Finance For Managers: Best Practices Related to Budgeting - Essay Example

Executive Summary This document, prepared by a new recruit fresh from a management institute, outlines established best practices related to budgeting, followed by some of the most consistently successful corporations in the world. It is based on a review of some key published papers on related aspects of strategic business development. The most important recommendations, which our company can consider adopting, are: 1. Budgeting should be used as a communication tool. It has to enable senior executives at headquarters appreciate market realities, and operational compulsions at the periphery as well. Budgeting is also an occasion for dialogue amongst colleagues about the vision and future direction which the business should take. 2. Budgeting is most meaningful when it is flexible, responding swiftly to changing conditions, with consensus on target setting, and understanding of the reasons for variances. 3. Budgets are annual, but should follow long term plans, so that there is consistency of direction. 4. Budgets based on undue optimism can affect employee morale, and place company interests at severe risks at the same time. The degree of stretch in budgets should be tempered with realism with regard to feasibility. 5. A great budget is one which inspires people to new heights of achievements, and which enables a company to make a new turn for the better. It could be that our own current budgeting practices can improve, moving away from arithmetic and bureaucracy alone, to a vibrant and meaningful process of business and team development. We can put the ideas in this note to use during our ensuing budget exercise. Ground Zero The size of a corporation can make management incredibly difficult. Senior group executives can easily lose touch with markets and employees in one of the many branches and layers of the hierarchy. This is especially the case with organizations which have operations in distant countries. A budget exercise can be a refreshing occasion to stay in touch (Genthner & Hebert, 1977). It also means that top-down target imposition can lead to large deviations from budgets, upsetting everyone in the bargain. Targets set in contradiction with local conditions can be counter-productive. Communication during a budget routine is not a one-way process: senior managers can convey important elements of corporate strategy to employees who they do not normally get to meet during the year. The process of budgeting can therefore lead to better cohesion within the company, and a clearer understanding of the company’s basic approach to the business. Relevance is a major concern of budgeting: planners must ensure that new trends with respect to customers, the latest competitive moves, changes in distribution systems, and revised regulatory requirements, are all reflected in the numbers set and the operational plans. Conversely, a budget which is prepared without thorough discussions, or is isolation of business realities, with a process that does not allow for iteration, can confuse employees, and lead to a loss of coordination. Excellence in the annual budgeting exercise is a weapon for performance improvement, and a hall mark of the most professionally managed companies. It can be hard to set aside time for a budget in the midst of pressing and routine matters, but the effort to forge agreement of the next year’s plan is sure to yield rich dividends. ABC Activities, bases, and controls are 3 fundamental parameters of effective budgets. This makes budgets flexible, with much emphasis on understanding and responding to the reasons behind variances (Scott, & Rochester, 1990). Budgets which have numerical tables alone, will not relate to daily actions. People responsible for budgeting should ensure that actions and activities are specified to back all key numbers targeted. The activity budget should dove tail with task setting, which always makes Management by Objectives (MBO) a useful adjunct to budgeting. The important thing is to make sure that targets do not just remain on paper, but act as reference points for recurring and individual work plans. Every employee must know exactly what needs to be done by when, so that targets are achieved. This applies equally to revenue and to cost numbers: limits set for discretionary expenses have to be linked to achievement of revenue projections. The control and review phase should not reflect on numbers alone, but consider whether planned actions have been completed. There may be times when employees perform very well, though circumstances force negative variances: the reverse can also take place. Therefore, action review should be as important as the numbers. The term ‘bases’ in the ‘ABC of Budgeting,’ refers to assumptions. The ones related to the macro-environment, and which are not controllable, are the ones which need the quickest responses. Inflation and exchange rates are amongst the most common assumptions, which can change dramatically during a year, and play havoc with a budget. Weather can matter greatly for some enterprises. What is most important is for the budget to make important assumptions implicit, so that targets can be recast soon after the environment for business changes substantially. Companies should not be bureaucratic and keep targets frozen in stone, even after they lose relevance. Control systems make up the third plank of good budgets. Most companies have monthly and quarterly review periods. Detailed contingency planning is not possible for each and every variance, and only long years of experience can tell which deviations from budgets need most scrutiny. Budget review is therefore an important managerial prerogative. However, it can be overdone and make people in line functions feel insecure. The best companies find ways to find harmonious balances between asking searching questions and keeping people motivated for target achievement. Long and Short The successful diversification of EMI from music to medical electronics, and the subsequent failure of this business, is often quoted as a demonstration of how annual budgets and long term plans need to converge (Bartlett, & Ghoshal, 1991). The EMI engineer won the Nobel Price for his computer scanning technology in the same year as the product drove the company out of the medical imaging business! It was a case of a U.K. company losing touch with international developments. These kinds of errors can creep in when separate teams make long term plans and annual budgets. Investments and liabilities to which a company gets irreversibly committed have to be kept in view when making revenue budgets for individual years of a Plan. There is a natural tendency to be relatively more optimistic in long term planning, so a company must guard against budgeting short of Plan milestones. Carrots and Sticks Ironically, the reverse of budgetary conservatism in reaching for Plan targets can also be true! Undue optimism in handing out budgets can result in huge risks and a narrow mentality for a company (Kahneman, & Lovallo, 1994). Companies with sophisticated information technology can work with ranges instead of point figures for budgets. Even smaller companies can use best, likely, and worst case scenarios for at least the major budget heads. A conservative budget with incentives for better performance, also works well. Companies in mature sections of the economy can suggest realistic targets quite easily, but new enterprises can find that they have no firm bases to make their projections. Top executives should ensure that employees are not penalized, or even stressed by targets which are almost impossible to achieve. Similarly, large incentives for crossing ‘easy’ targets can make teams complacent. Turning Point Corporations should use Budgeting to convert opportunities in to new business, and to sustain innovation (Holt, 1995). The exercise is expensive in terms of staff time, and only a substantially new direction can justify such deployment of resources. A budget which is merely an extension of the past is a waste of time. Employees get accustomed to pedestrian approaches to budgeting, and the exercise can become quite worthless over time. Creative and inspired budgeting is a common factor for most companies with sustained excellence in growth and profitability. Business diversification, rapid growth, downturns, and entry in to new markets, are all times when budgeting excellence can be linked to managing the risks of any company. Budgets help organizations change direction, exploit opportunities, and survive through lean periods as well. Conclusions The value of budgeting is in making employees of a company think differently, so that it climbs to new heights of sustainable competitiveness (Hamel, & Prahalad, 1994). Every organization can use budgeting to develop itself, and to improve performance also. It can be a suitable forum for colleagues to sit back and take stock of their business situations. However, no one can be certain about the future, so companies should not stick with budgets if conditions change during the course of years. A budget should always be reviewed for consonance with the long term plan. Targets should motivate people to continually upgrade their skills, but should appear to be unjustified and imposed by authority alone. Budgeting is one of the most valuable business processes of a company, and can become a source of competitive advantage. Budgets should never remain as figures on paper, and must permeate daily thinking and action throughout the organization. References Bartlett, C. A. & Ghoshal, S. 1991, Tap Your Subsidiaries for Global Reach, Strategy, Montgomery, C. A. & Porter, M. E. (eds.) Harvard Business Review Genthner H. J. & Hebert, J. L. 1977, Automating Zero Based Budgeting, Petrocelli, New York/Princeton Hamel, G. & Prahalad, C. K.1994 Competing For the Future, Harvard Business School Press, Boston, Massachusetts Holt, C. P. 1995, How Can Big Companies Keep the Entrepreneurial Spirit Alive, Harvard Buisness Review, November-December 1995 Kahneman, D. & Lovallo, D. 1994 Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking, Fundamental Issues in Strategy, Rumelt, R. P. & Schendel, D. E. & Teece, D. J. (eds.) Harvard Business School Press, Boston, Massachusetts Scott, J. & Rochester, A. 1990, Effective Management Skills: Managing Money, Sphere/British Institute of Management Read More