204 Part III: Accounting in Managing a Business 15_246009 ch09.qxp 4/17/08 12:50 AM Page 204 Chapter 10 Financial Planning, Budgeting, and Control In This Chapter ᮣ Defining the benefits of budgeting ᮣ Budgeting profit and cash flow ᮣ Keeping budgeting in perspective ᮣ Staying flexible with budgets A business can’t open its doors each day without having a pretty good idea of what to expect. And it can’t close its doors at the end of the day not knowing what happened. Recall the Boy Scouts’ motto: “Be prepared.” A business should follow that dictum: It should plan and be prepared for its future, and it should control its actual performance to reach its financial goals. Business managers can wait for results to be reported to them on a “look back” basis, and then wing it from there. Or, they can look ahead and care- fully plan profit, cash flows, and financial condition of the business, to chart its course into the future. The plan provides invaluable benchmarks; actual results can be compared against the plan to detect when things go off course. Planning the financial future of a business and comparing actual performance against the plan are the essence of business budgeting. Budgeting is not an end to itself but rather a means or tool of financial planning and control. But keep in mind that budgeting costs time and money. The business man- ager should put budgeting to the cost/benefit test. Frankly, budgeting may not earn its keep and could actually cause serious problems that contradict the very reasons for doing it. Budgeting offers important benefits, but a business may decide not to go to the effort of full-scale budgeting. I can’t argue with a minimal budgeting strategy for some businesses. However, a business should not throw out the budgeting baby with the bathwater. Certain techniques used in budgeting are very useful even when a business doesn’t do formal budgeting. 16_246009 ch10.qxp 4/17/08 12:02 AM Page 205 206 Part III: Accounting in Managing a Business Exploring the Reasons for Budgeting The financial statements included in the financial reports of a business are prepared after the fact; they’re based on transactions that have already taken place. (I explain business financial statements in Chapters 4, 5, and 6.) Budgeted financial statements, on the other hand, are prepared before the fact and reflect future transactions that are expected to take place based on the business’s strategy and financial goals. Note: Budgeted financial statements are not shared outside the business; they are strictly for internal management use. Business budgeting requires setting specific goals and developing the detailed plans necessary to achieve them. Business budgeting should be built on real- istic forecasts for the coming period. A business budget is an integrated plan of action — not simply a few trend lines on a financial chart. Budgeting is much more than slap-dashing together a few figures. A budget is an integrated financial plan put down on paper — or, more likely these days, entered in com- puter spreadsheets. (Many budgeting computer programs are on the market today; ask your CPA or other financial consultant which one he or she thinks is best for your business.) Business managers don’t just look out the window and come up with budget numbers. Budgeting is not pie-in-the-sky wishful thinking. Business budgeting — to have practical value — must start with a broad-based critical analysis of the most recent actual performance and position of the business by the managers who are responsible for the results. Then the managers decide on specific and concrete goals for the coming year. (Budgets can be done for more than one year, but the first stepping stone into the future is the budget for the coming year — see the sidebar “Taking it one game at a time.”) In short, budgeting demands a fair amount of managers’ time and energy. Budgets should be worth this time and effort. So why should a business go to the trouble of budgeting? Business managers do budgeting and prepare budgeted financial statements for three main reasons: modeling, planning, and control. Taking it one game at a time A company generally prepares one-year bud- gets, although many businesses also develop budgets for two, three, and five years out. Whenever you reach out beyond a year, what you’re doing becomes more tentative and iffy. Making forecasts and estimates for the next 12 months is tough enough. A one-year budget is more definite and detailed in comparison to longer-term budgets. As they say in the sports world, a business should take it one game (or year) at a time. Looking down the road beyond one year is a good idea, to set long-term goals and to develop long-term strategy. But long-term planning is different than short-term budgeting. 16_246009 ch10.qxp 4/17/08 12:02 AM Page 206 Modeling reasons for budgeting Business managers should make detailed analyses to determine how to improve the financial performance and condition of their business. The status quo is usually not good enough; business managers are paid to improve things — not to simply rest on their past accomplishments. For this reason managers should develop good models of profit, cash flow, and financial condition for their busi- ness. Models are blueprints or schematics of how things work. A financial model is like a roadmap that clearly marks the pathways to profit, cash flow, and finan- cial condition. Don’t be intimidated by the term model. Simply put, a model consists of vari- ables and how they interact. A variable is a critical factor that, in conjunction with other factors, determines results. A model is analytical, but not all models are mathematical. In fact, none of the financial models in this book is the least bit mathematical — but you do have to look at each factor of the model and how it interacts with one or more other factors. Here’s an example of an accounting model, which is called the accounting equation: Assets = Liabilities + Owners’ equity This is a very condensed model of the balance sheet. The accounting equa- tion is not detailed enough for budgeting, however. More detail about assets and liabilities is needed for budgeting purposes. Chapter 9 presents a profit and loss (P&L) report template for managers (see Figure 9-1). This P&L report is, at its core, a profit model. This model includes the critical variables that drive profit: sales volume, sales price, product cost, and so on. A P&L report, such as the one I show in Figure 9-1, provides the essential feedback information on profit performance of the organizational unit (a profit center in the example). The P&L report also serves as the platform and the point of departure for mapping out the profit strategies and goals for the coming year. Likewise, business managers need a model for planning cash flow from operating activities. (I explain this important source of cash flow in Chapter 6.) Managers should definitely forecast the amount of cash they will generate during the coming year from making profit. They need a reliable estimate of this source of cash flow in order to plan for other sources of cash flow they will need during the coming year — to provide the money for replacing and expanding the long- term operating (fixed) assets of the business and to make cash distributions from profit to owners. Managers need a model that provides a clear trail of how the sales and expenses of the business drive its assets and liabilities, which in turn drive the cash flow from operating activities. 207 Chapter 10: Financial Planning, Budgeting, and Control 16_246009 ch10.qxp 4/17/08 12:02 AM Page 207 Most business managers see the advantages of budgeting profit for the coming year; you don’t have to twist their arms to do this. At the same time, many businesses balk at budgeting changes in assets and liabilities during the coming year, which means they can’t budget cash flow from operating activities. All their budget effort is focused on profit, and they leave cash flows and financial condition in the dark. This is a dangerous strategy when the business is in a tight cash position. The business should not simply assume that its cash flow from operating activities will be adequate to its needs during the coming year. The best advice is to prepare all three budgeted financial statements: ߜ Budgeted income statement (profit report): The P&L report shown in Figure 9-1 serves as a hands-on profit model — one that highlights the critical variables that drive profit. This P&L report separates variable and fixed expenses and includes sales volume, margin per unit, and other factors that determine profit performance. The P&L report is a schematic that shows the path to operating profit. It reveals the factors that must be improved in order to improve profit performance in the coming period. ߜ Budgeted balance sheet: The key connections and ratios between sales revenue and expenses and their corresponding assets and liabilities are the elements in the model for the budgeted balance sheet. These vital connections are explained throughout Chapters 4 and 5. The budgeted changes in operating assets and liabilities provide the information needed for budgeting cash flows during the coming year. ߜ Budgeted statement of cash flows: The budgeted changes during the coming year in the assets and liabilities used in making profit (conduct- ing operating activities) determine cash flow from operating activities for the coming year (see Chapter 6). In contrast, the cash flows of investing and financing activities depend on the managers’ strategic decisions regard- ing capital expenditures that will be made during the coming year, how much new capital will be raised from debt and from owners’ sources of capital, and the business’s policy regarding cash distributions from profit. In short, budgeting requires good working models of making profit, financial condition (assets and liabilities), and cash flow. Budgeting provides a strong incentive for business managers to develop financial models that help them make strategic decisions and exercise control — and do better planning. Planning reasons for budgeting One main purpose of budgeting is to force managers to create a definite and detailed financial plan for the coming period. To construct a budget, man- agers have to establish explicit financial objectives for the coming year and identify exactly what has to be done to accomplish these financial objectives. 208 Part III: Accounting in Managing a Business 16_246009 ch10.qxp 4/17/08 12:02 AM Page 208 Budgeted financial statements and their supporting schedules provide clear destination points — the financial flight plan for a business. The process of putting together a budget directs attention to the specific things that you must do to achieve your profit objectives and optimize your assets and capital. Basically, budgets are a form of planning that push managers to answer the question “How are we going to get there from here?” Budgeting can also yield other important planning-related benefits: ߜ Budgeting encourages a business to articulate its vision, strategy, and goals. A business needs a clearly stated strategy guided by an overarching vision, and it should have definite and explicit goals. It is not enough for business managers to have strategies and goals in their heads. Developing budgeted financial statements forces managers to be explicit and definite about the objectives of the business, as well as to formulate realistic plans for achieving the business objectives. ߜ Budgeting imposes discipline and deadlines on the planning process. Busy managers have trouble finding enough time for lunch, let alone planning for the upcoming financial period. Budgeting pushes managers to set aside time to prepare a detailed plan that serves as a road map for the business. Good planning results in a concrete course of action that details how a company plans to achieve its financial objectives. Management control reasons for budgeting I deliberately put this reason last, after the modeling and planning reasons for budgeting. Many people have the mistaken notion that the main purpose of budgeting is to rein in managers and employees, who otherwise would spend money like drunken sailors. Budgeting should not put the business’s managers in a financial straitjacket. Tying the hands of managers is not the purpose of budgeting. Having said this, however, it’s true that budgets serve a management control function. Management control, first and foremost, means achieving the financial goals and objectives of the business, which requires comparing actual performance against benchmarks and holding individual managers responsible for keeping the business on schedule in reaching its financial objectives. The board of directors of a corporation focuses its attention on the master budget for the whole business: the budgeted income statement, balance sheet, and cash flow statement for the business as a whole for the coming year. The chief executive officer (CEO) of the business focuses on the master budget as well, but the CEO must also look at how each manager in the organization is doing on his or her part of the master budget. As you move down the organi- zation chart of a business, managers have narrower responsibilities — say, for the business’s northeastern territory or for one major product line. A 209 Chapter 10: Financial Planning, Budgeting, and Control 16_246009 ch10.qxp 4/17/08 12:02 AM Page 209 master budget consists of different segments that follow the business’s orga- nizational structure. In other words, the master budget is put together from many pieces, one for each separate organizational unit of the business. For example, the manager of one of the company’s far-flung warehouses has a separate budget for expenses and inventory levels for his or her bailiwick. By using budget targets as benchmarks against which actual performance is compared, managers can closely monitor progress toward (or deviations from) the budget goals and timetable. You use a budget plan like a navigation chart to keep your business on course. Significant variations from the budget raise red flags, in which case you can determine that performance is off course or that the budget needs to be revised because of unexpected developments. For management control, a budgeted profit report is divided into months or quarters for the coming year. The budgeted balance sheet and budgeted cash flow statement may also be put on a monthly or quarterly basis. The business should not wait too long to compare budgeted sales revenue and expenses against actual performance (or to compare actual cash flows and asset levels against the budget). You need to take prompt action when problems arise, such as a divergence between budgeted expenses and actual expenses. Profit is the main thing to pay attention to, but accounts receivable and inventory can also get out of control (become too high relative to actual sales revenue and cost of goods sold expense), causing cash flow problems. (Chapter 6 explains how increases in accounts receivable and inventory are negative factors on cash flow.) A business cannot afford to ignore its balance sheet and cash flow numbers until the end of the year. Additional benefits of budgeting, and a note of caution Budgeting has advantages and ramifications that go beyond the financial dimension and have more to do with business management in general. Consider the following: ߜ Budgeting forces managers to do better forecasting. Managers should be constantly scanning the business environment to spot changes that will impact the business. Vague generalizations about what the future may hold for the business are not good enough for assembling a budget. Managers are forced to put their predictions into definite and concrete forecasts. ߜ Budgeting motivates managers and employees by providing useful yard- sticks for evaluating performance. The budgeting process can have a good motivational impact by involving managers in the budgeting process (especially in setting goals and objectives) and by providing incentives to 210 Part III: Accounting in Managing a Business 16_246009 ch10.qxp 4/17/08 12:02 AM Page 210 managers to strive for and achieve the business’s goals and objectives. Budgets provide useful information for superiors to evaluate the perfor- mance of managers and can be used to reward good results. Employees may be equally motivated by budgets. For example, budgets supply base- line financial information for incentive compensation plans. And the profit plan (budget) for the year can be used to award year-end bonuses accord- ing to whether designated goals were achieved. ߜ Budgeting can assist in the communication between different levels of management. Putting plans and expectations in black and white in bud- geted financial statements — including definite numbers for forecasts and goals — minimizes confusion and creates a kind of common lan- guage. As you know, the “failure to communicate” lament is common in many business organizations. Well-crafted budgets can definitely help the communication process. ߜ Budgeting is essential in writing a business plan. New and emerging businesses need to present a convincing business plan when raising cap- ital. Because these businesses may have little or no history, the managers and owners must demonstrate convincingly that the company has a clear strategy and a realistic plan to make profit. A coherent, realistic budget fore- cast is an essential component of a business plan. Venture capital sources definitely want to see the budgeted financial statements of a business. In larger businesses, budgets are typically used to hold managers accountable for their areas of responsibility in the organization; actual results are compared against budgeted goals and timetables, and variances are highlighted. Managers do not mind taking credit for favorable variances, when actual comes in better than budget. But beating the budget for the period does not always indicate out- standing performance. A favorable variance could be the result of manipulating the budget in the first place, so that the budgeted benchmarks can be easily achieved. Likewise, unfavorable variances have to be interpreted carefully. If a manager’s budgeted goals and targets are fair and reasonable, the manager should be held responsible. The manager should carefully analyze what went wrong and what needs to be improved. Stern action may be called for, but the higher ups should recognize that the budget benchmarks may not be entirely fair; in par- ticular, they should make allowances for unexpected developments that occur after the budget goals and targets are established (such as a hurricane or tor- nado, or the bankruptcy of a major customer). When managers perceive the budgeted goals and targets to be arbitrarily imposed by superiors and not realistic, serious motivational problems can arise. Budgeting is not without its problems. Budgeting looks good in theory, but in actual practice things are not so rosy. Here are some issues to consider: ߜ Budgeting takes time, and the one thing all business managers will tell you is that they never have enough time for all the things they should do. 211 Chapter 10: Financial Planning, Budgeting, and Control 16_246009 ch10.qxp 4/17/08 12:02 AM Page 211 ߜ Budgeting done from the top down (from headquarters down to the lower levels of managers) can stifle innovation and discourage managers from taking the initiative when they should. ߜ Unrealistic budget goals can demotivate managers rather than motivate them. ߜ Managers may game the budget, which means they play the budget as a game in which they worry first and foremost about how they will be affected by the budget rather than what’s best for the business. ߜ There have been cases in which managers resorted to accounting fraud to make their budget numbers. Realizing That Not Everyone Budgets Most of what I’ve said so far in this chapter can be likened to a commercial for budgeting — emphasizing the reasons for and advantages of budgeting by a business. So every business does budgeting, right? Nope. Smaller businesses generally do little or no budgeting — and even many larger businesses avoid budgeting, at least in a formal and comprehensive manner. The reasons are many, and mostly practical in nature. Avoiding budgeting Some businesses are in relatively mature stages of their life cycle or operate in a mature and stable industry. These companies do not have to plan for any major changes or discontinuities. Next year will be a great deal like last year. The benefits of going through a formal budgeting process do not seem worth the time and cost. At the other extreme, a business may be in a very uncertain environment, where attempting to predict the future seems pointless. A business may lack the expertise and experience to prepare budgeted financial statements, and it may not be willing to pay the cost for a CPA or outside consultant to help. But what if your business applies for a loan? The lender will demand to see a well-thought-out budget in your business plan, right? Not necessarily. I served on a local bank’s board of directors for several years, and I reviewed many loan requests. Our bank did not expect a business to include a set of budgeted financial statements in the loan request package. Of course, we did demand to see the latest financial statements of the business. Very few of our smaller business clients prepared budgeted financial statements. 212 Part III: Accounting in Managing a Business 16_246009 ch10.qxp 4/17/08 12:02 AM Page 212 Relying on internal accounting reports Although many businesses do not prepare budgets, they still establish fairly specific goals and performance objectives that serve as good benchmarks for management control. Every business — whether it does budgeting or not — should design internal accounting reports that provide the information man- agers need in running a business. Obviously, managers should keep close tabs on what’s going on throughout the business. Some years ago, in one of my classes, I asked students for a short definition of management control. One student answered that management control means “watching every- thing.” That’s not bad. Even in a business that doesn’t do budgeting, managers depend on regular profit reports, balance sheets, and cash flow statements. These key internal financial statements should provide detailed management control information. These feedback reports are also used for looking ahead and thinking about the future. Other specialized accounting reports may be needed as well. Making reports useful for management control Most business managers, in my experience, would tell you that the account- ing reports they get are reasonably good for management control. Their accounting reports provide the detailed information they need for keeping a close watch on the 1,001 details of the business (or their particular sphere of responsibility in the business organization). What are the criticisms I hear most often about internal accounting reports? ߜ They contain too much information. ߜ All the information is flat, as if each piece of information is equally relevant. Managers are very busy people and have only so much time to read the accounting reports coming to them. Managers have a valid beef on this score, I think. Ideally, significant deviations and problems should be highlighted in the accounting reports they receive — but separating the important from the not-so-important is easier said than done. Making reports useful for decision-making If you were to ask a cross-section of business managers how useful their accounting reports are for making decisions, you would get a different answer than how good the accounting reports are for management control. Business managers make many decisions affecting profit: setting sales prices, buying products, determining wages and salaries, hiring independent con- tractors, and purchasing fixed assets, for example. Managers should carefully analyze how their actions would impact profit before reaching final decisions. Managers need internal profit reports that are good profit models — that 213 Chapter 10: Financial Planning, Budgeting, and Control 16_246009 ch10.qxp 4/17/08 12:02 AM Page 213 [...]... strike, legal issues, and so on In short, accounting reports provide only part of the information needed for business decisions, though an essential part for sure Making reports clear and straightforward Needless to say, the internal accounting reports to managers should be clear and straightforward The manner of presentation and means of communication should get the manager’s attention, and a manager should... based on the information given for this example and using your historical ratios for short-term assets and liabilities driven by sales and expenses Note: Increases in accrued interest payable and income tax payable are not included in your budgeted cash flow Your profit responsibility ends at the operating profit line, or earnings before interest and income tax expenses 219 220 Part III: Accounting in... process and budgeted financial statements ߜ Standard costs: Costs, primarily in the area of manufacturing, that are carefully engineered based on detailed analysis of operations and forecast costs for each component or step in an operation Developing standard costs for variable production costs is relatively straightforward because most are direct costs In contrast, most fixed costs are indirect, and standard... money for the capital expenditures that will be made during the coming year — and to meet the other demands for cash, such as for cash distributions from profit The business may have to raise more capital from debt or equity sources during the coming year to close the gap between cash flow from operating activities and its needs for cash This is a central topic in the field of business finance and beyond... common refrain among accountants is “different costs for different purposes.” True enough, but at its core, cost accounting serves two broad purposes: measuring profit and providing relevant information to managers for planning, control, and decision-making In my experience, people are inclined to take cost numbers for granted, as if they were handed down on stone tablets The phrase actual cost often... activities for the coming year Remember: The profit you’re responsible for as general manager of the division is the amount of earnings before interest and income tax (EBIT) Chapter 10: Financial Planning, Budgeting, and Control Chapter 6 explains that increases in accounts receivable, inventory, and prepaid expenses hurt cash flow from operating activities and that increases in accounts payable and accrued... reading the budgeted profit report for the coming year (refer to Figure 10-2), you see that virtually every budgeted figure for the coming year is higher than the figure for the year just ended Therefore, your operating assets and liabilities will increase at the higher sales revenue and expense levels next year — unless you can implement changes to prevent the increases For example, sales revenue increases... to the managers receiving them; the reports are too voluminous and technical and are not focused on the most urgent and important problems facing the managers Designing good internal accounting reports for managers is a challenging task, to be sure But every business should take a hard look at its internal management accounting reports and identify what should be improved Watching Budgeting in Action... capacity, condition, and efficiency of these resources — and decide whether it needs to expand and modernize its property, plant, and equipment In most cases, a business needs to invest substantial sums of money in purchasing new fixed assets or retrofitting and upgrading its old fixed assets These long-term investments require major cash outlays So, each division of a business prepares a formal list of... division, as well as the responsibility for meeting the financial expectations for your division To be Chapter 10: Financial Planning, Budgeting, and Control more specific, your profit responsibility is to produce a satisfactory annual operating profit, which is the amount of earnings before interest and income tax (EBIT) (Interest and income tax expenses are handled at the headquarters level in the . III: Accounting in Managing a Business 16_246009 ch10.qxp 4/ 17/ 08 12:02 AM Page 210 managers to strive for and achieve the business’s goals and objectives. Budgets provide useful information for. issues, and so on. In short, accounting reports provide only part of the information needed for business decisions, though an essential part for sure. Making reports clear and straightforward Needless. profit $26,000,000 $14,300,000 $11 ,70 0,000 $2,080,000 $1,300,000 $8,320,000 $5 ,72 0,000 $2,600,000 Budgeted for Coming Year 272 , 170 units Per Unit Totals $103.00 $ 57. 20 $45.80 $8.24 $5.00 $32.56 $28,033,968 $15,568, 378 $12,465,590 $2,242 ,71 8 $1,360, 872 $8,862,000 $6,006,000 $2,856,000 Figure