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Budgeting in the New Economy - Jul 16, 2009

Posted by: Stu Lipkin in Articles

As many financial professionals know, budgeting is a projection of future results based upon historical analysis. While that model may have worked in the past, the recent recession and upheavals in this economic climate require an overhaul to that process. No longer can most companies assume that their historical trends will continue in the future. In fact, most companies have already seen these trends destroyed in 2009 and may continue to see them deteriorate in 2010.

So how does a company begin the planning process with historical trending no longer reliable? The answer is, from the beginning. Ignore past data and assume this is the first year of operations. The process described below may have more or less participants depending on the size of the Company and the depth of the management team. However, the process will still be the same.

The first place to start is a very detailed Sales and Marketing Plan. This process must begin with the CEO/President and include all individuals in the business who are involved with Sales and Marketing. Each person who has sales responsibilities must develop their own sales projections for their specific list of customers. These projections should take into account lost customers and new customers which occurred in the preceding 12 months. It should also include product lines that are being terminated or projected new products that will be introduced in the upcoming periods. The projections should be detailed as to each Customer with a separate entry if any significant product lines are being terminated or added. The projections should be jointly reviewed with the CEO/President, CFO or Controller and the salesperson who prepared the information to verify that there is agreement. It is not uncommon for a salesperson to be more conservative in the projections compared to what the CEO/President is expecting from that person. Particularly if the salesperson is being paid commission and the projections are the basis for the calculations. The meeting will also give the CEO/President insight from the salesperson as to any problems that may have developed or opportunities for future growth with those Customers. Once the meetings are completed with all of the salespersons, the CFO or Controller will consolidate the data and use this as the basis that will drive the Sales numbers in the budget. As with all good budgeting techniques, it is advisable to develop Sales projections at 3 levels. While there are many labels (pessimistic/expected/optimistic, low/medium/high, etc.) it is important in these economic times to fully understand the impact of hitting the budget at these various levels. While the information supplied by the Salespersons should be used for the expected level, developing 2 additional budgets that reflect Sales %10-%20 below and %10-%20 above the expected level will become invaluable to managing the business.

The next step is to distribute the 3 sets of Sales numbers to the employees responsible for Procurement and to those responsible for Operations. The Procurement people will need to evaluate what gross margin levels can be achieved both with existing product lines and new lines to be introduced. This step is critical in light of today's economic environment. Every Customer is looking to their suppliers for ways to reduce costs. This competitive pressure has a tendency to lower margins from products previously sold. In addition, transportation costs need to be analyzed to verify the cost of receiving the products does not further diminish the margins. Again, these margin projections need to be reviewed and finalized in a meeting with the CEO/President, CFO or Controller and the person responsible for the Procurement process. It would also be advisable to develop similar scenarios to the Sales budget with a pessimistic/expected/optimistic set of margin numbers.

In addition to the Sales and Marketing Plans being sent to Procurement, the same information must be sent to Operations. The next step is to evaluate the cost structure required to maintain each of the 3 levels within the budgets. The process should initially involve the CFO or Controller working with the Operational people. Their focus needs to be in identifying the labor costs, related benefits and other administrative costs on a line by line level. Again, 3 separate Operational budgets need to be prepared for each of the Sales levels. Typically, labor costs and related benefits will change at each of the 3 levels of Sales while many of the Administrative costs are fixed. That is why it is critical to understand the impact on the Company if the pessimistic sales numbers are the ones being obtained. The fixed costs will not be able to be cut in proportion and could have a catastrophic impact on the business. The Operations budget must also be reviewed and approved in a joint meeting with the CEO/President, CFO or Controller and the person (s) responsible for Operations.

Once all 3 components of the budget have been completed, reviewed and approval given by the CEO/President, the CFO or Controller will consolidate all the data into 3 separate budgets. The CFO or Controller will also prepare calculations for other non-operational costs such as interest and taxes. The complete budget should be in the same format as the historical financials that are prepared for the Company. A final review and approval must be completed by the CEO/President and CFO or Controller comparing all 3 versions of the budget to historical data. This review process is critical since many times it raises questions about some of the budgeted numbers that may need to be addressed and revised.

While many Companies feel as though they've completed the budget process, there is still one critical component missing. It's important for the Company to have beacons and landmarks to help them through the process. However, it's critical for them to have done a cash flow projection for the same period of time. While it is possible (and in many cases very likely) for the budget to reflect growth and profitability for a Company, that growth may cause negative cash flow and put the Company in jeopardy of future growth and even their existence. The development of a budget without a cash flow projection is like being in a row boat without any oars. You may be afloat but you can't control your destiny.