The message of section 4 is that budgeting is both a systematic and a flexible study of facts, costs, and other figures. The many factors influencing a company’s future development must be accounted for, with due consideration not only of errors in appreciation but also of the vagueness and uncertainty involved in all projections. Hence, the multiple financial plans of which we have spoken.
We have also seen the reasons why before a budget is set up, facts and figures must be thoroughly checked and confirmed. Too many people in management are too much inclined to overlook details or to accept a rather low degree of accu- racy, because of expediency or lack of interest in making a budget. Because of expediency, managers often fail to scrutinize the background reasons for costs.
● Some budgetary calculations are taken for granted, or reckoned on assump- tions of little value to the end result, and
● Even if the reasoning behind other spending assumptions is logical, there is the risk that budgetary allocations are based on wrong facts.
A financial plan requires not only correct facts about future activities, and care- fully normalized costs, but also a well-tuned underlying system of values.
Pragmatism should dominate. There should be no excessive optimism if today sales are booming, whereas if sales are low the sort of pessimism which brings disinclination to take on new commitments is to be avoided.
No reasonable financial plan can be based on the optimist/pessimist type of unstable attitude. Only by objectively considering each and every important fac- tor liable to affect future activities, in each product line, can a satisfactory pic- ture be formed of the problems lying ahead.
● The budget system should be built to a pattern that puts every fact and fig- ure in its proper perspective, according to its true worth.
● Relations between the various levels of management, as well as the different divisions, should instil a dynamic rather than a formal, moribund approach.
Speaking from experience, this is the right strategy in all budgetary decisions, one that can be significantly assisted through mathematical modelling. Knowledge artifacts should be available to assist in handling the details of each budgetary chapter; and seamless access to distributed databases. An interactive visualization can be instrumental in setting up and controlling budgets.
Steady interactivity with databases is important because, among other key rea- sons, by reflecting the results of past decisions, through Plan vsActual analysis, accounting figures can help management to avoid repeating past mistakes. Taken together,
● Budgeting
● Accounting, and
● Statistics
provide the major part of the background information needed for formulating policy and reaching decisions. This is the sense of using a corporate memory facility (CMF) prior to making financial commitments. A corporate memory facil- ity is different from the other databases because its theme is decisions.
The information elements in CMF are management decisions on all important issues of the entity’s business, starting at board and CEO level and covering the levels of senior management:
● Why has a decision been made?
● Who participated in it?
● Which were the alternatives at the time?
● What was the expected return from that decision?
● What was the expected return from the alternative courses of action?
Post-mortem walkthroughs 1, 2 or 3 years down the line help management in bet- ter focusing future decisions. Budgeting is not the only activity benefiting from this experience, but it is one of those reaping the more important gains.
Not only cost and return should be examined in this way but also risk and return. One of the best-known approaches to risk analysis with fallouts to the overall conduct of the business was implemented many years ago by General Electric. It led to abandoning the single-option deterministic system and replac- ing it by estimates of a range, of bandwidth.
In a way similar to the flexible budget we examined in section 4, this approach does not lead to a single result but to a spectrum of risk and return results, with different probabilities. Its first implementation was made in the GE budget for 1970 and contained three parts:
● Risk analysis
● Results probability
● Budget partition.
The analysts module serves in determining the bandwidths of factors influencing profits. Not only does it register the expected value but also the limit values which can be exceededor fall shortat the 90% level of confidence (99% is better). The 90% level means that in the longer run, in one out of ten cases the estimated value can exceed the higher limit or fall short of lower limit values. This is part of man- agement by exception. Fluctuations can always happen, but in the stated example:
● This does not mean that budgetary costs altogether rise or fall by 10% (not even the out-of-control chapters vary by such a huge amount).
● What it does mean is that one out of ten budgeted items can present a vari- ation outside its limits due to uncertainties which prevailed when the budget was set.
Influencing factors are political and economic sensitivities, price and standard of living indices, market volume, the company’s own market share, variations in sales price, cost of material, wages, salaries, and other important issues.
Operational efficiency is under the control of management. This, however, is not true of other factors, as shown by the example in section 6, which explains how the method of budgetary bandwidth works.