_CH01 7/31/2000 4:39 PM Page 1 PART ONE BUDGETING AND FORECASTING OVERVIEW

01.66878_CH01 7/31/2000 4:39 PM Page 1 PART ONE BUDGETING AND FORECASTING OVERVIEW

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01.66878_CH01 7/31/2000 4:39 PM Page 3 CHAPTER 1 BUDGETING TODAY: OVERVIEW AND TRENDS For years, companies have viewed their budgets simply as a mandatory estimate of the upcoming year s revenues and expenses. However, this attitude is quickly changing as the marketplace becomes more competitive and organizations become more dynamic. Successful companies are constantly improving their ability to accurately predict their future operations and their related resource requirements. Not only does this heighten the importance of the budgeting and planning process, but it also changes the traditional roles of spreadsheets, legacy budget systems, and software created in-house. A study by the Institute of Management and Administration shows how important budgeting and planning is becoming to corporations. (See Figure 1.1.) Controllers of large and small companies were asked to identify their most critical job functions, and nearly 59% rated budgeting as their key job function. The same study showed that the budgeting process now involves more activities and individuals throughout the entire organization. In other words, the days where a few people at corporate headquarters created the budget in isolation are quickly disappearing: Budgeting has become an organizationwide activity. When asked how their role as controllers had expanded, the respondents ranked budgeting/control and strategic planning as the two leading activities. This further supports the notion that there is a strong trend toward a more complex budgeting and planning function. 3

01.66878_CH01 7/31/2000 4:39 PM Page 4 4 BUDGETING TODAY: OVERVIEW AND TRENDS Number of employees Combined Less than 250 More than 250 Annual planning and budgeting 58.6% 56.6% 63.3% Balance sheet management 52.2% 57.8% 48.0% Monitoring spending 45.2% 50.6% 37.8% Performance measurement 36.6% 32.5% 40.8% Internal control 30.6% 26.5% 33.7% Closing procedures 29.0% 30.1% 28.6% Long range financial planning 29.0% 28.9% 28.6% Other 8.1% 6.0% 10.2% The Controllers Report #1, 1998, The Institute of Management and Administration FIGURE 1.1 Critical job functions for controllers Reprinted by permission. 1998, Tim Harris, Editor, IOMA s Controller s Report. (212) 244-0360. http://www.ioma.com/. RE-ENGINEERING THE BUDGETING AND FORECASTING PROCESS Undoubtedly the expectations from corporate strategic planning have increased as a result of the changing competitive landscape and the availability of new technology. But even though companies are now spending more time than ever creating more detailed and more frequent budgets and forecasts, we are still in the early stages of advanced corporate planning. Most companies are still not happy with the planning processes they have in place and the results they see. Some often cited complaints and concerns are: Lack of employee motivation and initiative during the planning process Lack of clearly defined strategies to drive planning and forecasting efforts Minimal correlation between corporate strategy and operational plans Politics, rather than strategy, influencing the planning process There is little doubt that every company has room for improvement. However, the improvements must start within the organizations themselves, with a re-engineering of the planning process. Unless the organizational issues are addressed, the planning and budgeting process will not be as effective nor as useful as it needs to be.

01.66878_CH01 7/31/2000 4:39 PM Page 5 RE-ENGINEERING THE BUDGETING AND FORECASTING PROCESS 5 A great misconception is that new technology will take care of the current problems. Resolving problems with old, inflexible legacy budgeting software or out-of-control spreadsheet models often becomes management s focal point, rather than changing the company s planning process. As a result, a large number of companies go out and purchase one of the many new budgeting and planning software packages, thinking that it will completely solve their current challenges. However, in most cases, the problem is that although the new software usually replaces the old system and offers additional features and automation, the underlying organizational problems still remain. Thus the potential benefits to the company are smaller than if the whole planning process were revamped. According to leading management consultants, certain key issues should be addressed in order to streamline the planning process: The amount of planning data should be limited. The type of planning data produced should be standardized. Data should be shared across the organization, in real time. Employee compensation should be tied to strategic plans. Modern budgeting and forecasting software can help automate and improve many of these items, but the underlying weaknesses are usually not software related; they are organizational issues that must be addressed by top management. To fully realize the benefits of the software, all aspects of the budgeting process must be examined. When new software is implemented, maximum gains can be realized if everyone takes this as an opportunity to improve the entire budget cycle, not just the software used in the cycle. As an example, the inputs required, the flow of information, and the people involved should all be reviewed and questioned. (See Figure 1.2.) Many resources, such as people within your organization, trade and professional organizations, and outside consultants are available to help re-engineer these processes. As companies continue to redefine their budgeting and forecasting processes, several key trends have begun to emerge: Tighter integration of corporate strategy with budgeting Added detail in strategically important areas (such as revenue) More complex models Improved accuracy of budgets and forecasts Integration of available resources and tools More frequent revisions (re-forecasts and rolling forecasts) Increased employee participation and departmental involvement Streamlined budget reviews and approvals

01.66878_CH01 7/31/2000 4:39 PM Page 6 6 BUDGETING TODAY: OVERVIEW AND TRENDS Planning & Target Setting Decision Making Management Vision & Leadership Budgeting Reporting & Analysis FIGURE 1.2 Budgeting and planning process TIGHTER INTEGRATION OF CORPORATE STRATEGY WITH BUDGETING Companies want to tie their budgets to their corporate strategy to make sure that the projected resource requirements are available to support the anticipated future of the company. In order to be profitable, a company cannot afford to have any shortfall between its anticipated revenues and expenses and its plans for the future. Furthermore, these future plans need to be effectively communicated so that all employees involved in the planning process know and understand the activities that will ultimately lead to better operating results. In essence, what this means for the budgeting process is that headquarters must learn how to share strategy with the rest of the organization. For example, suppose a company has developed an operating plan to increase revenues by 10% and to decrease specific operating expenses by 5% over the next 24 months. After these targets have been set at the top level of the organization, they must be communicated effectively to all people affected by these targets. This information is vital so that managers can create budgets that reflect the corporate strategy.

01.66878_CH01 7/31/2000 4:39 PM Page 7 ADDED DETAIL IN STRATEGICALLY IMPORTANT AREAS 7 Historically, linking corporate strategy with the budget process has not been successful in most companies. This is due partly to corporate structure and partly to the technology used within the corporation. Without efficient inter-departmental communication and technology, it is difficult to link the two. Using effective budgeting software can help close the gap between strategy and the budget. Implementing a budgeting software package where corporate targets are visible to the end user and all key budget figures are measured against specific targets at the point of data entry is one solution. This break between strategy and budgeting may also be due to a general lack of focus on the budgeting process itself. Creating the local operating budget was often viewed as a completely separate activity from long-range planning. Today, however, it is becoming increasingly apparent that the two must overlap. Long-range budgets created at headquarters that do not agree with the current operating budgets used at the local level are completely useless. All plans and future projections at all levels of the organization must be geared toward the same goals and results. ADDED DETAIL IN STRATEGICALLY IMPORTANT AREAS As budgeting increases its importance to companies and accounting and budgeting tools become more integrated with increased functionality (including reporting capabilities), more, rather than less, detail has become the norm. However, the additional detail is manifested in the areas that drive the bulk of the business revenue and expenses. The resulting measurements are often referred to as key performance indicators (KPIs). Several reporting methodologies or performance measurement methods have been developed to assist companies in focusing on their key business drivers in both their planning processes and in their ongoing reporting. Some of the more recognizable ones are the balanced scorecard and activity-based budgeting. You can read more about these in Chapter 4. Regardless of their reporting methods and level of detail, most companies today budget for all their profit and loss accounts, sometimes with a different level of detail for different financial items, and for key statistical items such as headcount or sales volume. Newer budgeting systems also allow for line item detail with text comments even at the most detailed level (many line managers do their line item detail calculations in a local spreadsheet). This simply means, for example, that an account such as 5670-Travel could be opened in a screen where the user can enter as many subentries as needed in order to come up with the total for the account. The strategic implications of this can be very important. It is now possible for top management to focus on important business drivers and then drill down to the line item detail for any item. As a result, they

01.66878_CH01 7/31/2000 4:39 PM Page 8 8 BUDGETING TODAY: OVERVIEW AND TRENDS can spend more of their time analyzing and taking action on the items that represent the most problems or opportunities (such as salary expense or revenue), and less time on items that are fairly static from year to year (such as rent). Multi-dimensional Budgeting In order to produce measurements for the key business drivers discussed above, companies now have to integrate multi-dimensional data from many of their business applications (such as the sales order entry system or human resource system) with their budgeting application. Bill Gates, former CEO of Microsoft Corporation, says anyone who has participated in a budget review with the executive committee at Microsoft knows that we insist on having accurate numbers and insightful analysis of those numbers. Numbers give you the factual basis for the directions in which you take your products. 1 This means that with better integration between core accounting modules and with more focus on key performance indicators, line managers, as they sit down and attempt to enter their best vision of the future, will have access to much more historical transaction detail for these key items than ever before. (See Figure 1.3.) Product A March Mar Product B February Product C January Gross Margin REVENUE Cost of Sales Division Y Division Z Northeast Actual Budget Division X Southeast Northwest Forecast Southwest FIGURE 1.3 Information integration 1Bill Gates, Business at the Speed of Thought (New York: Warner Books, 1999), p. 214.

01.66878_CH01 7/31/2000 4:39 PM Page 9 MORE COMPLEX MODELS 9 This also gives management a possibility to compare actual figures with budgets in the key operational areas of the business complete with important details, for example, sales per product per market per customer. Or it can mean that management can look at a profit and loss report for an entire department in one instance, and look at the profitability of all the projects undertaken by that department at the same time. MORE COMPLEX MODELS Another important trend in budgeting is the increasing complexity of budgeting and forecasting models. Although there is also a trend toward focusing on fewer budgeting items, those items that are closely examined are split into more detail than ever. New measurements of business performance are constantly being invented, and many of them demand source numbers that have not traditionally been part of the budgeting process, for example, revenue per square foot, customer satisfaction, and so on. Frequent acquisitions and divestitures also represent challenges. It seems like corporations are getting ever more dynamic as they scramble for market share and positioning in a competitive marketplace. A majority of all organizations today are still using spreadsheets to distribute, collect, consolidate, and report budgets and forecasts. For small, stable companies with few departments and product lines or services, the spreadsheet is one of the best tools ever to support the budgeting process. However, mid-sized and larger companies face many challenges that make their spreadsheet budgeting models rather complex and hard to maintain. Some of these challenges are: Multiple acquisitions or divestitures per year Many products and services Large number of departments, divisions, subsidiaries Large number projects Large number of front-end systems to interface with the budgeting model Budgeting for subsidiaries and/or sales in foreign currencies and highinflation countries As companies are discovering the value of accurate, focused and detailed budgets as key strategic tools to their decision making, these business factors listed above represent challenges for their planning models. As a result, businesses now demand better budgeting and forecasting functionality from their software vendors (see Chapter 6 for more detail on budgeting software).

01.66878_CH01 7/31/2000 4:39 PM Page 10 10 BUDGETING TODAY: OVERVIEW AND TRENDS IMPROVED ACCURACY OF BUDGETS AND FORECASTS If your budgets and forecasts are always far off the actual results for the period, there is an evident danger that: Bad decisions will be based on incorrect projections of the future. Management will pay less attention to budgets because they do not trust the numbers. The organization as a whole will suffer from lack of proper planning. Poor accuracy of budgets has been and still is a problem for many companies. With the marketplace more competitive than ever, organizations are realizing the necessity of accurate numbers and forecasts. Some budgets are not accurate because: They are derived from poor budgeting tools (e.g., spreadsheets with formula errors). Employees are allowed too little time to create good projections. Employees lack motivation (e.g., they ignore seasonal trends while budgeting revenues or expenses). Employees lack training (e.g., a new line manager might not know the business well enough to create an accurate budget). Key employees are not involved in the budget process (e.g., many companies have a very top-down oriented budgeting process where most or all budget figures are created by top management, with little involvement from line managers). Improving the accuracy of budgets and forecasts will obviously make it easier for management to plan and execute a large number of operating activities in their company. Such activities include sustaining appropriate staffing levels, purchasing raw materials and supplies, maintaining inventory levels, properly adjusting employee incentive plans, and more. Just imagine the advantages over the competition if a company had accurate projections of how much they were going to earn and spend in the next year or two, which in turn would determine what cash flows they could expect, how many people they would need to hire, and in which markets they should focus their energy. Companies are now realizing how beneficial this information can be to them and are attempting to improve the accuracy of their budgets and forecasts by increasing employee involvement, investing in better budgeting tools, and so forth. INTEGRATION OF AVAILABLE RESOURCES AND TOOLS Larger and mid-sized companies, in particular, have many integration challenges in the budgeting process. On one side you have the integration of dif-

01.66878_CH01 7/31/2000 4:39 PM Page 11 INTEGRATION OF AVAILABLE RESOURCES AND TOOLS 11 ferent planning processes that exist in different organizational entities, and on the other side you have the physical integration of different software. Integration of the organization s planning processes A natural result of different operational units being involved in different activities (e.g. manufacturing vs. sales) is that they employ unique planning processes. (See Figure 1.4.) In addition, many corporations are frequently acquiring new companies, with completely different budgeting cultures and processes. However, for top management to come up with a corporate strategy and set specific and intelligent targets for the future, there is a need for good communication both from the top down and from the bottom up. Thus, with the surge in interest in budgeting and planning, companies should be spending more time on improving their internal communication processes and streamlining their different planning processes and the integration between them. - Set strategic targets - Analyze reports ABC Corporation Manufacturing Sales Accounting - Improve efficiency - Increase quality - Increase revenues - Grow market share - Control expenses - Financial reporting FIGURE 1.4 Planning integration Integration of the organization s software Typically, different planning processes also have meant the existence of local spreadsheet models that feed into a higher-level corporate budget model, or that companies have programmed their own budgeting software to handle their different divisions planning. (See Figure 1.5.) Needless to say, this often results in delayed reporting, poor integration possibilities, double data entry, and lack of integrity in the overall budget.

01.66878_CH01 7/31/2000 4:39 PM Page 12 12 BUDGETING TODAY: OVERVIEW AND TRENDS OLAP/ ROLAP Software Spreadsheets Budgeting Solution Sales Order Entry Software General Ledger Fixed Assets Payroll FIGURE 1. 5 Software integration MORE FREQUENT REVISIONS Nowadays, companies typically create an annual budget, and then revise this several times during the year (these revisions usually are called forecasts). Recently, a number of companies have dropped their extensive, annual budgeting process and instead have begun to rely on continuous forecasts, called rolling forecasts. Many companies prepare these forecasts on a quarterly basis, and they project for 12 to 24 months ahead. Companies also distinguish between a short-term plan and a long-term plan. Due to a lack of reliable information and changing circumstances, the latter is always at a high level, and often it is completed solely by top management. The recent trend for short-term plans has been to revise them more frequently than the once-a-year budgeting ritual that was once the standard. Monthly or even bi-monthly revisions are becoming normal. Also, it is important to distinguish between companies who simply revise their original budget until they reach the end of the year, and those that use the continuous rolling forecast discussed previously. The second is no doubt the best management tool, because it gives a continuously updated picture of a specific time in the future, which management can utilize in their decision making. However, because the planning becomes a monthly process, the

01.66878_CH01 7/31/2000 4:39 PM Page 13 INCREASED EMPLOYEE PARTICIPATION AND INVOLVEMENT 13 people involved must be disciplined and the technology used should automate and simplify the data entry and reporting processes. INCREASED EMPLOYEE PARTICIPATION AND DEPARTMENTAL INVOLVEMENT Companies that have maintained a central budgeting process, essentially handled by the budgeting manager, usually have managed to avoid the many pains and delays that come with involving the whole organization in the planning process. However, these companies also have found that it can be hard to motivate employees to reduce expenses, increase revenues, and so on, when they have not had a say in allocating funds in the first place. Another major disadvantage of a centralized budgeting process is that a tremendous amount of knowledge is hidden in the trenches of a company. Line managers know the day-to-day facts of their operational area, and most likely, they are the best people in the company to supply good budget numbers. For example, a sales manager is much closer to the action in the field than the corporate budget manager, and if there are some unexpected deals or trends on the horizon, these are not likely to be reflected in the budget or forecast unless the sales manager is involved. Because of new technology, it is now easier than ever to involve employees at all levels in the budgeting process. Using modern web-enabled budgeting applications, you can easily communicate corporate strategy and financial targets to employees, and they can enter local budget figures with text comments that roll up to a corporate total. The employees only need access to a workstation that is linked to the Internet or Intranet and that has a web-browser such as Microsoft s Internet Explorer or Netscape (this is free software). (See Figure 1.6.) The whole budgeting application and database resides on one central server, and there is no need to install or maintain the software in other places. Further on, a high level of security and simple budget screens allow a large number of employees at different levels in the organization to contribute their estimates with minimal need for training and supervision. With the use of web technology it is also possible to involve people not directly connected to your organization, such as a reseller channel, in the budgeting process. With very simple instructions, they can log on to your web site with a password and provide you with their estimated sales for a specific future period. Because all the numbers go directly to a central server, they are available immediately for analysis by top management. The ultimate goal for many companies that involve their whole organization in the planning process is to use their employees knowledge to boost corporate performance. This will happen through improved accuracy of the

01.66878_CH01 7/31/2000 4:39 PM Page 14 14 BUDGETING TODAY: OVERVIEW AND TRENDS HQ Reports & Analysis Div.A Reports & Analysis Web-based budgeting Solution Reports & Analysis Div.B Reports & Analysis Budget data entry Manufacturing Purchasing Marketing Sales FIGURE 1.6 Web-based budgeting company s numbers, increased employee understanding of why the budget figures are what they are, and by increasing each employee s motivation to achieve those numbers. STREAMLINED BUDGET REVIEWS AND APPROVALS Who does not want to streamline their budgeting process? When can you sit down and say that your budgeting process has reached an optimum level? Probably not for a while, because modern budgeting and forecasting are still being discovered, learned, and implemented in most organizations. That is why budget managers everywhere say that one of their primary goals is to streamline their company s budgeting process. There are many things to improve before the whole planning cycle is fast, frequent, accurate, and smooth. Improvements are needed both on the technology side and the human side: Existing operational data, competitive information, and economic data must be available to top management in an understandable format, so they can set realistic strategic targets for the organization.

01.66878_CH01 7/31/2000 4:39 PM Page 15 STREAMLINED BUDGET REVIEWS AND APPROVALS 15 Strategies and strategic targets must be developed by senior management and told to managers so that they can create budgets that realistically support the corporate strategy (Figure 1.7(a)) rather than just having managers create budgets without any guidance (Figure 1.7(b)). The budgeting software must be flexible enough to support all key budgeting initiatives, such as communicating strategies and strategic targets down through the organization, as well as giving line managers local power to create their budgets and send them back again with supporting schedules and comments. It must also be able to give management consolidated and detailed reports as well as exception reports. 6. Final Budget 1. Senior management sets strategic targets 5. Budget Submission 2. Division managers cascade targets 4. Budget Submission 3. Department heads enter budget FIGURE 1. 7A Top-down bottom-up budgeting

01.66878_CH01 7/31/2000 4:39 PM Page 16 16 BUDGETING TODAY: OVERVIEW AND TRENDS 6. Final Budget 1. Senior management reviews budget 4. Request for changes 2. Division managers review budget 5. Request for changes 3. Department heads enter budget FIGURE 1. 7B Bottom-up budgeting process A full budgeting cycle should take a few weeks (not months!) to complete. Periodical revisions to a budget (forecasts) should take only a few days. Streamlining the budgeting process requires all the trends discussed in this chapter, and it can dramatically improve your company s long-term performance and competitiveness. A frequently updated budget that is the result of the collective knowledge and intelligence in your organization, and that utilizes modern technology and software to automate the reporting process should be your company s ultimate goal.