Financial plans can be short-term, medium-termor long-term. Short-term finan- cial plans are made for up to 3 years, but sometimes can go to 5 years; long-term plans go beyond that. At the junction of short and medium term is the rolling year, a budget made for up to 2 years, with the average being 18 months.
The projected life cycle of a financial plan is very important. The shorter it is, the greater must be the detail. The establishment of procedures for annual budget should account for the fact that this is a short-term financial plan. All outlays
and schedules advanced by the annual budget have definite functionsand mean- ingfor the purpose of:
● Planning, and
● Controlling expenditures.
What the annual budget presents is a formal, detailed plan of all operations of the business for the defined future period which it targets. Although some of the aspects of preparing and stating the plan’s details vary from one company to another, the overall process can be described simply as:
● A forecast of all transactions that are expected, as well as their costs, and
● An estimate of all fixed costs and overheads, after having cut out the fat.
Well-managed organizations appreciate that the proper preparation of a pro- jected financial plan is made in an iterative way, between headquarters, depart- ments, and business units, as briefly described in section 2. Subsequent to an initial tentative schedule, the different entries are evaluated, altered if necessary, and accepted as next year’s financial plan.
In banking, this statement is just as valid of the interest budget as it is of the non-interest budget. In fact, both of them share some major conceptual and design issues in regard to projected, forthcoming transactions. The most impor- tant are:
● Costs
● Risks, and
● Returns associated to them.
For example, changes in margin during the budgetary period must not only be included in the interest budget but also appropriately explained. This is a good example of Plan vs Actual evaluation in a financial environment which includes significant uncertainties – as well as of risk and return analysis.
A similar statement can be made about marginal interest spread, including record- ing of the rates for the major groupings that are used in determining net interest margin. Such information allows management to quickly monitor changes, taking corrective action when necessary.
The message these paragraphs convey is that the budgetary process is not a one- way street, just piling up expense after expense and asking for funding of the
resulting balances. Quite to the contrary, it is a two-way process which can be properly executed only when there is a total view of:
● Planning premises
● Developing requirements, and
● Control procedures.
Moreover, even the most carefully elaborated interest budget will become obso- lete if it is not steadily upkept. Updating is no hit and run job. A comprehensive solution to budgeting means a valid approach to planning and control in a dis- tributed, complex business environment. And there is need for detail. A good way to look at requirements imposed by updating is to examine them in a multi- dimensional manner by:
● Organizational unit
● Market in which it operates
● Money market realities
● Trend in currency exchange
● Product or service being financed
● Customer relationship being supported.
Wisely set procedures for budget management will be focusing on value creation, not on mechanics. To promote value creation, we must appreciate that the elab- oration of budgets and making of analytical studies, have many issues in com- mon. The aim is to provide factual and documented evidence on the transition which takes place from financial plan to actual results – by customer, product, market and organizational unit. Their synergy permits us to:
● Streamline the planning process
● Improve the credibility of financial procedures, and
● Help to reduce costs of production and distribution of services.
Moreover, whether for planning purposes or for management control reasons, the on-line interactive presentation of budget information should be future oriented.
Past statistics are interesting, but we should never forget that, to a large extent, the budget is executed in the future.
On the side of the non-interest budget, a case to study with care is flexible or variable budgeting, which consist of a series of financial plans geared to differ- ent rates of activity. For instance, the cost of production and distribution of financial services may be estimated at several possible levels of output and oper- ating expenses. Another interesting approach is alternative budgets.
● In preparing alternative budgets, careful consideration must be given to the effect of changes in volume on each budgeted chapter.
● The process of alternative budgeting is no excuse for high overhead. The method must ensure that, in all cases, overhead is kept in control.
Financial plans geared to changing levels of activity contrast with the very com- mon practice of inflexible budgeting often based on best guesses that cannot stand the test of time. The processes of flexible and of alternative budgeting have, however, prerequisites. Their implementation requires correct identification of the activity basis that will be applicable to each of the alternative financial plans:
● Hours of work
● Standard costs
● Units of production
● Financial performance, and so on.
Section 2 made reference to zero budgeting, popularized in the late 1970s, dur- ing the years of the US Carter Administration. As the careful reader remembers, it supposes that the different chapters of the budget regarding the current year are zeroed out. Each department, down to the smallest unit, has to re-justify its existence, otherwise it will receive no funding in the next financial plan.
As a variation of flexible budgeting, some organizations follow the policy of maintaining and reporting on multiple budgets. Zero budgets and multiple budg- ets should not be confused. For multiple budgeting purposes companies prepare:
● A historical budget established on the basis of last year’s performance adjusted to accommodate new forecasts.
● A flexible current operating plan, which reflects the major revisions on the original ‘historical budget’.
● A budget focusing on variances between Plan and Actual data from the past three years, as a projection on possible new deviations.
● One or more alternative budgets, prepared on the hypothesis of major exoge- nous eventswhich radically alter budgetary considerations and allocations.
During the Cold War years, for example, several American companies had ready alternative budgets. For example, ifthere had been an outbreak of war, thenthe corresponding financial plan was ready to be applied.
Similarly, alternative scenarios can be built for major economic events such as inflation, deflation, and stagflation. Once the budgetary process has been mod- elled and mapped into the computer, there is a wealth of experimentation which
can be done practically at no extra cost, permitting the evaluation of different scenarios and their aftermath.
In conclusion, a great deal of financial analysis can effectively be done by means of budgeting models that are flexible, easily updateable and provide input to man- agement control. Technology helps in making interactively available copies of ver- sions of the current year’s budget. That is the:
● Original budget and all revised plans, whether they are updated quarterly or more frequently
● Variances from original budget and proposed, or preliminary, new operat- ing plans.
This approach can also be taken in terms of projections for one or more future years if our company budgets for the medium term. It also facilitates walkthroughs of past budgets, providing a retrospective look at past years. Since medium-term budgets are based on forecasts, emphasis is not placed on hard data but on soft data, including hypotheses and calculation of the probability of different events taking place.