiple uses

Budgeting

The word “budget” is derived from the old French “bougette”, meaning a small purse. In the mid-1700s, Great Britain’s Chancellor of the Exchequer was said “to open the budget” when presenting his annual statement. The term was extended to private and commercial finances in the late 1800s.

Useful Tips for Effective & Efficient Process

Clear assignments of responsibilities
Collaboration & Communication
Top Down vs Participatory
Timelines (FBI agent 233!)
Budget Templates
Accuracy vs Estimate
Central repository

SHORT TERM LONG TERM

Operational planning Strategic planning
Immediate forecast Trending
Less uncertainty More uncertainty
Focused on targets Focused on big picture
Sensitivity analysis – micro Sensitivity analysis – macro
Which one comes first?

Short Term vs. Long Term

Top line growth by 15% by next year Short Term
Achieve a CAGR of 10% in 5 years Long Term
Increase market share to 20% in 2015 Short Term
Become the market leader and brand of choice Long Term
Investment plan for an ERP system Short Term
Investment plan for continuously increasing production capacity Long Term
Improve diversity in the workforce by 15% Short Term
Become among the Top 10 best places to work in the country Long Term

Fixed vs. Rolling – Types of Budgeting

A Fixed budget is set for a specific time period which is then locked.
A Rolling is also for a time period but keeps moving ahead as time passes. EXAMPLE:
Fixed: Budget for 12 month period from Jan to Dec 2015
Rolling: Budget for immediately preceding 12 months. As each month ends, the budget gets updated for the next 12 months

FIXED ROLLING

Once the budget is approved, the numbers are locked (target control) Future numbers / targets keep changing (no target control)
By the time budget is approved, it may be outdated Always up to date
Unutilized budget does not carry over Unutilized budget can be utilized
Usually tied in with financial time period instead of business cycle Takes into account business cycle / seasonality
Once a year “blitz” activity Time consuming and expensive
Closer to the budget period end, focus becomes very short-term Keeps the focus on the entire future period
Difficult to manage working capital requirements as time goes by Easier to manage working capital requirements as continuously updated
One time opportunity for manipulating Greater chances of manipulating

Incremental vs. Zero Based

Incremental budgeting extrapolates from historical figures adjusting for expected changes in various factors / assumptions (e.g. inflation, exchange rate, fuel and other costs, manpower changes etc.).

Easy
Fast
May inflate budgets unnecessarily
May create motivations to utilize budgets unnessarily

Types of Budgeting

Incremental vs. Zero Based

Zero Based budgeting also called ground-up budgeting, uses the assumption of budget allowance of ZERO unless appropriately justified otherwise.

More detailed and in depth analysis required
Time consuming
Critical evaluation to allow only necessary budget
Starts with a zero budget every budget cycle regardless of the budget utilized previously

Kaizen Budgeting

Kaizen is a Japanese term that means continuous improvement. Kaizen budgeting attempts to incorporate continuous improvement into the budget process. For example, cost reductions are built into the budget on an incremental basis so that management tries to continuously reduce costs over time. If the costs are not reduced by a particular function as per budget, extra attention is given to that function.

Develops an attitude towards improvement
Critical review of costs / new ways to generate revenue
Difficult to sustain once low hanging fruits are utilized

EXAMPLE:

A purchasing department may budget for a continuous reduction in the cost of raw material to reduce cost of production as follows:
Incremental budgeting may not allow extrapolation for full inflation to force thinking of continuous improvement

Master Budget

Master budget is the ultimate “culmination” of the budgeting process for the company. It is the summary of all individual budgets into one final set of budgeted income statement, balance sheet and cash flows.

To prepare the Master budget, following are used:

Operating budgets (revenue, GOGS, administrative costs etc.)
Financial budgets (cash flows, working capital, financing, capital investments etc.)

This is the final check to ensure all information is flowing back-n-forth properly

Setting Assumptions

Inflation
Exchange rate
Fuel / Transportation costs
Interest rate / Discount rate
IRR
Others

Source: Harvard Business Press – The Essentials of Finance & Budgeting

Controls in Financial Budgeting

Variance Analysis

Comparison of actual results with budget
Control Framework to manage business performance
Only works if action is taken and budget is realistic Plan

Action

Control Monitor

Evaluate

Why do variances occur?

Difference in assumptions vs. actual results
Changes in volume / size
Incorrect budgeting
External / internal factors not predicted
Mathematical errors
Incorrect computation of actual results
Others?

Evaluating Variances

Positive vs. Adverse
Foreseen
Foreseeable
Materiality
Cause
Temporary (one-off) vs. Permanent (new trend)
Management By Exception

Variance Analysis – What to Avoid

Using different basis for budget and different for actual
Ignoring the cause of the variance
Accounting records vs. own records
Immaterial variances
Punishing all variances – The Blame Game
Are all adverse variances bad?

Variance Analysis – Fixed Budgets

Traditional variance analysis
Approved budget compared to actual results
Event Oriented Reconciliation (EOR)
Action steps identified and implemented
Determine if any change needed in budget for remaining period
Regular activity

Flexible Budgets

Adjusted for volume
Understand Variable costs vs. Fixed costs
More realistic picture of the actual variance
Prepare a flexible budget and variance with actual results

Prepare following for the Home Theatre jobs:

Difference in Profit between Original Budget vs. Flexible Budget
Price Variance – Revenue
Price Variance – Material Cost
Efficiency Variance – Material Cost
Price Variance – Labor Cost
Efficiency Variance – Labor Cost

Cash Budgeting

Why the need when profit / loss is already calculated?
Revenue vs. Receipts
Expenses vs. Disbursements
Periodic vs. Continuous
Capital investments
Financing / Investment requirements
Cash Budget
Financing requirements

Sensitivity Analysis

Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s). Planning, forecasting and budgeting involves many assumptions and predictions. Therefore, it is essential to do a “what if” analysis to determine what further actions are needed in case some of the “assumptions” did not hold true

Key Uses

Cash flow planning
Funding requirements in Financial Budgeting
Surplus investments
Funding type
Decision making
Launching a new product / new business
New investment
Hedging
Reviewing costs

Types of Analysis

Scenario Analysis: outcomes based on a combination of assumptions
Simulations: probabilities of different possible outcomes
Break-even analysis: combination of assumption at which indifferent

Capital Budgeting and Analysis in Financial Budgeting

Capital Budgeting is the process by which organizations evaluates and select which real investment projects should be accepted and given an allocation of funds. To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance.

Why Capital Budgeting and Analysis Important

Long – term decisions
Tied to strategy / objectives
Involve significant amounts
Critical to company’s future
Timing is key
Investment
Decision
Reinvestment Real Assets
Returns from Investment
Financing Decision
Refinancing Financial Markets
Returns to Security Holders

Process of Capital Budgeting and Analysis

Identify
Categorize

Replacement (sustainability / efficiency)
Capacity Enhancement
New Business
Safety / Environment

Evaluate

Payback
Discounted Cash Flow (DCF)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index

Fundamentals of Evaluation

Independent Projects: Cash flows of each project are not affected by each other

Mutually Exclusive Projects: Cash flows of one project are adversely affected if the other project is accepted

Normal Cash Flows: Cost in first year (cash outflow) followed by a series of cash inflows in the subsequent years. One change of sign

Non-Normal Cash Flows: Cost in first year (cash outflow) followed by a series of cash inflows in the subsequent year and then cost in last year to close the project. Two or more sign changes

Capital Budgeting and Analysis – Payback

The number of years required to recover a project’s cost DECISION MAKING:

Independent Projects: Set a criteria (e.g. Accept all projects with payback period less than X years)

Mutually Exclusive Projects: Select the project with shorter payback period

PROs:

Very easy / simple
Provides quick indication of a project’s risk and liquidity

CONs:

Ignores time value of money
Ignores cash flows AFTER the payback period

Discounted Cash Flow

The number of years required to recover a project’s cost, taking into account the time value of money
Uses the discount rate to calculate present value of future cash flows
Discount rate = interest rate earned on investments (opportunity cost)