The process of financial planning is a direct contribution to effective management.
Many experts believe that budgeting contributes more to good governance than any other process or tool at management’s disposal. This is true because each of a company’s primary functions is directly served by budgeting – ifand when care- ful study, investigation, and research have been undertaken in order to determine:
● Expected future operations, and
● Costs associated to them.
As financial plans, budgets are based on forecasts. Budgets can only be as good as the forecasts and standard costs used in making them. The forecasting and planning premises entering a budgetary process increase management’s ability to rely on fact-finding, lessening the role of hunches and intuition in running the enterprise.
Budgets based on last year’s activity multiplied by ‘something’, are irrelevant. In fact, one of the best ways available to prune a budget is the so-called zero budg- eting. This puts everybody working for the enterprise on an ‘active status’, with the requirement to justify the reason and deliverables of his or her job, before this job is again budgeted.
Jobs performed within an entity must have a synergy. Organization-wide coordi- nation through budgetary procedures is facilitated when each level of manage- ment participates in the preparation of the budget. The introduction brought the reader’s attention to the need for co-involvement.
Top management should be setting and explaining objectives and projected lev- els of activity, but each organizational unit must establish its budget under these guidelines – subject to subsequent approval by headquarters. On the other hand,
according to a very sound principle I learned when I was consultant to General Electric:
● Approval of a budget is noauthorization for spending money; it is only a financial plan.
● Beyond a certain level, each expenditure must be individually approved, and all expenses must be controlled for compliance to the plan.
‘We watch every dollar like a hawk,’ said Microsoft’s CEO when, in a Washington, DC, conference, he was asked what was his company’s secret in being so successful beyond the genius of Bill Gates. As I never tire of repeating, costs matter a great deal. This must be a company dictum appearing on the desk of every executive, because it is not embedded in the balance sheet and income statement (P&L).
Modelling the company’s cost structure is important, as is experimentation with alternative courses of action, but there also exist other prerequisites. One of the crucial issues with budgeting is a steady input of information directly to the database. This is necessary to permit realistic financial planning and manage- ment control. Inputs can come:
● Top downfrom senior management to the divisions, departments, operat- ing units and back to top management, or
● Bottom up, elaborated at operating unit level, and from there sent to the department or to top management for approval.
The best alternative is an interaction between these two, since it leads to a finan- cial plan which contains the salt of the earth. It starts with top management guidelines, then goes close to lower management level where the budget will have to be subsequently applied. As underlined in the Introduction, participa- tion down the line in budgetary processes motivates the people who will later on have to work with that budget.
Companies that have chosen the hierarchical top-down approach argue that the problem is the amount of time required by an iterative process. This amount of time, they say, can be long and the task may not be well coordinated. This can happen, but it does not need to be that way. Rather, the solution is that budget- ary planning is executed interactively on-line through:
● Models
● Computers, and
● Networks.
Various options have been provided to facilitate the input task in financial plan- ning, thereby enabling a manager to concentrate his or her efforts on those accounts that do warrant careful analysis. Short-cut methods are not necessarily the best solution, but for the information of the reader these include:
● An annual, quarterly and monthly amount to be prorated according to the actual number of days in each period.
The aim is to have projected amounts created automatically by the system, using forecasting techniques and standard costs. The downside is that this may per- petuate budgetary mistakes.
● A percentage increase or decrease over the current year’s actual and pro- jected data, to temper system-generated business forecasts.
Such entries may be coarse and will need to be subsequently refined, but as they stand they could serve as starting points. This is the opposite approach to zero budgeting.
● Combination entries, with distributions resting on algorithms that reflect marked variations or seasonal fluctuations.
The models used to produce this information are typically run by computer.
They work interactively and can provide results in real-time. These results, however, needed testing and pruning, by applying Microsoft’s dictum. Where this approach can help is in control of Plan vs Actual.
In spite of what was stated in Chapter 7 about model risk, computer-based arti- facts can be instrumental in preparation of financial plans, all the way to subse- quent analysis for control reasons. An example is interim profit and loss evaluation, based on information derived from the financial plan and operating statistics. This helps in producing ad hoc interactive reports:
● From evaluation of cost factors
● To a critical view of customer profitability (see the discussion on customer mirror in Chapter 7).
As a result of a real-time, interactive budgetary process, the activities of each unit of production, and of each department can be better integrated with those of related operations in the same area, nation-wide and internationally. But as the Introduction has underlined, though managerial planning and coordination are important, they must be accompanied by control.
In conclusion, budgeting contributes to effective management planning and con- trol by providing the standard(s) against which the entity’s actual performance will be evaluated and variances revealed. This needs to be done both for each operating unit and for the company as a whole. Hence, in both a detailed and in a consolidated way. Members of the board, CEO, and his immediate assistants must always keep in mind that financial planning and control is an integral part of management accounting (see Chapter 8).