BUDGETING

Effective budgeting allows management to plan their financial affairs, assess performance, know what factors or departures from the plan are affecting performance, adapt to changing circumstances, and produce better business plans to attract investment capital. The components of a budget should include sales, labor, materials, inventory, SG&A, capital expenditures and cash budgets.

Budgeting is an iterative process, with initial forecasts going through multiple formulations before being finalized. Formulation by small groups can cause budgets to be prepared without sufficient detail about business operations and prospects.

A top down approach in budgeting involves executive-management setting sales goals and restrictions on expenditures. A bottom up approach, however, involves lower level employees and, can vastly improve the quality of information and reliability of the budget. Involving those in day-to-day sales and operations can foster more realistic information, as well as enrollment, responsibility and accountability for variances.

With bottom up budgeting, there is a risk of intentional underestimating of sales and over-estimating of costs to ensure bonuses based upon hitting the budget are achieved. Previous trends should be tracked against proposed budgets to test the reasonableness of estimates. Other issues associated with bottom up budgeting include less control over spending and allocating resources, a loss of focus on long-term goals, and inefficiency as the process is more time consuming.

Blend the two approaches to develop budgets, which promote confidence in managers and investors when making decisions about the business.