A New Look at Budget Setting

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Corporate budgeting used to be simple: review fixed costs once a year, control variable expenses as much as possible, calculate the ROI on capital expenditures and relax until the end of the fiscal year.

The goal was clear and easily quantified (though not so easily achieved): maximize profit.

Smart organizations are adding three elements to the post-recession budgeting process:

  • Mitigate risk
  • Align the budget with corporate strategy
  • Make budgeting an ongoing, rather than annual, process

In addition, more and more companies are moving to zero-based budgeting: that is, rather than looking at the previous year’s budget and adding and deleting items, companies are beginning the budget process at zero, and then adding each and every cost.

Mitigating Risk

Mitigating risk goes beyond establishing a contingency fund to cover unexpected expenses, and perhaps building extra time into project schedules. Companies must analyze five areas of risk:

  • General business risk: the performance of the economy overall, prices of commodities (such as oil) that will have a major affect on costs and operations, interest rates and the general business climate
  • Regulatory risk: government regulations and similar activities that will affect a company’s costs and ability to do business.
  • Competitive risk: what are competitors doing? Are new potential competitors on the horizon?
  • Industry risk: will significant changes occur within the industry, such as the introduction of a new class of products? Will demand for the category’s products/services change significantly during the year?
  • Internal risk: will critical personnel be added or subtracted? How conservative/aggressive are the schedules for capital projects, such as construction or acquisition?

Every risk should have a contingency plan, no matter how unlikely the risk appears. No, the CEO may not ever want to leave the company, but what if he/she has a medical emergency and is unavailable to lead for an extended period of time? What if a situation in the Middle East causes oil prices to spike by 25%? Markets shift, engineering processes fail, large companies with deep pockets suddenly see opportunity and decide to invade your industry. Stuff happens.

Aligning The Budget

Budgeting and planning should be tied together in a holistic, performance management approach. If every budget item begins at zero, as outlined above, it should end with a goal. Those goals should answer five questions:

“How can we beat last year’s performance?”
“What is our competition doing, and how can we beat them?”
“Where are we going?”
“How are we going to get there?”
“What happens if things do not turn out as planned?”

Your plan should detail:

  • How you will maintain current operations
  • How you will improve the efficiency/performance of current operations
  • Which new ventures or initiatives you will undertake this year

In every case, strategies must be linked to activities, which are the “how” to the “what.” Not all activities will generate a positive ROI in 2011, and some infrastructure improvements, such as IT expenditures, may take a long time to generate positive cash flow. But a budget not linked to a strategic plan is a budget that is only doing half its job, and the less important half at that.

Ongoing Budgeting

The traditional budget cycle – begin in August, argue until October, finalize in December and implement in January – is being overtaken by an ongoing review/measurement/analysis/modification process. Whether weekly, monthly or quarterly, managers should review both the budget and its tie-in to strategic goals and implementation of those goals. Not only will the organization be far more nimble and able to spot trends, solve problems before they grow and seize opportunities, but there’s an added benefit: working with the company’s budget on an ongoing basis will make budgeting for 2012 much easier.