How to Prepare A Sound Budget Process. Six Steps in the Budgeting Process. Bottom-up versus Top-down Budget Plans.
A sound budget process communicates organizational goals, allocates resources, provides feedback, and motivates employees. The budgetary process should be standardized by using budget manuals, budget forms, and formal procedures. Software, Program Evaluation and Review Technique (PERT), and Gantt facilitate the budgeting process and preparation. The timetable for the budget must be kept. If the budget is a “rush job,” unrealistic targets may be set.
The budget process used by a company should suit its needs, be consistent with its organizational structure, and take into account human resources. The budgetary process establishes goals and policies, formulates limits, enumerates resource needs, examines specific requirements, provides flexibility, incorporates assumptions, and considers constraints. The budgeting process should take into account a careful analysis of the current status of the company. The process takes longer as the complexity of the operations increase. A budget is based on past experience plus a change in light of the current environment.
The six steps in the budgeting process are:
- Setting objectives
- Analyzing available resources
- Negotiating to estimate budget components
- Coordinating and reviewing components
- Obtaining final approval
- Distributing the approved budget
A budget committee should review budget estimates from each segment, make recommendations, revise budgeted figures as needed, and approve or disapprove of the budget. The committee should be available for advice if a problem arises in gathering financial data. The committee can also reconcile diverse interests of budget preparers and users.
The success of the budgeting process requires the cooperation of all levels within the organization. For example, without top management or operating management support, the budget will fail. Those involved in budgeting must be properly trained and guided in the objectives, benefits, steps, and procedures. There should be adequate supervision.
The preparation of a comprehensive budget usually begins with the anticipated volume of sales or services, which is a crucial factor that determines the level of activity for a period. In other cases, factory capacity, the supply of labor, or the availability of raw materials could be the limiting factor to sales. After sales are forecast, production costs and operating expenses can be estimated. The budgeting period varies with the type of business, but it should be long enough to include complete cycles of season, production, inventory turnover, and financial activities. Other considerations are product or service to be rendered and regulatory requirements.
The budget guidelines prepared by top management are passed down through successive levels in the company. Managers at each level may make additions and provide greater detail for subordinates. The managers at each level prepare the plans for items under their control. For example, Philip Morris formulates departmental budgets for each functional area.
The budgeting process will forewarn management of possible problems that may arise. By knowing the problems, solutions may be formulated. For example, at the valleys in cash flow, a shortage of cash may occur. By knowing this in advance, management may arrange for a short-term loan for the financing need rather than face a sudden financing crisis. In a similar vein, planning allows for a smooth manufacturing schedule to result in both lower production costs and lower inventory levels. It avoids a crisis situation requiring overtime or high transportation charges to receive supplies ordered on a rush basis. Without proper planning, cyclical product demand needs may arise, straining resources and capacity. Resources include material, labor, and storage.
Bottom-up versus Top-down
A budget plans for future business actions. Managers prefer a participative bottom-up approach to an authoritative top-down approach. The bottom-up method begins at the bottom or operating (departmental) level based on the objectives of the segment. However, operating levels must satisfy the overall company goals. Each department prepares its own budget (such as estimates of component activities and product lines by department) before it is integrated into the master budget.
Managers are more motivated to achieve budgeted goals when they are involved in budget preparation. A broad level of participation usually leads to greater support for the budget and the entity as a whole, as well as greater understanding of what is to be accomplished. Advantages of a participative budget include greater accuracy of budget estimates. Managers with immediate operational responsibility for activities have a better understanding of what results can be achieved and at what costs. Also, managers cannot blame unrealistic goals as an excuse for not achieving budget expectations when they have helped to establish those goals. Despite the involvement of lower-level managers, top management still must participate in the budget process to ensure that the combined goals of the various departments are consistent with profitability objectives of the company.
The goals may include growth rates, manpower needs, minimum return on investment, and pricing. In effect, departmental budgets are used to determine the organizational budget. The budget is reviewed, adjusted if necessary, and approved at each higher level. The bottom-up approach would forecast sales by product or other category, then by company sales, and then by market share. The bottom-up method may be used to increase the feeling of unit-level ownership in the budget. Disadvantages are the time-consuming process from participative input and the fact that operating units may neglect some company objectives. Bottom-up does not allow for control of the process, and the resulting budget is likely to be unbalanced with regard to the relationship of expenses to revenue.
Typical questions to answer when preparing a bottom-up budget are: What are the expected promotional and travel expenses for the coming period? What staff requirements will be needed? What are the expected raises for the coming year? What quantity of supplies will be needed?
This approach is particularly necessary when responsibility unit managers are expected to be very innovative. Unit managers know what must be achieved, where the opportunities are, what problem areas must be resolved, and where resources must be allocated.
In the top-down approach, a central corporate staff under the chief executive officer or president determines overall company objectives and strategies, enumerates resource constraints, considers competition, prepares the budget, and makes allocations. Management considers the competitive and economic environment. Top management knows the company’s objectives, strategies, resources, strengths, and weaknesses. Departmental objectives follow from the action plans.
Top-down is commonly used in long-range planning. A top-down approach is needed for a company having significant interdependence among operating units to enhance coordination. The top-down approach first would forecast sales based on an examination of the economy, then the company’s share of the market and the company’s sales, and then sales by products or other category. A top-down approach may be needed when business unit managers must be given specific performance objectives due to a crisis situation and when close coordination is required between business units. It is possible that the sum of the unit budgets would not meet corporate expectations. If unit managers develop budgets independently of other units, there are inconsistencies in the assumptions used by different units.
A disadvantage with this approach is that central staff may not have all the knowledge needed to prepare the budget within every segment of the organization. Managers at the operating levels are more knowledgeable and familiar with the segment’s operations. Managers will not support or commit to a budget they were not involved in preparing, which will cause a motivational problem. Further, the top-down approach stifles creativity. A budget needs input from affected managers, but top management knows the overall picture.
A combination of the bottom-up and top-down approaches may be appropriate in certain cases. Some large companies may integrate the methods. For example, Konica Imaging uses whichever method fits best. The company uses a blend. Direction is supplied from the top, and senior management develops action plans. Each department must then determine how it will actually implement the plan, specifically looking at the resources and expenditures required. This is the quantification of the action plans into dollars. It is then reviewed to see if it achieves the desired results. If it does not, it will be kicked back until it is brought in line with the desired outcomes. The what, why, and when is specified from the top, and the how and who is specified from the bottom.