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Function #1: Strategic Planning
At its utilitarian level, the budget is a mathematical model of how the company intends to realize its strategic plan. It incorporates management’s best guess as to what the future business environment will be and how the company will utilize its financial and other assets to realize a net income.
Start with Sales and Marketing’s “Crystal Ball”
For example, suppose management decides it wants to increase its sales by 25% in the next 12 months. While it is a challenging undertaking, it is relatively straightforward to produce a set of sales forecasts by carefully analyzing consumer buying trends, new technologies, current and new competitors, and economic forecasts and comparing these “crystal ball” expectations to past conditions and the sales performance of the company. From this data the sales and marketing team can produce a set of projected sales for each of the next 12 – 18 months. Each set will contain, at a minimum, a projection if future conditions are great, one if conditions become more challenging, and one if conditions are somewhere in between.
Of course, real sales forecasting requires complicated multivariate probability calculations across many uncontrollable variables – but for the sake of discussion, let’s just consider these three cases. Aiming for an increase in sales probably means an increase in marketing expenditures. Each of those costs will be added to the appropriate line item of the budget. With no small amount of perseverance, the sales and marketing team finally publishes a departmental budget that details to the rest of management how they will increase sales by 25% over the next 12 months, given the three probable future conditions.
Add Production’s Reaction
Of course, increasing sales by a significant amount will undoubtedly require an increase in production capacity for the rest of the company. Thus, once the sales team has delivered their budget, the production teams can figure out how they’re going to meet the additional demand. If this is for a manufacturing company, the operations management will need to determine if the current factory has the required mechanical capacity or if new / additional machinery is required. If it is a service company, management will need to determine if the workforce is sufficient in size and has the requisite skills, or if new hires will be necessary. Production will thus add a detailing of their expenses to the budget for each of the three probable future conditions.
Determine How to Finance the Plan
Once production completes their part of the budget the finance team will need to figure how to keep the company liquid while it expands. Will the company need to deal with a period of costly overcapacity while the sales ramp up, or is the company able to scale more in keeping with the sales volume? How will the expansion be financed – through equity, debt, or utilizing existing cash reserves? Each of the probable future conditions will put a different strain on the company’s finances. The finance department will need to incorporate various cash flow forecasts for each of the different future conditions.
Consider the Net Results
After all the departments add their specific inputs to the mathematical model it should produce a relatively reliable prediction of the company’s net profitability for increasing sales by 25%. And here’s where the real usefulness of the budget comes into play. While it may seem perfectly sensible to increase sales by 25% over the next year, it is also probable that the additional expenses to do so may end up driving the company’s profitability down or cause an unacceptable strain on company assets. The bottom-line result may be non-intuitive: but the mathematical modeling brings all things to light.
The above example considers how a run-of-the-mill static budget may be created on an annual basis. It’s a complicated process requiring tremendous collaboration and communication across all levels of management. Now consider doing this level of planning every month to create a rolling forecast based on dynamic business conditions. The process would be overwhelming if it were not for good budgeting software for business.
Function #2: Communicating the Plan and Coordinating Efforts
Because the net financial result being modeled by the budget is often non-intuitive, management may need to go through many iterations to find the right combination of resource utilization that maximizes the company’s ability to realize its strategic plan. However, once the mathematical model is established and accepted it becomes a powerful communication tool.
While good budgeting software allows for what-if scenario testing, great business budgeting software also allows for real-time communication throughout the organization so that management can incorporate the expertise and insights of those actually involved in the production process. Getting buy-in for the strategic plan throughout the organization is critically important to developing a workforce that is focused on achieving the corporate goals and committed to coordinating their efforts toward that end.
Functions #3 Monitoring Progress
Once the efforts are coordinated and the plan is set in motion, the budget becomes an effective means of comparing actual and anticipated results. Comparing real-time actual to expected results managers to respond quickly to variances in forecast conditions or to zero-in on operational areas needing improvement. At this point, the budget has gone past its utilitarian purpose and become a powerful management tool.
Function #4: Evaluating Performance
Not only do budgets effectively compare company results to those planned, but they also provide critical insight to management’s effectiveness. Did managers do well in anticipating future events? Were they able to make appropriate operational adjustments as actual events unfolded? Did the company achieve or surpass its goals and objectives? By examining each department’s managers against what they provided for the budget inputs, it is relatively easy to determine which team is managing well and where improvements should be made for future success.
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