Everybody must of heard about budgets and how important they are to a successful business, but why are they so important? Budgets are guidelines to manage how you will spend your money. So for example, let's say you know next year you'll make $1,500 a month of sales. You know you can't spend more than $1,500 a month. Therefore, you will allocate the $1,500 a month strategically to increase efficiency. Now if you mix your budget with key performance indicators, like a net profit after tax of 25%, then you will allocate a maximum of $1,125 to your spending, maximizing your profit. They also provide you with information on whether or not you can invest, like hiring new personnel or buying a new equipment to increase output of your operations. Now, budgets are a bit more complex than that, but it does give you an idea what to expect.
​
Budgets, also known as master budgets, are comprised of several sub-budgets:
-
The sales/customer budget, Prepared by the sales team.
-
The Cost of goods sold/inventory budget (if it applies), prepared by the procurement department. The information is all based on sales and stock level needed.
-
The production/work in progress budget (if it applies), is prepared by the manufacturing department and the information is also based on sales, capacity and logistics.
-
The expenditure/supplier budget, is prepared mostly by the shared services, the executive team as this portion related to operating costs.
-
The capital expenditure budget is prepared based on needs of capital and it's made by every department, everyone has to provide his input to ensure continuity of operations.
-
The cashflow/debt budget, is prepared based on the previous budgets. We figure out how much money we need to have at the end of every month and figure if we have enough cash or we need a loan or line of credit to operate.
​
It makes it easier to prepare the budget when you segregate the information and then combine it to form a full budgeted financial statement.
​
Each budget has to be prepared using the most relevant information to be as accurate as possible. To do so, we use what we call hypothesis. Hypothesis supports the relevance of the information. For example, focusing solely on sales, if we expect P.E.S.T.E.L. (Political, Economical, Social, Technological, Environmental and Legal) to stay the same compared to the current year and we don't expect any events affecting our sales next year, we should see an increase in sales by 5%. Therefore, in our budget, we will increase our sales to match our hypothesis. This is a simple example, again, it's a bit more complicated that, but it does give us an idea how hypothesis compliments the budget process.
​
To go even further, to compliment the budget, we compare the budget to the actual. This allows us to see if we were inline with the budget or we were off. It also gives us an idea if we should keep spending if we are under budget or cut back if we are over budget, that's if it's possible as some unexpected cost can materialize, consequently, have us spend more to continue operating, but at least we can explain the reason why we are under or over. The key here is to explain the variance, this will allow us to foresee these issues in our future budgets.
​
The forecast is a derivatives of the budget. Since the budget is static, meaning it should never change after being approved by the executive team, we need a tool to guide us through the current situation and navigate thought P.E.S.T.E.L. For example, again, solely focusing on sales, let's say we expected to make $1,500 a month, but there is a newer product that was launched by our competitor and now we expect to sale to decline to $1,000 a month instead of $1,500 a month. This is where the forecast come in to play, you start from the actual, where you stand and use your budget as a guiding tool, but you adjust with the current information. Therefore, helping us to cut down or increase cost to see the effect on the bottom line, giving us the reflex to change our strategy if possible.
​
Why is it so important the budget never change? If we change the budget, when comparing the actuals, we will not see how far off we were from the the initial budget. Also, we won't learn from our mistake and people who where involved in the budget process won't be accountable for not providing accurate information if it's the case. What we can do is, instead of manipulating the budget, we have the people involved in the budget process explain the variance between the budget and actual, keeping them accountable for accurate information.
​