A Necessary Evil? It's Budget Time Again - Industry Trend or Event

It's boring, cumbersome, expensive, and time-consuming. It's the annual rite at most companies--creating a budget for the next calendar or fiscal year.

This particular annual ritual has come under increasing criticism in recent years. According to Acountancy Age, more than 90 percent of senior finance professionals experience frustration with their organizations' budgeting process. E-business software provider, Comshare, reports that two-thirds of those questioned in a survey of clients reported the time it takes for budgeting as the major concern--one of more than 120 areas of frustration.

Last year's Y2K panic gave some executives a budgetary reprieve, according to a survey from KPMG's world-class finance benchmark database of more than 450 companies. The KPMG survey found approximately 25 percent of the companies tracked actually began the year 2000 without a budget. The survey also found that 25 percent of companies take eight weeks to complete the budget process; 20 percent take 16 weeks, and 5 percent take 20 weeks or more.

As companies become more sales and marketing oriented, the marketing budget becomes a more crucial document because it includes sales projections. Sales estimates will drive production, and predicted revenues from sales will establish the selling and administrative budgets and overhead. In service organizations, sales are replaced by "revenues," and projected income also drives the other internal budgets. Even nonprofit organizations must go through budgeting. The only real fiscal difference between the for-profit business and not-for-profit firm is that surpluses are distributed to owners of the for-profit business or reinvested in the organization, whereas surpluses in the not-for-profit company are simply reinvested. Not-for-profit organizations have no desire to operate in the red.

Although it's a pain in the neck, budgeting is a mandatory process because businesses can't operate in a vacuum. For companies looking for a new prospective on budgeting, here are some techniques and approaches you might consider as you begin the annual ritua.

Basically, there are two approaches: top-down and bottom-up. In top-down budgeting, the total amount is established at the firm's top executive level and monies are passed down to various departments such as marketing, production, research/development, and operations. In bottom up (or build-up) approaches, managers assess their needs and determine what monies are required to accomplish goals and objectives.

Top-down approaches

One top-down way to determine a budget is the affordable method. This approach is often favored by companies where the marketing function is subordinated to production. Generally, the firm determines the amounts to be spent on various areas such as research, production, and operations, and whatever is left over is allocated to sales and marketing. The logic for this approach is defensive: "It can't hurt us." The limits of this method are severe when a company seeks to launch new products or expand operations. On the other hand, more funds may be allocated than are needed, and the departments often face the year-end dilemma of spending budget funds or perhaps losing them for next year when they may, indeed, need all the funding they can get.

A second top-down approach is arbitrary allocation or historical allocation. Here management determines budgets based on what was spent in the past or by determining "what is necessary." Under arbitrary allocation, no systematic thinking has occurred and no real objectives have been set. It clearly is the "lazy man's" budgeting, and it could be done by a computer.

Perhaps the most common technique is percentage of sales or per-unit allocation. The latter would generally be applied to a situation where the product has a high price--for example, an automaker might allocate $200 per car for the promotional budget. Unlike the previous two top-down approaches, this method requires extensive analysis because it requires a sales projection.

Here are some ways an organization might try to predict sales or revenues. All have advantages as well as disadvantages:

* History--Based on what happened the previous year, on trends of the last several years, or on economic indicators like employment levels, interest rates, and the gross domestic product. The problem is the past isn't necessarily a true measure of the future.

* Jury of executive opinions--Top executives predict the future but they do so from the "ivory tower."

* Delphi method--The company brings in consultants, a process that can be costly and time-consuming.

* Salesforce composite--Rather than take the "ivory tower" approach, this goes into the trenches and lets salespeople make the predictions. This can be dangerous because salespeople will often predict on the low side since bonuses usually are based on exceeding quotas.

* Survey of buyer intentions--The problem here is the intention to buy is not necessarily reflected in an eventual sale. Although consumers may have every intention of buying new cars, if they lose jobs or feel insecure, they may simply put money into existing vehicles instead of purchasing new ones.

Competitive parity is another top-down technique. This is most appropriate for a promotional budget because data is usually available or can be estimated. Here a company would base budgeting on what peer companies are spending, and managers would create a budget by matching competitors' percentage of sales expenditures. This has a variety of limitations. Because it's historical, it starts out being out-of-date as it considers what competitors have done in the past. It also doesn't consider the need to develop and launch new products or to make changes in marketing, production, research and development, or operations. It can be a valuable yardstick or tool in the budgeting process, but it would be shortsighted to rely on this data to set a budget.

Return on investment is a highly quantitative method that takes the percentage of sales or per-unit allocation to another level. Here the budget-setters move from sales to profitability. Under this analysis, the monies allocated to the budgets are assumed to be investments into profits. Thus, a promotional budget wouldn't be judged on the amount of sales it generates but on the profits those sales produce. This might be an appropriate way to budget for mature products, but new products or start-up companies are more geared to the top-line (sales and revenues) rather than the bottom-line (profits). Many of the dot-com companies, such as Amazon.com, have yet to make a profit yet gauge their success on the top line.

Bottom-up approaches

Often referred to as "zero-based budgeting," the basis for these approaches involves considering the firm's objectives and budgeting to achieve these goals. Here the objective-setting and budgeting go hand-in-hand.

The objective-and-task method consists of three steps: (1) defining the objectives to be accomplished; (2) determining the specific strategies and tasks needed to attain them; and (3) establishing the costs associated with performance of these strategies and tasks. The total budget is based on a build-up of these costs. The process involves several steps:

1. Isolating the objectives. Often the objectives involve a variety of elements. For example, a firm's promotional budget might have both communications and marketing objectives. Communications objectives might focus on awareness levels, whereas marketing objectives might be tied to sales, profits, and/or market share.

2. Determining the tasks required. Such tasks might include plant modernization, research and development, expanding or contracting salesforces, computer/technology/communications advancements, or increasing levels of advertising and other promotional mix levels such as interactive communications, direct marketing, public relations, sales promotion, sales incentives, and so forth.

3. Estimating required expenditures. This simply puts a price tag on the various tasks.

4. Monitoring. Here the budgetary process takes on a longer life. Using this technique, the elements of the budget are watched and often adjusted to give greater weight to high-priority areas.

5. Reevaluation. As specific goals are attained, funds might be reallocated to other areas. In a promotional budget, if awareness levels have been achieved, funds might be allocated to advertising that focuses on product trials.

A major advantage of build-up approaches is that the budget is driven by what is needed. However, the challenge is determining what is needed and the costs associated with accomplishing these tasks.

Financial planning vs. budgeting

The New York-based Institute of Management and Administration suggests more companies are shifting from budgeting to financial planning because the budgeting process has become so cumbersome and expensive. They cite a study showing the average billion-dollar company spends 95 days and $250,000 to create a typical budget.

For companies making the shift, the institute suggests the following steps:

1. Link the financial-planning process to the strategic-planning process through operational targets based on strategic objectives.

2. Integrate forecasting with planning with a rolling five- to six-quarter time frame.

3. Ensure all staff people can retrieve and transmit data electronically so that all people involved in financial and/or marketing planning have a systemized, standard way of looking at customers.

4. Focus on reiterations for identifying how to meet operational targets and how to process financial statements.

Unlike end-of-the-year holidays, budgeting is hardly an annual rite that people anticipate with glee. However, it's a necessary fact of life for businesses and organizations of all sizes. There are many top-down and bottom-up approaches to the process and all have advantages and disadvantages.

James T. Berger is a Chicago-based freelance magazine writer who makes his living as a strategic marketing consultant.

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