CHAPTER SIX
Budgeting & Forecasting
Chapter learning objectives
01. 02. 03. 04. 05.
• Identify good Identify the Identify steps that must • Categorize
be taken before • Identify the traits expenses into the
ways for components of
preparing a budget of incremental four different
managers to a master budget
budgeting types of costs
use a budget
06. 07. 08. 09 10.
• Identify the • Identify causes
advantages of • Calculate •. Identify the Know when to
of favorable and
performing multiple variance goals of a use Solver and
unfavorable
regression analysis variance Goal Seek in
variances in percentage dashboard Excel
profit
11. change
• Identify reasons to use
dedicated budgeting
tools
01.
Budgeting Within
A Strategic Framework
Barriers to strategy execution
• Only 10% of organizations execute their strategy.
• The main barriers to strategy execution are:
People Management Resource
Vision barrier barrier barrier barrier
• 60% of organizations
• Only 5% of the Only 25% of 85% of executive
workforce
managers have teams spend less than don’t link
incentives linked to 1 hour per month budgets to
understands strategy talking about strategy
strategy strategy
Source: Adapted from material developed by Kaplan and Norton
• “Strategy is a plan of action (set of activities) designed to achieve a particular goal”
• Strategic planning: An organisation’s process for ascertaining the strategy it should adopt, taking into
account what they want to do, how they are going to do it and what resources they will need.
• Strategy Hierarchy:
1) Corporate strategy
2) Business strategy
3) Functional (or operational) strategy
The importance of budgets
Budgets must link strategies to objectives; it is the
tactical implementation of the business plan.
Strategic plan
Business plan
Now 5 year
objectives
Where we
are Budget
Where
we
want to be
Barrier to Budgeting Process
Consider the following question:
What is the most significant barrier to improving
your budgeting process?
Organizational There are
attitudes Inflexible IT Controlled other
toward Time Cost systems by another significant
budgeting barriers
group
Translating strategy into targets and budgets
• Translating high level strategy (mission, vision, goals, etc.)
requires you to consider four distinct but related dimensions:
OBJECTIVES STRATEGIES MEASURES TARGETS
How are you going to What are output
What are you achieve it? What must
Quantifiable
measures? What are input
trying to achieve? you do to support the Time-based
measures?
strategy?
1. $increase
01. Increase spend 1. Expand product offering 1. Average weekly spend
2. Volume increase
2. Source new suppliers per customer
per customer 3. Promotion and marketing 2. Spend by product type 3. %staff trained in new
4. Pricing 3. Average price changes products
Kaplan and Norton’s balanced scorecard
• Business performance should be measured from the perspective of
strategy implementation rather than relying simply on financial results.
• Organizations need a balanced set of financial and non-financial
performance measures and targets.
A balanced set of performance measures will ensure that the
entire organization participates in strategy
implementation and should include:
Financial Customer Process Learning
measures and growth
measures measures measures
Scorecard (BSC) perspectives
FINANCIAL
how should
To succeed financially,
we appear to our
shareholders?
PEOPLE MISSION CUSTOMERS
AND
To achieve our vision, STRATEGY To achieve our vision,
what capabilities how should we appear
must our people to our customers?
have? OPERATIONS
To satisfy customers,
what operational
processes must we
excel at?
What are our budgeting goals?
To aid the planning of actual operations:
• By getting managers to consider how conditions might
change and what steps they would take
• By encouraging managers to consider problems before they
arise
To co-ordinate the activities of the organization:
• By encouraging managers to examine relationships between
their own operation and those of other departments
To communicate plans to various managers:
• Everyone in the organization should have a clear understanding of
the part they are expected to play in achieving the annual budget
• By ensuring appropriate individuals are made accountable for
implementing the budget
What are our budgeting goals?
To motivate managers to strive to achieve
the budget goals:
• By focusing on participation
• By providing a challenge/target
To control activities:
• By comparison of actual with budget
(attention directing/management by
exception)
To evaluate the performance of managers:
• By providing a means of informing managers of how
well they are performing in meeting targets they have
previously set
Criticism of planning and budgeting
The main criticism of planning and budgeting include:
Budgets can Budgets are Budgets Budgets are Budgets may
become a major rarely encourage based on make people
barrier to strategically
responsiveness focused
“gaming” unsupported feel
assumptions undervalued
02.
Building a Robust
Budgeting Process
Building a robust budgeting framework
A robust budgeting framework is built around a master
budget consisting of:
Operating
budgets
When combined, these budgets
generate a budgeted income
statement, a balance sheet
and a cash flow statment.
Capital
Cash
expenditure
budgets
budgets
Types of budgets
OPERATING BUDGETS CAPITAL BUDGETS CASH BUDGETS
Revenues and expenses Requests for large An estimation of the cash
for the various budget assets which create inflows and outflows for a
centers within an major demands on an specific period of time
organization entity’s cash flow
Used to assess whether the
Budgeted amounts divided Buildings, renovations, entity has sufficient cash to
into major categories such automobiles, software
fulfill regular operations
as revenues, salaries, systems, furniture
benefits, and non-salary Identifies whether too much
expenses Purpose to allocate
funds, control risks in cash is being left in
Encompasses supporting decision making, and unproductive capacities
info such as head counts set priorities
Master budget for a manufacturer
Sales budget
Production budget
Direct materials
Direct labor budget Overhead budget
purchases budget
Operating
budgets
Cost of goods
manufactured budget
Selling and admin Cost of goods sold
expense budget budget
Budgeted
income statement
Cash budget
Budgeted Financial
Balance sheet
budgets
Capital
budget
Master budget for a retailer
Sales budget
Operating
Purchases budget
budgets
Selling and admin Cost of goods sold
expense budget budget
Budgeted
income statement
Budgeted Financial
Cash budget
Balance sheet budgets
Capital
budget
Master budget for a service provider
Revenue budget
Operating
Labor budget
Selling and admin
Overhead budget
budgets
expense budget
Budgeted
income statement
Budgeted Financial
Cash budget
Balance sheet budgets
Capital
budget
Operating budgets – where to start
• Before anything else, you first must:
budget
Establish
Create a clearly
defined budget
centers organization chart
• Prepare a Form a
budget budget
manual committee
A budgeting process
• Most larger companies start their budgeting process four to six months
before the start of the financial year. Most organization set budgets and
undertake variance analysis on a monthly basis.
Establish objectives
Planning Communication
& targets
Budget committee Compilation and Develop detailed
review & approval revision budget
Implementation and
Board approval
management
Budget psychology
• Behavioral and social aspects are an integral part of
the budgeting process and should not be divorced from
the technical side.
✓ Budgets may motivate or de-motivate
managers depending on:
• Where the target is set
• The level of controllability
• The level of involvement in budget setting
✓ Budgets should not be used to pinpoint blame
✓ Budgets should be linked to other performance
measures
Who should be involved?
• Obtaining goal congruence is essentially a behavioral issue.
• Involvement in the budgeting process is of significant importance in
motivating managers.
Imposed Negotiated Participative
budgeting budgeting budgeting
Top down Top down Recommend
targets for
activity and
Shared costs
responsibility
for budget
Impose budget preparation
targets for
activity and
costs Bottom up Bottom up
03.
A Practical Guide To
Developing Budgets
Developing the budget
There are 4 common approaches to developing a
budget:
Value
Incremental
proposition
budgeting
budgeting
Activity–based Zero-based
budgeting budgeting
1) Incremental budgeting
• Incremental budgeting is a very simple method that looks
at what was spent last year and then adds or subtracts a
percentage.
+x%
Last year’s Basis for this
actual figures year’s budget
Incremental budgeting
• This is still the most common way used to produce budgeted figures and it may be
appropriate if cost drivers do not change from year to year.
• However, it is:
Likely to perpetuate inefficiencies
Likely to result in budgetary slack
Likely to ignore external drivers of
activity and performance
2) Output/input or activity based budgeting
• Inputs are determined by outputs, not the other way around.
• Avoid starting by assessing the resources you have and then
trying to assess what is achievable.
The activities I
Output need to undertake
Input to achieve my
business aim
The cost
expectation of
delivering
these activities
3) Value proposition budgeting
For each budget item/amount, ask:
Why is this amount included in my budget? Has a
need for this item been demonstrated?
Does the item create value for customers, staff, or
other stakeholders?
Does the value of this item outweigh its cost? If
not, is there another
reason why this cost is justified?
4) Zero-based budgeting
• Zero-based budgeting starts with the assumption that all department budgets are
zero. Managers are required to build their budgets from the ground up, justifying
every penny they wish to spend.
• Bottom-up budgeting can be a highly effective way to “shake things up”. It is most
effective when there is an urgent need for cost containment. However it is:
• Best suited for discretionary costs (not
essential operating costs)
• Extremely time consuming
• Most effective when only used
occasionally
Beyond budgeting
“The budget is the bane of corporate America. It never should have existed.”
- Jack Welch, ex-CEO, General Electric.
• “Beyond Budgeting” argues that firms today need to be more flexible and
responsive to deal with unpredictable change, hyper competition and
increasingly fickle customers.
• The “Beyond Budgeting” movement has developed 12 principles to
replace traditional budgeting approaches.
• In essence, Beyond Budgeting entails a shift from a
performance emphasis on numbers to one based on people
and institutional arrangements.
04.
Forecasting Techniques
Types of cost behaviour
Fixed cost Variable cost Semi-variable cost
Cost Cost Cost
Volume of output Volume of output Volume of output
• What are the key fixed costs in your organization?
• What are the key variable costs in your organization?
Types of modified cost behaviour
Stepped fixed cost Variable cost with Variable cost with
economies of scale diseconomies of
scale
Cost
Cost
Cost
Volume of output
Volume of output
Volume of output
Cost structures and earnings volatility
Fixed cost Variable costs
$ $
Revenues Revenues
Costs
Costs
Time Time
High fixed cost organizations have volatile earnings: small volume changes have material impact on profits
Organizations with low fixed costs have to generate large increases in revenues for modest increases in profits
Cost structures and flexibility
Analyzing costs into fixed and variable highlights factors affecting the level and volatility of profits:
Example Service A Service B
$ % $ %
Sales
100,000 100 100,000 100
Variable labour costs
40,000 40 60,000 60
(overtime, casual, temps)
Gross contribution 60,000 60 40,000 40
Fixed labour costs
(full time staff salaries) 40,000 40 20,000 20
Net profit 20,000 20 20,000 20
Cost structures and flexibility
Example Service A Service B
What is the breakeven point?
Fixed costs 40,000 20,000
= $66,667 = $50,000
Contribution margin 60% 40%
What is the margin of safety?
Sales – Breakeven sales 33,333 50,000
X 100% = 33% = 50%
Sales 100,000 100,000
What will the profit be if volumes
fall by 50%?
= $10,000 loss = $0
What sales are needed to 90,000 70,000
produce $50,000 profit? 60% = $150,000 40% = $175,000
Quantitative forecasting methods
There are a range of widely used quantitative budget forecasting tools including:
Technique Use Math involved Data needed
Moving averages Repeated forecasts Minimum level Historic data
Comparing one
Simple linear independent with one
Statistical knowledge A sample of relevant
regression dependent variable
required observations
Compare more than one
Multiple linear Statistical knowledge A sample of relevant
independent variable with
regression required observations
one dependent variable
Moving averages
Moving averages is a smoothing technique that looks at the underlying pattern of a set of data to establish
an estimate of future values.
Last 12 3 month 5 month
months MA MA
5 Revenues
8 10.00
7 6.7 8.00
8 7.7 6.00
8 7.7 7.2 4.00
9 8.3 8.0 2.00
7 8.0 7.8 -
9 8.3 8.2 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
5 7.0 7.6 Revenues 3 month MA 5 month MA
7 7.0 7.4
5 5.7 6.6
8 6.7 6.8
Simple linear regression
Regression analysis is a widely used tool for analyzing the relationship between variables for prediction
purposes.
Month Radio Revenues
ads
Ads vs Revenue
Jan 21 8,350 $30,000.0
Feb 180 22,755
$25,000.0
Mar 50 13,455
Apr 195 21,100 $20,000.0
Revenue
May 96 15,000
$15,000.0
Jun 44 12,500 y = 78.075x + 7930.4
s
R² = 0.9327
$10,000.0
Jul 171 20,700
Aug 135 19,722 $5,000.0
Sep 120 16,115
$0.0
Oct 75 13,100 0 50 100 150 200
Nov 106 15,670 Number of radio ads
Dec 198 25,300
Multiple linear regression
When 2 or more independent variables are required for a prediction the analysis is referred to as multiple
linear regression.
Month Promotion Advertising Revenue
Multiple linear regression is available in
(X1) (X2) (Y) Excel via the “Analysis ToolPak” add-in:
Jan 63 123 900
Feb 117 234 1,000
Mar 161 321 1,200
Apr 117 234 1,050
May 116 231 876
Jun 117 432 778
Jul 216 234 1,550
Aug 117 333 777
Sep 167 234 678
Oct 117 333 876
Nov 216 123 1,075
Dec 63 234 925
Multiple linear regression using Excel
• Here the independent (X) variables are “Promotion” and
“Advertising” while the dependent (Y) variable is “Revenue”.
Multiple linear regression results using Excel
Here are the summary outputs and how to use them…
If we expect:
Forecast “Promotion” to be 125 and
Forecast “Advertising” to be 250…
Note: X Variable 1 is “Promotion”
Note: X Variable 2 is “Advertising”
Revenues = 763.10 + (2.46 x 125) + (-0.45 x 250) = 958.10
Qualitative forecasting tools
PEST is a useful framework for building expectations about the
future and its impact on the budget:
Political forecasting Economic forecasting
and trends and trends
Social forecasting Technological forecasting
and trends and trends
PEST analysis overview
Political Economic
forecasting forecasting
Identify
Anticipate Opportunities React
And threats
Social Technological
forecasting forecasting
PEST analysis checklist
Political Economic Social Technological
forecasting forecasting forecasting forecasting
• Legislation • Economic cycle • Demographics • Leading edge
• Taxation • Interest rates • Lifestyles developments
• Regulations • Consumer spending • Attitudes • Own R&D
• Gov’t/business • Government • Needs and desires • Competitors’ R&D
relations spending
• New competition • Business investment
• Exchange rates
Budgeting using Porter’s 5 forces
• Porter’s 5 forces is a powerful tool for assessing industry dynamics and how industry
dynamics may impact budgets.
• Michael Porter identified FIVE forces driving industry competition:
Potential new
entrants and
barriers to entry
Suppliers and their Rivalry amongst Buyers and their
bargaining power firms in industry bargaining power
Threat of
substitutes
05.
Tracking Budget Performance
With Variance Analysis
What is variance analysis all about?
Variance
The difference between budgeted/expected cost
and actual cost; and similarly for revenue
Variance Analysis
The process of examining in detail each variance
between actual and budgeted/expected costs to
determine the reasons why budgeted results were not
met (material costs too high, sales prices too low, etc.)
What is variance analysis all about?
Calculating Variances
Variances Budget
Sales Volume 100
Sales Value $1000
Variable Costs (500)
Fixed Costs (200)
Profit 300
Who’s to blame – breaking down variances
Calculating Variances
Variances Budget Actual
Sales Volume 100 90
Sales Value $1000 $990
Variable Costs (500) (495)
Fixed Costs (200) (210)
Profit 300 285
Variance = (15)
Sales volume variance
Flexing the budget – sales volume variance
Variances Original Budget Revised Budget Actual Variances
Sales Volume 100 90 90
Sales Value $1000 $900 $990 90
Variable Costs (500) (450) (495) (45)
Fixed Costs (200) (200) (210) (10)
Profit 300 250 285 35
Variance = (50)
Sales price variance
Flexing the budget – sales prices variance
Variances Original Budget Revised Budget Actual Variances
Sales Volume 100 90 90
Sales Value $1000 $900 $990 90
Variable Costs (500) (450) (495) (45)
Fixed Costs (200) (200) (210) (10)
Profit 300 250 285 35
Variance = 90
Variable cost variance
Flexing the budget – variable cost variance
Variances Original Budget Revised Budget Actual Variances
Sales Volume 100 90 90
Sales Value $1000 $900 $990 90
Variable Costs (500) (450) (495) (45)
Fixed Costs (200) (200) (210) (10)
Profit 300 250 285 35
Variance = (45)
Variable cost variance
Original variable 2.5m of material for each sales unit at a price of $2/m
cost budget 100units x 2.5m x $2 = $500
2.0m of material for each sales unit at a price of $2.75/m
Actual Result 90units x 2.0m x $2.75 = $495
Compare this result with the flexed budget
90units x 2.5m x $2 = $450
What caused the (S45) or U45 variance?
Variable cost variance
Total variance = (135) + 90 = (45)
Price We expected to pay $2/m. We did pay $2.75
180m purchased x (2.75-2.00) = (135)
Materials price variance ($135) or U135
Usage We expected to use 225m to make 90 units
and actually used 180m
At budgeted price ($2/m) we saved
2.0 x (225-180) = 90
Materials usage variance $90 or F90
Fixed cost variance
Flexing the budget – fixed cost variance
Variances Original Budget Revised Budget Actual Variances
Sales Volume 100 90 90
Sales Value $1000 $900 $990 90
Variable Costs (500) (450) (495) (45)
Fixed Costs (200) (200) (210) (10)
Profit 300 250 285 35
Variance = (10)
Summarizing variances
Variances
Sales volume (50)
Sales price 90
Materials price (135)
Materials usage 90
Fixed costs (10)
Sum of variances (15)
The sum of the variances equals the difference between the
actual profit of S285 and the budget of S300.
Investigating a variance – labour cost
Imagine you work at ACME Ltd. and the actual labour costs this month to produce
7,000 widgets are $84,000 over budget. Without breaking down this variance into
its core drivers, it is virtually impossible to get answers to the following questions:
What are the root causes?
Who is accountable?
What action(s) if any can be taken?
Breaking down variances unlocks the root causes of organizational
performance and enables appropriate correction action to be taken.
Investigating a variance – macro to micro
Total labour
variance
S84,000
Labour price Labour hours
variance variance
S42,000 F S126,000 U
What could be some of the possible causes of the:
Favourable labour price variance?
Unfavourable labour hours variance?
Investigating a variance – root causes
Labour price variance Labour quantity variance
1. Use of junior versus senior workers 1. Poor supervision
2. Use of workers commanding lower hourly rates 2. Improperly trained workers
3. Use of unskilled workers paid lower rates 3. Machine breakdowns
4. Use of unskilled workers
5. Use of more workers
Presenting variance analysis to management
Leading edge organizations are increasingly developing “information dashboards”
that summarize key messages coming out of variance analysis with the goal of:
Conveying a lot of information as quickly as possible
Presenting several different types of information all one screen
Using graphs in place of tables where appropriate
Sample budget dashboard
Source: CFI’s Dashboards & Data Visualization Course
06.
Applied Budgeting Tools
And Techniques
Reporting results using pivot tables
• Pivot tables are tools for dynamically summarizing, analyzing and reporting
data. They allow us to rotate (pivot) a summary data table so it can be viewed from
different angles.
Sumof Shipping Cost ColumnLabels
RowLabels 2018-01-01 2018-01-02 2018-01-03 2018-01-04 2018-01-05 2018-01-06 2018-01-07 Grand Total
Hat -2 -2 -10 -2 -8 -2 -10 -36
Pants -10 -10 -5 -5 -25 -20 -5 -80
Shorts -6 -9 -6 -6 -21 -9 -6 -63
T-shirt -15 -5 -10 -15 -15 -10 -10 -80
GrandTotal -33 -26 -31 -28 -69 -41 -31 -259
RowLabels Sumof Revenue
Hat 450
Pants 1,200
Shorts 735
T-shirt 720
Grand Total 3,105
Creating a pivot table
• Ensure data is in columns
• Row 1 should contain the field name
• Data can be numerical values, text or formulas
• Excel 2007 & later versions create a pivot table by choosing Insert / Tables /
PivotTable
• Excel 2003 & prior versions create a pivot table by choosing Data / PivotTables
and PivotChart Report
Excel 2007 & later versions
Are you building a budgeting house of cards?
Are you building a budgeting house of cards made up of numerous Excel spreadsheets?
If so, it may be time to move to a dedicated budgeting tool that:
Provides an Provides for a Provides two Provides drill Produces user-
automatic distributed way down and roll friendly and
process of process integration up flexible
data with the capabilities budget
accumulation general ledger reporting
The End!
