This is the ninth in a series of blogs on improving the corporate budgeting process. In the last blog I looked at checking budgets for realism. In this blog we will look at the power of developing scenarios.
It’s often been said that the budget is bound to be the one scenario that won’t happen. The main reason for this is that it’s impossible to predict exactly what will happen throughout the year, particularly when budgets have been set 12 – 15 months in advance. But what compounds the problem is the way in which the budget is then used to monitor performance.As mentioned in previous blogs, budget measures are typically either targets to be achieved or resources to be consumed. It is hoped that by performing the actions allowed by the resources, then associated targets will become a reality. This relationship is typically monitored through colour-coded ‘actual vs. budget’ variance analyses, which then leads to the question - is the variance ‘good’ or ‘bad’?The trouble is that the budget is usually set as specific values that create ‘heroes’ (those that stay within budget) and ‘villains’ (those that miss the budget). As a consequence much management time is lost in debating the merits of how the numbers were set and in apportioning blame.A far better way is to set a budget that has a range of values, for example, ‘best case’ and ‘worst case’ scenarios, within which performance is ‘acceptable’. In doing this, some of the resources such as rents, loan repayments, etc., will remain fixed, but others such as raw materials and energy consumption are more likely to fluctuate with volume. This is where splitting up fixed and variable costs, and associating drivers really helps.To generate a new scenario, the fixed costs can be ‘copied’, while the variable costs can be produced by changing some of the driver values or applying a percentage adjustment. Much of this can be done centrally, with the resulting scenario being passed out to departmental managers for comment.This type of budgeting is often connected with risk management and is performed by high-performing companies. But in order to have time to do this, they reduce the level of detail of the budget so they can focus on its variability.
- Decide how far budgets should be allowed to fluctuate before re-planning is required.
- Assess which budget values remain ‘fixed’ and those that are ‘variable’
- Report actual results alongside best, worse case and expected scenarios.