Budgeting plays a vital part in any organisation regardless of size. For some, the process of building a budget is downright tedious, time-consuming, and challenging. What's more, businesses have to worry about not only short-term budgets but also long-term ones.
The importance of having a budget is undeniable. It is even more crucial for organisations not to get tangled amidst budgeting processes.
Today's article will briefly address the basics of what makes budgeting the way it is.
What is a budget?
To simply put, the process of planning a budget is to make educated guesses of future expenses and revenue over a month, a quarter, a year, etc. The budget acts as a financial guideline, showcases where the business is currently at and where it aims to be in the next one, five or ten years.
The most effective practice for budget planning is to include both short-term (ranging from monthly to quarterly and yearly basis) and long-term goals (at least three years, some even up to five years). The long-term budget plans are revised when the short-term plans changes.
Budgeting is not limited to just companies. It is also applicable and vital for maintaining the financial stability of individuals, countries, not-for-profit organisations, or anything that makes and spends money.
There are five commonly used types of budget:
- Master budget: the complete picture of the entire organisation's financial activity and health, which is made up of individual, department-level budget plans.
- Operating budget: the forecast and analysis of the income and expenses that will incur over a specified time period.
- Cash flow budget: the flow of cash coming in and out of a business within a specified period.
- Financial budget: presents as a strategy of how companies manage their assets, cash flow, income, and expenses.
- Static budget: this type of budget remains unchanged despite how other factors, such as sales volume, revenue or inventory, fluctuate.
The variations between revenue and expenses determine the end result of the budget - whether it will be a surplus budget (a.k.a. incurring profits), a balanced budget (revenues equal to expenses), or a deficit budget (expenses surpass revenues).
How long should it take to build a budget?
Based on a study done by APQC on 2,617 organisations in 20171, the answer to this question is 25 days or less for top performers, and 56 days or more for the bottom performers. Median performers complete the process in 32 days.
This leads to a second question, why does it take such a long time to build a budget?
Businesses need to understand that budgets are compiled documents from Sales, Marketing, Human Resources, Administration, and other departments within the organisation.
These department-level budgets have to be revised multiple times before submitted to the higher management. Even the most prestigious companies, on average, have their department budgets revised at least three times before the final submission.
Furthermore, factors such as the unforeseeable currency movements, complex supply chains, geopolitical instability, and many other conflicts occur globally can contribute to the uncertainty nature of a budget.
How many budget iterations are required to build a budget?
It is without a reason that many finance professionals dread budgeting. Imagine one has to pack and unpack their belongings to move into their new home day in and day out, without a doubt, everybody will soon get tired and irritated.
In another study done by APQC on 1,450 organisations2, 25% of the top performers state that they have four or fewer budget iterations. On the other hand, 25% of the bottom performers have at least eight iterations before finalising their budgets.
To lessen the workload and to shorten the review process, organisations can strive to:
- Promote transparency: to avoid wasting time redoing the budget, the executive team and the unit managers should be completely transparent with each other about the achievable goals for the coming year. Encourage inputs from everyone who has a stake in the process can help prevent any misunderstanding and miscommunication.
- Set deadlines: clearly specify timeframes to complete budget in writing, be sure that everyone agrees to the set deadlines and they are committed to providing results before the time is up.
- Eliminate silos: one department's budget has a certain impact on another department's budget. If a manager decides to create a budget without consulting or acknowledging other teams, or share their information with the others, silos and multiple rounds of edits will definitely happen.
- Centralise budget creation process: sending the budgets back-and-forth for revision can easily lead to confusion. Therefore, it is critical to be on top of all the latest iterations and knowing who made the edits and what are the changes. Having one single file which is under the control of one person can potentially help to eliminate the duplication of the budget as well as minimise delays.
How many budget drivers are needed?
There are three basic financial statements used in a budget: the balance sheet, the income statement, and the statement of cash flows. It is important to include all three statements to understand the financial flows through the entire organisation.
- The statement of cash flows presents and analyses the inflows and outflows of cash over a period of time. Typically, cash will be categorised into three groups: operating, financing, and investing activities. The goal is to assign every cash transaction to one of these three categories and to maintain enough inflows to fund the business operations.
- The budgeted balance sheet predicts where the company's assets, liabilities as well as shareholders' equity would be at the end of the accounting period. Through this statement, it also reveals areas that need immediate attention (such as large amounts of debts).
- The budgeted income statement is sometimes called the profit and loss statement. This is where the expected revenue, costs, and expenses are displayed. Lenders and potential investors often want to see the budgeted income statement to understand the financial health of a company before deciding to make an investment. Due to this, all predictions made for this statement must be reasonable and complied with professional accounting standards.
What are the advantages of budgeting?
In general, having a budget on hand forces the executive team to think ahead to the company's next direction and targets.
To make a complete master budget, every department needs to submit its version of the expected budget. And as mentioned above, one budget can potentially impact others. Budget building in a way promotes interdepartmental collaboration and communication.
The actual performance will be compared to the projected budget. Differences are then assessed and investigated to be categorised into controllable and non-controllable groups. Based on the results, organisations will have a better view of the situation and make the appropriate actions to aid any emerging problems.
A well communicated and documented budget can help employees better understand the priorities of the business, encourage everyone to participate in the process, and keep them engaged during the revision and comparison of the budgets versus actuals.
A budget ensures scarce resources are allocated to the most suitable areas that will strategically support the business.
What are the disadvantages of budgeting?
Even though it is essential, there certainly are drawbacks that entail budgeting.
First and foremost, it is extremely time-consuming to put together a budget. Furthermore, most budgets are made based primarily on assumptions, their accuracy are highly questionable. Unless the management can adjust the budget accordingly and quickly, the department managers will continue to operate based on the initial budget, which is detrimental to the business.
In some cases, managers may feel attempted to deliberately lower the revenue estimates while over-exaggerating the expenses so they can gain favourable variances when compared with the actuals.
A common issue many companies experience is that annual budgets are used as a base for performance evaluation. If a department does not achieve the outcomes stated in the budget, they may be deemed underperforming, resulting in lower employee morale. Evaluation based solely on budgets can be a serious mistake.
Additionally, a budget's main concern is the allocation of financial resources, and thus other critical aspects of the business such as the quality of the products or services or customer satisfaction can be overlooked.
1. Brown, Marisa, “Metric of the Month: Annual Budget Cycle Times”, CFO Media, November 10, 2017, https://www.cfo.com/budgeting/2017/11/metric-month-annual-budget-cycle-times/
2. Wiggins, Perry, “Metric of the Month: Number of Budget Versions”, CFO Media, August 6, 2018, https://www.cfo.com/budgeting/2018/08/metric-of-the-month-number-budget-versions/