Conditional budgeting

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Conditional budgeting is a budgeting approach designed for companies with fluctuating income, high fixed costs, or income depending on sunk costs, as well as NPOs and NGOs. The approach builds on the strengths of proven budgeting approaches, leverages the respective advantages for situations of fluctuating incomes, and at the same time reduces possible negative impacts.

Contents

Summary

The core idea of conditional budgeting is to structure income and expenditures according to probabilities and priorities respectively. After the budget is approved, the actual status of the finances is reviewed and analyzed regularly, and if income reaches a certain level (or probability), the corresponding level of expenses is approved.

Therefore, conditional budgeting does not focus on spending a certain amount of money or consuming certain resources; rather, it defines priorities of expenses and resources as well as income and earning levels that will allow releasing the funds for expenses and resource consumption.

Background

While different understandings of budgeting exist, for the purpose of this article budgeting shall be understood as the implementation of the long-term plan for the year ahead. Because of the shorter planning horizon budgets are more precise and detailed. Budgets are a clear indication of what is expected to be achieved during the budget period whereas long-term plans represent the broad directions that are intended to be followed. [1]

Traditional line item budgeting

The traditional budgeting approach develops a plan within the context of ongoing business and it is ruled by previous decisions that have been taken within the long-term planning process. [1] Budgeting may serve different functions such as: forcing managers to plan ahead and therewith reducing ad hoc decisions; communicating objectives, perceived problems and opportunities, as well as the role that everyone is expected to play; coordinating the separate activities and ensuring that all parts of the organization are in mutual harmony; aiding motivation through setting targets and providing a challenge; or providing standards which can be employed as part of the control process. [2] To establish a budget, Smith suggests the following six steps: [3]

The traditional budgeting approach, also called line-item budget, normally consists of a set of several budgets that build on one another and have to be integrated. For a manufacturing company, these budgets may be: [4]

This approach typically builds on the previous year sales and cost structure and it works fine for unit level costs where the consumption of resources varies proportionately with the volume of the final output of products or services. Such approaches are also called incremental budgeting. [5]

Activity-based budgeting (ABB)

While basing the budget on previous effective costs figures, and therewith accepting the cost of non-unit level activities to be fixed, and consequently inherent past inefficiencies and waste in the current way of doing things, activity-base budgeting allows to manage costs more effectively. Adopting the underlying ideas of activity-based costing (ABC), ABB authorizes the supply of only those resources that are needed to perform activities required to meet the budgeted production and sales volume. In this budgeting process, cost objects are the starting point and their budgeted output determines the necessary activities which are then used to estimate the resourced that are required for the budget period. The process stages are: [5]

Zero-based budgeting (ZBB)

Zero-based budgeting, also known as priority-based budgeting, emerged in the late 1960s as an attempt to overcome the limitations of incremental budgets.- This approach requires that all activities are justified and prioritized before decisions are taken relating to the amount of resources allocated to each activity. ZBB typically also focuses on activities instead of functional departments. [6] Zero-based budgeting involves the following three stages: [7]

Criticism of budgeting

The major criticism of the traditional annual budgeting approach is that the process is incapable of meeting the demands of the competitive environment in the information age. The specific criticism points are: [8]

Steven Bragg adds that the typical budget process requires a large number of iterations and many meetings by the management team before a satisfactory budget is created. This is not an efficient use of managers' time, since they must meet many times to make incremental changes to the budget and then wait for the budget team to process the changes and give the results back to them. [9] Jack Welch, the former CEO of General Electrics, concludes that the budgeting process at most companies has to be the most ineffective practice in management. It sucks the energy, time, fun, and big dreams out of an organization. It hides opportunity and stunts growth. It brings out the most unproductive behaviors in an organization, from sandbagging to settling for mediocrity. In fact, when companies win, in most cases it is despite their budgets, not because of them. [10] Jack Welch instead imagines a system of budgeting where both the field and headquarters have a shared goal: to use the budgeting process to ferret out every possible opportunity for growth, identify real obstacles in the environment, and come up with a plan for stretching dreams to sky; not being internally focused and based on hitting fabricated targets, but throwing open the shutters and look outside. Such a budgeting system must be focused on two questions: [11]

Other alternative approaches include:

Rolling Forecasts / Rolling Budgets: A rolling budget is a budget or plan that is always available for a specific future period by adding a month, quarter or year in the future as the month, quarter or year just ended is dropped. Thus, a 12-month rolling budget for March 2008 to February 2009 period becomes a 12-month rolling budget for the April 2008 to March 2009 period the next month, and so on. There is always a 12-month budget in place. Rolling budgets constantly force management to think concretely about the forthcoming 12 months, regardless of the month at hand. [12]

Flexible Budgets: The concept of flexible budgets is an extension of the traditional budgeting methodology that is most valuable when the company expects or any experience wide variations in levels of activity within some area of the company, such as sales, or if many of the costs vary directly with those levels of activities, e.g. they are direct costs tied to sales, and the budget controls for these costs would be marginally useless if activity levels were significantly different from those in the budget. In such situations, direct costs are budgeted for various levels of activity and the budget used for a comparison with actual results is the budget that is based on the actual activity levels achieved. [13]

Beyond Budgeting: Beyond Budgeting, promoted by the international movement Beyond Budgeting Round Table, advocates the replacement of the traditional budgetary control system with an assortment of 'adaptive processes'. These are planning and decision-making processes which are not strictly part of the traditional budgetary control system. Such a new budget system would show summary figures of sales, costs, profits and cash flow, which enables managers to review the financial outlook of the business without being constrained by the corporate financial year used for the annual reporting cycle. This removing of the traditional budget process must be accompanied by the removal of fixed performance contracts and therefore organizations are able to change the attitudes and behaviors of people at every level of the organization, incl. eradicating the undesirable behaviors that result from setting a fixed target that must be met even though the outcome is highly uncertain. To manage without annual budgets, organizations should adhere to the following six principles: [14]

Better Budgeting: Better Budgeting, also known as advanced budgeting, intends to increase the efficiency of the traditional budgeting approach, mainly by streamlining budgetary processes through market orientation and optimization. Therewith better budgeting aims for a more flexible and less resource consuming design of budgeting. The designing elements of a better budgeting approach are: [15]

Besides tailored approaches, Damian Markus Slebioda names zero-based budgeting and activity-based budgeting to be two examples of better budgeting approaches. [16]

Kaizen Budgeting: Budgeting approach that explicitly incorporates continuous improvements during the budget period into the resultant budget numbers. [17]

Methodology

Conditional budgeting derives many ideas from multiple budgeting approaches, however, it is unique in the way how it combines budgeting and analysis of current status, and then releases expenses (while other budgeting approaches compare variances between actual and budget). The budget becomes a process for everyone to agree on income probability and expense priority. It no longer defines a certain level of expenses; rather, it is a process for an organization to agree at what income and earning level to release what amount of expenses and resources.

The budgeting approaches that served as the foundation for conditional budgeting include traditional budgeting, zero-based budgeting, better budgeting and beyond budgeting. While building on the strengths of these approaches, conditional budgeting avoids the disadvantages of these approaches for organizations or in times of unstable income streams. The two main benefits are:

  1. Expenses are budgeted according to priority level and in correlation with income and cash flow. In the effective year, expenses are only released based on the corresponding positive income and cash situation.
  2. During the effective year, the ongoing analysis does not explain deviations, the analysis rather focuses on defining the appropriate point in time when to release the conditionally pre-agreed expenses.

Planning objective

While any budget approach aims to think through different future scenarios and the respective reactions of the company regarding capacity and resources, different approaches set different priorities regarding other aspects, e.g. how flexibly resources shall be adapted to changing market conditions or who shall be entitled to define targets.

One of the strengths of traditional budgeting is the integration with financial reporting. While this close relationship is also mentioned as disadvantage above, all organizations remain to be confronted with financial reporting (see also Financial statement). [18] One advantage arising from this close relationship is that financial reporting as well as traditional budgeting have established procedures how operational figures regarding sales and costs (at all levels, departmental up to group-wide) are reflected in the Income Statement, and then combined with capital expenditure and financing roll into the Statement of Financial Position, Statement of changes in equity and cash flow statement. Given the growing importance of the Statement of Financial Positions (the financial situation of companies is no longer dependent on the Income Statement only, Financing and the Statement of Financial Positions enjoys an increasing importance), allowing the budget to use existing and established mechanisms to roll into a full set of financial reports can clearly be used as an advantage. And so it the reuse of existing knowledge regarding interpretation and taking decisions based on financial reporting and Financial ratio (this aspect relates to the above-mentioned advantage of communication).

A third objective besides reusing the existing advantage of integrated financial analysis and building on existing financial reporting knowledge is the ongoing review of actual versus budget and taking corrective actions if necessary. While other budgeting approaches allow analyzing such variations after they did occur, conditional budgeting strives to take a more proactive approach. It only releases costs only after a pre-defined level of income, which has jointly been agreed upon to be necessary in order to release the costs, has been achieved.

Planning income

As suggested by Peter Drucker, income is key for any business: there are only cost centers within a business, and the only profit center is a customer whose check has not bounced. [19] However, estimating income is not an easy task, and it might be harder for certain organizations such as NPOs (Non-profit organization) being dependent on number of visitors or NGOs (Non-governmental organization) being dependent on donations), or at certain times such as during changes in consumer habits (e.g. consumers avoiding department stores and turning to fast fashion retailers), society values (a company being perceived to be involved in a scandal, e.g. Shell's income in Germany fell by 50% during the Brent Spar crisis [20] ), or during economic crises.

Based on this understanding of fluctuating income, conditional budgeting requires executives to plan income at the following four stages:

These four stages result in a minimum income, consisting of stage one and stage two, and a maximum income, consisting of all four stages. These two income levels, minimum and maximum, will then be compared to planned expenses.

Planning expenses

For planning expenses, the organization shall take a strict analysis regarding the necessity of expenses. Expenses then are grouped according to how important the payment of the respective expenses is regarding to the success and survival of the organization. While in most cases the costs may be assess regarding their importance to the success of the companies, in times of crisis an organization may be forces to rate the importance of their expenses according to the survival or the organization. The four groups of expenses are:

These four groups result in minimum expenses, consisting of fixed expenses, and maximum expenses, consisting of all four groups of expenses.

Planning cash

Based on the cash flow calculation according to the cash flow statement, changes in cash result mainly from:

Planning of cash focuses on investment and disinvestments as all other figures are derived from other planning sections (income, expenses and financing). For simplicity reasons and as for a majority of companies disinvestment many enjoy minor significance only (exceptions apply), disinvestments shall be planned at one stage only. For the investments, the same stages apply as for planning of expenses. In total, planning of cash consists of the following five stages:

These five stages result in minimum cash, consisting of disinvestments and fixed investments, and maximum cash, consisting of all five stages.

Planning financing

Planning of financing requires to plan all financial positions that influence the required level of financing, including accounts payable, accounts receivable, inventory, loan, provision (accounting), and equity (finance). As these positions influence one another (e.g. additional investments may be finance by different ratios of loans and equity), they must be planned dynamically. All these figures must be planned at two stages:

Providing additional ratios, e.g. inventory turnover, may help to define the right value for each figure.

The planning of financing at minimum and maximum level provides the remaining figures to integrate the different planning and take the necessary budget decisions.

Tying the planning to a budget

After all necessary details have been provided to result in minimum and maximum income, expenses, cash, and financing, the plans can be tied together into an integrated budget. However, this first requires to:

The resulting budget shows the integrated minimum and maximum figures. At least, the minimum budget should be positive (i.e. the minimum income and cash covers the fixed expenses and capital expenditures). Ideally, the maximum budget is also positive, i.e. under realistic-optimistic assumptions the income pays all expenses and capital expenses. If the maximum budget it seems adequate to inform the respective people that priority 3 resources may never be released through the budgeting period and therefore they may be taken off the plan. Alternatively, additional income generating measures or fund-raising may be planned in order to ensure a positive enough income and cash situation to possibly also accommodate for Priority 3 expenses and capital expenditures. And these are the discussions on resource priority that a budget intends to foster to then agree for the focus of the respective period, and therewith having the possibility to set different focus for the next period (e.g. invest in people the first year, and the following year invest in machinery).

Such iterations bear the risk that one additional income generating measure is added after the other, which may reduce the overall effectiveness of each measure. Other potential violations of the budget structure include increasing the level of optimistic income. While such violations are real risks, it is a question of leadership to gear the discussions into the right direction. The conditional budgeting approach may provide supporting ratios for cross-checking and comparison (e.g. revenue by sales person, if increasing too much optimistic income levels may be estimated too high).

Budget review: analyzing conditions

The first step of analyzing actual results with the budget is to enter effective figures for the previous year (the forecast at the time the budget was established). If the effective figures divide too far away from the forecast figure, the budget may be not achievable (e.g. the available cash is too low for fixed investments even). Then the current year figures are added, following the same structure as budget (four stages for income, four stages for expenses, and five stages for cash).

Base on the actual situation of income and cash, assessment of releasing priority 1, 2 or 3 expenses and investments may be discusses. Therefore the organization does not have to stick to one of the scenarios or alternatives that it has decided upon some month ago, rather the organization understands what the current income and cash situation is, how much additional income may be expected, and what the impact of releasing the next bundle of expenses and investments is. Therewith, the discussion turns from analyzing variances and possibly explaining why the actual did not turn out to be what the budget was, the discussion is more forward-looking focusing on how much the income and cash has to increase before additional expenses are release, and how such an increase may be achieved.

While conditional budgeting may support an organization regarding if the income and cash conditions are meat so that releasing the next bundle of expenses and investments is save, the organizations still has to decide on the details of such a release:

While traditional budgets answer such questions upfront, organizations using conditional budgeting may be confronted with such questions several times during the budget period. Answering these questions may be difficult as the expenses in one bundle may be of very different character, e.g. Priority 2 expenses may include individual education for staff as well as upgrading the office software package to the current release. While upgrading the software requires all installations to be upgraded at once (otherwise the heterogeneous environment may cause even higher costs), selecting what employees to allow attending an education needs to be aligned with leadership, motivation and compensation approaches.

Examples

Conditional budgeting has been used successfully at Foundation Green Ethiopia, an NGO supporting agriculture and afforestation projects in rural Ethiopia. Any project expenses are clearly tied to respective income. Conditional budgeting has allowed the organization to successfully implement projects to benefit rural farmers in Ethiopia, and it has allowed the organization to smoothly grow 5-fold within 10 years without adding more complexity to the budgeting and financial performance measurement. Instead, the resources have been used for conducting projects, manage operational performance, and therewith focus on income and growth instead of managing costs and expenses.

See also

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References

  1. 1 2 Smith, Julia; Handbook of Management Accounting, Fourth Edition; Oxford, CIMA Publishing, 2007; p. 137
  2. ↑ Smith, Julia; Handbook of Management Accounting, Fourth Edition; Oxford, CIMA Publishing, 2007; p. 138
  3. ↑ Smith, Julia; Handbook of Management Accounting, Fourth Edition; Oxford, CIMA Publishing, 2007; p. 140
  4. ↑ Drury, Colin; Management and Cost Accounting, 7th Edition; London, Cengage Learning, 2008; p. 363
  5. 1 2 Drury, Colin; Management and Cost Accounting, 7th Edition; London, Cengage Learning, 2008; p. 371
  6. ↑ Drury, Colin; Management and Cost Accounting, 7th Edition; London, Cengage Learning, 2008; p. 375
  7. ↑ Drury, Colin; Management and Cost Accounting, 7th Edition; London, Cengage Learning, 2008; p. 376
  8. ↑ Drury, Colin; Management and Cost Accounting, 7th Edition; London, Cengage Learning, 2008; p. 377
  9. ↑ Bragg, Steven; Just-in-time accounting: how to decrease costs and increase efficiency; New York: Wiley Publishing, 2001; p. 276
  10. ↑ Welch, Jack; Winning; New York: Harper Business, 2005; p. 189
  11. ↑ Welch, Jack; Winning; New York: Harper Business, 2005; p. 197
  12. ↑ Bhimani, Alnoor; Horngren, Charles; Datar, Srikant; Foster, George; Management and Cost Accounting; Essex: Prentice Hall, 2008; p. 473
  13. ↑ Siciliano, Gene; Finance for the non-financial manager; New York: McGraw-Hill Companies, 2003; p. 166
  14. ↑ Proctor, Ray; Managerial accounting for business decisions; Essex: Pearson Education, 2006; p. 420
  15. ↑ Slebioda; Damian Markus; Better und Beyond Budgeting: Kritische Diskussion der Weiterentwicklung der Weiterentwicklung der klassischen Budgetierungsformen; Norderstedt: GRIN, 2008, pp. 5f
  16. ↑ Slebioda; Damian Markus; Better und Beyond Budgeting: Kritische Diskussion der Weiterentwicklung der Weiterentwicklung der klassischen Budgetierungsformen; Norderstedt: GRIN, 2008, p. 6
  17. ↑ Bhimani, Alnoor; Horngren, Charles; Datar, Srikant; Foster, George; Management and Cost Accounting; Essex: Prentice Hall, 2008; p. 484
  18. ↑ As all organizations are somehow bond to some form of taxation (even it results into being tax exempted), and taxation builds on some form of annual financial reporting, fueled by accounting and local GAAPs (Generally Accepted Accounting Principles)
  19. ↑ Drucker, Peter; Managing in the Next Society. New York: St. Martin's Griffin, 2002; p. 84
  20. ↑ The Brent Spar
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