Early in my career, I had a narrow view of budgeting. To me, budgeting was a very constricted exercise that an organization plodded through annually. At the end of the process, the company would generate a very defined budget that was “hard-coded”. By hard-coded, I mean a set number or desired number for each account on the projected income statement, by month, for the budget year. Then, when this process was generated, these numbers would be entered into a “budget” file, typically within some module of the general ledger operating system.
As the year would proceed, we would compare this information to the actual results and measure the difference between actual and budgeted expenses. Typically over time, the gulf between the budget and actual sales and expenditures would grow as the year progressed. Over time, this difference began to make the budget process feel more like the writing of an unnecessary piece of fiction, than a necessary management tool.
Fortunately, I was introduced to the folks at Oliver Wight and, in particular, to Tom Wallace. I was lucky because Tom was able to show us that there was another, better way to budget. He pointed out that the problem with most budgets were they were based on a sales forecast. Usually, these forecasts were generated by some member of senior management. Almost without fail, these estimates were the best guess or desired sales goal of the organization; almost equally without fail, we would miss those numbers on the low side.
Tom pointed out to us that essentially there are three kinds of expenses: fixed, variable and semi-variable. Fixed expenses do not vary. For example, depreciation expense remains fixed unless the company buys or sells fixed assets. Regardless of whether sales go up or down, fixed expenses remain constant. Variable expense, on the other hand, is entirely tied to the fortune of sales. If there are no sales, then there is no variable expense. As sales rise, so does a variable expense. An example of a variable expense would be ice cream at an ice cream stand. The vendor buys the ice cream and that purchase remains an asset on the books of the firm until someone comes and orders ice cream. Once the ice cream is sold, the cost is shown as expense under materials sold.
Occasionally, an item will act as a semi-variable expense. These costs run somewhere between a fixed cost and a variable cost. Semi-variable costs act like a fixed cost up until there is some triggering event. A triggering event is some decision or action that forces the company to add expenses, such as additional supervisors when a shift is added to a plant or additional indirect personnel to meet the demands of production. In my experience, these expenses are almost always treated as fixed and then the budget is adjusted if the triggering event occurs. Or, rather than having expenses increase, a company decides to downsize. Essentially, these costs are reductions of semi-variable expenses. In fact, almost every fixed cost is actually semi-variable. Given some event, those costs can and will go up or down. That is why controlling the discretionary decisions related to fixed costs are often key for companies to reach or regain profitability.
Eventually, we were able to develop a process that allowed for “flexible” budgets. A flexible budget means that rather than comparing the budget against a constant sales figure, sales are adjusted as well as variable expenses. Then the budget is compared against figures that are consistent with the actual results. The end result is a budget that is consistent with sales; far more realistic when compared with actual sales and expenditures and a budgeted bottom line that, not only is understandable, but plausible.
This reasonableness creates “buy-in” or acceptance from budget managers and gives owners, CEO’s and CFO’s a much better ability to generate “what-if” scenarios. In essence, you create a model that provides a roadmap for the organization showing the effect of increases or decreases in sales. With that roadmap, the company can begin to improve their ability to forecast future profits. Once the company is able to master this process, closing the financial statement becomes an exercise in verifying the profitability the firm expected instead of closing the books to find out the financial results each month.