Traditional Budgeting Process

In chapter 12 we described the traditional budget process that became a cornerstone of management systems in the twenty‐first century. While many organizations have adopted more evolved methods of developing business projections explored later in this chapter, others continue to use the traditional budget process.

The traditional budget process follows an annual cycle. The budget for next year would be developed several months before the new year begins. It is characterized by a very detailed and financially oriented process illustrated in Figure 13.1.

Departmental managers complete budget forms for their respective areas of responsibility as illustrated in Table 13.1.

These are then rolled up into cost summaries and ultimately profit and loss (P&L) projections as shown in Figure 13.2. After a series of reviews and revisions, the budget would be presented to senior executives and the board of directors for approval. The budget then served as the basis for operating and evaluating actual performance against these budget expectations.

Problems with Traditional Budgeting

Annual plans and budgets have been the subject of criticism for years. While many organizations have made substantial improvements, most organizations do not extract the potential utility out of this very time‐consuming activity.

One of the major problems with budgeting is the focus on finance, including general ledger accounts and financial statement captions, rather than processes, activities, customers, projects, and critical assumptions. Department managers often had to create “shadow” planning tools to develop budget estimates from an operating perspective and link to their processes and activities.

The output of a traditional budget process would often lock into a single‐scenario document; the emphasis was on the document rather than the potential value of the process. As President Dwight Eisenhower said, “Plans are useless, but planning is essential.”¹ In other words, the value is not in the plan document itself or in a single course of action set forth in the plan. Once the battle begins, the conditions and circumstances will depart from those used in developing the plan. The value in planning lies in the thought process, including assessing strengths and weaknesses, evaluating critical assumptions, and developing potential scenarios and contingency plans. Budgets tend to be numbers driven and tend not to focus attention on issues and opportunities, on risks and upsides, or on execution planning.

Traditional budgets do not adequately identify and test critical assumptions and performance drivers. The financial focus often means that assumptions are buried in the details and not adequately identified and tested.

Budgets were useful for a time, when business was more static. Their utility has declined significantly, resulting from the development of the global economy, the accelerated rate of change, and significant geopolitical events that reshape markets dramatically and frequently. Traditional budget processes are very labor intensive. Due to the level of detail and the typical need for multiple revisions, the budget process can often lead to a substantial investment (or waste) of time by finance and operating managers alike. Many companies issue planning guidelines and boundaries (discussed in Chapter 12) to establish goals and targets in order to create a starting point and to minimize the number of revisions.

In most cases, the organization would be better served by developing an operating plan as described in the next section.

Assess Current Situation

Before a plan can be effectively developed for the coming year, management must assess the current situation. Has the external environment changed? Has the competitive landscape changed? Are we meeting or exceeding strategic goals? Are we meeting current performance targets? This assessment should include a review and an evaluation of recent financial results as well as key performance indicators (KPIs). Many organizations find it useful to benchmark competitors and customers (refer to Chapter 11, The External View: Benchmarking Performance and Competitive Analysis) as part of this situational analysis.

Review Strategic Objectives

The annual operating plan should be an installment of the company's strategic plan. The operating plan process should include a review of the strategy. Are the critical assumptions supporting the strategic plan still valid? Where do we stand on the implementation or attainment of strategic objectives?

The operating plan is an opportunity to develop an execution plan for the strategic objectives for the next year. It should ensure that the objectives are still valid, and plan for human and financial resources to execute and achieve those objectives.

Establish Performance Goals and Targets

Prior to turning the troops loose on developing the operating plan, the leadership team and board should develop performance goals and targets. In establishing goals and targets, the organization should consider the following:

• Strategic plan
• Business model
• Recent performance trends
• Benchmarking and competitor analysis
• Objectives for value creation

Develop a Game Plan

Next, managers should develop a preliminary execution or game plan for the coming year. This should be based on the situational analysis and preliminary goals. In order to prevent the chaos of a bottom‐up wish list, it is useful to establish parameters or high‐level targets of revenue growth and expense and investment levels, and communicate to all involved in developing the plan.

Develop Preliminary Financial Projections

The organization should develop a preliminary model of projections for the plan year. Not all revenues, costs, and expenses are created equal. The team should focus on the most significant and most variable, using the Pareto rule introduced in Chapter 3.

This phase will be very easy if the organization uses rolling forecasts or an on‐demand business outlook (DBO), discussed later in this chapter, since the team has already developed and evaluated projections for the plan year. In fact, most organizations utilize the DBO model to develop the preliminary projections for the operating plan. These preliminary projections must identify and present key assumptions.

Identify Critical Assumptions and Key Actions

The operating plan for next year has hundreds of assumptions. These assumptions likely include everything from general economic conditions to weather, from inflation to pricing, and from the availability of critical materials to their cost. In many plans, these assumptions are buried in the details and are not explicitly identified. Key assumptions should be identified and reviewed. Managers should understand how sensitive the planned results are to changes in critical assumptions. These assumptions should be tracked over the plan horizon, and any signals indicating that the assumptions may not be valid should trigger a review and a response. Identifying and reacting to changes in significant assumptions early will allow you to minimize the impact of downside events and trends and to fully capitalize on the upsides.

Successful plans place significant attention on the activities required to achieve the planned results. For example, sales growth arising from the introduction of a new product in the next year requires a series of activities related to the development, production, marketing, and selling of the product. Each of these activities must be thoroughly planned out and adequately resourced to ensure that the planned sales are achieved. In addition, each of the responsible managers must be committed to the completion dates to support the product introduction and revenue plan.

Identify Upside and Downside Events and Develop Multiple Scenarios

Owing to the rate of change and uncertainty that exists in the current environment, the use of a single‐point plan generally is not valid or meaningful. A single plan estimate, by definition, must reflect a position on the probability and estimated impact of numerous events, transactions, and conditions. Managers should set the expectation that a base projection should be the best estimate of the outcome under the present strategy and expected market and economic conditions. Some organizations clarify this expectation by using language such as “most probable” or establishing desired confidence levels. This base plan includes a multitude of assumptions, including the probability and estimated impact of potential events. It is useful to identify and present how these potential events have been reflected in the plan. For example, if the plan assumes a continued favorable economic expansion, then a potential downside would be an economic recession. Other downside events may include competitive threats or loss of a major customer or contract.

In addition to assessing the potential impact on the financial projections, this analysis allows management to monitor these potential factors and to develop preliminary contingency and response plans. The development of multiple scenarios and upside/downside events was discussed in detail in Chapter 12.

Communicate Plan Objectives and Targets

The objectives and targets set during the plan process must be communicated throughout the organization. Failure to communicate is the equivalent of a coach not sharing the game plan with the team prior to the start of the game. Of course, the specific content shared will depend on several factors such as the need for confidentiality and the level and role within organization.

A good test of the organization's understanding of the plan is to ask: Can our managers and employees list the five critical priorities for the coming year? Significant leverage is possible by communicating key objectives and activities included in the plan. For example, imagine the potential benefits to a critical project if all finance, human resources, and procurement teams recognized and supported the project as the number one priority for the company. Even more effective results can be achieved if the objective setting and performance management process for individual managers and employees is a part of the annual planning process, instead of an independent, subsequent drill.

Develop Process to Monitor Key Assumptions and Track Progress

In many companies, performance tracking and monitoring are focused on financial results. This is problematic since financial results are lagging measures of business activities and processes. If you wait until trends or problems are visible in the financials, it is already too late to correct for that period. Many problems are easily addressed at an early stage, but grow and compound as time passes. Dashboards should be developed to track performance on leading indicators that will alert managers to unfavorable trends in near real time so that corrective action can be taken.

You can't manage financials; you can manage people, processes, transactions, and projects. The financials are a result of these business activities and inputs. For example, if you want to improve accounts receivable days sales outstanding from 75 to 60 days, it won't happen unless you focus on the critical business processes that impact receivables. Create a plan that identifies improvement opportunities on critical drivers of receivables: revenue hockey sticks, improving quality and on‐time delivery, and resolving customer problems faster. Establish targets and then monitor KPIs covering revenue linearity, quality, past‐due orders and collections, and problem resolution. KPIs were discussed in greater detail in Chapter 8, Dashboards and Key Performance Indicators.

Evaluate the Annual Plan Process

Each year, the annual plan process should be evaluated to identify potential improvement opportunities. Start by reviewing the current planning and forecasting processes and products. Measure the duration of the entire planning process. Document the process flow, including required inputs, processing, review and revision, and presentation. Identify the most critical assumptions and most significant revenue and cost drivers. Identify time spent in major stages of the process. Review the critical output/presentations of the plan. Do a postreview of the planning process, identifying impediments, issues, and improvement opportunities. Also review actual performance against the original plan, identifying the root causes of any variances. This will highlight bottlenecks, identify redundant and inefficient aspects, and provide a recap of critical assumptions and performance drivers.

Figure 13.3 is a dashboard summarizing KPIs for the planning process. This team started with some significant issues including a long plan duration, multiple revisions and ineffective results in the form of large variances to plan. By identifying and addressing root causes, the team implemented changes to make the process both more efficient and effective. The two most important changes were the use of planning guidelines and boundaries at the start of the process and the implementation of a rolling forecast.

Historical Evolution of Forecasts

Forecasts emerged because of the need to update or recast the budgets. As business became more complex and the pace of change increased, the original budgets often were outdated early in the year. These updates were often done at a higher level than the original budget projections.

Many organizations began preparing an update to the budget on a monthly or quarterly basis. As the actual results were available, the remaining forecast period was evaluated to reflect known trends and any additional information that had surfaced since the original plan or budget had been prepared. Companies with stock owned by the public were pressured to confirm or adjust annual estimates. The forecast horizon ended abruptly at the end of the company's fiscal year (see Figure 13.4).

In the 1980s a number of companies began extending the forecast horizon as they progressed through the year. For example, as the first quarter actual results were known, the forecast was extended to include the first quarter of the following year. Described as a “rolling forecast,” this methodology provided a full‐year future outlook on the financial results, as illustrated in Figure 13.5. This became extremely helpful in the final several months of a fiscal year, providing a view into the next year before the budget process had been complete.

My first encounter with rolling forecasts occurred in 1985. At that time, I was a division CFO of a technology unit of a large publicly traded company, and the corporation began requiring us to provide rolling forecasts. At first this was simply a mechanical exercise by the folks in finance to extrapolate or extend the current forecast one additional quarter. The projections were based on the prior‐year actuals and adjusted for any significant expected changes. Of course, we were not excited by the additional work and the perceived difficulty in developing an extended estimate of performance.

The true value of the rolling forecast became apparent after several months. A few major changes to our business had become apparent. We had several major nonrecurring sales that needed to be reflected as “one‐timers” and not built into our run rate or trend for setting expectations for the following year. We also recognized a serious competitive threat that would have a significant impact on our performance in the next fiscal year, now seven to eight months away. We included our initial estimated impact of these factors into our extended projections. More important, the management team developed a plan to address the threats, including the introduction of new products, revisions to pricing, and other actions to respond to the competitive threat well ahead of the annual planning timeline.

Additional value was realized during the annual planning process for the subsequent year. When we began this process in August, we had already begun to internalize and estimate these factors into projections for the first six months of the following year. This greatly simplified the preparation of our annual plan/budget.

The rolling forecast has gained wide acceptance and serves as the cornerstone of planning and projections for many organizations. It provides a good starting point for a more rigorous annual planning process, long‐term projections and scenarios, and “what if?” analysis. By far its greatest value is in providing an early view into future trends, upsides, and risks, thereby affording management more time to react to changes and drive performance.

Continuous Business Outlook/On‐Demand Business Outlook

Many organizations think of the forecast as a “business outlook” or “continuous business outlook.” Describing the forecast as a business outlook changes the view from a financial exercise to a business or operating process. Adding “continuous” or “on‐demand” signifies that it can be updated as required by the organization. We will explore the use of rolling forecasts and on‐demand business outlooks (DBOs) for the remainder of this chapter.

Implementing Rolling Forecasts/Business Outlooks

Despite the compelling case for using some form of rolling forecast/business outlook, surveys indicate many organizations have not adopted them. These organizations cite limited resources, capabilities, or enabling software. Many organizations envision the need to repeat the annual planning process four times per year! Getting started with rolling forecasts is much less formidable than most imagine.

Getting Started: A Practical Approach

To overcome the inertia inherent in starting a DBO initiative, I have found that a practical, phased approach is the best way to get started. Utilizing Microsoft Excel is recommended, especially since it is hard to define needs and evaluate and procure other software products without prior experience in using DBO models.

Articulate the Objectives of Developing the On‐Demand Business Outlook

A clear statement of objectives will focus attention on developing a process that meets important needs and requirements. Most organizations point to one or more of the following objectives:

• Provide a view into expected performance for the next 12 months. This will engage the organization more frequently and reduce surprises that arise in one‐year planning cycles.
• Provide a timely basis for setting future expectations with executives, boards of directors, and investors.
• Identify performance trends and estimate future impact.
• Identify issues and opportunities that will impact future performance.
• Afford the greatest lead time possible to address problems and opportunities.
• Reduce inefficiencies and effort in the annual planning process.

Document and Review Current Operating Plans, Budgets, and Forecasts

Start by reviewing the current planning and forecasting activities and products as described earlier in the chapter. What are the major problems and improvement opportunities? What are the most significant performance drivers? What issues give rise to variances from the plan?

Identify Critical Business Drivers

Identification of critical business drivers is a critical step in developing a more effective and efficient forecast process, with the intent to extend the horizon of the projections. The key is to move away from a process that affords equal attention to all costs, expenses, and revenues. Identify the most significant drivers of performance. Here we can apply the 80/20 rule: 20% of the line items will represent 80% of the value. For example, the top 20% of products or programs will typically account for 80% of total revenues. The top 20% of line items of expenses (labor, facilities, materials, etc.) will typically account for 80% of all expenses.

Another important analysis is to identify those significant drivers that are most likely to fluctuate – that is, are most variable. Examples include revenues from new products or contracts, contract services, commodity prices, foreign currency fluctuations, and new home starts. These can be contrasted with drivers that are relatively stable and are more easily predicted by aggregation and extrapolation using trend analysis, such as salaries, facilities, and other costs. Critical assumptions should also be identified, including macroeconomic factors such as gross domestic product (GDP), political policy, and interest rates.

As we construct a DBO process and model, we will ensure that these critical drivers and assumptions are fully considered and emphasized, and that less important factors are deemphasized. Figure 13.6 highlights typical drivers that are emphasized in the development of business outlooks.

Design Process and Model Architecture

After stating the objectives and identifying critical performance drivers, we can begin to visualize an overview of the model. Most organizations should define the product (output) of the model to include the three basic financial statements (income statement, balance sheet, and statement of cash flows), analysis, and a presentation summary. Beginning with this end in mind, we can lay out the supporting schedules to forecast key elements of financial performance. For example, the revenue and product (or service) margin projections are of critical importance in all organizations. These supporting schedules should be constructed to incorporate the most significant and most variable business drivers and assumptions identified above.

This is a critical step in the process. We must be careful not to replicate the annual planning process here. Instead we need to be disciplined and thoughtful to construct a working model that incorporates the key drivers and assumptions, without resorting to the lowest level of detail. (See Figure 13.7.)

Practical Implementation Path

At the center of any outlook is a performance trend schedule (typically quarterly). This trend schedule should include prior year history, the current year plan/outlook, and provision for the next year's outlook. Table 13.2 illustrates a trend schedule for Thomas Technologies, Inc. The company has just closed out the second quarter of 2017. Under a traditional approach, the forecast horizon is compressed to the rest of 2017 (i.e. Q3 and Q4). To implement a rolling outlook, we simply need to extend the projections to include Q1 and Q2 for the subsequent year (2018). What is the minimal information we need to make reasonable estimates? We can start by reviewing the actual results of Q1 and Q2 of 2017. What items can be extrapolated from the previous periods or trends? What significant factors will shape the performance for these future periods? For example, for revenue, the projection must consider major product introductions and contract wins and losses.

For each income statement caption, I like to construct a one‐page supporting schedule that provides a capsule of information, including actual and projected financial results (presented in a way that is meaningful to the responsible operating manager) and includes all major assumptions and key drivers. By focusing on a one‐page summary at this level, we are forced to identify the most significant factors and drivers. It is important to tailor these schedules to each specific situation. Supporting schedules for product margins, gross margins, and marketing are illustrated in Tables 13.3 to 13.5. A complete, fully integrated forecast model is illustrated in the book's companion website.

The supporting schedules roll up to an income statement presenting the forecast for the extended forecast horizon in Table 13.6.

Comprehensive Financial Picture

To provide a complete view of expected financial performance, financial projections in the rolling forecast should include the P&L statement, balance sheet, and statement of cash flows. Many forecasts focus only on the P&L, which does not provide a complete picture of the financial performance of the organization.

There are two reasons for this. First, the focus for many companies is on earnings per share (EPS) and therefore all attention is directed to the P&L. Even where the CEO is primarily focused on the P&L and EPS, finance should continue to prepare and present the key balance sheet and cash flow projections. Most competent finance and general managers understand that profit must be evaluated in the context of the investment levels required. Therefore, measures such as asset turnover and return on investment should be presented. Attention to cash balances, liquidity, intermediate financing, and loan covenants are all important responsibilities of financial management and should be incorporated into all projections.

The second reason is that finance teams are much more comfortable in the mechanics of revenue and expense projections. However, once key models are established, it is relatively easy to project key balance sheet and cash flow information. An illustration of a balance sheet and cash flow model is provided in Table 13.7. Techniques to project the balance sheet and cash flow are found in Chapters 17 and 18.

Summarizing and Presenting Business Forecasts and Outlooks

The most effective way to review and present the results of a revised forecast or outlook is to incorporate a presentation summary directly into the forecast model. This will facilitate review, discussions with managers, and revisions. It enables a high‐level quality control review of the projections, since the presentation summary will include key variables. Key items that are typically included are major assumptions, changes from prior outlook, key performance metrics, and major risks and upsides. An example of a presentation summary is provided in Figure 13.8.

Frequency and Timing of Forecasts

The frequency and timing of forecasts will depend on several factors. A very dynamic environment will require more frequent updates than a stable environment. Companies that report earnings and provide earnings or other guidance to public capital markets typically use a quarterly cycle. Private companies typically update the outlook around management or board of directors meetings. Significant events, such as contract awards or losses, may dictate a special revision to the business outlook.

Analysis and Evaluation of Financial Projections

In Chapter 12, we introduced tools for analyzing and evaluating projections. These tools should be incorporated into the DBO model. For short‐term projections, revenue and expense levels can be compared to current run rates and results from the prior period. It is vital to identify and evaluate critical assumptions included in the projections.