A company’s budget, sometimes referred to as its financial forecast or plan, is a prediction of the expenditures necessary to operate the company and the revenues that will be generated through these operations. Being able to budget accurately is a critical skill for a company’s management. Large variances from the plan can mean serious shortfalls in cash flow that could put the company’s survival in jeopardy. The test of a budget’s accuracy comes when actual financial results become available and are compared to the budget numbers.
A complete, thorough budgeting process results in a more accurate budget. It is important that each line item expenditure necessary to run that type of business is incorporated in the budget. Start-up companies in particular often forget to include expense items — sometimes significant ones such as insurance or legal fees. Think of expenses as resources — the tools you and your employees need to run the business. Envision the day-to-day operation of the company and the costs associated with each task you want to accomplish.
Budget accuracy is impaired when the management team creates the plan with faulty assumptions that greatly underestimate the cost of running the company, or are too optimistic in the forecast of revenue growth. Obtaining sound assumptions requires significant depth of research. Managers who are responsible for parts of the budget need to be able to provide senior management with sound logic for how they calculated these assumptions. Input and statistical information from all members of the organization should be encouraged during the budget preparation process. For example, marketing managers would have the most accurate information regarding the cost of advertising or the cost of having sales personnel on the road.
In general, positive surprises in variances from the budget are preferable to negative ones. Negative variances are looked at as failures in the budgeting process — and in the company’s management — whereas positive variances can result in managers receiving bonuses at the end of the year. One way to increase the likelihood of positive variances is to budget conservatively. Recognizing that unfavorable events can occur and budgeting for them can help prevent unpleasant surprises. Include extra funds in the budget to cover the unexpected. This can help prevent large overall variances from the budget.
Variances in Narrow Ranges
Companies have a bottom line focus: Net profit is the most important number to the senior executives of an organization. If net profit is close to what was forecast, they are satisfied. Even so, all the revenue and expense line item variances should be analyzed. A huge positive variance in one category can negate a huge negative one in another category for a given month or quarter. The causes of each of these must be analyzed in case they indicate a change in the business environment that needs to be addressed with a change in strategy. If the positive variance was a one-time event and the negative variance recurs, the company could be in trouble. The most accurate budgets are those in which line item variances are in narrow ranges, neither significantly higher nor lower than the budget.