Budget Model Improvements (#71)
/In this podcast episode, we discuss a number of ways to improve the budget model. Key points made are noted below.
I’ve seen a number of companies churn out some amazingly unrealistic budgets; or to put it another way, I’ve hardly ever seen anyone put out an achievable budget. A big part of the problem is that the mechanics of their budget models are just wrong. Here are some things to look out for.
Include Capacity Planning in the Budget
First up is a large issue – which is capacity planning. How many times have you seen a senior-level manager decide that his company can achieve far more sales in the next year, but he doesn’t work through the mechanics of how the company is going to pull in those sales. Don’t forget – a company’s future results will probably match its historical results unless it takes some significant action to change the situation.
One of the best examples of capacity planning is salesperson productivity. A manager decides that sales will double, but he gives no thought to the sales staff that has to produce the increase. If the current sales productivity is $1 million dollars per year per person, then you can’t realistically expect the exact same sales staff to somehow generate twice as much sales volume the next year. Instead, there needs to be adequate staffing to match historical productivity levels.
And don’t go thinking that you can drop a bunch of raw new recruits into a company and expect them to be just as productive as the old timers. Instead, and to keep using the same example, the sales staff may need months – or a year – before they can even begin to match the historical sales level of the existing staff. Which brings me to another budget point, which is – timing.
Incorporate Ramp-Up Time into the Budget
Again, let’s say that management wants to double sales, and you’ve even convinced them to acquire enough staff to do so. But, how long does it take to ramp up? OK, we just talked about the sales staff requiring a lengthy training period, but that’s not remotely all of it. In addition, what is the sales cycle for the customers who are supposed to provide the extra revenue? If more equipment is needed to produce for those new incoming orders, what’s the lead time to buy, and install, and test it? And what about adding other overhead staff, such as customer support or engineering?
The ramp up interval for all of these activities can be enormous – what if you discover that it takes a half a year before you can even begin to expect additional sales? Hmm.. Sounds like you won’t meet the target.
Incorporate Staff Turnover into the Budget
And another budgeting issue is the turnover of new staff. Let’s face it, you can’t hire perfect people based on a couple of interviews. Sometimes, you’ve got to let them go, or they look elsewhere. Depending on the industry and position, the turnover among new recruits could be really high. If so, this slows down your timing even more, so those budgeted revenue increases are beginning to look mighty far down the road.
Incorporate Step Costing into the Budget
Now, I’d like to circle back around to another part of capacity planning, which is step costing. This is when you reach a certain activity level, and you just have to incur a really large new expense in order to manufacture one more unit of production. The new expense could be anything – a new factory, a production cell, a major new hire.
For example, a manager decides to double revenues, but the factory foreman tells him that this will require 100% utilization of the factory. The manager tells the foreman to do it, but doesn’t realize that this is a mathematical impossibility, because some downtime is always needed for ongoing maintenance. And, the cost of that maintenance keeps going up as you get closer to 100% utilization. The result is no authorization to increase capacity, and instead the company does not meet its budget – since it can’t – and it incurs massive expenses in order to operate too close to the 100% utilization level.
Instead, the budget analyst needs to know the earliest and most likely points at which the really big new step costs must be incurred, and make sure that everyone else knows about it, too.
Incorporate Cash Needs into the Budget
Another major problem with budgets is going into financing fantasy land. For some reason, managers don’t seem to realize that a massive ramp up in operations requires a lot of new working capital – their budget models may not even contain this information, so they just follow the budget, find themselves running short on cash very suddenly, and then have to scramble to fund money at the last minute. A much better alternative is to have a working capital calculation within the budget, and keep referring to it as you go through the various budget model iterations.
If anything, keep it on the front page of the budget, where no one can miss it. That way, you can easily see what each new budget iteration does to your cash needs.
Reduce the Number of Accounts
There’re also a lot of low-level efficiency improvements you can make to a budget model. For example, reduce the number of accounts that you budget for, since each one requires some time to maintain. If a line item is too small to bother with, then merge it into some larger account. Also, if you have some hard numbers that just aren’t going to change, like scheduled rent payments, then lock them down, or at least change the cell color to something glaring – like red. That way, no one will touch those cells.
Set Variable Costs to Vary with Activity Levels
Another issue is variable expenses. This isn’t just the cost of goods sold, but also things like training, or telephones. These expenses change as a cost driver changes, so set up the cost driver in the model, and have those expenses vary automatically with the drivers. For example, if a company usually pays out $500 per year in training expenses for each employee, then just create a formula that automatically plugs in an expense based on the head count. By setting up some of the expenses under a formula, you don’t have to worry about making changes to those expenses as you go through multiple budget iterations – they take care of themselves.
Centralize the Variables
And yet another issue is where you put all of your variables. If you sprinkle them all over the model, it can be really difficult to find them all, let alone update them. So instead, put all of them in one place.
Additional Enhancements
Now, what about having managers create an entirely new budget for themselves every year? That can be a laugh. Since they’re not trained in creating budgets, they have a terrible time creating anything that reflects reality. Instead, if the budget analyst knows what the general strategic direction is, then have that person go ahead and plug in the bulk of the budget line items, which are mostly based on historical information anyways. Then she makes notes on the key items that the manager has to decide on, and goes over just those items with the manager. The result is a budget that probably has the right amounts in the right months, and also wastes the least possible amount of manager time.
And finally, the budget will be viewed as nothing more than an annual annoyance unless you integrate it into two key systems. The first one is purchasing. If the budgeted expenses are loaded into the purchasing system, it can issue a warning when expenditures exceed budgeted amounts. This tends to keep managers extremely aware of their budget commitments. The second item is the performance pay system. Bonuses should be paid based on what managers committed to in the budget. If they don’t make plan, they don’t get a bonus. It seems simple, but most companies don’t link the budget to pay, so the budget is ignored.